Benjamin Graham is considered by many to be the father of financial analysis and value investing. He revolutionized investment philosophy by introducing the concept of security analysis, fundamental analysis and value-investing theories. More than 20 years after his death, he continues to have one of the largest and most loyal followings of any investment philosopher.
Graham put into practice a fundamental analytical process that has been adopted by a generation of stellar money managers. By using his methods, many of these managers have been able to consistently beat the market averages. Graham influenced investing superstars such as: Warren Buffett, Mario Gabelli, Michael Price, John Bogle and John Neff.
Simply put, Graham turned speculating into investing. By devising sound principles for analyzing a company's fundamentals and its future prospects, he enabled stock pickers to be analysts -- not gamblers. He espoused many of these value-oriented principles in two timeless investing books: 'Security Analysis' and 'The Intelligent Investor.' These best-selling books explain how investors can arrive at a stock or bond's true intrinsic value through extensive fundamental research and financial statement analysis.
Below is a brief overview of Benjamin Graham's investing philosophy…
Graham argued that even with the best research, investors will never know all there is to know about a company. They also can't predict the negative surprises that often send individual stocks sharply lower.
Look For A 'Margin of Safety'
One key concept taught by Graham and still referred to today by Warren Buffett, among others, is 'Margin of Safety.' The basic meaning of this term is that investors should only purchase a security when it is available at a discount to its underlying intrinsic value -- what the business would be worth if it were sold today. In order to do this, of course, the investor must be able to accurately estimate what the intrinsic value of any given company might be. Along those lines, Graham offered some guidelines as to how to calculate this intrinsic value.
The key point for investors to remember is that they should only invest in a company when its stock is trading below what the firm would sell for in the open market. Those investors who ignore valuation concerns and overpay for their investments are operating with zero margin of safety. Even if their underlying companies do well, these investors can still get burned.
Graham made his fortune by buying businesses that were so battered and neglected that they sold for less than the value of their working capital (calculated as current assets minus current liabilities). He developed a Net Current Asset Value (NCAV) model to determine if the company was worth its market price. The NCAV formula subtracts all liabilities, including short-term debt and preferred stock, from a company's current asset balance. Graham's contention was that by buying stocks that were trading below their NCAV, investors could manage to pay essentially nothing for a firm's fixed assets.
Opt For Big Companies With Strong Sales
According to Graham, larger firms pose much less risk. Graham's rationale was that small companies have far more trouble dealing with economic downturns, so it is best to invest in larger companies.
Graham was an active investor during the Great Depression, where he saw hundreds of once-thriving small firms go belly-up. Based on his observations, he concluded that companies with more diverse customer bases and greater revenues had a better chance of surviving any sort of economic downturn.
Choose Companies That Are Paying Dividends
Graham was adamant about investing in companies that pay dividends. He believed that conservative investors should only consider companies that have paid a dividend every year for at least the last 20 years. He argued that dividends are a sign that a company is profitable (dividends are paid from profits, after all) and that they also offer investors a return even if the company's stock does not perform well.
Seek Out Companies That Are In Strong Financial Shape
Always mindful of liquidity, Graham looked for companies whose current assets exceeded the sum of their current and long-term debt. Companies with ample access to cash (liquidity) are generally not as risky as those with low cash balances and heavy debt loads.
Seek Companies With Sustainable Earnings Growth
Graham looked for companies with steady, rising earnings trends. He believed that steadily improving earnings would lead to improved share price performance.
Keep An Eye On Price Multiples
Graham sought companies with price/earnings ratios that were below their historical average. He also took a careful look at price/book values. In fact, he wouldn't purchase a stock unless it was trading for less than 1.2 times its book value (total assets minus total liabilities) per share. Example: A company with $1 ebtllion in assets and $700 million in debt has a book value of $300 million. If the company has 10 million outstanding shares of stock, then its per-share book value is $30. Graham would not pay more than $36 per share (1.2 times the book value per share) for this particular stock.