At a glance:
Margin of safety
Summary of Benjamin Graham lessons
Benjamin Graham taught an investment class at the Columbia University business school for 28 years.
If you had been a student in Graham's classes during the early 1950s, your textbook, Security Analysis, would have been written by Graham himself, along with David Dodd.
You may have also met a few interesting students by the name of Warren Buffett, Bill Ruane, Tom Knapp, and Walter Schloss. Each of these men would go on to manage investments in one form or another.
Buffett and Schloss both started investment partnerships. Buffett folded his partnership in 1969, but his partners were given the opportunity to receive shares of a struggling textile manufacturer named Berkshire Hathaway (BRK.B). Ruane and Knapp started firms that manage public mutual funds.
In 1984, Buffett returned to Columbia to give a speech commemorating the 50th anniversary of the publication of Security Analysis.
During that speech, he presented his own investment record as well as those of Ruane, Knapp, and Schloss. In short, each of these men posted investment results that blew away the returns of the overall market.
Buffett noted that each of the portfolios varied greatly in the number and type of stocks, but what did not vary was the managers' adherence to Graham's investment principles.
The investment principles taught by Graham at Columbia served his students exceptionally well, and it is difficult to overstate the influence Graham had on the field of professional stock analysis.
The good news is that Graham made the same principles easily accessible for ordinary investors by writing the classic book The Intelligent Investor.
The principles of value investing
Multibillion-dollar casinos have been built in the desert because of the insatiable human desire to speculate.
However, when speculation is confused with investment, trouble inevitably follows.
The Internet bubble of the late 1990s is merely one example of the speculative frenzies that occasionally occur in financial markets.
In The Intelligent Investor, famous investor Benjamin Graham set forth the principles that form the foundation of value investing. Value investors seek to purchase assets at prices that are substantially below the assets' true, or intrinsic, value.
Graham's timeless principles provide a map that all value investors can follow to stock market success. According to Graham, investing consists of three elements:
1. Thorough analysis
Stocks are not merely pieces of paper or electronic quotations on a computer screen, but partial ownership interests in real businesses.
Therefore, you must thoroughly analyze the underlying business and its prospects before purchasing a stock. Equally important—given the endless amount of data that flows from the stock market on a daily basis—is recognizing the information you must ignore or discard.
For example, the average price of a stock over the past 50 days may be important to so-called chartists or technical analysts, but does that have any effect on the safety or value of the underlying business?
As Graham wrote, you must study "the facts in light of established standards of safety and value."
2. Safety of principal
Warren Buffett is fond of saying that his two rules of investing are Rule #1: Don't lose money; and Rule #2: Don't forget Rule #1.
Buffett undoubtedly inherited his strong aversion to permanent capital loss from Graham.
To succeed over an investment lifetime, you do not have to find the next Microsoft (MSFT), but it is necessary that you avoid significant losses.
3. Adequate return
For Graham, an "adequate" or "satisfactory" return meant "any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence."
Many investors will find that the best way to own common stocks is through a low-cost mutual fund or ETF (exchange-traded fund) that tracks a broad market index such as the S&P 500.
Index funds allow investors to participate in the growth of American business, which has been very satisfactory over the last century. In addition, very few active managers have outperformed S&P 500 index funds over long periods of time.
Therefore, if you decide to construct your own portfolio of stocks or to purchase shares of an actively managed mutual fund, your investment return must exceed that of a low-cost index fund over the long term to be "adequate."
Otherwise, "reasonable intelligence" should dictate that you own an index fund.
What is intrinsic value? Here are the basics
How much should you pay for a business?
Every day the stock market offers prices for thousands of businesses, but how do you know if the price for any particular business is too low or too high?
To succeed as an investor, you must be able to estimate a business's true worth, or "intrinsic value," which may be entirely separate from its stock market price.
Look at the financial statements
For Benjamin Graham, a business's intrinsic value could be estimated from its financial statements, namely the balance sheet and income statement.
