Benjamin Graham - The Original Value Investor
8 FEBRUARY 2014
- By Asad Dossani, Author, The Lucrative Derivative Report
Benjamin Graham is credited as the founder of value investing. In 1934, he published 'Security Analysis', and this today remains one of the most important texts for value investing. The famous investor Warren Buffet learned value investing from Benjamin Graham himself. In this article, we'll discuss Benjamin Graham's approach and philosophy to value investing, and why it is successful.
Graham's approach to value investing is to look for companies that trade below their intrinsic value. Based on a company's financial statements, we can use book to market ratios or price to earnings ratios in order to find value stocks. Specifically, we look for companies trading at below their book values, or companies with small P/E ratios.
Next, we build a portfolio of these companies (e.g. 25-30 companies) that meet the criteria of a value stock. The reason we build a portfolio is diversify against the risk of any individual stock losing money. Once we've built a portfolio, we hold it for the long term. Our goal is to sell companies once they reach their intrinsic values.
Graham's philosophy of the stock market is as follows: In the short term, markets can be irrational and so prices deviate from their fundamental values. This is what allows us to find stocks that are undervalued. In the long term, stock prices will reflect the fundamentals of the company. For this reason, we can expect undervalued stocks to appreciate to their true value over time.
This approach to investing is successful primarily due to the short term vs long term behavior of the stock market. The pattern of short term irrationality and long term convergence to fundamental values is what allows us to find undervalued stocks in the first place, and sell them for a profit later on.
Graham's approach is primarily quantitative. This means that we select stocks based on our analysis of a company's financial statements. We place less emphasis on qualitative factors such as a company's management quality or economic moat (i.e. competitive advantage). The advantage of primarily focusing on quantitative factors is that the analysis is more objective. When we analyze qualitative factors, our judgments are more subjective, and we are more likely to make mistakes.
For a long term investor, Graham's approach has proven itself as an effective method to outperform the stock market over time, while minimising risks. It is important to keep in mind that this method works over the long term only, and it requires patience and discipline from the investor to be successful.
In the Equitymaster club forum, we are asking the question, "Do you agree with Graham's philosophy behind value investing?" We invite you to please post your responses and views.
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