- The Intelligent Investor – Preface by WARREN E. BUFFETT
- The Intelligent Investor – Introduction by JASON ZWEIG
- The Intelligent Investor – Introduction by BENJAMIN GRAHAM
- The Intelligent Investor – Chapter 1: INVESTMENT VS SPECULATION: RESULTS THAT CAN BE EXPECTED by the Intelligent Investor
- The Intelligent Investor – Chapter 2: THE INVESTOR AND INFLATION
- The Intelligent Investor – Chapter 3: A CENTURY OF HISTORY IN THE STOCK MARKET: THE STOCK PRICE LEVEL AT THE BEGINNING OF 1972
- The Intelligent Investor – Chapter 4: GENERAL PORTFOLIO POLICY: THE DEFENSIVE INVESTOR
- The Intelligent Investor – Chapter 5: THE DEFENSIVE INVESTOR AND COMMON STOCK
- The Intelligent Investor – Chapter 6: PORTFOLIO POLICY FOR THE ENTREPRENEURIAL INVESTOR: A NEGATIVE APPROACH
- The Intelligent Investor – Chapter 7: PORTFOLIO POLICY FOR THE ENTREPRENEURIAL INVESTOR: THE POSITIVE SIDE
- The Intelligent Investor – Chapter 8: THE INVESTOR AND MARKET FLUCTUATIONS
If you’ve come this far, it’s because you’re interested in learning to invest or at least reading one of the greatest investors of all time, Benjamin Graham through his bestseller The Intelligent Investor.
What you’ll find below is a full PDF summary of the key chapters of this investment masterpiece.
On the other hand, if you are determined to learn in depth the teachings of Benjamin Graham to earn money I recommend you buy the book directly.
This guide reviews the main concepts transmitted by Benjamin Graham in his classic treatise on how to invest: The Intelligent Investor.
You will be able to have a brief summary of each chapter in PDF where you will have an overview of the teachings transmitted by Graham from which Warren Buffett has learned so much.
I hope it serves you and that you can start your way in the world of investments in the best way!
The Intelligent Investor – Preface by WARREN E. BUFFETT
The Intelligent Investor is one of the founding books of the discipline of Value Investing, so this book written by Benjamin Graham could not have had the preface of any other than Warren E. Buffett, his most famous disciple.
While Buffett probably outperformed his teacher Benjamin Graham, the words in the preface show nothing but admiration and respect for his “teacher, employer, and friend.
In this PDF preface Warren Buffett mentions that he first read this book in 1950 when he was only 19 years old and still thinks it is one of the best investment books of all time.
To invest successfully, Buffett continues, you don’t need a high IQ, unusual business prospects or inside information.
All it takes is a reliable intellectual framework for decision making and the ability to keep emotions at bay.
This book provides the intellectual framework, but the reader must provide the emotional discipline concludes Buffett.
In this preface, Warren Buffett emphasizes the teachings of chapters 8 and 20 of this book.
In fact, at Berkshire Hathaway’s last conference in Omaha in May 2018, in response to one of the questions he was asked, Warren Buffett replied that he would rather hire a person who is very clear about chapters 8 and 20 than a graduate with honors from one of the top business schools in the United States.
For Buffett the concepts of Value Investing are simple and do not require great intellectual capacities to learn them. It does require extraordinary discipline and common sense to carry them out.
Continuing with the preface, Warren mentions that anyone who follows the steps and concepts outlined in The Intelligent Investor can achieve results in the stock market NOT THAT BAD. Which, according to him, is a lot to say.
The results that one should expect by investing in the stock market should be related to the effort and intellect that one applies to deciding where to invest and to the NONTIERS that the market falls victim to during the time that one is investing and that therefore offer good opportunities to the investor.
The more stupid or foolish the market becomes, the greater the opportunities the intelligent investor will have to make a profit.
The preface ends with an editorial written by Warren E. Buffett when Benjamin Graham died in 1976. In that editorial you can see Buffett’s great admiration for Graham.
According to Buffet, Graham expected to do something silly, something creative and something generous every day.
It is rare that the founder of a discipline such as Graham’s was in investment analysis, is still in force 40 years after his first publications.
Graham had virtually a photographic memory, an endless fascination with new knowledge, and an unprecedented ability to apply that new knowledge to seemingly unrelated problems.
In closing, Buffett quotes a quote from Walter Lippmann: “There are men who plant trees so that other men sit underneath, Ben Graham was one of those men.
The Intelligent Investor – Introduction by JASON ZWEIG
The latest edition of The Intelligent Investor features the comments of finance journalist Jason Zweig, who has been a columnist for The Wall Street Journal since 2008.
Zweig not only contributed to the introduction to The Intelligent Investor, but was also its editor and comments at the end of each chapter.
The original text reproduced in this edition is the last text revised by Graham and corresponds to the 4th edition updated in 1971-1972 and initially published in 1973.
Zweig begins his introduction by rescuing the character and conceptual clarity proposed by Graham in his book by proclaiming that all bull markets must always end badly and that this is an absolute certainty.
Zweig began to enter the world of finance in 1987 with the brutal fall of the stock market that year, finding Graham’s words almost prophetic.
After expressing the importance and influence that Graham has for the investment world, Zweig goes on to review his life: where he grew up, what were his studies, where he began to work, etc.
Graham graduated from Columbia, second in his class, in 1914 where he had managed to secure a scholarship for his brilliance. After Columbia, Graham decided to try his luck on Wall Street and started working at a brokerage firm and soon was running his own investment firm.
Although Graham was hit by the 1929 stock market crash, accumulating a 70% loss between 1929 and 1932, I can then recover and take advantage of the bull market that came after that crisis.
While there is no exact record of what Graham’s returns were in his time as an investor, from 1936 to 1956 when he retired, Graham-Newman Corp. earned at least 14.7% annualized versus 12.2% for the total stock market during those years.
Graham-Newman Corp. was an open-ended mutual fund that Graham managed along with Jerome Newman, another prominent investor of the time.
