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Is
the Graham and Dodd "look for values with a significant margin of
safety relative to prices" approach to security analysis out of
date? Many of the professors who write textbooks today say yes.
They argue that the stock market is efficient; that is, that stock
prices reflect everything that is known about a company's prospects
and about the state of the economy. There are no undervalued stocks,
these theorists argue, because there are smart security analysts
who utilize all available information to ensure unfailingly appropriate
prices. Investors who seem to beat the market year after year are
just lucky. "If prices fully reflect available information, this
sort of investment adeptness is ruled out," writes one of today's
textbook authors.
Well,
maybe. But I want to present to you a group of investors who have,
year in and year out, beaten the Standard & Poor's 500 stock index.
The hypothesis that they do this by pure chance is at least worth
examining. Crucial to this examination is the fact that these winners
were all well known to me and pre-identified as superior investors,
the most recent identification occurring over fifteen years ago.
Absent this condition - that is, if I had just recently searched
among thousands of records to select a few names for you this morning
-- I would advise you to stop reading right here. I should add that
all of these records have been audited. And I should further add
that I have known many of those who have invested with these managers,
and the checks received by those participants over the years have
matched the stated records.
Before
we begin this examination, I would like you to imagine a national
coin-flipping contest. Let's assume we get 225 million Americans
up tomorrow morning and we ask them all to wager a dollar. They
go out in the morning at sunrise, and they all call the flip of
a coin. If they call correctly, they win a dollar from those who
called wrong. Each day the losers drop out, and on the subsequent
day the stakes build as all previous winnings are put on the line.
After ten flips on ten mornings, there will be approximately 220,000
people in the United States who have correctly called ten flips
in a row. They each will have won a little over $1,000.
Now
this group will probably start getting a little puffed up about
this, human nature being what it is. They may try to be modest,
but at cocktail parties they will occasionally admit to attractive
members of the opposite sex what their technique is, and what marvelous
insights they bring to the field of flipping.
Assuming
that the winners are getting the appropriate rewards from the losers,
in another ten days we will have 215 people who have successfully
called their coin flips 20 times in a row and who, by this exercise,
each have turned one dollar into a little over $1 million. $225
million would have been lost, $225 million would have been won.
By
then, this group will really lose their heads. They will probably
write books on "How I turned a Dollar into a Million in Twenty Days
Working Thirty Seconds a Morning." Worse yet, they'll probably start
jetting around the country attending seminars on efficient coin-flipping
and tackling skeptical professors with, " If it can't be done, why
are there 215 of us?"
By
then some business school professor will probably be rude enough
to bring up the fact that if 225 million orangutans had engaged
in a similar exercise, the results would be much the same - 215
egotistical orangutans with 20 straight winning flips.
I would
argue, however, that there are some important differences in the
examples I am going to present. For one thing, if (a) you had taken
225 million orangutans distributed roughly as the U.S. population
is; if (b) 215 winners were left after 20 days; and if (c) you found
that 40 came from a particular zoo in Omaha, you would be pretty
sure you were on to something. So you would probably go out and
ask the zookeeper about what he's feeding them, whether they had
special exercises, what books they read, and who knows what else.
That is, if you found any really extraordinary concentrations of
success, you might want to see if you could identify concentrations
of unusual characteristics that might be causal factors.
Scientific
inquiry naturally follows such a pattern. If you were trying to
analyze possible causes of a rare type of cancer -- with, say, 1,500
cases a year in the United States -- and you found that 400 of them
occurred in some little mining town in Montana, you would get very
interested in the water there, or the occupation of those afflicted,
or other variables. You know it's not random chance that 400 come
from a small area. You would not necessarily know the causal factors,
but you would know where to search.
I submit
to you that there are ways of defining an origin other than geography.
In addition to geographical origins, there can be what I call an
intellectual origin. I think you will find that a disproportionate
number of successful coin-flippers in the investment world came
from a very small intellectual village that could be called Graham-and-Doddsville.
A concentration of winners that simply cannot be explained by chance
can be traced to this particular intellectual village.
Conditions
could exist that would make even that concentration unimportant.
