What you will learn from reading The Intelligent Investor:
– Timeless investment principles to bear in mind before you buy shares in a company.
– The difference between investment and speculation.
– Why buying a stock after a substantial rise is always a bad idea.
The Intelligent Investor Book Summary:
The intelligent is the value investing bible since it was first published in 1949. This is Warren Buffets most recommended investment book and it’s easy to see why. No nonsense, practical guidelines on how to be a better investor. It’s a particularly good antidote to the speculative bubble we are currently living in with crypto and tech stocks being massively inflated in price. It’s a must read!
A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price.
The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists.
The future value of every investment is a function of its present price. The higher the price you pay, the lower your return will be.
No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on what Graham called the “margin of safety”-never overpaying, no matter how exciting an investment seems to be-can you minimise your odds of error.
As Graham never stops reminding us, stocks do well or poorly in the future because the businesses behind them do well or poorly-nothing more, and nothing less.
Why you should study the past:
No statement is more true and better applicable to Wall Street than the famous warning of Santayana: “Those who do not remember the past are condemned to repeat it.”
Investments Vs Speculation:
As far back as 1934, in our textbook Security Analysis,’ we attempted a precise formulation of the difference between the two, as follows: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
An investor calculates what a stock is worth, based on the value of its businesses. A speculator gambles that a stock will go up in price because somebody else will pay even more for it.
People who invest make money for themselves; people who speculate make money for their brokers. And that, in turn, is why Wall Street perennially downplays the durable virtues of investing and hypes the gaudy appeal of speculation.
Risk is never eliminated when you sell:
Secondly, risk is exchanged (but never eliminated) every time a stock is bought or sold. The buyer purchases the primary risk that this stock may go down. Meanwhile, the seller still retains a residual risk-the chance that the stock he just sold may go up!
What is Short Selling:
In “selling short” (or “shorting”) a stock, you make a bet that its share price will go down, not up. Shorting is a three-step process: First, you borrow shares from someone who owns them; then you immediately sell the borrowed shares; finally, you replace them with shares you buy later.
If the stock drops, you will be able to buy your replacement shares at a lower price.
The difference between the price at which you sold your borrowed shares and the price you paid for the replacement shares is your gross profit (reduced by dividend or interest charges, along with brokerage costs). However, if the stock goes up in price instead of down, your potential loss is unlimited-making short sales unacceptably speculative for most individual investors.
Just because something works now doesn’t mean it will work forever:
People began believing that the test of an investment technique was simply whether it “worked.” If they beat the market over any period, no matter how dangerous or dumb their tactics, people boasted that they were “right.” But the intelligent investor has no interest in being temporarily right. To reach your long-term financial goals you must be sustainably and reliably right.
Flashy gimmicks for beating the market are much the same: In short streaks, so long as your luck holds out, they work. Over time, they will get you killed.
Data doesn’t = Knowledge:
By pouring continuous data about stocks into bars and barbershops, kitchens and cafés, taxicabs and truck stops, financial websites and financial TV turned the stock market into a nonstop national video game. The public felt more knowledgeable about the markets than ever before.
High Prices = More Risk:
Jeffrey M. Applegate, then the chief investment strategist at Lehman Brothers, asked rhetorically: “Is the stock market riskier today than two years ago simply because prices are higher? The answer is no.” But the answer is yes. It always has been. It always will be.
And when Graham asked, ““Can such heedlessness go unpunished?” he knew that the eternal answer to that question is no.
IPO’s and New Issues:
Our one recommendation is that all investors should be wary of new issues-which means, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased.
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 “favourable market conditions”which means favourable for the seller and consequently less favourable for the buyer.
Bull-market periods are usually characterised by the transformation of a large number of privately owned businesses into companies with quoted shares.
Weighing the evidence objectively, the intelligent investor should conclude that IPO does not stand only for “initial public offering.” More accurately, it is also shorthand for:
It’s Probably Overpriced,
Imaginary Profits Only,
Insiders’ Private Opportunity,
or Idiotic, Preposterous, and Outrageous.
Averaging out the P/E Ratio:
Graham insists on calculating the price/earnings ratio based on a multiyear average of past earnings. That way, you lower the odds that you will overestimate a company’s value based on a temporarily high burst of profitability.
