The Intelligent Investor
The intelligent Investor, many people dream of getting rich through the stock market, but not many actually achieve success in this challenging endeavor. Benjamin Graham, who is considered the father of value investing and mentored Warren Buffett, provides a practical guide for long-term success using the value investment philosophy that he played a key role in establishing.
The Intelligent Investor By Benjamin Graham, revised edition of 1973.
Chronicle and summary of “The Intelligent Investor”:
Chapter 1: Investment versus Speculation
In The Intelligent Investor, Graham talks about two main ways people act in the stock market: investing and speculating. He says investing is when you carefully study and expect your money to be safe and make a good profit. Speculation is when you don’t meet these conditions. In Wall Street language, everyone who puts money in the markets is often called an “investor,” but Graham makes it clear that there’s a big difference. He doesn’t say speculation is bad, but he strongly recommends not doing both investing and speculating with the same money.
Chapter 2: The Investor and Inflation
After a time of strong inflation starting in 1965, many finance experts thought that bonds were not as good an investment as stocks. Graham in The Intelligent Investor disagrees with this idea. He says it’s silly to claim that stocks, even high-quality ones, are always better than bonds, no matter what the market is like. It’s just as silly to say the opposite. While stocks have sometimes done better than bonds in the past, there’s no guarantee that the stock market isn’t too expensive and won’t give a weaker return than the bond market. Anything is possible!
Graham also shows that the belief that moderate inflation is good for company profits is wrong when you look at historical numbers. He talks about the common practice of buying gold to fight inflation. He says it was good that the US banned this from 1935 to 1972 because, during that time, gold only went up by 35%. Also, the person who owned the gold didn’t get any profit on their money during that whole period. Putting the money in a savings account would have been a better idea.
Chapter 3: A Century of Stock-Market History
In this chapter of The Intelligent Investor, Graham looks at how the Dow Jones (DJIA) and the S&P 500 behaved from 1900 to 1970. He sees three main phases:
From 1900 to 1924, there were ups and downs that lasted 3 to 5 years each. The average yearly return was about 3%.
Then came a market high and the Great Depression of 1929. Until 1949, the market went up and down irregularly, with an average performance of 1.5% per year.
In 1949, not many people were excited about buying shares. But from then until 1969, the market went up! There were two short recessions in 1956-57 and 1961-62, but they bounced back quickly. The average performance of the DJIA from 1949 to 1969 was 11% per year, not counting dividends, which were around 3.5% per year. In 1969, everyone thought this would keep going, but then the DJIA fell by 37%! The S&P 500’s performance from ’49 to ’71 was 9% per year.
Additionally, corporate profits mostly kept rising, except for two down decades (1891-1900 and 1931-1940), supporting the idea of having some long-term share investments.
Looking at the price/profit ratio per share of the indexes, it was just 6.3 for the S&P 500 in June 1949, while the dividend was 7%. But in March 1961, the ratio was 22.9 for a dividend of 3%. This means you could buy shares for much less in 1949 than in 1969. Meanwhile, bond rates went up from 2.6% in 1949 to 4.5% in 1961.
This shows a big change in attitude towards shares between the two periods. People were willing to pay much more for S&P 500 profits in 1961 than in 1949. This extreme change should make an investor cautious because it might mean the stock market is overvalued.
At the end of the chapter of The Intelligent Investor, Graham gives his opinion on the market in 1972, predicting a stock market drop (which turned out to be right with the recession of 1973-1974).
Chapter 4: General Portfolio Policy: The Defensive Investor
Graham doesn’t aim to set a specific target for portfolio returns. He thinks the earnings will depend on how smartly the investor works on building their portfolio. So, if you want a safe and calm approach, you might get modest earnings. But if you’re more adventurous and use your smarts and skills, you could earn more.
Graham also gives advice in The Intelligent Investor on how to divide your money between bonds and shares. For a defensive investor, he suggests a basic split of 50% bonds and 50% high-quality shares. However, when the stock market seems high, like it did in the 1970s with high price/earnings and low dividends, you might want to shift to 75% bonds and 25% shares. This is easier said than done because, during high market times, there’s often a feeling of excitement. Similarly, after a market fall, if shares are paying more than bonds, you can increase your share portion.
The balance between shares and bonds depends on the investor’s personality, and the suggested strategy is just a general guideline.
