The Investing Style of Benjamin Graham
The Intelligent Investor
" To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." Quote by Benjamin Graham
How Benjamin Invested
Most stock investors have heard of Benjamin Graham, but for many new and beginner investors, they are not sure how he actually invested.
The general impression is that he was a traditional value investor. After all he is referred to as the father of value investing.
While it is true he is a value investor, his tactics used are for the most part not the conventional strategies used by most value investors, as Benjamin was essentially a hedge fund manager.
Benjamin formed a partnership with Jerome Newman in 1926 called the Graham-Newman partnership which was later renamed to Graham-Newman Corporation.
This partnership was basically an open-ended mutual fund which operated more like a modern day hedge fund.
Benjamin Graham would have been at odds with the Efficient Market Theory.
The theory is based on the notion that all information from analysts and fund managers is reflected in the stock price and therefore the stock price is its fundamental value.
This theory is based on the stock valuation rather than the business valuation which is what Benjamin Graham was interested in.
The stock price is what a share can be bought or sold at any given point in time, but Benjamin Graham was interested in at what price level was the stock price considered cheap compared to what the business was worth as a private enterprise.
This formed the foundations for Benjamin's value investing strategies.
Investing Strategies of Graham-Newman Corporation
Benjamin Graham actually started his career in Corporate Bonds and through his investing career also applied his value concepts to corporate bonds.
In fact his portfolios generally held around 50% in bonds. He was however not a bond holder as such, but more a speculative bond investor who bought bonds while they were cheap and sold them when he considered them overvalued.
The value strategies Benjamin mostly used with the Graham-Newman Corporation can be broadly summarized as follows:
Arbitrage strategies were commonly applied by Benjamin to reorganizations, mergers and takeovers (acquisitions).
An arbitrage existed when a stock or bond could be purchased and a price they could be sold for was essentially known in advance.
Arbitrages also existed when the risk could be effectively hedged away.
The hedged version of this strategy involves the purchase of a security and the simultaneous sale of one or more other securities.
If a takeover was considered undesirable, he would buy shares in the takeover company and short sell shares in the acquiring company.
Un-hedged, Benjamin would buy shares in a company that was splitting up or spinning off part of its operations or a division as a separate company.
He would buy if the end resulting value would be higher than the stock price he paid.
Another tactic was to buy shares in a holding company when the shares in the companies held were worth more than the holding companies own stock price.
With this strategy Benjamin would purchase bonds or preferred stock at a deep discount in companies being liquidated. Benjamin would analyze the financial statements to determine whether the liquidated value was greater than the net tangible assets recorded on the balance sheet.
The success of this strategy was reliant on the liquidated value being higher than the recorded value as the creditors were first in line for payment.
Benjamin through his financial statement analysis would ensure the liquidated value was sufficient to cover the bond and even the preferred stock holders.
The companies Benjamin Graham was interested in had significant hard assets, especially real estate such as land, buildings and factories.
He was after the cash payment returned and favored bonds and preferred stock as these had priority over common stock for payment.
In Benjamin's days, fundamental analysis was in its infancy which meant most investors had no idea of whether the liquidated value was higher than the book value.
These investors sold their stock in a panic frenzy when bankruptcy threatened and had no idea of the cheap prices they where selling their stock. Benjamin Graham would buy sufficient bonds and preferred stock in order to become a substantial holder and could force a companies' liquidation along with its creditors.
This strategy is nowadays basically referred to as distressed investing as it involves taking a position in a financially distressed company facing bankruptcy.
Related hedges as Benjamin called this strategy, involved the purchase of convertible bonds or convertible preferred shares, and the simultaneous sale of common stock into which they were exchangeable.
The position was established at close to parity, which is when the bond or preferred stock conversion price was close to the common stock price.
This strategy was profitable during market corrections and bear markets in general.
The strategy would be profitable when the short sold common stock fell considerably more in price than the bond or preferred stock.
A small loss would result if the common stock price went up. In this case the bond or preferred stock would simply be converted to common stock to cover the short sold common stock and thus exit the position.
What made this strategy profitable was that common stock is far more volatile in price movements than that of either bonds or preferred stock.
