Warren Buffett, the Oracle of Omaha, is a household name. Fewer, though, have heard much about Benjamin Graham. In fact, it was under the able tutelage of the unassuming Graham that Buffett mastered his art. Graham’s timeless classic “The Intelligent Investor” stands out as a comprehensive value investing manual, even seven decades after its publication in 1949. If you’re interested in becoming a successful value investor (not a speculator or trader!), Graham’s principles are as good a place to begin as any. Here are three timeless investment maxims from the great man that are as relevant today as they were in Graham’s heydays.
Principle 1 – Know Yourself
Are you aware of your risk tolerance and risk appetite, or do you tend to rush into investments headlong without giving them much thought? Graham considered ‘self-awareness’ to be a critical aspect of successful value investing. He categorised investors into two primary types, namely – ‘enterprising’ and ‘defensive’. Enterprising investors are higher risk takers who are willing to devote more time and energy to the process of selecting securities. “The determining trait of the enterprising investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average”, writes Graham. Defensive investors constitute those with relative inexperience, lower risk tolerance levels, or lesser time and energy to devote to the craft. Enterprising investors can consider deep value stocks and small & mid cap stocks, whereas Defensive investors should stick with blue chips, and maintain a relatively higher allocation to bonds and debt funds.
Principle 2 – Know Mr. Market
Volatility has most investors running for the hills in panic, but Graham had other views about it. He believed that profit opportunities result from the volatility that is intrinsic to capital markets. Graham likened equity markets to a rather erratic and persistent individual whom he called “Mr. Market”. It is the nature of Mr. Market to aim to buy stocks from you at bargain basement prices when sentiment was weak, and at vastly inflated prices when market morale was more buoyant. He advised investors to not be swayed by Mr. Market, but follow a disciplined approach instead. Graham proposed two ways of outwitting Mr. Market. The first was to employ “dollar cost averaging” by purchasing a fixed dollar (or rupee) amount of a pre-planned stock each month. The second was to follow the principle of maintaining a fixed allocation between “stocks and bonds”, and rebalancing periodically against the grain, in a manner that dynamic asset allocation funds do.
Principle 3 – Margin of Safety
Graham believed that the principal task of a securities analyst was to arrive at a ‘fair value’ or ‘intrinsic value’. If you’re just starting out as a value investor, you should begin by formulating your model for evaluating a security and arriving at its intrinsic value. For instance, some analysts use the formula “V = {EPS x (8.5 + 2g) x 4.4} / Y” to arrive at the intrinsic value of a share (this is known as the “Graham’s Formula”). “g” represents the expected annual growth rate, and Y represents the yield on 20-year AAA’s. Graham advised investors to invest in stocks which traded below this intrinsic value, terming this gap as the ‘margin of safety’ for that stock. He advocated a ‘wait and watch’ approach if the such stocks were largely unavailable, rather than jumping in with speculative trades.