Today, Warren Buffett is the most famous investor in the world, with people all over the globe soaking in every bit of advice and wisdom they can get from him. But before Buffett was at the pinnacle of Wall Street, he had his own investment inspiration: Benjamin Graham. It was Graham's renowned book, "The Intelligent Investor", that inspired Buffett to become an investor, and Graham who served as a mentor to Buffett, first as Buffett's professor at Columbia University and later as his boss at Graham's New York investment firm. And Buffett was certainly not alone in his reverence for Graham, who has become known as the "father of value investing".
Much like his famous protégé, Graham (1894-1976) was a thoughtful bargain hunter who never bought stocks on whims or hunches. His method, which produced a sterling 20 percent annual return over two decades, is the basis for one of my most successful "Guru Strategies", computer models that are each based on the philosophy of a different investing great. Since its July 2003 inception, my portfolio of Graham-type stocks has gained more than 180 percent, more than three times the gains of the S&P 500.
Much of Graham's approach is reflected in the way he defines the two main words that make up the title of his famous book, "The Intelligent Investor". To Graham, an "investor" wasn't someone who bought and traded stocks simply because he thought the market or the individual stock's price was about to go up; someone who did that was a speculator, and to Graham their hunch-playing trading was a recipe for ruin. "The people who persist in trying it," he said of such trading, "are either (a) unintelligent, or (b) willing to lose money for the fun of the game, or (c) gifted with some uncommon and incommunicable talent. In any case, they are not investors."
To Graham, an investment wasn't something that could be turned into quick, easy profits, because anything that offers quick and easy profits also comes with substantial risk. Investment was instead something that took a lot of research and study, something that was as much about protecting your initial capital as it was about making profits off of it. True "investment", he wrote, deals with the future "more as a hazard to be guarded against than as a source of profit through prophecy."
The other main word in his book's title -- "intelligent" -- also holds some major clues to Graham's take on investing. He doesn't use the word as a reference to someone who is shrewd or gifted with unusual foresight or insight; such people are few and far between. Rather, he says, "Successful investment may become substantially a matter of techniques and criteria that are learnable, rather than the product of unique and incommunicable mental powers. … The intelligence here presupposed is a trait more of the character than of the brain."
The message: Far more often than not, great investors are made, not born. And to Graham a big part of how they are made involved developing a willingness to think differently from the crowd, by distinguishing themselves "in kind -- not in a fancied superior degree", from the trading public, which by and large reacts emotionally to short-term price fluctuations. To beat the market, Graham believed that you couldn't just play the game better than the masses -- being a better speculator than others doesn't change the fact that you're a speculator. Instead, Graham believed that you needed to play the game differently. And to him, that meant focusing not on price fluctuations, but on a company's intrinsic value.
Start with sector and sale
The question, of course, is how one can measure the intrinsic value of a share of stock, and the answer is a big part of the strategy that I base on Graham's writings. But before we get into those details, there are a couple of broader criteria that are key to Graham's approach.
First, Graham lived in an era when technology was far less developed -- and a far riskier investment -- than it is today. His focused a great deal on avoiding risk and preserving your original investment, so he avoided tech stocks. While today's reliance on technology makes tech stocks not quite as risky nowadays, they are excluded from my Graham-based model.
Second, Graham focused on large, prominent companies, believing that they tended to have less volatile stocks, larger assets and fewer negative surprises, and better track records than their smaller counterparts.
Graham acknowledged that "large" and "prominent" can be difficult to define, but he suggested that thresholds of $50 million in assets or $50 million in sales should be used. My model focuses on the latter. (Prices, of course, have changed a great deal from Graham's day, and I equate Graham's suggestion to a modern-day figure of $340 million in trailing 12-month sales.)
An example of a company that meets these initial criteria: Leggett & Platt (LEG), a Missouri-based firm that manufactures a variety of components for everyday products, such as box springs and foam used in bedding, shelving used in retail stores, and aluminum used in barbecue grills. A member of the consumer sector, Leggett & Platt is not a technology company, and the firm has posted more than $5.3 billion in trailing 12-month sales, passing both of these initial tests.
Judging value
Now let's return to the core of Graham's philosophy, the way to properly value companies and their stocks. Graham believed that when buying a share of stock, you should focus on the kind of "real" value that you'd look for when buying a stake in a private company. And if you were buying a stake in a private firm, one way you'd value your investment was by comparing the value of the company's assets to the value of its liabilities. Naturally, Graham liked it when a company's assets were more than its liabilities, and the model I base on his writings requires a firm's "current ratio" -- the ratio of its assets to its liabilities -- to be at least 2. This indicates that the firm has liquidity, and lower risk of getting into financial trouble.
Leggett & Platt scores well in this regard. Its assets are 2.53 times its liabilities, indicating that the firm is in good financial shape.
