...and Happy Birthday Ben Graham
05/06/2005 12:00 am EST
"Thirty years after his passing, Ben Graham's ideas live on," says Dreyfus Neean, analyst with Don Phillips' Morningstar . "With the 111th anniversary of his birthday on May 9, we revisit his strategies, and highlight some stock ideas based on his philosophy."
"One of the earliest professional analysts, Ben Graham started teaching a course in security analysis at Columbia, his alma mater, hoping that the discipline of teaching and interacting with students would help refine and structure his ideas. His course became one of Columbia's most popular, and the resultant book, Security Analysis became one of the best-selling investment books, followed by his The Intelligent Investor. It's unfortunate that Ben Graham is no longer with us, but his approach to investing is as relevant today as ever. We can only hope to honor his memory by renewing our appreciation of his ideas."
"Of the many intellectual advances Graham delivered, we'd like to highlight three. Graham was one of the first to distinguish the value of a business from its price in the market. From this, Graham's corollary was that the price an investor paid for a security determined that investor's return. Graham also recognized that valuing securities was inherently difficult and racked with uncertainty, and concluded that investors should only purchase securities when a margin of safety was available. In other words, Graham was the first analyst to realize that the odds of attractive investment returns could be greatly improved by accurately valuing securities, and then only investing when an ownership interest could be acquired at a discount to the underlying fair value of the business.
"With that in mind, let's apply two Graham techniques to uncover stocks with above-average potential for attractive returns. We will employ techniques Graham subsequently developed, which were detailed in Financial Analysts' Journal in 1976. His first technique was to invest in stocks that sold for not more than seven times the previous year's earnings. With this is mind, we've scoured our universe looking for candidates. We restricted our choices to stocks with a Morningstar Rating for stocks of 5 stars, average or below-average risk, and at least a 25% margin of safety. While few stocks meet these criteria in today's market, we're confident that Graham would have selected these three for further research: Steel Dynamics (STLD NASDAQ), trading at 5.5 times earnings; LandAmerica (LFG NYSE), a real estate financing firm, trading at 6 times earnings; and auto interior supplier, Lear (LEA NYSE), trading at 6.8 times earnings. Graham's other technique was to invest in stocks sporting a price/book ratio no higher than 83%. This is a much tougher test, and we only found one 5-star, average-risk stock that passed- Celestica (CLS NYSE), which provides electronics manufacturing services to the computing and communications industries.
"But there's one more stock we'd like to suggest-and we know from history that Graham actually did buy this one. What's more, it survives as a cheap stock. Graham noted that when he bought this particular stock, he parted from his usual extreme diversification, investing 25% of his partnership's assets, and paid a much higher price in relation to earnings or book than he was accustomed. Yet, somewhat ironically, Graham made more than 200 times his money during the next 15 years- far more than most of his other investment profits combined. Graham himself noted that this experience taught just how important a single investment decision could be. The stock was GEICO, which was then a listed company. Today, GEICO is part of Berkshire Hathaway (BRK.A and BRK.B NYSE), a firm headed by Graham's star pupil, former employee, and subsequent coauthor, Warren Buffett. While we guarantee that today's GEICO investors won't make 200 times their money in 15 years and that Berkshire easily fails Graham's price/earnings and price/book tests, we do think Graham would approve. After all, Berkshire easily passes our modern (discounted cash-flow valuation) margin of safety requirement, and it is run by a friend he admired greatly."