The Timeless Wisdom of Graham and Dodd

September 3, 2023The seventh edition ofSecurity Analysis, by Benjamin Graham and David Dodd, was published this year. It is edited by Seth A. Klarman. Various sections of the book contain introductory essays by many leaders value investors. The preface to the book is written by Klarman and is entitled "The Timeless Wisdom of Graham and Dodd." This blog post is a summary of Klarman's essay.Klarman writes:

The world of investments is one of unlimited choices, significant opportunity, and great rewards, as well as shifting landscapes, untold nuances, and serious perils. Against that backdrop, investors must weigh multiple and sometimes competing objectives: generating income, growing principal over time, protecting against loss and the ravages of inflation, and maintaining a degree of liquidity to provide future flexibility and meet unexpected needs. Finding the right balance is essential.To do so, investors need a guidebook that offers them not a plan to succeed in a particular moment but rather a set of principles to steer them through any and all environments. In 1934, in the depths of the Great Depression, Benjamin Graham and his colleague, David Dodd, produced such a volume,Security Analysis, detailing how to sort through thousands of different common stocks, preferred issues, and bonds and identify those worthy of investments. Over the ensuing 90 years, during which it has remained consistently in print,Security Analysis has been crowned the bible of value investing. The stringing together of their very names–"Graham and Dodd"–has become synonymous with this sensible and timeless approach....As with the sixth edition, we have assembled leading practitioners and market observers to update and provide commentary on the content of the book's acclaimed second edition. In our attempt to distill what has changed over the years, we have striven to separate reality and enduring wisdom from what is ephemeral, protean, and illusory.

Here are the sections:

• • Enduring Principles
  • Fluctuating Share Prices Are a Major Driver of Opportunity
  • At the Core of Value investing: Buying a Dollar at a Discount
  • Drivers of Financial Market Inefficiency
  • The Art of Business Valuation
  • Navigating the Age of Big Data and Technological Disruption
  • Maintaining a Long-Term Horizon: The Difference Between Investment and Speculation
  • Value Investing is a Risk-Averse Approach
  • Defining and Managing Risk
  • The Academic View
  • The Importance of Process and Temperament
  • Value Investing in 2022: Challenges and Opportunities
  • The Burgeoning Growth of Institutional Investing and Alternative Investment Vehicles
  • Value-Investing Principles are Relevant Beyond the Financial Markets

ENDURING PRINCIPLESAlthough Graham and Dodd were writing 90 years ago, their enduring principles are still relevant. Klarman says:

...After all, each new day has the potential to throw a curveball: a war, a pandemic, a macroeconomic shock, a real estate crash, a financial crisis, the unexpected failure of a prominent company, a sovereign default, af broad-based technological upheaval, or dramatic political or regulatory change. People tend to assume that tomorrow will look very much like today, and most of the time, it does. But every once in a while, conditions change abruptly and conventional wisdom is turned on its head. In those times, many investors don't know what to do and may become paralyzed; they need a guiding philosophy, and Graham and Dodd offer an excellent one... It is during periods of tumult and upheaval that a value-investing philosophy is especially beneficial.

FLUCTUATING SHARE PRICES ARE A MAJOR DRIVER OF OPPORTUNITYStocks are fractional ownership interests in a business:

...The most important element of an investor's return from an equity investment is the cash flows generated by the underlying business itself. When McDonald's sells billions of hamburgers, the owner of 1% of the company's shares sells tens of millions.

Stocks prices fluctuate above and below intrinsic value. However, even when a value investor buys a stock when it is far below intrinsic value, the mispricing can take a long time to correct. Klarman:

These fluctuations give rise to one of the greatest challenges of investing. While an analysis of a company and its value can be spot on, the stock market can fail to reward that insight and can even appear to refute it. Indeed, an investor may not be rewarded for quite some time, and perhaps experience sizable paper losses. Investors, therefore, canbe right yetappear wrong, to themselves and to anyone who looks.

Klarman then notes a quote attributed to Graham: "In the short run the market is a voting machine, but in the long run it is a weighing machine."Klarman concludes:

It is also important to recognize that while the outcomes of investments are determined by the fundamentals of the underlying businesses in which you invest, the returns are intextricably linked to the purchase price. The less you pay relative to underlying value, the higher your investment returns will be; discipline matters in both buying and selling.

AT THE CORE OF VALUE INVESTING: BUYING A DOLLAR AT A DISCOUNTKlarman writes:

Value investing, whether in Graham and Dodd's day or ours, is the practice of purchasing securities or assets for less than they are worth–buying the proverbial dollar for 50 cents. Value investors can profit two ways: both from the cash flows generated by the underlying business and from a capital gain when the market better recognizes the underlying value and reprices the security. They also benefit from an important margin of safety conferred by the bargain purchase. A margin of safety provides room for error, imprecision, bad luck, or the vicissitudes of the economy and stock market. It offers a degree of downside protection.

