Value Investor Alert: Benjamin Graham may have been right all along

To say that Warren Buffet has had a profound impact on investor behaviour would be a massive understatement. Not only has he cemented the position of value investing as a philosophy but also that of higher conviction and more concentrated position taking as a central means of outperforming markets. Yet the information revolution, alongside the growth in artificial intelligence, has the potential to undermined some of the central tenants of value investing as a source of outperformance. Critically these potential changes in dynamics may make it important to redefine investment objectives. In the process investors may need to go back to the original ideas expressed by Warren Buffet’s mentor and the ‘father’ of value investing Benjamin Graham.

The Changing Environment for Value Investing

One of the more robust tenets of stock investing is that a disciplined and well thought out process with a value orientation will result in an out-performance of the market over the long term. Underpinning this tenant is a rationale for value investing which is not only simple but conceptually alluring. Intrinsic to the attraction of value investing is a core assumption regarding market behaviour specifically that the world is rational where any fundamental mispricing eventually corrects itself. The only uncertainties for the value investor are (a) the ultimate magnitude of the perceived mispricing and (b) the timing of the correction in the mispricing; i.e. timing and size of mean reversion. Effectively the value investor is identifying and then buying cash flows the market had forgotten or undervalued and then waits for the sentiment associated with a rational market to correct; i.e. the strategy waits for mean reversion to do the work for you. For decades that formula produced steady out-performance with value managers thriving in a world where time, patience, and accounting discipline were the ultimate edges.

This bias to value investing has been supported by historical stock market performance. For the patient investor value indices have generally outperforming over the last hundred years (see Figure 1).

Figure 1 :

Yet the evolving dynamics of financial markets arising from the information revolution and artificial intelligence may act to undermine the foundations of value investing as a source of ‘value add’. Specifically as the ‘story’ around a stock becomes the more important driver of share price performance accounting based fundamentals may increasingly take a back seat. The potential that investor sentiment and momentum become more important determinants of market behaviour risks undermining the very foundations on which the ability of value investing to add value depends. This is not to say that there may not be periods where value investing may outperform but such periods could become increasingly episodic with greater cross sectional dispersion.

Does this mean that value investing has less relevance going forward? Not necessarily but then today’s objective for value investing as a major source of ‘value add’, or market outperformance, is not the same as originally envisaged. To better understand this drift in objectives it is useful to take a step back in time to the writings of Benjamin Graham (‘BG’) and specifically his book “The Intelligent Investor” first published in 1949. So what were the key messages for investors from ‘The Intelligent Investor’?

Market Dynamics

One of the key issues addressed by BG was why most funds fail to outperform the market. BG gave two possible explanations. The first was that most active managers are handicapped by flaws within their processes; i.e. aren’t that good due to systematic errors within processes.

Though plausible this was not a strong argument and so BG focused on the next explanation which was that :

“the stock market does in fact reflect in the current prices not only all the important facts about the companies’ past and current performance, but also whatever expectations can be reasonably formed as to their future. If this is so, then the diverse market movements which subsequently take place—and these are often extreme—must be the result of new developments and probabilities that could not be reliably foreseen. This would make the price movements essentially fortuitous and random. To the extent that the foregoing is true, the work of the security analyst—however intelligent and thorough—must be largely ineffective, because in essence he is trying to predict the unpredictable”.

Effectively the key assumption which BG was making regarding market dynamics is that markets are by and large efficient.

Investment Objective

The assumption regarding efficient markets is important as it establishes the investors objectives. The objective set forth by BG was one of :

“preserving capital while earning a suitable return”.

Indeed this objective is the distinction which BG utilises to differentiate between speculators and investors. Those that pursue the above objective are referred to by BG as ‘defensive investors’. Importantly there is no mention of outperforming a benchmark as the aim of the ‘defensive investor’ is simply to earn a suitable return for the risk assumed while preserving capital.

The focus on capital preservation is an important underpinning to BG’s work specifically the avoidance of large losses which make it difficult for investors to recover and stay invested for the longer term. The preservation of capital is accordingly associated with two key investment style characteristics.

Safety Margin

The first investment style characteristic involves only buying stocks which exhibit a “safety margin”. There are several dimensions to determining the safety margin such as industry type/position as well as possession of a history of paying dividends. The main dimension however which distinguishes value investing is the holding of undervalued, or bargain, securities. Undervalued securities are those that exhibit :

“by definition, a favorable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck. The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments. … If these are bought on a bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results. The margin of safety will then have served its proper purpose.”

