Broadly, investment strategies fall into one – or a mixture of – the following categories: growth, income, and value. Income investment is, for the purposes of this discussion, irrelevant because a successful growth or value investor will, as a by-product of his or her success, enjoy healthy income returns from dividends and fixed income instruments.
Many have argued that in reality value and growth investing are two halves of the same coin; one purchases an undervalued stock expecting it to rise in value as its operations expand and grow. However, this particular form of growth investing is distinct from, for instance, Snap’s recent IPO, which involved Millennials, in particular, investing in a stock that is yet to turn a profit.
Taking a step back, it is clear that much-maligned “animal spirits” – the innate human reaction to do something – are driving global equity markets. Surely, therefore, it is especially apposite in today’s climate to pay special attention to company fundamentals, and do their best to ignore market hysteria?
This was the essential message in Benjamin Graham’s 1947 investment classic, The Intelligent Investor, which, to this day, Warren Buffet insists is the “best book about investing ever written”.
The Intelligent Investor
Graham insisted that an investor’s portfolio policy should not be determined by temperament or risk profile, but the amount of intelligent effort that they could afford to apply towards researching their investment decisions. A ‘defensive’ investor was one who could not spend significant time researching stocks, whereas someone who could was, in his words, an ‘enterprising investor’. Graham was very clear about this: there was no middle ground, and the individual must be certain as to which category they fall under.
In actuality, however, Graham largely imparted the same advice to both types of investors but altered the criteria for particular metrics for enterprising investors. He suggested that the defensive investor buys into large companies with strong historic earnings and dividend growth, whereas an enterprising investor could pick from a broader field that included what Graham termed ‘secondary’ issues, which would equate to mid and small-cap companies in today’s jargon. Similarly, a defensive investor should pay no more than 1.5 times book value (net tangible assets), whereas an enterprising should – in order to reflect his higher risk profile – pay less than 1.2 times.
The Ideal P/E Ratio
Graham’s ideal value stock would trade at a price-to-earnings (P/E) ratio below 15 and, even better, would trade at a discount to its book value, which would mean the market had not priced in the value of the business’s actual operations. This may not be so viable a strategy in today’s climate for two reasons: first, tech companies’ high intangible assets (such as patents and software) that are not accounted for in book value; and second, markets are high, and there is a global dearth of such stocks.
Nonetheless, the concept of seeking value, rather than future growth remains theoretically sound. Foremost, Graham believed in taking a long investment horizon, the corollary of which is waiting for appropriate entry points. Buying at a time when markets are not high – as they are today – but when they are depressed would, in Graham’s view, make for a less risky portfolio.
A Word of Caution
On the other hand, Graham was wary of ‘growth’ stocks, which typically trade at high P/E ratios – or without a P/E ratio, as Snap currently is – because, as a proponent of Efficient Market theory, he believed their future growth prospects were already priced into their valuation.
A reductionist may equate Graham’s message to the simple adage of ‘buy low and sell high’. However, Graham was quick to articulate the dangers of falling into so-called value traps – stocks with high dividend yields and low P/E ratios caused by a sharp drop in share price, which are ultimately meretricious companies that may well be teetering on the verge of bankruptcy. Above all, Graham, much like his protégé, Buffet, staunchly advocated that individuals base investment decisions on quantitative research. Indeed, he devoted several chapters in his book to spotting accounting sleight of hand.
Similarly, Graham – again, like Buffet – espoused the notion of ‘buy and hold’, rather than simply selling ‘high’. Holding for the long-term avoids entering a new position in a bull market, and forgoing further gains and dividend payments. Graham fundamentally believed that investors were not buying into a stock, so much as they were buying into an actual, functioning business. Therefore, investors should invest with the aim of guaranteeing themselves a slice of a business’s future profits, while ignoring temporary fluctuations in the market.
This is merely a brief disquisition on the teachings of Benjamin Graham, but the aforementioned principles are indeed as relevant today as they were in Graham’s day. This is vindicated by those who bought an array of blue-chip FTSE stocks trading at attractive P/E ratios following the June 23rd Brexit vote today enjoying healthy returns on their prudent investments. Conversely, those who piled into Snap’s IPO may well be punished for their overzealousness and impulse.