Value Investing Lessons From Benjamin Graham

A poet, translator, mathematician and financial strategist, Benjamin Graham was all of this and more. But his most signification contribution has been to lay the foundations of an investing strategy that revolved around buying undervalued stocks with strong fundamentals and holding them for the long term. We have used a screening method based on his strategy to recommend a few stocks you may consider

Benjamin Graham was a poet, translator, mathematician, and financial strategist, but his most significant contribution to finance was the development of the concept of value investing. This strategy involves buying undervalued securities with strong fundamentals and holding them for the long term.

His meticulous analysis and emphasis on the margin of safety became the cornerstones of value investing. This philosophy was formalised in his seminal work, Security Analysis, co-authored with David Dodd in 1934. He further distilled his philosophy in his book The Intelligent Investor (1949), making his investment strategies accessible to a wider audience.

The key pillar of value investing was his principle of “the margin of safety”. This principle advocates purchasing securities at prices significantly below their “intrinsic value”, thus providing a cushion against errors in judgement or market volatility. This helps in protecting investors from making substantial losses, while ensuring higher probability.

In his 1976 interview with Medical Economics Journal, he said, “The only thing you can be sure of is that there are times when a large number of stocks are priced too high and other times when they’re priced too low. My investigations have convinced me you can predetermine these logical ‘buy’ and ‘sell’ levels for a widely diversified portfolio without getting involved in weighing the fundamental factors affecting the prospects of specific companies or industries.”

He added, “What’s needed is, first, a definite rule for purchasing that indicates that you’re acquiring stocks for less than they’re worth. Second, you have to operate with a large enough number of stocks to make the approach effective. And, finally, you need a very definite guideline for selling.” With this single response, he highlighted intrinsic value, diversification, and a plan to book profits beforehand.

Learnings From Graham

In line with his evolving strategies (see Evolving Approach To Investing), Graham recommended many options to investors.

On Growth Investing: In the 1962 edition of Security Analysis, in a chapter titled Newer Methods for Valuing Growth Stocks, he talked about the different techniques to arrive at the valuation of growth stocks, the weaknesses of such valuations, and lessons learnt from past experience. He also highlighted that the earnings tend to reduce for most companies as time passes; hence, the experience of the initial investors is not replicable for the ones that come in later.

This chapter was omitted from all the subsequent editions. Perhaps that was due to his 1976 interview in Medical Economics, where he said, “To my mind, the so-called growth-stock investor—or the average security analyst for that matter—has no idea of how much to pay for a growth stock, how many stocks to buy to obtain the desired return, or how their prices will behave. Yet these are basic questions. That’s why I feel the growth-stock philosophy can’t be applied with reasonably dependable results.”

On Picking Defensive Stocks: In Defensive Investor Strategy (The Intelligent Investor, 4th revised edition), Graham recommended a conservative approach focusing on large, well-established companies with strong financial positions for defensive investors. The key criteria included:

• Adequate company size
• Strong financial condition (current ratio > 2)
• Earnings stability over last 10 years
• Consistent dividend record over 20 years
• Earnings growth of at least one-third over last 10 years
• Price-to-earnings (PE) ratio not exceeding 15
• Price-to-book (PB) ratio not exceeding 1.5
• Or instead of PE and PB separately, the product of PE and PB should not exceed 22.5

On Enterprising Investors: In Enterprising Investor Strategy (The Intelligent Investor, 4th revised edition), for enterprising investors, Graham suggested a more active management with a focus on undervalued securities. The criteria included:

• Financial stability (current assets > 1.5x current liabilities)
• Debt not exceeding 110 per cent of the net current assets
• Earnings stability over last five years
• Some dividend record
• Earnings growth over  last five years
• Price below 120 per cent of net tangible assets

On Portfolio Construction: In The Intelligent Investor, 4th revised edition, Graham’s advice for portfolio construction included:

• Investing in a minimum of 10 and a maximum of 30 stocks
• Ensuring each company is large, prominent, and conservatively financed
• Focusing on companies with a history of dividend payouts
• Limiting the price paid for stocks relative to their average earnings over the past seven years
• Maintaining a balanced equity and debt ratio of 50:50 if there is no specific market view

On Stock Picking: According to Medical Economics, 1976, he enumerated the following metrics:

• Look for a relatively low PE; in fact those with PE below 8
• Whose PE ratio is two times the average yield of AAA-rated corporate debt
• Stockholders equity*/total assets = 50 per cent or more (then financial condition is sound and the stock is investible); *Stockholders equity = Assets - Debt

On Portfolio Rules: According to Medical Economics, 1976, he advised:

• A portfolio of 30 stocks will be ideal.
• If a stock doesn’t reach the target in 2-3 years, then sell it regardless.
• At least 25 per cent of the portfolio should be in equity and debt at all times. The remaining 50 per cent should be invested based on the opportunities available.
• If many companies are available at lower PE, have 75 per cent in equity.
• If few companies are available for lower PE, have 25 per cent in equity and the rest in government bonds.
• Regarding expectations from the strategy, he said the strategy may not show the desired results if implemented for less than five years.

