The Superinvestors of Graham-and-Doddsville

The Superinvestors of Graham-and-Doddsville is a seminal essay by Warren Buffett.

Buffett begins this essay by imagining a nationwide coin-flipping contest. Everyone in the US participates and calls the flip of a coin. Call correctly and move on to the next round, guess wrong and you’re out.After 20 days, about 215 lucky flippers will have correctly called 20 consecutive flips. They gloat about their success, yet the nature of coin-flipping tells us they’re just lucky. It’s a game of random chance.

But what if all 215 flippers lived in the same town? What if they all hailed from the same school? The same fraternity? Then we’d get excited. The laws of probability suggest 215 winners after 20 days. But those same laws tell us that if all 215 belonged to an associated group, that almost certainly wouldn’t be the product of random chance. These 215 flippers clearly would know something we don’t.

The real flippers in Buffett speech are nine “superinvestors” — himself included. All nine crushed the market averages over multiyear periods by between 8% and 22% per year.In a world with millions of investors, such returns can occur by sheer luck — just like the 215 coin-flippers appeared at first glance. But all nine superinvestors hailed from the investment school of Benjamin Graham and David Dodd — Columbia professors now known as the fathers of value investing. That meant something big. It meant that their success wasn’t the product of luck. It almost had to be attributable to the only common link they shared: the investing philosophy learned from Graham and Dodd. The “intellectual origin,” as Buffett put it.

What set Graham and Dodd’s philosophy apart? That’s where the title of this article comes in. Explaining it was simply the best advice Buffett ever gave.Here it is

The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market. Essentially, they exploit those discrepancies without the efficient market theorist’s concern as to whether the stocks are bought on Monday or Thursday, or whether it is January or July, etc …

It’s very important to understand that this group has assumed far less risk than average …While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock.

It’s that simple Most investors aren’t superinvestors. To them, there’s little distinction between price and value. A cratering stock means risk, while a soaring stock somehow indicates strength and safety — all with little regard to other, more deeply rooted factors. This is akin to assuming that all attractive people make great spouses.

But a more philosophical view shows how crazy this is. Risk appears when market value equals or exceeds the long-term value of a company’s discounted cash flows — its intrinsic value. It then diminishes in proportion to how far market price drops below intrinsic value. Really simple. The relationship between price and risk is often the opposite of what it’s comfortable to assume.

You can read the original article in full here:Link