The Father of Value Investing
Benjamin Graham, “the father of value investing,” is considered one of the most significant influences on Warren Buffett. Buffett himself says, “More than any other man except my father, [Graham] influenced my life.”
Buffet says one does not need “a stratospheric IQ, unusual business insights, or inside information” to be a successful investor. One needs a sound framework to make rational decisions and the ability to control their emotions. While the investor must provide the control, Buffet believes The Intelligent Investor “precisely and clearly prescribes the proper framework.”
In The Intelligent Investor, Benjamin Graham often refers to “rules” one should follow. Still, he will also admit any specific strategy only works for a short period as the markets are sure to change. However, many of the principles Graham shares are timeless and, as Buffett states, lay a solid foundation to begin successfully investing.
Investors versus Speculators
Investors and speculators are both discussed in detail in The Intelligent Investor. Graham establishes a distinction from the first chapter, and it then permeates the remainder of the writing. Graham’s goal for us is to be an investor, not a speculator.
The public often refers to buying and selling securities, mainly stocks, as investing. Jason Zweig calls out his employer, the Wall Street Journal, for its misuse of the term investor, “If you buy a stock purely because it’s gone up a lot, without doing any research on it whatsoever, you are not—as the Journal and its editors bizarrely insist on calling you—an ‘investor.'”
I think Zweig and Graham would both agree the market is full of speculative traders, not investors. Wall Street insiders are using television to belittle retail investors for not performing due diligence in the era of meme stocks. I’m sure Graham would be on the sidelines pointing out the hypocrisy of the personalities clamoring for air time.
What is the difference between a speculator and an investor?
A speculator is a gambler who believes the stock price will go up because someone will be willing to pay more for it in the near or distant future. Often, speculation can be based on research, say trend analysis or news of current or future events. Still, the idea is, if one pays X for a slip of paper today, another will pay 2X tomorrow, regardless of the actual value of the underlying business.
Emotions help drive speculation, especially FOMO (fear of missing out). The public will often refer to rising bull markets as suitable, sound investments that can only “go to the moon,” while bearish or declining stocks are speculative and risky buys.
An investor, too, wants the value of their security to go up. But an investor and speculator determine what and when they purchase using different methods. The critical difference – an investor tries to understand and establish the company’s value before buying it.
An investor analyzes the business behind the stock to find the value of the business. An investor appreciates lower prices, especially when the price falls below the company’s value, understanding when the stock is selling for a discount. They devise a margin of safety to compensate for their ignorance and expect an adequate return.
Graham further separates investing into two categories the defensive and enterprising.
The Defensive Investor
Graham first outlines the principles a defensive, or passive, investor should follow.
A passive investor’s portfolio should be diverse. If investing in individual companies, a portfolio of 10 to 30 issues could be sufficient. One should also ensure these companies represent a variety of industries within the market.
When reviewing potential investments, a passive investor should be looking for large, prominent, financially conservative companies.
Large has a different definition from what it did in Graham’s day and age, but a stock issue with a market cap of about $40 billion should be close.
Graham defines financially conservative as a company whose book value represents at least half of total capitalization, including debt.
A key point Graham makes is the need for all investors to remind themselves they cannot pick stocks without homework. One often hears Peter Lynch’s advice to choose companies one knows and uses. However, this ignores Lynch’s suggestion to then research and learn more about the company.
Instead, it is easy to be lazy when familiar with a company. One must not be inefficient and jump into a purchase without further review.
But maybe a passive investor should be lazy when it comes to their portfolio.
The passive investor could have a portfolio operating on autopilot with little to no further effort. Providing commentary for The Intelligent Investor, Jason Zweig remarks, “The knowledge of how little you can know about the future, coupled with the acceptance of your ignorance, is a defensive investor’s most powerful weapon.”
To sum it up, a passive investor should generally dollar cost average (invest a regular amount at regular intervals) into a predefined proportion of broad-market funds or ETFs. Warren Buffett often recommends this form of investing for those not willing to do their homework.
A Boglehead is what comes to mind when I think of passive investing. John Bogle is the founder of Vanguard and pioneered cost-effectively investing in indexes rather than specific stocks. A Boglehead often spreads their positions among three funds, a US market fund, a foreign market fund, and a bond fund. Except for the occasional rebalance, they, as Zweig says, “don’t know and don’t care.”
The Active Investor
The enterprising, aggressive, or active investor actively researches, selects, and monitors their securities.
What Graham calls an active investor would likely be called a passive investor by most traders today.
Warren Buffett comes to mind when I think of an active investor, at least as Graham describes one. One who diligently seeks out great companies, and when their price comes within their intrinsic value, they buy. Other notable value investors are Charlie Munger (Buffett’s partner), Bill Ackman, Monish Pabrai, and Li Lu.
There isn’t much difference between Graham’s initial advice for picking companies for a defensive investor and an active investor. The main difference is Graham lifts the limit of sticking with large companies and loosens the rule of how much debt should be held by a company.
Zweig points out one could be simultaneously a passive and active investor, having a portion of the portfolio running passively while another is more active. I’d consider myself to be in this third category.
