Ask any professional investor about Benjamin Graham and they will tell you he deserves his place amongst the top 10 greatest investors of all time. Ask Warren Buffet and he’ll certainly place Ben Graham as number 1. Benjamin Graham is the father of value investing and wrote one of the book that shaped many an investors career; investors Security Analysis. The book which is seen as the bible of the value investing world is an essential read for anyone wishing to invest in individual stocks.
Benjamin Graham’s value investing strategy was focused on buying stocks with the same discipline as an insurance underwriter, carefully considering the risks, rejecting potential securities that had too much uncertainty, and insisting upon a margin of safety in the event his calculation of intrinsic value was too optimistic.
The greatest investing lesson Ben Graham has bestowed upon his followers is the margin of safety principal. In simple terms, the margin of safety is the difference between a company’s intrinsic value and its market price. Only invest in a stock when there is sufficient margin of safety.
Warren Buffett – Ben Graham’s most famous and most successful disciple – compares margin of safety to driving across a bridge:
You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.
I love this analogy, and Warren Buffett has used it multiple times:
If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety…
Here are a few strategies Benjamin Graham used during his investing career.
Arbitrage: There can be little doubt that arbitrage was the secret weapon with which both Benjamin Graham and Warren Buffett accelerated their returns. In fact, Graham was convinced that disciplined arbitrage could regularly generate 20% returns, improving the overall rate of return earned on a value investing strategy portfolio.
The goal of arbitrage is to profit from price discrepancies with little or no risk. Imagine Unilever wanted to acquire Reckitt Benckiser and made a tender offer at £10 a share with the deal closing in three months. The shares of Reckitt Benckiser aren’t immediately going to go to £10 per share; they may, instead, trade at £9.50. Depending upon A) the probability of the deal closing, B) the time remaining before the deal closes, and C) the spread between the ultimate price you will receive in the merger and the price at which you can acquire the stock, you may have an opportunity to enter into an arbitrage transaction. The 50p in profit per share you could earn may only represent 5%, but you are generating it in three months. On an annualised basis, that’s a nearly 20% return compounded and, if you believe the deal is certain to close, comes with little risk. With arbitrage, the value investor is focusing on profiting from the time value of money, which is being undervalued by other investors.
Net Working Capital Investments: For a long period of time, net working capital investments was the cornerstone of value investing. Due to improvements in market technology and transparency, this opportunity has mostly evaporated. Nevertheless, it was net working capital investments that helped secure Graham’s name in history and helped make value investing a respected discipline.
Put simply, a net working capital investment was one in which the shares of stock were trading at a 30% or greater discount to modified working capital (that is, the current assets that could be quickly converted to cash less current liabilities and cash needs). The value investor was purchasing, quite literally, Pound Sterling (£) bills for 30, 50, or 70 pennies. Although some of the companies would inevitably go bust, by working with the law of averages, Graham insisted on widespread diversification because these commitments would prove extremely favourable on an aggregate basis. Net working capital investments factored heavily into the first years of the Buffett Partnership, which eventually led to Berkshire Hathaway.
Diversification: Benjamin Graham was a big advocate of diversification and made the point that those who followed a value investing strategy structure their portfolio to take advantage of the benefits of diversification. This included diversification of asset class just as much as individual investments. Examining his January 31, 1948 letter to shareholders of the Graham-Newman Corporation, we see that Graham invested:
- 15.82% of the money in bonds, which were sub-divided into railroads, utilities, real estate, holding companies, and the United States Government
- 22.93% of assets into preferred stocks, which were sub-divided into industrials, investment companies, utilities, insurance companies, and holding companies
- 61.25% into common stocks, which were sub-divided into industrials, holding companies, investment companies, railroads, utilities, and insurance companies.
The 61.25% invested in common stocks were spread among 57 different companies, ranging from ship builders to sugar companies in Puerto Rico. This meant that each of Graham’s value investments had a margin of safety all their own, plus the protection of sitting in a larger, extremely diversified portfolio of bonds, preferred stocks, and common stocks. This was consistent with Graham’s belief that the primary goal of value investing was to avoid losing money first, and then to enjoy a satisfactory return on capital thereafter.