Logische investeringsprincipes

In onderstaande tekst trachten we de voornaamste beleggingslessen van Benjamin Graham weer te geven. Deze tekst kan ook gedownload worden in PDF.

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EEN SET VAN REGELS

Benjamin Graham stelt dat bij de selectie van aandelen de belegger regels hanteert die:

(a) eenvoudig zijn in termen van berekening;

In 44 years of Wall Street experience and study, I have never seen dependable calculations made about common stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give speculation the deceptive guise of investment.

“Berekening” impliceert de aanname van een kwantitatieve i.p.v. kwalitatieve benadering bij de selectie van aandelen:

The first, or predictive, approach could also be called the qualitative approach, since it emphasizes prospects, management, and other non-measurable, albeit highly important, factors that go under the heading of quality. The second, or protective, approach may be called the quantitative or statistical approach, since it emphasizes the measurable relationships between selling price and earnings, assets, dividends, and so forth.

In our own attitude and professional work we are committed to the quantitative approach.

(b) geen uitgebreide fundamentele analyses vereisen;

I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, forty years ago, but the situation has changed a great deal since then. In the old days, any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent, I’m on the side of the efficient market school of thought now generally accepted by the professors.

(c) samenhangen met de constantes in het menselijke gedrag;

The rules that survive apply mainly to human nature and human conduct.

(d) een margin of safety introduceren;

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

De margin of safety beschermt de belegger tegen een verslechtering in de economische toestand van de onderneming:

Their main effort is to assure themselves of a substantial margin of indicated present value above the market price – which margin could absorb unfavorable developments in the future.

(e) geen voorspellingen vereisen.

Dit geldt op het niveau van

(e1) de aandelenmarkt;

It is absurd to think that the general public can ever make money out of market forecasts.

(e2) individuele ondernemingen.

Most enterprising investors, therefore, will be inclined to view as the chief role for their intelligence and judgment the correct appraisal of the future possibilities of the many companies they examine. How well can this be done? … The long-term future of a company is at best “an educated guess.” Some of the best-educated guesses, derived from the most painstaking research, have turned out to be abysmally wrong.

De uitkomst van de toepassing van dergelijke regels bestaat doorgaans uit de aandelen van ondernemingen die over de voorbije periode(s) wegens teleurstellende resultaten (zwaar) werden afgestraft:

If the latter [growth stocks] may often sell to high because they are too popular, many not non-growth stocks often sell too low because they are too unpopular? We believe the answer to this question is definitely “yes”.

De aankoop van de aandelen van ondernemingen met een ondermaatse track-record gaat gepaard met een psychologische drempel voor beleggers. Benjamin Graham stelt echter:

Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right. Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.

Er is geen garantie dat één onderneming die geselecteerd wordt op basis van een set van regels die voldoet aan bovenstaande voorwaarden niet zal resulteren in een verliespositie voor de belegger. Benjamin Graham schuift bijgevolg diversificatie naar voren als een noodzakelijk complement van het margin-of-safety principe:

Even with a margin in the investor’s favor, 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 the more the number of such commitments is multiplied the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses.

INTELLIGENT

Benjamin Graham omschrijft een belegger als intelligent indien deze laatste er in slaagt de set van regels op een systematische wijze toe te passen:

The common-stock investor can hold himself rigidly to a true investment pattern.

Systematisch impliceert onmiddellijk dat de belegger zich kan isoleren van de dagelijkse fluctuaties op de aandelenmarkt:

The investor cannot enter the arena of the stock market with any real hope of success unless he is armed with mental weapons that distinguish him in kind – not in a fancied superior degree – from the trading public. One possible weapon is indifference to market fluctuations; such an investor buys carefully when he has money to place and then lets prices take care of themselves.

De dagelijkse fluctuaties op de aandelenmarkt

The market is always making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.

dienen door de belegger beschouwd te worden als een opportuniteit op basis waarvan winst gerealiseerd kan worden:

The outstanding characteristic of the stock market is its tendency to react excessively to favorable and unfavorable influences.

The intelligent investor has no cause to berate the perversity of the stock market; in this very perversity lie both his opportunities and his ultimate profits.

The investor can profit from market fluctuations only by paying them little heed. He must fix his eye not on what the market has been doing – or what it apparently is going to do – but only on the result of its action as expressed in the relationship between the price level and the level of underlying or central values.

Op een dieper niveau impliceert systematische toepassing ook dat de belegger niet ontgoocheld wordt en gaat afwijken van de set van regels van zodra de return van de korf van geselecteerde aandelen in de eerste maanden onder de verwachtingen blijft:

The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored.

