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November 27, 2006

Why Warren Buffett Plays Bridge

John P. Hussman, Ph.D.
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In 1984, Warren Buffett gave a talk at the Columbia Business School in honor of his mentor, Ben Graham. He began by relating the academic argument that investors having long-term records of outperforming the market really owe their success to randomness. Buffett responded by describing a hypothetical coin-flipping contest, where each participant flips a coin each day for 20 days, and those who come up with all heads are declared winners.

Buffett continued, “if (a) you had taken 225 million orangutans distributed roughly as the U.S. population is; (b) 215 winners were left after 20 days, and if (c) you found that 40 came from a particular zoo in Omaha , you would be pretty sure you were onto something. So you would probably go out and ask the zookeeper about what he's feeding them, whether they had special exercises, what books they read, and who knows what else. That is, if you found any really extraordinary concentrations of success, you might want to see if you could identify concentrations of unusual characteristics that might be causal factors…

“I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville. While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock.”

Buffett concluded his talk by explaining why he had no fear of diluting the performance of value investing by winning more converts to it – “I can only tell you that the secret has been out for 50 years… yet I have seen no trend toward value investing in the 35 years that I've practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing 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 will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.”

Lessons from Ben Graham

On that advice, I've found it helpful over the years to periodically re-read Graham's writings. I should note that my own stock selection varies in style from pure value investing, in that my years as a “rational expectations” economist persuaded me that market prices and trading volume convey information, and shouldn't be overlooked. Still, my copies of Graham's writings are heavily underlined, and full of bent page corners and annotations. If you don't want to dive right into the textbook-like “Security Analysis,” the best starting point is “The Intelligent Investor,” which is an essential read. “The Rediscovered Benjamin Graham” is a compilation by Janet Lowe that contains some fascinating speeches and articles that aren't easily available elsewhere.

Readers of Graham's books will notice that his specific tests of value slightly changed from edition to edition and from earlier books to later ones, but his underlying principles did not. Among his key measures of investment merit included a market price near or below tangible net asset value, and a wide spread between normalized, fully-diluted earnings yields and high-grade bond yields. That spread between earnings yields and corporate bond yields had originally been enormous in the early part of the 20th century, and gradually eroded to nothing by the mid-1980's. Indeed, at this point, Wall Street analysts hasten to accept any excess earnings yield over-and-above the 10-year Treasury yield, even on the basis of “forward operating earnings” as the earmark of a cheap market. Graham would be appalled.

As it happens, the simple, normalized earnings yield on the S&P 500 has been a remarkably good indicator of subsequent 20-year total returns for the stock market. In the chart below, I take the inverse of the price/peak-earnings ratio as a “normalized” earnings yield. Recall also that peaks in S&P 500 earnings over the past century have been well contained by a 6% annual growth trendline. (Finding that level today is easy. To quote Madge in the Palmolive commercial; “you're soaking in it”). In order to further normalize the earnings yield, I've added the amount of annualized earnings growth that would be required to bring the prevailing peak-earnings figure earnings at any point in time up to that 6% growth trend.

I should add that it would be reasonable to expect the relationship between normalized earnings yields and subsequent market returns to have been affected by variations in the proportion of earnings retained and reinvested, the average rate of return on invested assets, and so forth. Evidently, these variations have not mattered much over the long-term. One might at least expect interest rate fluctuations to have mattered, but remember that a 10-year bond has a duration of just 7-9 years depending on its yield, while the duration of the stock market can fluctuate between just 16 years when yields are very high, to about 60 years (as is presently the case) when yields are very low. Over a 20-year horizon, which is usually about 3-4 complete bull-bear cycles, shorter cyclical variations in interest rates simply wash out.

Suffice it to say that if Graham's emphasis on normalized earnings yields has anything to say about the market here, it is that stocks are priced to deliver very disappointing long-term returns, regardless of short-term speculative (and even cyclical) influences.

Investment versus speculation

Graham drew a sharp distinction between investment and speculation. Investment, in Graham's view, was restricted to activities that had such a wide margin of safety that projections about the future – even about future earnings growth – were unnecessary.

