The original article was written by Thomas Niel.
When looking to the legends for value investing inspiration, why not start with the granddaddy of them all, Benjamin Graham?
The author of both Security Analysis and The Intelligent Investor.
The grandmaster of value investing who influenced Buffett, Schloss, Munger, and Klarman.
Benjamin Graham’s success is all and well good, but how does the story of this man pertain to your investing success today?
What can you learn from his nearly century-old strategies? And, how did he use investor activism in his early year to great effect? Read on to see how Graham-style investing is still relevant (and profitable!) in the 21st century.
How Benjamin Graham Wound Up on Wall Street
Benjamin Graham was born in London in 1894, but as an infant moved with his family to New York City.
Graham first stood out as a gifted academic, winning a scholarship to Columbia University and graduating second in his class.
Graham ended up on Wall Street due to financial pressures: his father had died, and he needed to become the family breadwinner. Turning down a teaching job at Columbia, Graham took an entry-level position at Newburger, Hender, and Loeb.
Within a few years, Graham rose up the ranks from runner, to clerk, to market letter writer, to analyst, to finally becoming a partner by the age of 26.
The Early Years of Graham-Newman
In 1923, Graham left Newburger to strike out on his own, partnering with Jerry Newman to start Graham-Newman.
In his early days, Benjamin Graham set the foundation for creating a systemized method of fundamental analysis. The rest of Wall Street depended on inside tips and the rumor mill to generate big returns. Graham scoured any source he could find for financial information to make his decisions.
Prior to the creation of the SEC in the 1930s, company information was scarce — company insiders and Wall Street moguls had access, but Joe and Jane Investor often were left in the dark.
With his resources, Graham was able to turn over many rocks to locate relevant information and gain an edge.
For example, a little bit of sleuthing enabled Graham to make one of his first waves as an investor, in a situation later known as the “Northern Pipeline Affair”:
Graham inadvertently discovered that pipeline companies filed financials with the Interstate Commerce Commission. Being one of the few on Wall Street who bothered to pore over these filings, he found a particularly undervalued company named Northern Pipeline.
Northern Pipeline was one of the companies spun off of Standard Oil after its court-ordered breakup a decade earlier, and it traded at a discount to a portfolio of cash and liquid securities.
Shares were trading for $65 a share, but the portfolio of cash and high-grade bonds was worth $90 a share!
Graham took a position, and attempted to convince the company’s management to distribute the investment portfolio to shareholders.
Management and the shareholders (including the Rockefeller Foundation and other Standard Oil insiders) were not convinced. Like with activist campaigns nearly a century later, company insiders did not want an outsider telling them how to run their business.
Graham, however, did not care to run the pipeline business; he just wanted to close the gap and realize the underlying value of his shares.
After failing to win over the board, Graham took more aggressive action, launching a proxy fight for two board seats.
Graham and his associate won the two seats, and within weeks the board agreed to distribute the excess capital.
Dogged in his efforts, Benjamin Graham spearheaded an aggressive strategy to value investing that would eventually be the playbook for activist investors nearly a century later.
In Graham’s early years, he was also a specialist in convertible bond arbitrage. Convertible bond arbitrage is when you go long on a convertible bond, but short the underlying stock.
For example, at one point Benjamin Graham went long $10,000 in convertible bonds from Lackawanna Steel, while shorting the stock at $100 per share. In this situation, his downside was just $25, while the upside was much greater if the stock declined in price. The stock did fall to $83, while the bonds begin trading for 94 cents on the dollar. This created a $1,100 gain with minimal risk.
While technological changes have reduced the arbitrage opportunities, there are still numerous funds that specialize in this strategy.
The Golden Years of Graham-style Value Investing
The 1930s and ’40s were the “golden years” for Benjamin Graham and his investment partnership (Graham-Newman).
Post-1929 crash, the government stepped in to regulate a corrupt Wall Street. This led to the requirement of public companies to issue quarterly financials.
While share prices absorbed the dissemination of this previously scarce information, this information still was not as accessible as it is today.
All screening was manual, and only specialists like Graham had the time and resources to flip through every page of the Moody’s manual, finding deep value plays hiding in plain sight.
Graham-Newman suffered severe losses during the 1929 crash, but by the mid-1930s had rebounded. Despite this setback, Graham-Newman was able to generate a 17% annualized return through its liquidation in 1956.
Graham-Newman made money by pursuing two separate strategies:
- Buying securities trading at discounts to their intrinsic value.
- Engaging in arbitrage situations (such as merger arbitrage, convertible arbitrage, and other special situations).
