Library / Investment Classics
Date of review: January 2019
Book author: Benjamin Graham
Вook published: 1949
Book author: Benjamin Graham
Вook published: 1949
''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
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.
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.
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.
I summarise the most important points from the book below
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'.
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'.
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 superior results is harder than it looks'.
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 superior 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
• 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).
• 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.
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'.
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.
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.
Key misconceptions about Graham's approach
Misconception 1. Graham's main advice is to buy cheap stocks.
Indeed, Graham put an emphasis on the price paid relative to company's assets (the value of which can be calculated relatively easy). However, he also wrote the following: "A caution is needed here. A stock does not become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years". Graham stressed the importance of price paid for the stock and strongly disagreed with the logic that "no price is high for a great company and no price is low enough for a bad company". Another thing to bear in mind is that the last edition of the book was written during the peak of the market after a 20-year bull market which took DJIA over 4x higher since its previous low in 1949 to its local peak in 1965. Obviously, there was a lot of euphoria in the market with little consideration paid to the fundamentals of the businesses and prices paid for them.
Misconception 2. Graham favoured mature companies with little growth.
Graham cautioned against making overly optimistic forecasts too far into the future, but he did not advise against buying growth stocks. In fact, he even suggested using a short formula to value growth stocks which is Value = Current (Normal) Earnings X (8.5 plus twice the expected annual growth rate). According to Graham, growth rate should cover a period over the next 7-10 years.
Misconception 3. Graham's method is a pure number crunching based on financial accounts.
In Chapter 11, Graham writes 'More so than in the past, the progress or retrogression of the typical company in the coming decade may depend on its relation to new products and new processes, which the analyst may have a chance to study and evaluate in advance.
Thus there is doubtless a promising area for effective work by the analyst, based on field trips, interviews with research men, and on intenstive technological investigation on his own. There are hazards connected with investment conclusions derived chiefly from such glimpses into the future, and not supported by presently demonstratable value.
Yet there are perhaps equal hazards in sticking closely to the limits of value set by sober calculations resting on actual results. The investor cannot have it both ways. He can be imaginative and play for the big profits that are the reward for vision proved sound by the event; bt then he must run a substantial risk of major or minor miscalculation. Or he can be conservative, and refuse to pay more than a minor premium for possibilities as yet unproved; but in that case he must be prepared for the later contemplation of golden opportunities forgone'.
Thus there is doubtless a promising area for effective work by the analyst, based on field trips, interviews with research men, and on intenstive technological investigation on his own. There are hazards connected with investment conclusions derived chiefly from such glimpses into the future, and not supported by presently demonstratable value.
Yet there are perhaps equal hazards in sticking closely to the limits of value set by sober calculations resting on actual results. The investor cannot have it both ways. He can be imaginative and play for the big profits that are the reward for vision proved sound by the event; bt then he must run a substantial risk of major or minor miscalculation. Or he can be conservative, and refuse to pay more than a minor premium for possibilities as yet unproved; but in that case he must be prepared for the later contemplation of golden opportunities forgone'.
Most interesting sections of Intelligent Investor
Warren Buffett recommends two most important chapters - Chapter 8 (The Investor and Market Fluctuations or simply 'Mr Market') and Chapter 20 (Margin of Safety)
I certainly agree. I would also add that I found the following chapters quite useful:
- Chapter 2: on inflation, in which he, unsurprisingly, makes arguments in favour of stocks vs bonds, but unlike some modern commentators he cautions against buying stocks at any price or setting expectations too high for stocks just because inflation is picking up. Just like Buffett, Graham views gold as a relatively poor hedge against inflation.
- Chapter 11: factors driving capitalisation rate and formula for cap rate for growth stocks);
- Chapter 14 and 15: provide criteria for selecting stocks for more conservative and more aggressive portfolios.
- Chapter 19 (Shareholders and Managements) is also quite useful as it discusses (among other things) appropriate dividend policy depending on the stage of growth of a company.
Last thought I would like to share is a little piece of advice: sometimes bookshops promote the first edition, but I suggest reading the latest (4th) edition without any commentary by other authors. If you cannot buy a clean version, then just read Graham's chapters and skip the comments. You will save time and enjoy the original message.
You can also find a link to a famous 1984 article that Warren Buffett wrote to explain the benefits of Graham's approach. In the article called "The Superinvestors of Graham-and-Doddsville" Buffett provided the outstanding track record of a select group of investors most of whom had been students of Ben Graham.
- Chapter 2: on inflation, in which he, unsurprisingly, makes arguments in favour of stocks vs bonds, but unlike some modern commentators he cautions against buying stocks at any price or setting expectations too high for stocks just because inflation is picking up. Just like Buffett, Graham views gold as a relatively poor hedge against inflation.
- Chapter 11: factors driving capitalisation rate and formula for cap rate for growth stocks);
- Chapter 14 and 15: provide criteria for selecting stocks for more conservative and more aggressive portfolios.
- Chapter 19 (Shareholders and Managements) is also quite useful as it discusses (among other things) appropriate dividend policy depending on the stage of growth of a company.
Last thought I would like to share is a little piece of advice: sometimes bookshops promote the first edition, but I suggest reading the latest (4th) edition without any commentary by other authors. If you cannot buy a clean version, then just read Graham's chapters and skip the comments. You will save time and enjoy the original message.
You can also find a link to a famous 1984 article that Warren Buffett wrote to explain the benefits of Graham's approach. In the article called "The Superinvestors of Graham-and-Doddsville" Buffett provided the outstanding track record of a select group of investors most of whom had been students of Ben Graham.
I would like to finish this review with a direct quote from one of my most favourite parts of the book:
"Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in your enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.
The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgement and inclination…Basically, 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".
If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in your enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.
The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgement and inclination…Basically, 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".