A quest for reality 2
Capital markets represent the epitome of statistics plus irrationality. As John Maynard Keynes said, “The market can remain irrational longer than you can remain solvent.” Clear thinking about markets has become increasingly important to me, given the latest implosions and scandals that have rocked Wall Street of late. I’ll soon be writing about FTX and SBF. It’s also helpful to have a clear head as we enter a new era of finance with elevated interest rates and inflation.
So, to better understand this animal spirit, I read several more books.
A Random Walk Down Wall Street by Burton G. Malkiel
The first book I read on markets sits between a popular view called the efficient market hypothesis (EMH) and a more convincing view, which I’ll discuss in a moment. EMH states that markets reflect all available information and that securities are thus priced accordingly. For example, EMH would essentially say that Apple stock, today valued at $134 per share, is appropriately priced because the market is efficient—all the investors in the market have access to roughly the same information and are trading based on that information.
Yet the first part of the book opens with theories of value and a survey of “the madness of crowds” that led to many bubbles throughout history. He shows that markets are often irrational because of human psychology. Indeed, even technical and fundamental security analyses are flawed: “God Almighty does not know the proper price-earnings multiple for a common stock.”
Instead, markets behave randomly, the so-called “random walk” theory. There is no discernible pattern in markets to capitalize on. This is due to any number of reasons, which the author describes in detail: Inconsistencies of human psychology, misleading information, corruption, conflicts of interest, and so on. Even more sophisticated strategies like smart beta and risk parity, and elegant statistical models like the capital asset pricing model (CAPM) and Black-Scholes model, fail to describe reality. Thus, all these techniques will result in real losses for investors over time.
What should an investor do? “Trust in time rather than in timing.” That is, investors should put their money in well-diversified index funds or ETFs, like those that track the S&P 500 or Russell 3000 indexes. The earlier they do this the better. This is also the advice of Warren Buffett, an accomplished and active investor.
But if that were true, how is that there are successful investors like Buffett who consistently beat the market year after year? And if the market is truly random, why do people continue to pour billions and billions of dollars into actively managed funds if they didn’t see some positive return?
To be fair, the author does offer a chapter on DIY stock picking, with a few rules for the brave:
Confine stock purchases to companies that appear to sustain above-average earnings growth for at least five years.
Never pay more for a stock than can reasonably be justified by a firm foundation of value.
It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air. (But he advises you do this before the story spreads, or else you’ll be buying at the peak.)
Trade as little as possible.
He concludes these rules with the dictum that “the efficient-market theory warns that following even sensible rules such as these is unlikely to lead to superior performance.”
Having learned how to value securities through methods like comparables and discounted cash flow (DCF) analyses, I’ve learned that it is in fact impossible to know for certain the value of a stock. Yet although it’s impossible to know for certain, however, intelligent investors need only rely on probability.
This led me to another theory about markets: value investing.
The Intelligent Investor by Benjamin Graham and David Dodd
The second book challenged many of the claims made in the first, while supporting three of its four rules.
Benjamin Graham is the man credited with starting many of the ideas we know today as security analysis. He wrote the language of Wall Street. He graduated and then taught at Columbia University. Before graduating, three departments asked him to join the faculty: English, philosophy, and mathematics. He was Warren Buffet’s most influential teacher, as well as an influence on modern value investors today, even those like DFV aka Roaring Kitty, the impetus of the GameStop fiasco.
Graham drew a sharp line between an investor and a speculator, as well as a distinction between the “enterprising” or active investor and the passive investor. The book is written mostly for the active investor.
First published in 1949, this book remains the Bible of value investing. The preface summarizes the contents of the book: “Combining his extraordinary intellectual powers with profound common sense and vast experience, Graham developed his core principles, which are at least as valid today as they were during his lifetime:
A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price.
The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists.
The future value of every investment is a function of its present price. The higher the price you pay, the lower your return will be.
No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on what Graham called the “margin of safety”—never overpaying, no matter how exciting an investment seems to be—can you minimize your odds of error.
The secret to your financial success is inside yourself. If you become a critical thinker who takes no Wall Street “fact” on faith, and you invest with patient confidence, you can take steady advantage of even the worst bear markets. By developing your discipline and courage, you can refuse to let other people’s mood swings govern your financial destiny. In the end, how your investments behave is much less important than how you behave.
The book goes into detail about how to do just that. Some great lines include:
To enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising, and (2) not popular on Wall Street.
An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.
A criterion based on adjectives is always ambiguous.
