Warren Buffett is widely considered to be one of the greatest investors of all time, but if you were to ask him who he thinks is the greatest investor, he probably would mention one man: his former teacher, Benjamin Graham. Graham was an investor and investing mentor who is generally considered the father of security analysis and value investing.
His ideas and methods on investing are well-documented in his books Security Analysis (1934) and The Intelligent Investor (1949), which are two of the most famous investing texts ever written. These texts are often considered requisite reading material for any investor, but they aren't easy reads.
In this article, we'll condense Graham's main investing principles and give you a head start on understanding his winning philosophy.
- Benjamin Graham is considered a legend in the investing field, having authored two key books on the subject, Security Analysis (1934), and The Intelligent Investor (1949).
- Graham refers to value investing as investing with a margin of safety, which is the amount he believes a stock is undervalued.
- Graham views market volatility as a given, but also as an opportunity to buy stocks at a discount and sell at a premium.
- Graham cautions his readers to understand what kind of investor they are (active versus passive) before they become involved with the market.
Principle #1: Always Invest with a Margin of Safety
Margin of safety is the principle of buying a security at a significant discount to its intrinsic value, which is thought to not only provide high-return opportunities but also to minimize the downside risk of an investment. In simple terms, Graham's goal was to buy assets worth $1 for 50 cents. He did this very, very well.
To Graham, business assets may have been valuable because of their stable earning power or simply because of their liquid cash value. For example, it wasn't uncommon for Graham to invest in stocks where the liquid assets on the balance sheet (net of all debt) were worth more than the total market capitalization of the company (also known as "net nets" to Graham followers). This means that Graham was effectively buying businesses for nothing. While he had a number of other strategies, this was the typical investment strategy for Graham.
This concept is quite important for investors to note, as value investing can provide substantial profits once the market inevitably re-evaluates the stock and increases its price to fair value. It also provides protection on the downside if things don't work out as planned and the business falters. The safety net of buying an underlying business for much less than it is worth was central to Graham's success. When chosen carefully, Graham found that a further decline in these undervalued stocks occurred infrequently.
While many of Graham's students succeeded using their own strategies, they all shared the main idea of the "margin of safety."
Principle #2: Expect Volatility and Profit from It
Investing in stocks means dealing with volatility. Instead of running for the exits during times of market stress, the smart investor greets downturns as chances to find great investments. Graham illustrated this with the analogy of "Mr. Market," the imaginary business partner of each and every investor. Mr. Market offers investors a daily price quote at which he would either buy an investor out or sell his share of the business. Sometimes, he will be excited about the prospects for the business and quote a high price. Other times, he is depressed about the business's prospects and quotes a low price.
Because the stock market is rife with these same emotions, the lesson here is that you shouldn't let Mr. Market's views dictate your own emotions, or worse, lead you to make poorly thought out investment decisions. Instead, you should form your own estimates of the business's value based on a sound and rational examination of the facts.
Furthermore, you should only buy when the price offered makes sense and sell when the price becomes too high.
The market will fluctuate, sometimes wildly, but rather than fearing volatility, use it to your advantage to get bargains in the market or to sell off when your holdings become too overvalued.
Here are two strategies that Graham suggested to help mitigate the negative effects of market volatility:
1) Dollar-Cost Averaging
Dollar-cost averaging is achieved by buying equal dollar amounts of investments at regular intervals. It takes advantage of dips in the price and means that an investor doesn't have to be concerned about buying his or her entire position at the top of the market. Dollar-cost averaging is ideal for passive investors and alleviates them of the responsibility of choosing when and at what price to buy their positions.
2) Investing in Stocks and Bonds
Graham recommended distributing one's portfolio evenly between stocks and bonds as a way to preserve capital in market downturns while still achieving growth of capital through bond income. Remember, Graham's philosophy was first and foremost to preserve capital, and then to try to make it grow. He suggested having 25% to 75% of your investments in bonds and varying this based on market conditions. This strategy had the added advantage of keeping investors from boredom, which leads to the temptation to participate in unprofitable trading (i.e., speculating).
