The Intelligent Investor by Benjamin Graham is the definitive book on value investing. The book is religiously read edition after edition, is cited and practised by legions of fanatic value investors the globe over. Its principles are as valid and relevant today as it ever were ever since its first publication in 1949.
“…many investors, when asked to describe their investment philosophies, describe themselves as value investors, not just because of its winning track record, but also because of its intellectual and academic backing. “– Aswath Damodaran, Professor of Finance at the Stern School of Business at NYU
What does the book aim to achieve?
The purpose of the book as put forth by the author himself is to serve as an introduction in a form suitable for the layman, the adoption and execution of an investment principle and strategy. The book focuses more on investment principles and investor attitude than in the techniques of analysing securities which he covered extensively in his other book, Securities Analysis. The author makes it clear that the book is meant only for investors and not meant for speculators or traders.
Mr Graham invokes the famous statement – a bit cheekily perhaps – “Those who do not remember the past are doomed to repeat it”. Accordingly, the book spends considerable time looking back at the historical patterns of financial markets stretching decades. The reasoning being that one cannot be knowledgeable about the stock market until one knows how they have performed under varying conditions – some of which a reader will likely come across.
The Intelligent Investor: Summary
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”Benjamin Graham, The Intelligent Investor, Chapter 1 – Fourth edition
The author posits that the risks that are inherent in stocks are inseparable from the opportunities of profits, both of which must be allowed for in the investor‘s calculation. Stocks should be bought using his seven criteria for stock selection so as to ensure safety of principal and an adequate return. He declares everything else to be speculation.
The author, in his veritable wisdom, also accounts for human nature by creating a distinction between a defensive (conservative) investor and the more aggressive (enterprising) investor. He gives the latter some leeway so as to allow the enterprising investor to seek more return for more risk.
The Intelligent Investor’s seven criteria of stock selection
- Adequate size
- Strong financial position
- Earnings stability
- Dividend record
- Earnings growth
- Moderate P/E ratio
- Moderate price-to-book ratio
According to Mr Graham, a stock’s price to earnings ratio should not exceed 15, and the price-to-book ratio (net worth) should not be more than 1.5. An easy to way find if a stock meets these two criteria is to use the Graham Number. Theoretically, any stock price below this number is considered undervalued. The formula is as follows:
√22.5 x (earnings per share) x (book value per share) = Graham’s Number
These two rules present a natural stock screening tool for investors to zero in on stocks that are undervalued. Then you can further drill down to the good ones as opposed to just cheap stocks using the other five criteria.
He then goes on to add that a portfolio should consist of 30 or so of carefully chosen stocks using these criteria.
Naturally, if you’ve applied these criteria, then you’ll have a potential list of undervalued but solid stocks. He recommends investors put their capital into such stocks. This approach to stock investment is better known as value investing.
Mr Graham suggests similar but less severe criteria for the enterprising investor. He foregoes adequate size as a criterion for the enterprising investor because he argues smaller stocks afford enough safety if bought carefully and on a well-diversified basis.
The Intelligent Investor’s weaknesses
Of course, there are a few detractors who’ve pointed out weaknesses in this approach to investing.
- The biggest criticism of value investing is called the value trap. There is often a long wait between when an undervalued stock actually reaches its fair value. In some cases, they may never do so. That’s the value trap.
- The book doesn’t cover many industries outside of utilities and manufacturing such as finance.
- It doesn’t cover growth stocks adequately.
- The comparisons used as examples are from a long bygone era.
Of course, his detractors are not just limited to the ones mentioned here, but even under such scrutiny, if this is what his detractors have come up with, it is a great testament to Mr Graham’s book.
Margin of safety as a central concept of investing
“…to have a true investment there must be a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.”– Graham, Benjamin (The Intelligent Investor)
A margin of safety in investing is the difference between the intrinsic value of a security and its market price. That difference or margin provides a cushion for investors. Please note that a margin of safety only guarantees that an investment has a better chance of profit than loss, and not that loss is impossible.
He had his own way of calculating the margin of safety. According to him, it is the difference between the percentage rate of the earnings on the stock at the price you pay for the stock and the rate of interest on bonds, and that margin of safety is the difference which would absorb unsatisfactory developments.
The original formula: Intrinsic value = [EPS × (8.5 + 2g) × 4.4]/Y
where EPS is earnings per share, 8.5 is the PE for a no-growth or zero growth company, g is the expected annual growth rate, 4.4 was the rate on high-grade corporate bonds (NYSE) at the time, and Y is the current yield on AAA-rated corporate bonds.
The margin of safety is the difference between this intrinsic value and the stock price.
Why do you need a margin of safety?
The author put it best when he wrote, “Fair weather stocks bought at fair weather prices are destined to suffer disturbing price declines when the horizon clouds over – and often sooner than that.”
The idea of margin of safety is doubly pertinent when buying stocks that are undervalued or are available at a bargain. Often the case with these stocks is the fact that the future neither looks too promising nor too grim. In such cases, the margin of safety applied will have served its purpose.
Interestingly, there also exists a close relation between the concept of diversification and the margin of safety. Because even if an investor has a reasonable margin of safety, a particular stock may still work out against the investor. For the margin only guarantees that he has a better chance of profit than loss, and not that loss is impossible.
But as the number of stocks in his portfolio selected on that basis increases, an investor can be more certain that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance underwriting business.
Final thoughts on the book: The Intelligent Investor
The book is a must-read for all investors. It is a way of looking past the stock ticker prices and focusing on the company behind the stock.
If you cannot be bothered to read this book before investing in equities, a mutual fund or an index fund may just be what you need.
Perhaps to temper expectations of enthusiastic beginners, as the final words in his book he wrote: “To achieve satisfactory investment returns is easier than most people realize; to achieve superior results is harder than it looks.”
Don’t fret. I’ll leave with you one of his more encouraging and positive quotes:
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).Benjamin Graham, The Intelligent Investor, Chapter 20 – Fourth edition
If you’d like a detailed analysis of The Intelligent Investor by Benjamin Graham in pdf format or otherwise, do let me know. Also, feel free to leave your thoughts in the comments. I would love to hear it.