“Buy not on optimism, but on arithmetic.” – Benjamin Graham
While he is widely known as the “father of value investing”, I think it’s far more appropriate to call him the “father of fundamentals-based investing”. While it’s wordier and not as catchy, it’s an important distinction in a polarized world where “value investing” has become a bit pigeon-holed; probably driven by zealots and self-appointed purveyors of Ben Graham’s teachings.
Most people would agree that probably the first thing that pops in your mind when you think of Graham is – “margin of safety”. The margin of safety is the concept of buying securities at a discount to its intrinsic value; simply put – can I buy a Rs 100 note for Rs 80 or lower. Investors usually butt heads on how to compute this intrinsic value.
Their primary method to compute intrinsic value is DCF of “discounted cash flow” analysis. Almost everything else is simply heuristics (PE, EV/EBITDA etc.) – derived metrics that have displaced the mother ship in popular media.
DCF is a hard nut to crack. Not because it involves some complex math – look it up online, its disarmingly simple for anyone with a basic background in finance. In fact, it’s this simplicity that belies the true issue.
It requires an analyst to make several assumptions regarding the underlying business. In its purest form, projecting free cash flows for 30-40 years. That is tough even with the best of intentions, but a general lack of discipline and in-built biases mean that most analysts manipulate assumptions that makes the whole thing a waste of time and ink. Just to reiterate, the problem lies not with the method but with analysts who are not disciplined enough to implement it. Hence, computing intrinsic value will be something that will remain a contentious issue, especially between “value-oriented” and “growth-oriented” investors.
Graham’s most popular bets (christened as “net nets” by his followers) were where the market cap of the company is LESS than the net liquid assets on the balance sheet. These types of opportunities are not readily available to most investors today. However, that does not mean that “low” PE stocks (typically, value investments) are in line with Graham’s teachings and “high” PE stocks (typically, growth investments) are not; it is all about intrinsic value. It is not a given that a single-digit PE stock is trading at a discount to its intrinsic value.
For non-professional investors, one of Graham’s most useful illustrations is the personification of the stock market as “Mr. Market”. Mr. Market, an imaginary friend or business associate to every investor, offers daily prices for shares in a business. Through Mr. Market, Graham conveyed that wild gyrations/volatility in the markets are often driven by the manic or depressive emotional states of its participants.
Instead of falling prey to herd mentality and letting Mr. Market’s prevalent emotional state bias your decision making, an investor must look at her investments rationally. In fact, if you have the tools and resources maybe even take advantage of Mr. Market’s shortcoming i.e. if Mr. Market is looking to buy hyped-up, overvalued shares, sell it to him, or vice versa.
In fact, Graham gave everyday investors the most effective tool to protect themselves from the vagarities of Mr. Market – “dollar cost averaging”. It simply means “investing a set dollar amount in the same investment at fixed intervals over time” or as we popularly know it in India – Systematic Investment Plans or SIPs.
Asset allocation is another important takeaway from Graham. Appropriate distribution of savings across equity and fixed-income products is important for principal protection over the long term and making sure one has easy access to capital when needed.
An important distinction that Graham elucidated well was between “investing” and “speculation”. While “investing” in equities one must think of herself as a part owner of a very real business (or businesses in the case of index investing) and hence daily prices quotes should not matter as much. Short-term trading and trying to take advantage of price movements is what he termed as “speculation”. This is especially relevant today, given the spurt in new brokerage accounts over the last year.
In my view, a non-professional investor should view speculation in stocks or cryptos as nights out at a casino. It may be prudent to only dabble with small sums that they are willing to lose in their entirety. Don’t expect regular income, just some entertainment.
Graham is my guru in every sense of the word. I had no background in finance or investing when I picked up “The Intelligent Investor” almost 15 years ago. It led me to Graham’s other seminal work “Security Analysis”, meant for professional investors. They are the inspiration and spark behind the idea for my investment firm (PMS) – Upside AI.
I don’t mean to sound like a zealot, but I think “The Intelligent Investor” in some form should be incorporated in school curriculums. It empowers its readers with a robust framework for arguably the most important resource in their lives.
Disclaimer: The views and investment tips expressed by investment expert on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.