An Interview With Charles Mizrahi on Value Investing and Benjamin Graham's Best Investing Rule
The following interview is extracted from my book, Breakthrough Strategies of Wall Street Traders. Similar to Market Wizards, within it I interview 17 remarkable traders and investors for their investing stories and unlike other investing books, get them to actually reveal the trading-investing rules and techniques they use as well as what they tried that didn't work. If you want to learn trading and investing, start with these systems.
People try to master all sorts of trading methods and investment techniques to beat the stock market. Warren Buffett made his fortune by studying the techniques of Benjamin Graham, the father of security analysis. However, after years of developing a way to value stocks, near the end of his life Graham gave an interview, “Simplest Way to Select Bargain Stocks,” where he explained a simplified technique that did away with complicated security analysis: “First, create as large a list as possible of common stocks currently selling at no more than seven times their latest (not projected) 12-month earnings. While Graham said to select shares with a P/E of less than 7, he explained that he arrived at this criteria because he wanted an earnings-to-price ratio (the inverted P/E ratio) that was at least twice the average current yield on top-quality (AAA) corporate bonds. Today we might use a P/E criteria of 10 or even 12. In any case, the low P/E requirement tends to be the first sieve that helps you select underpriced stocks selling at a discount.
“Once you have those initial candidates, you are looking to select a portfolio of at least 30 stocks (at a minimum) that not only meet the P/E requirements but also have strong balance sheets. You don’t just want a low P/E but also want companies that are financially strong because they have a satisfactory financial position. His only screening criteria for this condition was that a company should own at least twice what it owes, so its debt should be less than half of its assets. How can you measure this? You can look at the shareholder equity/total assets ratio to get an idea of debt levels. If you look at the ratio of stockholders’ equity to total assets and the ratio is at least 50 percent, the company’s financial condition can be considered sound.
“Now for the selling rules. After you buy such a stock, you would sell it after it appreciated by 50% or after two years went by, whichever came first, and then simply repeat the process when funds became available and new stocks met the tests.”
Fast forward to today where successful value investor Charles Mizrahi has updated these simple Ben Graham rules and proved that they work. The stocks within his Hidden Values Alert and Inevitable Wealth Portfolio are selected according to basic Graham value criteria, along with his own business judgement, and have readily beat the overall market over time just as Graham predicted. In this interview Charles explains how to apply this technique to value investing to soundly beat the market in a very simple manner.
Charles, I know you handle the stock picking for Hidden Values Alert and the Inevitable Wealth Portfolio, which are two value stock portfolio newsletters you publish, and you have also written books on value investing. What I want to know is how you initially got involved in trading and investing? What got you into this field so that it has become your career and life?
For that we have to go back to Elementary School. I was always interested in the stock market. I grew up in a middle class family where my father was a warehouse manager and we lived in a very middle class neighborhood. Taxi drivers were our neighbors as well as other blue-collar people.
From the time I was young I always loved the financial markets. They were always so fascinating to me. It was like a big puzzle trying to figure out where the pieces fall and who would profit from them and do well. When I was eleven or twelve years old I started reading about the stock market. I used to spend a lot of time at the library as a kid and in high school I used to spend a lot of the time in the back of the class reading annual reports. The teachers were pretty cool. They left me alone because I told them that if you leave me alone I'll share some of my stock picks with you and they enjoyed that. I wasn't too much of a good student in that sense, but I always knew that I wanted to be in the financial markets.
When I graduated from high school I went to college for one year and then I went down to Wall Street, which was only about a thirty minute train ride from my house. At the time the New York Stock Exchange had created an exchange called the New York Futures Exchange (NYFE), which was similar to the S&P 500 Index. They had the New York Stock Exchange Composite Index and they were looking for traders - floor traders - to buy and sell the Index. We were called “locals” in the trading pit, which used the open outcry system. I gathered up as much money as I could. I borrowed from my friends, my family and especially my grandmother and I became a local and traded on the floor of the New York Futures Exchange.
