Warren Buffett’s Single Mentor Benjamin Graham and His Strategy!
'In the short run, the market is a voting machine, but in the long run, it is a weighing machine.' – Benjamin Graham
Benjamin Graham was a renowned investor known for his in-depth analysis of value investing, which is still used as the foundation for modern investing today, though the craft has changed and evolved in dramatic fashion by now.
Born in 1894 in London, U.K., Graham's family moved to America, where he would eventually accept a job on Wall Street after graduation. During the stock market crash of 1929, Graham lost a considerable amount of his investments, teaching him critical lessons in the art of investing and averting risk.
Loss of capital is the greatest motivator for those possessing a high level of conviction to move forward and correct past mistakes.
The lessons learned from the crash were put into action, and with David Dodd, the two wrote the book Security Analysis in 1934 at the start of the momentous Great Depression.
Graham and Dodd began establishing the foundations of modern-day investing. The book explained the fundamentals of value investing and introduced a new method to determine the underlying intrinsic value of a company in a market that was, at the time, considered a highly speculative environment.
Value investing allows a person to assess the intrinsic value of a business and thus a single share with the purpose of comparing it to the market price. The criteria to determine this is based on a company's assets, liabilities and earnings power. The classic Graham trade is to buy when the margin of safety is wide and the stock is well below intrinsic value, wait for market forces to prevail and sell close to the fair price – this is called Mean Reversion today.
The mean reversion is a mathematical theory stating that prices and returns eventually move back to the historical average.
Graham sought to minimize risk and maximize potential for long-term portfolio growth. He was aware of the irrational behavior of the majority of investors and highlights buying and accumulating stocks that are disregarded by the markets. His strategy relies upon the nature of investors to speculate and revert to emotional decision-making over logic and data.
He also recommended companies with a low debt-to-equity ratio and explained the importance of portfolio diversification for the value investor.
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Below are the original and adjusted formulas used to determine the intrinsic value:
V = EPS x (8.5 + 2g)
V – Expected value expected from the formula
EPS – Earnings per share (company profit divided by outstanding shares)
8.5 – P/E ratio of zero-growth stock (market value divided by earning value per share)
G – Growth rate
Years later, Graham adjusted the formula to include a risk-free rate of 4.4% and the current yield on AAA corporate bonds, represented by Y, as follows:
V = EPS x (8.5 + 2g) x 4.4
Value investing, the way Graham saw it, is based on present facts, on today’s evidence and places no value on any estimated future growth potential. Essentially, he doesn’t want to pay for the uncertain future even one dime, a system that worked during the Great Depression but would be impossible to follow today, as the only companies trading for liquidation prices, like Graham liked them, are those in bankruptcy courts.
Below, we will look at the criteria of Benjamin Graham's philosophy on value investing:
- Graham recommended using Standard & Poor's rating system to help determine a company's long-term potential. Companies with an S&P earnings and dividend rating of at least B or higher is seen as good. The ratings range from D to A+.
- Make sure a business has enough cash and assets to survive any economic condition. Check the current ratio for companies with 1.50 or over.
- Look for companies with strong earnings per share for at least five years, with no earning deficits in the same period.
Seek companies with price to earnings per share (P/E) ratios of 9.0 or below. This helps find companies that are ripe for buying – very rare today.
- Invest in companies with low debt. Graham recommended companies with total debt to current asset ratios of 1.10 or less.
- My personal favorite, look only for dividend-paying companies. Investing in undervalued companies means it may take some time for the rest of the market to lock onto the opportunity. Earning dividends on a dormant investment means you are still growing and compounding your portfolio in the meantime.
'The Intelligent Investor is a realist who sells to optimists and buys from pessimists.' ― Benjamin Graham, The Intelligent Investor
In 1949, Graham magnified the fundamentals of security analysis, writing The Intelligent Investor, which is still considered as the ultimate guide to investing by amateurs and professionals alike.
With a handful of improved revisions, the book provides investors with critical insights on the herd mentality and why it's crucial to think independently, when investing in the stock market and the importance of being a contrarian.
Graham encourages in-depth analysis of a stock's potential; valuing it by real fundamentals based on the formulas explained earlier – not speculation, greed, and fear of missing out.
Graham's teachings built the core foundations of how many invested in the 20th and 21st centuries.
These key techniques also made Warren Buffett a household name and envied by many for his successful investing techniques taught by Graham himself.
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