Benjamin Graham geeft ons een indicatie omtrent het geduld dat een belegger aan de dag dient te leggen bij het aanhouden van een aandelenportefeuille:

Our own records indicate that the interval required for a substantial undervaluation to correct itself averages approximately 1 1/2 to 2 1/2 years.

“Intelligent” – systematische toepassing van een set van regels – betekent bijgevolg niet dat de belegger dient te beschikken over uitzonderlijke intellectuele capaciteiten:

The word “intelligent” in our title will be used throughout the book in its common and dictionary sense as meaning endowed with the capacity for knowledge and understanding. It will not be taken to mean smart or shrewd, or gifted with unusual foresight or insight. Actually the intelligence here presupposed is a trait more of the character then of the brain.

RESULTATEN

Benjamin Graham vermeldt tot slot welke resultaten bekomen kunnen worden indien de belegger er in slaagt de set van regels systematisch toe te passen:

Let us hazard a guess, however, as to what may be accomplished by an alert student of the investment art, who (a) is of average intelligence, (b) proceeds on sound principles, and (c) is advised by a competent security analyst, of whom he asks the right questions. With this equipment we think he should be able to double the average annual return obtained by his easy-going friend, the passive or defensive investor.

Bronnen: The Intelligent Investor, FAJ

Benjamin Graham speaks – (1)

In onderstaande tekst vinden we enkele antwoorden van Benjamin Graham uit het interview “A conversation with Benjamin Graham” met de FAJ. We schrijven september/oktober 1976.

In the light of your 60-odd years of experience in Wall Street what is your overall view of common stocks ?

Common stocks have one important investment characteristic and one important speculative characteristic. Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the reinvestment of undistributed earnings – incidentally, with no clear-cut plus or minus response to inflation. However, most of the time common stocks are subject to irrational and excessive price fluctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble – i.e., to give way to hope, fear and greed.

What is your view of Wall Street as a financial institution ?

A highly unfavorable – even a cynical – one. The Stock Exchanges appear to me chiefly as a John Bunyan type of Vanity Fair, or a Falstaffian joke, that frequently degenerates into a madhouse – “a tale full of sound and fury, signifying nothing.” The stock market resembles a huge laundry in which institutions take in large blocks of each other’s washing – nowadays to the tune of 30 million shares a day – without true rhyme or reason. But technologically it is remarkably well-organized.

What is your view of the financial community as a whole ?

Most of the stockbrokers, financial analysts, investment advisers, etc., are above average in intelligence, business honesty and sincerity. But they lack adequate experience with all types of security markets and an overall understanding of common stocks – of what I call “the nature of the beast.” They tend to take the market and themselves too seriously. They spend a large part of their time trying, valiantly and ineffectively, to do things they can’t do well.

What sort of things, for example ?

To forecast short- or long-term changes in the economy, and in the price level of common stocks, to select the most promising industry groups and individual issues – generally for the near-term future.

Turning now to individual investors, do you think that they are at a disadvantage compared with the institutions, because of the latter’s huge resources, superior facilities for obtaining information, etc. ?

On the contrary, the typical individual investor has a great advantage over the large institutions.

Why ?

Chiefly because these institutions have a relatively small field of common stocks to choose from – say 300 to 400 huge corporations – and they are constrained more or less to concentrate their research and decisions on this much over-analyzed group. By contrast, most individuals can choose at any time among some 3000 issues listed in the Standard & Poor’s Monthly Stock Guide. Following a wide variety of approaches and preferences, the individual investor should at all times be able to locate at least one per cent of the total list – say, 30 issues or more – that offer attractive buying opportunities.

Can you indicate concretely how an individual investor should create and maintain his common stock portfolio ?

I can give two examples of my suggested approach to this problem. One appears severely limited in its application, but we found it almost unfailingly dependable and satisfactory in 30-odd years of managing moderate-sized investment funds. The second represents a great deal of new thinking and research on our part in recent years. It is much wider in its application than the first one, but it combines the three virtues of sound logic, simplicity of application, and an extraordinarily good performance record, assuming – contrary to fact – that it had actually been followed as now formulated over the past 50 years – from 1925 to 1975.

What general rules would you offer the individual investor for his investment policy over the years ?

