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Investing for Beginners with Benjamin Graham

Successful investing is the key to financial stability and building wealth. But when you're starting out, the prospect can be daunting. The field of finance is surrounded by fears and misconceptions - investing is complicated, one must know advanced math, building wealth requires taking risks, stock markets are dangerous etc. Today we will try to debunk some of those myths, and see what you really need to know to invest safely and successfully.

Warren Buffett (Trades, Portfolio) is possibly the world's most successful investor, and his investments are primarily in stocks. Stocks have many advantages over other investments. They have more liquidity, they are naturally hedged (protected) against inflation, and most importantly, they have historically beaten all other forms of investment.

Benjamin Graham was Warren Buffett's professor and mentor at Columbia Business School. In fact, Buffett even named his son after Graham, and describes Graham's book The Intelligent Investor as "by far the best book about investing ever written". In this article, we'll look at how Graham's methods can be applied - as faithfully as possible - to today's stock markets using modern technology.

What Are Stocks and How Do They Grow

Owning a stock is the legal equivalent of owning a share of a company. For ease of investing, stocks are traded on stock markets. The price quoted for a stock on the market changes every day, and there are often large differences between the underlying worth of a stock and the price quoted for it. Highly underpriced and overpriced stocks tend to correct themselves over time, as do highly underpriced and overpriced markets as a whole.

If a stock is chosen correctly, one's investment will grow as the stock price corrects itself, and also as the company grows. This is where Graham's teachings come into play - finding the right companies at the right price. Companies and their accountants are constantly trying to make their stocks look better. The challenge for investors is to uncover the facts behind the financial statements and annual reports.

Evaluating Stocks - The Quantitative Measures

The first numbers to look at when evaluating a stock are its Earnings Per Share (EPS) and Book Value Per Share (BVPS). If you were buying groceries, EPS and BVPS are similar to weight or quantity. They tell you "how much" of something you're getting for your money.

Earnings Per Share:

EPS tells you how much profit that company makes per share.

EPS combined with price gives you a rough idea of what rate of return you can expect on your investment. EPS and Price are usually mentioned together as the PE ratio, or Price-to-Earnings ratio.

Book Value Per Share:

BVPS is the theoretical liquidation value of the stock. That is, if the company were to close tomorrow, BVPS tells you how much you would be paid per share after all the company's assets are sold at their depreciated prices, and all liabilities are paid.

However, most companies today also include things like Goodwill and other intangibles - which have no real resale value - in their balance sheets. So it's very important to use only tangible book values when evaluating stocks.

Evaluating Stocks - The Qualitative Measures

When buying something, we also need to look at "how good" it is, and not just "how much" we're getting. Graham recommended three different qualitative categories of stocks, and different quantitative requirements for each of them.

Just as with buying anything else, the fewer qualitative measures a stock meets, the more quantity (EPS and BVPS) it will be required to provide per Dollar.

First Quality - Defensive Stocks:

The safest qualitative category of stocks recommended by Graham are called Defensive stocks. The criteria that Graham specified for identifying Defensive stocks are as follows:

Summarized from Chapter 14 of The Intelligent Investor - Stock Selection for the Defensive Investor:
1. Not less than $100 million of annual sales.
[Note: This works out to $500 million today based on the difference in CPI/Inflation from 1973]
2-A. Current assets should be at least twice current liabilities.
2-B. Long-term debt should not exceed the net current assets.
3. Some earnings for the common stock in each of the past 10 years.
4. Uninterrupted [dividend] payments for at least the past 20 years.
5. A minimum increase of at least one-third in per-share earnings in the past 10 years.
6. Current price should not be more than 15 times average earnings.
7. Current price should not be more than 1-1⁄2 times the book value.
As a rule of thumb, we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5.

Graham's recommended price for Defensive stocks can be calculated from criteria #6 and #7. This price is popularly known as the Graham Number.

Note that the Graham Number is designed to quantitatively assess any stock that meets the Defensive qualitative requirements, regardless of sector or industry. For example, a public utility company that is typically low on Earnings will need a higher than average asset figure to justify its price. Similarly, a Financial Services company that is typically low on assets will need a higher than average Earnings figure to be an acceptable investment.

Graham recommended a minimum portfolio size of 10 for Defensive stocks, or in other words, not more than 10% of total investment per Defensive stock.