The reference to 'Related' means that the bond or preferred stock and the common stock are from same company. Benjamin Graham also held some Unrelated Hedges, but he found that these were not as profitable and stopped using unrelated hedges after several years of testing the strategy.
Benjamin Graham's related hedge strategy is nowadays referred to as convertible arbitrage.
Net Current Asset
This strategy simply involved purchasing companies when their stock price was less than two-thirds of their net current assets (also known as working capital).
This is the bargain hunting strategy for which Benjamin Graham is most famous for and is the ultimate in deep discount buying of companies which have a solid long-term fundamental outlook.
Benjamin only normally used this tactic with large-cap companies which were relatively unpopular because of their short-term recent financial performance, but the company has a solid long-term financial history and were considered fundamentally sound.
These companies usually have poor recent earnings history, but solid assets.
The large companies have the resources in capital and management to carry them through the temporary set back and the market will respond within time when the company regains its previous financial performance.
The market typically overvalues companies with excellent recent growth that are currently in favor and undervalues companies which are out of favor because of their short-term recent financial performance.
This is the fundamental law of the stock market.
The market undervalues companies which are out
of favor – due to short-term financial problems
The strategy essentially requires some short-term financial underperformance.
This is because for a company's stock price to be driven all the way down to two-thirds of its working capital, it required an extreme amount of pessimism from the market, which would only occur when the company was currently experiencing some short-term financial or business conditions which give the impression of a deteriorating company.
The working capital for most companies is less than its net tangible assets.
The working capital can only ever equal the net tangible assets when the long-term debt equals its noncurrent assets, which was something Benjamin Graham avoided.
Benjamin Graham used similar principles for locating corporate bonds that were priced well below what they would be worth once the company regained its former solid financial position.
With the net current asset strategy, Benjamin stated that either the price was way too cheap and must rise or if the price does not rise then the company should be liquidated.
The portfolio generally held at least 100 such stocks to provide safety in numbers as some of these companies actually wound up in bankruptcy.
The large diversification meant that the few companies that went bankrupt did not weigh too heavily on the portfolios returns.
Benjamin used a variety of exit strategies and the strategy profits from a price increase or the company itself may become a takeover or merger opportunity.
Benjamin was more of a short-term to medium-term investor. As a general rule his stocks where not held as long-term investments but were sold once the stock price went up past tangible book value.
He also had a policy to sell any stocks after two years if their stock price was not going up, so that the capital could be used to buy another company.
Benjamin also made some acquisitions with Graham-Newman Corporation.
This is where they bought the entire company rather than just a portion (in other words he would buy all of the shares).
Graham-Newman Corporation's most famous acquisition was the Government Employees Insurance Co. (GEICO) in 1948.
GEICO was acquired because its price was attractive based on the company's earnings and asset value which satisfied Benjamin's value investing principles.
Over the following years the share price of GEICO increased well over a hundred times and was their best performing investment.
Benjamin and his partner Jerome, these two well known partners spend their lives handling their own money and that of others.
They learnt from hard experience that it was better to be safe and cautious rather than attempting to make as much money as they could.
Graham-Newman Corporation averaged around 20% per year over a thirty year period from 1926 to 1956, which even included the biggest stock market crash in history of 1929 and the subsequent great depression of the 1930s.
They had some fantastic years and some bad years, but Benjamin instead of fearing bear markets he embraced them which was his secret to profiting when the next bull market began.
The related hedges performed well in bear markets and the working capital bargains profited well in bull markets.
While Benjamin was not called a hedge fund manager as the term was not used in those days, his rather radical investing strategies are still widely used by the modern day hedge fund managers.
Benjamin Graham placed relatively little emphasis in forecasting the future course of stock market or in the future prospects of companies, his general portfolio operations were to buy securities when general sentiment is pessimistic and prices are low, and sell them when optimism and prices are high.
Benjamin's strategies are not the usual strategies retail investors are used to seeing.
His strategies are actually professional tactics used by hedge fund managers and experienced investors and are mostly not suited to beginner or inexperienced investors.
" Investment is most intelligent when it is most businesslike." Quote by Benjamin Graham
The Famous Book
The notable Benjamin Graham wrote the famed book The Intelligent Investor which was first published in 1949.
The principles outlined in his book provide the stock investor of any level of experience with some sound investing principles.
