Who Makes Value Stock Picks?
Edited from Buffett’s essay in 1984 promoting value investing which offers a fascinating study of how Graham’s disciples [Buffett's teacher] have used value investing to realize phenomenal success in the stock market.
Is the Graham and Dodd “look for values with a significant margin of safety relative to prices” approach to security analysis out of date? Many of the professors who write textbooks today say yes. They argue that the stock market is efficient; that is, that stock prices reflect everything that is known about a company’s prospects and about the state of the economy.
There are no undervalued stocks, these theorists argue, because there are smart security analysts who utilize all available information to ensure unfailingly appropriate prices. Investors who seem to beat the market year after year are just lucky. “If prices fully reflect available information, this sort of investment adeptness is ruled out,” writes one of today’s textbook authors.
Well, maybe. But I want to present to you a group of investors who have, year
in and year out, beaten the Standard & Poor’s 500 stock index. The hypothesis
that they do this by pure chance is at least worth examining. Crucial to this
examination is the fact that these winners were all well known to me and
pre-identified as superior investors, the most recent identification occurring
over fifteen years ago.
I think you will find that a disproportionate number of successful
coin-flippers in the investment world came from a very small intellectual
village that could becalled Graham-and-Doddsville. A concentration of winners
that simply cannot be explained by chance can be traced to this particular
intellectual village. In this group of successful investors that I want to consider, there has been a
common intellectual patriarch, Ben Graham.
The common intellectual theme of the investors from Graham-and- Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market. The investors simply focus on two variables: price and value.
I always find it extraordinary that so many studies are made of price and volume behavior, the stuff of chartists. Can you imagine buying an entire business simply because the price of the business had been marked up substantially last week and the week before? Of course, the reason a lot of studies are made of these price and volume variables is that now, in the age of computers, there are almost endless data available about them. It isn’t necessarily because such studies have any utility; it’s simply that the data are there and academicians have worked hard to learn the mathematical skills needed to manipulate them. Once these skills are acquired, it seems sinful not to use them, even if the usage has no utility or negative utility. As a friend said, to a man with a hammer, everything looks like a nail.
I think the group that we have identified by a common intellectual home is
worthy of study. Incidentally, despite all the academic studies of the
influence of such variables as price, volume, seasonality, capitalization size,
etc., upon stock performance, no interest has been evidenced in studying the
methods of this unusual concentration of value-oriented winners.
The first example is that of Walter Schloss where his
partnership compounded a 23,104.7% return versus 887.2% for the S&P.
Walter never went to college, but took a course from Ben Graham at night at the
New York Institute of Finance.
He has no connections or access to useful information. Practically no one in
Wall Street knows him and he is not fed any ideas. He looks up the numbers in
the manuals and sends for the annual reports, and that’s about it. In
introducing me to [Schloss] Warren had also, to my mind, described himself. “He
never forgets that he is handling other people’s money and this reinforces his
normal strong aversion to loss.” He has total integrity and a realistic picture
of himself. Money is real to him and stocks are real—and from this flows an
attraction to the “margin of safety” principle.
Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does. He doesn’t worry about whether it’s January, he doesn’t worry about whether it’s Monday, he doesn’t worry about whether it’s an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again. He owns many more stocks than I do—and is far less interested in the underlying nature of the business: I don’t seem to have very much influence on Walter. That’s one of his strengths; no one has much influence on him.
The second case is Tom Knapp, who also worked at Graham-Newman with me and a Limited Partners return of 936.4% versus 238.5% for the S&P. Tom was a chemistry major at Princeton before the war; when he came back from the war, he was a beach bum. And then one day he read that Dave Dodd was giving a night course in investments at Columbia. Tom took it on a noncredit basis, and he got so interested in the subject from taking that course that he came up and enrolled at Columbia Business School, where he got the MBA degree. He took Dodd’s course again, and took Ben Graham’s course. Incidentally, 35 years later I called Tom to ascertain some of the facts involved here and I found him on the beach again. The only difference is that now he owns the beach!
In 1968 Tom Knapp and Ed Anderson, also a Graham disciple, along with one or
two other fellows of similar persuasion, formed Tweedy, Browne Partners. Tweedy, Browne built that record
with very wide diversification. They occasionally bought control of businesses,
but the record of the passive investments is equal to the record of the control
investments.
The Sequoia Fund which had a
775.3% compound return versus 270% for the S&P, and is managed by a man whom I
met in 1951 in Ben Graham’s class, Bill Ruane. After getting out of Harvard
Business School, he went to Wall Street. Then he realized that he needed to get
a real business education so he came up to take Ben’s course at Columbia, where
we met in early 1951. Bill’s record from 1951 to 1970, working with relatively
small sums, was far better than average. When I wound up Buffett Partnership I
asked Bill if he would set up a fund to handle all our partners, so he set up
the Sequoia Fund. He set it up at a terrible time, just when I was quitting. He
went right into the two-tier market and all the difficulties that made for
comparative performance for value-oriented investors. I am happy to say that my
partners, to an amazing degree, not only stayed with him but added money, with
the happy result shown. There’s no hindsight involved here. Bill was the only
person I recommended to my partners, and I said at the time that if he achieved
a four-point-per-annum advantage over the Standard & Poor’s, that would be
solid performance. Bill has achieved well over that, working with progressively
larger sums of money. That makes things much more difficult. Size is the anchor
of performance. There is no question about it. It doesn’t mean you can’t do
better than average when you get larger, but the margin shrinks. And if you
ever get so you’re managing two trillion dollars, and that happens to be the
amount of the total equity evaluation in the economy, don’t think that you’ll
do better than average!
