We all want to make a profit, but we also want to have as little hassle as possible. Besides we may find that we are not good with money, that we either gamble it too quickly, or are not storng enough to sell that falling stock, in the hope that it will recover. We would like to be ice-cool like the poker stars whenever we make those investment decisions, so what can we do to make more objective decisions.
It is important for investors to have some sort of rules or discipline in making investment decisions. They need to be objective and not make emotional decisions driven by greed or fear. This article looks a set of rules for fundamental investors created by Benjamin Graham “The Godfather of Investment Analyis.”
GRAHAM’S METHODOLOGY: THE DEFENSIVE INVESTOR
Benjamin Graham’s book “The Intelligent Investor” is regarded by many as the best book on investing ever written. The book first appeared in 1949. The 4th revised edition in 1973 was the last before Graham’s death in 1976.
The central concept Graham outlines in the book is that there is a half-price sale in the stock market every day. The trick for the investor is to know how to judge the difference between price and value. Graham outlines how to establish this value, but he is well aware that the value of the share in question may change, the estimate may be inaccurate, or that the market price movement may not be favorable. Therefore Graham creates a “margin of safety” approach. The greater the surplus of a stock’s “Intrinsic Value” over its price, the greater the margin of safety.
One of Graham’s objectives in his book was to give the investor an understanding of the risks involved in holding shares, which are inseparable from the opportunities for profit and must be carefully considered in the investor’s calculations. The investor must recognize the existence of a speculative factor affecting the value of his stocks. Graham says it is the task of the investor “to keep this component within minor limits and to be prepared financially and psychologically for adverse results that may be of short or long duration.” This in essence is the Defensive Investor strategy.
Graham defines the Defensive Investor as one interested in safety plus freedom from bother. Each Defensive Investor should divide his holdings between high grade bonds and common stocks. The proportion of each should never be less than 25% and never more than 75%. In setting the allocation of funds between equities and bonds, one of Graham’s concerns was inflation. Graham prophetically wrote in 1970 that that “the possibility of large scale inflation remains and that the investor must carry some insurance against it [and although] there is no certainty that a stock component will insure against inflation, it should carry more protection than the bond component”. The return of inflation makes this allocation all the more relevant today.
In selecting his Defensive Portfolio, Graham is categorically against Growth Stocks. He points out that their stock prices often grow at faster rates than profits and command high PE multiples based on inflated expectations, but that these stocks usually decline in the same way and are consequently too risky for the Defensive Investor. This PE contraction was experienced by many Growth Fund Managers during the 2000-2003 Bear Market, who were no match for their Value Driven peers.
TESTING THE DEFENSIVE INVESTOR STRATEGY
In 1981, Henry R. Oppenheimer tested Graham’s Defensive Investor methodology in his book “Common Stock Selection: An Analysis of Benjamin Graham’s Intelligent Investor Approach”. The results of his study suggest that above average results were available to the Defensive Investor, without following Graham’s advice on the equity v bond allocation. In his various strategies, Graham tried to gain from what we now recognize as persistent anomalies in the Efficient Market Hypothesis, such as the Low PE effect, the small firm effect and the high Dividend Yield strategy. Oppenheimer says that “Graham viewed the PE as a ratio of price paid to value received and was an indicator of current market optimism about a security’s future earnings”. Graham believed in the market’s mispricing of individual securities.
The academic world had started to pay attention to the outperformance of low P/E stocks after Basu’s article in the Journal of Finance in 1977. It appears though that Graham had been well aware of this outperformance as far back as 1951, as one of his students H.G. Schneider had tested the returns of low PE stocks between 1917 and 1950 and found they beat the blue chip Dow Jones Industrial Average.
Graham counselled that growth rates cannot be accurately predicted by analysts confirmed later by Malkiel and Cragg’s study in 1970. Accordingly, the prices of growth stocks will eventually be revised downward, while low PE stocks will be revised upward. In essence, Graham’s advice for the Defensive Investor is to judge each potential acquisition as a business entity and not to pay too high a price for value received. However, Graham realized that his PE criterion should change over time, particularly in relation to interest rates. Oppenheimer followed the investment criteria published in each edition of “The Intelligent Investor” namely:
Adequate diversification of between 10 and 30 shares Selected firms to be large, prominent and conservatively financed – Book value should be at least 50% of market capitalization (utilities 30%) – Assets/turnover should rank in the first quarter/third of its industry Dividends paid continuously over the previous 20 years Do not pay more than 25 times average earnings over the last seven years Do not pay more than 20 times average earnings over the last 12-month period
Graham would consider selling a stock if it’s price appreciated by more than 50%. However, if the stock had not reached this target it could still be sold as part of the annual review of the portfolio, where Graham reconsidered all portfolio consituents to see if they still satisfied the original selection criteria.
Oppenheimer wrote that in imperfect markets, with heterogeneous expectations and limited short-selling, many over- and underpriced securities will exist. Graham requires the investor to be immune to the market’s sometimes irrational behavior, to search for sound businesses and purchase those that are reasonably priced.
Oppenheimer tested the Defensive Investor strategy and concluded that “during the 20-year period 1955-1975 [statistically] significant returns were available to an investor” earning on average 3.25% per annum (before taxes) in excess of a market portfolio of comparable risk. He also tested the strategy in periods following publication dates and highlighted a statistically significant outperformance of 9.2% per annum during the 1973 to 1976 period.
Oppenheimer summarizes his extensive testing by saying that the results to the Defensive Investor are “surprisingly good”, especially in view of the little time involved.
Graham’s Defensive Investor approach has been proven to be successful, but is by no means the only set of rules for buying and selling. Investor need to find a set of rules best suited to them. However, establishing a sound set of buy and sell rules is only the start. As Jesse Livermore said: “what ultimately defeated most traders was their inability to stick to their own proven trading rules.” It is important that you rely on your own rules for buying and selling and that you avoid distractions. So if you do as Dorothy did and stick to the Yellow Brick Road then you should get to the plentiful land of Oz..