Bottom-up investing

Although he's often acclaimed as the father of value investing, Benjamin Graham has a surprisingly low profile. We tend to remember him during bear markets when stockmarket speculation is deeply unfashionable and bargain stocks abound.

Security Analysis, the textbook Graham wrote in collaboration with David Dodd, a colleague at Columbia University, is the bible of investing basics.

Graham started as a messenger on Wall Street in 1914, amassed a fortune by 1929, lost most of it in the Wall Street Crash, recovered by 1937 and retired in 1956 with an unrivalled reputation.
He thought a company was worth no more than the value of the assets it owned, or a generous fraction of its earning power. Those who paid more for a share in a company than it was worth weren't investing, they were speculating, and so were people who bought shares in unproven or troubled businesses of dubious value.

Companies are speculative because they are highly indebted or have a poor record of profitability. Prices are speculative because enthusiastic buyers create more demand for the shares than they really warrant.

Investors, Graham said, avoid speculation and focus on sound companies selling at low prices. He called them "bargain issues".

Graham was so cautious about his own ability and the uncertain stockmarket that he built in a margin of safety, preferring to pay even less than a company's net asset value per share or demand a high return, in terms of profits, for his investment.

Graham preferred to take the average of at least five years of profits - and preferably 10 - to calculate a company's earning power because a single year's profits can be unusually good or bad. An average of 10 years should include the peaks and troughs of the business cycle and provide a more accurate estimate.

To establish whether a company's shares were cheap or expensive, he divided the current price by the average earnings to give the price/earnings (p/e) ratio.

If you can do it the other way and divide the earnings by the price and express it as a percentage, you get the earnings yield, which can, in theory, be compared to an interest rate as a rough and ready indicator of the return an investor can expect.

As Graham refused to overpay for shares, a p/e share of 16, equating to an earnings yield of just over 6%, was his maximum and he preferred to buy shares with a p/e ratio of less than 10, giving an earnings yield of 10%. He didn't think it was worth investing in shares for less than 6% and 10% gave him his margin of safety.

His ideas created the 'value' style of investing, and investors and funds that use methods derived from Graham often apply the value tag to themselves, if only to distinguish their style from growth investing, which Graham described as 'fantasia' and 'pre-scientific'.

Growth investors, he said, are fixated on performance and the elaborate methods analysts concocted to forecast future profits were nothing more than speculation with a veneer of doubtful mathematics.

It's a criticism still made of modern methods like discounted cash flow, where assumptions about future growth and interest rates wildly affect the result. Since we can't see the future, Graham thought it best to make his results independent of it, thereby absolving the investor of performing any calculation beyond basic arithmetic.

Graham's critics, and even disciples such as Warren Buffett, counter that Graham's bargains are often cigar-butt companies: old companies, often in declining industries, from which it's possible to draw one or two last drags.

Graham might argue that it doesn't matter as long as you make a good return, but he recognised that when prices are low even great companies become affordable.

Critics also complain that the price of shares is so high most of the time, that often very few companies meet his strictest criteria. This is true of his favourite situation: companies selling at less than two thirds the value of their net working capital, also known as net-nets.

By net working capital Graham meant the current assets of a company, the value of its stocks, cash in the bank and debtors minus all its liabilities.

Having disregarded the fixed assets of the company such as property, equipment and intangibles that might be worth very little if it went bust and had to be sold quickly, Graham found that companies with shares priced below the value of their net working capital (per share) were often cheaper than estimates of their liquidation value.

A private owner would never sell at such low prices, but Graham found so many bargains on the stockmarket that he invested in little else most of the time. Companies at such low prices, he reasoned, would turn themselves around, succumb to bids, or liquidate at a profit to the shareholder.

The problem for modern value investors is that Graham was investing during the Great Depression and its aftermath. In prosperous times net-nets are difficult to find and it might not be possible to make a diversified portfolio of 20 or 30 shares, as Graham recommended.

Although net-nets tend to recover strongly, individually they are more likely to go bust, perhaps even catastrophically, leaving investors with nothing. Therefore buying a handful of net-nets is risky.

Shortly before his death, Graham devised new criteria for value investment, which he would use when net-nets were scarce. He recommended companies that were cheap, returning cash to their shareholders and not becoming laden with debt.
But is it wise to buy them in a recession when shares are cheap because their immediate prospects are bleak?

Psychologists in the relatively new field of behavioural finance are beginning to explain how investors trick themselves, seeing patterns in random information, placing too much confidence in their judgements and focusing on price and not what it is they're buying. When investors base their judgements on speculation, shares rise to irrational highs and fall to irrational lows.

Their theories vindicate Graham who said, in Security Analysis, that an investor should pay less than the 'intrinsic value' - the value justified by the assets, earnings, dividends and the definite prospects of a company... as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses'.

A disciplined investor avoids shares pushed up by waves of enthusiasm and buys the bargains, pushed down by despondency. Unlike speculators, who lose confidence when prices fall, value investors grow more confident.

This is an updated and abridged version of an article that first appeared in the January 2009 edition of Moneywise's sister publication Money Observer.

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