November 22, 2008

The basics of Graham Security Analysis (Session 1)

Benjamin Graham had a great investment philosophy. Find great companies determine their intrinsic value and then only buy them when they are cheap. Or as Graham puts it:
"apply a set of standards to each purchase, to make sure that he obtains (1) a minimum of quality in the past performance and current financial position of the company, and also (2) a minimum of quantity in terms of earnings and assets per dollar of price." (The Intelligent Investor P347-348 Harper Collins Edition 2003)

Not a wildly different philosophy from many others, where he did differ was that he built in insurance. Investing is all about risk and return; you want to keep the risk low and the return high. What Graham’s formula was all about was saying no one is perfect at predicting the future of a return so build in stop gaps to lower the risk and give you the best chance possible. Let’s have a look at a very boiled down summary of the Graham insurance technique.

Insurance Technique 1 Buy on the Cheap:

Buying a cheap company is about buying something that no one else wants. When they run away you run in- but not always. Most of the time when people run away from companies or sectors there are perfectly good reasons why they should run away from a company, but sometimes there are not. The history of investing is littered with these stories. A nuclear reactor melts down in Europe and every nuclear stock in the entire world gets hit hard. Is there really any reason for that overreaction? Time will answer that question.

Insurance Technique 2 Buy a company with a future:

But what if you are wrong about the reasons the company is cheap, or what if people stay afraid of the industry in question? Using our nuclear reactor example, let’s say that reactor melt down once a month for the next year, or that that reason the reactor melted down is due to faulty components that are also installed in the reactors of the companies you buy. Everyone will run further away from this industry or company and then you are in a pickle aren’t you?
So how do you mitigate the risk involved with this? Buy a company with a future. Buying one stock in a company is just like buying the company itself. You want a company that makes money, doesn’t have debt problems and looks positioned to have a future that will continue to be positive. To carry forward our nuclear reactor example you want a company that has enough money to pay its debts throughout the crisis that made it cheap, and a good solid source of reliable revenue that will continue to feed the company into the future.

Insurance Technique 3 Buy with a solid dividend:

What if it takes a while for investors to wake up to the fact that a company is a cheap company, with a good future? We can’t have all our money wrapped up in a stock for years without returns no matter how cheap it may appear to be or how solid its future will be once the current crisis is over. That money has to work for us or else we would put it in a bank account or a bond where we could get a guaranteed return rate.
This is where dividends come in. A dividend is a regular distribution of cash from the company and for us it is a tranquilizer to keep us calm as we wait for the market to realize that it has unfairly mistreated our company. I don’t mind holding a stock for a year to wait for it to rebound if I am getting a 9% dividend payment to do so, and neither did Graham.

In the next few posts I will examine each of these techniques and describe the basics of how it is done in the graham methodology.

4 comments:

GuruFocus said...

You got some very intereting articles here. If you like to republish some of them on GuruFocus.com, please email charlie@gurufocus.com.

Miguel Barbosa said...

I agree with Charlie from Guru Focus,

Great stuff. I have already linked to your mini book review in our nightly value investing links at www.simoleonsense.com

If you have time can you take a look at my blog I would love to get your feed back. In the meantime, Keep up the great work, we look forward to reading more insightful articles.

Best Regards,
Miguel Barbosa
www.simoleonsense.com

Mark said...

I like the site. Graham's book Security Analysis is a classic.

value investor said...

Thanks Mark!