Benjamin Graham’s Investment Strategy
Benjamin Graham is one of the best value investors in history. His investment strategies are built in the 1930s and primarily based on fundamental analysis of financial ratios and rejected short-term speculation.
Even Warren Buffet has accepted following Ben Graham’s strategies to some degree to reach where is today. To better understand Ben Graham’s investment philosophy, let’s look at an example.
Imagine yourself as an investor looking to acquire a number of shares in a particular company that manufactures or sells “plants.” This company is popular and delivers globally. However, the company’s stock sells at $60 per share, while it makes $6 profits annually.
Now, this company has a strong competitor who is relatively new in the market and makes lesser profits, about $2 annually. This competitor company’s stock sells at $10 per share, which is much cheaper than the first.
Applying Benjamin Graham’s investment strategy to invest in either of these companies would have you do this:
First, you have to take note of the figures (share prices and the profit per annum), as well as take into consideration other important data, which you’d use to run a fundamental analysis of both companies. Now, the first company’s price-to-earnings ratio is around 10, while that of the second company is around 5.
Considering Benjamin Method of investing, the said investor (you) would prefer to invest in the second company because the stock is cheaper is the profit is higher. The simple analysis above leaves the investor with the conclusion that the first company’s stock is overpriced because it is more popular; hence, the decision to go with the second one.
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The Benjamin Method of investing was introduced in one of Benjamin Graham’s books titled Security Analysis, which he co-wrote with David Dodd. Over the years, to date, Ben Graham’s Security Analysis book has acted as a guide and foundational resource for this day investors.
To proof the efficacy of Benjamin Graham’s philosophy, Warren Buffet confessed that Ben’s teachings and books “became the bedrock upon which all of my investment and business decisions have been built.”
Further, Benjamin Graham’s strategy indicates that there are basically two types of investors; long-term investors and short-term investors. A long-term investor is a value investor that views himself/herself as a company owner.
While a short-term investor is a speculator who targets the inconsistent prices of an asset to make profits.
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Benjamin Graham’s Investment Formula
Hereunder is the formula for Benjamin Graham’s investment strategy. The formula is thus: V = EPS × (8.5 + 2g).
V = intrinsic value
EPS = trailing 12-month EPS of the company
8.5 = Price-to-earnings ratio of a zero-growth stock
g = long-term growth rate of the company
However, this formula was adjusted in 1974 to include additional values. Thus, the new value is:
V= EPS × (8.5 + 2g) × 4.4
4.4(%) = the risk-free rate (the average yield of high-grade corporate bonds in 1962)
Y = the current yield on AAA corporate bonds
Benjamin Graham’s Value Investing Principles
With much already said, let’s talk about the main details of Benjamin Graham’s investment details.
Strategy #1: Margin of Safety
Ben Graham introduced the “Margin of Safety” principle for value investors. It is an investment principle that instructs an investor to purchase a stock at a discount to its intrinsic value.
What does this mean?
For example, given that the intrinsic value of a security or business is $500, but you found it listed on the stock market at $250 and then purchased it; the margin of safety here simply refers to the 50% discount you got.
Hence, it is safe to say that Graham’s margin of safety principle is the difference percentage difference between the actual value of a security or business and its price in the stock market.
This principle helps an investor to minimize the risk of investing in potential profitable security. There are other investment strategies initiated by Ben Graham, but this principle remained the typical investment strategy he practiced.
Apparently, Graham focused more on purchasing underlying stocks less than its worth and it always worked for him.
Strategy #2: What Type of Investor Are You? A Speculator or Investor?
“Beating the market is easier said than done,” Ben Graham.
Benjamin Graham believed that there are two types of people investing in stocks – the speculators and the investors. Also, Graham further divided investors into two types; Active (Enterprising) Investors and Passive (Defensive) Investors.
An active investor is such that dedicates time and energy to becoming a better investor. According to Ben Graham, “work = return.” This is to say that the more time you dedicate to investing, the possibly higher returns you’d get.
In contrast, Ben Graham hinted that passive investors (those who don’t have much time to spend on researching their investments) could invest in Indexes. According to him, a defensive investor is liable to get an average return by simply purchasing the 30 stocks of the Dow Jones Industrial Average in equal amounts.
However, Graham further indicated that most people believe that if little or no work is required to get an average return on an investment, then a little more effort should result in slightly higher returns.
But, the investor guru went on to say that most people that buy into this fallacy often end up doing worse than average. A passive investor should invest in index funds of bonds and stocks; this could yield better returns and certainly would save the investor from doing worse than average.
Coming over to speculators, the difference between an investor and a speculator, according to Ben Graham, is quite simple. An investor considers stocks as part of a business and sees the stockholder as the business owner.