“Nothing will appear more logical and natural to this audience than the idea that a common stock should be valued and priced primarily on the basis of the company's expected future performance. Yet this simple-appearing concept carries with it a number of paradoxes and pitfalls. For one thing, it obliterates a good part of the older, well-established distinctions between investment and speculation.”

For that reason, Graham's investment criteria largely focused on tangible assets, demonstrated (though normalized) earning power, and so forth, with as few assumptions as possible about the future. I can't imagine that he would have looked enthusiastically on the market's current willingness to place a historically rich multiple on record earnings based on record profit margins:

“The market has a tendency to set prices that will not be adequately protected by a conservative projection of future earnings… In most periods the investor must recognize the existence of a speculative factor in his common stock holdings. It is his task to keep this component within minor limits, and to be prepared financially and psychologically for adverse results that may be of short or long duration.”

Though one might have expected Graham to condemn speculation as something to be avoided entirely, he did not. Instead, he recognized that some speculation could be intelligent. Though he never strayed from the discipline of value investing, he provided enormously useful advice on the subject of speculation (which, in my view, includes accepting an exposure to market fluctuations when valuations are elevated). On this, Graham advised a rigorous, quantitative discipline.

“I should greatly welcome an effort by security analysts to deal intelligently with speculative operations. To my mind the prerequisite here is for the quantitative approach, which is based on the calculation of the probabilities in each case, and a conclusion that the odds are strongly in favor of the operation's success. It is not necessary that this calculation be completely dependable in each instance, and certainly not mathematically precise, but only that it be made with a fair degree of knowledge and skill. The law of averages will take care of minor errors and of the many individual disappointments which are inherent in speculation by its very definition.”

Elsewhere, he warned, “but there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.”

Managing risk

That distinction between investment and speculation has been a frequent topic in these weekly market comments over the years. In my view, stocks are claims on the stream of cash that will be delivered to business owners, either in the near-term through liquidation, or over time, as the result of ongoing business activities. When you can buy stocks at prices that can be reasonably expected, on conservative assumptions, to produce a satisfactory long-term return, the purchase meets the definition of an “investment.” When you buy stocks on the expectation that they'll increase in price, based on factors other than a discount to existing assets or conservatively discounted future cash flows, the purchase is a “speculation.”

In the terminology I use with the Funds, “investment merit” means that valuations appear favorable, while “speculative merit” means that market action and other short-term, measurable, and historically relevant pressures appear favorable. The market can have one, both, or neither in its favor at any point in time.

Of course, accepting the idea that stocks are sometimes neither good investments nor reliable speculations can make one vulnerable of missing certain market advances, particularly when they appear in overvalued conditions (such as those that we've observed in recent months). Graham wrote “it is a cliché that in a roaring bull market knowledge is superfluous and experience a handicap. But the typical experience of the speculator is one of temporary profit and ultimate loss.”

Graham's approach to risk management involved buying stocks when they appeared cheap and selling them when they became richly valued. “That sounds like timing,” he wrote, “but when you consider it you will see that it is not really timing at all but rather the purchase and sale of securities by the method of valuation. Essentially, it requires no opinion as to the future of the market; because if you buy securities cheap enough, your position is sound, even if the market should go down. And if you sell the securities at a fairly high price you have done the smart thing, even if the market should continue to go up.”

“If you believe – as I have always believed – that the value approach is inherently sound, workable, and profitable, then devote yourself to that principle. Stick to it, and don't be led astray by Wall Street's fashions, illusions, and its constant chase after the fast dollar. Let me emphasize that it does not take a genius or even a superior talent to be successful as a value analyst. What it needs is, first, a reasonably good intelligence; second, sound principles of operation; third, and most important, firmness of character.”

Why Warren Buffett plays bridge

Aside from an affection for cheeseburgers and cherry Coke, one of the personal facts commonly known about Warren Buffett is his love of bridge, which he periodically plays online with Bill Gates.

Why bridge? Though Graham wasn't talking about Buffett at the time, he offers a clue:

“I recall to those of you who are bridge players the emphasis that bridge experts place on playing a hand right rather than on playing it successfully. Because, as you know, if you play it right you are going to make money and if you play it wrong you lose money – in the long run. There is a beautiful little story about the man who was the weaker bridge player of the husband-and-wife team. It seems he bid a grand slam, and at the end he said very triumphantly to his wife ‘I saw you making faces at me all the time, but you notice I not only bid this grand slam but I made it. What can you say about that?' And his wife replied very dourly, ‘If you had played it right you would have lost it.'”

