Memo to Ben Graham: Help!

The king of value investing was almost wiped out in the Great Depression, but by sticking to his core principles, he bounced back and built a fortune

Globe Investor Magazine,
November 18, 2008
By Chris Taylor
Photographs by Bettmann/Corbis

Memo to Ben Graham Help!

Here's the advice (we believe) he'd give today

Mike Kazmaier doesn't know whether it's Christmas or Armageddon. The 28-year-old computer- systems engineer from Guelph has long been an investing buff, dating back to his university days, when he was reading The Wealthy Barber and trading stocks online while his classmates pondered the relative merits of draft versus bottled beer.

But this latest market plunge-swift, deep, often without mercy -is something new to Kazmaier's budding investing career. Never before has he seen the Dow off 40% from its highs, world credit markets paralyzed, governments and central banks befuddled, and investors in full retreat.

"It's easy to get caught up in the mania," says Kazmaier, who estimates his portfolio has already shed about 20% and counting. "People are reacting to the panic,not to the fundamentals, and it doesn't make a whole lot of sense. Sometimes you get a sick feeling in your stomach."

It's enough for him to look to the heavens and ask: What would Ben Graham do?

That's because Kazmaier, like countless other investors, is an ardent devotee of Graham, author of classics like Security Analysis (with David Dodd) and The Intelligent Investor. Another disciple of note: The richest man in America, Berkshire Hathaway billionaire Warren Buffett (whose son's middle name, not coincidentally, is Graham).

Graham is widely acknowledged as the father of value investing-the school of thought that's sober, numbers-based, and which aims to buy companies at hefty discounts to their intrinsic value, rather than according to the minute-by-minute mood swings of the investing public. So-called Mr. Market isn't at all rational, showing up at your door every day and offering you a different price for your shares. Just take a look at the bipolar Dow this fall: down 777 points one day, up almost 1,000 a few days later.

"Graham used to talk about Mr. Market being a manic, paranoid, schizophrenic individual who goes up and down for any reason at all, unrelated to the fundamentals," says George Athanassakos, director of the Ben Graham Centre for Value Investing at the University of Western Ontario. Our purpose as value investors is to find out what those fundamentals are, determine intrinsic value, and not be swayed by human emotions."

In theory and results, a solid philosophy. In practice, very hard to pull off, because when everyone in a crowded movie theatre is shouting fire and fleeing for the exits, it takes nerves of steel to do the exact opposite. "The hardest thing for value investors to do is to control their emotions,"says Kazmaier."I figure this crash is a great test of my resolve and emotional control, if I can keep my head about me in this environment."

Kazmaier's cold-blooded philosophy is being put to the test. So far in this plunge, value managers are under performing the general market-and in convincing fashion,too. The body count of firms that appeared dirt cheap, and then somehow managed to get even cheaper, keeps rising: Lehman Brothers, Fannie Mae, Freddie Mac, Bear Stearns, Washington Mutual, AIG and, by the time you read this, probably a few more. Along with those stock prices have fallen the reputations of famed value managers like Legg Mason's Bill Miller, Oakmark's Bill Nygren and the management team at Dodge & Cox, all of whom have been taken to the woodshed.

It's a stunning turnaround from the tech bust of 2000-2002, when it was the growth managers who took it on the chin, and value investors made it through relatively unscathed.

"There's a common perception that a deep-value approach is very safe," says Jordan Benincasa, a fund analyst at research shop Morningstar Canada. "But that doesn't mean investors won't be experiencing high volatility. In fact, during downturns, investors usually turn to the highest-quality companies for safety. Companies experiencing problems, which value managers are often attracted to, tend to fall even further than others."

To wit: As of Sept. 30, the TSE had slid a shade more than 13%, but some of Canada's biggest value funds have plunged even more. Mackenzie Cundill Value, led by prominent value manager Peter Cundill, shed 15.6%. ABC Fundamental-Value, led by Irwin Michael, was off 23.6%, and Francis Chou's Chou RRSP fell 22.9%. Brandes Canadian Equity plummeted 27.9%, and Tim McElvaine's McElvaine Investment Trust, down 28.2%, fared even worse.

The moral of the bloodbath: Common valuation metrics cherished by Graham enthusiasts, like a rock-bottom P/E or price-to-book ratio, don't seem to mean a whole lot in the short term,when you're in the middle of a financial hurricane. And just because a stock looks beaten down doesn't mean it can't get beaten down some more (or, in Lehman's case, drop to nothing).There's good reason why deep-value investing is likened to catching a falling knife.

This is high-risk territory, with your family's wealth at stake. So perhaps it's time to pause and return to a deep reading of Ben Graham's original thoughts. He isn't around any more to discuss the issue, of course, having passed away in 1976. But Graham was intimately familiar with a market gone wild: He began teaching his value-investing philosophy at Columbia University in 1928, just before the crash that would eventually erase around 90% of the total value of the stock market. That kind of performance makes the current drop in the Dow seem like a stroll in a field of wildflowers. It wiped out countless investors, and came close to claiming the king himself: Graham almost went bankrupt.

In 1929, his investing partnership sank 50%,and lost another 50% for good measure the following year. At his absolute low point, his investments had dropped by 85%-better than the general market, but hardly a record to crow about. It's what he did during that brutal time, though, that confirmed his legacy. He stuck with and refined his core principles like low P/E and debt-to-equity ratios, paired with strong records of dividend payments and earnings growth.