Graham’s legacy in the field of investment is profound. His rigorous approach to financial analysis and emphasis on a margin of safety has left an indelible mark on the world of investing. His teachings continue to be a guiding light for value investors around the globe, and his books remain essential reading for anyone seeking to understand the principles of sound investing. Graham’s main goal in writing for the public was to assist retail investors in making informed investment decisions and maintain a positive outlook.

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Parameters

We explored various sources that investors can use for screening stocks, and developed a simplified method tailored to Indian conditions. This criteria is a derivative of the “Defensive Investor Strategy”.

1. Adequate Company Size: With the advancement of technology, information discrepancies have decreased, allowing larger companies to trade closer to their intrinsic value most of the time. So, instead of focusing solely on large-cap stocks (the top 100 companies), we set a market cap cutoff at `5,000 crore and included 613 companies in our list.

2. Current ratio > 2: Graham believed that a strong current ratio, typically 2:1, indicated that a company had sufficient assets to cover its short-term liabilities, thus reducing the risk of financial distress.

3. EPS Growth Over 10 Years: Graham would have used year-on-year (y-o-y) earnings per share (EPS) growth for screening. However, since most available screening software does not offer this option, we ensured that EPS growth over 10, seven, five and three years is more than 12 per cent.

4. Consistent Dividend Record Over 20 Years: We have dropped the y-o-y EPS growth criteria from our screening. Instead, we examined the 12-year dividend history of the selected companies (see The Shortlist). The reasons for the drop were (a) that no software allows for y-o-y screening and (b) tax implications for investors and management influence many companies’ dividend policies.

5. Earnings Growth Of At Least One-Third Over Last 10 Years: We dropped this criterion because a 12 per cent compounded annual growth rate (CAGR) over 10 years would result in EPS growth of three times, which exceeds the threshold set by Graham.

6. PE x PB Not Exceeding 22.5: We adjusted this criterion because India is a growing economy, unlike the US in the 1970s, which contributed approximately 40 per cent of the global GDP. We also examined the historical PE x PB ratio of the Nifty 50 since 2005, with the average for this period being 82 and the current value at 90. Therefore, we set the cut-off limit at 65 (80 per cent of 82).

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Stocks To Consider

If selecting all 25 stocks is a hassle, then you could consider these five stocks mentioned below. Adjusting for Graham’s portfolio rule, we believe that investing in them for 3-5 years is a reasonable timeframe. If the stock gives 100 per cent returns any time before five years, then you should consider selling it and booking your profits. Since all of these stocks have a history of regularly giving dividends, it reduces the risk for the investors to some extent.

Bajaj Holdings: If an investor wants to own a cluster of Bajaj companies along with multiple companies from the private space, this is like an alternative to a Bajaj-plus listed companies. The primary investment will always be towards the Bajaj Group of companies. According to its December 2023 press release for Q32024, “BHIL holds strategic stakes in Bajaj Auto, Bajaj Finserv, Maharashtra Scooters, and other group companies. It has financial investments of over `12,500 crore (at market value).”

Natco Pharma: The company focuses on three segments: oncology, specialty pharmaceuticals, cardiology, and diabetes. It has a global sales force of nearly 4,800 personnel and more than 450 scientists. The company is trying to create a unique position by bringing niche products at affordable prices. On the valuation front, the company looks relatively cheaper compared to its historical level. Natco Pharma is available at a PE of 15.6 times compared to its historical average of 21 times.

Great Eastern Shipping (GES): GES is India’s largest private sector shipping company, owning and operating 43 ships and 23 offshore assets. India accounts for 35 per cent of its revenues. In H1FY2025, for 12 vessels and one rig, GES has repriced its contracts at significantly higher day rates. The disruption in Suez and Panama canals is also favourable for the industry-demand cycle. From a valuation perspective, the company is favourably positioned at a PE of 6.7 times compared to its long-term average PE of 8 times.

Nava: Nava Bharat is a multinational company operating in India, South East Asia and Africa with businesses in metals, manufacturing, power, mining, agribusiness and healthcare. In Q42024, the company announced that it has reduced consolidated long-term debt by 99 per cent. Its subsidiaries, Maamba Collieries (MCL), have repaid debt of $314.4 million during the year, thus becoming debt-free, and enabling distribution of free cash flows to its sponsors. Similarly, NBEIL reduced its intra-group debt by `63.9 crore during the year and further aims to become debt-free by June 24. Also, about 75,000-plus trees have been planted on 225 hectares of avocado plantation, with another 20,000-plus trees ready for planting. All of this is likely to benefit the business in the next financial year. While the valuation looks steep at this point, there is still potential for growth due to debt reduction and the expected impact of the cash flow.

Maharashtra Seamless:The company has a market share of 55 per cent in the seamless pipes segment and an 18 per cent market share in the API-certified, high-frequency ERW pipes segment. Some big clients of the company include Indian Oil Corporation, BHEL, Reliance Industries, ISGEC, NTPC, Larsen & Toubro, among others. Infrastructure clients include Adani, DLF, GAAR, IGL, and Unitech, among others. The company has an order book of `1,753 crore (May 2024). The stock’s current P-E stands at 9.7 times compared to the historical average of 10.2 times.

*Investments in securities markets are subject to market risks, consult a Sebi-registered investment advisor before investing.

The author is a Sebi-registered research analyst and a financial writer