Benjamin Graham is regarded as the father of value investing and his
books are investment classics. Securities Analysis (first published in
1934) and The Intelligent Investor (first published in 1949) continue
to sell steadily. In addition to this legacy, he has permanently
influenced many successful investors, including Warren Buffett, the
wealthiest man in America; William Ruane, founder of the
super-successful Sequoia Fund; and well-known investor Walter Schloss.
Ben was a prophet in a very specialised but important realm of life.
He preached commandments that any investor can use as stars when
navigating the vast and mysterious seas of the investment world. An
individual investor, who is not under pressure to shoot comets across
the heavens but would like to earn a smart and substantial return,
especially can benefit from Ben's guidance. In greatly simplified
terms, here are the 14 points Graham most consistently delivered in
his writing and speaking. Some of the counsel is technical, but much
of it is aimed at adopting the right attitude:
1. Be an investor, not a speculator
"Let us define the speculator as one who seeks to profit from market
movements, without primary regard to intrinsic values; the prudent
stock investor is one who (a) buys only at prices amply supported by
underlying value and (b) determinedly reduces his stock holdings when
the market enters the speculative phase of a sustained advance."
Speculation, Ben insisted, had its place in the securities markets,
but a speculator must do more research and tracking of investments and
be prepared for losses if they come.
2. Know the asking price
Multiply the company's share price by the number of company total
shares (undiluted) outstanding. Ask yourself, if I bought the whole
company would it be worth this much money?
3. Rake the market for bargains
Graham is best known for using his "net current asset value" (NCAV)
rule to decide if the company was worth its market price.
To get the NCAV of a company, subtract all liabilities, including
short-term debt and preferred stock, from current assets. By
purchasing stocks below the NCAV, the investor buys a bargain because
nothing at all is paid for the fixed assets of the company. The 1988
research of Professor Joseph D. Vu shows that buying stocks
immediately after their price drop below the NCAV per share and
selling two years afterward provides an excess return of more than 24
per cent.
Yet even Ben recognized that NCAV stocks are increasingly difficult to
find, and when one is located, this measure is only a starting point
in the evaluation. "If the investor has occasion to be fearful of the
future of such a company," he explained, "it is perfectly logical for
him to obey his fears and pass on from that enterprise to some other
security about which he is not so fearful."
Modern disciples of Graham look for hidden value in additional ways,
but still probe the question, "What is this company actually worth?"
Buffett modifies the Graham formula by looking at the quality of the
business itself. Other apostles use the amount of cash flow generated
by the company, the reliability and quality of dividends and other
factors.
4. Buy the formula
Ben devised another simple formula to tell if a stock is underpriced.
The concept has been tested in many different markets and still works.
It takes into account the company's earnings per share (E), its
expected earnings growth rate (R) and the current yield on AAA rated
corporate bonds (Y).
The intrinsic value of a stock equals:
E(2R + 8.5) x Y/4
The number 8.5, Ben believed, was the appropriate price-to-earnings
multiple for a company with static growth. P/E ratios have risen, but
a conservative investor still will use a low multiplier. At the time
this formula was printed, 4.4 per cent was the average bond yield, or
the Y factor.
5. Regard corporate figures with suspicion
It is a company's future earnings that will drive its share price
higher, but estimates are based on current numbers, of which an
investor must be wary. Even with more stringent rules, current
earnings can be manipulated by creative accountancy. An investor is
urged to pay special attention to reserves, accounting changes and
footnotes when reading company documents. As for estimates of future
earnings, anything from false expectations to unexpected world events
can repaint the picture. Nevertheless, an investor has to do the best
evaluation possible and then go with the results.
6. Don't stress out
Realise that you are unlikely to hit the precise "intrinsic value" of
a stock or a stock market right on the mark. A margin of safety
provides peace of mind. "Use an old Graham and Dodd guideline that you
can't be that precise about a simple value," suggested Professor Roger
Murray. "Give yourself a band of 20 per cent above or below, and say,
"that is the range of fair value."
