Benjamin Graham, on Security Analysis, and the Efficient Market Theory

[LinusKS]

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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.

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-- circa, 1976.

http://www.bylo.org/bgraham76.html

[DesertCat]

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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.

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-- circa, 1976.



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In 1975, Warren Buffett trailed the market by over 15%, one of his worst relative performance years ever. It was apparently a tough time for value based stock picking. Ben was 82, very close to the end of his life, and always had a conservative outlook. I think his comments reflected the tough current day results.

But in 1976, Buffett ended up beating the market by 35.7%. He followed that with 39.3%, 17.6%, and 17.5% outperformances in the following three years. After Ben said this (and died) Warren established one of his greatest four year spans of outperformance. I think if Ben was interviewed during those years he might have had a different perspective.

Ben's comments are also vague, and can be interpreted in another way. As Warren has said, the market is frequently efficient, just not always efficient. Many efficient market theorists believe in a "weaker" version of the theory that matches Warren's perspective. You could interpret Ben's comments similarly. I really doubt he'd agree with the "strong" version of EMT, that all securities are fairly priced at all times.

[LinusKS]

I've come across three different statements of EMT so far - other than the "strong," "weak," etc. -

The first is that information is quickly, or immediately incorporated into market prices.

For practical purposes, I think this is pretty much indisputable. Certainly you couldn't read an article about gas shortages, and call your broker, and hope to make a profit. By the time you placed your order, prices would have long ago responded to the story. Arguably, prices would have reponded even before the story hit the presses, even if you were somehow the first person to get the paper, since insiders, or friends of insiders, would have moved already.

The second statement is that equities are always fairly priced - or alternatively, that they always closely approximate intrinsic values.

This is a much more interesting statement, and much more subtle & complicated.

The third statement, sometimes said to follow from one or both of the others - is that you can't systematically make a beat the market - that excess profits are the result of luck or good fortune.

What's interesting is the the first two statements are saying entirely different things. And that while the third necessarily follows from the second, it doesn't from the first.

The problem with the second statement - that markets always fairly value securities - is that there any number of historical examples of markets not fairly valuing securities. The dot-com craze, the tulip bulb mania, etc. are all examples of speculators driving prices well beyond any reasonable approximation of value.

The problem of speculative bubbles, though, is that they're very hard to take advantage of.

The Graham & Dodson investor stays away from speculative bubbles, because he buys securities that represent value. He might be able to avoid losing money in a bubble, but he can't profit from one. The problem for a fundamentalist is that he can short bubbles, and he can buy put options, but those things don't pay dividends, and you can't hold them indefitely. Those two things - the willingness to hold a security indefinitely, and ability to profit from an investment, whether or not the market gets around to valuing it correctly - are what makes value investing so profitable in the first place.

To put it differently - that a bubble will pop might be pretty close to a certainty. When it will happen might be something else entirely. Speculators might well bankrupt you, long before they run out of money themselves.

Buffet - who stayed out of the internet bubble - did not, to my knowledge, figure out a way to profit from it.

In other words, it's possible markets might sometimes - or even often - behave irrationally, without giving investors opportunities to take excess profits, so long as markets confine themselves to excess exuberance & confidence.


BTW, according to Buffet's recent newsletter, he's beat the market in all but 6 of the past 40 years. That's a pretty frikken good record. According to my - possibly entirely inaccurate calculations - the chances of doing that well or better is only about 1 in 25,000.

[DesertCat]

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Buffet - who stayed out of the internet bubble - did not, to my knowledge, figure out a way to profit from it.

BTW, according to Buffet's recent newsletter, he's beat the market in all but 6 of the past 40 years. That's a pretty frikken good record. According to my - possibly entirely inaccurate calculations - the chances of doing that well or better is only about 1 in 25,000.

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Buffett doesn't believe in shorting, so he couldn't take much advantage of the Internet bubble. But there was a huge over correction afterwards, and he made some large profits from junk bonds and specifically from providing very high yield debt to Level 3 Communications.

He also was able to make substantial profits during the 1987 crash caused by irrational portfolio insurance, and during the 1970s bear market. It's not all bubbles, irrationality works both ways.

And 1 in 25k radically understimates the likelyhood of Buffetts results being from pure chance for several reasons. First, if you include the Buffett Partnership, he's actually something like 44 out of the last 50 years. And he didn't beat the market by a slim percentage, he's whipped it. A guy who's averaging 1% better than the market is much more likely to be lucky than a guy who's doubled the market's returns.

For example, assume you find an investor who trails the market two out of every three years. But overall, his cumulative results beat the market by about 20% a year because his good years he crushes the market, and his bad years he only trails by a little. If he does this for twenty five years he's clearly a skillful investor. Of course an EMT guy would agree, but say it doesn't matter because it's too late, the guy is either close to retirement, or managing too much money now to be able to outperform.

Beating the market x years out of y isn't a good measure. Cumulative performance is the best way to look at an investors results.

[LinusKS]

I agree with you. If anything, the extent to which he's out-performed the market is even more impressive than his consistency.

Buffet had this to say in his 1999 report:

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Please note that I spoke of hoping to beat the S&P “modestly.” For Berkshire, truly large superiorities over
that index are a thing of the past. They existed then because we could buy both businesses and stocks at far more
attractive prices than we can now, and also because we then had a much smaller capital base, a situation that allowed
us to consider a much wider range of investment opportunities than are available to us today.

Our optimism about Berkshire’s performance is also tempered by the expectation — indeed, in our minds,
the virtual certainty — that the S&P will do far less well in the next decade or two than it has done since 1982. A
recent article in Fortune expressed my views as to why this is inevitable, and I’m enclosing a copy with this report.

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I haven't found the Fortune article, yet. :-(

His observation - that securities were more attractively priced earlier in the twentieth century that they are today - seems like an accurate one to me. And it has some discouraging implications for people who take historical market returns as an indication of what we should expect in the future. I'm curious what you think.

[DesertCat]

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His observation - that securities were more attractively priced earlier in the twentieth century that they are today - seems like an accurate one to me. And it has some discouraging implications for people who take historical market returns as an indication of what we should expect in the future. I'm curious what you think.

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There are two different issues here. One is that he's gotten too big to take advantage of the areas of biggest mispricing, which occur in smaller cap stocks. I think that's most of his performance return decline. To be sure, with computers and great knowledge, he's probably right that in absolute measurements there were probably more opportunities a few decades ago than now. But from my vantage point, in the smaller end of the market there are still enough mispricings to make it worthwhile for the enterprising investor.

If I remember his S&P 500 article I think it revolved around PE ratios and implied yields. By 1999 the market had gotten so expensive (eventually PE's reached around 35 or so) that he felt it was clear that the average PE would have to decline, ergo, lower returns in the future. And he has so far been proven right.

My guess is that we still haven't gotten all of it out of the system. I believe the typical PE historically has been around 15, and that the S&P is still a little higher. There are some counter arguments that our more attractive tax rates mean make higher PEs reasonable, so maybe the new median is 20, which would imply a brighter future.

I don't spend much time worrying about any of it. I don't buy many big caps, and I just worry about the PE and value of the particular stocks I'm buying today, not what's happening in the vast universe I'm not buying. Best of luck, dc.

[buffett]

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I haven't found the Fortune article, yet. :-(

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this?