Benjamin Graham’s arrival on Wall Street in that summer of 1914 was not much more than a chance encounter. There were no telltales that Graham would live in that world for the next four decades, synthesize a dominant theory of value investing, and in the process create a class of thousands of superinvestors like himself.
Among the chief disciples is one-time student and employee Warren Buffett, who graces Graham with the ultimate accolade. Graham has been dead for more than three decades now, but there are still uncanny touches of his style in the discipline that has made Buffett and dozens of other disciples very rich men.
What did Graham so lastingly teach this school of brilliant portfolio managers? The simple hardheaded principle that is at the heart of value investing: the need to cut through market prices to reality. When you buy a stock, you are not buying a piece of paper; you’re buying part of a business.
There is often a huge spread between the “intrinsic value” of the business and the price that a frequently manic stock market is putting on the paper. Buy a stock significantly above intrinsic value and you court a loss. Buy below intrinsic value and you have a good chance of making money over the long haul, with little risk of taking a permanent hit on your capital. The basic bet is that market value and intrinsic value will ultimately converge.
In one of a number of lead articles he wrote for Forbes, Graham thought of his strategy as “buying dollar bills for 50ยข.” It was a strategy that enabled him to survive the bad years of the 1929 crash while others were sinking and it brought him returns of 20 percent or more over many good years. In his last years, Ben Graham distilled six decades of experience into ten criteria that would help the intelligent investor pick value stocks from the chaff of the market.
- An earnings-to-price yield of twice the triple-A bond yield. The earnings yield is the reciprocal of the price earnings ratio.
- A price/earnings ratio down to four-tenths of the highest average P/E ratio the stock reached in the most recent five years.
- A dividend yield of two-thirds of the triple-A bond yield.
- A stock price down to two-thirds of tangible book value per share.
- A stock price down to two-thirds of net current asset value — current assets less total debt.
- Total debt less than tangible book value.
- Current ratio (current assets divided by current liabilities) of two or more.
- Total debt equal or less than twice the net quick liquidation value as defined in No. 5.
- Earnings growth over the most recent ten years of seven percent compounded — a doubling of earnings in a ten-year period.
- Stability of growth in earnings — defined as no more than two declines of five percent or more in year-end earnings over the most recent ten years.
Together, Ben’s ten points construct a formidable risk/reward barrier. The first five point to potential reward by pinpointing a low price in relation to such key operating results as earnings. The second five measure risk by measuring financial soundness and stability of earnings.
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