How to invest like the best: Benjamin Graham

Benjamin Graham (left) with Robert E. Wood in Washington DC. Credit: Bettmann/Contributor/Getty.

“Of all the investments I ever made, buying Ben’s book was the best (except for my purchase of two marriage licences).” So said Warren Buffett – dubbed the “Sage of Omaha” for his investment prowess – of Benjamin Graham’s best-known work, The Intelligent Investor.

Published in 1949, the tome established Graham as one of the great investors of the 20th century – his ideas remain influential to this day.

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Born in London in 1894, Graham moved, aged one, with his family to New York, where his father set up a successful porcelain shop. The financial crisis of 1907 – when the New York Stock Exchange fell 50% in just three weeks – saw the shop go bust and plunged the Graham family into poverty. The traumatic episode taught Graham an early lesson about the vagaries and caprice of the stock market.

After graduating from Columbia University – attending thanks to a scholarship – Graham went to work on Wall Street at Newburger, Henderson and Loeb. He quickly made an impression. By his early 30s, Graham was reportedly earning $500,000 a year, only for a market panic to once again intervene; most of his wealth was wiped out in Wall Street Crash of 1929.

The foundations of value investment

This second brush with financial disaster prompted Graham to think more deeply about his approach to investment. His observations formed the basis of Security Analysis, co-written with fellow Columbia Business School professor David Dodd, the 1934 book that is widely regarded as having laid the foundations of value investment.

The book’s philosophy was deceptively simple, urging investors to look beyond trends in a company’s share price to focus instead on the underlying “intrinsic value” of the business, based on its assets, earnings and dividend payments. Graham also distanced himself from investors who he regarded as speculators. “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return; operations not meeting these requirements are speculative,” he explained.

Set of rules

Graham subsequently launched the Graham-Newman Corporation with partner Jerome Newman, a collective fund that for the next 20 years would consistently deliver market-beating returns for investors. The fund built a portfolio of investments according to the views Graham had set out in Security Analysis – and in line with a set of rules defined in The Intelligent Investor. The result was a record of annualised returns in excess of 20% between 1936 and 1956.

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Rule one calls for “adequate, though not excessive, diversification”. Graham urges investors to be conservative without being too risk-averse; a portfolio of between 10 and 30 stocks, say, provides investors with a “margin of safety” – a common Graham goal – while still allowing them to focus on their best ideas.

Graham’s second rule is that each company in the portfolio should be “large, prominent and conservatively financed”. The Intelligent Investor advocated for blue-chip shares with consistent cash flows and limited borrowing; prominent businesses are those that are leaders in their industry.

Next, Graham argued that “each company should have a long record of continuous dividend payments”. Such a track record, he maintained, was indicative of businesses with stable, repeatable business models, such as utilities or consumer staples, or those with strong brands and significant pricing power.

Graham’s fourth and final rule is that investors “should impose some limit on the price they will pay for an issue in relation to its average earnings”. The idea here is not to overpay for a company – Graham looked for businesses with earnings multiples at a level below their average over the previous seven years.

Such rules offered an early blueprint for value investment that many admirers – including Buffett – would embrace. But Graham also found less mechanistic ways to describe his craft.

Mr Market

In particular, The Intelligent Investor introduced the world to Mr Market, Graham’s imaginary business partner. Each day, the author explained, Mr Market tried to persuade Graham either to buy his shares, or to sell his own holdings to him. Most days, Mr Market behaved irrationally, offering different prices according to whether he was feeling optimistic or downbeat.

Graham’s argument was that investors needed to be dispassionate. Mr Market’s emotions – notably fear and greed – regularly offered opportunities for investors who understood the true value of businesses, based on their operations and financial positions.

The Graham-Newman Corporation closed in 1956 when Graham retired from active investment. The closure prompted one of his young securities analysts to set up his own partnership. Buffett, who had enrolled at Columbia Business School in 1950 precisely because Graham lectured there – worked for the fund for two years from 1954 – before setting up his first independent investment partnerships in 1957.

By the time Graham died in 1976 at the age of 82, he had been anointed the “father of value investment”, but his own views and interests had moved on. He acknowledged the value philosophy he espoused had become significantly more difficult to execute in an era when access to data and information, particularly about the largest companies, was so much better that wrongly valued businesses were in short supply.

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Graham had also devoted more of his time to economic theory – including work on how the US dollar might become a world currency that replaced the gold standard; these ideas would be an important influence on the response of policymakers to the 2007-08 global financial crisis.

Nevertheless, Graham remains revered for his work, with value investment retaining standard-bearers and disciples who have continued to refine his original principles as markets have evolved.

“It is rare that the founder of a discipline does not find his work eclipsed in rather short order by successors,” Buffett wrote shortly after Graham’s death. “But, over 40 years after publication of the book that brought structure and logic to a disorderly and confused activity, it is difficult to think of possible candidates for even the runner-up position in the field of security analysis.”

Another four decades on, that remains just as true today.

How to invest like Benjamin Graham

By his own admission, the principles on which Graham built his investment career have become tougher to follow.

He told the Financial Analysts Journal in 1976: “In the old days, any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies. In the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost; to that very limited extent I'm on the side of the efficient market school of thought now generally accepted by the professors.”

Nevertheless, many investors, including the professionals, continue to believe that markets aren’t aways efficient – and that there will be plenty of opportunities when emotion and irrationality drives inefficiencies.

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“You could argue that all investors are Graham investors as everyone is trying to buy a stock for less than they think it’s worth,” says Ben Yearsley, a director of independent consultant Fairview Investing. “However, in the true value sense, I would highlight Schroders’ value team led by Nick Kirrage, Ian Lance and Nick Purves at Redwheel, who manage Temple Bar Ord (LSE:TMPL) Investment Trust, and Alex Savvides of Jupiter UK Dynamic Equity.”

Yearsley also points out that certain sectors and markets may be more suited to Graham’s philosophy. “Banks and financials generally have been seen as value stocks for many years on different metrics – price-to-book ratios, for example,” he says. “Price-to-book is often used in Japan where stocks were cheap for 30 years – Man Japan CoreAlpha  has probably been the biggest proponent of that style.”

As for individual stocks, Richard Hunter, head of markets at interactive investor, considers some of the UK’s largest companies, reflecting Graham’s preference for blue-chips. “Based on filters including current valuations, discount to historic valuation and gaps between the current and estimated target prices of market analysts, three names in particular crop up,” he says. “Prudential (LSE:PRU), easyJet (LSE:EZJ) and JD Sports Fashion (LSE:JD.).”

Alternatively, what about Berkshire Hathaway Inc Class B (NYSE:BRK.B) itself? Warren Buffett’s investment vehicle is still making investment choices based on the philosophies espoused by its founder’s guru.