Benjamin Graham is widely regarded as the Father of Value Investing.
His books, Security Analysis and The Intelligent Investor, pioneered the concept of making money through ‘undervalued’ shares. Co-authored with David Dodd and published in 1934, Security Analysis is an epic tome, describing in detail how to analyse a company’s financial statements. However, penned in 1949, The Intelligent Investor is the book Graham is most well known for.
While touching on the techniques of company analysis, The Intelligent Investor largely focused on general investment principles and investors’ attitudes. Within the book, Graham introduced the concepts of “Margin of Safety” and “Mr. Market“. He also coined the phrases “Investing is most intelligent when it is most businesslike” and “In the short run, the market is a voting machine but in the long run, it is a weighing machine”.
Warren Buffett says The Intelligent Investor is “by far the best book about investing ever written“. Indeed, after reading the book in 1950, Buffett promptly signed up for Graham’s investment course and eventually started working for Graham in 1954.
Between 1926 and 1956, Graham’s investment fund generated a 17% average compound return. How did Graham’s value techniques produce that performance?
Look for value
Graham gave three pointers for the “enterprising investor”: the relatively unpopular large company, “special situations”, and “bargain issues”.
While “the purchase of low-multiplier stocks of important companies (such as the Dow Jones list)” and various arbitrage plays helped underpin his partnership’s record, it’s the bargain issues that Graham is most famed for. In this respect, Graham would look for companies who were valued at less than their net current assets.
As Graham wrote: “It always seemed… ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone — after deducting all prior claims, and counting as zero the fixed and other assets — the results should be quite satisfactory”.
Graham’s fund typically bought shares that were selling for two-thirds of their ‘stripped-down’ asset value. What’s more, Graham was happy with a wide diversification. During most years, his partnership had at least 100 different ‘bargain’ shares.
While Graham’s share picking strategy may now be a little dated, his advice on how investors should approach the share market remains firmly intact.
For instance, fifty years ago he pointed out the dangers of an investor’s ‘advisors’:
“The intelligent investor will not do his buying and selling solely on the basis of recommendation received from a financial service…Since his business is to earn commissions, [a customer’s broker] can hardly avoid being speculation-minded”.
Graham’s attitude towards market fluctuations is encapsulated in the imaginary Mr Market, an obliging character that quotes you a price on your shares every day. Fortunately for the investor, Mr Market often lets his enthusiasm or his fears run away with him, and sometimes proposes values that are “little short of silly“.
As Graham summarises: “[Price fluctuations] provide [the true investor] with an opportunity to buy wisely when prices fall sharply and sell wisely when they advance a great deal. At other times, he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”
Margin of safety
But the real crux of Graham’s investment philosophy, and for that matter, of all true investors, was this:
“Confronted with the challenge to distil the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY…
By definition, [a margin of safety is] a favourable difference between price on the one hand, and indicated or appraised value on the other… To have a true investment, there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by a reference to a body of actual experience“.
Essentially, the margin of safety is akin to buying what you think is worth $1 for just 50 cents. Thus if your assessment of the underlying company’s finances, its prospects, its products and so on, is eventually proved wrong, the margin of safety minimises the investment downside.
However, if your assessment proves correct and the market valuation moves higher to adequately reflect the company’s ongoing performance, so you generate your investment return.
Fair weather losses
Another point underpinning Graham’s aversion to investment loss was his distaste for ‘fair-weather’ businesses bought at ‘fair-weather’ prices. Published in 1972, just four years before his death, the fifth edition of The Intelligent Investor contains — in retrospect — an ominous appendix.
Between 1968 and 1971, Graham analysed the performance of a number of companies with names beginning with Compu-, Data-, Electro-, Scien- and Techno-.
“The harrowing results shown by these samples are no doubt indicative of the quality and price history of the entire group of “technology” issues. The phenomenal success of IBM and a few other companies was bound to produce a spate of public offerings of new issues in their fields, for which large losses were virtually guaranteed“.
For all investors, novice or experienced, Graham’s work makes essential reading.