It’s no coincidence some of the greatest investors of all time are prophets of value investing. Each may invest in different assets and securities but almost all of them look through the prism of a business-owner when buying a share, and, not coincidentally, a significant number of them are alumni of the Benjamin Graham School of investment and analysis.
1984 marked the 50th anniversary of Benjamin Graham and David Dodds book titled Security Analysis—the bible of value investing. Warren Buffet wrote an article to celebrate this milestone called “The Superinvestors of Graham and Doddsville.”
The article was based on a speech he gave at Columbia University Business School in May the same year. The speech and article challenged the idea that equity markets are efficient by using a study of nine successful investment funds generating long-terms returns above the market index.
All these funds were managed by disciples of Benjamin Graham following the same ‘Graham-and-Doddsville’ value investing strategy. And each fund was invested in different assets and stocks.
The speech from Buffett was part of a contest. It was a showdown with Michael Jensen, a University of Rochester professor and devotee of the efficient-market-hypothesis.
Jensen argued a simple coin tossing experiment among a large number of investors would generate a few successive winners. And the same happened in real financial markets (according to him).
Buffett grabbed Jensen's metaphor and started his own speech with the same coin tossing experiment. There was one difference. He made note of a ‘statistically significant’ share of the winning minority—the nine investment funds—and their allegiance to the same school of security analysis.
They all followed value investing rules founded by Graham and Dodd 50 years prior.
A Coincidence, or the Real Deal?
The names included in Buffett’s speech were Walter J. Schloss, Tom Knapp, Warren Buffett, William J. Ruane, Charles Munger, Rick Guerin, Stan Perimeter and 11 managers from two funds steering funds for the Washington Post and FMC Corporation super funds.
Buffett took special care to explain the nine funds had little in common but for a value strategy and some personal connections. You could say, without doubt, the managers were truly independent of each other.
Buffett made three side notes in his speech concerning value investment theory:
- He underscored Graham–Dodd's premise: the higher the margin between the price of undervalued stock and its value, the lower an investor’s risk. This is the ‘Margin of Safety’ principle at work. On the opposite end, as margin gets thinner, risks increases.
- Second, potential returns diminish when the size of a fund increases, as the number of undervalued stocks decreases.
- Third, after looking at the background of seven successful managers, Buffett came to the conclusion an individual either accepts value investing strategy at first sight, or never accepts it, regardless of training and other people's examples.
"There seems to be a perverse human characteristic that likes to make easy things difficult... it's likely to continue this way. Ships will sail around the world, but the Flat Earth Society will flourish... and those who read their Graham and Dodd will continue to prosper,” said Buffett.
The ‘Graham-and-Doddsville’ speech from Buffett influenced billionaire investor Seth Klarman's 1991 book called Margin of Safety. The book was cited by Klarman as a principal source for his best seller.
He believed, "Buffett's argument has never, to my knowledge, been addressed by the efficient-market theorists; they evidently prefer to continue to prove in theory what was refuted in practice".[1]
Klarman's book—never reprinted—has achieved a cult status, and now sells for four-digit prices online.
And Buffett, in spite of his god-like reputation in mainstream business press, remains a ghost-like figure in academic circles. A 2004 search of 23,000 papers on economics revealed only 20 references to any publication by Buffett.[2] 20 references out of 23,000 for the third richest man in the world.
A significant share of references simply rejects Buffett's statements or reduce his own success to pure luck and probability theory. William F. Sharpe (1995) called him "a three-sigma event",[3] Michael Lewis (1989) a "big winner produced by a random game.”[4]
On the other hand, Aswath Damodaran, Professor of Finance at the Stern School of Business at NYU, referred to it as a “proof that markets are not always efficient.”[5]
[1] https://www.bloomberg.com/news/articles/2006-08-06/the-700-used-book
[2] http://www.conscious-investor.com/cgi-sys/suspendedpage.cgi
[3] https://rss.onlinelibrary.wiley.com/doi/pdf/10.1111/j.1740-9713.2015.00851.x
[4] https://www.trendfollowing.com/whitepaper/buffett.pdf
[5] http://aswathdamodaran.blogspot.com/2019/02/the-perils-of-investing-idol-worship.html
A Cluster of Superinvestors
Whatever the case, Buffett and other managers from the school of Graham-and-Doddsville proved to be an unusually high concentration of investors using very similar principles they learnt from the same teacher.
One principle they all share in common is the focus on a ‘business-owner’ mindset. Having this mindset helps you get a feel for the ‘margin of safety’ when buying a business.
In an annual letter to shareholders in 1987, Buffett made reference to Benjamin Graham’s Mr. Market parable. He specifically shed some light on the ‘business-owner’ mindset.
“Whenever Charlie and I buy common stocks for Berkshire’s insurance companies, we approach the transaction as if we were buying into a private business.”
Buffett made further reference to the importance of looking at yourself as a, “business analyst—not as market analysts, not as macroeconomic analysts, and not even as security analysts.”
In 1996, Buffett again emphasised the need to view yourself as the “owner of a business,” not just the “holder of a ticket from the securities exchange.”
“Charlie and I hope you don’t think of yourself as merely owning a piece of paper whose price wiggles around daily and that makes you nervous,” Buffett said.
“We hope you see yourself as a part owner of a business that you expect to stay with indefinitely, much as you might if you owned a farm or apartment house in partnership with members of your family.”
The Business Owner Mindset
Why have this type of mindset when it comes to investing?
Surely it would be easier to ride the latest trends and respond to market movements ahead of time?
Well…Buffett believes, “investment success will not be produced by arcane formulae, computer programs, or signals flashed by the price behaviour of stocks and markets.”
