From the October 2008 issue of Research Magazine • Subscribe!

October 1, 2008

The Investment Classics

In the middle decades of the 20th century, investment strategy took on a newly serious demeanor. Stock picking began to be something investors could think about rigorously and systematically, rather than relying on hunches, rumors and insider connections.

Three individuals were crucial to this transformation: Benjamin Graham, David Dodd and Philip Fisher. Graham and Dodd pioneered what came to be known as value investing, and Fisher became the guru of growth investing. All three were enormously influential, and their impact plays out to this day. Their ideas are much discussed and debated -- and even worshipped and sneered at.

A contentious debate, for instance, arose recently from a Wall Street Journal column on whether Graham, if alive today, would be buying bank stocks. Columnist Jason Zweig, editor of a revised version of Graham's The Intelligent Investor, argued that financial shares are currently too opaque and risky to meet Graham's criteria; others contend weakness in such shares has brought the very kind of bargain Graham sought.

Some other disputes are more fundamental, delving into the merits of stock picking itself. The ideas of Graham, Dodd and Fisher run counter to the "efficient markets" hypothesis that by the late 20th century had made many finance theorists skeptical about the relevance of investor skill. But uncertainties about the applicability of that hypothesis have granted the classic stock pickers a degree of academic respect.

Moreover, the embrace of classic ideas by some successful investors -- very prominently including Warren Buffett, who has described his philosophy as "15 percent Fisher and 85 percent Benjamin Graham" -- ensures that those ideas will continue to exert a powerful influence and appeal on the investment scene. The history of the works of Graham, Dodd and Fisher is thus, in a sense, an ongoing story.

Depression LessonsIt was in the Great Depression's crucible that the classic theories began to take shape. Graham, who had come to Wall Street in 1914 at age 20, had started a high-flying career as an analyst and money manager but was battered badly by the 1929 Crash. The year before, he had taken up a sideline of teaching at his alma mater, Columbia University, and now his lectures there focused on developing a safer investment strategy. In 1934, Graham and fellow instructor Dodd published Security Analysis, a textbook that soon will be available in a sixth edition issued for its 75th anniversary.

Fisher also got a close-up view of the Crash and its aftermath. He began working as an analyst at Anglo & London Bank in San Francisco in the late 1920s, and was head of the institution's statistics department when the market plunged. In 1931, he started his own investment firm, Fisher & Company, reasoning that customers still in the battered market might be ready at this point for a new broker. Plus, it was a good time to be doing investment research, since managers at hard-hit companies now had more time to talk.

For Graham and Dodd, the imperative was to find companies that were trading at a discount from what their operations were actually worth. Although assessing such "intrinsic value" was imprecise, they argued it could be done well enough to present opportunities. "To use a homely simile," the authors wrote, "it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his exact weight."

"Things happen too fast in the economic world to permit authors to rest comfortably for long," declared Graham and Dodd in a new preface to the 1940 edition of Security Analysis. The authors indicated in the preface that there were "weaknesses to be corrected and some new judgments to be substituted," but mainly the second edition expanded the argument of the first, emphasizing careful valuation of individual securities and advising investors to seek a "margin of safety" by buying undervalued stocks.

In 1949, Graham published The Intelligent Investor, aimed at bringing that philosophy to a broader audience. Going on to sell over a million hard-covers, it included what became a famous parable: You own part of a small business and have a partner named Mr. Market, who routinely offers to buy your share (or sell you more) at what he thinks it's worth, which changes frequently. "Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them," wrote Graham. "Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly."

You should deal with Mr. Market, suggested Graham, when his assessments of the business are significantly at odds with what your own analysis indicates.

Fisher, meanwhile, was developing a notably different philosophy. Whereas Graham and Dodd emphasized crunching company numbers, Fisher focused in major part on qualitative factors, such as management integrity and workforce morale. And while the value investors sought discounted stock prices, Fisher searched for enterprises with robust growth potential. The greatest investment rewards, he wrote in his 1958 classic Common Stocks and Uncommon Profits, came from finding "the occasional company that over the years can grow in sales and profits far more than industry as a whole."

