GURU FOCUS: Warren Buffett's Mentor - Benjamin Graham's Investment Techniques

In case you didn't know Benjamin Graham was a sort of mentor to Warren Buffett and Buffett picked up a large part of his investing arsenal from him. Graham wrote the "bible" of investing, "The Intelligent Investor" and is something Buffett used to fashion his own style of investing, so he is inseparable from the Warren Buffett story.


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The Investment methods of Benjamin Graham

Dr John Price, 13 Jan 2008, Guru Focus


Most investors realize that book value is a poor method for deciding whether to buy stock in a company. But Benjamin Graham turned it into an art form that can give a boost to your profits.

Benjamin Graham was a genius. When he graduated from Columbia College he was offered teaching positions in English, mathematics and philosophy. But as fate would have it, he started his career on Wall Street working for Newburger, Henderson and Loeb as a runner delivering checks and securities. His talent was soon recognized and within a few months he was writing one of its daily market letters.

His reputation as the father of value investing can be dated from 1928 when he started teaching a course Advanced Security Analysis at his old college. He had been thinking of writing a book and he reasoned that the best way to get this done was to start by preparing and teaching the material in a classroom setting.

The notes from the course were transcribed by David Dodd and formed the basis of the investment classic Security Analysis which was published in 1934.

Graham's classes were often attended by financial analysts who freely acted on the tips given by Graham. In fact, many admitted that his courses were so profitable that they attended them over consecutive years. His classes and the Graham and Dodd book were the foundation of a whole new approach to the investment industry based on principles that appealed to common-sense but were at the same time exceedingly effective. "Understand the difference between price and value" and "always allow for a margin of safety" are two examples.

Returning to book value, the common equity or net worth of a company is defined as the assets of a company minus the liabilities. Dividing the result by the number of shares outstanding gives the book value. It is the amount that appears in the accounts or the books on a per share basis if the assets were sold and all liabilities were paid. (For simplicity we assume that there are no preferred shares.)

Comparison of the share price with the book value is a ratio that is often quoted. For example, Research in Motion (RIMM) has a book value of $5.50. Since its current price is $122.08, its price-to-book ratio is 22.20. A completely different company with an even higher price-to-book ratio is Amazon.com (AMZN). Its book value and current price are $1.83 and $89.15 and so its price-to-book ratio is 48.72. In contrast, the book value and price of Lennar, a housing construction compnay, are $31.80 and $14.77 so its price-to-book ratio is 0.46.

Examples such as these show that the price-to-book ratio on its own is a poor indicator of value. It can, however, be a useful guide when it is tracked over time for an individual company or when it is used as part of a comparison between companies in the same sector.

Instead of using book value, Benjamin Graham liked to modify its components to give what he believed was a more useful valuation measurement. In Security Analysis, we read, "The first rule in calculating liquidating value is that liabilities are real but the assets are of questionable value."

He would discount the different classes of assets depending upon their reliability to get an estimate of liquidating value by the amounts shown in the following table:

Asset Class	% of Face Value
Cash Assets	100%
Receivables	75-90%
Inventories	50-75%
Fixed Assets	1-50%

After calculating the new value of the assets according to the above table, he would subtract the liabilities to get an estimate of liquidating value. Once divided by the number of shares outstanding, this would be compared to the share price

Later, in The Intelligent Investor, Graham simplified this table by applying no discount to current assets (generally cash, receivables and inventory) and a 100% discount to everything else. He wrote:

It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone-after deducting all prior claims, and counting as zero the fixed and other assets-the results should be quite satisfactory.

To be specific, define the net current asset value NCAV of a stock as the current assets less all liabilities with the calculations done on a per-share basis. Usually the NCAV is negative. Occasionally it is positive. Even more rarely it exceeds the share price. These are the shares that Graham suggests buying.

Reporting in the Financial Analysts Journal in 1986, Henry Oppenheimer described a study over the period 1970 to 1983 involving the NCAV. Each year a portfolio was formed consisting of companies that had a share price no more than two-thirds of its NCAV. After each twelve months the portfolios were liquidated and new ones formed.