Perhaps the richest part of this introduction is when Zweig summarizes The Intelligent Investor’s investment principles that are more relevant today than ever before. Those principles are:
- A stock is not just a symbol or a piece of paper, it is a participation in a particular business with an underlying value that does not depend on the share price.
- The market is a perpetually swinging pendulum between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes stocks too cheap). the intelligent investor is a realist who sells to optimists and buys to pessimists.
- The future value of each investment is a function of its present price. the higher the price paid, the lower the future yield.
- No matter how careful you are, the only risk an investor can’t eliminate is the risk of being wrong. only by insisting on what graham calls a “margin of safety” can the chances of error be minimised.
- The secret to financial success lies within everyone. if you become a critical thinker and invest patiently and confidently you can achieve a sustainable advantage in the worst bear markets. developing discipline and courage without letting other people’s mood swings influence us can control our financial destiny. in the end how our investments behave is much less important than how we behave.
Using the concepts mentioned in The Intelligent Investor it is possible to educate ourselves and alternate the vision of how we see the financial world to surely become much wiser investors.
investment principles of the intelligent investor
Investment Principles Suggested by Benjamin Graham in The Intelligent Investor
The Intelligent Investor – Introduction by BENJAMIN GRAHAM
In this introduction written by Benjamin Graham the author emphasizes that the book is not about showing a technical methodology to perform investment analysis but rather what it tries to convey are investment principles and attitudes that any investor should have to achieve good results in financial markets.
In a series of earlier books, “Security Analysis,” Graham elaborates further on the description of the technique used to value different financial assets.
This book deals more with investment principles than with technical concepts of asset valuation.
Although the book mentions several examples of concrete actions or roles, it is only done to illustrate concepts and not as part of a valuation methodology.
More than anything else throughout the book is about identifying historical patterns that occur in financial markets in many cases over several decades.
It is especially important then to understand how bonds and stocks have behaved during different economic realities.
In general, Graham throughout The Intelligent Investor will always place a lot of emphasis on what percentage of stocks and what percentage of bonds an investor should have in his portfolio according to different criteria and situations.
“Those who do not remember the past are doomed to repeat it” Graham quotes Santayana’s famous phrase.
Another key distinction Graham makes in the introduction has to do with the fact that the book is not aimed at speculators who base their investment decisions on complicated charts and graphs and who buy stocks because they have been going up and selling stocks or financial assets because they have been “going down.
This technical approach, says Graham, whose goal is to “follow the market” has not shown good results for anyone he knows in the last 50 years of market experience analyzed by Graham.
As this is the 4th edition revised by Graham since the first publication of The Intelligent Investor in 1949, it analyzes the novelties that have occurred in the markets in the last 5 years, that is to say since the last revision made by the author in 1965.
At that time, 1971, several relevant events had taken place in the markets. Facts for which Graham tries to seek new explanations and, where appropriate, to adapt or update the investment principles of previous editions.
Some of these facts were:
A significant and unprecedented increase in interest rates on highly rated bonds.
A 35% drop in the price of market-leading shares from 1965 to 1970. The biggest drop in the last 30 years.
Persistent inflation in consumer prices.
The development or creation of conglomerate companies.
The bankruptcy of the largest railway company in the country until then.
While investment principles should not change between decades, Graham says they do need to be adjusted somewhat or adapted to significant changes in climate and investment mechanisms.
One of the significant changes that Graham is most concerned about or the most emphasized in the introduction is the increase in yields or interest rates on front-line corporate bonds.
From 1967 to 1970, an investor could have earned double the return by investing in corporate bonds instead of investing in major stocks including their dividends.
Graham then wonders whether, given this new situation in terms of bond yields compared to front-line stocks, he should make his portfolio recommendation for the intelligent investor 100% in bonds instead of 50% in bonds and 50% in stocks as he used to recommend in previous editions.
Graham then makes one of the book’s most important distinctions: the difference between two types of investors, passive or defensive investors versus entrepreneurial, active or aggressive investors.
Passive investors are those who do not want to devote much time to the process of selecting financial assets for investment and therefore want to make as little mistake as possible. Its focus is on avoiding the loss of principal.
On the other hand, enterprising investors or active or aggressive investors are actively seeking the best investment options to have a portfolio yield higher than the market.
Graham clarifies that in the long term, if these investors persist and try hard enough it is likely that their effort will be rewarded by obtaining yields above the market.
A very common methodology at that time for active investors was to identify growing industries and within those growing industries to see which are the companies with the greatest potential to invest.
For example, at that time in the computer industry, IBM was undoubtedly the star of that group of shares.
Now, in the 1950s, the aeronautical industry also had great growth prospects. However, although the industry had a great development, the funds that invested in aeronautical companies ended up losing money.
So, Graham concludes, the methodologies used by active or aggressive investors do not always work 100% effectively.
Two conclusions can then be drawn from these examples:
Obvious growth in the physical volume of business does not necessarily imply growth in earnings for investors.
Experts or active investors do not have reliable methods for selecting and concentrating investments in the best companies in the growing industries.
For Graham the main problem of the investor and his main enemy is ONE SAME. “Guilt, dear investor, is not in the stars -nor in our stocks- but in ourselves…”. The disciplined control of emotions is much more important than any technical framework that the car can transmit to us.
Another of the fundamental teachings that Benjamin Graham transmits to us in this first introduction is: “DO NOT BUY ACTIONS FROM COMPANIES THAT QUOTE VERY MUCH ABOVE THE VALUE OF THEIR TANGIBLE ASSETS*”.
*tangible assets of a business include buildings, plants, factories, equipment, inventory, cash, short-term investments and accounts receivable.
In other words, although there are many companies that may be priced well above the value of their tangible assets due to high growth prospects, the buyer of such shares will be too dependent on market fluctuations and what may happen in the future so it would not be advisable to invest in this type of asset.
In general, from the introduction of The Intelligent Investor we know then that it will be a book that will not teach to beat the market but yes:
How to minimize the chances of irreversible losses.
