Key Learnings from The Intelligent Investor by Benjamin Graham – The Curious Investor

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The Intelligent Investor by Benjamin Graham, written over 70 years ago, is a classic on value investing. While some of the specific practices prescribed in the book may not be applicable today, the book has got some pieces of timeless wisdom and principles that are even applicable now. It’s not surprising that Warren Buffet has called it “by far the best book about investing ever written”

We often read a lot of insightful material but fail to remember our key learnings or implement them in our lives. This is my attempt at putting together the key takeaways from a wonderful book so that I can refer to it repeatedly and ensure that I implement them in my investment journey.

In this post I try to distil the key learnings from this classic. I highlight the key takeaways from every chapter, which can help an investor form a strong intellectual framework for evaluating any investment decision. I end the post with my views on the value vs growth debate.

Top 3 takeaways from the book
  1. Develop an investment framework and keep emotions away from corroding your framework
  2. Your view of the value of a company should not be affected by what the market thinks
  3. Evaluate the long term earnings power of a company and purchase a stock only if its price is less than your assessment of its intrinsic value (along similar lines, don’t pay an excessive price even if you find a “great” company)
Introduction
  • It is important to build a strong set of investing principles and attitudes.
  • Much more money has been made and kept by “ordinary people” who were temperamentally well suited for the investment process than by those who lacked this quality, even though they were experts in finance, accounting and the stock market. 
  • We can have two kinds of investors – defensive and enterprising. The defensive investor’s emphasis is on the avoidance of serious losses and freedom from the need to make frequent decisions. The enterprising investor is willing to devote time and care to security selection
  • Obvious prospects for growth in a business do not translate into obvious profits for companies within the industry. This is most aptly shown with the case of the airline industry, where despite the tremendous growth in air traffic, most airlines have shown poor profit numbers. 
  • Keep your focus on not losing money. If one works to eliminate huge losses from a portfolio, one is bound to end up with a satisfactory return from investments
  • An intelligent investor is one that is patient, disciplined, eager to learn and able to harness emotions and think for oneself. This is a trait more of character than of the brain.
  • Stocks become more risky – not less – as their prices rise and they become less risky as their prices fall. Something that is difficult to keep in mind during a market meltdown.
Chapter 1: Investment versus Speculation
  • An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting this requirement are speculative.
  • We must not delude ourself into thinking that we are investing when we are speculating. Speculating becomes dangerous when we start taking it seriously.
  • Gambling instinct is a part of human nature. Its futile to try supressing it but we must confine and restrain it.
  • Just because certain strategies or formulae worked in the past (eg. the ‘January effect’) doesn’t mean they are likely to work in the future, especially if they have no logical basis behind them.
  • In our endeavour to select promising stocks we face two major obstacles. First is human fallibility i.e. the possibility that we may be wrong in our future estimates. The second is the nature of the competition – professional analysts are likely to have done the same analysis and come to the same conclusions about the future prospects of the company and hence the price could already fully reflect what we are anticipating
  • To enjoy a reasonable chance of sustainably earning better than average returns one must follow policies that are (1) sound and promising and (2) not popular in the stock market
Chapter 2: The investor and Inflation
  • Investors must understand the impact of inflation on their investments. A 10% return when inflation is 8% is not a great outcome
  • Stocks should provide a better hedge against inflation (if earnings rise in line with inflation) but this is not always the case
  • REITs and inflation protected securities can help in hedging against inflation
Chapter 3: A century of stock market history
  • An investor must never forecast the future by simply extrapolating the past
  • An investor must always ask the following questions:
    • Why should the future return of the stocks be the same as their past returns?
    • When every investor comes to believe that stocks are guaranteed to make money, wont the market end up being wildly overpriced?
    • Once that happens, can future returns possibly be high?
  • The future will always surprise us. The markets will most brutally surprise the very people who are most certain that their views about the future are right. Staying humble about your forecasting powers will keep you from risking too much on a view of the future that may turn out to be wrong. 
Chapter 4: General portfolio policy – The Defensive Investor
  • Every investor should be aware of their split between debt and equity investments
  • The split between debt and equity should be governed by their view on the valuation of the market and their personal circumstances (note that it is personal circumstances and not age that should govern your allocation – two 30-year olds can be in very different circumstances that would require a different allocation)
  • Preferred stocks, generally sold as the best of both worlds, are usually a bad idea as they are less secure than bonds and offer less profit potential than common stocks
Chapter 5: The Defensive investor and common stocks
  • 4 rules of common stock investing for the defensive investor:
    1. Adequate but not excessive diversification (10-30 stocks)
    2. Large, prominent and conservatively financed companies
    3. Long record of continuous dividend payment
    4. Available at a reasonable valuation
  • “Growth” stocks trading at a high multiple have a large speculative element about them. Any adverse development can cause earnings to fall and multiples to contract, resulting in a vicious erosion in value – “the hotter they are, the harder they fall’
  • Risk is a permanent (not temporary) loss in value – created by either deterioration in business fundamentals or by paying an excessive price for an investment
