Does Benjamin Graham Think You're a Gambler?

A lot of people think that an investor is anybody who buys a stock.

Maybe you’ve done this yourself – I know I have. You see a promising investment opportunity, something that your friend, or your uncle, or a TV commentator thinks is a sure bet. The stock is sitting at a few dollars per share but, due to a couple great quarters on the horizon, the price is set to rocket skyward. Perhaps the company is about to complete a new piece of technology, or management expects to sign a new business contract. You decide to buy a number of shares and then spend the next few months checking the stock price on your computer or smartphone.

I didn’t invest based on expected earnings when I began investing. A couple of years after I started I bought a little company named Ask Jeeves. Ask Jeeves, now called Ask, was a search engine company then sitting in third place in the search engine wars.

The idea behind the investment was simple: Google and Yahoo! had just increased in price by about 30%. According to Peter Lynch, when a group of stocks move up in price, investors have a tendency to put money into the stocks that have been left behind, expecting a similar rise in price. As investors put money into the stock, the price rises up to a valuation similar to its peers. As expected, a few months later my stock had risen by roughly 25% and I cashed out.

Some people would call that a successful investment. I wouldn’t – and neither would Benjamin Graham.

Benjamin Graham’s Definition of Investment

When I say investment, I’m specifically talking about the action you take when you buy or sell securities. Investment and being an investor are important concepts when it comes to managing your finances. Investing has a safe and responsible connotation. When you invest in your education, for example, you recognize it as a responsible and valuable undertaking. When you invest in a new car (or a car that’s new to you), you recognize it as a needed expense that will allow you to reap certain rewards – like picking up your kids from after school programs or getting yourself to work. Investing is safe and wise.

Here’s the thing about buying securities – not all security purchases qualify as investing. It doesn’t come down to the type of security you buy, either. Purchasing a bond or a mutual fund is not enough to call what you’re doing investing. According to Benjamin Graham, you can only call what you’re doing investing if you select securities that protect your capital investment and promise an adequate return. Any security purchase not meeting that standard constitutes speculation.

When it comes to stocks, most people just focus on the potential upside. Safety of principle is almost always ignored. This was why my purchase of Ask Jeeves was not an investment. While I did make a small gain on the purchase I did not even consider how secure my principle was.

That was a mistake considering how important downside protection is to your portfolio returns. Think about it this way: if you could eliminate all of the permanent losses you have experienced after buying stocks then how would your portfolio have done up until today? Would it be worth a lot more? I bet it would. You can increase how well you do as an investor by eliminating your downside or; as Warren Buffett says, you can do really well if you just avoid making big mistakes.

How to Protect Your Capital Through Value Investing

When it comes to protecting your downside there are better and worse ways to do it. The most obvious way is to buy stocks only when they are trading at very large discounts to intrinsic value -- the larger the better. The larger the price-value discrepancy is, the larger your buffer is against business deterioration. If you purchase a stock at a 30% discount to intrinsic value, for example, the company has to see a 30% erosion in it’s business value before the firm is fairly valued. At a 50% discount to intrinsic value, however, the business has to deteriorate by half before your holdings are fairly valued.

The lower the price you pay for the stock relative to its intrinsic value, the bigger the errors you can make when assessing the investment’s worth, as well. If you only demand a 30% margin of safety then you have to be much more accurate with your assessment of the stock’s worth than you do if you demand a 50% discount to intrinsic value. Make a mistake and overestimate the value of a business while demanding a tiny margin of safety and you can end up losing a lot of money on your investment.

Of course, investors should be looking at companies that are financially solid, as well. That doesn’t mean profitable; a company that is solid financially is one that has a clean balance sheet. The less long-term debt the company has relative to its equity, or the greater the company’s ratio of current assets to current liabilities, the better. Ideally, these ratios should be improving, as well. I like companies that either have no debt or have steadily been paying off their debt, and I like it when they have a lot of high quality liquid assets in relation to total liabilities. The more the better.

Protect Your Downside and the Upside Takes Care of Itself

A company doesn’t have to have a bright and promising future for you to earn large profits. You can make a lot of money by just protecting your downside through buying companies that have large margins of safety.

The truth is that nobody really knows what will happen in the future. When it comes to what’s in store for a business we’re all just making educated guesses. People routinely make guesses that are too optimistic or too pessimistic about a company’s future while, as a whole, businesses tend to experience average business results, or an equal number of positive and negative events, going forward.

Companies that have a lot of negative sentiment get knocked down in price, creating a margin of safety. Betting against the crowd by buying these unloved firms has proven to be a great way to profit in the stock market. After buying firms at a steep discount to intrinsic value, the gap between that value and the stock price tends to close. Since businesses experience, on the whole, an equal number of positive and negative events going forward eventually investors come to see the depressing sentiment to be unwarranted and bid the stock price up.

In other situations, a firm may be trading at a huge discount to intrinsic value because of a large temporary problem the company is facing. Investors have no stomach for business problems so dump the stock when things start to go sour. So long as the business remains largely intact, and the firm has a solid balance sheet to weather the current situation, the business is likely to come out of the situation and resume on its regular course. When that happens, investors flood back into the stock, increasing the stock price back up to intrinsic value in the process.

This last situation is what makes net net stocks such promising investments. These stocks have been written off by investors because of the significant business problems the companies are facing that they now trade well below any reasonable assessment of business value. At the prices they’re trading at, investors are well protected against further business problems or even errors in assessing the firm’s worth. Net net stocks, by definition, also have conservative balance sheets. So long as the firm’s balance sheet is not rapidly deteriorating then investors can be sure of making a sound investment.

Does Benjamin Graham Consider You an Investor or a Gambler?

Whether you are an investor or not really comes down to the process you use to select investments, not the assets you buy. Stick to Benjamin Graham’s definition of investing. By focusing on picking stocks that both protect your downside and are likely to show a decent profit you’ll end achieving good returns over the long run.

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Article Author: Evan Bleker