Grahamian Value Investing
My investment approach is inspired by Benjamin Graham, so I think it is only appropriate that my first post describe Benjamin Graham’s philosophy and how I plan to apply it in my own portfolio.
Benjamin Graham is the father of value investing. He was one of the first to advocate for fundamental analysis (trying to figure out what a company is worth based on financial statements), as opposed to technical analysis (analyzing chart patterns the way a fortune teller reads your palm). The Benjamin Graham approach is to look at stocks as ownership shares in a company, rather than pieces of paper or dots on a stock chart. His approach is simple to grasp: figure out what a company is worth and purchase shares in that company for less than they are worth. On the particulars, value investors differ greatly in approach, but this basic outlook remains consistent throughout the value community.
Graham’s 1949 book, The Intelligent Investor, espoused his principles to a mass audience. The key concept in the book was that investors should purchase stocks with a margin of safety. The margin of safety is the extent to which you are buying the stock below its true intrinsic value. He also described the market not as an all knowing master of the universe, but as a manic depressive called Mr. Market. When Mr. Market is in a good mood (think 1999 at the height of the “New Economy” financial euphoria), he offers absurdly high prices for companies. When Mr. Market is in a depressive mood (think the aftermath of the 2008-2009 financial meltdown), he pushes the prices of companies to absurdly low levels. The goal of the intelligent investor is not to allow his investment decisions to be dictated by the moods of Mr. Market, but to instead seek to gain from Mr. Market’s erratic behavior. In other words, buy from Mr. Market when he is depressed and sell when he is elated.
Influence on Warren Buffett
One of the readers of the 1949 edition of The Intelligent Investor was a 19 year old named Warren Buffett. Buffett sought a coherent investment framework throughout his teens but was unable to find one that was intellectually convincing until he came across Graham’s book. In fact, Warren Buffett later went on to say about the book: “It changed my life. If I hadn’t read that book in late 1949, I’d have had a different future.”
Buffett went on to enroll in Columbia primarily because Benjamin Graham taught an investing course at Columbia. He later went on to work for Ben Graham in his investment partnership. This is an excellent interview where Buffett describes his experience with Graham.
As everyone knows, Warren Buffett used Graham’s concepts to become the greatest investor of all time. Graham recommended buying stocks when they were deeply depressed. Buffett employed this method extensively in the 1950’s and 1960’s. Eventually, however, he outgrew this approach. Instead of buying stocks when they were deeply depressed and selling after a run up in price, Buffett sought to buy quality companies for the long term, still following Graham’s basic approach of waiting until the price was right but increasing his standards for quality and lowering his standards for price discounts.
This change in approach was due to two factors. The first reason was the influence of Charlie Munger, who was more interested in buying excellent businesses for the long term than looking for the kind of ugly bargain stocks that Graham advocated. The other reason was scale. Buffett simply became too big to operate exclusively in the world of depressed stocks.
Nevertheless, Buffett experienced his greatest returns in the 1950’s and 1960’s when he was small enough to focus on Graham style bargains.
Simple Quantitative Approaches
Graham advocated two quantitative methods of stock selection that make a lot of sense to me.
Method #1: Net-Nets. The first, and most famous, is the “net net” approach. He advocated buying stocks when they were selling at 66% or below of the company’s liquidation value. Why 66%? If the company were completely liquidated, the owner of the stock would experience a 50% gain. Graham suggested that investors buy 20-30 net-net stocks selling at 66% of their liquidation value, then selling after two years or when the stock price appreciated by 50%.
Famed investor Joel Greenblatt investigated the performance of net-net stocks when he was enrolled in Wharton in the 1970s. The underlying results were quite impressive. One of Joel’s portfolios experienced an annual compound return of 42.2%.
Other academic studies also verify that the returns of net-net stocks frequently deliver impressive results. Unfortunately, net-net stocks are difficult to come by, particularly during bull markets such as the one that we have experienced since 2009. During recessions, such as in 2002 or 2009, large numbers of them are frequently available. In my own portfolio, I plan on purchasing net-net stocks when they are available in sufficient quantities. Fortunately for small investors, the net-net stocks that are typically available are small companies that large investors can typically not exploit.
Method #2: Low P/E, safe balance sheet. The second, lesser known, approach that Graham advocated was explained in a 1976 interview that Graham gave shortly before his death. It was published in the September 1976 issue of Medical Economics. In the article, he suggested buying stocks when they delivered an earnings yield that was double that of a typical AAA corporate bond. As a measure of safety, he also suggested that they have a debt to equity ratio less than 50%. In other words, the stock should be cheap relative to its earnings and it should have double the amount of assets than it has in debt as a measure of the company’s solvency. Graham tested the method from 1926 to 1976 and found that a diversified portfolio of these of these safe bargain stocks would deliver 15% returns over the long term. Quite impressive for such a simple method with only two variables.
15% is an outstanding rate of return over a long period of time and it is what I would like to strive for over the next ten years. If I could achieve this rate of return, I will be able to turn my $50,000 value-oriented IRA into $200,000 over the next ten years.
Over at Alpha Architect, they backtested the simple P/E oriented Graham method and found it still works. The portfolios they tested produced long term compounded annual growth rates ranging between 15.07% and 16.42%, exactly as Graham predicted!
I plan on using this method extensively with my own portfolio. I also plan on pursuing net-net stocks and other quantitative bargains when they are available. A key thing to keep in mind is that while these methods succeed over the long haul, there are periods of time when they do not work. I hope this blog will help me remain disciplined and focused on my own value investment journey.
PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.