Perspectives from the father of value investing

After 2008's downturn and last year's strong recovery in stock markets, many had hoped that 2010 would see a return to relative normalcy and stability.

And certainly, the year started on a positive note, as stocks turned in one of the strongest first quarter increases on record.

Then, in rapid succession came:

• The intensification of the budget crisis in Greece that arose in February, with the risk of contagion across Europe
• Concerns that European budget cuts would slow down economies, with spillover effects globally; this is especially problematic in light of the need to compete with a devalued Euro
• The April 22 sinking of a BP oil drilling rig in the Gulf of Mexico
• The May 6 "flash crash" in which US markets plummeted in a matter of minutes without explanation.

Looking at these events, it's tempting to ask what the next catastrophe will be. In fact, based on the first six months history may view this as "the calamity decade", even though we're only 5% into it.

In talking to our clients about how portfolios should be positioned in light of this, we point to three guiding principles from Benjamin Graham, considered the father of value investing.

Starting in 1926, Graham taught at Columbia University and wrote on investments for thirty years. His views shaped a generation of money managers, among them Warren Buffett, who enrolled at Columbia with the explicit goal of studying with Graham and who joined his firm after graduation. In fact, Buffett describes Graham's book The Intelligent Investor as the best book on investing ever written.

Recently, financial journalist Jason Zweig unearthed a 1963 talk by Graham, which he posted on his website.

 Titled Securities in an Insecure World, Graham's talk reminds us of guiding principles that investors always need to bear in mind.

There are three principles we particularly focus on in chaotic times like those of late.

Principle one:                                                                                                                                Invest in stocks and bonds only so far as you can live with fluctuations in prices

The first principle is that investors have to understand their own ability to live with volatility.

This is something that investors were reminded of in 2008 - many investors discovered what their true risk tolerance was in that market.

In the concluding remarks to his 1963 talk, Graham mentioned an old Wall Street adage that whenever clients asked a broker to recommend stocks to buy, he'd answer by saying: "Do you want to eat well or sleep well? That will determine what I recommend."

Graham went on to say that he believed that by following sound policies, almost any investor should be able to eat well without losing any sleep- even in the insecure world of 1963, shortly after the Cuban missile crisis.

We share Benjamin Graham's view on the need to both eat well and sleep well - our goal with every client is to tailor a portfolio that achieves these dual and sometimes contradictory objectives.

And to help clients maintain peace of mind during periods of volatility, we normally recommend that three years of cash needs be kept in liquid, safe investments.

Principle two:                                                                                                                                                 The price you pay when you buy stocks is key

There are many factors that determine how investments perform over time - but few are more important than paying a reasonable price when you buy. After all, people who bought companies like Cisco, Intel and Microsoft 10 years ago have lost half their money - not because these aren't exceptional companies, but because the price they paid was too high.

In his talk, Benjamin Graham said that because of the level of insecurity in the world, investors should always have an allocation to stocks, bonds and cash. The minimum level for stocks should be 25% and the maximum 75% - and the amount should be determined by value considerations, owning more common stocks when the market seems low in relation to value and less in relation to when the market seems high.

There are many contradictory views on today's valuation levels.

Customize the next section to your own views

In his speech, Benjamin Graham outlined a methodology for valuing markets which would suggest that fair value for stocks today would be about 18 times the last twelve month's earnings - roughly in line US earnings as measured by the Standard and Poor 500 index.

This would suggest that while not cheap, the current market is fairly valued - and if we see a continuation in profit increases as the economic recovery continues, may end up being quite inexpensive.

Principle three:                                                                                                                                                                             Warren Buffett's two keys to investment success

Benjamin Graham's student Warren Buffett has said that it only takes two things to make money - having a sound plan and sticking to it ... and that of those two, it's the sticking to it part that most investors struggle with.

Markets like we've seen of late create understandable stress and can lead to short term decisions  - this New York Times article in May talks about the cost to investors of acting impulsively.

http://www.nytimes.com/2010/05/23/business/23stra.html?src=me&ref=business

At the risk of repeating a timeworn cliché, in our experience the only way to invest successfully over time is to maintain discipline and a long term focus - to have the right plan and then to stick to it.

The three charts on the next page speak to this. They show returns among large US stocks from 1926 to 2009 after inflation is taken out.

The first chart shows 1 year returns - and truly is a roller coaster. If this was what investing over time entailed, few would have the stomach for this. 

The next chart shows returns over three years - showing less volatility but still more than many investors would be comfortable with. And the third chart shows returns over ten year periods - the longer you own stocks, the more you lose the extremes on the high side and the low and end up with an experience that investors can live with.

In closing, let me reiterate my appreciation for the continuing opportunity to work together - as always, I welcome your calls and questions and would be happy to talk at any time.

Name of Advisor

P.S. If you're interested, you can read Benjamin Graham's 1963 talk here: http://www.jasonzweig.com/documents/BG_speech_SF1963.pdf