“The Intelligent Investor” by Benjamin Graham
If you ask Warren Buffett, the world’s most successful investor:
“What one book is most responsible for your success?” or “What is the single best book on investing?”
Benjamin Graham is known as “The Father of Value Investing”.
What is value investing?
Put simply: pay less for an asset than what it’s intrinsically worth. ie buying a nickel with a penny.
Margin of Safety & The Preservation of Capital
The central theme of The Intelligent Investor is making very safe investments.
Benjamin Graham coined this term “The Margin of Safety”.
Warren Buffett’s only two rules of investing are: 1) Don’t lose money; 2) Don’t forget rule #1.
In his entire approach to investment, The Margin of Safety is the one guiding principle that must always be met.
Investment vs. Speculation
Ben Graham differentiates the two as follows:
“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, page 18 (PDF | Audiobook)
“Safety of principal” – a.k.a. Margin of Safety.
Be honest, are you obsessed with stock quotes and financial news?
If you can relate, you are speculating, not investing. Ben Graham says:
“The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 203 (PDF | Audiobook)
Why check the prices? Do you need the money right now?
“Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 203 (PDF | Audiobook)
The more you obsess with price quotes, the more likely you are to make an irrational, emotional mistake.
Making mistakes violates the rule of The Margin of Safety.
Ben Graham’s solution?
“That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgement”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 203 (PDF | Audiobook)
So how do you know if you are an investor or a speculator? Graham says:
“The most realistic distinction between the investor and the speculator is found in their attitude toward stock market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices.”
– The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 205 (PDF | Audiobook)
General Portfolio Policy: Stocks, Bonds and the Intelligent Investor
Through-out the book, Graham generally and repeatedly recommends maintaining a 50/50 ratio of high quality stocks and high quality bonds in most cases.
When rare opportunities present themselves, you can overweight either component. Some examples in the past have been:
There have been times when so called “risk-free” assets, such as a 10 year US treasury, paid over 14% interest while stock dividends paid less than 3%. In such an instance, you may want to consider over-weight in bonds.
During the 2008 financial crisis, the stock market was in free-fall, especially bank stocks. Even as governments were bailing out the banks, the prices remained at extremely depressed levels. In such an instance, you may want to be overweight in stocks.
Benjamin Graham does recommend maximum allocations:
“It is still true that they may choose between maintaining a simple 50-50 devision between the two components or a ratio, dependent on their judgement, varying between a minimum of 25% and a maximum of 75% of either.”
– The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 27 (PDF | Audiobook)
There is a lot of literature that shows that stocks will outperform bonds in the long-run.
So why have any bonds at all?
Graham advises maintaining a bond position for several important reasons:
“… a truly conservative investor will be satisfied with the gains shown on half his portfolio in a rising market, while in a severe decline he may derive much solace from reflecting how much better off he is than many of his more venturesome friends.”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 91 (PDF | Audiobook)
“… if the investor concentrates his portfolio on common stocks he is very likely to be led astray either by exhilarating advances or by distressing declines.”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 55 (PDF | Audiobook)
In the extended edition, Jason Zweig quotes Gilbert and Timothy Wilson’s “Miswanting”:
- “Psychologists have shown that most of us do a very poor job of predicting today how we will feel about an emotionally charged event in the future.”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 103 (PDF | Audiobook)
Effectively, you are likely to make a mistake (such as selling at all-time lows) if your all-stock portfolio takes a huge dive, which it inevitably will at some point in the future.
It always does, and usually when you least suspect it.
Having some level of bonds both protects you psychologically and provides a margin of safety.
When you buy more stocks after they have fallen in price (to maintain your bond/stock allocation) your average cost goes down as well.
The Intelligent Investor is an Owner of a Business
Graham explains that buying a stock is like buying a little piece of a real business. Each share is a claim on the equity and profits of the company.
It is not a magical electronic ticker that just fluctuates in price all day for you to look at. (Sorry, “Technical Analysts”)
The underlying business, which has an intrinsic value, should determine what price you should pay for it.