It seems to me (and it has certainly been my experience) that it takes an enormous amount of restraint to focus on playing every investment hand “right,” according to an established discipline, allowing the law of averages to work in your favor, rather than trying to win every hand. I would guess that this is exactly what appeals to Warren Buffett's temperament. Over the long-term, good investing requires it.

Market Climate

As of last week, the Market Climate in stocks was characterized by unfavorable valuations, generally favorable market action on the basis of prices, breadth and other internals, but also overbought and overbullish characteristics that have historically removed the favorable implications of otherwise good market action, at least temporarily (the latest Investors Intelligence figures show only 22.3% of advisors are bearish here). In bonds, the Market Climate remains characterized by unfavorable valuations and modestly favorable market action.

It's important to recognize that our exposure to market fluctuations is generally proportional to the return/risk profile that has historically been associated with prevailing market conditions, on average. A speculative exposure of any consequence is generally only warranted when the expected market return exceeds Treasury bill yields. For any strategy that varies its exposure to market risk, that rule of “proportionality” is essential in setting the investment exposure.

Ben Graham also advocated setting market exposure in proportion to prevailing conditions. “Our recommended policy has, however, made provision for changes in the proportion of common stocks in the portfolio, if the investor chooses to do so, according as the level of stock prices appears more or less attractive by value standards.”

As I've noted in recent weeks, the overall combination of an overvalued, overbought, and overbullish market has historically been associated with stock market returns below Treasury bill yields, on average, even when recent price action has been generally constructive. Two weeks ago, I took profits on most of our speculative call options, though the Fund does hold a small further position on the sole basis of market action. I would expect to increase that toward about 2% of assets if the market clears its overbought or overbullish status without serious deterioration in market internals.

In the meantime, our emphasis on risk management means that I take a fairly dull view of rallies in overvalued, overbought, overbullish markets. Historically, these advances have little likelihood of being retained over the full cycle, and it's extremely hard to “time” their exit because the overbought/overbullish part invites abrupt reversals.

Final remarks

As I noted a few weeks ago, our stock selections in the Strategic Growth Fund have slightly lagged the major indices (by about 3%) in the past six months. Though this isn't a major “outlier,” it appears magnified because we're also hedged, presently lacking the evidence on which to reliably take unhedged, speculative positions. The net result over the past few months has been flat returns in the context of a market rally, so my efforts of late have admittedly not been very productive. That's frustrating, because I constantly hope to reward our shareholder's trust with growth in their investments.

Still, periodic lags in stock selection are part and parcel of long-term investing. Moreover, as I noted last week, our experience of the past few months has been shared by other value-conscious strategies. Such periods tend to be temporary setbacks, and often precede periods of more general market weakness.

Periods like the recent one always prompt research to make sure nothing important has been overlooked, but they don't change my adherence to the type of rigor that Graham endorsed: “reasoning from statistical data… demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience… based not on optimism but on arithmetic.”

Meanwhile, a word of thanks for the little swell of messages encouraging us to stick with our discipline (I will do nothing other). Our objective continues to be strong performance, at contained risk, as measured over the full market cycle. Though I hesitate slightly to include this final quote, because it's so close to the "peak-to-peak" or "full cycle" perspective that I've encouraged over the years, it would be remiss to finish this comment without the advice about mutual funds that Ben Graham offered in The Intelligent Investor:

“Our studies indicate that the investor in mutual-fund shares may properly consider comparative performance over a period of years in the past, say at least five, provided the data do not represent a large net upward movement of the market as a whole. In the latter case spectacularly favorable results may be achieved in unorthodox ways. Such results in themselves may indicate only that the fund managers are taking undue speculative risks, and getting away with same for the time being.” (original emphasis)

The memory of investors needn't extend more than 6 or 7 years to find ample proof of Graham's remarks. Still, it's the job of bull markets to erase the belief in bear markets, and vice versa. Unfortunately for short-term investors, they've generally done this job well.

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