Book Summary: The Intelligent Investor by Benjamin Graham
The Intelligent Investor by Benjamin Graham is considered the bible of investing.
Investment vs. Speculation
Speculative formulas like the January effect, O’Shaughnessy’s patented strategy, Foolish Four strategy were all the result of a simple mistake. Looking at large quantities of past financial data for a long enough period will produce some coincidental patterns. These strategies stopped working soon after they were published. The January effect is still there, though much less pronounced. Speculating is closer to gambling, and those pursuing it should put a hard limit on how much they are going to spend on speculation.
Investor and Inflation
Stocks protect against inflation. Bonds provide partial protection against inflation. REITs and TIPS are other bets against inflation. TIPS are better off in tax-protected accounts since the IRS treats an increase in their paper value as taxable gain.
Stock market history
Never try to predict the future solely by extrapolating the past. Stocks don’t outperform cash/bonds significantly once all the companies which went bankrupt are taken into consideration. Shiller index, a ratio of current price to average profits over the past ten years, is inspired by Graham’s valuation approach. If the index goes about 20, stock market returns are usually poor. The real growth of earnings and dividends is about 2%; inflation runs about 2%, the dividend yield is about 2%. Thus, the total return on stocks is 6% (4% adjusted for inflation) in the long run.
General Portfolio Policy: The Defensive Investor
The book does not prescribe the standard “(100 – age) % of the portfolio in stocks” since people at the same age can have different investment horizons. For anyone, putting a minimum of 25% in stocks is a safe bet and beyond 75% is too risky. Research shows that we are bad at predicting our reaction to an emotionally charged situation (stock market crash, in this case) in the future. Depending on one’s life situation, which determines the investment horizon, the stock component can be chosen between 25 and 75%. Taxable bonds should only go into tax-sheltered accounts like 401(K). If interest rates rise, a short-term bond falls far less than the long-term and vice-versa. The simpler bet is to buy intermediate-term bonds instead.
The Defensive Investor and Common Stocks
An individual investor can great common stocks just based on companies he is familiar with. Unfortunately, this familiarity breeds complacency. An individual investor should not invest without doing further research into the financial statements of the company. Index funds with dividend reinvesting leading to Dollar-cost averaging are the best bet for individual investors.
Portfolio Policy for the Enterprising Investor: Negative Approach
Junk bonds are usually a bad bet. Day-trading is a crime; it only makes the broker rich. IPOs are bad for individual investors. VA Linux went public at $30 a share in 1999, the stock then went up to $320 in a single day, and in 3 years, it was trading at $1.19 a share.
Portfolio Policy for the Enterprising Investor: The Positive Side
A great company is not a great investment if you pay too much for the stock. Bargain opportunities arise with big company stocks from time to time when the stock crashes due to bad news with a temporary effect. Investing in foreign stocks is important for diversification. In 1989, the Japanese stock market had made 21% annually on average for a decade against 17.5% for the USA. Japanese companies were booming, but then in the next decade, Nikkei lost two-thirds of its value.
The Investor and Market Fluctuations
Mr. market knocks on your door every day and tells you a price at which you can buy more shares of companies you own or sell your shares. His behavior is erratic; sometimes you feel he is offering too much and sometimes asking too much. Most people lose by imitating Mr. market. Most people fear losing money more than gaining, so, when the market tanks, they end up selling at the bottom. When stocks fall in price, they are actually on sale, whether the sale is worthy of it is not, is to be judged by the buyer.
Investing in Investment Funds
Index funds are good bets. Finding good mutual funds to invest in is hard, good ones are usually closed to new investors and most likely not even taking new money. Be careful of high turnover leading to excessive taxes.
The Investor and His Advisers
An adviser assists in developing a comprehensive financial plan regarding earning and investing (asset-allocation) and take care of the emotional health of the client during difficult times.
Security Analysis for the Lay Investor
Five important factors for a long-term prospect
- General long-term prospects of the company
- Management quality
- Financial strength and capital structure
- Dividend record
- Current dividend rate
Signs of trouble
- Serial acquirer
- OPM (other people’s money) addict – borrowing debt or selling stock
- The company is relying on only a few customers
- Strong brand identity, eg. Harley-Davidson
- Economies of scale, eg. Gillette
- Unique intangible asset, eg. Coca-cola
- Resistance to substitution e.g. electricity supplying utility companies
- The company is a marathon runner and sprinter; fast-growing companies tend to overheat and flame out (source)
- The company spends on R&D (and spending is not too little or too much)
Things to consider about per-share earnings
- Special charges – Companies can fudge their earnings by showing losses, taking inventory write-off, or shutting down a division as special charges. Such earnings before special charges are reported as primary earnings. Earnings after special charges are reported as net income.
- Dilution factor – The number of shares itself can be misleading if a company has stock warrants, convertible preferred stocks, or convertible bonds which under current circumstances might be favorable for their owners to convert. Usually, such shares, assuming conversion is reported as “fully diluted”.
- Income-tax deduction – If a company has taken losses in the past and still has income tax credits left to use, then-current earnings might be taxed at a lower rate.
- Depreciation – Depreciation of current assets can be linear or accelerated, usually, either is fine. But when a company jumps from one to another, it can cause EPS to fluctuate.
- Pro forma – Use of non-GAAP reporting, see a mockery of the same in My Pro Forma Life.
If you are reading financial reports, read them backward. Bad things are usually at the end or in the footnotes.
Stock selection for the defensive investor
A low-cost total stock market is the best of a defensive investor. Keep 90% of the money in that and play around with 10% picking stocks. For stock picking, focus on the strong financial condition of the underlying company, its earnings stability, dividend record, earnings growth, moderate P/E (< 15), and moderate Price-to-book (< 2.5).
Stock selection for the enterprising investor
- Good ROIC (not just EPS)
- Clear financial statements
- Focus on discipline and consistency of investment thesis, ignoring the market.
A convertible bond can be converted to stock at a conversion ratio. So, while they pay interest like a bond, they can be converted into a stock, which makes sense if the stock does well. They are more correlated with the stock market than the bond market. Another common thing that some investors do is selling covered calls, which effectively puts a ceiling on their gains while still giving the same exposure to losses. Hence, it’s a bad idea.
Margin of safety
It can take a long time to recover from large losses; therefore, losing is a dangerous proposition. Consequences should always dominate probabilities. So, rather than wondering about what’s the likelihood of equity going down 50%, first focus on how would you react when you face those losses. The value of any security is proportional to the square of its earnings and is inversely proportional to its market value.
5 Replies to “Book Summary: The Intelligent Investor by Benjamin Graham”
15 Second Summary: “Index funds with dividend reinvesting leading to Dollar cost averaging are the best bet for individual investors.”
Decent summary, but the grammatical errors and sometimes nonsensical sentence structure made parts difficult to understand. The last sentence in the Margin of Safety section is particularly confusing.
Thanks. I fixed a few grammatical errors that did slip through. Regarding “nonsensical sentence structure”, can you please point out a few examples? I would love to fix them as well.
The statement that you pointed out “The value of any security is proportional to the square of its earnings and is inversely proportional to its market value.” was taken verbatim and I am not sure how can I simplify it.
Are you sure the last sentence isn’t supposed to be: “value tends to increase directly as the square of the earnings, but inversely the book value.”
Doesn’t that mean almost the same thing?