Benjamin Graham and the Power of Growth Stocks
Benjamin Graham and the Power of Growth Stocks

Benjamin Graham and the Power of Growth Stocks

We believe that, thanks to Graham and Buffett, a “value” mindset has actually become a critical component of the growth investing process. (Location 180)

Any investment, and the subsequent return on that investment, depends first and foremost on the price paid for that investment. (Location 196)

Buffett’s contribution to Graham’s philosophy, similarly derived from decades of actual experience in the field, was a more refined sense of the ingredients of value in a business. (Location 251)

Every investor faces two key questions with the purchase of any stock: (1) what kind of company am I buying, and (2) have I built in an adequate margin of safety for purchase of that stock? (Location 305)

capital. If the average company grows earnings per share at perhaps 4 percent per year, then a growth company would grow faster than 4 percent per year and earn a satisfactory return on shareholders’ capital. (Location 312)

Every company has some reasonably definable value (intrinsic value), based on an analysis of its current earnings and cash flow and its future prospects. (Location 325)

Investing in value companies offers two sources of potential profit: dividends and capitalizing on the disparity between stock price and intrinsic value. (Location 350)

An investor in a growth company has three sources of potential return: (1) dividends, (2) exploiting the disparity between stock price and intrinsic value, and (3) long-term growth in intrinsic value. (Location 372)

While a value company investor must pay below intrinsic value in order to achieve a reasonable return, a growth company investor must seek to purchase the stock at a price of fair value or less. (Location 379)

In general, investors are best served by the idea of cautious optimism. (Location 398)

Investors A, B, and C begin their investment foray with $100,000 each. (Location 512)

What target return should Investor A shoot for in order to ensure reasonable odds of achieving a 9 percent compounded annual return? (Location 530)

The problem with trying to achieve double-digit returns with value companies is very similar to that of an average golfer who is trying to play at the level of the pros. You must constantly try to make difficult shots that you are simply not capable of making on a consistent basis. You might make those shots some of the time, but by stretching the limits and increasing the risk, you would also put yourself in some very difficult positions—sand traps, roughs, trees, and water traps. (Location 556)

200,000 − [$100,000 (beginning market value) + $100,000 (net contributions)] = 0 (Location 576)

Let’s imagine you have a choice of two stocks; one is a value company (V), and the other is a growth company (G). (Location 625)

It earns $1 per share, pays out $0.60 per share in dividends, and will grow at 5 percent per year over the next 50 years. If the stock is purchased at $10 per share, then the investor would forecast a nominal 11 percent compound return, with 6 percent per year from dividends and 5 percent from growth. (Location 626)

The reason: the need to reinvest the dividends leaves investors in Stock V vulnerable to future levels of stock prices because it’s impossible to predict what level stocks will be trading at in the future. (Location 633)

The greater the dividend yield, the more dependent our total return is on future stock prices. (Location 640)

Company G need invest only $167 in Stock G. This assumes that all dividends are reinvested in their respective stocks with no change in the future valuation of either stock. (Location 646)

Consider the example of a bond with an 8 percent coupon, a 30-year maturity, and selling at par. If an investor were to buy 100 bonds for $100,000, he would (Location 653)

earn $8,000 per year in interest payments. (Location 654)

Suppose the same investor buys a zero coupon bond offering 8 percent for 30 years. (Location 674)

The investor invests $100,000 in the bond. He will receive one payment of approximately $1,000,000 in 30 years. His distribution of returns is shown in Figure 2.6. (Location 675)

The zero coupon bond experiences significant price volatility in the early years, but the range of returns narrows as the bond approaches maturity. For the investor with a 30-year time horizon, the zero coupon bond has a much higher chance of achieving the desired 8 percent per year compound return goal. (Location 680)

Investors in both companies face internal reinvestment risk (that is, either company could make poor future investments). (Location 690)

Dividends are a prime source of return for long-term investors. If you buy a stock and never sell it, how else can you be compensated for owning the stock? (Location 700)

the earnings of the company will have increased by 117.4 times. (Location 703)

So should you buy and hold great companies that are capable of generating substantial gains and intrinsic value, or should you constantly trade static companies in hopes of earning a solid return on your dividends and trades? (Location 731)

