The Definitive Book on Value Investing – A Book of Practical Counsel
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Benjamin Graham’s Perspective
Benjamin Graham is often called the ‘father of value investing’. He wrote two of the founding texts in neoclassical investing: Security Analysis (1934) and The Intelligent Investor (1949). Graham attended Columbia University before starting a career on Wall Street. He then founded the Graham-Newman partnership and employed Warren Buffet. Warren Buffet benefited greatly from Graham’s approaches and subsequently wrote the foreword for this book. Graham’s investment philosophy was always based on investor psychology, minimal debt, buy-and-hold investing, concentrated diversification, and buying within the margin of safety.
The Intelligent Investor is a book that aims to help people invest in the stock market while minimizing their economic risks. It focuses on longer-term and more risk-averse approaches. Graham focuses on investments (based on research) rather than speculations (based on predictions). The Intelligent Investor provides guidance on how to get involved in value investing and how you can prevent Mr. Market from dictating your financial decisions.
Shot #1: The History of the Stock Market
Many new enterprising investors will use historical data to forecast the future. But the value of any investment is a function of the price you pay for it. Graham provides multiple examples of the most common reasons that people mistakenly extrapolate previous stock prices:
- Buying into the hype of strong Bull markets
- Not doing your own research
- Relying on experts who aren’t necessarily experts
- Not staying humble when your stocks are performing well
Shot #2: The Issue of Inflation
Cash becomes less valuable over time. For example, a dollar ten years ago is worth more than a dollar today. Therefore, instead of holding onto cash, we must be investing cash so we can beat inflation. Despite this, the majority of investors do not take inflation into account. Psychologists call this the money illusion. A 2% raise in salary is effectively a ‘cut’ in our available money if inflation has increased at 4%. Despite this, people generally prefer this scenario than taking a 1% pay cut during a year when inflation is zero. So, measure your investing success by how much you keep after inflation rather than how much you are making from your investments.
Shot #3: Stocks Can’t Reliable Overcome Inflation
One area which is riskier but has the potential for returns is investing in stocks. Graham explains that stocks tend to outpace inflation 80% of the time. That said, most stocks do not react well to high levels of inflation. For example, the stock market lost money in 8 of the 14 years that inflation has exceeded 6%. Slight inflation is good for stock prices, as it allows the companies to raise prices. But high inflation forces consumers to stop purchasing. So, investing in stocks is a good option when inflation is not overwhelmingly high.
Shot #4: REITs Can Overcome Inflation
One investment that is safe irrespective of how high inflation becomes is REITs. REITs are Real Estate Investment Trusts. REITs are companies that own and rent out buildings. Different examples of REITs exist, such as medical or commercial properties. The type does not matter too much, though. All REITs are relatively good at combating inflation.
Shot #5: Don’t Let Age Influence Your Investing
Graham believes that choosing which type of investor you should be is based on your willingness to put time and effort into your portfolio and your circumstances. It should not be dependent on your appetite for risk or your age. Graham provides these examples to show how age should not impact on your investments:
- An 89-year-old with 3 million dollars, an adequate pension, and several children would be foolish moving most of their money into bonds. This individual has enough money already, and their children would inherit their stocks.
- A 25-year-old saving for their wedding and a house deposit should never be putting all their money into stocks.
Both of these scenarios challenge the general advice of moving money from stocks to bonds as you age. Instead, other factors are more important. Instead, the type of investor you are should be based on your work’s characteristics, the number of people who rely on you, etc. Before choosing how you invest, you should consider the following factors:
- Are you single or married? Does your partner work, and how much money do they earn?
- Do you have children? If not, do you want children? When will high costs, such as college education, kick in?
- Will you inherit money at some point? Or, will you have to spend money keeping a parent in a care home?
- Is your job secure?
- If you are self-employed, how long do similar companies generally survive?
- Do you need your investments to supplement your cash income for you to survive? If so, you should have more money in bonds.
- How much money can you afford to lose on investments?
Shot #6: Defensive Investing
Graham believes that defensive investors should have a minimum of 25% of their savings in bonds. Then, a maximum of 75% of their savings in stocks. Graham also advises against buying lots of stocks in tiny increments over many years. Although diversification is essential, buying so many stocks in such small amounts will make tax returns challenging. So, if you are not prepared to keep an in-depth record of all your investments, you should not be investing. Try to invest in 10-30 stocks at the start and make sure you invest in multiple industries.
When choosing stocks, as a defensive investor, Graham recommends considering a few things about each company:
- How large is the enterprise? Choose larger and less volatile companies.
- Assets should be at least 2x liabilities, and long-term debt should be less than net current assets.
- Positive earnings should be recorded for the past ten years.
- Dividends should have been paid out without interruption for the past 20 years.
- The per-share earnings should have a minimum increase of at least one-third over the past ten years.
- The price-to-earnings ratio should be no more than 15 times the average earnings of the past three years.
- The ratio of price to assets should not be more than 1.5 times the book value last reported. Plus, the PE ratio x PB Ratio should not be more than 22.5.
Shot #7: Enterprising Investing
Graham recommends different considerations for enterprising investors looking into companies:
- The company’s current assets should be at least 1.5 times current liabilities. They should not have debt that is more than 110% of net current assets.
- There should be no earning deficit in the last five years.
