Benjamin Graham, Speculation Be Damned!

His Life 1894 - 1976

Benjamin Graham’s first Wall Street job was with Newberger, Henderson & Loeb. He made $12 per week as a runner. Soon after, he was writing concise descriptions of the firm’s daily bond purchase list. His career progressed quickly as he was soon promoted to partner.

His life milestones included teaching at Columbia University, authoring several books including the famous Intelligent Investor and Security Analysis. His greatest financial achievement was purchasing a controlling interest in GEICO Insurance...and of course, teaching Warren Buffett.

His Lessons

It's no secret Benjamin Graham was not a friend of technical analysis. Before we learn why he loved value investing, let’s review why he made fun of technical trading.

Benjamin Graham felt technical analysis had not been proven effective and leads the investor to speculative decisions. Making decisions based on the past history of stock prices is a gamble. Making decisions based on the financial condition of a company is far superior. Trying to buy when the market is down and sell when it is up is tough to do. Future price movements are not dependant on the past.

Investors are always looking for growth stocks. The problem here is by the time you discover one, Wall Street will have discovered it first. This means the price has already appreciated and you're overpaying. In addition, “growth” comes at a cost. It requires more expenditures on equipment, employees and inventory. All this chips away at the bottom line.

Try Value Line now and learn how to beat the Dow

A firm should have a brand name in the industry, not compete solely on price, have high barriers to entry and achieve consistent earnings. Otherwise, look elsewhere.

Market theory states that the market is efficient, and stock prices reflect everything you need to know about a company. If that is true, the only way to beat the market is through luck. After all, if a stock is properly valued at all times, when can you buy it lower than someone is willing to pay for it.

This leads us to ask the burning question: What is Value Investing?

This is the process of determining the fundamental value of a security by analyzing key data from the financial statements. We take this value and compare it to the market price (current value of stock). If the value is lower significantly lower than the market…we buy that stock. This difference is known as our cushion against risk. What I’m really try to say is buy good quality stocks at cheap prices and hold ‘em.

The Benjamin Graham investor does not wait for the market to drop before buying stocks. If you’ve identified a quality stock that you feel is undervalued, buy it. Ignore day to day fluctuations.

“The disciplined, rational investor neither follows popular choice nor plays market swings; rather he searches for stocks selling at a price below their intrinsic value and waits for the market to recognize and correct its errors.” - Benjamin Graham.

Graham would buy beat up companies if he felt they were “cheap” compared to their intrinsic value. As the market discovered these firms, their value might rise. Let’s take a look at Benjamin Graham’s Intrinsic Value Number.

Before we go there, let me add this. Intrinsic value is the true value of a company's worth; ignoring what the stock price is worth. We want companies where intrinsic value > market value.

Graham’s strategy would be to buy the stock of a company if it was at least two-thirds cheaper that it’s intrinsic value. Before I give an example, let me just say it’s a lot tougher these days to find stocks exhibiting this criteria.

Why? Finding undervalued stocks is about finding something that no one knows about yet. That's not easy. But Yahoo! and MSN have preset screeners that find stocks which fall into the "undervalued" catagory. I use the screeners myself. I have yet analyze financial statements. But if you do, here's a quick way:

Let’s say you’ve identified Acme International. Take the currents assets and subtract total liabilities. All this stuff is easily found on Yahoo! or MSN Money.

• Current Assets: $40 million

• minus

• Total Liabilities: $20 million

• Net Current Assets: $20 million

We go to Yahoo! Finance and discover the market capitalization value ($17 current price of stock x 1,000,000 outstanding shares) is $17 million. Is Acme a bargain selling at less than 2/3 of its net current assets?

2/3 (.66) x $20 million = $13.2 million

Even though Acme’s net current assets are selling at a discount in the market…they did not meet Graham’s 2/3 cutoff. The market value would’ve had to have been below $13.2 million.

Market value is $17 million & current value is $20 million

Whether you want to use 2/3 is up to you. The important thing is buying “stocks at a discount” and maintaining a nice margin.

More Graham Wisdom

Basically, you’d like to see the board of director’s have a bumper sticker on the back of their suits that says “How am I driving? Call 1-800 DON'T FIRE ME”

Dividends A dollar of surplus earnings is better in the investor’s pocket than paid back into the business. Companies that pay higher dividends usually have higher stock prices. A company’s dividend history is a bit of insight into how generous they are. Not a mind-blowing revelation, but it makes sense. If the stock is performing poorly, at least you get some return on your investment.

Earnings Benjamin Graham agrees that earnings are important. He’s just suspicious that management will fudge them. One time events can be included in earnings such as the sale of a division. With that being said, unless you have the time to comb through a balance sheet & income statement, stick with consistent earnings growth. That always puts the odds in your favor.

Index Funds History shows that most fund managers do not beat the S&P 500 or other broad market indexes. Why? High expense fees, there’re restricted to an industry, small companies may be off limits. Although Benjamin Graham did not figure mutual funds into his scheme of value investing; Warren Buffett did. Buffett believed if the investor does not have time to do the research, invest in index funds.

To be a successful value investor takes work. Where a stock chart lover needs only to look at the past history of prices; the Graham disciple looks at company financials. If the stock market value of the firm is lower than the book value…we buy. And we keep buying the stock while ignoring all that goes on around us.

Until that warm sunny day when Wall Street recognizes they have turnaround company on their hands and CNBC mentions it as a “stock to watch”. It will be on that day you proudly hit, the sell button.

Go from Benjamin Graham to Trading Pioneers

Go from Benjamin Graham to Home Page