THE BENJAMIN GRAHAM METHOD OF VALUE INVESTING

Few individuals have had a greater influence on how we think about investing in the stock market than Benjamin Graham. His disciplined approach to “Value Investing” developed during the Great Depression is practiced today by investors and fund managers around the world. Graham’s approach consists mostly of patience, common sense and thorough analysis of published information. His most famous disciple is Warren Buffett, once Graham’s pupil at Columbia University and an employee with Graham’s investment firm the Graham-Newman Corporation.

GRAHAM’S DISCIPLES

Giving a talk at Columbia University in 1984 to commemorate the 50th anniversary of Graham and Dodd’s book “Security Analysis”, Buffett asked if value investing was out of date. He stated that “many of the professors … argue that the stock market is efficient, i.e. stock prices reflect everything known about a company’s prospects and the state of the economy. There are no undervalued stocks…. Investors who beat the market year after year are just lucky.”

Now 24 years since this analysis was delivered, confidence in the Efficient Market Hypothesis is much diminished, particularly after the crash of 1987, followed by the TMT Bubble and then the worst Bear Market since 1974. Advocates of modern financial theory had once dismissed Graham’s work, although followers of the Graham approach continued to believe that they could earn returns above those of the stock market indices through consistent application of Graham’s methodology.

The success of Warren Buffett’s firm Berkshire Hathaway is well documented. However, Buffett’s classmates and work colleagues also did well, although they invested in different stocks. In its 30 years of operation, the Graham-Newman Corporation (“GNC”), which was wound-up in 1956, achieved an annual return of 17.4% and generated an alpha of 7.7%, before including its investment in GEICO. The firm’s GEICO investment was bought at 21 cents in 1948 and was worth $61 by 1972 and was to become the cornerstone of Berkshire Hathaway’s success.

After 9 years Walter Schloss left GNC in 1955. His firm “Walther J. Schloss Associates” earned a compounded 21.6% per annum in the 33 years ended 1988, compared to 9.8% for the S&P500. Tom Knapp, who replaced Schloss at GNC, later became principal at Tweedy, Browne and Partners. Tweedy Browne is nowadays a well-known global value player, generating alpha returns of over 15%. Bill Ruane was in Graham’s class in 1951 and set up the famous Sequoia Fund in 1970. This fund generated excess returns of over 8% up until the mid-1980s. Buffett’s friend Charlie Munger, who later became Buffett’s partner at Berkshire Hathaway, generated an alpha of 15% on his own fund from 1962 to 1975. Munger’s own disciple Rick Guerin generated an astounding alpha of 31.6% on his Pacific Partners Fund between 1965 and 1983. Over the same period, arts major Stan Perlmeter, who was introduced to Graham’s methods by Buffett, outperformed the S&P 500 by 17% per annum.
What these investors had in common was the Graham methodology and it is to this that we now turn.

GRAHAM’S METHODOLOGY: THE DEFENSIVE INVESTOR

Benjamin Graham’s book “The Intelligent Investor” is regarded by many as the best book on investing ever written. The book first appeared in 1949. The 4th revised edition in 1973 was the last before Graham’s death in 1976.
The central concept Graham outlines in the book is that there is a half-price sale in the stock market every day. The trick for the investor is to know how to judge the difference between price and value. Graham outlines how to establish this value, but he is well aware that the value of the share in question may change, the estimate may be inaccurate, or that the market price movement may not be favorable. Therefore Graham creates a “margin of safety” approach. The greater the surplus of a stock’s “Intrinsic Value” over its price, the greater the margin of safety.
One of Graham’s objectives in his book was to give the investor an understanding of the risks involved in holding shares, which are inseparable from the opportunities for profit and must be carefully considered in the investor’s calculations. The investor must recognize the existence of a speculative factor affecting the value of his stocks. Graham says it is the task of the investor “to keep this component within minor limits and to be prepared financially and psychologically for adverse results that may be of short or long duration.” This in essence is the Defensive Investor strategy.