Let me suggest three such rules: (1) The individual investor should act consistently as an investor and not as a speculator. This means, in sum, that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money’s worth for his purchase – in other words, that he has a margin of safety, in value terms, to protect his commitment. (2) The investor should have a definite selling policy for all his common stock commitments, corresponding to his buying techniques. Typically, he should set a reasonable profit objective on each purchase – say 50 to 100 per cent – a maximum holding period for this objective to be realized – say, two to three years. Purchases not realizing the gain objective at the end of the holding period should be sold out at the market. (3) Finally, the investor should always have a minimum percentage of his total portfolio in common stocks and a minimum percentage in bond equivalents. I recommend at least 25 per cent of the total at all times in each category. A good case can be made for a consistent 50-50 division here, with adjustments for changes in the market level. This means the investor would switch some of his stocks into bonds on significant rises of the market level, and vice-versa when the market declines. I would suggest, in general, an average seven- or eight-year maturity for his bond holdings.

In selecting the common stock portfolio, do you advise careful study of and selectivity among different issues ?

In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors.

What general approach to portfolio formation do you advocate ?

Essentially, a highly simplified one that applies a single criteria or perhaps two criteria to the price to assure that full value is present and that relies for its results on the performance of the portfolio as a whole – i.e., on the group results – rather than on the expectations for individual issues.

Some details, please, on your two recommended approaches.

My first, more limited, technique confines itself to the purchase of common stocks at less than their working-capital value, or net-current-asset value, giving no weight to the plant and other fixed assets, and deducting all liabilities in full from the current assets. We used this approach extensively in managing investment funds, and over a 30-odd year period we must have earned an average of some 20 per cent per year from this source. For a while, however, after the mid-1950’s, this brand of buying opportunity became very scarce because of the pervasive bull market. But is has returned in quantity since the 1973-74 decline. In January 1976 we counted over 300 such issues in the Standard & Poor’s Stock Guide – about 10 per cent of the total. I consider it a foolproof method of systematic investment – once again, not on the basis of individual results but in terms of the expectable group outcome.

Finally, what is your other approach ?

This is similar to the first in its underlying philosophy. It consists of buying groups of stocks at less than their current or intrinsic value as indicated by one or more simple criteria. The criterion I prefer is seven times the reported earnings for the past 12 months. You can use others – such as a current dividend return above seven per cent or book value more than 120 per cent of price, etc. We are just finishing a performance study of these approaches over the past half-century – 1925-75. They consistently show results of 15 per cent or better per annum, or twice the record of the DJIA for this long period. I have every confidence in the threefold merit of this general method based on (a) sound logic, (b) simplicity of application and (c) an excellent supporting record. At bottom it is a technique by which true investors can exploit the recurrent excessive optimism and excessive apprehension of the speculative public.

Benjamin Graham speaks – (2)

In onderstaande tekst vinden we enkele antwoorden van Benjamin Graham uit het interview “An hour with Mr. Graham” met de FAJ. Het interview verscheen in de november/oktober editie 1976. Benjamin Graham overleed op 21 september 1976. Meer dan dertig jaar later zijn de inzichten van Graham nog steeds even relevant.

HB: Looking back at your own life in the investment field, what are some of the key developments or key happenings, would you say ? You went to Wall Street in 1914 ?

Graham: Well, the first thing that happened was typical. As a special favor, I was paid $12 a weak instead of $10 to begin. The next thing that happened was World War I broke out two months later and the stock exchange was closed. My salary was reduced to $10 – that is one of the things more or less typical of any young man’s beginnings. The next thing that was really important to me – outside of having made a rather continuous success for 15 years – was the market crash of 1929.

HB: Did you see that coming at all – were you scared ?

Graham: No. All I knew was that prices were too high. I stayed away from the speculative favorites. I felt I had good investments. But I owed money, which was a mistake, and I had to sweat through the period 1929-1932. I didn’t repeat that error after that.

HB: Did anybody really see this coming – the crash of 1929 ?

Graham: Babson did, but he started selling five years earlier.

HB: Then in 1932, you began to come back ?

Graham: Well, we sweated through that period. By 1937, we had restored our financial position as it was in 1929. From then on, we went along pretty smoothly.

HB: The 1937-1938 decline, were you better prepared for that ?

Graham: Well, that led us to make some changes in our procedures that one of our directors had suggested to us, which was sound, and we followed his advice. We gave up certain things we had been trying to do and concentrated more on others that had been more consistently successful. We went along fine. In 1948, we made our GEICO investment and from then on, we seemed to be very brilliant people.

HB: What happened in the only interim bear market – 1940-1941 ?

Graham: Oh, that was only a typical setback period. We earned money in those years.

HB: You earned money after World War II broke out ?

Graham: Yes, we did. We had no real problems in running our business. That’s why I kind of lost interest. We were no longer very challenged after 1950. About 1956, I decided to quit and to come out here to California to live.