These principles formed the basis for the investing style of the renowned investor Warren Buffett who treats a stock for what it really is - a company which operates a business. The same principles when applied by ordinary investors will help them become intelligent investors.
Investment Grade Stocks
Benjamin Graham considered a company which is fundamentally sound with realistic and proving growth to be of investment grade.
Any company that does not meet the criteria of investment grade Benjamin is considered to be of speculative grade.
Benjamin used this basic definition in his classic book Security Analysis in order to make a distinction between investing in a company which has a solid balance sheet and a company which has a debt lading balance sheet.
The former he considered to be a company worth investing in and the second he considered to be merely speculative.
Benjamin Graham's use a value which he calls the intrinsic value.
The intrinsic value is what the investor thinks a business is worth and is not the same as a valuation conducted by a business valuator who uses a discounted cash flow analysis.
The intrinsic value is a value which an investor determines would be a fair price based on the fundamental information presented.
The purpose of determining an intrinsic value is so that an investor can make a rational decision as to whether the current stock price is high or low.
The logic is that a stock investor can make a greater return for the same stock if they obtain that stock at a better price.
Intelligent investors recognize that there is a difference between what an enterprise is worth and the stock market price, even if they cannot accurately determine what that enterprise is really worth.
Margin of Safety
Benjamin Graham uses a margin of safety which is a discount he applies to the intrinsic value. He generally suggests a 33% discount.
The reason for the discount is that the investors' determination of intrinsic value is likely to be a crude estimate and discounting this estimate provides a margin of error.
This margin of error helps prevent the stock investor from paying too high a price for a good quality stock, as these good quality stocks spent most of their time overvalued. Benjamin's principle is to buy these good quality stocks when their prices are attractive.
While using a discount will inevitably lead to missed opportunities, Benjamin's principle is to first preserve capital as profits essentially take care of themselves.
This preserving of capital is something that investors (especially beginners) usually learn the hard way through market corrections and in particular with bear markets.
Another form of safety comes from diversification as this provides the portfolio a margin of safety against any single investment performing poorly.
Intelligent investors use the margin of safety to help protect them against future events, incorrect intrinsic value and poor market conditions.
Benjamin Graham refers to the stock market price quoting system as Mr. Market.
Many will argue that an enterprise is worth the price the stock market is currently quoting. Benjamin Graham, rather than arguing with their irrational logic, uses the analogy of Mr. Market who every day will offer to sell you stock and offer to buy stock from you at a certain price which is current for the next second or two.
If you are quick enough you can buy from or sell to Mr. Market at that quoted price. Benjamin however rightly states that you do not have to buy from or sell to Mr. Market if you do not agree with Mr. Market's offered prices.
If you do agree with the price then buy or sell, but if you do not agree then ignore Mr. Market's ridiculous offer and wait until Mr. Market comes back with a more rational offer.
Truly intelligent investors can be thought of as enterprising investors who think like businessmen and businesswomen and ignore the ridiculous offers made by Mr. Market unless it suits them.
The Investor and their Attitude
Some of Benjamin Graham's principles relate to the stock investor and their attitudes towards investing.
As far as Benjamin is concerned, you are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.
To achieve satisfactory investment results is easier than most people realize, but to achieve superior results is harder than it looks and requires an enterprising investing attitude. There is probably no better role model for this than Warren Buffett.
The market risk is something that is talked about a lot.
But risk also exists within the investor - how well they really understand the market and how they react to adverse conditions. This risk is known as investor risk.
Ultimately the financial risk is not so much with the market but with the investors own attitude. It is how the investor reacts when Mr. Market presents his offers.
The intelligent investor is fully aware of their attitude towards investing and has already planned ahead for both the good times and the bad times so that they are not emotionally caught off guard as this is when the unintelligent decisions are made.
Intelligent Investing Styles
Benjamin Graham in his book The Intelligent Investor puts forward several investing strategies which can be applied by beginner stock investors, passive stock investors and active stock investors.
These strategies are discussed in detail in the following article on intelligent investing strategies and the strategies are based on the value investing concept of buying a company at a reasonable price with a margin of safety.
Intelligent Investing Strategies
" You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right." Quote by Benjamin Graham
The Father of Value Investing
The father of value investing is Benjamin Graham who unknown to many investors was actually a precursor to the modern day hedge fund manager.
