Great Investors: The Ben Graham Approach

An introduction to the Father of Value Investing.

When you start taking an interest in shares, you quickly realise there are many different approaches to investing. No one style is "the best". Rather, different approaches suit different people, and it can take some time to discover the style that most suits you.

This week, I'm going to introduce you to five investors, each of whom has been extremely successful with his particular way of going about making money from shares. We'll look at one of these master investors each day, examining his approach and running a "stock screen" to unearth examples of the type of company his approach produces.

First up is Benjamin Graham (1894-1976), often called the Father of Value Investing, whose ideas remain hugely influential today.

Reading value

Ben Graham pioneered the concept of investing in "undervalued" shares. His first book Security Analysis, written with David Dodd and published in 1934, is an epic tome, describing in detail how to analyse a company's financial statements -- "fundamental analysis".

Graham's second book, The Intelligent Investor, first published in 1949, is more accessible, and is said by many to be the best book about investing ever written.

In the final years of his life, Graham devoted himself to distilling 50 years of experience and research into a few easy-to-follow principles for selecting shares. He set these out in their most stripped-down form in an interview published in Medical Economics in 1976, titled "The Simplest Way to Select Bargain Stocks".

Buying and selling

Graham famously said: "In the short run, the market is a voting machine, but in the long run it is a weighing machine." The essence of his philosophy was to invest when the fickle and impatient "Mr Market" offered him financially sound companies at fundamental valuations that were "little short of silly", giving him a "margin of safety" on his investment.

In the interview with Medical Economics, Graham boiled share selection down to just one undervaluation measure and one measure of financial robustness.

Now, focusing only on this pair of measures skips over the full richness of Graham's investment oeuvre, but it does encapsulate where he was coming from with his approach for the lay investor.

Graham's measure of an undervalued company was one whose earnings-to-price ratio -- the inverse of the price-to-earnings (P/E) ratio – was at least twice the yield of top-quality (AAA) corporate bonds.

At the time he was talking, the bond yield was 7%. Thus, Graham required an earnings-to-price ratio of at least 14. In P/E terms, 14 goes into 100 roughly 7 times, so he wouldn't buy a share on a P/E of above 7.

Graham had a proviso: Never buy a share with a P/E of above 10 no matter how low bond yields get; conversely, a P/E of up to 7 is always acceptable no matter how high bond yields get.

Graham's measure of a company in a sound financial condition was one whose balance sheet showed stockholders' equity -- in the UK, shareholders' equity (also called shareholders' funds or shareholders' capital) -- to be at least 50% of total assets.

Graham said his research showed that a holding period for shares of two to three years worked out best. He recommended selling a share if it made a 50% profit, but: "If a stock hasn't met your objective by the end of the second calendar year from the time of purchase, sell it regardless of price."

A Graham screen

Before embarking on our Graham screen, here are three general warnings about stock screeners:

• There may be errors in the data, so always check numbers in the companies' financial reports.
• Screeners tend to take their data from companies' annual results, so there may be more up-to-date information in half- or quarter-year results.
• A screener is only a starting point for further investigation.

I screened for companies satisfying Graham's measures of undervaluation and financial health. Sterling AAA corporate bond yields are currently less than 5%. When yields are less than 5%, the acceptable P/E is always Graham's maximum of 10, so I set the filter accordingly.

For a manageable list of companies for this article (Graham recommended a portfolio of at least 30), I restricted the screen to FTSE 350 firms and added a third measure that Graham also rated highly: A dividend yield of at least two-thirds of the bond yield -- in our case, a dividend yield of 3% plus.

Despite being a limited list, you get a good idea of the sort of 'value' opportunities Graham's approach tosses up.

As the market frets about the state of the global economy, we find four miners in the table; plus Cape, a company that provides support services mainly to the energy and natural resources sectors.

UK retail is another out-of-favour sector, with the market worrying about consumer spending in the present austere times. There are three retailers on the list, one of which, Argos-owner Home Retail, has very recently slashed its divided. That's a handy reminder of the limitations of stock screeners -- as is the fact that Cable & Wireless has accepted a 38p per share takeover bid from phone giant Vodafone (LSE: VOD).

Finally, in addition to the companies in currently-unloved sectors, there are a couple of firms that Mr Market has spurned for company-specific reasons: Homeserve, a supplier of emergency plumbing and electricity services, has been in hot water over aggressive sales and marketing; while asset-manager Man's flagship fund hasn't been performing that well of late.

Foolish bottom line

I've only scratched the surface of Ben Graham's approach by focusing on his interview in Medical Economics. I'd recommend anyone, who hasn't already done so, to buy, beg, or borrow a copy of The Intelligent Investor.

Tomorrow, I'll be looking at one of Graham's contemporaries, who had a very different approach to investing.

Searching for dependable FTSE dividend shares? This free Motley Fool report -- "8 Shares Held By Britain's Super Investor" -- reveals the major companies favoured by high-yield legend Neil Woodford.

Further investment opportunities:

• Why I'm Backing Buffett And Beauty
• 5 Types Of Share That Can Beat The Market
• Should I Join Neil Woodford In A Blue-Sky Punt?

> G A Chester does not own shares in any of the companies mentioned in this article. The Motley Fool owns shares in Halfords.