Chapter 5: The Defensive Investor and Common Stocks
Stocks are a good addition to a portfolio because, over long periods, they often perform better than bonds, offering better protection against inflation. Another advantage is that when you own stocks, some of the profits are reinvested in the company, growing over time. In contrast, bonds provide a fixed rate regardless of what happens to a company’s profits.
For a defensive investor (someone who prefers a safer approach), choosing stocks is straightforward. Graham suggests four rules:
- Have a diverse portfolio with 10 to 30 stocks.
- Include well-established, financially stable, and recognized companies, avoiding those with too much debt.
- Pick companies with a history of paying dividends, preferably over a 20-year period.
- Don’t pay more than 25 times the average profits of the company over the past 7 years, and not more than 20 times the profits from the last year (a maximum PE ratio of 20). This helps avoid shares of high-risk growth companies.
In The Intelligent Investor, Graham also recommends a strategy called monthly investment averaging from the bottom: buy more shares when the price is low and fewer when it’s high. This approach works well even with small amounts over time.
He emphasizes that the chosen stocks for a defensive investor aren’t risky in the sense of losing all invested capital. Risk, in this context, refers to the chance of permanently losing all the invested money, not the regular ups and downs of the stock market.
Chapter 6: Portfolio Policy for the Enterprising Investor – Negative Approach
For the more daring investor, they should start with the same basic principles as a cautious investor, deciding how to divide their money between high-quality bonds and solid company shares at reasonable prices. The key difference is that this investor is open to exploring other investment options, but any deviation from their main strategy should be backed by good logical reasoning. The possibilities for this type of investor are vast and depend on their skills and temperament.
However, there are some things they should generally avoid. They’d steer clear of lower-quality bonds and convertible securities unless they can get them at a maximum of 70% of their face value for higher coupons or a much lower price for lower coupons. They wouldn’t buy foreign bonds, no matter how tempting the interest rates might be. Newly issued instruments (like initial public offerings, convertible securities, new bonds, etc.) and shares whose dividends have only recently performed exceptionally well are also on the “avoid” list.
When it comes to bond investments, the daring investor should act similarly to their more cautious counterpart. The risk of a quality bond defaulting is not worth taking because a decrease in its face value could be disastrous, possibly resulting in the investor losing their money. Graham warns against approaches suggesting buying a collection of low-quality bonds (known as “junk bonds”) under the assumption that the overall set will offer a better yield than high-quality bonds. They forget to mention that an investor can’t buy all the “junk bonds” on the market. Graham doesn’t even bother checking if this conclusion is accurate or not.
Investors should also avoid initial public offerings because many worthless companies tend to be introduced to the market at very high prices, especially during bullish markets and periods of high excitement.
Chapter 7: Portfolio Policy for the Enterprising Investor – The Positive Side
In The Intelligent Investor, when it comes to bonds, Graham suggests that the daring investor should consider certain US State bonds with coupons ranging from 5% to 7.25%, depending on the types.
For stocks, the adventurous investor aims to:
- Buy Low, Sell High: Purchase when the market is down and sell when it’s up.
- Select Growth Stocks: Carefully choose stocks that show potential for growth.
- Acquire Inexpensive Instruments: Look for stocks or other instruments that are reasonably priced.
- Invest in Special Situations: Explore unique investment opportunities.
However, there are challenges. Determining whether the market is high or low isn’t straightforward. Selecting growth stocks can be tricky because they often come with high price tags, introducing an element of speculation.
To achieve above-average results, the daring investor needs a unique and logical approach that differs from the majority. Following the crowd usually leads to similar outcomes.
Graham recommends three approaches based on his experience and shares it in The Intelligent Investor:
- Invest in Unpopular Big Companies: Popular or fast-growing companies are often overvalued, while unpopular ones facing temporary obstacles are undervalued. This approach is generally more reliable with larger companies.
- Purchase Discounted Instruments: Buy instruments whose value is over 50% higher than their price, especially when their profits are temporarily disappointing. Ensure the disappointment is temporary to avoid unfortunate outcomes.
- Engage in Special Operations: This involves complex investments, including arbitrage, which Graham briefly mentions. It requires specialized knowledge and is not for everyone.
The author doesn’t delve into special operations in “The Intelligent Investor,” but shares personal experience. Despite the fierce competition in the field, the described approach has yielded a return on investment (ROI) of over 40% annually for nearly nine years at a personal level. Whether this intelligent investment method will continue to be successful remains to be seen.
