“The concept that all useful information has already been factored into a stock’s price, and that analysis is futile, is know as The Efficient Market Hypothesis.” – William Bernstein.

As discussed in a previous post, I appreciate Benjamin Graham’s contributions, but I do not accept his conclusions.

Times Have Changed

When Graham first wrote The Intelligent Investor, there were no online sources for information, as stock prices were seen on a paper ticker tape with a 15 to 20 minute time delay, not a CRT with near real-time quotations. It took weeks, if not months, to analyze a single company’s balance sheet, using an old fashioned adding machine called a comptometer, They didn’t have multi-function calculators then, much less a spreadsheet program. Someone as smart as Graham could find under-priced securities, even stocks selling at less than liquidating value.

Investment techniques have changed over the last 40 years, and there has been a tremendous amount of research about how markets work. Anyone attempting to identify undervalued stocks is ignoring four decades worth of research, which proved that, because of all of the competition, it is very, very difficult to find the elusive “good bargain” stock.

In an article written for the 1976 Financial Analysts Journal, “A Conversation with Benjamin Graham,” he indicated that he had reached the same conclusion, and acknowledged the difficulty in finding these undervalued stocks.

Question. “In selecting the common stock portfolio, do you advise careful study of and selectivity among different issues?”

Answer. “In general, no. 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.”

Since that interview in 1976, mounting evidence has continued to demonstrate that markets are largely efficient, and that the current price of a stock is the “best estimate” of what it is actually worth.

Burton Malkiel’s paper provides a detailed discussion of Efficient Markets.

Conclusion

An intelligent investor should be cognizant of Graham’s contributions to, and impact on, investing theory and practice, but should go beyond his approach to one more appropriate for 21st Century’s equity markets.

“There is no free-lunch in investing. Higher rewards are associated with higher risk.” – Burton Malkiel.

As I mentioned in a previous post, Benjamin Graham’s The Intelligent Investor was extremely influential, not just to me, but to a lot of investors. Distinguishing between speculation and a decision based on careful analysis was certainly a breakthrough. Although his analysis was logical and thorough and his recommendations practical, I do not recommend following his approach.

Author Jason Zweig said, “Graham was not just one of the best investors of all time; he remains far and away the greatest thinker about investing who ever lived.”

Challenging the Master

Given that praise, how can I dare disagree with his approach? Well, Graham was heavily influenced by the Great Depression and its aftermath. Stocks were in such disfavor that they were selling at extreme bargain prices. That’s no longer true.

While many of his ideas do stand the test of time, they were established before the development of Modern Portfolio Theory. MPT is, in effect, a second revolution superseding Graham’s analytical approach.

Risk and Return

Graham disagreed that returns and risk are necessarily related. Instead, he believed that intelligent effort can tip the odds in your favor. Furthermore, he believed that skill can increase returns. I believe that risk and return are inextricably linked and that skill is unlikely to change that.

He maintained that an investor could learn to analyze a company and arrive at its “real” value. He further claimed that, if a stock was selling below its calculated “real” value, then an investor was sure to make a profit. More recent research suggests that, while “value stocks” have had periods of high returns, it is because of their higher risk. It is exceedingly difficult (some would say impossible) to find mis-priced securities, i.e. bargains, on a consistent basis.

Moreover, Graham advocated that one could profitably invest in companies that were “out of favor, because of unsatisfactory developments of the temporary nature.” In a situation such as that, he recommended that investors keep exclusively to large companies. Had he been privy to the research that was to be done two decades later, no doubt he would have acknowledged that small value companies generally outperform large value companies.

Diversification

Regarding diversification, he recommended a minimum of 10 different stocks and a maximum of about 30. If you were to restrict your investments to one asset class, say large cap stocks, 10 to 30 stocks might be enough for diversification.

But, you may wonder, what about small cap stocks, or foreign stocks from developed countries? When Graham was writing his magnum opus (remember, published in 1949), these stocks were thought to be too risky to even consider. In my opinion, in the current era, they should be included in a well-diversified investment portfolio.

And what about emerging markets stocks and Real Estate Investment Trusts? These investment instruments did not exist when Graham was writing, nor perhaps, were they even envisioned.

Security Analysis

Rather than a buy-and-hold strategy of a globally diversified portfolio, Graham recommended:

1. Buying in “low” markets and selling in “high” markets
2. Buying carefully chosen “growth stocks”
3. Buying “bargain issues” of various types
4. Buying into “special situations”

He admitted that it was difficult to implement this policy. Currently “difficult” would be considered an extreme understatement. Impossible would be more accurate.

To Be Fair

It is certainly unfair to crtiticize Graham for not knowing things that no one could have known at the time he was writing. However, the point is that if you only read The Intelligent Investor, you have done yourself a disservice. There are several other books worth considering, and I will cover them in the future.

For a more up to date view, read the 2003 edition of The Intelligent Investor, with Jason Zweig’s extensive commentaries on each chapter. These are a very valuable contribution in their own right. He provides extensive research, charts, and tables that update the book, at least through the period right after the Dot-Com bubble burst. He seems to take delight in quoting various Wall Street luminaries who were totally optimistic in 1999 and 2000, and who were totally wrong!

To be continued …