The Value Investing Approach ( Banjamin Graham ) - Research Paper Example

? The Graham Investor Introduction When it comes to long term investments, Benjamin Graham is believed to be the original intelligent investor. In his lifetime (1894 to 1976), he was able to enormously contribute to the main subject of investments and security analysis. His works vary from helping an individual perform his own portfolio management, searching for a timely company, purchasing of stocks, and investment of retirement savings at Wall Street (GrahamInvestor, 2012) It is worth noting that Graham was always trying to purchase stocks that were been traded at a discount as compared to their net Current Asset Value. In simpler terms, he purchased stocks that were undervalued and he would hold them until they were fully valued (Benjamin Graham’s 10 value tests, 2009). Graham was once known to have said that the determining characteristic of an investor will be his willingness to spare his time and care when selecting securities that are sound and can be seen to be attractive than the average (GrahamInvestor, 2012). Nonetheless, an enterprising investor of his caliber could expect a worthwhile reward when it comes to his extra skills and efforts. This could take the form of a better average return as compared to the returns realized from a passive investor. Graham’s Works The former world’s richest person (Warren Buffett) is one of the most known Graham’s disciples. Through Berkshire Hathaway, an investment vehicle that Buffet used for the last 40 years, he was able to make 22.2 percent annuals gains for all those years. This is one remarkable record. One may think that this form of percentage is small as compared to the 70 and 100 percent we witness on websites and newsletters. Fortunately, buffet was able to achieve his annual gain year after year, and what we see on the websites and newsletter is just the hype merchant’s use by the wayside. In the end, buffet still has the sovereignty as been the greatest investor of recent times (BuffetsSecrets, 2011). This paper will demonstrate what made Graham’s ideas stand out. It is not just the meager concept of buying low and sell high. It was more of purchasing cheap assets and sell them later as expensive assets while at the same time looking for large gaps between the worthiness of stock’s and their price. Graham is known to have referred to this as the Margin of Safety (GrahamInvestor, 2012). This form of approach is known to have consumed plenty of time as it was an active investment. It should be known that it could not be done submissively until recently. In any given financial matters, the management of finances is something very important for the immediate and event the later future of an individual’s finances or that of an organization. This means that finance management can either be long term or even short term. In that case, the management of finance will basically involve the future planning of someone’s finances or even that of a business. This is usually done so that there can be a guarantee of smooth financial flow for the business or one’s affairs. So as to be done in a much effective manner, it has always been necessary to have administration issues and maintenance of all possible financial goods and assets. Another important element of financial management is that it has to cover all the processes which are involved in the overall identification and management of risks. When it comes to the issues of financial management, there should be the element of assessment on the financial situations rather than involving the techniques which entail quantification of the finances. This gives the duty of a financial manager in ensuring that he or she looks keenly at all the available information and data in making useful judgments on the enterprise or business performance of enterprises. Management of finance should be applied as an interdisciplinary approach which has to effectively borrow from the areas of managerial aspects, accounting modalities, and with corporate financing. Graham’s Investment Techniques When it comes to value investment, it simply means to buy stocks or a business at a less intrinsic value. Graham was the pioneer of this investment method. Great investors, like Buffet and Peter Lynch, have been able to modify and enhance this investment method (Zweig, 2009). Graham is known to have taken the position that value investment is the only real form of investment and other forms were just mere speculation (BuffetsSecrets, 2011). The following are the other investment theories, and they include: the modern portfolio theory (this dealt with mixing unrelated stocks in a portfolio thus giving it less volatility as compared to the average volatility of the stocks), the proficient market theory (this theory deals with the assumption that the market price of a share can accurately reflect the information available about that particular investment), lastly is the random walk model (GrahamInvestor, 2012). In the next sections we will be looking at the value investment theories and approach of Graham and how Buffet and other men have successfully followed his approach. The Margin of Safety Graham once said that the investment policy can be reduced to jut three straightforward words: “Margin of Safety”. This as discussed earlier is whereby the price of an investment share can be purchased with very minimal downside risks. The main point hereby is the margin of safety price should not be the same as the price that the investor has used to intrinsically calculate the worthiness of the share. Next we will be looking at the intrinsic value of a share. The Intrinsic Value of a Share It is worth noting that an investor may compute the intrinsic value of a share through different techniques. The investor will ultimately have to develop a price that he or she believes that it captures or represent a good purchasing or buying value. It should be known that Graham had his own methods of calculating intrinsic values, Warren Buffet and others also had their own methods. Graham did go ahead and acknowledge that at times his calculation could be wrong and this could be attributed to external events (GrahamInvestor, 2012). External events are known to take place and when they do occur there has been a higher chance of it affecting the value of the share. These, therefore, cannot be predicted. It is due to this reasons that an investor need’s to have a Margin of Safety and inbuilt factors that have to take care or respond to these