Successful strategies
Benjamin Graham
Who is Benjamin Graham and why he is important
Born in London in May 1894, Benjamin Graham (born Grossbaum),
moved to New-York when he was a child. His family was rich until the death of
his father in 1903, and the bankrupt of the boarding house of his mother. After
his Bachelor of Science from Columbia University, Benjamin Graham started to
work in Wall Street at 20 years old. First as messenger in a brokerage firm, he
quickly became a partner. At 25 years old, his salary was $600,000 a year.
In 1926, he created an investment partnership. At the same
time Graham was managing his own company, he took courses of finance at
Columbia University. With the help of David Dodd, professor at the university,
Benjamin Graham wrote what will become a classic of the investment world,
«Security Analysis», published in 1934. The second book of Benjamin
Graham published in 1949 «The intelligent investor» is still a
classic of investment strategy. Buffett says that is «the best book on
investing ever written».
Because Benjamin Graham is still considered the father of
value investing and because his theory and strategies are still applicable
nowadays, we consider it's important to refer to him in order to give to the
reader a good approach of the market. It's also a good way to understand the
philosophy from which the strategy of this thesis is found.
Main ideas from «security analysis» and «The
intelligent investors» for selecting stocks
In order to understand perfectly how Benjamin Graham was
looking at the market, investors have to know that for Graham, the market is
non rational, and that non-rationality comes from being human. For Graham, fear
and greed are the factors that make stocks fluctuate. When investors are
greedy, it will drive the market to overprice stocks, and the opposite effect
can be expected when they are afraid. Benjamin Graham considers that stock
prices are not representative of the value of a company because the market is
driven by human emotion. In order to help the investor not to
«listen» to his emotion (which has no use in stock markets), Graham
gives us a way for selecting stocks.
Investment Vs Speculation
First of all, Benjamin Graham clears up a difference between
investment and speculation. He was not considering speculation as an investment
strategy, for him it was more relative to gambling than to investment. Graham's
idea is not always easy to understand because for him, there is no perfect
criteria to determine the difference between investment and speculation. Here
is a definition of investment given by Graham: «An investment operation is
one which, upon thorough analysis, promises safety of principal and a
satisfactory return. Operations not meeting these requirements are
speculative.29» For him, a bond with a low return can be
associated as a speculation even if it's a bond, as well as, a stock which is
priced under the value of the company, is not speculative just because it's a
stock. Graham considers that it's more why you are investing than in what you
are investing that defines if it's an investment or a speculation. He believes
that there are 3
29 Benjamin Graham, Security Analysis(18)
criteria that define investing. First the investor should
analyze the company, second the investor has to protect him or herself against
big losses and third, investors should expect adequate returns and not get rich
quick schemes.
Satisfactory return and a limited risk
Graham was considering that the return of a stock is made both
by the income it generates and by the appreciation of the stock itself. He
advises investors to not take into account the day to day fluctuation of a
stock because great returns need time. Any investment should be done for a long
period, which means several years. Because for him, an investment is a mix
between satisfactory return and a certain amount of risk, Graham also believes
that in order to reduce the risk, they should diversify their portfolio. It's
important to understand that for Graham, risk is inherent to investment, and a
limited risk exists when the potential of losses is restricted.
Because he wrote «The Intelligent Investor» for the
common investor who is not a professional, Graham is really prudent about the
amount an investor should put in the stock market. He explains that, any
investors should at minimum have 25% of their investment in bonds. He also asks
the question of the risk to put all the rest in stocks. At this time, the
general thinking was that the amount of money you put in stock is a function of
your age. (100 - your age = % of your investment in stocks). Graham refutes
this idea, explaining that a couple which are retired with a good pension,
don't have the same relation to the risk, that a young couple that want to
invest to buy a house, pay the school of kids, the medical care, and so on.
Margin of safety
The main notion that Graham gives to the investment world was
what he called «the margin of safety». The basic concept take for
sure that is impossible for any investors to always be right in their
valuation, the margin of safety is a way to limit the risk of loss. Defined
quickly, the concept is «By refusing to pay too much for an investment,
you minimize the chances that your wealth will ever disappear or suddenly be
destroyed.30»
Graham develops the idea of margin of safety this way. If an
investor has found a company which seems to have an expected growth, he or she
has to buy stocks of it. Investors have 2 ways to buy those stocks, in the
first case, the market is in a bear condition, and it undervalued most of the
stocks. In the second case, the market just undervalued the price of this stock
compare to the value that you asses to the company. In both case, because the
price of the stock is under the intrinsic value of the company, there is a
margin of safety which will limit the risk of loss. For Graham, the best way to
limit the risk is to buy companies which are undervalued by the market. The
bigger the difference between the price of the stock and the intrinsic value of
the company, the bigger the margin of safety and the smaller the risk of
loss.
In order to evaluate the value of the company, Graham suggests
using the «future earnings power» of the firm. Nowadays, investors
which are following the main idea of Graham are not using this «future
earning power» to determine the value but the future cash flow discounted
to today's value.
«There are two rules of investing,» said Graham.
«The first rule is: Don't lose money. The second rule is: Don't forget
rule number one. 31» This «don't-lose?» philosophy
steered Graham toward two approaches to selecting common stocks that, when
applied, adhered to the margin of safety: (1) buy a company for less than
two-thirds
30 Benjamin Graham, The Intelligent Investor, Revised
Edition(527)
31 G. Hagstrom The Essential Buffett: Timeless Principles for
the New Economy (83)
of its net asset value, and (2) focus on stocks with low
price-to-earnings ratios. As we have seen, Benjamin Graham which is considered
as the father of the «value investment» has developed a concept which
is always used now. Some investors like Warren Buffett are still using Graham's
principle in all their trading operations. If Graham is seen as the father of
value investment, let's have a look, on Philip Fisher, the father of
«growth investment».
| 
