Introduction
On May 17, 1984, Columbia University held a symposium in celebration of the 50th anniversary of former professors Benjamin Graham and David Dodd’s book Security Analysis. During the event, professor Michael Jensen, then at the University of Rochester, was invited to provide a defense of the then — and still — reigning investment theory in academic finance, known as the efficient market hypothesis, or EMH.
The EMH states that all available information is incorporated into a stock’s price, making it nearly impossible to generate superior long-term investment results. Proponents of the EMH, including Jensen, recognize that a few investors have beaten the market but attribute this success to random chance.
During his speech, Jensen suggested that the same outcome could be achieved during a random exercise, such as coin flipping. If a field of untalented analysts were doing nothing but flipping coins, Jensen argued, some would still toss repeated heads in a row by chance alone.
Warren Buffett, then and now the most famous Graham and Dodd disciple, provided the rebuttal to Jensen’s argument. Buffett suggested that if a coin-flipping contest were held among the roughly 225 million people in the United States, after 20 days a small group would remain who had each correctly predicted the outcome of the coin toss every day. These winners would likely claim to have superior ability.
But Buffett then asked what would happen if an unusually large number of the winners came from the same place. Surely no honest statistician would dismiss such a concentration as random chance. In the case of successful investors, Buffett argued that a disproportionate number came from a small intellectual village he called “Graham-and-Doddsville.”
Buffett recognized that while relatively few investors had achieved long-term success, a disproportionate number of them were disciples of Benjamin Graham and David Dodd and their investment philosophy known as value investing.
In this essay, we will attempt to broaden the description of value investing from merely an investment “style,” identified by statistical characteristics such as low price-to-earnings ratios, to a comprehensive investment philosophy.
Origins of the Value Approach
Benjamin Graham’s Early Career
Benjamin Graham graduated from Columbia University in 1914 and accepted a position with the investment firm Newburger, Henderson & Loeb. He eventually became the firm’s “statistician,” then the term for investment analyst, and made partner in 1923.
His responsibilities mostly involved studying bonds. It was during these years that Graham learned to analyze financial statements and identify a company’s assets and earnings. Graham applied his craft at a time before uniform disclosure rules existed at the national level. Companies did provide minimal financial information as promotional material to attract investors or to comply with exchange requirements, but this information was generally not used to analyze common stocks.
Graham was unique in identifying that financial statement analysis could be used to generate conservative profits in stocks. In 1915, the Guggenheim Exploration Company proposed to liquidate its assets and distribute the proceeds to shareholders. Graham noticed that the company owned interests in several New York Stock Exchange listed mining companies whose value, along with Guggenheim’s other assets, represented $76.23 per Guggenheim share. The quoted price for Guggenheim’s shares at that time was $68.88.
Graham reasoned that by shorting the stocks of the listed mining companies and simultaneously investing in Guggenheim, an investor could make a nearly risk-free arbitrage profit of $7.35 per share. Graham came to specialize in these arbitrage opportunities, and in 1923 he left Newburger, Henderson & Loeb to start his own investment firm.
The common view on Wall Street in the early 1920s was that an investor was interested in stable income while a speculator was interested in forecasting price movements. Thus, investors bought bonds while speculators bought stocks. The prevailing view, in other words, was that stocks could never be thought of as investments.
Graham disagreed, and he invested profitably in common stocks through the 1920s.
Edgar Lawrence Smith’s Common Stocks as Long Term Investments, which had shown statistically that stocks had outperformed bonds over time, became a widely read book on Wall Street. By the late 1920s, Smith’s book had become, according to Warren Buffett, the “intellectual underpinning of the 1929 stock-market mania.”
Graham, looking back, felt that Smith’s analysis was taking market participants to an illogical conclusion. The sound observation that common stocks had performed well over time was being used to justify paying prices far in excess of earnings and business value.
Unfortunately, Graham was not spared by the 1929 market crash. Graham, who by then had closed his first firm and begun a partnership with Jerome Newman, had borrowed heavily to leverage his arbitrage profits. 1930 proved to be the worst year for Graham, with his operation down roughly 50%, compared with a decline of about 29% for the Dow Jones Industrials.
Graham likely would have dissolved the firm if not for a $75,000 capital infusion from a relative of Jerome Newman. However, the fact that stocks were in such disfavor in the 1930s played to Graham’s analytical method. In 1932, Graham wrote a series of articles for Forbes titled “Is American Business Worth More Dead Than Alive?” in which he identified that more than 40% of NYSE-listed stocks were selling below net working capital.