I should add that in the records we’ve looked at so far, throughout this whole period there was practically no duplication in these portfolios. These are men who select securities based on discrepancies between price and value, but they make their selections very differently. Walter’s largest holdings have been such stalwarts as Hudson Pulp & Paper and Jeddo Highland Coal and New York Trap Rock Company and all those other names that come instantly to mind to even a casual reader of the business pages. Tweedy Browne’s selections have sunk even well below that level in terms of name recognition. On the other hand, Bill has worked with big companies. The overlap among these portfolios has been very, very low. These records do not reflect one guy calling the flip and fifty people yelling out the same thing after him.
Charlie Munger my partner for a
long time in the operation of Berkshire Hathaway, and
friend of mine who is a Harvard Law graduate, who set up a major law firm. I
ran into him in about 1960 and told him that law was fine as a hobby but he
could do better. He set up a partnership quite the opposite of Walter’s. His
portfolio was concentrated in very few securities and therefore his record was
much more volatile but it was based on the same discount from- value approach.
He was willing to accept greater peaks and valleys of performance, and he
happens to be a fellow whose whole psyche goes toward concentration,
who had a partnership return of 1156.7% versus the Dow of
96.8%. When he ran his partnership, however, his portfolio holdings were
almost completely different from mine and the other fellows mentioned
earlier.
A fellow who was a pal of Charlie Munger’s—another
non–business school type—who was a math major at USC. He went to work for IBM
after graduation and was an IBM salesman for a while. After I got to Charlie,
Charlie got to him. This happens to be the record of Rick Guerin. Rick, from
1965 to 1983, against a compounded gain of 316 percent for the S&P, came off
with 22,200 percent, which, probably because he lacks a business school
education, he regards as statistically significant.
One sidelight here: it is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately with people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find that you can talk to him for years and show him records, and it doesn’t make any difference. They just don’t seem able to grasp the concept, simple as it is. A fellow like Rick Guerin, who had no formal education in business, understands immediately the value approach to investing and he’s applying it five minutes later. I’ve never seen anyone who became a gradual convert over a ten-year period to this approach. It doesn’t seem to be a matter of IQ or academic training. It’s instant recognition, or it is nothing.
Stan Perlmeter who had a 4,277.2% return was a liberal arts major at the University of Michigan who was a partner in the advertising agency of Bozell & Jacobs. We happened to be in the same building in Omaha. In 1965 he figured out I had a better business than he did, so he left advertising. Again, it took five minutes for Stan to embrace the value approach. Perlmeter does not own what Walter Schloss owns. He does not own what Bill Ruane owns. These are records made independently. But every time Perlmeter buys a stock it’s because he’s getting more for his money than he’s paying. That’s the only thing he’s thinking about. He’s not looking at quarterly earnings projections, he’s not looking at next year’s earnings, he’s not thinking about what day of the week it is, he doesn’t care what investment research from any place says, he’s not interested in price momentum, volume, or anything. He’s simply asking: What is the business worth?
I selected these men years ago based upon their framework for investment decision-making. I knew what they had been taught and additionally I had some personal knowledge of their intellect, character, and temperament. It’s very important to understand that this group has assumed far less risk than average; note their record in years when the general market was weak. While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock. A few of them sometimes buy whole businesses. Far more often they simply buy small pieces of businesses. Their attitude, whether buying all or a tiny piece of a business, is the same. Some of them hold portfolios with dozens of stocks; others concentrate on a handful. But all exploit the difference between the market price of a business and its intrinsic value.
I’m convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical. I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, “I have here a six-shooter and I have slipped one cartridge into it. Why don’t you just spin it and pull it once? If you survive, I will give you $1 million.” I would decline— perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice—now that would be a positive correlation between risk and reward!
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.
One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets.
Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy. Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people who think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million, particularly if you do it by buying ten $40 million piles for $8 million each. Since you don’t have your hands on the $400 million, you want to be sure you are in with honest and reasonably competent people, but that’s not a difficult job.
You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying businesses. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing. In conclusion, some of the more commercially minded among you may wonder why I am writing this article. Adding many converts to the value approach will perforce narrow the spreads between price and value. I can only tell you that the secret has been out for 50 years, ever since Ben Graham and Dave Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the 35 years that I’ve practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing over the last 30 years. It’s likely to continue that way.
Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.
Who makes Value Stock Picks
What is the Value of Stock
Where do I Determine Stock Value
When are there Stock Market Values
Why do I Base My Investments on Value
How Do I Determine Stock Values
Diversify To Where You Are Comfortable With Daily And Even Yearly Price Fluctuations
Never Risk Money You Can't Afford To Lose
Be Fearful When Others Are Greedy and Greedy When Others Are Fearful