Benjamin Graham, the father of value investing, would have been 125 years old this week. The idea he fostered—buy cheap stocks and hold them for superior long-term returns—is looking geriatric, too.
Faster-growing, higher-priced stocks have outperformed by such huge margins recently that the long-run advantage of value stocks has withered away. Will that last? Probably not. Was Graham wrong? Almost certainly not. But value investors shouldn’t try to hide how dark the evidence looks—and they should ponder whether the world has changed.
Graham, Warren Buffett’s teacher and one of the greatest investors of the past century, had three profound insights.
First, a stock isn’t a piece of paper or an electronic blip, but an ownership stake in an underlying business that can be evaluated based on the cash it is likely to produce.
Second, the stock market may swing from euphoria to misery, but you aren’t obliged to share its moods.
Third, you must allow a margin of safety—a cushion of value that comes from thinking in ranges and probabilities rather than believing in exact certainty.
“The original Graham approach of looking for cases where you’re getting more than you’re paying for is correct,” Berkshire Hathaway Inc. (BRKB) Vice Chairman Charlie Munger told me and my colleague Nicole Friedman last month. “That will never go out of style.”
Still, Graham-style investing hasn’t been very stylish lately.
Over the past five years, the S&P 500 Growth index, led by such gazelles as Amazon.com Inc. (AMZN) and Google’s parent, Alphabet Inc. (GOOG), has generated an average 14.2% return annually. The S&P 500 Value index, full of such mastodons as JPMorgan Chase & Co. (JPM) and AT&T Inc. (T), gained 8.7% annually. At this point, growth has slightly outperformed value over the past 20, 25, 30, 35 and 40 years as well.
That may be partly because giant technology companies seem to be getting even more dominant as they grow bigger, instead of becoming more sluggish. That could mean weaker competitors may no longer be able to recover from setbacks that once would have been temporary—making the turnaround stocks long favored by value investors less likely to turn around.
Or perhaps value investing got too popular for its own good.
After technology stocks were crushed in 2000-2002, investors favored safety over growth. In the 10 years through the end of 2014, investors pulled an estimated $273 billion from funds investing in large growth stocks and poured $87 billion into large-company value funds, according to Morningstar. As value went from pariah to crowd-pleaser, its returns went cold.
Meanwhile, fewer investors analyze one value stock at a time by hand. Often, they use computers to buy the value “factor” en masse, capturing cheapness as a common attribute across hundreds of stocks at once.
That has lowered costs for investors. But it has also driven up prices, reducing the supply of bargains among value stocks, says Tano Santos, faculty co-director of the Heilbrunn Center for Graham & Dodd Investing at Columbia Business School.
Think of stock picking as a poker game, says Michael Mauboussin, director of research at BlueMountain Capital Management, a hedge-fund firm in New York. As low-cost index funds and “factor” strategies become more popular, they drive weaker managers out.
“If the weak players have left the table, then the only people left are the smart players,” he says. “For one of these remaining sharpies to win, the others have to lose. The game becomes more difficult, not simpler or easier.”
Even so, automated value-factor funds and traditional value investing by stock pickers can coexist, says Ronen Israel, co-head of portfolio management at AQR Capital Management in Greenwich, Conn.
The approaches, he says, are “complementary, not mutually exclusive.” Across many assets worldwide and for many decades (until recent years), value investing has prevailed—whether it was statistically driven across hundreds of stocks or built one selection at a time.
Graham might feel out of place today. In his book “The Intelligent Investor,” after which this column is named, he was deeply distrustful of businesses that produced a superabundance of cash. During the Great Depression, he fulminated against companies that hoarded cash for their own survival instead of paying it out for their investors’ benefit.
Graham therefore might not have known what to make of a company like Amazon, which generates rivers of cash that Chief Executive Jeff Bezos then reinvests in ventures that may not pay off for years. Amazon’s stock never looks cheap by conventional value measures, but Mr. Buffett’s Berkshire Hathaway recently bought some.
Evaluating the CEOs of cash-rich companies who must allocate billions in capital has become part of what it means to be a value investor, says Prof. Santos—and, so far at least, that might be a task humans can do better than computers.
It’s especially important, in a world increasingly dominated by index funds and managers mimicking them, for investors to separate themselves from the herd.
That means doing what even most professional investors can’t: investing patiently in companies that measure their own progress against long-term goals, rather than short-term earnings or recent stock-price changes. Above all, says Paul Woolley, a former professional investor who runs the Centre for the Study of Capital Market Dysfunctionality at the London School of Economics, “you need to be a long-horizon guy investing in long-horizon businesses.”
|For more news you can use to help guide your financial life, visit our Insights page.|