Investment Strategy Articulated by Benjamin Graham - Research Paper Example

?Investment Strategy The recent economic recession completely changed the economic landscape. For many, the significant economic fall-out and unemployment rates were the worst they had ever experienced. These drastic changes have left investors questioning the proper strategic approach. While a plethora of fad investment strategies have emerged and died off as a direct result of the recession, it’s clear that the most effective investment strategy is a traditional approach that was first articulated by Benjamin Graham over fifty-years ago. Graham’s investment strategy, as established in his now seminal text the ‘Intelligent Investor’, encourages a steady and conservative approach referred to as ‘defensive investing’. This strategy is contrasted with ‘speculative investing,’ an approach more closely linked to gambling. Graham’s strategy has lasted the test of time and drawn positive attention from billionaire investor Warren Buffet who claims it is the best investing text ever written. This essay examines Graham’s strategy in this text through an analysis of investment objectives, asset allocation, security selection process, and whether I would implement this strategy. Objectives The strategies articulated in the ‘Intelligent Investor’ are such that any sort of investor including an individual, hedge fund, or pension plan can adopt them. This is due to Graham’s deep understanding of market vicissitudes that make this strategy not simply a strategic angle on the market, but virtually the only safe approach to investment. In these regards, the only investors that this approach is not targeted for are what Graham terms ‘speculative investors’. Graham states, “every nonprofessional who operates on margin should recognize ipso facto that he is speculating…everyone who buys a so-called “hot” common-stock issue…is either speculating or gambling” (Graham, pg. 21). For Graham, the distinction between defensive investing and speculative investing come to constitute the backbone of his strategy. In considering the expected returns this strategy offers, Graham does not guarantee a specific percentage return. When considering Graham’s approach one recognizes that the very nature of guaranteeing a percentage return or benchmark is inimical to the nature of his approach, as he contends that future markets are almost always unpredictable. Instead Graham’s encourages a steady and conservative approach, the returns of which will be determined by the specific market conditions of the era. Graham indicates that strategic approaches that guarantee a specific return may be successful for a period, but in the long run have consistently proved ineffective. In terms of risk, Graham indicates that risk should be determined by the investor’s specific goals. For Graham risk is largely measured in the allocation of common stocks vs. bonds. Rather than implementing a time limit, Graham instead considers that risk and return are most concentrated in common stocks and as such they necessitate longer time horizons. One such example Graham gives is that a couple that are saving to buy a home would be better served consolidating their portfolio in bonds as this are safe and easily accessible; conversely, an individual with a longer time horizon should have a higher percentage of common stock. Asset Allocation Graham’s strategy as articulated in the ‘Intelligent Investor’ functions as a comprehensive approach to portfolio management. Indeed, intrinsic to Graham’s strategy is the mitigation of risk through the successful allocation of bonds and common stocks. There are a number of considerations within this mode of understanding. In regards to precious metals, Graham recommends a relatively small allocation of such securities, indicating 2-3% of a portfolio should be dedicated to them. In terms of determining the percentage of bonds vs. stocks in the portfolio Graham provides a variety of options. Graham begins in considering a base percentage differential of 50% bonds and 50% stocks. He then indicates that the investor should shift their percentage considerations as a function of market conditions and their own investment goals. For instance, individuals that are more risk averse, Graham indicates that a higher percentage of bonds should be included in the portfolio, with a 75% bond, 25% common stock allocation. For individuals that have the benefit of time a 75% stock and 25% bond allocation is more preferable. On the question of whether the percentage of stocks should ever exceed 75%, the text recommends that the investor should consider their actions in the latest bull market. If they were able to remain steady-minded and retain their stocks, then they are of the temperament that can handle an above 75% stock allocation. In general Graham recommends a top-down approach to investing wherein the defensive investor must be sure to purchase stocks in bear markets and sell them in bull times. Security Selection Process Graham’s security selection process is based on his conservative principles. Rather than attempting a complicated process of analysis that attempts to identify undervalued stocks, Graham recommends investing in companies with sound business principles. He notes, “you must thoroughly analyze a company, and the soundness of its underlying businesses, before you buy its stock” and that “you must aspire to ‘adequate,’ not extraordinary, performance” (Graham, pg. 35). Graham recognizes that most investors do not have the experience for highly advanced analytical stock selection. As such he emphasizes the process of security selection over the method of selecting securities; that is, rather than sophisticated evaluative procedures, Graham encourages investors to seek out solid and established business models – blue chip stocks. These stocks should be purchased in a bear market. In establishing the proper blue chip options, Graham recommends the defensive investor implement seven evaluative criteria: (1) adequate size of the enterprise, (2) a sufficiently strong financial position, (3) earnings stability, (4) dividend record (“uninterrupted payments for at least the past 20 years” (Graham, pg. 348), (5) earnings growth (“a minimum increase of at least one-third in per-share earnings in the past ten years” (Graham, pg. 348), (6) moderate PE ratio (“should not be more than 15 times average earnings of the past three years” (Graham, pg. 349), and (7) moderate ratio of price to assets (should not exceed 22.5). In addition, Graham indicates that bonds should be chosen in terms of the individual investor’s goals. Ultimately, these approaches can be applied to all sectors and markets. Implementation and Evaluation There are a variety of considerations to implementing this strategy. My current position as a long-term investor is such that I would have a higher allocation of stocks to bonds, with a 74% to 24% proportion. I would then include a 2% allocation of precious metals. In terms of stock considerations I would choose a diversified portfolio of blue chips stock. In these regards, technology stock such as IBM, would be balanced with fast food giant McDonalds, and perhaps bioengineering firm Merck. These are safe dividend driven stocks that also contain growth potential. In terms of bonds I would tend towards conservative mutual funds and REITs that function as a conservative foil and inflation hedge to higher risk potential stock allocation. I would not engage in the derivatives market. In terms of evaluative criteria Graham resists providing investors with guaranteed percentages. Instead he indicates the general percentages that have been expected through stocks and bonds throughout the previous century, indicating 3-4% after inflation. After reading Graham’s text one comes to understand the fallacious nature of guaranteed return percentage a true understanding of a century of market fluctuations make such certainty a near impossibility. Recommendation I would recommend Graham’s strategic approach. While some might argue that Graham is overly conservative, half a century of investing has demonstrated that his approach is highly consistent. Particularly in the current uncertain market, with the United States recession and European Debt Crisis, such a conservative approach is the only safe solution. References Graham, Benjamin. The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel. New York: Collins Business, 1993. Read More