A contrarian look at Benjamin Graham

When Benjamin Graham died at age 82, he was one of the great legends of Wall
Street, brilliant, successful, ethical - the man who invented the discipline of security
analysis. Now, 20 years after his death his memoirs are reaching the public at last -
a hugely successful chronicle of one of the richest and most eventful lives of the
century." - Kirkus Review, June 9, 1996

In a readable and incisive book "Practical Speculation" by Victor Niederhoffer and

Laurel Kenner, I came across a critical assessment of Benjamin Graham.

"The ancient Greeks had Hercules, the mighty hero deified by Zeus for noble deeds
and worshipped by men. In the twenty-first century, Americans have Benjamin
Graham.

Tales of the prowess of Hercules - and his promiscuity - passed from generation to
generation in Greece. The modern hero of the investment world has similar
characteristics and impact. On the Internet, we found thousands of articles
eulogizing Graham and not a single one with any negatives. The most frequent
epithets: "father of security analysis," "a prophet," "the legendary investor,"
"founder of value investing," "master of the investment game," "the Confucius of
value investing," "pioneer of value investing," and "the revered mentor to the most
successful investors of all time." Graham is said to have amassed a fortune by
following a method of buying stocks selling below half their net cash liquidation
value. The method is outlined in Graham and Dodd's Security Analysis, a book widely
known as the bible of value investing.

Graham's followers include such famous and successful investors as his former
student Warren Buffett, who was active during his mentor's lifetime in leading
worshipful tributes to him. "We are here for only one reason," Buffett said on a cruise
with Graham that he organized for wealthy investors, "to listen to the wisdom of
Benjamin."

Like most legends, many of these encomiums are half - truths at best.

Performance Test

Considering the great gap between Graham's theory of value investing and the
chances of putting it into practice, it is not surprising that performance of the funds
he managed was not as attractive as legend would have it. The universally revered
apostle of prudent investing was devastated after the crash of 1929. After finishing
1928 with a 60 percent return, he lost 20 percent in 1929. He lost 50 percent more
in 1930. In 1931, he lost 16 percent. In 1932, much to the relief of his investors, he
lost a mere 3 percent. Journalist Janet Lowe, in Benjamin Graham on Value
Investing: Lessons from the Dean of Wall Street, wrote:

Though Graham was able to stumble back and regain his footing in the market rather
quickly, after Black Tuesday, Ben's high-risk days were over. Afterward, he struggled
to squeeze the best possible return from his investments, while at the same time
seeking that wide margin of safety. The average returns on Ben's portfolio
descended from the heights of the pre-Depression years.
Graham always believed that a Dow of more than 100 was too high, and when it got
there, he never again felt comfortable in the market. As the Dow never fell below
100 after 1942, Graham was always leaning toward being too defensive. In the early
1950s, when the Dow was about 300, he began to pull back from his business and
advised his students against going into investing: The market was "too high."
Because he believed for so long that the market was overvalued, his investment
performance did not measure up to a buy-and-hold strategy or any other sensible
alternate strategy. In 1956, the year the Dow topped 500 for the first time, he left
the business for good and devoted himself to a life of pleasure.

One of the most curious - and murkiest - aspects of Graham's performance record is
the question of how much his success was attributable to Geico, the insurance
company he later sold to Buffett. Graham wrote in The Intelligent Investor that the
one investment he made without following his own methods was the purchase of
Geico. It is likely that the returns he realized from Geico were much greater than the
total returns he realized by applying his own methods. The insurer has also been the
mainstay of Buffett's success, providing copious cash float for arbitrage transactions.

One thing we do know about the returns from following Graham's methods. In 1976,
a student founded a mutual fund devoted to putting Graham's theories into practice.
It was called the Rea-Graham fund. When the fund was liquidated or merged in
1998, it was worth $3.6 million in assets. In this day and age, where a fund manager
with a good story can often start with $500 million in seed capital and attract billions
more with just a few successful years, the ending total assets of this fund shows that
its actual performance was meager at best.

Table 1 shows how $10,000 invested in the Rea-Graham fund at its inception in 1976
would have fared versus the S&P 500.

Thus we can summarize the performance in practice of Graham's method as follows:

His performance was disastrous in the 1930s when he liquidated. He stared again in
the late 1930s and got out of the market in 1956, missing the move from Dow 500
to Dow 1000 over the next 20 years. A fund that put his methods into practice from
1976 to 1996 underperformed the S&P500 by a factor of 4 to 1.

