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Graham & Dodd...

By

Apostasy!

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"Wall Street people learn nothing and forget everything."
- Ben Graham

The 1934 original book "Security Analysis" and the subsequent 1940 edition rest in the financial lore as a foundational work. With it Ben Graham and David Dodd etched their places in the foundation of fundamental analysis. By scrupulously mining balance sheets and income statements for "value," the two did more than any other investors to cement the notion that a careful analysis of fundamental data could consistently yield profits in equity investment.

But the thing is this: they were just market timers.

I know, it's heresy to say so. If there is a bible in this business, it is "Security Analysis." And if there was a stake on which to be burned, the pyre would be lit and I would be shuffled toward it.

Don't get me wrong: I was a disciple; and a dedicated one at that. I would routinely bore people to death (and embarrass my wife) at cocktail parties extolling the virtues of book value, about return on assets, about liquidation value. It was the first book I ever read on investing and like a first kiss, was never forgotten. Turning down a PhD in chemical engineering to take an analyst position in an investment bank on Wall Street had many costs. First among them was that I didn't know a stock from a bond. I literally knew nothing about investing when I said "I do" to the Wall Street maiden.

So, like any good engineer, I looked for the best book on the subject. And, no surprise here, everyone (including the economics professor who was incredulous that an investment bank would offer me a job making more than him) recommended Security Analysis by Graham and Dodd. So I read it. And re-read it. And read it a third time. "It makes so much sense," I remember thinking at the time.

Buy low with plenty of margin for safety. Buy assets for less than they are worth; as cheap as you can get them. Timeless advice, no? Investors should ignore social trends, company 'prospects', and management styles. Just focus on the balance sheet and income statement and everything will be alright.

Regular readers already know the import I place on the insights of Amos Tversky and Dan Kahneman - the behavioral economists who refuted the rational choice paradigm in economics. By proving that people make irrational decisions - and do so routinely - they ushered in, along with neuroeconomists, an entirely new understanding of why people make certain economic choices that are, to be polite, sub-optimal. They provided the insight that allows us to understand why investors routinely buy high and sell low. For why they ignore Graham's and Dodd's advice.

Graham certainly understood this waxing and waning optimism:

"Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble... to give way to hope, fear and greed."

...he once said. But he did not have the benefit of the genius of Amos Tversky or Dan Kahneman. It wasn't a "tendency to gamble" that made people buy stocks at lofty valuations, it was the brain's physical structure and the human instinct to use heuristics to make judgments in information partial vacuums.

Thus, I contend that all Ben Graham and David Dodd did was recognize that when people were most fearful - most risk-averse - it was a good time to buy stocks. The act of putting specific ratios around that insight - book value, replacement value, liquidation value ratios to current equity value for example - was, while certainly not trivial, not that truly insightful either. It was the recognition that fear and greed were - are - cyclical that was genius. Indeed, decades of subsequent work - and hard won experience by yours truly - has pretty much confirmed that value - in and of itself - is not a perfect pre-requisite for equity profits. Terms like 'value trap' speak to this idea; that things can be "cheap" and keep right on getting cheaper. Thus, buying things at 10% of book may not always lead to profits (though it probably will lead to a greater success rate than trend following).

That no research since the publication of "Security Analysis" in 1934 has been able to prove that a time-invariant data series associated with a company's fundamentals - balance sheet, incomes statement, cash flows - is predictive to future stock price behavior speaks to this larger point: fundamental analysis is backward looking. By setting certain threshold levels for "value", Ben Graham and David Dodd DID recognized that being a buyer of other people's fear was the best strategy for making money in stocks. They manifestly did NOT prove that fundamentals were able to predict future stock prices.

And neither has anyone else since 1934, making Graham and Dodd one of the progenitors of market timing.
No positions in stocks mentioned.

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