Benjamin Graham and the Power of Growth Stocks
Excerpts from Benjamin Graham and the Power of Growth Stocks by Frederick Martin (Ghostwritten by Gene Walden)
Chapter 1
Benjamin Graham and the Evolution of Value Investing
During an investment career that spanned more than half a century, Benjamin Graham had a greater influence over the way stocks are analyzed, bought, and sold than any other investor in the history of the stock market. Graham practiced his trade during an era in which the stock market evolved from an investment that was utilized almost exclusively by the very wealthy to a pervasive investment that was used by almost everyone with a job and a retirement savings account. As a professor, author, and stock market trader, Graham turned stock market investing from a frenzied, speculative practice based on intuition, emotion, and momentum to a precise science that relied on strict formulas, meticulous analysis, and methodical timing.
Graham, who died in 1976 at the age of 82, has been referred to as the “Dean of Wall Street,” the “Father of Security Analysis,” and the “Father of Value Investing.” As an author, he expounded on his methodology in two of the most successful investment books ever published: Security Analysis, which he wrote in 1934 with David Dodd, and The Intelligent Investor, which he wrote in 1949. Both books have been periodically updated and still sell briskly today.
To understand Graham’s impact on the financial world, all you really need to know is that he was Warren Buffett’s mentor for more than two decades before Buffett struck out on his own.
Graham is probably most widely recognized for his contribution to value investing, a methodology that relies on strict analysis and timing to acquire undervalued stocks when they’re trading at a discount to their intrinsic value and sell them once they’ve earned a suitable return.
But until now, one of Graham’s most brilliant revelations has been all but lost to the investing public. Although his name is nearly synonymous with value investing, Graham also began to see the value of growth stock investing late in his career. He even developed a formula and a methodology for growth stock investing that he introduced in the 1962 edition of Security Analysis in a chapter entitled “Newer Methods for Valuing Growth Stocks.” Unfortunately, although Security Analysis was reissued in 1988, 1996, and 2009, this chapter was omitted from all the subsequent editions.
There’s no real explanation for why this chapter was removed—a decision, oddly enough, that was made long after Graham’s death in 1976. (The chapter is reprinted in Chapter 3 of this book.) Regardless of the reasons for the omission, investors who have read the newer editions of Graham’s book over the past two decades have been denied one of the most significant investment insights ever offered by Graham.
The primary objective of this book is to unlock Graham’s lost formula and methodology so that investors—both individual and professional—can take advantage of his insights on analyzing and buying growth stocks. I consider myself one of the fortunate few investment managers to have come across Graham’s formula early in my career, and I have used it with great success ever since….
From Chapter 8. The Few, the Proud: Why So Few Investors use Graham’s Methodolgy
He did nothing in particular and he did it very well.
— W.S. Gilbert
To paraphrase Warren Buffett, many, if not most, investors tend to be “more comfortable failing conventionally than succeeding unconventionally.” Oddly enough, in their world, there’s a good reason for that approach.
In Seth Klarman’s book Margin of Safety: Risk Averse Investing Strategies for the Thoughtful Investor, he summarizes the issue very succinctly: “Individual and institutional investors alike frequently demonstrate an inability to make long-term investment decisions based on business fundamentals. There are a number of reasons for this. Among them are performance pressures, the compensation structure of Wall Street, the frenzied atmosphere of the financial markets. As a result, investors frequently become enmeshed in a short-term performance derby whereby temporary price fluctuations become the dominant focus.”
Institutions often settle for mediocrity because that’s what they think will help them retain clients. And client retention means fee income. And fee income means that the enterprise is successful. As long as the institution’s investment performance is in line with the general market trends, it can justify its performance to its customers—whether their portfolios are moving up or moving down. If the stock market is down 20 percent and their portfolio is down 20 percent, the institutions can justify their own failings by pointing out that their performance is in line with the market average. But an investment manager who uses a consistent investment strategy will not always mirror the overall market averages. This manager will have a harder time justifying his strategy when his portfolio falls short of the market trends.
