Ben Graham's Get-Rich Investing Secret, More Valuable Than Ever
Sep 14, 2011 |
Adapted from the new book, TAMING THE BEAST (John Wiley & Sons, 2011), this shows how modern investing strategies evolved and how to profit from them now.
Modern investing began when the world was burning down. Benjamin Graham, a celebrated financier who was in the middle of the flames, invented a process of evaluating investments and popularized it during the Depression-ridden 1930s. It was a way for ordinary people to rebuild their decimated holdings and become wealthy.
In today’s rocky markets, Graham (1894-1976) still has a lot to teach us about how to get rich investing. The big take-away: Be flexible enough not to get mired in any one discipline. They all have strengths and flaws. Knowing what they are lets you navigate around the perils and land on the opportunities. Or at least gives you a better chance.
Before Graham came along, there had been no widely used investing systems. The capital markets were like wild frontiers. They too often operated on cronyism and outright fraud; they were swept by manias and laden with onerous debt. Cornelius Vanderbilt concocted a massive stock slide in 1869 by flooding the market with shares from his railroads, as a means of thwarting rival Jay Gould.
Graham taught that investors must be analytical and diligent about choosing and managing their holdings. He provided an orderly method of evaluating stock and bonds.
Hand in hand with that insight was the strategy he invented, called value investing, which aims to find cheap, under-appreciated stocks. Inspired by his example, other investing systems later sprouted. Some extended Graham’s thinking; others were in opposition to it.
All sought to tame the unruly market beast, which was capable of bringing both destruction and riches. It’s significant that the symbols of Wall Street are both animals: the bull (optimistic) and the bear (pessimistic). Graham taught that people should be careful when dealing with such powerful and dangerous creatures.
Taken together, the approaches created by Graham and his various successors form the foundation of investing in the 21st century: indexing, behaviorism, growth investing, hedging, on and on.
But here’s the rub. While the adherents of each often swear by their preferred system as the one true path, they all have deep flaws. Even Graham’s beloved value investing has a pretty good track record, except when it doesn’t.
Value investors were big under-performers in the late 1990s tech boom, and were devastated by the bear market that erupted in 2008 because what looked cheap and reliable — financial outfits like Lehman Brothers and Fannie Mae — were the first to fall when the credit crunch occurred.
Successful investors have an ambidextrous ability. They don’t put all their chips in one pot. While Graham is considered the avatar of value stocks, he also advocated owning a large slug of bonds, for safety’s sake.
Under the Graham approach, smart managers who have the tools to delve into the innards of corporate finances can be among the 28% of actively managed large-cap funds that beat the index, and the same goes for the 24% of mid-cap funds and the 15% of small-cap ones that best the market.
In the end, Graham had one revelation that investors of all stripes can agree with: a lot of investing is done badly, which benefits those who do it well.
“It is fortunate for Wall Street as an institution, that a small minority of people can trade successfully, and that many others think they can,” he said.
Graham knew well that taming the beast of investing is hard, brain-challenging work.
Investing systems: pros and cons
Numerous studies indicate the strategy of finding under-valued gems does better over time than growth investing. Still, it flags badly in some periods, such as in the late 1990s tech boom. And the risk of a “value trap,” cheap stocks that should stay that way, always lurks. Warren Buffett got rich as a value investor. Not everyone has.
According to Wharton Professor Jeremy Siegel, stocks over the past two centuries have been the best investment by far, averaging 7% growth yearly, after inflation. Result: Stock funds dominate retirement accounts. But the Lost Decade (2000-2009), when stocks went nowhere, shows the limitations of this thesis.
Capturing the entire market, these funds routinely beat actively managed ones. Their flaws are that some index funds don’t track the indexes very well. And in bull markets, the indexes are over-exposed to the hottest stocks, which usually crash the worst when bad times arrive.
The increasing complexity of this once boring asset class has made it a better opportunity — and also riskier. Pimco’s Bill Gross demonstrates how to ride them to great profit. Bonds are good ballast for a portfolio, in general. Inflation and poor credit quality are their downsides. Mortgage-backed bonds and junk bonds have tanked in the past, damaging investors.
Thomas Rowe Price, founder of the T. Rowe Price securities firm, preached that the best time to invest in a stock with accelerating revenue and earnings was at the start of its life cycle. While many growth issues are faddish things that soon shrivel, smart growth investing can be very lucrative. Cliff Asness regularly beats the indexes by choosing the top stocks with the best price performance.
Only a quarter of U.S. investments are in foreign holdings. Yet as the iconic investor John Templeton showed, overseas is where great prospects lie. He spotted Japan’s emergence early. After World War II, America claimed 90% of global equity capitalization; by 2010, that had dwindled to half, as others arose. China is the latest darling, although it has many weaknesses that may thwart investors in its securities.
Property logged enormous appreciation since World War II. The weakness is its dependence on debt. That in recent years un-did many a zealous homeowner, saddled with a too-large mortgage. Packaging dicey mortgages into securities almost crashed the global financial system in 2008. Despite the current housing slump, nice ways to play property still exist via good real estate investment trusts.
Currencies, commodities, gold and timber were once the province of the rich. New investment vehicles make it possible for ordinary people to get into them. Alas, these assets all have suffered extended periods of price weakness. Currencies and commodities in particular are highly volatile.
Graham advocated spreading one’s holdings widely so weakness in one area could be offset by strength in another. An entire profession, financial planning, has been created to help people do that. Economist Harry Markowitz invented Modern Portfolio Theory to aid diversifying. Some financial models, however, depend on the bell curve and past returns, which proved tragically wrong in 2008.
Dedicated short sellers like James Chanos (he shorted Enron) and David Einhorn (Lehman Brothers) serve as good harbingers of trouble in various investments. While widely vilified, they cleanse the system. Yet this is a highly risky way to invest. Sometimes, a shorted stock will move badly against you.
These lightly regulated investing pools, long off-limits to those without $1 million in investable assets, can show extraordinary returns through their sophisticated moves. Lately, some have opened mutual fund arms to allow the less-wealthy in. Not all are winners, however. Long Term Capital Management’s wipeout in the late 1990s threatened to harm the entire financial system.
This new academic discipline seeks to codify what veteran investors like Graham knew first-hand: Emotions and human fallibility animate much of investing. Behavioral studies highlight what to avoid instead of what to invest in. Graham’s whimsical character, Mr. Market, is a manic-depressive, just the opposite of what a good investor should be.
Larry Light is the former senior editor for money and investing at Forbes and deputy personal finance editor at the Wall Street Journal.