Three Benjamin Graham Principles You Need To Know

This guest post on the three Benjamin Graham principles you need to know was written by Net Net Hunter member Jonas Åström. Jonas is a private investor from Stockholm, Sweden. Article image (creative commons) by ValueWalk, edited by Broken Leg Investing.

When most people think of the Benjamin Graham principles — you know, the father of security analysis — they think of the concepts of Margin of Safety and Mr. Market. Those concepts are central to Graham’s teaching and his investment philosophy, but there are concepts that are even more basic that often are missed by investors:

    • The difference between investing and speculation
    • Are you a defensive or enterprising investor?
  • Why a strong balance sheet matters

These concepts are as important today as when Graham wrote about them a half century ago.

Investing Or Speculating

After a long bull market, it seem as if no one is speculating — everyone is an investor as the market hits new all-time highs. Whether you are seen as an investor or speculator seems to be judged by the media and the bystanders. After the tremendous market crash of 1929, all common stocks were seen as highly speculative, and the only sane approach was to invest in bonds. Today, anyone in the market is considered to be an investor, and that is thanks to recent past performance. Benjamin Graham principles rightfully point out that this is nonsense and that the definition shouldn’t change depending on market valuation. In his book The Intelligent Investor, he defines investing and speculation thusly:

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

Graham doesn’t think that it is immoral to speculate, but it is an unproductive waste of time. He goes further and differentiates between intelligent and unintelligent speculation, and he also underlines that there are many unintelligent ways to speculate. The most important ones include:

“1) speculating when you think you are investing, 2) speculating seriously instead of as a pastime…. 3) risking more money in speculating than you can afford to lose.”

Today, people have completely forgotten the “safety of principal” part of the definition. Most of the technology and biomedicine startups’ valuations are 100% speculation with no safety of principal whatsoever. It will become a very painful experience to lots of speculators.

So, learn the lesson of this most basic of Benjamin Graham principles — understand what investing is and refuse to speculate.

Defensive Or Enterprising/Aggressive Investor

Have you ever thought about whether you are a defensive or an enterprising investor (Graham interchangeably also calls it aggressive investor)? I would guess not, but I think you should, as it is an important concept with important implications. Let me explain.

The Benjamin Graham principles define a defensive investor as a person “interested chiefly in safety plus freedom from bother.” Graham also points out that an enterprising investor is a person who dedicates a lot of time to investing and is most likely a full-time or professional investor.

A defensive investor can expect average market returns, while an enterprising investor should aim for at least 5% higher returns, or else it is not worth the effort and it is better to be a defensive investor. This means that if you don’t get at least 16% return in the long run, you should stop being an enterprising investor and accept the average 11% return that the market has given historically.

According to Graham, both the defensive and the enterprising investor should have a 25-75% mix of bonds and stocks to protect themselves from large market fluctuations and to reduce risk. It is important to remember that Graham experienced both very high and very low interest rates during his career, and his time horizon was always long term. He only draws conclusions from the market if he has more than 50 years of history — he considers everything else too short a time to judge. Therefore, it is important to have both bonds and stocks in the portfolio to protect the principal. The mix between bonds and stocks should depend on the current market price, and a high stock market price should mean a high bond percentage.

The defensive investor should choose high-quality stocks according to a few simple rules. However, the enterprising investor, the one with lots of time to analyze and invest, should instead focus on individual stocks (such as net-nets) and special situations (such as arbitrage and mergers).

Now ask yourself (and please be honest) — how much time do you have to spend on investing, and are you really the investor you think you are?

Ben Graham Balance Sheet Principle — Low Debt

Graham is well known for net-net investing and the importance that implicitly puts on the company’s financial strength. Less known is the importance that Benjamin Graham principles put on a strong balance sheet — and in particular on low debt — for all types of investments. For the defensive investor, Graham recommends that long-term debt ought to be lower than net current assets. Similarly, the rule for the enterprising investor should be debt lower than 110% of net current assets. Remember that we are not talking about distressed net-nets but about high-quality enterprises, so those levels are low.

Once again, this is based on Graham's long-term view that 50 years of history proves what works in investing. That is how he concludes that low debt is good — particularly when interest rates are low but rising, just as is the case in 2018.

Fundamental Benjamin Graham Principles Make You A Better Investor

Graham has taught us many great lessons about Margin of Safety and the concept of Mr. Market, but there are more fundamental concepts to study and lessons to learn from all the Benjamin Graham principles. If you have an incorrect understanding of investing and don’t know what type of investor you are, then you are unlikely to succeed in the stock market. Human beings tend to overcomplicate matters, so I urge you to study the basics of Benjamin Graham’s principles thoroughly.

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