Superinvestors of Graham and Doddsville: What We Learned

13 minutes


picture courtesy of ruleoneinvesting.com

“While they differ greatly in style, these investors are, mentally, always buying the business, not the stock. A few of them sometimes buy whole businesses, far more often they simply buy small pieces of the business.”  

        Warren Buffett, Superinvestors of Graham and Doddsville

In May 1984, Buffett laid out his thoughts on everything you need to know about his investing philosophy.

In a speech at Columbia Business School, which was later adapted into an essay. Buffett introduced what he termed “The Superinvestors of Graham and Doddsville.”

The “Superinvestors of Graham and Doddsville” is a name that Buffett gave to Benjamin Graham and a group of his proteges. The group of money managers once studied under or worked for Graham, Buffett or Munger, Buffett’s partner at Berkshire Hathaway. We will talk about each of them more in depth coming up.

The speech was given in honor of the 50th anniversary of “Security Analysis” which was written by Benjamin Graham and David Dodd. The book was published in 1934 and was the seminal book on analysis business using financial fundamentals that were outlined by Graham and Dodd.

Warren Buffett is arguably the world’s great investor, there have been many books, essays, and papers written on his greatness. I am not smart enough or eloquent enough to improve on them but I will touch on his beginnings for a moment.

Although Buffett’s father was a stock broker he didn’t have his a-ha moment until he read another very famous Graham book “The Intelligent Investor”. It caused Buffett to apply to the Columbia School of Business to study with Graham. To this day, Buffett credits that book with changing his professional life and Warren believes that most of what everybody needs to know about investing come from two chapters in the book.

The chapter on Mr. Market, which outlines behavioral finance concepts before the term even existed. And the chapter on Margin of Safety.

Breakdown of the speech

At the start of the speech he asks the question “is the Graham and Dodd look for values with a significant margin of safety relative to prices approach to security analysis out of date?”

He then touches on the theory of Efficient Market Hypothesis, which states that the market is efficient in how it prices each and every stock in the market. Meaning that the market is taking into account everything that is known about the company’s prospects and the state of the economy in the price of each stock.

The hypothesis states there are no undervalued stocks because there are smart security analysts who utilize all available information to ensure unfailingly accurate pricing.  

He thinks that this is bunk!

According to the theorists. Investors who are able to beat the market year after year are just lucky. Which would rule out anyone who follows the value investing philosophy of Benjamin Graham and his followers.

In his speech, he asks us to consider a group of investors who have beaten the S&P 500 consistently year in and year out. He wants us to consider their performance against the theory that the market is efficient.

To illustrate his point he starts out by using an example of coin flipping. The next comments are straight from his speech.

“I would like you to imagine a national coin-flipping contest. Let’s assume we get 225 million Americans up tomorrow morning and we ask them to all wager a dollar. They go out in the morning a call the flip of a coin. If they call correctly, they win a dollar from those that called incorrectly. Each day the losers drop out, and on the subsequent days, the stakes build as all previous winnings are put on the line. After ten flips on ten mornings, there will be approximately 220,000 people in the United States that have correctly called ten flips in a row. They have each won a little over $1,000.

Now this group will probably start getting a little puffed up about this, human nature being what it is. They may try to be modest, but at cocktail parties, they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping.

Assuming the winners are getting the appropriate rewards from the losers, in another ten days we will have 215 people who have successfully called their coin flips twenty times in a row, and who by this exercise, each have turned one dollar into a little over $1 million.”

Of course, there would be some professor who would state that you could take the same experiment and conduct it with orangutans and get the same result. And to break it down further you possibly find that there was a concentration of winners from a particular geographical region, such as Minneapolis. Your natural inclination would be to go to this zoo and study the habits, food and other environmental stimuli that could lead to this concentration of orangutans that produced these winning flips.

The other conclusion you could come to would be that maybe instead of geographical, maybe it could be the intellectual origin. Buffett thinks that a “disproportionate number of successful coin-flippers in the investment world come from a very small intellectual village that could be called Graham-and-Doddsville. A concentration of winners that simply can’t be explained by chance can be traced to this intellectual village.”

In the group of investors that Buffett wants us to consider, there has been a common intellectual patriarch, Benjamin Graham. All of the investors from this village have followed different paths, picked different stocks, and yet they have had a combined record that just simply can’t be ignored or written off as simply chance.

The common theme of the investors of Graham-and-Doddsville is this, they search for differences value of the business and the price of small pieces of that business in the market.

Efficient Market Hypothesis vs Graham-and-Doddsville

Before we get on with the individual investors of Graham-and-Doddsville, we need to discuss Efficient Market Hypothesis and why Warren Buffett disagrees with it and how he dismantles it.

