The Intelligent Investor by Benjamin Graham

“The Intelligent Investor” first written in 1949 (and revised from time to time) is considered to be the bible of investing.

Even though it is 70 years old the advice rendered in this book is still good.  Warren Buffett also swears by the teachings in the book even though his investment style is different. He acknowledges that most of what he practices is rooted in Graham’s teaching.

These are the key principles taught in the book:

Know the business you are investing in

Stocks are not only a ticker but ownership in a company which simply means that an “Intelligent investor” approaches investing the same way they would look at buying into a business or a partnership. You must have a good feel for a firm’s strengths, weaknesses, opportunities, and threats. In other words, do the SWOT analysis of the firm before any investment. You should also know who the company is managed by. It must be a team that will run the business honestly, competently, and efficiently.

Market swings between pessimism to optimism

So buy from pessimists and sell to optimists to make your money. This means that Graham takes the long-term approach. Instead of trading (buying and selling stock in a short period), his approach is finding quality companies to invest in over a long period.

Margin of Safety

One can not do away with the risk of being wrong so the margin of a safety net is very important. So Graham advocates an investing approach that provides a margin of safety—or room for human error—for the investor.

There are a couple of ways to accomplish this, but buying undervalued or out-of-favour stocks is the most important. The irrationality of investors, the inability to predict the future, and the fluctuations of the stock market can provide a margin of safety for investors.

Investors can also achieve a margin of safety by diversifying their portfolios and purchasing stocks in companies with high dividend yields and low debt-to-equity ratios. This margin of safety is intended to mitigate the investor’s losses if a company goes bankrupt. This is the tenet that most of his students including Warrant Buffett heavily rely upon.

The future value of the stock is dependent on the present price

Graham, like the book, suggests, only purchased stocks that were trading at two-thirds of their net-net value, as a way of establishing his margin of safety. Net-net value is another value investing technique developed by Graham, where a company is valued based solely on its net current assets.

Speculator vs Investor

The book makes a clear distinction between the speculator and an investor.

He makes it very clear right in the beginning itself that the book is not meant for traders who use technical charts to buy the stock when it goes up and sell when it goes down. It argues that this is directly opposite to the business sense.

Passive vs. Enterprising Investors

Graham goes on to distinguish between the type of investors as well, which according to him are Passive and enterprising investors.

Passive investors, according to Graham, are those who avoid any kind of mistakes, don’t want to make frequent decisions, and want freedom from any effort.

Enterprising investors, on the other hand, are willing to invest time and take care of the selection of the securities that end up being more attractive than the others.

Stock selection criteria for each type of investor

In the case of defensive investors, he suggests that they should have both debt and equity in their portfolio and should re-balance whenever the proportion changes by more than 5%. They should purchase shares of only well-established companies or index funds and should have a portfolio of 10-30 companies of large, prominent and conservatively financed companies, which have a long history of continuous dividend payments.

He also advises the defensive investor against buying growth stocks as they are usually overpriced and carry high risk. Risk in growth stocks arises not from the fear that such companies would degrow in the future, but from the risk that they might not grow as expected by markets.

How defensive you might be as an investor depends less on your tolerance of risk than more on your willingness to put time and energy into your portfolio.

However, as per Graham, no matter how defensive you are as an investor, in Graham’s sense or in the contemporary sense which is a low risk, you cannot ignore the fact that you need to have some stocks in your portfolio and for that, you need to do your homework.

The book suggests that Mutual Funds are the best way for defensive investors to tap into the upside of the stock markets without the need to police their portfolio.

Index Funds are especially the best as they are a defensive investors dream come true

For the enterprising or aggressive investor, who is willing to put in more hard work than a defensive investor, he suggests a different strategy to achieve higher returns.

He suggests carefully chosen growth stocks, bargain issues, and special situations arising out of mergers & acquisitions. relatively unpopular large companies, and in companies which are not large ones but operating in important industries. The strategy that the book suggests is that stocks selling at less than their net working capital per share can prove to be a good bargain.

Tools for analyzing a stock and its indicative value

The tools that he emphasizes are the P/E ratio, Price to assets ratio (P/B ratio), current ratio, debt to equity ratio, total asset and sales size of the company, earnings stability, and growth rates etc.

The book rationalizes that at any time, investors should have a mix of Bond and common stock in the portfolio. Graham suggests the mix should be a minimum of 25% and a maximum of 75% between the two.

He has also paid a lot of attention to Inflation and according to him, Inflation must be a concern for investors because it lowers real wealth as it erodes the purchasing power of profits and principal.

As the cost of living rises it especially hurts the principle of fixed income securities. One of the benefits of equity investments is the possibility that dividends and capital gains can redeem the lost purchasing power.

This is not to say there is a close connection between inflationary and deflationary conditions and stock prices. Graham is just pointing out that good quality companies can continue to grow and pay higher dividends versus a bond with a fixed payout.

Investors must be vigilant for the unanticipated. That means there is never a perfect time to be in only one asset category (don’t put all your eggs into one basket). The intelligent investor must minimize risk by anticipating the unforeseen. Diversification is the foundation of such a strategy.

