(Image: Zen Buddha Silence by Marilyn Barbone.)
March 27, 2022
According to the Efficient Market Hypothesis (EMH), stock prices reflect all available information and are thus fairly valued. It’s impossible to get investment results better than the market except by luck.
However, Warren Buffett, arguably the greatest investor of all time and a value investor, has argued that he knows a group of value investors, all of whom have done better than the market over time. Buffett argues that there’s no way every investor in this group could have gotten lucky at the same time. Also, Buffett didn’t pick this group of investors after they already had produced superior performance. Rather, he identified them ahead of time. The only thing these investors had in common was that they believed in the value investing framework, according to which sometimes the price of a stock can be far below the intrinsic value of the business in question.
Buffett presented his argument in 1984. But the logic still holds today. The title of Buffett’s speech was The Superinvestors of Graham-and-Doddsville. The speech is still available as an essay here: https://www8.gsb.columbia.edu/articles/columbia-business/superinvestors
Despite the unassailable logic and evidence of Buffett’s argument, still today many academic economists and theorists continue to argue that the stock market is efficient and therefore impossible to beat except by luck. These academics therefore argue that investors such as Warren Buffett just got lucky.
Let’s examine Buffett’s essay.
Buffett first says to imagine a national coin-flipping contest. 225 million Americans (the population in 1984) get up at sunrise and bet one dollar on the flip of a coin. If they call correctly, they win a dollar from those who called incorrectly. Each day the losers drop out. And the winners bet again the following morning, putting cumulative winnings on the line.
After ten straight days, there will be approximately 220,000 Americans who correctly called ten coin tosses in a row. Each of these participants will have a little more than $1,000.
Buffett writes hilariously:
Now 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 marvelous insights they bring to the field of flipping.
After another ten days of this daily contest, there will be approximately 215 flippers left who correctly called twenty coin tosses in a row. Each of these contestants will have turned a dollar into $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 skeptical professors with, “If it can’t be done, why are there 215 of us?”
By 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.
But then Buffett says:
I would argue, however, that there are some important differences in the examples I am going to present. For one thing, if (a) you had taken 225 million orangutans distributed roughly as the U.S. population is; if (b) 215 winners were left after 20 days; and if (c) you found that 40 came from a particular zoo in Omaha, you would be pretty sure you were on to something. So you would probably go out and ask the zookeeper about what he’s feeding them, whether they had special exercises, 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.
Scientific inquiry naturally follows such a pattern. If you were trying to analyze possible causes of a rare type of cancer — with, say, 1,500 cases a year in the United States — and you found that 400 of them occurred in some little mining town in Montana, you would get very interested in the water there, or the occupation of those afflicted, or other variables. You know it’s not random chance that 400 come from a small area. You would not necessarily know the causal factors, but you would know where to search.
I submit to you that there are ways of defining an origin other than geography. In addition to geographical origins, there can be what I call an intellectual origin. I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville. A concentration of winners that simply cannot be explained by chance can be traced to this particular intellectual village.
Buffett then argues:
In this group of successful investors that I want to consider, there has been a common intellectual patriarch, Ben Graham. 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 cannot be explained by random chance…
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… Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value.
As Ben Graham said:
Price is what you pay. Value is what you get.
The Efficient Market Hypothesis argues that the current value of any stock is already reflected in the price. Value investors, however, don’t believe that. Value investors believe that stock prices are usually correct – the market is usually efficient – but not always.
Buffett speculates on why there have been so many academic studies of stock prices:
I always find it extraordinary that so many studies are made of price and volume behavior, the stuff of chartists. Can you imagine buying an entire business simply because the price of the business had been marked up substantially last week and the week before? Of course, the reason a lot of studies are made of these price and volume variables is that now, in the age of computers, there are almost endless data available about them. It isn’t necessarily because such studies have any utility; it’s simply that the data are there and academicians have worked hard to learn the mathematical skills needed to manipulate them. Once these skills are acquired, it seems sinful not to use them, even if the usage has no utility or negative utility. As a friend said, to a man with a hammer, everything looks like a nail.
Buffett then proceeds to discuss the group of value investors that he had selected decades before 1984. Why is it that the value investors whom Buffett had identified decades ago before ended up far outperforming the market? The one thing they had in common was that they distinguished between price and value, and they only bought when price was far below value. Other than that, these investors had very little in common. They bought very different stocks from one another and they also had different methods of portfolio construction, with some like Charlie Munger having very concentrated portfolios and others like Walter Schloss having very diversified portfolios.
Buffett shows the records for Walter Schloss, Tom Knapp, Warren Buffett (himself), Bill Ruane, Charlie Munger, Rick Guerin, Stan Perlmeter, and two others. For details on the track records of the value investors Buffett had previously identified, see here: https://www8.gsb.columbia.edu/articles/columbia-business/superinvestors
While discussing Rick Guerin, Buffett offered the following interesting comments:
One sidelight here: it is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately to 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 IQ or academic training. It’s instant recognition, or it is nothing.
And when discussing Stan Perlmeter, Buffett says:
Perlmeter does not own what Walter Schloss owns. He does not own what Bill Ruane owns. These are records made independently. But every time Perlmeter 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?
Buffett then comments on the nine track records he mentioned:
So these are nine records of “coin-flippers” from Graham-and-Doddsville. I haven’t selected them with hindsight from among thousands. It’s not like I am reciting to you the names of a bunch of lottery winners — people I had never heard of before they won the lottery. I selected these men years ago based upon their framework for investment decision-making. I knew what they had been taught and additionally I had some personal knowledge of their intellect, character, and temperament. It’s very important to understand that this group has assumed far less risk than average; note their record in years when the general market was weak. While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock. A few of them sometimes buy whole businesses far more often they simply buy small pieces of businesses. Their attitude, whether buying all or a tiny piece of a business, is the same. Some of them hold portfolios with dozens of stocks; others concentrate on a handful. But all exploit the difference between the market price of a business and its intrinsic value.
I’m convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. 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.
Buffett then discusses risk versus reward. When you are practicing value investing, the lower the price is relative to probable intrinsic value, the less risk there is but simultaneously the greater upside there is. As Buffett puts it, if you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expected reward is greater in the latter case.
Speaking of risk versus reward, Buffett gives an example:
The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.
Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million.
Buffett adds that you also want to be sure that the managers of the business are reasonably competent. But this is a very doable task.
Buffett concludes his essay by saying that people may wonder why he is writing it in the first place, given that it may create more competitors using value investing. Buffett observes that the secret has been out since 1934, when Ben Graham and David Dodd published Security Analysis, and yet there has been no trend towards value investing.
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