What is Benjamin Graham’s Value Investing? (And Its 6 Core Principles)
Value investing is an investment strategy firstly introduced by Benjamin Graham at Columbia Business School in 1928. It usually involves buying securities (stocks, bonds…) which appear to be underpriced by fundamental analysis.
In order to identify whether a given security is underpriced or overpriced, the true intrinsic value has to be estimated. When the intrinsic value is below the market price (this is the price shown in the stock market for instance), the security is overpriced. If the intrinsic value is above the market price, the security is underpriced.
To sum it up, we have two security prices:
- The true price also called intrinsic: not reported
- The market price (“the known price”): reported
Despite the fact that this philosophy of investing is pretty simple to understand. The actual execution is much more difficult. Probably, the most known value investor is Benjamin Graham’s student, Warren Buffett. Others are Guy Spier, John Templeton, Michal Burry, and Mohnis Pabrai to name a few.
Are there any universal principles of value investing?
I’ve been interested in value investing for some time now. At first, I began reading biographies and autobiographies of famous value investors and their archived annual newsletters for their shareholders. Personally, I feel like almost all of them were trying to copy Warren Buffett though at the same time adding something of their own.
There is, for example, no doubt that the expertise of each individual varies and therefore a different value investor might focus on different opportunities in his or her circle of confidence.
There are, however, certain rules which in my opinion are almost like the Bible for each value investor.
1. PRINCIPLE: Intrinsic Value Vs. Market Value
I’ve already talked a bit about this above, but I want to explain it one more time using a real life example. Let’s say you want to buy a book and so you go to the bookshop. You see that the price of the book is 20 dollars (the market price). Assuming you don’t get the Alzheimer’s disease (knocking on wood), the inspiration, motivation, knowledge, and information you get, can last the rest of your life. We can safely conclude that the intrinsic value of this book is higher than the market price of 20 dollars.
On the other hand, if I buy a nice pair of shoes, maybe a limited edition of Michael Jordan, I’ll most likely pay much more than the intrinsic value of the shoes is. As I see it, shoes depreciate very quickly and their function is to keep my feet warm and protected. A limited edition of any shoes might cost +100 dollars and this is just a way above the true value. To buy and not wear limited edition shoes is a different story, I have never done it but I expect they might be sold for a higher price a few years later.
Start a habit of thinking in terms of the real intrinsic value while buying things.
A value investor never buys a stock by just looking at the market price. Warren Buffet said that he didn’t want to be influenced by the market price so he hadn’t looked at it until he calculated the intrinsic value first.
2. PRINCIPLE: Efficient Market Hypothesis (EMH) is incorrect
EMH is an economic theory which says that stock market prices already take all the information into consideration. This basically means that no arbitrage is possible – there is nothing like free lunch. If markets are perfectly efficient, then any deviation of a stock market price is immediately balanced back to its intrinsic value.
There is a famous financial joke about EMH, it goes something like this. There are two friends walking in the street and one of them sees a 100 dollar banknote next to a trash. He says: “Wait a sec, I am going to pick it up.” “Don’t bother, if it was a real 100 dollar banknote, someone would’ve already taken it”, replies his friend (a proponent of EMH).
A value investor believes that the efficient market hypothesis is unrealistic. Markets can’t be efficient because people are not 100% rational, opponents of EMH argue. The perfect rationality assumption is used in economics almost all the time, yet it’s very restrictive and most of the times not applicable in the real world.
Here’s a great article published by Business Insider, which talks about Warren Buffett and his speech on EMH from 1984.
3. PRINCIPLE: Value investors don’t follow the masses
As we said in the previous principle, value investing is not about making decisions based on emotions. It might be tempting to buy a stock when everyone else is buying it. But, bear in mind that most likely that stock is heavily overpriced. Currently, a good example is Tesla, Inc. (TSLA), which is today trading at around $355 a share (31.8.2017).
Personally, I wouldn’t buy a single share even if the price per share of this stock plummeted to half. There are many reasons why I wouldn’t. One of them is that the market value of Tesla, Inc. is most likely highly above the intrinsic value of the company. In my opinion, the market price has been driven up by emotional investors who were completely sold by Elon Musk’s personality and his clever marketing.
If you have a look at my personal goal list, you can paradoxically see that one of my goals is to buy a Tesla car. I love those cars, I feel like being inside an iPhone. But, would I invest in this company? No way, it just does not make sense from the value investing point of view.
4. PRINCIPLE: Your Margin of Safety
Having a margin of safety is important in value investing. Let’s say you find a depressed company which has a good management and a good projected growth. The company is currently being sued for some reason and that’s what has driven its market price down (let’s say $50 a share). You believe that the company will end up paying a small fine, which does not reduce its ability to produce in the future. It’s a bargain. You think the intrinsic value is around $100. In this case, your margin of safety is $80 (ratio 1/2).
It’s important to have your margin of safety because you’re limiting your potential loss in case of something unexpected happens or the estimate of intrinsic value is a bit off. In the example above, even if the stock doesn’t rise to its full intrinsic value of $100, you still make a profit.
Benjamin Graham says, in his book, Security Analysis that he only bought stocks when they were priced at 2/3 or less of their intrinsic value. Hence, he would buy our hypothetic stock.
5. PRINCIPLE: Value Investing Is a Long-Term Strategy
Although value investing is a relatively high return strategy, you have to be patient. It’s not about buying a stock in the morning and selling it in the afternoon for double. Most value investors buy stocks intending to hold them for at least 3 years. They are, of course, some exceptions, but this is usually what happens.
The reason for it is following. Long-term capital gains are taxed at a much lower rate. In fact, in the Czech Republic, where I live, after 3 years you pay no tax on capital gains. Moreover, value investing is all about finding a cheap company that has a high potential for growth. The growth does not occur over night.
6. PRINCIPLE: Continuous Learning and Researching
Value investors love learning and researching about the area of the market they want to invest in. Besides knowing basic financial ratios, you have to understand the macroeconomic’s trends that affect the financial world.
When evaluating a certain stock, there is a lot of research that has to be done. It’s almost as if you were a detective. You have to find all publicly available information and solve the case to find out whether the intrinsic value is higher or lower than the market price.
It’s important to note here, that some value investors prefer to stick with the data and financial statements. Others like to talk to the managers of the company they are valuing to see whether the company is led by crooks or competent people.
What’s necessary is to do your homework about the stock you want to buy or possibly short-sell.