39 Graham and Dodd and the Efficient Market

JANUARY 1998

Sell Discipline

Third Avenue Value Fund (TAVF) is going to continue to be a low turnover buy-and-hold fund, i.e, a reluctant seller. The Fund sells in the open market, rather than waiting for a takeover, when management suspects there might be a permanent impairment of capital. Occasionally, TAVF does make a good sale, such as Apple Computer common stock. More often, though, and especially for large-cap companies, the Fund sold prematurely; i.e., Piper, Digital Equipment Corp. and Kemper Financial. Over the years, Fund performance has been pretty good. However, I suspect, but don’t really know, that performance might have been even better if Third Avenue had never sold anything in the open market. I suspect, further, that the Fund’s buy criteria are so conservative that the sell side should continue to be used quite sparingly.

November 13, 1997

During the last quarter, I was asked to address the Seventh Annual Graham & Dodd breakfast sponsored by the Columbia University Graduate School of Business. Below is a reprint covering my talk at the breakfast.

I am especially honored to be a speaker at Columbia Business School’s Seventh Annual Graham & Dodd Breakfast. The writings of Benjamin Graham and David Dodd in Security Analysis and The Intelligent Investor have had such a dramatic influence on me: the way I invest; the way I think about finance.

Graham & Dodd, in the broad scheme of financial analysis, seems to be a case of arrested development. Since the early 1960’s, Modern Capital Theory as embodied in the Efficient Market Hypothesis (EMH) and Efficient Portfolio Theory (EPT) has taken over corporate finance. Graham & Dodd fundamentalism has virtually disappeared so that the financial world seems utterly bereft of the important scholarship that ought to exist to build upon the framework contained in the works of Graham & Dodd (and probably Dewing and others before Graham & Dodd).

It is a shame that Graham & Dodd have been shunted aside for the last 30 years or so. EMH and EPT are not at all useful tools for most value analysis, other than risk arbitrage analysis, a small sized offshoot of value analysis. EMH and EPT seem to be strictly technical-chartist approaches to studies of securities while Graham & Dodd place some emphasis on fundamental analysis. A technical-chartist approach is one where conclusions about securities are drawn from studying the prices of securities and the behavior of securities markets. Fundamentalism exists insofar as there is a focus (even though not always an exclusive focus) on gaining insight into matters internal to the firm which contribute to an assessment of the dynamics of the firms as well as the private, and/or takeover values of the business. Fundamentalism also involves obtaining an understanding of the specific terms existing for securities issued by a company.

EMH is a preferred approach useful where two “special case” conditions exist in concert:

  1. The solitary goal of a passive, non­control, “investor” is to maximize a risk­-adjusted total return consistently. Consistently means all the time. (It seems to me, as it did to Benjamin Graham, that most people or institutions trying to outperform, or even just equal, a market consistently are best described as short-­term speculators, not investors).
  2. The securities to be analyzed are best analyzed by reference to a very limited number of computer programmable variables. Such securities seem limited to the following:

The funny thing about Graham & Dodd is that lots of people talk about Graham & Dodd, but very few people seem to have actually read the earlier editions of Security Analysis or The Intelligent Investor.

In terms of equity investments, Graham & Dodd have given outside passive investors a series of terrific caveats by which to live if the investor really does not know very much about the company with which the investor is involved, or the specific securities issued by that company. The Graham & Dodd caveats provide a margin of safety.

I believe though that today, unlike the Graham & Dodd period, public disclosures have gotten so good that it is now possible for an outsider who is not a very, very short-term trader to know much about many companies just from the public record. Most of the improvements in public disclosures seem to have occurred subsequent to the publication of the pre-1988 editions of Security Analysis. There has been a disclosure revolution in this country which I trace to the Securities Acts Amendments of 1964. Now an outsider, who is a buy-and-hold investor trained in fundamental analysis, can know an awful lot about an awful lot of companies just by relying on the public record. For example, look at the overall success in earning excess returns for those involved in hostile takeovers from the 1970’s onward. In hostiles, all you have is the public record. Using inside information to acquire securities in a hostile is almost always a “show stopper.”

However, after 1964, there seems to have been little or no scholarship to advance fundamentalism beyond Graham & Dodd. All academics seemed to have focused on EMH and EPT. My fellow speaker, Seth Klarman, wrote a book on fundamental analysis, Margin of Safety, and I wrote a book on fundamental analysis, The Aggressive Conservative Investor. Almost nobody bothered to read either book.

