Did Ben Graham abandon value investing?
Benjamin Graham refined and changed many of his views at the end of his life in the 1970s.
Even though he was retired and surrounded by beautiful people and weather in California, he continued to conduct extensive research into the behavior of securities as an intellectual pursuit.
Reading some of his writings and interviews from the period, some have concluded that Graham abandoned his philosophy and embraced the efficient market hypothesis.
Here is a quote of his that led many to this conclusion:
“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook ‘Graham and Dodd’ was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”
This is a quote that efficient market types will often throw in the face of value investors. To paraphrase these people: “See, even Ben Graham thought this was all a bunch of nonsense! Shut up an buy an index fund, idiot!”
Reading these quotes, many value investors are left stung in disbelief. It’s like suddenly discovering that the Pope is an atheist, Mr. Miyagi was secretly helping the Cobra Kai, Picard collaborated with the Romulans, or that Johnny eventually put Baby in a corner.
The truth is more nuanced. Yes, Ben Graham didn’t think detailed, individual security analysis was as useful as it was when he originally wrote the book in the 1930s. That doesn’t mean he gave up on the concept of value investing.
In fact, Graham did not agree with the efficient market crowd. He had this to say about them:
“They say that the market is efficient in the sense that there is no practical point in getting more information than people already have. That might be true, but the idea of saying that the fact that the information is so widely spread that the resulting prices are logical prices – that is all wrong, I don’t see how you can say that the prices made in Wall Street are the right prices in any intelligent definition of what right prices would be.”
The behavior of markets is, indeed, crazy. You have to be slightly brainwashed by the beautiful, peer-reviewed, academic work of the Church of Beta to think that prices are logical. Look at all of the insane bubbles that have plagued securities markets in the last few decades. Look at the nonsensical valuation of stocks in early 2009.
Look at the activity in multiple asset classes. Dotcom stocks, crypto, even housing. Look at the wild ride that the S&P 500 had in the 1990s and 2000s. Was the late ’90s run up rational? Was the hammering that stocks endured in 2008 logical or emotional?
It was all irrational, it was crazy. It wasn’t a market unemotionally weighing information. It was herds of professional investors reacting emotionally to events.
Mr. Market is alive and still doing crazy shit. If you don’t believe me, just watch the cable coverage of market action every day. Cable financial news is a torrent of speculation, FOMO, greed, and fear.
If Mr. Market were a person, he would live in Florida.
Another important snippet from the quote really stands out: “the information is so widely spread.” Graham was writing in the 1970s. We tend to think of the 1970s as a time when people were using stone tablets in between bong hits and classic rock albums. The thinking is that modern markets are so much better because we have the internet, computers, financial Twitter, blogs. We are so sophisticated and technologically advanced!
This is a conceit of every generation. Everyone thinks that their era is remarkably sophisticated and eras of the past were the dark ages. The experiences of our ancestors are primitive and not useful. The reality is that history rhymes and human nature never changes, no matter our level of technological sophistication. Eventually, the innovations of every era are ultimately discarded and regarded as quaint.
In reality, the critical information people needed to know about markets was available in the 1970s. Just because there is more information and it is more convenient in today’s world, it doesn’t make modern investors any more sophisticated or less emotional than the investors of yore. Indeed, the critical information about stocks has been widely available for a long time.
There is a perception that because stock screening technology and the information is readily available, that the edge for value investors has been eliminated. I think that’s bunk. Whether it was Moody’s manuals in the 1950s, Value Line in the 1970s, or stock screeners today – it has never been hard to find cheap stocks. What’s hard is actually buying them, not discovering them.
The source of returns in value investing has never been informational, it has been behavioral. It has been revulsion towards companies that are in trouble contrasted with starry-eyed love for companies that are making all the right movies.
There is a perception that the cheap stocks of past markets were diamonds in the rough. With technology, the thinking goes, those diamonds have been scooped up. Nothing could be further from the truth. Cheap stocks were always ugly stocks. The idea that there were cheap situations without any hair on them is a myth. The reason that cheap stocks outperform in historical analysis is because they were ugly. It was because they had problems.
The only thing that has changed is the methods of gathering that information.
Quantitative Value Investing
Back to the topic at hand.
While Ben Graham thought that detailed individual security analysis was a waste of time, he also believed that the efficient market theory was bunk.
Graham supported quantitative value investing. In other words, systematically purchasing portfolios of cheap stocks. Within the portfolio, some stocks would undoubtedly be value traps. As a group, however, they would generate returns that would beat the market.
