The financial world looks markedly different today than it did when Graham was practicing and teaching. In 1934, a total of 323 million shares were traded on the New York Stock Exchange.12 As I write, on August 9, 2017, the total volume of shares traded on the NYSE was 3.2 billion. More than 10 times as many shares traded yesterday as all the shares traded during 1934! Today, supercomputers instantly parse the words contained in economic reports and company statements. Back in Graham's times, while quarterly statements were considered standard, they were not the law. And of the companies that made this information available, there was no uniformity; the reports varied from only net earnings to a line itemed income statement and balance sheet. Graham looked for the income statement to contain a minimum of: sales, net earnings, depreciation, interest charges, nonoperating income, income taxes, dividends paid, and surplus adjustments. Prior to the Securities and Exchange Act, less than half of industrial corporations supplied this breakdown.
Graham's idea of value investing involves buying cigar butts, businesses with one final puff, as he called them. These companies controlled significant property, plant and equipment, inventory, and raw materials. It wasn't difficult to measure the tangible assets and calculate the intrinsic value. From there, he could determine whether there was a margin of safety. If Graham were still alive, he wouldn't understand how some companies are valued today. For example, over the last five years, Walmart has earned $75 billion on $2.4 trillion in revenue. Its net margins have been 3.15% and it's lost $3.6 billion in market capitalization. Amazon, on the other hand, has earned $3.5 billion on $490 billion of revenue. Its net margins have been 0.73%, and over this time it has added $350 billion in market capitalization.13 While value investing intuitively makes a lot of sense, human emotions can overwhelm common sense. Prices can be driven both way below liquidating value and far past what any company can reasonably be expected to grow into. While Graham wouldn't recognize ETFs or high‐frequency trading, he would feel right at home in today's market, which is still driven by investors' emotions. The way investors behave today, driven by fear and the fear of missing out would be very recognizable to him.
Roger Lowenstein said, “It took Graham 20 years – which is to say, a complete cycle from the bull market of the Roaring Twenties through the dark, nearly ruinous days of the early 1930s – to refine his investment philosophy into a discipline that was as rigorous as the Euclidean theorems he had studied in college.”14 Let's return to the beginning.
Graham first started an investment partnership in 1923, the Graham Corporation, where he would apply arbitrage techniques, the simultaneous purchase of undervalued securities, and short sale of overvalued securities. This operation lasted for two years, and in 1926, he set up the Benjamin Graham Joint Account. In this structure, he would receive 20% of the first 20% return, 30% of the next 30%, and 50% of the balance. In 1926, he earned 32% while the Dow Jones Industrial Average gained just 0.34%. Word of his success spread throughout Wall Street and the famous financier Bernard Baruch asked Graham to become his partner. Graham was flattered, but having made $600,000 the previous year, he had no reason to accept the invitation.15 He began with $450,000, which ballooned to $2,500,000 in just three years. But this is a book about lessons we can learn from the failures of the best investors ever. Graham's was right around the corner.
In the final year of the great bull market of the 1920s, the Joint Account gained 60%, outpacing the 49.47% advance in the Dow. In the final months of 1929 when the market turned violently lower, Graham covered his shorts and held onto his convertible preferred securities, thinking that prices were too low and that Mr. Market was talking crazy. He finished the year down 20%, while the Dow fell 17%. Graham was about to learn that margins of safety don't matter when the baby is getting thrown out with the proverbial bathwater.
In 1930, thinking the worst was over, Graham went all in and then some. He used margin to leverage what he thought would be terrific returns. But the worst was not over, and when the Dow collapsed, Graham had his worst year ever, losing 50%. “He personally was wiped out in the crash. Having ducked the 1929 cataclysm, he was enticed back into the market before the final bottom.”16 In the four years from 1929 to the bottom in 1932, Graham lost 70%. If such a careful and thoughtful analyst can lose 70% of his money, we should be very careful to understand that while value investing is a wonderful option over the long term, it is not immune to the short‐term vicissitudes of the market.
In 1932, just weeks before stocks bottomed, Graham wrote three articles in Forbes. In one, “Inflated Treasuries and Deflated Stockholders,” he wrote:
There are literally dozens of other companies which also have a quoted value less than their cash in bank…. This means that a great number of American businesses are quoted in liquidating value; that in the best recent judgment of Wall Street, these businesses are worth more dead than alive.17
In this article, Ben Graham was a voice of reason in a mob of financially depressed zombies:
It is time, and high time, that the millions of American shareholders turned their eyes from the daily market reports long enough to give some attention to the enterprises themselves of which they are the proprietors, and which exist for their benefit and at their pleasure.18
After an 89% peak‐to‐trough decline in the Dow Jones Industrial Average, it was understandable why people would behave this way, and why a generation of investors would never return to the market. The fact that he remained steadfast in his conviction that security analysis was a worthwhile endeavor is nothing short of remarkable.
