“Walter Lippmann spoke of men who plant trees that other men will sit under. Ben Graham was such a man.” (Warren Buffett, preface of The Intelligent Investor)
For those unfamiliar with Benjamin Graham, some background to get us started. Graham graduated from Columbia University at the ripe old age of 20. He started his career on Wall Street and went on to found an investment firm (the Graham-Newman Partnership) and to teach at Columbia University.
Graham’s first book, Security Analysis, is credited with single-handedly creating a field in security analysis, as well as bringing structure to investing itself. He followed up that book’s success with The Intelligent Investor, which Warren Buffett has dubbed “by far the best book about investing ever written.” (I can just see the Amazon sales rising as I write this.)
But we don’t have to take Warren’s word for it. Let’s dive into Graham’s secrets to investing success, starting with what it really means to be an intelligent investor.
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
Here, Graham is talking about “defensive investing.” Defensive investors reach their long-term financial goals by being sustainably and reliably right. So, your clients might have some questions! To break it down for them, focus on the importance of finding a balance between controlling risk and maximizing gains, as well as curbing the self-defeating behavior that can reduce portfolio returns.
For example, mechanical formulas for higher stock performance (e.g., the January effect) may cause investors to pile in, create a crowded trade, and ultimately lead to underperformance. This is just one example you can use to illustrate how it doesn’t always make sense to follow the crowd. After all, being an intelligent investor isn’t about IQ. It is about learning to harness emotions and think for yourself—a perfect segue into the next lesson.
“With every new wave of optimism or pessimism, we are ready to abandon history and time-tested principles, but we cling tenaciously and unquestioningly to our prejudices.”
Investors’ emotions in volatile markets may tempt them to abandon time-tested investing principles. How can you help them control those knee-jerk tendencies? Once again, Graham recommends a defensive investing strategy:
- Start with a 50/50 portfolio design composed of high-quality stocks and bonds (Graham defines high quality as stocks and bonds of important companies with long records of profitable operations and in strong financial condition.)
- Hold up to a maximum of 75 percent in stocks as the market drops or a minimum of 25 percent in stocks as the market rises (Buy low and sell high—otherwise known as the rule of opposites.)
Many clients start to worry in a bear market. But using Graham’s rationale, the intelligent investor may actually welcome a bear market as an opportunity to buy low. Other time-tested strategies you might suggest include buying funds over individual stocks and dollar-cost-averaging into the market.
“It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity. . . . For, if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment.”
Graham’s true secret of sound investment is captured in the quote above: the margin of safety. The margin of safety is dependent on price paid—defined as the favorable difference between price, on one hand, and the indicated or appraised value, on the other. To help your clients determine the appraised (also known as intrinsic) value of a stock, Graham recommends finding companies that meet the following margin of safety criteria:
- Market cap of more than $2 billion; no small-caps except through a small-cap index fund
- Strong financial condition; current assets are 2 times liabilities; long-term debt less than net current assets
- Continued dividends for at least the past 20 years
- No earnings deficit in the past 10 years
- 10-year growth of at least one-third in per-share earnings
- Stock price not more than 1.5 times net asset value
- Stock price not more than 15 times average earnings of past 3 years
In actuality, all the factors that determine the margin of safety could fill an entire book (e.g., Seth Klarman’s Margin of Safety). But if you don’t want to get too into the weeds, the overriding philosophy is this: there really is no such thing as a good or bad stock. Instead, clients would be wise to think of stocks as either cheap or expensive.
“There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham . . . will continue to prosper.” (Warren Buffett, appendix of The Intelligent Investor)
Investing involves uncertainty and risk—two things many clients aren’t naturally comfortable with. But with some guidance supplied by the rules and best practices advocated by Graham, you can help your clients become intelligent investors and achieve their investment goals.
What other key lessons do you use to help your clients become intelligent investors? Are there other books you would recommend? Please share your thoughts with us below.
This post is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation. Investments are subject to risk, including the loss of principal.