I was trading basically the Index on a very short-term basis using a lot of technical analysis because of lot of people down there used technical analysis and they taught me that that is what works. My longest time horizon was a one-hour (sixty minute) chart, so I really wasn't looking to buy and hold for hours. In fact, I was just looking to buy and hold, not even buy and hold, but just to continually buy and sell. That's called “scalping,” and that's where I first got my taste of trading in the investment world.
By going on the floor you meet a lot of amazing people and you can watch the way human nature behaves. You can see what moves markets and you basically learn a lot. You learn a lot on the floor. Back then a friend of mine in Chicago said that six months trading soybeans is worth four years of business school. That really is true.
What type of things were you learning at that time that were mind shaking or still strike you today as quite valuable lessons for readers of today?
Temperament was the key. There were certain people there who regardless of which way the market was going always had an even keeled temperament. They didn't get overly excited when markets were going their way and they didn't get overly distressed when markets were going against them. If you make decisions based on emotion they are usually the wrong ones.
I watched and there weren't many of the floor traders like this. There were just a few who were very cool and steady customers. They would look at the market, do their analysis and then when they made a trade they wouldn't get excited or get depressed if things didn't go their way. They just looked at it in a non-emotional, intellectual way and I saw them make the most money.
You were impressed with their bearing alone and they actually were making more money than everybody else?
They weren't joining in the frenzy of things. They were standing apart from the crowd. When they were buying they didn't need to be buying in a rising market. They were just as happy buying in a falling market and selling into a bull market.
I noticed out of the corner of my eye, literally as well as figuratively, that these guys - and they were mostly guys although there were one or two women who traded on the floor - were the people who were making the most money. It didn't matter at the time when I was there that each one had a different philosophy and a different approach. One guy could have been a chartist and one guy could have been using algorithms or point and figure charts. It really didn't matter. They all were pretty successful and so it was really the temperament that really impressed me as to the key to success in investing and trading.
How did you go from trading the futures index to trading stocks?
I started trading the index and then as an extension of that people were asking me to manage their money. A floor trader is not set up to manage money. The only account you have is really your own. I left the floor in 1983. I was there for only about a year because it's a grueling business (it's from 9:30 every morning to 4:15 everyday) and it wears on you. You don't have many traders who were there for many years. Today that has all been replaced by computers, but in those days it wasn't.
I set up an investment advisory firm, but I couldn't do futures because that required the clients to put up more money and deal with margin, which nobody is interested in doing. What I did was mutual fund market timing. When my signals gave me a “buy” I bought a stock fund and when my signals gave me a “sell” I went into cash. We built a business on that which was a pretty successful money management business. It was rated one of the top among the asset allocators and tactical asset allocators over a ten-year, seven-year, and five-year period through the ‘80s and ‘90s.
I moved from trading the index into doing that and then after that we started to trade, but in a different division of our company, S&P 500 futures. Those were for more sophisticated investors, institutions and banks and we had some pretty sizeable accounts. We had several hundred million under management, which in those days was a lot of money, and we were trading indexes based on a technical approach.
How did that then progress to where you are now investing in undervalued stocks and publishing newsletters on how to do so? You started as a floor trader but went into mutual fund timing and then you went into S&P futures. I'm trying to trace how you finally got into individual stocks and value investing.
During this time period - from when I was on the floor to when I was trading futures - I was using technical analysis, which basically looked at price and volume and a whole bunch of other factors. I was not looking at the fundamentals at all, meaning the economy or individual stocks or anything of that extent. It was just one number and then we were using all sorts of mathematical models and computer algorithms on that. That's what we were doing for a good close to twenty years.
Then along came the 2000 dot-com bubble, and the relationships that had existed that my technical models were based on then no longer existed. For example, for the past seventy or eighty years when interest rates declined then stocks usually rose. Here it was the exact opposite, which is that interest rates were falling and stocks were declining. I looked at the model and the model didn't seem to be working. I saw this happen in 2000 and we stopped trading for our clients and gave everyone back their money and said, “I have to revamp this because this doesn't make sense.” So even the best technical model will break and you basically start from new with a track record of one day, and you start a new model.
