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Benjamin Graham: The Dean of Value Investing

February 20, 2018 by Frugal Prof

Investing Ben Graham

Ben Graham: Investment Legend.

Ben Graham is widely acknowledged as the Dean of Value Investing. His disciplined approach to investing has impacted generations of investors. His best-selling book, The Intelligent Investor has become a blueprint for investment success for generations of high profile Money Managers including

Warren Buffett,
Seth Klarman,
Leon Cooperman,
and Mario Gabelli.

In this article, I will review the books Ben Graham wrote as well as the basics of his life and investing style. The more knowledge we can acquire from Benjamin Graham and Warren Buffett, the better our investing success will be.

Value Investing

*Affiliate Disclosure: This post contains affiliate links. Business partners may compensate me for inclusion on this blog, but I strive to only partner with quality businesses and the reader pays nothing.

Who Was Ben Graham:

“The intelligent investor is a realist who sells to optimists and buys from pessimists.”
― Benjamin Graham, The Intelligent Investor

Benjamin Graham: Known as “the father of value investing” and the “dean of Wall Street,” excelled at making money in the stock market for himself and his clients without taking big risks.

Graham created and taught many principles of investing safely and successfully that modern investors continue to use today’s stock market.

The Intelligent Investor:

“By far the best book on investing ever written.” — Warren E. Buffett

Graham’s second book is much more user-friendly for the average investor. If you want to become a really good investor, this book is a great place to start. It is well worth the time and money. “The Intelligent Investor,”

This is the book I re-read during the 2008 Financial Crisis. And it helped me tremendously. You may want to read my post, Lessons Learned from the 2008 Financial Crisis.

“The best known and most likely to make you money is The Intelligent Investor.” — Andrew Tobias

“Graham ranks as this century’s (and perhaps history’s) most important thinker on applied portfolio investment.” — John Train, author of The Money Masters

1929 Crash and Great Depression:

Value investing is about minimizing risk.

Graham’s painful losses in the 1929 crash and Great Depression led him to hone his investment techniques. These techniques sought to profit in stocks while minimizing downside risk. He did this by investing in companies whose shares traded far below the companies’ liquidation value.

In simple terms, his goal was to buy a dollar’s worth of assets for $0.50. To do this, he utilized market psychology, using the fear and greed of the market to his advantage, and invested by the numbers.

These ideas were built on Graham’s diligent, almost surgical, financial evaluation of companies. His experience led to simple, effective logic, upon which Graham built a successful method for investing.

Margin of Safety:

Graham also stressed the importance of always having a margin of safety in one’s investments. This meant only buying into a stock at a price that is well below a conservative valuation of the business.

This is important because it allows profit on the upside as the market eventually revalues the stock to its fair value, and it also gives some protection on the downside if things don’t work out as planned.

Ben Graham & Value Investing

How do we apply his investment criteria to make money today. Many value managers use the following criteria to screen and filter for stocks that are worth much more than their current share price.

I use Graham’s investing criteria to find undervalued stocks.

See my investing articles on Signet or Ralph Lauren, the most undervalued brand in the world, as examples.

Relevant Articles:

45 Ways to Increase your Income

9 Best Ways to Save $7K This Year

7 Proven Books on Personal Finance to Take Control of Your Money

Investment Criteria:

Size: Sales $500 million ($100m originally, but adjusted for inflation since the time of Graham’s writing). Smaller companies are generally subject to wider fluctuations in earnings.

For industrial companies, Graham used annual sales as a proxy for company size but, for utilities, he used $50m of assets instead ($250m inflation adjusted).

Strong Financial Condition, Current Ratio: Greater than 2.0

A current ratio above 2 means that the cash and liquid assets of the company are more than twice the Total Debts.

This is a strong financial condition. And it was the painful lessons of the Great Depression that led Graham to be strict in terms of only selecting the companies with a strong financial condition.

Long Term debt: Low Debt Long term debt should not exceed the working capital or net current assets.

Earnings Stability: EPS for the last 10 Years on the basis that companies that have maintained at least some level of earnings are more likely to be stable going forward.

Dividend track record over a 20 year period – not as relevant today as few companies pass this test as nowadays, companies are more inclined to use excess cash to buy back their shares.