In contrast, a speculator believes “value” can only be calculated by the amount someone is willing to pay for an asset. A speculator believes that he’s just playing with some expensive pieces of paper that have no intrinsic value.
However, in summary, Ben Graham believes that there is “intelligent speculating” and “intelligent investing.” The individual only needs to be sure on which he is good at; speculating or investing.
Strategy #3: The Net Nets Technique
Benjamin Graham introduced the “net-nets technique” for value investing. This technique refers to a situation when a company’s stock is valued based on its net current assets per share (NCAVPS) without considering the company’s liabilities.
Simply put, net-nets is an investment technique where a stock is only valued using Net Current Asset Value Per Share (NCAVPS). This technique focuses on the current assets of a company.
Graham is alleged to earn an average of 20% annually, for three decades, by simply buying hundreds of “sub-liquidation” stocks. At some point, Graham dropped his other strategies to focus on net-nets, and again, it worked for him.
Also, Warren Buffett, who was mentored by Ben Graham paid attention to the net-nets strategies in the ’60s when he ran several partnerships. Warren referred to them as “generally undervalued stocks.”
Strategy #4: Learn To Accept Volatility And Profit From It (The Mr. Market Approach)
As an investor, Graham advises that instead of exiting in times of market stress, a smart investor would greet the downturns as chances to discover new profitable investments. To further clarify this strategy, Graham used the “Mr. Market” analogy.
What does Mr. Market mean? It is the unreal partner of every investor. Mr. Market provides investors with daily price quotes at which they could decide to sell their share of a business or buy another investor out of the business.
Mr. Market can either quote a higher or lower price based on the business’s prospects. However, you are expected to follow the predictions of Mr. Market, instead, you should craft out your estimates of a stock’s value after considering sound and rational facts.
Also, Graham believes it is best to purchase stocks only when the offered price makes sense and then sell it off when the price goes up. Apparently, the market will fluctuate, but instead of exiting due to volatility, see it as an advantage to bargain or sell out if your holdings is overvalued.
Furthermore, Ben Graham suggested Dollar-Cost Averaging and Investing in Stocks & Bonds as the two major strategies to deploy in times of market volatility.
The Dollar-Cost Averaging strategy is the act of buying equal dollar amounts of investment at regular intervals, and this looks perfect for passive investors because it relieves the responsibility of having to decide when and at what price to buy positions.
In contrast, Investing in Stocks and Bonds simply means distributing your portfolio as an investor to evenly accommodate stocks and bonds. This would help to preserve your capital in market downturns and allow the growth of the capital through bond income.
Strategy #5: The Mechanical Approach
Ben Graham considered how an average investor can bypass the market’s behavioral biases and introduced a “Mechanical Approach”, Mechanical Investing Strategy. This strategy hints that if an investor focuses more on buying groups of securities (e.g. net-nets) and subsequently selling them based on strict selling rules, the investor may benefit from the expected group outcome.
However, below are Ben Graham’s criteria for selling securities:
- An investor should only sell his securities when the price shoots above 50% of the purchase price
- An investor should sell his securities when the stock has stayed in his portfolio for over 2 years
Important tip: this approach considers selling securities once they trade above their intrinsic value.
Is Benjamin Graham’s Investment Strategy Still Profitable in 2021?
Most modern investors seek to know if Ben Graham’s value investing strategy is still as effective as it were; well, Graham’s strategies still work and deliver profitable returns. To date, Warren Buffet is still following the techniques, principles, and strategies he learned from Benjamin Graham.
Also, it is important to say that Benjamin Graham’s value investing strategies are quite numerous. However, they are all focused on utilizing several opportunities in the stock market to buy and sell securities.
“To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks,” Benjamin Graham.
Key Takeaways on Benjamin Graham’s Strategy
- The price-to-earnings (P/E) ratio of a stock should be less than 40% of its highest ratio over the last five years.
- Graham believes it is best to invest in value stocks that have a P/B ratio of 1.0 or lower.
- A company’s total book value is expected to be higher than its total debt. Also, the company’s total debt shouldn’t exceed twice the NCAV.
- A company’s total current liabilities and long-term debt should be lesser than its total stockholder equity.
- Ben Graham was more focused on long-term investments in stocks that are based on fundamental analysis of financial ratios, while he ditched short-term “speculation.”
Before practicing Benjamin Graham’s investment strategy, you need to first indicate the type of investor you are; a speculator (short-term investor) or a value investor (long-term) investor.
While Graham focused more on long-term investments, he randomly introduced some tips that could help speculators in the market to do more than average.
However, there are other profitable investment strategies that could work out for newer investors and intermediate investors.
The George Soros investment strategy and John Bogle investment strategy are also good for investors to follow in this recent times. Warren Buffet is one of the solid proof that Ben Graham’s strategy actually works and is still working.