Investing like Benjamin Graham – The father of value investing

Investing is easy.

The advantage of investing is clear. You are not only saving financial resources, but you use them to generate a passive income. On the contrary, buying consumer goods, such as a car, clothes etc. is spending money. The good itself will lose value. It might bring you several benefits while making you more effective, but that is another story. Let’s agree that it has definitely its logic to buy consumer goods as we are using these things on daily basis. However, it might be clever to put some money in assets that preserve value and even create some additional income.

There are many possibilities as where to invests, be it real estate, gems or other collectables. We will focus here on the stock market. The disadvantage of investing money in stocks is the potential risk. In particular, in short-term investment horizon.

Is investing in stocks really that risky?

First things first, what are the risks? Stocks can decrease in value or in worst case scenario companies can go bankrupt. However, you can substantially eliminate the risk by choosing the right investing approach. This will help you to select those companies which have sound financial basis, working business model and a potential to grow. Despite that, there is always some risk involved. Risks are everywhere, even when you cross the street on a green light.

In general, the stock markets grow and regularly reach new highs. Every now and then, there is a Premium-Flow logorecession when the majority of stocks decline. By the way, a market crash does not happen from one day to another. There are some signals to be observed and I might write about that in another post. Now, back to the topic. After every recession, there comes a recovery. One simple rule will make you a successful investor: “Do not sell your stock when they are the cheapest.”

The Graham’s way how to select stocks and eliminate risks

The best approach how to protect yourself from a decline is to buy stocks when they are cheap. That is why, I think the way of Benjamin Graham is the best for every beginning investors. Graham puts great emphasis on how to select undervalued stocks and so limit the risk of a decline. To know more, I would definitely recommend one of the best books that he wrote: “The Intelligent Investor”. This is a “bible” for everyone who wants to create value from her or his investments.

Graham distinguish between defensive and enterprising investor. The difference is basically that both want to make money, but the second one is willing to do research. Graham presents several criteria how a defensive investor can participate in a growing stock market while eliminating risks. I chose to present the criteria of a defensive investor as this might be more suited for beginner’s needs.

To be more practical, we can take one stock as an example and explore the 7 criteria how to select an undervalued stock.

Discovery Communications as a guinea pig for Graham’s approach

Discovery Communications - opportunity for investing?I have been recently following Discovery Communications because I find this stock interesting. The symbol of the stock is DISCA and this will be further used in the article.

DISCA might be one of the candidate for value investors, but there are two problems though. DISCA does not pay any dividends and it has quite a large debt.

Important to mention, I do not advise anybody to buy or sell this stock. My analysis might be wrong, without sufficient data or biased. Hence, do your own research.

Seven criteria for the defensive investor

1. Buy only companies with adequate size:

Here, the advice is to buy only large companies. Nowadays, a company is considered to be large with a market capitalization over $10 billion. In general, the reasoning is that buying shares of a large company provides you with more safety than buying a small company.

DISCA has current market capitalisation of $6.3 billion. The market capitalisation declined by almost a half in the last years due to the decrease of the stock price.

Does DISCA fulfil this condition? The answer is NO.

From my personal perspective, DISCA is also not a small company and this condition is not fulfilled due to the decrease of the shares’ price. Therefore, I do not see it as a big problem.

2. A sufficiently strong financial condition
  • A company should have sufficient amount of money to pay its debts. Graham defines a sufficiently strong financial condition for a company to have at least twice as high total current assets than total current liabilities.

DISCA had $2502 million of current assets and $1561 million of current liabilities in the year 2016.

  • Graham continues that the company’s long-term debt should not exceed its net current assets or in other words, its working capital.

The long-term debt of DISCA was $7841 million and the net current asset $941. Hence, the long-term debt was far exceeding the net current assets.

Does DISCA fulfil this condition? The answer is NO.

