Despite the cheesy title, “The Intelligent Investor” by Benjamin Graham is one of the best investing books (if read carefully)

Reading carefully

I first read this book about 20 years ago. While I got some out of it at the time, I found that reading it again now, something clicked and I find the advice in the book actionable (directly useful to understand finance and investing).

These are my (incomplete) notes of this second reading.

Scope

The author makes it clear that it only covers investing in marketable securities, there are other areas of personal finance such as mortgages which are not in scope. It also does not cover the details of security analysis, the author has another book on that subject. But it covers the ideas behind personal investment, and for that the book comes highly recommended by Warren Buffett.

Relevance of history

The book had multiple editions from 1949 to 1972. On the first read I found confusing that the securities it mentions are historical, e.g. companies I’ve never heard of. Now I understand, from one of Warren Buffett’s talks, that over a timespan of decades even large companies come and go, that’s how it is. Also Graham shows that the market has different patterns over long periods of time: it might be cyclical, it might be generally cheap, it might be generally expensive, low or high inflation. These historical notes are important for several reasons. The market might match a previous historical pattern or it might be different, e.g. today’s market is different from the general aversion to company shares in 1949, requiring adjustments to the investment strategy.

The concrete examples of securities are not to be taken as actionable today necessarily, but as similar circumstances that might occur in the future, though the available kinds of securities vary in time and by location, e.g. US saving bonds series E @5.20% or similar are not available in the UK in 2022, but things might be different in a high inflation environment.

Also it’s important to know the kind of fluctuations to expect for a class of securities over time, e.g. second-grade bonds might be available at a discount.

There are stories about Graham’s “cigar butt” approach to shares, but clearly the ethos of the book is that the investing principles must adapt rationally to the concrete financial climate, not a one size fits all approach.

Definitions

The book has several important and memorable definitions.

Foremost is the definition of investment as “an operation […] which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

This is the kind of definition that shows that a high IQ is less important in investing compared with being emotionally wise and remembering to evaluate each deal against this definition.

An example of a recurring situation is the misuse of terms in the media, which often applies it to any actor in the market. E.g. “reckless investors” is a contradiction by the definition above, akin to “spendthrift misers”.

Risk is also singled out as a word that gets misinterpreted as volatility. I noticed that myself in 2003, when the fact that the shares of a company dropped suddenly made them safer at the cheaper price, despite the increased volatility.

Graham goes further and questions the assumption that risk and reward go hand in hand with the security type, shares purchased cheaper have lower risk and higher reward potential, the risk/reward ratio is not inherent to a security type.

Not quite definitions, but with regards to various advisors he points to potential conflicts of interest, biases (e.g. toward speculation) or misinformation (e.g. buy or sell guidance regardless of price).

Defensive vs enterprising investors

The book caters largely for two investor scenarios.

The defensive investor aims to get average returns with minimal effort. The enterprising investor aims to beat the market, but with a significant amount of time spent understanding it, just a bit won’t do it, there is no middle route that would beat the market somewhat with a medium effort. Importantly, both should avoid serious mistakes and losses.

For both it recommends a bonds/cash to shares ratio of about 50-50, no less than 25, no more than 75 of either. He gives ample reasoning based on the historical context, the actual ratio one should employ depends on circumstances. Warren Buffett is often questioned about his cash holdings, this recommendation gives some explanation.

For the defensive investor he recommends high grade bonds and shares in between 10 to 30 (adequate, but not excessive diversification) large, conservatively financed companies with a long history of dividend payment, bought at a reasonable price.

For the enterprising investor he comes to the “following logical if disconcerting conclusion: To enjoy a reasonable chance for continued better than average results, the enterprising investor must follow policies which are (1) inherently sound and promising, and (2) are not popular in Wall Street.” This explains Warren Buffett’s investment in Coca-Cola avoiding the computer industry.

Putting it together

The book has a section on results to be expected by the defensive investor, in the 1970s US. At the time one could get a good return on US bonds compared with shares that were relatively overvalued. The author recommended a 50-50 split and gave an estimation of the expected results. How does this apply to 2022 (summer) Britain? Well, one could get 1.2% on savings, while a FTSE 100 index would give 4% in dividends with a P/E ratio of 14, i.e. about 7%, resulting in an additional 3% capital growth. So for a split of 25-75 of savings to shares a defensive investor could expect to get about 5.5% before tax.