Perhaps 100 people were simply imitating the coin-flipping call
of some terribly persuasive personality. When he called heads, 100
followers automatically called that coin the same way. If the leader
was part of the 215 left at the end, the fact that 100 came from
the same intellectual origin would mean nothing. You would simply
be identifying one case as a hundred cases. Similarly, let's assume
that you lived in a strongly patriarchal society and every family
in the United States conveniently consisted of ten members. Further
assume that the patriarchal culture was so strong that, when the
225 million people went out the first day, every member of the family
identified with the father's call. Now, at the end of the 20-day
period, you would have 215 winners, and you would find that they
came from only 21.5 families. Some naive types might say that this
indicates an enormous hereditary factor as an explanation of successful
coin-flipping. But, of course, it would have no significance at
all because it would simply mean that you didn't have 215 individual
winners, but rather 21.5 randomly distributed families who were
winners.
In
this group of successful investors that I want to consider, there
has been a common intellectual patriarch, Ben Graham. But the children
who left the house of this intellectual patriarch have called their
"flips" in very different ways. They have gone to different places
and bought and sold different stocks and companies, yet they have
had a combined record that simply cannot be explained by the fact
that they are all calling flips identically because a leader is
signaling the calls for them to make. The patriarch has merely set
forth the intellectual theory for making coin-calling decisions,
but each student has decided on his own manner of applying the theory.
The
common intellectual theme of the investors from Graham-and-Doddsville
is this: they search for discrepancies between the value
of a business and the price of small pieces of that business
in the market. Essentially, they exploit those discrepancies without
the efficient market theorist's concern as to whether the stocks
are bought on Monday or Thursday, or whether it is January or July,
etc. Incidentally, when businessmen buy businesses, which is just
what our Graham & Dodd investors are doing through the purchase
of marketable stocks -- I doubt that many are cranking into their
purchase decision the day of the week or the month in which the
transaction is going to occur. If it doesn't make any difference
whether all of a business is being bought on a Monday or a Friday,
I am baffled why academicians invest extensive time and effort to
see whether it makes a difference when buying small pieces of those
same businesses. Our Graham & Dodd investors, needless to say, do
not discuss beta, the capital asset pricing model, or covariance
in returns among securities. These are not subjects of any interest
to them. In fact, most of them would have difficulty defining those
terms. The investors simply focus on two variables: price and value.
I always
find it extraordinary that so many studies are made of price and
volume behavior, the stuff of chartists. Can you imagine buying
an entire business simply because the price of the business had
been marked up substantially last week and the week before?
Of course, the reason a lot of studies are made of these price and
volume variables is that now, in the age of computers, there are
almost endless data available about them. It isn't necessarily because
such studies have any utility; it's simply that the data are there
and academicians have [worked] hard to learn the mathematical skills
needed to manipulate them. Once these skills are acquired, it seems
sinful not to use them, even if the usage has no utility or negative
utility. As a friend said, to a man with a hammer, everything looks
like a nail.
I think
the group that we have identified by a common intellectual home
is worthy of study. Incidentally, despite all the academic studies
of the influence of such variables as price, volume, seasonality,
capitalization size, etc., upon stock performance, no interest has
been evidenced in studying the methods of this unusual concentration
of value-oriented winners.
I begin
this study of results by going back to a group of four of us who
worked at Graham-Newman Corporation from 1954 through 1956. There
were only four -- I have not selected these names from among thousands.
I offered to go to work at Graham-Newman for nothing after I took
Ben Graham's class, but he turned me down as overvalued. He took
this value stuff very seriously! After much pestering he finally
hired me. There were three partners and four of us as the "peasant"
level. All four left between 1955 and 1957 when the firm was wound
up, and it's possible to trace the record of three.
The
first example (see Table 1) is that of Walter Schloss. Walter never
went to college, but took a course from Ben Graham at night at the
New York Institute of Finance. Walter left Graham-Newman in 1955
and achieved the record shown here over 28 years. Here is what "Adam
Smith" -- after I told him about Walter -- wrote about him in Supermoney
(1972):
He
has no connections or access to useful information. Practically
no one in Wall Street knows him and he is not fed any ideas. He
looks up the numbers in the manuals and sends for the annual reports,
and that's about it.