Graham-Newman focused on low-risk opportunities that did not require “predicting the unpredictable.” Finding the areas of the markets where asymmetric wagers presented themselves, they could produce outsized returns for their investors.
Codification of Value Investing: “Security Analysis” and “The Intelligent Investor”
At the same time Graham was building a reputation as a professional investor, in the evenings he taught investing at his alma mater, Columbia University.
The combination of teaching his theories in the classroom and putting them into practice on the big board enabled him to solidify and codify his investment philosophy.
Working with his former student David Dodd, Graham published Security Analysis in 1934. This book became the Bible of value investing. The 851-page tome has sold over 1 million copies.
Graham would eventually publish a more digestible version of his investment theories: 1949’s The Intelligent Investor.
Graham’s Later Investing Career: Adapting to Changing Environments
Graham wound up his partnership in 1956, retiring from professional money management but continuing to actively invest his own portfolio.
Graham also continued to publish updated editions of his famed books. As the market environment changed, he developed a new type of investing criteria tailored for the more aggressive “go-go ’60s” markets:
“Those factors are significant in theory, but they turn out to be of little practical use in deciding what price to pay for particular stocks or when to sell them. My investigations have convinced me you can predetermine these logical ‘buy’ and ‘sell’ levels for a widely diversified portfolio without getting involved in weighing the fundamental factors affecting the prospects of specific companies or industries.”
In a 1973 interview, Graham outlined his new criteria for contrarian value investing:
- P/E ratio under 10
- Shares selling at half of market high
- Lowest price to book
Graham believed that a widely diversified portfolio (30 stocks) of these “dogs” would produce above-average returns.
Graham backtested this system to what was one of the worst market downturns in a generation — the 1973-74 crash. While the system would show a loss during the downturn, the shares immediately rebounded at a greater rate than the market in general.
Graham believed this was a medium-term strategy (five-year time horizon).
Backtesting further, the system over a 50-year timeframe (1926-1976) would have produced a 15% annualized return, beating the Dow twofold.
What Made Graham’s Style of Investing “Work”?
Benjamin Graham systemized equity analysis, creating a solid criteria helpful in screening low-risk opportunities with potential for outsized upside.
We would call these “asymmetric wagers” today. Similar to finding overlays in horse racing, Benjamin Graham figured out a way to handicap companies, determining which investments presented him a statistical advantage.
A key factor in Graham’s philosophy is the belief that stocks are a piece of a business, not a piece of paper that fluctuates in value. Combined with a solid investing criteria, the “business owner” mindset will give you the gumption to stick to your guns during market volatility.
In the short term, the market is a voting machine (prices based on popularity and public perception), in the long run, it is a weighing machine (valued on the true underlying value of the business).
Over the long run, and in the aggregate, a portfolio of stocks trading below intrinsic value will produce outsized returns in relation to general market returns.
Stock Market Overlay: Margin of Safety Defined
"One sentence changed my life. Ben Graham opened the course by saying: 'If you want to make money in Wall Street you must have the proper psychological attitude. No one expresses it better than Spinoza the philosopher.'
"When he said that, I nearly jumped out of my course. What? I suddenly look up, and he said, and I remember exactly what he said: 'Spinoza said you must look at things in the aspect of eternity.' And that’s what suddenly hooked me on Ben Graham."– Marshall Weinberg
Margin of safety, as per Benjamin Graham, is the spread between a stock’s trading price and the intrinsic value of the stock.
This margin of safety provides you with a margin of error in case an investment fails to perform or faces black swan events.
A good analogy is to compare margin of safety to building a bridge. If you expect a bridge to carry a maximum of 10,000 tons, you build it to carry 20,000 tons for safety and liability purposes. This margin of error ensures unforeseen events do not lead to ruin.
Benjamin Graham saw margin of safety as an important factor in selecting an investment, but he also knew it was not the “end all be all” of a buying opportunity.
Many times, a company will begin to trade at a discount as future expectations begin to look bleak.
It is common for many companies selling at discounts to tangible book to continue burning through cash, slowly eliminating the margin of safety. A good example is a biotech company, which temporarily can trade at a discount to cash, all while running huge losses that require dilutive capital infusions.
It is tough to find companies that are both profitable on a cash flow basis and selling at a discount to tangible book, but these opportunities are available — especially in international markets.
Spread Your Bets Widely And Still Have An Edge: Graham on Diversification
“Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss – not that loss is impossible. But as the number of such commitments is increased, the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.”— Benjamin Graham on diversification
Graham saw diversification as a way to spread risk across multiple asymmetric wagers, with the portfolio in the aggregate outperforming as a whole.
