High-Quality Value Investing With Benjamin Graham


Summary:

  • Benjamin Graham is rightly considered the father of value investing.
  • But the term "Value" is often misunderstood to refer to only price, and not quality.
  • Most of Graham's actual stock selection rules were concerned with the qualitative assessment of a stock.

Benjamin Graham was a scholar and financial analyst who mentored legendary investors such as Warren Buffett, William J. Ruane, Irving Kahn and Walter J. Schloss.

Irving Kahn, one of Graham's earliest students, passed away a few days ago (24th Feb 2015). To quote a line from yesterday's Bloomberg article on Kahn's passing:

"In 2012, at 106, Kahn told Bloomberg Businessweek that Graham’s principles, though relevant as ever, were increasingly being drowned out by noise."

Warren Buffett once wrote a lengthy article explaining how Graham's principles are everlasting, and how Graham's record of creating exceptional investors (such as Buffett himself) is unquestionable. The article is called The Superinvestors of Graham-and-Doddsville.

But most of what Benjamin Graham taught has been forgotten today, or is applied incorrectly.

In this article, we will look at some of the common misconceptions about Graham today, and also try to apply what Graham actually taught about stock selection.

Common misconceptions about Benjamin Graham today

Misconception #1: Graham only recommended cheap stocks

Benjamin Graham is rightly considered the father of value investing. But the popular perception of the term "value" as meaning "inexpensive" has resulted in the general misconception that Graham only recommended cheap stocks.

Net Current Asset Value (or NCAV) stocks are also the most well-known of Benjamin Graham's strategies, and have also contributed to this misconception.

Graham actually recommended Defensive and Enterprising stocks before NCAV stocks; and both required far greater Qualitative checks and were allowed far higher Quantitative valuations.

Graham did advocate paying more for Quality. His only prerequisite was that there be the Margin of Safety between price and value, whether the value be Qualitative or Quantitative.

In fact, when we look at Graham's actual stock selection rules, we see that most of the rules were concerned with the qualitative assessment of a stock.

Real value is factor of both quality and quantity. Even something expensive can be bargain if it's worth more than what you pay for it. This is what Graham was always trying to teach his students - that no matter how much they were paying, to make sure they are getting their money's worth.

"In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, "This too will pass." Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto - Margin of Safety."
The Intelligent Investor, Benjamin Graham

Misconception #2: Intrinsic Value = EPS x (8.5 + 2xGrowth)

Benjamin Graham actually gave several warnings about this formula and only mentioned it briefly to demonstrate why growth-based valuations are unreliable. But due to a printing omission in recent editions of The Intelligent Investor, this formula is sometimes mistakenly used today instead of Graham's actual (and more thorough) methods.

Understanding The Benjamin Graham Formula Correctly discusses the issue in detail.

Misconception #3: Buffett was influenced more by Charlie Munger/Phil Fisher

Others are often credited for Buffett's success instead of Graham because of two reasons:
1. A lack of understanding of Graham's actual principles, and the true concept of "value" (which includes quality)
2. The common human tendency to overlook simple answers in favor of complex ones.

But Buffett himself has always credited Graham for his investment acumen (Buffett even named his son after Graham!).

Buffett had been working with Munger for some time when he wrote "The Superinvestors of Graham-and-Doddsville" in 1984, and already had a net worth of $620 million (equivalent to $2.5 billion today).

Buffett never wrote an article called "The Superinvestors of Mungersville" (or Fishersville).
Bill Ruane, Irving Kahn and Walter Schloss never worked with Munger. But they too were students of Graham (Kahn named his son after Graham too).

Given below is part of the conclusion from the study "The Evolution of the Idea of Value Investing: From Benjamin Graham to Warren Buffett" by Robert F. Bierig, Duke University:

"A [casual] observer of Buffett today would find it difficult to see the Ben Graham influence in many of his activities. However, that influence remains at the core of Buffett's investment model. Buffett continues to think about stocks as fractional ownership interests in underlying businesses, he continues to operate under the assumption that there is a distinction between price and value, and he continues to search for the largest discrepancy between those two items. In other words, he continues to be a value investor."

Misconception #4: Graham is not relevant because of Globalization

Globalization is not a recent phenomenon. The two world wars are often attributed to differences in international trade. IMF and the World Bank were formed early in the 20th century to regulate globalization.

Misconception #5: Graham's principles do not work for growth stocks

Graham's rules do include objective checks for growth. Graham's principles may not catch phenomenal stocks but the fact is that no other strategy can do so consistently either. Making money on such a stock is really no different from winning the lottery. It's purely a matter of luck.

Graham's principles recognize this and Graham's students don't look for lotteries. Instead, they follow strategies that are proven to consistently give good results for long periods of time. They may miss the outliers but eventually, they fare better than everyone else (in spite of ignoring "growth stocks").

In fact, one might even say that to follow Graham is to stop looking for the lotteries, and to start treating investment as a business operation. Lotteries are exciting but ultimately, disappointing. Business is boring but eventually, very profitable.

"An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."
The Intelligent Investor, Benjamin Graham

Misconception #6: Graham is not relevant because of technological progress

It's always important to understand the difference between principle and application.

The application of principles may change with time, but the principles themselves remain the same and are the starting point on which one builds on (cars may have become faster, but wheels continue to be round).

The Amsterdam Stock Exchange is 400+ years old. NYSE is 150+ years old. The proliferation of technology may have made stock markets more competitive in recent years, but the fundamental ways in which they function remain the same.

Misconception #7: Incomplete Application of Graham's methods

It's also quite common today to see stocks being recommended based on the NCAV calculation alone, or the Graham Number alone.

Before being checked against the Graham Number, Benjamin Graham required that a stock first meet six other qualitative criteria.

Graham also required an NCAV stock to have a positive EPS figure to be eligible for investment. This is a requirement that most NCAV analyses today don't include.

Applying What Graham Actually Taught

Buffett describes Graham's book - The Intelligent Investor - as "by far the best book about investing ever written" (in its preface, which Buffett wrote).

In The Intelligent Investor, Graham recommended various categories of stocks and specified precise qualitative and quantitative rules for each category.

Quick Reference - Graham and Serenity gives a detailed explanation of Graham's 17 stock selection rules, and how one can assess stocks by them (with no adjustments other than those for inflation).

Serenity provides two web-based Graham stock screeners:

1. A free Classic Graham screener that lets you screen 5000+ NYSE and NASDAQ stocks by a strict 17-point Benjamin Graham assessment.
2. An Advanced Graham screener (more flexible) that lets you screen the same stocks by customized combinations of the 17 Graham rules (such as the Graham Number).

To Conclude

Please note that not all stocks failing Graham's rules are necessarily bad investments. Graham's rules are just extremely selective. Graham designed and backtested his framework for over 50 years, to deliver the best possible long-term results. Even when stocks don't clear them completely, Graham's rules give a clear and quantifiable frame of reference for measuring a stock's margin of safety.

The last of Graham's strategies is "Special Situations." But Graham did not recommend it for the ordinary investor as it supposedly required a high degree of skill, experience and resources. In the "Legacy of Benjamin Graham" video released by the Heilbrunn Center, Buffett explains how Graham was focussed on refining methods that ordinary investors - without specialized access - could apply to achieve results similar to his own (Graham's).

Buffett concluded "The Superinvestors of Graham-and-Doddsville" writing:

"Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper."

No one could have said it better.

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