At the same time I had always followed Berkshire Hathaway and Warren Buffett. In those days before the internet I used to mail away for their annual reports to read, but I didn't see how it could apply to me. However in 2000 I realized that there was a sea change in the marketplace and I started reading. In fact, I read close to seventy to eighty books and everything on value investing. The reason was because I saw a research paper put out by Tweedy Browne called, “What Has Worked In Investing.”
Yes, I've read it. It’s great. You can find it on the internet at the Tweedy.com website.
I looked at that and I said, “Wow, this makes so much sense. Buying stocks or anything when they are selling at low valuations makes more money over time than buying things at high valuations.” That just makes sense with everything in life.
For instance, when you go into a store you don't say, “Could you tell me what has increased in price and don't show me what you have on sale. I'm just going to buy things that keep going up.” A suit that was $500 last week isn’t a better suit this week because it's $700, but that's the way the market responded. People were buying things based on price and I was doing the same thing. The higher the price meant it was better while the lower the price meant get out.
Along came this notion of value investing. When I started reading this report, “What Has Worked In Investing,” which was a study looking over fifty years of returns, the logic was so compelling. That's one thing that I pretty much pride myself in, which is that I'm an un-emotional person when it comes to making decisions. Even though I had twenty to thirty years invested in technical analysis I said there has to be a better way so I continued reading and researching and then I came upon Security Analysis by Benjamin Graham and David Dodd. All roads led to Security Analysis and The Intelligent Investor by Ben Graham, which was published in 1949.
You have read so many books on value investing. Would you still tell people looking to get into it that those are the two primary books to read or would you suggest different books?
Well the first one would definitely be The Intelligent Investor, especially chapters 8 and 20. If you don't get chapters 8 and 20, put the book down because this is not for you. Basically chapters 8 and 20 speak about Mr. Market, how to deal with the market and also how to deal with looking at a stock as a piece of a business and not as a wiggle or jiggle on a chart. If you can't capture that and that doesn't resonate with you then it will probably never resonate with you as an investor.
What Graham did is he brought together three main principles: stocks as pieces of businesses, how to deal with Mr. Market (a way of looking at price changes in the market and not panicking where he used the metaphor of a Mr. Market to represent stock market daily gyrations), and margin of safety (which is buying and selling only when you are buying something that is substantially less than the price that it is trading at). For example, if a business is worth a million dollars and the stock is trading at a price which values the business at five hundred thousand dollars then you would have a margin of safety. You would be buying a dollar worth of assets for fifty cents.
I would highly recommend The Intelligent Investor and especially Jason Zweig's commentary where he updates a lot of it, and also my own book, Getting Started In Value Investing, which was put out in 2007. This walks the investor through not knowing anything on investing and how to be a much more intelligent investor.
Great. Those are the books that would really help somebody who is interested in value investing?
Those would be the starting points and really it’s quite simple, Bill. If you can't get through chapters 8 and 20 of The Intelligent Investor then you are never going to be a value investor.
Would you tell those people who don’t click with those chapters to look someplace else? In other words, to use a different investing method if they fail that test?
I wouldn't have to tell them. They would tell themselves. There is an excellent speech that Warren Buffett gave. I'm sure you're familiar with “The Superinvestors of Graham-and-Doddsville”?
Yes. I used it to write my own book Super Investing. You can find it on the Columbia University website I believe.
That's really a seminal piece where Buffett makes the case for value investing over randomness or luck when picking the market. What he does is take nine investors and goes through their track record. He shows them all dealing in the stock market, all picking different stocks, all having different principles but all dealing with the same approach.
He uses the analogy that if monkeys and chimpanzees in a certain zoo were able to do something really unique then when that’s the case we have to start looking at what the zookeeper is doing that's amazing. The zookeeper here was investor Ben Graham in what he was able to do with stock returns.
All of these investors follow that same approach and I think Buffett concludes in this speech that he gave in 1984 that there seems to be some perverse human characteristic that likes to make easy things difficult, and you can sit here and try to explain it to someone but if it doesn't resonate in just a few minutes then they are never going to get it. He said something to the effect that you either get it or you're never going to get it, and that's really true.
