The Intelligent Investor
"By far the best book on investing ever written" - Warren Buffett
The Intelligent Investor, by Benjamin Graham, first published in 1949, is widely acclaimed as the most important book on value investing. In principle, value investing opposes the assumption that the stock market is “efficient.” Graham promoted the idea of value investing – to buy stocks when the price is lower than their true value and then to hold those stocks until the price returns to the true value, thus earning a return on the investment.
The Intelligent Investor can be seen as the most important framework of investing for all investors including the novice and the intermediate ones. The most important points include:
The Defensive Investor vs. the Enterprising Investor
Graham introduces the defensive and enterprising investor in the very first chapter of his book. Those are the two different approaches you can adopt when you invest. It’s important to understand that in order to receive optimal returns, only one approach needs to be followed. A combination of both is likely to increase your risk while lowering your returns.
In the book, the defensive investor is also called the “Passive Investor” and that’s the path most investors need to follow. This type of stock investor would only invest in high quality stocks and bonds. High quality stocks are typically characterized by large companies that are pioneers in their field in terms of market share. The defensive investor will be searching for leading stable companies with an unbeatable record of at least 20 years with dividend payments. To spread his risk even more, the investor should buy about 10-30 of these high quality companies.
*During the time this book was written, ETFs (a bundle of stock tracking indexes like Dow Jones or S&P500) were yet to be invented, but it’s clear that Graham was thinking in this direction. He wants decent returns by investing in a variety of great businesses without being exposed to loss of principals from bad individual stock picks. At that point of time, fees charged by brokers were much higher than it is today, so the advice to invest in 10-30 companies was merely a suggestion to spread your risk over multiple securities, without paying outrageous fees by investing in too many, rather than a specific number.
Graham also recommends investing in high grade bonds when the market conditions are right. The most secure bonds are the US treasury bonds that are essentially viewed as risk free options. The reason is that the government has the option to print more money, thus giving them the ability to pay back your interest and principal after maturity.
Investors often hear about asset allocations that are optimal. For instance, 75% in high grade stocks and 25% in high grade bonds is considered good. However, in reality, it’s not that simple. Market conditions keep changing and it would be very profitable to have more than 75% of your portfolio in stocks when the stocks are priced really low at the bottom of a cycle. To figure out the best asset class that offers good returns, a defensive investor may take a closer look at the earnings yield of the US treasury bonds and S&P500. For instance, if the interest rate on bonds is 4% this would be the benchmark. We would then compare this to the Price to Earnings (P/E) of S&P500. Say that the P/E was 20, in other words you would be paying $20 for $1 profit in S&P500 companies. That would be the same as 1/20 = 5% expected return.
Simplicity is the key for a defensive investor. This is partly because the investor’s knowledge about stock investing is limited, but also because he doesn’t want to spend the time required for researching stocks. A neat method for a defensive investor is to subscribe to the method of “Dollar Cost Averaging”. Using this technique, the investor is not required to think about the current price level of a security. He keeps investing the same amount month after month in a number of securities, thereby ensuring that he receives average returns.
In The Intelligent Investor, the enterprising investor is also called the active or aggressive investor, a path very few investors should follow, according to Graham. These investors both have the time and are also willing to put in the effort required to beat the average return of the stock market. It’s important to understand that you can’t really pursue individual stock picking methods if you aren’t knowledgeable about investing in stocks and bonds. Actually, an enterprising investor who lacks adequate knowledge can expect to get a lower return than the defensive investor.
The enterprising investor’s method to beat the stock market is through investing in undervalued and under recognized companies. That is not the same as saying that he should be not focusing on buying high quality companies. High quality companies are always the main focus for the enterprising investor and he should be focusing on thorough analysis to find the very best stocks. Often, an enterprising investor will start his search for great stocks at low prices by listing interesting stocks according to a low P/E and a low price book value (P/B).
A low P/E indicates the potential for relatively high earnings in the future, thereby yielding a higher stock price. For instance, a P/E of only 8 is often a good indicator for a stock that needs to be scrutinized since the return can be expected to be high 1/8 = 12.5% return. Likewise, if the P/B is less than 1, or in other words if the investor needs to pay less than $1 for $1 in net assets, this company could very well be of interest.
In rare situations, the enterprising investor may choose to invest in companies that aren’t considered high quality. However, this is only in situations where the investor is very familiar with the security where he has only invested a limited amount, and only when the stock can be bought at extremely low prices. As a general rule though, the enterprising investor should be very cautious. He should even rarer, if at all, invest in growth stocks. Growth stocks represent companies with good prospects, but priced high to the current earnings.. The risk of a loss in principal is simply too high if the ambitious growth plan fail.
