Are you an Investor or a Speculator? Benjamin Graham proposed a clear definition of an investment in his first book Security Analysis, published in 1934.
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
An investor will regard the ownership of equity stocks as part ownership of a business. With that perspective in mind, thorough analysis of the fundamental business and its operating environment, an investor should not be too concerned with the erratic fluctuations in the stock prices.
“You do not have to trade with him [Mr. Market] just because he constantly begs you to”
In Graham’s classic book – The Intelligent Investor, he argues that the typical investor has a tendency to ‘follow the market’ in an attempt to beat Mr. Market. Instead, Graham presents us with an alternative investment strategy based on fundamental valuation.
“A great company is not a great investment if you pay too much for the stock”
Who is Mr. Market?
Graham describes Mr. Market as an emotional man. The market price is ultimately determined by fear and greed. His enthusiasm and despair can affect the price he is willing to buy and sell shares on any given day. Sometimes he is enthusiastic, setting the price above the fundamental value of the business. Some days he is pessimistic and fearful, setting the price below the fundamental value of the business. At emotional extremes, the difference between price and value can vary. The ‘intelligent investor’ will not follow Mr. Market’s emotions, they will simply take advantage of its emotional journey, buying when the price is low and selling when the price is high.
The Father of Value Investing
Graham is the Father of Value Investing. He has taught and mentored numerous value investors who have become extremely wealthy individuals, with the likes of Warren Buffett, Phillip Fisher and Charlie Munger. Graham produced a unique multiplier to aid his ability in finding a ‘bargain’ stock. In addition, he states 5 fundamental principles for the enterprising investor. Firstly, the Graham Multiplier consists of the P/E ratio and the P/B ratio. Graham preferred investors to look for companies that have a P/E ratio of less than 15 and a P/B ratio of less than 1.5. Thus, resulting with the ‘Graham Multiplier’ of 22.5. In addition to his multiplier, he encouraged the enterprising investor to look for 5 key fundamental principles in a company.
- Strong financial condition:
- Current assets at least 1.5 times current liabilities
- Total debt to net current assets ratio less than 1.1
- Earnings stability
- Positive earnings for at least 5 years
- Currently pays a dividend
- Current earnings greater than years ago
- Stock price less than 120% of net tangible assets
Margin of Safety
The margin of safety principle is one of the most important teachings of Graham. When the market price is significantly below your estimation of the intrinsic value, the difference is your margin of safety, thus allowing an investment to be made with minimal downside risk. For example: If you feel a stock is worth £100, buying it at £50 will give you a margin of safety in case the stock is really worth £80. Although margin of safety does not guarantee a successful investment, it acts as a cushion against errors in calculation.
Warren Buffet, a student of Graham’s, initially used value investing techniques to build his wealth. Mr. Buffett has evolved as an investor by developing his own fundamental principles from the early teachings of Graham.
“Price is what you pay, value is what you get”
It’s a simple principle and one that is not hard to grasp. Buy stocks that are priced below the true intrinsic value of the company. Warren Buffett states that you should buy companies in your ‘circle of competence’, typically companies that you truly understand. You should invest in a company based on thorough analysis of the fundamentals and the industry it operates in. However, not as a result of Mr. Markets erratic mood swings. It is important to be patient and consider each investment as if it was your last. This will enable you to find a worthy company, in an operating environment you understand and one that is priced below its intrinsic value.
Do not be influenced by Mr. Market
The Efficient Market Hypothesis (EMH) states that it is impossible to ‘beat the market’ because stock prices always trade at their fair value. However, market wide crashes, the dot-com bubble and investors such as Warren Buffett who have consistently beaten the market for long periods of time, certainly reveals some sort of inefficiency within the markets. The intelligent investor should identify facts to support their investment decisions, avoiding speculative behaviour. You should not be influenced by Mr. Market’s highs and lows and ultimately should not be afraid to go against the status-quo. In the short-term, a speculator may beat the market, but the same level of returns are unlikely to continue in the long-run.
“Investing is simple, but not easy.”