I've read that speech, which is a wonderful piece that helped shape my worldview. All the investors he mentioned in it had fabulous track records using some derivative of Ben Graham’s basic value investing methodology. Since that time there are a lot of books out now like Value Investors, Active Value Investing, Quantitative Value, and so on. In your opinion do these new value investors use Graham’s same ideas or something better? Also, when you go back to that speech that Buffett gave, who did you like the most that he mentioned? The big question is whether the new value investors today are doing the same thing or better, and what's successful and what isn't?
Okay, so that's a good question. Value investing is really a very large tent. There are so many people that claim to be value investors that are and there are also those who claim to be value investors that really aren't. There are many ways to apply this approach.
Some people apply it and just in this article, for example, Walter Schloss was mentioned. He had a tremendous career of fifty plus years of beating the market by three to four percentage points a year. He brought a portfolio of sometimes up to a hundred stocks and I think usually had maybe sixty or seventy stocks regularly in his portfolio. Some of these were companies that were on the verge of death, but he was getting more value than he was paying. On the other hand you have the Sequoia Fund run by Bill Ruane. He was doing something very similar to Warren Buffett. They both were taking very concentrated positions in just a few stocks.
There are many different ways of looking at it and it basically goes back to what skill set do you have? For example, I am not confident of holding 30% or 70% of my portfolio in one stock, but Buffett was and is. At one time in the 1960s he had close to 70% of his partners’ funds in one stock, which is American Express. That takes an incredible amount of confidence, an incredible amount of knowledge and an incredible amount of confidence in your research. I'm not Buffett, I don't think I'll ever be Buffett and I don't fool myself to think that I am.
On the other hand you have other investors who have a wide portfolio of a whole bunch of value stocks that are a lot of dollar bills they bought for fifty cents. None are great companies but they figure that if they hold a good portfolio then some will do great and some won't, but the great will outdo the mediocre. Then you have another investor like Charlie Munger. When he met Buffett, Buffett was buying stocks like Graham, which was a whole basketful of cheap stocks regardless of the quality of business. Munger said that doesn't make sense. Munger wanted to buy quality companies.
Those were the giants who were the old guard. Today you have the new guard of guys like Seth Klarman of Baupost Group, for example, who has an unbelievable track record. I think even Buffett said at one point that if he was giving his money out to be managed then Klarman would be one. Klarman learned from Max Heine of the Mutual Shares fund, and that is also where Michael Price was. That was a very small shop where they learned how to analyze a company and buy a dollar bill for fifty cents. Klarman applies it not only to stocks but to bonds and to real estate.
Then you have guys like Bill Ackman, who are activist investors but also follow a value approach. They won't buy into something if they don't perceive that they are getting more value than what they are paying.
So it is an extremely wide tent of different approaches but they all follow the same principles of value investing, which is getting a dollar bill for fifty cents and that really is the key. For me to list which ones I like and which ones I don't they all have good points and they all have points that I don't feel comfortable with.
I mentioned that Buffett put a large percentage of his money into one stock, but I couldn't do that. Buying cigar butt stocks like Schloss or Graham were doing doesn't resonate with me either. I don't really know how to buy only quality companies like Munger. I'm not as confident as Munger in knowing what a quality company is, or rather I can figure out what a quality company is but I don’t know if it will still be a quality company five or ten years from now. Therefore I try to take a little of everything such as buying quality companies when they are trading at discounted prices, staying away from cigar butts and diversifying my holdings among the portfolio.
Let's go to your approach. I know you have the Inevitable Wealth Portfolio and the Hidden Values Alert portfolios. Can you tell me what each of those are, what their track records are, the exact investing rules that you are using for picking those stocks and how that evolved?
Okay, so there are two newsletters. There is Hidden Values Alert, which started in 2006, and the Inevitable Wealth Portfolio (IWP) that started in 2009.
With Hidden Values Alert I looked around at the time because we used a lot of publishers and my partner said, “Well, why don't we publish a newsletter? You know a lot about value investing.” We looked around and there really wasn't a good value investing newsletter. In fact there weren't any that we saw that had something that I would be comfortable using for investing. We started that newsletter in the beginning of '06 and the “hidden value” approach was simple. It was buying dollar bills for fifty cents.
