Comprehensive Summary of the One of Best Classical Book on investing : The Intelligent Investor by Benjamin Graham

 

''To me, Ben Graham was far more than an author or a teacher. More than any other man except my father, he influenced my life'': Warren Buffett

 In the world of investing, Intelligent Investor has almost a Bible status and is a must-read book for any aspiring investor. However, most people first hear the key concepts of Graham and read the book through such prism. I think Intelligent Investor is not fully understood because of that. For example, Graham has not advocated to buy statistically cheap stocks without taking into consideration more qualitative factors. However, this is what many people believe to be the key message of the book.

Graham graduated from Columbia University in 1914 and started on Wall Street first as a clerk at a bond-trading firm, moving to an analyst role and later becoming a partner. From 1936 until his retirement in 1956, his Graham-Newman Corp. gained about 20% returns per year (at least 14.7% after-fees) compared to 12.2% for the broader stock market. Graham also taught Security Analysis at Columbia University where a few legendary investors were among his students.

1. 'Every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise

In other words, stock analysis should be focused on specific details of the business you own rather than on trying to forecast what the market will do in the future and whether now is the time to buy stocks. 'Investment is most intelligent when it is most businesslike.

It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings'. Graham provides 4 key business principles to follow:

(1) Know what you are doing – know your business.

(2) Do not let anyone else run your business, unless A. you can supervise his performance with adequate care, and B. you have unusually strong reasons for placing implicit confidence in his integrity and ability.

(3) Do not enter an operation unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. 'In particular, keep away from ventures in which you have little to gain and much to lose'.

(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 – even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right'.

2. The fact that a stock is listed on an exchange and is traded daily should not force investor to take action based on its quotations

But rather, it gives him an option to buy when the price is below the intrinsic value and sell when quoted prices are extremely high relative to the fair value.

Graham's two paragraphs on Mr Market (in Chapter 8) send a strong message on how best to deal with market volatility and market moves in general. 'Price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies'.

3. Risk

"Loss of value which is either realised through actual sale, or is caused by a significant deterioration in the company's position – or, more frequently perhaps, is the result of the payment of an excessive price in relation to the intrinsic worth of the security". Price paid relative to underlying profits (value) is a very important driver of risk you take – low price paid even for a below-average business may more than offset the risks (and vice versa).

4. Protection is more important than prediction

The first approach is quantitative aimed at "getting ample value for the money in concrete, demonstrable terms…not willing to accept the prospects and promises of the future as compensation for a lack of sufficient value in hand". The second approach (qualitative) "emphasises prospects, quality of management, other intangibles".

5. Why so many investors deliver below-market results

Graham provides two main reasons. Firstly, he points out rising efficiency of markets. As thousands of analysts study the same stocks, their prices start to better reflect underlying conditions and future performance becomes mostly driven by new developments which are impossible to predict in advance. Essentially, performance of well researched stocks becomes random (Graham compares this to a bridge tournament played by top players who can also see each others' cards).

The second reason has to do with a "flaw in the basic approach to stock selection". Investors "seek the industries with the best management and other advantages…They will buy into such industries and such companies at any price, however high, and they will avoid less promising industries and companies no matter how low the price of their shares. This would be the only correct procedure if the earnings of the good companies were sure to grow at a rapid rate indefinitely in the future, for then in theory their value would be indefinite. And if the less promising companies were headed for extinction, with no salvage, the analysts would be right to consier them unattractive…Extremely few companies have been able to show a high rate of uninterrupted growth for long periods of time. Remarkably few, also, of the larger companies suffer ultimate extinction'"

Temperament is another reason which Graham brings up as a challenge. As he puts it, "only a small minority of [investors] would have the type of temperament needed to limit themselves so severely to only a relatively small part of the world of securities. Most active-minded practitioners would prefer to venture into wider channels".

Graham also highlights the importance of patience to achieve strong results especially when buying 'bargain' stocks. "Can one really make money in 'bargain issues' without taking a serious risk? Yes indeed, if you can find enough of them to make a diversified group, and if you don't lose patience if they fail to advance soon after you buy them. Sometimes the patience needed may appear quite considerable'.