Earnings growth = 3% on average over last 10 years. Graham wanted to see defensive companies grow their EPS by at least one third over the last 10 years, implying this minimum compound growth rate.

Price Earnings Ratio 15, using an average of EPS for the last three years. This is to account for special charges and to overcome the impact of cyclical business.

Price to Book 1.5. Graham recommended that the current price should not be more than 1.5x the book value last reported.

Value Investing

Warren Buffett:

After reading “The Intelligent Investor” at age 19, Buffett enrolled in Columbia Business School in order to study under Graham, and they subsequently developed a lifelong friendship.

Later, he worked for Graham at his company, the Graham-Newman Corporation, which was similar to a closed-end mutual fund. Buffett worked there for two years until Graham decided to close the business and retire.

Security Analysis: In 1928 he began teaching investment classes at Columbia University.

Over time, working with former student David Dodd, the lessons of his classes were gathered into his first book, titled “Security Analysis,” which was published in 1934. More about Security Analysis here.

Security Analysis by Graham and Dodd is a lengthy and serious study of security analysis.

This book is for the knowledgeable and serious investor.

The book has sold over a million copies.

Warren Buffett says he’s read it at least four times.

Buffett Investing Strategy: Warren Buffett went on to develop his own strategy, which differed from Graham’s in that he stressed the importance of a business’ brand equity and of holding investments indefinitely.

Graham would typically invest based purely on the numbers of a company, and he would sell an investment at a predetermined value.

Even so, Buffett could not have achieved his incredible success if Benjamin Graham had not taught him the way.

One of the best in-depth profiles of Warren Buffett was done by Roger Lowenstein, a Wall Street Journal reporter.

Buffett: Making of an American Capitalist here.

Benjamin Graham: Legacy of Creating Incredible Value Investors:

Investors like Warren Buffett and Charlie Munger refined the principles by applying additional factors – such as franchise value, management quality and capital allocation – in the assessment of intrinsic value.
Those who applied Graham’s ideas to new situations: Investors like John Templeton showed how well value investing could work in international stocks, including emerging markets.
Others, like Joel Greenblatt, known for The Little Book that Beats the Market and Seth Klarman, applied the principles to special situations, such as bankruptcy securities, spinoffs, and complex structures.

Investing - Wall Street

Hedge Fund Titans Leon Cooperman & Mario Gabelli:

While a student at Columbia University’s business school, famed investor Leon Cooperman used to carpool to class with Mario Gabelli, CEO of GAMCO Investors. The two studied security analysis under Roger Murray, a noted value investing professor and co-author of the fifth edition of Graham’s Security Analysis, the bible of modern day value investing.

“Value investing became very appealing to me,” says Cooperman. “Why wouldn’t anyone want to get more for less?”

Cooperman, who was the head of research and a top strategist at Goldman, Sachs before launching Omega Advisors in 1991, says he shuns the risks of momentum investing, believing that a better long-term strategy is to know that he is making investments in stocks that are fundamentally mispriced.

The Sequoia Fund:

If there was ever a legendary fund, it’s Sequoia SYMBOL: (SEQUX), managed by New York-based Ruane, Cunniff & Goldfarb. This mutual fund was co-founded by Richard Cunniff and William Ruane, Buffett’s stockbroker, in 1970. It got a boost right from the beginning because Buffett, who was liquidating his own investment partnership, advised his clients to take their cash to Sequoia.

Ruane and Cunniff shared the Graham-inspired value underpinnings with Buffett and over the years developed a reputation for focusing on long-term growth of capital. The fund looks for undervalued companies with potential for growth and, like Buffett’s Berkshire Hathaway, is willing to hold positions for many years, even decades.

Seth Klarman:

Klarman’s fund has reportedly generated annual returns of 16.4 percent and $22.6 billion in net profit for his clients since inception more than three decades ago through 2015. Baupost generated a “high single-digit” return in 2016, according to an investor letter.