Importantly the safety margin to BG is less a measure of future out-performance but rather a risk management tool which facilitates withstanding adverse outcomes and thus preserving capital.

Diversification

The second investment style characteristic of the BG process is diversification. Specifically BG notes that :

“There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor’s favour, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss—not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business”.

So diversification is important to assist in preserving capital by reducing the loss if something goes wrong. The question now is what is the level of diversification which BG is advocating? This is where the ‘water gets a bit muddied’ and it is important to distinguish between theory and practice. From a theoretical perspective BG states that :

“There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty”.

This does appear to be the level of diversification adopted by many active value managers today and accords broadly with modern portfolio diversification theory. Yet in a later chapter when referring to the historical operations of the asset management business he ran (Graham-Newman Corporation) from 1926-1956 BG states that in practice :

“The idea was to acquire as many issues as possible at a cost for each of less than their book value in terms of net-current-assets alone—i.e., giving no value to the plant account and other assets. Our purchases were made typically at two-thirds or less of such stripped-down asset value. In most years we carried a wide diversification here—at least 100 different issues”.

At a practical level the diversification adopted by BG in practice is described by Alice Schroeder, author of ‘The Snowball : Warren Buffet and the Business of Life’ :

“Graham knew that a certain number of cigar butts would turn out foul, and thought it futile to spend time examining any individual cigar butt’s quality. The law of averages said most of them were good for a puff. He was always thinking in terms of how much companies would be worth dead—what their assets would be worth if liquidated. Buying at a discount to that value was his “margin of safety”—his backstop against the percentage that presumably would go bankrupt. As a further backstop, he bought tiny positions in a huge number of stocks—the principle of diversification. Graham’s idea of diversification was extreme …”.

It is here that the views of Warren Buffet and Benjamin Graham diverged materially. Warren Buffet believed in fewer large high conviction bets to maximise the upside while Benjamin Graham believed in a large amount of diversification to minimise the downside. Yet the difference between the approach to diversification of the two investors can best be summed up by the mindset as described below :

“The great successes of life are made by concentration with the really big fortunes from common stocks being made by people who packed all their money into one investment they knew supremely well. … However, almost no small fortunes have been made this way—and not many big fortunes have been kept this way. … concentration also makes most of the great failures of life”.

Importantly Benjamin Graham was writing for the everyday investor or the ‘defensive investor’ that wanted the stock market to generate a small fortune over time. Accordingly, his approach to diversification should be viewed in that context and is arguably more applicable to everyday investors than Warren Buffet’s. Yet ironically it is fair to say that over the years it is Warren Buffet’s approach to investing, higher conviction and more concentrated exposures, which has had a greater impact on the style adopted by many value investors.

As a digression it is also worth noting that there is another argument which can be put forward for greater diversification within a value portfolio and that deals with managing the risk around the timing of mean reversion. It is one thing to buy a stock that is undervalued, or possesses a high safety margin, it is another to determine when that valuation gap will close. For investors utilising the safety margin as a source of ‘value add’ the timing of mean reversion becomes one of the major risks; i.e. timing risk. Not only may this impact on the timing of any ‘value add’ realised but, more importantly, the longer it takes for a valuation gap to close the greater the potential that new information may adversely impact on the magnitude of the previously calculated safety margin. This isn’t something which BG addressed directly as his writings were focused on preserving capital not the idea of explicitly outperforming a benchmark. That said greater diversification is just as important in this context as with more bets the greater the likelihood that some of them will experience a positive re-rating over any sub period. This makes greater diversification more important as a means of managing ‘timing risk’ especially where the increased focus on the ‘story’ around stocks increases the uncertainty around the timing of any mean reversion dynamic; i.e. mean reversion may become increasingly stock and period specific.

The original framework which underpinned value investing was for there to be highly diversified portfolios exhibiting a high ‘safety margin’ so that investors could earn a suitable return while preserving capital. Over time the shift from preserving capital to outperforming a benchmark has moved value investors towards more concentrated higher conviction portfolios. But with the changing in market dynamics associated with the information revolution and artificial intelligence it may be a case of ‘to realise the promise of the future it is necessary to draw upon the past’. Increasingly value portfolios may need to be seen as the stable low risk element of a share portfolio to which are added higher risk (higher levels of concentration and turnover) momentum strategies to add value. The role of value investing accordingly shifts back from outperforming a benchmark to ‘capital preservation’ thereby becoming the lower risk return anchor to a multi strategy share portfolio. If this is the case then today’s typical active value portfolio may be under-diversified and may need to move back to the higher levels of diversification originally practiced by the ‘father’ of value investing Benjamin Graham.