Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 31

Ben Graham’s three most enduring principles

Benjamin Graham was the father of security analysis and the intellectual Dean of Wall Street. I believe Graham was many things, including the father of the many ratios we take for granted in our work as analysts, portfolio managers and investment officers. Perhaps controversially, I also believe he may not have reached some of his conclusions had he access to a computer that allowed him to properly test his ideas.

Having said that, there are many things that Ben said that not only made sense but made significant contributions to investment thinking. And despite the absence of a computer, Graham observed several characteristics of the market that the advent of modern computing has only served to reinforce.

For those grateful for executive summaries, here follows mine on the three most significant contributions Ben Graham made to the body of work on investing.

By understanding, testing and implementing the approaches that flow from a study of Graham’s principles, I believe any investor will benefit not only in terms of returns but also in terms of risk mitigation. In Part 2 next week, we will display anecdotal evidence of their truth with graphics using modern computing and the techniques of the development team at Skaffold.com.

Lesson One

The first of Graham’s significant contributions is his Mr. Market allegory, introduced in 1949. Mr. Market is of course a fictitious character, created to demonstrate the bipolar nature of the market.

Here is an excerpt from a speech made by Warren Buffett about Ben Graham on the subject:

“You should imagine market quotations as coming from a remarkably accommodating fellow named Mr Market who is your partner in a private business. Without fail, Mr Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains…

Mr Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow.

Transactions are strictly at your option…But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr Market is there to serve you, not to guide you.

It is his pocketbook, not his wisdom that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence.”

The implications of this little story cannot be understated. What Graham is saying is that there is a legitimate alternative to the Efficient Market Theory as a model of the way the market behaves and works. He said this before EMT became the cornerstone of every financial services firm that cared about “biggering and biggering and BIGGERING.”

Another significant implication is that as investors we should be less focused on price as our guide as we should on value. This challenges the validity of many streams of financial study that have as their root, the price of securities. Think about all the PHD papers and other academic studies that uncover relationships, or validate the power of explanatory variables, but whose concluding evidences are merely price, or some derivative of price. If prices in the short run are determined by those who are merely selling to renovate the bathroom or by events in Syria – events that have no impact on the number of $2 buckets being sold by The Reject Shop – what ‘value’ can we place on them?

Lesson Two

The second great lesson Ben Graham taught gave us the three most important words in value investing; margin of safety. In engineering the margin of safety is the strength of the material minus the anticipated stress. Building materials that are far stronger than that required to survive the anticipated stress ensures a degree of comfort.

When it comes to investing, the margin of safety is the estimated value of a share minus the price.  The greater the margin of safety, the greater the degree of comfort and more importantly, the greater the expected return. If the price is what we pay, and the value what we receive, then the lower the price we pay, the higher the return.

Lesson Three

Despite the high profile of these enduring two lessons, I believe there is a third observation of Graham’s, which is equally important. Fascinatingly, with the benefit of computers, we can also demonstrate that Graham was spot on.

Graham was paraphrased by Buffett in 1993:

In the short run the market is a voting machine - reflecting a voter-registration test that requires only money, not intelligence or emotional stability - but in the long run, the market is a weighing machine.

What Graham described is something that, as both a private and professional investor, I have observed myself; in the short term, the market is a popularity contest – prices often diverge significantly from that which is justified by the economic performance of the business.  But in the long term, prices eventually converge with intrinsic values, which themselves follow business performance.

Next week, we will compare intrinsic value and share prices for some major Australian stocks to illustrate Ben Graham’s enduring principles.

 

Roger Montgomery is the founder and Chief Investment Officer at The Montgomery Fund. 

 


 

Leave a Comment:

RELATED ARTICLES

Testing Ben Graham’s voting and weighing machines

Are rising oil prices bad for Australian shares?

Weekly newsletter to subscribers features important investment insights

banner

Most viewed in recent weeks

2024/25 super thresholds – key changes and implications

The ATO has released all the superannuation rates and thresholds that will apply from 1 July 2024. Here's what’s changing and what’s not, and some key considerations and opportunities in the lead up to 30 June and beyond.

Five months on from cancer diagnosis

Life has radically shifted with my brain cancer, and I don’t know if it will ever be the same again. After decades of writing and a dozen years with Firstlinks, I still want to contribute, but exactly how and when I do that is unclear.

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

Welcome to Firstlinks Edition 552 with weekend update

Being rich is having a high-paying job and accumulating fancy houses and cars, while being wealthy is owning assets that provide passive income, as well as freedom and flexibility. Knowing the difference can reframe your life.

  • 21 March 2024

Why LICs may be close to bottoming

Investor disgust, consolidation, de-listings, price discounts, activist investors entering - it’s what typically happens at business cycle troughs, and it’s happening to LICs now. That may present a potential opportunity.

The public servants demanding $3m super tax exemption

The $3 million super tax will capture retired, and soon to retire, public servants and politicians who are members of defined benefit superannuation schemes. Lobbying efforts for exemptions to the tax are intensifying.

Latest Updates

Retirement

Uncomfortable truths: The real cost of living in retirement

How useful are the retirement savings and spending targets put out by various groups such as ASFA? Not very, and it's reducing the ability of ordinary retirees to fully understand their retirement income options.

Shares

On the virtue of owning wonderful businesses like CBA

The US market has pummelled Australia's over the past 16 years and for good reason: it has some incredible businesses. Australia does too, but if you want to enjoy US-type returns, you need to know where to look.

Investment strategies

Why bank hybrids are being priced at a premium

As long as the banks have no desire to pay up for term deposit funding - which looks likely for a while yet - investors will continue to pay a premium for the higher yielding, but riskier hybrid instrument.

Investment strategies

The Magnificent Seven's dominance poses ever-growing risks

The rise of the Magnificent Seven and their large weighting in US indices has led to debate about concentration risk in markets. Whatever your view, the crowding into these stocks poses several challenges for global investors.

Strategy

Wealth is more than a number

Money can bolster our joy in real ways. However, if we relentlessly chase wealth at the expense of other facets of well-being, history and science both teach us that it will lead to a hollowing out of life.

The copper bull market may have years to run

The copper market is barrelling towards a significant deficit and price surge over the next few decades that investors should not discount when looking at the potential for artificial intelligence and renewable energy.

Property

Global REITs are on sale

Global REITs have been out of favour for some time. While office remains a concern, the rest of the sector is in good shape and offers compelling value, with many REITs trading below underlying asset replacement costs.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.