Benjamin Graham (1894-1976)

 

 

 

Background

 

·        Nicknamed the "Dean of Wall Street"

·        Laid out the principles of "value-oriented investment", i.e. the use of fundamentals in guiding the valuation of securities

·        Professor and mentor of Warren Buffett at Columbia University

·        Ran an investment firm Graham-Newman Corp. (1929 – 1956)

·        Influenced the development of Chartered Financial Analyst (CFA) certification

 

Investment vs. Speculation

 

"An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return."

- Benjamin Graham, Security Analysis: Principles and Techniques (1934 ed.), Chapter 4 (Distinctions between Investment and Speculation), p. 54

 

Six Essential Factors to Analyze a Business

 

1)      Profitability

2)      Stability

3)      Growth in earnings

4)      Financial position

5)      Dividends

6)      Price history

 

Investment Philosophy

 

Graham relied heavily on quantitative analysis to evaluate securities.  Graham suggested that an investor's focus should be on the balance sheet of a business and not the income statement.  By using concrete facts, Graham felt he could ensure a margin of safety that could not found using earnings figures.  Using the balance sheet and a number of numerical tests, Graham often found companies priced below net asset value.  Graham often looked for businesses with indicators such as the following:

 

Ø      Debt/Equity < 50%

Ø      Price/Book < 1.2

Ø      Current Ratio > 2

Ø      Quick Ratio > 1

Ø      Price/Net Working Capital < 1

Throughout Graham's life, there were fourteen investment philosophies he consistently preached.  Each of those is summarized below (Lowe, 1994).

 

  1. Be an investor, not a speculator.  “Let us define the speculator as one who seeks to profit from market movements, without primary regard to intrinsic values; the prudent stock investor is one who (a) buys only at prices fully supported by underlying value and (b) determinedly reduces his stockholdings when the market enters the speculative phase of a sustained advance.”
  2. Know the asking price.  Multiply the share price by the number of total shares (undiluted) outstanding. Ask yourself, if I bought the whole company would it be worth this much money? In other words, is the company worth its market capitalization?
  3. Hunt the market for bargains.  Apply the “net current asset value” rule (NCAV). Find NCAV by subtracting all liabilities (including short-term debt and preferred stock) from current assets.  By purchasing stocks below the NCAV, the investor buys a bargain because nothing at all is paid for the fixed assets of the company.
  4. Buy the Formula.  Intrinsic Value of a Stock = (EPS)(2 * Expected Earnings Growth Rate + 8.5)(Current yield on AAA corporate bonds / 4).  The 8.5 represents an appropriate P/E multiple for a company with static growth.
  5. Regard corporate figures with suspicion. It is a company's future earnings that will drive its share price higher, but estimates are based on current numbers, of which an investor must be wary. Even with more stringent rules, current earnings can be manipulated by creative accountancy. An investor is urged to pay special attention to reserves, accounting changes and footnotes when reading company documents.
  6. Don't bother about precision.  Realize that you are unlikely to hit the precise "intrinsic value" of a stock or a stock market right on the mark. A margin of safety should provide a peace of mind and protect an investor.
  7. Don't worry about the math.  “In 44 years of Wall Street experience and study, I have never seen dependable calculations made about common stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give speculation the deceptive guise of investment.”
  8. Diversify, Rule #1.  “My basic rule is that the investor should always have a minimum of 25 per cent in bonds or bond equivalents, and another minimum of 25 percent in common stocks. He can divide the other 50 percent between the two, according to the varying stock and bond prices.”
  9. Diversify, Rule #2.  An investor should have a large number of securities in his or her portfolio, if necessary, with a relatively small number of shares of each stock. Individual investors should have at least 30 different holdings of equities, even if it is necessary to buy odd lots. The least expensive way for an individual investor to buy odd lots is through a company's dividend re-investment program (DRP).
  10. When in doubt, stick to quality.  Good earnings, solid dividend payout histories, low debt, reasonable P/E's. “Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices. They make their serious mistakes by buying poor stocks, at lower prices, particularly the ones that are pushed for various reasons. And sometimes they make mistakes buying good stocks in the upper reaches of bull markets.”
  11. Use dividends as a clue.  Risky growth stocks seldom pay dividends. “I believe that Wall Street experience shows clearly that the best treatment for stockholders is the payment to them of fair and reasonable dividends in relation to the company's earnings and in relation to the true value of the security, as measured by any ordinary tests based on earnings power or assets.”
  12. Defend your shareholder rights.  “I want to say a word about disgruntled shareholders. In my humble opinion, not enough of them are disgruntled.” Pay attention to executive compensation, dividend policies, etc. and complain if you feel management is not acting in shareholders' best interest.
  13. Be Patient.  “Every investor should be prepared financially and psychologically for the possibility of short-term losses. For example, in the 1973-74 decline the investor would have lost money on paper, but if he'd held on and stuck with the approach, he would have recouped in 1975-1976 and gotten his 15 percent average return for the five year period.”
  14. Think for yourself.  Don't follow the crowd. “There are two requirements for the success in the Wall Street. One, you have to think correctly; and secondly, you have to think independently.” Do not ever stop thinking.

 

Approaches to Common Stock Investment

 

  1. Cross-Section Approach
  2. Anticipation Approach
  3. Margin of Safety Approach

 

Common Stock Selection Criteria

 

A. Reward Criteria

 

  1. An earnings-to-price yield at least twice the AAA bond yield
  2. A P/E ratio less than 40% of the highest P/E ratio the stock had over the past five years
  3. A dividend yield of at least two-thirds the AAA bond yield
  4. Stock price below two-thirds of tangible book value per share
  5. Stock price below two-thirds "net current asset value."

 

B. Risk Criteria

 

  1. Total debt less than book value
  2. Current ratio greater than two
  3. Total debt less than twice "net current asset"
  4. Earnings growth of prior 10 years at least at a 7% annual compound rate
  5. Stability of growth of earnings in that no more than two declines of 5% or more in year-end earnings in the prior 10 years are permissible.

 

 

References:

 

Graham, Benjamin and David L. Dodd, "Security Analysis: Principles and Techniques", New York: McGraw-Hill, 1934.

 

Graham, Benjamin and Spencer B. Meredith, "Interpretation of Financial Statements", New York: Harper, 1937.

 

Graham, Benjamin, "The Intelligent Investor: A book of practical counsel". New York: Harper Collins, 1949.

 

Lowe, Janet. "Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street", Chicago: Dearborn Financial Publishing, 1994.