As you ought to know, Benjamin Graham, author of “Security Analysis”, is considered the dean of financial analysis and value investing. He taught generations of bargain-hunters the concepts of “Margin of Safety”, net working capital (current assets of a company minus all liabilities), and dealings with Mr. Market.
Who is Benjamin Graham?
Benjamin Graham (1894 – 1976) was an American economist and a professional investor and is considered the “father of value investing”. Graham developed a track record of earning solid returns to the stock market for himself and his clients and for doing so without taking enormous risks.
He began teaching this investment approach at Columbia Business School in 1928 and published several books (with David Dodd) on the subject, the best known of which were Security Analysis (1934) and The Intelligent Investor (1949). While Graham has many disciples, the best known may be Warren Buffet. Graham’s Early Years
Born in London, Graham moved to New York as a child and spent his early years living in poverty. A star student, Graham graduated from Columbia University and went right to work on Wall Street. Over the next 15 years, Graham began to develop his stock market savvy and grew a considerable sum of money for himself through his investments.
His hardest lesson concerning risk came in 1929 when he lost it all in the stock market crash. His book Security Analysis (published in 1934) followed, focusing on new methods to analyze and value securities.
The Value Investing Approach
Through his writings, Graham began to draw distinctions between investing and speculating. His new approach to investing called for buying shares in companies whose market value was well below the company’s liquidation value.
Graham encouraged investors to regard stock investing as it truly is- part ownership of a business and to not be overly concerned with short-term price fluctuations. With this view, the investor understands that the stock market behaves like a voting machine in the short-term and as a weighing machine in the long-term.
Intrinsic Value and a Margin of Safety
Under the value investing approach, the first step is to identify the “intrinsic” or true value of a company based on all the aspects of the business. Value investors will only make a purchase decision when this intrinsic value is significantly greater than the current market price- the difference being the margin of safety. The greater the margin of safety, the lower the downside risk.
Intrinsic value is most often defined as the net present value of all the expected future cash flows to the company. This value can be calculated through a discounted cash flow analysis.
Graham’s Later Success as an Investor
It is believed that Graham averaged about a 20% annual return under the value investing approach. In recent years, Modern Portfolio Theory (which argues that it is normally not possible for an investor to outperform the market over the long-term) has challenged Graham’s theories. Even so, the value investing approach has been adopted by many successful investors.
Profit margin is a measure of how much of every dollar a company brings in a sales it keeps after costs as earnings. Profit margin is also called “Net Profit Margin,” “Net Margin,” and “Net Profit Ratio.
How is profit margin calculated?
Profit Margin = (Net Profit / Revenue) * 100
Net Profit is a company’s gross profit minus overhead, interest, and generally taxes as well; where gross profit is defined as revenue minus the costs of manufacturing a product or providing a service.
For example, if company X has a net profit of $100 million on revenue of $500 million, its profit margin is 20% [(100 / 500) * 100].
Why is profit margin important?
A high profit margin indicates that a company has flexibility in its pricing because a small reduction in pricing will not erase its profits.
Profit margins for companies in different industry cannot be compared directly, however, as the costs of operating and financing a business in different sectors vary greatly and monopoly pricing capabilities from patents may or may not apply. For example, the average profit margin of “major drug manufacturers,” more commonly called pharmaceutical companies, was 17.6% in 2009 while the average profit margin of “grocery stores” is 1.5%.
Benjamin Graham’s Basic Strategy and Teachings
We believe that all of our methods are based on Benjamin Graham’s basic strategy and teachings. We have studied The Intelligent Investor and Security Analysis, and understand his approach. Not only that, but we believe in no other way of investing – any method that is not based on value investing is merely speculating.
- Intrinsic Value – In The Intelligent Investor, Benjamin Graham presents a formula as follows: Intrinsic Value = EPS x (8.5 + 2g). After studying this model we found that it does provide a solid foundation for determining value. In modernizing the formula, we changed the EPS used to our normalized EPSmg.
We also looked at the 8.5 factor and determined in this post that if you are looking at a no-growth company (thus making the formula be EPS x 8.5), you are left with the perpetuity of the current earnings level. Therefore, the 8.5 comes from the valuation of perpetuity (V = earnings/discount factor) with a discount factor of 11.76%, which is near the long-term average return on equities. We also have a calculator page where you can run the formula.
