The Intelligent Investor: Benjamin Graham

If you have built castles in the air, your work need not be lost; that is where they should be, now put the foundations under them.

Henry David Thoreau, Walden

Definition of an investment:

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.  Operations not meeting these requirements are speculative.”

  1. You must thoroughly analyze a company, and the soundness of the underlying business, before buying its stock
  2. You must place a priority on protecting your principal from permanent loss
  3. Seek a reasonable return on your investment.

 

Circle of Competence:

“the aggressive investor must have a considerable knowledge of security values- enough, in fact, to warrant viewing his security operations as equivalent to a business enterprise”

1. See yourself as a minority owner in the business and conduct your security operations with a high degree of professionalism.

“The first rule of intelligent action by the enterprising investor must be that he will never embark on a security purchase which he does not fully comprehend and which he can not justify by reference to the results of his personal study or experience.” p.5

1. Do your homework.  Always know more about the situations you invest in than the market does.

Margin of Safety:

“Investment also depends on the future and depends on future developments for its vindication.  But the term is meaningless unless it implies that the investor seeks to obtain full present value for his money, that he judges this value in light of the past record and experience, and that he deals with the future more as a hazard to be guarded against than as a source of profit through prophecy.” p.12

“Investment requires and presupposes a margin of safety to protect against adverse developments.” p.12

1.  In trading, as with most forms of speculation, there is no margin for error.  You are either right or wrong.

Market Timing

p.13

Growth Investing

“With respect to our fourth method, it is appropriate for investors to select their securities-especially common stocks-with an eye to their long-term prospects.  A well chosen company can triple its earnings and quadruple the price of its stock over a period of years.” p.14

“Select stocks with the best prospects, if you wish, but take care that you are not paying too much for the promise of the future.” p.14

Undervalued Issues

“unfavorable circumstances are present-as actual developments, or perhaps as prospects-and in both cases the response may be excessive and thus create a genuine opportunity for the intelligent and courageous investor.” p.15

“when an individual company or industry begins to lose ground in the economy, Wall Street is quick to assume that its future is entirely hopeless and it should be avoided at any price.  The two types of reasoning are equally fallacious.” p.15

Graham on professional conduct:

“There is another field of accomplishment for the intelligent investor- and that is for him to act in an alert and businesslike fashion after he has become a security owner.” p.17

“At that time all the real money in investment will have to be made- as most of it has been in the past- not out of buying and selling but out of owning and holding securities, receiving interest and dividends thereon, and benefiting from their long-term increases in value”

 

 Stock-Market Fluctuations:

“Intelligent investment is more a matter of mental approach than it is of technique.  A sound mental approach toward stock fluctuations is the touchstone of all successful investment under present-day conditions.” p.22

“Nowadays the situation is different.  No one believes seriously that the common-stock investor can remain indifferent to price fluctuations.” p.22

“Clearly the success of his investment program in common stocks must depend in great part on what happens ultimately to their prices.  But how far must he commit himself to concern with the market’s conduct?  By what market tests should he consider that he has been successful or not?  Certainly not by short-term or minor fluctuations, for this attitude would make him indistinguishable from the stock trader.” p.23

“He is neither a smart investor nor a richer one when he buys in an advancing market and the market continues to rise.  That is true even when he cashes in a goodly profit, unless either (a) he is definitely through with buying stocks- an unlikely story- or (b) he is determined to reinvest only at considerably lower levels.” p.24

“he was entitled then to disregard the market decline as a temporary vagary of finance, unless he had the funds and the courage to take advantage of it by buying more on the bargain basis offered.” p.26

  1. Ignore short term or minor market fluctuations unless they present a buying opportunity.

 

Investment success:

“investment success may be judged by a long-term or secular rise in market price, without the necessity of sale.  The proof of that achievement lies in the price advances made between successive points of equality in the general market level.  In most cases this favorable price performance will be accompanied by a well-defined improvement in the average earnings, in the dividend, and the balance sheet position.” p.25

“A price decline is of no real importance to the bona fide investor unless it is either very substantial- say, more than a third from cost- or unless it reflects a known deterioration of consequence in the company’s position.” p.25

  1. Investment success: favorable price performance accompanied by clear improvement in the average earnings, in the dividend, and the balance sheet position.
  2. It is normal to see a paper loss of 50% in a well defined bear market without any permanent changes in the business condition.
  3. Graham advises that we should analyze our holdings in this scenario, but if the results are reassuring and we’re liquid, we should buy more.
  4. Price decline is not important unless it is very substantial or reflects a deterioration in the business.