Next, Klarman explains that a value investor should begin selling once a stock moves up to a 10% or 20% discount to intrinsic value. A value investor should completely exit when the stock has reached intrinsic value. It's better to get out too early and leave money on the table than it is to attempt to get out too late, possibly after a round-trip has brought the stock price back down to where the value investor bought it. Klarman:

Round-tripping an investment–watching it go up, failing to sell it, and watching it go back down–can be psychologically unsettling and economically costly. Disciplined selling, on the other hand, can open opportunities to exit your position and then possibly reinvest back into a company you already know well at an improved price.One might think of value investing as the marriage of a contrarian streak and a calculator, the mixing of deep, fundamental analysis with a propensity for going against the grain.

DRIVERS OF FINANCIAL MARKET INEFFICIENCYMost investors are far from rational. Klarman writes:

What drives financial market inefficiency? Investors, being human, sometimes buy or sell for emotionally charged reasons, such as exuberance or panic. They periodically alter their decision-making, not in response to investment fundamentals, but to recent performance that significantly expanded or shrank their own net worth. They might not want to miss out on a trend their peers have been profiting from. They can be lulled into complacency and even risk-seeking behavior by the momentum of the market. They might find it hard to maintain a contrarian view that has, so far, been costly. They might also overreact to surprises, particularly a quarterly earnings shortfall or an unexpected credit-rating downgrade. They may be overwhelmed by the analytical challenges involved with rapid corporate change, complexity, or heightened uncertainty. Investors always need to fight the tendencies to warm to investments whose price has been rising and bail on those whose price has been falling.Security prices deviate from fundamental value for myriad other reasons as well. One is that investors may well have different visions of reality; some are inveterate optimists while others are pessimists. Some become cheerleaders for their holdings, falling in love with their hypotheses. Investors' time horizons also differ, as do their expectations for the future... Individual risk tolerances also vary, both for interim price fluctuations but also, more important, for the prospect of a permanent loss of capital. Income needs from a portfolio differ as well, and some investors may be forced to exit a stock that omits its dividend or a bond that defaults, regardless of price.

Klarman continues:

In addition to all of these reasons for market inefficiency, people will always be subject to their own behavioral biases, as Daniel Kahneman brilliantly describes inThinking, Fast and Slow (2013). People tend to anchor to the price they paid for an investment and then stubbornly hold into the investment when it runs into trouble, irrationally waiting for it to return to the price they paid for it to get out without a loss when selling might have been the right thing to do. And after a financial loss, people often become more risk-averse, causing them to possibly miss out on the next fat pitch. People tend to overestimate the future likelihood of events that they recently experienced, and under-rate the possibility of events that haven't lately occurred. The cumulative effect of investors committing many small irrational acts can result in significant mispricings. A major challenge for investors is to be aware of, fight, and overcome their own biases, relying instead on objective realities and truths; this way, they can profit from mispricings rather than contribute to them.

Klarman then notes that institutional constraints are another source of securities mispricings:

Many investment funds, for example, are required by their charters to operate within narrow silos that restrict ownership of investments to those that have an investment-grade credit rating, pay a cash dividend, or are listed on an exchange. Others are restricted to a single industry. But in investing, price is king. Almost any security is a "buy" at one price, a "hold" at another, and a "sell" at yet another. Anything that prevents investors from buying or selling the most compelling opportunities available is a constraint that can lead to inferior performance.

Then Klarman explains how a value investor can take advantage of, rather than succumb to, these various sources of inefficient behavior:

At my firm, The Baupost Group, we actively and deliberately seek to create a culture that minimizes the risk of irrational or biased behavior. We work in teams to regularly incorporate fresh information and new perspectives into our analysis and calmly debate our decisions. We also work to ensure that we are not limited by institutional constraints. We search for opportunity by surveying, analyzing, and tracking the securities and assets we believe are most likely to be inefficiently priced. Those are often found in the gaps between traditional investment silos and include newly distressed or downgraded debt instruments; companies undergoing rapid corporate change such as mergers, major asset sales, and spin-offs; and situations involving great uncertainty, such as those subject to major litigation. We regularly pull at the threads of one interesting situation to find others; we look for patterns based on past investment successes. We rummage through the list of "new lows," knowing that out-of-favor securities can be an attractive source of bargains. We search expansively for potential opportunity and then dig deeply to verify that each situation is truly undervalued. Even after we buy, we keep digging.

