Benjamin Graham’s Long Lost Formula for Valuing Growth Stocks

April 6, 2016
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Benjamin Graham is best known as the author of Security Analysis and the Intelligent Investor, two seminal books in the pantheon of value investing texts. He’s also widely known as Warren Buffett’s first investment mentor. Almost anyone who has heard about Benjamin Graham knows that he is in many ways the “father of value investing”. He brought not only credibility to the profession of equity analysis but also developed the earliest formal methodologies and processes for systematic valuation analysis. Frederick Martin in his book, Benjamin Graham and the Power of Growth Stocks, highlights the long lost methodology Graham created to analyze and value growth stocks. Martin is the Founder and CIO (Chief Investment Officer) of Disciplined Growth Investors a Minneapolis, Minnesota-based investment management firm with USD 3 billion under management.

The first edition of Security Analysis was actually published in 1934. The last edition published by Graham himself was the 4th edition in 1962. In this edition of the book, Graham actually included a new chapter titled “Newer Methods for Valuing Growth Stocks.” Martin highlights that this chapter was subsequently omitted from the 5th and 6th editions, which were originally published in 1988 and 2008, respectively. Martin not only reprints this lost chapter in Benjamin Graham and the Power of Growth Stocks but also spends the majority of the book outlining the insights he’s gained from practicing Graham’s growth stock methodology throughout his investing career.

Why is Benjamin Graham and The Power of Growth Stocks different?

The financial industry tends to conveniently categorize growth and value as two separate approaches to investing. I think in large part, it’s due to the ease of marketing a fund as either being growth or value oriented. Unfortunately, this is a false dichotomy. Warren Buffett himself stated the following in his 1992 annual report.

“In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”

The main distinction between a growth stock and value stock is that your future return is dependent upon future growth in earnings vs current tangible asset value. In either case, your goal is to purchase the shares at a discount to intrinsic value. Benjamin Graham and the Power of Growth Stocks attempts to close the gap between both sides in the growth vs value debate. Martin states explicitly that the objective of the book is to highlight Graham’s lost formula and methodology for growth stock investing.

What are the three most important ideas?

The first major idea in the book is that companies that can sustain high growth in earnings will produce excellent returns for investors. Even if an investor pays what appears to be a hefty multiple relative to current earnings, the overall return achieved can still be excellent if growth in earnings is maintained.

The second major idea is that your long-term return from a stock will be determined by your purchase price. The price of a stock has much more volatility than the actual intrinsic value of the underlying company. In the short-term, factors unrelated to the fundamentals of the business such as sentiment can push the price of the shares to over or under-valuation. If you remain patient, the market will ultimately serve you up amazing opportunities. Martin himself states the following:

“An investor must take advantage of the volatility in stock prices at the time of purchase, and do so to a lesser extent at the time of sale. The rest of the time, however, the investor should ignore the market fluctuations and concentrate on the fundamental progress of the companies behind the stocks. The ability to do this requires discipline and preparation.”

The third major point in the book is that accurately assessing the future earnings potential of a company can result in tremendous gains relative to traditional value investing. The main evidence provided for this viewpoint is derived from Graham’s own investing experience. In the book, Martin states the following:

“The most powerful argument for growth in Graham’s experience came later in his career, when he purchased a major stake in GEICO. That single transaction, which accounted for about a quarter of his assets at the time, ultimately yielded more profit than all his other investments combined. He paid $27 per share for GEICO stock and watched it rise over the ensuing years to the equivalent of $54,000 per share. Ironically, although Graham is universally associated with value investing, his greatest profit came from a growth company.”

Essentially of all the thousands of investment decisions that Graham made over his career, his biggest gain came from taking a concentrated position in a company that had huge growth potential and a significant sustainable competitive advantage. I don’t think it’s a coincidence that Graham’s best student, Warren Buffett, eventually achieved investing success following a similar strategy.

Is the book worth reading?

In short, Benjamin Graham and The Power of Growth Stocks is definitely worth reading. Mr. Martin’s track record provides ample evidence that purchasing growth companies with a margin of safety produces superior long-term returns. This is the same strategy that Warren Buffett has used to achieve his stellar investing record. Both individual and institutional investors can improve their investment performance by incorporating the concepts and formulas that Graham derived into their own investing process. At a minimum, by reading the book you’ll most likely increase your time horizon when looking at potential investments. You want to own stocks not rent them. The book provides an investor with the tools to purchase growth stocks for the long-term with a reasonable margin of safety based on Graham’s methodology. Ultimately, I think Mr. Martin summarized his entire book quite effectively when he stated,

“Buy great companies when their stocks are priced at fair value or less. Then leave your holdings alone.”

Written by Ankur Shah

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