It was at this firm that Warren Buffett worked early in his career, learning from the master. As he amassed an astounding investing record, Graham divided his portfolio into several categories, or “operations”. These served value investing students well for more than seventy years and some still have value today.
The Benjamin Graham Value Investing Portfolio
Benjamin Graham’s value investing strategy was focused on buying stocks with the same discipline as an insurance underwriter, carefully considering the risks, rejecting potential securities that had too much uncertainty, and insisting upon a margin of safety in the event his calculation of intrinsic value was too optimistic. During his time as the President of the Graham-Newman Corporation, Benjamin Graham had the money entrusted to his care put into several different value investing operations.Net Working Capital Investments: For many years, net working capital investments were the cornerstone of value investing. Due to improvements in market technology and transparency, “that ship has sailed”, in the words of billionaire Charlie Munger. Nevertheless, it was net working capital investments that helped secure Graham’s place in the pantheon of Wall Street history and helped make value investing a respected discipline.
Put simply, a net working capital investment was one in which the shares of stock were trading at a 30% or greater discount to modified working capital (that is, the current assets that could be quickly converted to cash less current liabilities and cash needs). The value investor was purchasing, quite literally, dollar bills for 30, 50, or 70 cents. Although some of the companies would inevitably go bust, by working with the law of averages, Graham insisted on widespread diversification because these commitments would prove extremely favorable on an aggregate basis. Net working capital investments factored heavily into the first years of the Buffett Partnership, which eventually led to Berkshire Hathaway.
Arbitrage: There can be little doubt that arbitrage was the secret weapon with which both Benjamin Graham and Warren Buffett accelerated their returns. In fact, Graham was convinced that disciplined arbitrage could regularly generate 20% returns, improving the overall rate of return earned on a value investing strategy portfolio.
The goal of arbitrage is to profit from price discrepancies with little or no risk. Imagine Procter & Gamble wanted to acquire J.M. Smucker’s and made a tender offer at $50 per share with the deal closing in two months. The shares of Smucker’s aren’t immediately going to go to $50 per share; they may, instead, trade at $48.95. Depending upon 1.) the probability of the deal closing, 2.) the time remaining before the deal closes, and 3.) the spread between the ultimate price you will receive in the merger and the price at which you can acquire the stock, you may have an opportunity to enter into an arbitrage transaction. The $1.05 profit you could earn may only represent 2.1%, but you are generating it in two months. On an annualized basis, that’s a nearly 13% return compounded and, if you believe the deal is certain to close, comes with little risk. With arbitrage, the value investor is focusing on profiting from the time value of money, which is being undervalued by other investors.
Tangible Assets: Benjamin Graham looked at the real, tangible assets backing a bond, preferred stock, or common stock, such as railroad cars, real estate, office buildings, or factories. He then attempted to only invest in companies that offered sufficient asset backing to guarantee that if the bond interest payment, or preferred stock dividends, were not met, the investors could take control of the company and liquidate the property to recover their money. Graham admonished those who practiced value investing to always examine their own bond holdings and be willing to switch from your existing bonds to another bond issue if the latter enjoyed a better asset position. He was fond of pointing out that those who had followed this advice would have avoided losses from some of the 20th centuries biggest failures, such as the Pennsylvania Railroad.
Diversification: Benjamin Graham insisted that those who followed a value investing strategy structure their portfolio to take advantage of the benefits of diversification. This included diversification of asset class just as much as individual investments. Examining his January 31, 1948 letter to shareholders of the Graham-Newman Corporation, we see that Graham invested:
- 15.82% of the money in bonds, which were sub-divided into railroads, utilities, real estate, holding companies, and the United States Government,
- 22.93% of assets into preferred stocks, which were sub-divided into industrials, investment companies, utilities, insurance companies, and holding companies, and
- 61.25% into common stocks, which were sub-divided into industrials, holding companies, investment companies, railroads, utilities, and insurance companies.
Benjamin Graham Value Investing Strategy Portfolio for Defensive Investors
As we explained in Asset Allocation Rebalancing, Benjamin Graham recommended investors that didn’t want to learn how to read financial statements or spend their free time looking at ticker tape should instead split their money 50% to stocks and 50% to bonds. He then went on to say that they should take some time to study history and if they thought stocks were overvalued or undervalued, they should sell off some of those stocks and move the funds into bonds (and visa versa). This made Graham, and value investing, one of the first practitioners of Tactical Asset Allocation.www.about.com
