Benjamin Graham is often referred to as “the father of investing” – and for good reason.
Warren Buffett was one of Graham’s students at Columbia University (and the only one to have ever received an A in his class). Many other value investing legends, like Bill Ruane, Irving Kahn, and Walter Schloss, were also disciples of Benjamin Graham.
Although Graham started working at Columbia Business School in 1928, his works and teachings – which include Security Analysis (published in 1934) and The Intelligent Investor (published in 1949) – remain as relevant and useful today as they did 65+ years ago.
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More
And yet, as Andrew Hunt (portfolio manager and author of Better Value Investing) points out, Graham’s works and teachings were not the last word on value investing.
Since Graham’s classic books were first published, many investors, researchers, and writers have taken up his ideas and developed them in ways even the Dean of Wall Street could not have imagined.
Therefore, to really understand Ben Graham, you have to meet the whole family.
Click to enlarge.
The above graphic, which I adapted from an article by Andrew Hunt, shows the different ways that Ben Graham’s ideas have been used over the past 6+ decades.
BENJAMIN GRAHAM’S CHILDREN
If Graham is the father of value investing, then his children (the names in blue in the graphic) are those value investors who applied his ideas in the stock market. According to Hunt, this generation includes:
- Those who developed Graham’s principles of valuation (namely Warren Buffett and Charlie Munger): Many of Graham’s tools – such as liquidation value – were pretty crude. Investors like Warren Buffett and Charlie Munger refined them by applying additional factors – such as franchise value, management quality and capital allocation – in the assessment of intrinsic value.
- Those who applied Graham’s ideas to new situations: For example, investors like John Templeton showed how well value investing could work in international stocks, including emerging markets. Others, like Joel Greenblatt and Seth Klarman, applied the principles to special situations, such as bankruptcy securities, spinoffs, and complex structures.
- Researchers who have back-tested and proved Graham’s theories on cheap stocks (such as net-nets, low P/E, and low P/B stocks): In Graham’s day, the computing power was not there to thoroughly check his quantitative theories. However, beginning in the late 1970s with Eugene Fama and Kenneth French, many researchers have since found that buying cheap stocks is incredibly effective.
BENJAMIN GRAHAM’S GRANDCHILDREN
Graham’s observations often hinted at the human difficulties of investing (“the investor’s greatest enemy is likely to be himself”). The next generation of children – the “grandchildren” – (in red) answered the question of why the opportunities that Ben Graham found in the stock market existed at all.
There are four branches of explanation (which aren’t at all mutually exclusive):
- Behavioral finance: Probably the most famous explanation behind mispriced stocks, behavioral finance is concerned with the instinctive biases that our brains use in making decisions. When lots of people fall prey to the same biases, the result is an undervalued or overvalued opportunity. Behavioral biases include things like recency bias (giving too much weight to recent events), over-extrapolation (believing a trend will carry on just because it has done so in the past), and herding (following the actions of others). Well known pioneers in the field of behavioral finance include Daniel Kahneman, Amos Tversky, and James Montier.Read: 9 Cognitive Biases You Need to Understand to Master Your Money for more on this topic.
- Neuropsychology: A growing area related to behavioral finance, neuropsychology explains how decision-making can become impaired due to chemical imbalances in the brain. For example, cortisol – a natural chemical released in response to stress – impair both the learning function and the ability to assess probabilities, while dopamine can cause investors or traders to take on excessive risk. Writers such as John Coates and Jason Zweig have written some fascinating books, articles, and YouTube videos applying neuropsychology to financial markets.
- Institutional biases: Because most financial markets are now dominated by large institutional investors, their structures and biases can in turn create inefficiencies. These biases include things like shunning small or illiquid opportunities, selling holdings with headline risks, or groupthink caused by committee decision making.
- Reflexivity: Reflexivity explains bubbles and busts in terms of self-reinforcing flows of capital. For example, when investors and speculators threw money at the housing market, this pushed up prices and made it look like a safe and strong investment choice, thereby encouraging more people to push capital into the market – eventually creating a bubble. When the bubble bursts, the same self-feeding spiral goes into reverse, with falling prices encouraging everyone to view it as a dangerous place and to withdraw their capital. The most famous advocate of reflexivity theory is the billionaire George Soros. Many of his big bets have incorporated reflexivity theory.
BENJAMIN GRAHAM’S GREAT-GRANDCHILDREN
Finally, Benjamin Graham’s “great-grandchildren” (in green) have focused on how best to develop your organization or your own personality in order to overcome the obstacles explained by his “grandchildren” and to put value investing concepts into practice like Graham’s “children”.
Hunt notes that this is the youngest and most dynamic area in the evolution of Graham’s teachings, and encompasses a very broad range of theories and thinkers:
- Organizational Culture: Some of the most successful long-term value investment firms have written extensively on how to create the right culture and attract the right clients to make value investing possible. Some of the clearest examples are Howard Mark’s memos at Oaktree, Seth Klarman’s writings and talks on his Baupost Fund, and Richard Lawrence’s presentations at Overlook Partners.
- Checklists: Other value investors – most notably Mohnish Pabrai – have espoused using checklists as a key part of their value investing process. Checklists are an innovation borrowed from the airline industry and described by surgeon Atul Gawande in his best selling book, “The Checklist Manifesto“. Simple and objective checklists can be used by investors to cut out their most common mistakes and omissions.
- Positive Psychology: Still other investors have drawn on the positive psychology movement, which explains how an optimistic and happy mindset can lead to superior decision making, creativity, and more rewarding relationships.
- Intellectual Development: Finally, there are popular blogs like Farnam Street that focus on personal development and decision making, drawing on everything from the writings of Graham, Buffett, and Munger to Greek philosophy and quantum physics. And there are investors like Guy Spier, whose book “The Education of a Value Investor” deals almost exclusively with developing the right personality and temperament to invest successfully.
WHAT’S NEXT FOR VALUE INVESTING?
Well, value investing has recently found its way into sports.
As made famous in the book and then movie Moneyball, Billy Beane’s strategy of using certain statistics like on-base percentage and slugging percentage – rather than the more popular and headline-grabbing stats like number of home runs and stolen bases – to find baseball players that were “undervalued” by other teams allowed the Oakland Athletics to become one of the best teams in baseball on a payroll that was only a third the size of many other teams’. This strategy has since been replicated by other professional sports teams.
Where else do you think might value investing could be applied? Tell us about it in the comments section below.
