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The Intelligent Investor
(1949) Benjamin Graham When Benjamin Graham first started working on Wall Street in 1914, most investing took the form of railroad bonds. Stocks in companies as we know them today were aimed at insiders rather than the general public, and were seen as highly risky investments compared to bonds. This impression was only boosted by the Great Crash of 1929 and the ensuing Depression. However, Graham’s focus on the value of companies, as opposed to the speculation on stocks (he has been variously called the ‘Dean of Wall Street’ and the ‘Father of Value Investing’) showed it was possible for regular people to invest wisely without getting swept up in market hysteria. In the last 20 years, Graham’s profile has been boosted by billionaire investor Warren Buffett, who was tutored by Graham at Columbia University and then worked at his Graham-Newman brokerage business. Buffett has described The Intelligent Investor as “By far the best book on investing ever written.” Writing against a background of various post-war political upheavals, Graham considered it vitally important to highlight investing principles that worked, irrespective of changes in society or government or great swings in the market. The book is essentially about the difference between investment and speculation, between quoted stock prices and the underlying or real value of the companies behind them. His investing approach requires a long term horizon, the ability to tune out market ‘noise’ in the interim, and having enough confidence in your investing choices that you won’t be rattled by a catastrophe or correction. An investor, not a speculator Graham notes that the ‘intelligence’ the title of the book celebrates is not of the ‘smart’ or ‘shrewd’ type but relates more to the character of the investor: that is, not someone looking for a quick profit, but with a long-term view minded to conserve their capital, who can be firm about their investing principles in the face of an emotion-driven market. He sticks with the distinction between investing and speculation given in his earlier book Security Analysis (itself a classic): “An investment operation is one in which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” With speculation or ‘trading’, he notes, you are either right or you are wrong, the latter often disastrously so. An investor, in contrast, considers themselves a part owner in a large enterprise, looking mainly to its results and the quality of its management. Such a thing as intelligent speculation does exist, Graham says, but it is dangerous when people who think they are investing are actually speculating. Any stock purchase that you do quickly, when you don’t want to ‘lose out on a great opportunity’ is probably speculation driven by the emotions of the market. The intelligent investor should not get involved in trying to forecast the market’s direction. This makes you a trader or speculator. The only time an investor takes account of the ups and downs in the market is when they choose to buy a stock they had their eye on anyway, and can pick it up at a low price if market sentiment is bearish. If an investor starts ‘swimming with the speculative tide’ (particularly during a bull market when it seems easy to make money), they will lose sight of the companies they are investing in and focus only on the price of stocks. How to find value Graham reflected that the long-term prospects of a company can only ever be an educated guess. If those prospects are clear enough, then they will already be reflected in the company’s stock price. This is why ‘growth’ stocks are often expensive, and why there is rarely good value to be found in the ‘sexy’ companies that everybody likes. Better, Graham believed, to invest in companies without dramatic predictions attached to them, ‘boring’ companies that are overlooked and undervalued. He noted that when a company loses ground against the overall market, speculators will cast a pall of gloom over its stock and write it off as hopeless. The intelligent investor, however, will see that this is an overreaction. Surely the company is still selling things, has some market share, and may turnaround? An example he gives of undervaluation is Great Atlantic & Pacific Tea Company (A&P). In 1938 its stock was selling at 36 cents, a price which meant that the whole enterprise was being appraised as worth less than its working capital (meaning its assets minus its liabilities). No consideration was given to all its warehouses and other assets, and the goodwill of being the biggest retailer of its time. Graham observes that the real money to be made in the stock market is not in the buying or selling, but in having the discipline to hold and own, earning dividends and waiting for perceptions of the value of a company to align with reality. To do this obviously requires a degree of psychological strength, and indeed Graham observes that “Intelligent investment is more a matter of mental approach than it is of technique”. Margin of safety The secret of investing success, Graham ventured, could be summed up in the motto, Margin of Safety. In technical terms, this means evidence of a company’s earnings above what is required to service its interest on debt, particularly in the event of a significant sales or market decline. The intelligent investor always looks for this buffer because it means they do not need to have accurate estimates of a company’s future. A speculator does not usually consider the margin of safety important, but for the investor it is their touchstone. There are two ways to invest, Graham notes: the predictive approach, or how well you think a company will do within its market given its management, products et cetera; and the protective approach, which involves looking only at the statistics