I felt that I had established a way of doing business to a point where it no longer presented any basic problems to be solved. We were going along on what I thought was a satisfactory basis, and the things that presented themselves were typically repetitions of old problems which I found no special interest in solving.

About six years later, we decided to liquidate Graham-Newman Corporation – to end it primarily because the succession of management had not been satisfactorily established. We felt we had nothing special to look forward to that interested us. We could have built up an enormous business had we wanted to, but we limited ourselves to a maximum of $15 million of capital – only a drop in the bucket these days. The question of whether we could earn the maximum percentage per year was what interested us. It was not the question of total sums, but annual rates of return that we were able to accomplish.

HB: When did you decide to write your classic text, Security Analysis ?

Graham: What happened was that in about 1925, I thought that I knew enough about Wall Street after 11 years to write a book about it. But fortunately, I had the inspiration instead to learn more on the subject before I wrote the book, so I decided I would start teaching if I could. I became a lecturer at the Columbia School of Business for the extension courses. In 1928, we had a course in security analysis and finance – I think it was called investments – and I had 150 students. That was the time Wall Street was really booming.

The result was it took until 1934 before I actually wrote the book with Dave Dodd. He was a student of mine in the first year. Dave was then assistant professor at Columbia and was anxious to learn more. Naturally, he was indispensable to me in writing the book. The First Edition appeared in 1934. Actually, it came out the same time as a play of mine which was produced on Broadway and lasted only one week.

HB: You had a play on Broadway ?

Graham: Yes. “Baby Pompadour” or “True to the Marines”. It was produced twice under two titles. It was not successful. Fortunately, Security Analysis was much more successful.

HB: That was the book, wasn’t it ?

Graham: They called it the “Bible of Graham and Dodd.” Yes, well now I have lost most of the interest I had in the details of security analysis which I devoted myself to so strenuously for many years. I feel that they are relatively unimportant, which, in a sense, has put me opposed to developments in the whole profession. I think we can do it successfully with a few techniques and simple principles. The main point is to have the right general principles and the character to stick to them.

HB: My own experience is that you have to be a student of industries to realize the great differences in managements. I think that this is one thing an analyst can bring to the solution.

Graham: Well, I would not deny that. But I have a considerable amount of doubt on the question of how successful analysts can be overall when applying these selectivity approaches. The thing that I have been emphasizing in my own work for the last few years has been the group approach. To try to buy groups of stocks that meet some simple criterion for being undervalued – regardless of the industry and with very little attention to the individual company. My recent article on three simple methods applied to common stocks was published in one of your Seminar Proceedings.

I am just finishing a 50-year study – the application of these simple methods to groups of stocks, actually, to all the stocks in the Moody’s Industrial Stock Group. I found the results were very good for 50 years. They certainly did twice as well as the Dow Jones. And so my enthusiasm has been transferred from the selective to the group approach. What I want is an earnings ratio twice as good as the bond interest ratio typically for most years. One can also apply a dividend criterion or an asset value criterion and get good results. My research indicates the best results come from simple earnings criterions.

HB: By some coincidence as you were becoming less active as a writer, a number of professors started to work on the random walk theory. What do you think about this ?

Graham: Well, I am sure they are all very hardworking and serious. It’s hard for me to find a good connection between what they do and practical investment results. In fact, they say that the market is efficient in the sense that there is no particular point in getting more information than people already have. That might be true, but the idea of saying that the fact that the information is so widely spread that the resulting prices are logical prices – that is all wrong. I don’t see how you can say that the prices made in Wall Street are the right prices in any intelligent definition of what right prices would be.

HB: It is too bad there have not been more contributions from practicing analysts to provide some balance to the brilliant work of the academic community.

Graham: Well, when we talk about buying stocks, as I do, I am talking very practically in terms of dollars and cents, profits and losses, mainly profits. I would say that if a stock with $50 working capital sells at $32, that would be an interesting stock. If you buy 30 companies of that sort, you’re bound to make money. You can’t lose when you do that. There are two questions about this approach. One is, am I right in saying if you buy stocks at two-thirds of the working capital value, you have a dependable indication of group undervaluation ? That’s what our own business experience proved to us. The second question, are there other ways of doing this ?

HB: Are there any other ways ?

Graham: Well, naturally, the thing that I have been talking about so much this afternoon is applying a simple criterion of the value of a security. But what everybody else is trying to do pretty much is pick out the Xerox companies, the 3M’s, because of their long-term futures or to decide that next year the semiconductor industry would be a good industry. These don’t seem to be dependable ways to do it. There are certainly a lot of ways to keep busy.

