Benjamin Graham is credited as the founder of value investing.
In 1934, he published 'Security Analysis', and till this date it remains as one of the most important texts for value investing.
Arguably the world's richest and most famous investor Warren Buffett learned value investing from Benjamin Graham himself.
Here we share with you many of insights we've picked up along the way that define Benjamin Graham's approach and philosophy to value investing and the approach we follow in identifying the right deep value stocks.
In his introduction to The Intelligent Investor, Benjamin Graham makes a very important observation...
Graham hit the nail on the head here.
The most successful investors out there do not have better stock market knowledge than others.
Nor do they have access to some hidden information.
They are temperamentally better equipped and are willing to take the short-term market fluctuations in their stride.
They know that in the long-term, the stock market news will be good and are willing to just hang in there.
They did precisely that and ended up making a killing.
In fact, this whole incident reminds us of the famous Fidelity study. The fund did an internal review to figure out which type of investors received the best returns between 2003 and 2013.
The audit revealed that the best investors were either dead or inactive.
The key takeaway is simple:
Not doing anything and pretending to be dead is perhaps the biggest edge you can have in investing.
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The way Benjamin Graham viewed the stock markets is as follows...
The above approach is nothing but value investing.
It's 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 you to find undervalued stocks in the first place and sell them for a profit later on.
Graham's approach to stock market was primarily quantitative. This means selecting stocks based on analysis of a company's financial statements.
It places 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 than subjective and less prone to mistakes.
For a long-term investor, Benjamin Graham's approach has proven itself as an effective method to outperform the stock market over time, while minimising risks.
An important point to note about this method is that it works over the long-term. It requires patience and discipline from the investor to be successful.
Let us now dive a little deeper to see what was value investing as per Benjamin Graham...
Benjamin Graham's interview published in 1976, highlights how he used to look at value investing...
In the interview, Benjamin Graham laid out an investing approach that he had back-tested for over 50 years.
According to him, the approach trounced every other known value investing approach because of three virtues:
That's Benjamin Graham's own lesson from later in life - favoring a few techniques and simple principles over detailed analysis.
Let us now look at how did he went in applying these principles in stock markets and for investing...
Is there a way to figure out what the stock market is going to do over the next 12 months?
Can we figure this out and then decide whether to have maximum exposure to stocks or cash?
Here's what Benjamin Graham said about this in a famous speech back in 1963...
He advocates putting maximum money in stocks when the markets are cheap on a historical basis, and switch to bonds when the markets turn expensive.
Indeed, just before the Indian stock markets gained an impressive 81% in 2009 and 30% in 2014, they were visibly cheap and anyone heeding Graham's advice would have walked away with handsome profits.
What about the big losses in 2008 and 2011?
Well, yet again, the corrections were justified from a valuation perspective - at the start of these years, the Sensex was trading at expensive valuations.
Booking profits and getting into cash would have paid handsomely.
Of course, there is the odd year, like 2007, where the index will go up despite markets being expensive. Over the long-term, however, Benjamin Graham's philosophy pays well...
Take maximum exposure to stocks when markets are cheap, and book substantial profits when they become expensive.
Not only is this strategy profitable, it is also simple.
Once this is done, the next thing according to Graham was to pick cheap stocks and follow a portfolio approach.
On a stock specific basis, Benjamin Graham's approach to value investing was to look for companies that traded below their intrinsic value.
Based on a company's financial statements, use book value to market cap or price to earnings ratios in order to find value stocks. Specifically, look for companies trading at below their book values, or companies with small P/E ratios.
These are stocks available at attractive valuations.
One way to go about the concept of valuations is to use the 'discounted cash flow' (DCF) approach to value a stock.
DCF is a valuation technique, the purpose of which is to arrive at future cash flows that a company is expected to generate over its lifetime and adjust it for time value of money.
The resultant value is nothing but the company's 'intrinsic value'.
This value is compared to the prevailing stock price to judge the investment worthiness of the stock.
If the intrinsic value is higher than the stock price of the company, then the stock offers an investment opportunity.
The greater the discount to the intrinsic value, the more attractive the investment opportunity.
Conversely, if the intrinsic value is lower than the current market price, then the stock is 'over valued' and should be avoided.
Benjamin Graham also went a step ahead to this intrinsic value approach.
For a big, fat margin of safety, he suggested looking at stocks trading at a big discount to not just its book value but what he used to call 'net nets'.
These are stocks trading at a 20% discount to net current assets less all liabilities.
Next is to build a portfolio of these above companies (e.g. 25-30 companies) that meet the criteria of a value stock.
The importance of building a portfolio is to diversify against the risk of any individual stock losing a lot of money.
The last step, once we've built a portfolio, is to hold it for the long-term. The goal is to sell companies once they reach their intrinsic values.
Benjamin Graham also went ahead to give a twist to this approach of holding the portfolio for the long term.
BREAKING: Full Details of the #1 Investment of the Decade...
Buy and Hold occupies a permanent residence in most of value investor's thought process.
However, it took the towering intellect of none other Benjamin Graham to strike at the very foundation of this idea.
Benjamin Graham in an interview recommended a strategy that was polar opposite to Buy and Hold.
In other words, you should take maximum exposure to stocks when they are attractively valued and minimise your exposure when they turn expensive.
We decided to reconcile the above advice given by Benjamin Graham.
Have a look at the chart below.
You see, we have been told only half the story.
Sitting out of the market even for a small period of time is indeed a bad strategy.
But do you know what can make Buy and Hold look like a good strategy? It is avoiding the worst days.
As the chart highlights, if you had stayed out of the worst 25 days of the stock market over the last 30 years, you would have multiplied your money almost 300x.
Yes, that's correct. No extra zeroes.
If you could have made 7x more money by being Buy and Hold as opposed to missing the 25 best days, you could have made almost 8x more money than Buy and Hold by missing the 25 worst days.
It was Benjamin Graham that made me see the light here and then the chart above helped complete the circle.
As far as investing is concerned, Ben's strategy provides a more powerful booster shot to your long-term returns.
Now that you have read about Graham and how he went about picking stocks, here's the million-dollar question - Which Indian stocks match Benjamin Graham's stock picking criteria?
Indeed, this is a difficult question to answer...but we are here to help you get started!
Just use Equitymaster's Advanced Stock Screener and you could find your answer right away!
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