Looking Through Fogs — Ben Graham on Defensive, Enterprising, and Bargain-Bin Investing

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Looking through fogs — Ben Graham on defensive, enterprising, and bargain-bin investors

Thick fogs and intelligent analysis

The standard procedure for analyzing common stocks seems straightforward enough. We want to compare the current price of a security with our estimate of intrinsic value. This usually involves an assessment of the company’s long-term prospects, management team, future free cash flow generation potential, and whatnot.

But as Benjamin Graham reminds in The Intelligent Investor, “no one really knows anything about what will happen in the distant future”. Our tests for managerial integrity and competence, for instance, rests on historical track records and qualitative signals. Intelligent investing, in this sense, “will continue to be looked at through a fog”.

Minimum, defensive standards

For this reason, investing with prudence necessitates minimum standards. The defensive investor, Graham argues, should pursue opportunities with: (1) “a minimum of quality in the past performance and current financial position of the company”; and (2) “a minimum of quantity in terms of earnings and assets per dollar of price”.

Graham himself offers five standards or hurdles for the defensive investor to consider in his or her due diligence (which you are welcome to disagree with, of course): 

  1. Reasonable size. That is, to avoid “small companies [that are] subject to more than average vicissitudes”. Note that Graham is referring to economic and industry conditions, not price volatility. More on this later.
  2. Strong balance sheet. It goes without saying that a company with more excess cash and less obligations is better placed to navigate unexpected turmoil. All else equal, such a company is more valuable to the business owner.
  3. Earnings stability and growth. Here, Graham is referring to the company’s durability and track record over the last decade. Some prospects for minimal growth is desirable too. “Without it”, Graham notes, “the typical company would show retrogression”.
  4. Dividend record. Perhaps in strong contrast to the average modern investor, Graham wants “uninterrupted payments for at least the past 20 years”. To him, this is “one of the most persuasive tests of high quality”.
  5. Good price relative to earnings and assets. This harkens back to Graham’s tenet: the margin of safety. We do not want to pay too high a price in case our thesis is or business conditions sour.

Graham then and now

It is important to remember, of course, that Graham developed his principles and standards in the first half of the twentieth century. What passes for “adequate size” back then, for instance, is open for debate today. Likewise, Graham’s preference for dividends may not hold up if the company is buying back back shares. The modern defensive investor might instead want to focus on management’s ability to allocate and return free cash flow appropriately. 

“The basic argument now for paying small rather than liberal dividends is not that the company “needs” the money, but rather that it can use it to the shareholders’ direct and immediate advantage by retaining the funds for profitable expansion… It is our belief that shareholders should demand of their management either a normal payout of earnings… or else a clear-cut demonstration that the reinvested profits have produced a satisfactory increase in per-share earnings.”

Ben Graham. (1973). The Intelligent Investor. 

Similarly, what constitutes a fair price is not always straightforward. The price-to-asset ratio, for example, was more reliable a century ago when most companies derived their fair value from hard assets. Today, many service and technology companies depend on intangibles like sales and marketing, and research and development, to generate returns. Simple measures of cheapness, if we’re not careful, can be misleading.

A repeatable filter

Graham’s process and principles, however, are timeless in many respects. Minimum standards, for instance, provide a repeatable procedure to cope with the enormity of choice in the marketplace. Modernized application of Graham’s principles (e.g. quality, durability, bargain prices, etc.) in turn allows the investor to filter for a sample of opportunities to study in detail.

Aggressive, enterprising selection

Investors must also know whether they are of the defensive (passive) sort or the aggressive (enterprising) lot. The aggressive investor, in particular, whether due to ambition, bravado, or temperament, may find the defensive principles above unsatisfactory.

An enterprising investor that seeks superior returns may have to look for opportunities in: (1) timing, (2) growth, or (3) bargain bins. And on each of these fronts, Graham has several opinions (Graham himself specialized in arbitrages, liquidations, and bargain issues).

Market timing and formulas

Indeed, as we wrote in a previous post, Graham is skeptical of the average investor’s prospects to time the market reliably with any rigid formula. The average investor, after all, must contend with: (1) the vagaries of the market; (2) the reflexive, self-defeating nature of competition; and (3) general fallibility. Speculators, Graham says, “[require] a special talent or ‘feel’ for trading to take advantage of [market fluctuations]”. The average investor, by definition, will not possess such an ability. 

The promise of growth

On growth stocks, Graham has “two catches”. Firstly, “common stocks with good records and apparently good prospects sell at correspondingly high prices”. Secondly, markets are sometimes poor judges of the future. Company growth is not a never ending runaway process. And “unusually rapid growth”, Graham reminds, “cannot keep up forever”. For already large enterprises, sustained growth tends to get harder, not easier.

