Brandes Essay Competition winner 2021

Wednesday 10 November 2021

Forestry

 

Author: Tigran Manukyan, CFA

The most underappreciated aspects of Graham’s writings include his advocacy of and warnings for passive investing, his observations presaging today’s rise of private capital, and his unexpected advice in contrarianism for systematic investors. Explored through these lenses, Graham’s lessons on intelligent investing and security analysis find even more relevance today.


Introduction

Ben Graham’s writings have been studied and followed over the course of a century. Many of his most underappreciated lessons relate to domains less obviously connected to him, including passive funds, systematic investing and private capital. Graham’s principles and observations presaged the development of the modern investment industry we work in today. Explored through these less discussed lenses, Graham’s timeless lessons on security analysis and intelligent investing become even more poignant and relevant for us today.


The father of security analysis was an advocate for passive investing

It almost reads as a minor heresy, but Ben Graham was a strong advocate of what we’d today call ‘passive investing’ as the appropriate route for many investors.

He wrote that the attempt to be an outperformance-seeking enterprising investor is not a decision one takes lightly and cannot be done in half measures: “If you merely try to bring just a little extra knowledge and cleverness to bear upon your investment program, instead of realizing a little better than normal results, you may well find that you have done worse”[1]. Instead, “a credible if unspectacular result can be achieved with minimum effort and capability” by just buying and holding a representative list of “leading” stocks.

The relevance of this old but simple lesson was eventually seized upon by the investment industry in the passive revolution of the last few decades:

 

We tend to associate this recent surge in passive investing with a similarly recent increase in market efficiency and new challenges faced by active funds in outperforming net of fees. Certainly, there is more than a hint of truth to this. But Ben Graham reminds us that the depths of the 20th century were not an active investor’s nirvana: “the majority of investment funds… have not performed so well over the years as the general market”. An ever-changing and challenging investment landscape was a constant, even if hindsight bias makes us imagine that famous investors of old earned superior returns by just turning up.

One noteworthy development over the decades has been the use of more sophisticated benchmarking techniques that improved how we understand value-add, but ironically encouraged more closet indexing as seen in the chart[2], reducing the ability of such funds to outperform their fees:

 

The relevance of this today is that investors should embrace a barbell approach across low-cost index-based allocations and high conviction active managers according to their needs. A conservatively high hurdle must be set in the selection process so that one can form a strong thesis around the manager’s ability to go the whole hog in the way Graham describes.

The Cremers and Pareek (2015) study[3] suggests a good place to look for superior results would be the subset of managers who have high active share and low turnover. I imagine myself presenting Graham with this study. It would be like telling my grandmother that the latest scientific research[4] recommends chicken soup as a cold remedy.

 

 

Graham’s warnings for the ‘passive speculator’

Graham’s advocacy of passive investing was in specific domains such as diversified large cap equities (sometimes with additional qualifications like conservative financing) held for many decades. Such an allocation implicitly came with the thesis of “safety of principal and an adequate return”.

Today, the growth of passives and ETFs more broadly has encroached on every corner of the investing world, dividing markets into ever new products. Captured via an index (of which there are over 3 million, vastly more than stocks[5]) any esoteric basket of securities can lay claim to the self-serious title of asset class implying the ready existence of some sound investment thesis that one need only passively profit from. Would-be investors are lured into unintelligent speculation as Graham would describe, e.g., “speculating when you think you are investing”.

2021 has many examples of this in action, which I illustrate below with a US SPAC ETF I chose at random.

 

Total returns 24/09/2021, Bloomberg

 

Even as SPACS are marketed as vehicles for long term wealth creation, many investors simply chased performance both on the way up and on the way down. This ETF is up since launch, but its ‘investors’ are down on a dollar-weighted basis, meaning they managed to snatch defeat from the jaws of victory. Graham describes countless investment fads through history and warns against attempting to trade one’s way to “a quick profit” through “hot issues”.

