Do you know who your father is? Value investors everywhere would instantly answer, Benjamin Graham.
Photo: New York Guild for the Jewish Blind
Benjamin Graham, born in the late 1800s, is credited as being the father of the value investing movement. His legacy is the teachings he left behind, showing investors all over the globe how to manage, invest and grow their wealth. The theories and principles he came up with after graduating from Columbia University in 1914 are still in force, even today.
He was not just a teacher, but a very successful investor as well. Graham’s investment firm returned an average of 20% between 1936 and 1956. At that rate $10,000 invested with Ben Graham would grow to more than $380,000. This return easily beats the 12.2% average return of the overall market in the same time.
20% versus 12.2% may not seem like a big difference at first but $10,000 invested in the overall market would have returned just under $100,000 in the same time.
A man of much influence
Benjamin Graham introduced a number of foundational concepts in investing and wrote two of the seminal texts of the field: Security Analysis, published in 1934, and The Intelligent Investor, published in 1949.
In Security Analysis, Graham – with the help of his co-author David Dodd – lays out the foundations of what today is known as “value investing”. Value investing is the practice of researching and investing in stocks that are mispriced by the market. The driving idea behind this investment method is to find a bargain – find a company that is trading for a price below what it’s truly worth and snatch it up before the market figures out what’s happening.
It was in Security Analysis that the phrase margin of safety first appears. Margin of safety (value investing) refers to the difference between the price you pay for a stock and its intrinsic value. For example, imagine you’ve conducted extensive research on McDonald’s corporation. You find that the intrinsic value of the company is $200 a share. As of May 2017, the shares trade for $148, giving you a margin of safety of about $50.
Learn more: fundamental analysis of stocks
Graham then gave us The Intelligent Investor. In this book, what maybe one of the best books on investing ever written, he introduces the idea of Mr. Market – a character that embodies the financial markets. If you own a stock, Mr. Market is going to knock at your door every day offering to buy or sell shares of that stock at a certain price. The catch is that Mr. Market is a bit of a mischievous spirit. Usually the prices he quotes are reasonable but sometimes they’re just completely absurd.
The character of Mr. Market serves to illuminate the way in which the stock market behaves. On any given day, market prices can be right on, or otherwise totally undervalue or overvalue your ownership stake in a business. You are then faced with the decision to buy, sell or otherwise ignore Mr. Market.
Smart value investors know to mostly ignore the market. You may be faced with a price below what the company is worth, but you can rest easy because you know what the business is truly worth, and that Mr. Market will be back at your door the next day with a different price.
Graham’s works and teachings have immense influence in the modern world. Perhaps the most famous exponent of value investing is Warren Buffett – the world’s second richest man – who cites the Columbia professor as one of the most influential people in his life.
Benjamin Graham gave us margin of safety, intrinsic value, pushed investors to regard stocks as ownership stakes in a business, rather than a means of speculation and birthed Warren Buffett. Basically any sound investment advice you’ve heard in the last 50 years can be attributed to a British-born American investor named Ben Graham.
Learn more: warrant vs option
Benjamin Graham Game plan
Benjamin Graham followed the cigar-butt approach to investing.
His method involved finding beaten up, troubled companies whose shares were trading at low prices. Whether these companies were in trouble, or just perceived to be, Graham was interested because the stock prices were cheap enough where the earnings, cash flow and other fundamentals looked attractive even if the overall investment environment didn’t look great.
Graham would buy these stocks, and hold on long enough to make a quick profit. He likened this approach to someone walking down the street and spotting a discarded, but not fully smoked, cigar butt on the floor. Graham advocated stopping and picking up that cigar butt to enjoy that last puff before throwing it away for good. In a letter to his shareholders, Buffett explained that “[while] the stub might be ugly and soggy, the puff would be free”.
Beyond that philosophy Graham suggested a simple formula for beginners investing in stocks. He advocated holding a portfolio which met specific criteria:
· Strong and long track record of paying dividends: try to find companies that have paid dividends for at least 20 years uninterrupted
· In 1972 Graham suggested only investing in companies with $100 million in annual sales (industrials) and $50 million for public utilities. Today those numbers would be around $600 and $300 million respectively.
· Strong financials: for industrials, Graham recommended investing in companies with current assets twice that of current liabilities and debt that did not exceed net current assets.
· Positive earnings in the last five years and there should be evidence of growth in the last ten years (3% average annual growth rate).
· Price to earnings ratio no more than 15
· Price to book ratio no more than 1.5 (book value of shares)
By following this investment checklist a beginner investor could place themselves well for the future (investment terms for beginners). The focus is on companies with decent fundamentals and the ability to continue their performance into the future. John Reese, a money manager and contributor at Forbes, reports that his Graham-inspired portfolio, based on the criteria above, returned 13.3% annualized over a decade versus 3.9% for the S&P 500.
That’s a massive outperformance and is supported by the Graham Defensive Investor screen set up by the AAII. Since the inception of the screen, Graham’s strategy has outpaced the market by nearly 3 percentage points (7.7% vs. 4.8%).
Use the formula or tweak the rules at your own leisure. What remains is a philosophy of investing that emphasizes careful examination of the underlying investment. You can’t go wrong there.
Sources
Investing, Intelligent. “How Buffett And Greenblatt Both Moved On From ‘Cigar-Butt’ Investing.” Forbes. Forbes Magazine, 19 Jan. 2016. Web. 21 May 2017.
Investing, Intelligent. “Ben Graham’s 60-Year-Old Strategy Still Winning Big.” Forbes. Forbes Magazine, 18 Dec. 2012. Web. 22 May 2017.
Stockopedia. “Benjamin Graham Defensive Investor Screen: How does it work?” Business Insider. Business Insider, 06 May 2011. Web. 22 May 2017.
Jiva Kalan is a writer whose work has been featured on DailyFinance, the Wall Street Survivor, Plousio and Financial Choice.
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