2. Invest according to “pricing,” not “timing.”
“By timing we mean the endeavor to anticipate the action of the stock market – to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value.” (The Intelligent Investor, p. 189)

Focusing upon pricing is, by definition, called “buying low and selling high.” This discipline requires this action (or inaction as in not selling low or buying high) at all times, in all markets.

In good markets, following this discipline leads to the wildly unpopular activity of selling stocks when everyone else is sure they will continue to go up forever. In bad markets, it leads to either absolutely holding stocks if their prices go down and buying more stocks if funds are available. You basically ignore the stock market on a short-term basis, except to hold or buy when it offers high-quality, low-priced stocks to purchase and selling when it is substantially overvalued.

These points are obviously particularly relevant today, with the stock market down 20%. The following is what Mr. Graham taught investors regarding the temptation to sell high-quality stocks below their fair value because they have gone down short-term:

“Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other person’s mistakes of judgment.” (p. 203)

While Mr. Graham admitted that it may be possible to deliver excellent long-term investment returns through attempting to time the market, he believed it was highly unlikely and unusual. This has continued to be the experience of investors in recent times, and we have only found one investor who we believe can successfully time the market with sufficient safety. Keep in mind this is one out of millions, for if you study the actions of investors, you will find that the majority end up attempting to time the markets. Intellectually most know it probably won’t work, but their emotions practically force them to sell when they are scared the market is going to go lower, and greed leads them to buy high. This is market timing, and this is how most “practitioners” who try this approach act. Most do very poorly.

3. Buy the stocks of good companies at prices substantially below their fair value.

Knowing how to purchase individual stocks is perhaps Mr. Graham’s greatest legacy. It is beyond the scope of this paper to detail all the rules to be followed. In general, the approach is to purchase stocks of companies that have an unusually sound financial history, combined with a low price. For example, the company must have assets at least 1½ times current debts, must have exhibited earnings stability over 5 years, and preferably 10, and must have earnings growth in recent years. In addition, the price paid for the stock must be low compared to the current assets of the company. In other words, his approach focuses on companies that have good, steady growth over many years. But he would buy when he did not have to pay much, if anything, for future growth. This provides a large margin of safety, for the company is worth as much as he paid for it even if it has serious difficulties and stops growing.

Implementing Mr. Graham’s Discipline Today

Two of the greatest investors using this discipline today are Warren Buffett of Berkshire Hathaway and Bruce Berkowitz of the Fairholme Fund. This year has been unusual for both, as these two investments have rarely gone down, regardless of what the market has done. Over 43 years (52 if the Buffett Partnership returns are included), Mr. Buffett has only lost value one year – 6.2% in 2001. And since the beginning of 2000, Bruce Berkowitz has only gone down one year – 1.6% in 2002. Keep in mind that this was a year in which the stock market lost 22.1%. Of course, 2008 is far from over.
In looking at the actions of these two investors, we can see they are indeed continuing to follow the discipline. As you would expect, neither has panicked, selling their holdings at low prices! Instead, both anticipated the current downturn by amassing huge cash positions last year. Bruce Berkowitz had 28% of his $8.5 billion in cash at the end of 2007. As of the most recent reporting, this had gone down to 17%, as Mr. Berkowitz has bought the stock of 12 companies during this downturn.

Similarly, Berkshire Hathaway began the year with over $40 billion of its $175 billion market cap in cash. While we won’t know until later the exact amount still in cash – or how this “cash” is being invested – we do know that Mr. Buffett has purchased part ownership of Wrigley, 60% of Marmon Holdings, a privately held manufacturing conglomerate, purchased large stakes in three railroads, and begun a bond reinsurance company. (Some of these purchases were in late 2007.) Mr. Buffett has undoubtedly made additional investments this year, but he is not required to disclose many of his activities until the end of the year.

Warren Buffett has said he would never buy a stock if he would not make the same purchase if the stock market was going to close the next day – for 10 years. He literally ignores the stock market as it relates to his current stock holdings. Instead, he buys stocks that he is certain are worth substantially more than their current price. These are companies with track records that surpass even the high standards Benjamin Graham demanded. When Mr. Buffett invests in a stock, he is basically certain that company will continue to prosper through the years. While certainty is impossible to achieve in investing, over 50 years you can count on one hand the number of times Mr. Buffett has been wrong when purchasing companies.

Both Mr. Buffett and Mr. Berkowitz have substantially improved upon Mr. Graham’s discipline. Actually, Mr. Graham himself told his student Warren Buffett how to do so. In The Intelligent Investor, Mr. Graham briefly states that an investor could achieve significantly larger returns, with even more safety, if that person actually controlled the companies whose stock he purchased. Mr. Buffett therefore purchased all of Berkshire Hathaway, a Northeastern textile company. He then began to not only buy stocks of some large companies, but he also purchased numerous (over 75 at this time) companies in their entirety. He thereby gained complete control over the future functioning of these companies, which lowers the risk of the investments and increases the chances of making large profits.

Mr. Berkowitz does not purchase entire companies. However, by investing in a small number of companies, he is able to become intimately familiar with each company’s management.

Creating & Managing Retirement Portfolios

Mr. Graham taught precisely how to create and implement retirement portfolios. The first principle he used was to always make sure the portfolio has the correct level of safety. This is achieved by holding, at all times, a sufficient percentage of fixed income investments, typically bonds (or fixed annuities). He recommended the amount in bonds be from 75% of the total for very conservative investors to as low as 25% for more growth-oriented portfolios. For those who wanted to make larger long-term profits, he further recommended that the amount in fixed income be reduced as the market went down and increased as the market became overpriced, i.e. to buy more stocks as the stock market goes down and sell stocks when the market goes up.

