Graham was an investor and investing mentor. He is generally considered to be the father of security analysis and value investing. His ideas and methods on investing are well documented in his books Security Analysis (1934) and The Intelligent Investor (1949), which are two of the most famous investing books. Graham's main investing principle revolved around the margin of safety.
The margin of safety is the principle of buying a security at a significant discount to its intrinsic value, which is thought to not only provide high-return opportunities but also minimise the downside risk of an investment. In simple terms, Graham's goal was to buy assets worth $1 for 50 cents. He did this very, very well.
According to him, investors should analyse a company's financials and come up with the intrinsic value and then buy the stock only when it traded at a discount to this intrinsic value. His favourite margin of safety stocks were companies that were trading at two-thirds of their net current assets. The Great Depression of the late 1920s and 30s brought many such stocks up but this type of stocks has mostly vanished since.
Safety also showed up in Graham's approach in other ways, such as his reluctance to invest in stocks of companies that he found too risky. Graham's basic ideas are timeless and essential for long-term success. He turned the margin of safety into a science, which can be seen in the filters he used, at a time when almost all investors viewed stocks as speculative. He was indeed a pioneer and a trend-setter.
Timeless principles
Graham based his studies on the earnings yield (inverse of the P/E ratio) and the ratio of stockholders' equity. The margin of safety, another concept, played a big role. The margin of safety means that the investor should analyse a company's financials and come up with the intrinsic value. He should buy only when the stock traded at a discount to this intrinsic value. Graham called this the margin of safety. It's like buying a dollar for 50 cents.
Graham's filter
- The simple criteria that he used in his studies involved using the earnings yield (inverse of the P/E ratio) and the ratio of stockholders' equity.
- Earnings yield, the first criterion Graham put forward, was to be at least twice that of what AAA-rated corporate bonds yielded. According to him, for an investor to venture into stocks, that should be the minimum rate of return.
- The other criterion was based on the assumption that a company should own at least twice of what it owes. In other words, the ratio of shareholders' equity to total assets should be a minimum of 50 per cent.
- This mechanical stock selection called for holding a portfolio of 30 such stocks for a period of three years or till a 50 percent gain was realised-whichever occurred first.
- How much could an investor applying this technique expect to gain? Using both these fields, and on the basis of extensive back-testing dating back 50 years, Graham suggested that an investor following this strategy could have netted twice as much as the Dow and could, going forward, expect annualised gains of at least 15 per cent.
- Additionally, all stocks had to have a maximum P/E of 10. He was against buying stocks above that premium.