Graham sums it up in this quote:
“I recommend a highly simplified strategy that applies a single criteria or perhaps two criteria to the price [of a stock] to assure that full value is present and that relies for its results on the performance of the portfolio as a whole — i.e., on the group results–rather than on the expectations for individual issues.”
In other words, he believed that investors should select a portfolio of cheap stocks and construct a portfolio of them to systematically take advantage of market inefficiency.
What quantitative criteria, then, did Graham recommend to select bargain stocks?
The first method, which Graham was most famous for, was purchasing stocks selling below their net current asset value. Graham referred to investing in net-net’s in the following fashion:
“I consider it a foolproof method of systematic investment—once again, not on the basis of individual results but in terms of the expectable group outcome.”
A crucial part of Graham’s quote is his point that the results of individual net-net’s are not dependable. Graham recommends buying a basket of them and allowing the portfolio to generate returns.
The problem with this approach is that they aren’t available in bulk frequently in the U.S. markets. As Graham pointed out, net-net’s should only be purchased as a portfolio. The only time that there are enough net-net’s to create a portfolio is in market meltdowns like the early 2000s or 2008-09.
I am eagerly anticipating the next decline so I can buy a portfolio of net-net’s.
Simple Graham: Low Price/Earnings & Low Debt/Equity
The next approach that Graham outlined was buying a portfolio of stocks with simultaneously low P/E ratios and low debt/equity. The great thing about this approach is that it is applicable in the United States outside of meltdowns, unlike the net-net approach.
This is the approach that I take with my own investments, albeit with other criteria (low price/sales, low EV/EBIT, high F-Scores, etc.) and qualitative analysis added to it.
Regarding price/earnings ratios, Graham recommended purchasing stocks that double the yield on a corporate bond. He suggested looking at the inverse of the P/E ratio, or earnings yield. A P/E of 10 would be a 10% earnings yield, for instance.
“Basically, I want to double the interest rate in terms of earnings return.”
“Just double the bond yield and divided the result into 100. Right now the average current yield of AAA bonds is something over 7 percent. Doubling that you get 14, and 14 goes into 100 roughly seven times. So in building a portfolio using my system, the top price you should be willing to pay for a stock today is seven times earnings. If a stock’s P/E is higher than 7, you wouldn’t include it.”
In other words, the value criterion was remarkably simple: a low P/E ratio.
Graham’s second criteria was a low debt/equity ratio.
“You should select a portfolio of stocks that not only meet the P/E requirements but also are in companies with a satisfactory financial position . . . there are various tests you could apply, but I favor this simple rule: a company should own at least twice what it owes. An easy way to check on that is to look at the ratio of stockholders’ equity to total assets; if the ratio is at least 50 percent, the company’s financial condition can be considered sound.”
Concerning portfolio management, Graham recommended holding onto the stock for either two years or a 50% gain. I think this is an important point: Graham never recommended holding shares forever. That’s Buffett’s approach. Graham, in contrast, suggested a high turnover portfolio: buy a large group of undervalued stocks, wait for them to return to a reasonable valuation, then sell and move on to the next situation.
Graham backtested this method going back to the 1920s and found that it generated a 15% rate of return over the long run.
Wesley Gray and his team at Alpha Architect also backtested Graham’s method and found that Graham was right. The technique delivered 15% rates of return over several decades.
Even with an exceptional 15% rate of return, the strategy underperformed at some key moments. In 1998, for instance, it lost 1.94%. The S&P 500 was up 28% that year. In 1999, it gained only 2.51%. The S&P 500 was up 21% that year.
There was similar underperformance in the Nifty 50 era. In 1971, the Graham strategy returned only 1.57%. The S&P 500 gained 14.31% that year.
I believe we are in a similar moment right now. Only time will tell if I am correct.
The Simple Ben Graham Screen
I run multiple screens, but I use Graham’s criteria as a cornerstone in my stock selection. Even if I am wrong in my analysis, I know that I am at least looking in the right neighborhood.
Here are ten stocks that currently meet Graham’s criteria for earnings yield and debt/equity:
I am not recommending that you go out and purchase any of these stocks. I am merely showing that even in a frothy market like the U.S. today, there are still opportunities which meet Ben Graham’s criteria.
- The source of Graham’s 1970s quotes featured in this blog post is The Rediscovered Benjamin Graham by Janet Lowe. The book is a collection of articles written about Graham, Congressional testimony, interviews, and articles written by Graham himself. Of particular interest are the bullish articles that he wrote in the early 1970s and early 1930s, discussing the deep undervaluation of American stocks. You can buy it here on Amazon. It’s a great read and gives you a clear perspective on how Graham’s thoughts evolved over time.
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PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings. Read the full disclaimer.