When you pay less than what it’s worth, you are protected by a margin of safety.
Of course, even the best companies can make terrible investments if you pay too high a price. More on this later.
Likewise, a bad company can make a great investment if you pay a low enough price.
Buffett compares this to a cigar butt. It’s gross, wet, you will throw it away; but it’s free and has puffs left.
Business Valuations vs Stock-Market Valuations
Suppose you own 100% of a private company that has $100 in the bank and $50 in debt. If you looked at your net worth, you’d likely say that your company is worth $50.
Now suppose your company is traded on the stock market, and the market cap of your company is $500 and you own 100% of the shares. In other words, the market thinks your company is currently worth $500.
What is your net worth now?
Graham argues that the best way to think about the value is to use the tangible equity of the company in proportion to your ownership share to determine the true value of your net worth. He says:
“On the one hand his position is analogous to that of a minority shareholder or silent partners in a private business. Here his results are entirely dependent on the profits of the enterprise or on a change in the underlying value of its assets. He would usually determine the value of such a private-business interest by calculating his share of net worth as shown in the most recent balance sheet.”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 197 (PDF | Audiobook)
Looking at balance sheet value provides a margin of safety against the opinions and misjudgements of Mr. Market.
How Stocks are Priced: The Manic & Bi-Polar “Mr. Market”
Imagine you own a bakery.
An honorable baker, you have been in the business for 20 years and you know what your bakery is worth.
Every day, a man named “Mr. Market” walks into your shop and offers to buy your bakery.
He usually offers a reasonable price, but you don’t really need the money.
It’s not like you’d be better off buying a tech company or a bank or a retailer.
Baking is what you know. You politely decline Mr. Market’s offer to buy your bakery.
Take this a step further.
Some days Mr. Market get extremely scared about little things. He thinks that all bakeries are bound for bankruptcy and will become instinct.
Maybe the price of wheat is going up and fewer people are buying bread. A popular fad diet says bread causes obesity, or people are scared of gluten. Whatever.
These are all things that you, a baker of 20 years, have seen many times before.
When he panics, his offers to buy your bakery will be laughably low.
Obviously you wouldn’t sell to him when he offers the worst possible price.
In fact, maybe you should buy some of the other bakeries, since he’s offering a great price on them, too.
The flip side is true too.
On same days, he becomes so excited about baking.
Maybe new research shows that a loaf of bread per day prevents cancer. Maybe the yields on a new GMO form of wheat is forecasting increased profits by 50%, whatever.
He might even offer you over 100 years worth of annual profits!
When his blind-optimism and greed make him offer nearly any price, it’s time to sell.
This analogy perfectly describes what the stock market is.
It’s a herd of people, in once voice, offering prices for businesses. That is how stock prices are determined.
You wouldn’t let Mr. Market determine how you feel, or what your bakery is actually worth.
In fact, he’s just begging for you to take advantage of his mistakes.
You use him to buy businesses that you understand when he offers a cheap price, and sell to him when he is too excited about the future and is willing to pay insanely high prices.
The Defensive Investor vs. The Enterprising Investor
What is a defensive investor?
Graham describes the defensive investor as:
Chiefly in Safety. a.k.a. Margin of Safety.
In Chapter 14, “Stock Selection for the Defensive Investor”, Graham prophetically describes the structure of one of the greatest products for investors, the passive index fund.
In his time, these products weren’t available, so a defensive investor would have had to build it manually.
When describing bonds, he generally a portfolio similar to the Vanguard Total Bond Market ETF.
(It doesn’t have to be Vanguard, just ensure they are reputable and have the lowest expense ratio possible)
The majority of people would be very wise to be defensive investors, as more than 99% of active funds aren’t able to beat the market index in the long-run.
But even if you don’t try to beat the market, the average investor won’t even come close.
