My Takeaways from The Intelligent Investor by Benjamin Graham
This past week, I read the 2006 version of The Intelligent Investor. It consists of the 1973 book edition alongside commentary from Jason Zweig at the end of each chapter. Initially, I expected it to be a tedious book, but I found much of it to be very entertaining and insightful. By the end of it, I learned many valuable lessons, many of which I wish I knew about sooner.
While this book focuses on value investing, Graham’s wisdom can be applied to nearly all styles. In this post, I will talk about some of the main takeaways I got from reading this book.
Investing v Speculating
At the beginning of the book, Graham spent lots of time discussing the difference between investing and speculating. When you buy a stock, you are LITERALLY buying a company, albeit a small portion of it. That is why you have to be comfortable being a part-owner of the company. Graham talked about how investing meant using sound financial principles to make informed decisions about where to invest capital. On the other hand, speculation is when someone bases an investing decision on something very uncertain. Graham talked about the importance of understanding your investments rather than speculating and gambling them away.
1. Intrinsic Value Matters
Whenever you buy a stock, you always should keep its intrinsic value in mind. The intrinsic value of a stock is the calculated current value of a stock, regardless of what the market price is. Intrinsic value can vary a lot from person to person depending on how they choose to value the company. But having this target value is a good way to tell if you are making a good investment or not.
Surprisingly, Graham says not many people do this. Instead, they use more speculative methods to tell when to buy and sell a stock. For example, many people buy stocks simply if they go up or sell them simply because they have gone down. To Graham, this is crazy. If you went to the store and saw a 30% off sale, would you run away? No! You would buy more. The same logic applies in stocks as well.
2. Margin of Error
In the world of investing, you must understand that you will not always be right. Even stocks that seem like sure bets will eventually fail. But, to mitigate this chance of failure, you can apply a margin of error to all your investments.
To do this, you would first determine your intrinsic value for a stock. If the stock price is below your intrinsic value minus the margin of error, then you would buy the stock. For example, let’s say ROAR stock is trading around $60, but you think it should actually be worth $100. If your margin of safety is 30%, then you would subtract this from your intrinsic value to get $70 as a conservative intrinsic value estimate. Since even the marginalized intrinsic value of $70 is still above the current share price, then you are LESS likely to lose money. On top of that, you are actually MORE likely to get bigger gains since there is more room for the share price to grow. Pretty fantastic!
This is the overall basis of value investing. Most people think you need to invest in risky places in order to achieve high gains. But actually, by applying a margin of error, you can still increase your max gains while decreasing max losses. Therefore applying a margin of error, even if you are not a value investor, is still important.
3. Don’t get caught up in the hype!
Most of the time, it’s great to get others’ opinions before you make an investing decision. But don’t mindlessly follow the crowd without making your own opinion as well. What many people irrationally might think is a sure bet could very well just be a product of their madness.
Look at the 2000 Dot-Com bubble; everyone wanted to invest in tech because it was rising so much. However, if they took the time to fundamentally analyze the company, they would see most of these businesses were overvalued. Prices can’t go up forever, so many people ended up losing over 50% of their portfolio.
The Intelligent Investor would not get caught up in this nonsense. Instead of making speculative decisions, they would understand their investments and make sustainable and reliable decisions not susceptible to volatile markets. So, don’t get caught up trying to make a quick buck from a volatile market. There will always be a trendy new formula on Wall Street which seems to work for a bit, but most of the time, they disappear as quickly as they came. At times, it might seem hard, but in the end, you triumph by using sustainable strategies which are PROVEN to work.
Mr. Market
This is probably my favorite part of The Intelligent Investor since it gave me a new view on markets. Benjamin Graham believes that market prices are largely meaningless as they often incorrectly show the true value of a business. So rather than let these pointless prices dictate his actions, he used these inefficiencies to his benefit. This is well shown with his unique Mr. Market metaphor.
Imagine there is a bipolar salesman named Mr. Market who comes up to your house every day and offers you a price for your assets. Some days, he is euphoric, and he offers you extremely high prices for your assets. Other days, he is pessimistic, and he gives you dirt-cheap value. None of these prices reflect the true value of your asset. Still, most people panic and get caught up in his mood swings. They sell to Mr. Market for lower prices and buy at higher prices, despite KNOWING prices should be the opposite.
Instead of letting Mr. Market’s mood swings control you, you see him as someone to do business with. If he is ever too pessimistic, use this to your advantage and buy. On the other hand, if he is too optimistic, use this as an opportunity to sell. Just remember, the market value of an asset doesn’t always reflect its true value. Seeing the market from this view can help you make less emotional, more informed decisions.
How Markets Work
1. Inflation
Inflation should be a major concern for all investors. Every year, it deteriorates the value of your money. That is why it is important to stay invested in markets. Inflation should not only be a part of an investment’s end goal, but it should also play a role in choosing the correct investment portfolio.
