The Superinvestors of Graham-and-Doddsville

"The Superinvestors of Graham-and-Doddsville" is an article by Warren Buffett promoting value investing, published in the Fall, 1984 issue of "Hermes", Columbia Business School magazine. It was based on a speech given on May 17, 1984 at the Columbia University School of Business in honor of the 50th anniversary of the publication of Benjamin Graham and David Dodd's book "Security Analysis". The speech and article challenged the idea that equity markets are efficient through a study of nine successful investment funds generating long-term returns above the market index. All these funds were managed by Benjamin Graham's alumni, pursuing different investment tactics but following the same "Graham-and-Doddsville" value investing strategy.

The article has been reprinted in books on Buffet (e.g. Miles, 2004).

The speech

Columbia Business School arranged celebration of Graham–Dodd's jubilee as a contest between Michael Jensen, a University of Rochester professor and a proponent of efficient market theory, and Buffett, who was known to oppose it. Jensen argued that a simple coin tossing experiment among a large number of inverstors would generate a few successive winners, and the same happens in real financial markets. Buffett grabbed Jensen's metaphore and started his own speech with the same coin tossing experiment. There was one difference, he noted: somehow, a statistically significant share of the winning minority belongs to the same league. They follow value investing rules set up by Graham and Dodd.

The statement

Buffet starts the article with a rebuttal of a popular academic opinion that Graham and Dodd's approach ("look for values with a significant margin of safety relative to [stock] prices") [Buffett, p. 4] had been made obsolete by improvements in market analysis and information technology. If the markets are efficient, than noone can beat the market in the long run; an apparent long-term success can happen by pure chance only. However, argues Buffett, "if" a substantial share of these long-term winners belong to a group of value investing adherents, "and" they operate independently of each other "than" their success is more than a lottery win; it is a triumph of the right strategy. [Buffett, p. 6-7]

Buffet then proceeds to present nine successful investment funds. One is his own Buffett Partnership, liquidated in 1969. Two are pension funds with three and eigth portfolio managers; Buffett asserts that he had influence in selecting value-minded managers and overall strategy of the funds. Other six funds were managed by Buffett's business associates or people otherwise well known to Buffett. Seven investment partnerships have demonstrated average long-term returns with a double-digit lead over market average. Pension funds, bound to more conservative portfolio mix, showed 5% and 8% lead.

Buffett takes special care to explain that the nine funds have little in common except the value strategy and personal connections to himself. Even when there are no striking differences in stock portfolio, individual mixes and timing of purchases are substantially different. The managers were indeed independent of each other.

Buffett made three side notes concerning value investment theory. First, he underscored Graham-Dobbs postulate: the higher the margin between price of undervalued stock and its value, the "lower" is investors' risk. On the opposite, as margin gets thinner, risks increase. Second, potential returns diminish with increasing size of the fund, as the number of available undervalued stocks decreases. [Buffett, p. 14] Finally, analyzing the backgrounds of seven successful managers, he makes a conclusion that an individual either accepts value investing strategy at first sight, or never accepts it, regardless of training and other people's examples. [Buffett, p. 11] "There seems to be a perverse human characteristic that likes to make easy things difficult... it's likely to continue this way. Ships will sail around the world, but the Flat Earth Society will flourish... and those who read their Graham and Dodd will continue to prosper". [Buffett, p. 15]

Influence

"Graham-and-Doddsville" influenced Seth Klarman's 1991 "Margin of Safety" and was cited by Klarman as a principal source; "Buffett's argument has never, to my knowledge, been addressed by the efficient-market theorists; they evidently prefer to to continue to prove in theory what was refuted in practice". [Klarman, p. 99] In 2000s Klarman's book, never reprinted since 1991, achieved a cult status and sells for four-digit prices. [The $700 Used Book]

Buffett's article was a "titular subject" of 2001 "Value Investing: From Graham to Buffett and Beyond". [Greenwald et al.]

In 2005 Louis Lowenstein compiled "Graham-and-Doddsville Revisited" – a review of the changes in mutual fund economics, comparing the Goldfarb Ten funds against Buffett's value investing standard. Lowenstein pointed out that "value investing requires not just patient managers but also patient investors", since value investing managers have also demonstrated regular drops in portfolio values (offset by subsequent profits). [Lowenstein, 2006:14]

Rebuttal

Buffett, despite his untarnished reputation in mainstream business press, remains rarely cited within traditional academia. A 2004 search of 23,000 papers on economics revealed only 20 references to "any" publication by Buffett.Kelly, Price] A significant share of references simply rebutt Buffett's statements or reduce his own success to pure luck and probability theory. William Sharpe (1995) called him "a three-sigma event", Michael Lewis (1989) a "big winner produced by a random game".

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Notes