The idea of rules based investing, or systematic investing, is not new. Ben Graham offered new and old methods that worked with each iteration of The Intelligent Investor. He also offered up different methods outside of the book too.
In my last post on following simple principles, Graham refers to an article he wrote about three such methods, along with a 50-year study he did. Out of curiosity, I dug around for the study, but only found the article.
His three methods were interesting, but Graham makes the point that the lesson is not that his three methods are the best or only methods that work. Rather, the lesson is that any systematic approach should work and continue to do so as long as it’s based on sound investing principles and three other requirements:
- a logical theoretical basis;
- simplicity of application; and
- a satisfactory financial result when applied over a long-term period
Then he went on to explain why:
A basic question raised in this paper is not whether elaborate security analysis is required for common-stock selection under 1974-1975 conditions – to which my answer would be no – but rather the extent to which the simple approaches expounded today could be expected to prove rewarding to the stock markets of the future – say of the next 10 or 15 years – which will make up a significant part of the working careers of those in my audience. Those of you who have been following this presentation closely will have adduced that my attitude partakes of both the negative and the positive on the need for elaborate security analysis. I do not have much confidence in the practical worth for most analysts of detailed studies of individual companies, with emphasis placed either on their comparative past performance or on predictions of their relative future performance over a one-to-five-years time span.
My reputation – such as it is, or perhaps as recently revived – seems to be associated chiefly with the concept of “Value”. But I have been truly interested solely in such aspects of value as present themselves in a clear and convincing manner, derived from basic elements of earning power and balance-sheet-position, with no emphasis at all placed on such matters as small variations in the growth rate from quarter to quarter, or the inclusion or exclusion of minor items in calculating the so-called “primary earnings”. Most significant here, I have resolutely turned my back on efforts to predict the future.
To that extent I share the skepticism expressed by the “efficient market” theoreticians as to the ability of all but very superior security analysts to do a good job of individual stock selection. But this is far from saying that I think that individual stock prices reflect in general and under most conditions the “fair value” of each issue. On the contrary, my present emphasis on the tendency of most stocks to fluctuate widely and often wildly in price over the years should show my conviction that stock prices are often out of line with their fair or intrinsic values.
I see no reason to expect the disappearance or any great diminution of the age-old tendency of most common stocks to move up and down over a wide percentage range: I deem this a consequence of the psychological or rather the pathological nature of stock speculation. Nor have there been any signs that the institutional dominance of the stock market in the past decade has tended to lessen the amplitude of these fluctuations. We cannot predict the overall performance of common stocks in the next fifteen years — the exhilarating achievement of better than fifteen percent per annum for 1944-1959 was followed by practically a zero performance in 1960-1974. But in both the rewarding and the disillusioning periods the bulk of individual issues persisted in their wide upswings and downswings. It is happening once again in the current market. (The zebra will grow older but will not change his stripes.)
Coming back in conclusion to stocks selection in future years let me make two undeniable assertions: The first is that the behavior of stock prices in the past fifteen years and more does indicate that relatively simply criteria of purchase and sale could have been applied on a group basis with satisfactory results throughout this period, except naturally in 1973 and 1974; secondly, if the general character of future common stock movements will resemble basically that of the past, in their tendency to move up and down, then there is good reason for financial analysts to develop and apply systematically – each in his individual fashion – the type of investment policy I have discussed today.
Look at the 52-week high and low for any single stock and you’ll probably be surprised by the price range. Take Johnson & Johnson (JNJ), a blue chip known for its consistent dividend and steady earnings growth. In the past year, the price at which investors were willing to part with or purchase the stock ranged from $94 to $126 per share. From a market cap perspective that represents about an $87 billion difference ($256 billion to $343 billion).
Did the value of J&J (the company) change that much in one year to warrant such a swing? Or did the perception of J&J (the stock) change that much? It’s unlikely that valuation alone accounts for that large of a price swing. Valuations don’t change that drastically – at least not for a steady grower like J&J – unless there’s a dramatic change in fundamentals.
The more likely reason is a change in investor perception due to any number of events – quarterly earnings surprises, industry news, macro news, or any number of other variables – that affects how investors view the stock.
When a large percentage of the market is hyper-focused on the short term, more weight is put on recent events. A bad earnings miss or lowered outlook is enough to swing sentiment from optimism to pessimism, moving price along with it. And it can switch back just as quickly because the short term focused market tends to be just as forgetful.
Graham understood that all stocks are susceptible to wide swings due to this line of thinking. He believed that an investor could exploit this behavior with a simple method, and a little amount of work, and get a decent return over longer periods of time.
Armed with a systematic approach, the fortitude to stick with it, and the knowledge that stock prices swing widely, an investor can take advantage of the opportunity created by these short-term overreactions by simply taking a longer term view. Even looking out 2 to 3 years is far enough to be different from the short-term nature of the market.
Three Simple Methods of Common Stock Selection