How to maximize the chances of achieving sustainable profits.
How to control the self-destructive behavior that makes most investors unable to develop their full potential.
Rising markets make stocks riskier because prices are higher and, as seen above, the result of a future investment is proportional to the price paid in the present.
On the other hand, bear markets or crises make stocks less risky and therefore it is a period where value investors find many investment opportunities.
The Intelligent Investor – Chapter 1: INVESTMENT VS SPECULATION: RESULTS THAT CAN BE EXPECTED by the Intelligent Investor
In chapter 1 of The Intelligent Investor, Graham lays the conceptual foundation that he will use in the rest of the book to refer to what investing really means.
For the author, an investment operation is such that, after careful analysis, it promises security of principal and adequate return. Transactions that do not meet this requirement are purely speculative.
From here, with a well-defined investment transaction, Graham continues to analyze the market conditions that prevailed in the years following the publication of the first and second editions, where bonds and equities as an asset class had different yields (often very different from what would have been expected at the beginning of that period).
In relation to speculation, Graham argues that it is neither bad nor good, nor illegal, nor immoral. It is even necessary in certain cases when new companies go public and need capital to grow without having a proven product in the market or when they want to exchange risk.
Speculation can be intelligent or unintelligent. Graham mentions that unintelligent speculation occurs when:
1) you are speculating and you think you are investing,
2) speculation becomes the main activity and not a hobby when the necessary knowledge and skills are not available and
3) when you risk more money in speculation than you can actually afford to lose.
For Graham, any NON-PROFESSIONAL investor trading on margin is by definition a speculator.
What does it mean to trade on margin? Basically it means borrowing cash from the broker and buying stocks or bonds with that loan that has as collateral the same securities that are held in custody in the broker.
If the market value of those assets falls and margin is being used on the account, the broker will likely call the client to ask them to increase their positions by depositing more funds or else start liquidating the assets in the account at market price.
Another important point that Graham emphasizes in this chapter through different examples that occurred in the preceding decade is that THE FUTURE PRICE OF FINANCIAL ASSETS IS NEVER PREDECIBLE.
Therefore, since the behaviour of financial markets cannot be predicted, the only thing that can be done is to learn how to predict and control one’s own behaviour.
Much of the discussion in the chapter is based on understanding what the optimal portfolio allocation between bonds and stocks should be.
At a time when the outlook for bonds is still excellent, Graham does not risk recommending a portfolio other than a mix of 50% front-line stocks and 50% highly rated bonds.
At most a maximum of 75% in either asset class and a minimum of 25% respectively.
What kind of shares should the defensive or conservative investor buy according to Graham? Only shares of major companies with a long history of profitable operations and a strong financial condition.
While one option is to choose the shares of individual companies on your own, other options available to the conservative investor to build his stock portfolio are:
Buying a stake in a well-established investment fund.
Hire professional advisors to select the shares to buy.
Use “dollar-cost-averaging” to buy shares in the market. This means buying every month or every quarter the same amount in shares regardless of whether the market is high or low. So you will buy a lot of shares when prices are low and a little less when prices are high.
In relation to active investors Graham mentions that the first thing they have to make sure before they want to obtain returns superior to those of the passive investor is NOT TO LOSE.
Active investors should devote 110% of their time to market and company analysis, i.e. leave everything or better to conservative investors.
In general, Graham mentions that entrepreneurial investors or active investors have generally focused on generating better results than the market through three strategies that according to the author are not likely to work:
Trading in the market: buying when the market is rising and selling when the market is falling by performing various buy-sell operations during the year. It would be a kind of trend-setting and Graham has already spoken out against such strategies.
Short-term selectivity: would be buying shares of companies that are expected to perform well in the coming year or year. Graham argues that this strategy is not going to work because generally the expectations of earnings for the current year or the following year are within the current price and it is unlikely that a particular analyst could have better information or forecasts in this regard than the multitude of Wall Street analysts.
Long-term selectivity: in this case the argument against action selectivity based on long-term profit forecast is almost the same as in the previous case. It is very difficult for a particular analyst to make better predictions than all Wall Street analysts, and in the affirmative case that they can actually forecast future profits in a better way than Wall Street analysts, they should be wrong so that the investor can actually make a profit.
So is there a reliable strategy that guarantees principal security and generates adequate returns for the active or entrepreneurial investor? Graham argues that it is possible to find such a strategy and that if it exists, this strategy should not be popular on Wall Street.
One of the strategies of this type that Ben Graham used in the past is to buy companies that are trading for a lower total value than the company’s current assets. Graham’s famous “net net” strategy.
Basically if the market value of a company is less than the value of the assets that company had as cash or short-term investments minus liabilities, its working capital, then Graham bought that company.
Clearly this type of situation has disappeared today and it is very difficult to find a company that has such characteristics.
Following the discussion on how to buy shares, in the comment section of the Zweig chapter it refers to an investor buying a share because he sees a productive value in the business and not as a speculator waiting for someone to buy the same stock for a higher price.
In relation to this last paragraph Warren Buffett argued at the 2018 shareholders’ conference that he saw in the value of Bitcoin pure speculation where people bought crypto coins only in the hope that someone would come later and pay more than they paid to buy.
Buffett is a fundamentalist of investments in productive assets that generate cash flows or produce wealth.
One of Graham’s famous phrases in this regard is: “Ask yourself: if there were no market for these shares, would you be willing to have an investment in this company on these terms?
The Intelligent Investor – Chapter 2: THE INVESTOR AND INFLATION
In chapter 2 of the book, Benjamin Graham discusses the role inflation plays in investments and how a intelligent investor should make investment decisions based on how he expects the overall price level to behave.
It is worth mentioning that the author always analyzes the different scenarios available to the investor depending on what percentage of bonds and what percentage of shares an investor should have in his portfolio.