In fact, the average investor does significantly worse than the index for a few reasons:
- Paying high fees
- Paying more taxes
- Poor timing
- Making emotional and irrational decisions
- Acting way too frequently
- Overly complex decision making
If you approach your investment portfolio policy to contain 50% bonds and 50% stocks, then once per year you can re-balance your ETF allocation. This both gives you something to do, and automatically creates a relative “buy low, sell high” habit.
If you don’t plan to make investing your full time job, you are much better off focusing your energy on improving your personal earning power and savings habits, as opposed to trying to get excessive investment returns.
The Enterprising Investor
Graham repeatedly mentions that most people would be better suited as defensive investors, as opposed to enterprising investors.
In fact, I interpret his book almost as an argument against being an enterprising investor.
I agree very strongly with this and also wrote an essay on why you shouldn’t be a stock picker.
Sir Isaac Newton, lost the equivalent of $3,000,000 on his shares in the South Sea Company in 1720.
He famously said he “could calculate the motions of the heavenly bodies, but not the madness of the people.”
Do you have a better chance than Newton?
In “The Intelligent Investor”, Benjamin Graham says the following:
- “As for the aggressive investor, perhaps only a small minority of them would have the type of temperament needed to limit themselves so severely to only a relatively small part of the world of securities.”
- “For indeed, the investor’s chief problem – and even his worst enemy – is likely to be himself.” – Page 8
- “… the proportion of smart people who try this [beating the averages] and fail is surprisingly large” – Page 9
- “… for there is strong evidence that their [investment managers] calculated forecasts have been somewhat less reliable than the simple tossing of a coin” – Page 10
- “It is no difficult trick to bring a great deal of energy, study, and native ability into Wall Street and to end up with losses instead of profits” – Page 29
However, if security analysis is your passion, he offers his proven strategy to out-perform the market, known as “The Enterprising Investor”.
Rules of Stock Picking for the Enterprising Investor
In “The Intelligent Investor”, Graham outlines many principles to follow when selecting investments that can beat the averages. However, it was written in a general fashion and should be coupled by reading his more in-depth text, Security Analysis.
Temperament: It’s not about how smart you are
“We have seen much more money made and kept by ordinary people who were temperamentally well suited for the investment process than by those who lacked this quality, even though they had an extensive knowledge of finance, accounting, and stock-market lore”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 8 (PDF | Audiobook)
Most people find investing very stressful and emotional. You will have to endure:
- Watch a significant part of your net worth drop on a frequent basis;
- Be willing to invest more as the value continues to drop;
- Be willing to wait on the sidelines while everyone is “making money” (on paper);
- Buy boring and unpopular stocks while high tech and growth stocks are skyrocketing.
These ideas are simple in theory, but nearly impossible in practice.
Just ask anyone who was invested in stocks in 1998-2001, 2008-2009 (or October 1987).
No matter how smart you are, that doesn’t translate into being emotionally rational in highly stressful situations.
Buying Near Tangible Asset Value
This is an extension of the idea of a “Margin of Safety”.
Suppose a simple company has $200 in current assets, and $100 in total liabilities, with shareholder equity of $100.
If you could buy this company for $50, you could shut down the company, pay off the liabilities and have $100 in equity left over for yourself.
Obviously, your investment of $50 was virtually risk free. This is the idea behind a cigar butt.
“The type of bargain issue that can be most readily identified is a common stock that sells for less than the company’s net working capital alone, after deducting all prior obligations.”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 169 (PDF | Audiobook)
In this instance, “net working capital” is: current assets minus total liabilities.
These types of bargains in high quality stocks are very rare, but during times of great distress, fear and panic (the great depression, and in the 2007-2008 panic) these prices became available.
But even if these insanely low prices aren’t available, good deals are still available. Graham says:
“It might be best for him to concentrate on issues selling at reasonable close approximation to their tangible asset value — say, not at more than one-third above that figure”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 199
High Price = High Risk. Low Price = Low Risk
When peanut butter goes on sale, we buy more and stock up for the future.