The parallel extends to highly accessible and low-cost trading apps which have led to a “frenzy”[6] of large-scale retail investor participation in complex leveraged instruments.

On the one hand these innovations are democratising markets and allowing millions to tap into their growth with ease and low costs in a way Graham would have admired. On the other hand, these same innovations become a backdoor lure into value-destroying speculation against Graham’s advice. Repeating the same mistakes of history in slightly different forms means the simplest lessons in Graham’s writings can prove to be the most underappreciated. This irony would not be lost on him: “the whole tragicomedy was repeated...”


Graham’s value and the value factor

‘Value investing’ as practiced by Ben Graham and his disciples is often used interchangeably with ‘value’ in the factor investing sense. The two certainly have areas of overlap, with Graham frequently referring to rules of thumb valuation multiples. Some investors, typically from a more quantitative background, entirely blur distinctions between Graham’s heritage and value as a statistical factor[7]. They reject arguments that the record long underperformance in the factor stems from simple measurements no longer capturing intrinsic value. Instead, they emphasise the irrationally coiled spring that is the value factor. The case for this is most strikingly made when we see that the last decade’s underperformance seems to be driven almost entirely by shrinking relative valuations of value stocks rather than anything that can be identified as permanently flawed:

 

 

Other investors, often from a discretionary investing background, recognise that value-based factor investing was indeed a proxy of sorts for Graham’s philosophy over long stretches time[8], but typically conclude that these simplistic rules by themselves may not be sufficient due to developments including the digital revolution and record low bond yields. If you subscribe to this, the takeaway is to be more creative and adaptive in one’s execution of value investing, but certainly to avoid throwing the baby out with the bathwater[9].

Graham would no-doubt embrace many of the general observations by the first community, e.g., in drawing from history to be sceptical towards “this time is different” arguments. At the same time Graham’s primary concern was not in investing in hundreds of securities, but on being a long-term owner of a concentrated book of businesses, attuned to their bottom-up realities and prizing his general principles above specific rules of thumb: “the application of sound investing principles will change over time - adapted to suit financial mechanisms and climate”.

Regardless of how one adjudicates here, there is a far simpler lesson from Graham often left under-appreciated in such discussions.


How CAPM might break margin of safety

Modern portfolio theory, CAPM and its successor theories divide the market into linear parts, with crisp distinctions between the market beta, other risk factors and alpha. As already explored, these played a large part in driving transparency, accountability and value for money in a nascent investment management industry.

Within this framework one allocates to the market factor alongside diversifying return sources such as a long-short value factor. Superficially this looks like we’ve taken a leaf out of The Intelligent Investor. However, overly rigid adherence to this framework could corrupt some of the most important lessons Ben Graham’s writings teach around margin of safety. A thought experiment illustrates why.


A zealous student of Graham strikes out on her own

An enterprising student of Graham develops the thesis that formulaic investing in high multiple shares is indeed too speculative (perhaps overly zealous, she cares little for the nuances we just discussed). Investment in such shares requires belief in permanently low inflation and bond yields, plus a political arena that is friendly to dominant business models. She puts a reasonable probability on the violation of these assumptions which would dramatically jeopardize the safety of principal. Instead, she wishes to invest formulaically in low multiple shares, deciding that these offer both an adequate return and safety of principal. I will simplify and call this a value strategy. This can be a conservative yardstick (as Graham would wish) for expectation-setting around more thoughtful value strategies.

She observes the below historical results[10] of this strategy with self-satisfaction. Her strategy delivered adequate returns including through recent decades (in excess of cash or inflation) and at a similar rate to the long historical record:

 

 

Safety of principal has also continued to be delivered, with the strategy rarely underwater over rolling 5yr periods.

 

 

Her friend who reads more widely and regularly attends investment conferences is dismayed at this prehistoric approach. He shows her the below chart. The value factor is probably broken and is losing money. She will keep missing out on superior returns from high multiple shares.

