Successful investing does not need stratospheric IQ, insider information or luck for that matter. Instead what's needed is a sound intellectual method for making decisions combined with an ability to keep emotions from ruining it. In "The Intelligent Investor", Benjamin Graham presents such a framework together with logic that will help to keep your emotions under control. Arguably, his investing strategy has been one of the most successful one during the last hundred years. The impressive records, not just for Graham himself but also numerous of his disciples, are impossible to ignore. Among these disciples is the brightest shining star, Warren Buffet, who, at the time of this writing, is the 7th richest person in the world (Ranking dropped from 3rd due to the corona-virus pandemic).
Warren Buffet refers to this book as "by far the best book on investing ever written". Let us dive into the key points of this book.
Defining "Investing" and "Speculating"
Before we get into the key points, let us clarify the meaning of investment and how it is different from speculation. some definitions. Investing and speculation are interchangeably used and can be confusing for many people.
Investment is the action or process of investing money for profit. Investing promotes the safety of the principal at an adequate return. According to Graham, you should not try to get a 50% or 70% return of the principal in the short term. Instead, you should expect an adequate return of about 10%, for example.
Speculation, on the other hand, does the opposite of investing by trying to gain a very high return, usually in the short term, with the risk of loss. With speculation, the risk of loss is more than offset by the possibility of a substantial gain or other recompense.
1. Meet Mr. Market
Imagine that you own a part of a business that you paid $1000 for. Everyday, a certain bipolar person called Mr. Market calls you with an opinion about how much your part of that business is worth. Furthermore, he offers to buy your share or sell you an additional one on that basis. History has shown that Mr. Market's opinion (about how much your part of the business is worth) can be pure gibberish. For instance, back in March 2000, he estimated the value of your share to be $2600. Only one year later, in March 2001, he thought it was worth $500, even though the income of the company had increased by 50% and the profit increased by 20% during the same period. Should you let this guy decide how much your $1000 business is worth? Of course not!
One of Graham's core principles is that a stock is not just a ticker symbol combined with a price tag. It's an ownership with an interest in that business. Because Mr. Market is not always rational, the underlying value of the business can differ from the price he is willing to pay for it. In fact, it is frequently over or under priced as Mr. Market easily becomes over optimistic, or pessimistic. Graham advises you to invest only if you would feel comfortable to hold the stock in the future without seeing the fluctuating prices that Mr. Market presents you with.
However, for the investor who can keep his head cool, Mr. Market presents a great possibility of making money because he does not force you to strike a deal with him. He merely presents you with an opportunity of doing so! You should be happy to sell to him when he offers prices that are ridiculously high, and similarly, you should be happy to buy from him when he presents you with bargains. We must consider that, at the time when Graham wrote this book, people were far less bombarded with news, forecasts, stock quotes and so on, than we are today. Back in 1970s, Mr. Market arrived maybe once a day in the morning newspaper. Today, he wants to do business with us every time we open our phones. Just because Mr. Market visits you often, it does not mean that you must trade with him any more frequently than people had to in the 1970s. If he does not present you with an offer that meets your standard, ignore him and move on with your day!
2. How to invest as a defensive investor
There are 2 types of investors, according to Graham - The defensive (or passive) one and the enterprising (or active) one. Most people are better suited for the defensive strategy, as the time they are willing to dedicate to investing is limited. The defensive investor should create a portfolio with a mixture of bonds and stocks, of say 50% stocks and 50 % bonds. Note that how much you should devote to each asset category depends on your life situation and the current difference in the average yield of stocks versus bonds. Restore this allocation once or twice a year so that if stocks suddenly make up 60% of the portfolio compared to only 40% in bonds, sell the stocks and buy bonds until 50/50 is restored.
Invest a fixed amount of capital at regular intervals, out of your salary, for instance, or any other form of income that you have. This is called dollar-cost averaging and will allow for a fair average price of stocks and bonds. Most important of all, it will assure that you do not concentrate your buying at the wrong time. For the stock component of the portfolio, the defensive investor should aim for the following eight:
- Diversification in the companies being invested. 10 to 30 companies should be adequate. Also, make sure that you are not overexposed to a single industry.
- The companies should be large, which Graham defined as generating more than a $100 million in yearly sales. After inflation, this equals to approximately $700 million in today's value.
- Look for companies that are conservatively financed. Such a company has a so called "current ratio" of at least 200%. This means that its current assets are at least twice as big as its current liabilities.
- Dividends should have been paid to shareholders for at least the last 20 years.
- No earnings deficit in the last 10 years.
- At least 33% growth in earnings during the last ten years. This translates to a conservative growth of 2.9% annually.
- Do not overpay for assets. The price of the stock should not be higher than 1.5 times its net asset value. The net asset value can be calculated by subtracting the company's liabilities from its assets.
- Do not overpay for earnings. Do not let the P/E ratio be higher than 15 when using the last 12-month earnings.
An alternative today is to invest in an index fund, which by definition, will have returns similar to the average of the market. If you are satisfied with an average reward through your investing, you only need two of these takeaways. However, if you thirst for more, continue reading.
3. How to invest as an enterprising investor
As it is easy for the defensive investor to get the average return of the market, it would seem a simple matter to beat the market by devoting a little more time to investing than these average investors do, right?
To be an enterprising investor and to beat the market, it is much more demanding than such a logic suggests. It requires patience, discipline, an eagerness to learn and a lot of time. Many professionals and private investors alike are not suited for this. It is easier to fall victim to the price quotations of Mr. Market than one could possibly imagine. The following two statements are from the early 2000s, at the peak of the dot com bubble, made by the chief investment strategist at two large mutual funds:
"It's a new world order ... We see people discard all the right companies, with all the right people, with the right visions, because their stock price is too high. That's the worst mistake an investor can make."