The results were remarkable. If $10,000 was invested in the NCAV portfolio at the start of the study, by the end of 1983 it would have grown to $254,973. In contrast, if the same amount of money was invested in benchmark portfolios selected from the New York Stock Exchange and the American Exchange it would have grown to $37,296. If invested in a small firm index, it would have grown to $101,992.

In percentage terms, this represents annual growth rates of 28.3% for the general NCAV portfolio, 10.7% for the benchmark portfolio, and 19.6% for the small firm index.

A parallel study with similar results was carried out by Joseph Vu using stocks from Value Line over the period 1977 to 1984.

The type of companies that tend to be picked up using this method are those with a lot of inventory but which are having a tough period with depressed sales and little or no earnings. If the company pulls through, then there will be quite a boost in earnings and hence the share price. If it doesn't, it goes into bankruptcy and the inventory is sold off at bargain prices.

How easy are these stocks to find? Oppenheimer found about 50 each year during his study. However, in the late 1990s I could find none. (In the mid 1990s I had some success with Intertan and Blair using this method.)

It came as a surprise to me when I recently scanned the largest 1500 stocks in the US and found that quite a few satisfy the Graham NCAV criterion. (I coudn't find any in Australia.) The US stocks are displayed in the following table. The column called "NCAV ratio" is the current price of the stock divided by its NCAV. Only stocks with an NCAV ratio that is positive and less than 1 are displayed. I have included the current price as well as the 12 month high for each stock to give an idea of recent price movement.

Company Name	Ticker	Sector	Price	12m High	NCAV	NCAV Ratio
E*Trade Fin'l	ETFC	Brokerage - National	$3.52	$26.08	$72.08	0.05
Beazer Homes	BZH	Residential Construction	$8.45	$47.07	$46.62	0.18
Hovnanian Enterpr	HOV	Residential Construction	$7.11	$37.58	$30.98	0.23
Standard Pacific	SPF	Residential Construction	$3.95	$30.52	$9.23	0.43
Merrill Lynch.	MER	Brokerage - National	$53.90	$98.68	$117.49	0.46
Handleman Co.	HDL	Wholesale - Other	$1.95	$7.99	$3.79	0.52
Finish Line	FINL	Apparel Stores	$3.03	$14.75	$5.32	0.57
Trans World	TWMC	Music, Video Stores	$4.83	$6.28	$7.80	0.62
Loews Corp.	LTR	Property, Casualty Ins	$50.24	$53.46	$78.55	0.64
Lennar Corp.	LEN	Residential Construction	$17.90	$56.64	$27.42	0.65
UTStarcom Inc.	UTSI	Wireless Communication	$2.75	$10.32	$4.09	0.67
Friedman Billings	FBR	Brokerage - Regional	$3.49	$8.39	$4.89	0.71
InFocus Corp.	INFS	Computer Peripherals	$1.46	$2.94	$2.04	0.72
Capital Trust	CT	Property Management	$36.90	$55.97	$45.27	0.82
Pulte Homes	PHM	Residential Construction	$10.44	$35.56	$12.80	0.82
Sun-Times Media	SVN	Publishing - Newspapers	$1.83	$6.94	$2.00	0.92
Toll Brothers	TOL	Residential Construction	$21.18	$35.64	$22.66	0.93
Temple-Inland	TIN	Paper, Paper Products	$31.35	$66.28	$32.83	0.95
Horton D.R.	DHI	Residential Construction	$13.83	$31.13	$13.94	0.99
Source: Conscious Investor, Sherlock Investing, Value Line

As an example, consider Lennar Corporation, a major company in the residential construction sector. Almost 90% of its current assets are made up of inventory. Of these assets, approximately half are made up of finished homes and homes under construction and half are made up of land under development. This leads to a net current asset value of approximately $27 per share.

Consider the assets of the company in the areas of finished homes, homes under construction and land under development. If we could be sure that the company could turn them into the values described in the balance sheet, then Lennar would be an attractive purchase. The cloud arises because of the uncertainty that they will actually be able to do this. There may have to be some major write downs.

