While physicist Sir Isaac Newton is widely viewed as the leading authority on gravity and motion, economist Benjamin Graham, best known for his book The Intelligent Investor, is lauded as a top guru of finance and investment. Known as the father of value investing, The Intelligent Investor: The Definitive Book on Value Investing is considered one of the most important books on the topic. By evaluating companies with surgical precision, Graham excelled at making money in the stock market without taking big risks.
One of Graham's key contributions was to point out the irrationality and group-think that was often rampant in the stock market. Thus, according to Graham, investors should always aim to profit from the whims of the stock market, rather than participate in it. His principles of investing safely and successfully continue to influence investors today.
This article will examine Graham's early career work, some key concepts related to value investing from The Intelligent Investor, and how Graham's ideas helped inform the successful investing principles of later investors, namely Warren Buffett.
- Economist Benjamin Graham, best known for his book The Intelligent Investor, is lauded as a top guru of finance and investment.
- Known as the father of value investing, The Intelligent Investor: The Definitive Book on Value Investing is considered one of the most important books on the topic.
- Graham's method advises investors to concentrate on the real-life performance of their companies and the dividends they receive, rather than paying attention to the changing sentiments of the market.
- Graham also advocated for an investing approach that provides a margin of safety—or room for human error—for the investor.
- Most importantly, investors should look for price-value discrepancies—when the market price of a stock is less than its intrinsic value.
What is Value Investing?
The Intelligent Investor’s Beginnings
After graduating from Columbia University in 1914, Graham went to work on Wall Street. During his 15-year career, he was able to cultivate a sizable personal nest egg. Unfortunately, Graham, like many others, lost most of his money in the stock market crash of 1929 and the subsequent Great Depression.
Those experiences taught Graham lessons about minimizing downside risk by investing in companies whose shares traded far below the companies' liquidation value. In simple terms, his goal was to buy a dollar's worth of assets for $0.50. To do this, he utilized market psychology, using market fears to his advantage. These ideals inspired him to write Security Analysis, which was published in 1934 with a co-author, David Dodd. The book was written in the early 1930s when both authors were professors at Columbia University's business school. The book chronicles Graham's methods for analyzing securities.
In Security Analysis, Graham's first task is to help stock market participants distinguish between an investment and speculation. After a thorough analysis, it should be clear that an investment is going to protect the principal and provide an adequate return. Anything that does not meet these criteria is speculation. Graham also advocated for a different perspective in regards to stock ownership; equity stocks confer part ownership of a business. For Graham, in the short-term, the stock market acts like a voting machine, and in the long-term, the stock market acts like a weighing machine—so, in the long run, the true value will be reflected in the stock's price.
Graham's method focused on determining the value of the operating company behind a stock. Security Analysis enumerates several examples where the market under-valued certain out-of-favor stocks which ended up being important opportunities for the savviest investors. These and other concepts, including "margin of safety" and "period of financial distress", helped to lay the groundwork for Graham's later work in The Intelligent Investor and helped to pioneer some of his pivotal investing concepts.
What You Can Learn From The Intelligent Investor
Graham, along with David Dodd, began teaching value investing as an investment approach at Columbia Business School in 1928. In 1949, Graham and Dodd published The Intelligent Investor. Here are some of the key concepts from the book.
Graham's favorite allegory was that of Mr. Market. This imaginary person, "Mr. Market," turns up every day at the stockholder's office offering to buy or sell his shares at a different price. Sometimes the proposed prices make sense, but other times, the proposed prices are off the mark, given current economic realities.
Individual investors have the power to accept or reject Mr. Market's offers on any given day, giving them a leg up over those who feel compelled to be invested at all times, regardless of the current valuation of securities. It is most advisable for an investor to concentrate on the real-life performance of their companies and the dividends they receive, rather than paying attention to the changing sentiments of Mr. Market as determining the value of the stocks. An investor is neither right nor wrong if others share the same sentiments as them; only facts and analysis can make them right.
Value investing is deriving the intrinsic value of a common stock independent of its market price. Analyzing a company's assets, earnings, and dividend payouts can help identify the intrinsic value of a stock, which can then be compared to its market price. If the intrinsic value is more than the market value—in other words, the stock is undervalued in the market—the investor should buy and hold until a mean reversion occurs. The mean reversion theory holds that over time, the market price and the intrinsic price will converge. At this point, the stock price will reflect its true value.
Focus on stocks that are trading at two-thirds of their net-net value. Net-net is a value investing technique developed by Benjamin Graham in which a company is valued based solely on its net current assets.
When an investor buys a stock at a price less than its intrinsic value, they are essentially purchasing it at a discount. Once the stock is actually trading at its intrinsic value, they should sell.
Margin of Safety
Graham also advocated for an investing approach that provides a margin of safety—or room for human error—for the investor. There are a couple of ways to accomplish this, but buying undervalued or out-of-favor stocks is the most important. The irrationality of investors, the inability to predict the future, and the fluctuations of the stock market can provide a margin of safety for investors. Investors can also achieve a margin of safety by diversifying their portfolios and purchasing stocks in companies with high dividend yields and low debt-to-equity ratios. This margin of safety is intended to mitigate the investor's losses in the event that a company goes bankrupt.