Value's Dismal Performance

On the surface, Graham's message to buy value stocks seems perfectly reasonable.
Who does not want value for his money? But there is one small problem: Contrary to
widespread belief, value stocks have consistently underperformed growth stocks
since at least 1965. The evidence was provided, quite by chance, by the venerable
research firm Value Line.

Table 1. Rea-Graham Fund Performance versus S&P 500

(Dividends Reinvested)

Starting Investment = $10,000 (June 30, 1976)

 Period Ending Rea-Graham ($) S&P 500 ($)
12/31/76 10,846 10,513
12/31/77 11,194 9,758
12/31/78 12,355 10,394
12/31/79 14,362 12,312
12/31/80 15,837 16,312
12/31/81 18,391 15,516
8/19/82 18,856 13,820
3/31/83 23,035 20,734
3/31/84 23,789 22,534
3/31/85 26,928 26.774
3/31/86 34,380 36,814
3/31/87 37,602 46,455
3/31/88 38,273 42,564
3/31/89 41,182 50,234
3/31/90 43,101 59,874
3/31/91 43,478 68,473
3/31/92 45,797 76,002
3/31/93 49,662 87,548
3/31/94 48,213 88,825
3/31/95 48,291 102,627
3/31/96 54,005 135,470
3/31/97 57,467 162,290
3/31/98 65,215 240,000
9/30/98 57,709 223,290
11/15/98 60,898 247,606

Unintentional experiments often are provided by the gods to allow mortals to see the
light. John/Joan, who lost his penis in circumcision as an infant, was raised as a girl.
His twin brother was raised as a boy. The outcome was that Joan acted just like a
boy, and eventually reassumed the identity of a boy.

The gods of investment provided a similar unintentional experiment to determine

which class of stocks provides better long-run returns: value or growth. Value Line is
an admirable service whose research director, Sam Eisenstadt, is a young-hearted
person who always looks to improve his own knowledge and the products he
provides his customers, despite the firm's great track record. In 1965, prompted by
gains in value stocks and by Sam's desire to offer clients an alternate rating system,
Value Line started selecting the best value stocks in their universe. The firm divided
its sample of 1,500 companies into 10 groups based on value, updating the
selections each month. The selection system used the same key variables that
almost everyone else uses to define value stock (i.e., price to sales, price to book,
and price to earnings). But there was one difference that today, almost four decades
later, makes all the difference in evaluating the stocks' long-term performance. In
contrast to retrospective studies of value stocks, the Value Line companies were
selected contemporaneously. Thus, the Value Line value stock performance record is
a real-life unintentional experiment with no back-testing, survivor bias, or armchair
quarterbacking.
The procedure has remained the same since 1965. Each group is updated each
month. Results are reported every six months in Value Line's Selection and Opinion
publication. The one problem is that the firm reports price appreciation rather than
return, and our studies have shown that the dividend yields of value stocks are 2
percent higher, on average, than those of growth stocks.

We report the results of the experiment in Figure 1 and Table 2. Value Line Group I,
consisting mainly of growth stocks, quickly outpaced the three value stock
categories. By March 2002, the growth stocks had returned almost 28 times the
return of the best-performing "value" group, "low price / sales."

Figure 1. Value versus Growth

Table 2. Value versus Growth (Dividends Reinvested)

Low Low
Starting Group 1 Low P/E
Price/Sales Price/Book
Value 100 100
100 100
January 1970 216 191 205 188
January 1980 2,782 815 1,450 1,086
January 1990 16,540 1,326 3,034 1,296
March 2002 46,885 1,698 1,555 1,250

Certain aspects of Graham's life do have a mythical quality. After the tragic suicide of
Graham's son in France, Graham traveled from his home in California to collect the
deceased's belongings. On arriving, he fell in love with his late son's girlfriend, Marie
Louise. As Graham was already married, he suggested to his fourth wife, back home
in California, that she share him with his new amour. Much to Graham's wife's
distress, she thenceforth saw her husband only six months out of every year. The
tale has odd echoes of Zeus' philandering and Persephone's annual six-month
descent into the underworld to be with her husband, Hades, lord of the dead, during
the winter months.

Belief in Zeus and the feats of Hercules eventually dwindled into insignificance. We
suspect that the legendary father of value investing will be treated no better by the
gods."