Outstanding investing results comes as a result of research and market swings There is no doubt than an average investor who can control his emotions is headed for better results when compared to a knowledgeable investor who lacks control. Outstanding investing results can be achieved by an investor with both knowledge and control. The investor should focus on “pricing” and not the “timing” of stocks. Attempts to time the market are the characteristics of a speculator who thinks that he can predict the future; however, this strategy isn’t recommended. Pricing, on the other hand, is simply the process of estimating the value of a stock, and purchasing that stock at a bargain price that’s typically at least 50% below. The investor will first determine if the price is cheap based on a thorough quantitatively analysis of the financial statements, and subsequently if the stock seems to have a bright future after a thorough qualitative analysis. If the analysis checks out, he can go ahead and invest in that stock.
An investor should not look at a low price as the social proof, especially when it’s priced cheaper due to poor quality. Quite contrarily, one of the finest qualities of an investor is to go against the crowd knowing that his pricing is correct because his facts and analyses are correct too. Another important quality for the investor is to be patient. He won’t attempt to time the market and buy and sell his stocks when he thinks that they are under or overvalued. Rather, he knows that stocks will always return to its intrinsic value over time.
Graham argues that in many situations, the investor and not the market is his own worst enemy. Thanks to severe price fluctuations, the investor would be inclined to buy when everybody else is buying and will sell when everybody else is doing the same. This is not the way to look at stock investing.
The stock investor should instead use the price quotes at his convenience. Graham explains this concept by introducing an imaginary business partner called Mr. Market. He asks you to imagine that you own a small share of a private business that cost you $1,000. Mr. Market drops by your office every day and tells you that he’s knowledgeable about the stock you own. According to him, the price of your share could be $700 when he’s in a bad mood and $1300 when he’s in high spirits. It gets even better when he says that he’ll let you buy more than a piece of that business, and offers to take if off your hands for the very same price he quotes that day.
The Intelligent Investor will recognize an uncanny resemblance in situations he faces on the stock market every day. Instead of letting the constantly changing price affect him negatively, he should instead use the market fluctuations for his advantage, buying stock when other people are prepared to let those go at depressed prices, and sell his stocks, when other people become enthusiastic about stocks and drive up the price.
Buy assets at a “margin of safety”
The principle of the Margin of Safety is a very simple concept. As an investor, you might buy securities at a price lower than its true value. Basically this is because the cheaper the price of the security is, the higher the returns. In addition, you’ll expect to lose less if you’re wrong about your investment. We shouldn’t forget that we are actually buying a piece of a real business when buying stock, and if a business defaults, all investors would lose their money. It is however, rare that investors that have invested in large market leading company will lose their entire invested principal. Rather, we see that even when investors are wrong about an investment entered at a low price, they will keep or lose very little of their capital, thereby only paying the price that’s missing out of other better investments. Being right or wrong on a single investment, the importance of buying securities at a margin of safety is evident. It’s the most profitable and safe way to achieve superior returns.
But how do we measure margin of safety? The principle is more of an art than an exact science. In The Intelligent Investor, Graham explains the margin of safety in two different ways. The first approach is to estimate the value of an asset, and only buy that asset when it can be purchased with more than 50% discount. This process however, is not as simple as it sounds, as estimates of assets can’t be done accurately. It’s only in situations where stocks are very stable that we can make a realistic valuation, and even in these situations the best thing we can do, is to make assumptions placing the value of a stock within a certain range.
The other approach Graham has to the margin of safety is to compare the earnings yield between both bonds and stocks in general. We already covered how to calculate the earnings yield earlier in this summary of the Intelligent Investor, but let’s sum up. Firstly, you might take a look at the interest rate of the federal 10 year bonds. Say that the interest rate is 2.5%. Then, when you compare this to the earnings yield of the SP500, let’s assume that you found that the earnings yield was 5%. You would now have a margin of safety of 100% to compensate for unsatisfactory development. Whether or not that is enough for you as an investor, is up to you.
A very important point in relation to margin of safety is diversification. Holding a single stock with a wide margin of safety is by no means a guarantee for good results. But if you hold several stocks in your portfolio with a wide margin of safety you are less likely to achieve unsatisfactory results, and it’s even less likely that you will lose your principal over time. It can be compared to having insurance. However, an investor should be warned because it’s your margin of safety that has mitigated your risk and it’s not because you’re holding a higher number of stocks. If your bundle of stocks, no matter how many different stocks you have, is not reasonable priced at the time of purchase, it will not be profitable.