Benjamin Graham's Advice For This Stock Market

Includes: BF.B, BRK.B, HSY, IBM, RDS.B, WFC
by: Tim McAleenan Jr.

Benjamin Graham had spent most of his teaching life preaching the values of thrift and finding good bargains. In his class lectures, he gave the prototypical explanation of value investing by saying it's about "finding dollar bills trading for fifty cents." This phrase became more than a pithy saying to his star protégé, Warren Buffett, and Buffett attributed the success of his partnership (which earned 29.5% annually from 1957 to 1969) to Graham's insistence on bargain hunting. With this in mind, it may come as a surprise that Graham's advice to the typical investor paid little heed to the maximization of value by finding the best margin of safety.

In his legendary work The Intelligent Investor, Graham attempted to answer the question whether folks should try and build up cash positions and wait for a particularly cheap opportunity to make an investment, or invest in the stock market as funds became available. On page 206 of The Intelligent Investor, Graham offered this advice:

It is far from certain that the typical investor should regularly hold off buying until low market levels appear, because this may involve a long wait, very likely the loss of income, and the possible missing of investment opportunities. On the whole it may be better for the investor to do his stock buying whenever he has money to put in stocks, except when the general market level is much higher than can be justified by well-established standards of value. If he wants to be shrewd he can look for the ever-present bargain opportunities in individual securities.

Not everyone agrees with this Benjamin Graham recommendation. Charlie Munger, the Vice Chairman of Berkshire Hathaway (NYSE:BRK.B) and one of my investing heroes, said that most of his best investments have come when he was able to patiently sit on capital and then make heavy investments into excellent companies when they reach that "once in a decade or so" valuation level. Personally, I tilt in Munger's direction.

But I think Graham's advice is particularly useful to investors that are able to invest in their 401ks. For such an investor, the best thing is to increase the savings rate to a meaningful amount, reap the benefits of tax-deferred investing, and receive a company match if applicable. Right now, the index components of the S&P 500 are trading at around 18x earnings. That could indicate a modest overvaluation if there is a return to the historical valuation of 15-16x earnings. If you're dealing with retirement accounts, the tax deferred nature of the compounding more than offsets whatever modest headwind you would experience by dealing with slight overvaluation.

Graham's advice follows the line of thinking that suggests the pursuit of the perfect is the enemy of the good. You're not going to get burned socking away money in an S&P 500 index fund at 18x earnings and letting it compound for decades beyond Uncle Sam's reach. Rather, it is paying 25-30x earnings for broad market indices that can get you into some trouble.

Additionally, there is another appeal to following Graham's advice and applying it to an index strategy within a retirement account at this time. Namely, not all valuations in the market are similar. Companies like IBM (NYSE:IBM) and Wells Fargo (NYSE:WFC) are much cheaper than Brown-Forman (NYSE:BF.B) and Hershey (NYSE:HSY) using traditional and historical pricing metrics like P/E ratios and book value, and by using an index fund, you can achieve blended returns that have the overvaluations in some areas of the market balanced by the undervaluations in other areas of the market.

While I believe that Benjamin Graham's advice is best suited for investors considering owning index funds within a retirement account, Graham himself was speaking within the context of individual stocks. The main reason he argues why investors should invest as funds become available is because "this may involve a long wait, very likely the loss of income, and the possible missing of investment opportunities."

Right now, Royal Dutch Shell (NYSE:RDS.B) trades at $67 per share. The company earns about $8.50 per share. That's a P/E ratio below 8x earnings. Sure, it could be cheaper. But nevertheless, you get a $3.44 annual dividend. You could drive yourself crazy waiting for a lower price, or you could take the 5% starting dividend and buy an ownership stake in a firm that is projected to increase earnings to $11.00 per share in 2016. Make a determination about whether that prediction is realistic, then determine whether that would be a satisfactory result given your own evaluation of your opportunity costs, and if you answer both questions yes, you can make your purchase and go about life as the $0.86 per share dividend check shows up every three months (and, if history and earnings are any indication, will continue to grow).

Obviously, we are all interested in acquiring the most value (however we may measure that) for each dollar that we deploy into our investments. People like Charlie Munger wait for opportunities to become very attractive before they make their move. But the logic of what Benjamin Graham said on page 206 of The Intelligent Investor deserves consideration as well. It can be easy to look back with nostalgia at the prices in 2008 and 2009 and then swear off making additional purchases at this time. Although he did not intend this, Graham's advice seems particularly relevant for investors that have index fund options with their retirement accounts. The slight overvaluation of the market today will barely be a blip on the screen 10-20 years from now. There's no reason to stop plowing money into your retirement accounts. Graham was on to something when he said that, for the most part, money should be deployed as money becomes available.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.