Security Analysis and The Intelligent Investor
In 1928, Graham began teaching a night course in security analysis at Columbia University. Graham’s ultimate motivation was to write a book on the subject, and teaching allowed him to organize his thoughts and test his ideas on a live audience.
Attending Graham’s class was Columbia faculty member David Dodd, who was tasked with transcribing Graham’s lectures. Working from these notes, the professors would author their classic text, Security Analysis.
The first edition of Security Analysis was published in 1934 and eventually became the basic text for the teaching and practice of security analysis. To Graham, a stock was not categorically risky. Graham advocated that the price relative to the earnings and assets of the underlying business was the key to separating a sound investment from a risky speculation.
Just as stocks were considered risky after the crash, before the crash the opposite was true. Graham rejected the idea that “good” stocks were sound investments regardless of how high the price paid for them. In his view, this was simply a way of disguising speculation under the label of investment.
Graham advocated that investors devote attention to undervalued securities — issues, whether bonds or stocks, selling well below levels justified by careful analysis of the relevant facts.
To Graham, a stock had a price and an underlying value, and these two figures were distinct. A stock could be a sound investment if the underlying value, as carefully and conservatively calculated, was significantly higher than the stock’s price. A bargain price was central to the process.
Graham also recognized that markets could occasionally create bargains for behavioral reasons. He famously described the market not as a weighing machine but as a voting machine, with prices influenced partly by reason and partly by emotion.
In 1949, The Intelligent Investor was published. Whereas Security Analysis was written as a textbook for investment professionals, The Intelligent Investor was written for a more general audience. Warren Buffett, in a foreword to the fourth edition, advised readers to pay particular attention to chapters 8 and 20.
Graham’s View of Stock Market Prices
In chapter 8 of The Intelligent Investor, Graham presents a view of market prices that contrasts sharply with the view of market prices in modern finance theory.
Graham relates his views through his famous “Mr. Market” analogy. Graham asks the reader to imagine owning a small interest in a private company. One of your partners is named Mr. Market, and every day he offers you a price at which he will either buy your shares or sell you his.
Most of the time, Mr. Market will quote a price that is sensible given the business’s fundamentals. However, Mr. Market is subject to wild mood swings and may occasionally quote a wildly pessimistic or wildly optimistic price. It is up to the investor to take advantage of Mr. Market’s volatile temperament when prices become irrational, rather than allowing Mr. Market’s mood to dictate the investor’s own judgment.
To Graham, the market was there to serve the investor rather than guide the investor. Price fluctuations had one important meaning for the true investor: they occasionally created opportunities. At other times, Graham believed investors would do better to focus on the operating results of their companies rather than the stock market.
This view of stock markets is in significant contrast to the view of markets held by proponents of modern finance theory.
Margin of Safety
The second of Graham’s major insights in The Intelligent Investor has become the cornerstone of the philosophy followed by many successful investment practitioners. That concept is the margin of safety.
The margin of safety is the difference between a stock’s underlying value and its price. Graham explained that the margin of safety was a favorable difference between price and appraised value, available to absorb the effect of miscalculations or worse-than-average luck.
Graham wrote considerably on the need to differentiate between investment and speculation. Writing in the early 1930s, Graham recognized that no authoritative definition existed for the term investment. He offered the following definition in Security Analysis: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.”
In The Intelligent Investor, Graham proposed that the margin of safety concept be used to further his definition of investment. To have a true investment, there must be a true margin of safety, and that margin of safety must be capable of being demonstrated through figures, reasoning, and actual experience.
Origins of Modern Finance
Security Analysis, in its various editions, remained part of academic finance curriculums for several decades after its initial publication. The late Robert Haugen, a prominent EMH critic, remembered that when he entered the university in 1960, he was taught “old” finance. His textbooks included Graham and Dodd’s Security Analysis and Arthur Stone Dewing’s The Financial Policy of Corporations.
Today, few undergraduate or graduate finance students have more than a passing understanding of Graham’s methods.
By the early 1970s, Graham and Dodd’s Security Analysis had been supplanted by academic ideas collectively referred to as modern finance theory. While an in-depth study of modern finance theory is beyond the scope of this essay, we will examine a few key ideas below.
Harry Markowitz and Modern Portfolio Theory
In 1950, a young PhD student at the University of Chicago named Harry Markowitz was contemplating what to write for his doctoral dissertation. While waiting outside a professor’s office, Markowitz conversed with a stockbroker who suggested that he base his paper on the stock market. From this meeting emerged the birth of academic finance.
