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Considerations When Selecting Benjamin Graham-Type Stocks

October 29, 2013 | About:
Benjamin Graham, the father of value investing, had a set of rules that he would follow when selecting generally undervalued stocks. These rules would generally lead to the purchase of low price-to-earnings and low price-to-book stocks. This method of investment led individuals to buy quantitatively cheap stocks.

However, there are a few considerations that investors need to be aware of when purchasing these cheap stocks.

Below I have compiled a few quotes (from legendary investors) that discuss different aspects of investing in Benjamin Graham-type stocks. (Please note that I have bolded some words and phrases in the following quotations for emphasis.)

Quote 1

“It always seemed, and still seems, 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. There were so, in our experience, for more than 30 years – say, between 1923 and 1957 – excluding a time of real trial in 1930-1932.

…Thanks for the lecture, says the gentle reader. But what about your ‘bargain issues’? Can one really make money in them without taking a serious risk? Yes indeed, if you can find enough of them to make a diversified group, and if you don’t lose patience if they fail to advance soon after you buy them. Sometimes the patience needed may appear quite considerable.”

(Benjamin Graham, Intelligent Investor, pp. 391-393)

Quote 2

“DEMPSTER MILL MFG.

This situation started as a general in 1956. At that time the stock was selling at $18 with about $72 in book value of which $50 per share was in current assets (cash, receivables and inventory) less all liabilities. Dempster had earned good money in the past, but was only breaking even currently.

The qualitative situation was on the negative side (a fairly tough industry and unimpressive management), but the figures were extremely attractive. Experience shows you can buy 100 situations like this and have perhaps 70 or 80 work out to reasonable profits in one to three years. Just why any particular one should do so is hard to say at the time of purchase, but the group expectancy is favorable, whether the impetus is from an improved industry situation, a takeover offer, a change in investor psychology, etc.”

(Warren Buffett, Buffett Partnership Ltd., January 18, 1964 Letter to Partners)

Quote 3

Mistakes of the First Twenty-Five Years (A Condensed Version)

My first mistake, of course, was in buying control of Berkshire. Though I knew its business - textile manufacturing - to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal.

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long- term performance of the business may be terrible. I call this the "cigar butt" approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the "bargain purchase" will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original "bargain" price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.”

(Warren Buffett, Berkshire Hathaway Chairman’s Letter – 1989)

Quote 4

“As one factor, Graham had this concept of value to a private owner what the whole enterprise would sell for if it were available. And that was calculable in many cases.

Then, if you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, he would say that you've got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business, this significant excess of real value per share working for you means that all kinds of good things can happen to you. You had a huge margin of safety ‑ as he put it ‑ by having this big excess value going for you.

But he was, by and large, operating when the world was in shell shock from the 1930s ‑ which was the worst contraction in the English-speaking world in about 600 years…. People were so shell-shocked for a long time thereafter that Ben Graham could run his Geiger counter over this detritus from the collapse of the 1930s and find things selling below their working capital per share and so on.

And in those days, working capital actually belonged to the shareholders. If the employees were no longer useful, you just sacked them all, took the working capital and stuck it in the owners' pockets. That was the way capitalism then worked.

Nowadays, of course, the accounting is not realistic because the minute the business starts contracting, significant assets are not there. Under social norms and the new legal rules of the civilization, so much is owed to the employees that, the minute the enterprise goes into reverse, some of the assets on the balance sheet aren't there anymore.”

…At any rate, the trouble with what I call the classic Ben Graham concept is that gradually the world wised up and those real obvious bargains disappeared. You could run your Geiger counter over the rubble and it wouldn't click.”

…And, by the way, the bulk of the billions in Berkshire Hathaway have come from the better businesses. Much of the first $200 or $300 million came from scrambling around with our Geiger counter. But the great bulk of the money has come from the great businesses.”

(Charlie Munger, Art of Stock Picking)

The first item to consider when purchasing Benjamin Graham-type stocks is diversification. Quotes 1 & 2 talk about purchasing a diversified group of these “bargain issues” and that the “group expectancy is favorable” for these stocks. Trouble can occur when one tries to concentrate too heavily on just one of these bargain issues.

In Quote 3, Buffett states it was a mistake to buy control of Berkshire because “the price looked cheap.” In this same quote, he also discusses the merits of buying “cigar-butt” businesses versus buying wonderful businesses.

In Quote 4, Charlie Munger highlights the fact that when one purchases Benjamin Graham-type stocks nowadays, they have to understand that “the accounting is not realistic because the minute the business starts contracting, significant assets are not there.” Munger also mentions that bargain issues were more prevalent in the 1930s than today. Furthermore, he states that, while Berkshire Hathaway (BRK.A)(BRK.B) made much of its first $200 million or $300 million in bargain issues, the great bulk of the money made by Berkshire came from the better businesses.

So, if you are thinking about owning Graham-type stocks, you should probably do a few things:

1) Determine if you can purchase a diversified portfolio of bargain issues (concentration can be very dangerous even if you somehow get control of the company).

2) Make sure that whatever you decide to purchase is in fact a bargain issue (i.e. it is probably a good exercise to try and figure out what a company’s balance sheet would look like if the business started going into reverse – or had to be liquidated).

3) Ask yourself if bargain issues are the best investments available right now (i.e. are bargain issues currently better investments than wonderful businesses – where time is on your side?).

I hope that the considerations discussed in this article help you think through any purchases of Graham-type stocks you might choose to make in the future.

Happy hunting!

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