How come we don’t do the same with stocks?
We incorrectly believe that falling prices mean it’s a riskier bet. Benjamin Graham argues that the opposite is true.
As long as the underlying company is high quality and has a solid track record of stable earnings and dividend payments, you should welcome price drops as opportunities to buy.
In other words, a lower price provides a greater Margin of Safety.
The inverse is true too: the higher the stock prices climb, the more we want to buy in. Oops.
“The more enthusiastic the public grows about it, and the faster its advance as compared with the actual growth in its earnings, the riskier a proposition it becomes”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 160 (PDF | Audiobook)
Once again, we get this wrong. When stock prices are climbing, that is time to start selling small amounts of your position and deploy the cash to other undervalued holdings.
His view on bull markets:
“Nearly all he bull markets had a number of well-defined characteristics in common, such as (1) a historically high price level, (2) high price/earnings ratios, (3) low dividend yields as against bond yields, (4) much speculation on margin, and (5) many offerings of new common-stock issues of poor quality.”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 193 (PDF | Audiobook)
Must Be Contrarian and Buy Unpopular Stocks
When there are more buyers than there are sellers, stock prices go up. Then there are more sellers than buyers, prices go down. (simplified idea).
“If we assume that is is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue — relatively, at least — companies that are out of favor because of unsatisfactory developments of a temporary nature.”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 163 (PDF | Audiobook)
To be contrarian, you should be buying when most people are selling (when prices are falling). Luckily you don’t ever have to sell, especially when you are buying great companies.
Graham says that markets will be quite mistaken and blow negative setbacks way out of proportion.
“The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 166 (PDF | Audiobook)
The Intelligent Investor and Growth Stocks
As a general rule, Graham advises against buying “high flying” growth stocks sine they inherently violate the idea of the Margin of Safety. He says:
“For the more dependent the valuation becomes on anticipations of the future — and the less it is tied to a figure demonstrated by past performance — the more vulnerable it becomes to possible miscalculation and serious error”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 282 (PDF | Audiobook)
In other words, what happens if the future doesn’t go according to plan?
If the future high expectations don’t come to fruition, the price will likely crash, since they are already baked into the price.
So how much should you pay for a growth company? On one hand, Ben Graham offers this simple equation for a rough estimation of value:
Value = Current (Normal) Earnings * (8.5 plus twice the expected annual growth rate)
But he then goes on to say, which is consistent with the Margin of Safety:
“There is really no way of valuing a high-growth company (with an expected rate above, say, 8% annually), in which the analyst can make realistic assumptions of both the proper multiplier for the current earnings and the expectable multiplier for the future earnings”
–The Intelligent Investor, Benjamin Graham, The Revised Edition, Page 297 (PDF | Audiobook)
The Intelligent Investor: My High-Level Summary & Review
There are 7 high-level take-aways of this book:
- Margin of Safety: Don’t lose money above all else.
- Temperament: Don’t panic, don’t buy the hype, don’t envy “growth stocks”.
- Value and Price are different: You want to get more than what you paid for.
- The market is your servant: don’t let it stress you out, just use it for opportunity.
- Focus on quality: Top companies with long track records for most investors.
- Ensure you always have a mix of stocks and bonds.
- High-Quality stocks become riskier when the price goes up, and safer when the price goes down.
- Be Contrarian: Buy stocks when they become out of favor for temporary reasons.
There are no alternatives other than pure respect when discussing this book.
Written in 1973, it’s teachings still hold true; as demonstrated when Warren Buffett famously avoided serious loss during the dot-com bubble.
The book is easy to understand for any average Joe who is interested in investing.
It’s also important to understand that this is one, very well defined investing strategy, known as value investing. Of course, there are many other methods to invest successfully, and this is by no means the “only” way to invest.
That said, every investor owes it to themselves to read this book and make an informed decision not to pursuit this strategy.
“The Intelligent Investor” by Benjamin Graham is featured on my list of “The Best Books on Investing ever Written“.