Another interesting recent development (autumn 2022) was the announcement of the (now ousted) British chancellor of a decrease in taxes. The market reacted with the expectation of higher borrowing costs for Britain that were previously at historical lows. The consequence was drop in prices of long term bonds. The Bank of England intervened to purchase such long term bonds (presumably at high prices) to prop up pension funds. Why would any sane investor go for long term bonds that pay historically low interest. The answer is that the said institutional investors don’t invest their own money and get away with it, the Bank of England saving them so that it continues to have them of buyers in the future. But that’s not a prudent investment attitude for the intelligent investor that invests their own money and cannot expect a saving grace.

The other observation is that what there are times where a clear calculation can be made (summer 2022), and times where such clear calculation can’t me made (autumn 2022).

Growth stocks and IPOs

Obvious prospects of growth for an industry do not necessarily translate into profits. The growth expectation is often priced in. Also it’s hard to anticipate the future market leader in such an industry.

IPOs often come to the market in periods of enthusiasm and are priced optimistically to the seller’s advantage.

Don’ts

The book contains plenty of advice on what not to do:

  • don’t speculate and kid yourself that you’re investing
  • don’t speculate seriously with more money than you can afford to loose
  • don’t borrow to invest, including dealing on margin or shorting though this advice is given for circumstances where caution is required, one might decide differently in other circumstances e.g. house mortgage nowadays
  • don’t double count the impact of management if that’s already priced in the earnings history
  • don’t trade safety of principal for a small increase in bond interest

The importance of psychology

The Intelligent Investor” is a rich source of ideas on the importance of psychology in

Say you ignore the advice of the book and you purchase shares because they went up. The reality is that shares are likely to be available at a cheaper price (shorter) after purchase. When you see them going down then what are you going to do? If the purchase was made based on thorough rational analysis, the process can be repeated (“Did I miss anything?”) and more shares can be bought, potentially on better terms.

Ironically Warren Buffett also tells the story when he missed the opportunity of going big on Walmart because he purchased some, price went a bit up and he waited for the price to go lower than his initial purchase, but then this never happened. So chances are shares will likely be available at a cheaper price shorter after purchase, but this is not guaranteed.

Also the book warns against short selling. There might be special circumstances where that might make sense e.g. when a company wholly owns another, there might be some arbitrage case where short selling can be combined with a long position against basically the same asset. But other than these kind of situations, short selling does not make sense also including for the reason that it requires infinite patience. Even the “cigar-butt” approach: “buying a neglected and therefore undervalued issue for profit generally proves a protracted and patience-trying experience”.

Another example is the expectation of meaningful return on investment, the idea of having patience to find a good opportunity (e.g. with a large margin of safety) and having the energy to stay put in the meantime.

Formula based investing

There are many formulas that don’t work, particularly the kind that buy shares because they went up and sell because they went down.

But some work, such as:

  • invest regularly to achieve “dollar cost averaging”
  • keep the cash or shares holdings in the 25 to 75 percent range

He does provide a valuation formula, see comments in the next section.

Valuation

Two-part appraisal process:

  • evaluate the value based on past performance
  • adjust based on anticipated changes

He provides a formula: value = earnings * (8.5 + 2 * (expected annual growth ratio))

Now the theory is that the value of a company is the sum of all the income received (as dividends and maybe eventual sale) discounted to account for the fact that money received later is worth less than money in hand today. This is the basis of models like Dividend Discount Model or Discounted Cash Flow. While theoretically true, there are issues with this kind of models. One is that the theoretical value could be infinite on paper which is unrealistic. The other is that it is relatively easy to plonk it into a spreadsheet formula and come with some magic number, becoming overly technical hiding the fact that there are many assumptions such as the holding period, the price a buyer might want to pay, the earnings growth etc. Warren Buffett talked that while the idea is sound, if you have to do such a calculation the stock is not cheap enough.

We can debate if Graham’s formula is any better and an in-depth analysis of it would be interesting, but it has some positive characteristics. It ends with a finite value. It is relatively simple so the assumptions can be accounted for better (e.g. what’s a realistic growth rate to expect, what’s the 8.5 etc.).

Note that the formula does not talk about the PE ratio, accounting for the capital structure of the company (two companies with same earnings might have the same value, but the share price needs to account for the long term liabilities).

Interesting example of ALCOA in chapter 12 about the unreliability of stated earnings. In that case the reported earnings per share have a footnote reference indicating that the earnings do not include “special charges” some of which were provisions for future years without a clear breakdown as to how much for which year etc.

“Eventually the intelligent analyst will confine himself to those groups in which the future appears reasonably predictable, or where the margin of safety of past-performance value over current price is so large that he can take his chances on future variations”

Chapter 8 and 20

TODO

Reference

Benjamin Graham: “The Intelligent Investor” 1973