The Benjamin Graham Formula
Typically, Graham only purchased stocks that were trading at two-thirds of their net-net value, as a way of establishing his margin of safety. Net-net value is another value investing technique developed by Graham, where a company is valued based solely on its net current assets.
The original Benjamin Graham Formula for finding the intrinsic value of a stock was:
V=EPS×(8.5+2g)where:EPS=Trailing 12-month earnings per shareg=Long-term growth rate
With V representing the intrinsic value of the stock, EPS as the trailing 12-month earnings per share, , 8.5 is the price/earnings ratio of a zero-growth company, and g is the company's long-term growth rate.
Later, Graham revised his formula to include both a risk-free rate of 4.4% (the average yield of high-grade corporate bonds in 1962) and the current yield on AAA corporate bonds represented by the letter Y:
V=YEPS×(8.5+2g)×4.4where:Y=AAA corporate bond yield (in 1962)
Many of Graham's investment principles are timeless—they remain as relevant today as they were when he penned them. Graham criticized corporations for their obscure and irregular methods of financial reporting that made it difficult for investors to get an accurate picture of the health of a company. Graham would later write a book about how to interpret financial statements, from balance sheets and income and expense statements to financial ratios. Graham also advocated for companies paying dividends to their shareholders, rather than keeping all of their profits as retained earnings.
The Intelligent Investor and Warren Buffett
About The Intelligent Investor, legendary investor Warren Buffett, who Graham famously mentored, described it as "by far the best book on investing ever written.” In fact, after reading it at age 19, Buffett enrolled in Columbia Business School in order to study under Graham, with whom he developed a lifelong friendship. He later worked for Graham at his investment company, the Graham-Newman Corporation, until Graham retired.
The price of a Warren Buffett-signed copy of The Intelligent Investor that sold at an auction in 2010.
Graham's students all eventually developed their own strategies and philosophies, but they all shared the main principle of creating a margin of safety.
In general, Buffett follows the principles of value investing, which looks for securities whose prices are unjustifiably low based on their intrinsic worth. Buffett also considers company performance, company debt, profit margins, whether companies are public, how reliant they are on commodities, and how cheap they are.
Buffett's strategy differs from Graham's in that he stresses the importance of a business's quality, and he preaches the virtue of holding stocks for the long haul. Buffett doesn't seek capital gain. Rather, his goal is ownership in quality companies that are extremely capable of generating earnings; Buffett is not concerned that the stock market ever recognizes a company's value. Even so, Buffett said that no one ever lost money by following Graham's methods.
What Does The Intelligent Investor Teach You?
The Intelligent Investor is widely considered to be the definitive text on value investing. According to Graham, investors should analyze a company's financial reports and its operations but ignore the market noise. The whims of investors—their greed and fear—are what creates this noise and fuels daily market sentiments.
Most importantly, investors should look for price-value discrepancies—when the market price of a stock is less than its intrinsic value. When these opportunities are identified, investors should make a purchase. Once the market price and the intrinsic value are aligned, investors should sell.
The Intelligent Investor also advises investors to hold a portfolio of 50% stocks and 50% bonds or cash, to be the pitfalls of day trading, to take advantage of market fluctuations and market volatility, to avoid buying stocks simply when they are fashionable, and to look out for ways that companies may be manipulating their accounting methods in order to inflate their EPS value.
Is the Intelligent Investor Good for Beginners?
The Intelligent Investor is a great book for beginners, especially since it's been continually updated and revised since its original publication in 1949. It's considered a must-have for new investors who are trying to figure out the basics of how the market works. The book is written with long-term investors in mind. For those who are interested in something more glamorous and potentially trendier, this book may not hit the spot. It dispenses a lot of common-sense advice, rather than how to profit in the short-term through day trading or other frequent trading strategies.
Is The Intelligent Investor Outdated?
Even though this book is over 70 years old, it is still relevant. The advice to buy with a margin of safety is just as sound today as it was when Graham was first teaching his philosophy. Investors should do their homework (research, research, research) and once they have identified what a company is worth, buy it at a price that will give them a cushion, should prices fall.
Graham's advice that investors should always be prepared for volatility is also still very relevant.
What Type of Book Is The Intelligent Investor?
The Intelligent Investor, first published in 1949, is a widely acclaimed book on value investing. Value investing is intended to protect investors from substantial harm and teaches them to develop long-term strategies. The Intelligent Investor is a practical book; it teaches readers to apply Graham's principles.
How Do I Become an Intelligent Investor?
Benjamin Graham urges the twin principles of valuation and patience for anyone that wants to succeed as an investor. In order to determine a company's true worth, you must be prepared to do the research. Then, once you've bought shares of a company, you must be prepared to wait until the market realizes it is undervalued and marks up its price. If you only buy into those companies that are trading below their true worth, or intrinsic value, even when a business suffers, the investor has a cushion. This is called a margin of safety and is the key to investing success.
The Bottom Line
Although details of Graham's specific investments aren’t readily available, he reportedly averaged an approximate 20% annual return over his many years managing money. His method of buying low-risk stocks with high return potential has made him a true pioneer in the financial analysis space, and many other successful value investors have his methodology to thank.
While he is best known for the books he published in the field of value investing—most notably The Intelligent Investor—Graham was also instrumental in drafting elements of the Securities Act of 1933, legislation requiring companies to provide financial statements certified by independent accountants.