HB: Would you have said that 30 years ago ?

Graham: Well, no, I would not have taken as negative an attitude 30 years ago. But my positive attitude would have been to say, rather that you would have found sufficient examples of individual companies that were undervalued.

HB: The efficient market people have kind of muddied the waters, haven’t they, in a way ?

Graham: Well, they would claim that if they are correct in their basic contentious about the efficient market, the thing for people to do is to try to study the behavior of stock prices and try to profit from these interpretations. To me, that is not a very encouraging conclusion because if I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.

HB: That is certainly true.

Graham: And all you have to do is to listen to Wall Street Week and you can see that none of them has any particular claim to authority or opinions as to what will happen in the stock market. They, and economists, all have opinions and they are willing to express them if you ask them. But I don’t think they insist that their opinions are correct, though.

HB: Mr. Graham, what advice would you give to a young man or woman coming along now who wants to be a security analyst and a Chartered Financial Analyst ?

Graham: I would tell them to study the past record of the stock market, study their own capabilities, and find out whether they can identify an approach to investment they feel would be satisfactory in their own case. And if they have done that, pursue that without any reference to what other people do or think or say. Stick to their own methods. That’s what we did with our own business. We never followed the crowd, and I think that’s favorable for the young analyst. If he or she reads The Intelligent Investor – which I feel would be more useful than Security Analysis of the two books – and selects from what we say some approach which one thinks would be profitable, then I say that one should do this and stick to it.

HB: Do you think that Wall Street or the typical analyst or portfolio managers have learned their lessons of the “Go-Go” funds, the growth cult, the one-decision stocks, the two-tier market, and all ?

Graham: No. They used to say about the Bourbons that they forgot nothing and they learned nothing, and I’ll say about the Wall Street people, typically, is that they learn nothing, and they forget everything. I have no confidence whatever in the future behavior of the Wall Street people. I think this business of greed – the excessive hopes and fears and so on – will be with us as long as there will be people. There is a famous passage in Bagehot, the English economist, in which he describes how panics come about. Typically, if people have money, it is available to be lost and they speculate with it and they lose it – that’s how panics are done. I am very cynical about Wall Street.

HB: But there are independent thinkers on Wall Street and throughout the country who do well, aren’t there ?

Graham: Yes. There are two requirements for success in Wall Street. One, you have to think correctly, and secondly, you have to think independently.

HB: Yes, correctly and independently. The sun is trying to come out now, literally, here in La Jolla. What do you see of the sunshine on Wall Street ?

Graham: Well, there has been plenty of sunshine since the middle of 1974 when the bottom of the market was reached. And my guess is that Wall Street hasn’t changed at all. The present optimism is going to be overdone, and the next pessimism will be overdone, and you are back on the Ferris Wheel – whatever you want to call it – seesaw, merry-go-round. You will be back on that. Right now, stocks as a whole are not overvalued, in my opinion. But nobody seems concerned with what are the possibilities that 1970 and 1973-1974 will be duplicated in the next five years. Apparently, nobody has given any thought to that question. But that such experiences will be duplicated in the next five years or so, you can bet your Dow Jones Average on that.

Benjamin Graham speaks – (3)

In onderstaande tekst vinden we enkele antwoorden van Benjamin Graham uit het interview “The Simplest Way to Select Bargain Stocks” met Medical Economics. Het interview verscheen in de september editie 1976.

Q: Are you seeking out growth issues ?

A: No. To my mind the so-called growth-stock investor – or the average security analyst for that matter – has no idea of how much to pay for a growth stock, how many stocks to buy to obtain the desired return, or how their prices will behave. Yet these are basic questions. That’s why I feel the growth-stock philosophy can’t be applied with reasonably dependable results.

Q: What about the conventional yard sticks like a company’s projected earnings or market share for evaluating stocks ?

A: Those factors are significant in theory, but they turn out to be of little practical use in deciding what price to pay for particular stocks or when to sell them. The only thing you can be sure of is that there are times when large numbers of stocks are priced too high and other times when they’re priced too low. My investigations have convinced me you can predetermine these logical “buy” and “sell” levels for a widely diversified portfolio without getting involved in weighing the fundamental factors affecting the prospects of specific companies or industries.

Q: That kind of thinking – ignoring fundamentals – would be branded as heresy by many analysts today.

A: Maybe so, but my research shows it works. What’s needed is, first, a definite rule for purchasing which indicates a priori that you’re acquiring stocks for less than they’re worth. Second, you have to operate with a large enough number of stocks to make the approach effective. And finally you need a very definite guideline for selling.