Mr Market

This imaginary person, “Mr Market,” turns up every day at your doorsteps offering to buy or sell his shares at a different price. Sometimes the proposed prices make sense, but other times, the proposed prices are off the mark, given current economic realities.

So basically on some days Mr Market is in good mood and is high, so he offers high prices and on others, he is unhappy and is down and so he offers cheap prices on these days.

Individual investors have the power to accept or reject Mr Market’s offers on any given day, giving them a leg up over those who feel compelled to be invested at all times, regardless of the current valuation of securities.

An investor should concentrate on the real-life performance of their companies and the dividends they receive, rather than getting swayed by the changing sentiments of Mr Market in determining the value of the stocks.

If you start letting his sentiments govern your decisions of holding a security, then chances are that you will end up in a loss-making proposition. An investor is neither right nor wrong if others share the same sentiments as them; only facts and analysis can make them right.

The most important advice that Graham dishes out is that investing is not about beating others in their game but controlling your own game.

Simply put it means that for an intelligent investor the challenge is not to find a stock that will go up the most and down the least but to prevent yourself from being your enemy and buying high just because Mr Market says buy.

The book also gives the investor insight into Mutual fund investments and clearly says that these funds should be chosen carefully to avoid ending in a mess as most of the funds underperform the market, overcharge their investors, and do not do the stock selection well enough. One whole chapter has been devoted to this topic and people who are interested in investing in MF should go through it.

Seeking advice from others

Are you seeking advice from relatives, friends, TV channels, brokerage houses, etc? So should I hire a professional to do the selection of the securities in my account?

As per Graham, there is no guarantee that they can do a better stock selection. However many of us do take comfort from the experience, judgment, and opinion of the financial advisor.

The best advisors do not claim to give you the best returns but are cautious and like to preserve the principal value and charge you heavily for that. The brokerage houses make their commission on brokerage and so an intelligent investor can see that their views are aligned to day-to-day market trading and therefore are not viable for long-term investment.

We need to be careful though as there are many unethical individuals or fly-by-night operators who are working the market.

Security analysis

According to Graham, 5 main elements decide the differences of the companies. He summaries them as

–          Company’s long term prospects

–          Management quality

–          Financial health and records

–          Dividend record

–          Current dividend rate

He has also described in detail the problems to watch out for in a company while doing the stock selection and the plus points of the company that you should consider while making the investment decision.

He has clearly stated that one should pay attention to the debt structuring of the company to find out that the company is not suffering from the OPM(other people Money) syndrome heavily and if you find that it’s not, then this is the company to invest in.

Should we invest in IPOs?

Graham advises that all investors should be wary of new issues and there are two main caveats to this suggestion.

• a) these issues are sold under special salesmanship and
• b) these are always sold under favourable market conditions i.e. favourable for the seller which means less favourable for the buyer.

He has called it a toxic way of investing, and the biggest reason why one should stay away from the  IPO’s is that it violates the most fundamental rules of Graham that one should buy the stock when it is cheap to own the business.

How about high yield/foreign bonds?

Another thumbs down given by Graham is to the High yield bonds or what we today call Junk Bonds.

Today there are fund houses that manage these bonds but charge a huge fee and do not work hard to preserve the original capital. A similar thumbs down is for the foreign bonds which according to Graham investors should stay away from.

However, there is one type of foreign bond that might be slightly appealing for the investors who can take plenty of risks and that is the Emerging Market Funds.

What about day trading?

Day Trading is complete No-No as per  Graham. He clearly states that some of the trades may make money, most of the trades will lose money and one person who will make money in both the conditions is your broker.

What you don’t understand in all this eagerness to trade and make money by buying and selling the stocks is that it can lower your returns. There is also an extra cost associated which can be called the impact cost which never shows on the brokerage statement but is a real cost that lowers your returns.

Taxation is another reason which can lower your returns.

Timing the market

Graham also warns the investors in falling prey to the most common pitfall of all which is timing the market. No one can predict with certainty that the bull run will continue for a long time or when the bear phase will be over.

Graham further cautions that a stock does not become a  sound investment just because it was bought close to the asset value. He says that the investor should also ask for a better price-to-earnings ratio, better financial statements, and more years of good financial health.

As per Graham, there is a fine distinction between a speculator and an investor. It is up to you whether you want to be a speculator or an investor.

The speculators’ interest lies in profiting from the market fluctuation whereas the investor would like to acquire and hold suitable security. Speculation can be a lot of fun when you are ahead of the game but this can not be expected forever and chances are that you would end up losing more money than making it.

Conclusion

Graham also didn’t see any evidence that the average money manager could obtain better results than the market indices over the long run. Trying to beat the market is a fool’s game… “In effect, that would mean that the stock market experts as a whole could beat themselves — a logical contradiction.”

So the main takeaway from the book is that you have to make your own investment decisions based on your analysis — nobody else can do it for you, not even those professionals who offer their recommendations to you. When you do turn to professional advisors, you should be content with earning the market’s return, not more.