In the investing community, Ben Graham has been referred to as the father of value investing. He set the precedent for investing in businesses, rather than speculating in stocks. Graham’s three main principles were to find a stock with margin of safety, understand market sentiment, and invest in a business, not just a stock. The successful investor avoids Graham’s first principle in its literal form; to find a stock with margin of safety.
According to Graham, finding margin of safety involved two steps. First, the investor calculated a business’s net working capital: Net Net Working Capital = Cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) – total liabilities. Second, the investor looked for businesses whose market value was two thirds of its net working capital. Although Graham’s margin of safety equation is applicable, one will undoubtedly be faced with the challenge of finding the stock that satisfies his equation in the current market. To shed light, Graham wrote the intelligent investor in 1949, a period in which investors’ pain loomed from the 1929 market crash and subsequent depression. Therefore, stocks then were still very much reasonably priced. However, Graham conceded later in his career that his margin of safety equation was null and void; “I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities”.
Given Graham’s words of defeat, though, value investing is certainly not dead. The successful investor simply evolved Graham’s margin of safety concept. Rather than heeding to Graham’s strict equation, the successful investor liberally factors P/E, P/S, and M/B into his equation to find businesses with margin of safety. Simply, if the successful investor were to believe the market was undervaluing a quality business based on those factors, he invested in its stock, achieving margin of safety. The margin of safety principle asserts that in due time, the market aligns a stock’s price with its underlying business value. Further, the successful investor disagreed with Graham on one subject – a stock’s holding period. Indeed, Graham was not a buy and hold forever investor. Instead, Graham invested in a business that satisfied his definition of margin of safety and divested that business once its stock’s price aligned with its underlying business value. Graham’s holding period then was akin to looking for smoked cigars, picking up cigars that had one puff left, inhaling, and then discarding.
Disclosure: No positions