Q: Can a doctor or any investor, like me, do all that ?

A: Absolutely.

Q: How should I start ?

A: By making as large a list as possible of common stocks currently selling at no more than seven times their latest – not projected – 12-month earnings. Just look up the price-earnings ratios listed in the stock quotation columns of The Wall Street Journal or other major daily newspapers.

Q: Why a P-E ratio of seven instead of, say, nine or five ?

A: One of the ways to determine what you should pay for stocks at any given time is to look at what quality bonds are yielding. If bond yields are high, you want to buy stocks cheaply, meaning you will look for relatively low P-Es. And if bond yields drop, then you can pay more for the stock and accept a higher P-E. As a rule of thumb in pricing stocks this way, I select only those issues whose earnings-to-price ratio – simply the P-E in reverse – is at least twice the average current yield on top-quality (triple-A) corporate bonds.

Q: Okay. So, as of today, your formula says to consider only stocks with a P-E of seven or less. Is that all there is to it ?

A: Well, that group alone should provide the basis for a pretty good portfolio, but by using an additional criterion you could do even better. You should select a portfolio of stocks that not only meet the P-E requirements but also are in companies with a satisfactory financial position.

Q: How do I determine that ?

A: There are various tests you could apply, but I favor this simple rule: A company should own at least twice what it owes. An easy way to check on that is to look at the ratio of stockholders’ equity to total assets; if the ratio is at least 50 percent, the company’s financial condition can be considered sound.

Q: Are there stocks around today that meet these requirements ?

A: Oh, yes. Not nearly as many as in the market decline of 1973 and 1974, but there are still plenty.

Q: Once I’ve gone through the screening process and settled on my “buy” candidates, how do I go about structuring a portfolio ?

A: To give yourself the best odds statistically, the more stocks you have to play with, the better. A portfolio of 30 would probably be an ideal minimum. If your capital is limited, you can deal in “odd lots” – less than 100 shares of stock.

Q: How long should I hold onto these stocks ?

A: First you set a profit objective for yourself. An objective of 50 percent of cost should give good results.

Q: You mean that I should aim for a 50 percent profit on every stock I buy ?

A: Yes. As soon as a stock goes up that much, sell it.

Q: What if it doesn’t reach that objective ?

A: You have to set a limit on your holding period in advance. My research shows that two to three years works out best. So I recommend this rule: If a stock hasn’t met your objective by the end of the second calendar year from the time of purchase, sell it regardless of price. For example, if you bought a stock in September 1976, you’d sell it no later than the end of 1978.

Q: What do I do with the money when I sell off a stock ? Reinvest it in other issues that meet your requirements ?

A: Usually, yes, with some flexibility dictated by market conditions. In times like the 1974 drop, when you find many good companies whose stocks are selling at low P-E levels, you should take advantage of the situation and put up to 75 percent of your investment capital into common stocks. Conversely, in periods when the market as a whole is overpriced you’d have trouble finding stocks to reinvest in that meet my criteria. In such periods you should have no more than 25 percent of your funds in stocks and the rest in, say, U.S. Government bonds.

Q: Using your strategy what kind of results can I expect ?

A: Obviously you’re not going to get a 50 percent gain on every stock you buy. If your holding-period limit on a stock expires, you’ll have to sell it at a smaller profit or even take a loss. But in the long run, you should average a return of 15 percent a year or better on your total investment, plus dividends and minus commissions. Over all, dividends should amount to more than commissions.

Q: This is the return you’d have gotten over 50 years according to your research ?

A: Yes, and the results have been very consistent for successive periods as short as five years. I don’t think a shorter period gives the strategy a really fair chance to prove itself. In applying the approach every investor should be prepared financially and psychologically for the possibility of poor short-term results. For example, in the 1973-1974 decline the investor would have lost money on paper, but if he’d held on and stuck with the approach, he would have recouped in 1975-1976 and gotten his 15 percent average return for the five-year period. If we get a repeat of that situation, the investor should be prepared to ride out the downturn.

Q: With the Dow around 1000 and many issues at their five-year highs, is there a danger of the kind of drop that followed the overpriced markets of the late 1960s and early 1970s ?

A: I have no particular confidence in my powers – or anyone else’s – to predict what will happen with the market, but I do know that if the price level is dangerously high, chances are you will get a serious correction. In my own tests there were a number of periods of overvaluation, and the number of stocks available at attractive prices was very small; that proved a warning that the market as a whole was too high.

