Ruminations on Ben Graham’s 1963 Lecture
I’ve been reading a 1963 lecture by Ben Graham entitled “Securities in an Insecure World” recently posted on Jason Zweig’s website. It’s remarkable how relevant Graham’s comments are today despite the intervening 47 years, and though he antedates the behavioral finance school by multiple decades his arguments are in many ways quite similar.
One of his first observations is that the operating performance of a company and performance of its common share price are not similar. I believe this is something investors, myself included, too often forget. Companies that perform well operationally in one year can, in general, be expected to perform well the next. Not so the share price of a company. If the company performs well one year and therefore can be expected to perform well the next, its share price may, by the end of year 1, already reflect the expected good performance in year 2. I think this is the same thing as saying that the operational performance of a company has a long-term trend while the share price gyrate around the trend line to such an extent that it is hardly possible to identify the trend line from the share price movement. Furthermore, I think Graham was also saying that the history of a share’s price can’t be used to predict its future direction with any certainty, with which I concur exquisitely. [Please prove me wrong you Chartists out there] So why are quarterly earnings reports so important? Why do they move share prices 5%, 10%, 15% or more in a single day? I think this has mostly to do with the sensitive nature of a discounted cash flow analysis relative to its inputs; small changes in inputs result in large changes in present values. It is because of this sensitivity that I don’t hold much stake in dcf analyses. Why should a $.03 per share earnings miss translate into the loss of 10% of a company’s market value? Does anyone outside the company really know if its simply a quarter-to-quarter revenue or expense recognition issue or whether revenue or expense has suffered a long-term change? I tend to doubt it, as even those within the company with all the detailed numbers are, I’m sure, still discussing their meaning months after the earnings release. Simply put, no one can see into the future. So we can just forget about small misses on quarterly earnings, right? I think so. But more importantly, can’t we profit from this shortsighted reaction of most investors? Here, I think so too.
However, profiting from others shortsightedness is not as easy as it might seem. For example, BP’s share price has lost nearly 50% in value since the Gulf oil spill began. What is the real value of BP? No one knows, but surely it is greater than the market capitalization today; no one has yet estimated that the cost of the Gulf clean-up plus eventual other liabilities are as great as BP’s loss in market capitalization since the spill began. Thus, it must be the negative news surrounding the spill that has created a market discount; analysts downgrading the stock, portfolio managers dumping the shares in proximity to the next quarter end reporting, etc. So, is now the time to invest? Well, already some weeks ago certain hedge fund managers were taking a position in the company’s shares at prices 20% or more higher than today’s. Were they wrong? Probably not in the long run, but they jumped the gun as all value managers are wont to do. The market often overshoots valuations in the short-term. How low will the shares go? When should we pull the trigger? There is no easy answer. It’s more of a question of personal risk profile. I am resisting the siren call of BP shares until they trade into the mid to upper $20’s; I am happy to buy into BP only when I think there is a super discount. After all I only have to swing if the ball is in my strike zone; there is no penalty for waiting for another pitch. In any case, I don’t think the discount is going away soon, so there is plenty of time to take a position.
That’s just one example, and an obvious one at that. In the everyday world of stock selection how do we identify the company’s trend line, and above all, how do we estimate where in the fluctuation around the trend line the stock price is? Deep value investing avoids this question; you just wait until the trend line has been going down so long that there’s no place to go but up. You’re looking for investor capitulation rather than really trying to value the stock based on future operational performance. All you need is for the company to be worth more dead (in liquidation) than alive. Then the probabilities are that there is little more value destruction that management can achieve (though one should never underestimate the amount of value destruction that can go on!).
Getting back to the lecture, it is more a study in common sense, an exhortation to use market history to combat the tendency to say “things are different this time”. It is a reflection on the postwar bull market and how the pullback of the early 60’s merely confirmed, first the natural human tendency to abandon common sense in stock valuation and then the tendency to overreact, the boom and bust cycle, that develops not only in economies but also in markets. The question I leave you with is how to profit not only from the short-term fluctuations of individual stocks but more importantly how to profit from the long-term fluctuations of the boom and bust cycle, if indeed we can.