Have you ever heard a story that so profoundly affected you that it changed your entire point of view? I'm sure you have. There are all sorts of tall tales of investing: of fortunes won and lost, of Rule Breakers and Rule Makers, of small-cap skyrockets and deeply hidden values. Of all the stories I've heard in my brief investing career, the one that inspires me most features Benjamin Graham, founder of value investing and mentor to Warren Buffett.
Graham emigrated from England with his family when he was barely a year old. He grew up in Manhattan and Brooklyn and went on to Columbia University, where he graduated in 1914. Though he had an opportunity with the family business, Graham instead opted for a career on Wall Street. By 1920, he was a partner at a major securities firm. Six years later, he formed the Benjamin Graham Joint Account, an investment fund he ran with partner Jerome Newman. But hard times would follow. From 1929 to 1932, the Joint Account declined by a breathtaking 70%.
But there was more bad news to come. It turned out that Graham had used substantial margin in making his selections. So when the stock market crashed, the massive debt he had incurred to buy stocks suddenly came due. That borrowing nearly ruined him.
Graham persevered by selling personal assets and taking out loans with friends and family. Over the next 30 years, he and Newman would deliver 17% annualized returns to investors in the Joint Account. That's a remarkable record by any measure, and well north of the stock market's historical annual average return of 11%.
Graham never recounts this story in his landmark work, The Intelligent Investor, but the lessons he learned over 30 years of making money for others spring forth from every page. Here are two that continue to serve me well in my own investing.
Lesson No. 1: Buying stocks makes you an owner
My favorite part of The Intelligent Investor comes toward the end, in the section that covers shareholder rights and responsibilities. Graham exhorts common stockholders to think of themselves as owners who have a right to answers. He writes: "Shareholders are justified in raising questions as to the competence of the management when the results (1) are unsatisfactory in themselves, (2) are poorer than those obtained by other companies that appear similarly situated, and (3) have resulted in an unsatisfactory market price of long duration."
In other words: If your investment is underperforming, you have every right to demand better. On more than one occasion, Graham did exactly that. Consider this tidbit from another wonderful investing work, John Train's Money Masters of Our Time: While combing through Interstate Commerce Commission filings in the mid-1920s, Graham found that Northern Pipeline had $95 per share in assets. The stock, however, was selling for $65 per share and yielding 9% at that price. Graham jumped at the opportunity. At the 1928 annual meeting, he garnered 38% of the proxies and was named to the company's board of directors. In that position, he would help persuade Northern Pipeline to pay out a huge $50 per-stub distribution to shareholders, clinching his original valuation thesis.
Graham considered managers the stewards of stockholder money. They ought to invest intelligently and create market-trouncing returns or, in lieu of that, earn enough to pay a steady, growing dividend. He also expected them to act competently and behave ethically. He'd never stand to be a victim of corporate shenanigans, such as recent allegations of stock option backdating at roughly 40 firms, including Openwave Systems (NASDAQ:OPWV), Monster Worldwide (NASDAQ:MNST), and Equinix (NASDAQ:EQIX). Or, for that matter, the ridiculous hype surrounding GlobeTel (AMEX:GTE). Instead, he'd have taken action, as an owner should. Thanks to Graham's teachings, today I take proxy season as seriously as any national election. You should, too.
Lesson No. 2: Always buy with a margin of safety
Graham was perhaps the first stock analyst to understand that in investing, price is everything. Indeed, buying shares of a great company means nothing if you overpaid. And buying rubbish on the cheap will frequently leave you with only the unpleasant odor of a rotting portfolio.
Graham details how to buy with a margin of safety, which he calls the "central concept" of investing. Put simply, the margin of safety is the difference between intrinsic value and the price at which a stock trades. For example, a security worth $50 per share, but trading at $25 per share, enjoys a massive 100% margin of safety. Buying in that situation heavily stacks the odds in the investor's favor.
Conversely, a stock that trades close to or above its intrinsic value offers almost no margin of safety. And buying without a margin of safety, in Graham's book, is no better than mere speculation.
Consider the case of General Motors (NYSE:GM), which refused to adjust its business model despite a rapidly changing industry. Such situations rarely offer a margin of safety. No wonder investors have been scorched.
Or think of Hoku Scientific (NASDAQ:HOKU), which, in recent months, has seen its stock fall faster than a boulder in the ocean. That may be because the company burns cash faster than it pumps out dreamy press releases.
Finally, seeking a substantial margin of safety can light the path to outsized returns. It has certainly helped Philip Durell, lead analyst for Motley Fool Inside Value. Take his investment in Colgate-Palmolive (NYSE:CL), for example. When Philip recommended it in the December 2004 issue, the stock enjoyed a 24% margin of safety. Subscribers who followed his advice are up 30% as I write.
The Foolish bottom line
I've read and reread my copy of The Intelligent Investor. It's lined with yellow highlighter ink. Reading that book was one of the most important steps I took toward developing a lucid investment strategy. And I believe Buffett was right when he called it the "best book on investing ever written." Now, we're prepared to give it to you for free.
Sign up for a one-year subscription to Inside Value, and you'll get the book and full access to a service that has outperformed the S&P 500 since inception. We'll refund your money in full within 30 days if you're not completely satisfied. And you can cancel at any time without obligation. That's a margin of safety any Fool can appreciate.
This article was originally published on May 31, 2005. It has been updated.
Fool contributor Tim Beyers breaks the rules in his portfolio from time to time, but he appreciates a good value as much as any Fool. Tim didn't own stock in any of the companies mentioned in this story at the time of publication. To see what stocks are in Tim's portfolio, check out his Fool profile . Openwave is a Rule Breakers selection. The Motley Fool has an ironcladdisclosure policy.