In fact his tactics are still used today by hedge fund mangers.
While Benjamin Graham was an early form of hedge fund investor, he was also a lecturer in finance and he wrote the famed book The Intelligent Investor first published in 1949.
The investing principles of this book are still widely used throughout the investing community today and the book was the basis for Warren Buffett's investing style; that is to treat a stock for what it really is - a company which operates a business.
The strategy Benjamin Graham puts forward for the stock investor is a common sense approach which dictates that a stock is actually a business and that it is a business that the investor is buying.
This approach is still based on his hedge fund tactics but is a modified more conservative approach suited to long-term investing.
Benjamin Graham's The Intelligent Investor provides the stock investor of any level of experience with some sound investing principles.
These principles when applied help make ordinary investors become intelligent investors.
Benjamin's Strategy for the Beginner Investor
The beginner investor all too often falls victim to over paying for stocks and the consequences of a bear markets is always the same - they buy high and end up selling low. There is no better way to loss money in the stock market.
While the high flying growth stocks may be appealing to the beginner stock investor, without an adequate knowledge of market dynamics the eventual outcome for the beginner is almost always a financial loss.
Benjamin Graham put forward a simple investing strategy to at least help prevent a significant loss in adverse market conditions while still allowing a reasonable long-term investment return.
This simple strategy is suitable for the beginner stock investor and enables them to be an intelligent investor.
Benjamin Graham's simple investing strategy is as follows:
Simple investing strategy:
- The investor should have adequate but not excessive diversification. A portfolio of a minimum of 10 stocks and a maximum of 30 stocks are appropriate for diversification. It is best if these stocks come from different industry groups.
- Each company selected should be a large-cap prominent company and be conservatively financed. The stocks in the S&P 100 index contain the largest 100 stocks which are suitable for beginners. Benjamin advises against smaller companies for the beginner.
- Each company selected should have a good history of paying dividends. Preferably the company has paid a dividend for the last of every ten years. It is even better if the divided has generally been increasing. The dividend yield is not so important unless the beginner investor is looking for income.
- Benjamin Graham suggests a maximum price paid for the stock should be no more than 25 times the earnings of any of the last seven years and no more than 20 times last years earnings. The earnings are full year earnings as reported on the income statements.
Note that this strategy will exclude most high priced growth stocks which Benjamin Graham considered are not suitable for the beginner investor.
This is because high priced growth stocks are vulnerable to sharp price corrections which make them too risky.
The stock price typically grows faster than company and the high earnings growth for large-caps is only sustained for short periods - only around one in ten companies can maintain a 20% growth rate for 5 years.
These high priced growth stocks are best left to the experienced stock investors.
If the stock price is too high then it is best if the beginner stock investor avoids them and avoiding them is a sign that they are an intelligent investor.
After all, the investor simply needs to wait for the next bear market and prices will be low enough to buy.
Benjamin's Strategy for the Defensive Investor
Benjamin Graham refers to the defensive investor as a passive investor whose main emphasis is on avoiding serious mistakes and losses, and does not want to make frequent investment decisions.
Benjamin also advises the defensive investor against high priced growth stocks as they are too risky for the same reasons as for the beginner stock investor.
Benjamin Graham put forward an investing strategy suitable for the defensive investor who has some experience with the stock market.
The strategy helps preserve capital in adverse market conditions while still allowing a good long-term investment return and enables the defensive stock investor to be an intelligent investor.
Benjamin Graham's investing strategy for the defensive investor is as follows:
Defensive investing strategy:
- Each company selected should be a large-cap prominent company and be conservatively financed. The stocks in the S&P 100 index contain the largest 100 stocks which are suitable for defensive investor. Benjamin advises against smaller companies.
- The companies should be in a sufficiently strong financial condition and fundamentally sound. Industrial companies should have current assets at least twice their current liabilities. Also long-term debt should not exceed the net current assets. For public utilities the debt should not exceed twice stockholders' equity (book value).
- Each company selected should have a good history of paying dividends. Preferably the company has paid a dividend for the last of every twenty years. It is even better if the divided has generally been increasing. The dividend yield is not so important unless the beginner investor is looking for income.
