April 28, 2015

A Century Later, Ben Graham Still Seems Like a Prophet

The Wall Street Journal had a recent story detailing the trend of small investors jumping back into stocks, some trading options and futures.  I’m old enough now, combined with twin quirks of being interested in finance at such a young age and having my lifespan line up with some interesting times in the capital markets, that I’ve watched this play out three times.  At this point, you’d think it would lose its novelty but I still find my mouth dropping open and my head shaking in disbelief, mixed in with a bit of sadness.  Reading what people are doing with their hard earned money – money that they exchanged for part of their life by selling time that could have been used traveling, reading, painting, or hanging out on the beach – doesn’t compute.  If you took $5 out of their wallet, they’d throw a fit, but they’ll gamble $5,000 on something they barely understand.

The same people that had no interest buying shares of American Express at $10 now want to speculate on derivatives with it pushing $90.  The same families that weren’t buying shares of low cost index funds when the S&P 500 was in the 600’s now want to leverage their cash by several multiples to get in on it at 1,836.  As perverse as it sounds, they are behaving as if Wells Fargo at $45 is better than Wells Fargo at $9.  The only explanation that satisfies me is that, at their core, they don’t actually understand what a share of stock is or what causes it to have value.  They must think they are just lottery tickets that fluctuate randomly with no seeming rhyme or reason.

Take this guy.  He’s my age.

Brandon Garretson started dabbling in stocks a few years ago as the market began to rally. He got more serious last year after joining an online-trading forum. Now, the 31-year-old salesman of equipment to chemical plants makes about two trades an hour via his TD Ameritrade account.

“I love it,” said the Baton Rouge, La., resident. “You look over charts and come up with ideas for the next day. There’s really not a better feeling,” he said. He says he is considering quitting his job to trade full time.

He’s placing 2 trades an hour.  For my personal household accounts, I placed less than 60 trades last year.  He’s looking for something more from his portfolio than making money; there’s a sense of adventure, speculation, excitement.  My adrenaline rush comes from the decades of money that gets added to the streams and gushers flooding in from sources that I’ve spent my career carefully putting together.  I use the capital market as nothing more than a tool – a mechanism – to get my hands on more ownership.  These people have no interest in owning businesses.  They treat the stock as if it is something entirely unique from the operating enterprise itself.

Their Optimism on Stock Prices Is Misguided

Why are people more optimistic now?  The market isn’t terribly overvalued, but we were doing cartwheels in 2009.  We were jumping up and down in 2010.  We were still smiling deliriously in 2011, when bargains could be found en masse by buying almost anything that had a good history of solid earnings and rising dividends.  In 2012, we largely sat on our hands, collecting dividends.  Last year, we had to look a lot closer to find opportunities because most excellent firms had risen to right around intrinsic value.

These fully valued businesses can still be a great deal for a 25+ year holder – I imagine, though can’t guarantee, a person who bought a $100,000 block of blue chips spread between firms like Coca-Cola, Unilever, Johnson & Johnson, and United Technologies is going to be happy with the purchase.  Under 95% of scenarios, he’d end up with somewhere between $547,000 and $1,700,000 depending on the exact date he wanted to sell and interest rates in effect at the time.  He’d have paid very low taxes due to the power of deferred taxes working for him and not had to do an ounce of work during that entire time except for devote a few hours a year to reading the annual report to make sure the company was still healthy.

It’s started.  Margin debt levels at brokerage firms have also begun to spike, indicating that now that stocks are more expensive, people are borrowing against their holdings.  And when some event happens, be it a sudden crash like 1987 or a prolonged history-defining collapse like 1929-1933, they’ll blame someone else when it’s entirely self-inflicted pain.  If someone were young enough, all it would take is following Ben Graham’s suggestion of holdings a mix of stocks and bonds, never less than 25% of either, for a long period of time in a low-cost, tax-efficient way.  Even if the results were mediocre, a person in his or her 20’s has enough time that mediocre can still lead to shoot-the-lights-out wealth.  Time makes up for a lot when compounding.

What is that saying?  Something like, “Discipline is choosing what you want most over what you want right now.”  It’s so very true.  If you asked these small investors what they want, they’d say, “To make more money” or “To be financially independent”.  Yet, their actions, based on probability alone, will almost assure a majority of them end up poorer than they’d otherwise be.  They’re letting their impatience rob them of a rich future.

  • John

    While I believe value investing is a smart strategy, value investors should remember it is just that. A strategy.

    Times are different now then when traditional value investing was conceived. Now it has morphed from net nets, to low P/E’s and finally to Buffett’s version GARP.

    But I think new investors can be blinded by the idea of “getting something for nothing” in value investing which can lead people to buying atrophying businesses.

    GARP now barely resembles value investing and more resembles simply being a good analyst, knowing the strength of a competitive position etc.

    The danger with value investing for newbie investors is it takes away the stop loss that almost all other methods preach. But if you’re going to invest without a stop-loss and average down a position like Buffett, you best be a damn good analyst with amazing foresight just like him.