As we discussed earlier, with Efficient Market Hypothesis (EMH) it is not possible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.

According to EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to purchase undervalued stocks or to sell stocks for inflated prices. This would indicate that it would be impossible to outperform the overall market through expert stock picking or market timing, The only way an investor could possibly get better returns would be to find riskier investments.

As you could imagine, this news was a great relief to the investing community because now they knew that they didn’t need to worry about market timing or stock picking skills. Since all the relevant information was already included in the stock price, one didn’t need to worry anymore about doing research on the companies, or the macroeconomic developments, or the regulatory environment.

The didn’t need to do anything. Zip. Nada. How liberating.

You could purchase anything you wanted at any price because all factors are already included which means that you just need to buy and all will be ok.

This hypothesis was partially developed by Eugene Fama in the 1960s. And part of this theory falls into Modern Portfolio Theory, that was developed by Harry Markowitz in 1952. This theory states that to achieve higher returns you must take on higher risk. Lower returns mean lower risk.

In 2013 Eugene was awarded the Nobel Prize for his work on this theory.

So what did Warren Buffett think of this hypothesis? Let’s take a look at his words directly. This is an excerpt from one of his shareholder letters for Berkshire Hathaway from 1988.

Amazingly, EMH was embraced not only by academics but by many investment professionals and corporate managers as well. Observing that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.

In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp, Buffett Partnership, and Berkshire illustrates just how foolish EMH 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 earned 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%. (Of course, I operated in an environment far more favorable than Ben’s, he had 1929-1932 to contend with.)

All of the conditions are present that are required for a fair test of portfolio performance: (1) the three organizations traded hundreds of different securities while building this 63-year record; (2) the results are not skewed by a few fortunate experiences; (3) we did not have to dig for obscure facts or develop keen insights about products or managements – we simply acted on highly-publicized events; and (4) our arbitrage positions were a clearly identified universe – they have not been selected by hindsight.

Over the 63 years, the general market delivered just under a 10% annual return, including dividends. That means $1000 would have grown to $405,000 if all income had been reinvested. A 20% rate of return, however, would have produced $97 million. That strikes us as a statistically significant differential might, conceivably, arouse one’s curiosity.

Yet proponents of the theory have never seemed interested in discordant evidence of this type. True, they don’t talk quite as much about their theory today as they used to. But no one, to my knowledge, has ever said he was wrong, no matter how many thousands of students he has sent forth misinstructed. EMT, moreover, continues to be an integral part of the investment curriculum at major business schools. Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians.

Naturally, the disservice is done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham. In any other contest – financial, mental, and physical – it’s an enormous advantage to have opponents who have been taught that it’s useless to even try. From a selfish point of view, Grahamites would probably endow chairs to ensure the perpetual teaching of EMT.”

I would say that pretty much sums up what he thinks of EMH. I don’t think I could have said it any more eloquently.

Superinvestors of Graham and Doddsville

We have talked about EMH and what Buffett thinks of it, now let’s take a look at the investors that he discusses and their records.

First up is Walter Schloss. Over a 28 year period, he compiled a 21.3% rate compounded annually. Schloss never went to college, but took a night course from Benjamin Graham at the New York Institute of Finance. Afterward, he worked at Graham-Newman until 1955.

Schloss was different. He didn’t play by the rules of Wall Street. He ignored the news, bought cigar butts or really cheap, depressed stocks and held them forever. He looked for stocks that were trading for less than their book value. He also looked for companies with no debt, low price-to-book value, simple businesses that he could easily understand. He was a buy-and-hold investor who held onto his picks for many years. For more info on Walter, check out this great article from Old School Value here.

Next up is Tom Knapp, who with Tom Anderson formed Tweedy, Brown in 1968. Tom was a chemistry major at Princeton before WW2 and after the war spent some time at the beach. One day he learned that David Dodd was teaching an investing course at night at Columbia. He took it as a non-credit course and loved it so much that he ended up enrolling at Columbia Business school and received his MBA from there.

Tweedy, Brown Partners had a record over 16 years of 20% returns compounded annually. They have a wonderful manual called “What Has Worked in Investing.” I highly recommend you check it out. It’s Free!

Next up is the author himself. Warren Buffett. We have spent quite a bit of time talking about so I won’t go into much detail here. His returns at the time of this speech were 23.8% compounded annually. Not too shabby.

The fourth investor that Buffett used for comparison purposes was Bill Ruane who ran the Sequoia Fund. This fund is arguably one of the most famous funds out there. It has been closed to new investors for years. As a matter of fact, I just learned that Guy Spier, an amazing investor himself bought a share of Sequoia on eBay so that he could attend the annual meetings.

