Benjamin Graham – The MR. perfectionist of value investing

Benjamin Graham is known as the father of value investing. He was an economist, professor, and investor whose research led to the foundation of fundamental valuation.

During the economic depression of 1929 that staggered the US economy, Graham lost his entire investment that taught him some valuable lessons of the stock market investment, which led him to put down his learning into a book named Security Analysis and The Intelligent Investor.

Just like the inclination of any other risk-averse investor, Graham made money from the stock market without taking high risks. He evaluated the companies closely for selecting the high dividend yield stocks that, in a way, stunned each and every investor up to the present.

His investing style stressed studying the effect of psychological, emotional, cultural, and social factors in making the right investment decisions. Also, he analyzed the financial statements, health status, debt condition, and the competitive edge of the company before investing.

Moreover, Graham favoured the strategy of position trading, where the investor purchases the financial instruments, including the real estate: to hold them for a long time, despite the fluctuations in the security market. Subsequently, he trusted the power of diversification for meeting investment goals and reducing the risk in the portfolio by investing in different types of assets.

According to Graham, investors should consider buying within the margin of safety by evaluating the difference between the intrinsic value and market value of stocks. Besides, Benjamin rendered a non-conforming behavior of going against the market sentiments by purchasing and selling in contrast to the trends of bulls and bears in the market.

Let’s look at the detailed strategy practiced by Graham that even influenced Warren Buffett, who called him the second most influential person in his life after his father.

Value Investing Strategy of Benjamin Graham

Graham was the foremost proponent of value investing and built a heap of wealth by picking the best-valued companies trading at a temporary low price as compared to their intrinsic value. He conferred the investors to calculate the value of the company on their own, where the calculated market value of the company should be higher than the current value. Graham uses various criterions to value stocks, some of them are listed below: -

• Quality investing
  Graham had proposed quality investing as an investment strategy, where the investors should perform a qualitative assessment of the stocks. Investors must consider the fundamental criteria, such as management credibility and balance sheet stability, under a quality investing approach.
• Financial leverage
  A company offering low financial leverage got to be the ideal ones for quick pick up. Financial leverage is typified by debt to total asset ratio (measures total debt to total assets). Graham suggests the investors select a company by debt less than 110% of the net current assets, particularly for industrial companies.
• Current ratio
  Under value investing the current ratio (measures the current asset to current liabilities) is a crucial rumination before investing, that signifies the ability to pay short term liabilities of the company. The current assets of the company should be no less than 1 ½ times of current liabilities to qualify for value investing.
• Price to earnings ratio and earning per share
  The price to earnings ratio (P/E) and percentage change in earning per share are critical considerations for value investing. In the case of the P/E ratio, Benjamin Graham advises selecting the company with a low to moderate P/E ratio. On the other hand, earning per share of the company should be in the positive figures, both depicting the stock market value and profitability of the company, respectively.
• Price to book value
  Price to book value compares the market and book value of the company. Book value refers to the company’s total asset minus the unpaid (outstanding) liabilities as per the date of the balance sheet.
  Investors should invest in stocks selling near or below the book value of the company.
  Further, a higher price to book value ratio depicts that the stock is trading expensive. Investors can select a company with a price to book value ratio less than 1.20.
• Dividends
  The companies distributing dividends to the investors on time are the ideal pick for the investors in value investing. The company must have a track record of paying a timely profit to its investors for no less than 20 years.

Investors should follow these investing principles to invest, like Benjamin Graham, and select the right investment after a detailed examination.

Strategy of liquidations

The liquidating value is the money; the investors will get when they sell all or a part of their holding to other investors.

Under this strategy Graham purchased preferred stocks traded at less than par value of companies that were liquidated. He examined the financial statement to evaluate whether the liquidated value was greater than the net tangible assets of the company or whether the investors can turn the various kinds of assets into cash in a piece by piece manner.

The companies in which Graham invested had a significant sum total of hard assets and real estate.

Preserve capital

Preservation of capital is a conservation investment strategy where the investors invest in the safest short term fixed income securities such as treasury bills and certificates of deposits. Graham directed to preserve capital chiefly and then let the investment grow. He recommended distributing the portfolio between stocks and bonds to preserve capital during a market downtrend. Graham directed to preserve capital chiefly and then let the investment grow. He urged having 25% to 75% of investment in bonds and modifying it based on market trends and conditions.

Dollar-Cost Averaging

Dollar-Cost Averaging is performed by investing a fixed amount of dollars in security at uniform intervals over a period of time. It results in a lower average cost per share, along with purchasing the set number of shares at regular intervals. The investors get an advantage with the dip in the price. The Dollar-Cost Averaging is suitable for passive investors, and it relieves them from choosing the right time to buy their positions.

Strategy of analysing the company on the basis of business factors

Benjamin Graham examines five business factors to evaluate a company before investing.

• Profitability
  Profitability is the first and foremost factor to be considered for analysing companies. It measures the ability of the company to generate profit as compared to its expenses. Without the ability to generate profit, the company cannot sustain itself in the long term. Graham measures profitability by dividing the operating income by sales. Besides, operating income is the amount of profit left after deducting operating expenses such as wages, rent, depreciation, cost of goods sold, etc.
• Stability
  The second factor examined is the stability of the business. Graham focused on companies that performed predictably for which he checked the earnings per share of a company for at least 10-years.
• Growth
  Graham compared the growth of one company with the growth of its counterparts. If the growth of a particular company is higher than its equivalents, then investing in such a company would be considered as worthwhile.
• Financial position
  The financial position of a company is another crucial factor for examining the company. He uses the debt to asset ratio to compare debts with the assets of the company. The company should possess more assets to debt in order to be qualified as notable for investing.
• Price history
  At last, Graham reviewed the price history of the company for investing. He was interested in companies whose share price increased steadily over the years.