THE ART OF BUSINESS VALUATIONValuing a business is typically not easy or straightforward. Skepticism and humility are needed. Also, there are several methods for valuing a business, and usually an investor must estimate a range for intrinsic value. Klarman writes:

While value investing is about buying into businesses at discounts to their fair value, doing so is by no means a paint-by-numbers exercise. It is not simply the practice of buying securities trading at the lowest multiples of recent earnings, cash flows, or book value. After all, sometimes a stock sports a low valuation multiple of good reason: troubling trends, competitive challenges, a broken business model, hidden liabilities, protracted and potentially crippling litigation, or incompetent or corrupt management. Investors must consider every potential investment with skepticism and humility, relentlessly hunting for additional information while realizing that they will never know everything about a company.So how exactly do we ascertain value in order to recognize if a bargain is available? There are a number of useful methodologies, among them the calculation of the present value of estimated future cash flows; applying sensible multiples of relevant income-statement, balance-sheet, and cash flow metrics; assessing the private-market value of a company (i.e., the value a knowledgeable third party would reasonably pay for the business); and establishing the breakup value (i.e., the amount to be realized if the various segments of a business were sold separately to the highest bidders). Value cannot usually be captured in a single-point estimate, and an investor would be wise to consider all these methodologies to determine a plausible range of value.

One area where contemporary value investors differ from the original Graham and Dodd suggestions relates to the future cash flows of a given business. Graham and Dodd thought it best to avoid such forecasting, but contemporary value investors believe otherwise. Klarman explains:

But in today's investing world, something can and in fact must be said about future cash flow. Clearly, a company that generates $1 per share of cash flow today that is reasonably expected to grow to $2 per share of cash flow five years from now is worth considerably more than one with no growth. The quality and source of these cash flows are also relevant. It matters whether the growth is organic or is expected to come from acquisitions, is steady or cyclical, and whether large capital investments are necessary to achieve it. A further complication is that companies can increase their cash flows in many different ways. They can sell the same volume of goods but at a higher unit price, or sell more goods albeit at the same, or an even lower, price. They might change their product offferings, to sell more of the higher profit-margin items, or they may develop an entirely new product line. Cash flow growth from cutting costs has very different ramifications for a company than the growth that occurs from expanding one's customer base; when expenses are trimmed, muscle may be lost as well as fat. Such decisions, inevitably, also impact customer satisfaction and competitor response. Obviously, some forms of growth are worth more than others.

Klarman adds:

Investors need to dig into the details to understand the true growth characteristics of a business and value them properly. Ultimately, despite Graham and Dodd's understandable reservations about the difficulties of projecting the future, in the context of today's rapid and powerful disruption of existing businesses, and the steady formation of promising new ones, it is simply not possible to disregard the trajectory of growth or decline when determining the valuation of a business.

Klarman then mentions that when using a discounted cash flow approach to valuing a business, the investor must select an appropriate discount rate.

To set the proper discount rate, investors must assess the quality, consistency, and riskiness of the company's cash flows. The best businesses usually have such attributes as strong barriers to entry, limited capital requirements, organic growth, repeat customers, significant pricing power, high margins, low risk of technological obsolescence, competitive moats, and thus strong, sustained, and increasing free cash flow. In many cases, the growth of such businesses is interwoven with those of other enterprises so that they become larger and more profitable as other companies execute their plans. The highest-quality businesses deserve to have their cash flows discounted at a lower rate than other businesses, conferring a higher valuation multiple. How much higher, however, is a subject of never-ending calibration and debate.

A value investor must also judge management:

In all of these valuation analyses, investors must also attempt to asses the skills, capabilities, priorities, and core values of a company's top management. Talented managers clearly enhance the cash flows and improve the capital-allocation decisions of the businesses they lead, but managerial ability can't easily be quantified... The past actions of any management team, whether in their current or previous roles, are perhaps the most reliable guide to future behavior. Alignment of their incentives with the interests of shareholders is also crucial.In addition to running the business well, managers have many other ways to positively impact investor returns. These include timely share repurchases, prudent use of leverage, and astute acquisitions. Managers who are unwilling to make shareholder-friendly decisions risk their companies turning into "value traps." They may be undervalued but ultimately poor investments, because the assets are likely to remain underutilized and cash flows may be squandered. Such underperforming companies should not necessarily be shunned, however, because those firms often attract activist investors seeking to join the board, change management, improve decision-making, and unlock value.

NAVIGATING THE AGE OF BIG DATA AND TECHNOLOGICAL DISRUPTIONToday, there are far more technology companies than existed at the time Graham and Dodd were writing. Klarman:

...Security Analysis offers, of course, no examples of how to value a software developer, internet search engine, or smartphone manufacturer, but its analytical tools will be useful in evaluating almost any company, assessing the value of its marketable securities, and determining the presence of a margin of safety. Questions of predictability, persistence, growth, business strategy, liquidity, and risk cut across businesses, markets, nations, and time.Over the past quarter century, the internet has enabled the formation of an enormous number of businesses that simply were not imaginable before, some of the best in the world. One such example is Google (now Alphabet), which collects and analyzes vast and growing quantities of data that give the company an insurmountable advantage in providing increasingly targeted advertising. This capability has enabled the company to completely disrupt the traditional advertising business, building a deeper and deeper moat.Thanks to the internet and the burgeoning growth of venture capital, an entrepreneur can now envision a business or even an industry that has never existed before, and he or she can raise venture funding, grow the fledgling enterprise exponentially at little or no cost, and if executed successfully, create a new market leader. This revolution arrived so rapidly that value investors found themselves in an unfamiliar position: many apparent bargains, evaluated on the basis of a continuation of historic cash flows, were turning out not to be bargains at all. Many such companies were not sound businesses facing a temporary down cycle as in Graham's day. Rather, they had become endangered by technological disruption from innovations that simultaneously destroyed their incumbent businesses while birthing phenomenal new ones that ate their lunch.

Klarman explains that technology is "the 800-pound gorilla in almost every room." The cash flows of a business today might tell you little about future prospects, even though its the future cash flows that determine the value of a business.Klarman points out that analysis of the consistency of earnings was less sophisticated in Graham's day.

Investors today examine businesses but also business models to identify the best ones. The bottom-line impact of changes in revenues, profit margins, product mix, and other variables is carefully studied by managements and financial analysts alike. Investors know that businesses do not exist in a vacuum; competitors, suppliers, and customers can greatly influence corporate profitability. They also understand that the rapid pace of innovation means that business circumstances can change quickly. Analysts evaluating fast-growing companies must consider not only the current volume of business, but also the potential demand for that product or service and its total addressable market (TAM) in order to assess for how long a company's growth might persist and when it might taper. Similarly, analysts think about the "right to win" of a business, the market share it might reasonably compete for, based on its cost structure and product advantages. While assessing future prospects of businesses in newly created industries is always difficult, investors would fall short if they failed to analyze and place a value on likely future growth or consider when and whether that growth might lead to enhanced profitability and cash flows.

The bottom line:

Value investors have had to become better business analysts than ever before.Value investors cannot ignore the future. They must assign value to rapid and sustainable growth in cash flows, but with caution... Investors should be especially vigilant to not focus on growth exclusively, as that would increase the risk of overpaying. Again, Graham and Dodd were spot on in warning that "carried to its logical extreme... [there is no price] too high for a good stock, and that such an issue was equally 'safe'... after it had advanced to 200 as it had been at 25." (Chap. 1) This precise mistake was made when stock prices surged skyward during the Nifty Fifty era of the early 1970s, the dot-come bubble of 1999-2000, and the low-interest-rate, post-economic stimulus stock market of 2021.

Klarman concludes:

My firm's approach to analyzing the value of those businesses we believe are likely to consistently grow involves rigorous fundamental analysis and making conservative projections of future results over the next two to three years, then comparing the multiple of those cash flows to today's share price. If the multiple of near-future earnings is reasonable (i.e., significantly less than today's market multiple and no higher than low double-digits), then the downside is probably limited even if the rate of growth ultimately slows. Broadly speaking, we aim to earn for all our investments an internal rate of return, modeled under conservative assumptions, in at least the mid-teens, a level high enough to result in a margin of safety for our capital. Investments with lower prospective returns are not sufficiently mispriced to attract our interest.

MAINTAINING A LONG-TERM HORIZON: THE DIFFERENCE BETWEEN INVESTMENT AND SPECULATIONWhile value investors know that it usually takes time for an investment to work, speculators want to make money quickly. Klarman writes:

Far too many people buy stocks wanting to make money quickly. But reliable investment returns cannot be earned this way; value investing works only when allowed the fullness of time. In the short run, any security can trade at any price. If your goal is to make a quick buck, value investing will hold no interest. Speculators generally regard stocks as blips constantly in motion on an electronic screen, like the ball in a spinning roulette wheel, capable of generating gains for those who guess right. Those minute-by-minute fluctuations may generate excitement, but ultimately they are "random walks," unpredictable short-term meanderings. Since speculators foolishly decouple share prices from underlying business realities, they are often drawn to whatever has been going up in price, regardless of the foolishness of the valuation. They regularly mistake luck for skill, pointing to an upward price blip as proof that their gambling is paying off. Speculative approaches–which pay little or no attention to downside risk–are especially popular in rising markets. In heady times, few are sufficiently disciplined to maintain strict standards of valuation and risk aversion, especially at a time when many of those who have abandoned such standards are outpacing the pack and becoming rich.In recent years, some have attempted to expand the definition of an investment to include any asset that has recently appreciated in price–or might soon: art, rare stamps and coins, wine collections, NFTs (nonfungible tokens), and hundreds of alternative (crypto) currencies. Because these items generate no present or future cash flows and have values that depend entirely on buyer whim, they should be regarded as speculations, not investments.Ubiquitous 24/7/365 media coverage of the stock market has reinforced investors' overemphasis on the short term. The cheerleading television pundits exult at rallies and record highs and commiserate over market reversals; viewers get the impression that up is the only rational market direction, and that selling or sitting on the sidelines is not just a poor choice, it's maybe even unpatriotic. These shows promote a herdlike mentality, blurring the ilnes between investing and speculation. Financial cable channels also create the false perception that one can reasonably formulate an opinion on everything pertinent to the financial markets. We live in a sound-bite culture that peddles the idea that investing is not painstaking or rigorous, but easy. There will never be a Graham and Dodd channel on cable business TV; human nature ensures it. That channel would be the broadcasting equivalent of watching paint dry.Then there is the influence of social media. In recent years, speculators gathering on Reddit and other such platforms have gained notoriety for their involvement in "meme stocks," typically frail and even near-bankrupt companies that are often being sold short by hedge funds. This herd regards the stocks as speculative vehicles and treats them like a casino game. While occasionally their bull raids squeeze a short seller overexposed to a single name, the combination of poor fundamentals and overvaluation is toxic–and can be expected to sink most meme stocks over time. When you overpay and ignore fundamental value, you've almost certainly locked in future losses; you simply don't realize it yet.