As Graham noted, this is similar to insurance underwriting: insurers price risk based on statistical information, determining at what price they can assume risks while in the aggregate generate a positive return.
Margin of safety and diversification go hand-in-hand when it comes to Graham-style value investing. Margin of safety ensures a margin of error in case of unforeseen risks. Diversification provides a large enough sample size for the portfolio to perform close to its expected outcome.
“Mr. Market”: Benjamin Graham on Market Volatility
Graham explained his philosophy on market volatility by using the character “Mr. Market.”
Mr. Market is a bipolar investor in your business. Some days, he’s irrationally exuberant about the prospects of your business, so he offers to buy you out at a ridiculous premium to inherent value.
Other days, he is one step from jumping out a window. He offers to sell out to you at fire sale prices.
Mr. Market’s volatile opinions should not influence your investment strategy, but his mood swings are prime opportunity to either buy or sell.
Through this parable, Graham captures the essence of market psychology, and how you, as an “intelligent investor,” can profit from this social dynamic.
When markets are going strong, it creates “social proof” in the eyes of those who haven’t jumped in: having the “fear of missing out,” they bid prices higher, creating bubbles.
On the flip side, when the tide begins to turn, investors run for the exit. As the bulls capitulate, more investors lose faith and jump ship as well. This leads to overselling, pushing stocks to trade at discounts far below their inherent value.
Market volatility is the value investor’s best friend — if markets were not volatile and stocks simply rose in value as their earnings increased, there would be few deep value opportunities.
Market volatility works for the value investor because of mean reversion. Over time, results skew towards their average.
As a whole, a portfolio of moribund companies will, on average, skew back to their mean. Some of them may go bankrupt, but others will rebound, resulting in a portfolio that over time trades closer to its intrinsic value.
Is My Deep Value Idea a Grahamesque Idea?
Here is Graham’s original systemized criteria for selecting investment opportunities. While the specifics were more relevant in Graham’s time, the broad strokes remain pertinent today:
- Earnings yield twice the yield of AAA bonds.
- A P/E ratio less than 40% of the stock’s highest P/E in the past 5 years.
- Dividend yield at least two-thirds of a AAA bond yield
- Stock price below two-thirds of tangible book
- Stock price below two-thirds of NCAV (net current asset value)
- Total debt less than book value (Debt ratio of 1:1 or less)
- Current ratio greater than 2
- Total debt less than twice “net current assets”
- Compounded earnings growth over the past 10 years of at least 7%.
- No more than two declines of 5% or more in year-end earnings in the prior 10 years
Like the strategy we practice in our own investing, Benjamin Graham created a simple value strategy to screen for deep value and net net opportunities.
These ideas produced minimal downside and sufficient upside potential to be an asymmetric wager.
When Did Graham Know “When to Fold ’Em”?
Profits are made in investing when you buy, not when you sell. If you buy at a price below the inherent value of the asset, you will most likely come out ahead in the long run.
Graham took a mechanical view of selling securities. Here are Graham’s two main criteria for knowing when to sell:
- When the price rose above 50% of the purchase price
- If a stock has been in your portfolio for more than 2 years
These methods may be too mechanical, but they offer a strong rule of thumb when it comes to selling winners and letting go of stragglers.
An important takeaway is to consider selling a stock once it trades above its intrinsic value.
While there are many ways to value a stock, if a company starts to trade on future expectations as opposed to current fundamentals, you likely entered overvalued territory, and it may be high time to sell.
Why Benjamin Graham’s Investment Strategies Can Still Generate Big Returns!
Benjamin Graham developed and codified the fundamentals of value investing, creating an investment style with a 100-year track record of market outperformance.
The key takeaway from Graham’s work is not to follow his system blindly: the markets of today have material differences to those seen in the 1920s-1940s. From Graham’s later theories, you can see his strategies also needed adaptation to stay relevant in the 1960s and ’70s!
Above all else, Graham preached a value-oriented investment bent, tailored to the conditions of the current market.
As we’ve said before, Benjamin Graham would be jealous of the advantages individual investors have today. We can screen for opportunities efficiently, scour the globe for deep value stocks at the click of a button, and quickly enter and exit positions with minimal cost.
By following a simple value strategy, rooted in the fundamentals of Benjamin Graham-style deep value investing, you too can generate big returns over a long investing timeframe.
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Read next: Would Ben Graham Buy A Deep Value Technology Stock?
