"One of the first and most eye-opening books I read about investing was “The Intelligent Investor”, by Benjamin Graham. As Warren Buffett wrote in the preface, when he first read it at about the same age I did, he felt like he was being let in on an incredible secret. That is exactly how I felt. I started reading it one night and I did not stop until I finished, long after the sun came up. I've heard people say there’s a gene for value investing. People either get it right away or they don’t seem to ever get it at all." - Tom Salvatore
Ben Graham is widely viewed as the grandfather of security analysis and, in particular, what is widely known as “Value Investing” - an intellectual framework that emphasizes investing in securities based upon “Intrinsic Value”, which can be defined as:
- the amount that would accrue to the owner of a security if the underlying business or assets were (1) liquidated, or (2) sold to a rational and well-informed buyer and the proceeds distributed to the security holder.
Graham made a compelling and surprisingly simple case that the most intelligent and consistently profitable way to select investments was to only purchase them at a substantial (at least 35-50%) discount to a conservative estimate of Intrinsic Value. In doing so, the investor was positioned for a high probability of positive gain with a disproportionate protection against loss; what Graham defined as a “Margin of Safety”.
Among other things, Graham distinguished between permanent and temporary loss of capital. Permanent loss results from the collapse of investment bubbles like biotech stocks of the late 1980’s, Internet stocks of the late 1990’s or the housing market in 2007-08. On the other hand, temporary loss results from the periodic (but sometimes significant) decline in market price of carefully selected securities, but the Intrinsic Value of the underlying business hasn’t declined much, if at all, and still far exceeds the market price. In these cases, investors shouldn’t be unduly concerned and should remain patient.
Graham’s process and value investing generally is like a Multi-Year Value Arbitrage - purchasing $1 of intrinsic value for 50-65 cents with the expectation that the gap will close over time, thereby having a high probability of earning 50-100% above your purchase price. Obviously, they all won’t work out as expected, but the average of a group of securities selected in this manner should provide a satisfactory multi-year result.
This type of “arbitrage” investing is unique in that the gap between price and value is wide enough that leverage is not necessary to achieve a satisfactory result. There is currently a mountain of money attempting to exploit small price inefficiencies that depends upon leverage (and a lot of it) to magnify itself into a satisfactory result. For a while it might appear to work. But eventually, so many of these strategies are revealed to be nothing more than leveraged speculations.
Value investing seems not to be “sexy” enough and it’s riches not instant enough to be widely practiced. As a result, diligent and disciplined long-term investors continue to find wide inefficiencies to exploit.