Mr. Market – The Famous Value Investing Allegory

In his classic treatise, The Intelligent Investor, Benjamin Graham, the father of value investing, created an allegory to help new investors understand how to think about stock prices and value investing in general.

By using it, you can help protect yourself from overpaying for a stock, panicking when the market crashes, or doing foolish things resulting from emotional reactions to the nightly news.  Along with the margin of safety concept, Mr. Market is a cornerstone of the value investing strategy.

Your Business Partner, Mr. Market

Benjamin Graham recommended that someone who wanted to become a disciplined, successful investor imagine a scenario every time he or she wanted to buy or sell shares of stock, which, to Graham, represented ownership in a business, not just pieces of paper that moved around on the ticker tape.  Picture yourself in a partnership with a man named Mr. Market.  Now, Mr. Market is a manic depressive fellow and sometimes he is euphoric about the state of the economy and specific stocks, bonds, real estate, or other assets.  Other times, Mr. Market believes the world is ending and doesn’t want to own anything for cash.

Every day, Mr. Market knocks on your office door and comes in offering to buy or sell his share of the company to you.  He’s rather agnostic on which you choose because he has set the price based on his mood.  Sometimes, Mr. Market is close to what you, a far more rational investor, believes is the true, or intrinsic value, of your company.  Other times, he offers ridiculously low prices or unjustifiably high prices.  What should you do as his business partner?

You have three choices, based upon how much cash you have available:

Margin of Safety – The Secret Value Investing Strategy

The single most important concept in all of investing, according to Benjamin Graham and later confirmed by his star student, Warren Buffett, comes down to three simple words: Margin of Safety.

What is the margin of safety?  How do you calculate it?  How important is it to developing a successful value investing strategy?  As you’ll see in a moment, the ultimate return you earn on your investments will likely be closely related to the size and quality of the margin of safety you build in to your purchasing decisions, whether you are buying shares of Coca-Cola or building a hotel.  By understanding the concept and, just as importantly, the reason great value investing practitioners have treated it as holy scripture throughout their career, you can better position yourself to utilize the strategy in your own day-to-day money management activities.

Value Investing Margin of Safety Defined

Benjamin Graham basically described the margin of safety for any asset to be the discount between your carefully and conservatively calculated “true” value of the business (often called “intrinsic value” of a company or assets) and the price you paid for that asset.  In other words, if you calculate that a building, company, or timber rights, for example, are worth $1,000,000 and you pay $600,000, your margin of safety is $400,000 ($1,000,000 intrinsic value – $600,000 purchase price = $400,000).

Graham borrowed the margin of safety concept for his value investing strategy from the engineering field.  He pointed out that if a bridge says it can handle a load of 10,000 lbs., it will have actually been constructed to handle, say, 15,000 lbs. or more.  This difference of 5,000 is the margin of safety to ensure that the bridge doesn’t collapse and kill someone if a stupid, inpatient driver decides to take a risk and drive his 10,200 lbs. truck onto the structure.  The bigger the margin of safety, the less risk involved for the truck driver, the city or county, and those standing by or who happen to be parked on the bridge or coming from the opposite direction.

Tweedy, Browne Value Investing

For years, my family has maintained a substantial portion of our retirement accounts through Tweedy, Browne & Company, the oldest value investing firm in the world.

Originally serving as stock broker to the father of value investing, Benjamin Graham, Tweedy, Browne & Company converted to a money management company and eventually launched several highly successful mutual funds that operated with the same value investing style for which they had become renowned.  After beating the market by several percentage points for nearly forty years, the firm’s place in the halls of investing greats has been securely established.

In his book, The Little Book of Value Investing, the late Christopher Browne laid out how he and the other Managing Directors of Tweedy, Browne & Company put the value investing principles they learned from Benjamin Graham to work each day when they arrived at the office.

The Value Investing Secret: Keep 3 Years Worth of Spending Parked In Bonds

Christopher Browne recommended that those who want to follow a disciplined value investing strategy keep three years’ worth of spending money parked in safe, investment grade bonds.  That way, when the market crashes, you can avoid selling shares to support your lifestyle needs, liquidating the bonds, instead.  Although simple, this strategy can be incredibly effective by helping avoid the need to sell assets in the event they become even more undervalued after you purchased them.

Then, and only then, should the value investor move on to selecting individual stocks.