"Is the stock market riskier today than two years ago, simply because the prices are higher? The answer is no!" - But the answer is actually YES!
Of course, both statements turned out to be costly for the investors who put their money into these funds. Since the profit that companies can earn are finite, the price the intelligent investor should be willing to pay for these companies must also be finite. Price is truly an important factor for the enterprising investor. Just like the market tends to overvalue companies when they are growing fast or are glamorous for some other reason, it tends to undervalue the ones with unsatisfactory development. The intelligent investor should, therefore, try to avoid the so called "growth stocks" as much as possible. Why? Simply because the investment decision is based relatively on future earnings, and future earnings are less reliable than current valuations. If you, on the other hand, can find a company which is valued lower than its net working capital, you essentially pay nothing for all the fixed assets, such as buildings, machinery, goodwill, etc. The net working capital can be calculated by subtracting total liabilities from current assets. Such companies were proven truly profitable during Graham's investment career. Unfortunately, they are rare today except during tough bear markets.
Luckily, Graham suggests as additional method of finding investments for the enterprising investor. These criteria are similar to the ones that the defensive investors should use but the constraints are looser, allowing for the enterprising investor to consider more companies. Note that there is no constraint at all regarding company size. Also, some diversification should be applied, but the number of companies held is not carved in stone for the active investor. In analyzing a company, the enterprising investor should also study its annual financial reports. Graham has written a whole book on this subject called "The Interpretation of Financial Statements". This will be another article for another day.
4. Insist on a margin of safety
There is one risk that no careful consideration can truly eliminate: the risk of being wrong. You can, however, minimize this risk. To do this, you must insist that every investment you make has a "margin of safety". As mentioned before, the price and value of a company is not always the same. When the price is at most 2/3 of its calculated value, the investor has found a company with enough margin of safety. You would not build a ship that will sink if 31 Vikings had boarded it, if before you were told that only 30 Vikings would be boarding. Neither should you invest in stock you think is worth, say, $31 if it is currently priced at $30. It might be your calculation is wrong. In the first case, a group of angry (and wet) vikings might hunt you down. In the second, you might postpone your financial freedom by a couple of years. I do not know which situation that I'd consider to be worse: use margins of safety!
A formula used in the book can give you a heads up regarding what the value of a company is, and therefore, if it can be bought with a margin of safety.
The growth rate should be equal to the expected yearly growth rate of earnings for the next 7 to 10 years. Here is how much the three largest companies of the S&P are worth according to the formula in Sept 2018:
| Company | Share Price | Value | Expected Growth |
|---|---|---|---|
| Apple | $220 | $371 | 5.8% |
| Microsoft | $108 | $72 | 21.5% |
| Amazon | $1971 | $2115 | 74% |
Note that we can use the formula backwards too, to trace how much these companies must grow in the coming 7 to 10 years, for today's stock prices to be rational. There's a huge discrepancy here! Amazon is expected to grow at 74% per year according to its stock price, while Apple is expected to grow at a mere 5.8%. Do you think this is reasonable?
5. Risk and reward are not always correlated
According to academic theory, the rate of return which an investor can expect must be proportional to the degree of risk that he is willing to accept. Risk is then measured as the volatility of the returns on the investment. Meaning, how much it has differed historically from its expected value. Graham does not agree with this statement. Instead, he argues that the price and value of assets are often disconnected. Therefore, the return that an investor can expect is a function of how much time and effort he brings in his pursuit of finding bargain assets. The minimum return goes to the defensive (or passive) investor, while the maximum goes to the enterprising investor who exercises maximum intelligence and skill. Consider this: It's 4 am in the morning and you've been out drinking on the streets of Moscow together with your friends. You decided that it's too early to call it a night, and therefore you end up in the more obscure parts of town. At a particularly ambiguous bar, you're approached by a man who asks, "Do you want to play a game?".
"Well, of course, games are fun!" your bravest, least sober friend replies. The man puts a revolving gun in front of you loaded with a single bullet. "I'll give you $10,000 if you dare to take a shot, Russian Roulette". Your drunk friend reaches out for the gun, but you stopped him. "I think we'll pass on this one", you politely informed the man. "I thought so .. ", he replies, "What about $100,000 for taking two shots?"
Now this story represents the academic way of demanding a higher potential reward for taking a higher risk. In the first offer, you were to receive $10,000 reward at a 16.7% risk of blowing your brains out. In the second offer, the reward is a $100,000 reward because the risk of putting a hole through you head has increased to 33.3%. Seems logical, but stock market investing does not have to be like that! Remember that price and value are not the same. When you buy a company at 60 cents on the dollar, you have a great potential reward, and a low risk. Furthermore, if you can find another company that you can buy at 40 cents on the dollar, you have found a better potential reward, combined with an even lower risk! How could anyone in their right mind argue that it's riskier to buy a dollar at the price of 40 cents than to buy a dollar at 60 cents, just because the potential reward is higher?
A quick recap of the takeaways:
- The market tends to be over optimistic and too pessimistic from time to time. Do not let this influence what you think the true value of your assets are. Instead, see it as a business opportunity, where you get to deal with a person who has no idea of what he is doing!
- The defensive investor should go for a diversified portfolio of stocks and bonds, where the stock category consists of primarily low-priced issues.
- The enterprising investor should also aim for stocks that show lower price tendencies. If he can find a company that is trading below its net working capital, he might have found his El Dorado.
- The intelligent investor should insist on a margin of safety when acquiring an asset.
- RISK and REWARD are not necessarily correlated.
What do you think of Graham's advise? Are they still as applicable today as they were back in the 1970s. Share your thought and comments below.
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