No. of Recommendations: 12
MadCapitalist asked: What do you think about The Superinvestors of Graham-and-Doddsville that Warren Buffett wrote about?

MC, I think that Warren Buffet’s write-up on Graham and Dodd investors was very accurate. Once again, I don’t think it offers up much help for the average US investor. A few points:

1) Take the first investor discussed, Walter Schloss. WEB documents that his fund outperformed the SP 500 by 16.1% versus 8.4% over a 28 year period. Darned impressive to have 7.7% outperformance for that long a time.

2) The Scholl fund was NOT open to mom and pop small investors with $250 to invest back in 1956. Schloss only took money from 92 investors when he started his fund. If you were one of the 92, it worked out very well. If you were one of the tens of millions potential small investors, you were out of luck.

3) We will make a new set of assumptions starting today. Walter Schloss was kept in a time machine from 1956 and did not age. (Unfortunately he passed away this year at age 92.) Walter starts the new Schloss fund today as a mutual fund, open to all investors with $1,000 minimum to invest. He raises say $100 million to start which would be a small mutual fund. The first year, he beats the SP 500 by 7.7%. Morningstar and Fool write feature articles about the fund. All of a sudden, he takes in $10 billion more assets. He outperformed the second year by another 7.7%. Every investor in the US decides he MUST put all of his investable assets in the fund. The fund balloons to $100 billion.

4) All of a sudden, Schloss is NO longer able to buy enough shares of enough Graham and Dodd, deeply undervalued companies. Schloss has already bought them all and has three choices:

a) Stop taking in new money, because it cannot be effectively deployed.
b) Lower the value standards to buy stocks, which will lower the return.
c) Leave a lot of the assets in cash, which lowers the return long term.

In all cases, these are negatives for the small investor.

5) Stated differently, when a fund gets to a certain size, it will become the market. Its returns will converge to that of the market. In the ridiculous extreme, every single equity dollar invested in the US is in the Schloss fund. They own every single share of every available equity. By definition, their return will be equal to the market MINUS “the vig,” When that happens, the fund will UNDERPERFORM the index. BTW, this is exactly what happened to Fidelity Magellan. It got too big to outperform. This has also happened to quite a few hedge funds recently

6) I think this is why you do NOT see any funds that are available to small investors that have outperformed their index by 7.7% for 28 years. I do not recall seeing any of them on Morningstar.

7) One of the challenges for Graham and Dodd investors is that at times, “value” goes out of style, like in the 1995 through 2000 market. Value investors looked pretty stupid. Ask Jeremy Grantham who literally lost 50% of his assets under management in that period. Most small investors do NOT have the intestinal fortitude to suffer through 5 years of significant underperformance. They would have pulled their money out probably the day before value stocks started outperforming again.

8) I am NOT down on Graham and Dodd investing, only on how applicable it is to the average, small, non fulltime investor. My answer is that it is marginally applicable. By that I mean that using a Graham and Dodd fund, he MIGHT be able to get an average investor an extra 1% to 3% return over the very long term IF the investor sticks it out in the lean times. If he happens to pick a Bill Miller like fund (LMVTX), he might be end up underperforming the index. So it is NOT a panacea.

9) I do think that some value approaches do have merit. The Fama French Three Factor model for one. Rob Arnott’s ‘Fundamental Index” is another. There are funds and ETF’s that are widely available for these. I don’t expect any of them to outperform by 7.7% for the next 28 years.

Believe it or not, I shortened this for the sake of brevity. There are a lot of other pertinent points that could be made. . .


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