Without a viable growth investment methodology, an investor conforming to the tenets of prudent diversification is unlikely to fully benefit from the best growth ideas. (Location 771)

determined by the quality of the portfolio not by the quality of a single issue within it. And the quality of the portfolio will be determined by the quality of the investor’s methodology. (Location 773)

If an investor owns several major winning positions, his or her portfolio has a reasonable chance of remaining balanced, where no portfolio position is outsized. (Location 785)

Portfolios with one or two highly concentrated positions force the investor to emphasize the margin of safety for those particular holdings. (Location 791)

But the chances of actually finding a value company with a dividend yield of 6 percent and a long-term growth rate of 5 percent or a no-growth company with a dividend yield of 11 percent are very slim. (Location 807)

The enduring characteristic of growth companies is their dynamism—they are constantly in flux. (Location 830)

The question is not whether the universe of growth stocks is expensive, but whether you can find individual opportunities to build an investment position. (Location 833)

But for long-term investors, the choice is clear. The growth company universe simply offers far greater potential for significant long-term returns than the value company universe. (Location 839)

Time is your friend. To earn a suitable compound return on your investment in a growth company, you simply need patience. You do not have to gamble on random, short-term market movements as you would with value companies. Instead, you’re relying on the long-term ruthless efficiency of the market. With growth companies, time is your friend. If the company keeps growing, the stock (Location 845)

compound returns. As we illustrated earlier, long-term compound returns are not easy to achieve. Because growth investing is a buy-and-hold strategy, you can watch your stocks grow and multiply for many years without paying a dime of taxes. Value investing, with its active buying and selling (Location 853)

multiply the earnings growth rate by 2 and add 8.5 to the total, then multiply that by the current earnings per share. Here’s the formula: (Location 886)

Intrinsic value per share = EPS year 1/(h − g) (Location 927)

Our suggestion to investors: keep the effects of high interest rates in mind, but do not adjust P/E ratios downward unless you have a strong conviction that the investment environment is entering a long period of significantly rising interest rates. (Location 967)

In order to calculate today’s intrinsic value using Graham’s formula, one must estimate the company’s normalized current earnings per share and forecast the company’s earnings growth rate into the future. (Location 971)

In order to use the Graham model effectively, investors should convert current earnings per share into normalized earnings per share. (Location 977)

One must also forecast a growth rate in earnings for each company. We encourage investors to base a growth rate on normalized earnings. (Location 982)

For a growth company, calculating today’s intrinsic value is just the beginning of the process. Investing in growth companies requires that investors base their decision on the future value of the company. (Location 991)

In the process of calculating the current intrinsic value, you should get a more thorough understanding of the company and its operations. Only by gaining a thorough understanding of the company’s current operations can an investor begin to assess its future value. (Location 994)

Intrinsic value per share, Company A = [8.5 + (2 × 7)] × $2 per share (Location 1037)

A over the next seven years. If the company has earnings per share today of $1, with an earnings growth rate of 8 percent, then earnings per share would grow to $1.71 per share in Year 7. (Location 1039)

By using the Graham model, you can free yourself to focus on two important parts of the process: understanding the company’s operations and building a reasonable seven-year budget. (Location 1066)

In this chapter we propose: (1) to discuss in as elementary form as possible the mathematical theory of growth-stock valuation as now practiced; (2) to present a few illustrations of the application of this theory, selected from the copious literature on the subject; (3) to state our views on the dependability of this approach, and even to offer a very simple substitute for its usually complicated mathematics. (Location 1102)

An elementary-arithmetic formula for valuing future growth can easily be found if we assume that growth at a fixed rate will continue in the indefinite future. (Location 1106)

This study assumed a permanent growth rate of 4 percent for the DJIA and an over-all investor’s return (or “discount rate”) of 7 percent. (Location 1110)

On this basis the investor would require a current dividend yield of 3 percent, and this figure would determine the value of the DJIA. We will assume that the dividend will increase each (Location 1111)

