Sometimes beating the market isn’t all it’s cracked up to be. Just ask Ben Graham.
Graham set up his second fund, the Graham Joint Account, in 1926 after closing down the first fund he set up with Louis Harris, Grahar Corp., run from 1923 to 1925. Over the first three years, 1926 to 1928, Graham’s new fund would earn 25.7% annually against the Dow’s 20.2%. He handily beat the market on the way up.
And he beat it on the way down…
From 1929 to 1932, Graham’s fund lost 70% compared to the Dow’s 80% loss (a beating alright). If he was chasing relative returns, he succeeded.
But Graham knew he failed. He barely survived the worst four year period ever in the stock market.
Not surprisingly, it would leave a lasting impression on him. James Grant explained exactly what went wrong during a 2008 Graham and Dodd event:
Value investors were supposed to have a deep-rooted aversion to financial leverage, but Graham and his partners went into the crash in a highly encumbered position. He relates that he was operating with two and a half million dollars in capital and that two and a half million of longs was hedged with two and a half million of shorts. So far so good. But Graham had in addition, as much as four and a half million in unhedged long positions against which he had borrowed 2 million. “We were convinced,” he explains, “that all of our long securities were intrinsically worth more than the market price.” Mark that word intrinsically. Now forget it. “Although many,” he said, “although many of our issues were little known to active Wall Street hands, similar ones had previously shown a praiseworthy tendency to come to life in a decent interval after we bought them and give us a chance to sell out at a nice profit.” So, he had come into the crash levered and with the muscle memory of value redeeming itself because it was intrinsically value laden.
Then came the turn of the seasons… Graham’s fund was down 20 percent in 1929…50 percent in 1930, and 16 percent in 1931. By 1932, the year in which the Dow bottomed at 41 spot 22, Graham had managed to achieve a kind of moral victory by losing a mere two percent. Still, there was only thirty cents remaining of each dollar entrusted to a stewardship at the peak only three years before.
For comparison, the Dow lost 17% in 1929, 34% in 1930, 53% in 1931, and 23% in 1932. In total, an 80% loss over the four years.
Using leverage — margin debt — was common in the 1920s. Everyone used it. And the long bull market from 1921 to 1929 was propelled by its use. The Dow was up 450% over the period.
The big draw of leverage is that it makes great returns even better. The downside nobody advertises is that it makes losses even worse.
Graham would swear off using leverage after being burned from four years of losses. That, of course, is the first lesson.
The second lesson? In a long, drawn-out bull market, it’s easy to become complacent. Which is exactly what happened to Graham.
He carried a 44% margin debt on his fund because all the previous times he bought cheaply, the market gave him a chance to sell for a profit. Year after year of doing the same thing worked…until it didn’t. Even Graham’s value strategy has limits (made worse by complacency and leverage).
The third lesson was harder. How does one recover, mentally and financially, from such a devastating loss?
Graham dug himself out financially and then some. By 1935, he, and his investors, had fully recovered from the losses (a feat in itself).
But mentally, he was never the same. As rational as Graham was, the experience would completely redefine him. He became a much more conservative investor. And sometimes, as James Grant tells it, the experience seeped into his writing:
I’m going to close with, to me, what is the great irony of Graham’s career as an analyst and as a participant in the financial markets… So Mr. Market was not content to ruin everyone’s life between the years 1929 and ’32. He wanted another lesson in 1937 just to make sure that you knew he was serious. So in 1937, there was what they call — the Roosevelt people call — a recession. It sounded so much more palatable than depression. The stock market, again, took a pratfall, a huge — I forgot what the decline was — say 40 percent. By this time, I think Graham had had enough. He was a wonderful, indeed, a great human being in so many ways, but he was a mortal being and he had had it. He had had it. And you could see his weariness shine through in the 1940 edition a little bit. And let this too be a lesson to us…
So, he had been through the mill, had Graham, and he seemed to let it show in the words of advice that he proffered to the institutional investors of his time. There weren’t so many of them. The people who manage trust funds and banks and who managed endowments, there weren’t so many of these people. There were some. And in his closing paragraphs, he spoke to them, these professionals. What should they do? Well, they should buy bonds, he said, bonds that were yielding two and three percent — two and three percent! Stocks, some of the better-paying stocks were yielding six, seven, eight percent, and up. Still, he says that institutional investors ought to avoid the stock market if they possibly could and buy bonds. This was five years before the all-time bottom in yields, high in prices… And indeed, Benjamin Graham said, stand clear. This is after like 750 pages of the most exquisite analysis of the risks and rewards of equities. Stand clear of them if you can. So learn from Graham’s example, both of his rising above his times and at intervals of his all too human weakness in being and succumbing to them.
Walter Schloss tried to explain just how impactful the 1929 experience was on Graham, and others, at the time and why crushing losses are so hard for investors to get over:
But Graham was concerned with limiting his risk and he didn’t want to lose money. People don’t remember what happened before and how things were. And that’s one of the mistakes people make in investing as well… People forget what things were like during the 1930s. I think Graham — because he lived through that period — remembered it, was scared it would happen again, and did everything he could to avoid it.
But in the process of avoiding it, he missed a lot of opportunities. That’s one of the problems you always have — you don’t really lose, but you don’t really make, either. I believe you should remember what took place — even if you weren’t around at the time. One of the problems of a lot of the people who went through the Depression — Ben Graham, Jerry Newman, and others — is that they keep on thinking that things will always be like that.
Even Graham used to say — and quite correctly — that you can’t run your investments as if a repeat of 1932 is around the corner. We can have a recession and things can get bad. But you can’t plan on that happening. People who did, missed this tremendous market.
Some people can do it. Most people can’t and I don’t think they should try.
Despite all of it, Graham never abandoned his underlying philosophy. After experiencing the worst four years ever, anyone not penniless would likely quit. But not Graham. I think Michael Batnick, in Big Mistakes, sums it up best:
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… 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.
This post was originally published on July 11, 2018.
James Grant: Graham and Dodd Breakfast Oct. 2008
Walter Schloss: Outstanding Investor Digest 1989
Big Mistakes: The Best Investors and Their Worst Investments
Ben Graham’s 1920’s Hedging Strategy
Ben Graham’s Lesson from the Computing-Tabulating-Recording Co.
Ben Graham on the Risk of Bull Market Optimism