Often known as the father of value investing, Benjamin Graham was also Warren
Buffett's mentor. The author of two investments classics, Graham was one of the
first true proponents of Fundamental Analysis -- the science of evaluating
companies based on their financial performance or fundamentals.
We can glean some valuable investing lessons by taking a look at Graham's early
life, investing career, and the investing principles he developed during his
lifetime.
Early Life
Ben Graham was born Benjamin Grossbaum in on May 9, 1894, in London. His father
was a dealer in china dishes and figurines. The family migrated to the United
States when Graham was only one.
At first, the family lived in the lap of luxury on upper Fifth Avenue. But in
1903, Graham's father passed away. The porcelain business stumbled, and the
family's financial health steadily declined. Graham's mother turned their house
into a boardinghouse to make money. She also borrowed money to trade stocks "on
margin." This proved to be a costly mistake - she was wiped out in the crash of
1907.
Graham's teenage years were filled with financial humiliation. Fortunately,
Graham won a scholarship to Columbia, where he shone brilliantly. He graduated
second in his class in 1914. So remarkable were his academic achievements, that
by the time he graduated, three departments - English, Philosophy, and
Mathematics - asked him to join the faculty. Graham was only 20 years old.
Graham's Investment Career
Graham chose Wall Street over academia. He started as a clerk in a bond-trading
firm, quickly progressing to analyst, then partner, and shortly after that he
started his own investment partnership.
Graham pioneered the science of investing as against speculation. Quite
shockingly, trading of stocks was largely a speculative exercise in those days
and hardly any attention was paid to the fundamentals of a company.
Graham became an expert in researching stocks in painstaking detail. In 1925,
for example, in the course of his research, he came across some interesting
findings .... Northern Pipe Line Co. held at least $80 a share in high-quality
bonds. Northern Pipe Line's stock price at that time? $65 a share. Graham
exploited this discrepancy by buying the stock and persuading the management to
raise the dividend. Three years later, he walked away with $110 a share - a
return of almost 70%.
Graham was not always successful, though, in those days. During the great crash
of 1929-32, he lost 70% of his portfolio. But despite this steep decline, he was
able to apply his methods and scoop up stunning bargains when the rest of the
market was deeply pessimistic. From 1936 until his retirement in 1956,
Graham-Newman Corp., the partnership he created with Jerome Newman, gained
almost 20% annually (14.7% after accounting for fees), while the rest of the
market was up 12.2%. This enviable performance is one of the best Wall Street
has ever seen.
Graham's Investment Principles
Two of the books that Graham authored have stood the test of time to achieve
classic status - The Intelligent Investor, and Security Analysis.
The following investment principles can be distilled from these masterpieces:
- Buying stock in a company is like buying the business - This falls under
Graham's recommendation to invest rather than speculate. Buying stock in a
company should involve research and analysis along the same lines as buying a
business.
- Know your investing style - Graham talks about two types of investors:
"defensive" and "enterprising". A defensive investor is a passive investor who
does not spend much time analyzing companies and picking his investment
opportunities. Graham's recommendation for the defensive investor would be, in
today's terminology, to stick to index funds. A defensive investor should expect
average returns. An enterprising investor, on the other hand, is one who is
seriously committed to researching and analyzing companies to invest in. Graham
believed that the more work you put into your investments, the higher the return
you could expect.
- Use market fluctuations to your advantage - The market usually is fairly
accurate in pricing stocks. However, sometimes, emotions get the better of
investors. At times like this stocks can be mispriced. What advice does Graham
have for the intelligent investor in such conditions? Never sell in panic just
because the market is under-valuing your stock. In most cases, this is only
temporary. In fact, times of maximum pessimism like these are when the best
bargains are to be had. Graham recommends buying meaningful amount of stock at
huge discounts in companies that you've researched. What about the other extreme
- overvaluing? If you find the stock price of companies you've invested in way
above what you've valued them, this might be a good time to sell. Sooner or
later the market will correct itself and it's best to lock in your gains before
that happens.
- Always use a margin of safety - Graham called this the central concept
of investment. When asked to distill the "secret" of sound investment, margin of
safety was the motto he offered. But first, what exactly does this mean? When
conducting a valuation on a company, the intrinsic value we come up
with is based on our best prediction of the future. Like any prediction, there
is a probability that things won't go as planned. In order to insulate ourselves
from such uncertainties, we need to add a safety factor to our calculations.
This is your safety margin. So how much of a margin do we need? Depends on our
measure of uncertainty of the future. Companies that are more stable and have a
proven track record of great financial performance will demand less margin.
Anywhere between 25-50% off our calculated value would be a good starting point.
The Mr. Market Parable
In the Intelligent Investor, Ben Graham uses a
very powerful parable to illustrate market fluctuation. In Graham's own
words....
"Imagine you had a partner in a private business named Mr. Market. Mr. Market,
the obliging fellow that he is, shows up daily to tell you what he thinks your
interest in the business is worth.
On most days, the price he quotes is reasonable and justified by the business's
prospects. However, Mr. Market suffers from some rather incurable emotional
problems; you see, he is very temperamental. When Mr. Market is overcome by
boundless optimism or bottomless pessimism, he will quote you a price that seems
to you a little short of silly. As an intelligent investor, you should not fall
under Mr. Market's influence, but rather you should learn to take advantage of
him.
The value of your interest should be determined by rationally appraising the
business's prospects, and you can happily sell when Mr. Market quotes you a
ridiculously high price and buy when he quotes you an absurdly low price. The
best part of your association with Mr. Market is that he does not care how many
times you take advantage of him. No matter how many times you saddle him with
losses or rob him of gains, he will arrive the next day ready to do business
with you again."
Summing Up
Benjamin Graham was undoubtedly one of the most profound financial thinkers. His
contribution to the field is invaluable. A good testimony to his achievements is
the outstandingly successful group of disciples he spawned .... Warren Buffett,
Jean-Marie Eveillard, William J. Ruane, Irving Kahn, Hani M. Anklis, and Walter
J. Schloss.
Graham's investment principles are easy to understand, but sometimes difficult
to put into practice. For instance, it takes a great deal of courage to invest
when everyone else is panicking. But if you pick your companies based on sound
analysis of the fundamentals, there is a high probability that you will profit
handsomely when the market eventually corrects itself.