Benjamin Graham (2)

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Ben Graham, in his book The Intelligent Investor, contrasted what he felt was an investment with what he termed speculation.  An investment involved thorough analysis of a company with the investor looking for safety of principal and an "adequate return."  In other words, find a company whose stock will, in all probability, not result in a loss as opposed to a company whose stock may "promise" unusually large returns; returns that are very rarely realized.  He was very strict about this definition, saying that anything else was mere speculation.

If he had been the manager of a baseball team, he would have trained the players to hit singles and doubles.  He would have coached them to avoid swinging for home runs.  The player must first get on base before he can score a run.  Hitting for the fences, although exciting when it happens, usually results in a large number of strike outs.  The big home run hitters also sport the highest number of strike outs.  The slugger goes back to the dug out and waits for his next at bat.  The investor goes to his or her bank to get more money.

Mr. Graham advised an asset allocation between high quality bonds and common stock, with the percentage of bonds being never below 25% nor more than 75% of the portfolio.  Common stocks make up the difference.  Mr. Graham felt that the easiest method was to divide the portfolio between 50% in bonds and 50% in stocks.  He recommended that if the percentages between the two investment categories changed due to market movements by as much as 5%, it was time to rebalance the portfolio by selling bonds and  buying stocks or vice versa in order to retain the desired percentages.  In effect, this is a very easy form of market timing; however, very difficult to do.  If the stock component of the portfolio has appreciated to such an extent that the portfolio is out of balance, the individual investor will find it psychologically difficult to "leave the party" and sell the gainers.

I have always liked the age related method of allocating the bonds and stocks in an individual investor's portfolio.  The investor subtracts his or her age from 100.  The percentage of your portfolio in bonds would be your age, and the percentage in stocks would be the difference.  This form of asset allocation seems a little better tailored to the individual and his or her stage of life.  Young investors have ample time to recover from market losses.  Older investors, sadly, do not.  A retired investor should safe guard his or her portfolio from market gyrations with a larger percentage of interest bearing instruments.  Those, of course, should be high grade corporate bonds or US Treasuries, both of a short duration.  If an investor finds that he or she needs cash and is forced to liquidate bonds, there is the possibility of a capital loss if interest rates have increased sharply above the interest rate being paid on the bond to be sold.  The value of a bond fluctuates inversely with the prevailing interest rates available in the market.  If a lower interest rate prevails in the market, the value of a bond with a higher rate goes up.  If a higher interest rate is available to investors, the value of a bond with a lower rate must go down.

Like Phillip Carret, Benjamin Graham recommended a diversified stock portfolio.  He suggested a portfolio with a minimum of ten and a maximum of thirty different companies.  Investors should only consider companies which were "large, prominent and conservatively financed."  The companies he liked would have a continuous record of paying dividends for not less than ten to twenty years.  As a general rule, Mr. Graham looked for a stock with a price/earnings ratio not to exceed 20 times the company's last twelve months' earnings nor 15 times its average earnings for the past three years.

Mr. Graham described a company worthy of investment as being "large, prominent and conservatively financed."  He admitted his description was indefinite, but he believed that it provided a general sense of what he was looking for.  In the next blog we will learn some of the financial metrics Ben Graham used to identify those types of companies.

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