I recently re-read Warren Buffett (Trades, Portfolio)'s famous essay, "The Super Investors of Graham-and-Doddsville."
I like to go back and read these historic texts occasionally to refresh my memory and apply new information to the data.
Indeed, I think it has been roughly a year since I read the text in full, and in the time since then I've learned a lot more about Buffett and Charlie Munger (Trades, Portfolio)'s investment style, particularly their methods in the early years when their strategies were just starting to take shape.
Efficient market theory
Buffett wrote this essay as part of a fightback against the efficient market theory, which was all the rage at the time. He wanted to show that despite Wall Street's views that the market was entirely efficient, there was evidence that highly-skilled investors could still outperform by picking undervalued equities and following the lessons taught by Benjamin Graham.
"In this group of successful investors that I want to consider," Buffett wrote, "there has been a common intellectual patriarch, Benjamin Graham."
He went on:
"But the children who left the house of this intellectual patriarch have called their "flips" in very different ways. They have gone to different places and bought and sold different stocks and companies, yet they have a combined record that simply can't be explained by random chance. It certainly cannot be explained by the fact that they are all calling flips identically because a leader is signaling the calls to make. The patriarch has nearly set forth the intellectual theory for making coin-calling decisions but each student has decided on his own manner of applying the theory."
Buffett then went on to profile the returns of some of the greatest value managers of the last century, including Walter Schloss, Tweedy Browne, the Sequoia Fund, Perlmeter Investments and Pacific Partners, as well as Buffett and Munger's own performance.
All of these investment managers generated terrific gains. Pacific Partners, which was managed by Rick Guerin, recorded a compound gain of 22,200% between 1965 and 1983. That's compared to just 316% for the S&P 500 index over the same period.
However, while the market-beating returns of all of these investors are notable, what also stands out are the drawdowns suffered.
For Pacific Partners, its long-term returns look outstanding, but in 1973 investors suffered a loss of 42%, and then in 1974, the value of the portfolio declined 34%. This implies that the value of a $100 investment in the fund at the beginning of 1973 was worth just $38.30 at the end of 1974.
During this time frame, Munger's portfolio also suffered. It lost 32% in 1973 and then a similar amount in 1974.
Buffett managed to escape this turbulence, mainly because he closed his partnerships in 1969. Tweedy, Browne also managed to escape the turmoil, although it only produced a total cumulative return of 1,661% for partners between 1968 and 1983.
Figures tell a story
These figures tell a story about volatility. Value investing is all about buying stocks trading at a discount to intrinsic value, but there is never any guarantee that the market will realize that this gap exists. Moreover, there's a good chance the gap could become wider before it gets smaller.
At the same time, investors are exposed to the risk of general market volatility. Just because you are buying a value stock does not mean that it will move in a different direction to the rest of the market.
That said, there is some research that shows that less liquid investments (where the most value can be found) outperform during bear markets as investors literally can't sell fast enough. By the time they get an offer, the market on the rise again.
The ability to hold on to investments through market drawdowns and concentrate on the underlying intrinsic value, rather than the market price, is another reason why these legendary value investors have the reputation they do.
In conclusion, even though it is now several decades old, we can still learn a lot from this text about value investing and how to be a good investor in general.
Disclosure: The author owns no share mentioned.
Read more here:
- Why Warren Buffett Decided to Launch Berkshire's B Shares
- Warren Buffett: Diversification Is 'Protection Against Ignorance'
- Some Thoughts on Warren Buffett's Cash Problem
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