In this business, if you’re going to split from the herd, you had better be right. If you’re different and right, you’re a hero. If you’re different and wrong, you’re a loser and a stiff. The challenge, of course, involves those times when the investor is right over the long term but wrong over the short term. Client scrutiny and skepticism increase when your performance is trailing the market. Clients will want to know what you’re doing, why you’re doing it, and why it’s not working. That is a discussion that most of us would naturally prefer to avoid, which is why we are all tempted to use investment strategies that favor mediocrity over intelligent risk taking.
There is another, less flattering reason why institutional investment firms tend to favor mediocrity: their large base of institutional customers tends to favor that approach. The 401(k) market is a prime example. Most employers are content to offer a variety of mutual fund options to their employees, and the mutual fund companies have cleverly designed a variety of offerings designed to appeal to the whims of the 401(k) participants. The latest gimmick is “target-date funds.” With these types of funds, investors are required only to pick a date on which they plan to retire, and, voilà, the fund automatically adjusts its asset mix as the investor’s retirement age approaches. What could be simpler?
However, there are two critical missing pieces of data in this approach: what is the likely performance of the fund manager, and what are the fees? These are far more important considerations than the employee’s retirement date.
By offering gimmick investments such as target-date funds, the fund managers are able to obscure their performance and their fees, which is not necessarily in the best interest of the clients. But that’s the way the institutions have chosen to do it. Or as famed screenwriter Damon Runyon once put it, “The race is not always to the swift, nor the battle to the strong, but that’s the way to bet.”
At our firm, we rely on a disciplined buy-and-hold approach that doesn’t always coincide with the movements of the market. When we’re beating the averages, we rarely hear a word from our clients. They’re quite content to beat the market. But there are times when our approach may trail the market averages for an uncomfortably long period.
During periods when our portfolio is trailing the market, we invariably get calls from some of our clients wondering whether we’ve lost our touch. We find ourselves explaining that we follow a strict discipline geared to the long term that may result in below-average returns during certain times in the market cycle. We must constantly reassure them that the short-term results are of little or no consequence, and that we expect our strategy to provide exceptional returns over the long term, as it has for the past three decades.
In the more than 30 years that we have been managing portfolios for clients, we have suffered only one short period in which our competence was questioned to the point that we lost clients. In late 1999 and most of 2000, our portfolios were not going up fast enough for some of our clients. But the clients who stayed with us helped build an even stronger long-term relationship. The strength of those relationships paid huge dividends after the market downturn in late 2008 and early 2009.
Dealing with clients and reassuring them during the down periods is part of the business. We are more than willing to continue to do that because we are confident in what we’re doing and firm in our conviction that adhering to Graham’s principles and methodology, including the margin of safety, is in the best interest of our clients over the long term.
Individual investors are subject to many of the same pressures as institutional money managers. Spouses can put the pressure on when your investments don’t appear to be working out. What dutiful spouse wouldn’t voice some concern when the family savings seemingly falls 25 percent? And relatives, who are often the source of bad marital advice, can be as bad or worse when it comes to investment advice. How many fathers have told their children that investing in stocks is gambling? Or that the stock market is rigged against the individual investor? How many parents have chided their children when their stocks declined along with the market? That’s why it’s important to have the courage of your convictions in order to stick with your strategy and Graham’s principles when the market turns against you. As Rudyard Kipling wrote, “If you can keep your head when all about you are losing theirs . . . yours is the Earth and everything that’s in it.”
A stock broker is someone who invests your money until it is all gone.