Chapter 8: The Investor and Market Fluctuations
When an investor puts money into good quality bonds that mature in a relatively short time, let’s say less than 7 years, they won’t be greatly affected by changes in the market. Bonds that take longer to mature are more likely to go up and down, and it’s a fact that stock prices will change over time. The investor needs to be fully aware of this and be ready both mentally and financially.
Because all stocks, even the good ones, will go through significant price changes, the investor should make the most of it. There are two well-known methods: “timing” and “pricing.”
“Timing” involves buying when you think prices will go up and selling (or not buying) when you expect a drop.
“Pricing” involves buying shares in a company for less than what they’re truly worth and selling them when they’re worth more.
While “timing” often turns an investor into a speculator (someone who takes more risks), Graham suggests focusing on “pricing.” Some speculators might get good results, but that’s not the case for the average person. With “pricing,” the average investor has a better chance of getting very good results simply by buying shares at a low price and selling them at a high price, without worrying too much about market movements.
For a long time, there was a theory that said to buy when markets are down and sell when they’re up, considering the market’s valuation (using the Price/Earnings ratio). Graham explains that although this idea isn’t bad, no one can really predict how the market will behave in the future. The bull market between 1949 and 1969 challenged this theory because there was no significant market correction during that time. Not buying any shares throughout that period wouldn’t have been beneficial for any investor.
The lesson here is that it’s better not to buy just any share. Regardless of market conditions, you should be picky and selective in your choices.
A serious investor should not let short-term changes in the market, like those happening over a few months, dictate whether they feel richer or poorer. However, many of us find ourselves caught up in emotions when a stock’s price goes up: “I’m richer now! Great!” or “The price is too high, time to sell!” or “I regret not buying more when it was cheaper!” or even “I need to buy more because everything is going up in this bullish market!”
To counter these emotional reactions, Graham suggests adopting a mechanical approach to investing in stocks traded below or at a price similar to the company’s tangible assets’ value. Other factors, like a reasonable Price/Earnings ratio (PE), can also be considered.
In The Intelligent Investor, Graham illustrates this with the example of A&P, a company introduced to the stock market in 1929. Its share price reached $494, dropped to $104 in 1933, and further to $36 in 1938 during a bearish market. Despite being the largest chain of stores in the USA, Wall Street considered A&P worth more dead than alive due to fears of upcoming taxes and temporary obstacles.
Suppose an investor bought A&P in 1937 for $80, at 12 times its average profits per share over 5 years. The drop to $36 would naturally concern them. However, Graham advises a meticulous check to ensure no calculation errors. If satisfied, the investor can then ignore market fluctuations. In fact, if they have funds and conviction, they might even strengthen their position at a low cost.
In 1939, A&P’s share price rose to $117.50, a common occurrence. But by 1961, it reached $705, 30 times the profits in that year, reflecting high growth expectations. The lesson here is that the market often makes mistakes, and an intelligent investor can benefit from these errors.
Crucially, an investor is not obligated to sell shares to cover losses. Learning not to take market fluctuations too seriously is key to success.
Chapter 9: Investing in Investment Funds
Graham examines how investment funds perform and observes that most of them don’t perform as well as the overall stock market. It’s not the fault of the fund managers; it’s because they have so many funds to handle that their portfolios end up looking a lot like a broader index, such as the S&P 500.
Graham also looks at open funds and closed funds during his time and decides that it’s generally more advantageous to buy closed funds when their price is 10 to 15% lower than their net assets. As for the other funds he talks about from his era, he doesn’t think they are particularly worthwhile.
Chapter 10: The Investor and His Advisers
Contrary to common beliefs, an advisor cannot guarantee their client a better investment return than the general market by using their services. The role of an advisor is to rely on their experience to guide investors and prevent them from making serious mistakes, whether the advisor is a friend, an amateur, or a professional.
Prominent investment consulting firms do a commendable job without making extravagant promises regarding returns. Brokers, however, may have conflicts of interest when providing recommendations because they might be inclined to encourage clients to engage in speculative activities. Therefore, it’s crucial to ensure that the analyst at the brokerage firm you’re dealing with is inclined toward value investment before following their advice. Exercise caution with advice from investment banks as well, as they have a vested interest in selling their services. Investors should use their own judgment alongside the recommendations given.
Regardless of the advisor chosen, investors must be confident in their integrity and professional competence before entering into a working relationship. Quality advice comes at a cost, and it’s unrealistic to expect much from free advice.
