When was the last time you read something that changed the way you view the world?
It does not happen that often, does it?
The experience can be so profound that it makes you question your core beliefs and doubt your previous thoughts and actions. Once you fully absorb the meaning of the new insights, you wonder how ignorant you were before.
Such an experience happened to me two years ago, when I read Benjamin’s Graham 1976 interview, an interview he gave just before he passed away later that year. I’d like to share with you those 500 words which had turned how I think about the investing 180 degrees. Oh sure, I read that interview many times before, but it didn’t resonate with me. I guess that it’s not enough to be faced with wisdom. You really have to be mentally and intellectually prepared to absorb new insights. And that can take time.
Moreover, Graham’s ideas in that interview are so controversial and contradictory to his previous writings, that it’s easier to dismiss them or even ignore them altogether. Accepting them requires intellectual honesty and willingness to forgo previous beliefs.
In essence, Graham is advising the individual investor to adopt a rule-based systematic investing methodology, suggesting that deep fundamental security analysis is a futile effort. He writes:
I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do
a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”
Please stop here, and reread this text.
Then get up, take a walk, think about it, and come back and reread it again.
Don’t take it lightly.
It may be the most important piece of wisdom you have encountered in your investing life. That was the case for me.
Allow me to explain why I think it is so profound.
You see, Graham is considered to be the father of Value Investing. The book he had co-authored with David Dodd, Security Analysis, published in 1934, revolutionalized the way investors approach common stocks investing. Graham claimed that investors should treat stocks as partial stakes in businesses, rather than merely ticker symbols. He advocated performing in-depth fundamental analysis, researching the financial standings of a company, and searching for discrepancies between its stock price and the intrinsic value of its underlying business.
Graham has invented the Security Analysis profession. Before his time, there were only Statisticians, people that merely looked at dividends and their stability, and occasionally on stock price patterns (a practice known as Dow Theory). Graham had shown, through theory and practice, that spending the time researching company fundamentals and finding those stocks that trade below intrinsic value, can be a very lucrative operation. On these very theories grew generations of venerable billionaire investors, some of which were highlighted in Buffett’s speech, The super-investors of Graham-and-Dodsville.
So how come in his late age, giving his last interview just before he passed away, Graham is dismissing his own lifelong work, which made him a wealthy man and the most respected scholar in the realm of investing?
Graham is saying that the reason for in-depth fundamental analysis to not being practical anymore, is it’s the enormous success it had throughout the 40 years since he published his Security Analysis book. He claims that since there are so many analysts scrutinizing every aspect of almost every stock, the ability of an individual investor to detect and exploit undervaluation is limited.
Alternatively, Graham could have concluded that individual investors should entrust their money to professionals, assuming that those professionals will have the access and capacity needed to perform fundamental research profitably. He could also advocate investing in a market portfolio, a practice which is called today indexing.
But he didn’t.
He made it clear that he is not an advocate of the efficient market hypothesis, meaning that he still believes that the markets are inefficient and that the intelligent investor can still exploit market inefficiencies to generate outsized returns. In fact, he stressed that individual investors have an advantageous position vs. professionals in exploiting those inefficiencies, as they are not subject to career risk.
The interviewer then asks,
What general approach to portfolio formation do you advocate?
Essentially, a highly simplified one that applies a single criterion or perhaps two criteria to the price to assure that full value is present and that relies for its results on the performance of the portfolio as a whole–i.e., on the group results–rather than on the expectations for individual issues.”
In his fantastic response, Graham repeats his notion that investing is “a group operation.” The investor earns excess returns from exploiting stock factors, such as low valuation, quality, smaller size, low beta (also known today as smart beta factors). Graham’s response implies that an investor cannot expect to exploit the idiosyncratic characteristics of individual stocks efficiently, and therefore is better off focusing on common attributes of groups of stocks that have been tested to generate alpha.
