Would Benjamin Graham Approve of These Stocks?

Benjamin Graham is perhaps best known as the man who taught investing to Warren Buffett and a whole host of other world-class investors. An astute money manager in his own right, Graham is generally considered to be the father of the concept known as value investing.

One of the original "buy low and sell high" investing strategies, Graham's method involved assigning an intrinsic value to a stock. That value is based on reasonable estimates of its business prospects if it's viewed to be a "going concern" or its liquidation value in the event that it's not expected to last. By comparing its intrinsic value with the market's price, Graham made buy and sell decisions -- buying if the market priced it too low and selling if the market priced it too high.

What's it worth?
Figuring out that intrinsic value is part art and part science. The science is in the calculations that come up with the value. Graham developed an equation to estimate it, once you nail down your assumptions. The art is in coming up with reasonable estimates for expected earnings and longer-term growth that are core to that valuation.

On top of valuation, Graham also looked for evidence that a company was truly managed in its shareholders' best interests. One of the key factors he considered was whether it paid dividends. In Graham's view, a company with a decent dividend payout ratio is one where management respected the fact that it works for the shareholders who really own the company. And while not perfect, looking for dividends does tend to produce owner-friendly enterprises.

Nobody's always right -- not even Graham
Value investing sounds great in theory, and it generally works well in practice, but there is a catch. As with any investing strategy, it relies on projecting the future. Anybody who claims to be perfect at that is lying. Fortunately, Graham acknowledged that problem and designed a brilliant workaround to mitigate its effect. That workaround consists of two parts: a fudge factor and a roulette wheel.

The fudge factor is more formally known as the margin of safety -- the level of the discount that the stock trades for in the market versus its intrinsic value. The bigger its margin of safety, the more wrong your estimate of its future prospects can be while still providing you a decent return on your investment.

For instance, assume your best assessment of a company called Fabulous Fancy Fireworks (Ticker: FRWK) places its intrinsic value at $50 a share. The market, on the other hand, offers to sell you the stock at $30. That's a very solid 40% margin of safety, giving you substantial room to be wrong. But what if there's an explosion that knocks out one of the company's three factories, just before the start of production for the big Fourth of July celebration?

About a third of the company's intrinsic value just vanished -- in a noisy and brilliant puff of smoke. What should have been a $50 stock would now really be worth about $33. That could have been a significant loss had you bought at the company's intrinsic value, but because you had that margin of safety by buying at $30, you still have a chance at a gain. Thanks to that fudge factor, you can profit even if the company falls somewhat short of your expectations.

What if you're completely wrong?
Of course, sometimes stuff happens that completely sinks a business rather than just knocking its potential down a notch or two. A complete loss of your capital is possible in any stock investment you make. Graham's workaround to that problem -- known as diversification -- likens intelligent investing to being a casino running a roulette wheel.

Occasionally, the casino has to pay out when a gambler's number comes up. But by stacking the odds in its favor and spreading its risks over multiple spins of the wheel, the casino tends to do quite well over time. Likewise, an investor with a portfolio that has risk diversified over multiple industries may occasionally wind up with a complete loser. But across an entire portfolio of stocks bought with a decent margin of safety? That investor should still do just fine.

Put Graham to practice
The table below shows the beginnings of a portfolio built around Graham's criteria:

With companies across a wide swath of business lines, a single company or industry failure won't sink the investor's portfolio. With prices providing around a 10% or better margin of safety to Graham's valuation equation, there's some protection against a future that doesn't quite work out as expected. And with payout ratios between 40% and 70% of earnings, they all show respect to their shareholders while still retaining enough cash to reinvest for growth.

Individually, they're all fine companies, but bound together in a portfolio, they make a much more compelling package for an investor looking to follow in Graham's footsteps.