Out Of Fashion But Never Out Of Style: The Value Investing Theory Of Graham And Dodd

Contrasting Two Styles Of Investing: Value And Growth

From 2010 through 2020, the Russell 1000 Growth Index took flight and gave investors an annualized return +17%, while the Russell 1000 Value Index only had a +10% annualized return in the same period. 

 Investing in growth stocks has been the best advice for clients in the last ten years. But is it always the best advice? Take a look at these statistics: since 1926, value investing has returned 1,344,600% vs growth investing, which returned 626,600%. [1]

Does Anyone Use The Value Investing Theory Now?

One of the most successful value investors of the last fifty years is Warren Buffet, who took classes on the theory from Graham and Dodd themselves in the early 50s. The textbook used for the courses was Security Analysis, the magisterial work by Graham and Dodd first published in 1934, which remains the definitive work on the theory of value investing.

Should We Toss Value Investing Because Of Its Underperformance?

Because returns on value investing have substantially trailed growth investing in the last ten years, should we dismiss value? Most assuredly not. Diversifying client portfolios by investment style is a crucial way to reduce investment risk. Further, value investing carries less risk than growth investing, which might be especially important for your older clients who have long been retired.

Yet, for many Financial Advisors without long tenure in the business, value investing seems like is a relic from the late 20th Century, like the fax machine. Why pay attention to the theory these men posited in 1934? Did they ever work on the Street with real clients with real money?

On Wall Street In The 1920s Graham Making $500,000 A Year By Age 25

After graduating from Columbia University in 1920, Graham went to work as a runner at a major Wall Street investment house for $12 a week. His genius became readily apparent since he became a full partner by age twenty-five, earning more than $500,000 a year, an astounding sum at the time. [2] Today that would equal $6,511,850. [3]

Develops His Theory After Losing Everything In Market Crash of 1929

When the market crashed in 1929, Graham lost everything. That experience sent him on the intellectual journey to develop his theory of value investing, one of the few investment strategies that has withstood the test of time.  

What Is Value Investing?

At its most basic, value investing posits that the irrational investor fights with the efficient market theory, which always wins. Because the stock market is a price discovery mechanism, and because everyone has access to the same publicly available material facts, the market will eventually price stocks at their true worth. But that can take a while because investors are irrational, acting on rumors, gut feelings, horoscopes, etc. A value investor ignores the market price of a company’s stock and instead researches the company’s fundamentals, including assets, history of dividends, and earnings. Using value investing formulas, you should be able to determine the rational price of the stock in question.

Irrational Investors Have Set Current Price

Suppose the rational price of a stock determined by the value investing theory is above the market price, which irrational investors have set. When you discern this, you buy and hold the stock, then wait for the price to undergo a reversion to the mean. That is, the intrinsic value of the stock will be recognized, and the price will rise to the rational level.

It’s not an exciting strategy. But then again, many investors prefer feeling calm about their portfolios and not excited.  

Resources:

[1] https://markets.businessinsider.com/news/stocks/value-investing-dead-growth-poised-comeback-bank-of-america-forecast-2020-7-1029393582

[2] https://www.investopedia.com/terms/b/bengraham.asp

[3] https://www.carinsurancedata.org/calculators/inflation/500000/1920

Contributing Writer: Subject Matter Expert Charles McCain

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