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What Do Superinvestors Have in Common?
That’s what Warren Buffett asked himself1 on the eve of the 50th anniversary of Ben Graham’s Security Analysis in 1984. Graham and Dodd’s "look for values with a significant margin of safety relative to prices" approach to security analysis was becoming outdated according to “professors who write textbooks”.
They argued that in the modern day, markets had become efficient; reflecting all known information about a company’s prospects and the state of the economy. There could be no undervalued stocks and investors who beat the market over the long haul were lucky. Almost forty years, and a stretch of unimaginable technological advancement later and I believe most investors would concur markets are not as efficient in practice. Seth Klarman describes2 market efficiency as an “elegant hypothesis that bears quite limited resemblance to the real world”.
“If academics espousing the efficient market theory had no influence, their flawed views would make little difference. But, in fact, their thinking is mainstream and millions of investors make their decisions based on the supposition that owning stocks, regardless of valuation and analysis, is safe and reasonable. Because so many have been taught that outperforming the market is impossible and that stocks are always fairly and efficiently priced, investors, have increasingly adopted strategies that eventually will prove both riskier and far less rewarding than they are currently able to comprehend”.
Seth Klarman, 2015
To rebut the academics and their claims that successful long-term investors are simply the benefactors of luck, Buffett examined the commonalities of a handful of superinvestors. He would find that while the structure of their portfolios differed significantly, the mutual principles they held were as follows:
They don’t believe in the efficient market hypothesis
They hail from the same intellectual origin
They all follow the margin of safety principle
Orangutans are just as lucky as us
He begins with a simple analogy; asking the reader to imagine a nationwide coin-flipping content that begins with 225 million Americans3 and the wager of one Dollar. On the first morning, they call a coin toss and the ones who guessed correctly collect a dollar from those who called wrong. Once per day, this process repeats and each subsequent day the stakes compound as all prior winnings are staked.
After 10 days, there will be as few as 220,000 people left; each having earned a tidy sum of $1,000. After 20 days there will be just 215 people; each winning $1 million. The remaining contestants gradually shift from thinking “damn, it’s my lucky day” to “damn, I am gifted”.
[After winning $1,000] This group will probably start getting a little puffed up about this, human nature being what it is. They may try to be modest, but at cocktail parties, they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvellous insights they bring to the field of flipping.
[After winning $1 million] By then, this group will really lose their heads. They will probably write books on "How I Turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning." Worse yet, they'll probably start jetting around the country attending seminars on efficient coin-flipping and tackling sceptical professors with, "If it can't be done, why are there 215 of us?".
This is how professors believed winners were borne from the stock market. Not natural selection, pure chance. The benefactors fool themselves, and others, into believing it was the byproduct of process.
But then some business school professor will probably be rude enough to bring up the fact that if 225 million orangutans had engaged in a similar exercise the results would be much the same - 215 egotistical orangutans with 20 straight winning flips.
Here’s the deal breaker. If a large enough number of these orangutans came from the same zoo, you would be intrigued as to why that might be. You’d probably enquire about what they are being fed, what their curriculum looks like, “what books they read, and who knows what else”.
That is, if you found any really extraordinary concentrations of success, you might want to see if you could identify concentrations of unusual characteristics that might be causal factors. You would not necessarily know the causal factors, but you would know where to search.
As it happens, a disproportionate number of successful coin-flippers in the investment world hail from a small intellectual village that Buffett refers to as Graham-and-Doddsville. The fact that these investors hail from the same intellectual origin4 is, in itself, a commonality of outperformance. It depends on how liberal your use of the term value investor is but Munger is often quoted as saying “all good investing is value investing” and that's the idea I want to convey here. Not any of this "growth vs value" nonsense.
“Basically, all investment is value investment in the sense that you're always trying to get better prospects that you're paying for”.
Charlie Munger
The group of investors that Buffett discusses, all share a common intellectual patriarch in Ben Graham. They all studied his work, and they all utilise his methods. Importantly, Buffett makes the distinction that this commonality is not borne from mimicking exactly how Graham invests; but rather his intellectual theory for how to pick stocks.
But the children who left the house of this intellectual patriarch have called their "flips" in very different. ways. They have gone to different places and bought and sold different stocks and companies, yet they have had a combined record that simply can't be explained by random chance. It certainly cannot be explained by the fact that they are all calling flips identically because a leader is signalling the calls to make. 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.
The Superinvestors of Graham-and-Doddsville
The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market. Essentially, they exploit those discrepancies without the efficient market theorist's concern as to whether the stocks are bought on Monday or Thursday, or whether it is January or July, etc.
Warren Buffett
The Quartet of Graham Newman Corp
After graduating from Ben Graham’s class at college, Buffett enquired about working for his former professor at Graham Newman. After “much pestering” he was finally hired and there he would meet four gentlemen between 1954 and 1956 (the fund was wound up in 1957). Those men were Walter Schloss, Tom Knapp, Ed Anderson, and Bill Ruane. These are men who selected securities based on discrepancies between price and value, but they made their selections very differently.