In this sense then, Graham mentions that in inflationary contexts the bonds are always a bad investment since both the interest they pay and the principal that is returned at the end of the period are fixed amounts not indexed by inflation with which the investor would be losing purchasing power (at the time Graham wrote these lines there were still no U.S. government bonds called TIPS whose principal is adjusted annually according to the amount of inflation in that country).
On the other hand, an investor could expect the effect of inflation to be mitigated by holding shares since in inflationary contexts this asset class could increase in price or dividends could be higher.
In order to continue with the analysis, data are taken from the beginning of the 20th century in relation to inflation levels, stock price levels, profits and dividends.
Apart from the fact that it is not only very difficult to find some kind of correlation between the price of shares and the level of inflation, Graham concludes that it is impossible to predict what the increase, or decrease, in the general price index will be in the following years.
Since it is impossible to predict what the inflation level will be, the exercise of planning the portfolio in relation to this variable is useless.
Despite this, in one segment of the Graham chapter he mentions that, as a general rule, it is possible to take an annual rate of 3% for future inflation. This is one of the few predictions in which Graham was wrong because the level of inflation in the years following 1972 was above 8.7%.
After an analysis of the different variables, Graham concludes that there is no close correlation between price movement and stock earnings with the level of inflation or deflation in the economy.
The chapter continues with a historical analysis of stock performance over the different decades preceding 1971, the year the book was revised.
From this analysis Grahama concludes that it is reasonable to expect a future return on shares of 8% from 1971 onwards, however such returns will not be even year on year but will only be a long-term return.
In relation to the annual returns of the stock market, Graham quotes a famous phrase by John Pierpont Morgan, which he always mentioned when asked what his perspective was on the future price of shares. JP Morgan always responded, “They’re going to fluctuate.”
In another section of the chapter Graham analyzes what the different investment alternatives may be to protect against inflation and there he mentions that gold is a bad safeguard against rising levels in the general level of prices.
Since 1935 it has been illegal in the United States to buy gold for hoarding. Graham mentions that this has been a blessing for American investors since in the 35 years preceding 1972 the price of gold rose only 35% and in addition the holder did not receive any kind of income and surely also had to face the costs of treasury.
It would have been better to put a fixed term on the bank, argues Graham.
Generally speaking, Graham says that inflation cannot be won by putting money or investing in the purchase of “things”, be they precious metals, art, diamonds, etc. The same applies to the purchase of real estate assets as they are subject to large price variations.
As a final conclusion, the author mentions that the initial diversification between bonds and shares must always be maintained and that one asset class cannot be overweight in relation to the other by the sole effect of expected future inflation.
In the comments section Jason Sweig clarifies that we must always measure the outcome of investments in real and not nominal terms. In other words, taking into account the effect of inflation.
Governments that get into debt are always going to have incentives to generate more inflation as they can thus liquefy the debt burden. On the other hand, in scenarios where there is deflation it is convenient to have bonds or to be a lender since the principal is revalued at the same time that I am receiving interest.
Already in the comments section, and doing an analysis of more years, Zweig concludes that actions are a good safeguard only against scenarios of moderate inflation, for example less than 6%. If inflation exceeds that number then we are faced with scenarios in which economic forces are unleashed to the detriment of companies and we can even see a fall in the stock market.
Analyzing periods of 5 years from 1926 to 2002, 64 periods of 5 years can be formed in which 50 the yield of the shares surpassed the inflation (78% of the times) however in almost ⅕ of the occasions the inflation was very superior to the yield of the shares.
Finishing with the chapter, it is mentioned that currently there are two tools that can provide greater coverage against inflation, TIPS (government bonds that adjust the principal according to the level of inflation) and REITs (funds administered exclusively dedicated to real estate investments).
The Intelligent Investor – Chapter 3: A CENTURY OF HISTORY IN THE STOCK MARKET: THE STOCK PRICE LEVEL AT THE BEGINNING OF 1972
In chapter 3, Graham analyses almost a century of data based on three fundamental variables related to the stock market: the level of stock prices, earnings and finally the percentage of dividends distributed.
The data used by the author to carry out this analysis begin in 1871, which is the year from which relevant data on share prices and yields can actually be obtained. In spite of this, Zweig in the comments mentions that the data even until the late 20s may also be overvalued due mostly to what he knows in English as survivorship bias or survivor bias.
According to this well-known cognitive bias, only the data of those companies that actually survived are being considered, not the hundreds of automobile or railway companies that declared bankruptcy in those years. It is for this reason that data may still be affected and stock yields may be lower.
Data on companies effectively listed on the Dow Jones Industrial Average begin as such in 1897.
Throughout the chapter and based on these data, Graham analyzes the different ups and downs of the American stock market during almost the entire twentieth century, arguing whether it was expensive or cheap in each of the preceding decades and also mentioning what would have been the correct course of action as the different markets presented themselves.
To find out if the stock market is expensive or cheap in a given period, Graham analyzes the P/E ratio or price earnings built on the current stock price but the average earnings of the last 3 years. Depending on the evolution of this metric and the ratio of the percentage yield of highly rated bonds to the yield of the shares, it issues a value judgment on the market.
The latter ratio is constructed by dividing the return ratio of shares (earnings per share / share price) by the return ratio of high-denomination bonds.
Already in the comments of the chapter and as Graham’s final conclusion it follows that an intelligent investor should never predict the future exclusively from the extrapolation of the past.
Something we must always remember that the return on an investment is a function of the price we pay for it. In relation to this he cites as an example the 90s where inflation was falling, there was peace in the world and corporate profits were rising; however this did not mean that the share price should rise to infinity.
As the profits a company can have are finite, the increase in stock price should also be finite.
Generally speaking, and based on all the information analyzed in the chapter, it could be concluded that the performance of the shares is determined by:
Real growth: increased profits and dividends for companies.
Inflationary growth: the generalized rise in prices throughout the economy.
Speculative growth: the increase or decrease in the public’s appetite for stocks.
