Benjamin Graham Case

CHAPTER 1

 INTRODUCTION

1.1     INTRODUCTION

This chapter provides a general understanding of the research topic of the application of the stock screening criteria of Joel Greenblatt’s Magic Formula. First and foremost, the research background is documented. Secondly, the problem statement comprising of the practical and literature gaps is developed. Thirdly, the research questions are developed based on the problem statement. Fourthly, the research objectives are developed according to the research questions. Fifth, the significances of this study are explained. Lastly, the construction of this thesis is explained.

1.2    BACKGROUND OF STUDY

In 1949, Benjamin Graham has introduced a structured approached to investing called value investing in his book titled the “The Intelligent Investor”. His books including the “Security Analysis” published in 1934 have been the two of the most famous investing books which is considered as the requisite reading material of any investors. One of the main contributions of Graham is that he was able to draw the fundamental distinction between investing and speculations.

The main difference between the two is the amount of risk that is undertaken. Speculators take high risk in deciding the direction of the trade with the hope of gaining abnormal return with a shorter time horizon than an investor. On the other hand, the lower risk investors are only seeking a satisfactory return on their capital based on analysis and fundamentals of the underlying asset in the long run. In other words, speculators are in for a quick killing by holding assets for a short period of time and sell them off at a huge profit before moving on to another asset. In fact, speculators are much more focused on the price action of stocks rather than understanding the business behind it (FCIC, 2010). As Graham would have put it, investors would see themselves owning a piece of the business when buying stocks whereas the speculators would be buying an expensive piece of paper which does not have any intrinsic value.

Value investing encompasses three main characteristics as defined by Graham and Zweigh (2003). The first characteristic is that prices of assets are subjected to significant movement or also known as volatility. Despite this, this brings to the second characteristics whereby they have fairly stable underlying value that are measurable with due diligence though not reflected in current market price. Lastly, the third characteristic is that, the best time to buy is when they are selling significantly below intrinsic value or what they are really worth based on their assets.

Value investors look for opportunities whereby prices of assets misalign with their true values.  They care little about pricing as cheap stocks do not mean it’s a bargain if there is no value to it. However if it is a valuable stock, chances are one would have purchased it when it is undervalued or at a cheap price relative to its value. In that case, one would have gained advantage of its low price and they would have a lot of “staying power” as any ups and downs of the stock market would not affect them as they would have taken the least risk in that position. Over a long term horizon, value investing would be able to create wealth as opposed to the short term abnormal gains through speculations. This is because if a stock is backed by a fundamentally strong business, value investors would not be bothered by the volatility of the prices as these investments would offer tremendous value, reasonable income and great safety over the long run.