The required dividend return can be converted into an equivalent multiplier of earnings by assuming a standard payout rate. In this article the payout was taken at about two-thirds; hence the multiplier of earnings becomes ⅔ of 33 or 22.3 (Location 1114)

Since an expected growth rate of 7 percent is almost the minimum required to qualify an issue as a true “growth stock” in the estimation of many security analysts, it should be obvious that the above simplified method of valuation cannot be used in that area. (Location 1124)

The standard method now employed for the valuation of growth stocks follows this prescription. Typically it assumes growth at a relatively high rate— varying greatly between companies—for a period of ten years, more or less. (Location 1128)

Application of this method may be illustrated in making the following rather representative assumptions: (Location 1133)

discount rate, or required annual return of 7½ percent; (Location 1133)

(2) an annual growth rate of about 7.2 percent for a ten-year period—i.e., a doubling of earnings and dividends in the decade; (Location 1134)

(3) a multiplier of 13½ for the tenth year’s earnings. (This multiplier corresponds to an expected growth rate after the tenth year of 2½ percent, requiring a dividend return of 5 percent. It is adopted by Molodovsky as a “level of ignorance” with respect to later growth. (Location 1135)

This would result in a ten-year increase of 63 percent, raise earnings from a 1960 “normal” of, say, $35 to $57, and produce a 1970 expected price of 765, with a 1960 discounted value of 365. (Location 1147)

a uniform discount or required-return (Location 1163)

(Similarly, Bohmfalk assumes that all the 100 growth stocks he valued in his article will sell at between 11 and 12½ times their earnings 12 to 13 years hence.) (Location 1193)

If a stock doubles its earnings in 10 years, and is presumed to be now worth 20 times its earnings, why should it not be expected to sell in 1971 as well at no less than 20 times its earnings? (Location 1198)

The mathematical fact is that for any stock presumed to give a combined dividend return and growth exceeding the discount rate the assumed multiplier in the target year must be lower than the derived current multiplier. (Location 1202)

We consider it perfectly logical for the investor to require this mathematical result as compensation for the very large risk that the actual growth realized will prove less than the estimates. (Location 1208)

The first would seek to approximate the true probable rate of return to the investor if the projected growth rate is realized. (Location 1212)

The difference will indicate either (1) the extra profit that may be expected from realization of the growth prediction, (Location 1215)

(2) the amount of the safety factor embedded in the primary valuation. (Location 1216)

by a similar method, how much below the estimate the actual growth rate may fall and still produce the required 7½ percent return to the purchaser at the primary valuation. (Location 1217)

He calculates the growth rate implicit in the present price—i.e., that rate which, by his formulas would produce a value equal to the July 1960 price. (Location 1236)

(1) what rate of growth is necessary to produce a required overall return within a given number of years, (2) how many years’ growth at various rates would be needed to produce the required return, and (3) what actual returns would follow from given rates of growth proceeding over given periods. (Location 1250)

A study of actual investment results in groups of popular growth stocks will point up the need for substantial safety margin in calculating present values of such issues. (Location 1255)

Our first method endeavored to apply to growth stocks the same basic treatment that we have recommended for common stocks generally, except that we eliminate the dividend factor in the valuation. (Location 1292)

The first was a limitation of the seven-year growth rates to 20 percent per annum. (Location 1297)

Finally, our study of the various mathematical processes used by others led us to formulate two highly simplified methods of attaining approximately the same results as those produced by more complicated calculations. The first was our “8.6T plus 2.1” multiplier, developed directly out of the Molodovsky concept and previously discussed. The second is even simpler and reads as follows: (Location 1309)

Value = current “normal” earnings × (8.5 plus 2G), where G is the average (Location 1313)

that a multiplier of 8.5 is appropriate for a company with zero expected growth, and a current multiplier of 13.5 is satisfactory for one with an expected 2½ percent growth. (Location 1315)

For higher rates our recommended multipliers are more conservative than the others. (Location 1321)

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. (Location 1419)

Both Graham and Buffett have said that it is relatively easy to achieve reasonable returns from stocks but very difficult to achieve returns that exceed the market averages. (Location 1459)

Buying a stock slowly allows the investor to gain real-time experience with a management team before his position becomes too large. (Location 1660)

flying is a very poor idea. All’s well that ends (Location 1760)

