I've been reading your blog for a little over a year and now that you've started writing for GuruFocus exclusively, I thought I'd ask about gurus.
Are there any mutual funds, CEFs or actively managed ETFs that still use the traditional Graham & Dodd approach to investing in net-nets? A lot of investment professionals honor Graham, but there seems to be a dearth of funds that still follow the basic 2/3rds ncav approach. It would seem to me given the outsized influence Graham has had on value investing and the (deceptive?) ease with which a computer could screen for net-nets, if Graham and Dodd security analysis is still the best chance to outperform the market why isn't anyone marketing a product that replicates their classic approach?
It would be a great resource for stealing ideas to research and would be a great diversifier for those of us working folk who have the overwhelming majority of our savings in company-run 401k vehicles (where you are often limited in your choice of investment vehicles).
Pinnacle Value (PVFIX), stands out as a possible example of this type of investor but he tends to take big macro bets. Marty Whitman's small value fund seems to have started out using that approach but then got too big to continue using it.
And a follow through: Is my interest in such a fund a waste of time? Because a successful version of such a fund would inevitably have to change its investment style as AUM increased. And finally, do you think the method has lost some of its edge to information arbitrage over the years?
Hope you’re enjoying the new job.
It depends on what you mean. Marty Whitman – who is retiring in a couple days – is a Graham & Dodd investor. He just managed a much bigger portfolio than Ben Graham ever did. Also, he went beyond the valuation approach used in Graham & Dodd’s day to incorporate the market value of the assets on a balance sheet. In that sense you can say he relaxed Ben Graham’s original ideas. Though I don’t think this is true. Ben Graham operated at a different time. Some of the companies he bought shares in were much less forthcoming than companies are today. In cases like Northern Pipeline, Graham had almost no information available to him from the company’s own reports. They just reported earnings and dividends. Graham had to uncover the report made with the company’s regulator to get balance sheet data.
At times, Marty Whitman has owned stocks – in his Third Avenue Value Fund – that are exactly the stocks Ben Graham would own if he were around today. For examples, he’s owned shares of holding companies as a cheap way to invest in their portfolio companies. That’s classic Ben Graham. He also owned busted tech stocks after the dot-com crash. Ben Graham would’ve done that too. These were hated companies trading for less than their liquidation value. So, Marty Whitman – who like I said, is no longer an option because he’s retiring – was a real Graham & Dodd investor.
Also, I think you’re talking about net-net investing rather than Graham and Dodd. Graham and Dodd – in "Security Analysis" – are not all about net-net investing. That was just the bread and butter of Ben Graham’s hedge fund (Graham-Newman).
But Graham-Newman did more than net-net investing. Graham-Newman’s best returns came from three key areas:
· Controlled Companies (big blocks of stock)
Graham-Newman also bought what we would now call junk bonds – at the time, these were all fallen angels – and preferred stock. They also engaged in related hedges. And part of their arbitrage investments were “workouts” of a more general nature. They would buy stock in a company that was planning to liquidate or something like that. This was an announced event. Not a rumor. Although in some cases, this involved quite a bit more risk – or at least more uncertainty – than what people usually mean when they say arbitrage today. Returns were very good in this category (15% or more before leverage and with better consistency than the market).
But if we’re talking about Graham-Newman’s entire method of operation – we’re really talking about simple, arithmetical procedures to see that a stock is undervalued relative to its conservatively calculated value to a private owner.
There are money managers who still do that. Generally, they aren’t mutual fund managers. Remember, Ben Graham managed a hedge fund – not a mutual fund. While it is true that Graham-Newman was an open-ended fund, it traded at a premium to its net asset value. So, it effectively became a closed fund. Graham was paid a very nice bit of incentive compensation based on performance. He never denied this. In his Senate testimony, he makes it very clear he was extraordinarily well paid for a fund manager at that time. The exact method isn’t quite like that normally used for hedge funds – because Graham-Newman paid “distributions” rather than focusing entirely on compounded results. Like Walter Schloss, Ben Graham preferred to pay out capital gains and simply earn the highest dollar-for-dollar return on his client’s money – even though that meant keeping the fund small. But in most every sense of the word, Graham-Newman was a hedge fund. Warren Buffett’s investment partnership was also a hedge fund. He’s gone on record a few times saying that he once ran a hedge fund. That’s what he meant.
Now, Graham was often asked about mutual funds later in his life – mutual funds became an important feature of the investment landscape only in the second half of his career. In the first half of Graham’s career, the idea of a fund like Graham-Newman – while not totally unheard of – was quite rare. There were cases where a family, company, etc., gave trading responsibilities over to an individual who collected a percentage of the account’s profits. But Graham-Newman turned into much more than that. Regardless of what it was called at the time – Graham-Newman was really a forerunner of hedge funds rather than mutual funds.