We ask two questions before we buy a stock. The first question is, “Is the company financially sound?” If the answer was “yes” then we would ask, “Are we buying it at a bargain price?”
It had to pass those two filters - nothing more than that. By doing that we created three portfolios in that newsletter - a Prime Time portfolio that contained mid to larger cap stocks, Special Situation portfolio which was composed of slightly mid to smaller cap stocks, and a Bargain Basement portfolio which was what Buffett would have called “cigar butt” stocks. These are not quality companies by and large, but there were always twenty-five of them in the portfolio. The whole point was that they were small-caps that we were able to buy at discounted prices.
Fast forward to today. We send our numbers into the Hulbert Financial Digest, which is put out by Market Watch. We send them in each month and they keep our track record so it's much easier to relay what they are. What is really great is that all three portfolios at Hidden Value Alert (the Prime Time, the Special Situation, and the Bargain Basement) have outperformed the market since inception, which was rather interesting because each of them holds different stocks. There is very little overlap between the three portfolios. Each of the portfolios deals with different market caps and each portfolio deals with a different diversification.
For example, Bargain Basement always has twenty-five stocks, whereas Prime Time or Special Situation could come down to as few as five or six or as high as twenty stocks, so we really replicated over the past nine years or so what Buffett has found, which is that if you follow a value approach and you do it well then you could have different selections, different stocks, different market caps, different industries, a whole bunch of differences, but overall they should outperform the market, which all three of them have done.
But what is your general rule for telling whether a stock is financially sound? What is the exact rule and what is the exact rule for whether you are buying it at a discount? There has got to be some criteria that you are using that is a measurement we can follow.
Okay, before I give you the keys to the kingdom let me just explain what IWP was.
We started the IWP, the Inevitable Wealth Portfolio, when we saw the success of the Bargain Basement portfolio. Then we broke that out into being a portfolio of thirty stocks that are financially sound, trading at a discounted price, and the difference was that they were quality companies. It was really a blending of the Munger approach of getting good quality companies and getting them at a discounted price.
We started this in February 2009 or a little before that. I think we started in January 2009 when the bear market was already on its last leg, but when we started the market fell another 15-20% so we felt this was an excellent time because you could just run your finger down the newspaper and there were amazing companies like Disney, Microsoft, Carnival Cruises and Tiffany all selling at P/Es of 7 to 10, which was a joke. This was a price of seven to ten times earnings for world-class companies.
We put that portfolio together and that portfolio from then until now is also outperforming the S&P. All four of the portfolios all follow the same approach, yet we have different criteria for figuring out the price to pay and evaluating the balance sheet to see if the company is financially sound.
Now before I tell you more or less what some of the investing rules are, one must be aware that value investing is part science and part art. It is not physics. Investing is not physics where the formulas are predetermined and the results will always be the same no matter how many times you run the formula. It's not the same with investing. There is an art to it in knowing something about the business.
Take Blockbuster, for example. Prior to going out of business because of technological changes, Blockbuster had a great balance sheet and was trading at a discounted price, but if you didn't see the coming of what was going to happen to the company then you lost money. The same thing goes for the newspaper industry, so just giving a hard and fast rule could lead you down the path of disaster if you don't know something about the business.
So you can't just go by numbers. In other words, you really have to know something about trends?
Not trends. You have to know something about where the business is headed. For example, if you were investing in Blockbuster and didn't see what was happening to the DVD market or the VHS market then you were buying a buggy whip company. If you were buying newspaper companies five, six, or seven years ago because you thought they were cheap and you didn't see the power of what the internet was going to be then you would have lost money as well, so it is not so much trends in the stocks per se but seeing where the business is going.
That's the art part. You could find financially sound companies trading at discounted prices in a whole bunch of ways, but you have to always ask yourself, “Am I buying the next Blockbuster or am I buying the next Google?” and that really is going to be the key to your success. That's the art part.