- Each company selected should have a positive annual earnings result for each of the last ten years.
- There should be a minimum earnings growth of at least one-third calculated over a ten year period as follows. Calculate the average earnings of the last three years and then calculate the average of the three years of earnings from years 8, 9 and 10. Then divide the first three year average earnings by the last three year average earnings. If the calculated ratio is greater than 1.33 then the earnings growth is satisfactory.
- The stock price is no more than 15 times the average of last three years of earnings.
- The price-book value multiplied by the PE ratio should be less than 22.5.
Using this strategy from Benjamin Graham will exclude a large portion of stocks.
The defensive investor does not want to pay too much for a stock as there is not an adequate margin of safety if prices fall. This is because a high portion of the price paid for the stock is reliant on ever-increasing earnings into the future.
The margin of safety is required since the future earnings growth may not eventuate.
Benjamin Graham suggests that the portfolio be checked for its total earnings yield based on the total price paid.
The purchased total earnings/price ratio (inverse of PE ratio) should be at least as high as the high-grade bond yield.
For example, if the AAA bond yield is 7.5% then the minimum portfolio total earnings/price ratio based on purchased prices should be at least 7.5% which gives the portfolio PE ratio of 13.3. Benjamin Graham further suggests that portfolio PE ratio should be less than 15.
Benjamin Graham's strategy does not intend for the defensive investor to buy any stock at any time, but rather to buy the occasional good quality company at an attractive price which gives a margin of safety should stock prices fall.
This is what intelligent investing is all about? Benjamin's main defense is not to lose money by avoiding the high speculative risk involved with paying high stock prices.
Benjamin's Strategy for the Enterprising Investor
The enterprising investor is an active investor who devotes time to market education and looks for investment opportunities which are more attractive than the average.
The enterprising investor still has the defensive attributes but due to them being active investors they can afford to take on more risky investments.
Benjamin Graham provides a strategy for enterprising investor which seeks out stocks with growth potential but still uses a value investing approach whereby good quality stocks with growth potential are only bought at bargain prices.
This makes the enterprising investor an intelligent investor as they are buying good quality stocks at sensible prices which helps protect their portfolio against adverse market condition by providing a margin of safety.
Benjamin Graham's investing strategy for the enterprising investor is as follows:
Enterprising investing strategy:
- The companies should be in a sufficiently strong financial condition. The current assets should be at least 1.5 times their current liabilities.
- The debt should not be more than 110% of the net current assets.
- The selected companies should have earnings stability with positive annual earnings reported in each of the last five years.
- The companies should be paying some current dividends.
- The company's last years earnings should be more than the earnings of five years ago.
- The stock price should be less than 120% of net tangible assets.
The stocks in the S&P 500 provide a good list for the enterprising investor to explore.
These companies are the largest 500 which generally have the financial strength to whether any short-term financial issues.
The criteria listed can be expanded upon by including additional criteria such as financial ratio analysis and performing a bankruptcy test using the Z-score indicator.
Increasing the criteria would allow the smaller companies to be analyzed with a higher degree of confidence.
The enterprising strategy essentially involves locating good quality stocks which are temporarily trading near their tangible book value.
Any stocks will likely be currently out of favor with the market and will probably have recently reported some short-term financial underperformance.
Benjamin Graham's strategy does not intend for the enterprising investor to buy a growth stock, but rather buy a good quality stock at a good price which has the potential for some future growth.
For Benjamin, intelligent investing is not to lose money by avoiding the high speculative risk involved with paying high stock prices.
Benjamin's Growth Formula
While Benjamin Graham's The Intelligent Investor predominately deals with value investing, Benjamin does provide a formula for calculating the possible increase in stock price from a growing stock.
The formula is intended for the retail investor and is a simplified version of the version analysts use to justify high priced growth stocks.
It is not an intrinsic valuation formula to calculate the intrinsic value.
The formula is only applicable while the company is growing its earnings and gives a likely price target if the expected future growth is actually realized. The formula is as follows:
Value = current earnings x (8.5 + 2 x expected growth rate)
The expected growth rate is the annual growth rate expected over the next seven to ten years.
This is what the stock price in bull markets might reach in ten years time if the expected growth rate actually eventuates in the future.
This formula is only for growing stocks - if the stock does not grow in the future then the formula is useless.