    Imo the ideas of value investing are dangerous to armchair investors, if you’re not a great business analyst there is a good possibility you’ll end up buying dying companies and averaging all the way down thinking you’re getting something for nothing.

    • http://www.joshuakennon.com/ Joshua Kennon

      You’re writing as if “Ben Graham” = 1934 Security Analysis or Value Investing, only. He wasn’t. The other half of his career was writing for the average investor, who had no ability to analyze investments. I’m not sure if you’ve ever read his entire body of work, but his books, essays, and even speeches for lay people address everything you mention, arguing exactly what you argue for precisely the reasons you’re arguing it.

      For the average family, he essentially laid out a course of portfolio management similar to what John Bogle does today: A mix of stocks and bonds (held either directly or through mutual funds), owned for long periods of time with very little turnover, often acquired through regular savings (dollar cost averaging), so you benefited from the power of compounding rather than finding undervalued assets or trying to value the overall level of the stock or bond markets. That’s the Ben Graham I’m talking about in this context.

      If you’re only familiar with the Ben Graham of the Great Depression or net-nets, I’d say you’re doing yourself a disservice. There is a lot more to discover there. He was touching on topics like index investing and behavioral economics before they even had names in some of his academic papers and speech transcripts.

    • Jon


      I don’t think value investing for “armchair investors” is nearly as detrimental as speculating on hot growth stocks. If Wal-Mart fails to meet expectations over the next decade, I will still collect dividends. However if Amazon or Tesla don’t meet the high expectations baked in to their price, then I stand to lose a lot of my investment.

      • John

        That’s why on those stocks you buy them while they’re basing and then keep moving up your sell stop as it rises. Any significant adverse movement and your sell stop gets you out. I’m not against value investing, I just think times have changed such that being a blind follower can be just as dangerous as other methods.

        • http://www.joshuakennon.com/ Joshua Kennon

          This entire philosophy is insane to me. If even a 30% drop in the price would cause me not to want to own something, I don’t buy it in the first place. I don’t know very many rich people who behave this way. Imagine if I bought an office building and negotiated a sell contract if local real estate prices fell by a certain percentage point. Why would I treat a minority stake in General Mills or PepsiCo any differently?

          It’s such a bizarre way to behave. If you don’t want an asset solely for the underlying earning power, you are speculating on some level, whether you realize it or not. It gives way too much power to market forces.

          I’m not big on speculating, personally. I like being rich and not spending time thinking about what’s happening on Wall Street.

        • John

          There’s many ways to skin a cat. The great thing about value investing is how it works with huge sums of capital. Stop losses etc lose their value when dealing in tens of billions. But anyway, just as there are rich value investors there are also rich “traders” who follow price action for clues (soros, paul tudor jones, steve cohen to name a few. All have multi billion net worths).

        • innerscorecard

          That’s a gross mis-characterization of Peter Lynch. Lynch invested based on the characteristics of businesses, not whether the stock price itself was going to go up in the short term, like you say. That’s the entire reason he flew around the country, kicking tires and talking to management. His entire approach was about the companies themselves, not stocks as pieces of paper.

        • John

          Equally however people mischaracterize Lynch as a value investor. If I recall at one point in his book he ridicules value investors. This is all by the by however because imo Peter Lynch’s methods aren’t replicable by small investors, I suspect his edge comes perilously close to insider trading.

    • innerscorecard

      John’s comment is the type of comment that is very dangerous for the retail investor to read. Much more dangerous than Ben Graham. Once you go down the slippery slope of “just buy what feels good” you are completely rolling the dice and dooming yourself to sub-par returns.

      The alternative should be (as Joshua has said on this site, and as many say) to make monthly contributions from your salary into a low-cost index fund, not to just buy what you feel like buying.

      • John

        Essentially my argument is there are basically two styles of investing. We’ll call them growth and value, but we could also call them mean reversion and trend following.

        Value Investors believe in mean reversion, something that has gone down will likely come back up and something that has gone up will likely come back down.

        Growth Investors believe in following trends, something that has gone up has likely gone up for a reason and something that has gone down has likely gone down for a reason (i.e. trends are likely to persist because price discovery takes time, it is not immediate).

        Both strategies work, its been proven by many different investors. Buffett vs Soros for example.

        But only value investors act with the disadvantage that they believe they have found the holy grail. Just think if “fundamental only” investors had listened to the strong sell signals in 2007, both housing stocks and financials showed relative weakness and gave technical sell signals well before their final low.

        • Joshua

          “…something that has gone up has likely gone up for a reason…”

          Good luck with that. I’m sure that someone was saying something similar about tulip bulbs in the 1600’s.

        • John

          Would it be so bad to have bought tulip bulbs on the way up and sold out perhaps 10% from the top when your stop loss is hit? ;p

          It’s the buy and hold folks who give back gains in corrections.

        • Miguel

          Yes. You would lost 10% for no reason at all… A share represents an interest in a business (legally, even if you don’t believe it) so it’s better to invest with your downside protected by the business than to invest in future expectations that if are not met what you have it’s “worthless”.
          I prefer Walter Schloss method to Warren Buffet only because I know that I can’t pick the next Coke, or American Express I don’t have that business vision… at least for know.