- EPSmg – Graham taught us to normalize the earnings to determine what level of earnings can be expected in the future. As a result, instead of using the current EPS, we use a 5-year weighted average of the diluted EPS to determine the EPSmg level. The weights are based on a sum of the year’s digits method (often used for depreciation) with emphasis on the most current annual periods.
- Estimates – We make a very conservative estimate when determining what the future earnings may be. Earnings estimates are often wrong, and we limit our forecasts to a maximum of three quarters. Specifically, if the first quarter actual earnings are not available at the time of valuation, we do not make any estimate on the next fiscal year. If the first quarter actuals are available, we will use the lowest published analyst estimate for the remaining quarters in the company’s fiscal year.
If the first and second quarter actuals are available, we add those to the lowest published estimates for the third and fourth quarters to determine our fiscal year estimate. If the third quarter actuals are available, we add the lowest published estimate for the fourth quarter to the actuals produced in the three quarters to date.
- Growth – Our estimate for growth is based on taking the growth in EPSmg from the current period (or estimate) less than the EPSmg from five years prior. The average over the period is then taken, subject to a safety margin of 0.75 of the result, and capped at 15%. For example, given a current EPSmg of $5 and five years prior value of $3.50, the overall growth would be 42.9%. The average annual growth over the period would be 8.56%. Subject to a 0.75 safety of margin-multiple, the estimate of growth would then be 6.42%. Since this is less than 15%, the cap does not apply.
PEGg Ratio – The PEGg ratio is the Price divided by the EPSmg.
Defensive and Enterprising Investors – Benjamin Graham taught that a Defensive Investor is one who is not willing or able to take the time to do extremely thorough research.
As a result, the defensive investor must seek companies that have very solid financials to minimize the risk of losing an investment. An Enterprising Investor is willing and able to do more research on potential investments, and as a result, can take on slightly higher risk through investing in companies that do not hold as strong financial positions.
Graham suggested some basic requirements for each type of investor, and we have updated those requirements to fit today’s marketplace. Every company valued by Graham must go through a series of tests to determine whether it would be suitable for a Defensive Investor or an Enterprising Investor. If it is not suitable for either type of investor, the company is deemed to be speculative.
Benjamin Graham, the Father of Value Investing
How to Value Stocks?
When you consider investing in a stock, don’t just see how much it can go up; check how low it can get. Here are a few guidelines that could help you:
Before analyzing the company’s finances and management, find out if its business can generate profits over the long term. The focus should be on judging the company’s growth potential in view of future demand for its products/services.
The balance sheet is the best way to judge a company’s health. Check the company’s target debt-equity ratio for the near future. How much is it committed to loan agreements? How strongly has it performed in various market conditions?
What is the reputation of the promoters? What changes have been made to the senior management in the last two years? Does the company plan to grow internally or through acquisitions? What about restructuring plans?
Buy a stock only when a company’s fundamental worth and future growth potential are not adequately reflected in its current stock price. Search for solid companies selling at bargain prices compared to their intrinsic value. Favorable fundamentals are necessary, but not sufficient. Consider companies that have both solid fundamentals and a low price-to-earnings (P/E) multiple.
Looking for hidden value in small and medium-sized companies that aren’t well researched could be rewarding. This does not mean you must totally avoid stalwarts. If an established company reports lower-than-expected earnings due to short-term transitional problems and the stock is hammered down, it could be a good time to buy.
Low P/E stocks
Low P/Es have a natural appeal to risk-averse investors. Historically, they have tended to provide greater protection in down markets than stocks with high P/Es. However, investing purely on the basis of a low P/E factor could prove disastrous. Since relative P/Es are a function of a number of intangible factors such as promoter quality and technical expertise, a low P/E for a stock may be a reflection of its inherent weaknesses and not an under-valuation of its potential.
Low-priced vs cheap stocks. Not all low-priced stocks are cheap. A company’s success factor could depend on other things:
- A revolutionary product
- Consolidation in the industry which can lead to the company being bought at an attractive price
- Intangible assets
Invest in such companies as soon as they start receiving media attention or their stocks start to trade in increased volumes.