VALUE INVESTING IS A RISK-AVERSE APPROACHThe lower the stock price compared to intrinsic value, the less downside there is and the more upside there is. This is the opposite of what is taught in modern finance, according to which higher returns require higher risk. Klarman writes:

The proper goal of a long-term investor is not to make as much money as possible as quickly as possible. It's to earn good, sustainable returns and hang onto them. It's also to increase one's purchasing power over time, after taking inflation into account. Equities are able to support this objective in a way that most fixed-income investments cannot.Unlike speculators and their preoccupation with quick gain, value investors strive to limit or avoid loss and thereby mitigate risk. When buying at a bargain price, one's downside is, by definition, truncated. Should the price fall from that level (assuming the value hasn't changed), the downside is further diminished–and the upside greater still. Contrary to academic theory, when a bargain becomes an even better bargain, you have both less risk and higher prospective return. What's key is having long-term capital that makes it possible to hold this perspective and benefit from it.

Klarman adds:

The best way to guard against loss is to conduct deep and rigorous fundamental research. When a small slice of a business is offered through the stock market at a bargain price, it is helpful to evaluate it as if the whole business were being offered for sale there. This analytical anchor helps value investors remain focused on the pursuit of long-term results, rather than profitability of their daily trading ledger.

DEFINING AND MANAGING RISKMost academics and even many professional investors define the riskiness of a stock by its volatility. By contrast, value investors define risk as the chance of loss. Klarman pens:

Many academics and professional investors define risk in terms of the Greek letter beta, which they use as a measure of past share price volatility: meaning that a stock with a relative volatility that has been greater than the overall market's is seen as riskier than one whose volatility has been lower. From this perspective, the greater the risk, the greater the return. But value investors, who are inclined to think about risk differently–as the probability and amount of potential loss–find such reasoning absurd. A volatile stock can become particularly undervalued, in fact, and at a reduced price it may become a very low-risk investment.In the gravity-defying market environment that followed the 2008-2009 financial crises, the most speculative investments regularly performed the best, and many institutional investors came to act as if return achieved is always commensurate with risk incurred. Specifically, they have made the decision to deliberately bear more risk to earn incremental return. But from a value-investing perspective, returns come from avoiding risk. When you take on additional risk, you always get the risk, but you may or may not achieve the return. Remember the carnage that comes when market bubbles burst. Stocks that investors eagerly bought at elevated prices based on overly optimistic assumptions find trouble attracting bids at much lower prices, even though at such levels the prospective returns could now outweigh the risks.Risk must also be considered over a period of time. Any security, as mentioned, can trade at any price at a particular moment, but its value is ultimately tethered to the value of the underlying business. Short-term volatility can drive markdowns in the value of one's portfolio (a negative if you're forced to sell, and a positive if you can buy more). Longer term, the only risks that really matter are being overly optimistic on corporate cash flows or choosing an inadequate discount rate.

Klarman later writes:

One of the most difficult questions for value investors is position sizing and its impact on portfolio diversification and risk. How much can you comfortably own of even the most attractive opportunities? I believe value investors should pack their portfolios with their best ideas; if you can tell the good from the bad, you should be able to distinguish the great from the good.

THE ACADEMIC VIEWAccording to academic theory, stocks are efficiently priced and higher return only comes from higher risk. As noted earlier, this is the opposite of what value investors believe: that the lower the price you pay relative to estimated intrinsic value, the lower your risk and the higher your potential return. Klarman writes:

Thanks to these theories becoming academic dogma, generations of students have been taught that security analysis is worthless and that they must prioritize portfolio diversification, allocating capital away from their best ideas (because in efficient markets there can be no good ideas) and spreading it into mediocre or poor ones. The very market inefficiencies that introductory finance textbooks brush away provide the opportunity for value investors to earn outsized returns over time.

