Three Investing Lessons From Benjamin Graham, Part I

 “Walter Lippmann spoke of men who plant trees that other men will sit under. Ben Graham was such a man.”

– Warren Buffett

 

Source: Deepstash

Who is Benjamin Graham?

Benjamin Graham is often known as the father of value investing. His most famous student is Warren Buffett, arguably the greatest investor of all time. Other great investors such as Walter Schloss, Bill Ruane, Bill Ackman, Seth Klarman, and many more have been inspired by Graham’s investment philosophy. He is also the inventor of the CFA exams and the author of the two investing bibles: “The Intelligent Investor” and “Security Analysis”.

“Buffett had read Graham’s new book, The Intelligent Investor, while at Lincoln, and had found it highly captivating. Wood, Buffett’s housemane, said, “It was almost like he had found a god.”

– Roger Lowenstein, Buffett, Chapter 2 “RUNAWAY”.

Graham was a great investor himself, achieving around a 20% annualized return for 20 years. Yet, his talents did not stop at investing. Weeks before he graduated Columbia University, he was offered teaching positions in three different subjects –  Greek and Latin Philosophy, Mathematics, and English. Graham also invented and patented two types of hand-held calculators and even wrote a play for Broadway. Investing was just one of his many hobbies.

Regardless, the pioneer of value investing has left us with many invaluable lessons, one of which we will discuss today. This article is part one of a three-part series: Three Lessons from Benjamin Graham. 

Lesson 1: A Stock Represents Part Ownership in a Business.

A stock represents part ownership of a company’s equity. Therefore, the value of a stock is determined by how much that equity will grow in the future. If you are completely new to investing and want an in-depth definition of what a stock is, comment down below, and I will provide one in a later article.

Benjamin Graham’s key investment philosophy is a “value mindset”. Again, a stock represents a business, and that business has a certain value (we talked about what “value” exactly is in “The Feud Between Growth and Value”). This is a pretty obvious concept for modern-day investors. Then why is this one of the three key lessons Graham can teach us?

Innovative ideas have an antithesis. They directly oppose a commonly held idea. What commonly held idea did Benjamin Graham reject?

It was the view that stocks were valueless papers that rose and fell, seen as just tools for gambling. 

Graham published the first edition of  “Security Analysis” in 1934. This was just a little more than 20 years after the establishment of the Federal Reserve. From 1914 to 1918, there was a World War, and the United States prospered afterwards. Demand for innovative technologies such as refrigerators and washing machines rose, and there was a major sector shift from railroads to cars. Then, the Great Depression struck in 1929, and 1934 was when the US was slowly recovering from the impact.

Can you imagine what the atmosphere was like? New technologies, volatile prices of goods, and news of war greatly shook the price of equities. Most people who traded stocks in this era were interested in obtaining insider information and what stocks the “big players” were buying. It was in this environment that Graham urged people to focus on fundamentals.

How does having a value mindset separate one from other investors?

Let’s assume stocks do not have value. If so, prices will move up when people hurry to buy and move down when they hurry to sell. In this case, how would investors profit? They would have to pay careful attention to price movements, who is buying or selling, and changes in volume. Value does not matter. What matters is that the next person in line is willing to pay a higher price for whatever the investor has bought.

If one thinks of a stock as something of value, then price movements are merely a chance to buy cheap or sell expensive. If you saw a pair of shoes worth $100 on sale for $50, you would be happy to buy it. If the price of the pair drops to $40 the next day, you might be a bit annoyed, but you could buy another one if you wanted to. What if it’s selling at $300? You probably wouldn’t touch it. You might even consider selling the pair you already have.

How would an investor without a value mindset act? Even if they bought this pair of shoes worth $100 at $50, they might consider selling when the price drops to $40. If the price rises to $300, they will scramble to buy another shoe. 

Investors without a value mindset are constantly anxious. They do not know the approximate value of the company they own, so they react excessively to price changes. Value minded investors can remain calm amidst the volatility of stock prices. There’s news to worry about every day and prices fluctuate, but value minded investors understand that there is a business behind every stock and the people who operate the business are working hard to keep it afloat. Price is just price.

“Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard.” 

– Warren Buffett

Source: Raptis Rare Books

In Chapter 8 of Intelligent Investor, Graham discusses two possible sources of outperformance: “timing” and “pricing”. Timing is buying when one thinks the price will go up and selling when it seems like the price will drop. Pricing is buying when value is greater than price and selling when price is greater than value. Graham states that timing is extremely difficult and that an investor can achieve satisfactory returns simply by focusing on the gap between price and value.

So here is the first lesson: A stock represents part ownership in a business. This ownership holds value. 

This is such an obvious fact. But you’d be surprised how many people remain oblivious, or worse, ignore it.

Next up is the second lesson from Graham: Mr. Market.

This article is adapted from a book called “거인의 어깨 1” by a successful fund manager, 홍진채 (Jin Chae Hong). The book has unfortunately not been translated into English. If you are fluent in Korean, I strongly recommend reading this book and his two other books “거인의 어깨 2” and “주식하는 마음”