Value Investing with Benjamin Graham

None other than Emperor Napoleon Bonaparte once made the following statement about success:

“Be nothing unless it be lasting”

In other words, you can achieve success in the short term, but the real challenge lies in being successful for a long consecutive period. A statement pursued by any long-term investor, but which only a few have been able to realize so far.

If there is one man who managed to consistently outperform the benchmark, it is the “Father of Value Investing” Benjamin Graham. Look at the table below with the returns of his investments and those of some followers of his philosophy.

 

Time frame Average annual return Average annual return S&P
Graham’s Graham – Newman Corporation 21 20.0% 12.2%
Walter J. Schloss, WSJ Partnership
28 21.3%  8.4%
Tom Knapp & Ed Anderson 16 20.0% 7.0%
Waren Buffet (pre Bershire Hathaway) 13 29.5% 7.4%
Bill Ruane, Sequoia Fund 14 17.2% 10.0%
Charles Munger’s, Overall Partnership 14 19.8% 5.0%
Rick Guerin, Pacific Partners Overall Partnership 19 32.9% 7.8%

If the name Benjamin Graham does not immediately ring a bell, then the name Warren Buffet certainly will. If anyone would agree that Graham is the founder of Value Investing, it is Warren Buffet.

Buffet was one of the students who was taught by Graham. The admiration for Graham went so far that he named his middle son after Graham (Graham Howard Buffet).

Who was the man Benjamin Graham?

What makes his way of investing so successful? And perhaps most importantly, how can you become as successful as Graham?

Who was Benjamin Graham?

Benjamin Graham (1894-1976) was born into a wealthy family with a successful investor as a father. His father, however, died when Graham was only nine years old. Unfortunately, his mother did not have the same talent for investing as his father and the family soon found themselves in a prolonged period of financial problems.

This experience played an important role in Graham’s pursuit of preservation of capital. He tries to achieve this by always maintaining a portion of its portfolio in bonds. However, he will always hold at least 25% of his portfolio in shares, regardless of the market situation.

He argues that investing only in bonds can not compensate for inflation, which would cause his portfolio to lose value.

Besides the construction of his portfolio, there are several other aspects that characterize the investment philosophy of Graham. He once made the following statement.graham_quote
Benjamin GrahamIn other words, you don’t have to be a genius to obtain satisfying results, but you will in order to achieve superior results.

It is very important that you are willing to familiarize yourself with the “real” value of a company. A share is not just a number, which you hope will increase in value after you purchase it. Behind it is a company’s buildings, profits, debt, future revenues and employees, which are all important for the continuity of the company and therefore to the value of the share.

In his book “The Intelligent Investor” he takes as an example the rise of the aviation sector in the early 20th century. At first sight, the aviation industry was a great invention that would make a major contribution to the emerging globalization. The popularity of the aviation sector quickly rose among investors as well.The intelligent investor - Benjamin Graham

Graham also recognized this rapidly growing industry, but dared look beyond the market.

Producing aircraft was very capital intensive and in order to finance it, manufacturers had to take out huge loans. At the same time, these firms had just very little equity. (High debt-equity ratios)

Soon, there was the well-known bubble in the aviation sector. Benjamin Graham was one of the few not to burn his fingers when the bubble burst.

Should we project the above on a more recent situation, we arrive at the dot-com bubble at the beginning of the century. Here too, for a long time it almost didn’t matter what technology shares you bought, they would go up anyway.

“The technology market as a whole had in fact so much potential that you would make a profit anyhow,” said the optimistic investors who later would be confronted with reality.

Take for example the share Intel, the maker of computer chips, which announced to grow by 5% in the next quarter in early 2000. At first sight not a bad prospect at all, most companies can only dream of such growth in one quarter.

Still, the stock fell on that day by as much as 22%, or $ 91 billion!

And why? Analysts had expected a growth of 10%.

Total Return Index P&G

P&G total return index
Total Return Index P&G

Because of this uncertainty Graham advises to avoid growth companies as much as possible, unless you have sufficiently familiarized yourself with the company and are very confident in the continuity and growth of the company. Graham prefers to look at companies like Coca Cola, Proctor and Gamble and General Motors that have repeatedly proven their stable reputation and pay a relatively high dividend.

The dividends he would invest in the company again and again, because he invests only if he is convinced that the company is worth more than the market tells him.graham_quote2

Benjamin GrahamBut even a stable company with a high dividend does not mean that you can purchase the company at any time. Shares can be temporarily overvalued by investors who continue to buy a popular share.

These shares can also fall due to poor market conditions, while the company itself is performing outstanding. It is precisely at times of declining share prices that Graham strikes. If you are patient enough, low-priced shares always move to their “real” value, despite the price level of the overall stock market at that time.

It just depends on how well you investigate the company and how much courage you have in bad times. The schema below briefly summarizes how to behave according to the philosophy of Graham.

Criteria for a successful value investor

Personal characteristics

  • Confidence in your own decisions
  • Disciplined
  • Willing to investigate and familiarize yourself with a company
  • Not afraid when you suffer temporary losses

Business characteristics

  • Stable company
  • High dividend
  • Avoid as much as possible the growth companies

Portfolio

  • Preservation of capital of the invested principal
  • Long-term
  • Never less than 25% in both fixed income and equity
  • Buy when “true” value of a business is higher than market value
  • Diversified across different sectors

 

We have now provided you with a brief introduction to stock market guru Benjamin Graham. If you want to read more information about Benjamin Graham and his investment philosophy, then it is advisable to read the rewritten edition of his book ‘The Intelligent Investor’. In this book Jason Zweig and Warren Buffet make a connection between Graham’s philosophy and more contemporary situations of the market and value investing.

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