Sunday, 22 April 2012

Benjamin Graham and his 9 commandments of value investing


Janet Lowe, in her biography of Ben Graham, notes that while his lectures were based upon practical examples, he had a series of maxims that he emphasized on investing. Because these maxims can be viewed as the equivalent of the 10 commandments of value investing, they are worth revisiting:

1. Be an investor, not a speculator. Graham believed that investors bought companies for the long term, but speculators looked for short-term profits.

2. Know the asking price. Even the best company can be a poor investment at the wrong (too high) price.

3. Rake the market for bargains. Markets make mistakes.

4. Stay disciplined and buy the formula:
E (2g + 8.5) (T.Bond rate/Y)
where E = Earnings per share, g = Expected growth rate in earnings, Y is the yield on AAA-rated corporate bonds, and 8.5 is the appropriate multiple for a firm with no growth.

For example, consider a stock with $2 in earnings in 2002 and 10 percent growth rate when the Treasury bond rate was 5 percent and the AAA bond rate was 6 percent. The formula would have yielded the following price:
Price = $2.00 (2 (10)+8.5)* (5/6) = $47.5

If the stock traded at less than this price, you would buy the stock.

5. Regard corporate figures with suspicion (advice that carries resonance in the aftermath of recent accounting scandals).

6. Diversify. Do not bet it all on one or a few stocks.

7. When in doubt, stick to quality.

8. Defend your shareholder’s rights. This topic was another issue on which Graham was ahead of his time. He was one of the first advocates of strong corporate governance.

9. Be patient. This follows directly from the first maxim.

It was Ben Graham who created the figure of Mr. Market, which was later much referenced by Warren Buffett. As described by Mr. Graham, Mr. Market was a manic-depressive who did not mind being ignored and was there to serve and not to lead you. Investors, he argued, could take advantage of Mr. Market’s volatile disposition to make money.

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