In that book, Fisher provided 15 points that investors should take into consideration when choosing stocks. This list, which would become well-known in investment circles, included such items as: "Does the management talk freely to investors about its affairs when things are going well but 'clam up' when troubles and disappointments occur?" Such clamming, Fisher observed, likely meant managers had not worked out a response to the troubles, were panicky or lacked an adequate sense of responsibility to shareholders.

Despite the differences between the Graham-Dodd and Fisher strategies, they shared an essentially conservative approach to investment. These strategies involved patience and hard work, sought to reduce risk and avoided in-and-out trading. They were for people who were pretty serious about not just making money but also not losing it.

Picking StocksThe philosophers of value and growth gained credibility by putting their ideas into action. Graham had an early success, even before he and Dodd had refined value investing into a book, when he bought Northern Pipeline stock in the late 1920s after concluding from little-read Interstate Commerce Commission reports that the pipeline operator's assets were worth $95 a share while the stock was trading at $65 with a $6 dividend. After a proxy fight, he got management to distribute the cash it was sitting on.

In 1948, Graham and his investment partner Jerry Newman bought a major stake in the insurance firm GEICO. This involved spinning off shares to investors at $27 a piece and having Graham and Newman take active roles on GEICO's board. By 1956, the investment had returned over 1,600 percent, and it continued soaring into the early 1970s.

Fisher, meanwhile, made a renowned investment in Motorola. He bought the stock in 1955, when the company was mainly making radios for police cars but had set its sights on semiconductors and other growth markets. Fisher still had Motorola in his portfolio when he died in 2004. Holding for the long term, as long as a company was well-run, was central to his philosophy. "Never sell the most attractive stocks you own for short-term reasons," he wrote.

In a 1976 interview with Financial Analysts Journal, Graham said his valuation techniques no longer had the power they did 40 years earlier. "In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I'm on the side of the 'efficient market' school of thought now generally accepted by the professors."

Graham died later that year at the age of 82. Investor and writer Ken Fisher (the son of Philip Fisher and also a contributor to Research) argued in his book 100 Minds That Made the Market that Graham in his old age had erred in selling his own ideas short. "Ironically, Graham's adoption of 'the efficient market' was just before computer backtests would poke all kinds of holes in that theory," the younger Fisher wrote.

Warren Buffett, in an influential article titled "The Superinvestors of Graham and Doddsville," based on a 1984 speech he gave at Columbia on the 50th anniversary of Security Analysis, noted that a number of highly successful investors, including himself, had "a common intellectual patriarch" in Graham. He suggested this was unlikely to have occurred in an efficient market in which stock-picking was something like coin-flipping.

The elder Fisher, for his part, stayed skeptical about market efficiency late in life. He wrote about how the tech company Raychem gave a thorough presentation in 1978 that had no discernible impact on the stock price even though it accurately depicted how earnings would grow in the next few years. The stock eventually doubled, Fisher noted, but the market evidently was less than efficient in absorbing what Raychem had told the assembled analysts and investors.

Fisher lived to the age of 96. Dodd outlived his co-author Graham by 12 years, dying at age 93 in 1988. Books written by the three men remain in print, and continue to be big sellers. The classics are alive.


Graham Economics

Benjamin Graham had ideas for improving not just investment portfolios but the overall economy. During the Depression, he proposed creating and maintaining commodity reserves as a means of stabilizing prices and stimulating recovery. He explained this proposal in his 1937 book Storage and Stability: A Modern Ever-Normal Granary, and considered the idea so important as to give the book free to anyone who requested it. In 1944, Graham published World Commodities and World Currencies. In this book, he developed the idea of commodity storage further, proposing a new international currency system in which money would be stabilized by linkage to a basket of commodities. Both books were reissued in 1998.

Graham's commodity currency plan was developed further by economist Frank Graham of Princeton and got some favorable attention from economists of such varying views as John Maynard Keynes and Friedrich Hayek. However, the proposal's actual influence was modest, and the postwar Bretton Woods system of currencies relied on the more conventional idea of a link between the dollar and just one commodity, gold.


Kenneth Silber is a senior editor at Research. His work on science, economics and history has appeared in a variety of publications, including The Wall Street Journal.

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