The Intelligent Investor
When Benjamin Graham first started working on Wall Street in 1914, most investing took the form of railroad bonds. Stocks and shares in companies as we know them today were aimed at insiders rather than the general public and were seen as highly risky investments.
Graham’s focus on the value of companies showed it was possible for people to invest wisely without getting swept up in market hysteria.
The Intelligent Investor is essentially about the difference between investment and speculation, between quoted stock prices and the underlying or real value of the companies behind them.
This ‘value’ investing approach requires a long-term horizon, the ability to tune out market noise in the interim and having enough confidence in your investment choices that you will not be rattled by a correction, crash or recession.
Graham repeats the distinction between investing and speculation given in his earlier book Security Analysis: ‘An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.’
With speculation or ‘trading’, he notes, you are either right or you are wrong, the latter often disastrously so. An investor, in contrast, considers themselves a part-owner in a large enterprise, looking mainly to its results and the quality of its management.
Any stock purchase that you do quickly, when you do not want to ‘lose out on a great opportunity’ is probably speculation driven by the emotions of the market.
The only time an investor should take account of the ups and downs in the market is when they choose to buy a stock they had their eye on anyway, and can pick it up at a low price if market sentiment is bearish.
How to find value
Graham reflects that the long-term prospects of a company can only ever be an educated guess. If those prospects are clear enough, then they will already be reflected in the company’s stock price. This is why ‘growth’ stocks are often expensive, and why there is rarely good value to be found in the ‘sexy’ companies that everybody likes.
Better, Graham believed, to invest in companies without dramatic predictions attached to them, ‘boring’ companies that are overlooked and undervalued.
He noted that when a company loses ground against the overall market, speculators will cast a pall of gloom over its stock and write it off as hopeless. The intelligent investor, however, will see that this is an overreaction.
Graham observes that the real money to be made in the stock market is not in the buying or selling, but in having the discipline to hold and own, earning dividends and waiting for perceptions of the value of a company to align with reality.
To do this obviously requires a degree of psychological strength, and indeed Graham observes that ‘intelligent investment is more a matter of mental approach than it is of technique’.
The secret of investing success, Graham says, could be summed up in the term ‘margin of safety’. In technical terms, this means evidence of a company’s earnings above what is required to service its interest on debt, particularly in the event of a significant sales or market decline.
The intelligent investor always looks for this buffer because it means they do not need to have accurate estimates of a company’s future.
There are two ways to invest, Graham notes: the predictive approach, or how well you think a company will do within its market given its management, products and so on; and the protective approach, which involves looking only at the statistics of a company, such as the relationship between selling price and earnings, assets and dividend payments. Value investors favour the second because it is based ‘not on optimism but on arithmetic’.
The conventional wisdom is that if you are prepared to take higher risks you will get higher returns. Graham rejects this, saying that high returns are not necessarily related to risk, but to putting more time and effort into your investing. His pointers include:
- Look for companies that have a regular dividend payment record going back 25 years or more.
- Do not invest in companies with price to earnings ratios of more than 10.
- When looking at a company’s annual report, separate out non-recurrent or ‘one-off’ profits and losses from the normal operating results.
- Don’t invest in an ‘industry’, invest in companies.
Graham writes that ‘investment is most intelligent when it is most business like’. People in the financial world too easily forget the basic fact of investing: that it is about companies, and buying a stock means part-ownership of a ‘specific business enterprise’.
Trying to make money beyond earnings related to a firm’s performance is fraught with danger.
Copyright © Tom Butler-Bowdon, 2017. The above is an abridged extract from 50 Economics Classics by Tom Butler-Bowdon, published by Nicholas Brealey Publishing.