I’m convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When theprice of a stock can be influenced by a “herd” on Wall Street with prices set at the marginby the most emotional person, or the greediest person, or the most depressed person, it ishard to argue that the market always prices rationally. In fact, market prices are frequentlynonsensical. I would like to say one important thing about risk and reward. Sometimes riskand reward are correlated in a positive fashion. If someone were to say to me, “I have herea six-shooter and I have slipped one cartridge into it. Why don’t you just spin it and pull itonce· If you survive, I will give you $1 million.” I would decline—perhaps stating that $1million is not enough. Then he might offer me $5 million to pull the trigger twice—now thatwould be a positive correlation between risk and reward!
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’sriskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in thelatter case. The greater the potential for reward in the value portfolio, the less risk there is.
One quick example: The Washington Post Company in 1973 was selling for $80 millionin the market. At the time, that day, you could have sold the assets to any one of ten buyersfor not less than $400 million, probably appreciably more. The company owned the Post,Newsweek, plus several television stations in major markets.
Those same properties are worth $2 billion now, so the person who would havepaid $400 million would not have been crazy. Now, if the stock had declined evenfurther to a price that made the valuation $40 million instead of $80 million, its betawould have been greater. And to people who think beta measures risk, the cheaper pricewould have made it look riskier. This is truly Alice in Wonderland. I have never been able tofigure out why it’s riskier to buy $400 million worth of properties for $40 million than $80million. And, as a matter of fact, if you buy a group of such securities and you know anythingat all about business valuation, there is essentially no risk in buying $400 million for $80million, particularly if you do it by buying ten $40 million piles for $8 million each. Since youdon’t have your hands on the $400 million, you want to be sure you are in with honest andreasonably competent people, but that’s not a difficult job.
You also have to have the knowledge to enable you to make a very general estimateabout the value of the underlying businesses. But you do not cut it close. That is what BenGraham meant by having a margin of safety. You don’t try and buy businesses worth $83million for $80 million. You leave yourself an enormous margin. When you build a bridge,you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. Andthat same principle works in investing. In conclusion, some of the more commercially mindedamong you may wonder why I am writing this article. Adding many converts to the valueapproach will perforce narrow the spreads between price and value. I can only tell you thatthe secret has been out for 50 years, ever since Ben Graham and Dave Dodd wrote SecurityAnalysis, yet I have seen no trend toward value investing in the 35 years that I’ve practicedit. There seems to be some perverse human characteristic that likes to make easy thingsdifficult. The academic world, if anything, has actually backed away from the teaching of valueinvesting over the last 30 years. It’s likely to continue that way.
Ships will sail around the world but the Flat Earth Society will flourish. There willcontinue to be wide discrepancies between price and value in the marketplace, and those whoread their Graham & Dodd will continue to prosper.
