It was Ben Graham who taught me how to invest. Sure, I had played around with stocks before him, but I didn’t really know what I was doing. His book, The Intelligent Investor, is a one-book course on investing by understanding value.I recommend (and link to) the most recent edition, which has the 1970 edition of Graham’s writing, plus a 2002 commentary by financial writer Jason Zweig. This swells the book to over 600 pages, but it is all useful. I will try to outline below a couple of Graham’s key points.
The most important point that Graham emphasizes is that because we cannot accurately predict the future, we must have an adequate margin of safety. That is, we do not buy a company when it is fairly valued, because there is no room for error. Rather, we buy a stock that is very undervalued; even if the business starts to do a little worse it will still be a great value.
There are two ways we can look at value in companies. We can look at value from the viewpoint of the present value of the future earnings of the company or we can look at the present value of the assets of the company.
Graham liked to buy companies that were trading below 2/3 of their net tangible asset value. You calculate net tangible assets by subtracting all the debts of a company from all ‘hard’ assets, such as cash, receivables, investments, property (while ignoring goodwill, patents, and other hard to value assets).
In buying a company trading at a fraction of its tangible asset value, we are in essence buying it for less than its assets; theoretically, we could close the company and sell off its assets and make a decent profit.
Graham was not usually looking to do this, but in buying a company like that, he knew that its price could not fall much further–if it did, someone would buy up a majority of the company and sell off its assets for a profit. This gave the investor a very small downside risk but a lot of chance for a large profit on the upside.
Companies selling for less than their assets are rare nowadays, although if we wait until the next bear market, we will be able to find some and profit from them. In the meantime, though, we will most often buy companies that are undervalued in terms of their earning potential.
Another important point that Graham made is that, for an intelligent investor, there should be no difference between ‘growth’ and ‘value’ investing. If a company is increasing its earnings at a rapid pace, then its present value will be higher than a company that is not growing.
Thus, a rational value investor will be willing to pay more for a fast-growing company than for a slow-growing company. The problem with most so-called ‘growth’ investors is that they are willing to pay so much for stellar growth that they are left with no margin of safety. During the internet stock bubble, companies such as Yahoo [[YHOO]] and Amazon.com [[AMZN]] sold at astronomical P/E ratios. If you had bought Yahoo in late 1999 and held until today, you would have lost over half your money. Buying Amazon would have netted you a small loss–better than Yahoo, but not good considering it has been 8 years since 1999.
Even today, with P/E ratios of 44 and 108, these companies are not cheap. Most likely holding them for the next few years will not be a great investment.
While a company with a high valuation may continue to grow impressively, if its growth starts to slow even a bit, the stock will get hammered. This is why we stay away from overvalued companies, no matter how good they are. There is just too much risk.
Well, in one page I cannot do Ben Graham justice. Buy his book. If you buy only one investment book, this should be it.
Disclosure: I am neither long nor short any of the stocks mentioned above. I own The Intelligent Investor. See my disclosure policy.