Net Working Capital:
By “net working capital,” Graham means a company’s current assets (such as cash, marketable securities, and inventories) minus its total liabilities (including preferred stock and long-term debt).
The type of bargain issue that can be most readily identified is a common stock that sells for less than the company’s net working capital alone, after deducting all prior obligations.
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.
The Characteristics of a Bull Market:
Nearly all the bull markets had a number of well-defined characteristics in common, such as (1) a historically high price level, (2) high price/earnings ratios, (3) low dividend yields as against bond yields, (4) much speculation on margin, and (5) many offerings of new common-stock issues of poor quality.
What Price Fluctuations Mean:
In our view such signals are misleading at least as often as they are helpful. 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.
Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment.
The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored. He should never buy a stock because it has gone up or sell one because it has gone down. He would not be far wrong if this motto read more simply: “Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop.”
Growth Rates and Errors:
A large part of the value found for a high-multiplier growth stock is derived from future projections which differ markedly from past performance-except perhaps in the growth rate itself. Thus it may be said that security analysts today find themselves compelled to become most mathematical and “scientific” in the very situations which lend themselves least auspiciously to exact treatment.”
The higher the growth rate you project, and the longer the future period over which you project it, the more sensitive your forecast becomes to the slightest error.
Because advanced mathematics gives the appearance of precision to the inherently iffy process of foreseeing the future, investors must be highly skeptical of anyone who claims to hold any complex computational key to basic financial problems.
Evaluating a Company:
Graham feels that five elements are decisive.’ He summarises them as:
The company’s “general long-term prospects”
The quality of its management
Its financial strength and capital structure
Its dividend record
and its current dividend rate.
Long term prospects:
Then comb through the financial statements, gathering evidence to help you answer two overriding questions. What makes this company grow? Where do (and where will) its profits come from? Among the problems to watch for:
The company is a “serial acquirer.” An average of more than two or three acquisitions a year is a sign of potential trouble. After all, if the company itself would rather buy the stock of other businesses than invest in its own, shouldn’t you take the hint and look elsewhere too?
The company is an OPM addict, borrowing debt or selling stock to raise boatloads of Other People’s Money. These fat infusions of OPM are labeled “cash from financing activities” on the statement of cash flows in the annual report.
The quality and conduct of management:
A company’s executives should say what they will do, then do what they said. Read the past annual reports to see what forecasts the managers made and if they fulfilled them or fell short. Managers should forthrightly admit their failures and take responsibility for them, rather than blaming all-purpose scapegoats like ““the economy,” “uncertainty,” or “weak demand.”
Financial strength and capital structure:
The most basic possible definition of a good business is this: It generates more cash than it consumes. Good managers keep finding ways of putting that cash to productive use. In the long run, companies that meet this definition are virtually certain to grow in value, no matter what the stock market does.
If owner earnings per share have grown at a steady average of at least 6% or 7% over the past 10 years, the company is a stable generator of cash, and its prospects for growth are good.
The State of Investing:
“Today’s investor,” Graham tells us, is so concerned with anticipating the future that he is already paying handsomely for it in advance. Thus what he has projected with so much study and care may actually happen and still not bring him any profit. If it should fail to materialise to the degree expected he may in fact be faced with a serious temporary and perhaps even permanent loss.”?
Earnings / Price:
Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings/price ratio the reverse of the P/E ratio-at least as high as the current high-grade bond rate. This would mean a P/E ratio no higher than 13.3 against an AA bond yield of 7.5%.*
The Double Basis of Market Valuations:
Our statement that the current price reflects both known facts and future expectations was intended to emphasise the double basis for market valuations.
Corresponding with these two kinds of value elements are two basically different approaches to security analysis. To be sure, every competent analyst looks forward to the future rather than backward to the past, and he realises that his work will prove good or bad depending on what will happen and not on what has happened.
Nevertheless, the future itself can be approached in two different ways, which may be called the prediction (or projection) and the way of protection.
Investing on the basis of projection is a fool’s errand; even the forecasts of the so-called experts are less reliable than the flip of a coin. For most people, investing on the basis of protection-from overpaying for a stock and from overconfidence in the quality of their own judgment-is the best solution.