THE IMPORTANCE OF PROCESS AND TEMPERAMENTSuccessful value investing requires not only having a good process, but also a calm and rational temperament. Evaluating one's process, however, is rarely easy or straightforward. Making money does not necessarily mean you made a good investment, whereas losing money does not necessarily mean you made a bad investment. Klarman writes:

A necessary part of investing is being intellectually honest. Sometimes, you make money because your investment thesis was correct. Other times, you simply get lucky. Just because you made money doesn't mean you made a good investment, and just because you lost money doesn't mean you made a poor investment. In order to be successful over the long run, investors must distinguish skill from luck, and learn from successes and failures alike....Decision-making must be examined over time, and postmortems must be conducted in order to improve future decision-making. The best investors focus on process rather than outcomes, because they know that good process eventually leds to better outcomes, while good outcomes are not necessarily reflective of good process and could reflect mere luck, not skill.Investors need a plan that can succeed over a full market cycle, one they can stick to with conviction during the inevitable periods of underperformance. If you could predict the future meanderings of the market, you'd want to be fully invested at the bottom and get out at the top. But because we can't predict the path of share prices, the only way to proceed is to invest with the idea of holding your investments through thick and thin. This means buying investments with good upside potential and limited downside risk. But as Graham and Dodd argued so forcefully, we must remember that conditions change. It makes little sense, for example, to pivot to a more defensive strategy after the market and economy have cratered, or to adopt a more aggressive strategy after the market has surged. In each case, that horse may well have already left the barn.

Klarman reminds the reader that Graham and Dodd were writing during the Great Depression. Klarman:

The economy was not actively managed by central bankers the way it is today, and it was thus subject to higher volatility. There was no Fed "put" to support the stock market through periods of economic tumult.Nevertheless, in an extemely challenging market, Graham and Dodd remained faithful to their principles. They knew that the economy and markets would sometimes go through painful cycles, and they also know these periods must be endured because neither their beginning not end could be reliably predicted. They expressed confidence, in the darkest days, that the economy and stock market would eventually rebound... Even if you're fully expecting mean reversion for the economy as a whole, it's hard to maintain that view in the face of painful loss or persistent underperformance.Over time, just as investors must deal with down cycles in which business results deteriorate and undervalued stocks become more deeply undervalued, they must also endure and remain disciplined during protracted up cycles in which bargains are scarce and investment capital seems limitless. Between 2010 and 2021, the financial markets performed exceedingly well by historic standards, rewarding the bulls while making downside protection seem a fool's errand, or at least an unnecessary waste. Fear of missing out (FOMO) replaced the fear of loss. The sole focus of most investors became earning a high return on capital, rather than ensuring the returnof capital.Capital-market manias regularly occur on a grand scale: Japanese stocks in the late 1980s, internet and technology stocks in 1999-2000, subprime mortgage lending in 2006, and high-growth though not yet profitable stocks, fixed income investments, and cryptocurrencies in 2020 and 2021. It's hard to bet against bubbles when you're in one; even experienced investors can wither under the market's relentless message that they are wrong. The pressure to succumb in enormous; many investment managers fear they'll lose business if they stand too far apart from the crowd or underperform for very long. FOMO can be a powerful force, but value investors must maintain a contrary stance as others around them lose their heads.

Klarman also explains that investors today have to consider that the Federal Reserve often intervenes at the first sign of trouble. The Fed tends to lower interest rates to prop up stock prices and restore investor confidence. The Fed will also print money and buy bonds if deemed necessary. Although the Fed may simply be trying to maintain orderly capital markets, some money managers view Fed intervention as a license to speculate. Klarman:

Aggressive Fed tactics to prop up markets, originally referred to as the "Greenspan Put" (and now the "Powell Put"), create a growing moral hazard that encourages speculation while prolonging and even exacerbating overvaluation. While Ben Graham recommended focusing on the bottom-up fundamentals of specific investments and largely ignoring macro factors, the Fed has become the 800-pound gorilla, something that cannot be ignored and a presence that tends to get its own way...My best advice for readers is to continue to invest bottom-up, while avoiding being completely wrong-footed by keeping one eye on the prevailing macro backdrop. To ignore the Fed's presence would be to put oneself fully at the mercy of policymaker overreach or misstep. Most important, value investors must fight the tendency to be lulled into a false sense of security by subdued volatility or elevated vluations that may swiftly reverse, and they must never rely on the Fed to rescue them from the overvalued investments they may make.

