An old joke that Peter Lynch often brought up when given the opportunity to give a speech went as follows: Lynch would describe a press release that has legendary Magellan mutual fund trounced the S&P 500 by five, even ten percentage points in some years, and later that day, he’d get a call from a client saying, “Yeah, that’s nice, but why’d you buy that dog Bethlehem Steel? You lost 80% on that one!”
The example was used to show how irrational some clients can be; even when your returns are in the top 1% of all investment managers out there, some people can still find something to complain about (as an aside, that is why the truly successful mutual fund managers quickly exit the public domain once they have made “enough”, and then they tend to go super private by either managing their own money or investing privately on behalf of some particular clients that they know to be rational—when you’re worth tens and tens of millions of dollars, you don’t need to deal with people that don’t truly believe that good value investing often means underperforming the S&P 500 at least one out of every three years).
I mention that lead in for one reason: Benjamin Graham’s style of investing would not make him a popular investor today. There are two reasons why this would necessarily be so: stocks don’t trade at prices that grant the same kind of margin of safety you could get in the aftermath of the Great Depression years. While steering the Graham-Newman fund, Graham was able to find stocks that were trading for amounts that closely resembled the amount of cash assets they had on hand. There were companies in his portfolio that had a total market capitalization of $25 million and $20 million in the bank. A full cash dividend could almost give you your entire investment back overnight!
The valuations seem absurd to us, but the context explains it: When one out of four able-bodied men are lining up for soup and pieces of bread, and you’re not even sure that your country will be existing five years from now, you’re not going to be thinking about investing, let alone doing it rationally. That’s why Graham and Templeton earned the respect of so many; they had cash, and they acted upon it, during a time in which almost no one could do so (people who say “oh, they’re rich, that made it easy” is a casual, beer-in-hand-while-sitting-in-an-armchair insult that ignores how much preparation is necessary to structure your life in a way that you’ll be able to meaningfully participate in super deep stock market declines).
The second reason why Graham would have struggled in today’s world relates to the Lynch anecdote mentioned above: Graham’s investment style incorporated a lot of failure. By that I mean, he would build a diversified collection of 200-400 stocks that were quantitatively cheap, with it being fully understood that some of the investments would go bankrupt. When successfully executed, the Graham strategy would witness the best picks triple or quadrupling in a timeframe under five years, thus overcompensating for the dozens of picks that ultimately go bankrupt. Even though the returns were there (19% annually for 10+ years), I’m not sure investors in a Graham mutual fund would be okay seeing a listed holding in the fund go bankrupt every couple weeks. Sure, they might tolerate it doing boom times, but my guess is that lay investors in a Graham fund would bail during a 2008-2009 type of situation when the fund would be falling substantially while you’d be learning about bankrupt holdings within it (this should be distinguished from Berkshire Hathaway, which had the lowest turnover among any corporation worth more than $50 billion during the 2008-2009 period).
Even if it’s not right, it is understandable—from a psychological perspective, people experience more pain from $1 of loss than the amount of joy they receive from $1 of gain. I don’t know if it’s an evolutionary vestige or what, but my guess is that a lot of people wouldn’t be able to handle Graham’s investment style that bakes in a certain amount of failure. I think a lot of people would enjoy the ride of owning 10 stocks that appreciate at 8% annually a lot more than they’d enjoy getting 9% aggregate returns from a ten-stock portfolio that experienced two bankruptcies.
That brings us full circle back to the kinds of companies that I typically discuss on this site: With companies like Exxon, Nestle, and Colgate-Palmolive, the risk of holding the stock is not that the companies will go bankrupt. Rather, the risk is that growth will disappoint or you’ll pay too high of a price for your shares, and your money might compound at 6% while the S&P 500 goes up at 8% annually (or whatever the figures might turn out to be). In other words, it’s a strategy that involves very few strikeouts (you might have a Wachovia here and there). Rather, the risk is that you could spend a while hitting singles while the S&P 500 is hitting doubles (particularly in the boom years). While there are too many variables at play to determine whether a blue-chip dividend strategy would beat someone employing a Benjamin Graham quantitative strategy, the blue-chip strategy is much more psychologically appealing because growing dividends and negligible bankruptcy risk appeals to people’s cautionary desires to protect their money.
With Graham, the safety is in diversification and the low price paid for the stocks (the safety is not in the companies selected). With a blue-chip dividend strategy, you get safety in both diversification and the companies chosen, and occasionally the price paid (such as purchasers in ’73-’74, ’90, ’08-09, etc.). The near elimination of bankruptcy risk is a trump card that blue-chip investors possess, and I think its psychological value is all too easily dismissed when people discuss preferred investment strategies that real people in the real world ought to adopt.
Originally posted 2014-05-20 09:00:09.