BENJAMIN GRAHAM: THE FATHER OF VALUE INVESTING AND HIS FAMILY

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BENJAMIN GRAHAM: THE FATHER OF VALUE INVESTING AND HIS FAMILY

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.

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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.

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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.

The Value Investing Family - Vintage Value InvestingClick 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.

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Ben Graham, the father of value investing, wasn’t born in this century. Nor was he born in the last century. Benjamin Graham – born Benjamin Grossbaum – was born in London, England in 1894. He published the value investing bible Security Analysis in 1934, which was followed by the value investing New Testament The Intelligent Investor in 1949. Warren Buffett, the value investing messiah and Graham’s most famous and successful disciple, was born in 1930 and attended Graham’s classes at Columbia in 1950-51. And the not-so-prodigal son Charlie Munger even has Warren beat by six years – he was born in 1924. I’m not trying to give a history lesson here, but I find these dates very interesting. Value investing is an old strategy. It’s been around for a long time, long before the Capital Asset Pricing Model, long before the Black-Scholes Model, long before CLO’s, long before the founders of today’s hottest high-tech IPOs were even born. And yet people have very short term memories. Once a bull market gets some legs in it, the quest to get “the most money as quickly as possible” causes prices to get bid up. Human nature kicks in and dollar signs start appearing in people’s eyes. New methodologies are touted and fundamental principles are left in the rear view mirror. “Today is always the dawning of a new age. Things are different than they were yesterday. The world is changing and we must adapt.” Yes, all very true statements but the new and “fool-proof” methods and strategies and overleveraging and excess risk-taking only work when the economic environmental conditions allow them to work. Using the latest “fool-proof” investment strategy is like running around a thunderstorm with a lightning rod in your hand: if you’re unharmed after a while then it might seem like you’ve developed a method to avoid getting struck by lightning – but sooner or later you will get hit. And yet value investors are for the most part immune to the thunder and lightning. This isn’t at all to say that value investors never lose money, go bust, or suffer during recessions. However, by sticking to fundamentals and avoiding excessive risk-taking (i.e. dumb decisions), the collective value investor class seems to have much fewer examples of the spectacular crash-and-burn cases that often are found with investors’ who employ different strategies. As a result, value investors have historically outperformed other types of investors over the long term. And there is plenty of empirical evidence to back this up. Check this and this and this and this out. In fact, since 1926 value stocks have outperformed growth stocks by an average of four percentage points annually, according to the authoritative index compiled by finance professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College. So, the value investing philosophy has endured for over 80 years and is the most consistently successful strategy that can be applied. And while hot stocks, over-leveraged portfolios, and the newest complicated financial strategies will come and go, making many wishful investors rich very quick and poor even quicker, value investing will quietly continue to help its adherents fatten their wallets. It will always endure and will always remain classically in fashion. In other words, value investing is vintage. Which explains half of this website’s name. As for the value part? The intention of this site is to explain, discuss, ask, learn, teach, and debate those topics and questions that I’ve always been most interested in, and hopefully that you’re most curious about, too. This includes: What is value investing? Value investing strategies Stock picks Company reviews Basic financial concepts Investor profiles Investment ideas Current events Economics Behavioral finance And, ultimately, ways to become a better investor I want to note the importance of the way I use value here. It’s not the simplistic definition of “low P/E” stocks that some financial services lazily use to classify investors, which the word “value” has recently morphed into meaning. To me, value investing equates to the term “Intelligent Investing,” as described by Ben Graham. Intelligent investing involves analyzing a company’s fundamentals and can be characterized by an intense focus on a stock’s price, it’s intrinsic value, and the very important ratio between the two. This is value investing as the term was originally meant to be used decades ago, and is the only way it should be used today. So without much further ado, it’s my very good honor to meet you and you may call me…
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