Saturday, July 20, 2013

How Benjamin Graham Actually Invested

I have been intensifying my research on the internet and I have been surprised at the little gems of info you can find by looking hard. I have found the annual reports of the Graham-Newman Corp, hedge fund letters, and even free copies of financial books. From this experience, I have gained valuable insight into the opaque money management world. And I am going to share my conclusions here because I don't think any other bloggers have expressed such views.

Benjamin Graham is the father of value investing. Money managers try to make money using various styles of investing. But a huge subset of these managers use the value investing style.

To me, value investing is buying a equity at below some intrinsic value which is calculated based on current earnings and balance sheet. Many investors try to follow Graham's methods with their own individual touch. For example, Warren Buffet buys top notch firms for good value. However, not everyone can have success being a value investor. I like the following quote by Charlie Munger:

I think the idea that everyone can have wonderful results from stocks is inherently crazy. Nobody expects everyone to succeed at poker."

But some money managers are failing not only because of the law of averages. I see that some hedge fund managers are losing at the value strategy also because they aren't truly following Graham. And I am expounding on that here mainly to remind myself how I can go wrong and to avoid it.

Benjamin Graham ran the Graham-Newman Corporation as a investment partnership between 1936 and 1956. It beat the market on average by 2.5% and it could be a template for hedge fund managers. Benjamin Graham wrote The Intelligent Investor and in it he described how he invested for his firm. His value approach practically assumes the future is unknowable and thus to discount future growth projections. He devotes a chapter to Margin of Safety, which covers outcomes that may go against his investment.

Graham eventually closed his firm because he wanted to move to California and focus on other interests. He wasn't challenged by investing anymore because it became mechanical. That's the holy grail! To beat the market by 2.5% without creative thought required! That should be the investment strategy of any long term investor. Graham and Walter Schloss have done that.

But many of the the value money managers out there do not follow this strategy. One big reason is the incentives. A hedge fund's management fees is based on its performance each year. They typically get 20% of the profits from the previous year. And if the fund has losses the previous year, the manager must recoup the loss before collecting his 20% fee. So the manager is motivated to shoot for the moon, and if he fails at it, especially if the fund blows up, then just close it. And this strategy is especially effective when starting a hedge fund in the middle of a bear market, because a bear market is the easiest time to make money.

An investor cannot make good money long term investing this way because this investing style is too risky. It is almost like gambling. But I think many investors fall into this because they are impatient. Long term investing means waiting over a entire bull and bear market for the above average returns.

As an example I came upon the letters of Seller's Capital, a value hedge fund. Seller's Capital started in 2003 in the middle of a bull market and had tremendous returns, until 2008. Shortly after, the management started talk of winding down the fund. It finally did in 2010. At 2008, it had concentrated positions in Contango and Premier. Contango is a driller of oil and natural gas. The pros for Contango sounds great, it has low cost, rights to great sites, etc. But each trade involves two sides, a buyer and a seller; thus, the trade must involve a pro and a con. So I have heard the pros but what is the con? In hindsight one con appears to be the crash in gas prices due to the proliferation of fracking. Premier also went very wrong in part due to a lawsuit over the rights to the Titanic wreckage. Both these cases teach us what can happen to a portfolio if we do not invest with an adequate a margin of safety.

When I looked closely at Graham's partnership, I was most surprised at how diversified his investments were. His disciple Schloss was even more so. Some have said diversification is a defense against ignorance. But this is not. If one diversifies to the extreme across all sectors and all markets and all types of companies then that's investing to match the market. Graham and Schloss invested in many companies of a peculiar class as an added margin of safety. Graham mostly invested in four types of securities:

  1. Arbitrages: e.g., mergers
  2. Liquidations: e.g., company shutdown
  3. Related hedges: for convertible bonds or preferred shares
  4. Net-nets: as in value of the equity minus intangibles and long term assets; buying companies with net-net less than market cap

Schloss mostly liked #4, which is my favourite, also called picking up cigarette butts. In this manner Graham and Schloss are taking luck out of the equation, and they made money because their investment strategy was right.

This is the Graham style of value investing, which I want to emulate. I am not saying it is the only way to be a value investor, because the notion of value investing is subjective. But this is how the father of value investing did it very successfully.

I also like to read fund letters and the histories of famous investors who made big mistakes, because life is too short to make all the mistakes yourself. The investing world is full of the carcasses hedge funds that have blown up. A good post-mortem can save ourselves the same grief.

As a final note, below is the Graham-Newman Corp Annual letter from 1950. Enjoy.

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