of a company, such as relationship between selling price and earnings, assets, dividend payments. Value investors favor the second because it is based “not on optimism but on arithmetic”. The first approach, in contrast, would lead you to buy on ‘hunches’ rather than statistical data and reasoning. Thanks to the way ‘Mr Market’ overreacts, it is possible to find a margin of safety in unexpected places. He mentions real estate bonds, many of which after the crash of 1929 collapsed sometimes to near rubbish value, for example 10 cents when they had been valued at a dollar. However, at these prices speculative bonds suddenly became very good value, with a margin of safety well in excess of assets. Two types of investor Within the Graham framework of value and safety, there is room to be either a defensive or an aggressive investor. He gives the example of a widow left $100,000 that she will need to support her kids, who obviously has to be defensive or conservative. However, a doctor in mid career with several thousand to sock away every year, or a young person just starting out and wanting to invest, can both be more aggressive or enterprising. Defensive: safety + freedom from bother Graham’s guiding rule for the conservative investor is to keep a split of roughly 50% of their funds in high-grade bonds (or savings accounts with an equivalent interest rate), and 50% in large, prominent, financially conservative companies which have a history of continuous dividend payments and whose price is not more than 25 times annual earnings (this generally excludes all growth stocks). When the market looks dangerously high, you can reduce your exposure to common stocks to less than 50%, or go over 50% in a downmarket to pick up low priced but good stocks. The formula stops the investor from getting swayed by the hysteria of the market, but at the same time gives exposure to higher potential returns. When the market goes down, Graham notes, he will feel good compared to his bolder friends who have gone into stocks in a big way. Aggressive or Enterprising: safety + more active involvement The conventional wisdom is that if you are prepared to take higher risks you will get higher returns. Graham rejects this, saying that high returns are not necessarily related to risk, but to putting more time and effort into your investing. For those who decide to make their own stock picks but still require the margin of safety, Graham’s pointers include:
If you do ask others to manage your funds, he counsels, either: 1) Limit the investing activity contracted out to very conservative investments; OR 2) Make sure you have “an unusually intimate and favourable knowledge of the person” who is going to direct your funds. Never go with the advice of people who promise spectacular returns. Be careful also of getting advice from friends or relatives: “much bad advice is given for free”. Final word On the penultimate page of the book Graham writes, “Investment is most intelligent when it is most businesslike”’. This, Warren Buffett thought, was the wisest sentence ever penned on investing. Graham meant that people in the financial world too easily forget the basic fact of investing: that it is about companies, and buying a stock means part ownership of a ‘specific business enterprise’. Trying to make money beyond earnings related to a firm’s performance was fraught with danger. Reflecting on whether there were any rules of investment that had stood the test of time, he noted that most of the rules relating to particular types of securities (e.g. “A bond is a safer investment than a stock”) were no longer valid, while the ones relating to human nature did not date, such as “Buy when most people (including experts) are pessimistic, and sell when they are actively optimistic.” Everything changes, including companies, regulations and the economy, but people do not, and people are what drive markets. The Efficient Market Hypothesis says that stock prices are always an accurate reflection of the value of a company and its probably future earnings, therefore it is not possible for anyone to ‘beat the market’ in any sustained way by picking individual stocks. But could the phenomenal success of value investors like Warren Buffett, who base their judgements on a knowledge of human nature, really be just ‘chance’? In the Introduction to the original 1949 edition, Graham candidly notes the risk that his book ‘may not stand the test of future developments’, any more than a finance book written in 1914 would be relevant to investors of the 1950s. In fact, The Intelligent Investor is considered by many – despite many references to companies that have now faded into history – to be quite timeless. His humility only makes you trust him more, and he has a calm style and does not talk down to the reader. Coming up to its 65th anniversary, the book has rarely been more popular, and though the commentary and examples change slightly from edition to edition, the principles remain the same. It doesn’t matter which one you read. Source: 50 Prosperity Classics: Attract It, Create It, Manage It, Share It by Tom Butler-Bowdon (London & Boston: Nicholas Brealey). |
Benjamin Graham
Born in 1894, Graham was born in London to Jewish parents (Grossbaum was their original name) who emigrated to the United States while he still a baby. He did well in school and won a place at Columbia University in New York. Graham started working on Wall Street in 1914 when he was 20, and later founded the famous Graham-Newman Partnership brokerage business. He also taught at Columbia’s Graduate School of Business from 1928 to 1957. Other key books are Security Analysis, with Graham Dodd, Sidney Cottle and Charles Tatham (1934) and The Interpretation of Financial Statements (1964). Graham died in 1976. |
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