This article was published in the New Haven Register on 4/29/17.
Editor’s note: First of four parts on legendary investors.
Everyone has heard of Warren Buffett, the Oracle of Omaha, one of the most successful investors in history. But who taught Buffett what he knows?
Today I am starting a four-part series on legendary investors by profiling Benjamin Graham, known as “The Dean of Wall Street” and “The Father of Value Investing.” Graham was Buffett’s mentor at Columbia University and later at Graham-Newman Corp. in the early 1950s.
Buffett has credited Graham with providing the road map he used to become the world’s third richest man in 2016. So let’s explore the investing philosophy of Benjamin Graham.
First and foremost, Graham outlined an objective approach to investing, a method based on disciplined analysis rather than emotion and speculation. He based his strategy on the fact that there is a difference between the price of a security or other asset and its actual value. In other words, most stocks are mispriced for a variety of reasons, and if you apply a rigorous method to evaluating the actual value of the company, you can identify opportunities to “buy low” when a company’s stock price sits below its true value.That philosophy is the opposite of the “efficient market hypothesis,” which holds that securities are priced accurately because they reflect all information available to investors. Graham believed that an active investor could, over time, make money in the stock market by pinpointing “estimated value” and buying in at the right amount below that estimate.
Achieving that goal requires two things: You must understand how to analyze securities, and you must know how to contain risk by investing rationally and avoiding decisions based on emotion. Investing based on a neighbor’s tip or the evening news is gambling, not investing. As Graham said, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
Graham laid out his philosophy and methods in two books, “Security Analysis” from 1934 and “The Intelligent Investor” from 1949. Here are some basic principles from those classic texts:
Find the Margin of Safety. Only buy a stock or other asset when it is priced lower than its real value, providing a “Margin of Safety” should the company lose value (either due to specific developments or market downturns). Graham’s books lay out in great detail how to determine the intrinsic value of a company by studying assets, earnings, dividends, quality of management and other factors.
Choose Big Dividend-Paying Companies. Larger firms are better able to deal with economic downturns than smaller firms, Graham believed. And a long history of paying dividends shows a company is profitable over time, since dividends are paid out of profits.
Look for Financial Strength. Positive signs for investors include a favorable asset-to-debt ratio, substantial cash on hand, steadily rising earnings, and price/earnings ratios below the company’s long-term average.
Finally, Graham always reminded investors they couldn’t know everything about a company regardless of how much research they do. Therefore diversification is always necessary in order to soften the blow when some assets lose market value.
Next: Sir John Templeton