Three Key Investing Principles from 'Benjamin Graham and the Power of Growth Stocks'

Three Key Investing Principles from 'Benjamin Graham and the Power of Growth Stocks'

This book lays out a thorough and meticulous strategy for investing successfully in growth stocks. You may not be able to apply every concept detailed in this book on every stock that you buy, but if, at the very least, you can incorporate the three most important concepts from this book into your own investment process, you will be well ahead of the vast majority of stock market investors. What are those three concepts?

1. Margin of safety. In a 1976 interview with the Financial Analysts Journal, Benjamin Graham was asked what he considered to be the most important rules of investing. The first rule he offered was to make sure that there is a margin of safety for every stock you buy. “He [the investor] should be able to justify every purchase he makes,” said Graham, “and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money’s worth for his purchase—in other words, that he has a margin of safety, in value terms, to protect his commitment.”

2. Mr. Market. The incarnation of the entire universe of stock market investors, Mr. Market shows up every day willing to buy or sell any number of shares in any company. Sometimes the share prices are ridiculously high, and sometimes they are ridiculously low. It’s the fickle nature of Mr. Market that gives shrewd investors the occasional opportunity to buy stocks well below their intrinsic value. As Warren Buffett put it in a 1984 article in the Columbia Business School Magazine, “I’m convinced that there is much inefficiency in the market. When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.” For the alert investor, Mr. Market brings those nonsensical prices right to your door every business day.

3. The power of compounding. Albert Einstein and many, many others have marveled at the power of compound interest; it has been called “the most powerful force in the universe.” Over a lifetime, a single percentage point can be worth millions of dollars through the power of compounding. That’s why it’s important to squeeze every possible percentage point out of every investment that you make.

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Build In a Margin of Safety

When you make a decision to buy a stock, make sure you build in a margin of safety. The “margin of safety” is typically defined as the difference between the intrinsic value of a stock and its market price. In other words, a stock that is trading significantly below its intrinsic value has a wide margin of safety, while a stock that is trading at or above its intrinsic value has no margin of safety. The cheaper you can buy a stock relative to its intrinsic value, the bigger your margin of safety. Buying a stock with a margin of safety doesn’t ensure that you will not have a loss on the stock—occasionally a company will fall out of favor for any of a variety of reasons and fall well below its previous trading level—but the margin of safety gives you a better chance of avoiding a loss on the stock.

For individual investors, a margin of safety is developed by strict adherence to quantitative analysis. You must play by the book. As you gain experience, qualitative factors can come into play. Before you purchase a stock, make sure you have a “warm and fuzzy feeling” in your gut.

Those who want to become great investors must understand that the next stock purchase should be regarded as a do-or-die effort. Just as in golf, the last shot you hit has little to do with your next shot. When you are investing, remember that a series of winning investments does not mean that the next one will work out, nor does a string of losers mean that the next one will be bad. Often the inverse is true, if you stick to the basics of Graham’s methodology. Great investors insist on an adequate margin of safety for the next purchase, regardless of prior results.

Your ability to build an adequate margin of safety for each purchase determines how many stocks you should own.

Graham suggested that to determine an accurate margin of safety based on a true valuation of the company, an investor needs to evaluate the performance of the company over a period of several years— “including preferably a period of subnormal business.”

We follow three key rules for setting a margin of safety for the growth companies we buy:

1. Know what you own.

2. Develop reasonable forecasts.

3. Set a reasonable hurdle rate.

For a value company, you can incorporate a margin of safety by buying the stock at a price below its intrinsic value. But with a growth company, investors need to take into account the future value of the company. The margin of safety shouldn’t be predicated on the current intrinsic value of the stock, but rather on the future value. When we set a margin of safety for the stocks we buy, we base it on our projection of the company’s intrinsic value seven years out. At our firm, we have used a hurdle rate of 12 percent for years. If we miss our mark by a little bit and end up with a 10 percent rate of return, we are not happy, but we have still achieved a reasonable profit.

