When Benjamin Graham arrived on Wall Street, he had no idea he would one day be heralded as the father of value investing.
Here is a essential principles that formed the bedrock of his investing style. If Warren Buffett is to be believed (“no one ever became poor by reading Graham”), it would do you good to base your investing strategy on principles.
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.
Price fluctuations have only one significant meaning; they provide an opportunity to buy wisely when prices fall sharply and sell wisely when they advance a great deal. Consequently, view downturns as great buying opportunities since that is the time when the market insists upon offering a stock at considerably less than its indicated true value.
Investing with a margin of safety is 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.
By refusing to pay too much for an investment, you minimize the chances that your wealth will ever disappear or suddenly be destroyed.
Imagine that you find a stock that you think can grow at 10% a year even if the market only grows 5% annually. Unfortunately, you are so enthusiastic that you pay too high a price, and the stock loses 50% of its value the first year. Even if the stock then generates double the market’s return, it will take you more than 16 years to overtake the market-simply because you paid too much, and lost too much, at the outset.
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.