Category Archives: Benjamin Graham’s thoughts

Investment versus Speculation

“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

Benjamin Graham, “The Intelligent Investor”

Benjamin Graham, widely known as the  father of value investing, said that “outright speculation  is neither illegal, immoral, nor (for most people) fattening to the pocketbook”. He acknowledged speculation is necessary and unavoidable, saying that in many common-stock situations there are substantial possibilities of both profit and loss, and the risks must be assumed by someone. But there is intelligent speculation as there is intelligent investing. He mentioned three ways in which speculation is unintelligent: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation that you can afford to lose.

Benjamin Graham went on to say that every non-professional who operates on a  margin should recognize that he is ipso facto speculating. Also, everyone who buys a so-called “hot” common-stock issue , or makes a purchase in any way similar thereto, is either speculating or gambling.

His advice: If you want to try your luck at it, put aside a portion – the smaller the better – of your capital in a separate fund for the purpose. Never add money to this account just because the market has gone up and the profits are rolling in.  (That is the time to think of taking money out of your speculative fund.)

Warren Buffett: Two things to remember during scary periods

“The years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks,” Warren Buffett said in his FY2016 letter to Berkshire Hathaway shareholders.

“No one can tell you when these traumas will occur – not me, not Charlie, not economists, not the media. Meg McConnell of the New York Fed aptly described the reality of panics: “We spend a lot of time looking for systemic risk; in truth, however, it tends to find us.”,” said Mr Buffett.

What should investors do during such scary periods?

“…you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well,” said Mr Buffett, who is chairman and CEO of Berkshire Hathaway.

Mr Buffett started his thought on this subject by saying: “America’s economic achievements have led to staggering profits for stockholders. During the 20th century the Dow-Jones Industrials advanced from 66 to 11,497, a 17,320% capital gain that was materially boosted by steadily increasing dividends. The trend continues: By yearend 2016, the index had advanced a further 72%, to 19,763.

” American business – and consequently a basket of stocks – is virtually certain to be worth far more in the years ahead. Innovation, productivity gains, entrepreneurial spirit and an abundance of capital will see to that.”

Taking a dig at naysayers, Mr Buffett said: “Ever-present naysayers may prosper by marketing their gloomy forecasts. But heaven help them if they act on the nonsense they peddle. ”

Then driving home a point about reality, Mr Buffett said: “Many companies, of course, will fall behind, and some will fail. Winnowing of that sort is a product of market dynamism. Moreover, the years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks. ”

Mr Buffett went on to talk about the two things that investors should not forget during such scary periods.


Benjamin Graham on dollar-cost averaging

In Chapter 5 (The Defensive Investor and Common Stocks) of The Intelligent Investor, Benjamin Graham, the father of value investing, touched on various aspects of defensive investment, among which was dollar-cost averaging, an application of a “formula investment”.

Elaborating, he said: “The New York Stock Exchange has put considerable effort into popularizing its ‘monthly purchase plan’, under which an investor devotes the same dollar amount each month to buying one or more common stocks.”

“During the predominantly rising-market experience since 1949 the results from such a procedure were certain to be highly satisfactory, especially since they prevented the practitioner from concentrating his buying at the wrong times,” added Benjamin Graham.

The father of value investing cited a comprehensive study of formula investment plans in which the author Lucile Tomlinson presented a calculation of the results of dollar-cost averaging in the group of stocks making up the Dow Jones industrial index. The average indicated profit at the end of 23 ten-year buying periods was 21.5 per cent, exclusive of dividends received. There were of course some instances of a substantial temporary depreciation at market value.

The author of the study said: “No one has yet discovered any other formula for investing which can be used with so much confidence of ultimate success, regardless of what may happen to security prices, as Dollar Cost Averaging.”

Benjamin Graham Theory Of Diversification

In investment, having a margin of safety itself is not sufficient.  Why is this so?

Benjamin Graham, the founder of value investing, uses the simple basis of the insurance-underwriting business to explain the need for diversification. He said that  diversification is the companion of margin of safety. In other words, margin of safety and diversification go side by side.

Benjamin Graham put it this way:  “Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss  –  not that loss is impossible. But as the number of such commitments is increased, the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.”

The founder of value investor added that diversification is an established tenet of conservative investment.

