I read the 2006 version of The Intelligent Investor. It consists of the 1973 version by Ben Graham with commentary from Jason Zweig. I expected a dry, boring read, but found the majority of it entertaining and breezed through it quickly.
Though it’s an investing book, Graham places a lot of emphasis on psychology and temperament. A great investing strategy won’t succeed in practice if the investor doesn’t have the right temperament.
Graham distinguishes between Defensive Investors — investors who are passive and will be satisfied earning the average market return — and Enterprising Investors — who are willing to put in the work to try to beat the market. Graham believed most people are not temperamentally suited to be Enterprising Investors and recommended the vast majority of us be Defensive.
Graham shares a great deal of wisdom that is applicable to both styles of investing. I’m going to share a few of my favorite insights first, then distill the key points of Graham’s (and Zweig’s) tactical advice for the two types of investors.
- Base decisions on the value of the underlying business. When you’re buying shares — ask yourself if you’d be willing to buy the whole company for the valuation implied by that share price. Graham’s approach is built on analyzing businesses and not analyzing securities or trying to time the market.
- Markets are fickle and market prices are largely meaningless. Don’t let market prices dictate your actions. Rather, view the market as a benefit. The market offers liquidity and provides the opportunity to buy more of a great investment or get out of an underperforming one.
- The key concept of this book is “Margin of Safety”. Buy stocks that are clearly underpriced in the market. Look for “no brainer opportunities”, so even if your calculations were a little bit off or specific assumptions about future prospects don’t materialize, you’re still likely to earn a profit. These opportunities are hard to find, but worth waiting for.
- The higher the price the riskier the investment. At a high price your margin of safety shrinks. Some of the biggest losses come from buying bad stocks in a bull market.
- Dollar-cost averaging is critical. Make purchases every month so you buy at a variety of prices and smooth out regular market fluctuations. Employee contributions to 401(k) plans or IRAs are a great way to accomplish this.
- That being said, don’t ignore the performance of your investments. It’s important to be an intelligent investor and an intelligent owner. Read proxy statements, 10-Q filings, etc., and make sure the company is performing.
- Obvious growth in an industry does not translate to good investment returns. Graham uses the example of the airline industry. It was clear in the early days that the industry would experience dramatic growth. Yet, it’s been absolutely terrible for investors.
- Buying lightly-traded stocks is risky. Even if you find a great opportunity that the market grossly undervalues, it may take a very long time for the market to realize and the price to correct. (Given higher trading volumes, algorithmic trading, etc., I imagine this is less relevant today than it was at the time of Graham’s writing)
Advice for Defensive Investors
Boiling Graham’s (and Zweig’s) advice into a few sentences:
- Buy a mix of stocks and bonds. A 50/50 mix of low cost stock and bond index funds is a good starting point. Revise based on your risk tolerance, but don’t put more than 75% of your investments in one or the other.
- Rebalance every six months.
- Zweig adds a few additional suggestions not discussed by Graham:
- Investing up to 2% of portfolio in a low fee (<1%) mutual fund specializing in precious metals.
- Investing up to 10% of retirement assets in TIPS to provide inflation protection.
- Investing up to 33% of stock portfolio (i.e. up to 16.6% to 25% of total portfolio) in low cost index funds focused on foreign stocks.
The good news: being a defensive investor is easy, particularly with the abundance of low cost index funds. The bad news: it’s boring. Zweig offers the suggestion of actively managing up to 10% of your portfolio if you’re feeling the itch to be more hands-on.
Advice for Enterprising Investors
If you want to take the leap and be an Enterprising Investor, Zweig suggests testing the waters with a portfolio tracker for one year before putting any money at risk. If you’re unsuccessful or don’t like it — you haven’t done any harm and can go back to being Defensive.
· The first step is to identify financially sound businesses. Graham’s approach is all about identifying undervalued — but sound — companies, not taking speculative risks. Graham’s suggested criteria (updated by Zweig in 2006) that a company should meet are as follows:
- Market cap of at least $10B
- Revenues of at least $1B
- 20 year dividend history
- 2-to-1 current assets to current liabilities
- D/E ratio less than 50%
As mentioned above, Margin of Safety is the key concept. After identifying companies that meet the standards above, Graham recommends only purchasing securities that offer a large margin of safety. Graham and Zweig offer some criteria to look for:
- Stocks trading at market cap less than net working capital
- Asset value exceeds market cap
- Companies where the product of the P/E ratio and Price / Book Value ratio is less than 22.5. When calculating, use average earnings over the last three years. [Note: P/E ratios can be a useful first screen, but can be misleading. If a company reported a year of bad earnings, resulting in a disproportionate drop in share price, the P/E ratio may appear excessive even though it could be a great investment. The converse is also true if unexpected good news caused a disproportionate increase in share price]
- Examine the inverse of the P/E ratio (E/P ratio). If E/P (which is essentially earnings yield) is greater than the bond yield that could be supported by the company, the stock is worth considering
It’s hard to distill this whole book into a single blog post and I’m sure I missed some important points. While the first edition of the book dates back to 1949, it still offers a lot of timeless advice and wisdom. Most importantly, that it’s critical to understand yourself and your tendencies to put yourself in a position to succeed. If you reacts strongly to changes in market price (good or bad) it’s better to be more passive — don’t put yourself in a position to make bad decisions.
[One final note: I’m still trying to reconcile how Graham’s recommendations fit into today’s markets. Following his advice, you would pass on most tech companies because they lacked an adequate dividend history or a large enough margin of safety. Per Jason Zweig’s comments, that largely proved to be good advice in the early 2000’s. But, today tech companies are more important and comprise a larger portion of the market. This probably warrants some further exploration and another post at some point. I don’t want to digress too much]