It is interesting to note that the balance sheet for Lennar has changed very little over the past 5 quarters. Both assets and liabilities are slightly lower then they were 12 months ago with an overall drop in equity from $5.9 billion to $5.1 billion.

The major change has been in the profit and loss statement with quarterly earnings per share dropping from $1.30 a year ago to -$3.25 in the last quarter. This has resulted in a massive drop in price which in turn means that it now passes the Graham NCAV criterion.

The broad interpretation is that when a company is running full steam ahead, the profit and loss statement may be the best guide to its "investability". In contrast, when it is in a distressed state, the balance sheet become more important.

Lennar is fairly typical of the type of companies that pass the Graham NCAV criterion. As stated above, they usually that have a large amount of inventory but have undergone a major drop in earnings. This in turn has caused a major drop in price. If the companies manage to turn around, then the inventory will be processed and sold for its proper value. But if they do not recover, the inventory is likely to be sold for a few cents on the dollar.

Buffett's initial apprenticeship with Benjamin Graham involved looking for companies satisfying the NCAV and related criteria. They were referred to as cigar butt companies: they had a few "puffs" left in them. One drawback was that their stock prices tended to be very volatile. At a recent annual meeting of Berkshire Hathaway Buffett explained that they would hold two or three hundred cigar butts in order to smooth out the volatility. He continued by saying that it was no fun waiting to see if a company was going into bankruptcy or was going to make a substantial profit.

He also had this to say about this approach in the 1989 Annual Report of Berkshire Hathaway:

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the "cigar butt" approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the "bargain purchase" will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original "bargain" price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost.

Buffett ended by writing, "Time is the friend of the wonderful business, the enemy of the mediocre."

Perhaps, as Buffett said, this approach was both foolish and no fun, but Oppenheimer's and Vu's studies showed that, at least in the past, you could have made healthy returns using this strategy.

In his later years Graham sort other combinations of conditions that could be used by any investor to find attractive stocks. In the 1970s he described a set of ten criteria that, he declared, "seemed to be practically a foolproof way of getting good results out of common stock investments with a minimum of work."

The ten rules developed by Graham are to choose stocks with:

1. An earnings-to-price yield at least twice the AAA bond yield.
2. A price-earnings ratio less than 40 percent of the highest price-earnings ratio the stock had over the past five years.
3. A dividend yield of at least two-thirds the AAA bond yield.
4. Stock price below two-thirds of tangible book value per share.
5. Stock price two-thirds "net current asset value."
6. Total debt less than book value.
7. Current ratio greater than two.
8. Total debt less than twice "net current asset value."
9. Earnings growth of prior ten years at least 7 percent on an annual basis.
10. Stability of growth of earnings in that no more than two declines of 5 percent or more in the prior 10 years.

The first five criteria were meant to determine "reward" and the second five "risk." I was interested to note that Benjamin Graham included "stability of growth of earnings" as one of the criteria. The degree of this stability is measured precisely by a function I developed for my investment software Conscious Investor. See also the site www.stablegrowthcompanies.com.

In 1984 Henry Oppenheimer published a study of Graham's selection criteria in the Financial Analysts Journal. He used various groupings of the criteria to test which were the best at predicting superior performance over the period from 1974 to 1981. Amongst other results, he found that an investor who chose stocks using just criteria (1) and (6) would have achieved a mean annual return of 38 percent compared to a market return of just 14 percent. Use of criteria (3) and (6) would have given an annual return of 26 percent.

Oppenheimer also observed that the performance of Graham's criteria declined after 1976 but still outperformed basic benchmarks.

Just as with any other screening method based on simple criteria, results can be excellent in one period and limited in another. So blind application is never recommended. But as a starting point for finding quality stocks, Graham's NCAV and ten-criteria methods are well worth a second look.

In the fifth article in this series I am going to look at discount cash valuation methods, the standard method taught in finance courses around the world and used by all the major financial institutions. It was first described by Robert Weise in a Barrons' article in 1930. He wrote, "The proper price of any security, whether a stock or a bond, is the sum of all future income payments discounted at the current rate of interest in order to arrive at the present value." I will look at what this means in practice and discuss the benefits and weaknesses of the method.