In spite of the undeniably impressive track record of many trend following funds, most investors are more at home with the idea of value investing. Value investing is intuitively appealing: we all like the idea of buying something when it’s inexpensive and selling it when overvalued. To boot, value investing counts Warren Buffett and Benjamin Graham as its proponents, arguably two among the most successful investment managers ever. However, a more careful analysis of Graham’s as well as Buffett’s writings and investments turns up a big surprise… Delving into this subject, below is an excerpt from my recently published book, “Mastering Uncertainty in Commodities Trading”
Market trends and value investing
The success of trend following and momentum strategies seems puzzling from the strictly common-sense aspect. Namely, they both involve buying high and selling low, which is contrary to our natural inclination to buy things at low prices and try selling them at higher prices. After all, this approach is at the core of value investing that made Benjamin Graham and his disciple Warren Buffet some of the world’s most successful investors of all time.
Graham authored “Security Analysis” and “The Intelligent Investor,” widely considered as the most important books on investing ever written. He generated an extraordinary annualized return of about 20% over a 20-year period. During this time the stock-market overall returned ‘only’ about 12% per year. Warren Buffett himself generated a compound annual rate of return of over 18% during 30 years . The S&P 500 index returned 10.8% during the same period.
While Graham and Buffett are generally regarded as value investors, a closer look at their performance reveals however, that their success had more to do with market trends than with superior value-finding skills. In the “The Intelligent Investor,” Graham observes powerful market trends as they confound his value judgment on stocks.
In 1953, as the US stock market enjoyed one of the longest running bull-markets until that point, he cautioned investors that the stock prices were getting too high. “As it turned out,” he later wrote, “this was not a particularly brilliant counsel. A good prophet would have foreseen that the market level was due to advance an additional 100% in the next five years.”  By 1959, the Dow Jones Industrial Average reached an all-time high at 58.4, and again Graham warned investors that stock prices were “far too high.” Regardless, the Dow rose to 73.5 by late 1961 and after a 27% correction in 1962, it soared further to 89.2 in 1964.
In sum, Graham thought that stocks were overpriced in 1953 as they were about to treble in value over the next eleven years. Selling your investments before a 200+ percent bull market isn’t a good way to earn great investment returns. So how did Graham generate the remarkable results from his investments? The simple answer: by not following his own investment advice.
Instead, Graham inadvertently did what a trend-follower or a momentum investor might have advised him to do: he held onto his best performing investment even though it was overpriced from the get-go. Namely, in 1948, he and his partner Jerome Newman purchased a 50% interest in the Government Employees Insurance Company (GEICO). The $712,500 purchase was roughly a quarter of their fund’s assets at that time.
Here’s what Graham says about their GEICO investment in the post-script to “The Intelligent Investor”: “… it did so well that the price of its shares advanced to two hundred times or more than the price paid for the half-interest. The advance far outstripped the actual growth in profits, and almost from the start the quotation appeared much too high in terms of partners’ own investment standards.”
Graham explains why he and Newman did not sell GEICO even though they judged its price “much too high.” Because of the size of their commitment and involvement in the firm, they regarded it “as a sort of ‘family business,’ ” and maintained ownership in it in spite of its spectacular price appreciation. In Graham’s words, the profits from this single investment decision, “far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering and countless individual decisions.”
In other words, far more than one half of Graham and Newman’s performance came from the one investment they kept through a two-decades’ bull market and did not sell it even though it was grossly overpriced “in terms of partners’ own investment standards”. That implies that all their “investigation” and “endless pondering” contributed less than 10% in annual returns, underperforming the stock market by at least 2 percentage points over 20 years.
That further implies that if Graham and Newman only invested in GEICO and spent the rest of their careers fishing and golfing rather than burdening themselves with investigations and endless ponderings, they would have done at least twice as well as they have done, generating annual returns of 40% or more from 1948 to 1966!
For his part, Warren Buffett’s style reveals much more of a momentum player than value picker. He made many of his large investments on the back of major run-ups in stock prices. Examples include his investments in Capital Cities (1985), Salomon Inc. (1987 and 1994), Coca Cola (1988), Gilette (1991), Freddie Mac (1991/2), General Dynamics, (1992), and Gannet Company (1994).
When Buffett bought over $1 billion of Coca-Cola shares, they have appreciated more than five-fold over the prior six years and more than five hundred-fold in the previous sixty years. This decision proved right, as his investment in Coca Cola quadrupled in value over the following three years, far outstripping the S&P 500.
And like Graham before him, Buffett owes much of his success to GEICO. He started buying its stock in 1975 at $2 per share, and kept adding to this investment even as the company’s market cap went from $296 million in 1980 to $4.6 billion in 1996. This growth in valuation corresponded to a compound annual rate of return of 29.2%, an outperformance of over 20% per year more than the S&P500! 
Did Warren Buffett sell his stake in this overvalued  company? To the contrary, in 1996 Buffett bought 50% of GEICO making his firm, Berishire Hathaway 100% owner of GEICO. This was not exactly a value pick, but the decision again proved a winner: by 2011, GEICO’s market cap nearly quadrupled to $20.5 billion based on Warren Buffet’s valuation model.
Even though Graham and Buffett somehow come to epitomize the so-called value-driven investing, both owe a large degree of their success to market trends. In the American stock markets, bullish trends were out in full force through most of Graham’s as well as Buffett’s careers which were most abundantly blessed by some of their most “overvalued” investments. In essence, Graham and Buffett may both have overtly espoused value investing because it’s a rational style that sits well with investors. However, their investment performance was arguably driven far more by momentum and trends than by superior value picks.
The foregoing was an excerpt from Chapter 6 of my book (see below).
Alex Krainer is an author and hedge fund manager based in Monaco. Recently he has published the book “Mastering Uncertainty in Commodities Trading“.
 Sizemore, Charles. “The Worst Investment of Warren Buffett’s Career.” Forbes, 5/8/2013.
 Graham, Benjamin. The Intelligent Investor. New York: HarperBusiness, 2003. p. 73.
 When Graham says, “partners,” he means himself and Newman.
 Graham, Benjamin. The Intelligent Investor. New York: HarperBusiness, 2003. p. 532, 533.
 These investments are treated in some detail in R. Hagstrom’s “The Warren Buffett Way.”
 Hagstron, Robert G. The Warren Buffett Way. New York: Wiley Investments, 1995. (v)
 During the same period, S&P500 grew by 8.9% per year
 At the time, GEICO’s book value was $1.9 billion, which means that the remaining part of its $4.6 billion market cap was goodwill, rendering GEICO’s shares very “expensive” by Buffett’s value standards.