possibilities. The Prime Bonds versus Government Bond As per Graham, the standard by which Margin of Safety could be calculated was based on the interest rate that was payable for quality bonds. During his time, prime bonds were prominent and even more practical to adopt right now. This has been done by Warren Buffet and the benchmark applied has been the rate of return of government bonds. Graham did go ahead and use a comparative approach (GrahamInvestor, 2012). Here, we learn from him that when two forms of investment have the same risk, then it is advisable to choose the investment with even higher returns. On the contrary, investments like shares that have higher risk when calculating their Margin of Safety should have a higher return (BuffetsSecrets, 2011). Illustration: By modifying the then example that Graham is using in his book, we can use a share investment that yields 10 percent earnings. An example is when Business A earns 90 cent per share and sells in the market at 10 dollars. When the return on the government bonds is 5 percent, then the share should yield an annually excess of 5 per cent. In a period of ten years, yields that are in excess should total 50 per cent. In graham opinions, this is enough if the share was chosen wisely in the first place. Certainly, the total Margin of Safety has to fluctuate and this depend upon the quality of the share investment (GrahamInvestor, 2012). Even with these calculations, something may go wrong. Nonetheless, graham believes that with a diversified portfolio of over 20 representations of share investments, the margin of error approach reduces and in the long run it will create satisfactory results. As per graham, in order to have a true investment, there is the need for a true Margin of Safety (Benjamin Graham, 2006). It is noteworthy that a true margin of Safety is the one that can be demonstrated through the use of figures, credible reasoning and reference to a body of actual experience. Overview of Graham’s Investment Principles Under the intelligent investor, Graham has summarized up his investment philosophy by stating that any intelligent investor should be businesslike or minded in his approach (Benjamin Graham, 2006). One needs to know that when investing in shares in a company, it will be like owning a share in a business organization. Thus, the investment needs to be approached as if an individual was purchasing a business or he is a partner in one of the business. The following are the guiding principles for Graham: Know the Business As an investor, we learn from this Graham principle that there is a need for the investor to be knowledgeable about the business or activities been carried in the company as they are the basis for investment (BuffetsSecrets, 2011). One needs to understand how the company sells, operates, how is the competition environment, and the strengths, weakness, opportunities, and threats (Benjamin Graham, 2006). It is worth stating that with an investor buying a fruit shop or cafe without investigating the above things would have made a foolish investment (Scott, 1995). This same principle applies in hare investment and when an investor does not understand the business, he or she should not invest in the business. Understand who runs The Business When an investor is unable to operate a business by himself, he or she will need a manager (Benjamin Graham, 2006). This is, therefore, the position of an average share investor who owns a share of the business and is been run by others. The owner of the business has to be in a position whereby the hired manager has the power and will to manage the business competently, efficiently and honestly (Benjamin Graham, 2006). It is worth pointing out that the share investor should not settle for/ be satisfied with less. If the investor is not satisfied after doing sound and extreme research on the company, it is in the interests of investors that the investment should not be made. As stated earlier, the company has to be clearly managed in competent and efficient way (Nofsinger, 2005). One Should Invest for Profits It is obvious that people make investments for the money. Thus, an investor would not in a normal condition purchase a business that from his research he has found out that their expectations f making great profits over time are very low (Scott, 1995). Graham therefore suggests that share investors should take the same approach when investing (Benjamin Graham, 2006). Their investment should not be based on optimism but arithmetic. Confidence is Key Graham is known to encourage his investors to accurately research on their investments. It is after proper research that when one believes that their investment judgment is sound and can act on it (Benjamin Graham, 2006). Graham, therefore, cautions investors who are in this position against listening to others. He points out that an individual is neither right nor wrong just because the masses do not agree with you (Scott, 1995). He sums it by stating that one is wrong or wring because his data and reasoning are right or wrong. Graham with His Imaginary Investor Mr. Market Graham is known for widely using an imaginary investor known as Mr. Market (Benjamin Graham, 2006). He mostly used him to demonstrate the point that a wise investor should chose his investments based on their elementary value and not on the opinions of other people of the directions of the current markets. The choice of Mr. Market has an explanation. Graham’s explanation goes like this: Graham is demonstrating that Mr. Market’s judgment is created merely from mood swings rather than a rational thought (Benjamin Graham, 2006). Therefore, it gives a wise investor buying and selling chances. When Mr. Market’s price is found to be unreasonably high, investors have the opportunity to sell. On the same circumstances, if his price is also unreasonably low, the investors have the chance/ opportunity to buy shares (Scott, 1995). The point being that a successful investor has to learn how to make your own decisions and they should be founded on your own ideas of the worthiness of the investment. The Significance of Mr. Market From the extensive research I have carried out, it is worth pointing out that Graham did not conclude from Mr. Market’s wild behaviors that fluctuations in the market should be ignored. It should be known that they can be valuable in the sense that they can indicate when something goes wrong or right with the investment (Scott, 1995). Their significance from Graham’s perspective is that they do provide