The Intelligent Investor

Book Review

Book Title: The Intelligent Investor : The Definitive Book on Value Investing

Author: Benjamin Graham (with additional commentary from Jason Zweig)

Date Published: 2003 (original edition was published in 1949)

Rating: 7.5/10

The Intelligent Investor – Author Background Facts and Tidbits

• Born: 9 May, 1894 (London)
• Name: Benjamin Grossbaum (later changed to Benjamin Graham)
• First Job: Chalker with the firm Newburger, Hendersen
• Earnings: At 25-years old, Graham was earning more than $500,000 a year
• Nickname: Graham is frequently called the ‘Father of Security Analysis and Value Investing’
• Success: The Graham-Newman Corp mutual fund (he ran with Jerome Newman), from 1936 – 1956 returned on average 14.7% per annum.

 

The following is a summary of the book chapters and some key words/notes extracted. These extractions are a combination of Graham’s original work plus additional commentary from Jason Zweig. Jason Zweig became a personal finance columnist for The Wall Street Journal in 2008. He is the author of Your Money and Your Brain (Simon & Schuster, 2007), one of the first books to explore the neuroscience of investing.

 

Introduction

• The investors chief problem is likely to be him/herself
• Lessons to be gained in future chapters include:
  • Minimize the odds of suffering irrecoverable losses
  • Maximise the change of achieving sustainable gains
  • Control our own self-defeating behavior.
• Definition of an Intelligent Investor
  • Patient
  • Disciplined
  • Eager to learn
  • Harness your emotions
  • Think for yourself

Chapter 1 – Investment vs Speculation – Results to be expected by the Intelligent Investor

• Graham’s definition of investing: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return”. This approach to investing, according to Graham, has three important elements, namely:
  • You must thoroughly analyze a company and the soundness of the business, before buying
  • You must deliberately protect yourself against serious losses
  • You must aspire to adequate and not extraordinary performance

Chapter 2 – The Investor and Inflation

• “Because of the uncertainties of the future, the investor cannot afford to put all his funds into one basket”

Chapter 3 – A century of Stock Market History – TH Level of Stock Prices in early 1972

• Price/earnings ratio
  • <10 = low
  • 10 – 20 = moderate
  • >20 is expensive
• The intelligent investor must never forecast the future exclusively by extrapolating the past
• The stock market’s performance depends on three factors:
  • Real growth (rise of company earnings and dividends)
  • Inflationary growth (general rise of process throughout the economy)
  • Speculative growth / decline (any increase or decrease in the investing public’s appetite for stocks)

Chapter 4 – General Portfolio Policy: The Defensive Investor

• There are two ways to be an intelligent investor:
• By continually researching, selecting and monitoring a dynamic mix of stocks, bonds or mutual funds
• Or by creating a permanent portfolio that runs on autopilot and requires no further effort
• Graham’s general advice is that you should never have more than 75% of your total assets in stocks; however, if your are younger, say early 20’s, it makes sense to have a more aggressive portfolio, weighted in stocks

Chapter 5 – The Defensive Investor and Common Stocks

• Graham’s guideline of owning between 10 and 30 stocks remains a good starting point for investors – don’t be overexposed to one industry
• If you want to invest in a company you know, eg Starbucks, that is fine, however, do your research on top of that to ensure you are paying a reasonable price
• Dollar cost averaging (investing a portion of your budget over a regular period, eg every month or every 3 months) is a good approach; this could be into stocks or even a portfolio of index funds

Chapter 6 – Portfolio Policy for the Enterprising Investor: Negative Approach

• Avoid ‘junk’ bonds
• Avoid day trading – most traders will lose over time and you will pay higher taxes
• Avoid buying Initial Public Offering’s (IPO’s )

Chapter 7 – Portfolio Policy for the Enterprising Investor: The Positive Side

• A great company is not a great investment if you pay too much for the stock
• Growth stocks are worth buying when their prices are reasonable but when their price/earnings ratios go much above 25 or 30, the odds get ugly
• Putting a third of your money in mutual funds that hold foreign stocks helps insure against the risk that out own backyard may not always be the best place in the world to invest