The Most Important Questions Every Value Investor Should Ask About a Stock

Tweedy Browne The Little Book of Value InvestingOnce you’re ready to put together a portfolio of value investing stocks, it’s time to begin the research process.  Browne said that the folks at Tweedy, Browne & Company focused on several questions when examining potential value stocks.  These were:

Charlie Munger Value Investing Strategy

Charlie Munger, the Vice Chairman of Berkshire Hathaway, former hedge fund manager, and billionaire value investor, was instrumental in changing Warren Buffett’s way of thinking about value investing.

Charlie insisted that the investor would be better served by focusing on better quality businesses, even if the price were higher, because those businesses could be held for decades, continually churning out cash and profits for the owners. In fact, it was this influence that resulted in Berkshire Hathaway shifting from acquiring undervalued “cigar butt” companies such the textile mills for which the firm was named to high-quality companies such as Coca-Cola.

In the book about his value investing philosophy, Poor Charlie’s Almanack, Munger discussed how easy it was to grow rich.  His formula was:

Bill Ruane Value Investing Strategy

In 1950, William Ruane, or Bill Ruane as he was known, took a course on value investing taught by Benjamin Graham and David Dodd at Columbia University despite having graduated from Harvard Business School.  One of his classmates was Warren Buffett, with whom he formed a friendship. 

Years later, when Buffett dissolved his investment partnership, he recommended that any partners still interested in value investing put their money with Ruane, who had launched his own firm, Ruane, Cunniff.  The flagship value investing vehicle of the new firm was the Sequoia Fund, an open-ended mutual fund.

Over the next 38 years, the Sequoia fund outperformed the S&P 500 by compounding at 15% per annum versus 13% for the broader index. Ruane was concerned with protecting returns for his existing investors, so the fund was closed in 1982 and no one could purchase additional shares unless you had already had a stake in the fund.  This restriction remained in place until 2008.  This created a thriving underground market for shares of Sequoia, which were even listed for $1,000 on eBay so investors who wanted to acquire one share could join the fund, then qualify to invest additional money.

Walter Schloss Value Investing Strategy

Walter Schloss, a legendary value investor who learned directly from Benjamin Graham, the father of value investing, never graduated from college and was hired as a runner on Wall Street in 1934, at the age of 18. Schloss enrolled in the New York Stock Exchange Institute, where he took courses from Benjamin Graham on how to value businesses, find value stocks, and manage money.

Using the lessons he learned there, Schloss launched his own value investing fund in 1955, with a starting balance of $100,000, eventually growing to manage money for as many as 92 investors. 

For more than 50 years, he earned a 15.3% compounded annual rate of return, turning a $10,000 initial investment into $12,344,268, far outstripping the 10% return offered by the S&P 500 during the same period, which would have resulted in only $1,173,909.

Putting Together a Walter Schloss Value Investing Portfolio

Unlike most professional money managers, Walter Schloss remained faithful to his value investing principles, refusing to deviate from the same formula he learned from Benjamin Graham, even in spite of his friendship with and exposure to Warren Buffett.

Working from a small desk in the offices of Tweedy, Browne & Company, the brokerage firm that handled both Graham’s trades and bought Warren Buffett his shares of Berkshire Hathaway, Schloss sought to acquire as many companies trading at a 1/3 net working capital as possible.  Schloss believed that he would come out ahead due to the benefits of widespread diversification, even though many of the companies he owned were considered unattractive by most of Wall Street due to some underlying problem in the business or with a key supplier.

Benjamin Graham Value Investing Strategy

In addition to penning several of the most important value investing books in history, Benjamin Graham, the father of value investing, was one of the two partners in the Graham Newman Corporation, the investment fund through which he put money to work.

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.

Value Investing 101

Value Investing StrategySome of the greatest investors in history have been value investors including Warren Buffett, Walter Schloss, the Managing Directors of Tweedy, Browne & Company, Bill Ruane, and Eddie Lampert, just to name a few.  With hundreds of billions of dollars in wealth between them, you may be tempted to look into the value investing philosophy and see if it is right for you.  Before we can do that, you need to learn what value investing is and how it is implemented into a portfolio.

” An investment operations is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

– Benjamin Graham, Father of Value Investing

The Three Questions of Value Investing

Value investing is a type of investing strategy that relies upon paying a price for an asset such as a stock, bond, mutual fund, apartment building, oil well, or song rights, that will generate attractive returns relative to the present value of the cash you will be able to drain from the asset from now until doomsday.

Put another way, value investing attempts to answer several questions: