Graham or Growth? Part 1 - Will the mean revert?

May 2019
James Anderson
JOINT MANAGER, SCOTTISH MORTGAGE INVESTMENT TRUST

When we first attempted to explore and explain our enthusiasm for Growth Investing 15 years ago it was natural to try to learn from our predecessors. The problem was that there was very little literature to guide us. The only text in the canon of investment that espoused Growth Investing was Phillip Fisher’s ‘Common Stocks and Uncommon Profits’. It dates from 1958. What follows is James’s musings after he reread Ben Graham’s value bible, ‘The Intelligent Investor’.

Two traditions, but only one literature

Fifteen years on, markets and facts have been generally kind to the cause of Growth Investing. But there is still a shortage of material, whether written, internet or podcast, available that makes the case for a serious and consistent commitment to Growth investing. There’s little evidence here that when the facts change investment opinion adapts. There’s equally little evidence given for the widespread presumption that time will inevitably and eventually ride to the rescue of value. All too often this is accompanied by a disconcerting sub-text of moral superiority that Growth investors are momentum junkies with no serious commitment or beliefs. Perhaps as a consequence the great majority of clients still seem set on rebalancing away from Growth in determined manner, despite or because of long-term performance well ahead of supposedly unbeatable passive benchmarks.

But in marked contrast to the poverty of the Growth literature there is an intellectual tradition, a canon of classics, that surrounds Value investing. This is very much intact in our era from Buffett and Munger to Klarman and Marks. In addition the doctrine of Value has a bible or at very least an Old Testament. So I reread Ben Graham’s The Intelligent Investor (in the edition with Jason Zweig’s excellent commentary).[1] Of course it is wonderful. Of course it has fathered magnificent interpreters and investors. But I don’t believe that it invalidates Growth investing. I do believe that transformations in our economic and corporate structures open serious alternative interpretations.

The Intelligent Investor

What are the main tenets of Graham’s philosophy? Early on he sets out his case:

“We shall suggest as one of our chief requirements here that readers limit themselves to issues selling not far above their tangible asset value…The ultimate result of such a conservative policy is likely to work out better than exciting adventures into the glamorous and dangerous fields of anticipated growth.” – Ben Graham

This summarises his position and requires little embellishment but a few further quotations may be worthwhile. Graham regards “true growth” as meaning per share earnings “should at least double” in 10 years but that any such stocks are commonly subject to “excessive” enthusiasm that has “introduced a speculative element of considerable weight”. This means that growth stocks are subject to losses in market downdraughts. Such volatility saw IBM twice losing 50 per cent of its value in its era as the ‘best’ growth stock. Better therefore to invest in a “group of large companies that are relatively unpopular”. Later this evolves into a verdict that:

“Extremely few companies have been able to show a high rate of uninterrupted growth for long periods. Remarkably few, also, of the larger companies suffer ultimate extinction. For most, their history is one of vicissitudes, of ups and downs…”.

This formulation is, I think, the closest Graham comes to explicitly endorsing what has become the extraordinarily influential belief in the return to the mean as a fundamental principle of investing. Not though quite as fundamental to Graham as to where he concludes that “to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.” Most uncharacteristically the capitals are his.

As these quotations make clear, Graham was willing to set out broad statements of principle and philosophy. But he always backed these by references to specific examples and overall market outcomes over a period of time. He tells of market declines, of the inability of Growth mutual funds to outperform. In the background is the knowledge of his own superior performance which is not trumpeted as much as the failure of others.

So let’s start with performance. It’s quite plain that in the last decade the situation has not been the same as that Graham points to and that many of his clumsier successors point to as an iron rule. It hasn’t been better to invest in “a group of large companies that are relatively unpopular”. It’s been much better to participate in the “glamorous and dangerous fields of anticipated growth.”

It becomes still more troublesome if we turn to individual stocks and to far longer periods. Graham believed that doubling earnings over 10 years was a reasonable definition of growth and that such is difficult to achieve – especially for an already large company. At least by implication extending such a record was highly improbable.

Yet this simply hasn’t been the case. Let’s take the comparatively staid Microsoft as an example. By 2008 it had revenues of $60 billion and earnings of $1.87 per share but it also had Steve Ballmer as CEO and not unrelatedly appeared to have gone permanently ex-growth. Regulators had controlled its influence and the attempt to reinvent led to the damaging acquisition of Nokia in the years ahead. But by 2018 Microsoft had revenues of $110 billion, clean earnings of $3.88 and appears still to be growing at low double digits.

Growth vs Value Performance graph

The story of Microsoft’s last decade is one of impressive persistence of growth and returns at scale and from apparently dire initial circumstances. But its entire history since its IPO in March 1986 at an implied value of a little over $0.5 billion (which Bill Gates thought worryingly demanding) represents an extraordinary challenge to the sceptics of Growth and proselytisers of mean reversion.

In its last year as a private company Microsoft made net profits of $24 million. For fiscal 2018 it earned $30.27 billion. That’s at a 24 per cent compound growth rate over 33 years with operating margins still over 30 per cent. It’s hard to prove but equally easy to believe that this is the most extraordinary record in global corporate history.

It’s most improbable that anyone predicted such a prolonged period of extraordinary success – and even more improbable that any investor who argued that it was possible and invested accordingly would have been taken seriously. But it’s such extremes that matter – and that need to be acknowledged and understood.

Alphabet is far racier. Again it’s quite a challenge to the Graham hypothesis. In 2008 Google earned $4.2 billion on revenues of $21.8 billion. Ten years later this has become $30.7 billion on revenue of $136.8 billion for Alphabet. Moreover it has never been that difficult an investment thesis to comprehend: as Graham’s disciples at Berkshire Hathaway acknowledge the competitive moat was such that as Charlie Munger put it in 2017 he and Buffett were “probably smart enough” to have figured out Google so “we failed you there”.