For example, in 1926 Graham discovered that Northern Pipe Line, an oil transport company, owned a collection of railroad bonds that were worth $95 for each of its shares.
However, Northern's stock was selling for only $65 per share. It does not take a genius of Graham's caliber to see from Northern's balance sheet that its intrinsic value was at least $95 per share since the company also owned valuable pipeline assets.
Although it took a proxy fight, Graham eventually brought Northern's management to his way of thinking: Northern sold the bonds and paid a $70 per share dividend.
If all investors based their investment decisions on rational and conservative estimates of intrinsic value, it would be very difficult to make money in the stock market.
Fortunately, the participants in the stock market are humans subject to the corroding influence of emotions.
Investors are frequently given to bouts of over-optimism and greed, which causes stock prices to be bid up to very high levels.
These same investors are also vulnerable to excessive pessimism and fear, in which case, stock prices are driven down substantially below intrinsic value.
Graham's words of advice for investors
Benjamin Graham offers intelligent investors an escape from the swift tides of greed and fear.
He wrote,:"Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market."
Graham's attitude toward market fluctuations, of course, makes perfect sense.
Can you imagine waiting to purchase a television until its price went up, but refusing to buy the same television when it went on sale?
Strange as it seems, behavior that is blatantly irrational in most aspects of life is commonplace in the stock market.
The parable of Mr. Market
Graham succinctly captured his liberating philosophy toward market fluctuations in the famous parable of Mr. Market.
Graham said to imagine you had a partner in a private business named Mr. Market. Mr. Market, the obliging fellow that he is, shows up daily to tell you what he thinks your interest in the business is worth.
On most days, the price he quotes is reasonable and justified by the business's prospects. However, Mr. Market suffers from some rather incurable emotional problems; you see, he is very temperamental.
When Mr. Market is overcome by boundless optimism or bottomless pessimism, he will quote you a price that, as Graham noted, "seems to you a little short of silly."
As an intelligent investor, you should not fall under Mr. Market's influence, but rather you should learn to take advantage of him.
You should outsmart Mr. Market
The value of your interest should be determined by rationally appraising the business's prospects, and you can happily sell when Mr. Market quotes you a ridiculously high price and buy when he quotes you an absurdly low price.
The best part of your association with Mr. Market is that he does not care how many times you take advantage of him.
No matter how many times you saddle him with losses or rob him of gains, he will arrive the next day ready to do business with you again.
The lesson behind Graham's Mr. Market parable is obvious.
Every day the stock market offers investors quotes on thousands of businesses, and you are free either to ignore or take advantage of those prices.
You must always remember that it is not Mr. Market's guidance you are interested in, but rather his wallet.
Margin of safety
If you had asked Benjamin Graham to distill the secret of sound investing into three words, he might have replied, "margin of safety."
Those are still the right three words and will remain so for as long as humans are unable to accurately predict the future.
As Graham repeatedly warned, any estimate of intrinsic value is based on numerous assumptions about the future, which are unlikely to be completely accurate.
By allowing yourself a margin of safety—paying only $60 for a stock you think is worth $100, for example—you provide for errors in your forecasts and unforeseeable events that may alter the business landscape.
Just think, if you were asked to build a bridge over which 10,000-pound trucks were to pass, would you build it to hold exactly 10,000 pounds? Of course not—you'd build the bridge to hold 15,000 or 20,000 pounds.
That is your margin of safety.
Summary of Benjamin Graham lessons
When Benjamin Graham passed away in 1976, Warren Buffett wrote this about Graham's teachings: "In an area where much looks foolish within weeks or months after publication, Ben's principles have remained sound—their value often enhanced and better understood in the wake of financial storms that demolished flimsier intellectual structures. His counsel of soundness brought unfailing rewards to his followers—even to those with natural abilities inferior to more gifted practitioners who stumbled while following counsels of brilliance or fashion."
Buffett's words remain undeniably true today. Investing is most intelligent when it is most businesslike, and investors who follow Graham's principles will continue to reap rewards in the stock market.
This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.
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