Benjamin Graham is often considered the Father of Value Investing and we as value investors, lay a lot of store by his principles. The three important concepts that Ben Graham talked about extensively are 1) Equities represent a fractional ownership in the underlying business 2) The concept of Mr. Market and 3) Margin of Safety.
As per Ben Graham, a stock is not a scrap of paper whose value fluctuates on a daily basis, but it represents a fractional interest in the underlying business. So if there are a total of 100,000 shares of a company that have been issued, then if a person owns 1000 shares of said company, then they would own 1000 divided by 100,000 or 1% fractional interest in the underlying business. This implies a 1% ownership of the sales of the company, its profits and also the balance sheet of the company i.e. its assets and its debt outstanding. This principle focuses an investor’s mind on the underlying business of the company and its value rather than on its stock price.
In his book, “The Intelligent Investor”, Ben Graham said that investors should imagine that they are in a 50:50 partnership with Mr. Market, who by his nature is a manic depressive – sometimes he is very ebullient and cheerful and feels that all is well with the world and at other times, he is extremely depressed. The endearing quality of Mr. Market is that he knocks on your door every morning with a two way quote – one at which he is willing to sell his 50% share of the partnership and another at which he is willing to buy your 50% share of the partnership. Depending on his mood, Mr. Market offers wildly different prices to investors. As value investors, it is our job to use the manic depressive nature of Mr. Market to our advantage. To be guided by Mr. Market would be a great folly.
This brings us to the concept of margin of safety, which is the difference between a stock’s market price and its intrinsic value. The further a stock is trading below its intrinsic value, the higher is the margin of safety. Warren Buffett calls it “buying 1 dollar for 50 cents”. So, a stock is not necessarily cheap, if it has fallen 30-50% from its high price – it is cheap only if it is trading at a significant discount to its intrinsic value. Needless to say, an analyst must focus a lot of his time and attention on determining the intrinsic value of the business. The intrinsic value of a business can be defined as the sum total of all free cash flows that can be derived from the business from now to eternity, discounted back to today.
We as value investors, focus on buying high quality businesses at prices that are reasonable in comparison to their intrinsic value. While there is no denying that a far greater risk is assumed by investors when they buy poor quality businesses, high quality stocks may also carry risks, if the price is too high. This is particularly important in today’s Indian market context when several high quality stocks have been bid up aggressively by investors and one wonders whether there is adequate margin of safety left in them. Perhaps only time will tell, if this is true. In the past, we have seen that when a stock becomes very expensive, then it fails to generate adequate subsequent returns for investors, despite delivering good sales and profit growth.