Benjamin Graham the Father of Value Investing.docx
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BenjaminGrahamtheFatherofValueInvesting
HonoringBenjaminGraham:
TheFatherofValueInvesting
AslightlyeditedversionofthisworkwaspublishedintheMay9,1994issueofBarron’sunderthetitle,“HappyBirthday,BenjaminGraham:
ACenturyafterHisBirth,HisLegacylivesOn”
byAlbertL.Auxier,Ph.D.
AssociateProfessorofFinanceUniversityofTennessee,Knoxville
FewWallStreetershavebeenmoreobservantnormoreinfluentialthanBenjaminGraham.PerhapsthegreatesttributetoBenGrahamcomesfromlegendaryOmahainvestorandbusinessman,WarrenE.Buffett.AccordingtoForbesmagazine'slatesttally,Buffett,ourrichestAmericanandarguablytheworld'sgreatestinvestor,isworth$8.3billion.Buffett,saysForbes,creditshisfather,astockbrokerandformercongressman,withinfluencinghimmost,andnexthecreditsBenjaminGraham.Asayoungman,BuffettwasBenGraham'sstudentatColumbiaUniversity,andhewassoimpressedbyGrahamthatheofferedtoworkforhimfornothing.Butthegreatmanturnedhimdown!
Whichsuggeststhatinvestmentgeniusisn'talwaysapparentatanearlyage.BuffettlaterdidworkforGraham,andhedevelopedatremendousrespectforhim.
BenjaminGrahamwasborninLondonin1894ofjewishparents,andhisfamilyemigratedtoAmericawhenhewasayearold.Whenhewasnineyearsold,hisfatherdied.Thefather'sdeathwasapparentlynotonlyanemotionallossforthefamilybutcausedfinancialhardshipaswell,andthisscarringexperienceatayoung,impressionableagesurelyleftalastingimprintonhim.Grahamwasattractedtobeautifulwomen,andtheytohim.Onecanonlysurmisewhetherthismutualattractionwasthesourceofmuchpainandsorrowormuchhappiness.Grahamdiedin1976,buthadhelivedhewouldhavebeen100yearsoldonMay9th.Moreover,1994yearisthe60thanniversaryofthepublicationofhisgreatwork,SecurityAnalysis:
PrinciplesandTechnique,ofwhichhewastheleadauthorandwhichwascoauthoredbyDavidL.Dodd.(McGraw-Hillpublishedthe5thandlatesteditionofthisworkin1988withnewauthorsSidneyCottle,RogerF.Murray,andFrankE.Block,andwiththecollaborationofMartinL.Leibowitz.)GrahamandDoddwasthe"bible"forseriousstudentsofinvestmentsfordecades--andformanyitstillis.
BenbeganhiscareeronWallStreetinJune,1914,andneartheendofhislife,whenhepublishedthefourthrevisionofhisinvestmentphilosophyinTheIntelligentInvestor:
ABookofPracticalCounsel,hehadcompleted57years'experienceonWallStreet.(Harper&Row,thepublisherofTheIntelligentInvestor,hasreissuedthisworkwithanewPrefaceandAppendixbyWarrenBuffett.)BenGrahamtaughtinvestmentsfor28yearsatColumbiaUniversity,andperhapshissuccessasaprofessionalinvestorismatchedbyhissuccessasanacademic,whichismostunusual--mostfinanceacademiciansarenotnotedinvestors.Hispublishedworkshaveinstructedmanythousandsofstudentsand,indeed,hisstrengthasanacademicisderivedfromhismanyyearsexperienceonWallStreet.
WecelebrateBenjaminGraham's100thbirthday--andthe60thanniversaryofthepublicationofSecurityAnalysis--byexamininghisinvestmentphilosophy.Forthispurpose,werelyheavilyonTheIntelligentInvestor,whichheconsideredmoreusefulthanSecurityAnalysistoayoungsecurityanalyst.
BenGrahamistheFatherofValueInvesting.Theessenceofvalueinvestingisthatanyinvestmentshouldbeworthsubstantiallymorethananinvestorhastopayforit.Thisinvestmentphilosophymayseemlikecommonsense,butstrangelyenough--asBenmighthaveputit--manyinvestorsarenotcarefultoseethattheyreceivegoodvaluefortheirmoney.Benwasn'tthefirstvalueinvestor.BernardBaruchandothervalueinvestorspredatehim.Infact,thefirstvalueinvestorprobablywasacaveperson.ButGraham,amongearlyWallStreeters,didthemosttoinventasystemizedbodyofinvestmentknowledge.Hebuiltthisbodyofknowledgethroughresearchandpractice,andhedisseminateditthroughhisteachingandwritings.Whereas,BenGrahamisconsideredtheFatherofValueInvesting,heactuallyfatheredthemodernstudyofinvestments.
MarginofSafetyConcept
Grahamwasmostinsistentthatanysecuritypurchasedshouldrepresentgoodvalue.Hefeltstocksshouldbeboughtlikegroceries,notlikeperfume,andhedistilledhisinvestmentphilosophydowntojustthreewords,"MARGINOFSAFETY".Bymarginofsafety,hemeantthatanystockboughtshouldbeworthconsiderablymorethanitcosts.Hesometimessuggestedatleast50percentmore.Stocksboughtwithamarginofsafetygivesomeassurancethatonehasinvestedwisely.Andstocksboughtwithamarginofsafetyshouldbelowrisk,highreturninvestments--thekindweallwant.
