/Ben Graham: Just Plain Lucky?

Ben Graham: Just Plain Lucky?

Remember Ben Graham, the guy who wrote The Intelligent Investor? And who taught Warren Buffett to become Warren Buffett?

Well, if you really know who Graham was, you also know that he is associated with buying something cheap (one dollar worth at fifty cents) and then selling it when it reaches a value that reflects what it’s worth.

A very copybook, calculated approach, right? Like what a Rahul Dravid would do in cricket.

But, for once, go back and read the postscript of The Intelligent Investor (Pg. 532), where Graham shares a story of some other kind. He starts by describing two partners of an investment firm who –

…combined good profit possibilities with sound values. They avoided anything that appeared overpriced and were rather too quick to dispose of issues that had advanced to levels they deemed no longer attractive. Their portfolio was always well diversified, with more than a hundred different issues represented. In this way they did quite well through many years of ups and downs in the general market; they averaged about 20% per annum on the several millions of capital they had accepted for management, and their clients were well pleased with the results.

In short, these were conservative, well-diversified investors who played it very safe with their and other people’s money. Like Graham is known to have always advocated.

Anyhow, somewhere in 1948, these partners found an opportunity to purchase around 50% of a growing business. They were so impressed by this opportunity that they broke their rule and invested around 25% of the assets they managed into this single stock.

This was, Graham wrote, “…a highly unusual departure for the conservative managers, who normally diversified widely and seldom invested more than 5% or so in any one holding.”

Anyways, over years, this stock went up more than 200-times, and the partners didn’t sell it, again breaking their rule of selling stocks when they reached fair values. This was even though they couldn’t justify keeping it based on their strict standards of valuation and margin of safety they otherwise practiced.

Graham added in the Postscript –

Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.

In cricketing parlance, these partners who had always played their game like Rahul Dravid, pinch-hit a big one like Virendra Sehwag, and succeeded massively at that.

“Are there morals to this story of value to the intelligent investor?” asks Graham, and then provides an answer –

…one lucky break, or one supremely shrewd decision – can we tell them apart? – may count for more than a lifetime of journeyman efforts.

Remember these words of the father of value investing when you find a fund manager boasting about how skillful he is at picking stocks.

Well, to spill the beans, one of the abovementioned partners was Graham himself (yes, Graham himself!). The stock was the insurance company GEICO, and Graham credited much of this phenomenal success to luck alone.

How big the success it really was? Graham’s fund’s $712,500 investment in GEICO turned to more than $400 million in 25 years. In Peter Lynch parlance, Graham had hit upon a 500 bagger!

Graham suggested that he got tremendously lucky with GEICO. But was that just luck? No!

As he added to the Postscript –

…behind the luck, or the crucial decision, there must usually exist a background of preparation and disciplines capacity. One needs to be sufficiently established and recognized so that these opportunities will knock at his particular door. One must have the means, the judgment, and the courage to take advantage of them.

Ultimately, what’s the moral of the story of Graham’s tryst with GEICO?

We investors tend to think it’s easy to be a successful investor. The ultra-successful, even though they are few, have an outsized effect on us. We believe we can succeed because they did, and ignore the role of luck in their success.

Investing in a game of probabilities. Uncertainty rules the roost here. And thus, luck plays an important part in separating winners from losers.

Unfortunately, even if the achievement is purely random, as in coin flipping or in stock investing, we usually look back and credit the successful individual with great skill for having accomplished it. We make many mistakes of this type, attributing skill to a person who had only luck.

Our tendency to base decisions on observed success, while ignoring unobserved failure, is called the survivorship bias. Graham wouldn’t have been known to us if he had failed in his big bet on GEICO. Or he may have been known as just another “successful” fund manager who attributed his success entirely to his skill in identifying the stock early. Like he is quoted as saying this in 1976 –

In 1948, we made our GEICO investment and from then on, we seemed to be very brilliant people.

The world of investing, like most things in life, produces success stories and failures. It’s human nature to wish to copy success. However, the ironic truth is this: To accept success at face value without acknowledging the role of luck is a strategy for failure. Graham, in being lucky with GEICO, knew this well.

But it’s also important to note that luck, like love, is a verb. It requires dedication and effort and the conviction and courage to act. Like Graham wrote –

…behind the luck, or the crucial decision, there must usually exist a background of preparation and disciplines capacity.

Another key lesson here is that of not selling your winning stock just because you think it has reached fair value or has gotten overpriced. Thank Graham for breaking this rule that he had himself practiced so strictly. GEICO started off as a value investment, but as the business grew, Graham held on and reaped the benefits over a 25-year period.

In fact, the reason Graham deliberately concentrated in GEICO was that his analysis showed it was undervalued and provided an asymmetric outcome. He played down this very important ‘skill’ part in the entire process of making money on GEICO.

The way to win in the stock market, according to Charlie Munger, is to work, work, work, work and hope to have a few insights. The question is – how many insights do you need in your investing lifetime?

Not many, as Munger says (and Graham proved with GEICO) –

…you don’t need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that’s with a very brilliant man — Warren’s a lot more able than I am and very disciplined—devoting his lifetime to it. I don’t mean to say that he’s only had ten insights. I’m just saying, that most of the money came from ten insights.

…you’re probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It’s just that simple.

To conclude, here is a formula, derived from Graham’s investment in GEICO, to create wealth from stock market investing over time – Be prepared and wait for a high-quality business at reasonable price, stick with it over time till the business does well, then be humble to credit luck more than your skill for whatever success you achieve, and repeat this process if you get another fat pitch. Rest of the time, don’t act much. That will be your true skill.

And yes, please read The Intelligent Investor.

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