Who was Benjamin Graham?
Benjamin Graham was an influential investor whose securities research laid the foundation for the valuation of companies based on the in-depth analysis of fundamentals used by many market participants in equity analysis today. His famous books “The Intelligent Investor” and “Security Analysis” are considered the foundational works of value investing.
Benjamin Graham was born in 1894. After just one year, his family moved to New York. After Graham’s father died, his mother invested the rest of her fortune inshares, which is why the family lost their savings during the banking panic of 1907. The family therefore lived in poor circumstances. However, Graham received a scholarship to Columbia University and studied philosophy, English, Greek and mathematics. After graduating, Graham accepted a job offer on Wall Street with Newburger, Henderson and Loeb. He also worked as an appraiser on valuation issues. At the age of 25, he was already earning around 500,000 dollars a year. The stock market crash of 1929 cost Graham almost all of his investments and taught him some valuable lessons about the world of investing.
In 1988, a chair was established at Columbia University in honor of Benjamin Graham. A notable student of Benjamin Graham is Warren Buffett, who was one of his students at Columbia University. In addition to teaching at Columbia Business School, Graham also taught at the UCLA Graduate School of Business and the New York Institute of Finance. Benjamin Graham died in 1976 at the age of 82.
Books by Benjamin Graham
His observations after the crash inspired him to write a research book entitled “Security Analysis” together with David Dodd. Irving Kahn, one of the biggest American investors, also contributed to the research content of the book.
“Security Analysis” was first published in 1934, at the beginning of the Great Depression, while Graham was a lecturer at Columbia Business School. The book set out the fundamentals of value investing. The first edition appeared in 1934 and was revised a total of 6 times and published in 1940, 1951, 1962, 1988, 2008 and 2020.
In 1949, Graham wrote the book “The Intelligent Investor: The Definitive Book on Value Investing”. Further editions were published in 1954, 1959 and 1973. In the book, Mr. Market is the business partner of an investor who tries every day either to sell his shares to the investor or to buy the shares from the investor. Mr. Market is supposed to represent the market, so to speak, which is volatile and subject to constant (sentiment) fluctuations. Mr. Market is responsible for market prices on a daily basis. He is often irrational and appears on the investor’s doorstep on different days with different prices, depending on how optimistic or pessimistic his mood is. Of course, the investor is under no obligation to accept an offer to buy or sell.
Graham points out with Mr. Market that the investor should not rely on daily market sentiment, which is driven by investors’ emotions, but should conduct their own analysis of a stock’s value. The analysis should be based on the company’s reports on its operations and financial position. This analysis should strengthen the investor’s judgment when an offer is made by Mr. Market. According to Graham, the intelligent investor is the one who sells to optimists and buys from pessimists. The investor should look for opportunities to buy low and sell high that arise due to price-value discrepancies caused by economic depressions, market crashes, one-time events, temporary negative publicity and human error. If no such opportunity arises, the investor should ignore the market noise.
Graham’s key investment principles
Graham’s key investment principles are summarized below. In general, Graham advises the investor not to follow the herd or the crowd, to hold a portfolio of 50%stocks and 50% bonds or cash, to be wary of day trading, to take advantage of market swings, to not buy stocks simply because they are popular, to understand that market volatility is a given and can be used to the investor’s advantage, and to pay attention to creative accounting techniquesthat companies use to make their earnings per share (EPS) look better.
- Always invest with a margin of safety: according to the principle of value investing, a security should only be bought if it is trading at a discount to the intrinsic value of the security. This discount offers an opportunity for a return, but also hedges against downside risk.
- Assume volatility and profit from it: shares are volatile and must be reckoned with. Mr. Market’s mood swings are emblematic of volatility on the stock market. Investors should not be impressed by this volatility, as it is fueled by many emotions and other influencing factors. Instead, every investor should evaluate the company on the basis of a sound and rational assessment. Since the evaluation can be very complex, it may be worthwhile to hire a goodasset manager. Volatility should be exploited by selling overvalued stocks and buying undervalued stocks.
- Know your investment type: There are active and passive investors. An active investor must balance the quality and scope of the research with the expected return. This can take a lot of time and energy. If this time and energy cannot be spent, the investor should rather settle for a passive, possibly lower return. Investing in an index is a good alternative. Alternatively, an active investment approach can be pursued with an independent asset management company without investing a lot of time and energy yourself.
- Know the difference between a speculator and an investor: According to Graham, there is both smart speculating and smart investing; the key is to realize what you are good at. An investor sees a stock as part of a company and the shareholder as the owner of the company, while the speculator sees himself as a gambler playing with expensive pieces of paper with no intrinsic value. For the speculator, value is only determined by what someone is willing to pay for theasset.
How is the intrinsic value of a share determined?
According to Graham and Dodd, value investing is the derivation of the intrinsic value of a share regardless of its market price. The intrinsic value of a share can be determined on the basis of company factors such asassets, profits anddividend distributionsand compared with its market value. If the intrinsic value is higher than the current price, the investor should buy and hold until the intrinsic value and the market value of the share converge again (also known as mean reversion). Benjamin Graham believed in the theory of efficient markets. The theory states that all available information is already contained in the share price. Price convergence is only inevitable in an efficient market. According to Graham, the irrationality of investors provides room for human error and therefore a margin of safety when prices are irrationally low. Other factors such as uncertainty about the future and stock market fluctuations also contribute to this margin of safety.
Other methods and ratios can also be used to value companies in order to determine whether a share is potentially overvalued or undervalued. These include, for example, the price-to-book ratio (P/B ratio ), the price-to-earningsratio, the freecashflow, the debt-to-equity ratio and reading the performance reports. It can also be worth analyzing the purchases and sales of insiders. Goodasset managers are proficient in several valuation methods and take a wide range of key figures into account when analyzing investment opportunities.
The calculation of the intrinsic value
The original Benjamin Graham formula for determining the intrinsic value of a share was as follows:
W = Earnings per share (EPS) x (8.5 + 2g)
where,
W = intrinsic value of a share
Earnings per share (EPS) = trailing 12-month EPS of the company
8.5 = price/earnings ratio of a zero-growth share
g = long-term growth rate of the company
In 1974, the formula was revised to include both a risk-free interest rate of 4.4% and the current yield on AAA corporate bonds, represented by the letter Y:
W = (Earnings per share (EPS) x (8.5 + 2g) x 4.4)/Y
where,
Y = Yield on AAA-rated corporate bonds
The Graham number 22.5 (Graham Number)
The Graham number is a very simple approach to valuing a stock and was named after Benjamin Graham. It is used as a general test to identify stocks that are currently selling at a low price. Graham believed that the price-earnings ratio(P/E) should not exceed 15 times (fair value) and the price-to-book ratio (P/B ) should not exceed 1.5 times. He therefore arrived at the figure 22.5 (= 15 x 1.5).
However, caution is advised with such highly simplified valuation models, as the P/E ratios and P/B ratios for a fair value can vary greatly depending on the sector and there are many other factors to consider. It can therefore make sense to seek advice from a professional, such as an independent asset management company.