Second Quality - Enterprising Stocks:

For Enterprising investors who are looking for greater profits - and are willing to put in more effort into the maintenance of their portfolio - Graham then recommended the following criteria for identifying Enterprising quality stocks:

Summarized from Chapter 15 of The Intelligent Investor - Stock Selection for the Enterprising Investor:
[Note: For issues selling at P/E multipliers under 10]
1-A. Current assets at least 1 1⁄2 times current liabilities.
1-B. Debt not more than 110% of net current assets.
2. Earnings stability: No deficit in the last five years covered in the Stock Guide.
3. Dividend record: Some current dividend.
4. Earnings growth: Last year's earnings more than those of 1966.
[Note: Corresponds to the earnings of 5 years ago]
5. Price: Less than 120% net tangible assets.

Thus, the price limit for a stock meeting Enterprising quality requirements is the lower of 120% net tangible assets (book value), or 10 times current earnings. We can combine the two - as Graham did for the Defensive Price - to yield a quantitative price calculation similar to the Graham Number. We'll call this the Serenity Number.

Just like the Graham Number, the Serenity Number too applies to any stock, regardless of sector or industry, because it's a combination of both Assets and Earnings. A lower value in one will have to be compensated for by a higher value in the other.

Serenity's recommendation is for a minimum portfolio size of 20 for Enterprising stocks, or in other words, not more than 5% of total investment per Enterprising stock.

Third Quality - NCAV Stocks or Net-Net Stocks:

For investors who were willing to put in the most effort into the maintenance of their portfolio, Graham finally recommended NCAV quality stocks, which he defined as:

Summarized from Chapter 15 of The Intelligent Investor - Stock Selection for the Enterprising Investor:
"Bargain Issues, or Net-Current-Asset Stocks"
"...price less than the applicable net current assets alone - after deducting all prior claims, and counting as zero the fixed and other assets."
"...eliminated those which had reported net losses in the last 12-month period."

These criteria give us stocks selling for less than the value of their cash worth alone, and with positive earnings in the last one year.

Since NCAV stocks are the least established of all stocks, they also require the most diversification. A portfolio of NCAV stocks will require at least 30 NCAV stocks, or not more than 3.3% of total investment per NCAV stock.

Getting Down to Business - Finding Graham Stocks Today

The good news is that today's technology makes it easy to find stocks that meet even such advanced criteria. Applying data-mining algorithms on Serenity's data warehouse of 5000 NYSE and NASDAQ stocks allows us to screen the entire stock market and filter out just the ones that meet the Graham criteria.

Few stocks meet all of Graham's Defensive criteria today. But it is also possible to find stocks that meet all the qualitative Defensive criteria, and part of the quantitative Defensive criteria. Both types are shown on The Benjamin Graham Stock Screener below.

Symbols: UVV, CATO, DE, HP, CSH, SCL

Stocks like Helmerich & Payne (NYSE:HP) and HollyFrontier (NYSE:HFC) that had previously been demonstrated by Serenity's screeners to be Defensive have now appreciated far beyond the quantitative Defensive criteria. The same screener can also be used for similar searches to find stocks meet Graham's Enterprising and NCAV criteria.

Using the more customizable Graham-Number Stock Screener, we can also find stocks that meet different combinations of qualitative and quantitative criteria.

Symbols: MWV, WMK, FRED, CCJ

The Graham Number is essentially 137% of the Serenity Number. Basically, for a given EPS and BVPS, we pay 137% more for a Defensive stock since it is of higher quality than an Enterprising stock.


Thus the search for Enterprising stocks can be replicated on the customizable screener using the values - Current Assets / Liabilities: 75%, Current Assets / Long Term Debt: 90% , Earnings Stability: 50%, Dividend Record: 5% and Graham Number / Price: 137%.

We can also see each of the individual Graham ratings - as well as all the data used for analysis - for each stock.

So once a list of potential stocks for investment is shortlisted with the screeners, the figures used for analysis can be verified with the annual reports on the company websites.

General Graham Principles

A detailed study of all of Graham's principles is beyond the scope of this article. But given below is a summarized list of general Dos and Don'ts based on Graham's teachings and The Intelligent Investor.