He believes an investor will have more chance of succeeding when they “combine good business judgement with an ability to separate your thoughts and behaviour from the wild emotions that characterise the market on a daily basis.”
Interestingly, senior executives have no trouble understanding the value of the business-owner mentality—when focused on a business they operate that is.
For example, a parent company that owns a subsidiary with superb long-term economics is not likely to sell that entity regardless of price. Why would you part with a “crown jewel?” Buffett says.
Yet the same CEOs will cut a stock from their portfolio at the drop of a hat when presented with nothing more than a superficial argument from their stockbroker or an analyst report published by a 26-year-old MBA graduate.
The two worst lines of all from your advisor: “You can’t go broke taking a profit” & “cut your losses, let your profits run”.
Imagine a CEO using this line to urge his board to sell a star subsidiary business, or Warren Buffett selling a great business simply because ‘Mr. Market’ had reduced the value by a pre-ordained percentage?
In the minds of Buffett and Munger and other superinvestors, what makes sense in business also makes sense in stocks: “An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business.”
And they’ve remained true to their philosophy. It’s anything but a passing fad when implemented with zeal for a period of 50 years or more.
Cutting the Flowers and Watering the Weeds
When you think of yourself as the part-owner of a business, you can avoid the temptation of holding on to businesses that chronically disappoint and booking profits on companies because they had a solid first quarter. You wouldn’t do either if you were the owner of the business.
This is akin to, “cutting the flowers and watering the weeds” according to another Graham and Dodds’ disciple, Peter Lynch. Lynch wrote a book called, “One up on Wall St” after his success managing the multi-billion-dollar Magellan Fund at Fidelity—a giant in the world of funds management.
Lynch shares a similar view with Buffett and believes the basic story of the market remains “simple and never-ending.” He says, “Stocks aren’t lottery tickets.”
“There’s a company attached to every share you own.”
“If a company does worse than before, its stock will fall. If a company does better, its stock will rise. If you own good companies that continue to increase their earnings, you’ll do well.”
And Buffett echoes the thoughts of Lynch, “regardless of price, we have no interest at all in selling any good businesses that Berkshire owns.”
“We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations.”[1]
[1] Berkshire Hathaway 2013 Annual Report, pages 105 and 106
Putting It to the Test
There’s a great quote from Warren Buffett to help you determine whether you have a business-owner mindset:
“I say the real test of what you're doing is whether you care whether the markets are open. When I buy a stock, I don't care whether they close the stock market tomorrow or for a couple of years... Now if I care whether the stock market is open tomorrow then I say to some extent I'm speculating because I'm thinking about whether the price is going to go up.”
In theory, it seems so easy. But in practice the great majority of investors would be classified as "speculators" rather than "investors" as defined by these terms.
The more important part to consider is whether or not you act on your emotions. Or will you act in an intelligent and rational manner because you have a business-owner mindset?
The live feed on bid prices in today’s digital world helps to fuel the feeling of speculation. Returning to the analogy of buying a physical asset; think about buying an apartment with the intent of renting a unit.
If you buy it today. You're not waking up the next morning thinking about how much you could turn around and sell it for. Instead you're thinking about finding a tenant, taking care of the property and monitoring the cash flow.
If you buy a commercial property, you're not thinking about trying to find a willing buyer later on that day, or hour, or minute or second. Instead you're thinking about how much it can produce in the coming years, perhaps getting a solid tenant in place and seeing the asset being put to productive use.
Yet, when most of us buy a stock (or partner with a business?) we check in on the share price immediately. Literally seconds after the transaction you get to see how "well" or "badly" you did. Instantly.
You’re Buying a Business
As an investor your job is a lot easier than a speculator. But it is still fundamental. The first goal ought to be checking in on the business performance of your holdings or potential holdings.
This can be influenced by what you see in the day-to-day mass of financial media. If possible, it'd be ideal to separate the function of checking in on a business from looking at the share price.
Once you have an understanding of the business, you can then look to the market to see if it is offering anything that looks particularly attractive or else unappealing.
That's the difference between investing and speculating. Speculating fixates on the price first. Investing looks at the business from the start.
Then you can ask, “Am I a speculator or a business owner?”
Those Little Pieces of Paper
Shares are frequently thought of as nothing more than little pieces of paper being traded back and forth among investors.
This might help prevent investors from becoming too emotional over a given position, but it doesn't necessarily allow one to make the best investment decisions.
Buffett, Lynch, Klarman and other superinvestors have stated again and again that shareholders should think of themselves as "part owners" of the business in which they are investing.
By thinking this way, you’ll tend to avoid making off-the-cuff investment decisions and become more focussed on the long-term. Plus… as a long-term "owner," you’ll tend to analyse situations in greater detail, and put more thought into buy and sell decisions.
This thought and analytical style tends to lead to improved investment returns over the medium-long term (fads come and go in the short-term).
It’s evident in the investment records of Benjamin Graham, Warren Buffett, Charlie Munger, Peter Lynch, John Templeton, Seth Klarman, Bill Ackman, Joel Greenblatt and other great modern-day investors who’ve all adopted the principles of Benjamin Graham.
Stop believing in redundant methods like charting, option trading, and structured, or leveraged, products and the rhetoric from mass financial media.
Instead, picture yourself as the part-owner of a business. This will help you become a successful long-term investor and maybe even a super investor someday.
If you’d like to hear about Leyland Private Asset Management’s approach to long-term value investment then please get in touch with us today. We’ve helped a number of wealthy families and business owners grow and preserve their wealth through good times and bad. We invest for the long-term and our clients remain with us for the long-term.