In
introducing me to (Schloss) Warren had also, to my mind, described
himself. "He never forgets that he is handling other people's
money, and this reinforces his normal strong aversion to loss."
He has total integrity and a realistic picture of himself. Money
is real to him and stocks are real -- and from this flows an attraction
to the "margin of safety" principle.
Walter
has diversified enormously, owning well over 100 stocks currently.
He knows how to identify securities that sell at considerably less
than their value to a private owner. And that's all he does.
He doesn't worry about whether it it's January, he doesn't worry
about whether it's Monday, he doesn't worry about whether it's an
election year. He simply says, if a business is worth a dollar and
I can buy it for 40 cents, something good may happen to me. And
he does it over and over and over again. He owns many more stocks
than I do -- and is far less interested in the underlying nature
of the business; I don't seem to have very much influence on Walter.
That's one of his strengths; no one has much influence on him.
The
second case is Tom Knapp, who also worked at Graham-Newman with
me. Tom was a chemistry major at Princeton before the war; when
he came back from the war, he was a beach bum. And then one day
he read that Dave Dodd was giving a night course in investments
at Columbia. Tom took it on a noncredit basis, and he got so interested
in the subject from taking that course that he came up and enrolled
at Columbia Business School, where he got the MBA degree. He took
Dodd's course again, and took Ben Graham's course. Incidentally,
35 years later I called Tom to ascertain some of the facts involved
here and I found him on the beach again. The only difference is
that now he owns the beach!
In
1968, Tom Knapp and Ed Anderson, also a Graham disciple, along with
one or two other fellows of similar persuasion, formed Tweedy, Browne
Partners, and their investment results appear in Table 2. Tweedy,
Browne built that record with very wide diversification. They occasionally
bought control of businesses, but the record of the passive investments
is equal to the record of the control investments.
Table
3 describes the third member of the group who formed Buffett Partnership
in 1957. The best thing he did was to quit in 1969. Since then,
in a sense, Berkshire Hathaway has been a continuation of the partnership
in some respects. There is no single index I can give you that I
would feel would be a fair test of investment management at Berkshire.
But I think that any way you figure it, it has been satisfactory.
Table
4 shows the record of the Sequoia Fund, which is managed by a man
whom I met in 1951 in Ben Graham's class, Bill Ruane. After getting
out of Harvard Business School, he went to Wall Street. Then he
realized that he needed to get a real business education so he came
up to take Ben's course at Columbia, where we met in early 1951.
Bill's record from 1951 to 1970, working with relatively small sums,
was far better than average. When I wound up Buffett Partnership
I asked Bill if he would set up a fund to handle all our partners,
so he set up the Sequoia Fund. He set it up at a terrible time,
just when I was quitting. He went right into the two-tier market
and all the difficulties that made for comparative performance for
value-oriented investors. I am happy to say that my partners, to
an amazing degree, not only stayed with him but added money, with
the happy result shown here.
There's
no hindsight involved here. Bill was the only person I recommended
to my partners, and I said at the time that if he achieved a four-point-per-annum
advantage over the Standard & Poor's, that would be solid performance.
Bill has achieved well over that, working with progressively larger
sums of money. That makes things much more difficult. Size is the
anchor of performance. There is no question about it. It doesn't
mean you can't do better than average when you get larger, but the
margin shrinks. And if you ever get so you're managing two trillion
dollars, and that happens to be the amount of the total equity valuation
in the economy, don't think that you'll do better than average!
I should
add that in the records we've looked at so far, throughout this
whole period there was practically no duplication in these portfolios.
These are men who select securities based on discrepancies between
price and value, but they make their selections very differently.
Walter's largest holdings have been such stalwarts as Hudson Pulp
& Paper and Jeddo Highland Coal and New York Trap Rock Company and
all those other names that come instantly to mind to even a casual
reader of the business pages. Tweedy Browne's selections have sunk
even well below that level in terms of name recognition. On the
other hand, Bill has worked with big companies. The overlap among
these portfolios has been very, very low. These records do not reflect
one guy calling the flip and fifty people yelling out the same thing
after him.