– Woody Allen
From our experience in the investment industry, we believe that financial institutions operate with three goals in mind:
1. To gather assets
2. To induce transactions
3. To improve the client’s net worth
Unfortunately, the goal of improving the client’s net worth is a distant third on this list and is subordinated to the first two goals. An individual who wants to develop and manage a successful investment program must recognize that financial institutions are not concerned about his situation. Brokers are in it for the transactions, and institutions (including mutual funds) are in it to gather as many assets and collect as many fees as possible from their clients. The best interest of their clients—including the implementation of any new strategy that could improve the long-term returns for those clients—often takes a backseat to their own priorities.
The idea that brokers, fund managers, and investment institutions are in business strictly to help their clients make money is a common misconception. Many people are attracted to the industry because of the high wages or hefty commissions it offers—the big payday. Although their intentions may be honorable, their clients’ tepid results often reflect a more self-serving agenda.
You don’t have to look far to find examples of investment institutions putting their own interests ahead of their clients’. In the days leading up to the global financial meltdown of 2008, there were reports that some Wall Street firms were instructing their brokers to ramp up the sale of mortgage-backed securities. But they weren’t pushing the sale of those securities because they believed that this was in the best interest of their clients. They were pushing them because the mortgage market was on the verge of collapse and they had a vast inventory of highly leveraged mortgage-backed securities that they needed to unload. They were trying to minimize their losses and save their businesses by dumping those securities onto their unsuspecting clients before the bottom fell out of the market.
In 2000, with the stocks of high-tech companies near their all-time highs, Merrill Lynch was still publicly recommending the purchase of certain high-tech stocks that its technology analyst, Henry Blodget, was privately berating in his e-mails. The PBS Web site (http://www.pbs.org/now/politics/wallstreet.html) published some of the findings of the New York attorney general’s investigation, including specific e-mails. For instance, on the same day the firm gave Excite@Home (ATHM) a positive rating of “buy” or “accumulate,” Blodget sent a private e-mail that said, “ATHM is such a piece of crap!” The day after the firm gave Internet Capital Group a rating of “buy” or “accumulate,” Blodget sent a private e-mail that said, “This has been a disaster. There really is no floor to the stock.” Why was the firm publicly recommending stocks that Blodget privately disdained? Because those companies were investment banking clients that Merrill Lynch was reluctant to alienate. That breach of ethics cost Merrill Lynch $200 million in fines and other legal assessments, and it cost its clients untold millions in investment losses.
But Wall Street firms aren’t the only ones known for putting their own interests ahead of their clients’. In the Midwest, Piper Jaffray established itself as one of the largest regionally based brokers in the United States during the 1980s and 1990s, specializing in stocks from the food, agricultural, and medical technology industries. In 1992, the Minneapolis-based firm ranked as the nation’s fifth-largest securities underwriter.
The company also ran a bond trading operation that became one of the leading operations in the nation in the early 1990s. Worth Bruntjen, the manager of its successful Institutional Government Income Portfolio (a short-term bond mutual fund), was able to attract billions of dollars to the fund by enhancing its return through a complex trading strategy.
According to an account at www.fundinguniverse.com, Bruntjen “attempted to boost his funds’ returns by using derivatives, a financial instrument in which the return is tied to—or ‘derived from’—the performance of another instrument such as currencies, commodities, or bonds. Because the link between these interwoven instruments can be so substantial and so complex, the unexpected collapse of a derivative’s underlying assets can quickly balloon into an enormous, snowballing loss. Bruntjen had invested as much as 90 percent of his funds’ $3.5 billion assets into such derivatives (in his case, derivatives based on residential mortgages grouped together as securities) and exacerbated his risk by borrowing to fund his purchases.”
Bruntjen had based his investment strategy on his expectation that interest rates would continue to decline, as they had in the previous two years. But interest rates began to rise in 1994, giving the fund a $700 million paper loss.
What made the situation even worse for Piper Jaffray was that the firm had marketed the fund as a conservative strategy for risk-averse investors. The fallout from the debacle was devastating for Piper Jaffray, which ended up paying out more than $100 million in settlements to investors, as well as a fine of more than $1 million levied by the Securities and Exchange Commission. If Piper had relied instead on a conventional strategy for its bond fund, with a rate of return that was in line with the market averages, the firm would have avoided the firestorm that Bruntjen’s funds ignited.
