Stock prices fell during July, only to recover to new highs before the end of the third quarter. Bonds, likewise, fell and then rose. There is nothing particularly remarkable about these events except for the astounding numbers of people who pay attention to them, and the incredible amounts of time expended by some on Wall Street and in the news media in attempting to divine the market's “message” in order to forecast future price movements. “Just one damned thing after another”—to quote one of our former history professors--summarizes our view of the matter.
The point we are trying to make is that there are things which, from our perspective, just needn't be of concern to investors, foremost among them being market fluctuations. We can imagine, however, that many investors, professional as well as non-professional, find themselves perplexed by the information overload we all experience and have difficulty distinguishing what is truly useful input. Because this is a concern of ours, one of the tasks we have set for ourselves in these letters has been to raise the level of consciousness of our readers to enable them to separate the wheat from the chaff and prevent their becoming preoccupied with things less deserving of their attention.
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While experience is always a good teacher and years spent dealing with the markets and their often-colorful players offer invaluable lessons, an appropriate theoretical and psychological preparation lends a considerable advantage to its possessor. Accordingly, we have from time to time in these pages mentioned the work of Benjamin Graham who, with his co-author David Dodd, published the textbook Security Analysis in 1934 and became known as the father of the “value” school of investing. Given the outstanding investment records compiled by Graham and his followers in the succeeding decades, we felt it would be instructive to review some of the history of his work and the principles at the heart of his teachings.
Interestingly enough, Graham's objective wasn't so much to create a particular school of investing as it was to define what “investing” was to begin with. It has perhaps been forgotten that in the early 1930s, in the aftermath of the 1929 crash, serious observers denounced the purchase of common stock as ipso facto speculation and confined investing solely to the purchase of high-grade bonds.
Given what investors had gone through since 1929, such a conclusion was not easy to dismiss. Speculation in all types of securities had reached fantastic levels during the late 1920s, far surpassing anything we have experienced in recent decades even during the frothiest periods. Stocks were especially susceptible to the general bullishness: a consensus view held sway which maintained that the U.S. had entered a “new era” economically that implied unlimited potential for growth. Hence, no price was too much to pay for a stock, since future growth would justify it. The danger inherent in this situation was magnified by the huge amount of debt that had been used to buy stocks. In fact, capital had been sucked into the U.S. markets from all over the world. When the slide began these debts came due, aggravating the catastrophe of 1929-32. At the end of that period, companies which had once sported enormous market valuations could have been acquired at prices representing less than the amount of cash they had in the bank. Although it is something of an extreme example, investors during the years up to 1929 were facing the same predicament we set out to address in our opening paragraphs: what to believe? Do we accept the consensus view, proclaimed in the press and by numerous well-respected financial authorities, that stocks will continue to rise indefinitely? After the deluge, Graham set out to examine these questions, and the general problem of how one should approach the markets and potential investments, in a more systematic and satisfactory way than had hitherto been the case.
We find interesting parallels between Graham's contribution to investment thinking and the work of the fourteenth-century English philosopher William of Ockham who penned the dictum “Entities are not to be multiplied beyond necessity,” which came to be known as Ockham's “razor”. Although the philosophical debates of his time are obscure to most of us today, the “razor” in essence cut out a lot of unnecessary explanations for natural phenomena that lay outside the bounds of ordinary experience -- spirits, humors, etc. -- and contributed to the intellectual transformation that led to the scientific revolution. Like Ockham, Graham tended to focus on what was knowable and measurable to the exclusion of what was merely speculative.
In Security Analysis and other writings, Graham sought to instill a few simple precepts in his readers, among them that shares of stock represent ownership interests in a business and that the value of a business, and that of its stock, can be assessed. Most importantly for investors, he maintained that the purchase of shares at a significant discount from their value builds in a “margin of safety” for the owner in case of miscalculation or negative developments in the future. In contrast to the view prevailing during the 1920s, Graham held that the future was not something to be counted upon, but instead protected against.
Equally important for Graham was an appropriate psychological attitude towards the marketplace. It was, in his view, critically important to avoid being seduced by the fascinations of the markets, as had happened to so many preceding the Crash. Predicting the markets was futile and getting caught up in their emotions dangerous. Graham's investor did neither and instead took a dispassionate view of the markets as a place whose irrational fluctuations can be taken advantage of, since depressed markets offer investors the opportunity to acquire shares with a requisite margin of safety while markets in the midst of bullish excitement offer the chance to liquidate holdings profitably.
In summary, Graham proposed that investments be approached in a business-like manner free from the marketplace emotions and guesswork that eventually get investors into trouble. Securities have value which can be determined in a fashion and careful application of sensible rules to their purchase promises good results at reduced risk. Questions such as “Where is the market going?” just aren't worthy of consideration.
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A national financial newspaper advertises itself as the source of “hard-core” data on stocks -- just the facts. Its competitors, the paper says, are too full of “fluff” that wastes readers' time. Upon examination we find that our hard-core paper contains lots of price charts, terms such as “relative strength” (having to do with short term price movements), and articles touting individual companies. “Fluff,” on the other hand, seems to refer to in-depth stories about particular businesses, industries, managements, government affairs or even scam artists: in other words, the type of material that can help investors learn how a business operates, how much it might be worth and, conceivably, what to avoid. We hope our readers can now distinguish what is truly useful information. For us, finding out why a business does what it does or how much a company might be worth are valuable uses of time. The rest is fluff.
Dennis Butler, MBA, CFA