Table
5 is the record of a friend of mine who is a Harvard Law graduate,
who set up a major law firm. I ran into him in about 1960 and told
him that law was fine as a hobby but he could do better. He set
up a partnership quite the opposite of Walter's. His portfolio was
concentrated in very few securities and therefore his record was
much more volatile but it was based on the same discount-from-value
approach. He was willing to accept greater peaks and valleys of
performance, and he happens to be a fellow whose whole psyche goes
toward concentration, with the results shown. Incidentally, this
record belongs to Charlie Munger, my partner for a long time in
the operation of Berkshire Hathaway. When he ran his partnership,
however, his portfolio holdings were almost completely different
from mine and the other fellows mentioned earlier.
Table
6 is the record of a fellow who was a pal of Charlie Munger's --
another non-business school type -- who was a math major at USC.
He went to work for IBM after graduation and was an IBM salesman
for a while. After I got to Charlie, Charlie got to him. This happens
to be the record of Rick Guerin. Rick, from 1965 to 1983, against
a compounded gain of 316 percent for the S&P, came off with 22,200
percent, which probably because he lacks a business school education,
he regards as statistically significant.
One
sidelight here: it is extraordinary to me that the idea of buying
dollar bills for 40 cents takes immediately to people or it doesn't
take at all. It's like an inoculation. If it doesn't grab a person
right away, I find that you can talk to him for years and show him
records, and it doesn't make any difference. They just don't seem
able to grasp the concept, simple as it is. A fellow like Rick Guerin,
who had no formal education in business, understands immediately
the value approach to investing and he's applying it five minutes
later. I've never seen anyone who became a gradual convert over
a ten-year period to this approach. It doesn't seem to be a matter
of IQ or academic training. It's instant recognition, or it is nothing.
Table
7 is the record of Stan Perlmeter. Stan was a liberal arts major
at the University of Michigan who was a partner in the advertising
agency of Bozell & Jacobs. We happened to be in the same building
in Omaha. In 1965 he figured out I had a better business than he
did, so he left advertising. Again, it took five minutes for Stan
to embrace the value approach.
Perlmeter
does not own what Walter Schloss owns. He does not own what Bill
Ruane owns. These are records made independently. But every
time Perlmeter buys a stock it's because he's getting more for his
money than he's paying. That's the only thing he's thinking about.
He's not looking at quarterly earnings projections, he's not looking
at next year's earnings, he's not thinking about what day of the
week it is, he doesn't care what investment research from any place
says, he's not interested in price momentum, volume, or anything.
He's simply asking: what is the business worth?
Table
8 and Table 9 are the records of two pension funds I've been involved
in. They are not selected from dozens of pension funds with which
I have had involvement; they are the only two I have influenced.
In both cases I have steered them toward value-oriented managers.
Very, very few pension funds are managed from a value standpoint.
Table 8 is the Washington Post Company's Pension Fund. It was with
a large bank some years ago, and I suggested that they would do
well to select managers who had a value orientation.
As
you can see, overall they have been in the top percentile ever since
they made the change. The Post told the managers to keep at least
25 percent of these funds in bonds, which would not have been necessarily
the choice of these managers. So I've included the bond performance
simply to illustrate that this group has no particular expertise
about bonds. They wouldn't have said they did. Even with this drag
of 25 percent of their fund in an area that was not their game,
they were in the top percentile of fund management. The Washington
Post experience does not cover a terribly long period but it does
represent many investment decisions by three managers who were not
identified retroactively.
Table
9 is the record of the FMC Corporation fund. I don't manage a dime
of it myself but I did, in 1974, influence their decision to select
value-oriented managers. Prior to that time they had selected managers
much the same way as most larger companies. They now rank number
one in the Becker survey of pension funds for their size over the
period of time subsequent to this "conversion" to the value approach.
Last year they had eight equity managers of any duration beyond
a year. Seven of them had a cumulative record better than the S&P.
The net difference now between a median performance and the actual
performance of the FMC fund over this period is $243 million. FMC
attributes this to the mindset given to them about the selection
of managers. Those managers are not the managers I would necessarily
select but they have the common denominators of selecting securities
based on value.
So
these are nine records of "coin-flippers" from Graham-and-Doddsville.
