Benjamin Graham got his first introduction to the stock market when his mother bought shares of the United States Steel Company on margin not long after his father’s death.  The Graham family lost every penny of that investment and more in a Wall Street crash, which later became known as the Panic of 1907.

Despite such a start, Graham went on to graduate from Columbia University and take a job on Wall Street in a bond department.  He arrived just in time for another crash – the Panic of 1914.  

By 1926, he was successful enough to form his own investment brokerage firm with a partner, Jerome Newman.

In 1929, the greatest market crash in history brought Graham to his knees, but he survived.  Rather than walk away, he sold almost everything he had and borrowed from friends and family to keep his investment firm afloat.  Then he set about the task of applying his considerable skills as a financial analyst towards uncovering principles for safely investing in common stock.

Together with Columbia colleague David Dodd, he shared these principles with the investing world in his first book – Security Analysis – published in 1934.  He expanded his investing principles with some practical advice in the 1949 book, the Intelligent Investor.  Despite their age, neither of these difficult to read works has ever been out of print.

Graham is best known as the father of value investing but today many of us forget his principles were forged in the fires of momentous investment crashes.  With that experience as backdrop, it is no wonder that a cornerstone of value investing is the preservation of capital.

The world is slowly recovering from the greatest investing crash since the Great Depression began with the market collapse in 1929.  Already, the latest calamity has come to be known as the Great Financial Crisis (GFC).  Benjamin Graham learned from his crises, and so should we.  Here are three tenets from the work of Graham all contemporary investors should know:

•    Margin of Safety
•    Market Volatility
•    Know Yourself

Margin of Safety

A basic principle of Value Investing is to buy shares in a company whose current share price is below the intrinsic value of the company.  In theory, it is hard to argue with this idea, but in practice, it is very difficult to determine a company’s true intrinsic value.

The margin of safety assumes that even if an investor could accurately determine intrinsic value to the penny, market forces external to the company still pose major risks.  Thus, assuming an intrinsic value of $10 per share, investing in the company at $10, or even $9, or $8 provides no margin of safety.  But buying in at $5 per share not only ensures a high return when the market recognizes the value of the company, it also protects investors from the risks of extreme market volatility.

Today, investors have a variety of ways of gauging intrinsic value.  However, regardless of how an investor arrives at his or her estimate of intrinsic value, the margin of safety applies.

Market Volatility

In today’s investing climate of wildly fluctuating share prices, many investors fear volatility and long for more predictability.  Value investors love volatility.  For Graham, downturns were buying opportunities, something akin to a giant sale at Woolworths!  Moreover, when the “irrational exuberance” of the market drove one of his investments to ridiculous levels, Graham saw that as an “offer he couldn’t refuse,” and sold out.

Intelligent investors maintain “shopping lists” of companies they like but are just too expensive.  In market downturns, those lists come out of the desk drawer.

Know Yourself

Of all the valuable insight Graham gave to the investing community, this may the most significant, albeit the most overlooked.  He urged investors to determine what kind of investors they are.  

He drew a distinction between investors and speculators – with investors approaching the share market as potential owners of a business and speculators approaching shares as profit generation vehicles.  Investors are concerned about value, while speculators are more concerned about price.

While some believe Graham saw speculation as somehow an unworthy investment approach, he did not.  He acknowledged intelligent speculating as well as intelligent investing.  His caution was simply this.  Investors need to understand the difference between the two and recognize what kind of investors they are.

There is another distinction Graham drew, and that is the difference between what he called an enterprising investor and a defensive investor.  Today, the terms have evolved to active investor and passive investor.

It takes time and effort to be a successful investor.  In Graham’s view, your return was proportional to your effort more than to the investment’s risks.  Simply put, he felt those who had neither the time nor the inclination to pore through financial statements and every piece of information about a business they could lay their hands on should be content to look for defensive, or passive, investments.

In today’s world that means index investing, mixed with bonds.  Investing in an index and holding it over time will produce an average rate of return.  Unfortunately, many investors are willing to deceive themselves about their own ability to do the work to get above average returns.  In their minds, if passive investing produces average returns, perhaps with just a little extra effort, they could achieve returns a little above average.

The result is applying investing principles that rely on rigorous research and analysis with minimal research and analysis.  There are successful investors today who view value investing with scorn simply because it is hard work.

Too many investors today really do not know themselves.  Some with superior intellect feel intellect alone is a substitute for hard work, when it is not.  Perhaps Shakespeare said it best when Polonius advised his son Laertes in the play Hamlet: -- This above all – to thine own self be true.

Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au.You should seek professional advice before making any investment decisions.