Benjamin Graham was perhaps the most influential investment theorist ever. He developed and codified value investing after suffering much personal pain and loss during the Wall Street Crash of 1929.
During the decadelong bear market of the 1930s, Graham honed his theories and patiently invested in businesses that he identified as likely to outlast the downturn. When the US economy turned around and boomed through the 1940s (after WWII) and 1950s, he reaped handsome profits.
Graham believed in always keeping a margin of safety. His caution was a direct reaction to his painful experience during bear markets. As a result, he worked out methods to identify the companies least likely to suffer capital loss or dwindling profits (which eventually cause capital losses).
The investment guru introduced the concept of “intrinsic value”. An ongoing business is generally worth something. In the worst case, this is the price received at an auction after bankruptcy. He believed that, if you could identify and buy businesses trading close to intrinsic value or less, there was little chance of losing money. In the longrun, if the business was profitable, share prices would rise.
Graham used the concept of book value as a basic benchmark of intrinsic value. (Americans often call this ratio “networth”; Graham uses both terms). Let’s try and understand what book value means. Every business has fixed assets (which may appreciate in case of real estate and depreciate in case of machinery, etc). If the business generates and retains profits, those profits are added to the asset base.
From this, you should subtract debt and other obligations (“liabilities”) on the books. What is left is the networth (NW) of the company. If NW is divided by the number of shares outstanding, you have the NW per share. This is the “book value” (BV).
Graham’s favourite ratio was share price divided by BV or profit to book value (PBV). He loved finding profit-making companies trading at a PBV of less than 1. His logic: even in bankruptcy (and there were lots of those in the 1930s!), the investor gets his money back. Graham hated debt. Debt can cripple companies on the downside of business cycles. A debt-free business can last out through bad times because there is no external obligation to be met. However, a debt-ridden business must meet those obligations or go bankrupt.
Ideally a business should be debt free. If there is debt, the business should be generating enough profits to service obligations comfortably. One way to compare debt to shareholders equity is by the debt to equity ratio. If shareholders’ funds are more than the debt (the debt:equity ratio is much lower than 1), obligations can be met. Graham insisted on low debt-equity ratios.
A second way to judge debt obligations is via the current ratio. This matches current assets (cash the company will receive within the fiscal) against current liabilities (debt plus other payments that must be made inside the fiscal). If the current ratio is better than 2, the company can comfortably meet all obligations.
These very conservative calculations guarantee safety but obviously an investor doesn’t buy a business simply because it won’t go bankrupt. Graham also paid attention to income streams from dividends — he considered a stable dividend record a must. He also preferred single-digit PE ratios — that way, there is more of an eventual upside.
In Indian terms, very few companies measure up to Graham’s PBV cut-off. This is for several reasons. One: service businesses don’t have large fixed asset base and many of the best Indian businesses are services. In fact, Graham’s PBV ratios need adjustment since his judgments were made during a manufacturing era.
Another reason for relatively high PBV ratios is that Indian companies often keep real estate on the books at cost price for decades — this means “official” BV is much lower than the reality. However, other considerations (low debt, low PE) are valid for any value-investor. We used Graham’s criteria to generate a list of 10 Indian companies the late great may have found interesting.
Graham’s most successful pupil is Warren Buffett, who worked with his guru in the 1950s before setting up his own operations. Buffett has not written books but he has discussed his methods many times, especially in his annual letter to shareholders in his company, Berkshire Hathaway. Buffett is also the only person on the billionaires’ list who has reached those heights purely through his investment acumen, rather than via inheritance or entrepreneurship.
The Omaha-based megainvestor publicly acknowledges his debt to Graham and his methods. But he added a few modifications of his own. He places higher weight on growth prospects vis-a-vis safety. He also believes in focus — Buffett concentrates on businesses that he understands rather than diversifying. His daughter-in-law Mary Buffett, herself a money manager, wrote a book Buffettology, where she revealed some of his secrets.
Buffett too likes debt-free balance sheets and low PE ratios — no surprises there. He also concurs with Graham in refusing to buy businesses without a long track record and respectable dividend record. Neither would touch an IPO without a track record. But Buffett also looks for the twin qualities of stability and predictable growth. He doesn’t like cyclical businesses. Most people look at PE ratios. Buffett inverts the ratio and calculates the earnings as a percentage of the price he paid.
That is, if he paid Rs 100 for a stock with earnings of Rs 7, he will consider that equivalent to a return of 7%. The reason why he likes predictable growth and earnings is that he can project forward and derive reliable estimates for coming years as well. He will compare that return to the one available from debt.
Like Graham, Buffett also relies on networth but he uses different ratios. Buffett insists on a high return on net worth (RoNW) — that is a high ratio of profits to net worth. A high RoNW ratio shows that a company is using its resources efficiently to generate profits. An inefficient business may also generate profits but it will have a low RoNW.
Despite just one difference in emphasis, the “Buffett list” (see table below) of investment-worthy Indian stocks differs a lot from the “Graham list”. The Buffett list contains several IT stocks which is mildly surprising. Buffett has always famously refused to buy Microsoft, IBM or other IT MNCs because he considers these businesses too cyclical and too unpredictable.
Apparently Indian IT majors generate profits so consistently, even a Buffett might be tempted. Take a look at the methodology if you want the details of how we got there. We also explain why some of the most well-known Indian businesses don’t make the cut. Of course, we must emphasise that these are our choices based on what we know of the Graham-Buffett method!
The capital gains these stocks have generated so far, vary. But only one out of 20 has suffered a loss—the rest are in the black. Graham’s conservatism obviously translates into conservation of capital. Predictably the Buffett method picks up higher returns. But both lists seem to offer outstanding returns for the buy-andhold investor.
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