Do’s Don’ts
Always invest with a quantifiable Margin of Safety*. Avoid risky transactions. Don’t speculate or gamble.
Invest for the long term, plan for periods of 1-3 years. Don’t try to get rich quick, from frequent trading or from tips/trends.
Apply intelligent effort. Spend time and energy on research. Minimize buying and selling. Ignore forecasts and price/volume behaviors.
Grow your savings, and earn dividends. Don't try to earn an income from frequent trading.
Use discount brokers. They don't give stock advice and charge less in commissions. Avoid full service brokers. Most stock advice is just meant to generate more trades.
Manage your own money as far as possible. Don't trust others with your money, especially when it involves Moral Hazard**.
Invest in Index funds (if you don’t have the time for stock research). Avoid actively managed funds. Most of them do not keep up with the indices.
Pricing - always buy and sell only at the right price. Avoid timing - never enter a position at the wrong price, intending to exit at "the right time".
Buy stocks like groceries - look for good quality, and value for money. Not like perfume - famous and fashionable names are expensive, and usually unprofitable.
Be logical, patient and courageous. If your research is thorough, you will be proved right. Don't be emotional. Don’t sell on panic or buy on greed. Ignore the “manic-depressive" market and its fluctuations.
Be an independent thinker. Success depends on correct data and reasoning, not consensus. Don't follow the herd. Successful strategies and stocks are also usually unpopular.
Keep adequate diversification to mitigate risk. But don't compromise on quality of research with excessive diversification.
Keep it simple. Use basic arithmetic well. Don't be influenced, or intimidated, by big words and financial jargon.

*A Margin of Safety is the central concept of investing as taught by Graham. Essentially, it means to maintain a safe difference between the calculated worth of a stock and the price one pays for it.
**Moral Hazard is the ability to take risks with no fear of personal loss. Most professionals - doctors, lawyers, accountants etc - can be held accountable for their work and their mistakes. But in finance, - since stock markets are considered unpredictable, and since the professionals work with your money - they can take risks with it, lose it, and still get paid.

To Conclude

In The Intelligent Investor, Graham says "Confronted with a [like] challenge to distill the secret of sound investment into three words, we venture the motto - Margin of Safety". This is perhaps the most significant difference in Graham's principles and the generally accepted way of thinking. Almost everyone in the financial world will tell you that for better returns, you need to take greater risks. But Graham taught that in the long run, an investor's overall returns depend on the amount of intelligent effort he was willing to put into his investments, and that increased risk actually reduces returns!

There are those who will say that Graham's principles are outdated or not applicable to all markets. Warren Buffett's article "The Superinvestors of Graham-and-Doddsville" gives a detailed explanation of why the world's most successful investors are Graham's students, and why Graham's principles are fundamental tenets that will hold true forever. The article is available freely online and is also printed as an appendix to The Intelligent Investor. A reading of both Buffett's article and The Intelligent Investor is strongly recommended for any aspiring investor.

About the author:

SerenityStocks - 17-Point Value Investing with Benjamin Graham

Rating: 4.9/5 (7 votes)



SerenityStocks - 8 months ago

Note that there is no reference to the "sell at 50% gains or 2 years" rule in The Intelligent Investor, or any of Graham's recorded interviews. Please be advised that many such misinterpretations are often wrongly attributed to Graham.

Here are Graham's actual notes on selling:

"the only principle of timing that has ever worked well consistently is to buy common stocks at such times as they are cheap by analysis, and to sell them at such times as they are dear, or at least no longer cheap, by analysis."
- Lecture Number Ten, The Rediscovered Benjamin Graham Lectures

"buy wisely when prices fall sharply and to 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."
- The Investor and Market Fluctuations, The Intelligent Investor

"even defensive portfolios should be changed from time to time, especially if the securities purchased have an apparently excessive advance and can be replaced by issues much more reasonably priced"
- Stock Selection for the Defensive Investor, The Intelligent Investor

And here is an important addendum:

"The intelligent investor must carefully evaluate the costs of trading and taxes before attempting to take advantage of any price discrepancy—and should never count on being able to sell for the exact price currently quoted in the market."
- Things to Consider About Per-Share Earnings, The Intelligent Investor

There are numerous such references and the underlying principle in all of them is consistent. The investor is to run the numbers for the Graham portfolio every year, and replace any stock that no longer clears the Graham criteria - either due to price appreciation or company deterioration - with a new stock that does.

If the Graham numbers were run rigorously earlier, the latter scenario - company deterioration - should be unlikely. Graham's Margin of Safety requirements are very thorough. That's why it's so difficult to find stocks that meet them in the first place.

LwC - 8 months ago

SerenitySpam wrote:

"Note that there is no reference to the 'sell at 50% gains or 2 years' rule in The Intelligent Investor, or any of Graham's recorded interviews. Please be advised that many such misinterpretations are often wrongly attributed to Graham." (italics added)

From a Graham interview published in the Financial Journal, Sept/Oct 1976:

"The investor should have a definite selling policy for all his common-stock commitments, corresponding to his buying techniques. Typically, he should set a reasonable profit objective on each purchase--say 50% to 100%--and a maximum holding period for this objective to be realized--say, two to three years. Purchases not realizing the gain objective at the end of the holding period should be sold out at the market."

SerenityStocks - 8 months ago

So the rule is actually "50-100% or 2-3 years", and attributed to a Graham interview of which there is no official record.

