Without Benjamin Graham, would there have been value investing? Or would there have been a Warren Buffett (Trades, Portfolio)? Perhaps, perhaps not.
In chapter five of “Value Investing: A Comprehensive Beginner Investor’s Guide,” author Blaine Robertson told us about the work of Graham, who pioneered the value investing strategy.
The author started with several prominent markers:
- The 1929 crash, in which Graham lost most of the money he had earned working on Wall Street.
- The Securities Act of 1933, which required corporations to provide financial statements that had been audited by independent accountants.
- Publication of “Securities Analysis” in 1934, which was written by Graham and David Dodd.
- Publication of “The Intelligent Investor,” written solely by Graham, in 1949.
In addition to his work on Wall Street, Graham also taught at Columbia University, his alma mater. There he taught a young Buffett, as well as many other young investors who were to become successful money managers. Buffett would later go on to work for his mentor at the Graham-Newman Corp.
Before writing “Securities Analysis,” Graham observed that many companies had liquidation values that were greater than their share prices. And so he began the practice of buying such shares for their “true value.” The author offered the simple example of a stock having value (liquidation) of $6; if that stock could be bought for $3 per share, he would buy it.
Robertson noted that one of Graham’s most important teachings was about the freedom of the investor. Graham illustrated this idea by introducing Mr. Market, a constant investment companion who will continually offer to sell you shares and to buy the shares you now own. Some days his offers are high and some days they are low. But you always have the right to refuse, you cannot be pressured into buying or selling.
There is no pressure because Mr. Market will always be around with his offers. This means you can wait for an offer that combines low risk (margin of safety) with potentially higher prices in the long run. All in all, Mr. Market was an early introduction to the psychology of the market (now captured within the field of behavioral finance).
Continuing his case, Robertson pointed out that an investor who is not caught up in the emotions of the market will have opportunities to buy low-risk stocks. Graham, he wrote, had two techniques to cope with the emotions and volatility of the market:
- Dollar-cost averaging, in which a person invests the same number of dollars in regular intervals, such as monthly, rather than investing it all in just one transaction. This allows investors to take advantage of any reductions in the price and dampens higher prices when the stock’s price increases. It also removes most timing concerns that come with making a big purchase.
- Invest in debt as well as equities to help preserve and grow your capital. Graham advocated making bonds 25% to 75% of portfolios.
The margin of safety was also introduced by Graham, which he described as buying a stock at a price that is below its fair value. Using the margin concept reduces risk and could increase profits. As Robertson wrote, the margin of safety concept continues to be the backbone of all new innovations in the field of value investing.
The author also pointed to the necessity of knowing one’s self, as an antidote to the emotion of the market. To start, are you an active investor or a passive investor?
- Active investors, whom Graham referred to as “enterprising investors,” are those who spend a lot of time and energy in order to become good investors. They expect above-average returns to be the reward for their hard work.
- Passive investors are those who are unwilling or unable to commit time and energy to investing, and thus must be satisfied with average returns. In many cases, this will involve investing in index funds. Even Buffett is an advocate for index funds, arguing that bringing in average returns should be considered an accomplishment. For Graham, a defensive investor was someone who invested in both bond and equity index funds.
Robertson returned to the issue of investor versus speculator and cited Graham as saying not everyone in the equities market deserved to be called an investor. Real investors consider themselves the owners of a business, while speculators are people who trade pieces of paper.
The “Graham number” was also brought in by the author. This involves a company’s book value per share and its earnings per share. The number is calculated by taking the square root of “22.5 x (earnings per share) x (book value per share).” The output, the Graham number, is considered a stock’s fair value. Thus, a number that is below a stock’s price would have a margin of safety and a number above the price would be considered overpriced.
That 22.5 figure in the formula is a constant, and Graham arrived at it by arguing that only price-earnings ratios below 15 should be considered and that the ratio should not be greater than 1.5. Multiplying 15 by 1.5 produces 22.5.
Conclusion
In chapter five of “Value Investing: A Comprehensive Beginner Investor’s Guide,” Robertson introduced his readers to some of the main ideas of Graham. The inclusion of Graham is important because he is considered the father of value investing, and his ideas have propelled many of his followers into what Buffett called “The Superinvestors of Graham-and-Doddsville” fame.
Graham lost much of his capital in the crash of 1929 and, as a result, began looking for a better way to invest. Out of that came what we now know as value investing, which is based on the idea of buying a stock for less than its intrinsic or fair value. That provided a margin of safety, which reduced risk and presented an opportunity to profit when the stock price rose to or above its fair value.
The guru also introduced Mr. Market, the ever-present associate who is always offering to buy from and to sell to investors. He represents the changing emotional state of markets, and the freedom of investors to reject his offers until they find something that is right for them.
Read more here:
- Value Investing: What's Behind Fundamental Analysis?
- Value Investing: Value vs. Growth Investing and Speculation
- Value Investing: An Introduction
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