I haven't selected them with hindsight from among thousands. It's
not like I am reciting to you the names of a bunch of lottery winners
-- people I had never heard of before they won the lottery. I selected
these men years ago based upon their framework for investment decision-making.
I knew what they had been taught and additionally I had some personal
knowledge of their intellect, character, and temperament. It's very
important to understand that this group has assumed far less risk
than average; note their record in years when the general market
was weak. While they differ greatly in style, these investors are,
mentally, always buying the business, not buying the stock.
A few of them sometimes buy whole businesses. Far more often they
simply buy small pieces of businesses. Their attitude, whether buying
all or a tiny piece of a business, is the same. Some of them hold
portfolios with dozens of stocks; others concentrate on a handful.
But all exploit the difference between the market price of a business
and its intrinsic value.
I'm
convinced that there is much inefficiency in the market. These Graham-and-Doddsville
investors have successfully exploited gaps between price and value.
When the price of a stock can be influenced by a "herd" on Wall
Street with prices set at the margin by the most emotional person,
or the greediest person, or the most depressed person, it is hard
to argue that the market always prices rationally. In fact, market
prices are frequently nonsensical.
I would
like to say one important thing about risk and reward. Sometimes
risk and reward are correlated in a positive fashion. If someone
were to say to me, "I have here a six-shooter and I have slipped
one cartridge into it. Why don't you just spin it and pull it once?
If you survive, I will give you $1 million." I would decline --
perhaps stating that $1 million is not enough. Then he might offer
me $5 million to pull the trigger twice -- now that would be a positive
correlation between risk and reward!
The
exact opposite is true with value investing. If you buy a dollar
bill for 60 cents, it's riskier than if you buy a dollar bill for
40 cents, but the expectation of reward is greater in the latter
case. The greater the potential for reward in the value portfolio,
the less risk there is.
One
quick example: The Washington Post Company in 1973 was selling for
$80 million in the market. At the time, that day, you could have
sold the assets to any one of ten buyers for not less than $400
million, probably appreciably more. The company owned the Post,
Newsweek, plus several television stations in major markets.
Those same properties are worth $2 billion now, so the person who
would have paid $400 million would not have been crazy.
Now,
if the stock had declined even further to a price that made the
valuation $40 million instead of $80 million, its beta would have
been greater. And to people that think beta measures risk, the cheaper
price would have made it look riskier. This is truly Alice in Wonderland.
I have never been able to figure out why it's riskier to buy $400
million worth of properties for $40 million than $80 million. And,
as a matter of fact, if you buy a group of such securities and you
know anything at all about business valuation, there is essentially
no risk in buying $400 million for $80 million, particularly if
you do it by buying ten $40 million piles of $8 million each. Since
you don't have your hands on the $400 million, you want to be sure
you are in with honest and reasonably competent people, but that's
not a difficult job.
You
also have to have the knowledge to enable you to make a very general
estimate about the value of the underlying businesses. But you do
not cut it close. That is what Ben Graham meant by having a margin
of safety. You don't try and buy businesses worth $83 million for
$80 million. You leave yourself an enormous margin. When you build
a bridge, you insist it can carry 30,000 pounds, but you only drive
10,000 pound trucks across it. And that same principle works in
investing.
In
conclusion, some of the more commercially minded among you may wonder
why I am writing this article. Adding many converts to the value
approach will perforce narrow the spreads between price and value.
I can only tell you that the secret has been out for 50 years, ever
since Ben Graham and Dave Dodd wrote Security
Analysis, yet I have seen no trend toward value investing
in the 35 years that I've practiced it. There seems to be some perverse
human characteristic that likes to make easy things difficult. The
academic world, if anything, has actually backed away from the teaching
of value investing over the last 30 years. It's likely to continue
that way. Ships will sail around the world but the Flat Earth Society
will flourish. There will continue to be wide discrepancies between
price and value in the marketplace, and those who read their Graham
& Dodd will continue to prosper.
Tables
1-9 follow:
[Note:
the tables Buffett mentions are in The
Intelligent Investor, but are not reproduced here. The Sequoia
and Munger records are published here.]
If
you have a high-speed internet connection, you may prefer to read
this version of the speech (a 1.6
MB .pdf file), which has all of the tables.
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