In 2018 during my master’s studies at Lund Uni I read Ben Graham’s magnum opus, “Security Analysis”. His more famous book, “The Intelligent Investor”, is one of the major reasons for writing this blog. In this post, we’ll walk through Security Analysis and some of its greatest takeaways.
The “Red Pill” of Investing
In the 1999 sci-fi action movie “The Matrix” there is a scene where the protagonist Neo is offered two pills. Blue and red. By taking the blue pill, your story ends and you live in a fantasy world, detached from reality. If you take the red pill, the real world will be exposed to you. It may be shocking, horrifying or relieving, but once you’ve taken it, there’s no going back.
The Dean of Wall Street
Benjamin Graham (May 9, 1894 – September 21, 1976) was known as the “father of value investing”. Though he wrote his books long ago, they still influence investors today, including famous names such as Bill Ackman and Seth Klarman. As a teacher at Columbia University, his most famous student was the oracle himself, Warren Buffett. Legend has it, that Warren was the only student to receive all A’s from Graham. Why was Graham so influential? What were his key investing philosophies? And if people know them, why aren’t they practiced by the majority?
Buy Companies, Not Stocks
Though Graham’s books are filled with case studies and examples of companies from the days of yore, there are some key philosophical truths that still apply. The first one is that the investors should not view stock prices as anything else than just that. Price. All the price tells you is if a company is outrageously expensive, cheap, or somewhere in between. Price alone does not give any indication to the underlying business. Stocks represent ownership interest in a real business. Therefore, you must have an owner mindset with all securities you buy. A shrewd businessman looking to buy an entire non-listed operation would look at its financial statements, evaluate the longevity of the business and try to pay as little as possible for what it’s worth. Why should you buy stocks with any other mindset?
Margin of Safety
Graham defined investment as follows:
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
If you should live by one investment rule, it’s margin of safety. The quote states: “Promises safety of principal”. By securing the safety of the principal, you create the opportunity for “adequate return”. Thus, if you can figure out what a business is worth, and pay a lot less, you have a big margin of safety. If you cannot figure out what a business is worth, forget it and move on. As the final part of the quote says: “Operations not meeting these requirements are speculative”. Mohnish Pabrai has a wonderful twist on Graham’s quote:
“The return of capital is more important than the return on capital.”
The below image illustrates exactly what it means to buy with a margin of safety, and protect your investment.
Why We Don’t Adhere
So now you say, “Of course! We should buy low and sell high! That’s easy, everyone knows that!”.
If everyone knew this and behaved rationally, we would never have under or overpriced securities. Just look at the ridiculousness going on now with “meme stocks” and the like. Is this rational behavior or rampant speculation? I understand that many participants in this circus know it’s a gamble. And therein lies the fault of why we don’t adhere to the margin of safety, or “buying low, selling high”.
People love to speculate. It’s hard wired in our DNA. We speculate on everything. We speculate on the future of our lives, our peers, friends, family, society and everything in between. Everyone seems to have a “gut feeling” on everything. We believe we know more than the next person. This trait of human nature spills into markets, and causes irrational behavior. Now, if you can detach yourself from this, you have a massive advantage. But for most people, this is intensely difficult.
Mr. Market
One of the most important concepts coined by Ben Graham is “Mr. Market”. If you truly internalize this idea, you’ll behave in a totally different manner from most market participants.
Mr. Market is a fellow who arrives at your door on weekdays during working hours. Every day he shows his wares. Thousands of companies at different prices. He’s definitely an opinionated fellow. Some he loves, some he loathes. Some are somewhere in between. This is reflected in the price of the businesses. The darlings are dear and fetch a pretty penny. The (perceived) underperforming businesses are priced low. But Mr. Market doesn’t understand that expectations alone doesn’t equal a good or bad investment. The main determinant of a good or bad investment is the price you pay. No matter how wonderful a business, it’s not worth an infinite price. And no matter how terrible a business, there is always a price too low compared to underlying, realizable value. Since Mr. Market likes instant gratification, in many instances he can’t visualize business performance beyond 6 months.
Mr. Market is known to have wild mood swings and his trademark behavior is one of unpredictability. This unpredictability coupled with short-term perspective gives the intelligent investor an enormous advantage. However, this advantage will quickly turn to a handicap if you take take advice from Mr. Market, rather than treating him as a servant. Always remember that your interests will never be aligned. You want to get as much value for your money as possible. The only way to do this is to be patient, and wait for Mr. Market to give you a true bargain.
Graham’s famous student Warren Buffett has said he’d only teach two courses in finance. 1. How to value a business. 2. How to think about markets. This second course is a reference to Mr. Market.