 

Value Approach:

“By shifting his emphasis from price movements as such to their effect on the level of values the investor can retain his original and proper status as the buyer of sound securities and at the same time react intelligently to the recurrent fluctuations of the stock market” p.31

  • Focus on value and react intelligently to stock market volatility.
  • Value Investors can buy intelligently during periods of pessimism and low prices.  Conversely, then can sell during periods of optimism and high prices.  In this capacity, they are acting as businessmen seizing clearly evident investment opportunities.  What they don’t do is make predictions about market movements.  According to Graham, that is for prophets.

 

“His role is not that of a prophet but of a businessman seizing clearly evident investment opportunities.  He is not trying to be smarter than his fellow investors but simply trying to be less irrational than the mass of speculators who insist on buying after the market advances and selling after it goes down.  If the market persists in behaving foolishly, all he seems to need is ordinary common sense in order to exploit its foolishness.” p.31

New Issues Generally

“There are two reasons for this double caveat.  The first is that new issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance.  The second is that most new issues are sold under “favorable market conditions” –which means favorable for the seller and consequently less favorable for the buyer.” p.80

  • initial public offering
  • bond refinancing
  • convertible issues

 

“An elementary requirement for the intelligent investor is an ability to resist the blandishments of salesman offering new common-stock issues during bull markets.  Even if one or two can be found that can pass severe tests of quality and value, it is probably bad policy to get mixed up in this sort of business.”

  1. Resist the influence or “blandishments” of salesman offering new common stock issues during bull markets.
  2. The form of the security does not make it attractive or unattractive.  Focus on the facts surrounding the individual issue.
  3. New issues have special salesmanship behind them, which calls for a special degree of sales resistance.
  4. New issues are generally sold under favorable conditions for the seller, thus less favorable conditions for the buyer.
  5. Some of these issues may prove excellent buys–a few years later, when nobody wants them and they can be had at a fraction of their true worth.

 

Portfolio Policy – Growth Approach

p.92

  1. Stocks with good records and good prospects sell at correspondingly high-prices
  2. The investor may be right in his judgement of their prospects but may not fare well because he has paid in full or perhaps overpaid for the expected prosperity.
  3. Unusually rapid growth cannot keep up forever; when a company registers a brilliant expansion, its very increase in size makes a repetition of its achievement more difficult.  The growth curve flattens out or turns downward.

 

p.93

  1. No matter how enthusiastic the investor may feel about the prospects of a particular company, he should set a limit upon the price that he is willing to pay for such prospects.

 

Portfolio Policy – Bargain Issues

“The market is always making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.  Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels.  Thus we have two major sources of undervaluation: (a) currently disappointing results, and (b) protracted neglect or unpopularity” p.97

  1.   Graham offers too methods of valuation for determining if a business is undervalued: 1) estimating future earnings and multiplying them by an appropriate PE. 2) Value to a private owner test.

 

“By way of exception, any company that has established itself as a growth stock is not ordinarily considered as “secondary” p.99

Rules for Investment

“The aggressive investor must have a considerable knowledge of security values–enough, in fact, to warrant viewing his security operations as equivalent to a business enterprise.  There is no room in this philosophy for a middle ground, or a series of gradations, between passive and aggressive status.” p.105

“The enterprising investor may properly embark upon any security operation for which his training and judgment are adequate and which appears sufficiently promising when measured by established business standards.” p.106

Common Stock Analysis

“The reason why the analyst devotes himself so diligently to studying and arranging the past figures is largely because they are there to work upon.  With them he is on solid ground–ground that responds to his skillful cultivation.  He can work out ratios; he can point out trends; he can even throw out items which the accountants properly put into the income account but which the analyst asserts are not part of the “normal earning power.” p.128

“If follows that a prime test of the competent analyst is his power to distinguish between important and unimportant factors and figures in a given situation.” p.128

Earning-Power Estimates

  1. General Long-Term Prospects: these are valid if they are not carried too far
  2. Management: very successful companies tend to have exceptional managers, but this is typically already reflected in the stock prices and can lead to over-valuation
  3. Financial Strength and Capital Structure: understand the funding structure; ratio of bonds & preferred to common.
  4. Dividend Record: an uninterrupted record of dividend payments going back over many years reflects high quality in the business.
  5. Current Dividend Rate: see p.132 – 133
  6. Filter out non-recurrent earning from the income account.
  7. Industry Analysis: when future developments are clearly under-appreciated by the current market and conclusions can be drawn with a high degree of confidence, it affords a sound basis for investment decisions. p.135

 

Stock Selection for the Enterprising Investor

“The aggressive investor should obtain the best available estimates of what a number of stocks are worth, apart from their market price.  He will then make his choices from among those which are selling at the largest discounts from their indicated values.”

“These values will be based chiefly upon the expected average future earning power, capitalized at a rate which reflects the quality of the issue in view.” p.146

 

 

 

 

 

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