According to Zweig, in the long term growth in earnings per share has averaged 1.5% to 2% (excluding inflation), inflation in 2002 could be estimated at 2.4% and the percentage of dividends paid was 1.9%. So we have the sum of the 3 at: 1.5%+2.4%+1.9% gives us approximately 5.8% annual return on long-term equities.
History has shown that the more convinced an investor is about the future, the more likely he is to be brutally hit by the market. This is why one must always question all assumptions and adjust one’s view of reality as events unfold.
In financial markets, the worse the future looks, the better it usually ends up being.
The Intelligent Investor – Chapter 4: GENERAL PORTFOLIO POLICY: THE DEFENSIVE INVESTOR
In this chapter, Graham again makes the typical distinction between the defensive and conservative investor and the entrepreneurial or active investor. The first is the one that is looking for adequate results but wants to spend as little time as possible on defining its investment portfolio. On the other hand, the active or entrepreneurial investor is one who devotes time and resources to the search for investment opportunities in order to obtain better than average returns.
Graham argues against the theory of efficient markets saying that one should not expect more or less return according to the risk being assumed. For Graham one should expect more or less return according to the amount of intelligent effort he is willing to give looking for investment opportunities.
In many cases, Graham says, he sees less risk by buying a share that went down 40% and is therefore at “given” prices compared to a high-denomination bond that yields 4% a year.
From this declaration, the auto faces again the problem of allocating resources in the portfolio of an intelligent investor. It is then that he mentions again that the percentage of bonds and shares should be 50% and 50% with a rebalancing for example half-yearly, where if the percentage of value invested in shares has risen to 55% the 11th part should be sold to return to 50% and 50% of percentage between both types of assets.
On the other hand, Graham allows a variation of up to 75% in one asset class with the corresponding offsetting entry of 25% in the other asset class. The problem, Graham says, is that while the rule is simple, it is very difficult to determine when one or the other kind of asset should be overweighed because this goes against human nature.
The investor will try to sell when the market has gone down and there is bad news and buy when the market has gone up and apparently everything is going well in the economy. That is to say, he would make purchases and sales contrary to what it should be.
After this analysis, Graham goes on to enumerate the different advantages and disadvantages of each fixed income instrument available at that time based on two fundamental variables: whether the bond’s income is going to be taxed or not and whether to opt for long-term or short-term bonds.
Zweig mentions that there is currently a third dimension that should be analyzed and that has to do with whether you opt for bonds or directly for bond funds.
Graham then goes on to analyze:
- Series E and Series H U.S. Savings Bonds.
- Other U.S. bonds
- Provincial and municipal bonds
- Corporate Bonds
- High yield or junk bonds
- Certificates of deposit
- Convertible Emissions
Call Provisions: In this sense, Graham recommends never buying bonds that have this clause or that are callable.
Bonds that are callable are liable to be redeemed by their issuers before the maturity date.
The net effect of this clause for the investor is that he would probably be losing all the upside or capital gain he might have in the event of a decline in interest because in such a scenario the issuer of the bond would declare it callable at the stipulated price and issue new debt at a lower rate depriving the investor of the capital gain.
In this chapter, Graham also speaks out against preferred stocks because they are said to be an investment instrument that concentrates the worst of the bond world and the worst of the stock world.
Preferred stocks do not have as much priority as bonds at the time of a bankruptcy, and on the other hand they do not have the appreciation potential of common stocks (not to mention that they do not generally have voting rights either). That’s why he only recommends buying preferred stock when it’s at auction.
The Intelligent Investor – Chapter 5: THE DEFENSIVE INVESTOR AND COMMON STOCK
In this chapter, Graham sets out how a conservative investor should behave in relation to common shares. According to Graham, stocks have two major advantages. 1) offer some protection against inflation and 2) may give a higher return than bonds over the years through dividends and capital appreciation.
Always remember that the entry price does not have to be very high, otherwise the results can be meager. In this sense, Zweig mentions the example of when stocks fell with the 1929 crisis, it took 25 years to return to the same level in 1954.
This means that although stocks are a good investment in the long term, if entry prices are very high and have no reason to be then the periods needed to see a profit can be extremely long.
This is one of the best book chapters as Graham gives us 4 practical rules that conservative investors should follow when choosing stocks:
Diversification: there should be adequate diversification but not excessive diversification when choosing the shares that will make up the equity part of the portfolio. Graham recommends no less than 10 shares and no more than 30 shares to build the portfolio.
Types of companies: the selected companies should meet certain criteria that are basic to Graham, should be large (today they would be companies with at least $10 billion market capitalization), prominent and conservatively funded (in industrial companies the book value of shares should represent at least 50% of market capitalization including debt, on the other hand in railway or public utility companies, the book value of shares should be at least 30% of total market capitalization).
Dividends: Each company should have a long history of paying dividends. At that time at least 20 years of continuous dividend payment, today Zweig mentions that we might be fine with companies that have paid dividends over the past 10 years.
Price: the investor should impose some limits on the price to be paid for the shares in relation to their average earnings over the last 7 years. Graham recommends that the P/E ratio not be greater than 25 if we take into account the current share price and divide it by the average earnings per share for the past 7 years and not greater than 20 if we take the current price and divide it by the earnings for the past 12 months. Clearly this leaves out stocks considered growth for the conservative investor portfolio.
As we saw in this last point, Graham leaves out of the portfolio of conservative investors the shares of growing companies.
What are the shares of growing companies? These are shares of companies that have increased their earnings per share in the past at a much faster rate than other companies and that are predicted to continue growing in the future (some say that the fair criterion is to double earnings per share within 10 years, ie to grow at 7.1% per year).
The problem with the shares of growth companies, argues Graham, is that because their future cash flows or future profits are so difficult to project, many times the price of these shares goes up too unjustifiably and then falls sharply generating large fluctuations in the price of these assets.
This type of large fluctuations then have no place within the portfolio of a conservative investor.
Other techniques for investing in stocks that Graham mentions in the chapter have to do with the methodology of dollar-cost AVERAGING and the good results it has shown throughout history.