 

 

She replies that she does not wish to invest in the high multiple shares (but she does lament their dominance in the index). In her words, she does not wish to play chicken with central banks when with grounded assumptions she can already get adequate returns. Even if that risk does not come home to roost this year or this decade, it does not change her need for safety of principal.

Besides, her investment bears no resemblance to the chart above. She is not shorting the high multiple shares - an activity which Graham would disapprove of since one is exposed to unlimited losses, nullifying any margin of safety in the simpler execution of value investing that Graham encourages.

This thought experiment should not be taken literally. But it illustrates the simple but under-appreciated point that Graham thought about portfolios holistically; not as the sum of a neat stack of modules. Perhaps when it comes to concepts like margin of safety, the whole is more than the sum of its parts.

The relevance of this in the modern investing paradigm might mean attempting to blur the lines between strategic asset allocation and manager selection. Of these specialised silos, the former typically concerns itself with cap-weighted indices and multi-decade investment horizons, whilst the latter often concerns itself with tracking error to this pre-established index, with a far less forgiving horizon, and with little care for any defensive properties of a strategy beyond what this means for benchmark-relative risk. The consequence of this blurring may be greater allocations to benchmark-agnostic managers and reliance on a more creative and qualitative evaluation of the performance which results.

Furthermore, investment strategies that use shorting and leverage can be an effective part of the investor’s toolkit as diversifying allocations. Graham levies warnings but concludes that “successful application is not impossible”. Once again, the relevance of his advice is simply to assess prospects for such strategies soberly and remember that volatility reduction as pursued by modern portfolio theory is not always compatible with concepts like margin of safety. Perhaps more importantly than for individual investments, even investment frameworks require stress-testing.


The relevance of Graham’s writings for being a contrarian systematic investor

To outperform, Ben Graham writes that “the investor must follow policies which are 1) inherently sound and promising and 2) not popular on Wall Street”. The second part is underappreciated but of great relevance for systematic investors today.

An investor searching for new factors typically finds themselves gravitating towards those with faster signals, particularly if they’re exploring novel data sources with short histories. This is because for a given sample of historical data, a strategy with more “trades” will produce back-test results of higher statistical significance. Yelnik (2017)[11] explores this, positing that these faster strategies are ironically likelier to collapse under their own weight as other investors are lured to what looks like a highly certain factor – not dissimilar to investors chasing overvalued glamour stocks. To exacerbate the issue, higher turnover strategies are lower capacity in the first instance, requiring fewer assets to flock to it before the discovered effect is eliminated.

It is impossible to establish this thesis definitively, but charts like the below are consistent with the idea that trading activity is becoming more short term[12]:

 

 

By contrast, factors with longer holding periods enjoy a lack of popularity thanks to the discomfort of lower statistical significance. They might be less certain, but should be more robust out of sample. Graham recognised this non-stationary property of markets, a result of fierce competition: “any approach which can be easily described and followed by a lot of people is by its terms too simple and too easy to last”. He recounts countless examples of previously effective investment rules ceasing to make money: “the advent of popularity marked almost the exact moment when the system ceased to work well”.

The under-appreciated relevance of Graham’s writing is that the merits of patient investing and contrarianism can also apply to the domain of systematic investing.


The rise of private capital and “the investor’s worst enemy”

The rise of private capital has been another disruptive force in our industry this decade with AUM rising beyond $7tn[13].

 

 

The so-called illiquidity premium is an important part of the draw for investors. Yet, evidence of its existence today is decidedly mixed. A rich literature is dedicated to discussing the ways in which, for example, buyout fund performance can be replicated (even exceeded) by mimicking their features in liquid markets[14].

If this potential for replication/outperformance is there, why the surging popularity of private capital? Graham’s writings offer a simple, under-appreciated and validatory perspective: “the investor’s chief problem - and even his worst enemy - is likely to be himself.” The reality is that many large institutions find it incredibly difficult to operate in volatile public markets with the temperament of dispassionate investors like Ben Graham. Behaviours like evoking “lack of permanent capital impairment” when VaR spikes, investing with an owner’s mindset agnostic to the benchmark and eschewing excessive diversification in a committee environment are difficult.

