SINGAPORE (Feb 26): Warren Buffett and Walter Schloss are known for their extraordinary skills in investing. But for every student, there is a master. Who is this master? He is none other than Benjamin Graham, also known as the “father of value investing”. Born in 1894, Graham started his investment journey at the age of 20 after graduating from Columbia University. He is known for authoring The Intelligent Investor (1949) and Security Analysis (1934). The principles and philosophy encapsulated in the book have stood the test of time. But, is his wisdom and principle still relevant today?
Graham once said, “There are two requirements for success in Wall Street. One, you have to think correctly and, second, you have to think independently”. As humans, we are susceptible to what scientists call “herding”. Evolution has favoured herding because it has ensured that humans thrive and survive. In the investment world, however, herding can be a very dangerous thing. Herding has led to many prominent bubbles such as Tulip Mania, the dotcom bubble and the 2007 uranium bubble.
Independent thinking, when coupled with the right information, can help you avoid succumbing to Mr Market’s unpredictable mood.
Graham said: “The essence of investment management is the management of risk, not the management of returns.”
His approach was to buy stocks that were selling below their intrinsic value. On top of that, he also advocated buying a business only when there was sufficient margin of safety. To do that, Graham’s focus was to buy assets (net of all debt) that were worth one dollar for 66 cents and lower. In the event the company went bankrupt, their liquidation value would provide him with a safety net.
Buffett calls this “Cigar-Butt” investing. What this means is that buying cheap stocks is like finding discarded cigar-butts in the streets, where there is one or two good puffs left. Despite the unglamorous term used by Buffett, we find that this strategy still works. As recent as 2009, Victor J Wendl conducted a study by constructing a portfolio that was trading below 75% of the net current asset value (NCAV). Stocks were held for a period of one to five years. The NCAV portfolio gave a return of 19.89%, beating the Standard & Poor’s 500 by over 9%.
Graham tested his own strategy from 1957 to 1970. His portfolio gained a total of 75% against 50% for the S&P 500. Henry Oppenheimer took over the studies from 1970 to 1983. His portfolio generated 29.4% a year against 11.5% for the NYSE Amex index. Tobias E Carlisle, Jeffrey Oxmanin and Sunil Mohantyn then took over the studies from 1983 until 2008. The strategy returned 35.3% every year on average for 25 years. Although the studies are not forward-looking, as they span the past 60 years, we believe the results will provide some confidence in its future performance. These results are not just limited to the US. James Montier examined the performance of all developed markets from 1985 to 2007. The portfolio generated returns of 35% against the average market returns of 17% yearly.
Another strategy of Graham was to buy companies that delivered an earnings yield that was double that of a typical AAA corporate bond. To add in the margin of safety, he also advised a debt to equity ratio of under 50%. He tested the portfolio with a diversified list of stocks from 1926 to 1976. The portfolio generated 15% over the long term. Alpha Architect backtested Graham’s strategy and found that the long-term compound annual growth rates range from 15% to 16.4%.
At Aggregate Asset Management, we are avid students of Graham as well. We have also conducted our own studies and tested his strategies in Asia for more than 10 years. It shows a mean return of 14.22%. We have used his methods in the Asian markets and have generated an average of 11% annual returns, net of all fees. This is a testament to Graham’s principles and philosophies.
We believe that his principles are still alive and well. We will end off with another quote from the father of value investing. “Without a saving faith in the future, no one would ever invest at all. To be an investor, you must be a believer in a better tomorrow.”
Aaron Oh is an investment analyst at Aggregate Asset Management (AAM). AAM is a no-management-fee value manager that serves accredited investors.