Benjamin also adds a warning that the future projected prices from the formula cannot be relied upon due to the uncertainty of future growth.
There is a revised version of this formula which takes into account the yield from AAA corporate bonds.
Revised Growth formula:
Value = current earnings x (8.5 + 2 x expected growth rate) x 4.4 / bond yield
The modified formula will give a lower value in high interest rate environments and a higher value when interest rates are low.
The use of these formulas for the enterprising value investor is in determining whether its time to sell their value stocks which in ten years time have become growth stocks and are now priced by the market as high priced growth stocks.
The Life of Benjamin Graham
Benjamin Graham was born in 1894 and died in 1976. He was an analyst, investor and financial lecturer and is one of the most famous names in the investing world. Benjamin Graham's fame stems from two classic books he wrote and he was also the mentor of Warren Buffett in his early days.
His classic books Security Analysis and The Intelligent Investor are well known amongst investment professionals and these books have never been out of print with the original publications still available today.
The life of Benjamin Graham begins near the end of the 19th century in England where he was born.
When Benjamin was only a one-year old baby his parents immigrated to America in 1895. They lived in New York where Benjamin Graham was raised and when he was nine-years old his father died. Times were hard for Benjamin, his two brothers and his mother.
When Benjamin Graham was 13, his mother opened a margin account and bought stock in a steel company.
The 1907 crash caused a margin call and wiped out the account and this was Benjamin's first experience with the stock market.
Benjamin Graham received a scholarship to study at Columbia University in New York and graduated in 1914. Benjamin was offered a lecturing position at Columbia but declined the offer to pursue a career in the business world.
Benjamin never actually studied economics at Columbia but read numerous books on the subject.
He became an assistant to the bonds department with the firm Newburger, Henderson & Loeb. In those days bonds were considered investments and stocks (other than the major railroads and utilities) were considered purely speculative.
In his first couple of years Benjamin Graham became a bond salesman. This is where he learned that most investors had a limited understanding about stocks and bonds.
Benjamin began to study financial reports to see whether bonds should be held or not. As a result of his efforts he was promoted to Statistician which is what security analysts were called in those days.
Benjamin Graham learned that most investors had a
limited understanding about stocks and bonds
The first child of Benjamin and his wife Hazel was born in 1919. He was a boy and they named him Isaac Newton Graham.
In 1920, Benjamin Graham was made a partner in Newburger, Henderson & Loeb.
Benjamin and Hazel's second child was a girl named Marjorie born in 1921.
In 1923, Benjamin Graham became a portfolio manager and formed a business with the high profile investor Louis Harris and called the firm Grahar Corporation. The firm used the offices at Newburger, Henderson & Loeb, but Benjamin was no longer an employee.
In 1925 Benjamin and Hazel's second daughter named Elaine was born.
Grahar Corporation ceased operations in 1926. Benjamin Graham then formed an investment partnership. Later that year a broker named Jerome Newman joined Benjamin as an associate.
Benjamin and Hazel's first child Isaac Newton died in 1927 while only eight-years old from meningitis (since antibiotics were not available then).
In 1928, Benjamin Graham began lecturing at night on finance at Columbia University which he continued until 1956.
In 1929 Benjamin and Hazel's second boy born was born whom they named Newton in memory of their deceased first son.
Benjamin Graham wrote the renowned book Securities Analysis together with a faculty member Professor David Dodd who collaborated by checking facts and figures.
The book was first published in 1934 and has had several revisions to date by Graham and Dodd. In the same year Benjamin and Hazel's fifth child was born whom they named Winifred.
In 1936 the Internal Revenue Service questioned whether Benjamin Graham and Jerome Newman qualified as a partnership. As a consequence they decided to create the firm Graham-Newman Corporation.
Benjamin Graham and Hazel divorced in 1937.
The renowned book The Intelligent Investor was written by Benjamin Graham and was first published in 1949 which provided a guide for intelligent investing in the value investing style.
Tragedy struck again for Benjamin Graham when his second son Newton II committed suicide while serving in the U.S. Army in 1954. His son had been suffering from a lifelong mental illness.
Benjamin moved to California in 1956 and became an Adjunct Professor of Finance at the University of California at Los Angeles.