Book Summary: The Intelligent Investor by Benjamin Graham

15 Jan 2017

In this summary, you will learn

  • How to understand the fundamental principles of value investing as propounded by its founder Benjamin Graham, the man who literally taught Warren Buffett how to invest.

 

Take-Aways

  • Investors fall into two broad categories: the "defensive" and the "enterprising."

  • Speculation is not investing.

  • To succeed, enterprising investors must treat investing as they would treat any other business they entered.

  • Because most investors do not have the time to treat investing as a business, they should adopt a defensive strategy.

  • No evidence suggests that market forecasting and market timing work.

  • Value investors should pay more attention to the dividends and operating performance of the companies they own than to the movement of their stock prices.

  • As a preliminary to calculating value, estimate the company’s earning ability, multiply appropriately and adjust for the value of assets.

  • Stockholders should observe the fidelity of management, and the confidence it inspires.

  • Stockholders have the rights and responsibilities of ownership, and should exercise them consistently and seriously.

 

Foreword by John Bogle

 

“The genuine investor in common stocks does not need a great equipment of brains and knowledge, but he does need some unusual qualities of character.”

 

Graham conceded that his ideas might not pass the test of time, however, some of his principles remain valid, including:

  • Speculation usually leads to losses.

  • Buy when others are eager to sell and sell when others are eager to buy.

  • Do your homework before you invest - investigate carefully.

 

The Intelligent Investor

 

Investors - as opposed to speculators - come in two broad categories:

  1. Defensive - This investor intends to preserve capital, make as few mistakes as possible, enjoy a good return and hedge against inflation. Defensive investors want safety and freedom, so they are well-advised to put up to 40% of their money in savings bonds and a good portion in common stocks, both as an inflation hedge, and as an opportunity to earn dividend income and profit from the stocks' appreciation.

  2. Enterprising (or aggressive) - This investor wants to buy securities at less than their intrinsic value. Enterprising investors may try to profit by trading on the market averages, picking market-beating stocks, selecting growth stocks, purchasing bargains, and, overall, buying when the market is pessimistic and selling when it is optimistic. Attempts to beat the market average and pick winning stocks are more akin to speculation than investing. The other techniques, however, are genuine investment strategies. Purchasing undervalued securities may be the most certain route to riches, if the investor devotes enough time and effort to becoming an investment expert.

“That attitude is summed up in the phrase: 'If you don't like the management, sell your stocks'.”

 

Investors need a sense of history, so they can put market moves in perspective. Because most investors lack such perspective, the market treats trends like they are permanent.

 

“Investment is most intelligent when it is most businesslike.”

 

Investing is a business and investors should treat it as such. Many business people who are quite prudent in their own work seem to lose this discipline when they encounter Mr. Market.

 

Intelligent investors are not uncommonly smart, shrewd or insightful, but they understand the market as a business. Investing success is more a matter of character than brains. The investor must have the personal strength to resist urges to speculate, make quick money and follow the crowd.


 

Market Movements
 

Speculators aim to make money on market moves. Investors, by contrast, intend to buy good stocks at good prices and hold them.

 

Market movements matter only because they offer prices at which it becomes prudent for the investor to buy or sell. The average investor should not wait for the market to drop before buying stocks. As long as prices are not unreasonably high, you should work to build a portfolio of stocks through prudent purchasing patterns, such as averaging.

 

“Good managements produce a good average market price, and bad managements produce bad market prices.”

 

 

Many investors attempt to identify stocks that will outperform the market in the short term. This is too close to speculation to be worth recommending. The stock price includes information about forecasts of higher or lower prices (both are always present in the market, for any stock) and reflects the net effect of these opinions. The value investor can ignore daily price fluctuations.

 

“The intelligent investor (needs) an ability to resist the blandishments of salesmen offering new common-stock issues during bull markets.”

 
Portfolio Policies: Defensive, Aggressive and Enterprising

 

“A prime test of the competent analyst is his power to distinguish between important and unimportant facts and figures in a given situation.”

 

The enterprising investor may seek to profit by:

  • Market timing - Trying to buy when the market is down and sell when it is up is both attractive and dangerous. Future market fluctuations may not resemble past shifts. The one advantage of market timing formulas is that they may encourage investors to behave as contrarians, selling and buying against the crowd. This is a sound approach - but the rest of market timing has little merit.

  • Growth stocks - Many investors want to pick stocks that will outperform the market in the future. Identifying stocks that have outperformed in the past is relatively easy, but forecasting future performance is difficult. Do not overpay for growth.

  • Buying bargains - Bonds and preferred stocks may be bargains when their prices are below par. Common stocks may be bargains if their intrinsic value is higher than the market price. Some stocks, sometimes, sell for less than the value of their working capital. An industry's secondary stocks may also be bargains. The market tends to exaggerate the risk of stocks that are not industry leaders. However, those who buy bargain-priced stocks can profit from the high dividend returns, earnings reinvestment and price escalation that come in the course of time or as the result of a bull market.

  • "Special situations" - Events such as bankruptcy, reorganization, mergers and the like offer profit opportunities for investors. The market often discounts stocks excessively in the face of such concerns as, for example, potential involvement in lawsuits.

Aggressive investors require a great deal of knowledge to conduct what is, in fact, an investing business. No middle ground exists between passive and active. Because relatively few investors have the expertise or the character attributes necessary to act like aggressive investors, most investors should adopt a defensive strategy.

 

 

Rules for Appraising Stocks

 

“It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings.”

 

The following 11 rules can guide investors and analysts:

  1. As a preliminary to calculating value, estimate the company's earning ability, multiply appropriately and adjust for the value of assets.

  2. Earning power is an estimate of the company's earnings over a five-year horizon.

  3. Estimate a company's average earnings over this five-year horizon by averaging good and bad prior years, then projecting revenues and margins into the future.

  4. Adjust prior years' figures to reflect any capitalization changes in the company.

  5. Use a minimum multiplier of eight and a maximum of 20. The multiplier allows for earnings changes over the long term.

  6. If the value calculated on the basis of earning power is greater than the value of tangible assets, deduct from the earnings value appraisal. "Our suggested factor is as follows: Deduct one-quarter of the amount by which the earning-power value exceeds twice the asset value. (This permits a 100% premium over tangible assets without penalty.)"

  7. If the valuation based on earnings power is less than the value of net current assets, add 50% of the difference to the value calculated on earning power.

  8. In unusual circumstances, such as those related to war, rentals or short-lived royalties, adjust the appraised value accordingly.

  9. Allocate value among stockholders and bondholders or preferred stockholders. Before taking this step, calculate the enterprise value as if its capital structure consisted only of common stock.

  10. The more aggressive the capital structure is (that is, the more debt and preferred stock in proportion to common stock), the less the appraised value can be relied upon when making a decision.

  11. When a stock's appraisal is a third higher or lower than its current market value, that can be the basis for a decision to buy or sell. When the differential is less, the appraisal is merely another fact to consider in the analysis.

 
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