Serious physicists read about Sir Isaac Newton to learn his teachings about gravity and motion. Serious investors read Benjamin Graham's work to learn about finance and investments.
Known as "the father of value investing" and the "dean of Wall Street," Graham (1894-1976) excelled at making money on the stock market for himself and his clients – without taking big risks. Graham created and taught many principles of investing safely and successfully that modern investors continue to use today.
These ideas were built on Graham's diligent, almost surgical, financial evaluation of companies. His experience led to simple, effective logic, upon which Graham built a successful method for investing.
Graham's Legacy and Beginnings
Graham's work is legendary in investment circles. He's been credited as the creator of the security analysis profession. While best known as Warren Buffett's mentor, Graham was also a famous author, most notably for his books "Security Analysis" (1934) and "The Intelligent Investor" (1949). Graham was one of the first to solely use financial analysis to successfully invest in stocks. He was also instrumental in drafting many elements of the Securities Act of 1933, also known as the "Truth in Securities Act," which, among other things, required companies to provide financial statements certified by independent accountants. This made Graham's work of financial analysis much easier and more efficient, and in this new paradigm he succeeded.
Graham was a star student at Columbia University in New York, and went to work on Wall Street shortly after graduation in 1914. He built up a sizable personal nest egg over the next 15 years. However, he lost most of his money in the stock market crash of 1929 and subsequent Great Depression. After learning a hard lesson about risk, he wrote "Security Analysis" (published in 1934), which chronicled Graham's methods to analyze and value securities. This book has been used for decades in finance courses as the seminal work in the field.
Graham's losses in the 1929 crash and Great Depression led him to hone his investment techniques. These techniques sought to profit in stocks while minimizing downside risk. He did this 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 the fear and greed of the market to his advantage, and invested by the numbers.
Theories: "Mr. Market" and Margin of Safety
Graham stressed the importance of looking at the market as one would a business partner who offers to buy you out, or sell you his interest daily. Graham referred to this imaginary person as "Mr. Market." Graham said that sometimes Mr. Market's price makes sense, but sometimes it is way too high or low given the economic realities of the business.
You, as the investor, are free to buy Mr. Market's interest, sell out to him or even ignore him if you don't like his price. You may ignore him because he always comes back tomorrow with a different offer. This is the "use market" psychology. Graham viewed the freedom to be able to say "no" as a major advantage the average investor had over the professional who was required to be invested at all times, regardless of the current valuation of securities.
Graham also stressed the importance of always having a margin of safety in one's investments. This meant only buying into a stock at a price that is well below a conservative valuation of the business. This is important because it allows profit on the upside as the market eventually revalues the stock to its fair value, and it also gives some protection on the downside if things don't work out as planned and the business falters. This was the mathematical side of his work.
A Great Investor and Teacher
In addition to his investment work, Graham taught a class in security analysis at his alma mater, Columbia University. Here, he was fascinated with the process and strategy of investing just as much as he was fascinated with making money. To this end, he wrote "The Intelligent Investor" in 1949. This book provided more practical advice to the common investor than did "Security Analysis," and it became one of the best-selling investment books of all time.
Warren Buffett describes "The Intelligent Investor" as "by far the best book on investing ever written" – high praise for a relatively simple book. Buffett has said that Graham was incredibly generous toward others, especially with his investment ideas. In fact, Graham spent the better part of his retirement years working on new, simplified formulas to help average investors invest in stocks. Buffett now also follows this credo as he views his annual meetings as a chance to share his knowledge with the average investor.
After reading "The Intelligent Investor" at age 19, Buffett enrolled in Columbia Business School in order to study under Graham, and they subsequently developed a lifelong friendship. Later, he worked for Graham at his company, the Graham-Newman Corporation, which was similar to a closed-end mutual fund. Buffett worked there for two years until Graham decided to close the business and retire.
Afterward, many of Graham's clients asked Buffett to manage their money, and as they say, the rest is history. Buffett went on to develop his own strategy, which differed from Graham's in that he stressed the importance of a business's quality and of holding investments indefinitely. Graham would typically invest based purely on the numbers of a company, and he would sell an investment at a predetermined value. Even so, Buffett has said that no one ever lost money by following Graham's methods and advice. (See also: 3 Differences Between Benjamin Graham and Warren Buffett.)
The Bottom Line
Graham reportedly averaged about a 20% annual return through his many years of managing money, although details of Graham's investments are not readily available. He achieved these results at a time when buying common stocks was widely regarded as a pure gamble. But Graham bought stocks with a method that provided both low risk and a high return. For this reason, Graham was a true pioneer of financial analysis.