Graham’s view on mutual funds was not especially kind. He figured that a hedge fund – the sort of thing he ran – made sense if it could either deliver superior results or turn in profits even in down markets. I’ll remind you that second part was Graham’s goal. Basically, he wanted to consistently deliver an adequate investment return for his fund’s shareholders. He was not interested in providing exposure to some asset class. And the idea of being fit into a style box or anything like that – that didn’t make sense to Graham.
He figured you either invested with a fund – there weren’t yet index funds in Graham’s day – that’s job was to provide returns similar to the overall market while keeping fees low. Or you invested with someone like Ben Graham. Someone who used specialized techniques, procedures, etc., and focused on a few categories of investing they were good at. The idea here is that Graham was a specialist. And you could either invest with a generalist – in which you should expect to have reasonable fees that cause only a slight lag between your returns and those of the market – or you could pay a specialist handsomely to deliver returns that were quite unlike the overall market.
That’s what Graham-Newman was. And that still exists today. I could go through a whole list of funds – hedge fund, not mutual funds – that do the sort of thing Graham would understand and accept as the sort of thing an investment specialist should do.
Graham was an activist investor when there were no activist investors. Graham took big blocks of stock in companies when management wanted the entire block placed in firm hands. He always insisted on paying a low price for a safe situation. But Graham bought GEICO. And he bought a lot of other stocks – you can see Graham-Newman’s positions here – that were control positions of some sort. Or at least big blocks of stock.
Also, if you look at some of Graham-Newman’s positions and check the reported balance sheets of those companies – not everything was technically a net-net. Sometimes the company was only a net-net if you did a little extra digging. So, Graham did some investing where you were getting some very valuable assets – like stocks, bonds, etc. – along with a business with good earning power. In some of those cases, the stock was not a net-net. But it was absurdly cheap if you backed out the cash. And there was no denying the sum of the parts were worth much, much more than the stock was trading for.
So, everybody from arbitrageurs to activists can lay claim to following in Ben Graham’s footsteps. In fact, there are a couple funds engaged in very quantitative work that do things very similar to the way Graham would be doing things today. Essentially, Graham would take advantage of discrepancies between different classes of stock, common stock vs. convertible securities in the same company, the relationship between the shares of two public companies one of which owns shares in the other – and so on. People still do this. Often it’s outside of the highly liquid – and highly public – U.S. stock market we normally talk about. In other countries and in other securities – people do buy things that are just incorrectly priced relative to some other security that also trades.
Especially outside the U.S. there are some rather elaborate corporate structures of some publicly traded companies that Graham would be buying. He would certainly buy Japanese net-nets. He would’ve been buying Korean stocks in the early 2000s when his student Warren Buffett was.
So, a lot of people are doing the sort of things Ben Graham would do if he were around today.
But if you’re asking about the very narrow field of net-net investing in the U.S. – no, mutual funds don’t do that.
There are a few reasons for this. One, I have no idea if there’s demand for this. Mutual funds reveal their portfolios. To be a successful net-net investor of client money, you generally would want to hide your positions from them as much as possible. Nobody wants to own a net-net. And with illiquid stocks, you have to keep the information from your own clients at least while you are actually buying the stock.
Warren Buffett was very secretive when he bought illiquid stocks. And for good reason. You don’t want to compete with your own clients. There’s a reason Graham’s fund traded for more than its NAV. Graham sent an annual letter that actually showed his positions.
Graham-Newman ended up with a lot of tiny shareholders who bought into the fund just so they could see Graham’s stock list and gobble up choice shares for themselves. That’s what happens to net-net investors who talk. It’s not a good strategy for a fund that has to be public about what it’s doing.
Could a fund practice net-net investing?
If it invested the way Graham once did – and did it on a worldwide basis – I actually think a small fund wouldn’t have problems investing the way Graham did. But let’s consider a few key points about the way Graham invested:
· He reported to his fund’s shareholders once a year.
· He had low turnover (compared to modern mutual funds).
· He bought illiquid stocks.
· He bought large blocks of stock.
· He engaged in shareholder activism.
· He exerted some influence/control over a couple companies.
That’s not the kind of business mutual funds are in. First of all, it’s bad for your image. If you do what Graham once did you get a lot of publicity today unless you operate in a way to discourage that. Mutual funds don’t discourage publicity. And today we have public portfolios, Morningstar ratings, etc. It’s just a recipe for too much publicity.