(1) Walter Schloss
Walter was a man who never attended college, but took a night class at the New York Institute of Finance which Ben Graham taught. He left Graham Newman in 1955 and between 1956 and 1984 the WJS Partnership generated a 21.3% compounded annual return vs the S&P’s 8.4%.
He was a man with “no connections or access to useful information” and “practically no one in Wall Street” knew who he was. He would look up the numbers in the manuals and that was about it. Schloss owned over 800 stocks in those 28 years at WSJ and would routinely hold as many as 100 at any given time. Seemingly less interested in the underlying fundamentals of the businesses he purchased, Buffett notes that his inability to influence him was one of Walter’s biggest strengths.
He knows how to identify securities that sell at considerably less than their value to a private owner. And that's all he does. He doesn't worry about whether it's January, he doesn't worry about whether it's Monday, he doesn't worry about whether it's an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me.
Schloss had a profound sense of duty in managing other people’s money which to him “is real to him and stocks are real”. From this flowed an attraction to the margin of safety principle.
(2-3) Tom Knapp and Ed Anderson
Both students of Graham, and former members of Graham Newman. In 1968 the pair formed Tweedy Browne Partners and between 1968 and 1983 would generate a 20% compounded annual return vs the S&P’s 7.0%.
The pair, alongside two other gentlemen of Graham and Doddsville, would build their record with substantial diversification but, unlike Schloss, occasionally acquire wholly owned businesses. Much like Buffett has shown an aptitude for. Neither came from privileged backgrounds; Knapp was a former chemistry major turned soldier who Buffett describes as a “beach bum”. He would enrol in an MBA at Columbia where Dodd and Graham taught; taking Graham’s class twice. Bumping into Knapp some 35 years later Buffett remarks that he was still a beach bum; “the only difference is that now he owns the beach!”.
(4) Bill Ruane
Ruane graduated from Harvard and went direcetly to Wall Street. After reasoning that he “needed to get a real business education” Bill would cross paths with Buffett in Ben Graham’s 1951 Columbia class. When Warren set up the Buffett partnership, he would ask Bill to create a fund to handle all of their partners. That fund was Sequoia, which between 1970 and 1984 would generate a 17.2% compounded annual return vs the S&P’s 10.0%.
Buffett was initially impressed by Ruane after seeing his record from 1951 to 1970 working with small sums of money. Despite managing increasingly larger pools of capital from 1970 onwards, he continued to apply the principles that had served him well until then; and the returns speak for themselves.
Size is the anchor of performance. There is no question about it. It doesn't mean you can't do better than average when you get larger, but the margin shrinks. And if you ever get so you're managing two trillion dollars, and that happens to be the amount of the total equity evaluation in the economy, don't think that you'll do better than average!
Schloss would typically own hundreds of securities, but his largest holdings were often names that would “come instantly to mind to even a casual reader of the business pages”. Tweedy Browne would work with names on nobody’s radar and Bill Ruane would mix it up. The overlap among these portfolios was low, but the commonalities they shared were superior performance and an affinity to Dodd and Graham’s teachings.
The Oracle’s Right-Hand Man
(5) Charlie Munger
Needing no introduction, Charlie Munger is Buffett’s closest confidant and business partner. A Harvard Law graduate who later set up a major law firm, Munger would bump into Buffett in the 1960s when he was told that “law was fine as a hobby but he could do better”.
It turned out Munger was a pretty good coin tosser; generating substantial returns but in a way diametrically opposed to Schloss. Munger’s portfolio would be concentrated in a handful of stocks and endure considerably more volatility. In Buffett’s words; “he was willing to accept greater peaks and valleys of performance, and he happens to be a fellow whose whole psyche goes toward concentration, with the results shown”. While the pair now collectively pick businesses together at Berkshire, back then Munger’s holdings were completely different from Buffett’s and the gentlemen mentioned earlier.
The Salesman
(6) Rick Guerin
A friend of Munger’s and math major, Guerin was a salesman at IBM before he came under the influence of Charlie. He would form Pacific Partners in 1965 and generate a 33% compounded annual return through 1983, versus the S&P’s 7.8%. Over a 19 year period that translated to a net 22,200% gain vs the S&P's 316%.
With no formal education in business, Buffett suggests that Guerin immediately understood the value investing approach.
It is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately with people or it doesn't take at all. It's like an inoculation. If it doesn't grab a person right away, I find that you can talk to him for years and show him records, and it doesn't make any difference. They just don't seem able to grasp the concept, simple as it is. A fellow like Rick Guerin, who had no formal education in business, understands immediately the value approach to investing and he's applying it five minutes later. I've never seen anyone who became a gradual convert over a ten-year period to this approach. It doesn't seem to be a matter of I.Q. or academic training. It's instant recognition, or it is nothing.