When buying part of a private company, another issue you'd be wise to look at is debt. Graham didn't want companies to have excessive long-term debt, and the method I base on his approach calls for a firm's long-term debt to be no greater than its net current assets (its assets minus its current liabilities). In essence, the investor should ask himself, "If this company were to liquidate its assets today, would it be able to pay off all its short-term liabilities and long-term debts?"
In the case of Leggett & Platt, the answer is yes. The company's long-term debt is $1.05 billion, but its net current assets are $1.17 billion. It passes this test.
One note: Graham's methodology focused in part on having low debt, so financial firms (which inherently have a lot of debt because of the nature of their businesses) are excluded from my Graham-based model.
Earnings and price
After determining what a company's "real" value was, Graham targeted stocks that he thought were worth substantially more than their market values. Eventually, he thought, Wall Street would recognize that these stocks were being undervalued and buy them; that meant that even if the company performed worse than hoped, its stock price drop would be tempered, or even negated altogether, by investors adjusting to its previous undervaluation. He called this gap between a stock's real value and its market value the "margin of safety" because of that built-in protection.
In terms of identifying good values, one thing Graham looked for was a moderate price-to-earnings ratio; my method considers "moderate" to be no greater than 15. It's important to note that while most people use trailing 12-month earnings in determining the "E" part of the P/E ratio, Graham preferred to use the average of the last three years' earnings. This expanded timeframe gave the risk-averse Graham a more conservative idea of what he could expect a company's earnings to be. Using that standard, Leggett's P/E is 13.7, passing this test.
Another way Graham compared a company's real value to the value ascribed to it by Wall Street was through the price/book ratio. This divides the stock's price by its book value (tangible assets less liabilities). Leggett's P/B ratio is 1.43. My Graham-based model takes that figure and multiplies it by the stock's P/E ratio; if the result is less than 22, the stock is a good value. For Leggett, the P/B times the P/E equals 19.6, which makes the grade.
While Graham is known as the "father of value investing", growth did play a role in his stock picks. But unlike many other investors, Graham wasn't concerned with using historical earnings growth as a means to predict strong future growth. Instead, he used growth as another indication of financial stability. My Graham-based model looks for signs of growth, requiring a firm's earnings to have grown by at least 30 percent over the past 10 years, with no negative EPS years in the last five years. (Again, this isn't an indication that the company's earnings will jump dramatically in the future, but instead a sign that the firm has been a consistent, solid performer -- the type of lower-risk investment Graham liked.) Leggett's total growth over the past ten years: 38.4 percent, with no years of negative growth in the past five years, passing this test.
Because he guarded so closely against risky picks, Graham's approach was highly selective. Appropriately, my Graham-based method currently has strong interest in just 13 stocks besides Leggett. Here's a look at a few that make the grade:
Foot Locker (FL): This New York City-based sneaker and athletic apparel store has more than 2,000 stores in more than a dozen countries, including about 1,400 in the U.S. It also has the kind of high sales -- $5.68 billion over the past 12 months -- that my Graham model likes. Its assets are also 3.31 times its liabilities, and its net current assets ($1.47 billion) easily exceed its long-term debt ($216 million).
JAKKS Pacific (JAKK): Based in California, JAKKS makes a wide variety of children's toys and leisure products. It has taken in $787.7 million in sales over the past year, and is among the top five U.S. firms in the toys and leisure products sector. Its assets are 4.22 times its liabilities, and its debt -- a mere $98 million -- is much less than its $292.1 million in net assets.
Encore Wire Corporation (WIRE): This Texas-based firm manufactures a range of copper electrical wire used inside homes, apartments, manufactured housing and commercial and industrial buildings. It has trailing 12-month sales of almost $1.23 billion, and its current ratio is very impressive, with assets being 7.19 times its liabilities. In addition, the company's P/E is relatively low (9.30). And when that P/E is multiplied by its price/book ratio of 1.73, we get about 16.09, which comes in under my Graham method's 22 maximum.
Stick to the numbers A key part of buying undervalued stocks, as Graham did, is that such stocks are by definition unpopular in the investment world. In that sense, there's a pattern developing in the broader approaches of the gurus I've examined over the past couple months. Decades before the likes of Buffett and Peter Lynch and David Dreman advocated sticking to a proven quantitative approach -- even when other investors shun the companies you believe in -- Graham wrote: "[The investor] must be relatively immune to optimism or pessimism and impervious to business or stock-market forecasts. … Have the courage of your knowledge and experience. … You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right."
Graham understood as well as anyone -- and perhaps before anyone -- the crowd mentality of the stock market, where most people get swept up by their emotions, buying popular stocks (those whose prices are rising) and selling unpopular stocks (those whose prices are falling). Such people are in essence making decisions based on what others think of a stock, rather than on hard facts and data. Graham, like those gurus who followed him, knew such emotional reactions were a recipe for failure. He carefully researched his stock picks and did what he believed was right regardless of whether it was popular. If you're willing to do the same, your portfolio should reap the benefits.
Published by Globes [online], Israel business news - www.globes.co.il - on October 18, 2007