This very same conduct is behaviourally and organisationally far easier for LPs and GPs alike in the illiquid, mark-to-model and un-benchmarked domain of private capital. Whilst it rings of a defeatist attitude and an unspectacular reason to move towards private markets, Graham’s writings would support this trend if it stems from a self-aware appraisal of one’s strengths and weaknesses: one should control oneself “at one’s own game” rather than attempting “beating others at their game”.

Even half a century ago Graham noted: “the development of the stock market in recent decades has made the typical investor more dependent on the course of price quotations and less free than formerly to consider himself merely a business owner”. As this essay already laid out, this trend appears to have progressed further still in public markets, with sophisticated risk models, lower active shares and higher turnover being some of the causes and symptoms of this trend. The result has been that the industry has increasingly bifurcated towards the dual extremes of passive investing and private capital.


Full circle to the obliging Mr Market

Far from finding these developments disconcerting, long term public market investors should be excited.

With a record $2.5tn of dry powder waiting to be deployed by private capital, it is entirely conceivable that the illiquidity premium will at times be negative, i.e., that pockets of public markets may offer a “volatility premium”[15]

Ruffer illustrates this[16] by noting the record value of PE bids in unloved UK stocks this year, asking of fellow stock market investors: “what can they see that we can’t?” Having escaped to PE from the jitters of Mr Market, the same capital comes back in a different form to pick up its bargains.

 

 

This is an opportunity for long term public market investors, namely for institutions that can cultivate the collective temperament required to invest in the manner espoused by Graham. This would include creating a strong culture; developing a robust process, combining the diversity and balance of team-based decision making with the trust and shared accountability required for individual flair, for taking calculated risks and stomaching volatility with a long-term mindset.

Such investors might today find relevance in the one aspect of Graham’s writing which stays perennially under-appreciated by the majority - by definition. That is, embrace the lonely but rewarding position of investing in a way that is “not popular on Wall Street”.

 

Tigran Manukyan, CFA, Portfolio Manager & Senior Manager Selection Analyst, Fidelity

 


[1] Graham, B., The Intelligent Investor: The Definitive Book on Value Investing (revised edition), HarperCollins

[2] Petajisto, A. (2013) Active Share & Mutual Fund Performance

[3] Cremers, M. & Pareek, A. (2015) Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently; chart reproduced by Baillie Gifford

[4] https://www.sciencedaily.com/releases/2000/10/001018075252.htm

[5] IIA 2020 Index Survey

[6] https://www.ft.com/content/7a91e3ea-b9ec-4611-9a03-a8dd3b8bddb5

[7] Research Affiliates (2020) Is Value Investing Structurally Impaired?

[8] Onizuka, M. (2020) Is there now ‘value’ in value investing?

[9] Bulinski, T. (2019) The financial world has changed significantly since Benjamin Graham first published Security Analysis in 1934. Which, if any, of his ideas do you find still have relevance to the modern investor, and how do you apply them in your career?

[10] Asness, C. & Frazzini, A. (2013) The Devil in HML’s Details. My long-only series is approximated through the sum of the market factor and half of the HML Devil factor from the AQR paper. The general conclusion is not sensitive to this approximation

[11] Yelnik, I. (2017) Patience Premium

[12] https://www.reuters.com/article/us-health-coronavirus-short-termism-anal-idUSKBN24Z0XZ

[13] https://www.ft.com/content/4d0e6f18-2d56-4175-98c5-e13559bdbc25

[14] Stafford, E. (2016) Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting

[15] https://accelerateshares.com/blog/private-equitys-mark-to-model-career-risk-and-the-volatility-premium/

[16] Ruffer (2021) Going, going, gone!

 

 

 

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