7. Don't sweat the math
Ben, who loved mathematics, said so himself: "In 44 years of Wall
Street experience and study, I have never seen dependable calculations
made about common stock values, or related investment policies, that
went beyond simple arithmetic or the most elementary algebra. Whenever
calculus is brought in, or higher algebra, you could take it as a
warning signal that the operator was trying to substitute theory for
experience, and usually also to give speculation the deceptive guise
of investment."
8. Diversify, rule #1
"My basic rule," Graham said, "is that the investor should always have
a minimum of 25 per cent in bonds or bond equivalents, and another
minimum of 25 per cent in common stocks. He can divide the other 50
per cent between the two, according to the varying stock and bond
prices." This is ho-hum advice to anyone in a hurry to get rich, but
it helps preserve capital. Remember, earnings cannot compound on money
that has evaporated.
Using this rule, an investor would sell stocks when stock prices are
high and buy bonds. When the stock market declines, the investor would
sell bonds and buy bargain stocks. At all times, however, he or she
would hold the minimum 25 per cent of the assets either in stocks or
bonds — retaining particularly those that offer some contrarian
advantage.
As a rule of thumb, an investor should back away from the stock market
when the earnings per share on leading indices (such as the Dow Jones
Industrial Average or the Standard & Poor's composite index) is less
than the yield on high-quality bonds. When the reverse is true, lean
toward bonds.
9. Diversify, rule #2
An investor should have a large number of securities in his or her
portfolio, if necessary, with a relatively small number of shares of
each stock. While investors such as Buffett may have fewer than a
dozen or so carefully chosen companies, Graham usually held 75 or more
stocks at any given time. Ben suggested that individual investors try
to have at least 30 different holdings.
10. When in doubt, stick to quality
Companies with good earnings, solid dividend histories, low debts and
reasonable price/to/earnings ratios serve best. "Investors do not make
mistakes, or bad mistakes, in buying good stocks at fair prices," Ben
said. "They make their serious mistakes by buying poor stocks,
particularly the ones that are pushed for various reasons. And
sometimes — in fact, very frequently — they make mistakes by buying
good stocks in the upper reaches of bull markets."
11. Dividends as a clue
A long record of paying dividends, as long as 20 years, shows that a
company has substance and is a limited risk. Chancy growth stocks
seldom pay dividends. Furthermore, Ben contended that no dividends or
a niggardly dividend policy harms investors in two ways. Not only are
shareholders deprived of income from their investment, but when
comparable companies are studied, the one with the lower dividend
consistently sells for a lower share price. "I believe that Wall
Street experience shows clearly that the best treatment for
stockholders," Ben said, "is the payment to them of fair and
reasonable dividends in relation to the company's earnings and in
relation to the true value of the security, as measured by any
ordinary tests based on earning power or assets."
12. Defend your shareholder rights
"I want to say a word about disgruntled shareholders," Ben said. "In
my humble opinion, not enough of them are disgruntled. And one of the
great troubles with Wall Street is that it cannot distinguish between
a mere troublemaker or "strike suitor" in corporate affairs and a
stockholder with a legitimate complaint that deserves attention from
his management and from his fellow stockholders." If you object to a
dividend policy, executive compensation package or golden parachutes,
organize a sharcholder' s offensive.
13. Be Patient
". . . every investor should be prepared financially and
psychologically for the possibility of poor short-term results. For
example, in the 1973-1974 decline the investor would have lost money
on paper, but if he'd held on and stuck with the approach, he would
have recouped in 1975-1976 and gotten his 15 per cent average return
for the five-year period."
14. Think for yourself
Don't follow the crowd. "There are two requirements for success in
Wall Street," Ben once said. "One, you have to think correctly; and
secondly, you have to think independently."
Finally, continue to search for better ways to ensure safety and
maximise growth. Do not ever stop thinking.