Graham and Doddsville

Take 225 million monkeys, 225 million bananas and 225 million coins—add some basic rules — and you end up with one of the most noted investing theories of all time. It works like this: Each day, the monkeys flip the coins once, calling heads or tails. If the monkeys call it correctly, they win a banana from those who called wrong. The losers drop out, and the next day, all of the previous day’s banana winnings are put on the line.

With this simple game, it wouldn’t take long before you had a lot of banana-rich monkeys. After 10 coin flips on 10 mornings, there would be 220,000 monkeys left, each with around 1,000 bananas. Another 10 days and 10 coin flips, and there would be 215 monkeys left, each with one million bananas.

The point is, when any one group achieves success at any one feat, in many cases it’s pure chance. The monkeys, after all, are not gloating in their success and celebrating the brainpower behind their superior coin-flipping skills.

Now let’s assume that those original 225 moneys were distributed as far and wide as the U.S. population, but of the 215 monkeys left after 20 days, 40 or 50 or 60 came from one specific zoo.  Then you might be on to something. No one would blink an eye if you looked into what the monkeys from that particular zoo were doing differently from all the other monkeys in the world—eating genetically modified bananas, taking shots of monkey steroids or training hours a day with super-smart zookeepers, perhaps?

Similarly, when you have a group of investors as diverse as those in the United States, but a somehow a subsection of that group achieves considerable and consistent success, many people want to know—what are those investors doing differently?

In May 1984, noted investor Warren Buffett—whom in March 2008 Forbes named the richest man in the world, with a net worth of $62 billion—answered that question in a speech at Columbia University.

For many years, a popular investing theory has held that the stock market is efficient. In other words, a stock’s price reflects everything that is known about a company, from how the economy is affecting it to how its management is doing. As a result, according to this “efficient market” theory, there can be no overvalued or undervalued stocks. Investors who beat the market year after year are simply lucky, like monkeys flipping coins for bananas.

In his speech—which commemorated the fiftieth anniversary of Security Analysis, a treatise on value investing written by Benjamin Graham and David Dodd—Buffett challenged the efficient market theory by pointing out that a small group of investors have beaten the odds and achieved consistent success in the stock market.

                                                 Fourth of July fireworks on the shoreline, Lake Tahoe, California

                                                 Fourth of July fireworks on the shoreline, Lake Tahoe, California

What did those investors do differently? They all came from the same place—not physically, but intellectually. They trained with Graham.  Buffet pointed out that training with Graham, in and of itself, did not mean that the investors were successful rather than lucky. After all, conditions could have existed that made the investors’ concentration as students of Graham unimportant. Perhaps, Buffett said, they were just imitating the metaphorical coin-flipping call of a persuasive and dominant leader.

But that’s not what happened with these investors.  Although Graham was an intellectual leader, his students flipped their coins in different ways. Specifically, they bought and sold different types of stocks.  For example, one investor, Walter Schloss, bought well-known names such as Hudson Pulp & Paper and New York Trap Rock Company.  Other students, who formed investment company Tweedy Browne Partners, bought names that were barely recognizable. The result: The overlap between the different investors’ portfolios was extremely low.  Certainly, this situation didn’t indicate that one leader (Graham) was calling the coin flip and everyone else was imitating it.  “The patriarch has merely set forth the intellectual theory for making coin-calling decisions, but each student has decided on his own manner of applying the theory,” Buffet said in his speech.

So, what is that common intellectual theory of what Buffet called “the superinvestors of Grahamand-Doddsville?”  They all searched for discrepancies between the value of a company and the price of that company.

Unlike efficient market theorists, the superinvestors of Graham-and-Doddsville didn’t make charts showing if stocks were more successful when bought on Mondays instead of Fridays, or in January instead of July, or in election years instead of in non-election years; they acted liked businessmen buying businesses.  They said, essentially, “If a business is worth $100 per share and I can buy it for $60 per share, it’s a deal.” They looked for stocks that were on sale, and they did it again and again.

These investors, according to Buffet’s records, which were independently audited, were tremendously successful.  Despite this recognition, however, there has still been no consistent trend toward their approach, which is referred to as value investing.  As a result, said Buffet in his speech, there will continue to be discrepancies between price and value in the marketplace—and investors who take a stroll through Graham & Doddsville by reading and practicing the ideas in Security Analysis will prosper.