From Graham to Buffett to You

Like many investors, Benjamin Graham saw his net worth devastated by the 1929 stock market crash that helped usher in the Great Depression. But unlike those who threw in the towel, Graham decided to fight back. Determined to figure out how to avoid getting caught in a future catastrophe, he pieced together a strategy that has revolutionized successful investing for generations.

What makes that 1929 market crash and Graham's response relevant today is how eerily similar the crash looked to the one that ended the dot-com bubble in 2000. In both the late 1920s and the late 1990s, the market had been:

• Driven to new highs
• Supported by far-too-easy leverage
• Overconfident after a long bull run
• Buoyed by talk of "a new era"

And both bubbles ended with spectacular, wealth-destroying crashes. Investors clearly haven't changed in spite of 70 years of experience. So is there any real question as to whether a strategy that worked well back then would likely still work well today?

Learning from the master
Fortunately for us, rather than keep his successful techniques to himself, Graham published them for all the world to see. In addition to writing Security Analysis and The Intelligent Investor, the cornerstone works on value investing, Graham also taught investing at Columbia University. One of Graham's pupils, Warren Buffett, became one of the richest men on the planet, largely by adapting and following Graham's principles:

• Nearly every company is worth something
• That worth is based on the company's net equity, earnings, and dividends
• By investigating the company's financials, you can estimate that true worth
• The less you pay with respect to that true worth, the better off you'll be

Or to borrow some sage advice from Buffett, "Rule No. 1: Never Lose Money. Rule No. 2: Never Forget Rule No. 1."

The limits of growth
There's a simple reason why these straightforward principles add up to market-beating success: Investors want to get rich. By and large, a company's recent history drives people's expectations for its future. Those expectations, in turn, determine the market's price for a company. If a company has doubled in size annually for the past few years, investors may be tempted to project that the trend will continue. Yet at some point, all that doubling would mean that a company would take over the entire world economy. So a company's growth must slow as it becomes a larger part of a maturing market. There's simply no two ways about it.

In spite of that cold, hard reality, as I recently pointed out, Google (NASDAQ:GOOG) trades as if it owned a substantial slice of the world's total advertising market, not just the online content. For it to grow into its valuation, it needs to not only continue to fend off the likes of Yahoo! (NASDAQ:YHOO) and Microsoft (NASDAQ:MSFT) but also break into the offline world. It's one thing to forge new ground and lead a revolution in a brand-new market. Cracking the grasp of entrenched and strong competition on an already mature market takes a totally different level of commitment and investment.

When growth stalls
Unfortunately, at some point in a company's maturation, it becomes painfully obvious that it can't continue to grow as rapidly as it could when it was smaller. At that point, the market resets its expectations for the company, sending its once-skyrocketing shares into the cellar. As this table shows, even over time, the results can be painful for investors:

Each of these companies hit an all-time high well over a year ago, yet they're all substantially below those pinnacles today. As so often happens, investors who bought into the growth story at Cisco, for instance, have more or less seen significant growth materialize for the business. Yet because its shares were once priced to expect so much more than could possibly be delivered, its stock still stands well below its high. Over time, the valuation anchor pulls stocks back to their true worth, no matter how far they stray.

Get started now
Graham learned how to beat the market after losing his money during the Great Depression. If you're still staring down investing losses in companies whose growth once made them look invincible, then it's time to learn from his experience. As long as there's a conflict between what a company is expected to deliver and what it actually does deliver, there will be a chance for value investors to profit. That has held true for nearly a century, and there's every reason to believe it will continue to hold true well into the future. To become part of the next generation of market-beating value investors, join us at Motley Fool Inside Value.

In fact, at Inside Value, we believe so strongly in Graham's principles that we happily continue his tradition of freely sharing the value strategy with all who care to learn it. You can try our service for free for the next 30 days and learn what it takes to master the market on your own. Simply click here to start your education.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of Microsoft. Microsoft is an Inside Value selection. Yahoo! is a Stock Advisor pick. Taser is a current Rule Breakers pick; XM is a former Rule Breakers pick. The Fool has a disclosure policy.