This methodology only recommends that investors invest the same amount of dollars every month regardless of whether the market is high or low. This mitigates the risk of entering a market when it is at a peak and takes advantage of buying shares when the market is in a valley.
Later in the chapter another one of the things Benjamin Graham asks himself is whether conservative investors should have different investment strategies according to their personal situation. In this sense Graham is categorical, it is necessary to invest according to the knowledge and the degree of effort that one is willing to lend and not according to the age, the amount of money, etc.
To close the chapter, Zweig proposes a very simple diversification strategy using ETFs and dollar-cost averaging. Put $500 USD in only 3 ETFs every month, $300 USD in one that traces the entire American stock market such as SPY, $100 USD in an ETF that has a mix of first line foreign stocks and $100 USD in another ETF that has US bonds.
Investing every month a fixed sum in this type of assets is the best investment system that exists to be able to have good investment results having exposure to everything that is convenient to have exposure.
Always recognizing that we know practically nothing about the future, so using this technique we can ensure that we are not going to be entering the market 100% at a bad time or 100% at a good time.
The Intelligent Investor – Chapter 6: PORTFOLIO POLICY FOR THE ENTREPRENEURIAL INVESTOR: A NEGATIVE APPROACH
The title of this chapter mentions “a negative approach” because Graham is going to argue everything that an entrepreneurial investor should NOT do, in other words, which asset classes he should not touch.
As for bonds, Benjamin Graham recommends that the entrepreneurial investor, no matter how active an investor may be, should avoid low-rated bonds or junk bonds as they are known today and invest only in high-denomination corporate bonds or tax-free government bonds that also have excellent credit ratings.
For Graham, the few extra points of return one could get by investing in junk bonds or low-credit denominated bonds aren’t worth taking on that extra risk. In fact, many examples are given where risky bond issues that paid good rates ended up defaulted after a short time and investors lost all their capital.
As for foreign government bonds, Graham mentions several examples of the volatility that these types of debt instruments have had throughout history.
Again arguing that an active or enterprising investor should also abstain from this type of bonds since in case of having to claim against a default they should resort to foreign courts where they will probably always have to lose.
Continuing his review of the assets in which an entrepreneurial investor should invest, Graham mentions the case of initial offers of both bonds and preferred stock or common stock.
In this sense Graham recommends to stay as far away as possible from investing in this type of assets basically for two reasons:
Wall Street has higher commissions for the sale of these assets which drives the placement of these instruments with the full force of its sales apparatus. As long as Wall Street can earn double commission it’s probably at the expense of investors.
Initial offers, usually of common shares, occur at market peaks i.e. when managers think that the markets are at their peak and that they will therefore be able to obtain maximum returns by selling their shares to the public.
In fact, the fact that many initial stock offers are made in a given year is seen as a proxy indicator that market highs are being reached.
As a closing or conclusion to this chapter where Graham mentions all the financial instruments that an active or entrepreneurial investor should not touch, already in the comments Zweig mentions that although the junk bond recommendation is still in force, today it is possible to buy diversified junk bond funds that atomize the risk of these assets and therefore might be more suitable to active or entrepreneurial investors.
To put it simply, Graham generally recommends NOT buying the following asset classes unless it is at a “bargain” or “auction” price:
- Ordinary B-preferred shares
- C- common secondary actions including clear initial public offerings.
If these types of assets are at par value (for bonds and preferred stock) or at fair market value then Graham recommends NOT buying them.
The Intelligent Investor – Chapter 7: PORTFOLIO POLICY FOR THE ENTREPRENEURIAL INVESTOR: THE POSITIVE SIDE
In this chapter, Graham moves on to the positive side of recommendations for the active or entrepreneurial investor. In other words, it illustrates the types of assets that should be invested in by someone who will actively look after your portfolio.
First Graham is going to outline 4 sets of strategies that active investors can use to make the purchase of common stock:
- Buy in low markets and sell in the market when they reach their highs:
- Of course, one could say how easy it is to say it and how difficult it is to do it. Graham mentions however that until before 1971 one could have used an approach with formulas and equations to understand if the market was really high or if it was really low.
- However, says Graham, since the early 1970s the characteristics of the market have been such and the changes that have taken place have been of such magnitude that the recent history of the markets at that time was not sufficient to generate a clear recommendation about when the market was going to be high or when the market was low.
- Buy carefully selected growth shares.
- As mentioned in previous chapters, growth stocks are those that have been growing their earnings and are projected to continue growing in the future (some mention that such growth should be at least 7.1% per year).
In this section Graham also has reservations about recommending the active or entrepreneurial investor to start buying growth stocks basically for the following:
- A- The future growth that one could estimate or find out with some ease is the short-term future growth i.e. for the following year or at most two years ahead. Normally this growth, although predicted with greater certainty, is already discounted in the share price and therefore it would not be possible to obtain greater profits by paying the market price.
- B- Secondly, it is very difficult to predict a company’s profits over a longer period of time because there can be many imponderable factors. Not only that, but it also has to happen that our projections are different from the rest of the market in order to make a profit. In addition, says Graham, companies with accelerated growth cannot maintain them at infinity, let alone if they come from a high level of growth in previous years.
Graham concludes after analyzing the performance of funds that only invest in growing stocks, that the performance of those funds is not very different from the performance of those funds that invest in common stocks.
That said, the car also mentions that the entrepreneurial investor should refrain from buying growth stocks as it is very difficult to beat the specialized funds that have hundreds of analysts dedicated to these issues.
An interesting point Graham mentions before closing this section is that growing stocks, having such uncertain or difficult to predict future earnings forecasts, tend to have very strong fluctuations in their price levels.
In the bull markets these stocks grow too much and too fast as a result of optimism and how easy it is to modify the profit forecasts because they are not so accurate, on the other hand when the market becomes bearish, these same companies are the first to fall as a result of pessimism.