Chapter 8 – The Investor and Market Fluctuations

• The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities ay suitable prices
• The investor with a portfolio of sound stocks should expect their process to fluctuate and should neither be concerned by sizable declines or sizable advances.
• The investor who permits him/herself to be stampeded or unduly worries by unjustified market declines in his holdings is perversely transforming his basic advantage into a disadvantage
• You can’t control where the market will head or behave, but you can control:
  • Brokerage costs
  • Ownership costs
  • Expectations
  • Risk
  • Tax bills
  • Your own behavior.
• If your investment horizon is long, say at least 25-30 years, there is only on sensible approach: Buy every month, automatically and whenever else you have spare money. The single best choice for the lifelong holding is a total stock-market index fund. Sell only when you need the money.

Chapter 9 – Investing in Investment Funds

• Most funds underperform the market, overcharge their investors, create tax headaches and suffer erratic swings
• Typical funds traits:
  • The average fund does not pick stocks well enough to overcome its costs of researching and trading them
  • The higher a funs expenses, the lower the returns
  • The more frequently a fund trades its stocks, the less it tends to earn
  • Highly volatile funds, which bounce up and down more than average are likely to stay volatile
  • Funds with high past return are unlikely to remain winners for long
• Recognize that an index fund which owns all of the stocks in the market, all of the time, ….will beat most of the funds over the long run
• Hold an index fund for 20 years or more, adding new money every month, and you are al but certain to outperform the vast majority of professional and individual investors alike. Later in his life, Graham praised index funds as the best choice for individual investors, as does Warren Buffett
• If you are going to buy a fund, check the following:
  • expenses
  • evaluate risk – check the Morningstar rating
  • check if the managers are major shareholders
  • look at past performance
• Note that yesterday’s losers almost never become tomorrow’s winders and avoid funds with consistently poor past returns, especially if they have above average annual expenses
• When should you sell a fund? Some indicators are as follows:
  • A sharp and unexpected change in strategy – eg value fund buying up technology stocks
  • An increase in expenses
  • Large and frequent tax bills – generated by excessive trading
  • Sudden erratic returns
• If you are not prepared to stick with a fund through at least 3 lean years, you shouldn’t buy it in the first place. Patience is the fund investor’s single most powerful ally

Chapter 10 – The Investor and his Advisors

• Seek professional advice/guidance as required – there is no shame in this, and it may save you lots down the track
• It is imperative that you find someone who not only makes you feel comfortable but whose honesty is beyond reproach
• Next do your research on this person to ensure there is no negative press/records against them
• If all ok, then interview them – just google up an appropriate set of questions depending on their profession, eg if a financial planner you will find good lists of suitable questions to ask
• Talk to some references – current clients
• If you have less than $100,000 to invest, you may not be able to find a financial adviser to take your account. In that case, buy a diversified basket of low-cost index funds
• A good adviser should have the following in place:
  • A comprehensive financial plan – that outlines how you will earn, save, spend, borrow and invest your money
  • An investment policy statement – that spells out your fundamental approach to investing
  • An asset allocation plan – that details how much money you will keep in different investment categories

Chapter 11 – Security Analysis for the Lay Investor – General Approach

• Valuation of growth stocks that should be expected over the next 7-10 years:

Value = current (normal) earnings X (8.5 + twice the expected annual growth rate)

• Five important elements to consider for determining future price:
  • The company’s “general long-term prospects”
  • The quality of its management
  • The financial strength and capital structure
  • Its dividend records
  • Current dividend rate

Chapter 12 – Things to consider about per share earnings

• To assist the intelligent investor from buying a stock that turns out to have financial troubles, the following is recommended:
  • Read a company’s financial report from the last page and work your way toward the front
  • Read the associated footnotes to the financial statements
  • Read more – get as much valuable information as is possible for the stock you are researching

