You may have heard of Warren Buffett, but you might not have heard of the man who taught him. Benjamin Graham was a successful investor and taught the young Warren Buffett at Columbia University in the US.
Graham promoted two principles that underpinned his investing process. First, an investor should view stocks and shares as ownership of a business, meaning they should not buy a single stock unless they would willingly buy the entire company if they had the funds to do so.
Second, an investor should buy businesses at a price that generated a large margin of safety. He reasoned that a bank would not lend you money if you could barely afford to cover the interest and principal payments each month, or if you had no assets for them to go after if you lost your job or got sick.
He also created the ‘Mr Market’ character. Mr Market is fickle, offering investors high and low prices for stocks and shares based on his mood. The market price will fluctuate around the true value of the business, and investors should expect volatility. Dealing with Mr Market means forming your own opinions of a company, and buying when he is in a bad mood.
Buy low, sell high
To put these ideas into practice, Graham recommended looking for large, stable companies that have delivered positive earnings for at least 10 years and paid dividends without interruption.
A Graham stock should also have a price-to-earnings (PE) ratio less than 15 times its average earnings over the last three years. There are other screens he used, avoiding high debt, for example, but we have enough to get started.
The FTSE 100 contains large companies, but we have to screen out cyclical stocks like oil & gas producers and miners because they tend to make the occasional loss.
GlaxoSmithKline comes to mind as a Graham stock. It has had paid dividends and generated positive earnings in each of the last 10 years. However, its average earnings per share in the previous three years are 44.03p, which at the current share price of around 1,800p makes the PE ratio over 40, so Mr Market’s mood is to good at the moment.
Once you had assembled multiple stocks — Graham did recommend diversification — into a portfolio, they were sold if either two years had passed or they had gone up by 50%.
Holding wonderful businesses forever
Buffett took on board much of what his mentor taught him, but he invests slightly differently. Like Graham, Buffett likes to buy companies at a discount, but his favourite holding period is forever.
You should not need to sell, ever, if you buy a business with a competitive advantage on the cheap. Its earnings and dividend payments should keep increasing because it has a ‘moat’ around it to prevent other companies from stealing its customers.
You might want to look up ‘Porter’s 5-forces’ for a method of judging competitive advantage, but as an example, strong brands are something Buffett wants in his companies.
Unilever fits the profile of a Buffett stock. It has paid dividends and made a profit for at least five years, its P/E ratio is a little under 15, and you will probably have bought one of its products recently: you could probably hold it forever.
James J. McCombie owns shares of Unilever. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline and Unilever. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
Motley Fool UK 2019