The Intelligent Investor by Benjamin Graham – Book Review
The book was written in 1949 by a guru of the industry who outlines the general approaches to investment and the principles of security selection.
I found the book at times difficult to follow as the references and examples date back 75 years, and it is Dow jones centric with a strong reference to government bonds as a benchmark comparison.
However, if you use the American context and apply it to Australia today, or any other national stock exchange, then there are timeless investing concepts that can be gained by the reading of the book.
I was less interested in the mechanics of investing (of which there is a lot in the book), and more in the principles of safe investment. To this end I got a lot from its reading.
Am I a defensive or aggressive investor?
A defensive investor will buy.
1. Government Bonds
2. Diversified list of common stocks at prices that seem reasonable based on past market experience.
3. Shares of investment firms e.g., trusts, funds
An aggressive investor will buy.
1. 1, 2 & 3 above
2. Growth Stocks but with caution
3. Common stocks where the market is historically low.
4. Secondary stocks, corporate bonds, and preferred stocks at bargain levels
5. Exceptional convertible issues
Investor v speculator
Differing attitude towards stock market movements
Speculators primary interest is in profiting from market fluctuations.
Investors primary interest lies in acquiring and holding suitable securities at suitable prices.
‘Market movements are relevant if they create low price levels at which he would be wise to buy, or high price levels at which he should refrain from buying. Overall, it may be better for an investor to buy stock when he has the funds available, except when the general market level is higher than can be justified by well-established standards of value’.
· An investor should expect stock price to fluctuate and should neither be concerned by sizable declines or excited by sizable advances.
· Market quotations are there for the investor’s convenience, either to be taken advantage of or ignored.
· Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop.
Value
Graham contends that the general rule as to price is that the price of the stock as a multiple of earnings should not exceed 20-25 times (P/E ratio).
Market Capitalisation is the number of outstanding shares times the price per share.
Generally, the true value of stocks is not only what the market prices values them at, it is what a prudent investor places on them after conducting an analysis using well established standards of value. It may be consistent dividends, or working capital, or industry expected capital investment, or industry future, level of earnings reinvestment, or all the above.
Graham has chapters dedicated to selection of stocks as a defensive investor or as an aggressive investor. I skipped through to the final chapter which summarises the central concepts of Investment.
Margin of Safety
Graham explains that all experienced investors recognise the margin of safety concept is essential to the selection of sound corporate bonds and stocks.
Bonds
The calculation of margin of safety for fixed value investments e.g., corporate bonds is based on past ability to earn in excess of the interest quoted in the bond, and over twice the interest rate over prior years i.e. They borrow in a bonds issue, and pay an interest rate of say 3%. Graham holds that the company must have earnings exceeding 6% to provide a margin of safety to protect against future declines in earnings.
Another way of calculating margin of safety is by comparing the total value of the enterprise with the amount of debt. If the business owes $10 million and is worth $30 million, there is room for shrinkage of two thirds in value (theoretically), before bond holders would suffer a loss. He maintains that average market stock prices over prior years equate to average earning power. Therefore, the margin of ‘enterprise value over debt’, and the margin of ‘earnings over charges’ will in most cases yield similar results.
Stocks
Graham compares stocks with bonds as a benchmark. ‘In ordinary common stock bought for investment under normal conditions, the margin of safety lies in expected earning power that is considerably above the going rate for bonds.
He cites the example 8% as the earning power based on price of the share, and the bond rate is 3%.
‘Then the stockholder will have an average annual margin of 5% accruing in his favour’. ‘Some of the excess is paid as a dividend rate and even though spent, it adds to his overall investment result. The undistributed balance is reinvested in the business for his account. In many cases reinvested earnings fail to add commensurately to the earning power and value of his stock (That is why the market has a stubborn habit of valuing earnings disbursed as dividends more generously than the portion retained in the business). But if the picture is viewed as a whole there is a reasonably close connection between growth of corporate surpluses through reinvested earnings and the growth of corporate values’.
Diversification
Graham holds that there is a close logical connection between the concept of margin of safety and the principle of diversification.
The margin guarantees only that the investor has a better chance for profit than for loss – not that loss is impossible. However, the greater the number of individual investments, the better the chance that the aggregate of profits will exceed the aggregate of losses.
Investment v Speculation
Most speculators will rest on subjective judgement, unsupported by any body of favourable evidence or any conclusive line of reasoning.
By contrast an Investor will rest upon simple and definite arithmetic reasoning from statistical data.
‘To have a true investment there must be a present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience’.
Conventional v Unconventional Investments
Conventional investments include government bonds and high-grade dividend paying common stocks.
Unconventional investments include undervalued stocks or bonds of secondary companies. Graham recommends for purchase when they can be bought at two thirds or less of their indicated value.
Final word from Graham
Investment is most intelligent when it is most businesslike and is underpinned by 4 principles.
1. Know what you are doing – know your business.
2. Do not let anyone else run your business unless you have unusually strong reasons for placing implicit confidence in their integrity and ability.
3. Do not enter upon an operation that is manufacturing or trading in an item unless a reliable calculation shows that it has a fair chance to yield a reasonable profit.
4. Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgement is sound, act on it.
Final Word from Me
I own shares but I do not consider myself an investor. As an accountant, professionally I cannot recommend an investment or advise on wealth management. I leave investing to others who do it for a living and their reputation depends on performance e.g., Fund Managers in general.
It could be argued that there are notable exceptions to Graham’s stock valuation guidelines. E.g. in the way some tech stocks are valued today. In 2023, Tech stocks P/E may be considerably higher due to the level of investment which generates capital growth and increases intrinsic value based on intellectual property. In Grahams book, investment in tech stocks would probably be classed as speculation.To me, The Intelligent Investor by Benjamin Graham, reinforces prudent investing norms that should not be underestimated in our financial endeavours.
Times may have changed, but the investing mistakes we make today are the same mistakes we made 75 years ago. The financial products are more complex, but the safe investing principles outlined by Graham, apply equally today as they did in 1949.