Look for once Hot Stocks:
The best values today are often found in the stocks that were once hot and have since gone cold. Throughout history, such stocks have often provided the margin of safety that a defensive investor demands.
Enterprising Investment Criteria:
So let us apply to our list some additional criteria, rather similar to those we suggested for the defensive investor, but not so severe. We suggest the following:
1. Financial condition: (a) Current assets at least 1½ times current liabilities, and (b) debt not more than 110% of net current assets (for industrial companies).
2. Earnings stability: No deficit in the last five years covered in the Stock Guide.
3. Dividend record: Some current dividend.
4. Earnings growth: Last year’s earnings more than those of 1966.
5. Price: Less than 120% net tangible assets.
Traits of Successful Investors:
Unlike most people, many of the best professional investors first get interested in a company when its share price goes down, not up.
No matter which techniques they use in picking stocks, successful investing professionals have two things in common: First, they are disciplined and consistent, refusing to change their approach even when it is unfashionable. Second, they think a great deal about what they do and how to do it, but they pay very little attention to what the market is doing.
There are only good stock prices:
At some point in its life, almost every stock is a bargain; at another time, it will be expensive.
Although there are good and bad companies, there is no such thing as a good stock; there are only good stock prices, which come and go.
The investment motto – Margin of Safety:
In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.”* Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.
Here the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.
“The margin of safety is the difference between the percentage rate of the earnings on the stock at the price you pay for it and the rate of interest on bonds, and that margin of safety is the difference which would absorb unsatisfactory developments.
Avoid favourable business conditions:
Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.
The purchasers view the current good earnings as equivalent to “earning power” and assume that prosperity is synonymous with safety. It is in those years that bonds and preferred stocks of inferior grade can be sold to the public at a price around par, because they carry a little higher income return or a deceptively attractive conversion privilege.
Investment should be business like:
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.
Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success.
In particular, keep away from ventures in which you have little to gain and much to lose.” For the enterprising investor this means that his operations for profit should be based not on optimism but on arithmetic. For every investor it means that when he limits his return to a small figure-as formerly, at least, in a conventional bond or preferred stock-he must demand convincing evidence that he is not risking a substantial part of his principal.
Reasoning and data > Crowd:
If you have formed a conclusion from the facts and if you know your judgment 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.)
Characteristics of Good Decisions:
The Nobel-prize-winning psychologist Daniel Kahneman explains two factors that characterise good decisions:
“well-calibrated confidence” (do I understand this investment as well as I think I do?)
“correctly-anticipated regret” (how will I react if my analysis turns out to be wrong?).
To find out whether your confidence is well-calibrated, look in the mirror and ask yourself: “What is the likelihood that my analysis 1s right?”
Next, look in the mirror to find out whether you are the kind of person who correctly anticipates your regret. Start by asking: “Do I fully understand the consequences if my analysis turns out to be wrong?”
Risk is made of two ingredients:
You should always remember, in the words of the psychologist Paul Slovic, that “risk is brewed from an equal dose of two ingredients probabilities and consequences.”
Before you invest, you must ensure that you have realistically assessed your probability of being right and how you will react to the consequences of being wrong.
Concludes Bernstein: “In making decisions under conditions of uncertainty, the consequences must dominate the probabilities. We never know the future.”
Thus, as Graham has reminded you in every chapter of this book, the intelligent investor must focus not just on getting the analysis right. You must also ensure against loss if your analysis turns out to be wrong-as even the best analyses will be at least some of the time.
Investors vs Chartists:
In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value.
It’s extraordinary that so many studies are made of price and volume behaviour, the stuff of chartists. Can you imagine buying an entire business simply because the price of the business had been marked up substantially last week and the week before?
Of course, the reason a lot of studies are made of these price and volume variables is that now, in the age of computers, there are almost endless data available about them. It isn’t necessarily because such studies have any utility; it’s simply that the data are there and academicians have worked hard to learn the mathematical skills needed to manipulate them. Once these skills are acquired, it seems sinful not to use them, even if the usage has no utility or negative utility. As a friend said, to a man with a hammer, everything looks like a nail.