Benjamin Graham's mistakes and summary

 The mistakes of master investors should be divided into two parts. The first part is investment mistakes and the second is thinking mistakes. Evaluating investment mistakes is the easiest part. In them, losses tell the absolute truth. Finding mistakes in thinking is not easy. Finding them never tells the absolute truth. It is more about the perspective of the one who finds the mistakes than the truth. Some of the investors in the book have admitted their thinking mistakes themselves. Others have not realized them themselves. Graham is among the latter, at least according to the sources I have found about him.

Graham's biggest relative losses came in the late 1920s and early 1930s. In the late 1920s, Graham was worried when prices were at their peak. At that time, his investment firm Graham-Newman was leveraged. It had most of its investments in stocks and a small part as short positions. The firm lost just under 70% of its capital by the end of 1932. Graham had not trusted his own instincts and therefore lost a lot of money. Considering the leverage and the general decline in stock prices, it can be said that the company survived well compared to its starting points. The Dow lost a maximum of 90% in the same period. It is difficult to estimate the size of the mistake, but I can say with a clear conscience that the leveraged portfolio was a mistake. The investments were on average better than the indices, so Graham did not make any shocking mistakes. I have no information about the content, so I cannot say anything about individual investments during that time.

As I already mentioned, understanding the fallacy is difficult and is always based on the author's estimates. Another reason for the fallacy is that more information is constantly being released and Graham lived at a time when there was much less of it to share. One such factor is the concept of permanent competitive advantage. This is what Graham did not recognize during the decades that he passed on his understanding of markets and companies. He believed that when profit margins were high, they would decrease over time, because high margins would attract new competitors, increasing pressure to lower prices. A sustainable competitive advantage is real and can arise in many ways. One is the image created by a brand or the brand created by the image. An example from Graham's time is Coca Cola, whose sustainable competitive advantage certainly existed even in his time. I consider the failure to understand sustainable competitive advantage to be Graham's biggest mistake.

In addition, Graham's mistakes include a rather short investment horizon and a lack of a safety margin, which he has partially compensated for through diversification. Graham often gave an investment two years to prove its worth. He advised selling if it did not happen, no matter how good the future seemed. He also advised selling a stock if it achieved the target increase in value faster. For example, in 1974, he advised buying stocks, diversifying them into at least twenty stocks, when the market price of companies was a maximum of 2/3 of their book value. He advised selling individual stocks when they rose to their book value. This leads to short-term action and the investor often misses the biggest value increases. Companies move in the same direction for an average of more than a couple of years. This often happens through profit improvements.

Evaluating the magnitude of the errors mentioned in the previous paragraph is not simple, so I will leave it to you. I want to mention one thing against which you need to evaluate it, and it can be found in the parts of Graham's definition of investing. "The purpose of investing is the preservation of capital and a satisfactory return." Both options can be found in the previous paragraph, because Graham emphasized a diversified portfolio, a reasonable price paid, and a satisfactory return meant something different to him than to many others.

Brief summary

Investing is an activity where long-term, i.e. several decades of returns tell the truth about the goodness of an investor. Graham's long-term returns are not as exceptional as those of many other investment masters mentioned in the book. Graham did not focus on making maximum profit but wanted to get a satisfactory return with a low risk of losing capital, as can be seen from his definition of investing. He succeeded excellently in this. Whether he is a master investor is up to you to judge.

I think he is overrated as an investor. He can still be considered a pioneer. He was also a better teacher than an investor. Many of his disciples have done much better than him. He has created a few concepts and ways of doing things that work well even today. Margin of Safety and Mr. Market are still important concepts. The use of margin of safety has been refined by a few of his disciples and have been more successful than him. This is what should happen if the teacher is successful in his work. Mr. Market is a brilliant concept and there is no better way to describe the irrationality of the market. Many apostles of the efficient market concept disagree with this, but they are more wrong.

Graham was a genius. He could write well. His books are masterpieces. I recommend Intelligent Investor to every investor. Security Analysis is more difficult to understand and I recommend reading it to those who have been investing for a longer time. Both have their own shortcomings. Despite these, they are among the best books about investing that I have read. Both books are investments with high returns. I also recommend other sources of Graham's ideas if you have the time. However, I consider the books mentioned to be the most important.

