Ben Graham 1894 -1976
The Shoulders of Giants
“If I have seen further, it is by standing on the shoulders of giants.” Sir Isaac Newton
The Intelligent Investor (1949).
If anybody talks to you about long-term fundamental investing in equities, that person has indirectly or directly, an intellectual lineage standing on the shoulders of a true giant, Benjamin Graham. Most of us have been influenced by people who have read Graham or we have learned directly from his books.
The story of his life is well known. He grew up in poverty in New York but his brilliant mind saw him get a place at Columbia University at the age of 16. He was a brilliant student and upon graduation was offered an academic post by three different departments: mathematics, English, and philosophy. However, he went to Wall Street as he had to support his widowed mother.
He suffered badly in the 1929 Wall Street Crash and in response to this experience, he went on to develop and perfect a very conservative investment philosophy. Graham was a dedicated and disciplined investor, a generous teacher and a truly original thinker.
Graham's investment performance was approximately a ~20% annualized return over 1936 to 1956. The overall market performance for the same time period was 12.2% annually on average.[
Graham wrote two books Security Analysis (1934) with David Dodd and “The Intelligent Investor”. He also taught investing for many years at Columbia Business School for many years in the evenings where many of his students were working in Wall Street. “Security Analysis” based on Graham’s lectures written down by David Dodd and edited by the two. Graham’s students included Warren Buffett, Bill Ruane (who later founded The Sequoia Fund), Irving Kahn, and Walter Schloss among many others. Graham was a major influence on other well-known investors including Mario Gabelli, Seth Klarman, Howard Marks John Neff and Sir John Templeton.
Ben Graham’s work was instrumental in creating the discipline of profession of Investment Analysis and he was driving force behind the creation of the Chartered Financial Analyst (CFA) programme and designation. If the 1934 book “Security Analysis” is a technical textbook, the 1949 book “The Intelligent Investor” was aimed at the general reader. A 19-year-old Warren Buffett discovered the book in the Omaha Public Library and his whole world view of investing was changed. Buffett calls it "the best book about investing ever written." Buffet read it and “Security Analysis” several times in 1949. Thanks to the Omaha Public Library, Buffet also discovered that Graham and Dodd were not long-dead academics but very much alive and teaching an evening class at Columbia. In 1950, Buffett moved to New York to study with Graham and Dodd.
In an interview he said he knew what Graham was going to lecture and teach but the course allowed him to have a dialogue with Graham and Dodd.
“I had these two marvelous professors here at Columbia that just being around -- I had read all the stuff they had written. So it wasn’t I was acquiring lots of incremental knowledge but I was getting inspired. They were terrific for me. They treated me like a son. They would take me out to dinner. Ben Graham did the same thing for me. So it gave me confidence in myself. It just propelled me into a field I already love with a terrific tailwind from these professors that believed in me.”
Buffett was 20 and looked younger. Many of his fellow students had served in World War Two and were working in Wall Street. Bill Ruane later recalled that the class often became a dialogue between Graham and Buffett with rest of the class mere spectators. Graham gave Buffett an A+, the only such grade he ever awarded.
Aspiring investors are told to read “The Intelligent Investor.” Many copies are bought but probably only a fraction are read. The fact that Buffett read it in 1949 gives an indication why many copies gather dust- the book is dated, and it is difficult for modern readers to relate to much of the text.
Fortunately, the third edition of the book has extensive commentary by Jason Zweig of the Wall Street Journal. whose weekly newspaper column is called The Intelligent Investor. Zweig has a useful introduction to the book and summarises the essence of each chapter using contemporary examples.
What are the key ideas in the book?
Buffett has said everybody should read Chapter 8 and Chapter 20 as these deal with the most important issues.
Chapter 8 is called “The Investor and Market Fluctuations”.
This outlines how investors should view, and mentally deal with, market fluctuations. At the end of the chapter, Graham introduces us to a character called Mr. Market in a parable. Mr. Market is a hyper-active, relentless, manic fellow. We will not reveal too much so as not to spoil it for those who have not yet read the book. Graham argues that true long-term fundamental investors must form their own view of the value of companies. In other words, they must derive their own independent valuation of a security. They should not rely on the unstable Mr. Market’s prices for guidance. Most of the time, Mr. Market should be ignored (he never gets upset if nobody pays him the slightest bit of attention) but investors should take advantage of him, if he does something foolish in (mis) pricing a security.
Chapter 20 is called “Margin of Safety”
"The three most important words in investing are Margin of Safety." Warren Buffett.
If an engineer wants to design a bridge that can safely carry a 10,000 pound truck, she should design one which can handle 13,000 pounds not 10,200 pounds and thus build in a Margin of Safety (MoS).