Margin of safety and diversification

The margin of safety is the margin required in order to ensure safety for calculating unpredicted risk. On the other hand, diversification provides for more variety in the portfolio to generate expected returns. The margin of safety harmonizes with diversification.

Graham saw diversification as a way to spread risk across asymmetric trade where the potential upside of the position seemed greater than the potential downside. For example: - if an investor risks ₹1000 to get ₹10,000, he makes an asymmetric trade.

“Even with a margin in the investor’s favour, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss – not that loss is impossible. But as the number of such commitments is increased, the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.” — Benjamin Graham on diversification

Graham proposed holding at least 30 stocks in the portfolio for ensuring diversification. Other prominent investors followed the same path. Walter Schloss owned more than 100 stocks, Seth Klarman managed and owned 35 shares, and Irving Kahn owned 20-30 securities at any given time.

Use Volatility to earn profits in Graham’s way

The investors will quickly make a way out when they get the traces of a stock market downturn. But the eminent investors spot an opportunity when everything seems pessimistic. Volatility in the stock market is unavoidable. Therefore investors should do detailed research and analyses to take an advantage of the volatility present in the market.

According to Benjamin Graham investors should use Rupee Cost Averaging and must invest in stocks and bonds to balance the portfolio.

Investors should employ the strategy of investing recurrently in a systematic investment plan as it is ideal for equity holders who can invest regardless of the prevailing market conditions. Also, Graham gave a bit of advice to balance both stocks and bonds in the portfolio. The slogan of investment of the investor should be to preserve the capital and then think of growth.

Conclusion

Finally, Benjamin Graham's strategy is still relevant today. He was the proponent of value investing and created a style of investment that had a proven track record of market outperformance.

The key takeaway in Graham's investment strategy is not to follow his axioms blindly. Investors should carry out extensive research on the stock market that has made progress from the early 1920s to the present 2020.

Dollar-Cost Averaging

Dollar-Cost Averaging is performed by investing a fixed amount of dollars in security at uniform intervals over a period of time. It results in a lower average cost per share, along with purchasing the set number of shares at regular intervals. The investors get an advantage with the dip in the price. The Dollar-Cost Averaging is suitable for passive investors, and it relieves them from choosing the right time to buy their positions.

Strategy of Analysing the Company on the Basis of Business Factors

Benjamin Graham examines five business factors to evaluate a company before investing.

• Profitability is the first and foremost factor to be considered for analysing companies. It measures the ability of the company to generate profit as compared to its expenses. Without the ability to generate profit, the company cannot sustain itself in the long term. Graham measures profitability by dividing the operating income by sales. Besides, operating income is the amount of profit left after deducting operating expenses such as wages, rent, depreciation, cost of goods sold, etc.
• The second factor examined is the stability of the business. Graham focused on companies that performed predictably. He checked the earnings per share of a company for at least 10-years.
• Graham compared the growth of one company with the growth of its counterparts. If the growth of a particular company is higher than its equivalent, then investing in such a company would be considered as worthwhile.
• The financial position of a company is another crucial factor for examining the company. He uses the debt to asset ratio to compare debts with the assets of the company. The company should possess more assets to debt in order to be qualified as notable for investing.
• At last, Graham reviewed the price history of the company for investing. He was interested in companies whose share price increased steadily over the years.

Margin of Safety and Diversification

Graham saw diversification as a way to spread risk across asymmetric trade where the potential upside of the position seemed greater than the potential downside.

For example: - if an investor risks ₹1000 to get ₹10,000, he makes an asymmetric trade.

The margin of safety harmonies with diversification. The margin of safety is the margin required in order to ensure safety for calculating unpredictable risk. On the other hand, diversification provides for more variety in the portfolio to generate expected returns.

“Even with a margin in the investor’s favour, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss – not that loss is impossible. But as the number of such commitments is increased, the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.” — Benjamin Graham on diversification

Graham proposed holding at least 30 stocks in the portfolio for ensuring diversification. Other prominent investors followed the same path. Walter Schloss owned more than 100 stocks, Seth Klarman managed and owned 35 shares, and Irving Kahn owned 20-30 securities at any given time.

Use Volatility to Earn Profits

The investors will quickly make a way out when they get the traces of a stock market downturn. But the eminent investors spot an opportunity when everything seems pessimistic. Volatility in the stock market is unavoidable. Therefore investors should do detailed research and analyses to take an advantage of the volatility present in the market.

According to Benjamin Graham investors should use Rupee Cost Averaging and must invest in stocks and bonds to balance the portfolio. Investors should employ the strategy of investing recurrently in a systematic investment plan as it is ideal for equity holders who can invest regardless of the prevailing market conditions. Also, Graham gave a bit of advice to balance both stocks and bonds in the portfolio. The slogan of investment of the investor should be to preserve the capital and then think of growth.

Finally, Benjamin Graham's strategy is still relevant today. He was the proponent of value investing and created a style of investment that had a proven track record of market out performance.

The key takeaway in Graham's investment strategy is not to follow his axioms blindly. Investors should carry out extensive research on the stock market that has made progress from the early 1920's to the present 2020.

Nevertheless, his value investing theory holds relevance to date.