An investment in knowledge pays the best interest
- Benjamin Franklin -
Whether it’s nature or nurture (we think it’s more nature), we find it very difficult to spend money on expensive things. The cheaper we can get something at, the better – as long as it can serve its purpose.
That’s why Benjamin Graham makes so much sense to us. Graham was the father of value investing, and together with David Dodd, authored the value investor’s bible Security Analysis in 1934.
It was Graham’s view that equity securities should be regarded as a part share in a business. To succeed in investing, an investor should thoroughly analyse a security’s financial statement to determine a conservative valuation for the security. If the price of the security is available in the market at a sufficient discount to the rough valuation to provide a margin of safety, the security could be purchased. This is the essence of “value” investing.
The issue with finding a “fair or intrinsic value” of a stock is that we have to estimate it through some proxy, a model populated by imperfect, backward-looking information, and we must make assumptions about the future. Change the assumptions, and we change our estimate of “intrinsic value”.
And after we arrived at the “intrinsic value”, the market somehow has to come round to our view that this is indeed the “intrinsic or fair” value of the stock.
When and whether the market will agree is uncertain.
But empirically, there is incontrovertible evidence that value stocks as a basket revert to fair value – in the process generating above market returns for investors.
Some 40 years after the publication of Security Analysis, Graham modified his approach in an important way. When asked in one of his last interviews whether he still selected stocks by carefully studying individual issues, Graham responded:
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. To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors.
Instead, Graham promoted a highly simplified approach that relied for its results on the performance of the portfolio as a whole rather than on the selection of individual issues. Graham believed that such an approach “[combined] the three virtues of sound logic, simplicity of application, and an extraordinarily good performance record.”
Graham said of his simplified value investment strategy:
What’s needed is first, a definite value for purchasing which indicates a priori that you are acquiring stocks for less than they are worth. Second, you have to operate with a large enough number of stocks to make the approach effective. And finally, you need a very definitive guideline for selling.
Graham’s thoughts above, as captured in the book Quantitative Value – A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioural Errors, succinctly described our process.
Another scholar whose thinking influenced us a lot is Nassim Nicholas Taleb, he of Fooled by Randomness and The Black Swan: The Impact of the Highly Improbable fame. He drove home the point that there is a lot of randomness in the world. Hence we are obsessed with not leaving anything to luck.
As such we take a probabilistic approach to valuation and construct a large enough portfolio. We rely on “the law of large numbers” – a law which states that the more observations we make, the closer our sample will be to the population, and hence the greater the certainty of our prediction – to construct portfolios of securities that would, in aggregate, outperform the market.
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