The Intelligent Investor is a book based on value investing, an investment approach that the author Benjamin Graham began teaching at Columbia Business School in 1928. The greatest investment advisor of the twentieth century, Benjamin Graham taught and inspired people worldwide. Graham’s philosophy of “value investing” — which shields investors from substantial error and teaches them to develop long-term strategies — has made The Intelligent Investor the stock market bible ever since its original publication in 1949.

Graham stressed on two vital principles for stock investors:

1) never overpay for any stock and

2) always keep a sufficient margin of safety while investing.

The stocks, which satisfy Graham’s two principles, are invariably the stocks that trade at a PE ratio of less than 10. times or low P/E stocks.

Low PE ratio segment contains stocks, which are excellent businesses, growing at a fast pace with good business advantage & efficient management but currently these companies or the industry sectors they operate in are in a nascent stage of the life cycle. Such stocks are yet to be recognized by general market participants and therefore, available at low valuations. On the contrary, this segment also contains stocks that have poor business fundamentals, running in losses and have questionable management that has eroded wealth of shareholders over the years. There are also some large cap companies in unfavored industry sectors and some PSU companies quoting at low PE ratio. So low PE ratio is the area, which in addition to exciting investing opportunities, also contains the entire junkyard of stock market.

Therefore, the key to benefit from low PE ratio stocks is to separate the wheat from the chaff. Selecting good stocks in this segment is a treasure hunt, where hard work put in is well rewarded. Low PE stocks can also turn out to be dud stocks, if you make a wrong choice.

Graham believed that the prevalent notion of undertaking higher risk being necessary for expecting higher return is a myth. He believed that expectation of returns depends upon the intelligent effort put in by the investors. Graham said that market inefficiencies provide many opportunities of earning high returns by taking minimal risk provided the investors do the hard work of identifying them.

Graham introduced a novel concept of Margin of Safety (MoS) in his book. Margin of safety compares the earnings yield (EY) of a stock with the yield on government securities (GSec) or treasury securities. Earnings Yield (EY) is calculated as the ratio of earnings per share (EPS) and current market price (CMP) of any share. Earning Yield is the reverse of P/E ratio.

EY = EPS/CMP (where EPS is earnings per share and CMP is current market price of any share).

Margin of Safety implies that the higher the Earnings Yield (EY) of a share over the yield on government securities (GSec), the safer is the stock investment.

Most of the low PE stocks are small to mid-cap companies that are yet to be recognized by market or large cap companies that are currently out of market favor.

If the investor does proper research and identify small to mid-cap companies, which have scalable business model, strong balance sheet, good management and low valuation, such companies can prove to be excellent investments in the long run, because of many subsequent underlying developments which work in their favor.

Increased Coverage by Market Participants and Equity Research firms, Improvement in Credit Rating and Increase in Stake by Institutional Investors can expand the P/E ratio of such companies. Combined with the growth in the earnings of such companies, they can give handsome stock returns in 5 to 10 years’ time horizon.