Buying High P/E Stocks: Was Benjamin Graham Wrong?


(Dinesh Sairam) #22

So, if I understand this correctly, you are saying that you don’t take additional steps to verify if the Price makes sense (Numerator) or whether the Earnings are sustainable (Denominator).

In any case, there’s not much to be done now. Maybe we could compare notes for 5-10 years and see how our very different investment approaches have fared.

Ciao.


(shreys) #23

My apologies I didn’t elucidate well.
Once, a stock reaches the market PE multiple I embark on the journey of assessing further upside potential. If prospects don’t seem to be bright I book my profits.But, like all other humans I too err. And, then as you rightly said that only time will tell which approach does well.


(Krishnaraj) #24

Your post claims Ben Graham was the first to posit PE ratio.

The concept was first introduced by Benjamin Graham of ‘The Intelligent Investor’ fame. Here is the first ever description of the P/E Ratio:…

I don’t think that is correct. Ben Graham did not introduce it.

  1. The footnote that you present is from the Revised Edition of the Intelligent Investor. This edition is updated with commentary by Jason Zweig, including footnotes ~ 2003. The foot note that you have presented is not by Benjamin Graham but by Jason Zweig, as can be seen by the different font used for his commentary vs Ben Graham’s chapters. I have an older 4th Edition as well that does not have Jason’s footnotes that you have pasted. Nett these are not Ben Graham’s statements.

  2. Additionally, Ben Graham wrote multiple editions of The Intelligent Investor, the first one being 1949, and the last one, called 4th Revised Edition, in 1973. Each of these editions are different and have differing views on markets, as can be seen from the reading of the texts. Ben refers to his prognosis made in older editions and analyzes them in newer editions based on what transpired. So he covered a really wide and varying market conditions.

  3. PE ratio had been in use even before the Great Depression, and Ben Graham refers to a Wall Street Journal article of March 26, 1928, where a market pundit is quoted as saying that General Motors should quote at 15 PE vs 12. This can be seen in page 451 of the 1934 Edition of the Security Analysis by Ben Graham (attached below)

  1. Finally the footnote that you have produced here is not a definitive comment by Jason and is a general indication as can be seen by the language.

To summarize,

this statement from the blog, “The concept was first introduced by Benjamin Graham of ‘The Intelligent Investor’ fame. Here is the first ever description of the P/E Ratio:…” is wrong.

Thus it follows that this statement, “Ben Graham proposed that, as a rule of thumb, stocks having a P/E greater than 20 should be considered as expensive.” is also wrong.

This statement, “Later in the book, he suggests that it’s best to avoid purchasing stocks which trade at a P/E of 20 or above.” I could not find in the book (as Ben’s text). Would be glad to have it pointed out.


(Dinesh Sairam) #25

#1. Thank you for pointing that out. I will update my blog accordingly.

#2 and #3. I can attest that I’m not wrong. Ben Graham proposes in the chapters for the ‘Defensive Investor’ that he should limit himself to 15 P/E.

In the chapters for the ‘Enterprising Investor’, he simply adds a few more criteria, while retaining the above:

AdditionalCriteria

I guess I misquoted 15 P/E as 20 P/E. I will fix that as well.


(Krishnaraj) #26

Can you please quote the page numbers of the above? I presume you are talking of The Intelligent Investor, revised edition with commentary by Jason Zweig.


(Krishnaraj) #27

I searched for these notes referred by you, and having searched them I wanted to make my comments:

  1. On page 349 of the revised edition, Ben says the following

image

This is among the 7 criteria he lists for a “quantitatively-tested portfolio” for a defensive investor who follows the suggestion of bonds and diversified stocks. This is in lieu of investing in the index.

Thus this PE recommendation is one of the 7 criteria for the defensive investor. This brings us to the question, who does Ben define as the defensive investor?

He defines the investor and his expectations on page 6. He says, "The defensive (or passive) investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions."

In other words there is no returns expectation that Ben sets for the defensive investor. Consequently taking just one aspect of his 7 criteria derived out of a set of standards, for one type of investor who does not have any returns objective, from one edition of a 4 editions book spanning atleast 24 years, and say that Ben was wrong, seems to me highly misguided.

You may say that buying stocks at low PE is not the way to make wealth, even high PE stocks can make wealth etc etc. But to pull Ben Graham into this by quoting his book without context, and question if he was wrong and try proving that, besmirches him and his work.

I am a student of security analysis and have read almost all of Ben Graham’s work (books, lectures, his memoir and his some papers). In my opinion, I find him so brilliant that not only do I collect all his books / writings / speeches, I collect multiple editions of his book Security Analysis spending a bomb, just so that I can get a few additional chapters or thoughts of that brilliant mind. I have also read others but Ben’s writings stand out so brightly that it dims out others. You can say I am almost a beggar for his ideas and thoughts.

In that light I hope you can understand how I feel when you say he is wrong on recommending a certain PE :slight_smile:. I know Charlie Munger said he is wrong (maybe he was but that’s hindsight), I know Ben made more money outside of his advice, but they pale when compared to his overgenerous contribution to the field of finance.


(Dinesh Sairam) #28

Two things.

Kindly check out the second quote (Picture) I made above.

