"Friends and Romans, I come to tease Graham and Dodd, not to praise them."
The speech focuses on the limits/disadvantages of Graham and Dodd and is backed up with lots of useful and interesting data (according to Grantham...some of it is proprietary). Well worth reading the whole speech.
- Too much reliance on low price-to-book
Low P/B ratios are, after all, the market's way of saying "these are the assets in which I have the least trust." It should not be surprising, therefore, that when you have a depression, or nearly have one, that more of these "cheap" companies go bust than is the case for the "expensive" Coca-Colas.
- Too much emphasis on outperformance of benchmarks in lieu of risk-adjusted returns
To cut to the chase, P/B does not represent intrinsic value. Nor do P/E ratios or yields. To make this point I regularly pose a question to investment audiences: "I give you Coca-Cola at 1.2 times book or General Motors at 1.0 times book. Hands up, who wants General Motors?" No one ever puts up their hand, and I say, "Therefore, Q.E.D., P/B is not value." You know that the extra qualities represented by Coca-Cola are worth a premium. The question is only, "How much?"
Grantham points out Ben Graham learned some hard lessons that informed his later investment style.
The Inconvenient Real World Special Case
In fact, Quality stocks have outperformed the market since 1965 (when our quality data begins)... We define "quality" using primarily a high and stable return. I think you would agree that this is a workable definition of a franchise since to be both high and stable means you have the ability to set your own prices. Secondarily, we look at debt. This yields a very uncontroversial list of stocks of the Coca-Cola, Johnson & Johnson, and Microsoft ilk with not even one financial! Even though the "quality" factor is now cheap, it has still outperformed by a decent (maybe you'd say "modest") 40% over almost 50 years. But this 40% is an amazing free lunch. Warren Buffett doesn't really talk much about the fact that he is playing in a superior universe. Why should he?
Grantham adds that it's like having a Triple A bond outperform a B+.
Price-to-book [low P/B], despite its low beta, is a risk factor because of its low fundamental quality and its vulnerability to failure in a depression. This is true with small cap as well. But what about "Quality?" This factor has outperformed forever. (The S&P had a High Grade Index that started in 1925 and handsomely outperformed the S&P 500 to the end of 1965 when our data starts.) Since the market is efficient, to Fama and French quality must be a risk factor! So, by protecting you in the 1929 Crash and in 2008, and by having a low beta for that matter, Quality as represented by Coca-Cola and Johnson & Johnson must be a hidden risk factor. Oh, I know: "The real world is merely an inconvenient special case!"
Grantham also calls quality stocks (Coca-Cola, Johnson & Johnson) the only free lunch in investing in his 3Q 2009 Letter.
The good news is that unlike most of the past decade or so the quality franchises are not expensive. Check out Grantham's full letter.
Grantham on Quality Stocks - November 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - April 2009
Best and Worst Performing DJIA Stock - April 2009
Defensive Stocks? - April 2009
* "Friends, Romans, countrymen, lend me your ears..." - Mark Antony in Julius Caesar