Q: Can you summarize the key to making your approach work ?

A: The investor needs the patience to apply these simple criteria consistently over a long enough stretch so that the statistical probabilities will operate in his favor.

The father of value investing

by Albert L. Auxier (1994)

We celebrate Benjamin Graham’s 100th birthday – and the 60th anniversary of the publication of Security Analysis – by examining his investment philosophy. For this purpose, we rely heavily on The Intelligent Investor, which he considered more useful than Security Analysis to a young security analyst.

FATHER OF VALUE INVESTING

Ben Graham is the Father of Value Investing. The essence of value investing is that any investment should be worth substantially more than an investor has to pay for it. This investment philosophy may seem like common sense, but strangely enough – as Ben might have put it – many investors are not careful to see that they receive good value for their money. Ben wasn’t the first value investor. Bernard Baruch and other value investors predate him. In fact, the first value investor probably was a cave person. But Graham, among early Wall Streeters, did the most to invent a systemized body of investment knowledge. He built this body of knowledge through research and practice, and he disseminated it through his teaching and writings. Whereas, Ben Graham is considered the Father of Value Investing, he actually fathered the modern study of investments.

MARGIN OF SATEFY CONCEPT

Graham was most insistent that any security purchased should represent good value. He felt stocks should be bought like groceries, not like perfume, and he distilled his investment philosophy down to just three words, “MARGIN OF SAFETY”. By margin of safety, he meant that any stock bought should be worth considerably more than it costs. He sometimes suggested at least 50 percent more. Stocks bought with a margin of safety give some assurance that one has invested wisely. And stocks bought with a margin of safety should be low risk, high return investments – the kind we all want.

How do you find stocks with a margin of safety? In part, they are found by avoiding stocks which are unlikely to possess this margin. Popular stocks are avoided since they are likely to be fully priced, and growth stocks are avoided since they tend to be popular and since they tend to perform poorly in bad markets. And you follow rules pertaining to low price/earnings ratios, low price/book value ratios, etc., which are designed to exclude stocks without a margin of safety.

INVESTMENT PERFORMANCE DEPENDS ON INTELLIGENT EFFORT

Graham disagreed with the usual postulated risk-return relationship, that is, to earn a higher return an investor must accept higher risk. To the contrary, he felt that the more intelligent effort one put into investing, the better the bargains bought. And the better the bargains, the lower the risk. Thus intelligent investing provides high yields and low risk. Finance academicians often fail to appreciate this point.

INVESTMENT VERSUS SPECULATION

The distinction between investment and speculation is central to Graham’s investment philosophy. He defined these terms thusly: “An investment operation is one which, upon thorough analysis promises safety of principal and adequate return. Operations not meeting these requirements are speculative.” Based on this distinction, a speculator is either taking substantial risk or is not knowledgeable. While “speculation is always fascinating,” Graham believed that for most speculators it is not “fattening to the pocketbook.” Speculation is akin to gambling, and Graham warned that one must be vigilant so as not to unconsciously slip into this mode.

FAMOUS MR. MARKET PARABLE

Stocks will fluctuate substantially in value. For a true investor, the only significant meaning of price fluctuations is that they offer “an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.”

Using his famous Mr. Market parable, Graham suggests the attitude one should adopt toward fluctuations in prices. Imagine owning a $1,000 interest in a business along with a partner, Mr. Market. Every day the accommodating Mr. Market offers either to buy your interest or to sell you a larger interest. Sometimes his price is ridiculously high, allowing you a good opportunity to sell. At other times his price is ridiculously low, allowing you a good opportunity to buy. Still at other times, his quotes are roughly justified by the business outlook, and you can ignore them.

The point is that the market is there for your convenience and profit. And market valuations are often wrong. Price fluctuations, Graham believes “bear no relationship to underlying conditions and values.” It is a mistake, he argued, to let the market determine what stocks are worth. “In an astonishingly large proportion of the trading in common stocks,” Graham stated, “those engaged therein don’t appear to know – in polite terms – one part of their anatomy from another.” Generally an investor will be wiser to form independent stock valuations, and then to exploit divergences between those valuations and the market’s prices.

GRAHAM DECLINES TO PREDICT EARNINGS

In The Intelligent Investor, Graham evaluated the investment merit of several stocks, but not once did he predict earnings for those stocks. (On other occasions, however, he did venture to predict earnings.) For instance, at the conclusion of his analyses of ELTRA and Emhart stocks, he concluded, “We make no predictions about the future earnings performance.”

