Everyone knows about Warren Buffet. He’s the richest man in the world on a given day, his company’s stock is currently sitting at $116,000 per share (not a type-o), and even Lebron James has sought out his advice. But who did Buffet turn to when he needed advice? Where did he get all these ideas for value investing?
Benjamin Graham was Buffet’s teacher in college. He was the one who introduced the idea of buying undervalued assets and selling overvalued ones. Graham was the originator of value investing, and these were the rules he used to make his fortune. Keep in mind, this is just a guideline that he used and in no way guarantees success. Obviously, Graham investing worked for him, but that doesn’t mean it’s foolproof.
Graham investing involves knowing the business.
He needed to be familiar with the industry to feel comfortable investing in the stock; biotech companies would have been off limits to him. He needed to understand who they sold to, who their competition was, and what their strengths and weaknesses are. It would be similar to starting a new company; all of that information would need to be discovered beforehand.
Graham investing focused on a company’s profits.
Graham made sure that a company was growing consistently. He wanted the sales to grow at least 10% per year for the most recent five years. This was a minimum. He believed with this consistent growth for this period of time, his stock would definitely continue that trend. To follow the Graham investing principles, one needs an established company with a record of success.
Graham investing involves getting to know the leaders in the company.
Knowing the history of the CEO and/or owners is very important in the Graham investing strategy. When buying a stock, he would be the new owner of this company. He would want to make sure that the people he has working for him are the best for the job.
Luckily, we have websites like forbes.com that make this much easier for us. If a CEO had a ton of stock options, or had sold a lot of their stock recently, the company might not be worth investing. Likewise, if the CEO had full confidence in the company, had purchased or had accumulated stock, and earned a reasonable salary, Graham knew that the CEO believed in the company and so should he.
Graham investing provided a margin of safety.
Every investor has a different method for calculating a stock’s value. This value is what price a stock should be. If the stock is currently trading below that mark, it is undervalued. The key was to find undervalued stocks and assume they would eventually reach their true value. Of course, this is a tricky business where calculations can be off, so Graham needed a margin of safety incase his numbers were wrong. He proposed that a stock would need to be undervalued by 40-50% before he would purchase it. This means that, if a stock’s calculated value was $40, it would need to be trading somewhere near $20 for Graham investing strategy to allow it.
For more information and practical uses of Graham investing strategies, I highly recommend two books: Intelligent Investor by Benjamin Graham, and Rule #1 Investing by Phil Town. Both are very detailed, give excellent formulas, and dive a little into the history of Warren Buffets idol. Graham investing worked for him, it’s worked for Buffet, and it’s worked for me. Investing like Graham and Buffet seems to be the most consistent path to success, and hopefully it will work just as well for you too.
Sources:
The Intelligent Investor, Benjamin Graham. 4th edition, 1986
Rule #1, Phil Town. 2007
