Tuesday, July 10, 2012

Was Benjamin Graham a Great Stock Picker?

Why should investment advisers (or investment managers) seek to pick individual stocks for their clients (or fund shareholders)?  The goal should be simple - to outperform the stock market, or the particular asset class, net of fees, costs and taxes.  History shows that there are a few great stock pickers - some for shorter periods of time (e.g., Peter Lynch, Bill Miller) and others for longer time periods (e.g., Benjamin Graham, Warren Buffet).  This blog post asks - how great was the "greatest" of them all - Benjamin Graham?

By way of background, Benjamin Graham was an influential investment sage for several decades.  He was a proponent of "value investing" long before statistical analysis was applied to vast volumes of data to reveal the value effect.  (The value effect is, simply put, a statistical probability, with a 80% to 90% (approx.) certainty over any 20-year period of time, that a highly diversified basket of "value stocks" will outperform "growth stocks.)  His writings (including his consumer book, The Intelligent Investor, as well as his influence on investment sages - including Warren Buffet - should not be underestimated.

Benjamin Graham believed in thorough analysis of a company and its underlying business, in order to calculate the value of the underlying business.  Then, the investor should purchase large company stocks that are deeply discounted to the calculated value.  The depth of the discount provides a cushion against errors in the analysis.  His core principles included (but were not limited to): (1) Each business has an underlying value independent of its stock price. (2) The market can be overly optimistic or overly pessimistic. (3) The higher a price you pay for a stock, relative to its underlying value, the lower your long-term returns. (4) NEVER OVERPAY for a stock.

Even then, Benjamin Graham acknowledged that the perspective of the investor must be very, very long in order to invest in equities, given the wide and often prolonged fluctuation in value of the overall stock market.  For example, Benjamin Graham noted that it took 25 years for GE and the Dow Jones Industrial Average to recover the ground lost in the 1929-1932 stock market downturn.  Benjamin Graham correctly noted that the major benefit of investing in common stocks - protection of the investment portfolio against inflation (over most time periods, not all) - was lost if the investor overpaid for stocks.

Benjamin Graham sought out, as an investment manager, stocks with low price-to-book ratios, low price-earnings ratios, and companies in a strong financial position with the prospect that earnings will be maintained over the years.  He was not an advocate of frequent trading ("the more you trade, the less you keep"), and he acknowledged that it could take many, many years for an undervalued ("unpopular") stock to attain its true value.

How did Benjamin Graham do, in applying this methodology?  Quite well.  As manager of the Graham-Newman Corp. portfolio from 1936 to 1956, his portfolio earned 14.7% (gross of taxes), compared to an average annualized return for the S&P 500 (S&P 50, at one point) Index of only 12.2%.

But, just as bank trust departments who run individual stock portfolios for their clients today often compare their investment results to the S&P 500, we must question whether those who compared Benjamin Graham's returns utilized the right index in the comparison.  Running a "value portfolio" is not without risks.  For example, in the Great Depression, value stocks took a far bigger hit than growth stocks - reflective of the fact that value stocks are often undervalued for a reason (often relating to their ability to withstand economic stresses, should they occur, over the long term).

Hence, a more accurate method of comparing Benjamin Graham's stellar 14.7% return would be to compare it against a "large cap value" index.  Of course, back in Benjamin Graham's days, such an index did not exist.  However, Professors Eugene Fama, Sr. and Kenneth French have assembled their Fama-French Large Value Index (ex-utilities).  How did this index do - over the same time period (1936 to 1956)?  15.2% annually - a small but still significant improvement over Benjamin Graham's 14.7% annual return.

(Small cap value stocks, using the Fama-French Small Value Index, ex-util, did even better over the same time period, providing a 16.9% average annualized return - but that would be an unfair comparison, given the different risk characteristics present for this asset class.)

The comparison of Benjamin Graham's portfolio to that of a research index of large company value stocks seems appropriate, with some caveats.  For example, Benjamin Graham's portfolio of stocks typically did not possess more than 30 individual companies at any one time; as a result, in comparison to a broad index containing many more (and perhaps hundreds) of stocks, Benjamin Graham's portfolio did not minimize, as greatly, "specific company risk."  However, given Benjamin Graham's investment philosophy of investing in financially stable companies, with a long history of growing earnings, it might also be inferred that Benjamin Graham's stock portfolio may not have possessed as "deep" a dive into value stocks as the index created by Professors Fama and French (more analysis on this point would be required, assuming the data is available).

What about now?  Can investment managers duplicate Benjamin Graham's efforts - beating the overall market, even if he did not beat a large value index over the same time period?  Yes, and no.

Yes, in the sense that an investment manager can track one of many large cap value indices which exist today.  Many index funds, or other passively managed investment vehicles, exist which provide this type of exposure to the U.S. large cap value asset class with broad diversification and very low total fees and costs.

No, in the sense that selecting a portfolio of only 10-30 stocks likely brings with it risks which Benjamin Graham likely did not have to endure.  These risks result from the many complexities of corporations today, with often diverse operations spread out over the several continents, compounded by corporate accounting rules which contain far too many loopholes.  Time and time again we hear, today, of "aggressive" accounting techniques, even to the point of liabilities being transferred off the balance sheet through the use of affiliated subsidiaries.  The adjusted book value of a corporation's assets is much more difficult to determine, given the presence of risk-taking (or risk-hedging) techniques such as the use of derivatives, and either the application or non-application or misapplication of "mark-to-market" accounting.  The "composite balance sheets" and "composite income statements" presented in the financial reports of the modern-day corporations, which often possess multiple divisions, often frustrates the analysis of a company - applying Benjamin Graham's principles.

And, of course, intentional fraud regarding financial statements seems far more prevalent today, despite reforms attempted by Sarbanes-Oxley.  While the quantity of financial information available today, and the speed at which it is transmitted, is greater, it appears (at least to this observer) that greater "specific company risk" is present due to shoddy accounting practices which have become embedded into the financial reporting system, as well as a corporate culture which focuses on short-term profits, thereby engendering excessive risk-taking and/or fraud.

Many investment managers have tried to duplicate Benjamin Graham's techniques, and yet the majority (net of fees and costs incurred) have failed to outperform the broader market.  When compared to large cap value indices, very, very few have succeeded over the long term.

Despite this, I love active stock pickers.  By their collective tens of thousands of decisions which weigh the valuation of stocks on a daily basis, they make the stock market more "efficient" - in terms of the value of an individual stock relative to other stocks.  This is not to say that the stock market is perfectly "efficient" - but discerning anomalies in the pricing of an individual stock (relative to its peers) is very, very difficult - and likely not worth the added costs incurred.

This is not to say that their are not dimensions of risk that should be explored or utilized in portfolio construction.  The value and small cap effects are just two examples of such risk attributes.  Nor do I mean to say that the stock market, while "efficient" in valuing stocks relative to their peers, is not at times (as Benjamin Graham's "Mr. Market" would say) at times "manic" or "depressed" (i.e., irrational, as to overall valuation levels).

In conclusion, Benjamin Graham was a wise sage.  His shorter book, The Intelligent Investor, is required reading in the intermediate investment planning class this author teaches.  But, having said that, it seems that the best way to replicate Benjamin Graham's portfolio (if that is the desire), in this modern era, is imply to invest in a low-cost, broadly diversified, low-turnover large cap value index fund.  And, as good as Benjamin Graham was during his time, perhaps with the benefit of 20/20 hindsight and the modern evolution of indices his performance - more accurately judged - was perhaps not "stellar" but rather just "good."

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