an opportunity for one to purchase wisely as the prices fall sharply and they can make wise sells when the prices advance in a great deal (Benjamin Graham, 2006). It is from these principles and approaches that Warren Buffet considered Graham’s views and opinions on Market fluctuations to warrant special attention from the investor (GrahamInvestor, 2012). Shortfall of Graham’s Approaches From the demonstrations of the late 1990s stock markets, value stocks cannot be able to always beat growth stock. Nevertheless, when it happens that the value stocks are performing greatly, it should not mean that the market is unproductive, as at the same time it may imply that the value stocks are just simply riskier and thus they require greater returns (Scott, 1995). The other issue with purchasing shares in a bear market may be that despite the shares value appearing to be undervalued at that moment, the prices could still drop along with the markets all together (GrahamInvestor, 2012). Contrary, an issue with one not purchasing shares in a bull market could be despite it appearing to be overvalued at one moment, and prices could still rise along with the market all together. The other shortfall is with the method or means of calculating the intrinsic value. Market analysts have come to the conclusions that two investors can analyze the same information and yet reach different conclusions with regards to the intrinsic value of the company (Benjamin Graham, 2006). At the same time there is no systematic or standard way one can value a stock. It should be known that there should be no ambiguity when it comes to the calculated value and value been invested (BuffetsSecrets, 2011). This can be seen as elaborated by Graham. When we look at the stock selection means provided by Graham, they are very specific and they are clearly intended to avoid this type of subjectivity. The focus is on the documented and objective past numbers rather than the subjective and predicted future ones. The ambiguity will always and only arise when an investor use formulas that are not given by Graham or he/ she uses subjective predicted numbers that are against Graham’s Recommendations. Performance of Value Investing We will start by focusing on the performance of value strategies that Graham implemented. It is a known fact that Value investing has proven to be a very successful investment strategy. Several process and ways to evaluate this success have been suggested. An example of the ways through which one can evaluate the performance of a simple value strategy is by purchasing low PE ratio stocks and low price to cash flow (Scott, 1995). Many academic institutions have published studies that have investigated the effects of purchasing value stocks. These studies in the end have constantly found out that value stocks tend to do better than growth stocks and the market as one (Morris, 1996). The other means of finding the performance of value investing is through analyzing the performance of value investors. The other way one can examine the performance of value investing strategy is by examining the investing performance of value investing strategies. Here, one will examine the investing performance of one of the most known value investors. By examining the performance of the best and well known value investor will make it not instructive (Scott, 1995). This is because investors do not get to be well known unless they have been really successfully. The above procedure tends to introduce a selection bias. In 1984, Buffet suggested that the best way to investigate the performance of a group is by dealing simply with value investing strategies (BuffetsSecrets, 2011). We can, therefore, state that Buffet conclusion is identical to that of the academic professional we had stated earlier. In the long run, value investing will always be on average successful. Conclusion As we know, value investing was established by Graham. In his book “The intelligent Investor”, we have been able to see that his main advocacy is on the concept of Margin of Safety. This concept has been successful as it was also introduced in Security Analysis. To sum up, Graham did suggest that when it comes to picking stock, one should use a more defensive investment approach to stock trading as when they are below their tangible value, they are safe against any adverse future developments which often occur in the stock markets (Ross, 2001). It is worth pointing out that Graham’s emphasis on assets that are tangible may require modifications to be used at present. This is mainly because many of the companies nowadays have invested heavily in their lines of business on the intangible assets. At the same time, his concern on value relativity to price will continue to maintain its relevance (Business Wire, 2006). Graham is known to have summarized his own investing philosophy by stating that intelligent investing will always consist of analyzing potential purchases and bargains. This is according to his sound business principles. They include: understanding the business, make your own decisions, do not risk any portion of your original investment and always stick to your own judgment with disregard to the market’s opinion. References Benjamin Graham (1894-1976). (2006). Retrieved April 2 2012 from http://www.bolseros.com/viewtopic.php?t=1841 Benjamin Graham’s 10 value tests. (2009). Report on Business Magazine, pp 33-33. BuffetsSecrets. (2011). Benjamin Graham’s investment principles. Retrieved April 2, 2012 from, http://www.buffettsecrets.com/investment-principles.htm GrahamInvestor. (2012). The Graham Investor: Intelligent Value Investing. Retrieved April 2, 2012 from http://www.grahaminvestor.com/ Morris, V. (1996). Benjamin Graham on value investing: Lessons from the dean of Wall Street. Financial Analysts Journal, 52 (2), 77-77. Nofsinger, J. (2005). Social Mood and Financial Economics. The Journal of Behavioral Finance, 6(3), 144–160. Ross, N. (2001). Benjamin Graham: Father of security analysis. Better Investing, 50(7), 42-42. Scott, M. C. (1995). Value Investing: A Look at the Benjamin Graham Approach. Retrieved from http://www.aaii.com/journal/article/value-investing-a-look-at-the-benjamin-graham-approach Zero in on winning stocks using the same strategies as Warren Buffett and Benjamin Graham with new investment software from Aptus Communications. (2006). Business Wire, pp. 1-1. Zweig, J. (2009). The intelligent investor: If you think worst is over, take Benjamin Graham’s advice. Wall Street Journal, pp. B.1-B.1. Read More