Ben Graham is regarded as the intellectual Dean of Wall Street. He literally invented equity security analysis at a time where bonds were all the rage, and a couple of his mantras have stood the test of time. His ‘Mr Market’ allegory is of course a brilliant retort to the efficient market theories on which an entire generation has based their trust through index funds. And it’s his idea that the three most important words for an investor are ‘Margin of Safety’.
Interestingly, however, if Ben Graham had access to a computer back in the 1930s and 1940s, I suspect he might not have reached some of his other conclusions.
Whilst many investors use Ben Graham’s models for intrinsic value to evaluate the attractiveness of companies, we don’t. Let me explain why.
Moving on from Ben Graham
First, though, I am a little nervous about publishing an article advocating against a strict Graham-approach, as it may put a few noses out of joint. So I have referenced what I believe to be the pertinent quotes that have reinforced my conclusion that value investors should move on from many parts of Graham’s framework.
In the 1940s, Ben Graham (who passed away in 1976) “was one of the most successful and best known money managers in the country.” (quoted in the book, Damn Right, by Janet Low, page 75). In 1949, an eager Warren Buffett read Graham’s book The Intelligent Investor and the rest, as they say, is history.
Warren Buffett regards Graham’s book Security Analysis as the best text on investing, regularly referring investors to it and his other seminal work, The Intelligent Investor. One of my favourite Graham publications is The Interpretation of Financial Statements.
It might surprise many value investing students to know that, thanks to his long time partner at Berkshire Hathaway, Charlie Munger, Buffett has moved far from the original techniques taught by Graham. Ben Graham advocated a mostly, if not purely, quantitative approach to finding bargains. He sought to buy businesses trading at a discount to net current asset values – what has been subsequently referred to as ‘net-nets’. That is, he sought companies whose shares could be purchased for less than the current assets – the cash, inventory and receivables – of the company, minus all the liabilities.
Graham felt that talking to management was sort of cheating because smaller investors didn’t have the same opportunity. Whilst the method had been very successful for Graham and the students who continued in his tradition, people like Warren Buffet, Walter Schloss, and Tom Knapp, Graham’s ignorance of the quality of the business and its future prospects did not impress Charlie Munger. Munger thought a lot of Graham’s precepts “were just madness”, as “they ignored relevant facts” (also quoted in Damn Right, page 77)
So while Munger agreed with Graham’s basic premise – that when buying and selling one should be motivated by reference to intrinsic value rather than price momentum – he also noted “Ben Graham had blind spots; he had too low of an appreciation of the fact that some businesses were worth paying big premiums for” and “the trick is to get more quality than you pay for in price.” (Damn Right, page 78)
When Munger referred to quality, he was likely referring to the now common belief held by many sophisticated investors that an assessment of the strategic position of a company is essential to a proper estimation of its value.
In 1972, with Munger’s help, Buffett left behind the strict adherence to buying businesses at prices below net current assets, when, through a company called Blue Chip Stamps, they paid three times book value for See’s Candies. Buffett noted; “Charlie shoved me in the direction of not just buying bargains, as Ben Graham had taught me. This was the real impact he had on me. It took a powerful force to move me on from Graham’s limiting view. It was the power of Charlie’s mind. He expanded my horizons”. Furthermore, “… My guess is the last big time to do it Ben’s way was in ’73 or ’74, when you could have done it quite easily.” (Robert Lezner, ‘Warren Buffett’s Idea of Heaven’, Forbes 400, 18 October 1993, page 40).
So Buffett eventually came around, and the final confirmation that a superior method of value investing exists was this from Buffett: “Boy, if I had listened only to Ben, would I ever be a lot poorer.” (Carol J. Loomis, ‘The Inside Story of Warren Buffett’, Fortune, 11 April 1988, page 26).
Investing techniques evolve
Times in the United States were of course changing as well, and it is vital for investors to realise that the world’s best, those who have been in the business of investing for many decades, do indeed need to evolve. In the first part of the twentieth century, industrial manufacturing companies, for example, in steel and textiles, dominated the United States. These businesses were loaded with property, plant and equipment – hard assets. An investor could value these businesses based on what a trade buyer might pay for the entire business or just the assets, and from there, determine if the stock market was doing anything foolish.
But somewhere between the 1960s and the 1980s, many retail and service businesses emerged that had fewer hard or tangible assets. Their value was in their brands and mastheads, their reach, distribution networks or systems. They leased property rather than bought it. And so it became much more difficult to find businesses whose market capitalisation was lower than the book value of the business, let alone the liquidating value or net current assets. The profits of these companies were being generated by intangible assets and the hard assets were less relevant.
To stay world-beating, the investor had to evolve. Buffet again: “I evolved … I didn’t go from ape to human or human to ape in a nice, even manner.” (L.J. Davis, ‘Buffett Takes Stock’, New York Times Magazine, 1 April 1990, page 61).
Many investors cling to the Graham approach to investing even though some, if not many of his brightest and most successful students, moved on decades ago.
If you want to adopt a value-investing approach, there is no doubt in my mind that your search for solutions will take you into an examination of the traditional Graham application of value investing. It is my hope, however, that these words will serve as a guide towards something more relevant, and whilst unable to be guaranteed, more profitable.
If you have tried to adopt the Graham approach and had some success, well done. Now move on.
Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able’. This article is for general educational purposes and does not consider the specific needs of any investor.