StockWatch
The Comeback Kid
Maybe Ben Graham isn’t old-fashioned after all.
If this is true, it would represent a big shift from the attitude toward him that has prevailed for virtually the entire period since 1980 when I began monitoring the performance of the investment newsletter industry: Graham’s approach might once have been worthwhile -- everyone argued, including admirers -- but what did the approach have to offer to modern investors?
It took the bear market of the last 18 months to answer that question.
Graham, of course, is perhaps most famous as the author of the investment classic, The Intelligent Investor. His definition of value is far stricter than the approach taken in recent decades by most value-oriented advisers who tend to define value in relative terms. Via this relative approach, value stocks are simply those that are trading for lower prices, relative to earnings and book value, than the rest of the market.
To understand the risks inherent to defining value in relative terms, just talk to any realtor.
To avoid such risks, Graham defined value in absolute terms. His most famous stock picking criterion, for example, was that a stock should only be bought if it is trading for less than two-thirds of its net current asset value per share. (Net current assets are total current assets minus total current liabilities, long-term debt and the redemption value of preferred stock.)
Graham had other absolute criteria too, of course, having to do with things such as debt. The combined effect of the criteria was to create a “margin of safety” around an investment.
For obvious reasons, this margin of safety was important during the Depression, when Graham began managing money. When you’re “buying a dollar bill for forty cents,” as Warren Buffett, a Graham disciple, has often put it, you can be way off in your market timing and still come out ahead.
Given that Graham’s conservative approach seems eminently prudent, why did it fall out of favor? The biggest reason, I suspect, is that the number of stocks satisfying his demanding criteria fell over the years -- it fell so far, in fact, that during the 1980s and 1990s, there were many occasions when not one common stock on the NYSE was able to do so.
Needless to say, it’s difficult to make a stock-picking approach look very attractive when it, in effect, says to keep most of your money in cash. In response, value managers simply relaxed their definition of value.
No doubt the bear market that began in October 2007 has led many of those advisers to wish that they had not done so.
Not coincidentally, that bear market is also causing more and more companies to come at least within shouting distance of satisfying Graham’s value criteria. Those reconsidering whether his approach might, after all, be relevant to investors should take note.
Let me hasten to add that stocks picked using Graham’s approach are not without risk. In individual cases, there may be ample good reason why the stocks’ prices are so low. That's why Graham insisted that investors have a widely diversified portfolio so that individual mistakes wouldn’t be fatal.Mark can be contacted via email at mhulbert@marketwatch.com.
