Benjamin Graham: Mr. Market, the margin of safety and the birth of value investing
The teacher of Warren Buffett wrote the two books that turned stock picking into a discipline. What he actually taught, where it holds up, and how six current portfolios compare with his rules.
Who he was
Benjamin Graham (1894–1976) was a Wall Street analyst and professor at Columbia Business School. He lost heavily in the crash of 1929 and the years after it, and the experience shaped everything he wrote. With David Dodd he published Security Analysis in 1934, and in 1949 he published The Intelligent Investor, the book Warren Buffett has called the best about investing ever written.
Graham's importance is less in a single formula than in a change of attitude. Before him, buying a share was mostly a bet on what the price would do. He insisted that a share is a piece of a business, and that you should be able to say what that piece is worth.
The core ideas
The first idea is Mr. Market. Imagine that you own a share of a business together with a partner who comes to you every day and offers to buy your part or sell you his, at a different price each time. Sometimes he is euphoric and names a high price, sometimes he is gloomy and names a low one. You are free to ignore him. The price on the screen is an offer, not a verdict, and the investor's advantage is to be calm when the partner is not.
The second is the margin of safety: buy only when the price is well below your estimate of value, so that the estimate can be wrong and you still do not lose. The third is the difference between investing and speculating. An investment, he wrote, promises safety of the money invested and an adequate return after thorough analysis; everything else is speculation, which is allowed but must be recognised as such and limited to a small part of the money.
What he asked an investor to do
Graham described two kinds of investor. The defensive investor wants little work and should hold a diversified portfolio of large, financially strong companies with a long record of paying dividends and stable earnings, and pay a moderate price for them. In the book he gives concrete limits, such as a price of no more than about fifteen times average earnings and no more than about one and a half times book value. He also suggested splitting money between stocks and bonds, in a range from a quarter to three quarters in each, and adjusting it slowly.
The enterprising investor is willing to do more work. For this person Graham described buying companies below the value of their net current assets, a method sometimes called net-nets, and other special situations where the price was far below a careful estimate of value. These rules were designed for the market of the 1930s to 1950s, and he himself later said that the easy bargains had become harder to find.
What six current portfolios show
Graham's followers are known for holding few stocks and for buying what is unloved, and the table shows how different the real portfolios of today are. Pabrai's book has 4 positions and behaves like 2.9 equal positions; Ackman's ten stocks behave like 6.9; Buffett's 26 positions behave like 8.1 because Apple alone is 22.0%. Klarman, who wrote the modern classic on the margin of safety, has 23 positions that behave like 13.4, and the ten largest are 74.9% of his book.
By contrast, the two broadest portfolios, Bridgewater and Duquesne, have 990 and 94 positions and behave like 23.9 and 22.2 equal positions. Concentration is not what Graham demanded: he wanted a diversified portfolio for the defensive investor. What the value investors share is the slow turnover: Buffett opens or closes about 1.0% of his book per quarter, Klarman 9.5%, Pabrai 4.4%, while Duquesne turns over 23.8%.
Six real portfolios side by side, from the latest filing of each investor (Form 13F, US-listed stocks only). Effective positions is the number of equal-sized positions that would be as concentrated as the real portfolio: one divided by the sum of the squared shares. Opened or closed is the average over the four quarters of half the combined share of positions that were opened or closed.
| Investor | Reported stocks | Positions | Effective positions | Largest position | Ten largest | Opened or closed per quarter |
|---|---|---|---|---|---|---|
| Warren Buffett | $299.3 billion | 26 | 8.1 | 22.0% | 91.0% | 1.0% |
| Ray Dalio | $24.4 billion | 990 | 23.9 | 16.3% | 42.1% | 5.8% |
| Bill Ackman | $13.7 billion | 10 | 6.9 | 17.6% | 100.0% | 7.0% |
| Stanley Druckenmiller | $5.2 billion | 94 | 22.2 | 16.6% | 46.3% | 23.8% |
| Seth Klarman | $5.4 billion | 23 | 13.4 | 16.5% | 74.9% | 9.5% |
| Mohnish Pabrai | $0.3 billion | 4 | 2.9 | 43.3% | 100.0% | 4.4% |
Where the teaching is challenged
Three criticisms are fair. First, Graham's numerical screens, low price to earnings and price to book, worked well in his time but have done much less well when companies' value lies in brands, software and data that do not appear on the balance sheet. Buffett himself moved from cheap-but-poor businesses to good businesses at fair prices, with the encouragement of Fisher and Munger.
Second, 'cheap' can be a trap: a low price often reflects a business that is really worse. Third, the margin of safety depends on your estimate of value, and the estimate is the hard part. The evidence of our table is that the best-known value investors today also own Amazon and Alphabet (Klarman 16.5% and 9.0%, Berkshire 12.6% in Alphabet), which would not pass Graham's own screens. They decided that the business is worth more than the screen says.
What to take from it
The lasting lessons are not the formulas. Treat the price as an offer from a moody partner. Write down what you think a business is worth before you look at the price. Leave a gap. Keep a part of the money in safe assets so that you can wait and are not forced to sell at the bottom. And be honest about which part of your portfolio is investing and which is speculation.
None of this guarantees a profit. Waiting for bargains means that you may sit in cash while the market rises, and following a disciplined method means you will underperform for years at a time.
Where it meets our bots
Graham's idea of splitting money between stocks and bonds is the basis of our 60/40 bot, and our permanent portfolio extends it with gold and cash. His preference for steady, solid companies has a rough counterpart in the bot that holds the twenty calmest stocks. The bot that buys sharp dips of the S&P 500 acts on the logic of Mr. Market's mood swings, but it uses price alone and has no estimate of value, which is exactly the part Graham would say matters.
All accounts are virtual and public. The guides below explain each rule.
Related strategy guides
Buy and hold the S&P 500: the yardstick for every strategy
Low-volatility stocks: the twenty calmest
The RSI(2) strategy: buying sharp dips in an uptrend
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