Bill Ruane was a graduate of Harvard Business School and afterward went to work on Wall Street. When Warren Buffett wound up his Buffett Partnership he asked Bill if he would handle all of his partners, and they to a person went with Bill to set up the Sequoia Fund to invest those funds. The Sequoia Fund was able to generate returns of 17.2% compounded annually over 14 years. Pretty outstanding.

One thing I should note. Of the investors that we have discussed, there has been very little overlap in the companies that they owned, which I find very interesting. This indicates that there are many ways to value companies that you are interested in buying and it is not always the same companies that will strike your fancy.

One of the great things about value investing is that you can take the teachings of Ben Graham as a foundation and then branch off from there. That is what every single investor that we have discussed so far have done and you can too.

The fifth investor on the list is none other than Charlie Munger, who has been Warren’s right-hand man through the last 56 years. Charlie graduated from Harvard Law and worked as a lawyer for many years. After a conversation with Warren about changing careers, he told Charlie that law was a fine hobby, but that he could do better.

He was right. Charlie was a very concentrated investor who only held a few stocks in his portfolios, which lead to some pretty crazy volatility but he was mentally prepared for that. He has become a brilliant teacher of mental models and some awesome talks and speeches that you should check out. My favorite is here.

Charlie’s returns during the 13 years shown here were 19.8% compounded annually. Pretty impressive.

Next up on the list is Rick Guerin, who was a math major at USC, where he met Charlie Munger. He worked at IBM after graduation and was a convert after Charlie was converted from Warren. He operated the Pacific Partners and his returns were an eye-popping 32.9% compounded annually. That is simply amazing and from probably the least know of the people mentioned in Warren’s speech. His returns were the best of any of the people mentioned. Little is known of him after 1984.

The seventh investor from the speech is Stan Perlmeter who was a liberal art major from the University of Michigan. He was a partner of an ad agency before making the switch to investing. Another investor that is little known and not much more after the speech. He was not trained in business but took to value investing quite naturally. He was only interested in what the business was worth. When the business was trading at a discount to what he thought it was worth, he would buy it. He was only interested in deep value. His returns of 23% compounded annually over 18 years are pretty impressive.

The last two investments that Buffett mentions are pension funds that he didn’t have direct involvement in but who he recommended that they install value-oriented managers to help improve the fund’s performances. Both funds have subsequently held a number one rating in their size class for funds.

A final note about all the investors that Buffett selected. These were people that he personally knew and was familiar with their backgrounds, teachings, and philosophies when it came to investing. They all had different takes on value investing and there was very little overlap in the portfolios but the results they achieved are nothing short of extraordinary.

Their philosophy was simple. Buy businesses, not stocks. Find a good business that is selling for less than it is worth. Do that and you will have a margin of safety in case you make a mistake. And you will make money over time. That is the key, patience and time.

Final Thoughts

The speech Warren Buffett gave was amazing. He laid out his thoughts on value investing and compared it to the latest theories on how stock markets worked. He pulled no punches when he stated that the EMH and modern portfolio theory are wrong.

His whole goal with the speech was to educate. He wanted to show everyone that his way of looking at businesses was a much easy and more practical way to do it. His results and the other investors that he mentions should lay to rest any doubt about what he is talking about. They speak for themselves.

A note about Eugene Fama, later on in life he came to change his opinion on value investing and as a matter of fact did studies that showed that small-cap stocks could outperform the market over a period of time. He felt like this was based on the higher risk premium of a small cap stock. They have more volatility to them because of their size.

So over time, he has come to agree that there are mispriced stocks in the market. Which is what Warren was preaching from the beginning.

Value investing is not easy and it takes a certain type of individual that has the right mental capacity to handle the ups and downs of the market. It has nothing to do with brain power. Only that you have the stomach for the roller-coaster ride that can be the stock market.

The principles of buying dollar bills for 40 cents is a pretty simple process to understand. In Warren’s opinion, it either takes to you immediately or it doesn’t take at all. Of course, there is more to it than we are discussing here, but the concept of buying at a discount is pretty simple and what we all strive to look for.

I will close this up with a quote from Warren, after all, he says it best.

In conclusion, some of the more commercially minded among you may wonder why I am writing this article. Adding many converts to 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 Benjamin Graham and David Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the 35 years 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.”

I will put the link to this amazing speech here.

As always, thank you for taking the time to read this post. I hope you have found it educational as well as entertaining. If you think anyone you know would benefit from this information please share it with them.

Take care,

Dave

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