The margin of safety is as fundamental to managing our lives as it is to managing our portfolios. (Location 1763)

“To have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.” (Location 1778)

The number varies by investor and is a function of the number of stocks for which the investor can calculate a satisfactory margin of safety. (Location 1782)

Skilled and safe pilots obsessively evaluate the margin of safety before takeoff. (Location 1788)

They don’t buy the stock until they can attain a margin of safety that helps assure a successful result. (Location 1790)

“The chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions,” (Location 1800)

Graham also pointed out a key flaw in the use of margin of safety. “Even with a margin [of safety] in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss—not that loss is impossible.” (Location 1805)

Most investors do not explicitly choose to violate the margin of safety. But they often unknowingly operate on the edge of the safety zone. (Location 1812)

Most investors do not appreciate the importance of margin of safety. They do not commit themselves to learning how to handle the margin of safety in a variety of different investments. (Location 1823)

The difference relates to the dynamic changes in the intrinsic value of growth companies over extended periods of time. (Location 1828)

The practice of investing in value companies tends to focus on price paid as a dominant variable in the margin of safety. (Location 1830)

the future value of the company is far more important than the current value of the company. (Location 1832)

“The growth stock buyer relies on an expected earning power that is greater than the average shown in the past. Thus he may be said to substitute these expected earnings for the past record in calculating his margin of safety.” (Location 1834)

1. Know what you own. 2. Develop reasonable estimates of future value. 3. Set a reasonable hurdle rate. (Location 1841)

Growth rates above 10 percent are fairly rare; growth rates of 20 percent or more are extremely uncommon—and rarely last for more than a few years. (Location 1871)

Investors must take great care in developing a long-term revenue forecast. From a purely mathematical standpoint, every stock is cheap if one estimates a high enough growth rate. (Location 1876)

A company might show very high profit margins today, but increasing competition may trim those margins. (Location 1885)

If we are lucky enough to own one or more of those rare companies that are able to sustain double-digit growth rates for long periods, then we are poised to benefit from that growth. (Location 1897)

If we purchase the stock at a price that should yield an average annual compound return of 8 percent, we are still likely to make a long-term profit on the purchase, but we have eaten into our margin of safety. (Location 1912)

Investors who both honor the margin of safety and adhere to a relative performance standard would need a higher-than-average expected return in order to purchase a stock. (Location 1929)

The same is true with growth stock investing. While failure to honor the margin of safety when investing in value companies can prove painful, failure to honor the margin of safety when investing in growth stocks can be catastrophic. (Location 1945)

First, investing in growth stocks can bring extreme temptations. Fabulous results can lead to irrational purchasing; terrible times can lead to irrational selling. Investors in growth stocks must develop the self-discipline to deal with these temptations. (Location 1976)

Second, we can only speculate as to what the fund manager was thinking with regard to the portfolio holdings during the entire period. (Location 1978)

were not. A defensible business model is the defining characteristic of a great growth company and the key to separating the big potential investment winners from the rest of the pack. (Location 2018)

If you can improve your ability to distinguish businesses with defensible businesses models, and be disciplined buyers of their stocks, you will greatly increase your odds of earning 10, 20, or even 100 times your initial investment. (Location 2030)

For instance, Southwest Airlines was able to institutionalize a demonstrably lower cost structure than its larger, more established rivals by exploiting second-tier airports, flying point-to-point routes, offering limited amenities, and purchasing only one model of aircraft. (Location 2035)

Competitive advantage also allows the company to devote more time and effort to improving the existing value proposition for customers instead of squandering precious resources reacting to competitive assaults. (Location 2041)

“The key to investing,” said Buffett, “is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company, and above all, the durability of that advantage.” (Location 2046)

potential investment, you need to understand the distinction between competitive advantage and competitive strategy. (Location 2049)

The permutations of competitive strategy are limitless; the expression of competitive advantage is not. (Location 2056)

once it has been firmly established in the marketplace, it exists independent of future strategy choices. (Location 2058)

