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 (HP) and HollyFrontier (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.
|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.
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.