Stock Investing Basics: Benjamin Graham’s 4 Rules on Investing in Common Stock

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As I’ve mentioned in several of my articles, aside from just working to earn money, you also need to Save and Invest if you want to be financially successful.

Now, I’ve already explained why I don’t want to recommend particular stocks on another article (Read that one if you want to know how “Investment Advisors” can manipulate you), but I CAN teach you what I’ve learned from OTHER investors through their books and research!

“Fools say that they learn by experience. I prefer to profit by others experience.” – Otto von Bismarck

Now, you don’t need to be an extremely wealthy super-genius to become an investor. All you need (aside from a broker like BPITrade or ColFinancial if you live in the Philippines) is some money, discipline, and applied knowledge.

Here’s some simple guidelines from Benjamin Graham, author of the classic “The Intelligent Investor.”

How to Invest in Common Stock: Benjamin Graham’s 4 Rules for Defensive Investors

 

First Rule: Diversify!

Own at least 10-30 different stocks, preferably in different industries.

A fruit farmer won’t plant just one tree in his land, he’ll plant MANY trees. If a few trees die for any reason, there’s a LOT more that can still bear fruit. You must do the same thing with stocks.

While it’s tempting to bet everything on a few “sure-win” stocks, you open yourself to a LOT of risk that way if any one of those companies suddenly fall in value.

If you ever heard people “don’t put all your eggs in one basket” when talking about stocks, this is what they meant: Don’t put all your money in one company/mutual fund/industry and invest in a wide variety of them.

 

Second Rule: Select Large, Prominent, Conservatively Financed Companies

Invest in established leaders in the industry, preferably companies in the top 25% or 30%.

Generally, you want companies that have found a winning formula and have withstood the test of time.

While new ideas and startups sound exciting and it IS possible to build fortunes from them, remember that there is a MUCH bigger risk for failure, especially if you didn’t check the fundamentals correctly. In the late 90s to early 2000s, brand new, web-based businesses were the most popular and stock prices soared. Suddenly, when many of those new web-based businesses failed and the “dot-com bubble” burst, people LOST their investments overnight and nearly TRILLIONS of dollars worth of market value disappeared.

Choose great and stable companies. Remember: We’re investing in businesses, not gambling on racehorses.

 

Third Rule: The Company you’re buying should have a Long, Unbroken Record of Dividend Payments

Graham recommends at least 20 years of dividend payments (profit given to company stockholders).

Why are dividend payments so valuable? Lowell Miller, author of “The Single Best Investment: Creating Wealth with Dividend Growth” explained that dividends signify actual profit. Companies can lie on their “Earnings” reports to look good to investors and boost their stock price, but as Geraldine Weiss wrote, “Dividends Don’t Lie.” They’re real, solid proof that the company is making money.

If a company gives good dividends to their stockholders, it means it has actual earnings to pay it.

 

Fourth Rule: Choose companies with a 7-year Price-to-Earnings (P/E) Ratio of Less than 25 (and less than 20 in the past 12 months)

What’s the P/E Ratio? According to Investopedia, it’s the “ratio for valuing a company that measures its current share price relative to its per-share earnings.” In short the P/E Ratio is how much the share currently costs compared to the earnings each share gives.

Why is a low P/E desirable? A very high P/E means that the stock is likely overpriced and that there’s a lot of speculation with it. In layman’s terms, many people are betting on it so as they buy the stock, the price increases.

It’s like paying P500 for a P100 T-shirt, hoping that the T-shirt can be sold for P1,000 later (You lose P400 if the shirt’s value rightfully goes down to P100). That’s a rough example, but you get the idea.

Choose good companies with a moderately low P/E Ratio (less than 25).

 

So there you have it! The Four Rules for Defensive Investors! Remember:

• Diversify! Own around 10-30 different stocks in many different industries!
• Select Large, Prominent, Conservatively Financed Companies
• Choose companies with Long, Unbroken Records of Dividend Payments
• A 7-year Price-to-Earnings (P/E) Ratio of Less than 25, and less than 20 in the past 12 months

 

If you want to learn more about Benjamin Graham’s Investing method, you can check out his book, “The Intelligent Investor” below. If you want the absolute basics or a quick reviewer of the book, there’s also a 100-Page Summary version by Preston Pysh and Stig Brodersen on this link.

 

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