Is Benjamin Graham Still Relevant in 2015? by Evan Bleker, Net Net Hunter
Is Benjamin Graham still relevant?
I first heard of Benjamin Graham when reading Jason Kelly’s excellent investment book, The Neatest Little Guide to Stock Market Investing. At the time I had no idea how to invest, never mind what the price-to-earnings ratio was. I was a complete novice.
I found it interesting that someone who that had been in the investment industry so long ago could be regarded so highly entering the 2000s. Despite his popularity, I had lingering doubts. In the modern world of computers, instant data, and new economic conditions, was Graham’s advice now worth anything?
To answer this question, I’m going to unpack Benjamin Graham’s philosophy for you. Then, I’ll draw some basic implications of Benjamin Graham’s teachings and, finally, show you how classic Benjamin Graham styled value investing works in today’s markets. When we’re done, I’m going to show you just how well Benjamin Graham’s best strategy has worked for my portfolio over the last 4 years (Hint: it’s been nothing short of spectacular). Ready?
Essential Lessons from Benjamin Graham
To understand whether Benjamin Graham is still relevant today you really have to go back to the essential lessons or investment principles that Benjamin Graham taught. While Graham had a lot to say, I see these five principles as being the foundation of Benjamin Graham’s philosophy:
- Investing is most intelligent when it is most businesslike.
- Nobody can tell the future.
- The future is something to protect against.
- Investors are moved in large part by irrational forces.
- Mean reversion is a fundamental law.
1. Benjamin Graham on Intelligent, Businesslike, Investing.
Benjamin Graham famously said that investing is most intelligent when it’s most businesslike. At its core, this means that you have to recognize that a stock is just a fractional piece of a business that is traded on the public markets. Since businesses have a certain value intrinsic to them, any stock has an intrinsic value based on fractional ownership of the business the stock represents.
It’s obvious that businesses make more or less money each year but Benjamin Graham was steadfast in his conviction that over the long term stocks rise and fall based on changes in the value of the businesses they represent. If a business suddenly wins a new major client which adds profoundly to the bottom line, for example, then you can bet on the business being worth more because of that — and your shares should rise accordingly.
Likewise, Benjamin Graham also advocated that you exercise the say you have over business operations and management — it is partly your company, after all.
2. Benjamin Graham on The Future.
Despite what most people think, it is nearly impossible to tell what will happen in the future. Analysts spend a lot of time reading financial statements and looking at past trends to try to get a sense of what’s likely to happen in the future. Investors then use these predictions to determine which stock is a worthwhile investment. While the past record is the best way to assess what’s likely to happen in the future, it’s still not very reliable.
Network World has a great article called “Predictions gone wrong: Losing bets analysts made for 2013? which
showcases some of the predictions that analysts made about 2013 back in 2008. Let’s take a look:
Prediction A: The market for green IT services will peak at $4.8B in 2013.
Outcome: The recession destroyed any chance of that happening. Was the recession seen? Clearly not.
Prediction B: PC sales will double from 2008 to 2013 lead by laptops and netbooks.
Outcome: Net-what? Apple killed PC sales by introducing the iPad. Now the install base of tablets is expected to overtake PCs and PCs are expected to decline in computing market share — until something else disrupts the trend.
Prediction C: Mobile phones will overtake PCs as the most common internet-accessing device.
Outcome: PCs, despite the stagnant growth, are still well in the lead.
Prediction D: Symbian will claim 47% of the mobile operating system market while Microsoft will claim 15%
Outcome: I don’t even know what a symbian is. Windows has a 3.9% market share.
Benjamin Graham thinks predicting the future is nearly impossible.
The error rate of stock analysts has been well documented. In fact, as reported by Business Insider, in general analysts begin any given year predicting that earnings growth will be 14% over the next 12 months but predictions decline throughout the year, as assumed trends fail to materialize, finally reaching estimates of ~5% towards the end of the year. The Economist recently reported on a study done by Roger Loh and René Stulz who looked at a subset of analyst estimates from 1983 to 2011 — those made during falling markets. As it turns out, analysts made even worse earnings predictions during falling markets — nearly 50% worse!
It’s fairly clear that analyst predictions can’t compete with the forces of creative destruction — or even predict outcomes even 12 months away. Of course, Benjamin Graham knew this long ago which is why he told investors in the 1951 ed. of Security Analysis not to base intrinsic value on trends that have been extrapolated into the future. Since then, other great value investing books have come out to say the same thing.
3. Benjamin Graham on Protection.
Since the future is not knowable, it should not be relied upon to pick stocks.
Judgments of what will happen in the future are wrong just as often as they’re right. Often negative events can materialize that completely blindside you, as we saw in those 4 cases of creative destruction above. Instead of looking to the future to earn a profit, Benjamin Graham favoured protection from future negative events in order to reduce risk. The best way to do this is to look for multiple margins of safety when purchasing a stock.
Margin of safety is one of Benjamin Graham’s most famous concepts. Graham’s basic idea was that investors should seek out some margin of error that they can use to protect themselves from unforeseen unfortunate events. The best known analogy of Benjamin Graham’s margin of safety concept is that of building a new bridge. If you expect the bridge to hold 10 000 tonnes during peak hours you don’t build it to be able to hold 10 000 tonnes — you build it to hold 20 000 tonnes for safety’s sake. If it turns out that you were wrong about how much the structure could hold, or the amount of traffic passing over the bridge during peak hours, the bridge would still hold.
Despite what mainstream financial or economic theory preach, investors and business leaders are not perfect number-crunching machines.
Typically, value investors seek out Benjamin Graham’s margin of safety by buying stocks for less than they’re worth. This is the well known price-value discrepancy that value investors love to take advantage of. Since a stock is just a fractional piece of ownership in a business then the share certificate should reflect what that business is actually worth, its intrinsic value. Liquidity and the errors in human judgement mean that shares are sometimes priced either above or below a realistic assessment of their true intrinsic value. According to Benjamin Graham, a margin of safety exists when the shares are trading well below