Benjamin Graham uses the arithmetic of American roulette to explain when diversification is foolish.  In American roulette,  most wheels use “0” and “00” along with numbers “1” through “36”. There are therefore 38 slots. A person betting $roulette1 on a single number will be paid $35 when he wins but the chances are 37 to one that he will lose. The player thus has a “negative margin of safety”. The more number he bets on, the smaller his chance of ending with a profit.  If he regularly bets $1 on every number (including 0 and 00), he is certain to lose $2 on each turn of the wheel.  Diversification in this case is therefore foolish.  Suppose the winner received $39 profit instead of $35. In this case, he would have a small but important margin of safety. Therefore the more numbers he wagers on, the better the chance of gain.

Bottom line: What Benjamin Graham was saying is that margin of safety goes hand in hand with diversification.


Margin of Safety: Secret of Sound Investment

Benjamin Graham's teacher and friend. Mr Graham used Mr. Market as the character to personify the behavior of the stock market. Photo: Wikipedia.
Benjamin Graham – Wikipedia

Benjamin Graham (May 8, 1894 – September 21, 1976), the father of value investing, in his book, The Intelligent Investor, summed up the secret of sound investment in three words: margin of safety. Warren Buffett, Benjamin Graham’s most famous disciple, explained his mentor’s margin of safety concept this way (Source: The Superinvestors of Graham-and-Doddsville by Warren E. Buffett): “You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin (of safety). When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”

In Chapter 20 (“Margin of Safety” as the Concept of Investment”) of The Intelligent Investor, Benjamin Graham summed up the chapter by saying: “Investment is most intelligent when it is most businesslike”.

“If a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success,” said Benjamin Graham. In other words, view a corporate security as an ownership interest in a specific business enterprise.

Benjamin Graham listed four sound business principles and explained how they were related to the securities investor:

(1) “Know what you’re doing – know your business.” Benjamin Graham said that the investor should not try to make “business profits” out of securities – that is, returns in excess of normal interest and dividend income – unless “you know as much about security values as you would need to know about the value of merchandise that you proposed to manufacture or deal in”.

(2) “Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.” For the investor, it means understanding the conditions under which he will permit someone to decide what is done with his money.

(3) “Do not enter upon an operation – that is, manufacturing or trading in an item – unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular, keep away from ventures in which you have little to gain and much to lose.” The enterprising investor should make sure that his operations for profit should not be based on optimism but on arithmetic. For every investor who limits his return to a small figure, such as in a conventional bond or preferred stock – he needs to ask for convincing evidence that he is not risking a substantial part of his principal.

(4) “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even others may hesitate or differ.” “In the securities world, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand,” said Benjamin Graham.

Related post: Benjamin Graham’s theory of diversification

Benjamin Graham on stock selection for the defensive investor

The Intelligent Investor Chapter 14 – Stock Selection for the Defensive Investor

1.  Adequate Size of the Enterprise

The idea is to exclude small companies which may be subject to more than average vicissitudes especially in the industrial field.

(I) Not less than S$100 million of annual sales for an industrial company and, not less than $50 million of total assets for a public utility.

(Note:  These figures in 2015 are approximately $600 million and $300 million respectively. Veteran investment writer Jason Zweig in his accompanying commentary for Benjamin Graham’s The Intelligent Investor, Chapter 14 said: “Nowadays, “to exclude small companies,” most defensive investors should steer clear of stocks with a total market value of less than $2 billion.” Jason Zweig  also said: “However, today’s defensive investors – unlike those in Graham’s days – can conveniently own small companies by buying a mutual fund specializing in small stocks.”).

2. A Sufficiently Strong Financial Condition
According to Benjamin Graham, for industrial companies, current assets should be at least twice current liabilities – a so-called two-to-one current ratio. Also, long-term debt should not exceed the net current assets (or working capital). For public utilities, the debt should not exceed twice the stock equity (at book value).

3. Earnings Stability
Some earnings for the common stock in each of the past ten years.

4. Dividend Record
Uninterrupted payments for at least the past 20 years.

5. Earnings Growth
A minimum increase of at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end.

6. Moderate Price/Earnings Ratio
Current price should not be more than 15 times average earnings of the past three years.

7. Moderate Ratio of Price to Assets
Benjamin Graham said that current price should not be more than 1.5 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. “As a rule of thumb,” he said, ” we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5 (this figure corresponds to 15 times earnings and 1.5  times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.).”