Howdoyoufindstockswithamarginofsafety?
Inpart,theyarefoundbyavoidingstockswhichareunlikelytopossessthismargin.Popularstocksareavoidedsincetheyarelikelytobefullypriced,andgrowthstocksareavoidedsincetheytendtobepopularandsincetheytendtoperformpoorlyinbadmarkets.Andyoufollowrulespertainingtolowprice/earningsratios,lowprice/bookvalueratios,etc.,whicharedesignedtoexcludestockswithoutamarginofsafety.
Graham'sadvicetoavoidgrowthstocksmaybesurprising.Thereasonisthatgreatwealthisseldomachievedwithoutgrowthstockinvestment,andBenjaminGrahamhimselfapparentlyamassedmuchofhisfortune,whileconsiderablyenhancinghisreputation,fromasinglegrowthstock.However,whenGrahamandhisinvestmentpartnersviolatedthisprinciple,theycontrolledthefirmandthuspossessedinsideknowledgeofitsaffairs.Grahamandpartnersheldontothisstocks,too,becauseithadbecome"familybusiness."Inthiscase,theyalsoviolatedGraham'soften-statedadmonitiontobewelldiversified;20percentoftheirfundsinitiallywentintothisonestock.Still,Graham'sdisdainforgrowthstocks--becausetheyareoftenpopular,tendtobecomeoverpricedingoodmarkets,andtendtoperformpoorlyinbadmarkets--iswellfounded.
InvestmentPerformanceDependsonIntelligentEffort
Grahamdisagreedwiththeusualpostulatedrisk-returnrelationship,thatis,toearnahigherreturnaninvestormustaccepthigherrisk.Tothecontrary,hefeltthatthemoreintelligenteffortoneputintoinvesting,thebetterthebargainsbought.Andthebetterthebargains,thelowertherisk.Thusintelligentinvestingprovideshighyieldsandlowrisk.Financeacademiciansoftenfailtoappreciatethispoint.
InvestmentVersusSpeculation
ThedistinctionbetweeninvestmentandspeculationiscentraltoGraham'sinvestmentphilosophy.Hedefinedthesetermsthusly:
"Aninvestmentoperationisonewhich,uponthoroughanalysispromisessafetyofprincipalandadequatereturn.Operationsnotmeetingtheserequirementsarespeculative."Basedonthisdistinction,aspeculatoriseithertakingsubstantialriskorisnotknowledgeable.While"speculationisalwaysfascinating,"Grahambelievedthatformostspeculatorsitisnot"fatteningtothepocketbook."Speculationisakintogambling,andGrahamwarnedthatonemustbevigilantsoasnottounconsciouslyslipintothismode.
DefensiveVersusEnterprisingInvestors
AnotherdistinctionGrahammakesisthedifferencebetweenadefensiveandanenterprising(aggressive)investor.Adefensiveinvestorisonewhohasn'tthetime,knowledgeortemperamenttorealisticallyseeksuperiorinvestmentreturns.Sincemostinvestorsdonotpossesstheserequirements,itislogicalthatmostinvestorsshouldbedefensiveinvestors.Thedefensiveinvestorshouldfollowsimple,mechanisticrules,suchasselectingadiversifiedportfoliooflowprice/earningsratiostockswhicharedesignedtoproduceaconservativeportfoliowithaverageoralittlebetterperformance.
Conversely,theenterprisinginvestorhasagreatdealoftimeandknowledgetodevotetoinvesting,andheorshepossessestherequisitetemperament.Theenterprisinginvestorisseekingsuperiorperformance,althoughGrahamemphasizedthatitisdifficultforevenprofessionalstoachievesuperiorresults.Theenterprisinginvestorseekssuperiorperformancethroughtheapplicationofrulessimilartothoseappliedbythedefensiveinvestor,butwithgreaterflexibilityintheirapplication,throughapplyinggreatereffortandknowledge,andperhapsthroughbeingmoreventuresome.
BondVersusStockInvestment
Grahambelievedthatthedivisionofone'sportfoliobetweenstockandbondsisabasicpolicydecision.Headvisedthedefensiveinvestoralwaystohaveatleast25percentofhisorherassetsinbondsandatleast25percentinstock.Butheobviouslyfeltitpreferablefordefensiveinvestorstoshootforafifty-fiftysplitoftheirassetsbetweenhighgradestockandhighgradebonds.
Whyalwayssomestockandsomebonds?
Grahambelievedthatstockcannotalwaysofferbettervaluethanbonds.Especiallywhenthestockmarketisdangerouslyhigh,bondswillofferbettervaluethanstock.Conversely,bondscannotalwaysofferbettervaluethanstock.Inparticular,Grahambelievedthatstockoffersbetterinflationprotectionthanbonds.ImplicitintheserecommendationsisGraham'sbeliefthatinvestorsreallydon'thavegoodabilityatanygiventimetotellwhetherstocksorbondsarethebetterinvestment.Sotheintelligentthingtodoistobewellrepresentedinbothtypesofinvestments.
Supposethataninvestorwishestoaddtobondsandreducestocksasthestockmarketbecomesoverpriced,andtoreversetheseoperationsasthemarketbecomesunderpriced.Asoneconsiderationinmakingthesedecisions,Grahamcautiouslysuggestedcomparingtheearnings/priceratiofor