Even if you accept that the individual investor is better off investing in simple rule-based methods, wouldn’t expert investors be able to beat the market? Wouldn’t it be better for individuals to entrust their money to those who have the access and skill to analyze individual stocks professionally?
In my honest personal opinion, experts provide no help. Even those that show market-beating track records of 5 and even 10 years, often fail to deliver superior performance consistently over a span of their investing career. Check out Bill Ackman’s Pershing Square Holdings performance. Or David Einhorn’s. After a winning streak of several years, their overperformance has been reversed by a few failed bets.
And those Wall Street sharks employing the best of the best minds in the World.
But what about Warren Buffett? Isn’t he the greatest investor even lived?
Some would say, there is only one Buffett and one Charlie Munger, and you are neither. Don’t try to be one. Others would say (here) that Warren Buffett’s approach, stripped down from all the flare, is essentially investing in low-beta low cheap stocks using Leverage. Using a similar method quantitatively would have resulted in similar results.
As the interview proceeds, Graham outlines examples for such a systematic strategy:
It consists of buying groups of stocks at less than their current or intrinsic value as indicated by one or more simple criteria. The criterion I prefer is seven times the reported earnings for the past 12 months. You can use others–such as a current dividend return above seven per cent or book value more than 120 percent of price, etc. We are just finishing a performance study of these approaches over the past half-century–1925-1975. They consistently show results of 15 per cent or better per annum, or twice the record of the DJIA for this long period. I have every confidence in the threefold merit of this general method based on (a) sound logic, (b) simplicity of application, and (c) an excellent supporting record. At bottom it is a technique by which true investors can exploit the recurrent excessive optimism and excessive apprehension of the speculative public.”
Wow. What is it if not a quantitative method?
And today, with powerful computers and backtesting software at our disposal, we can follow Graham’s advice with greater consistency and predictability.
Throughout the interview, Graham emphasizes that individual investors are in an advantage over institutional investors, in the sense that they are not bound to institutional constraints, and they are free to invest for the long term in both large and prominent companies as well as small and obscure ones.
If Graham was successful in conveying his message, he probably removed your desire delve into SEC filings and stock analysis reports. From now you may doubt expert opinion – can anyone really identify an undervalued stock? And if they can, can they do it consistently? Is it worth the effort?
Those questions resonated in my mind for long months. It wasn’t easy for me to dismiss my previous beliefs that only in-depth fundamental analysis of individual stocks can result in excessive gains. After all, I was educated to believe that hard work bears fruit. That there is no pain without gain. That you must do more work and better work than others if you want to get ahead.
I was even disappointed with Graham. First, he writes this thick book, Security Analysis, and now he dismissed it?
Maybe at his late age, Graham had simply lost his mind?
It is definitely easier to think that Graham had lost it, and wasn’t making sense during his last interview. I thought, maybe he was too old. Perhaps he wasn’t thinking clearly anymore. You know, it happens.
But I couldn’t dismiss thinking that Graham was intellectually honest, and what he said actually made sense. Not surprisingly, it wasn’t just common sense but was supported by hard evidence. The decades of research and investing experience proves Graham’s point:
The quantitative approach to investing wins expert opinion.
For me, it wasn’t easy to change the way I invest. The process of becoming a 100% quantitative investor took me over two years. Gradually I allocated more and more of my own money to time-tested quantitative value and quantitative momentum strategies.
This blog is dedicated to my findings. I have learned a lot along the way of transforming from a fundamental amateur analyst, who used to delve into 10-K’s and listen to company conference calls, to a quantitative investor who program algorithm which prunes SEC filings. There are quite a few insights that I collected along the way. I share some of them on this blog, and others I share only with the most interested individuals who are signed up to my mailing list. If you care to learn what I have discovered over the years, please go ahead and sign up to the mailing list.
I invite you to browse through this website, read and critic. Please do spot inconsistencies and challenge my claims. Your critical comments are very welcomed. If you prefer, send me an email. I read and respond to all the emails I get.