One of the objections Graham makes is that the great fortunes of history were made by people who invested in a very concentrated way in growth actions, examples are several: Bill Gates with Microsoft, Carnegie with US Steel, and so on. However, Graham replies, in these cases those people had a direct influence on the destiny of the company.
Unless the investor can directly control and influence the company’s strategy and operations Graham again recommends avoiding growth stocks.
3) Buying various types of settlement shares or bargains
In this section Graham begins to analyze the cases in which a intelligent investor can buy shares at liquidation prices. In order to obtain better than average results in the long term, an investor should follow a selection policy that meets two conditions:
1) it should comply with objective and rational tests and
2) such a selection policy should be different from the policy followed by most investors on Wall Street.
Now, where is it possible to find companies at liquidation prices or “bargains” as Graham calls them?
A- Large, unpopular companies: these are large market capitalization companies that have been “abandoned” by the market and can therefore be at low prices. These companies have generally had some particular or temporary setback that has made their valuation lower than it should be.
Graham mentions that the investor should only concentrate on large companies and not on the girls who can become more risky because they can go bankrupt more easily and also if their earnings improve there is a risk that the market will continue to have them forgotten and therefore not recognize that improvement in earnings in the share price.
Large companies are better then for two main reasons: 1) they generally have more capital and human resources to carry them out in difficult times and 2) when they improve the market is quicker to realize and reward that improvement.
Graham analyzes a very successful strategy at that time that consisted in buying the high market capitalization shares of the Dow Jones Industrial Average that had the lowest P/E, i.e. the cheapest. With this strategy you could beat the market. It was known as “Dogs of the Dow.”
In relation to this strategy, there is a caveat that has to be done since many times there are companies that can show low P/E ratios and still be highly speculative stocks because they correspond to companies with future profits that are very difficult to predict.
These companies can quote at very high prices and have low P/E in their good years and conversely have very low prices and very high P/E in their worst years.
By pure arithmetic, when a company’s profits are low or nil, the share will necessarily trade at a high P/E. An easy way to avoid this type of special case is to also require that the price be low in relation to past averages of earnings.
The ideal scenario to find bargains using this strategy would be to find a prominent company with a high market capitalization whose price is below its historical average and whose P/E is also below the average figure of recent years.
One type of bargain for which Graham is widely recognized is the famous “nets nets,” that is, finding companies that are trading for less than the value of their current assets minus total liabilities (including long-term debt and preferred stock).
If a company quotes for less than the result of this account basically we would be giving away the business because the cash or short-term investments could be used to pay not only debts but also to buy the company.
Naturally such opportunities no longer exist today.
B- Secondary companies: Graham also mentions in this chapter the case of the shares of secondary companies (i.e. companies that are not leaders in their industries and are generally medium or small). While these companies may remain off the radar of the market for a long time without recognizing any improvement in their situation, Graham admits that the investor may still benefit from this type of investment due:
- First to the fact that the dividend is usually very high compared to the share price.
- Reinvested earnings are generally very high and will eventually affect the share price
- Bull markets are generally more generous with stocks that are low priced so they tend to raise those prices to a reasonable level.
- Even without major developments in the markets, there is a constant mechanism of price adjustments that makes the price of the shares of secondary companies reach at least acceptable levels.
- The conditions that caused the company to have lower than expected profit numbers are generally corrected by the adoption of new policies or changes in management; and
- Finally the company may be bought by a larger company in which case it will surely end up paying a premium over the original share price.
4) Buying shares in special situations
One last set of strategies mentioned by Graham has to do with buying stocks in special situations. However, as he mentions in recent years this type of strategy has become more risky for the ordinary non-professional entrepreneurial investor.
A typical case of a “special situation” is when a large company is about to buy from a smaller company. At the time Graham wrote these lines, conglomerates and diversification of products or regions for large companies were becoming fashionable.
Before entering a new market it was much easier for a large company to buy a girl than to try to develop that same market by investing in the creation of a new entity.
In order to gain the acceptance of the majority of the shareholders and the board of directors this type of transaction generally involved a premium on the share price.
The Intelligent Investor – Chapter 8: THE INVESTOR AND MARKET FLUCTUATIONS
Chapter 8 is perhaps one of the most important chapters of all the investment literature written in recent decades. In this chapter Graham establishes his well-known metaphor about Mr. Market and includes recommendations on the methodology to follow for the purchase of shares and bonds by the Intelligent Investor.
First, the chapter begins with recommendations for building a portfolio of bonds and stocks. If the investor wants to make sure that his portfolio does not have a lot of price volatility, he should opt for bonds of no more than 7 years of maturity.
On the other hand, if you choose to focus more on bonds with maturities of more than two years and on common stocks then you will surely have to be prepared to see the value of your portfolio fluctuate in much larger percentages.
MARKET FLUCTUATIONS AS A GUIDE TO MAKING INVESTMENT DECISIONS
For Graham there are two types of strategies to make decisions about buying or selling stocks: there are those who make market timing and those who make market timing.
These are the two ways to take advantage of market swings. Those who make market timing buy when it is going up and try to sell before it starts to go down on the other hand those who make market pricing (the school of Graham and Buffett) try to understand what is the fundamental value of the company they are buying and comparing with the market price to understand if it is a good time to buy or if on the contrary it is time to sell.
Those who make timing try all the time to anticipate what the movements of the market are going to be in order to be able to make a decision of sale or purchase. This group of investors, says Graham, can’t be qualified any other way than to call them speculators.
While there is a small group of individuals who can make money by practicing market timing and therefore anticipating upward or downward movements, it is ridiculous, says Graham, to think that the general public can make profits under this methodology.
For market speculators, who seem to be struggling to make some profit, the idea of waiting a year for the stock to move up seems disgusting.
In general, Graham says, formulas that set immutable criteria for buying or selling shares don’t work basically for two reasons:
- Markets are dynamic and variables change constantly.
- When such formulas become popular they influence the market itself and become unprofitable.