Mutual funds face redemptions. The market is a much faster turnover place today than it was for Graham’s post-1929 career. Volume was often low. And competition among money managers was extremely low. You didn’t have people jumping out of one fund and into another fund like they do today. This is a really big issue. Graham rarely had down years. But it was not his goal to beat an up market. He expected to underperform the Dow whenever the bulls were really running – but make up for it with outperformance in down markets and consistency throughout all markets. In mutual funds, that’s not necessarily going to keep your shareholders happy. The kind of investing Graham did would not have worked at all in the late 1990s. It’s very likely Graham would’ve been down in 1999. I know the kinds of stocks Graham liked to buy – and what they were doing in 1999 – and it’s entirely possible Graham would’ve underperformed the market by more than 20%. People abandon you when that happens. Although Graham would’ve made it all back over three years – if he were running a mutual fund, his shareholders wouldn’t have stuck around.
Okay. So that’s the answer to your question: no. There aren’t really mutual funds doing exactly what you describe – at least not mutual funds I knew about before sitting down to write this article.
But I did try to find some funds that match what I consider the key aspects of Ben Graham’s style. Here I’m talking about how Graham actually ran Graham-Newman.
The key points – as compared to today’s average mutual fund – were low turnover, low price-to-assets, and small overall fund size. This last point is key. Because Graham could’ve turned Graham-Newman into a very big fund if he wanted to. He didn’t.
So, I looked for stocks that beat three out of four funds (were in the top 25% of funds) in terms of:
1. Low turnover
2. Low price-to-book ratio
3. Low total assets
And were above average when it came to the length of time the same manager had been with the fund. Obviously, this is critical. Graham-Newman and its predecessor fund lasted about 30 years with the same manager.
Anyway, here are funds that share some similarities in terms of low turnover, low price to assets, small fund size, and long manager tenure.
There are four such funds. They are:
1. Pinnacle Value (PVFIX)
2. Mundoval (MUNDX)
3. Boyar Value (BOYAX)
4. Shelton European Growth & Income (EUGIX)
Of those, only Pinnacle Value actually has holdings similar to what Ben Graham might put in his portfolio.
Mundoval has the biggest of global big caps in its portfolio. And generally shows little selectivity in the Ben Graham sense of ensuring a margin of safety. It seems to make the list purely because of the kind of stocks it's holding. This is more of a category thing though. I’d cross it off the list.
Boyar Value doesn’t own Graham-type businesses either. So, cross that off.
Shelton European Growth & Income is more interesting. It’s not a Ben Graham fund because it’s investing in huge companies – which Graham himself didn’t do. But it seems to adhere to Graham-like selection processes for big stocks. In other words, if Graham had to pick big caps, the kinds of methods he mentioned would give you names like what is in this fund. But, again, totally not a net-net fund. It’s a European big-cap fund. Its top positions are stocks like Siemens, Nestle, Novartis, etc. But on things like price-to-book, price-to-average-earnings, dividend history, etc., it’s a very Ben Graham-looking portfolio. It’s the kind of thing he might suggest if you wanted big-cap stocks. But this fund would fall into the “defensive investor” rather than “enterprising investor” part of Ben Graham’s philosophy. Not so much great stock picking here – just application of minimum standards of value. Basically, Shelton European Growth & Income doesn’t overpay.
There are some problems with the fund. For one, it underperformed its benchmark – European stocks – over the last 10 years. If European stocks had been up 15% a year, this would be fine and totally Graham-like. They weren’t. And this fund only returned 4% a year over the last 10 years. Graham wouldn’t consider that an adequate return. So I’d scrap this fund too.
By far, the most interesting fund is the one you mentioned – Pinnacle Value. The average market cap of its holdings is around $150 million. It keeps half of its assets in cash – it’s had more than 50% in cash at times – and it has some very Graham-like holdings.
In fact, I’m looking at the holdings right now and can recognize a couple (former) net-nets, a cash shell, a closed-end fund and a Japanese small-cap fund.
That’s a Ben Graham fund right there. If you absolutely want a mutual fund that invests in the kinds of things Ben Graham would own today – go with Pinnacle Value.
I’d be remiss if I didn’t mention Bridgeway at this point. It’s an interesting group of funds that are totally unlike the kind of investing you normally associate with Graham – picking individual net-nets, holding them for a long time, etc.
However, it’s very likely that if Ben Graham were around today, he’d actually be interested in – and suggest others invest in – something like what Bridgeway offers. Graham was always interested in simple, proven rules that could be applied to group operations. Bridgeway does this. Their very best fund – and one I’d recommend to anyone as what a mutual fund should be – is Bridgeway Ultra-Small Company. But it’s closed to new investors. The fund has returned just under 15% a year since inception in 1994. If you look at what the fund does – basically the stocks it owns – it is no surprise. It provides a diversified entry into stocks that are – as a group – frequently very attractive and very underpriced yet something individual investors rarely pick for themselves. It would probably be my top recommendation for a mutual fund. I have weird views about mutual funds. Generally, I don’t think they should do anything that can be replicated either by:
A. Your own stock picking
B. An index fund
So, I’d say the kinds of funds people should consider are Bridgeway, Hussman, Third Value Focused Credit, etc. Not the funds most people talk about. With most funds, you’re just hoping the manager can do the same thing you could do for yourself – only better – in bigger stocks with more hassles holding him back. I don’t think that’s realistic. And so I generally think you should either own an index fund (and zero mutual funds) or own funds that are extremely specialized in some area you have neither the time nor inclination to thoroughly study.