An examination of the practices of some of the leading mutual fund companies also illustrates all too clearly that the primary goal of these investment firms is to gather assets and generate fee income, while the needs of the customers come in a distant second.
Fidelity Investments is one of the leading names in the mutual fund business, with nearly 500 different mutual funds and about $1 trillion in investor assets. The fund that put Fidelity on the map was the Magellan Fund, managed by the legendary Peter Lynch. During his tenure, the fund grew from $18 million in 1977 to $14 billion in 1990 and achieved a 29.2 percent average annual return during that period—a phenomenal feat for any fund manager.
Lynch, who is also the author of the investment classic One Up on Wall Street, personalized the Magellan Fund in a unique way. His thinking and investment style was so straightforward that everyone could identify with his success. And, unlike many of his colleagues in the mutual fund business, he recognized the value of long-term investing. “Selling your winners and holding your losers,” said Lynch, “is like cutting your flowers and watering your weeds.”
By the time Lynch left the Magellan Fund, it had ballooned to more than $14 billion in assets with more than a thousand individual stock positions. It’s little wonder that the performance of the fund has been pedestrian since Lynch’s departure. According to Fidelity, the Magellan Fund earned an average annual return of 1.09 percent for the 10-year period ended February 28, 2011. The S&P 500 earned 2.62 percent per year during the same period. The expense ratio of the fund was 0.75 percent per year, which means that the investors in the fund received about 60 percent of the return from Magellan during that period, while the mutual fund company received nearly 40 percent. This does not seem like much of a deal to me.
In recent years, Fidelity has been touting the performance of its Contrafund. With a 10-year average annual return of 6.7 percent, the Contrafund has been performing far better than the Magellan Fund, but its expense ratio is also higher, at 0.92 percent. Higher fees might be justified until one considers that the Contrafund has more than $60 billion under management—more than three times the size of Magellan. Where are the economies of scale?
All investors—institutional and individual alike—must be careful not to get caught in the crossfire in the war between the mutual fund industry and the brokerage industry. Mutual funds want to gather assets; institutional brokers want transactions. Today we have the spectacle of the mutual funds using participants’ fees to gather assets while their institutional brokers are pushing for more transactions. It appears that the brokers are winning the war—and, as usual, they’re doing it at the expense of their customers. In addition to the customary fees that funds charge to cover transactions and to pay the salaries of the fund management team, many funds also tack on other fees that cut into the investors’ total return. Many funds charge annual 12b-1 fees that can add 0.25 percent or more to the total cost of owning a fund. Those 12b-1 fees do nothing to contribute to the investors’ performance, but are used, instead, strictly for the purpose of marketing the fund to other investors. Fund companies can use revenues generated by 12b-1 fees to place ads in newspapers and other publications, compensate sales professionals for providing services, cover the cost of printing prospectuses for prospective investors, and pay for other marketing initiatives aimed at attracting more investors to the fund.
In addition to the 12b-1 fees, fund companies may also charge investors another 0.4 percent of total assets each year to pay the cost of listing their funds on retail trading platforms, such as those of Charles Schwab or TD Ameritrade, in order to attract new investors.
Determining exactly how much you’re paying in annual fees to your mutual fund company can be very difficult. Some of the most confusing language you will ever read can be found in the “expenses” section of a fund’s prospectus. The confusing language makes it almost impossible to decipher exactly what you’re going to be charged to own the fund. The important point to recognize is that financial services companies are not in business to make you wealthy. They are in business to make a profit—and that profit comes from fees paid by their customers. As an investor, it’s important for you to identify the real costs of your broker-client relationship and to try to keep those costs to a minimum. After all, it’s not what you make as an investor that matters—it’s what you keep.