For time makers or market timing, Graham assures that before 1949 a certain prediction of the market level was possible according to a careful analysis of certain conditions such as for example:
- If the price was at historical highs
- A high P/E ratio
- Low dividend yields compared to bond yields
- A lot of speculation with margin and
- Many new low quality introductory offers
These indicators that a market peak was being reached, says Graham, were no longer valid for the market conditions from 1949 onwards.
The only possible course of action, according to the author, is (in case we believe the stocks are expensive) to make a greater weighting within the portfolio for the stock side against the bonds but never more than 75%. This is now known as tactical asset allocation.
As a conclusion in this section, it is mentioned that automatic formulas for selecting investments or shares that can be followed by a large number of people and that are too simple is very difficult to endure over time.
MARKET FLUCTUATIONS OF THE INVESTOR’S PORTFOLIO
In this section, Graham warns us that if we have a portfolio biased towards shares it is not only possible but also likely that we will see the shares rise by 50% from their lowest point and that we will also see them fall by 33% from their highest point regardless of what shares we have or the prevailing market conditions.
This is so because if we have a share that is worth $100 and goes up 50% to $150 then to return to its previous level would have to go down not 50% but 33%.
Basically we must be willing to tolerate fluctuations in the value of the portfolio in relation to those numbers of volatility.
How to respond to these unavoidable market fluctuations first? Graham recommends that if we do have to do something to keep ourselves busy, what he recommends most is to rebalance the portfolio every certain amount of time to return to the initial proportions.
If stocks became 80% of the portfolio and we want to have only 75%, we should sell 5% and buy bonds.
BUSINESS VALUATION VERSUS STOCK MARKET VALUATION
In this section of the chapter, Graham mentions that the holder of an action has a double status that can be exploited:
- On the one hand, he owns part of the business and has an interest in its operating results and in the payment of its dividends.
- On the other hand, it is the holder of a financial asset tradable on the stock market that can be sold at the quoted price of the day.
The intelligent investor can choose to alternate between these two statuses to take advantage of his position in the company.
In this sense, Graham repeats his point of view as he has mentioned in previous chapters that we should not buy shares of companies that are trading well above the value of net tangible assets*.
You should never pay above ⅓ book value because if this happens, argues Graham, we will be putting our fortune in the hands of the market and we will need the opinion of others to validate our investment and this can be very risky.
*The net value of tangible assets, book value, time value of balance sheets and value of tangible assets are used throughout the book as synonymous with net value, the total value of the physical and financial assets of the company minus the value of all liabilities.
Something important that is mentioned in this section and that according to Graham is a contradiction of the stock market itself is that: the better the history and prospects of a company the less relation will have the price of its share with the book value.
But the greater the difference between the share price and the book value, the more difficult it will be to determine its intrinsic value because it will depend more on the vagaries of the market.
The great parable is then that the more successful the company is, the more the value of its shares will fluctuate on the stock market. The better the quality of a common share the more speculative it is likely to be, at least compared to the rest of the less spectacular common shares.
Always keep in mind that no matter how much a stock is trading in values close to its book value, that doesn’t automatically mean it becomes a good investment. In addition the shares must have an acceptable P/E ratio, a sufficiently strong financial position and prospects that at least their earnings will be maintained over time.
As long as the companies in which the investor has invested continue to make profits, the market can be ignored or better still continue to buy when the shares are below their intrinsic value.
The real investor is seldom really forced to sell his position in the market and most of the time can ignore the market quotes without problems.
The investor who allows himself to be influenced by the market quotations in a decline would be better off if the quotations did not exist in their entirety because he would save himself the suffering and mental anguish caused by other people’s errors of judgment.
Finally Graham comes to his famous metaphor of Mr. Market in which he asks us to imagine that we are part of a business where we have $1,000 worth of stock.
In addition, one of our partners, Mr.Market, comes to us every day and tells us what he thinks our stake in the business is worth and, based on that, offers to buy our stake at that price or sell us even more shares.
Many times the quotation that Mr.Market gives us seems to be reasonable and aligned with the current state of the business and other times Mr. Market lets himself be carried away by fear and the quotations that he offers us are derisory.
If you’re an entrepreneur or a intelligent investor, says Graham, would you let yourself be carried away by Mr. Market cyclothymic mood? Obviously you can sell when you think you’re being too optimistic or buy when you think you’re being too pessimistic.
And that’s probably Benjamin Graham’s great teaching.
Already in the comments Zweig analyzes what are the reasons why mutual fund managers tend not to achieve the best results for the funds they manage:
- With billions of dollars under management they can only choose from the set of shares whose companies have high market capitalization, so many funds end up buying the same large companies that are overvalued.
- Individual investors tend to put more money into investment funds as the market rises, so the managers of those funds increase the positions of the stocks they already have by making everything rise to even riskier levels
- When the market starts to fall, usually investors in the funds start bailing out their investments then the managers of the mutual investment funds are forced to sell just when the shares are cheap and they could buy for a good profit.
- Many mutual fund managers receive bonuses based on their performance compared to benchmarks such as the S&P 500. If a company enters the index then all the funds start buying it, because if that stock is doing very well the manager’s skill would be questioned while if it is doing badly nobody would say anything.
- More and more managers tend to specialize in certain stock types so if a stock grows too much and that fund only specializes in small caps then they have to sell that stock for more than it is an excellent company.
After this brilliant summary of why mutual funds often fail to achieve the best results, Zweig continues to analyze the Graham teachings that investing wisely is always about trying to control what is controllable:
- BROKER’S COSTS: buying patiently and cheaply.
- OWNERSHIP COSTS: avoiding mutual investment funds that have annual fees just for investing our funds with them.
- OUR EXPECTATIONS: trying to be realistic about our returns.
- OUR RISK: deciding what percentage is to be invested in shares.
- TAX ACCOUNT: holding shares for at least 1 year in the U.S. or if possible for at least 5 years to pay only long-term capital gains tax.
- OUR BEHAVIOUR: it is the most important thing to control so as not to fall prey to the investment panic in the falling markets.