The Liberal Arts Major
(7) Stan Perimeter
From Liberal arts to marketing, Stan would one day happen to be in the same building as Buffett in Omaha, and in 1965 would discern that Warren’s business was better than his. He left advertising and, like Guerin, would understand the value approach in minutes.
Perimeter does not own what Walter Schloss owns. He does not own what Bill Ruane owns. These are records made independently. But every time Perimeter buys a stock it's because he's getting more for his money than he's paying. That's the only thing he's thinking about. He's not looking at quarterly earnings projections, he's not looking at next year's earnings, he's not thinking about what day of the week it is, he doesn't care what investment research from any place says, he's not interested in price momentum, volume or anything. He's simply asking: What is the business worth?
The Pension Funds
(8-9) The Washington Post and FMC Corp
The final two coin tossers that Buffett mentions in this study are the pension funds of the Washington Post5 and FMC Corp6. The TLDR for these funds is that Buffett would steer them towards value-orientated managers and are the only two pension funds that Buffett had been directly involved in. Very few pensions took a value orientation in those days. I will leave their impressive records buried in the footnotes because I think you have done enough reading for today and I want to hold your attention for this last part.
The Commonalities of Superinvestors
The nine investors, or “coin flippers” that Buffett presents in his article are all residents of Graham and Doddsville. Selected based on their framework for investment decision-making, intellect, character, temperament, and the fact that Buffett had, first-hand, observed these traits in each of them. While some of them hold portfolios with dozens of stocks and others concentrate on a handful, they all share these common traits.
They think of stocks as pieces of a business and sometimes own whole businesses.
They have assumed less risk than average, exemplified by their performance during years when the general market was weak.
They do not discuss beta, the capital asset pricing model or covariance in returns among securities. They focus on two variables, price and value.
They exploit the difference between the market price of a business and its intrinsic value.
These performance records are decades old now, but you will find these commonalities in many of the world’s most-known investors today. And then there is Buffett and Munger who, miraculously, are still going well into their late mid to late 90s. So long as there continue to be wide discrepancies between price and value in the market, then the idea of efficient markets cannot exist in tandem.
I'm convinced that there is much inefficiency in the market. When the price of a stock can be influenced by a "herd" on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.
If you can understand this, and be patient enough to wait for moments that present these opportunities and have the resolve to battle your emotional demons, then you might just be onto something. For the more conservative investor, Buffett feels that you must abide by the margin of safety principle too.
You have to have the knowledge to enable you to make a very general estimate about the value of the underlying businesses. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don't try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it.
This conflicts with the ideals of those who demonstrate a liking for “growthy” companies. If a business is going to continually beat expectations and double in size in the space of 5 years, then it seldom trades cheaply. Paying up for quality has proven to be warranted in some cases. However, survivorship bias often masks the bulging graveyard of occurrences when it was not wise to cough up. For every Amazon, there are a hundred eToys. Never heard of eToys? Case in point. As a finishing memento here is Buffett’s take on the relationship between risk and reward.
Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, "I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million." I would decline-perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice-now that would be a positive correlation between risk and reward!
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.
Thanks for reading,
Conor
A Response to Lowenstein’s Searching for Rational Investors In a Perfect Storm by Seth Klarman (2015). I write more about Seth’s and my own thoughts on market efficiency here.
So as much as I think the efficient market theory is great for understanding the varying levels of efficiency and how that impacts stock prices, I don’t think there is ever a time when the market is actually fully efficient. Instead, I view the market as something which is constantly calibrating itself, attempting to find that sweet equilibrium where assets are priced “correctly”, but will never do so.
In my opinion, as long as there is a human behind a trading screen, there will never be a fully efficient market.
The approximate population at the time.
Buffett defines intellectual origin as conditions that exist which would make geography unimportant. He suggests that superinvestors share the same patriarchal figure as Ben Graham. The important caveat, which I shall explain back in the main body of the text, is that they don’t simply mimic Graham’s calls, they simply follow his teachings on the fundamentals of how to call coin flips.
Buffett: “Let's assume that you lived in a strongly patriarchal society and every family in the United States conveniently consisted of ten members. Further assume that the patriarchal culture was so strong that, when the 225 million people went out on the first day, every member of the family identified with the father's call. Now, at the end of the 20-day period, you would have 215 winners, and you would find that they came from only 21.5 families. Some naive types might say that this indicates an enormous hereditary factor as an explanation of successful coin-flipping. But, of course, it would have no significance at all because it would simply mean that you didn't have 215 individual winners, but rather 21.5 randomly-distributed families who were winners. In this group of successful investors that I want to consider, there has been a common intellectual patriarch, Ben Graham”.
Washinton Post returns
FMC Corp returns
Walter Schloss is such a cool unique dude. Have you ever seen any of his video interviews on Youtube? 👍👍
Fantastic post. Thank you for sharing it with us all.