Ben Graham

It’s with good reason that Benjamin Graham is known as ‘the Father of Value Investing’. The principles he pioneered have inspired investors for more than seventy years, and even the great Warren Buffett can be counted among his followers.

Background

Born Benjamin Grossbaum, in London in 1894, Graham’s family moved to New York when he was still a baby. His father died when Ben was just nine years old, and he grew up in poverty. But having graduated from Columbia University, he went to work on Wall Street where he built a successful career.

According to some sources he lost heavily when the markets crashed in 1929, and this led him to distill the lessons of that experience into his first book, Security Analysis, written with David Dodds and published in 1934. This was followed fifteen years later by The Intelligent Investor, which Warren Buffett described as “the best book about investing ever written”.

Philosophy

Graham’s approach is based on the principle that, while markets are not good at pricing investments, over the long term the true value of businesses will be revealed. “In the short run, the market is a voting machine but in the long run, it is a weighing machine”.

‘Mr Market’, as he described the emotional and irrational marketplace, sets share prices that you may not agree with, based on your fundamental analysis of a share’s value. When Mr Market’s price is sufficiently below your assessment of the share’s value, you have the opportunity to buy with what he referred to as a ‘margin of safety’.

Allowing yourself this margin of safety is in stark contrast to the ‘greater fool theory’ (note the lowercase ‘f’), whereby people buy shares regardless of valuation in the hope of finding someone to buy them later at an even higher price. It’s all about risk and reward.

Risk can also be mitigated to an extent by buying a portfolio of shares, so that even if some companies go bust, the overall return may still beat the market.

Selection criteria

In the mid 1970s, Graham and his colleague, James B. Rea, refined his ideas into ten criteria for selecting a portfolio:

1) earnings yield at least twice the AAA bond yield;

2) price/earnings ratio below 40% of the highest P/E ratio the stock had over the previous five years;

3) dividend yield of at least two-thirds the AAA bond yield;

4) share price below two-thirds of tangible book value per share;

5) share price below two-thirds of net current asset value per share;

6) total debt less than tangible book value;

7) current ratio greater than two;

8) total debt less than twice net current asset value;

9) earnings growth over the previous ten years of at least 7% per annum; and

10) a maximum of two annual earnings falls of 5% or more over the previous ten years.

Finding shares that tick all these boxes is quite difficult, but tests 1), 3), 5), and 6) were deemed to be the most important.

The following were considered sell signals:

1) share price up more than 50% since buying;

2) share held for more than two years;

3) company stopped paying dividends; or

4) profits fell enough to make it overpriced by 50% or more on the earnings yield criterion.

Criticism

Over the long term, value shares selected according to Graham’s thinking have out-performed the market, but according to some this is not due to the mis-pricing of value shares, but rather a normal reward for buying more risky investments. Proponents of Graham’s philosophy would counter that the risk is already more than factored into the buying price, and that the return is a reward for rejecting the irrational fears of Mr Market.

The buying criteria are also very sensitive to errors in the asset valuations that are used. As anyone investing in property-related shares will be aware, even tangible asset values are very subjective and prone to revision. Taking published figures at face value can be very risky.

Many would also argue the first two selling criteria are a bit arbitrary, and could lead to unnecessary trading. Suggesting that you should sell after two years could be seen as ignoring Graham’s voting machine and weighing machine analogy.

While one can pick holes in some of these ideas, Ben Graham is probably the most influential investor that the world has ever seen.


 

Free investing reports

The Motley Fool can help you invest better. We have several investing reports which are free to access and packed full of useful information on investing strategies and share ideas.

Click to find out more