Investing Tips from Seth Klarman, author of Margin of Safety: (via FT)

Value investing works. Buy bargains.
Quality matters, in businesses and in people. Better-quality businesses are more likely to grow and compound cash flow; low-quality businesses often erode and even superior managers, who are difficult to identify, attract, and retain, may not be enough to save them. Always partner with highly capable managers whose interests are aligned with yours.
There is no need to overly diversify. Invest like you have a single, lifetime “punch card” with only 20 punches, so make each one count. Look broadly for opportunity, which can be found globally and in unexpected industries and structures.
Consistency and patience are crucial. Most investors are their own worst enemies. Endurance enables compounding.

Legacy: Ben Graham’s disciplined approach to investing has impacted generations of investors. His best-selling book, The Intelligent Investor and Security Analysis have become a blueprint for investment success for generations of high profile Money Managers including Warren Buffett, Seth Klarman, Mario Gabelli, and Leon Cooperman.

These books still deliver value to new investors today. If you want to become a great investor there is no better place to begin.

2008 Financial Crisis: Profit From the Next Panic

February 13, 2018 by Frugal Prof

The purpose of looking back at the 2008 Financial Crisis is to learn to make better investment decisions the next time a crisis comes. Making smart decisions during a crisis can lead to tremendous gains that cannot be achieved during any other time in the investing cycle.

The next crisis will present great opportunities for the investor willing to buy when others are panicking.

September 2008: The Financial Crisis

A tumultuous time on Wall Street (September 24, 2008):

Late Sunday, both Goldman (GS) and Morgan Stanley (NYSE symbol MS),Fortune 500, were converted into bank holding companies by federal regulators, effectively closing the book on the stand-alone investment bank business model.
Just a day earlier, Morgan agreed to sell up to a fifth of the company to Mitsubishi UFJ Financial Group (NYSE: symbol MTU), one of Japan’s largest banks.
Merrill Lynch was acquired by Bank of America (Stock symbol: BAC) .Fortune 500 (via CNN).

Value Investing

During the 2008 financial crisis, I decided to re-read The Intelligent Investor by Benjamin Graham since things were very chaotic and I found it immensely helpful.

As most investors know, Benjamin Graham is known for having taught Warren Buffet about value investing.

The book is the Bible of value investing.

It is a template of how to filter the market for stocks that are truly undervalued. By using the principles in the book, many prominent investors like Warren Buffett have made significant fortunes in the stock market and avoided the losses and frustrations of average investors.

Buffett takes a stake in Goldman Sachs:

Buffett agreed to purchase preferred stock, which worked out much better for his investment in the company. This allowed him to receive dividends on the shares.

Goldman, Sachs (GS) will sell $5 billion of preferred stock to the insurance and investment giant, which will also receive warrants to purchase $5 billion of common stock with a strike price of $115 per share, the company said.

Berkshire (BRK.A, Fortune 500) has five years to exercise the warrants.

Buffett will be paid a 10% dividend on his shares.

Warren Buffett (via Berkshire Hathaway) moved up the capital structure when he negotiated his transaction with Goldman, Sachs & Co.

And these dividends enabled him to outperform the performance of the common stock.

If I didn’t think the government was going to act, I would not be doing anything this week, Buffett told CNBC. “It would be a mistake to be buying anything now if the government was going to walk away from the Paulson proposal.”

Value Investing

Genworth: (GNW):

An undervalued insurance giant.

In the financial crisis, instead of buying common stock, I looked at preferred stock, bonds, or used options to hedge. This allowed me to keep adding undervalued investments to my portfolio in an uncertain time and be comfortable with the overall risk. Genworth is provided as an example. (via Morningstar)

Based on the price to cash flow, the current ratio, and the price to book, Genworth’s stock was already on my radar as an undervalued situation.

The decision to opt for the bonds was an attempt to move up the capital structure and take less risk as the uncertainty of how the financial crisis would play out was very much on my mind and created an added level of worry. In addition, the large debt level was a concern and made the common stock less attractive and riskier.

Genworth: Bonds Vs. Stock

It seemed a good strategy in individual situations and in my overall portfolio to move up the capital structure, as Warren Buffett had done.

I decided to purchase the Genworth bonds (6.515% 2018) and paid 63 cents on the dollar during the financial crisis in October 2008.

As we see from the price action of the bonds, I was very early and could have purchased the bonds much later at a bargain price of 23 cents on the dollar. In hindsight, the best move I could have made was to sell the common stock (even at a loss) and purchase more bonds at 23.

