Friday, January 30, 2015

Revisiting Benjamin Graham, the Father of Alternative Investing

This article appeared in the Financial Post    on April 26, 2013,

Throughout Benjamin Graham’s life and through his seminal 1934 book, Securities Analysis, the accepted father of value investing taught his loyal followers (including Warren Buffet) that the value of a company’s shares was tied to the fundamentals of that company rather than whatever the market was prepared to pay for its shares on any given day.

Alternative ETFs head for the mainstream

The switch to ETFs may not happen overnight, but it is underway in a powerful fashion, and momentum in that direction should only rise. 
The basic theory was that, over the long run, the true value of a security would be revealed through its price, and value investors would therefore profit through their practice of fundamental analysis. But for years, a debate has persisted between value investors and the followers of modern portfolio theory as to whether the market is, essentially, efficient, and whether it is possible for individual investors to beat the market on a consistent basis by capitalizing on purported inefficiencies.
Like most observers, I have always believed Mr. Graham would have been strongly in the “you can beat the market” camp. Recently, however, I have learned that his views on the matter were far more nuanced. In fact, Mr. Graham was an early adopter of the concept of alternative investing: garnering higher risk-adjusted returns than the market by doing things differently, rather than following the crowd.
On Nov. 15, 1963, (notably only a week before the assassination of President Kennedy), Graham delivered a speech in San Francisco with the evergreen title, “Securities in an Insecure World.” It’s a fascinating read. I expected to find the basic theories described above, albeit in more than the standard 140 characters that defines our modern knowledge base. Instead, I found evidence of a man who was a pragmatist and a thinker, whose views are equally as applicable to today’s capital markets as they were 50 years ago.
At the top of the speech, Mr. Graham described the challenges faced by 1963 market participants. If one were to replace the phrase “atomic war” with “terrorism,” these thoughts might just as well have been uttered last week rather than last century:
“In the field of financial security, as limited to the problems of investment policy, I would say there are three kinds of threats or dangers that investors should recognize as possibly existing at the present time,” he wrote. “One of them would be the threat from atomic war; the second would be the threat from inflation; and the third would be the threat from severe market fluctuations up and down, and of course primarily down.”

Mr. Graham had no “just add water” solutions to these serious and permanent concerns, but his admonitions to investors about addressing them were particularly insightful and prophetic.
With respect to atomic war and inflation, he pointed out that investors had historically dismissed larger issues over which they had no control, and would likely to continue this head-in-the-sand approach.
Regarding market fluctuations, he was careful to point out that assuming the markets must always go up and that a rising market was a sign of further increases were both fallacious — a truth borne out in the infamous 1966-1982 secular bear market, in which investors saw virtually no returns.

He was bold enough to assert that “a large advance in the stock market is basically a sign for caution and not a reason for confidence,” finally concluding that “investors as well as speculators must be prepared in their thinking and in their policy for wide price movements in either direction. They should not be taken in by soothing statements that a real investor doesn’t have to worry about the fluctuations of the stock market.”

Turning to the specific question of whether investors ought to engage in specific security selection rather than buying broadly diversified low-cost mutual funds (the precursors of today’s exchange-traded funds), Mr. Graham was very clear:
“For obvious reasons it is impossible for investors as whole, and therefore for the average investor or speculator, to do better than the general market. The reason is that you are the general market and you can’t do better than yourselves. I do believe it is possible for a minority of investors to get significantly better results than the average. Two conditions are necessary for that,” he wrote.

“One is that they must follow some sound principles of selection which are related to the value of the securities and not to their market price action. The other is that their method of operation much be basically different than that of the majority of security buyers. They have to cut themselves off from the general public and put themselves into a special category.”

Rather than continuing with a diatribe on the importance of fundamental analysis in order to separate one’s self from the market at large, Mr. Graham then touched on a theme that put him squarely in what most observers would classify as the modern portfolio camp.
Diversification between stocks and bonds, he asserted, was the true source of excess returns compared to the market. Specifically, he said the relative allocation to stocks and bonds should be between 25% and 75% one way or the other, commenting that “any such variations should be clearly based on value considerations, which would lead [the investor] to own more common stocks when the market seems low in relation to value and less… when the market seems high in relation to value”.

In other words, he was very closely espousing what today is called dynamic (or tactical) asset allocation — a moving allocation among multiple asset classes or investment strategies that depends not on specific security selection but rather on macro principles.
The fact that he referenced only stocks and bonds is, I would posit, more a function of the times than Graham’s particular favour for those specific asset classes. If he were making the same speech today, I am confident he would include numerous other asset classes (whether currencies, commodities or real estate, all available through cheap, liquid and broadly diversified ETFs) and promote tactical allocation among them based on a fundamental view of their relative value over time.

Dynamic asset allocation is considered pretty cutting edge, even in 2013. Only in the past few years have individual and institutional investors begun to subscribe to the notion that a high percentage of investors’ returns are the result of asset allocation, not security selection.
Because, by definition, dynamic asset allocation is quite different from strategic asset allocation (such as a classic static 60/40 portfolio of stocks and bonds), its use is considered to be part of an increasing trend towards alternative investing.

And so it turns out that a man at the very heart of traditional investing was, once we take the time to read what he had to say in his own words, a very early adopter of some very modern ideas. Benjamin Graham: the father of alternative investing. Has a nice ring to it.

David Kaufman is president of Westcourt Capital Corp., a portfolio manager specializing in traditional and alternative asset classes and investment strategies. He can be contacted at

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