Value Investing: The Importance Of Studying History by John Chew, CSInvesting
Many outstanding investors have been fanatical students of history because history teaches you to place events into perspective, to understand that industries boom and fade; cycles repeat and human folly is never-ending. Bill Gross of Pimco (The Fixed Income Money Manager) said that the history books in his office have been a better guide to making money in the bond markets than any financial analysis. Seth Klarman, value investor extraordinaire, has endowed a history chair (here: http://www.facinghistory.org/).1 Warren Buffett sat for weeks in the Columbia University Library reading newspapers—including the ads!–from the 1930s to gain a sense of the Great Depression2.
Jim Rogers, the peripatetic investor, speaks about the value of studying history as an investor in the foreword to Financial Reckoning Day Fallout (2009) by William Bonner and Addison Wiggin. Jim Rogers: ?The only other way (besides visiting countries around the world yourself) to know what is going on is to study history. When I teach or speak at universities, young people always ask me: ?I want to be successful and travel around the world; what should I study?
The latest Robinhood Investors Conference is in the books, and some hedge funds made an appearance at the conference. In a panel on hedge funds moderated by Maverick Capital's Lee Ainslie, Ricky Sandler of Eminence Capital, Gaurav Kapadia of XN and Glen Kacher of Light Street discussed their own hedge funds and various aspects of Read More
I always tell them the same thing: ?Study history.
And they always look at me very perplexed and say, ?What are you talking about….what about economics, what about marketing?
?If you want to be successful, ?I always say, ?You‘ve got to understand history. You will see how the world his always changing. You will see how a lot of the things we see today have happened before. Believe it or not, the stock market didn‘t begin the day you graduated from school. The stock market‘s been around for centuries. All markets have. These things have happened before. And will happen again.? (Editor: The players change, but the music never stops).
Alan Greenspan went on record before he left his post at the Federal Reserve saying he had never seen a bubble before. I know in his adult lifetime there have been several bubbles. There was a bubble in the late 1960s in the U.S. stock market; the oil bubble (in the late 1970s); the gold bubble (in the 1980s); the (stock) bubble in Kuwait; the bubble in Japan; the bubble in real estate in Texas. So what is he talking about? Had he not seen those things, he could have at least read some histories…all these things and others have been written about repeatedly.
Another lesson to learn from studying past market cycles is about market psychology. As the late Peter Bernstein observed, ?In their calmer moments, investors recognize their inability to know what the future holds. In moments of extreme panic or enthusiasm, however, they become remarkably bold in their predictions: they act as though uncertainty has vanished and the outcome is beyond doubt. Reality is abruptly transformed into that hypothetical future where the outcome is known. These are rare occasions, but they are unforgettable: major tops and bottoms in markets are defined by this switch from doubt to certainty.
The venerable Ben Graham argued that an investor should “have an adequate idea of stock market history, in terms, particularly, of the major fluctuations. With this background he may be in a position to form some worthwhile judgment of the attractiveness or dangers….of the market.”
John Templeton in the book, The Templeton Way by Lauren C. Templeton, said that understanding the history of the market is a huge asset for investing. This is the case not because events repeat themselves exactly but because patterns of events and the way the people who make up the market react can be typical and predictable. History shows that crises always appear worse at the outset and that all panics are subdued in time. When panics die down, stock prices rise.
The study of past financial history can be a rich source of inspiration and guidance for investors. A historical perspective has always underpinned his (John Templeton‘s) own impressive achievements as an investor. (Introduction to Engines That Move Markets by Alasdair Nairn.
The study of market and economic history is excellent preparation for an investor, but the study of past events without a coherent theory for human action can often lead to confusion. I highly recommend downloading, What Austrian Economics Can Teach Historians by Thomas Woods at the following link: www.mises.org/journals/scholar/woods1.pdf
But no record of facts, no matter how judiciously arranged, interprets itself. ?History,? wrote Ludwig von Mises, ?cannot be imagined without theory. The naïve belief that, unprejudiced by any theory, one can derive history directly from the sources is quite untenable…. No explanations reveal themselves directly from the facts? (2003, pp. 107-108).
An epistemological dualist, Mises denied that methods appropriate to the natural sciences could be employed in the social sciences, where man, rather than inanimate objects, was the object of study. For one thing, the historian did not have the natural scientist‘s advantage of a laboratory in which he could observe the consequences of isolating a single factor. ?[H]istorical experience,? Mises wrote, ?is always the experience of complex phenomena, of the joint effects brought about by the operation of a multiplicity of elements? (Mises 1985, p. 208; Mises 1998, p. 31). With laboratory methods unavailable to him, if he was to make sense of historical events the historian could not approach his subject with his mind a tabula rasa but instead needed some acquaintance with social theory, lest he be overwhelmed by data he was helpless to interpret. ?The ?pure fact‘ – let us set aside the epistemological question whether there is such a thing – is open to different interpretations. These interpretations require elucidation by theoretical insight? (Mises 1990, p. 10).
