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Remember Ben Graham, the guy who wrote it The smart investor? And who taught Warren Buffett how to become Warren Buffett?
Well, if you really know who Graham was, you also know that he is associated with buying something cheap (a dollar for fifty cents) and then selling it when it reaches a value that reflects what it is worth.
A very exemplary, calculated approach, right? Like what a Rahul Dravid would do in cricket.
But for once, go back and read the postdate of The smart investor (P. 532), where Graham shares a story of some other kind. It begins by describing two partners in an investment firm who:
… combined good profit potentials with solid values. They avoided everything that seemed expensive and were too quick to eliminate the problems they had advanced to levels they considered unattractive. His portfolio was always well diversified, with over a hundred different themes represented. In this way they came out pretty well for many years of ups and downs in the general market; they averaged approximately 20% annually over the various millions of capitals they had accepted for management and their clients were satisfied with the results.
In short, they were conservative and well-diversified investors who played very safe with their own and others ’money. As Graham is known to have always defended.
However, somewhere in 1948, these partners found the opportunity to buy about 50% of a growing business. They were so impressed by this opportunity that they broke their rule and invested around 25% of the assets they managed in this unique stock.
That was, Graham wrote, “… a very unusual exit for Conservative executives, who typically diversified widely and rarely invested more than about 5% in any stake.”
However, over the years, these shares increased more than 200 times and the partners did not sell it, again violating the share sale rule when they reached fair values. This although they could not justify maintaining it based on their strict standards of valuation and safety margin which they practiced otherwise.
Graham added in Postscript –
Ironically, the aggregate of profits derived from this single investment decision far exceeded the sum of all the others carried out during 20 years of extensive operations in the specialized areas of the partners, which involved a lot of research, an endless reflection. and infinity of individual decisions.
In cricket language, these partners who had always played their game like Rahul Dravid, hit a big one like Virendra Sehwag, and got it en masse.
“Is there morale in this story of value to the smart investor?” Graham asks and then gives an answer:
… an opportunity for luck, or an extremely cunning decision: can we differentiate them? – You can count on more than a lifetime of traveler efforts.
Remember these words from the parent of value investing when you find a fund manager who brags about his ability to select stocks.
Well, to shed the beans, one of the partners mentioned was Graham himself (yes, Graham himself!). The shares were the insurance company GEICO, and Graham credited much of this phenomenal success only to luck.
What success did he really have? Graham’s fund’s $ 712,500 investment in GEICO became more than $ 400 million in 25 years. In the language of Peter Lynch, Graham had hit a 500 wrap!
Graham suggested he was hugely lucky with GEICO. But was it just luck? No!
How to add to Postscript –
… behind luck, or the crucial decision, there is usually a baggage of preparation and disciplinary capacity. You need to be established and recognized enough for these opportunities to knock on your private door. You have to have the means, the judgment and the courage to take advantage of them.
In short, what is the moral of the story of Graham’s test with GEICO?
Investors often think that it is easy to be a successful investor. Ultra-successes, while few, have an excessive effect on us. We believe we can succeed because they did so and ignore the role of luck in their success.
Invest in a game of chance. Uncertainty reigns here. And so luck plays an important role in separating winners from losers.
Unfortunately, even if the achievement is purely random, such as in currency exchange or in investing in stocks, we usually look back and credit the successful individual with great skill for having achieved it. We make many such mistakes by attributing skill to a person who was just lucky.
Our tendency to base decisions on observed success, while ignoring unobserved failure, is called survival bias. Graham would not have been known to us if he had failed in his great bet on GEICO. Or perhaps he was known as a “successful” fund manager who attributed his success entirely to his ability to identify actions early. As he is quoted as saying in 1976 –
In 1948 we made our investment in GEICO and from then on we looked like very bright people.
The world of investing, like most things in life, produces cases of success and failure. It is human nature to want to copy success. The ironic truth, however, is this: accepting success at face value without recognizing the role of luck is a strategy for failure. Graham, being lucky with GEICO, knew this well.
But it’s also important to keep in mind that luck, like love, is a verb. It requires dedication and effort and conviction and courage to act. As Graham wrote –
… behind luck, or the crucial decision, there is usually a baggage of preparation and disciplinary capacity.
Another key lesson here is that of no selling your winning shares just because you think it has reached fair value or has been overestimated. Thanks to Graham for breaking this rule that he himself had practiced so strictly. GEICO started out as a value investment, but as the business grew, Graham held on and made a profit for a period of 25 years.
In fact, the reason Graham deliberately focused on GEICO was that his analysis showed that it was undervalued and provided an asymmetric result. He downplayed this all-important “skill” throughout the process of making money with GEICO.
The way to earn on the stock market, according to Charlie Munger, is to work, work, work, work and hope to have few ideas. The question is: how much data do you need during your investment life?
Not many, as Munger says (and Graham proved it with GEICO) –
… you don’t need many in life. If we look at Berkshire Hathaway and all its billions accumulated, most of the top ten knowledge. And that’s with a very bright man (Warren is much more capable than me and very disciplined) dedicating his life to it. I don’t mean he only has ten ideas. I’m just saying most of the money came from ten acquaintances.
… you’re probably not smart enough to find thousands in life. And when you have a few, you really load up. It’s that simple.
To conclude, here is a formula, derived from Graham’s investment in GEICO, to create wealth from stock market investment over time – Be prepared and expect a high quality business at a reasonable price, follow it over time until the business goes well, then be humble to credit luck rather than your skill for the success you will achieve and repeat this process if you have another Brea fat. The rest of the time, don’t act too much. This will be your true skill.
And yes, read The Intelligent Investor.
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