Capitalization rates

Graham himself provided a formula for valuing growth stocks in The Intelligent Investor:

Value = Current (Normal) Earnings × (8.5 plus twice the expected annual growth rate1)

1 Growth here refers to expectations over the next decade.

I list Graham’s formula here not as a rule for application but for historical context. (For the general reader, it is unwise to apply blanket formulas without extensive due diligence and an understanding of the valuation assumptions that underpin such formulations. For further reading, I recommend Aswath Damodaran’s Narrative and Numbers, Tim Koller’s Valuation, and Bruce Greenwald’s Value Investing.) 

Growth and safety

In Graham’s judgment, “there is really no way of valuing a high-growth company” with sensible assumptions about future earnings and multipliers. Future cash flows, for example, are very sensitive to your assumed discount rate, which is, in turn, sensitive to future interest rates and macro conditions. How confident and skillful are you in projecting these quantities?

As Graham suggests:   

“There is no reason at all for thinking that the average intelligent investor, even with much devoted effort, can derive better results over the years from the purchase of growth stocks than the investment companies specializing in this area. Surely these organizations have more brains and better research facilities at their disposal than you do.”

Ben Graham. (1973). The Intelligent Investor.

Mountains and molehills

Of course, the intelligent investor can make do with reasonable ranges and conservative assumptions. Growth stocks may still be worthwhile if the enterprising investor finds an opportunity with a sufficiently wide margin of safety.

Here, Graham agrees but with two caveats: the stock must: (1) “meet objective or rational tests of underlying soundness”; and (2) “be different from the policy followed by most investors” (given its impact on prices). Indeed, if neither points hold, where is the margin of safety?

“Many corporate leaders fail to understand these odds. The intelligent investor [is] interested in big growth stocks not when they are at their most popular — but when something goes wrong. … This kind of temporary unpopularity can create lasting wealth by enabling you to buy a great company at a good price.”

Ben Graham. (1973). The Intelligent Investor.

Graham recalls, for example, when the price of Northern Pacific Railway stock fell more than 60 percent to $13.5 in the mid-late 40s. Its price was muted in part by a weak dividend payout. But its earnings steadied at nearly $10 per share. To Graham, Northern Pacific at that time was a classic example of “the market’s failure to recognize its true earnings picture”. 

“The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks. Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels.”

Ben Graham. (1973). The Intelligent Investor.

The big and the unpopular

According to Graham, it follows that “the key requirement… [is to] concentrate on the larger companies that are going through a period of unpopularity”. That’s not to say that there are no opportunities in undervalued small cap stocks.  Graham is biased towards “adequate size” for two reasons: (1) business risk and (2) relative market efficiency.

With regards to business risk, small companies that are not among the most dominant and well-capitalized in their industry tend to face greater threats to sustained profitability. Indeed, Graham’s view anticipates much of the modern commentary on competitive advantage, from Michael Porter’s Competitive Advantage to Bruce Greenwald’s Competition Demystified.

The second issue pertains to relative efficiencies in the marketplace. In Graham’s view, small, obscure businesses may experience “protracted neglect by the market in spite of better earnings”.2 The market for larger companies, by contrast, “is likely to respond with reasonable speed to any improvement shown”. 

But “it would be foolish”, Graham emphasizes, “to insist upon such arbitrary criteria”. What he is suggesting is only a rough guide. Everything is context sensitive. Company size, for example, may be a non-issue if the big players are inefficient, lumbering giants. What we are really looking for is evidence of competitive advantage, enduring quality, and margin-of-safety.

2 Some investors address this challenge by looking for undervalued opportunities with upcoming catalysts (e.g., new products or significant turnarounds) to rewrite the prevailing narratives in the public mind.

Ashtrays and cigarette butts

We come now to what Graham is famous for: the purchase of stocks at bargain prices. To Graham, a security “is not a true ‘bargain’ unless the indicated value is at least 50 percent more than the price”. Graham himself constructed a diversified portfolio with more than 100 issues at prices below their net working capital. It was like buying a basket of companies and getting all their fixed assets for free.

Of course, such opportunities today are rare. Graham’s tenets are better reflected in twenty-first century market prices. And many specialists, like those in distressed assets, are always on the lookout for mispriced bargains. What’s more, bargains are usually bargains for good reason. It’s not difficult to find heavily discounted stocks with serious defects. It might take particular expertise to find safe value in an ashtray of cigarette butts.

What is a cynic?

Graham published the first edition of The Intelligent Investor just four years after the end of the Second World War. The world of industry, technology, and finance has changed mightily since then. Indeed, as we’ve mentioned, some of the formulations and criteria that Graham espouses are no longer as reliable as they once were.

However, the common thread that runs across his views on defensive, enterprising, and bargain investing stands to this day. It is the insight that safety, risk, and ruin in investing are functions, ultimately, of price and intrinsic value over a foggy, variable future. The intelligent investor, Graham reminds, never forgets this relation even if and when markets do. 

“What is a cynic?… A man who knows the price of everything and the value of nothing.”

C. Graham and L. Darlington in Oscar Wilde. (1892). Lady Windermere’s Fan.

Sources and further reading

  • Graham, Benjamin. (1973). The Intelligent Investor: The Definitive Book on Value Investing. 4th Revised Edition.

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