However—if you study history, past facts and figures, you must have a theory or latticework of mental models in which to understand what you are looking at. If not, you will be lost or even learn the wrong lessons. I strongly suggest learning about Austrian Business Cycle Theory. Many free books are available at www.mises.org. No record of facts, no matter how judiciously arranged, interprets itself. ?History,? wrote Ludwig von Mises, ?cannot be imagined without theory. The naïve belief that, unprejudiced by any theory, one can derive history directly from the sources is quite untenable…No explanations reveal themselves directly from the facts? (2003, pp. 107-108 in Epistemological Problems of Economics. Trans. George Reisman)
Without an economic theory to understand why the Great Depression occurred including its depth of 25% unemployment and length 1929-1946, then you will not gain an understanding of the past to help you anticipate and interpret future events. (Note the date of 1946 rather than 1939. How can anyone count the sending of men, women and material to war and to destruction as economic growth?)
Since we begin with the Great Crash of 19293, investors should understand the true causes behind the market crash rather than just view charts or accept the standard historical explanations for the crash.
Paul Johnson‘s introduction to Fifth Edition of Murray Rothbard‘s America’s Great Depression (A devastating critique on how interventionism and inflationism deepened and prolonged the Depression) is available here: http://mises.org/rothbard/agd.pdf
Here is Paul Johnson‘s Introduction:
The Wall Street collapse of September–October 1929 and the Great Depression which followed it were among the most important events of the twentieth century. They made the Second World War possible, though not inevitable, and by undermining confidence in the efficacy of the market and the capitalist system, they helped to explain why the absurdly inefficient and murderous system of Soviet communism survived for so long. Indeed, it could be argued that the ultimate emotional and intellectual consequences of the Great Depression were not finally erased from the mind of humanity until the end of the 1980s, when the Soviet collectivist alternative to capitalism crumbled in hopeless ruin and the entire world accepted there was no substitute for the market.
Granted the importance of these events, then, the failure of historians to explain either their magnitude or duration is one of the great mysteries of modern historiography. The Wall Street plunge itself was not remarkable, at any rate to begin with. The United States economy had expanded rapidly since the last downturn in 1920, latterly with the inflationary assistance of the bankers and the federal government. So a correction was due, indeed overdue. The economy, in fact, ceased to expand in June, and it was inevitable that this change in the real economy would be reflected in the stock market.
The bull market effectively came to an end on September 3, 1929, immediately the shrewder operators returned from vacation and looked hard at the underlying figures. Later rises were merely hiccups in a steady downward trend. On Monday October 21, for the first time, the ticker tape could not keep pace with the news of falls and never caught up. Margin calls had begun to go out by telegram the Saturday before, and by the beginning of the week speculators began to realize they might lose their savings and even their homes. On Thursday, October 24, shares dropped vertically with no one buying, and speculators were sold out as they failed to respond to margin calls. Then came Black Tuesday, October 29, and the first selling of sound stocks to raise desperately needed liquidity.
So far all was explicable and might easily have been predicted. This particular stock market corrective was bound to be severe because of the unprecedented amount of speculation which Wall Street rules then permitted. In 1929, 1,548,707 customers had accounts with America‘s 29 stock exchanges. In a population of 120 million, nearly 30 million families had an active association with the market, and a million investors could be called speculators.
Moreover, of these nearly two-thirds, or 600,000, were trading on margin; that is, on funds they either did not possess or could not easily produce.
The danger of this growth in margin trading was compounded by the mushrooming of investment trusts which marked the last phase of the bull market. Traditionally, stocks were valued at about ten times earnings. With high margin trading, earnings on shares (dividends), only one or two percent, were far less than the eight to ten percent interest on loans used to buy them. This meant that any profits were in capital gains alone. Thus, Radio Corporation of America (RCA), which had never paid a dividend at all, went from 85 to 410 points in 1928.
By 1929, some stocks were selling at 50 times earnings. A market boom based entirely on capital gains is merely a form of pyramid selling. By the end of 1928 the new investment trusts were coming onto the market at the rate of one a day, and virtually all were archetype inverted pyramids. They had ?high leverage?—a new term in 1929—through their own supposedly shrewd investments, and secured phenomenal stock exchange growth on the basis of a very small plinth of real growth. United Founders Corporation, for instance, had been created by a bankruptcy with an investment of $500, and by 1929 its nominal resources, which determined its share price, were listed as $686,165,000. Another investment trust had a market value of over a billion dollars, but its chief asset was an electric company which in 1921 had been worth only $6 million. These crazy trusts, whose assets were almost entirely dubious paper, gave the boom an additional superstructure of pure speculation, and once the market broke, the ?high leverage? worked in reverse.