Chapter 11: Security Analysis for the Lay Investor
An analyst looks at the past, present, and future of a company before giving recommendations on its stocks or bonds. They examine the business, financial performance, strengths and weaknesses, possibilities, and risks. Their goal is to determine whether it’s a good time to invest.
In the past, analysts didn’t use the same standards for stocks as they did for bonds. Oddly, mathematical analyses applied to stocks focus heavily on the future, even though it’s the most uncertain aspect. The analyst questions the usefulness of rigorous mathematical reasoning based on uncertain assumptions.
How to analyze a company bond
Analyzing a company bond is straightforward: check if the annual interest cost is well-covered by the company’s average profits over a certain period, like 7 years. Alternatively, you can consider the lowest profits during that period to add a touch of pessimism and enhance investment security. Different industries may have specific profit-to-interest ratio criteria, for example, 2.1 times for an energy supplier, 2.65 for railways, and so on. You can also consider the company’s size and asset value.
While the future is uncertain, following these standards, based on extensive experience, helps navigate uncertainties and safeguard investments.
What to do when it comes to shares
When it comes to stocks, Graham, using the example of Value Line in The Intelligent Investor, suggests that analysts who predict the future are often wrong. For lay investors, he recommends focusing on the past and only considering long-term future perspectives broadly. Factors such as management, financial health, longevity, and current dividend rates are essential.
For growth companies, Graham provides a conservative formula to estimate their value:
Value=Normalized current profits×(8.5+2×annual expected rate of growth)
Being extremely conservative in estimating the annual expected growth rate over 7 to 10 years is crucial. This formula can also help determine the expected market growth of a company by replacing the Value with the Market Price. This aids in assessing whether expectations are too high. For instance, in 1963, the market predicted annual profit growth of 32.4% for Xerox but only 2% for General Motors. Despite this, Xerox met expectations until 1969.
Chapter 12: Things to Consider About Per-Share Earnings
The earnings per share that companies announce may not give a true picture of their actual profitability. Sometimes, companies announce profits that don’t include certain expenses known as “special.” For instance, ALCOA reported earnings of $5.20 per share in 1970, a slight decrease from $5.58 per share in 1969. However, if you look closely, you’ll find that after factoring in special expenses, the earnings were actually $4.19 per share for the year and $0.70 per share for the final quarter.
To understand the real earnings, you need to consider the fully diluted earnings, which are related to the number of shares that would be in circulation if all options and warrants were exercised. Additionally, examining these special expenditures is crucial. In ALCOA’s case, these costs were associated with future site closures, credit branches, and the expenses needed to complete a contract.
The question arises: Are these costs truly exceptional, or are they regular expenses for a large company like ALCOA? Graham suggests that it’s normal for a company of such size to undergo regular reorganization and fulfill its contracts. Perhaps these costs are more like actual cash outlays that could happen again. Shouldn’t the reported results include both profitable and non-profitable operations?
To address this, Graham recommends that a lay investor focus on the average earnings over a relatively long period rather than getting swayed by short-term variations. Similarly, when considering growth, he suggests relying on long periods in the past, say 10-12 years, rather than recent spikes in growth. This approach helps in gaining a more stable and realistic perspective on a company’s performance.
Chapter 13: A Comparison of 4 Listed Companies
Graham compares four listed companies: Eltra, Emhart, Emerson, and Emery. Eltra and Emhart have PEs (Price to Earnings ratios) of 10 and 11.9, PBs (Price to Book values) of 1 and 1.22, and dividend yields of 4.45% and 3.65%, respectively. On the other hand, Emerson and Emery have PEs of 30 and 38.5, PBs of 6.37 and 14.3, and dividend yields of 1.78% and 1.76%.
Despite being in good financial health with low debt and experiencing long-term profit growth, analysts favored Emerson and Emery over Eltra and Emhart. Emery showed rapid growth, while Emerson had slower growth.
Graham refrains from making predictions about stock performance but suggests that Eltra and Emhart possess the qualities that would make them suitable for a defensive investor’s portfolio. These qualities include adequate size, good financial health, consistent dividend payments for the past 20 years, no losses in the last decade, profits growing by more than 33% over the past ten years, a share price lower than 1.5 times the net asset value after debt, and a price lower than 15 times the average profit over the past three years.
Chapter 14: Stock Selection for the Defensive Investor
The defensive investor, faced with two options, can either invest in an entire stock index like the DJIA or select individual stocks that meet specific criteria outlined in the previous chapter. These criteria emphasize stable profits and moderate prices in relation to earnings and net debt-free assets.
