In 1946-47, Benjamin Graham delivered a legendary series of 10 lectures on security analysis at the New York Institute of Finance. Nearly 80 years later, these lectures remain a goldmine of timeless insights and wisdom for investors and analysts seeking an edge in turbulent markets. I will be discussing each lecture in a 10-part series, so we can revisit Graham's teachings and unearth lessons still relevant today. Let's get into the first lecture.
The market is like a moody spouse
Graham made an amusing comparison between an analyst's view of the market and a husband's relationship with his wife. Just as a husband should not ignore everything his wife says, an analyst cannot afford to completely tune out the market's ups and downs. But at the same time, a husband should not overreact and overanalyze every little comment from his wife. Similarly, analysts should acknowledge market fluctuations, but not obsess over them.
Despite major events like World Wars and the Great Depression, Graham pointed out that overall market prices have stayed within a continuous range over the past 30 years (at that time). They have not spun out of control or crashed permanently. This means analysts should keep market volatility in perspective rather than assuming every short-term move signals a new permanent trend.
The principle of continuity in market fluctuations
Graham cited what he termed the “principle of continuity” to explain why investors need not assume new permanent paradigms for asset prices have emerged after large market moves. Even at peaks, prices eventually revert back toward previously established levels and averages over long periods.
While prices may diverge from underlying business values over shorter periods due to psychological factors like fear and greed, ultimately gravitational forces reconnect the two in the long run. However, Graham cautions this reversion can take very long periods to play out. Shorter-term investors may not live to see these mean-reverting tendencies fully manifest.
This highlights the conundrum analysts face – while they cannot prudently ignore the market’s moods altogether lest they miss profitable opportunities, neither can they afford to be whipsawed and unnerved by every gyration. Patience and discipline are required to smooth out the emotional reactions to which the market’s randomness might otherwise provoke them.
The market’s deceptive selectivity
Graham cautioned the common investing approach of "selectivity" - choosing stocks based on strong perceived future earnings prospects - is an extremely misleading idea that has misguided many market analysts and advisers.
He explained that in the weeks leading up to a recent market decline, many brokerage firm analysts were recommending clients exercise selectivity in their stock purchases, buying securities with strong projected earnings and avoiding those with weaker outlooks. The premise was that selectivity would allow investors to continue benefiting from favorable price changes even as overall markets fell.
The flawed nature of simplistic selectivity
While this logic of buying the strongest stocks may seem intuitively sensible, Graham detailed how actual market history reveals it to be a deceptive illusion. He demonstrated the flawed nature of simplistic selectivity using the example of National Distillers and United Aircraft from 1940 to 1942.
During World War II, based on a surface analysis of earnings prospects, most investors favored aviation leader United Aircraft and shunned "sin stock" National Distillers. The logic was straightforward. United Aircraft manufactured airplanes, which were clearly going to see increased demand and production due to the wartime needs. Airplanes were essential for the war effort, so investors expected the company to benefit.
National Distillers produced whiskey, which was considered a non-essential "luxury" product. With rationing and scarcity of resources during wartime, whiskey production would likely decline or be limited. So investors expected National Distillers to be hurt by wartime conditions.
The unexpected outcome of selectivity
As Graham detailed, United Aircraft was thus priced at a premium while National Distillers traded at lower valuations around that time. Investors were engaging in a simple form of selectivity, gravitating toward the "strong" company with robust growth prospects and avoiding the one facing headwinds.
Yet counterintuitively, in the post-war period, National Distillers dramatically outperformed while United Aircraft did poorly. By 1947, National Distillers had surged over 5 times from its 1942 lows while United Aircraft saw a 30%-plus price decline.
This stark divergence reveals the hazards of superficial selectivity based on simple forward projections. The future is uncertain - factors like changing consumer demand, new competitors and technology shifts can rapidly alter a company's trajectory. Assumed "winners" can quickly become "losers" once the fog of war lifted.
Graham's approach to selectivity
Graham's deeper point is that no one can reliably predict future earnings. Simplistic stories tend to fall apart in hindsight. Rather than selectivity based on guessing future winners, he advocated for selectivity based on prudent value and margin of safety. By buying discounted and diversified bargains, one had a built-in advantage while avoiding speculative risks of relying on earnings forecasts alone.
The National Distillers versus United Aircraft example remains a cautionary tale about the illusion of selectivity based solely on earnings projections. There are no crystal balls revealing future prospects with certainty. Maintaining humility about one's predictive powers is vital.
The allure and pitfalls of market forecasting
In conclusion, Graham reiterated that while the randomness of the market poses an inherent dilemma for security analysts, the solution lies in adhering to analytical rigor and financial prudence, not in trying to predict or time market movements. Analysts must resist the allure of attempting market forecasts, as even with perfect foresight of future earnings, psychology dominates in the short run. Staying rational amidst bipolar manic-depressive market swings is imperative.
Though economic, political and business backdrops evolve substantially over decades, human mass psychology remains much the same. By clinging to objectivity and continuous learning, analysts can better serve the public interest despite the market’s uncertainties. Bridging the gap between investors’ emotions and risk management realities is a key differentiator.