Hence, awakening from the pipe dream was bound to be painful, and it is not surprising that by the end of the day on October 24, eleven men well-known on Wall Street had committed suicide. The immediate panic subsided on November 13, at which point the index had fallen from 452 to 224. That was indeed a severe correction but it has to be remembered that in December 1928 the index had been 245, only 21 points higher. Business and stock exchange downturns serve essential economic purposes. They have to be sharp, but they need not be long because they are self-adjusting. All they require on the part of the government, the business community, and the public is patience. The 1920 recession had adjusted itself within a year. There was no reason why the 1929 recession should have taken longer, for the American economy was fundamentally sound. If the recession had been allowed to adjust itself, as it would have done by the end of 1930 on any earlier analogy, confidence would have returned and the world slump need never have occurred.
Instead, the stock market became an engine of doom, carrying to destruction the entire nation and, in its wake, the world. By July 8, 1932, New York Times industrials had fallen from 224 at the end of the initial panic to 58. U.S. Steel, the world‘s biggest and most efficient steel-maker, which had been 262 points before the market broke in 1929, was now only 22. General Motors, already one of the best-run and most successful manufacturing groups in the world, had fallen from 73 to 8. These calamitous falls were gradually reflected in the real economy. Industrial production, which had been 114 in August 1929, was 54 by March 1933, a fall of more than half, while manufactured durables fell by 77 percent, nearly four-fifths. Business construction fell from $8.7 billion in 1929 to only $1.4 billion in 1933. Unemployment rose over the same period from a mere 3.2 percent to 24.9 percent in 1933, and 26.7 percent the following year.
At one point, 34 million men, women, and children were without any income at all, and this figure excluded farm families who were also desperately hit. City revenues collapsed, schools and universities shut or went bankrupt, and malnutrition leapt to 20 percent, something that had never happened before in United States history—even in the harsh early days of settlement.
This pattern was repeated all over the industrial world. It was the worst slump in history, and the most protracted. Indeed there was no natural recovery. France, for instance, did not get back to its 1929 level of industrial production until the mid-1950s. The world economy, insofar as it was ?saved? at all, was saved by war, or its preparations. (I believe this assertion is totally false. How can war—the death of people and the building of armaments that will be destroyed–produce wealth and capital? Unemployed men became conscripted into the war). The first major economy to revitalize itself was Germany‘s, which with the advent of Hitler‘s Nazi regime in January, 1933, embarked on an immediate rearmament program. Within a year, Germany had full employment. None of the others fared so well. Britain began to rearm in 1937, and thereafter unemployment fell gradually, though it was still at historically high levels when war broke out on September 3, 1939. That was the date on which Wall Street, anticipating lucrative arms sales and eventually U.S. participation in the war, at last returned to 1929 prices.
It is a dismal story, and I do not feel that any historian has satisfactorily explained it. Why so deep? Why so long? We do not really know, to this day. But the writer who, in my judgment, has come closest to providing a satisfactory analysis is Murray N. Rothbard in America’s Great Depression. For half a century, the conventional, orthodox explanation, provided by John Maynard Keynes and his followers, was that capitalism was incapable of saving itself, and that government did too little to rescue an intellectually bankrupt market system from the consequences of its own folly. This analysis seemed less and less convincing as the years went by, especially as Keynesianism itself became discredited.
In the meantime, Rothbard had produced, in 1963, his own explanation, which turned the conventional one on its head. The severity of the Wall Street crash, he argued, was not due to the unrestrained license of a freebooting capitalist system, but to government insistence on keeping a boom going artificially by pumping in inflationary credit. The slide in stocks continued, and the real economy went into freefall, not because government interfered too little, but because it interfered too much. Rothbard was the first to make the point, in this context that the spirit of the times in the 1920s, and still more so in the 1930s, was for government to plan, to meddle, to order, and to exhort. It was a hangover from the First World War, and President Hoover, who had risen to worldwide prominence in the war by managing relief schemes, and had then held high economic office throughout the twenties before moving into the White House itself in 1929, was a born planner, meddler, orderer, and exhorter.
Hoover‘s was the only department of the U.S. federal government which had expanded steadily in numbers and power during the 1920s, and he had constantly urged Presidents Harding and Coolidge to take a more active role in managing the economy.