- There should be a dividend.
- Last year’s earnings should be more than those of the year before.
- The price of the stock should be less than 120% of net tangible assets.
Shot #8: How to Invest in Stocks
Graham provides several tips for investing in stocks:
- Avoid day trading as it is extremely risky.
- IPOs are not a good investment as they are often overpriced.
- Treat cheap bonds with skepticism.
- Only buy foreign bonds if you are incredibly confident.
- A great company is not an excellent investment if you are overpaying for the stock.
- Big firms grow slower; therefore, avoid companies with price/earnings ratios over 25-30.
- Look out for temporary unpopularity. The market quickly forgets, and this stock will probably rebound if you get it at a reasonable price.
Shot #9: Adopt an Evidence-Based Approach to Investing
Graham describes investing as evidence-based. Speculation does not have the same level of scrutiny as an effective investment should. So, Graham describes investing as requiring thorough analysis, a principal of safety, and an adequate return. If your investment does not meet these requirements, you are speculating rather than investing.
As will be considered later, Graham outlines two approaches you can take to engage with genuine investment. Firstly, you can be a defensive investor. This type of investor is mainly interested in safety and freedom from effort. To become a defensive investor, you must be willing to deal with emotional demands, such as detaching yourself from market panic. In comparison, an enterprising investor places a large amount of their time and effort into investments. So, enterprising investors have to be physically and intellectually invested.
Graham did not say you can never ‘speculate’ economically. Instead, he recommended allocating no more than 10% of your investment funds to what he calls your ‘Mad Money Account’. You should never let these speculation funds leak into your investment funds.
Both defensive and enterprising investors have to be intelligent investors. An intelligent investor will never dump a stock based on its share price. Instead, they will consider the value of the company and decide based on that.
Shot #10: You Can Make Lots of Money Off Market Volatility
Market volatility can be scary, but it is also an opportunity to make lots of money. Firstly, you want to limit your risk of losing money through volatility by making evidence-based investment decisions. You also shouldn’t sell your stocks in a panic. Graham also explains that a paradox exists where the more successful a company, the greater its fluctuations in share prices. So, you should be aiming to buy successful companies’ stocks when they hit a low. You might even want to avoid successful companies altogether, as they are more speculative than investments.
Graham uses the Mr. Market parable to explain how we should not panic when stocks dip and instead make our own decisions. Suppose we own small shares in a business that cost us $1,000. Our partner, named Mr. Market, tells us every day what he thinks our shares are worth. Sometimes he values these stocks at a justified level based on plausible business development and prospects. That said, sometimes Mr. Market gets a bit too enthusiastic and values our stocks at ridiculous prices. If you are an intelligent investor, you will not let Mr. Market determine your stocks’ worth. Instead, you should make your own decisions based on your own research. You can then decide to sell the stocks when they are ridiculously high and buy more stocks when the price is ridiculously low.
Shot #11: Be Careful About Using Financial Advisors
Financial advisors are not for everybody. You have to provide at least $100,000 for investing to obtain a financial advisor. So, low-cost index funds are the best choice for individuals with less money.
For those who do have money, you have to decide whether an advisor will be useful. Many investors are more comfortable if they have a second opinion when investing. This is especially the case for people who struggle to calculate the rate of return they need to earn on their investments.
These are some of the telltale signs that you should be seeking help with your investments:
- You have suffered a significant loss of more than 40% for your portfolio.
- You struggle to make ends meet.
- Your portfolio is chaotic and not well thought out.
- You have just had a significant change in your life, such as retiring or becoming self-employed.
Graham stated that some advisors are fakes. They try to prevent you from researching their results further and will ultimately lose your money. So, Graham suggests looking out for these sayings that a fake investor will use:
- This is your opportunity of a lifetime.
- Don’t you want to be rich like me?
- It would be best if you focused on performance rather than my fees.
- You can’t lose with my method.
- You have huge amounts of money to earn.
- This is a trick that only I know.
- You don’t even need to question the legitimacy of this method.
Shot #12: Security Analysis
Graham describes something called security analysis. This is the analysis that should be conducted to estimate the value of a given stock. You can then compare this value to the stock’s actual price and decide whether or not the stock is an attractive purchase. Security analyses should not be complicated, though. They should only require basic algebra. So, any other form of security analysis is most likely flawed.
As well as conducting security analysis, you should also consider the following factors to ensure you are not overpaying for a company’s stocks:
- The company’s long-term prospects
- The quality of the company’s management
- Financial strength and capital structure
- Dividend record
- Current dividend rate
For bonds, Graham recommends that you note the number of times that available earnings have covered total interest charges. The covering of these charges should have occurred for at least seven years running.
Shot #13: The Margin of Safety
Graham focuses on the Margin of Safety as the most critical part of your investment strategy. You should always buy a company’s stock at least 50% below its true value. This practice will minimize your downside as much as possible and maximize your opportunities for making money. The picture below showcases the concept of a margin of safety. The description outlines how we can put it into practice.
インテリジェント・インベスター is focused on making evidence-based investing decisions. By understanding your financial position and goals you can make effective decisions about how you manage your money. For some, investing in index funds and REITs is the way forward. For others, financial advisors are the key to financial success. But choosing the right financial advisor is crucial, too. For each financial decision, you must consider the evidence.
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