Strategy experts may be quick to point out that a well-defined and well-executed business strategy may allow a company to carve out a competitive advantage where one did not previously exist, as was the case with Southwest Airlines. (Location 2061)

In our experience, competitive advantage takes one of two forms: barriers that keep potential competitors out of the market, or handcuffs on customers that make them reluctant to switch to an alternative supplier. (Location 2067)

At a minimum, effective competitive barriers severely impede a competitor’s ability to offer a similar product or service to potential customers. (Location 2070)

This type of drawing power makes Cabela’s a coveted retail business for municipalities that are seeking to spur economic growth and development. Consequently, a number of local municipalities have provided preferred tax treatment as well as targeted investment in roads and other public infrastructure to lure Cabela’s to their taxing jurisdiction. (Location 2134)

Asset barriers are barriers to competition that are created by a company’s having preferred or sole access to proprietary assets. (Location 2147)

Asset barriers to competition generally stem from favorable access to hard assets, geographic location, or proprietary intellectual property. A competitive advantage built on (Location 2151)

For instance, coal companies have an asset barrier in the form of their ownership of the mineral rights to large reserves of coal. (Location 2153)

Geographic location is also a relatively straightforward form of competitive advantage. For instance, a waste management company that owns the only landfill in a local geographic area has a near monopoly position. (Location 2158)

CoStar Group has accumulated more than 400 different pieces of information on approximately 3.7 million commercial real estate properties in major markets in the United States, the United Kingdom, and France. (Location 2167)

The company has methodically assembled this proprietary database over the past 20 years, (Location 2170)

The barriers presented by such a database are illustrated by the company’s high client retention rate (exceeding 90 percent in most years) as well as by its long-term improvements in return on invested capital in the face of continued aggressive reinvestment in new markets and products (Location 2171)

Varian Medical Systems, the leading provider of radiation therapy systems used in the treatment of cancer. Varian’s competitive barriers are twofold: proprietary IP and a robust feedback loop with customers. (Location 2176)

Scale-Based Barriers Scale-based barriers refer to the proverbial “low-cost producer” position in the market, attained as a result of the efficiencies associated with increased size. (Location 2183)

But Walmart had developed scale advantages where it counts, on the local and regional level. (Location 2190)

UPS and FedEx have developed an unassailable duopoly in the priority package delivery business in the United States. Their (Location 2193)

companies can still create a competitive advantage by developing a captive customer base. (Location 2204)

but rather from building customer loyalty to discourage them from switching to competitive offerings. (Location 2206)

is a function of the costs that a customer must incur to switch to a competitive or substitute product. (Location 2207)

all forms of customer captivity are based on switching costs of one form or another, we will use the two terms interchangeably. (Location 2213)

the tangible or “hard” costs and the intangible or “soft” costs of switching. (Location 2215)

Brand loyalty is another classic example of the power of soft switching costs on customer captivity. (Location 2246)

Network economics is a rare, but powerful, type of switching cost in which each incremental customer increases the overall value of the network. (Location 2266)

Arm Holdings is a little-known technology company that serves as a compelling example of network economics at work. (Location 2275)

rather, it licenses its proprietary intellectual property to hundreds of semiconductor manufacturers, who pay Arm a license fee for access to the chip design (or core) and/or a royalty for each chip manufactured. (Location 2278)

Each new entrant to the Arm ecosystem increases the overall value of the network by broadening customer choice and functionality when deploying (Location 2282)

Potential Signs of Competitive Advantage • High and stable market share • Steady market share gains • Low frequency of exit or entrance of industry competitors • Persistent pricing power • Materially higher operating margins than direct (Location 2292)

competitors • Loyal customers and low customer churn • High repeat purchases • Brand transferability to new categories • Strong consumer routine or habit • Long product cycles • Robust domain expertise • Proprietary manufacturing or business processes (Location 2296)

(Normalized operating earnings are what the company should earn in a “normal” operating environment, (Location 2307)

To further complicate matters, the assertions of competitive advantage tend to be loudest when they are best supported by positive near-term financial performance (Location 2335)

A hot new product is not a sustainable competitive advantage. (Location 2347)

A smart and charismatic CEO is not a sustainable competitive advantage. (Location 2357)