Benjamin Graham Study
Back to the times of Benjamin Graham
However, few of us are fully aware of what Graham bought while running Graham-Newman, a firm where Warren Buffett worked as an investment analyst poring over annual reports before the strike on his own.
Graham was essentially interested in quantitative metrics, which is why the networking capital valuation was so appealing to him. Here is an update on the definition of networking capital:
Networking capital= current assets – current liabilities – financial debt.
But even in the thirties, Graham and his disciples delved deeper than just reported figures and calculated the readily ascertainable and appraisable value of the assets listed on the balance sheets they devoted their time scouring. (pretty much what we successfully did with BFCF).
Here is a hint at an early tour de force of his, so much an epitome of the value conundrum:
Guggenheim Exploration Company, holding large interests in copper-mining companies. At the announcement of the liquidation/dissolution of the company, Graham computed the sum-of-the-parts valuation of the portfolio holdings (just using reported market prices ): U$ 54.63 a share.
The balance sheet carried other assets whose net value was U$ 21.6 a share. Graham looked at the U$ 68.8 a share stock price and concluded the stock was trading at a discount. In a liquidation process, the owners of the company will soon receive more than the price-weighted by the market. To hedge against any potential downside, in addition to buying large amounts of the stock, he sells short the individual stocks. Graham thus made his reputation. In 1915……
Northern Pipeline: a case study on a Graham Investment
In 1928, aged 34, Graham in the midst of analyzing the oil pipeline industry. Narrowing his investigation to eight prominent companies in the field, he found a common pattern on their balance sheets: instead of reinvesting the cash-flows generated by the underlying business, the managers have conservatively (and according to the financial standards of that time) reinvested all the money in investment-grade (high quality) railroad bonds (this highly capital intensive industry was essentially financed by bonds issuance).
Noticeably, one company, Northern Pipeline, held a remarkable fixed-income portfolio of railroad bonds. Reassessed at its market value (much higher than the book value at cost), it turned out that this sole line of the balance sheet was worth $95 a share, while the stock of NPL was languishing at $65. Graham had no reason to believe that the management, of its own will, would unlock this hidden value.
In a stunning move that would later inspire shareholder activists, he vehemently fought the entrenched management and gathered proxies accounting for 38 % of the shares.
He eventually gained two board seats, and, having now a say in the management of the company, forced it to close the gap between the intrinsic value of the business and its market value through an asset-conversion event: a U$ 70 special distribution (which did not make a dent into the company’s business, for only surplus marketable securities were sold to be redeployed at the profit of the investors) to the shareholders.
The stock price went down after the transaction was completed (because the market rightly recognized that the distributed assets made up for the essential part of the value, and effectively what occurred at Graham’s impulse had been a partial liquidation with funds returned to the shareholders). Nonetheless, through the distribution, even compounded by a capital loss, Graham reached a 54 % annual return. The kind of performance any investor would die for. Literally.
- Investigate, hither and thither, you will find opportunities of this kind if you are equipped with the intellectual framework to uncover asset values.
- Be an activist, join activists, or support activists, instead of just being an Outside Passive Minority Investor (to use Martin Whitman’s phraseology).
Hitherto, we have presented specific case studies of Graham investments.
Graham arbitrage operations
They were of three kinds:
- Merger arbitrage: in the event of a merger announcement (he confined himself to announced cash tender offers), the strategy entails buying the security of the acquiree and selling short the security of the acquirer to capture the gap between the date of the announcement and the closing of the deal (considering only deals very likely to close in).
- Convertible bond arbitrage: purchasing a convertible bond near par value (betting on its rise) while selling call options or an equivalent amount of the underlying stock to protect against a possible declining bond price and a rising stock price.
- Long/short arbitrage: let us say that Company X owns 20 % of Company Y, and Graham had figured out that X is undervalued. He would then not only buy X but also hedge selling short Y (ratio:20 % of the number of X he has acquired)to profit on the other side of the deal if eventually, Y goes down. In a normal scenario, he expects X price to rise, but if Y and X eventually go down in price, he still can exercise the short position.