When looking for a fund to invest in, a passive investor will prioritize the reverse of the market. Priority should first go to a fund with low fees, then one with low risk and volatility, then a manager with a good reputation, and finally past performance.
Nearly all funds underperform the market. If an index fund follows the S&P 500, it may only perform as well as the S&P 500 minus the fees and costs of upkeep. Or, if a fund is following a segment of hot stocks or industry, it may vastly outperform the market until the hype subsides.
That said, most investors who buy into a good index fund and refuse to move their money will outperform most speculators in the market. A fund will protect an investor from succumbing to the wiles and emotions found in tracking and speculating the market.
An active investor should learn how to appropriately analyze a securities past, present, and potential future.
A proper analysis describes a business and summarizes its operating results, financial positions, lists its strengths and weaknesses, the possibilities and risks, and estimates future earnings power. One should also compare a company with its competitors, its industry, and even itself over time.
And though one may try to estimate future earnings, the more a valuation depends on future estimates, the more superficial/less sound an analysis becomes.
What Makes a Good Company
A good company will have a competitive advantage over others, often referred to as a moat. This advantage could come in the form of a strong brand identity, being a near-monopoly, have economics of scale (supply large amounts of goods at a low price), have a unique intangible asset, or have resistance to substitution.
Find companies that are marathoners rather than sprinters. These companies have a good plan and strategy, follow it, and grow their revenues and earnings smoothly and steadily each year.
A growing company doesn’t do so by luck. It takes investment into new ideas, products, and technology to continue strong growth. A company spending nothing on research and development exposes itself to competition as much as one spending too much.
Before adding a company to a portfolio, it should generate more cash than it consumes. Regardless of what the stock market does day-to-day, a company continually creating cash will perform well in the long run.
One could review whether cash from operations had grown over the past ten years or use owner earnings. If owner earnings per share increased by 6 to 7% over the past ten years, prospects for continued growth are positive.
Debt can also be a huge indicator of whether a company will perform well. Graham proposes finding companies whose long-term debt is less than 50% of total capital. It’s a great idea to determine if the long-term debt has a fixed or variable rate. A variable-rate could become more costly for the business in the future. Comparing earnings to fixed charges can help determine if the company can even afford its debt payments.
Growth can be further obtained, for the business owner, when the company uses excess cash to pay dividends or buy back stock. There’s a ton of discussion around whether either is beneficial to the stockholder or not. Buffett often claims he prefers companies that invest in themselves before paying a dividend. Still, the question is whether management can grow investments more by investing back into the company over what an investor might make looking at other securities.
Stock buybacks could be preferable if the company does so when stock prices are reasonable and at lower prices. A stock buyback also mitigates the issue of taxes on a potential dividend, allowing wealth to grow without Uncle Sam taking a portion until selling the stock.
Lastly, a company should have quality management. A CEO should say what they will do, then do what they say. They should take responsibility for their failures and not enlist scapegoats. A good manager spends more time managing than hawking their stock.
Suppose management sprints for numbers to take advantage of bonuses or uses stock buybacks to enable multi-million dollar paydays. In this case, one should be cautious about the motivations of the company’s leaders.
Some investors, like Phil Town, add a separate score for management when determining the company’s value. However, this could be considered a duplicative score and unjustly create an artificially higher valuation for a company. Good management will often yield the prerequisites already discussed. It is best to review leadership when there is little track record due to a recent change in the c-suite.
One should not purchase a stock whose price is considerably greater than its value. The fundamental rule is not to lose money, and the frenzy of a bull market should be a cautious moment.
Graham further suggests staying away from junk bonds, foreign bonds, and entering IPOs.
Know the Stock Market
Many of these warnings are due to an adequate understanding of the stock market. No event will fully duplicate itself, but any determination of the future will fall between “probably conclusion” and “strict demonstration.” No one will ever be entirely right, but one can be confident prices tend to fall when overpriced and rise when underpriced.
Bull markets often share common characteristics:
- historical price levels
- high price/earnings ratios
- low dividend yields compared to bond yields
- traders speculating with margin
- several IPOs offered for poor companies
Outside of the dividends to bond yields – bonds are uncommonly low due to current monetary policy – pretty much all of these are spot-on in today’s environment.
There are always market theories or a get-rich-quick scheme. Graham cautions against their reliability as they often coincide with the moment they are working, but time brings new conditions the formula will no longer fit. The popularity of one of these schemes can influence the market and impact itself, diminishing potential returns.
Investing is Self-Control
Investing is as much psychological as it is anything else. How does one not lose money?
An investor is rarely forced to sell their shares and should disregard the price at any given moment. A portfolio of even the most sound stocks will fluctuate in price, and one shouldn’t be concerned with the declines or advances.
Creating a mechanical method of rebalancing one’s portfolio, say annually, could be used to keep one busy without causing significant harm to their portfolio.
As Jason Zweig mentions, “Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.”
It’s understandable why so many recommend Benjamin Graham’s The Intelligent Investor. The rules may evolve, but the principles are timeless.
How does one mitigate risk and keep themselves from losing money?
Create a strategy, do the necessary homework, and then implement and stick to the strategy.