Chapter 13 – A Comparison of four listed companies

• Graham lists seven statistical requirements for inclusion in a defensive investor’s portfolio. These include:
  • Adequate size
  • Sufficiently strong financial position
  • Continued dividends for a least last 20 years
  • No earnings deficit in past 10 years
  • 10-year growth of at least 1/3 in per share earnings
  • Price of stock no more than 1.5 times next asset value
  • Price no more than 15 times earnings of the past 3 years

Chapter 14 – Stock selection for the Defensive Investor

• Graham suggest that the defensive investor can “most simply” buy every stock in the Dow Jones Industrial Average
• Today, however, you can buy a total stock-market index fund that holds essentially, every stock worth having….a low cost index fund is the best tool ever created for low maintenance stock investing
• If you want to own individual stocks, then keep 90% of your stock money in an index fund and leave 10% for picking your own stocks

Chapter 15 – Stock selection for the Enterprising Investor

• Criteria for consideration:
  • Financial condition: current assets at least 1.5 times current liabilities; debt not more than 110% od net current assets (for industrial companies)
  • Earnings stability: no deficit in the last 5 years covered in the stock guide
  • Dividend record; some current dividend
  • Earnings growth: last years earnings more than those of previous year
  • Price: less than 120% net tangible assets
• Warren Buffett approach:
  • Looks for ‘franchise’ companies with strong consumer brands, easily understandable businesses, robust financial health, and near monopolies in their markets – eg H & R Block, Gillette and the Washington Post Co.

Chapter 16 – Convertible Issues and warrants

• They are negative on Covered Calls – this is because if the stock price hits your agreed strike price, you need to sell the underlying shares at the agreed price. This then implies that if the stock races up in value, you have lost this capital gain and you only obtain the original premium plus any capital gain up until the strike price is reached. The brokerage costs can be excessive.

Chapter 17 – Four Extremely Instructive Case Studies

• Graham highlights:
  • An overpriced “tottering giant”
  • An empire building conglomerate
  • A merger in which a tiny firm took over a big one
  • An IPO of shares in a basically worthless company

Chapter 18 – A Comparison of Eight pairs of Companies

• The market scoffs at Graham’s principles in the short run, but they are always revalidated in the end; if you buy a stock purely because its price has been going up…..sooner or later you will be extremely sorry.

Chapter 19 – Shareholders and Managements: Dividend Policy

• There are two basic questions shareholders should turn their attention to:

1. 1. Is the management reasonably efficient?
   2. Are the interests of the average outside shareholder receiving proper recognition?

Chapter 20 – Margin of Safety as the Central Concept of Investment

• In 1972, Graham summarized ‘margin of safety’ as “the difference between the percentage rate of the earnings on the stock at the price you pay for it and the rate of interest on bonds, and that margin of safety is the difference which would absorb unsatisfactory development”
• For most investors, diversification is the simplest and cheapest way to widen your margin of safety
• As an intelligent investor, you must never lose most or all of your money. Using Graham’s margin of safety, you minimize the chances that your wealth will ever disappear or suddenly be destroyed
• Before you invest, you must ensure that you have realistically assessed your probability of being right and how you will react to the consequences of being wrong.

 

The Intelligent Investor – Key Takeaways

• True value investing in line with Graham’s methodology takes some time to master and a lot of patience to comes to terms with
• Identifying true value stocks whilst amid a stock market boom is not easy. The best opportunities lie in place following severe market corrections once valuations have approached more realistic values
• As is often highlighted by the worlds leading value investors, such as Graham and Buffett, if you simply do not have the time to put in to find individual value stocks, then simply invest in a diverse set of low cost index funds.

 

The Intelligent Investor – Closing thoughts

This book was not an easy read and to absorb its many teachings and deeper insights into value investing, it probably needs to be read several times. In the words of Graham himself, “I am an exponent of the philosophy that the main objective of common stock investment should be pricing, not timing; and by pricing I mean the endeavor to buy securities at prices which are attractive, letting timing take care of itself”.

If you enjoyed this book review, you will also enjoy my review of the “Richest Man in Babylon“.

Read, learn, enjoy, be persistent and most importantly, take action!