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Course 506
Great Investors: Benjamin Graham

Introduction

You're ready to build a stock portfolio that's right for you. Now, we'll take a look at how great investors of the past and present have picked stocks and built their own portfolios. Benjamin Graham is probably the most famous value investor in history, but not for any performance record set while managing a mutual fund. Graham is credited for the success of one of his well-known disciples, Warren Buffett, the creator and longtime chairman of Berkshire Hathaway BRK.B. By following Graham's teachings (and adapting some stock-picking principles of his own), Buffett has made Berkshire one of the most successful investment vehicles of all time. We'll talk more about Buffett later. Here, in a nutshell, is Graham's approach.

Seek a Margin of Safety

A lecturer at the Columbia School of Business during the 1930s, Graham detailed his investment philosophy in two classic books: Security Analysis (co-authored with David Dodd in 1934) and The Intelligent Investor (first published in 1949). These books expand on Graham's definition of a cheap company, which is based on a principle he calls margin of safety. Margin of safety simply means buying companies that are cheap relative to their intrinsic worth, or what the company would be worth if the entire business were sold. The thinking is that if the company doesn't rebound, you can cut your losses with minimal harm. Graham bought businesses that were so cheap, so battered, and so neglected, that they sold for less than the value of their working capital, which is current assets minus current liabilities. Graham's argument was that even with the best research, investors can never know all there is to know about a company. More importantly, investors can't always predict the negative surprises that can zap a stock price. So Graham championed this idea of margin of safety.

Favor Big Companies with Strong Sales

An investor during the Great Depression, Graham saw once-thriving, smaller firms fall by the wayside as their sales grew smaller and smaller. Based on his observations, he discerned that if a company had at least $100 million in revenues it had a better chance of surviving. (That would translate into about $1 billion in sales today. Remember that Graham's books were written in the 1930s and 1940s, so think in terms of what $100 million meant back then.) His rationale was that tiny companies have a harder time cushioning the blows of an economic downturn, so it's best to invest in larger companies.

Seek Dividends

Graham was adamant about seeking dividends. In fact, he believed that conservative investors (like himself) need only consider companies that have paid a dividend every year for at least 20 years. Not only are dividends a sign that a company is profitable (they are paid from profits, after all), but they also offer investors a return even if the company's stock is performing poorly.

Choose Companies That Are in Good Financial Shape

Graham looked for what people today refer to as "net-nets," or companies whose current assets exceed the sum of current and long-term debt. Graham was always mindful of liquidity. His thinking was that companies with ample liquidity (access to cash) were less risky because their assets could always be sold to raise cash.

Look for Companies with Sustainable Earnings Growth

Graham always sought companies with an upward earnings trend, but profits didn't necessarily have to rise every year. They just couldn't be regressing. Graham felt that steadily improving earnings would lead to improving stock performance.

Pay Attention to Price Multiples

Graham searched for companies with price/earnings ratios below their historical average. Moreover, he wouldn't buy a stock unless it was trading for less than 1.2 times its book value per share. (A simple equation for book value is assets minus liabilities.) So, for example, a company with $2 billion in assets and $1.6 billion in debt has a book value of $400 million. If the company has 20 million outstanding shares of stock, then the book value of each share is $20 ($400 million divided by 20 million). Using Graham's own formula, he wouldn't pay more than $24 per share for that company's stock (1.2 times the book value per share). Some may find it difficult to replicate Graham's investment style in this day and age of overvalued, profitless, and sometimes debt-ridden Internet startups. Even Buffett has said that were his mentor alive, he would have a hard time finding stocks to buy. But the father of value investing (as Graham is often called) would not have succumbed to the pressure. Even at today's price levels, Buffett insists that Graham would have found some bargains.

Quiz 506
There is only one correct answer to each question.

1 What famous book did Graham co-author with investor David Dodd?
a. Security Analysis.
b. Security Angst.
c. The Intelligent Investor.
2 Which description is closest to Graham's philosophy of "margin of safety?"
a. Investors should look for stocks with glamorous growth projections.
b. Investors should look for stocks that are dirt cheap.
c. Investors should look for stocks with high returns on invested capital.
3 Why did Graham favor bigger companies, "big" meaning a company's sales?
a. Should the economy go south, a company with a larger sales base has a better chance for survival.
b. The bigger the company the better chance that its stock will go up.
c. Bigger companies usually have better profits.
4 According to Graham's principles, in what way does a company's asset size matter?
a. The bigger the assets, the better the profits.
b. The bigger the assets, the more investors the company draws.
c. Assets can always be sold to raise money fast.
5 Who was Graham's most famous apprentice?
a. Warren Beatty.
b. Warren Buffett.
c. Jimmy Buffet.
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