I wrote a response to Jason Zweig's column on Ben Graham and bank stocks. Now Tom Brown of Bankstocks.com has done the same.
I have to admit, Tom's article is better than mine. Both take Zweig to task for his explanation of why Ben Graham wouldn't be a buyer of bank stocks today. However, Tom's post does a better job of presenting the opportunities and challenges in analyzing bank stocks today:
Zweig's premise seems to be that no one inside or outside a financial services company can ever reasonably value the institution's assets--particularly if the assets are secured by real estate at a time when real estate values are declining on average. The stock's valuation? Irrelevant. Investor sentiment? Beside the point. Rather, Zweig sees the companies as no more than black boxes. By his logic, Graham-style investors (as opposed to speculators) would never own these companies. But we know as a matter of fact that that is not true.
Graham saw every investment as a black box -- and that didn't trouble him. A lot of investors spend a lot of their time worrying about the inner workings of the companies they own -- Graham never did. He didn't look inside the "system," i.e. the company itself; instead he looked only at the outputs -- the financial statements. He spent almost no time worrying about a business's management, corporate culture or future prospects. He didn't worry about competitive advantages. He looked to the balance sheet first. When he moved on from there to consider earnings, his usual approach was to rely heavily on the past record in an attempt to discover what "normal" earnings might look like.
Graham was a rear view mirror guy. His margin of safety was based on making purchases at prices that would've worked well in the past. He liked sure things. For instance, he knew that NCAV stocks were sure things -- and subsequent research continues to support that claim. I mentioned NCAV stocks in my previous post, because they are perhaps Graham's most characteristic investment category. They combine elementary arithmetic and logic in a potentially lucrative but almost certainly safe investment operation. Also, unlike much of what he wrote about in The Intelligent Investor and Security Analysis, Graham actually made NCAV investments during his Wall Street career.
Before we can answer what Graham would do today, we need to know what he did do in his own lifetime. When writing about Graham, one needs to consider three separate categories: what Graham practiced, what Graham preached, and what Graham's principles were.
What Graham Practiced
In The Intelligent Investor, Graham lists the five successful techniques his partnership employed from 1926 to 1956: arbitrage, liquidations, related hedges, net-current asset issues and control investments.
Control Investments
Graham does not discuss control investments in any of his books; however, Geico is a well-known example of a Grahamian control investment.
Arbitrage
Buffett has discussed this techniques in some detail. See especially Buffett's discussion of Berkshire's purchase of Arcata shares. Both Buffett and Graham had stellar results in the arbitrage field, as Buffett explains in his 1988 letter to shareholders:
In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is. (There's plenty of other evidence, also.) While at Graham-Newman, I made a study of its earnings from arbitrage during the entire 1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Graham's arbitrage principles, first at Buffett Partnership and then Berkshire. Though I've not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%.
That's a long history of success. From 1926 to 1988, unleveraged arbitrage returns from Graham's partnerships, Buffett's partnerships and Berkshire averaged better than 20% a year. Since some leverage was employed, actual returns over this 63-year period were even better than 20% per annum. Arbitrage works.
Liquidations
Liquidations are the simplest type of investment there is. You simply buy the stock below the expected final payout and wait for things to wind down. Buffett has invested in liquidations several times — most are not well-known. For a recent example, see Comdisco Holdings (CDCO). For a less recent example, see the Kaiser liquidation (from the 1970s).
Net/Nets
Net current asset issues are not well-known, even today. However, the technique itself is well-known. Jonathan Heller of Cheap Stocks created an index to track (some) NCAV stocks. Since inception, the Net/Net index has outperformed the relevant benchmark. However, it is a very young index.
Related Hedges
Related hedges are not appropriate for individual investors. They belong to a category of techniques that Graham employed with some success, but which have subsequently become far less fertile ground for investors, because modern theory and practice is better able to efficiently price a variety of more complex securities. Basically, Graham would go long a certain company's convertible senior security and go short that same company's common stock. If the stock rose, he would take a small loss. If it dropped sharply, he would make a nice gain. Obviously, these related hedges would provide a performance boost when the rest of Graham's portfolio was struggling (since stock prices in general would be falling) and vice versa.
The first real coup of Graham's career belongs to this category of mispriced special securities. Graham was a low-level employee of Newburger, Henderson and Loeb when he brought up the idea of investing in the bankrupt Missouri, Kansas and Texas Railway. The company's bankruptcy plan gave owners of the old common stock the right (but not the obligation) to buy shares in the new company. This went mostly unnoticed at the time -- or, if it was noticed, speculators were not using the old common stock as a way to play the new MKT. As a result, the old stock traded at just fifty cents. Graham figured that during a strong period for railroads, the old common stock could easily rise three or four dollars -- while the maximum loss on each share would still be just fifty cents. The firm bought into Graham's idea and ended up making $15,000 on its $2,500 investment in less than a year (this was back in 1915 when $15,000 was real money -- perhaps something like $300,000 today).
Graham's partnership was a prototypical hedge fund. For starters, Graham actually hedged. He was short some securities and long others. For a while, he tried a basic long/short value approach, where he went long clearly cheap stocks and when short clearly expensive stocks. However, he found riding out the speculative surges in the stocks he was short to be an extremely unpleasant experience. He also found, over time, that he wasn't especially good at finding stocks to short -- certainly not good enough to get a better overall result (an investor has to be a lot more skilled at going short than going long to make it worth his while to short— if volatility and consistency aren't as important to him as long-term results). Also, since Graham was always invested in an unusual mix of cheap stocks, liquidations, and related hedges, he was able to deliver rather consistent results without resorting to a more conventional long/short strategy. Eventually, Graham took the technique of shorting overpriced stocks out of his repertoire.
For Part II, please click here.