When Graham applied these criteria to all DJIA stocks, only 5 stocks met the standards. It’s important to note that applying these filters significantly narrows down the available stocks for investment. Graham suggests a quantitative approach, aiming to eliminate emotional influences often associated with qualitative considerations.
The defensive investor is advised against trying to pick the single best stock among the cheapest options, as there’s no guarantee of outperforming others in this regard. Graham advocates for a diversified approach. While an investor skilled in selecting the best stocks might not need diversification, this isn’t typically the case for the defensive investor. Despite the seemingly restrictive criteria, the defensive investor should have a sufficient number of stocks to choose from, allowing for diversification based on personal preferences without feeling limited.
Chapter 15: Stock Selection for the Enterprising Investor
For the enterprising investor aiming for superior performance, choosing stocks is not a straightforward task. Despite professional funds struggling to outperform the S&P 500, there is hope, as demonstrated by the success of the Graham-Newman funds over their existence from 1926 to 1956.
The Graham-Newman funds engaged in operations such as arbitrage, involving buying one instrument and selling others due to events like restructuring or mergers, and liquidation, which meant buying shares in companies undergoing liquidation. These operations needed to meet specific criteria:
- A calculable return on investment of 20% per year or higher.
- Probability of success estimated at more than 80%.
Correlated hedging involved buying convertible instruments while simultaneously short-selling the corresponding stock. Buying net-net shares meant investing in companies trading below the value of current assets released from all debt. Graham and Newman, with a portfolio of over 100 such companies, found success in this approach.
While Graham is cautious about recommending these strategies to lay investors due to their complexity, he suggests the enterprising investor consider stocks with the following criteria:
- Acceptable financial health, with current assets at least 50% higher than current liabilities and total debt not exceeding 110% of current assets (for industrial companies).
- Stable profits without negative results in the past 5 years.
- Payment of dividends.
- Satisfactory growth in profits, with the latest profits higher than those of 5 or 6 years ago.
- Price lower than 120% of the net value of tangible assets.
While there isn’t a single criterion for choosing stocks, Graham’s experience indicates that investing in large companies with low PE or a diverse group of net-nets can lead to satisfactory results over extended periods.
Chapter 16: Convertible Issues and Warrants
Convertible securities are often thought to benefit both investors and issuing companies. Investors get added protection through a bond and contribute to a rise in the share price. For the issuing company, convertibles offer a lower interest rate on borrowing and an opportunity to refinance debt at a lower cost by exchanging it for shares.
However, the reality may not be as ideal. Investors may have to sacrifice yield, quality, or both, and the company dilutes existing shareholders, potentially leading to dissatisfaction. The conclusion is that convertible issues, like any other instruments, aren’t inherently attractive or dismissible. Graham’s experience reveals that convertibles during bullish markets may not be very appealing and should be analyzed individually. Exchanging a share for a convertible might make sense if the share pays lower dividends and the conversion cost is minimal compared to the dividend difference.
In The Intelligent Investor, Graham then addresses warrants, expressing concern about their widespread use, which he considers a threat. Originally attached to bonds for share conversion at a set price, warrants were few and posed no danger. However, their proliferation can massively dilute shareholders, impacting the value of shares. Graham emphasizes that the sole issue with warrants is their abundance. Despite this, warrants can be studied like any other market instrument, estimating their intrinsic value and potentially profiting from them.
Chapter 17: Four Extremely Instructive Case Studies
Graham shares four cautionary tales from Wall Street:
- Penn Central:
- In 1970, the bankruptcy of the largest U.S. rail company shocked the financial community.
- Reasons not to invest included low interest coverage, tax-free profits, better alternatives in the same sector, and questionable merger-related profits.
- Analysts should have questioned tax-related issues and company figures.
- Ling-Temco-Vought Inc. (LTV):
- A company’s rapid expansion through acquisitions resulted in astronomical debt.
- Despite having no tangible assets, banks continued lending.
- Massive losses led to significant drops in share prices.
- NVF and Sharon Steel:
- NVF acquired Sharon Steel, seven times its size, with substantial debt.
- Post-acquisition, financial irregularities surfaced, harming shareholders’ interests.
- AAA Enterprises:
- A mobile home business with seemingly innovative strategies.
- Went public, but after rapid expansion and acquisitions, the company faced significant losses.
- Despite mounting losses, shares remained overvalued, and bankruptcy eventually ensued.
