Graham, author of The Intelligent Investor, used several different methods of investing, but the concept of value underpinned them all.
His best known system was based on analysing the relationship between a company's Net Current Assets and its Share Price.
It worked like this:
"Buy shares at a price that represents not more than two-thirds of a company's net current assets, deducting all prior charges and attributing no value to any of the fixed assets of the company including property, plant and machinery, brand names and goodwill."
In other words, buy the assets that have a realisable cash value at a discount, and pick up rest of the business for nothing.
The second part of Graham's method was in deciding when to sell shares that were formerly undervalued but whose price had risen to the point at which they were no longer undervalued.
"Sell the shares when the share price advances to a price equal to the net current assets less all prior charges."
When the formula worked, the gain would therefore be 50%. Between 1946 and 1976 Graham found that this method produced a compound annual rate of return in excess of 19%.
Due to the wide publicity that value investing has attracted (and the fact that information on companies is now much easier to come by) it is almost impossible to find stocks that fulfil the strict criteria required by Ben Graham, but his mechanical approach still has some useful lessons to teach the modern-day investor.
| A simplified presentation of Ben Graham's Value Investing Model | |
|---|---|
| A. Decision to purchase | |
| Step 1 | Establish market capitalisation No. Shares in Issue: 5,000,000 Current Share Price: £1.25 Current Market Cap: £6,250,000 |
| Step 2 | Establish net current assets: £10,000,000 |
| Step 3 | Calculate ratio of market cap. to net current assets Market Cap: £6,250,000 Net Current Assets: £10,000,000 Ratio: 62.5% |
| Step 4 | Make Buying decision Market cap. represents less than two-thirds of net current assets, so shares are a 'buy' |
| B. Event - share price to £2.00 | |
| C. Decision to sell | |
| Step 1 | Establish market capitalisation No. Shares in Issue: 5,000,000 Current Share Price: £2.00 Current Market Cap: £10,000,000 |
| Step 2 | Establish net current assets: £10,000,000 |
| Step 3 | Calculate ratio of market cap. to net current assets Market Cap: £10,000,000 Net Current Assets: £10,000,000 Ratio: 100% |
| Step 4 | Make Selling decision Market cap. now represents 100% of net current assets, so shares are a 'sell' |
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"If Graham was alive today, he might argue that you should simply withdraw from the market for a few years until conditions arise which offer you value for money that you are seeking. Graham might be right, but my problem is that I would get so bored waiting."Book offers!
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