You may not always reach your targeted rate of return, but if you do a good job of building a seven-year financial model with a conservative projected intrinsic value, and if you build in a substantial margin of safety for every stock you buy, the odds of success will be in your favor.

Take Advantage of Mr. Market

The behavioral characteristics of Mr. Market give the astute investor a continuing set of opportunities to purchase stocks at attractive prices. The ability to buy stocks at a moment’s notice gives us the flexibility we need to take advantage of price declines and buy stocks at attractive prices. Mr. Market’s actions also tempt us to sell our positions needlessly. We can easily become distracted by the daily movements of the market. Astute investors need to become somewhat bipolar in their approach to the stock market. An investor should take advantage of the volatility in stock prices at the time of purchase. The rest of the time, however, the investor should ignore the market fluctuations and concentrate on the fundamental progress of the companies behind the stocks. The ability to do this requires discipline and preparation.

Only when the stock price rises so high as to threaten the margin of safety should an investor think about selling the stock.

Graham’s insightful observation that a company’s intrinsic value and its stock price can differ widely is critical to investment success— although it is often difficult to separate the two. This is especially critical when a stock is declining sharply on what is clearly bad news. In this situation, clear-headed thinking and defensible decisions can pay huge dividends.

If you want to succeed in the investment world, you must understand the difference between intrinsic value and stock prices. When stock prices fall, for whatever reason, we feel bad, but stocks are now cheaper. Our margin of safety is increasing. When stock prices rise, we feel better, but our margin of safety is decreasing.

We firmly believe that any investor who understands the difference between a stock price and the intrinsic value of the company behind the stock is on firmer ground than at least 75 percent of all investors. Learning to use Mr. Market to your advantage can help you buy great stocks at the best possible prices.

Be Mindful of the Power of Compound Interest

Compound interest is a critically important principle of investing. In fact, we encourage every reader to keep compound interest tables handy when investing.

There is much to be learned from perusing these tables, including the fact that achieving a double-digit return over long periods of time makes one very rich. If you were to begin with $100,000 and compound it at 10 percent per year for 50 years, your investment would grow to $11,739,000. From this example, we can also deduce that very few people earn a return of 10 percent or greater because so few people get rich.

You can use the compound interest tables to establish a hurdle rate for yourself or to understand the devastation that can result from a 50 percent decline in value with no recovery. They help us recognize the importance of high compound returns when we have substantial amounts of assets under management.

Compound interest tables show the fallacy of using volatility as a measure of risk. Superior results produced by an additional 1 to 3 percent return per year over the market averages can be obscured by volatility over shorter time periods. If you look at your progress one year at a time, you may wonder why you are trying so hard to gain 1 to 3 percent. But viewed over long periods of time, superior incremental returns produce stunning differences in performance. If Investor A invests $100,000 and earns a compound return of 10 percent, at the end of 50 years, he will have $11,739,000. If Investor B earns 7 percent per year over the same time frame, his portfolio will be worth $2,945,670. Investor A’s portfolio will be four times larger than Investor B’s! Compound interest tables can also illustrate the deadly effects of excessive investment fees and brokerage commissions. Investors A and B both earn a compound return of 10 percent on their portfolios over 50 years. Investor A pays no fees, while Investor B pays investment management and brokerage fees of 1.5 percent per year, reducing his net return to 8.5 percent per year. At the end of 50 years, Investor A’s portfolio will be approximately double Investor B’s portfolio. Investment management fees and brokerage costs are expensive! Investors may also want to examine the effects of high turnover on portfolio returns. High turnover can generate short-term capital gains, which are taxed at higher rates than long-term capital gains. Higher tax payments can seriously diminish long-term performance. Consider the favorable impact on an investor who buys a stock and holds it for 50 years without paying capital gains taxes.

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Benjamin Graham and the Power of Growth Stocks,

Frederick K. Martin