Graham said portfolios that focus more on fixed income securities (such as bonds) will feel the wrath of inflation the hardest. Essentially, he believes that bonds will not be able to accommodate well to high inflation environments. For example, let’s say you own a bond that gains 1.5% per year. If inflation is at 2%, then you are “technically” losing money. This is because your inflation-adjusted buying power has decreased, even though your principal value has increased. It is important for your return on investment to at least exceed inflation.
So, Graham believes every portfolio should have some exposure to stocks, even the most defensive ones. In the long-term, stocks will perform better against inflation. They will provide substantial gains as opposed to simply “hedging” against inflation. What mainly matters for the stock allocation is the investor’s long-term goals and how financially and psychologically they are against adverse movements.
2. Market history
The history of the stock market can provide valuable insights into the future. It allows investors to see how markets will react under different environments. While some people can use these lessons to profit in the future, most people can see the market is crazy.
Throughout history, one can see how unpredictable the market can be. Nearly every short-term prediction one makes will turn out wrong. Even fool-proof investments can be wrong, and it is important to be humble with your predictions. Whenever making an investment, always determine a company’s intrinsic value, and apply a margin of safety to it. It is also important to diversify into different stocks and assets to mitigate risk. This way, if an investment goes south, it won’t tank your entire portfolio.
Leading up to 2000, many investors thought tech stocks were a sure thing. Many people put large portions of their portfolio into this area. When 2000 came, these same people who thought their investments were foolproof lost over 50% of their portfolio in one year.
History has told us time and time again that short-term market predictions are almost meaningless. Over the long run, the stock market has shown us that it is profitable every single time. That is why it’s important to have a long-term view of most positions you take.
Investment Selections
In the book, Benjamin Graham also gave us his criteria for his investments. Graham paired his criteria alongside his beliefs on a company to ensure he was making smart and non-speculative decisions. Since markets change so much, some of these criteria might be outdated or less effective in today’s time. Still, much of it is timeless, and can still be applied today to help make sound investing decisions. However, it is important you make your own investment criteria to better fit your investing goals and beliefs.
Here are 6 of Graham’s investing criteria:
1. The company should have strong financial conditions
Graham wanted to be confident that the companies he invested in could survive a recession. Graham wanted a company’s current assets to be at least twice the current liabilities. This way, a company wouldn’t have to worry about their debt during hard times.
2. Earnings Stability
Earnings play a major factor in dictating the value of a company. To reduce speculation, Graham wanted a company to have positive earnings for the past 10 years. He also wanted a proven track record of being profitable, even during the depths of a recession. This makes it more likely the company will maintain its value during difficult times.
3. Dividend Record
Graham liked companies that paid out dividends. He believed they were great cushions during difficult times. Graham wanted companies to have paid out a dividend for the past 25 years. Furthermore, he also wanted dividend increases over the past 25 years. This way, it would be more likely dividends would increase in the future.
***At the time of his writing, most companies paid out dividends. Their dividends were also more liberal; around 50–67% of earnings were paid back to shareholders. Now, dividend payouts are much more conservative. Company’s elect to pay smaller portions of earnings back to shareholders, and instead re-invest the earnings through stock buybacks or to grow operations. I feel this criteria may not be as relevant today, but this mainly depends on each investor’s personal style and beliefs.
4. Earnings Growth
Earnings growth also plays a major factor in determining the value of a company. The faster and larger they can grow, the faster the fundamental share price will grow as well. Graham prefers that a company’s “per share” earnings increase by at least ⅓ over the next decade. Compounded annually, this equates to a modest 3% year-over-year growth. This minimum growth can help narrow many “dying” companies from his selection.
5. Moderate p/e ratio
Along with earnings stability and growth, Graham also wanted earnings to be relatively high compared to the share price. Graham suggests that p/e ratios should be under 15. He also suggested what he called the “cumulative p/e” (which uses the average earnings over the past 3 years) to be below 20. This can help iron out any short-term volatility in earnings.
6. Moderate p/b ratio
Every company has a current book value which is determined by its assets subtracted by liabilities. The price to book ratio compares a company’s current market value to its book value. This ratio shows how much “real value” you get whenever you buy a stock, excluding future earnings, etc.
A company’s book value can often serve as a cushion for the share price against adverse movements. Graham suggests that the p/b ratio of a stock is under 1.5. This can help ensure he gets safety and value in his stocks.
Conclusion
The Intelligent Investor is typically referred to as the Holy Grail of value investing. It has inspired notable value investors such as Warren Buffet to accumulate insane amounts of wealth. Still, many of the lessons from this book can be applied to all forms of investing. It is important to understand what you are investing in; stocks are not lottery tickets, and behind every ticker symbol is a real business. Before buying a stock, make sure you look at its fundamentals alongside your opinion about the company’s direction. The market price should also be well below what you believe is its “true value.” Finally, don’t get caught up in Mr. Market’s mood swings. In the short term, the market is crazy, but in the long-term, everything will iron itself out. That is why you have faith and buy when stocks are especially undervalued, not sell.
