In chapter three of “The Little Book of Value Investing,” Christopher Browne helped us understand value investing by directing our attention to Benjamin Graham’s early years as a loan analyst at a bank.
From that experience, Graham developed what were to become the two key principles of value investing: only buy stocks that are on sale to get a margin of safety and intrinsic value.
In this chapter, Browne built on the safety and profitability provided by these principles. As a credit analyst, Graham wanted to see some collateral to justify a loan (or a stock purchase). In the case of a stock purchase, that collateral was the difference between the price being asked and price at which a knowledgeable buyer would purchase the whole company in an open auction (the margin of safety).
Graham recognized he might make mistakes in his analysis or that there might be unforeseen events, either of which would force him to lower his estimate of a company’s value. As long as he had a reasonable cushion—or intrinsic value—he was relatively safe. Browne wrote, “These are sound lending principles and should be sound investing principles.”
This approach seems obvious to value investors today, but in Graham’s day it was revolutionary. Most investors in the 1920s and 1930s were speculators and stock manipulators; the need for safety was far greater than it is today.
Browne also reminded us of Warren Buffett (Trades, Portfolio)’s famous two rules of investing: The first is to not lose money, and the second is to not forget rule number one. Graham’s experience helps put Buffett’s rules into context (Graham had been Buffett’s teacher, mentor and employer).
Also, the author urged readers to think of the S&P 500 as a giant conglomerate with 500 divisions. Normally it will grow, on average, about 6% per year. Half of that comes from growth in the economy (as measured by gross domestic product) and half from inflation. In addition, the S&P “pays” a dividend of 3% to 4% per year, making the total return about 10% per year over the long term. That’s about what index investors can expect when returns are averaged over a business cycle.
Of course, returns from the stock market are not like those from savings accounts paying 10%. They fluctuate, so sometimes you get less than 10%, sometimes you get more and, on rare occasions, it comes out at exactly 10%.
Given these ups and downs, Browne observed, “What you would like is some mechanism that forces you into the market when stocks are cheap and eases you out when they are dear. Getting in at the bottom of a stock market cycle produces better returns than getting in at the top.”
Graham had such a rule: Only buy stocks selling at two-thirds or less of their intrinsic value. That provided his margin of safety, for two reasons:
- If he estimated intrinsic value correctly, the stock could move up 50% and still not be overvalued.
- If the market seriously pulled back, he would comfortable knowing his stock was ultimately worth more than he paid.
Browne added, “Over the years, our margin of safety in the stocks we buy has provided more of our overall gain than the underlying growth in the value of the business.” Along with that is an aversion to debt, especially companies that use most of their earnings to pay interest. Debt payments erode the margin of safety.
He also noted how Graham connected margin of safety and diversification. To protect his portfolios, the guru insisted on having stocks from different companies and different industries. Browne wrote, “By diversifying, you provide yourself with insurance that if one of your stocks blows up, it will not severely impact your net worth.” Diversification was very important for Graham because he dealt in what later became known as cigar-butt stocks (very cheap and low quality).
A third factor in Browne’s thinking about margin of safety involves the allowance it provides for contrarian actions. He wrote, “The best time to buy stocks is when they are cheap. However, when stocks are at their cheapest, there are usually a whole host of reasons not to buy them.”
Recalling the recession of the early 1970s, he described how the Nifty Fifty growth stocks had crashed, writing, “Maybe value investors were simpletons to go on a buying spree, but we all felt like kids in a candy store.” And, being contrarian paid off: He reported that the years following 1974 were some of the best investing years in his career.
Getting back to his main themes, he argued that if stocks are cheap you should buy them, regardless of the noise around you. Similarly, if valuations hit or go above intrinsic value and there is no longer a margin of safety, then sell.
Browne concluded the chapter by writing, “These two simple investment principles, intrinsic value and margin of safety, provide the courage and the reassurance that buying in bad times and selling in good times is the better course to follow.”
Read more here:
- Christopher Browne: 'Think Like a Banker'
- Christopher Browne: 'Buy Stocks Like Steaks...on Sale'
- Indexing for Dummies: Boring but Rewarding
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
