Graham’s investment philosophy is based on 5 principles that serve as a foundation.
- Investing is most intelligent when it is most businesslike.
- Nobody can tell the future.
- The future is something to protect against.
- Investors are moved in large part by irrational forces.
- Mean reversion is a fundamental law.
The Intelligent Investor blog writes about it in greater detail. Having said that, there are three investing guidelines that investors should pay heed to.
Expect volatility and profit from it
When investing in stocks, volatility comes with the territory. In his book The Intelligent Investor, Graham makes note of the market fluctuation in the price of General Motors. It rose from $13 in 1925 to $92 in 1929; collapsed to $7½ in 1932; climbed back to $77 in 1936; relapsed to $25½ in 1938; then mounted to $80½ in 1946 and fell back to $48 the very same year.
The behaviour of stock prices departs radically from the stock’s intrinsic worth. Prices respond vigorously to any significant change in either current earnings or short-term earning prospects. Both favourable and unfavourable situations are part of any normal long-term picture and both should be accepted without undue excitement.
Graham offers intelligent investors an escape from the swift tides of greed and fear. According to him, price fluctuations have only one significant meaning for the true investor: they provide him with an opportunity to buy wisely when prices fall sharply and sell wisely when they advance a great deal. At other times, Graham reckons, the investor will do better to forget about the market.
The investor should view downturns as great buying opportunities and not let the market’s views dictate buy and sell decisions. Graham encourages investors to be strong-minded people who refuse to buy any security expect when the market insists upon offering it to him at considerably less than its indicated true value.
Price matters
Stock price matters. However, it matters in relation to the value of the company. In other words, train your guns on value rather price during periods of turbulence. It’s a smart and sound way to reap financial dividends.
You could buy the best of stocks during times of exuberance, which could translate into a bad investment decision. That is why Graham advocates investing with a margin of safety – what he refers to as the “central concept” of investing. It is the difference between the fundamental, or intrinsic, value of the stock and the price at which the stock is trading. The aim is to pay less than the real value. In other words, purchase assets at a rate below the valuation of the business because it offers a safety net in case your evaluation of the business was wrong or if the business falters.
So let’s say according to your evaluation, a security is worth Rs 100 per share but trading at Rs 25. It enjoys a massive margin of safety and heavily stacks the odds in your favour. The greater the margin, the more leeway the investor has for negative conditions or unforeseen events before he loses money. The greater the margin of safety, the less risky the investment. Conversely, a stock that trades close to or above its intrinsic value offers almost no margin of safety. And buying without a margin of safety, in Graham's book, is no better than mere speculation.
Act like an owner
Stocks are not merely pieces of paper or electronic quotations on a computer screen, but partial ownership interests in real businesses. Investors must have an obligation to themselves to thoroughly analyse the underlying business and its prospects before purchasing a stock. As Graham wrote, you must study "the facts in light of established standards of safety and value."
Talking of acting like an owner of the business, Graham often bemoaned the apathy of shareholders. He noted that the typical American stockholder was the most docile animal in captivity who never thinks of asserting his individual rights as owner of the business. They vote in a sheeplike fashion for whatever the management recommends, not matter how poor the management’s record of accomplishment may be.
He urged shareholders never to forget that they are owners of a business and not merely owners of a quotation on the stock ticket. It is obvious from his writings that Graham considered managements the stewards of stockholder money and cited four important ways in which management may fail to act in the best interests of shareholders:
- Failure to pay dividends commensurate both with earnings and the value of the stockholders’ equity
- Use of stockholders’ money in a relatively unprofitable manner
- Use of stockholders’ money to buy back their stock at an inadequate price
- Maintenance of a holding company set-up in the face of the fact that the shareholders would be much better off if they owned the underlying assets directly
Most importantly, Graham urges potential investors to give thought as to what kind of investors they are. Enterprising or defensive? Being able to understand yourself would go a long way in making the right decisions. Not to forget, investors or speculators? In case you think you are both, he has some words of advice: Never mingle your speculative and investment operations in the same account, nor in any part of your thinking.