The last edition of The Intelligent Investor was completed in 1972. This makes it particularly relevant to today’s economy and markets, as inflation had begun to increase rapidly. Mr. Graham was therefore quite concerned about the fate of the bond market, as well as the stock market. And in fact, from 1973-1974 the bond market lost 28% of its value, while the stock market lost 41.4%. In 1972 Mr. Graham recommended investing in bonds that were tied to inflation, which unfortunately did not exist at that time.

However, today we have precisely the types of bonds Mr. Graham recommended during inflationary times. These are called Treasury Inflation-Protected Securities or TIPS – U.S. Government bonds that go up as inflation rises. At Secure Retirement, these types of bonds have been our largest bond holdings for the last year, and we are purchasing several million dollars more of these bonds at this time.

We will conclude with a look at what happened to Mr. Graham’s students the last time inflation spiraled out of control. One of his students, Warren Buffett, actually took the drastic action of selling everything he owned, returning the principal plus huge profits to all his investors. He then proceeded to purchase Berkshire Hathaway, which proceeded to go up 10.2% from 1973-1974. Selling all his stock funds was a highly unusual action, but in 1969 the market was overpriced, so Mr. Buffett sold all his stocks at a high point. He then began purchasing other stocks, and entire companies, through Berkshire Hathaway as the market swooned, first in late 1969-70 and then from 1973-1974.

Mr. Graham’s other students did not fare nearly as well – in the short-term. Rampant inflation leads to financial ruin for many, and it is difficult to go through it unscathed. However, following the discipline, these investors quickly returned to profitability. For example, as the stock market lost 41.4% from 1973-1974, Walter J. Schloss went down 40.05%. But the next two years his fund went up 71.2%. Perimeter Investments lost 40.1% in 1973-1974, but went up 81.5% in 1975-1976. Tweedy, Browne Limited Partners went down 29.9%, only to go up 66.5% the next two years. And then we had Pacific Partners, who lost a whopping 76.5% in 1973-1974, but gained 159% the following two years.

None of these legendary investors panicked, and I am sure not one sold any stock when it was at a low price. Instead, they went about finding stocks they were confident would deliver large gains when the market turned around. Of course, most investors sold throughout 1973-1974, convinced the market would never rebound – or that they would sell and return later. Remaining level-headed when others were panicking and heading for the exits is a major reason why these four funds combined made 26.78% a year over 15-28 years, versus an average of 7.75% a year for the stock market during the same time periods.

Of course, losses such as these would be completely unacceptable in a retirement portfolio! This takes us back to Mr. Graham’s principles regarding safety. At Secure Retirement, we presently have 45% of the total amount we are managing in bonds – which have done quite well in the last year. Partially as a result, for the year ended 7/30/08, we did go down 2.93% - versus a loss of 14.58% for the stock market. This year has been even more difficult, as widespread financial panic has hurt even the most conservative stock funds, including ours. But at its low-point earlier this week (July 15), the market was down over 15% for the year, while Secure Retirement’s combined accounts were down 5%. Should this continue, and double, we would be down 10% versus 30% for the stock market. While I believe, and history strongly suggests, that the stock funds we own at Secure Retirement will never go down double what they have in recent months, if they did they would be poised to return the types of gains those using our discipline have delivered after every large stock market downturn since 1929.

None of the above means we believe our economy is going to experience out-of-control inflation. In our most recently quarterly report I outlined why this is indeed unlikely. Although Warren Buffett recently said we should all be concerned about inflation, and at Secure Retirement we are very concerned, he does not believe we are likely to have a repeat of 1973-1974. And he isn’t selling his stock holdings, but continues to buy the stock of great companies at low prices. This is what we will also continue to do at Secure Retirement, as the closest thing to a certainty in the stock market may be that buying the stock of great companies at low prices leads to long-term success. At least, it has been since people could invest in the first company!

Conclusion

Discipline is the key to investment success. You must have the right discipline, and you must have the emotional stability to follow it. For the last 82 years, the best, most successful discipline has been the one taught by Benjamin Graham and followed by a group of his students. It works when followed, safely delivering higher returns than any other approach to investing.

Appendix

Practitioners of Benjamin Graham’s Discipline

Berkshire Hathaway Inc.: 21.7% a year over 43 years, 1965-2007
vs 10.3% for Dow Jones Industrial Average

Buffett Partnership: 29.5% a year over 13 years, 1957-1969,
vs 7.4% for Dow Jones Industrial Average

Charles Munger: 19.8% a year over 14 years, 1962-1975
vs 5.0% for the Dow Jones Industrial Average

Bruce Berkowitz: 17.9% a year over 8 years, 2000-2007
vs 2.8% for the S&P 500

Pacific Partners: 32.9% a year over 19 years, 1965-1983
vs. 7.8% for the S&P 50

Perimeter Investments: 23.0% a year over 19 years, 1965-1983
vs 7.8% for the S&P 500

Walter J. Schloss: 21.3% a year over 28.5 years, 1956-1984
vs 8.4% for the S&P 500


Tweedy, Browne LP: 20.0% a year over 15.75 years, 1968-1983
vs 7.0% for the S&P 500