Benjamin Graham, legendary value investor & tutor of Warren Buffet.
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Benjamin Graham. Renowned value investor, and author of The Intelligent Investor.
The book was originally written in 1949 and described by Warren Buffet as the best book about investing ever written. Buffet himself was tutored by Graham at the Columbia University and later worked for his brokerage company, Graham-Newman Corporation.
Essentially written about the difference between investment and speculation, we explore and summarise the key aspects of the book. Let’s take a look.
Graham says to be an intelligent investor you must be patient, disciplined and keen to learn new things. You must also be able to control your emotions and think for yourself.
Graham is keen to establish the difference between investors and speculators, and according to him intelligent investing consists of three things.
1) A thorough analysis of the company’s fundamentals
2) Protecting against severe losses.
3) Not anticipating extraordinary results but aiming for adequate performance.
Graham points out that for an intelligent investor, money is not made by simply ‘following the market’ or buying because the price has gone up. He argues the exact opposite is true, suggesting that stocks become more riskier the more the price increases, and, stocks become less risky the more the price decreases.
An investor believes the market price is judged on established standards of value, like the PE ratio for example. Whereas a speculator bases all their judgement on market price.
An excellent way to check if the market trend is swaying your judgment is to ask yourself if you would invest in a stock without seeing a chart….
It is also important to note that unlike the speculator the intelligent investor is not looking for quick gains, rather sustainable long-term investment goals that are not subject to the markets short term volatility.
At the time of writing the updated version of the intelligent investor, it was 1973 and Benjamin Graham managed to predict the bear market through to the end of 1974. Wall street eventually lost 37% of its value.
The Benjamin Graham formula suggested the ‘rule of opposites’ which suggests that the more enthusiastic investors or speculators become in the long run the more certain they are likely to be proved wrong in the short run.
The singular truth however is the market teaches us that the future is unpredictable, and the more certain people are about the future the more surprised they become when it proves otherwise.
The key is to remain humble, expect the unexpected and therefore maintain a good risk profile.
The aggressiveness of your portfolio depends on the type of investor you are.
The ’active’ or ‘enterprising’ type requires continual research of stocks, bonds and mutual funds. It requires time and energy.
The ‘passive’ or ’defensive’ type requires a fixed portfolio that runs autonomously regardless of the situation. Minimal time or effort is usually required.
Both approaches are equally good choices, but your success will be determined by selecting the one which suits your personality the best. This will ensure the longevity of the approach and keep your emotions in check.
The defensive investor takes a low-risk, long term approach to investing, and Graham advises this investor type to allocate 50% of their capital into bonds or an index fund depending on market conditions. The other 50% into individual stocks.
Here we can see the SPX 500 index and its performance over the last 10 years. Grahams proposal is to invest the initial lump sum and then make regular, perhaps monthly investments into the fund, which will have the effect of ‘dollar cost averaging’.
Graham says;-
“The way a defensive investor both participates in and wins the race is by sitting still”.
In terms of the 50% individual stocks portion, Graham advises on some key metrics to help produce selections.
1) Avoid small cap stocks unless it is a diversified small cap index.
2) Current assets should be at least double current liabilities
3) Earnings show stability over the previous ten year period.
4) Look for companies that have a history of paying dividends.
5) Only select stocks with a PE ratio no more than 15 times the average earnings over the previous 3 years
6) Multiply the PE ratio by the price to book ratio, if the figure is less than 22.5 it is considered to be a reasonably priced stock.
It is essential that a sense of familiarity with a company does not replace researching the company’s financial statements. As psychologists at the Carnegie Mellon University showed, the more familiar an individual feels they are with a subject, the more likely they are to exaggerate how much they know about it.
Quant investor Tal Davidson provides some excellent stats based on Graham’s defensive stock selection, he does however add one criterion to improve the results, that is selecting the top 15 stocks with the lowest 3 year BETA and rebalancing every year.
From the year 1999 to 2019 the total return was 518% against the S and P 500 of 181%. Note too how the drawdown was 24% less than the benchmark. In fact, Tal found that the strategy significantly outperformed the benchmark for more than 70 years with far less volatility.
For investors looking to improve results and be a bit more active, Graham suggests the enterprising approach to stock selection, with the following criteria.
1) The current assets should be at least one and a half times current liabilities.
2) Debt must be no more than 110% of working capital
3) Earnings per share should be greater than the earnings per share of 5 years ago.
4) It must be paying a current dividend, regardless of the amount.
5) The price to book ratio should be less than 1.2
6) The PE ratio must be less than 10.
The enterprising approach is similar to that of the defensive style in terms of it being a deep value investing strategy, in particular focusing on value stocks but with the ability to buy them with a significant margin of safety. The deeper you dig, the more margin of safety.
Since Enterprising stocks are often unpopular companies, not as well established or as large as Defensive stocks, the portfolio needs to be diversified more, perhaps 20 plus stocks.
Graham says;
"The determining trait of the enterprising investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average."
I personally use the Stockopedia service for all my fundamental analysis, they offer numerous screening filters including Benjamin Grahams Enterprising screen which we can see here.
In this example I have chosen to filter the UK market. The criteria Graham advises is seen at the top.
I have sorted 15 of the 26 qualifying stocks against the highly regarded Stockopedia rank.
Please let me know in the comments below If you would like me to regularly rebalance and report the performance of the portfolio. If enough people are interested, I will provide an update in the comments section below every six months.
Graham also gave another popular approach, which he referred to as a deep value ‘bargain’ investing strategy.
The approach is quite simple in that it looks for companies which have lower current liabilities than the current assets. His reasoning being that even if the stocks were failures the overall return could still be positive due to the value of the assets remaining.
Adding to the theory, Graham says;
"You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right."
To further enhance the strategy Graham added in a margin of safety, therefore his basket of stocks (ideally 30) would be trading at below 66% of the Net Current Asset Value.
Calculated as; Market Cap divided by Net Current Asset Value.
The research department at Salford Business School, found that between 1981 and 2005 UK listed stocks, with a Market Cap divided by the NCAV ratio of less than 66%, displayed annualised returns of 19.7% per year.
Stockopedia also have the screener for this strategy, and as of today there are 43 qualifying stocks in the UK, interestingly only 3 stocks have a rank greater than 80.
The results of the strategy have been tracked by Stockopedia since 2012 and provide a guide as to the performance. On average the annualised return has been 15.3% with a 33.9% drawdown.
Perhaps more interestingly the last two years has seen a 26.9% return, against the FTSE 100 index of minus 20.4%.
Lets now look at the core theory behind all of Benjamin Grahams approaches.
In essence, Graham looks for a ‘margin of safety’ below ‘intrinsic value’. We demonstrate the theory here.
Graham determines the intrinsic value of a stock by using the fundamental criteria already discussed. During the lifetime of a stock it would look something like this line.
The stocks price can range depending on the emotions of the market, sometimes investors are greedy, sometimes fearful.
This can cause the price to get either overvalued, or in Grahams approach, undervalued.
Over time the price will present buying opportunities, and the margin of safety is calculated from the buy point to the intrinsic value, shown here.
If every investor did their research and only bought stocks with a margin of safety below the intrinsic value of the company, the market would be efficient. But we know that this is not true. The market swings wildly from day to day and presents large changes in valuation, over periods of euphoria and pessimism.
In summary, Graham alludes that the market is driven by fear and greed, don’t be the market, be the ‘intelligent investor’ that measures price and value.
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