        • John

          Take a look at Joel Greenblatt’s magic formula. That way you can buy stocks that are cheap and have high returns on invested capital.

        • Richard Garand

          Trying to mix two opposing views into one system seems dangerous. A lack of long-term consistency is one of the major reasons for investor losses.

        • innerscorecard

          …or there is the third “style,” which everyone from Buffett to John Bogle to Joshua Kennon says should be the default for most individual investors – just make regular contributions to low-cost index funds of stocks (and bonds) and don’t try to pick stocks or time the market.

          And what you described as growth investing isn’t growth investing, but speculating based on price. You may make some money but good luck not losing it. Especially when you are competing against every high-frequency trading hedge fund, with their servers located right next to the exchanges, out there.

        • John

          @innerscorecard index investing, otherwise known as giving up.

          I’m not particularly talking about personal finance here. I’m talking about investment philosophies that are and can be used to make hundreds of millions. No one will pay you 2 and 20 to index for them.

        • innerscorecard

          But this article is about personal finance and small investors, not making hundreds of millions. It’s obviously small investors that are reading this blog, not people running hedge funds.

  • Richard Garand

    I’ve long suspected that the stock market recovery would turn into a full rush after there was a big gain, but I wasn’t sure if last year would do it. This is the first sign that says it did. I can’t help but think that the combination of record highs and rapid gains will get some momentum that really pushes it into over-valued territory (moderated a bit by people who will stay out for decades after the recent experience).

    This is by no means certain but it would take a fairly large negative shock to stop it. The psychological bias to see patterns and focus on recent results is very strong when combined with the lure of large profits.

  • peterpatch79

    Good article. I find it very interesting how the stock market is almost always riskiest when the majority of people are the most optimistic about it. This makes total sense but unfortunately most people are wired to see an upward price trend over a couple of years as being something reliable that they can trust. I went to Vegas for a friends wedding once and it was amusing to watch people betting at the craps tables, thinking someone was on a streak and betting money on this improbable trend. The stock market has an appeal to these personalities because it exhibits these trends which do tend to continue over periods of months and years and appear dependable. The risk to return line is getting flatter every month, high grade bond yields are very low and stock returns are getting are priced lower by the month. People are being led down the garden path with a low return ‘stick’ in the rear and a ‘carrot’ of seemingly cheap debt (for leverage) in front of them. The 2009-2010 fear made the risk-return line nice and steep, heck even Joshua’s “white whale” Brown Forman (class b) shares sold for around 15x earnings at some point in ’09.

  • http://jecrooks.com/ James Crooks

    Good points, and good article.

    When I see articles like this, I often wonder where I fall. My financial capital is small, as a graduate student, so my investments focus on the simple: I have a small number of conservative low-cost ETFs, which I purchase every pay period (in my case, once a quarter!) and on which I pay no commission fees. Given that my time horizon is between 10 years and forever (inclusive) with these purchases, I buy regardless of the market conditions.

    And then I focus on the other side of things: keeping costs reasonable (i.e. solidly below what I earn) and raising earning capability. The latter is already set to start paying off, and I haven’t even graduated yet, which is both a nice feeling and a fun story.

  • innerscorecard

    It’s fascinating to me that despite publicly available information on how to gamble optimally, almost no one does. Vegas and Macau weren’t built on winners. If people simply played blackjack (or baccarat, or whatever games it was) according to basic strategy (which it took me about an afternoon to memorize), they would be able to lose money much slower, enjoy more drinks by stretching out their money with a slightly higher expected value (still negative of course).

    But people are lazy, and want the big wins. It’s shocking seeing this kind of self-destructive behavior repeat itself over and over in every possible arena. But, in the end, this irrationality allows the rational to take advantage. That’s what was so odd learning about value investing over the past year or so for me. It seems so obvious that it would not be so…but it is. People live disastrously, not maxing out their free retirement matching funds, not using their limited tax shelters, and just living a very un-optimized life.

    The positive way to look at things is that if you optimize your life just a bit, you will definitely get ahead in the long run, barring major life disasters (your expected value is just so much higher!).

  • Anon

    Mandatory 7-day holding period on all stock purchases? For GS & the regular guy?

  • Jeb

    Hovering the mouse over your link I saw the topic and didn’t click. Kind of like the “billionaire is predicting historical doom in stocks” ad I’ve seen for years now and never bothered with.

    I clicked on one today written by an economics professor at American University. He said the 4% withdrawal rule is old and that 3% should be used. One comment person dove into the paper and found the writer was assuming at least 1% per year eaten up by an investment “professional”. Remove that 1% cost and hey! you’d be safe with 4% withdrawal. I fear for those the professor “instructs”.

    • innerscorecard

      Haha, the billionaire predicting stock doom ad was a great contrarian indicator if there ever was one. I suppose that if euphoria returns, we’ll see basically the opposite ad taking its place.