Coolidge, a genuine minimalist in government, had complained: ?For six years that man has given me unsolicited advice—all of it bad.? When Hoover finally took over the White House, he followed his own advice, and made it an engine of interference, first pumping more credit into an already overheated economy and, then, when the bubble burst, doing everything in his power to organize government rescue operations.
We now see, thanks to Rothbard‘s insights, that the Hoover–Roosevelt period was really a continuum, that most of the ?innovations? of the New Deal were in fact expansions or intensifications of Hoover solutions, or pseudo-solutions, and that Franklin Delano Roosevelt‘s administration differed from Herbert Hoover‘s in only two important respects—it was infinitely more successful in managing its public relations, and it spent rather more taxpayers‘ money. And, in Rothbard‘s argument, the net effect of the Hoover–Roosevelt continuum of policy was to make the slump more severe and to prolong it virtually to the end of the 1930s.
The Great Depression was a failure not of capitalism but of the hyperactive state. I will not spoil the reader‘s pleasure by entering more deeply into Rothbard‘s arguments. His book is an intellectual tour de force, in that it consists, from start to finish, of a sustained thesis, presented with relentless logic, abundant illustration, and great eloquence. I know of few books which bring the world of economic history so vividly to life, and which contain so many cogent lessons, still valid in our own day. It is also a rich mine of interesting and arcane knowledge, and I urge readers to explore its footnotes, which contain many delicious quotations from the great and the foolish of those days, three-quarters of a century ago. It is not surprising that the book is going into yet another edition. It has stood the test of time with success, even with panache, and I feel honored to be invited to introduce it to a new generation of readers.
When you read Graham‘s articles during the Great Depression, you will gain insight as to what caused the huge boom and inevitable bust which then led to prices trading well below liquidating asset values by reading, America’s Great Depression at mises.org/rothbard/agd.pdf. I can‘t emphasize the study of the Great Depression enough.
Ben Graham recommends studying market history.
Benjamin Graham‘s interview in An Hour with Mr. Graham by Hartman L. Butler, Jr. from the book, Benjamin Graham Building a Profession, Ed. By Jason Zweig
Hartman L. Butler, Jr. (?HB?): Mr. Graham, what advice would you give to a young man or woman coming along now who wants to be a security analyst and a Chartered Financial Analyst?
Graham: I would tell them to study the past record of the stock market, study their own capabilities, and find out whether they can identify an approach to investment that they feel would be satisfactory to their own case. And if they have done that, pursue that without any reference to what other people do or think or say. Stick to their own methods. That is what we did with our own business (Graham-Newman Corp.). We never followed the crowd, and I think that is favorable for the young analyst. If he or she reads The Intelligent Investor—which I feel would be more useful than Security Analysis of the two books—and selects from what we say some approach which one thinks would be profitable, then I way that one should do this and stick to it.
I had a nephew who started in Wall Street a number of years ago and came to me for some advice. I said to him, ?Dick, I have some practical advice to five you, which is this. You can buy closed-end investment companies at 15% discounts on an average. Get your friends to put ?x‘ amount of dollars a month in these closed-end companies at discounts and you will start ahead of the game and you will make out all right.
……They used to say about the Bourbons that they forgot nothing and they learned nothing, and (what) I will say about the Wall Street people, typically, is that they learn nothing, and they forget everything. I have no confidence whatever in the future behavior of the Wall Street people. I think this business of greed—the excessive hopes and fears and so on—will be with us as long as there will be people.
….There are two requirements for success in Wall Street. One, you have to think correctly; and secondly, you have to think independently.
John Schultz (Forbes Columnist, 1959 – 1976) laid down this simple truth, ?The stock market is rarely ?sensible‘ in commonsense terms. Stock prices have always gone up or down in response to rationalizations rather than reasons, and to levels that, in retrospect, appeared to be un-mistakably excessive and irrational.
These articles will give you a perspective on how to think about prices versus stock market valuation.
Value investing articles
When Ben Graham’s three part series, “Is American Business Worth More Dead than Alive?” was published in Forbes magazine, America, and indeed the world, had gone through the punishing stock market crashes of 1929 and 1930 and was in the depths of the Great Depression. Though the Depression continued until nearly the end of the decade, Graham‘s articles signaled to investors that it was now safe to return to the stock market. At that time, Graham pointed out, more than 30 percent of the companies listed on the NYSE were selling at less than what they would be worth if they were broken up and sold. In this series of articles, Graham took corporate management to task for taking advantage of investors and putting their own welfare ahead of that of the shareholders.
FORBES published a series of three articles by Benjamin Graham written at the bottom of the Great Crash. This is the first, Are Corporations Milking Their Owners?
At its worst level, the Dow dropped to 40.56 in July, 1932. That is a drop of 89%.
See full PDF below.