Graham defines the Defensive Investor as one interested in safety plus freedom from bother. Each Defensive Investor should divide his holdings between high grade bonds and common stocks. The proportion of each should never be less than 25% and never more than 75%. In setting the allocation of funds between equities and bonds, one of Graham’s concerns was inflation. Graham prophetically wrote in 1970 that that “the possibility of large scale inflation remains and that the investor must carry some insurance against it [and although] there is no certainty that a stock component will insure against inflation, it should carry more protection than the bond component”. The return of inflation makes this allocation all the more relevant today.

In selecting his Defensive Portfolio, Graham is categorically against Growth Stocks. He points out that their stock prices often grow at faster rates than profits and command high PE multiples based on inflated expectations, but that these stocks usually decline in the same way and are consequently too risky for the Defensive Investor. This PE contraction was experienced by many Growth Fund Managers during the 2000-2003 Bear Market, who were no match for their Value Driven peers.

TESTING THE DEFENSIVE INVESTOR STRATEGY

In 1981, Henry R. Oppenheimer tested Graham’s Defensive Investor methodology in his book “Common Stock Selection: An Analysis of Benjamin Graham’s Intelligent Investor Approach”. The results of his study suggest that above average results were available to the Defensive Investor, without following Graham’s advice on the equity v bond allocation.

In his various strategies, Graham tried to gain from what we now recognize as persistent anomalies in the Efficient Market Hypothesis, such as the Low PE effect, the small firm effect and the high Dividend Yield strategy. Oppenheimer says that “Graham viewed the PE as a ratio of price paid to value received and was an indicator of current market optimism about a security’s future earnings”. Graham believed in the market’s mispricing of individual securities.

The academic world had started to pay attention to the outperformance of low P/E stocks after Basu’s article in the Journal of Finance in 1977. It appears though that Graham had been well aware of this outperformance as far back as 1951, as one of his students H.G. Schneider had tested the returns of low PE stocks between 1917 and 1950 and found they beat the blue chip Dow Jones Industrial Average.
Graham counselled that growth rates cannot be accurately predicted by analysts – confirmed later by Malkiel and Cragg’s study in 1970. Accordingly, the prices of growth stocks will eventually be revised downward, while low PE stocks will be revised upward. In essence, Graham’s advice for the Defensive Investor is to judge each potential acquisition as a business entity and not to pay too high a price for value received. However, Graham realized that his PE criterion should change over time, particularly in relation to interest rates.

Oppenheimer followed the investment criteria published in each edition of “The Intelligent Investor” namely:

• Adequate diversification of between 10 and 30 shares
• Selected firms to be large, prominent and conservatively financed
a) Book value should be at least 50% of market capitalization (utilities 30%)
b) Assets/turnover should rank in the first quarter/third of its industry
• Dividends paid continuously over the previous 20 years
• Do not pay more than 25 times average earnings over the last seven years
• Do not pay more than 20 times average earnings over the last 12-month period

Furthermore, the portfolios selected under the above principles should be reviewed once every year.

Oppenheimer wrote that in imperfect markets, with heterogeneous expectations and limited short-selling, many over- and underpriced securities will exist. Graham requires the investor to be immune to the market’s sometimes irrational behavior, to search for sound businesses and purchase those that are reasonably priced.

Oppenheimer tested the Defensive Investor strategy and concluded that “during the 20-year period 1955-1975 [statistically] significant returns were available to an investor” – earning on average 3.25% per annum (before taxes) in excess of a market portfolio of comparable risk. He also tested the strategy in periods following publication dates and highlighted a statistically significant outperformance of 9.2% per annum during the 1973 to 1976 period. Oppenheimer summarizes his extensive testing by saying that the results to the Defensive Investor are “surprisingly good”, especially in view of the little time involved.

CONCLUSION

In this essay I have looked at Graham’s Defensive Investor approach, how it has been successfully tested and the success of Graham’s disciples. Graham used other techniques, for example: the Enterprising Investor; the Net Current Asset Approach; and the Central Value Formulae. Although not included in this article, they all have something in common, which is Graham’s philosophy of how to find value in markets. His techniques continue to be refined 32 years after his death, most notably by his chief disciple Warren Buffett, who was recently declared to be the richest man in the world. But Graham remains, as Buffett once wrote, one of those men who plant trees that other men will sit under.