It is very difficult to make money from the stock market. There is nothing more difficult for an investor than to see mediocre returns on his portfolio. I should know because I speak from personal experience. When I was assembling a portfolio of stocks to save for my retirement I was never happy with the returns that I got.
That was until I learned about an investment strategy that is more than sixty years old but remains very relevant today. This approach is known as value investing and was developed by the late Benjamin Graham, who is known on Wall Street as the “Father of Value Investing” and was the mentor of the venerable Warren Buffett.
Value investing can be summarized simply as “price is what you pay; value is what you get”.
This means that you should look for companies that have good fundamentals and are financially sound but whose shares you can scoop up cheaply.
Using this approach, Graham was so successful that his investment firm recorded annualized returns from 1936 to 1956 of around 20%, which was substantially better than the average 12.2% return that was recorded by the broader stock market over the same period.
In fact, Marshall Weinberg has said that everyone he knew who followed Graham‘s philosophy “never lost money”.
Benjamin Graham’s Investing Rules
Here are the basic guidelines for value investing as laid out by Graham in his classic 1949 book The Intelligent Investor:
- Meticulous analysis. As Warren Buffet puts it: “never invest in a business that you don’t understand”. Before you purchase stock in a business, you should analyze it thoroughly. At the same time, you should recognize what is the essential information that can help you understand the underlying business as well as its prospects, and what you should ignore since it only represents static that can distract you from what is important.
- Safety of Principal. The one essential rule of the stock market is that you should never lose money. The most successful investor is not the one who can make the biggest stock picks but the one who is able to avoid major losses.
- Satisfactory return. What exactly constitutes a ‘satisfactory’ or ‘adequate’ return ultimately depends on the individual investor. However, one benchmark that you can use to measure your success in picking stocks to construct your portfolio is if its returns exceed those you can enjoy in the long-term from a low-cost index fund.
Graham’s Principles for Picking Stocks
Late in life, Graham codified his stock-picking philosophy into ten item checklist , that can be divided into two categories: the first five are intended to help investors find undervalued stocks that had strong return possibilities and the second to find stocks that did not represent a high risk to the investor.
- The stock’s earnings yield should be at least two times the rate of an investment grade (AAA) bond.
- The price-to-earnings ratio should be below 40% of the highest level the stock’s P/E ratio has reached over the past five years.
- The dividend yield should be a minimum of two-thirds the yield of an investment grade bond.
- The price of the stock is less than two-thirds of its tangible book value per share.
- The price of the stock is less than two-thirds of its net current asset value.
- The total debt held is below the stock’s book value.
- The total debt held is less than two times the stock’s net current asset value.
- The stock’s compounded earnings growth over the past decade is a minimum seven percent.
- The stock’s current ratio is above 2.
- The stock has suffered no more than two earnings declines over the past decade.
Using these ten rules as the criteria for assembling your stock portfolio will surely give you the returns you want. However, depending on your preferences you might want to cut them down to just the ones that you deem essential.
Applying Graham’s Investment Philosophy
There are a number of ways you can apply Ben Graham’s investment philosophy to assembling a stock portfolio. The easiest way is simply to buy into an index fund.
While Graham’s original recommendation was that the investor buy equal amounts of thirty stocks listed in indices like the Dow Jones Industrial Average.
Since this can take a lot of time and effort, an easier approach is simply to invest in a high performing index fund. One highly recommended fund is the S&P 500 Index Fund which you can get from providers such as Fidelity and Vanguard.
Another approach is to use online stock screeners that use Graham’s investment philosophies to pick stocks.
For example, you can use the screener offered by Serenity Stocks, which offers a screener that uses Graham’s value investing rules. Or if you are willing to do the hard work, you can do the analysis yourself.
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About the author – Bill Achola is a financial publisher who owns a fast-growing, dynamic and innovative investment blog that empowers investors with high-quality and unique content. Check out his popular post about 15 jaw dropping tips for investing in gold and silver that can make your investing easy.