Benjamin Graham, the father of value investing, said that investment is most intelligent when it is most businesslike. According to Ben Graham, there are 4 business principles that an intelligent investor should follow to increase his/her chances of success. Graham has talked about these 4 principles in Chapter 20 of the Intelligent Investor. In this blog post, we will go over those 4 principles and what they mean.
1. “Know what you are doing – know your business”
Graham says that an investor should not make “business profits” out of securities, unless the investor knows as much about security value as he would need to know about the value of merchandise that he proposed to manufacture or deal in.
Let’s take the example of Apple (AAPL). The message that Graham is trying to convey is that don’t just buy Apple shares because you expect the price of Apple to appreciate. Before you invest in Apple, you should analyze the financial statements to figure out the true value of the company. Look at the net sales, cost of goods sold, net income, and see if such a business is sustainable in the long run. You need to cultivate the mentality to think like an investor, and not a speculator. You need to understand that the moment you buy 1 share of Apple, you will be the owner of the entire company. Is Apple a company you understand? If it is not your cup of tea, move onto a company/business that you do understand.
2. “Do not let anyone else run your business”
Graham says that an investor should not let anyone else run his business, unless he can supervise the performance with adequate care and comprehension, or he has unusually strong reasons for placing implicit confidence in the individual’s integrity and ability.
Let’s take the example of Apple (AAPL) again. The message Graham is trying to convey is that before you invest in Apple, you need to analyze the performance of Apple’s management. For example, looking at Apple’s Return on Equity (ROE) will give you an idea of how efficient Apple’s management has been with the shareholder’s money. Other metrics that could give you an idea of the management are debt to equity ratio and current ratio. Lastly, before investing in Apple, you need to make sure that management is paid on performance and long term goals. The last thing you want is a management who is heavily incentivized for simply increasing the stock price of the company. It is crucial to have vigilant leaders, who are working in the best interest of the owners of the company (you). Note: you will find information about the executive’s compensation program in the company’s proxy statement.
3. “Do not enter upon an operation… unless it has a fair chance to yield a reasonable profit”
The message that Graham is trying to convey here is that an investor should demand convincing evidence that he is not risking a substantial part of his principal. Graham wants investors to make decisions on arithmetic, and not optimism. He wants investors to stay away from ventures in which investors have little to gain and much to lose. Let’s look at Apple (AAPL), Amazon (AMZN), and the 10 Year Federal Note:
Apple has a Price to Earnings ratio of 14.99 (TTM). This means that the Earnings Yield of Apple is 1/PE = 1/14.99 = 0.0667 = 6.67%.
Amazon has a Price to Earnings ratio of 94.70 (TTM). This means that the Earnings Yield of Amazon is 1/PE = 1/94.70 = 0.0106 = 1.06%.
The 10 Year Federal Note Rate is 3.01% (Constant Maturity Treasury Rate) on Friday, November 30, 2018. Note that the 10 year federal note is considered to be a zero risk investment.
Looking at these 3 numbers above, Graham would not have touched Amazon even with a 10 foot pole. He would have seen that a zero risk investment has a higher yield, so he would have considered Amazon to be a venture in which investors might have little to gain and much to lose. Apple, on the other hand, would have piqued his interest. Graham would have seen that Apple, which has a yield of 3.66% greater than the treasury note, has a margin of safety. In conclusion, Graham wants you to focus on investments have a fair chance to yield a reasonable profit.
4. “Have the courage of your knowledge and experience”
Graham says that if you have formed a conclusion from the facts and if you know your judgement is sound, act on it – even though other may hesitate or differ. Graham explains that you are neither right nor wrong because the crowd disagrees with you; you are right because your data and reasoning is right. Graham concludes by saying, “In the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgement are at hand.”
Hope you learned a little and found this blog post helpful. We talked about the 4 business principles discussed by Benjamin Graham in the Intelligent Investor. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
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