From my personal perspective, this might be a problem, in particular for a defensive investor. The situation is also currently changing as DISCA acquires another company Scripps Networks. That causes even more debt. The high debt of DISCA does not automatically mean that it will go bankrupt. In particular in times of low interest rates, it might make sense to take loans. Nevertheless, the high debt indicates that there might be a higher risk connected with DISCA. This Graham’s condition should provide a very simplified method how to assess the company’s financial health without going too much in details.

3. Continued dividend for at least the past 20 years

DISCA does not pay any dividends.

Does DISCA fulfil this condition? This is easy. The answer is NO.

From my personal perspective, there is not much to say. Some companies do not pay dividends as they think that reinvesting all profits might be more beneficial for a company. This should however be reflected in higher price of its shares.

4. No earnings deficit in the past 10 years

This condition means than a company earned at least something every year in the last 10 years. In other words, the company never used red ink in its reports in this category.

There have always been some earnings in DISCA. The company did not end a year with a loss.

Does DISCA fulfil this condition? The answer is YES.

From my personal perspective, this is a strong side of DISCA. The business is profitable and it has a quite good margin. A defensive investor should not buy unprofitable businesses with a hope for the future. The reason is very simple, they might stay unprofitable.

5. Ten-year growth of at least 33% per share earnings

Graham does not want to rely on just one year, which might have been exceptionally good or bad. Instead, he uses 3-years averages and the beginning and at the end of the ten-year period.

We will look at the earnings per share of DISCA

2008 – 0.43                        2014 – 1.63

2009 – 0.65                        2015 – 1.76

2010 – 0.88                        2016 – 2.13

Average earning per share for the three year period:

0.653                                    1.84

Earnings growth was 182%.

Does DISCA fulfil this condition? The answer is YES.

From my personal perspective, this is another strong point of DISCA. The earnings constantly grow every year, which is something every investor wants to see. I started with the year 2008 because I had these figures. So the period is not really ten years based on the averages, but rather six years. The more impressive the growth is. This year however might not beat the strong earnings in 2016. We will see.

6. Price of stock no more than 1.5x net asset value

Price to book value of DISCA is 1.14x

Does DISCA fulfil this condition? The answer is YES.

From my personal perspective, this is not an easy condition to fulfill. It often happens only in case that a company experiences some kind of troubles. Currently, many stocks are rather expensive. The future growth is already reflected in their price, making the price of many stocks several times as high as their net asset value.

Price no more than 15x average earnings of the past three years

The price of DISCA is 9.2x average earnings of the past three years.

Does DISCA fulfil this condition? The answer is YES.

From my personal perspective, it is always good to look what is the usual Price/Earnings (P/E) ratio for the very concrete company. Some companies or the whole industries have very low P/E ratio on a long term basis because they might be associated with higher risks. This has been the case for example for airlines. DISCA had P/E ratio of 30 and in most instances it was between 15-25. Therefore, the current P/E ratio of 9.2 indicates undervaluation.

Investing in DISCA might be only for enterprising investors

The result is 4x YES and 3x NO. This would not be sufficient for the defensive investor described by Graham. However, it might be ok for an enterprising investor who is willing to research further.

I think the reason why DISCA seems to be undervalued are the current trends. With the huge popularity of Netflix, Youtube etc., there are concerns that people will stop watching the classic TV. That is probably also true. Nevertheless, DISCA offers content and this might be distributed on TV or the internet or wherever else. DISCA might also reach a deal with Netflix. So, I personally think that its price might have slipped lower that what the fair value is.

It was not my aim to make a fully-fledged financial analysis of DISCA. One would have to consider a number of other fact and also the last developments, among other things, the announced acquisition of Scripps Networks by DISCA. That is indeed a major factor to consider. The main aim was to provide a first practical look at Graham’s principles how to select a stock for a sound investment. Still, the best source is to read directly Graham’s books on investing.

Investing has a lot to offer. For the long term, it can make your life much easier. Even if you do not have money to invest, you can start small and accumulate a piece by piece. Over time, these pieces will create a fortune. As Bill Gates said: “Most people overestimate what they can do in one year and underestimate what they can do in ten years.”

If you want to know more about different approaches to the financial markets, feel free to check out the section on Option selling – Investing – Trading.

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