Alphabet, of course, has generated huge amounts of free cash but there’s still another category of deeply successful stocks to this point that would presumably have aroused wry and mordant humour from Graham. What would he have made of Netflix? Or Amazon? Almost certainly he’d have mocked their tolerance of losses but if we are tempted by potential how do we think about subscribers or sales growing as shown below:

Of course Graham didn’t cover China but Alibaba and Tencent would probably not have met his desire for a margin of safety at any point in their ascent.

Now in a sense I’m reluctant to lay out these examples over the last decade as I really don’t wish to seem either dismissive or smug. What I’m trying to convey is that over time frames Graham himself used the outcomes have been inordinately different from his philosophical and practical expectations.

Yet outcomes are simply the starting point for attempting to understand what might be happening. Graham and several of his most notable followers were and are great investors and deep thinkers. So for their approaches to be so challenged by events there must be at least the possibility that something profound may have changed in heaven and earth. What this might be is fascinating. It’s also potentially vital to trying to understand what may come next. This is much more important than crowing about the last decade.

Netflix and Amazon graph

Uncertainty

First though we need to reflect on the limitations of our understanding. It’s crucial that we acknowledge this. Whether it be the inherent confidence of Graham that despite oscillations he would turn out to be generally correct, or less justified certainties of the great majority of market commentators and stock analysts that we now have to endure, I’d suggest that we need to be acutely more sceptical about the significance of outcomes.

This is the direction that the far more rigorous disciplines of science and mathematics are encouraging us to take. The very idea that 150 years of chance occurrences in a small and acutely biased selection of countries provides satisfactory evidence to make projections about the working of markets and the range of outcomes would horrify most of the greatest minds of our times. As Nobel laureate, co-founder of the Santa Fe Institute (and according to The New York Times headline The Man Who Knows Everything) Murray Gell- Mann frequently stresses we are far too prone to see what has happened as both preordained and a far smaller percentage of the possible outcomes than we care to believe. As he wrote we and our surroundings are better thought of as “the frozen accidents of history”.

An example he used over 20 years ago has especial piquancy today. Gell- Mann pointed out that Henry VIII only inherited the English throne because his brother Arthur, of a rather different temperament, happened to die (after making a marriage that immensely influenced the Reformation). Gell- Mann concluded that this led on finally to the “antics of Charles and Diana.” Brought up to date he might well say it led onto Brexit.

There’s another example that is perhaps even more provocative. In Buffalo Bill’s Wild West Show Annie Oakley proclaimed her ability to shoot the end off a cigarette and requested volunteers to demonstrate her skill. Normally no one came forward. So Annie’s husband hid in the audience in order to take on the role. But at a show in Europe there was a brave volunteer. Annie had been drinking in a beer garden late the previous evening and was unnerved by the turn of events. Such was her professionalism that even with a thick head she managed the trick. Now this may be thought of as impressive but unimportant. But the unexpected volunteer was her great admirer the young Kaiser Wilhelm. There have been many lurches in the accepted historiography of the First World War but few, if any, accounts, think his aggression and personal failings were irrelevant. If only Annie’s hand shook or if the beer had been of Belgian not German strength world history might have taken a very different path.

If only Annie’s hand shook or if the beer had been of Belgian not German strength world history might have taken a very different path

These are historical examples but they are emblematic of the flaws of both financial and economic theories. Personally I lost any belief in the twin notions of predictability and efficiency on October 19, 1987. The S&P 500 losing 20 per cent of its value on no news at all seemed a little hard to rationalise away. But whatever the trigger for each of us, surely we have to accept that we live in markets and economies (see 2008) that are profoundly inimical to the traditions of equilibrium economics.

Instead we live and work within complex, unpredictable and probably inexplicable systems. In an analogy described by Melanie Mitchell in Complexity capital markets are as strange, opaque and puzzling as the workings of our immune system. Or as Gell-Mann suggests, as hard to predict as circulating particles with brains and emotions. The actual outcome that occurs is just one choice amongst an infinite number. Moreover that one now frozen occurrence influences the future path in often unfathomable ways. Soccer commentators are fond of mouthing the cliché that ‘goals change games’ but in business too reversing time and chance is impossible. We can write all we like about the underlying causes of Microsoft’s astounding success but it rested on accidents.

One of the twists was that when IBM first asked Bill Gates for advice on its proposed operating system Gates suggested that their best source was a company called Digital Resources. But it was run by a gentleman named Gary Kildare who preferred to go hot-air ballooning rather than turn up on time to meet IBM. Only then did IBM go back to Gates.

It seems likely that the complexity, unpredictability and path dependence of our markets has grown over the decades since the early rites of Microsoft let alone the marriages of Henry VIII. But even without this surmise it seems that we may be better off simply acknowledging existential uncertainty in return structures. Both the Value driven dictums of Graham and the extremes of Microsoft and other platform Growth stocks may be the near random outcome of an almost infinite set of possibilities in each period. Neither should be treated as permanent laws of finance.

[1] Graham, B., Buffett, W. and Zweig, J. (2013). The Intelligent Investor. New York: Harper Collins

The views expressed in this article are those of the author. Its express purpose is to highlight areas of intellectual thought and debate which inform the investment philosophy that underpins Scottish Mortgage, in the hope that they may be of wider interest. The author(s) therefore make(s) no suggestion that this article constitutes independent investment research and it is not subject to the protections afforded to such.

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