The partnership earned 6% a year from 1926 to 1935, compared to 5.8% for the S&P 500 and 3.8% for the Dow.19 Despite the hard times and enormous drawdown, Graham would continue to operate under the assumption that value investing is the most intelligent way to achieve superior results. Believing that stocks eventually find their true value, the prospectus of Graham‐Newman Corporation's stated that its investment policy is “To purchase securities at less than their intrinsic value as determined by careful analysis, with particular emphasis on purchase of securities at less than their liquidating value.”20 When asked what causes a stock to find its value, Graham answered, “That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realizes it in one way or another.”21 Graham was proven right; over the long, long term, buying cheap stocks is a great strategy. Graham‐Newman would outperform the market by nearly 3% a year for 20 years, a record that very few people have ever achieved.22
The fact that investors are willing to pay as little as five times for the prior 12 months' worth of earnings, and as much as 34, shows that relying on valuation alone is not enough. If you're not a dyed‐in‐the‐wool value investor, and even if you are, surviving the long periods of time when the market separates price from value, on the upside and on the downside, can be mentally exhausting. You have the right to pay whatever you feel is fair value for stocks. Think 25 times trailing 12‐month earnings is too high a price? Want to go all in at 10 times? Okay, but understand that waiting for valuations to “normalize” has stained the legacy of some of the greatest value investors to ever live. You can read all about the mood swings of Mr. Market, but that doesn't make you Dr. Freud.
Even though Graham pioneered security analysis, he was humble and open minded to the idea that what used to work no longer works, and what works today might not work as well in the future. He said:
Unfortunately in this kind of work, where you are trying to determine relationships based upon past behavior, the almost invariable experience is that by the time you have had a long enough period to give you sufficient confidence in your form of measurement just then new conditions supersede and the measurement is no longer dependable in the future.23
Value investing still “works,” but because it used to work so incredibly well, it has seen an influx of aspiring Warren Buffetts. This has made i
t much more challenging to identify undervalued opportunities. Graham recognized this dynamics long before this was a widely held belief. In a 1976 interview he said:
I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, forty years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a good deal since then. In the old days any well‐trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their costs. To that very limited extent I'm on the side of the “efficient market” school of thought now generally accepted by professors.24
He was asked whether “Wall Street professionals are usually more accurate in their near or long‐term market trends, forecasts of stock market trends, if not, why not?” With a smile on his face, he answered:
Well, we've been following that interesting question for a generation or more and I must say frankly our studies indicate you have your choice of tossing coins and taking the consensus of expert opinion, and the results are just about the same in each case. Your question is to why they are not more dependable is a very good one and an interesting one and my own explanation for that is this; that everybody in Wall Street is so smart that their brilliance offsets each other. And that whatever they know is already reflected in the level of stock prices pretty much and consequently what happens in the future represents what they don't know.25
It's critically important to be aware of value, but it's more important not to be a slave to it. Graham taught us that there are no iron‐clad laws in finance and that cheap can get cheaper.
Like every lesson we'll come across in this book, the unfortunate reality is most of these have to be learned the hard way. Nobody can tell you that picking stocks is hard and that you're better off in an index fund. You'll never believe that a stock that falls 50% in a year might not necessarily be a bargain. You have to catch a few of these falling knives before scars develop and you learn that a falling price might not equate to better value. Many of the investors covered in this book began with Ben Graham's teachings, but they, like you, had to discover their own paths.
Notes
1. Benjamin Graham and David L. Dodd, Security Analysis (New York: McGraw‐Hill Education, 2008), 61.
2. Jason Zweig, “A Note about Benjamin Graham,” in The Intelligent Investor by Benjamin Graham (New York: HarperBusiness, 2003), xi.
3. Graham and Dodd, Security Analysis, 67.
4. Warren Buffett, “Preface to the Fourth Edition,” in The Intelligent Investor by Benjamin Graham (New York: HarperBusiness, 2003), ix.
5. Quoted in Roger Lowenstein, Buffett: The Making of an American Capitalist (New York: Random House, 2008), 36.
6. Quoted in Rupert Hargreaves, “Why Charlie Munger Hates Value Investing,” Nasdaq.com, April 13, 2017.
7. Graham and Dodd, Security Analysis, 373.
8. Benjamin Graham, “Securities in an Insecure World” (speech given at Town Hall at St. Francis Hotel, San Francisco, CA, November 15, 1963).
9. Graham and Dodd, Security Analysis, 66.
10. Ibid., 30.
11. Benjamin Graham, The Intelligent Investor (New York: HarperBusiness, 2003).
12. New York Stock Exchange, “Daily Share Volume 1930–1939.”
13. Data provided by Ycharts, author's calculations.
14. Roger Lowenstein, “Introduction to Part I,” in Security Analysis, 6th ed., by Benjamin Graham and David L. Dodd (New York: McGraw‐Hill Education, 2008), 41.
15. Irving Kahn and Robert D. Milne, “Benjamin Graham: The Father of Financial Analysis” (Charlottesville, VA: Financial Analysts Research Foundation, 1977).
