Great Depression lessons apply today

The basic challenge for equity investors hasn’t changed much over the last century: how do you assemble a portfolio of stocks that are likely to grow over time, at prices that allow for attractive returns relative to the level of risk?

The answer lies in investing in high-quality companies for the long term, using fundamental analysis to select those companies and determine their intrinsic value. It’s a simple concept, but executing it effectively and consistently is no simple matter. The work of investment pioneers Benjamin Graham and Ken Fisher creates a clear framework for this approach, and their lessons are more relevant than ever in the wake of the past decade’s challenges.

Value, growth and security analysis

While the advent of the stock market predates the industrial revolution, its modern era dates from the Black Thursday crash of the New York Stock Exchange in 1929. The subsequent Great Depression triggered regulatory reforms meant to provide a fair playing field for investors and restore confidence in the securities exchanges, starting with the Securities Act of 1933.

Drawing lessons from the Crash of ’29 and the frequent irrationality of market pricing, Columbia Business School Professors Benjamin Graham and David Dodd laid the groundwork for what would come to be known as value investing in their 1934 book, Security Analysis. In it, they introduced a new way to determine the real value of a security by gauging the value of the underlying business through disciplined analysis of its financial statements. Thus armed with a true or intrinsic value, Graham and Dodd suggested that the savvy investor could earn returns and collect dividends with a minimum of risk by purchasing undervalued securities and selling them once the market price reflected their true value.

Graham advocated maintaining a margin of safety between the price paid for a stock and its intrinsic value to give the investor room for error. He labelled this the central concept of investing, and further developed it in the 1949 book The Intelligent Investor. His methods focused on the quantitative analysis of financial statements and, since they could be uniformly applied to publicly available data for a large number of companies, typically led to the construction of diversified portfolios across a range of industries.

A famous student, new ideas

One of Graham’s best-known students is famed investor Warren Buffett – the Oracle of Omaha – who took Economics at Columbia so he could study under Graham. Buffett has praised Graham as one of his main influences, and has explained his own investment approach as: “I’m 15% Fisher and 85% Benjamin Graham.”

Philip Arthur Fisher, an investor and professor at Stanford’s Graduate School of Business, is known as one of the progenitors and greatest practitioners of “growth” investing. His first book, Common Stocks and Uncommon Profits, advised investors to purchase and hold for the long term a concentrated portfolio of outstanding companies with compelling growth prospects that they understood very well. Fisher stressed one should thoroughly understand a company before buying, and should then be attentive to any negative changes in its prospects. That exhaustive research and monitoring required investments in fewer companies and produced more concentrated portfolios than Graham’s approach.

Unlike Graham’s emphasis on financial statements, Fisher’s research focused on qualitative study of a company and its management. His book listed “Fifteen Points to Look for in a Common Stock” and constituted a guide to finding well-managed companies with excellent growth prospects. In contrast to statistical bargains that were merely inexpensively priced, Fisher argued that good growth stocks are ones with excellent long-term growth prospects, based on an intelligent appraisal of their underlying business. Paying the optimum purchase price for a growth stock, according to Fisher, mattered less than its underlying fundamentals did. The fifth of his “Five Don’ts for Investors” was clear on this point: “Don’t quibble over eighths and quarters.” Buffett combined Graham’s quantitative-driven value perspective and diversified portfolios with Fisher’s qualitative and concentrated growth, and refined it into what many would now consider an evidently common-sense approach – one that has been widely followed and copied among investors for decades.

The lost decade

The ten-year period from 1999 to 2009 – the so-called lost decade – was the first decade of negative annualized returns (including dividends) for the S&P 500 Index since its inception in 1927. Given the advances made in technology, finance and academic study since the days of Graham and Fisher, one may wonder, how could this have come to pass? One key reason: for much of the past decade, the underlying quality of an individual company or security as measured by its fundamentals was often seen as an inconsequential factor in a new paradigm of increasingly sophisticated financial engineering.

At the start of the decade, the speed with which the emerging technologies of the Internet produced a new dot-com economy and outsized investments in the technology sector was matched only by the speed of this new economy’s collapse when the speculative bubble burst in the so-called dot-bomb of 2000.

To many in this new economy, the old economy’s fundamental measurements of a security’s worth – which often didn’t correspond to the soaring prices these new companies’ stocks were awarded upon their initial public offerings – were either meaningless or incapable of capturing the true value promised by these new ventures. It appeared that any company with an “e–” before its name or a “.com” at the end had discovered a surefire formula for rising share prices without demonstrating the ability to consistently generate earnings or, in some cases, even without a business model that could eventually produce them.

In the aftermath of the tech collapse, investors admonished themselves for succumbing to a speculative mania. Lessons had been learned, and investors, we were told, would not be so easily swayed the next time by phantom earnings or illusory valuations based on poorly understood black-box business models.

Yet the ensuing economic and stock market recovery coincided with the inflation of another speculative bubble where values were detached from fundamentals – this time in the housing sector, fuelled by collateralized debt obligations composed of subprime home loans and complex derivative instruments. The quality of the underlying assets mattered little, investors were assured, because their value would only rise – and further, the application of novel securitization techniques would effectively eliminate risk of default or loss from the equation.

The collapse of that bubble in 2007 triggered a recession and a global liquidity and financial crisis of truly historic proportions – labelled a Black Swan event for its rarity – and took with it many of the financial institutions that had helped create the crisis in the first place.

Lessons learned?

Given this pattern, it should come as no surprise that in the wake of this latest crash there has been a significant market rally. But while the economic indicators provided mixed messages in the wake of the recession – which officially began in December of 2007 and appears to have ended in the fall of 2009 – the speed and extent of the stock market gains seen following the lows of March were remarkable. The S&P 500 Index gained 65% from its 12-year low on March 9, 2009 through the end of the year.

However, the securities that typically made the greatest gains during this rally were considered to be low-quality stocks that benefited most from the historically low interest rate environment and supportive policies of the federal government. The conventional wisdom now says the run-up seen in these low-quality stocks in 2009 is unlikely to continue much further, and investors are advised to position their portfolios cautiously for the coming year. They are told to invest in high-quality stocks and to adjust their expectations to a slower-growth, narrower-margin and lower-return environment dubbed the New Normal by fixed-income manager Bill Gross.

It’s heartening to see the lessons on fundamental security analysis and quality assets – shared by the likes of Graham and Fisher and championed by Buffett – seem to be back in favour with the investing public, at least for the time being. Hopefully, investors will heed them when the next new paradigm hits the market.

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Jeffrey Russell , CFA, is Managing Director, Senior Portfolio Manager and Robert Swab is Managing Director, Portfolio Manager, Senior Client Portfolio Manager at ClearBridge Advisors, LLC. ClearBridge Advisors, LLC is a wholly owned, independently managed subsidiary of Legg Mason, Inc.

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Jeffrey Russell and Robert Swab