These stories highlight the importance of scrutinizing financial health, management decisions, and underlying realities before investing in a company.
Chapter 18: A Comparison of 8 Pairs of Companies
Let’s take a look at two pairs of companies analyzed by Graham, along with a contemporary comparison between Amazon and Facebook:
Pair 1: Real Estate Investment Trust (REI) vs. Realty Equities Corp (REC)
- REI: A conservative New England trust with over a century of prudent management.
- REC: A rapidly expanding company with assets growing from 6.2 million to 154 million, accompanied by proportional debt increase.
- Both were healthy in 1960, but REC suffered due to poor management in 1970.
Pair 2: Air Products and Chemicals (APC) vs. Air Reduction (AR)
- APC: A newer company with half the turnover of AR in 1969.
- AR: Lower PE (Price to Earnings) and PB (Price to Book) ratios, reasonable debt-to-equity ratio, higher dividend yield (4.9%), but lower profit growth compared to APC.
- While APC seemed more promising to many analysts, Graham favored AR for its relatively lower share price, reducing speculative risks.
In Graham’s view, the choice between seemingly attractive investments depends on an unpredictable future. While APC might be favored for its apparent quality, Graham’s preference for AR lies in its lower share price, reducing speculative elements. In investing, past performance doesn’t guarantee future results, emphasizing the importance of a diversified portfolio.
Pair 3: American Home Products Co. (AHP) vs. American Hospital Supply Co. (AHS)
Both companies, operating in the health industry, represented profitable sectors with robust growth in 1969.
AHS had superior growth (405% in 10 years) compared to AHP (161%), but AHP boasted better margins and return on shareholder equity.
AHP was valued at 31 times its profits, paying 1.9% in dividends, while AHS traded at 58.5 times profits with a lower dividend yield of 0.55%.
Both were deemed too expensive according to Graham’s principles, holding too many promises and expectations rather than genuine performance.
In 1970, AHS faced a slight profit dip, resulting in a 30% drop in share price. AHP experienced an 8% profit increase, leading to a modest rise in share price.
Pair 4: H & R Block, Inc. (HRB) vs. Blue Bell, Inc. (BB)
BB, a leader in work uniform production, faced fluctuating profits in a competitive industry but displayed satisfactory growth (68% from 1965 to 1969).
HRB exhibited incredible growth, with profits soaring from $83,000 in 1961 to $6.3 million in 1969. However, it traded at 108 times its profits and 30 times tangible assets.
Despite HRB’s impressive profitability and growth, an experienced analyst might question the high valuation and competitive nature of tax handling services.
BB, trading at less than a third of HRB’s total price, with four times higher turnover and reasonable profits, was considered a more reasonable investment.
Market panic in March 1970 led to a 33% drop in HRB’s price and a 25% drop in BB’s price. During the recovery until February 1971, BB’s share price doubled, while HRB increased by 35%.
Pair 5: International Flavors & Fragrances (IFF) vs. International Harvester (IH)
Despite being less known, IFF had a higher market capitalization (747 million) than IH (710 million).
IH, a well-known Dow Jones company, had significantly larger turnover (27 times) than IFF.
IFF’s success was driven by organic growth, marked by profitability and market favoritism, trading at 55 times its profits.
IH, despite its size, raised concerns about its profitability, with profits representing only 5.5% of shareholder equity.
Graham advises against including shares of either company for different reasons: IFF is overvalued, and IH lacks profitability even at a lower price.
In 1970, IH shares dropped by 10%, likely due to its already low price, while IFF shares fell by 30%.
Pair 6: Mc Graw Edison (MGE) vs. Mc Graw Hill (MGH)
In 1968, MGH had twice the market capitalization of MGE, even though MGE had 50% higher turnover.
MGE had a reasonable PE (15.5) compared to MGH (35), and its growth (+104% over 5 years) was superior to MGH’s growth (+71% over 5 years).
MGH’s profits declined, possibly influenced by the popularity of publishers on Wall Street in 1968.
MGE seemed reasonably priced in relation to its performance in the high 1968 market, making it suitable for an intelligent investor’s portfolio.
Both companies suffered in mid-1970, with MGE’s shares dropping almost 50%, but it rebounded in 1971. MGH’s shares, despite a 60% recovery, remained below the 1968 price.
Pair 7: National General (NG) vs. National Presto Industries (NPI)
In 1968, NG was a conglomerate with diverse businesses like theatres, cinema, TV production, and more. NPI, focused on household appliances, had a simpler financial structure.