The quotes in Serenity's previous comment are from Graham's published books and lectures.

LwC - 8 months ago

SerenitySpam: My mistake, I left out the word "Analysts"; the interview was published in the September/October 1976 issue of Financial Analysts Journal. The interview notes were provided to the Journal for publication by Charles Ellis, who at the time was a member of the Journal's editorial board. FYI the Financial Analysts Journal (originally called Analysts Journal) is published by the New York Society of Security Analysts, of which Graham was one of the founders, and Graham served on the editorial board of the Journal. Contrary to your assertion that there is no official record of the interview, what source might be more credible than a Journal which at one time was co-edited by Graham, published by an entity that was co-founded by Graham?

AFAIK you are the only party who disputes the reality of the interview. Rather than a mea culpa acknowledging your error, apparently you dispute its existence simply because it contradicts your self-described expertise of all things Graham. What a joke. LOL

SerenityStocks - 8 months ago

Graham and Buffett are surrounded by false attributions, LwC.

The material quoted in Serenity's comment is all in print to this today. But there seems to be no official record or copy of the said interview in the said journal.

So while Graham may have made that statement, it just seems more prudent to follow the printed material.

PS: You will greatly improve your credibility by avoiding personal attacks.

Batbeer2 premium member - 8 months ago

Now that it has been discussed what Graham said, perhaps we can discuss what the article says.

Quote 1: Successful investing is the key to financial stability and building wealth.

I'm not sure that's true. I'd say underspending your income is the key. Then if you are left with cash you don't need, you could consider investing in stocks. I can think of half a dozen ways to build wealth without trading on the stock market as long as you underspend your income.

Quote 2: But when you're starting out, the prospect can be daunting.

Again, as long as you are using cash you don't need, why would it be daunting?

Quote 3: If a stock is chosen correctly, one's investment will grow as the stock price corrects itself.

I would argue that if a stock is chosen correctly, the price will not refect the value for a very long time. There are stocks that have never traded at the right price. Ever. Take Danaher. Split adjusted it was trading at $3.5 in 1995. Now it's at $85.

So at what point in the past two decades did the price of Danaher accurately reflect its value?

Graham taught one thing and often did another. He was heavily invested in Geico which is even better than Danaher.

FWIW I believe he was teaching a method that he knew any of his students could execute while as an investor he was often doing what he knew only the talented could do. Of course those students with the requisite talent would eventually figure it out anyway. Perhaps Graham knew this. Buffett now owns Geico.

Just some thoughts from a beginner. Thanks for an interesting article.

LwC - 8 months ago

"But there seems to be no official record or copy of the said interview in the said journal."

SerenitySpam: A copy of the interview published in the September/October 1976 Financial Analyst Journal is available from the New York Society of Security Analysts; what could be more "official" than that?. Also the interview has been reprinted recently so it's currently in print, and now you have revealed your ignorance again. You seem to think that if you don't know about it, it doesn't exist. LOL. Even worse, even though I have provided you with the information, you still argue that it doesn't exist which must mean that you haven't bothered to check, or you're just lying about it. Rather than acknowledge your error, you just keep digging your hole. IMO the "prudent" thing to do is just acknowledge your error.

SerenityStocks - 8 months ago

Thank you for a very informative comment, Batbeer2.

You may be right on most counts. Here are a few things to consider.
1. Graham always recommended against day trading and speculation, and so does Serenity. The word "investing" here does not imply trading, only long term investing.
Investment could be in stocks, land, gold or even one's own brand (like celebrities) or company. The meaning intended here was that to grow wealthy, one needs to understand the power of compounding (as compared to linear income).
This article in particular discusses compounding with stocks.
2. It's quite difficult to grow wealthy using only cash you don't need. Realistic average annual returns don't usually exceed 20-25%. So one needs to be able to deploy valuable assets for significant gains. That's why it becomes important to understand and stay within the Margin of Safety.
3. Voting machine vs Weighing machine. Stocks can stay under/overvalued for prolonged periods and yes, many at the extreme ends of the spectrum may never completely correct.

But they don't need to correct completely for you to profit from them. In fact, stocks at the extreme end offer a higher probability for profits, even if they never fully correct.

Laslty, your point about Graham's advanced methodologies is actually quite well known. He's even said that himself.

The last of Graham's strategies is "Special Situations". But Graham did not recommend it for the ordinary investor as it supposedly required a high degree of skill, experience and resources.

Warren Buffett himself explains - in the "Legacy of Benjamin Graham" video - how Graham was completely focussed on refining methods that ordinary investors could apply to achieve results similar to his own (Grahams's).

Again, thank you for a very thoughtful comment!

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