16. John Train, Money Masters of Our Time (New York: HarperBusiness, 2003).
17. Benjamin Graham, “Inflated Treasuries and Deflated Stockholders,” Forbes, June 1, 1932.
18. Ibid.
19. Kahn and Milne, “Benjamin Graham,” 42.
20. Benjamin Graham and Jerome A. Newton, Letter to Graham‐Newton Corporation stockholders, January 31, 1946.
21. Ibid.
22. Roger Lowenstein, Buffett: The Making of an American Capitalist (New York: Random House, 2008), p. 58.
23. Jason Zweig, “A Rediscovered Masterpiece by Benjamin Graham,” JasonZweig.com, March 31, 2015.
24. Benjamin Graham, “A Conversation with Benjamin Graham,” Financial Analysts Journal 32, no. 5 (September/October 1976): 20–23.
25. “Legacy of Benjamin Graham: The Original Adjunct Professor,” Heilbrunn Center for Graham and Dodd Investing, Columbia Business School, February 1, 2013.
CHAPTER 2
Jesse Livermore
Manage Your Risk
Jesse Livermore was a larger‐than‐life, full‐blooded character who happened to embody every great trading maxim of the time.
—Paul Tudor Jones
“Buy low, sell high.”
“Nobody ever went broke taking a profit.”
“Buy when there's blood in the streets.”
We often use these axioms to justify why we bought, sold, or held onto an investment. The problem with rules of thumb, specifically when it comes to investing, is that they mask complexity. There are far too many variables and crosscurrents pushing and pulling on the price of a security to boil everything down to a cute little phrase. Doing this can lead to systematic biases, blind spots and bad decisions that are repeated again and again. Consider the following example from Daniel Kahneman's Thinking, Fast and Slow:
Steve is very shy and withdrawn, invariably helpful but with little interest in people or in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail. Is Steve more likely to be a librarian or a farmer?
The resemblance of Steve's personality to that of a stereotypical librarian strikes everyone immediately, but equally relevant statistical considerations are almost always ignored…. Because there are so many more farmers, it is almost certain that more “meek and tidy” souls will be found on tractors than at library information desks. However, we found that participants in our experiments ignored the relevant statistical facts and relied exclusively on resemblance. We proposed that they used resemblance as a simplifying heuristic (roughly, a rule of thumb) to make a difficult judgment. The reliance on the heuristic caused predictable biases (systematic errors) in their predictions.1
Think about how this sort of thinking manifests itself in investing. There are so many variables that you almost have to use shortcuts and sayings. And nobody's words or sayings are repeated more often than Jesse Livermore. For example: “Speculation is as old as the hills. Whatever happened in the stock market today has happened before and will happen again.” And: “They said there are two sides to everything. But there is only one side to the stock market; and it's not the bull side or the bear side, but the right side.”
If you're a trader, concerned primarily with being on the right side, keeping things simple can be overwhelming. Where are stocks going and which direction are they coming from? Are they being led higher (lower) by a narrowing group of stocks, or is there broad participation? How bullish (bearish) are investors? Is my own portfolio keeping me from answering this objectively? The list goes on and on. And while it's true that simplifying things generally leads to better decisions, it's not true that every situation can be condensed into a saying. No investor is more emblematic of the dangers of heuristics than Jesse Livermore, who made and lost several fortunes, and each time came away with beautifully elegant analysis.
Jesse Livermore is the most famous, maybe the first famous, market speculator. The lesson that investors should learn from Livermore is how dangerous rules of thumb can be. If you catch yourself saying “buy when there is blood in the streets,” it's
a good idea to remember that the man who basically invented market phrases couldn't even stick to them. Buy low, sell high sounds great, and the idea is, but like many things, it's easy to say, hard to do.
Jesse Livermore, or JL, as his friends knew him, was born and raised on a farm in Acton, Massachusetts, in 1877. At 14, he left home for the big city—Boston—where he quickly got a job at Paine Webber as a board boy, earning $6 a week.
While he was learning about the market, young Livermore kept a journal, recording fictional trades. After 18 months of preparation, he visited a bucket shop, which were places where investors, mostly amateurs, could trade. His first purchase was Chicago, Burlington and Quincy Railroad, and with a $10 investment, he netted $3.12 in just two days.2 He was immediately successful, and by 17, he built up a bankroll of $1,200. He had tasted the spoils of success and wanted more of it. He decided to leave Paine Webber and pursue speculating full time.
Bucket shops were used to traders leaving with empty pockets, and the traders who made money did not do so for long without the bosses taking notice. He became a victim of his own success, and before long, he was persona non grata in every bucket shop in Boston.
Livermore accumulated a bankroll and a few years of experience when he was forced to leave Boston if he wanted to continue trading. He already suffered his first big loss, which would become a recurring theme throughout his life.
Livermore left Boston for New York in 1900 when he was 23 years old. The same day he arrived, he walked into the offices of the brokerage house, Harris, Hutton & Company, run by 25‐year‐old Edward Hutton, who would later go on to found E.F. Hutton.3 Hutton and Livermore immediately hit it off. JL deposited his $2,500 and was extended another $22,500 of credit, allowing him to drop $25,000 into the market.
Big Mistakes Page 2