NG, at 69 times its profits, was much more expensive than NPI, which sold at 6.9 times its profits. NPI had a high return on shareholder equity (21.4%) and significant growth (450% over 5 years and 600% over 10 years).
NG’s advice was to avoid it, while NPI, with a low price, was a perfect recommendation for intelligent investors.
In 1970, NG faced losses, and its share price dropped to 15% of its 1968 price. NPI grew but experienced a market correction, leading to a nearly 50% drop in its share price. Despite recovering to its 1968 level, the ratios remained low.
Pair 8: Whiting (W) vs. Willcox & Gibbs (WG)
In 1969, WG, a sewing machine manufacturer turned mediocre, had a high PE (around 120), while W, dealing in materials treatment, had a moderate PE of 9.3.
W, with lower turnover and profits, had a stock market capitalization four times higher than WG. WG’s profits had fallen considerably.
In January 1971, W’s profits fell over 50%, but its share price, dropping by 40%, made it acceptable for the enterprising investor’s portfolio.
WG declared small losses, and its share price was cut by 4 in January 1971. By February 1971, WG recovered two-thirds of its 1969 price, while W increased by over 50%.
Graham emphasizes analyzing situations where the price is confidently lower than the value, whether it’s over- or under-evaluated.
Chapter 19: Stockholders and Managements: Dividend Policy
In this part of The Intelligent Investor, Graham criticizes the passive behavior of shareholders who are not actively involved in managing the companies they own. He highlights that shareholders are the actual owners of the company and its management is accountable to them. Graham encourages shareholders to carefully read company materials and communicate with fellow shareholders if something seems questionable.
Regarding dividends, Graham acknowledges the importance of reinvesting profits for business growth. However, he warns that management often misuses these funds. Therefore, he suggests shareholders demand a significant portion of profits as dividends (like 66%) or evidence that reinvested money truly contributes to substantial profit increases.
Graham also clarifies the distinction between stock dividends and stock splits. He explains that a stock split merely reduces share prices and doesn’t distribute anything. In contrast, a true stock dividend represents the distribution of real profits accumulated, moving from “excess profits” to the “capital” account. Additionally, Graham notes the tax advantages for shareholders with stock dividends.
Chapter 20: “Margin of Safety” as the Central Concept of Investment
If Graham had to sum up the key to smart investing in just three words, he’d say “margin of safety.” This concept is crucial for bond investors who seek protection by ensuring that a company can generate enough profits to cover future interest payments, guarding against potential declines in earnings. These investors, often skeptical, don’t wait for a company to return to past profitability; they look for a substantial margin of safety.
Now, can we apply this idea to stocks? Certainly, with some adjustments. In certain cases, a stock can be treated like a bond, especially when the company’s capital consists solely of shares and the collective share price is less than the potential bonds issued against the company’s assets and profits. Consider National Presto Industries (NPI) in 1972, which sold for $43 million. With $16 million in pre-tax profits, the company could easily support issuing $43 million in bonds, providing investors both the safety of a bond and the potential for better returns – the best of both worlds!
In more typical market conditions where such situations are rare, the margin of safety lies in the earnings yield (1/PE) being higher than the bond yield. For example, if a stock has an earnings yield of 9% while a bond pays a 4% coupon, the margin of safety is 5%. Some of this excess could potentially be returned to investors in the form of dividends.
Graham points out that in 1972, the average profit-making capacity of stocks was not as high as 9%. Suppose a defensive investor builds a portfolio with an average profit-making capacity of 8.33% (PE of 12), and 4% comes back as dividends. In this case, only 4.33% is reinvested in the companies’ business. Considering that state bonds offer 5 to 7.5% with no risk, the excess profit-making capacity seems too low for a sufficient margin of safety. This is why Graham saw real risks for a diverse stock portfolio in 1972.
While the risk of buying expensive high-quality stocks is real, Graham argues that the main reason for investor failure is buying low-quality stocks in favorable business conditions. Current high profits may not represent a company’s true profit-making capacity. Testing the interest cover and dividends over several years is crucial.
Investing in growth stocks can also have a margin of safety, but projections must be extremely conservative. Wall Street often projects unsustainable long-term growth for growing companies. When growth slows down, investors who paid too much may face losses.