Principle #3: Know What Kind of Investor You Are
Graham advised that investors should know their investment personalities. To illustrate this, he made clear distinctions among various groups operating in the stock market.
Active vs. Passive Investors
Graham referred to active and passive investors as "enterprising investors" and "defensive investors."
You only have two real choices: The first choice is to make a serious commitment in time and energy to become a good investor who equates the quality and amount of hands-on research with the expected return. If this isn't your cup of tea, then be content to get a passive (possibly lower) return, but with much less time and work. Graham turned the academic notion of "risk = return" on its head. For him, "work = return." The more work you put into your investments, the higher your return should be.
If you have neither the time nor the inclination to do quality research on your investments, then investing in an index is a good alternative.
Graham said that the defensive investor could get an average return by simply buying the 30 stocks of the Dow Jones Industrial Average in equal amounts. Both Graham and Buffett have said that getting even an average return, such as the return of the S&P 500, is more of an accomplishment than it might seem.
The fallacy that many people buy into, according to Graham, is that if it's so easy to get an average return with little or no work (through indexing), then just a little more work should yield a slightly higher return. The reality is that most people who try this end up doing much worse than average.
In modern terms, the defensive investor would be an investor in index funds of both stocks and bonds. In essence, they own the entire market, benefiting from the areas that perform the best without trying to predict those areas ahead of time. In doing so, an investor is virtually guaranteed the market's return and avoids doing worse than average by just letting the stock market's overall results dictate long-term returns. According to Graham, beating the market is much easier said than done, and many investors will find they don't beat the market.
Speculator vs. Investor
Not all people in the stock market are investors. Graham believed that it was critical for people to determine whether they were investors or speculators. The difference is simple: An investor looks at a stock as part of a business and the stockholder as the owner of the business, while the speculator views himself as playing with expensive pieces of paper, with no intrinsic value. For the speculator, value is only determined by what someone will pay for the asset.
To paraphrase Graham, there is intelligent speculating as well as intelligent investing; the key is to be sure you understand which you are good at.
What is the Essence of Graham's Investing Philosophy?
Benjamin Graham's investing philosophy boils down to value investing, looking to buy those stocks that are undervalued according to earnings per share (EPS), book value, and investing multiple (e.g., the price is trading at nine times earnings instead of proper valuation, of, say, 15 times earnings). Graham refers to this as a "margin of safety." The flip side of that coin is to take profit (sell what you own) when a stock becomes overvalued.
How Does Graham View Market Volatility?
Graham views the inevitable market volatility as an opportunity to exploit excessive weakness as a buying opportunity, and excessive strength as a time to take profit. In short, Graham looks for stocks that are trading at a discount to their proper market value and then holding those stocks until the market regains its balance and the stock price moves higher in line with its proper valuation.
How does Graham Differentiate Between Investors and Speculators?
Graham looks at investors as long-term thinkers, those not willing to buy and sell for a quick profit. Speculators, on the other hand, are traders who are very active and looking for short-term gains and minimal losses. The problem with speculating, as Graham sees it, is that there is no fundamental research given to the stock, the current price is all that matters. Graham urges his readers to decide what kind of trader they are, speculator or value investor, before taking any exposure in the market.
The Bottom Line
Benjamin Graham is considered the father of "value investing," looking for stocks that are undervalued and holding them until they reach a valuation more in line with the stock's fundamentals. At the same time, he is also ready to sell a stock if it becomes overvalued relative to its fundamental metrics such as earnings multiple, EPS, and book value, to name a few.
Graham cautions his readers to know what kind of trader they are before they enter the market. He offers two paradigms for investors: active vs. passive investors. So-called active investors spend a great deal of time and energy researching stocks they have identified as potential investments. Passive investors instead are more likely to buy indexes through exchange-traded funds (ETFs) and take the market return on the investment. For Graham and Buffet, meeting the market rate of return is perfectly acceptable, while trying to beat the market is highly unlikely.