Graham & Dodd were less good in their approach to credit analysis than they were in their approach to equity analysis. Graham & Dodd’s credit analysis essentially involved gauging the prospects of whether or not a money default might occur for any debt issue in a corporate capitalization. The analysis was basically quantitative with an emphasis on overall coverage. My fundamental credit analysis, on the other hand, involves the assumption that a money default will occur and then gauging how the security will work out either in an out-of-court restructuring or a Chapter 11. For this type of approach, analysis of debt covenants become crucial, and coverage is measured at various levels of seniority and not on an overall basis (unless you are looking at the most junior issue in a company’s debt capitalization).

It seems to me that the most successful people in the financial community — control buyers such as Warren Buffett, Carl Icahn, Ron Perelman and Richard Rainwater — approach securities analysis quite differently from Graham & Dodd or EMH theorists. In investing passively, I try to emulate these control buyers. These successful people analyze what a business is worth and what its dynamics might be; all done from the bottom-up. They then stop. The focus in Graham & Dodd and EMH is different. The Graham & Dodd and EMH goals are to predict where a security will sell in a market populated by outside, passive minority investors. Compared with the best investors, Graham and Dodd seem to carry a lot of excess analytical baggage. This excess baggage is mostly irrelevant to determining an underlying business value. Among these extraneous factors that are irrelevant to valuing a business’ fundamentals are the following:

  1. Dividend policy
  2. Macro market factors
  3. General level of interest rates
  4. Technical factors, such as supply and demand for marketable securities

Graham & Dodd, along with EMH, undertake virtually all their analysis of companies whose common stocks are publicly traded (other than investment companies whose assets consist of marketable securities) based on a strict going-concern assumption. It is assumed that the company being analyzed will continue to operate in the same industry it always has been in, financed the way the business has always been financed, managed as it has traditionally been managed, controlled as it has been controlled and owned as it has been owned. I am convinced that the strict going-concern assumption is unrealistic. Few, if any, companies are going to go as long as five years without being engaged in mergers and acquisitions, massive refinancings and restructurings, massive asset redeployments, changes in control, and liquidations, in whole or in part. Until the early 1990’s, the strict going-concern assumption seems to have been accurate for the electric utility industry but in few other places. The strict going-concern assumption is no longer accurate even for electric utilities.

A logical concomitant of the strict going-concern assumption is that the past earnings record, or in the case of EMH, the past cash flow record, is the best indicator of what future results will be for the company. Thus, there is a belief in the primacy of earnings, or cash flow, as determinants of corporate value. This emphasis on flows, whether cash or earnings, denigrates in importance two other areas where corporate values are created

In our fundamental analysis of equities, we do not place much emphasis on predicting the future. Rather we try to buy what is “safe and cheap.” The companies in whose equities we invest are supposed to have four characteristics:

  1. Exceptionally strong financial position, as measured by an absence of liabilities either on balance sheet or off balance sheet; the presence of high quality assets such as surplus cash; and/or the presence of operations that generate unencumbered cash flows available to service the capitalization, e.g., money management firms.
  2. Reasonable managements from the outside stockholders’ point of view. (This is the toughest area for us in most analyses).
  3. An understandable business, which in each case means complete public filings, especially with the SEC, and reliable audits useful to us as objective benchmarks which we treat as tools of analysis. We use financial statements, not because they are Truth, but rather because they are Objective Benchmarks.
  4. We try to pay no more than 50 cents for each $1 we think the common stock would be worth, were the company a private business or a take­over candidate.

There are trade-offs involved in following our approach. In almost all cases when we acquire a security, the near-term earnings outlook is terrible. Managements of the companies whose common stocks are in our portfolios tend to be non-promotional and highly conservative, willing in up periods to sacrifice returns on equity and returns on assets for safety. The markets for many securities we own are relatively illiquid.

There are two important respects in which I would like to distinguish Graham & Dodd from EMH:

EMH is information unconscious. EMH theory is that in order to outperform a market, an investor has to have superior information. Graham & Dodd, in contrast, are right on the money in their premise that the route to investment success is to use the available information in a superior manner. As technician-chartists, EMH people seem to have no conception of what corporate information is and how it is used. Some of them even seem to think that algebra is more important than Financial Accounting. In the preface to a leading EMH text, Principles of Corporate Finance by Brealy and Myers, there appears this statement, “There are no ironclad prerequisites for reading this book except algebra and the English language. An elementary knowledge of accounting, statistics and microeconomics is helpful, however.”

EMH is price unconscious. Market price in EMH represents a universal equilibrium establishing business values for all purposes. Graham & Dodd, on the other hand, point out that market prices can be too high or too low; or to paraphrase Ben Graham, Mr. Market is an extremely emotional fellow, subject to frequent fits of irrationality. The EMH view seems summarized by the statement of William F. Sharpe, a Nobel Laureate, in the Third Edition of his book, Investments, “Every security’s price equals its investment value at all times.” If Bill Sharpe really believes that, I own a bridge to Brooklyn which I would like to sell to him.

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