At the University of Chicago, Markowitz had studied a then-new mathematical application called linear programming. This method was a means of finding optimum relationships among variables. Markowitz realized that this application was well suited to the field of investment because investors were always seeking to maximize gains while minimizing risk.
Markowitz determined to concentrate his efforts on two timeless questions facing investors:
- The tradeoff between risk and reward; and
- How to use diversification to minimize a portfolio’s risk.
To systematize the problem, Markowitz needed a measure for an asset’s risk. For risk, he used standard deviation, a statistical measure of the dispersion of past returns.
Because Markowitz was concerned with the risk and return tradeoff of a portfolio, and not just an individual asset, he added a third input: covariance. Covariance is a measure of the relationship between the returns of two assets.
This third element was Markowitz’s unique insight. By constructing a portfolio of assets whose returns had low or negative correlation, the standard deviation of the portfolio would be lower than the average standard deviation of the individual assets. Thus, Markowitz showed how to diversify to reduce portfolio volatility. His work was later considered a mathematical proof for the importance of portfolio diversification.
For the average investment professional in the 1950s, applying Markowitz’s method was nearly impossible. The method worked best when applied to a wide universe of financial securities, but the correlations among each combination had to be calculated. The use of Markowitz’s portfolio optimization methods increased with the rise of affordable computing power.
Today, even most personal computers are equipped with basic optimization software. Many financial planners and advisers rely heavily on optimization programs to set portfolio allocations for clients.
William Sharpe and Beta
Shortly after producing his landmark paper, Markowitz accepted a position doing linear programming for the RAND Corporation. At RAND, Markowitz was introduced to a young staffer and UCLA doctoral student named William Sharpe. At Markowitz’s suggestion, Sharpe focused his dissertation research on making Markowitz’s insights regarding portfolio optimization more practical.
Sharpe set out to simplify Markowitz’s work by seeking a common statistical relationship among stocks. His PhD dissertation was published in Management Science in 1963. In the paper, Sharpe created a simplified model in which a stock’s return would be determined by several random factors and some measure of a common relationship.
To Sharpe, the key driver of a security’s returns was the security’s correlation with this common factor. The common factor that seemed to have the most explanatory value was the market itself. Sharpe represented this correlation with the symbol B, which would later be referred to as beta.
Sharpe recognized that the price of an asset should compensate the investor for the asset’s risk. To Sharpe, an asset’s risk had two components. The first component was the correlation between an asset’s returns and the returns of the market itself. The second component was risk specific to the individual asset.
Sharpe referred to the first component as systematic risk and the second as unsystematic risk. For the sake of his analysis, Sharpe assumed that all investors followed Markowitz’s model of portfolio diversification, thus diversifying away any specific risk.
The proposition proved alluring to academics and finance professionals: a stock’s risk could be measured by a single statistic — beta.
The Efficient Market Hypothesis
The third major idea of academic finance is the efficient market hypothesis. This idea is also perhaps the most controversial and widely subscribed to idea in finance. The EMH is especially controversial for practitioners of active security selection.
The EMH evolved from the work of several economists regarding the predictability of securities prices. The real birth of the EMH, however, may lie in an obscure doctoral dissertation written in 1900 by a French mathematician named Louis Bachelier. Bachelier’s work was a mathematical analysis of security prices on the Paris Bourse. Through dense mathematical application, Bachelier demonstrated that securities prices fluctuate randomly.
In 1934, a statistician at Stanford University named Holbrook Working produced a study of commodity prices. The study showed that while seemingly nonrandom patterns occur in commodity prices, commodity price changes occurred in an entirely random sequence.
Working’s statistical methodology was later applied to a study of stock prices by University of Chicago professor Harry Roberts. Roberts’s paper, published in The Journal of Finance in 1959, was particularly aimed at debunking the “chart reading” services popular at the time. Roberts made a compelling case that classical patterns of technical analysis could be generated by chance.
The conclusions of these and other academic studies — that securities prices were random and thus could not be predicted — later became known as the random walk hypothesis.
Eugene Fama of the University of Chicago expanded the work done by Roberts and others into a more comprehensive theory of asset prices, which he called the efficient markets model. To Fama, a market is efficient when prices “fully reflect” available information.