That Graham, an eminent security analyst, should decline to predict earnings is intriguing. He obviously did not have much confidence in his ability to predict earnings – nor in others’ predictions, especially long-term predictions. Sophisticated investors have always been aware of this difficulty. For instance, John Maynard Keynes, the British economist, more than a half-century ago emphasized the great difficulty involved in forecasting investment returns. In regard to this difficulty, Keynes said:

The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence.

Graham apparently felt that earnings forecasting is too inaccurate to be useful, given that the market already incorporates the consensus estimate. There also is danger of double counting for good earnings prospects. When this occurs, the market price allows for the good prospects but the investor counts them again.

Apparently because of such problems, Graham believed that the security valuation process is not very reliable. The inherent inaccuracy of this valuation process may explain Graham’s observation that he had never “seen dependable calculations made about common-stock values … that went beyond simple arithmetic or the most elementary algebra.” In valuing stock, crude, simple calculations often are as good as you can do.

THE PREVALENT APPROACH TO INVESTING OFTEN DOES NOT WORK

The prevalent approach to investing is first to choose the best industry, and then to invest in the best company in that industry, regardless of the stock’s price. Graham did not think well of this approach because he believed it was too unreliable. Good business does not always translate into good investment returns, and even the experts have difficulty selecting and concentrating on those issues which will become winners. Finally, the application of this method may place an investor in popular, overvalued stocks.

SELECT LOW PRICE/BOOK VALUE STOCKS

Graham felt rather strongly that an investor should not pay much more than book value for a stock. In his word, “Strangely enough we shall suggest as one of our chief requirements … that our readers limit themselves to issues selling not far above their tangible-asset value.” He advised conservative (defensive) investors not to pay above one-third more than book value, and aggressive (enterprising) investors not to pay above 20 percent more than book value.

Graham’s bias against high price-to-book value stocks is simply explained: These stocks tend to be popular, speculative, overpriced and more risky. Often, popular growth stocks fall into this category and should be avoided. It is paradoxical, Graham thought, that our most successful companies should be avoided for investment purposes.

SELECTING UNPOPULAR STOCKS

If an investor is to do better than average, Graham argued that his or her investment policies should not be popular. He believed that most Wall Street professionals tend to seek out stocks with the best growth prospects and to ignore other stocks. This bias causes unpopular stocks to become undervalued and good buys. “It would be rather strange”, Graham suggested, “if – with all the brains at work professionally in the stock market – there could be approaches which are both sound and relatively unpopular. Yet our career and reputation have been based on this unlikely fact.” An investor who follows the crowd is unlikely to experience even average results, if for no other reason because of transactions costs.

ENTHUSIASM ON WALL STREET IS DANGEROUS

Graham warned “that while enthusiasm may be necessary for great accomplishments elsewhere, in Wall Street it almost invariable leads to disaster.” He didn’t explain his rationale for this view, but enthusiasm destroys our critical faculties and leads us to believe we have a “sure thing”. Coupled with greed, thinking an investment is a sure thing is most dangerous. We tend to bet heavily on the stock, forgetting the legendary Bernard Baruch’s warning that every investment is something of a gamble. Moreover, enthusiasm leads a person into speculation, which Graham greatly deplored.

INVESTMENT EXPERIENCE AND STOCK MARKET HISTORY ARE IMPORTANT

Ben Graham’s 57 years on Wall Street were most instructive, and he expressed his appreciation to them when he alluded to his “old ally, experience”. To an important extent, you learn to invest by investing. Too often we have to make the same mistake as others before the lesson is instructive. All of us, it seems, must learn through the school of hard knocks. We would do better to learn from the likes of Ben Graham.

Graham was a careful student of stock market history, and he placed great emphasis on it. He thought that “No statement is more true and better applicable to Wall Street than the famous warning of Santayana: `Those who do not remember the past are condemned to repeat it.’” Graham could ridicule investors grasp of stock market history, referring to their “proverbial short memories”.

It was Graham’s knowledge of the long sweep of stock market history that prompted his view that “the investor may as well resign himself … to the probability … that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next 5 years.” Historical insight is critical to successful investing. It is only through knowledge of the past that we can tell anything about the future.

USING AN INVESTMENT ADVISOR

A great majority of investors are amateurs, and naturally many of these investors turn to professionals for advice. Yet there is something naive, Graham cautioned, about asking others how to make money. Unless an investor has an intimate and favorable knowledge of the advisor, Graham suggested the investor limit his or her investments to “conservative and even unimaginative forms”. The main benefit of a professional advisor, Graham argued, is to protect the investor from costly mistakes, not to beat the averages.

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