The father of value investing

Ben Graham is usually known as the father of value investing. Graham's ideas have become popular among investors in recent years, not least because of frequent references made to Graham by Warren Buffett and the bracketing of the two together in the minds of many.

Graham's techniques were set out in the book Security Analysis, first published in 1934. It is not stating things too strongly to say that this is the ultimate source book for any investment analyst, even though some of the examples and techniques may appear a little dated.

Value investing today, though, means something a little different. He was, for example, an outspoken critic of the companies of his day and their opaque accounting policies. No change there. Buffett has done the same.

He was also an advocate of what would now be called income investing, preferring dividends paid out as cash to shareholders, rather than retained within the company. He also selected companies for investing on value criteria - he preferred to rely on tangible assets rather than nebulous profits as his yardstick.

Net-net asset value approach

Graham's main method, known as the net-net asset value approach, was to try and buy companies that were selling at less than the value of their net current assets less any long-term debt. In other words, he ignored fixed assets as being potentially worthless if they had to be sold in a hurry.

Once the net-net asset value had been worked out, the resulting per share figure had to be at least 50% greater than the share price, to make sure that the investor had a margin of safety. This concept is also a key part of Buffett's investment method. In Graham's theory, though, a serious value investor would buy all the shares in the companies that satisfied this rule. No attention would be paid to the type of business they were in. The shares would be sold when they ceased to satisfy the value criteria.

The problem with this approach is that there are very few - if any - conventional companies that satisfy these highly demanding criteria in today's stockmarket. It is also open to question whether the technique as stated is actually completely valid. Stocks, which are included in current assets, may be considerably harder to sell than fixed property assets in the event of liquidation, for example.

The modern day approach to value investing relies on a number of other criteria to establish value, including a price-sales ratio less than one and single figure multiple of price to cash flow. Value investors also seek out companies with minimal levels of debt.

Although we can dismiss the net-net approach as impractical, we cannot dismiss Graham's value investing approach quite so easily.

For ordinary investors, he advocated buying between 10 and 30 shares in large conservatively financed companies (that is, ones with low gearing and decent asset backing), with a long period of continuous dividend payments and a low price earnings ratio. The net-net approach was designed for more sophisticated investors.

Peter says

Graham's book Security Analysis was the first investment book I ever bought and it has taken me over 30 years to digest its lessons.

Graham's approach has spawned numerous interpretations and side-theories. One obvious point about it is that, if you use his method, the shares select themselves. One need pay no attention to the underlying business. The selection process is entirely quantitative.

A lot of gurus don't like this much because it seems too deterministic. The guru's judgement is not really required if the stocks pick themselves.

Investing gurus like Buffett tend to loosen Graham's strict criteria and pay attention to the characteristics of the underlying business, in order to supply their own input. An alternate guru approach is that advocated by fund managers like Mario Gabelli, best described as the value with a catalyst approach. 

In other words, picking a value stock may be all very well, but what is required to produce performance from the stock is some sort of catalyst that will lead to its undervalued nature being recognised. Catalysts might include the takeover of another company in the same industry at a premium price, a regulatory change, a management change at the company, or some other event. This seems to me to make eminent sense.

Graham, who died in 1976, has nonetheless pointed the way for generations of later investors to use systematic criteria to pick the stocks they bought. His other famous book, The Intelligent Investor, published in 1949 is still a classic worth the attention of any serious investor.