Why We Don’t Adhere
Human beings are biologically wired to be a pack animal. Over the course of our evolution, it’s been much safer to be in the group than to be alone. A rising stock is a sign of the herd being bullish. This draws the attention of others, and as they participate, the stock moves higher. This rise in price signals to the brain that the herd is moving upward. It’s safe here. But the higher the price goes and detaches from fundaments, the riskier it becomes. Now the company must continue to outperform in order to justify its lofty price. This sets the stage for an inevitable drop. No one knows when it will come, but as sure as the sun rises in the east, it will come. Stein’s Law applies to stocks: “If something cannot go on forever, it will stop.”. But seeing other people make money is so intolerable to so many, we humans just cannot resist the temptation to join the party.
A downtrodden stock laced with pessimism is one that the herd has left. No green pastures here. So the price is low. Most people believe that volatility or a price decline equals more risk. This implies that risk is quantifiable. In truth, the lower the price goes, the less risky a stock becomes. There is a low enough price where even a bankrupt company has salvageable value. Enlightened investors understand that risk is not knowing what you’re doing, and doing it anyway. Still, a drop in price alone does not indicate a buy. In order to do well, you need to stick to your circle of competence religiously.
Many notable value investors believe that in order to do well in markets, you have to “wired” in a particular way. What they mean is that you need a high degree of independent thought and the willingness to go against the crowd. To “ignore the street”. A common trait among many value investors is that they don’t care what the crowd thinks. And they don’t care if they “look foolish” to others.
Management and Qualitative Factors
To paraphrase Security Analysis’ take on evaluating management; it’s quite difficult. Objective tests of managerial ability are few and far from scientific. In most cases, the investor must rely on a reputation which may or may not be deserved. The most convincing proof of capable management lies in a superior comparative record over a period of time. The past average cannot be assumed to be repeated, but it is logical to conclude that it supplies a rough index to what may be expected of the future.
Most people have fairly definite notions as to what is a “good business” and what isn’t. These views are partly based on the financial results, partly on knowledge of specific conditions in the industry, and partly also on surmise or bias. Abnormally good or abnormally bad conditions do not last forever. This is true not only of general businesses but of particular industries as well. Corrective forces are often set in motion which tend to restore profits where they have disappeared, or to reduce them where they are excessive in relation to capital. The qualitative factor in which the investor should be most interested in is that of inherent stability. For stability means resistance to change and hence greater dependability for the results shown in the past.
Though Ben Graham’s approach was almost exclusively quantitative, you can read through the pages of Security Analysis and see that he understood the importance of moats. Back in his day, the term “competitive advantage” didn’t exist, and it would be over a decade before Michael Porter would even be conceived.
Why We Don’t Adhere
Evaluating management is difficult. Even if you got to meet them, do you think they would give an honest assessment of their business? Would they tell you where they’re struggling? Would they tell you what the competition is doing better? Investors need to understand that incentives guide behavior. If management is incentivized to to behave in value destroying ways, don’t be surprised when it happens. Thankfully, public companies are required to disclose executive compensation and the metrics they use as incentives to deliver value. Though this information is public, most investors don’t look into this.
Executives usually rise to the top because they are great salespeople. They have a halo effect, and their charisma charms the investment crowd. Take Elon Musk as an example. No one is denying that he is an exceptional entrepreneur. But it’s prudent to ask yourself if he’s incentivized to maintain or increase Tesla’s ridiculous stock price.
Great management is not a cure-all solution for all business ailments. If the underlying economics of the business is foul, it’s usually the stench of the business that lingers, not management’s eau de parfum. Warren Buffett, quotable as always, has said:
“When buying companies or common stocks, we look for first-class businesses accompanied by first class managements. That leads right into a related lesson: Good jockeys will do well on good horses but not on broken down nags.”
Conclusion
Though the case examples in Security Analysis may not be applicable today, the core philosophies will always remain relevant. If you understand that stock represent a piece of a business, that price and value are not always in equilibrium, and that Mr. Market has wild mood swings, you’re well on your way in becoming a better investor. The professional crowd who get to have one-on-ones with executives don’t have an advantage over you. Famous value investor Irving Kahn never met with management in the companies he invested in. And his track record was phenomenal.
The key is knowing yourself, and the boundaries of your competence. In investing, it doesn’t matter how large your circle of competence is. As long as you stay within it obsessively.
- Principle for the untrained security buyer: Do not put money in a low-grade enterprise on any terms.
- Principles for the securities analyst: Nearly every issue might conceivably be cheap in one price range and dear in another.
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
Sir John Templeton – Wisdom From Global Value Investing Legend
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
If you wan’t to support my writing endeavours, click the green “Subscribe” link below to be notified on all my future posts. It’s completely free, and you’ll be richer, wiser and happier. Cheers!