Benjamin Graham about owners and inflation

 According to Graham, owners do not really care about their own interests. They let management act as they please when it is not in the owners' interest. Most owners never even consider the option of management acting against them. As a result, management controls the company and the owners as a larger group submit to its will. A company should always primarily act in the best interests of the owners and not give management the power to act the way they want. The owners, as a larger group, can decide how the company operates and, if necessary, get rid of managers who do not pursue their interests.

On average, managers know more about the company's business than the owners. This does not mean that they think in the owners' interest or that they are always capable of doing their jobs. Owners should not give managers the opportunity to act as they please, even though they are more likely to be right. Investors should investigate the actions of management if they find an attractive investment or owns part of the company. Many companies are poorly managed, which costs the owners lots of money.

The interests of owners and management are not always the same. In particular, compensation systems can destroy the value of a company. Options can generate significant income for management at the expense of owners. They can make management focus more on increasing the share price than on the value of the company. Options often create destructive incentives for managers, which hurts owners. Compensation systems that are higher than normal are always a red flag. The amount of compensation received by management is not directly proportional to their efficiency. Management can also grow the company in order to justify their increasing compensation.

In addition to the management team, listed companies also have a board of directors. The owners elect them at the general meeting. The board of directors must promote the interests of the owners. This works in theory, but in practice it is often overlooked. This is because management often proposes board members to the general meeting. In this case, board members can promote the interests of management because they receive a salary. This can happen if a board member does not promote management's interests. Often, the board of directors and the management team work in symbiosis, pursuing each other's interests while the owners are less concerned. Understanding the internal dynamics of the management team helps to understand whose songs the board representing the owners is singing.

The interests of the owners are not identical. In Finland, the owners of a listed company do not always follow the same line in terms of taxation. An ownership stake of more than 10% means tax-free dividends. This pushes the owners into different positions. It can change the dividend policy to favor large owners, which should reduce the attractiveness of the company as an investment. In the United States, on the other hand, the interests of the owners intersect, for example, when index funds own companies. There, the company management is allowed to decide, for example, on the management of pension assets, so index funds may have a conflict of interest with other owners. The management can threaten to transfer pension assets to another fund company if the index fund interferes with its proposals. This is one of the disadvantages of the growth of index funds.

The owner must guard his interests. Few owners do that. Individual owners can rarely influence the investment targets, but nothing prevents them from gathering a larger group of shareholders and thus influencing the company management or board. One option is always to sell the shares, but few owners do so even when there are reasons to do so.

Graham on inflation

Inflation is a creeping income trap. It eats away at investors’ returns year after year. About once a century it peaks, and once a century there is a longer period of deflation. Both are exceptional cases. They affect investors’ returns significantly in the short term, but over decades the effects of both even out. Graham’s Intelligent Investor states that from 1915 to 1970, the average inflation rate in the United States was 2.5%. In the 1970s and 1980s, inflation was much higher. After this exceptional period, inflation leveled off and has been roughly at the 1915-1970 levels.

From these starting points, we can conclude that inflation will probably be high at some point. This happened in 2021 and 2022. No one knows when that will happen gain. In the long run, stocks are the most effective inflation hedge, but in shorter time frames, there may be better alternatives. This applies especially to companies that can either increase their efficiency more than inflation destroys profits or companies that can raise the prices of their products more than costs rise. In the best case, a company can do both. Graham believed that assets on a company's balance sheet, such as real estate, machinery, and raw materials, protect investors more effectively than direct investments in gold or real estate.

When inflation becomes exceptionally high, most companies are unable to increase their earnings enough to offset the increase in costs caused by inflation. This increases the debts which increases costs. This makes bonds, among other things, more attractive alternatives. This exceptional situation will not continue for decades, but it makes bonds better options for investors than stocks. Investors need to monitor cost developments because it is not easy to notice the acceleration of inflation. It almost always takes a part of the investor's returns. Deflationary environments are an exception. At least the United States offers investors the opportunity to buy inflation-protected government bonds. Hedging against inflation is not free, so everyone should decide how much it is worth paying for it.