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The Environment One Endures Defines the Value Investing Path Chosen

Jared Diamond in his book Guns, Germs, and Steel: The Fates of Human Societies provided compelling evidence on why certain groups of people manage to gain the upper hand over the indigenous people they have conquered. One of the reasons certain societies gain a competitive advantage over others comes from the environments to which they were exposed over generations. A classic example of this is European dominance over the various indigenous groups they encountered in Africa and in the Americas. Europeans had the lead in comparison with other social groups in both forging weapons into steel and enjoying immunity from certain diseases because of their close proximity to the livestock they raised. The environmental factors to which they were exposed over generations played a key role in providing them with competitive advantages, enabling them to establish colonies in the New World as opposed to being subjugated.

Environment also plays a role in the type of investment philosophy chosen. This includes investors who fall into the value-investing camp. Benjamin Graham's version of value investing can be partially explained by the environment in which he grew up. Graham's father made a decision to expand his kitchenware import business, moving his family to New York from London when Benjamin Graham was only an infant. His early years in New York enabled Graham to have a taste of the good life until his father's untimely death when he was only 9 years old. With no competent successor found to run his father's import business, the absence of capable management resulted in the business's spiraling down into oblivion. Growing up poor and without a father makes Graham's accomplishments even more impressive. Blessed with a superior intellect and a herculean work ethic, Graham graduated from Columbia University with a degree in mathematics in only 2 ½ years while simultaneously working full-time to pay for his schooling. After graduating from college, he enjoyed a brief period of success on Wall Street before the situation changed for the worse. By the age of 35, his advisory firm, the Graham-Newman Partnership, would endure the stock market crash of 1929. The experience resulted in catastrophic losses for his clients to the tune of 70%, forcing Graham back into a life of frugality, flirting with bankruptcy the entire time. Enduring severe financial losses was a necessary condition that set the stage for Graham to carve out an investment philosophy that would return him to prosperity. Graham's writings on the subject of investing followed the course they did because of the personal experiences that had shaped him.

The first page of Graham's textbook, Security Analysis, includes a translated line of Latin text that Horace wrote. "Many shall be restored that now are fallen and many shall fall that now are in honor." This line of text is appropriate given that Graham's textbook was written in 1934 shortly after the Great Crash that nearly ended his future legendary career and the value-investment philosophy he would go on to formulate. Enduring a hostile investment climate that dragged stocks down 85% from peak to trough was necessary in order for Graham's value-investment philosophy to come to fruition.

The version of value investing with which Graham ended his career in 1956 stands in contrast to the version Warren Buffett would go on to embrace. Once again, environment defines the value-investing path chosen, and Buffett is no exception to that rule. Using the value-investing ideas he learned in Graham's classroom and as an employee of the Graham-Newman Partnership, the young Buffett would go on to form the Buffett Partnerships, turning him into a millionaire at a young age. These partnerships followed a model of purchasing stocks in much the same way Graham did, buying many securities at a discount to net current asset value; these securities were nicknamed cigar-butt stocks. The most famous net current asset value stock that his partnership purchased was the public company Berkshire Hathaway. Unlike Graham, Buffett did not work on Wall Street during the Great Depression or have a first-hand experience with the Crash of '29. The environmental backdrop of a total collapse in stocks did not scar Buffett as it did his mentor and former teacher, thus resulting in a different evolutionary path in the value investment form he would go on to follow later in life.

After returning his investors' capital from the Buffett Partnership, he made the decision to keep his shares in Berkshire Hathaway and to run the public company outright. It was the 1970s, and the version of value investing Buffett followed had morphed into something different from what Graham had followed. He still believed in Graham's concepts of buying stocks below "intrinsic value" and factoring in a "margin of safety" before making any purchase decision, but they were redefined in his mind in terms of how they were implemented. Over the coming years, Buffett's company, Berkshire Hathaway, enjoyed a backdrop of ever-loftier stock valuations, eventually reaching nosebleed valuation levels far removed from the Wall Street that Graham had experienced. Buffett's favorite stock market valuation indicator, U.S. Stock Market Capitalization to GDP Ratio, is now close to triple what Graham experienced in the 1950s. The Berkshire Hathaway financial engineering marvel has ridden this expanding valuation wave to its current glorious pinnacle.

With the Federal Reserve dropping interest rates to zero, buying companies below some measure of intrinsic value has once again been redefined. Buffett's latest engineering feat has been to orchestrate the acquisition of Kraft Foods by H.J. Heinz, a company that Berkshire Hathaway owned in partnership with the Brazilian investment company 3G Capital. Kraft had a lofty stock valuation of approximately 31x earnings before the acquisition was announced. Some market pundits have looked upon the acquisition of Kraft with a healthy degree of skepticism. This nosebleed valuation level of a macaroni and cheese company is a long way away from the cigar-butt stocks on which Buffett "cut his teeth" when he worked for Graham.

The latest Berkshire Hathaway letter to shareholders comments on his leaving the Graham form of value investing.

My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance.

Even then, however, I made a few exceptions to cigar butts, the most important being GEICO. Thanks to a 1951 conversation I had with Lorimer Davidson, a wonderful man who later became CEO of the company, I learned that GEICO was a terrific business and promptly put 65% of my $9,800 net worth into its shares. Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices. Ben Graham had taught me that technique, and it worked.

But a major weakness in this approach gradually became apparent: Cigar-butt investing was scalable only to a point. With large sums, it would never work well.

Using a lofty figure for what the intrinsic value of Kraft Foods is worth appears to be the new normal in value investing for a large organization such as Berkshire Hathaway that is eager to acquire scalable businesses. It remains to be seen how long this form of value investing will remain popular before the investment environment changes once again to something closer to Graham's cigar-butt value-investing philosophy.


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