However, it also speaks to the volatility of the financial crisis. I purchased a bond I thought was attractive at 63. Within a few weeks, as the crisis worsens, the bonds had plummeted to 23 cents on the dollar, a massive paper loss.

GNW Chart

GNW Stock

I also purchased a small amount of stock and sold calls against the position. I made money on the shares and they were called away some time later. Because I owned the bonds, I didn’t want to have too much exposure to one name, so I let the shares get called away.

In the end, the bonds recovered and paid a healthy 13.49% yield for the past eight years and now trade above par at $102.50. The stock has had a couple of spikes in price into the teens, but is again back at the $3 level. It’s been a very difficult decade for Genworth shares.

The lack of progress in the shares since the financial crisis is striking. I now view Genworth as a classic value trap, a stock that has been perennially undervalued: lacks enough earnings power and cash flow to create value for shareholders, or a buyer willing to pay a significant premium.

The goal is not just to own an undervalued security. The goal is to profit from investing with a margin of safety. Over the past eight years, it was very difficult for any value investor to profit from owning Genworth shares.

This scenario is why a call selling strategy can be very helpful to the investor.

Washington Mutual: Unknown Investment Risks

At $2, I estimated the risk/ reward in Washington Mutual Preferreds to be 1,000% (not including dividends) on the upside with the potential of a 40% loss. Even with what I considered to be a very favorable risk/reward I kept my position size small.

My position in the Genworth bonds was five times the size of my position in WaMu.

It was a good speculation. I felt that the company had value since TPG, a prominent global investment firm, and others were willing to bid on the company. But it had too much debt and risk for me to invest in the common shares.

WaMu Is Seized, Sold Off to J.P. Morgan, In Largest Failure in U.S. Banking History (Wall Street Journal)

In hindsight, as I read Warren Buffett’s previous quote, I realize he had a much better grasp on the investment situation than I did. He was not going to act in an investment during the crisis without some type of government approval.

The government had given an indication it would support Goldman Sachs via the TARP program. No such assurances or indications were ever given on Washington Mutual.

Moving up the capital structure didn’t protect the investor in this situation. I purchased the Preferred Shares in Washington Mutual along with some very successful hedge fund managers (David Bonderman and TPG).

The known risk was bankruptcy. The unknown risk was government intervention.

The end result was an orchestrated seizure of the bank and arranged sale, which wiped out both the equity holders and the preferred shareholders.

Value Investing

(Sept. 26, 2008 WaMu is Seized)

The collapse of the Seattle thrift, which was triggered by a wave of deposit withdrawals, marks a new low point in the country’s financial crisis. But the deal, as constructed by the Federal Deposit Insurance Corp., could hold some glimmers of hope for the beleaguered banking system because it averts any hit to the bank-insurance fund. All WaMu depositors will have access to their cash, but holders of more than $30 billion in debt and preferred stock will likely see little if any recovery.
In March, J.P. Morgan offered to acquire WaMu but was spurned in favor of a $7 billion infusion led by the private-equity firm TPG, considered one of the savviest buyout firms. TPG, led by investor David Bonderman, said it will lose $1.35 billion, wiping out its investment. (via WSJ)

Ego and Investing

Every investor dreams of a huge winner. And both Washington Mutual and Genworth seemed to have those characteristics.

Being able to tell people for years to come that I purchased the shares at $3 and have the stock at $20, $30, or higher would be great for my ego. However, I gave up on bragging rights to the situation when I bought the bonds. No one brags about buying bonds. But being able to measure risk and reward and keep my ego out of the decision was very helpful in hindsight.

In fact, looking at the performance of the S&P 500, Goldman Sachs and Genworth, it is striking how little reward Genworth shareholders received from buying during the crisis. However, the Genworth shareholders fared much better than the Washington Mutual preferreds, which were a complete loss.

GNW Chart

Conclusion

The 2008 financial crisis provides many important lessons for investors on investing, risk, position sizing, moving up the capital structure, unknown risks, and security selection. Learning from prominent investors like Warren Buffett and Benjamin Graham is always enlightening an helpful for the investor.

One never knows when another crisis will occur and create opportunities for the intelligent investor.