At the end of his book, Graham shares this interesting thought: 'To achieve satisfactory investment results is easier than most people realise; to achieve superiror results is harder than it looks'.

6. Stock selection for the defensive investor

• Adequate size
• Strong financial condition
• Earnings stability (no losses in the past 10 years)
• Dividend record (uninterrupted payments for the past 20 years at least)
• Earnings growth (minimum 1/3 increase in EPS in the past 10 years using 3-year averages at the beginning and end)
• Moderate PE (not more than 15x average 3-year earnings)
• Moderate ratio of price to assets (not more than 1.5 or a product of PE and P/B should not be more than 22.5)
• 10-30 stocks in portfolio ('adequate diversification')
• Other considerations. Investors shold select 'large, prominent and conservatively financed' companies. Investors should impose some limit on the price they will pay – 25x for average earnings over the past 7 years and 20x for the past 12 months

7. Stock selection for the enterprising investor

Secondary companies – unpoplular companies with good track record
• Financial condition: (a) current assets at least 1.5x higher than current liabilities; and (b) debt not more than 110% of net current assets
• Earnings stability: no loss in the last 5 years
• Dividend record: some current dividend
• Earnings growth: earnings in Year 5 higher than in Year 1 (over the last 5 years)
• Price: Less than 120% of net tangible assets. 'Low' PE multiple (e.g. 10x or less). Importantly, Graham did not specify the exact level of PE that enterprising investor should be looking for specifically, just emphasised the benefits of buying stocks with low PE multiples (mainly low expectations, less speculative interest and, consequently, lower risk)

Graham also discusses his approach to buying 'bargain stocks', or net-current-asset stocks – those selling below their net working capital (Working capital less financial debt which means that investors get fixed assets of the business for free). When he ran his Graham-Newman partnerhship – he was looking to buy companies at a cost of less than their book value in terms of net-current-assets alone. He typically paid 2/3 or less for such companies and held at least 100 of such companies to achieve adequate diversification.

Graham also shares techniques applied by the Graham-Newman partnership which included Arbitrage, Liquidations, Related Hedges (buying convertible bonds and selling common stocks into which such bonds could be exchanged), Net-Current-Asset Issues, Control operations (full acquisitions of businesses).

8. Fair Price of a growth stock = Current (Normal) Earnings X (8.5 + twice the expected annual growth rate)

Growth period should be about 10 years. So, if a company is growing at 10% a year, its stock could be worth 28.5x PE.

Factors affecting Capitalisation rate (which is equal to Discount rate less growth rate, or inverse of a PE multiple) are more qualitative than quantitative, according to Graham. This is contrary to other studies which focus more on quantitative ones (e.g. Beta, Equity risk premium, Risk free rate). As per Graham, they include General Long-Term Prospects, Management, Financial Strength and Capital Structure, Dividend Record, Current Dividend Rate.

9. Graham is against looking for one simple formula for generating exceptional investment

He provides results of applying various formulae which show that most of them work only in a short period of time (except, perhaps, for Dollar Cost Averaging which he considers appropriate for less sophisticated investors (Defensive Investor as he refers to them). "Any approach to moneymaking in the stock market which can be easily described and followed by a lot of people is by its terms too simple and too easy to last. Spinoza's concluding remark applies to Wall Street as well as to philosophy: "All things excellent are as difficult as they are rare".

10. On when to buy stocks

On when to buy stocks – 'It is far from certain that the typical investor should regularly hold off buying until low market levels appear, because this may involve a long wait, very likely the loss of income, and the possible missing of investment opportunities.

On the whole, it may be better for the investor to do his stock buying whenever he has money to put in stocks, except when the general market level is much higher than can be justified by well-established standards of value. If he wants to be shrewd he can look for the ever-present bargain opportunities in individual securities'.

11. Signs of market excess

(1) a historically high price level, (2) high price/earnings ratios, (3) low divided yields against bond yields, (4) much speculation on margin, and (5) many offerings of new common-stock issues of poor quality'.

However, Graham also warns that there is no way of knowing when the market has bottomed or peaked with absolute certainty, so these 5 criteria should be viewed more as guiding principles rather than firm rules.