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What did Ben Graham get right? by Roger Montgomery

So you have your head buried in efficient frontiers, modern portfolio theory, beta and weighted average cost of capital? I’d be surprised if it’s not the case, but you may not have heard of Ben Graham.

Benjamin Graham was the father of security analysis and the intellectual Dean of Wall Street. I believe Graham was many things, including the father of the many ratios we take for granted in our work as analysts, portfolio managers and investment officers, but perhaps controversially, I also believe he may not have reached some of his conclusions had he access to a computer that allowed him to properly test his ideas.

Having said that, there are many things that Ben said that not only made sense but made significant contributions to investment thinking. And despite the absence of a computer, Graham observed several characteristics of the market that the advent of modern computing has only served to reinforce.

For those grateful for executive summaries, here follows mine on the three most significant contributions Ben Graham made to the body of work on investing, which he also arguably commenced, and which subsequently diverged when Miller and Modigliani’s work met that of James Walter. As an aside, the investment world sided with Miller and Modigliani. Buffett, Munger and a few others since, including Montgomery, sided with Walter.

By understanding, testing and implementing the approaches that flow, self-evidently, from a study of Graham’s principles, I believe any investor will benefit not only in terms of returns but also in terms of risk mitigation. So here follow three of Graham’s principles. Where possible we display anecdotal evidence of their truth with the attractive graphics now possible through modern computing and the technical mastery of the development team at Skaffold.com.

The first of Graham’s significant contributions is his “Mr Market” allegory, introduced in 1949. Mr Market is of course a fictitious character, created to demonstrate the bipolar nature of the market.

Here is an excerpt from a speech made by Warren Buffett about Ben Graham on the subject:

“You should imagine market quotations as coming from a remarkably accommodating fellow named Mr Market who is your partner in a private business. Without fail, Mr Market appears daily and names a price at which he will either buy your interest or sell you his.

 Even though the business that the two of you own may have economic characteristics that are stable, Mr Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains…

Mr Market has another endearing characteristic: he doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow.

Transactions are strictly at your option…But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr Market is there to serve you, not to guide you.

It is his pocketbook, not his wisdom that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence.”

The implications of this little story cannot be understated. What Graham is saying is that there is a legitimate alternative to the Efficient Market Hypothesis as a model of the way the market behaves and works. Thing is, he said it before EMT became the cornerstone of every financial services firm that cared about “biggering and biggering and BIGGERING.”

 

Another significant implication is that as investors we should be less focused on price as our guide as we should on value. This challenges the validity of many streams of financial study that have as their root the price of securities. Think about all the PHD papers and other academic studies that uncover relationships, or validate the power of explanatory variables, but whose concluding evidences are merely price, or some derivative of price. If prices in the short run are determined by those who are merely selling to renovate the bathroom or by events in Syria – events that have no impact on the number of $2 buckets being sold by The Reject Shop – what ‘value’ can we place on them?

The other great lesson Ben Graham taught was – arguably the three most important words in value investing – margin of safety. In engineering terms, the margin of safety is the strength of the material minus the anticipated stress. Building materials that are far stronger than that required to survive the anticipated stress ensures a degree of comfort.

When it comes to investing, the margin of safety is the estimated value of a share minus the price. The greater the margin of safety, the greater the degree of comfort and more importantly, the greater the expected return. If the price is what we pay, and the value what we receive, then the lower the price we pay, the higher the return.

Despite the high profile of these enduring two lessons, I believe there is a third observation of Graham’s that is equally important. Fascinatingly, with the benefit of computers, I can also demonstrate that Graham was spot on.

Graham was paraphrased thus by Buffett in 1993:

In the short run the market is a voting machine - reflecting a voter-registration test that requires only money, not intelligence or emotional stability - but in the long run, the market is a weighing machine.

What Graham described is something that, as both a private and professional investor, I have observed myself; in the short term, the market is a popularity contest – prices often diverge significantly from those that are justified by the economic performance of the business. But in the long term, prices eventually converge with intrinsic values, which themselves follow business performance.

Have a look at the following chart. Figure 1 displays ten years of price and intrinsic value history for Qantas. Stand back, and what you will notice is that Qantas’s intrinsic value (the stepped grey line), which is based on its economic performance, has at best not changed. In fact, the intrinsic value of Qantas today is lower than it was a decade ago. And just as Ben Graham predicted, the long term weighing machine has also correctly appraised its worth. The price today is also lower than a decade ago.

Figure 1. Ten years of historic and three years of forecast intrinsic values, Qantas (QAN, Quality Score: B3)

To digress again momentarily, airlines are businesses with particularly challenging economics, and whether they run well or poorly, they have a long-term tendency to destroy wealth. Take a look at the Figure 2, which shows the intrinsic value of Virgin Australia Holdings.

Figure 2. Ten years of intrinsic value, Virgin Australia Holdings (VAH, Quality Score C5)

Unless you can see a reason for a permanent change in the prospects of these companies, the long-term trend in intrinsic value gives you all the information you need to steer well clear. Irrespective of how hard the oarsmen of these business boats row, and no matter how qualified they are for the task, their rowing will always be distracted by the need to perpetually fix leaks in the boats’ sides.

Now take a look at Figure 3. This time, you’re looking at a ten-year history of price and intrinsic value for Telstra. Sure, there have been short-term episodes of price buoyancy (such as the present affliction due to a bout of faddish infatuation with yield), but over the long run, the weighing machine has done and will continue to do its work. The intrinsic value of Telstra has barely changed in a decade. Neither has its price, and over time, the share price will generally reflect the company’s worth.

Figure 3. Ten years of intrinsic value, Telstra (MQR B3)

Finally, take a look at the change in intrinsic value of Oroton prior to and after Sally Macdonald joined the company as CEO in 2005/06 (she recently announced her resignation). Once again, price and value show a strong correlation over longer periods of time. You can see that prior to Sally’s arrival the price of Oroton tracked the somewhat benign performance of estimated intrinsic value. Then, from 2006 onwards, Sally’s efforts at improving the value of the company, which continued to rise up until 2012, were also reflected in Oroton’s expanding share price.

Figure 3. Ten years of intrinsic value, Oroton (MQR A1)

You may be surprised, but I acknowledge that there are critics of the approach to intrinsic value that we follow. Indeed, I am delighted that there are and we should, as has already been suggested by a number of investing luminaries, be endowing chairs to the ongoing study of whatever branch of investing these experts are researching and advocating as an alternative.  

The critics are also necessary for a much more immediate commercial reason. Not only do they help refine one’s ideas, but how else would we be able to buy McMillan Shakespeare recently at $7.25, JBH around $12.00, or Flight Centre below $20.00! If it were universal agreement I was after I would simply tell jokes to children.

The approach works. At Montgomery, we know this to be the case.

Figures 1 through to 4 (just four examples of those that we have for every listed company) confirm what Ben Graham had discovered without the power of modern computing: that in the short run, the market is indeed a voting machine, and will always reflect what is popular, but in the long run, the market is a weighing machine, and price will reflect intrinsic value.

If you concentrate on long term intrinsic values rather than allow yourself to be seduced by short-term prices, I cannot see how, over a long period of time, you cannot help but improve your investing. Ben Graham outperformed the market materially over an extended period of time. By abiding by his most popular edicts, you too are more likely to do the same.

 
Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, blog.rogermontogmery.com. Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of Value.able and learn how Roger Montgomery values the best stocks and buys them for less than they’re worth. Grab the book now at special price!