VALUE INVESTING IN 2022: CHALLENGES AND OPPORTUNITIESKlarman writes:

...the good news for value investors is that even with a large value-investing community, there are far more market participants who invest without a long-term value orientation. Most managers concentrate almost single-mindedly on the growth rate of a company's earnings or the momentum of its share price. Meanwhile, vast amounts of capital have been flowing into index funds to save money on fees and transaction costs. Index managers automatically buy the stocks in an index, doing no fundamental analysis to validate the purchases. Of course, with more and more investment capital being indexed, future mispricings may increasingly linger and the incremental returns achievable through fundamental analysis could start to rise.

Klarman cautions against defining value stocks as "low-multiple" stocks:

Those who define value investing as the purchase of the statistically lowest-multiple stocks (as measured by price to earnings, price to cash flow, price to book value, etc.) are making a serious error. As discussed, the rapid and well-funded innovation we observe every day has accelerated the demise of many "old economy" businesses. The stock market is hardly unaware of this. The obvious losers in this "creative destruction" fall in price to a low multiple of yesterday's results. But in a great many cases, this does not make them bargains. Many declining businesses are eroding faster than ever now. They are not value investments and should generally be avoided, except when the market has significantly overreacted and the situation can be assessed to be not as dire as commonly perceived.

Klarman also cautions against "growth" investing:

The poor relative performance of "value" strategies in recent years has driven many investors to use other strategies, most prominently a "growth" approach. For many, there has been no price too high to pay for a rapidly growing and promising business. Thirteen years after the Great Financial Crisis, more than a decade of meager interest rates had driven investors, even conservative ones, into larger and larger equity allocations. TINA ("There Is No Alternative") thinking drove them out of low-yielding bonds and into stocks and, for many endowments and pension funds, into illiquid and often risky alternative investments such as private equity and venture capital. This led to sizable excesses in the valuation of rapidly growing but still unprofitable businesses, many of which were not expected to produce their first profits or positive cash flows for years. Many slower-growing companies, in contrast, significantly lagged the market indices, trading at levels where they had become quite undervalued compared, for example, to what a private buyer might pay for them.

Klarman explains that many investors put more money into "growth", which has been working, and take money out of "value", which has not been working. Klarman:

This drives up the price of what has worked while reducing the price of what hasn't. This may seem like value hell, but it is actually driving prices in the direction of value heaven–meaning, exactly the sort of environment that Graham wrote about, a market in which undervalued companies were as unloved as overvalued companies were adored, one in which bargains became plentiful.Value investors can build edge by taking a view that is longer-term than their competitors'. Because of the short-term, relative performance orientiation of most investors and the constant performance comparisons they are subjected to, they can find it hard to look past a valley to imagine the next peak. Not many want to buy a stock if the next few quarters look disappointing, since stocks that fail to beat Wall Street's quarterly estimates are regularly thrashed. Even when short-term negatives have been more than fully baked into share prices, many hold back, waiting for obvious evidence of turnaround or recovery. In effect, they'd rather pay a higher price when the road ahead seems clear, even though by the time everyone can see what they see, the moment of greatest opportunity will have passed.

Klarman concludes:

In general, for a value investor, companies that disappoint or surprise with lower-than-expected results, sudden management changes, accounting problems, or ratings downgrades are more likely to be sources of opportunity than the consistently strong performers are.If there are no immediately compelling opportunities at hand, value investors should choose to wait rather than overpay, holding some cash in reserve. Compromising one's standards can lead to disaster. At various times in his career, including in his 2021 Berkshire Hathaway shareholder letter, Warren Buffett has stated that he has more cash to invest than he has good investments. As all value investors must do from time to time, Buffett exercises patience. While waiting, value investors should keep digging to identify new mispricings, uncover incremental kernels of information, and develop fresh insights. New opportunities will inevitably emerge. Importantly, value investors don't need the entire market to be bargain-priced, just 20 or 25 unrelated investments–a number sufficient for diversification of risk.

THE BURGEONING GROWTH OF INSTITUTIONAL INVESTING AND ALTERNATIVE INVESTMENT VEHICLESKlarman:

The advent of these large, professionally managed pools of capital have not brought a longer-term orientiation to the financial markets. Institutional managers find it hard to have such an outlook when their committees and external consultants keep making increasingly short-term performance comparisons. Constant performance assessment inevitably leads to relative performance comparions. As with animals in the wild, in investment management wandering from the herd is risky, subjecting managers to possible relative underperformance and client termination. While the only way to outperform the herd is to be different, only a few investors can weather the inevitable periods of relative underperformance.

Klarman continues:

Thinking that traditional equity and debt markets are too expensive to provide adequate returns and increasingly too efficiently priced to possibly produce alpha (market outperformance), institutional investors have been allocating a growing portion of their assets under management to alternatives. In his 2000 bookPioneering Portfolio Management, the groundbreaking head of Yale's Investment Office, the late David Swensen, makes a strong case for these investments. He points to the historically inefficient pricing of many asset classes, the record-high risk-adjusted returns of many alternative managers, the high dispersion between the best such managers and the rest of the pack, and the limited performance correlation between alternatives and other asset classes. He highlights the importance of choosing the right alternative managers by noting the large dispersion of returns between top-quartile and third-quartile performers. Many endowment managers have emulated Swensen by committing to these asset classes.

