This is the second part of a series devoted to notes of Graham’s lectures between September 1946 and February 1947 at the New York Institute of Finance. The series of lectures was titled Current Problems in Security Analysis and it gives a great insight into Graham’s process . This article is devoted to Graham’s seventh lecture focusing at good stocks.
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Benjamin Graham: Buying Good Stocks At Fair Prices
Graham spends plenty of time in his lecturers discussing the process of estimating company earnings power and investing with an appropriate margin of safety based on the outcome of this process.
In the seventh lecture, Graham covers the processes of analysts approach to securities as a whole. The godfather of value investing believed they were two fundamentally different approaches the analyst could take to security analysis. Firstly, the conventional approach, based on quality and a company's prospects. The second approach named the "penetrating one" is based on value. Graham explained the differences between the two:
"The conventional approach can be divided into three separate ways of dealing with securities. The first is the identification of “good stocks” -- that is “strong stocks,” “strong companies,” “well-entrenched companies,” or “high quality companies.” Those companies presumably can be bought with safety at reasonable prices. That seems like a simple enough activity.
The second is the selection of companies which have better than average long-term prospects of growth in earnings. They are generally called “growth stocks.”
The third is an intermediate activity, which involves the selection of companies which are expected to do better business in the near term than the average company. All three of those activities I call conventional.
The second approach divides itself into two sub-classes of action, namely, first, the purchase of securities generally whenever the market is at a low level, as the market level may be judged by analysts. The second is the purchase of special or individual securities at almost any time when their price appears to be well below the appraised or analyzed value. "
Of the three so-called conventional approaches, the process of buying "good stocks" at fair prices is Graham's favorite as he believed "Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices." Therefore, the best advice any the investor could receive Graham believed is "These are good companies, and their prices are wholly reasonable."
The lecture goes on to discuss the benefits and drawbacks of investing in growth companies. Graham notes:
"The successful purchase of growth stocks requires two rather obvious conditions: First, that their prospect of growth be realized; and, second, that the market has not already pretty well discounted these growth prospects."
In order for an analyst to be successful at picking growth stocks, they have to be "smart or shrewd" according to Graham, but interestingly, he does not consider these qualities to be desirable for security analyst. Instead, Graham believes a growth analyst should "be wise". What does he mean by this? Well, Graham explains that a "wise" analyst is technically competent, experienced and prudent.
These qualities are required for the successful selection of growth stocks because the market is so full of "surprises and disappointments." Without the adequate experience, trying to select growth stocks is a risky business because some sectors will fall in and out of fashion.
Analysts' (not just limited to Wall Street analysts, private investors who analyze their own investments are subject to the same biases) views are influenced by all sorts of outside factors, and that's really the key takeaway from Graham's lecture. To help the students try to keep biases from altering their perception, and valuation process of stocks, Graham recommends the following:
"I would suggest, and this is a practical suggestion -- what I said before has been perhaps only a theoretical analysis in your eyes -- that if you want to carry on the conventional lines of activity as analysts, that you impose some fairly obvious but nonetheless rigorous conditions on your own thinking, and perhaps on your own writing and recommending.
In that way you can make sure that you are discharging your responsibilities as analysts.
If you want to select good stocks -- good, strong, respectable stocks -- for your clients, that’s fine, I’m all for it. But determine and specify that the price is within the range of fair value when you make such a recommendation. And when you select growth stocks for yourself and your clients, determine and specify the round amount which the buyer at the current price is already paying for the growth factor, as compared with its reasonable price if the growth prospect were only average. And then determine and state whether, in the analyst’s judgment, the growth prospects are such as to warrant the payment of the current price by a prudent investor. "