You can't really quantify that. You can't really put a formula to it. You either have a good and extensive knowledge of business or you don't and you get lucky, so every time I think about buying a stock and adding it to one of our portfolios my job is that I must always ask myself, “Am I buying a Blockbuster or am I buying a Google?” If I can't answer that question then I pass. It should be quite evident that I'm not buying another Blockbuster.
Now do I make mistakes? Absolutely, absolutely, but the point is to limit your mistakes and don't make them so that it leads to a permanent loss of capital and you are out of the game. Does that answer the art and science part of the question for you?
Yes, it does but it brings up another question. Many people talk about Buffett and say he's really great because he has all these business models in his head and says, “I don't look at projections. I always look at history.”
I'm wondering, out of all those value investors that you mentioned, who else impresses you with that sort of business knowledge?
Well, there is no one better than Buffett. No one is better than Buffett. He'll find new businesses that have enduring, competitive advantages or what he calls a “moat.” His track record speaks to that - 20% annualized for fifty years - and if he didn't give away his money he would be the richest man in the world with over a hundred billion dollars so there is no one better. He is in a class by himself. For instance, you talk about Babe Ruth and then you talk about every one else so you put that aside. That's always a struggle.
He had losers as well, but the point is that the losers don't dominate. For example, he had The Washington Post for forty something years until they changed the company, Don Graham took it back and they did a swap or whatever. He also had The Buffalo News. These weren't great businesses the last seven to ten years so I don't think anyone can predict where industries are going 100% of the time. There has to be mistakes because no one has a crystal ball.
The thing about value investing in general and with me per se is that you don't want to pay for future growth. You don't want to pay for future growth because it's an unknown. No matter how good the projections look, no matter how great the next company's innovation is, I don't want to pay for that.
What do I mean by that? When we value a company we only value it based on trailing twelve-month earnings. For example, we are not looking for projected twelve-month earnings because they can be anything. I'd like to do my wealth based on a twelve-month projection but the projection is not real. Banks that lend based on projections usually end up losing money. Look at the real estate crisis. Every projection that every real estate developer gave to banks showed an upward growth but it didn't happen.
Projections are no more than that. They are trying to guess where the future is going to be and as human beings we have a terrible, terrible, terrible track record of predicting future events. There are so many books written on the subject of why humans are not geared up to make predictions and all the biases we have so therefore we try to stay away from that. We don't try to. We do stay away from that.
When we value a business or company, and let's just use a standard P/E (Price Earnings) ratio of 10, we are basically saying that last year's earnings times ten was more or less the price we want to pay for something. So if ABC company had a past twelve months earnings of $5 a share then I'd pay up to fifty $50 for the shares. If the shares are trading at $57 dollars then I'm not interested. If the shares are trading at $45 dollars then I'm definitely interested. If they are trading at $35 dollars then I'm even more interested.
When we look at earnings we are looking at normalized earnings, not if they had one great quarter or had a big judgment in their way or they had a big tremendous loss that was a one-time event. We try to normalize the earnings over a twelve-month period.
That's really it. We are not paying a nickel for future earnings and that's the key because when you pay for future earnings you run the risk of them not happening and then all your projections that you used based on those numbers that never happened throw your price out of kilter. In that case, what looked like a cheap price today based on projections can be an enormously expensive price tomorrow if those projections don't come true. The reason I don't have any confidence in predicting the future is that no one can do it. No one can do it consistently.
I've seen people use EBITDA instead of the P/E ratio for valuations. What do you think is the best measure for stock valuations?
For the rest of the interview, pick up a copy of Breakthrough Strategies of Wall Street Traders (an average interview includes 20+ pages of techniques) on amazon.com.
An Interview with Wesley Gray on Value Investing
An Interview with Mike Messier on Catalyst Trading the Biotech Stocks
An Interview with Steve Hawkins on How to Trade Using Pete Steidlmayer's Market Profile
An Interview with Tim Sykes on Profitable Penny Stock Trading
An Interview with Bill Spetrino on Dividend Investing to Make Yourself Rich
An Interview with Charles Mizrahi on Benjamin Graham Value Investing
An Interview with Raymond Barros on Trading Stocks