At Harry Roberts’s suggestion, Fama’s efficient markets model, later referred to as the efficient market hypothesis, recognized three degrees of market efficiency:
- Weak-form efficiency, which holds that past price patterns cannot be used to predict future price patterns;
- Semi-strong-form efficiency, which suggests that all public information is fully reflected in stock prices; and
- Strong-form efficiency, which suggests that both public and private information are fully reflected in stock prices.
Value Investing and Modern Finance Theory
A full analysis of the EMH is beyond the scope of this essay. It is enough to recognize that the Graham and Dodd philosophy of identifying bargains and patiently waiting has attracted a new generation of practitioners, many of whom have produced impressive long-term results.
These investors, while recognizing that markets are highly competitive, are largely opposed to the idea of perfectly efficient markets. Value investing practitioners believe disciplined analysis can identify securities whose prices depart appreciably from underlying value. Under the right conditions, this can allow investors to pursue attractive returns while taking less risk than the market price may imply.
Value investing practitioners also disagree with the notion that investment risk can be captured in a single statistical figure. Graham advocated that investors analytically treat stocks as if they were purchasing the entire business. As he wrote, “Investment is most intelligent when it is most businesslike.”
The proponents of modern finance theory, in contrast, advocate that investors ignore all idiosyncratic risks of business ownership because they can be diversified away, and focus only on systematic risk as measured by beta. Even Eugene Fama, in collaboration with Kenneth French, conducted a study in which they concluded that beta was a weak explanation for returns over their sample period. The concept of beta, however, continues to be taught in universities and used by investment practitioners.
As noted earlier, modern finance theory continues to dominate the teaching of finance. Thus, few finance students at the undergraduate or graduate levels are exposed to Graham and Dodd’s teachings. We should recognize, however, that numerous academic studies emerged in the 1980s and 1990s that at least partially discredited the EMH.
It is interesting to note that the 2013 Nobel Prize in Economic Sciences was shared by Eugene Fama, Lars Peter Hansen, and Robert Shiller. This is notable because while Fama is the father of the EMH, Shiller is most recognized for his work in behavioral finance, a discipline that stands in contrast with the EMH. Academic finance has at least become a bit more balanced.
Still, many university courses titled “Security Analysis” prioritize the portfolio approach to stock selection, in which stocks are primarily chosen based on their diversification benefits to a portfolio and not on whether they are undervalued. Graham and Dodd remain underrepresented in academia.
The EMH remains the most widely accepted market theory among finance academics. The persistent faith in the EMH seems to lie in the general inability of fund managers to beat their respective benchmarks. As professor Burton Malkiel, a leading proponent of the EMH, has stated, direct tests of professional fund managers’ ability to outperform the market are among the most convincing tests of market efficiency.
In response to the pervasive underperformance argument, value practitioners may point out that few professional investors follow a true value investing philosophy. The mutual fund industry has embraced a definition of “value” as an investment style characterized by the selection of stocks based on low P/E ratios and similar metrics. But this definition of value investing does not fully capture Graham’s underlying philosophy, nor does it describe the methods of most true value investing practitioners.
Bill Ruane, the late founder of the Sequoia Fund, once suggested that value investors account for approximately 5% of professionally managed money. Similarly, fund manager Jean-Marie Eveillard stated in a speech at Columbia University that perhaps only 5% of professional money managers are true value investors.
Anyone who has followed this small subset of professional money managers understands that their collective superior long-term performance is more than chance. As Buffett concluded in his 1984 speech, there will continue to be wide discrepancies between price and value in the marketplace, and those who read Graham and Dodd will continue to prosper.
Conclusion
Value investing is often reduced to a statistical category. In the mutual fund industry, “value” is commonly associated with low price-to-earnings ratios, low price-to-book ratios, or other valuation metrics. But the Graham and Dodd approach is much broader than a factor label.
Value investing is a comprehensive philosophy grounded in several core ideas:
- A security represents an economic interest in an underlying business.
- Market price and business value are distinct.
- Markets are sometimes driven by emotion, institutional behavior, and short-term thinking.
- Careful analysis can identify discrepancies between price and value.
- A margin of safety helps protect the investor against error and uncertainty.
- Long-term patience is necessary because market recognition of value may take time.
The value investor does not rely on the market to provide instruction. The market is a tool, not a master. Prices fluctuate, but the investor’s task is to understand business value and act only when price and value diverge meaningfully.
That is why value investing should not be understood merely as an investment style. Properly understood, value investing is a way of thinking about business, risk, price, value, and human behavior.
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