The Intelligent Investor
Applying Benjamin Graham's Discipline today

A study of the greatest long-term investors reveals that most followed exactly the same discipline. This is the approach that was taught by Benjamin Graham at Columbia’s Graduate School of Business. The appendix to this report shows the returns his students delivered to their investors from 1956-2007.

As a group, these remarkable students have more than doubled – and in many cases tripled or quadrupled – the returns from the stock market over different time periods, covering from 15 to 50 years each. And the discipline is built, first and foremost, on avoiding risk of principal. If we included Mr. Graham’s similarly stellar track record from 1925-1956, this approach to investing has delivered the highest returns, safely, for over 80 years.

One might think that such a discipline would attract a huge following. But as Mr. Graham said, his books were the most read in the industry, and the least followed. Discipline is never popular on Wall Street or Main Street when it comes to investing, particularly one that has a person going the opposite direction from the crowd a good amount of the time.

In this paper we will look at some of the key principles in this discipline, and how Mr. Graham’s leading students are implementing it today.

KEY PRINCIPLES

1. Make sure your portfolio is constructed to provide the necessary level of safety at all times. This is explained in detail in our report on Risk Control.

2. Invest according to “pricing,” not “timing.”

“ By timing we mean the endeavor to anticipate the action of the stock market – to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value.” (The Intelligent Investor, p. 189)

Focusing upon pricing is, by definition, called “buying low and selling high.” This discipline requires this action (or inaction as in not selling low or buying high) at all times, in all markets.

In good markets, following this discipline leads to the wildly unpopular activity of selling stocks when everyone else is sure they will continue to go up forever. In bad markets, it leads to either holding stocks if their prices go down or buying more stocks if funds are available.

The following is what Mr. Graham taught investors regarding the temptation to sell high-quality stocks below their fair value because they have gone down short-term:

“Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other person’s mistakes of judgment.” (p. 203)

While Mr. Graham admitted that it may be possible to achieve good returns through attempting to time the market, he believed it was highly unlikely and unusual. This has continued to be the experience of investors in recent times, and we still haven't found one investor who we are confident can successfully time the market on an ongoing basis. But if you study the actions of investors, you will find that the majority end up attempting to time the markets. Intellectually most know it probably won’t work, but their emotions practically force them to sell when they are scared the market is going to go lower, and greed leads them to buy high. This is market timing, and this is how most investors who try this approach act. Most do very poorly.

3. Buy the stocks of good companies at prices substantially below their fair value.
Knowing how to purchase individual stocks is perhaps Mr. Graham’s greatest legacy, and he is still considered one of the greatest experts ever on selecting stocks. It is beyond the scope of this paper to detail all the rules to be followed. In general, the approach is to purchase the stock of companies that have an unusually sound financial history, combined with a low price. For example, the company must have exhibited earnings growth and stability over 5 years, and preferably 10. In addition, the price paid for the stock must be low compared to the current assets of the company. When you buy a company whose stock price is little or no more than its current assets, you are essentially getting the future growth for free. When that company has a track record of good, steady growth, your chances of profiting are quite high. This is also a safe approach to stock investing. It provides a large margin of safety, for the company is worth as much as you paid for it even if it has serious difficulties and grows more slowly going forward.

Implementing Mr. Graham’s Discipline Today

Two of the greatest investors using this discipline today are Warren Buffett of Berkshire Hathaway and Bruce Berkowitz of the Fairholme Fund. As one might expect, 2008 was an unusual year for both, as these two investments have rarely gone down, regardless of what the market has done. Over 45 years (54 if the Buffett Partnership returns are included), Mr. Buffett has only lost value two years, while Bruce Berkowitz made an astounding 52% from 2000-2002 when the stock market went down 43%. Although both had losses in 2008, each did do better than the stock market.

In looking at the actions of these two investors, we can see they continued to follow the discipline during the financial crisis. Both anticipated the downturn by amassing huge cash positions in late 2007. Bruce Berkowitz had 28% of his $8.5 billion in cash at the end of 2007, while Berkshire Hathaway began 2007 with over $40 billion in cash. As the stock market began to plummet, both began to buy great stocks at low prices. We have complete confidence their wise investments will once again lead to superb profits going forward.

Appendix

Practitioners of Benjamin Graham’s Discipline

Berkshire Hathaway Inc.: 21.7% a year over 43 years, 1965-2007
vs 10.3% for Dow Jones Industrial Average

Buffett Partnership: 29.5% a year over 13 years, 1957-1969,
vs 7.4% for Dow Jones Industrial Average

Charles Munger: 19.8% a year over 14 years, 1962-1975
vs 5.0% for the Dow Jones Industrial Average

Bruce Berkowitz: 17.9% a year over 8 years, 2000-2007
vs 2.8% for the S&P 500

Pacific Partners: 32.9% a year over 19 years, 1965-1983
vs. 7.8% for the S&P 500

Perimeter Investments: 23.0% a year over 19 years, 1965-1983
vs 7.8% for the S&P 500

Walter J. Schloss: 21.3% a year over 28.5 years, 1956-1984
vs 8.4% for the S&P 500

Tweedy, Browne LP: 20.0% a year over 15.75 years, 1968-1983
vs 7.0% for the S &P 500