HOT TOPICS LIST
LIST OF TOPICS
Those of you who have read Security Analysis and The Intelligent Investor, those two classics of financial writing, know why Benjamin Graham is often called the "father of security analysis." Graham was a strong believer in investing for the long term, and felt that daily price and volume fluctuations were irrelevant to stock market investment. Graham asserted that price fluctuations have only one significant meaning for the investor — they provide him or her with an opportunity to buy wisely when prices plummet and to sell wisely when they skyrocket. Graham's approach focused on the fundamental value of a business — that is, the company's earnings and its prospects for the future.
GROWING UP GRAHAM
Graham put his ideas into practice as the president of the Graham-Newman Corp., a money management firm. Warren Buffett was an employee of Graham-Newman early in his career, and would later use the investment skills that he learned from Graham to become one of the richest men in the world. As he proclaimed later on, "I'm 85% Graham."
Graham is most noted among investment professionals for expressing the idea that every stock has an "intrinsic value" that is based on the issuer's ability to generate earnings, and that a stock should only be purchased when the price is below that value. In such cases, investors are provided with a "margin of safety" (the greater the discount, the greater the margin of safety), and eventually the market will recognize the stock's intrinsic value and bid it up to its proper price.
Graham believed that in the long run, securities would sell close to a price level not significantly different from their value. This observation is not based in time; in some cases, it could take several years for this to happen.
VALUE AND INTRINSIC VALUE
Graham determined that a stock's intrinsic value is based on its earning power value, which he calculated by estimating its earning power and applying a suitable multiplier. Earning power is usually the company's estimated average annual earnings per share for the next five years, which is based on the company's revenues and profit margins. Graham believed that a multiplier of 12 is suitable for stocks with "neutral" prospects. He would increase the multiplier for growth companies up to a maximum of 20, and decrease it for companies that could have a future decrease in earnings. Today, many followers of Graham believe that the multiplier should be the earnings growth rate; for example, if a company's earnings were growing at a rate of 25% per year, they would apply a multiplier of 25.
Further, Graham stated that if the value of the company's assets is less than half of the company's value based on earnings, a deduction should be made of 25% of the amount by which the earning power value exceeds twice the asset value. He added that the accuracy of earning power value is inversely related to the volatility of earnings.
Graham concluded that if intrinsic value is more than a third greater than the market value, the security is likely to be undervalued and should be purchased. If earning power value is more than a third less than the market value, the stock is likely to be overvalued and should be sold.
For example, if a company is likely to earn on average about $5 per share each year over the next five years and has annual earnings growth of about 15% to 20%, applying a multiplier of 15 (and assuming that the company is backed with sufficient assets and its earnings are not highly volatile) would result in an intrinsic value of $75 per share. If this stock were selling for $50 per share or less, Graham would be a buyer, and he would sell when the stock price reached about $100.
At the heart of intrinsic value is an attempt to provide a reasonable estimate of the likely earnings of a company into the near future. And according to Graham, it is that value that is determined by the facts, as opposed to unfounded optimism or wishful thinking.
He summarized his approach by asserting that a successful listed company is one that has sufficient earnings to justify an average valuation of its shares in excess of the capital invested in them. This is a fancy way of saying that Graham was only interested in companies that demonstrated that they were likely to produce a reasonable profit for shareholders.
GRAHAM GUIDELINESDiversify — Graham believed that a portfolio should have between 10 and 30 stocks to protect against becoming too reliant on the performance of one or two firms. He recognized that even the best-run companies could have setbacks and that not all investments end on a positive note.
Focus on solid stocks— Graham only invested in large, prominent, and conservatively financed companies. It is clear that Graham believed that an investor wins by not losing; he wanted to minimize the risk of putting money into a company that would eventually fail. This was particularly important to Graham because he had huge losses during the stock market correction of 1929.
Pay attention to history— Graham would only invest in companies with a long and continuous record of dividend payments. Today, this probably does not make sense because the market is generally more interested in a company's ability to generate capital gains, rather than dividends. Many solid companies do not pay dividends, while most others pay only a token amount. However, the underlying principle still makes sense: Graham was only interested in companies with a proven ability to generate positive results. Today, that generally translates as companies with a record of growing earnings.
Do not overpay—Graham believed that the price to earnings ratio (P/E) should not exceed 20. P/E is the ratio of a stock's price to its earnings per share. In the present market, a P/E limit of 20 might be too conservative because the average P/E is much greater than in Graham's day. But the principle is still valid. A stock that has an exceptionally high P/E is risky even if the company is in great condition, because the risk exists that the stock has become overpriced.
Graham's investment approach has also been referred to as the cornerstone of value investing. Value investing involves searching for out-of-favor companies that are fundamentally sound, and holding them until the market discovers their worth and the price of the stocks moves up. Value investors like Graham often buy stocks when most investors are selling and sell when most are buying — the essence of contrarian investing.
James Maccaro is an attorney and freelance writer. He has written articles for Newsday, Ideas on Liberty, The Massachusetts Law Review, and other magazines. He can be reached at email@example.com.
SUGGESTED READINGGraham, Benjamin, and Warren E. Buffett . The Intelligent Investor, 4th rev. ed., HarperCollins.
Graham, Benjamin, and David Dodd (originally); Sidney Cottle et al. . Graham & Dodd's Security Analysis, 5th ed., McGraw-Hill.
Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.
|Address:||154-61 22nd AVE|
|Whitestone, NY 11357|