Benjamin Graham: The Start of a Movement
April 10, 2017
Who’s your daddy?
The answer any value investor worth their salt would give, is Benjamin Graham.
Ben Graham, born in 1894, taught investors how to safely manage their money using principles and theories created by himself after graduating from Columbia University in the 1910s. To this day, investors still use his formulas and theories to smartly invest their money.
He was no slouch when it came to managing money himself either; Graham’s investment company returned an average of 20% from 1936 to 1956, handily beating the overall market’s average return of 12.2%.
His influence reaches far and wide
If you are a value investor, or really an investor of any type, you’ve probably read Ben Graham’s two books: Security Analysis, published in 1934, and The Intelligent Investor.
In Security Analysis, Graham and Dodd laid the framework of what we would later call “value investing”. The text was supposed to be a simple, quick guide for investors but ended up being a detailed textbook. It has gone on to sell over a quarter of a million copies.
The book continues to have influence in the modern era. Warren Buffet praises the work of Graham (who once taught Buffet at Columbia) and Dodd, in his article “The Superinvestors of Graham-and-Doddsville”. Buffet, the second-richest man in the world, has always been a student of the works and teachings of Graham, stating that Ben Graham was the second most influential person in Buffet’s life. Seth Klarman, another legendary value investor, conceded that his book, Margin of Safety, was also influenced by Ben Graham.
It’s fair to say that Graham’s legacy is his outlook on investing.
It was he who urged investors to make the distinction between speculation, buying a stock with the hope of making money but not really understanding the risk involved, and investing, a practice he defined as “an operation, [which, upon] thorough analysis, promises safety of principal and an adequate return”.
Basically, when you invest in something, you understand the risks involved and take steps to mitigate that risk as best you can.
He’s also the man who pushed for investors to think of owning equity stocks as owning a piece of the business you’re investing in. When you adopt that perspective, you are better placed to make sound decisions regarding investments.
Pretty much any investment advice you’ve heard of can be traced back to Benjamin Graham in some form.
Margin of safety? Intrinsic value? We have Benjamin Graham to thank for both of those concepts.
In his Graham’s follow-up book, “The Intelligent Investor” published in 1949, Graham created the allegory of Mr. Market.
Mr. Market, the embodiment of the stock market, is your business partner, with whom you own a company with. Every day Mr. Market shows up to either buy your shares or sell you his shares at a certain price. You can either make a deal with him or ignore him until he comes back the next day with a different price. Usually the price he quotes you makes sense, but occasionally it’s absurd and way off base.
That’s how the stock market behaves. It offers you a different price every day and you have to make the decision to make a deal or ignore it entirely.
The larger point is that on any given day stock market prices can either be on point, or completely under or overvalue your company. The market is irrational and your best bet is to mostly ignore it. Concentrate on the business you own and if the market offers you an overvalued price, sell.
If the market offers you a price below what the company is worth, ignore it. You don’t panic, because you know the true worth of the business and you understand that Mr. Market will be back with a new price tomorrow.
Following the stock market crash of 1929, Graham expounded the virtues of focusing on the hard facts – looking at a company’s reported earnings per share, historical earnings and trying to understand the value of its assets.
Graham also came up with a simple formula to follow. He recommended creating a portfolio of 30 stocks or more, that met specific criteria. These included:
- Price-to-earnings ratio less than 10
- Debt to equity ratio under 50%
- Hold these stocks until they returned 50%
- Sell any stocks that don’t meet the 50% return target within 2 years – regardless of the price.
It sounds simple, but the strategy has been tested, and it works. Graham’s research suggested that this approach would return 15% per year.
Here’s what Tobias Carlyle at Greenbackd found.
The above image shows the performance of Graham’s very simple strategy versus what investing in the S&P 500 over the same time would have returned.
From 1976 to 2011, a portfolio following Graham’s guidelines would have returned 17.8% versus 11.05% for the S&P 500.
To understand how valuable an extra 6% compounded over 35 years is, consider this: $100 invested in the Graham portfolio would have turned into nearly $37,000. $100 invested in the S&P 500 would have turned into $4,351.
If you wanted to build your very own portfolio you can use Buycel to identify which stocks fit into the Graham criteria.
Simply fetch data on earnings, debt and equity for any number of companies using Buycel’s STOCK_LATEST() function. Once you load up all the data, evaluate all the businesses on the two Graham criteria: the debt-to-equity ratio and the price-to-earnings ratio.
This example is just meant as a guide. To properly follow Graham’s portfolio directives, it would make sense to look at how debt to equity changes over time as well as putting together a completely-fleshed out picture of how a company’s 12-month price to earnings ratio behaves over a 7-10 year period.
What’s really great is that Graham left us with another formula, one investors can use to calculate the intrinsic value of a company.
Combine this intrinsic value calculation with the strategy described above and you’ve got the makings of a stellar portfolio. Imagine, using Graham’s teachings one can narrow down a group of stocks to the most promising ones, and then apply an intrinsic value analysis to only buy the ones that are the most affordable.
Intrinsic value calculations try to put a value on a business that accurately reflects its worth, with the understanding that the valuation the market places on a company can often be over or undervalued.
In 1962, Ben Graham’s original intrinsic value formula was calculated as follows:
- V is Intrinsic Value
- EPS is the diluted earnings per share
- 5 is the price to earnings ratio for a no-growth company
- G is the conservatively estimated growth rate in EPS over the next 7 to 10 years.
In 1974, he revised his formula to:
- V is intrinsic value
- 5 is the price to earnings ratio for a no-growth company
- G is the company’s long term (five years) earnings growth estimate
- 4 is the average yield of high-grade corporate bonds in 1962 (when the model was introduced)
- Y is the current yield on 20 year AAA corporate bonds.
Let’s use this formula to see how the intrinsic value of a few companies shapes up in comparison to its market valuation. However, we’ll make a few updates to bring this formula to the present-day.
The first thing we have to understand is that the 8.5 is a subjective number denoting the P/E ratio for a no-growth company. We can be more conservative and assume that the right number is 7.
The current yield on 20 year AAA corporate bonds sits at 3.63%.
Finally, we’ll adjust the 2g in the formula to 1g, as 2 times a company’s 5-year earnings growth estimate is very aggressive. Remember, we want to be conservative but the larger point here is that one should feel free to update the formula to where they feel it reflects their understanding of market conditions.
Then all we have to do is punch in the numbers. We’ll use the EPS from 2012 to calculate g, the long-term growth estimate.
This is an extremely rough estimate, but we can use it to go ahead and calculate our intrinsic value. Finally, an issue with Graham’s formula is that it doesn’t account for personal judgement. For example, owning stock in a company that produces a product soon to be obsolete wouldn’t register as overvalued. In fact, it still might come in as undervalued using the formula.
There is still use in calculating Benjamin Graham’s formula for intrinsic value as long as it’s used in conjunction with other tools at your disposal. Still, it’s solid and Ben Graham’s teachings on value investing have stood the test of time in an otherwise ever changing landscape.
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