So, the answer to your question is yes – Pinnacle Value is about as close to Ben Graham as you’re going to get in a mutual fund.
On the bigger topic, there are plenty of people in hedge funds doing things similar to what Graham once did.
And if Graham were around today I’m sure he’d be:
1. Investing worldwide
2. Using quantitative methods
These are things that were much harder to do during Ben Graham’s career. They are possible now. And I’m sure he’d take advantage of them.
Finally, yes I think your search for a Graham-style fund is a waste of time. I’m not being glib. And I’m not just trying to push a product here. But I write the Ben Graham Net-Net Newsletter for GuruFocus. I pick one net-net a month. And then I go out and buy it with my own money. We use the price I get as the price we track. And we release the newsletter over the weekend. So, you can have a buy order in the same time I do. Anyway, the point is that something like that is the way to go. It doesn’t have to be the newsletter I write. But the way the math works, if you have about $15,000 or more to invest in a Graham-style, the annual fee for a GuruFocus Premium membership is less than 2% of the funds you’d be investing. Get a discount brokerage account. I use Scottrade for the Ben Graham Net-Net Newsletter’s model portfolio. It’s $7 a trade. And they don’t charge more – like some brokers do – for tiny stocks that aren’t traded on an exchange. A lot of net-nets fall into that category.
In this way, you can actually replicate a true net-net strategy. And you can do it (if you have enough cash to invest in this strategy) at expense levels that are similar to what mutual funds charge.
Now, you absolutely don’t have to pay money to use a newsletter like GuruFocus’s Ben Graham Net-Net Newsletter. You can invests in net-nets for free by religiously reading blogs like:
· Whopper Investments
· Interactive Investor Blog (for U.K. net-nets)
· Oddball Stocks
· Cheap Stocks
And many other blogs that cover net-nets. By following these blogs, you can put a group of net-nets together for yourself and save the cost of a GuruFocus premium membership. Or you can subscribe and get a new net-net every month.
Honestly, I’d recommend doing that over trying to find a Ben Graham type mutual fund. Just find a newsletter, blog, etc., that you truly trust – if there is one – and then put actual money to work in their ideas. That’ll give you a much more authentic Graham portfolio than any mutual fund I know of.
Of course, I’m not an expert on mutual funds. Not even close. So, there may very well be funds I don’t know about that follow Graham’s methods of operation.
You also asked if I thought the net-net approach was losing some of its edge to “information arbitrage”. The answer is yes and no. In big stocks, you have fewer net-nets. They’re less available.
But returns in net-nets have stayed very good over the decades. Even today you can expect really good returns in a group of net-nets – if you can assemble a group. The number of net-nets in the $100 million market cap and up category is not big today. In fact, it’s really small under anything approaching normal market conditions.
That is the extent of the “information arbitrage”. People do buy big net-nets and near net-nets. The same thing happens with net cash stocks – even where there is no real operating business. Computers can pick up on that. And as long as the stock is liquid enough, somebody will be out there buying a cash shell. That was much, much less true in Graham’s day. And, yes, it’s totally a result of having data you can search using a computer instead of having to flip through a Moody’s Manual yourself.
I run into this sometimes when talking to people who buy net-nets in Europe or Japan. Sometimes, they mention the data they have access to. They mean the data they have searchable through a computer. Everybody can have all the data they want on European and Japanese net-nets just by doing manual searches (like I do). But it’s not a good use of a manager’s time if he’s only going to put at best a couple percent of his portfolio into any one stock he finds. And chances are he won’t even get that – because the stock is simply too illiquid.
So individuals always have an advantage over funds when it comes to things like net-nets. I tend to think individuals have a lot more advantages over funds than they think. The big disadvantages for individuals are – like you mentioned – restrictions caused by a 401k or something like that. That’s a huge hindrance to have part of the investment universe closed to some of your investable funds.
The other big hindrance is time. Individual investors are amateurs. They are not researching stocks at the office. Those are the two hurdles individual investors face. But the hurdles – especially in illiquid micro-cap stocks – are higher than most people think for mutual funds. It’s much harder for a fund to invest like Ben Graham than it is for an individual investor.
You actually have the advantage when it comes to Ben Graham-style investing.
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