The margin of safety is clear for net-nets, which trade below the value of their current assets. Diversification is closely tied to the margin of safety, acting as insurance against potential losses. Graham emphasizes that conservative investors diversify, seeing it as the beginning of accepting the margin of safety.
The margin of safety is the main difference between investors and speculators. Graham recommends conventional investments in US bonds and high-quality stocks for defensive investors. Enterprising investors can explore different possibilities but should always buy at a very low price.
Graham concludes that the most intelligent investment approach mimics a businessman’s attitude closely. Remember that instruments represent a reality, and shares are titles of ownership. Therefore, act responsibly as an owner.
For someone investing:
- Know your stuff and be an expert in your field.
- Don’t let others invest for you unless you can oversee their performance and trust their integrity and competence.
- Base decisions on calculations, not just optimism.
- Have the courage to act on your knowledge and experience.
For a conservative investor, not all these qualities are necessary. They need to align their ambitions with their capabilities and follow a defensive investment plan. Getting decent results is simpler than many think, but achieving superior results is more challenging than it appears.
The Intelligent Investor
The Intelligent Investor by Graham covers three key aspects:
- How to minimize the risk of losing money in the long run.
- How to increase the likelihood of making profits in the stock market over several years.
- How to better control emotions, a crucial factor for achieving maximum investment potential.
The book holds significance for various reasons, influencing perspectives on finance and investments by alleviating concerns about personal finances. Regarded as one of the finest investment books, The Intelligent Investor offers a comprehensive exploration of the subject. The principles outlined in the book have been diligently applied, with exceptions made for diversification, which is implemented in the presence of sufficient undervalued investments or a lack of profound understanding of a company’s business despite an appealing valuation.
From a broader perspective, Graham’s principles continue to demonstrate effectiveness in today’s investment landscape. While certain examples and metrics may be outdated due to changes in business sectors, the behavioral advice remains pertinent, possibly more so. Graham’s insights withstand the test of time, as historical events, like the Penn Central affair, find parallels in contemporary situations, exemplifying the enduring relevance of the book’s teachings. The saying, “The more things change, the more they stay the same,” captures the timeless nature of The Intelligent Investor.
A point of contention arises regarding the conclusion about National Presto Industries. The belief is that when encountering a high-quality company trading below its asset value, concentrating a substantial portion of capital in that company, akin to Warren Buffett’s approach, is a prudent strategy. The book’s straightforward and timeless ideas stress the significance of avoiding overpayment for investments and ensuring a considerable margin of safety against potential disappointments.
In the current era of constant information flow, The Intelligent Investor directs attention back to fundamental realities: stocks represent ownership in a company, and bonds constitute loans to a company. It underscores the essence of these financial instruments and emphasizes the need to detach from market fluctuations. Despite the challenging nature of reading the book, the investment of time aligns with the principles of value investment – no pain, no gain.
The Intelligent Investor conclusion
The strengths of “The Intelligent Investor” lie in Graham’s profound expertise, showcasing his exceptional career in investment. The book effectively distinguishes between investment and speculation, establishing the philosophy of value investment used by top global investors. It delves into crucial stock market concepts, notably in chapters 8 and 20 on market fluctuations and the margin of safety.
Concrete examples enhance the book’s clarity and relevance. Adhering to Graham’s advice guides readers toward wise stock market investment, safeguarding against losses and facilitating wealth accumulation. Moreover, it serves as a stepping stone to other books exploring practical value investment strategies, such as Joel Greenblatt’s “You Can Be a Stock Market Genius” or Seth Klarman’s “Margin of Safety.”
However, the book has weaknesses. Its weighty and occasionally pompous writing style might render it tedious. For those lacking passion or strong determination to learn, it may not instill a passion for stock market investment. Graham doesn’t teach readers to understand and analyze financial statements but rather how to draw conclusions from a correct analysis, a point he addresses by suggesting another book, “The Interpretation of Financial Statements.”
The absence of the concept of Free Cash Flow is a notable drawback, considering its importance in investment. Graham emphasizes the difference between announced profits and actual profits but doesn’t sufficiently stress the importance of choosing a company with the best return on shareholder equity at equal prices, except in the case of International Harvester. This lack of emphasis on quality, despite Graham’s evident understanding, contrasts with Warren Buffett’s success strategy.
In Chapter 18, the conclusion about National Presto raises questions about the necessity of over-diversification. Before diving into “The Intelligent Investor,” readers should familiarize themselves with terms like stocks, shares, bonds, convertible securities, and warrants, which can be easily found online.
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