In investing terms, MoS means that, if your independently appraised conservative valuation of a company is $100 per share, do not buy until Mr. Market offers you at $70 per share, a large enough discount to its intrinsic value, that is constitutes a sufficient margin of safety. Price is what you pay but value is what you get. Investors have to make sure the latter is higher than the former and the difference represents a sufficient margin of safety.
“Price refers to what you pay for an asset, while value reflects the intrinsic worth of the asset.” - Warren Buffett.
Some other key ideas in “The Intelligent Investor”
In the introduction, Graham writes about what has become known as behavioural investing.
“We shall say quite a bit about the psychology of investors. For Indeed, the investor's chief problem, and even his worst enemy, is likely to be himself”
In both books, Graham spends a lot of effort making a distinction between investment and speculation.
Investment is defined as “an investment operation as one that, upon thorough analysis, promises safety of principal and an adequate return. Any operation not meeting these criteria is speculative.”
The choice of words is very important.
1. The analysis must be truly thorough. This clearly refers to the process for the determination of security valuation noted above.
2. The operation must promise safety of principal, the probability of a permanent loss of capital must be reduced as much as practicably possible. This is a reference to the concept of Margin of Safety noted above.
Everything else that does not meet these very criteria is speculation. There is clear and important implication here. A lot of people, perhaps most, who think of themselves as investors are just fooling themselves, for they are in fact, speculators.
Of course, even the most intelligent investor cannot avoid some element of speculation.
“In most periods, the investor must recognise the existence of a speculative factor in his common- stock holdings. It is his task to keep this component within minor limits, and he must be prepared financially and psychologically for adverse results that may be of short or long duration.”
There has to be some speculation in markets and people willing to bear speculative risks.
There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are:
1. Speculating when you think you are investing
2. Speculating seriously instead of a pastime, when you lack proper knowledge and skill for it; and
3. Risking more money in speculation than you can afford to lose.
Graham also notes there are two types of intelligent investors. There is the defensive or conservative intelligent investor and the enterprising or aggressive intelligent investors.
The defensive investor is defined as “one who is chiefly interested in safety and plus freedom form bother.”
The Defensive Investor
For such an investor, there should be two investments and common stocks. The percentage allocated to stocks should be between a minimum of 25% and 75%. When the stock markets have risen a lot, the allocation to stocks should be reduced. It should be increased and after stocks have fallen significantly. More simply, the allocation could be just left at 50% and 50%, with occasional rebalancing to bring it back in line.
As the defensive investors wants freedom from “bother”, he does not pick stocks but just invests in good quality mutual funds. These days, low-cost, broad-based Index ETFs would be ideal. As a further risk-reducing element, Graham suggested the defensive investor could invest by dollar cost averaging.
In the simple version of this process, the investor does not have do too much work. He does not need to make any decisions. As the process is automated, the investor is protected from himself and prevented from making stupid or risky decisions. He also can’t be talked into making a mistake by a persuasive salesman or tip giver.
Graham argues that the defensive investors who follows this process will get a very creditable return.
The Enterprising Investor
This investor is prepared to do more work and take more risk than the defensive investor. In Graham’s view , even this investor should have some allocation to high quality bonds.
“The aggressive investor should start from the same base as the defensive investor, namely, a division between high-grade bonds and high-grade common stocks bought at reasonable prices. He will be prepared to branch out into other kinds of investments, but in each case will want a well-reasoned justification for the departure.”
Unlike the strategy for the defensive investor, the one for the enterprising investor cannot be a one size fits all but a multi-faceted one depending on a variety of factors.
“There is a difficulty in discussing this topic in orderly fashion because there is no single or ideal pattern for aggressive operations. The field of choice is wide; the selection should depend not only on the individual’s competence and equipment but perhaps equally well upon his interests and preferences.”
Graham discusses stock selection strategies for both types of investors. He also considers some case studies which are now perhaps too dated.
The enterprising investor must earn a higher return than the defensive investor. Otherwise, why bother and do the extra work. However, that is not and cannot be guaranteed. After a long period of diligent effort, the aggressive investor might underperform the defensive investor.
“Our enterprising security buyer, of course, will desire and expect to attain better overall results than his defensive or passive companion. But first he must make sure that his results will not be worse. It is no difficult trick to bring a great dela of energy, study and native ability into Wall Street and to end up with losses instead of profits.”
Graham then goes through a list of mistakes that enterprising investors might make which would lead them to underperform.
Conclusions
Graham’s “The Intelligent Investor” is a classic and should be read by all serious long term investors. It is hard to read it all the way through as some of the details are now dated but the principles are timeless.
Readers of the third edition will have the pleasure of reading Jason Zweig illuminating commentaries, Warren Buffet’s preface as well as his classic essay “The Superinvestors of Graham-and-Doddsville. We will discuss the latter on another occasion.
If long-term fundamental investors have any success, they do so, in large part, because they are sitting on the shoulders of Benjamin Graham.