Klarman notes that, with regard to private equity, the reasons private companies become mispriced are often similar to the reasons public companies become mispriced. Klarman then points out:

While their holdings are illiquid, private equity investors gain a lever of corporate control to help drive business success and favorable investment outcomes. Control enables an investor not only to benefit from a disciplined approach, a bargain purchase, and timely buy and sell decisions, but also to enact more far-reaching measures, such as returning excess capital to the equity owners, changing a business plan, accelerating capital expenditures, making accretive acquisitions, exiting business units, and even selling the entire company.

Klarman again:

Similarly, Graham and Dodd never addressed how to analyze direct investments in real estate (buildings of various use as well as land), a vast asset class that has become more popular with institutions. But there are bargains to be had in real estate, too, and they happen for all the same reasons–e.g., the seller has an urgent need for cash, an inability to perform proper analysis, differences in investor outlooks and time horizons, or investor disfavor or neglect... Graham and Dodd's principles–such as the stability of cash flows, sufficiency of return, analysis of downside risk, debt coverage ratios, and contingency analysis of what can go wrong–allow investors to identify real estate investments with a margin of safety in any market environment.

Next, Klarman comments on venture capital:

Graham and Dodd would have had trouble embracing one type of alternative investment–venture capital–because they would be unlikely to find a margin of safety in it. While there is often the prospect of enormous upside in such an investment, there is also a very high risk of failure. Nor is it clear how to evaluate fledgling enterprises to see if the potential return justifies the risk. Naturally, investors with considerable risk tolerance and sophistication will want to participate in the businesses of tomorrow (and to buy in before they come public at what are generally particularly lofty valuations), by allocating a limited portion of capital to this sector while expecting a very bumpy ride. But investors should take note that the venture capital returns of 2020-2021 are virtually unprecedented and have benefitted greatly from exuberant public market valuations. Further, capital inflows have caused deal pricing at every stage of venture investing to be bid up considerably, increasing the probability that future returns will be lower.These accelerating flows of capital into early-stage companies increases the likelihood that these nascent businesses may face intensified competition in the future. It's unclear whether the businesses enabled by ongoing technological advances can withstand the competitive forces unleashed by the burgeoning volumes of venture capital looking to back their current and future competitors.

VALUE-INVESTING PRINCIPLES ARE RELEVANT BEYOND FINANCIAL MARKETSKlarman notes that value investing principles apply in other fields, like baseball. But new sources of edge must constantly be identified and developed once the original edges are copied.FINAL THOUGHTSKlarman writes:

The essential characteristics of a value investor--patience and discipline--are rare. As Warren Buffett noted (in his famous article "The Superinvestors of Graham-and-Doddsville"), "It is extraordinary to me that the idea of buying dollar bills for 40 cents take immediately with people or it doesn't take at all. It's like an inoculation. If it doesn't grab a person right away, I find you can talk to him for years and show him records, and it doesn't make any difference."

Klarman concludes:

In a rising market, everyone makes money and a value philosophy may be unnecessary. But because there is no sure way to predict what the market will do, one needs to follow a value philosophy at all times. Value investors must remain hungry and agile, developing new areas of edge to replace those that are arbitraged away as more investors pile in. They must remain humble, intellectually honest, and deeply curious. They must be responsible stewards of capital, taking into account the influence of their companies on their customers, their communities, and the planet. And they must constantly hone their investment process and develop new insights into human behavior, including their own, while learning from mistakes and successes alike. Finally, they must fight the belief that the way things are today is theh way they'll always be; history promises us otherwise. By controlling risk and limiting loss through extensive fundamental analysis, strict discipline, and endless patience, however, value investors can expect good results with limited downside.The real secret to investing is that there is no secret to investing. Every important aspect of value investing has been made available to the public many times over, beginning in 1934 with the first edition ofSecurity Analysis. That so many people fail to follow this timeless approach enables those who adopt it to be successful. I know of no long-time investor who regrets adhering to a value philosophy, and few will ever abandon this time-tested approach for another. Human nature guarantees that the hope for and pursuit of rapid and effortless gain will be with us forever. So as long as others succumb to the siren song of getting rich fast, value investing will remain, as it has been for some 90 years, a sound, low-risk, and successful approach. Truly, the concept of buying securities for less than they're worth never grows old. You may not get rich quickly, but you will keep what you have, and if the future of value investing resembles its past, you are likely to get rich slowly. As strategies go, this is the most any reasonable investor can hope for.

BOOLE MICROCAP FUNDAn equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.If you are interested in finding out more, please e-mail me or leave a comment.My e-mail: jb@boolefund.comDisclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.