An elementary requirement for the intelligent investor is an ability to resist the blandishments of salesmen offering new common-stock issues during bull markets.
An issue is not a true “bargain” unless the indicated value is at least 50% more than the price.
There is so much more in this book that I would recommend it to anyone interested in markets to study it carefully. I may end up writing more about this and the next work.
Security Analysis by Benjamin Graham and David Dodd
This book, first published in 1934 and intended as a textbook, is a door stopper. In over 720 pages, including introductions and commentaries, the tome attempts to provide a reasonable system for investing. In other words, Graham literally wrote the book on investing generally and value investing particularly.
The book comprises eight parts, with parts two and three a real snooze fest:
Survey and approach, including the scope and limits of security analysis and distinctions between investment and speculation
Fixed-value investments, like bonds, preferred stocks, and other guaranteed securities
Senior securities with speculative features, including privileged and convertibles, warrants, and more
Theory of common-stock investment: The dividend factor
Analysis of the income account: The earnings factor in common-stock valuation
Balance-sheet analysis: Implications of asset values
Additional aspects of security analysis: Discrepancies between price and value
Global value investing
It’s hard to compress 700 pages of text into a paragraph or two, so here are a few essential tidbits.
Many financiers will tell you that there’s a correlation between risk and return. This is so common as to be a cliche. No pain, no gain. Risk it for the biscuit. And so on.
A historically more volatile stock is seen as riskier. But “value investors, who are inclined to think about risk as the probability and amount of potential loss, find such reasoning absurd. In fact, a volatile stock may become deeply undervalued, rendering it a very low risk investment.” That is, volatility and risk are two different things.
Another common belief is that you should spread your bets across many investments, perhaps as many as thirty or more. However, value investors “should concentrate their holdings in their best ideas.” Some argument is made to invest in a small but diversified group, perhaps as few as ten stocks.
One of Graham’s most famous principles is about a “margin of safety,” defined here by Seth Klarman: “One risk-related consideration should be paramount above all others: the ability to sleep at night, confident that your financial position is secure whatever the future may bring.”
“For investment,” Graham writes, contrasting mere speculation, “the future is essentially something to be guarded against rather than to be profited from.”
Other great lines include:
The disadvantages of ignorance, of human greed, of mob psychology, of trading costs, of weighting of the dice by insiders and manipulators, will in the aggregate far overbalance the purely theoretical superiority of speculation…
The impersonal character of the securities market relieves this procedure of ethical stigma, and it is considered merely as establishing a proper premium for shrewdness and a deserved penalty for lack of care.
We are sceptical of the ability of any paid agency to provide reliable forecasts of the market action of either bonds or stocks.
It is always good to know the truth, but it may not always be wise to act upon it, particularly in Wall Street.
When an enterprise pursues questionable accounting policies, all its securities must be shunned by the investor, no matter how safe or attractive some of them may appear.
You cannot make a quantitative deduction to allow for an unscrupulous management; the only way to deal with such situations is to avoid them.
Quantitative data are useful only to the extent that they are supported by a qualitative survey of the enterprise.
Security analysis cannot presume to lay down general rules as to the “proper value” of any given common stock. Practically speaking, there is no such thing. The bases of value are too shifting to admit of any formulation that could claim to be even reasonably accurate. The whole idea of basing the value upon current earnings seems inherently absurd, since we know that the current earnings are constantly changing. And whether the multiplier should be ten or fifteen or thirty would seem at bottom a matter of purely arbitrary choice.
The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly but only as they affect the decisions of buyers and sellers.
I could go on. The point is that the philosophies outlined in Security Analysis have stood the test of time and provide a better view of the reality of markets—and their participants—than any other book I’ve read.
My takeaway from the MBA and these works regarding markets can be summarized by saying that the future is uncertain. Period. No amount of fantastic calculations—in any field—will help us better understand it. Our mathematical abilities to “forecast” events, as well as much of the average person’s knowledge across a range of subjects, are specious at best. Yet our aversion to boredom, tendency for emotions to overwhelm reason, greed, and our need to be seen as intelligent will careen our minds into continual chaos.
What do investors do knowing this?
“Obviously,” writes Graham and Dodd, “it requires strength of character in order to think and act in opposite fashion from the crowd and also patience to wait for opportunities that may be spaced years apart.”
This quote could be said of many events in life. But it also helps me become more comfortable with the fact that I really don’t think that well. This led me to learn more about thinking in general, which I’ll discuss next.