Even though he recommends this for the Defensive Investor, he also recommends the same for the Enterprising Investor. He simply says, “in addition to the above criteria, we have the following criteria” and such.

So, he also wants the Enterprising Investor to limit himself to 15 P/E.

If you have a quote proving otherwise, feel free to share.

This, again, is what I concluded in my blog post. You can find it in the last part of my blog. To avoid any further confusions, kindly read my blog post once.

Some investors diss Ben Graham for having this P/E rule, but they have no idea how far ahead of his time Mr. Graham was. He, along with Dodd, were the very first people to start thinking about stocks systematically. We should be thankful that they shared their knowledge with us.


(Bheeshma Sanghani, PhD) #29

I think in the 1962 edition of security analysis , Chap 39 ( Newer methods of valuing growth stocks), Ben Graham introduced his popular 8.5+2g formula to estimate the intrinsic value of growth cos through a PE Multiple. This chapter altogether was omitted in the subsequent editions of security analysis for reasons unknown. It is well known that his investment in GEICO and the subsequent growth of the co, made him more money than all his past investments combined which prompted him to state this in the concluding chapter of the final edition of Security Analysis

"The philosophy of investment in growth stocks parallels in part and in
part contravenes the margin-of-safety principle. The growth-stock buyer
relies on an expected earnings 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. In
investment theory there is no reason why carefully estimated future
earnings should be a less reliable guide than the bare record of the past;
in fact, security analysis is coming more and more to prefer a competently
executed evaluation of the future. Thus the growth-stock approach may
supply as dependable a margin of safety as is found in the ordinary
investment—provided the calculation of the future is conservatively
made, and provided it shows a satisfactory margin in relation to price
paid"

To reiterate, Ben Graham outlined a specific formula to calculate the PE multiple of a growth co to estimate the intrinsic value. The 1962 edition Chap 39 contains it.

Thanks
Bheeshma


(Dinesh Sairam) #30

This article provides a great explanation of what the ‘Graham Intrinsic Value Formula’ is and how it does not work as well as an Intrinsic Value calculator:

https://www.serenitystocks.com/benjamin-graham-formula

The Graham Number is something very similar, some sort of an extension of the recommendations he makes in ‘The Intelligent Investor’ for the Defensive Investor. Indirectly, he says:

  1. P/E should be limited 15
  2. P/B should be limited to 1.5

(Krishnaraj) #31

The first picture of Moderate P/E is Jason’s comments, and not made by Ben. Let me reiterate that he does not recommend a PE of 15.

The second picture is on page 385 and from another chapter for Enterprising Investor. The additional criteria are not ones over and above for the Defensive Investor, but over and above what is mentioned in the S&P Guide that he refers to. That can also be inferred from his words, “rather similar to what we recommended for the Defensive Investor, but not so severe”. So this means a more relaxed set of criteria, so obviously cannot be as restrictive as the one for Defensive investor.

If you insist that he gave a rule.

Yes, he did, but with ifs and buts. He (the authors) said a different method was needed to value growth stocks. This formula was a slight modification of some previous work. g or G (as mentioned). G is the annual growth rate expected over the next 7 - 10 years. This was also done with a conservative bias (there is always some bias in any estimate). The 3 pages of the chapter are attached below.

But, a reading of the chapter (that was then omitted later as you say) implies that these approaches were developing not final or definitive. For eg he defines what a growth stock is and says (page 527) that we offer a "simple substitute for its usually complicated mathematics" and “to state our views on the dependability of this approach”, implying its tentativeness. After citing a few studies, here is what the authors stated about the dependability of the formula / approaches.

Page 536:

In summary I think he says, growth stocks needs another approach, do not use complex formulas, and if you want a simple formula, try 8.5+2G, but there’s nothing dependable.

This extract, “The philosophy of investment in growth stocks parallels in part and inpart contravenes the margin-of-safety principle. The growth-stock buyer…” seems to come from Intelligent Investor and not from the concluding chapter of 6th edition of SA.

Ben Graham has given various PE ratios to go by including in the Intelligent Investor and SA for various types of investors and types of stocks, including growth stocks as seen above. My point was that he never gave a PE ratio as a rule and said this was it.


(Dinesh Sairam) #32

Look at what Graham talks about in relation to the P/E in the exact same chapter you are referring to.

So, clearly one criteria he applied to the list was a 9 P/E limit. Later he goes on to admit:

He says the companies with ‘low P/E’ will give good returns going forward. So, Graham thinks:

  1. 9 P/E is a ‘low Multiple’
  2. ‘Low Multiples’ produce good returns

I don’t know how I can explain it in any clearer way.

He does, for the Defensive Investor. And as an extension, when he writes about strategies for the Enterprising Investor, he refers to 9-10 P/E as ‘low’ and that ‘low P/E’ produce good returns.

The commentary did not appear out of thin air. If you go back to Graham’s words in Chapter 14, you can find that he indeed suggests a limit of 15 P/E.

You yourself made this screencap a few posts ago.


(Dinesh Sairam) #33

I was recently informed by an acquaintance of mine (In the comments of the post) that I had made some silly mistakes in the calculations and indeed, I had. I have made the changes, but point I was trying to make still holds. Just thought I should update this here.