Efficient execution is not a sustainable competitive advantage. (Location 2362)

some cases it is obvious, as massive structural changes in the industry, changes in regulatory or political regimes, or disruptive technology rapidly undermine an existing competitive advantage. (Location 2369)

In fact, we would contend that it is extremely difficult to maintain a defensible business model for an extended period of time (structural competitive advantage notwithstanding) without an ability to execute the business strategy at a high level day in and day out. (Location 2380)

culture is the foundation upon which those blocks are laid. (Location 2383)

Great operating companies provide employees with a significant amount of latitude. (Location 2409)

The tidal wave of demand offered by an attractive, growing market can drive substantial growth for the business. (Location 2448)

Bad growth often stems from a “growth for growth’s sake” mentality that results in costly acquired growth or misguided attempts to diversify the business. (Location 2536)

“Run the business like (1) you own 100 percent of it, (2) it is the only asset in the world that you and your family will ever have, and (3) you cannot sell or merge it for at least a century.” (Location 2568)

they must understand that a management team has three basic options for investing shareholders’ capital: (1) reinvesting in the core business, (2) investing in other businesses, or (3) investing in its own shares through share repurchase plans. (Location 2641)

The only true return of shareholders’ capital is a dividend. Dividends treat all shareholders equally. (Location 2681)

Dividends are an underutilized tool for increasing alignment. Yet, despite the arguments for paying a dividend, (Location 2683)

As famed fund manager and author Peter Lynch once put it, “You only need a few good stocks in your lifetime. I mean how many times do you need a stock to go up tenfold to make a lot of money? Not a lot.” (Location 2741)

Investors who want to use Graham’s methodology can free themselves. They can choose to unbind themselves from their broker’s advice. (Location 3454)

reason why institutional investment firms tend to favor mediocrity: their large base of institutional customers tends to favor that approach. The 401(k) market is a prime example. Most employers are content to offer a variety of mutual fund options to their employees, and the mutual fund companies have cleverly designed a variety of offerings designed to appeal to the whims of the 401(k) participants. The latest gimmick is “target-date funds.” With these types of funds, investors are required only to pick a date on which they plan to retire, and, voilà, the fund automatically adjusts its asset mix as the investor’s retirement age approaches. What could be simpler? However, there are two critical missing pieces of data in this approach: what is the likely performance of the fund manager, and what are the fees? These are far more important considerations than the employee’s retirement date. By offering gimmick investments such as target-date funds, the fund managers are able to obscure their performance and their fees, which is not necessarily in the best interest of the clients. But that’s the way the institutions have chosen to do it. Or as famed screenwriter Damon Runyon once put it, “The race is not always to the swift, nor the battle to the strong, but that’s the way to bet.” At our firm, we rely on a disciplined buy-and-hold approach that doesn’t always coincide with the movements of the market. When we’re beating the averages, we rarely hear a word from our clients. They’re quite content to beat the market. But there are times when our approach may trail the market averages for an uncomfortably long period. During (Location 3475)

We believe most investors believe that long holding periods offer the best chance to earn average or superior returns from stocks. We suspect that most investors do not know how to hold stock positions for long periods of time. Here is a critical piece of knowledge that most investors lack: the most difficult time to own a stock is when the investor has a profit over his cost approaching 50 to 100 percent. The reason is that there is not a large enough cushion over his purchase price. He could easily lose his profits even in a normal market correction. If an investor buys a stock at $10 per share and the stock appreciates to $20 per share, the investor does not have much of a profit cushion if the stock should decline. (Location 3648)

Which can be generically expressed as PV = [D0 yr × (1 + g)]/(k − g) PV = D1 yr/(k − g) Where PV = present value   D = dividends   g = growth rate   k = hurdle rate (Location 4008)

100 G = ($5 × 104.75%)/(10% − 4.75%) = $100 (Location 4028)

diligent, savvy investors have a greater chance of successfully evaluating the long-term prospects of several high-quality, growing companies than of evaluating the immense complexity of the world’s economy, and therefore they are better equipped to invest their time, effort, and money in these opportunities for the long run. (Location 4097)