  • Never pick stocks without doing adequate homework.  Peter Lynch has popularised the idea of “invest in what you know”. But he has also advised that one shouldn’t invest in a company without studying its financial statements or estimating its business value. If you use a company’s products, are an employee in a company or in any way have greater “information” on a company, that does not make you a better investor in the company. Familiarity often breeds complacency. The more you think you know about what is going on, the less likely you are to probe for weaknesses. One must always conduct adequate diligence.
  • Your refusal to be an active trader, your renunciation of any pretended ability to predict the future can become your most powerful weapon as an investor.
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Chapter 6: Portfolio Approach for the Enterprising Investor – The Negative Side
  • Don’t buy lower quality bonds just for a marginally higher yield.
    • Don’t risk capital loss just to eke out a 1-1.5% higher yield
    • In a downturn you can buy these lower quality bonds at a steep discount
  • Evaluate IPOs very carefully. Too many IPOs of small/mid sized companies is often the sign of a bull market ending (IPO = “It’s Probably Overpriced”)
Chapter 7: Portfolio Approach for the Enterprising Investor – The Positive Side
  • An enterprising investor is not one who takes more risk or buys “aggressive growth”. It is one who is willing to put in extra effort in researching their portfolio
  • Even for enterprising investors it is often difficult to time the market or buy rapidly growing companies at reasonable prices
  • A great company is not necessarily a great stock if bought at an unreasonable valuation
  • The three recommended fields for the enterprising investor are:
    1. The relatively unpopular large companies – can start by looking at companies that are trading at a low multiple, then apply other qualitative and quantitative analysis to arrive at a portfolio
    2. Purchase of bargain issues – Stocks selling for less than the company’s net working capital
    3. Special situations or “workouts”
Chapter 8: The Investor and Market Fluctuations
  • An intelligent investor can take advantage of market fluctuations by timing or pricing.
    • Timing is the endeavour to predict (and profit from) stock market movements.
    • Pricing is the endeavour to purchase stocks when they are reasonably valued (and sell when they are highly valued)
  • Even professional forecasters have found it impossible to reliably forecast market movements. Financial news and brokerages have persuaded investors that it is necessary to always have some view on the market
  • The very popularity of a market timing theory will erode its effectiveness
  • The longer a bull market lasts, the more severely investors will be afflicted by amnesia. After 5 years or so, many people no longer believe that bear markets are even possible
  • An investor will need considerable will power to keep from following the crowd.
  • Even the most impressive companies can have erratic price behaviour. Large drawdowns in good companies may not be because the long term growth of a company is in jeopardy – it could simply reflect a lack of confidence in the premium valuation that the stock market itself placed on the company.
  • As long as the earnings power of your investment remains intact, you can pay little attention to the vagaries of the stock market – pay more attention to the operating results of your companies
  • “Mr Market” exists to serve you. Every day Mr Market will tell you what a company is worth. It is up to you to decide whether you want to buy or sell a particular company at a particular price. These market quotations are there for your convenience – either to be taken advantage of or to be ignored. So one should not be concerned by sizable declines or be excited by sizable advances. Don’t ever make decisions because of market fluctuations. You will be wiser to form your own ideas about the value of your holdings. By refusing to let Mr Market be your master, you let it be your servant.
  • Investing isn’t about beating others at their game. It is about controlling yourself at your own game
Chapter 9: Investing in Investment Funds
  • Regular investment in investment funds inculcates the habits and discipline of investing regularly. The results are likely to be better than speculation
  • It is very difficult to choose a fund manager that will perform well consistently, over a long period of time. There is a wide variation between managers and the winners of today are unlikely to be the winners of tomorrow. In every time period there will be “bright young people” with innovative ideas promising to perform miracles in the market
  • When choosing investment funds one should look at the fund’s expenses and management reputation. Ideally you want a fund whose managers are major shareholders, dare to be different, don’t hype their returns, and have shown a willingness to shut down before they get too big
  • While past returns are important to look at they rarely correlate with future returns
Chapter 10: The Investor and His Advisers
  • Nearly everyone interested in stocks wants to be told by someone else what they think the market is going to do in the short term. There is a demand and hence it is being supplied to. Professional salesmen will confidently provide forecasts without their being any logical basis for them and no repercussions when the forecasts are consistently inaccurate
  • Do not buy/sell a stock (regardless of the current price) just because its near term prospects are favourable/unfavourable. Try to evaluate whether a stock is over or undervalued at the current price given its long term earnings power
  • Financial con artists thrive by talking you into trusting them and talking you out of evaluating them
  • It is important to make your broker understand that you are an investor and not a speculator and are not engaged in the guesswork about short term price movements
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Chapter 11: Security Analysis for the Lay Investor – General Approach
  • Bond analysis:  The chief criterion to be used to evaluate corporate bonds should be the earnings coverage ratio (no. of times that interest charges have been covered by earnings) over a period of time – never compromise on this. Other factors include size of enterprise, debt/equity ratio and property value
  • Stock analysis: Five factors are important (with important details in the book and chapter commentary)
    1. The company’s general long-term prospects
    2. The quality of its management (manifests in past performance)
    3. Its financial strength and capital structure
    4. Its dividend record
    5. Its current dividend rate
  • For any stock, one can perform a two-part appraisal process. First work out a “past-performance value” (valuation solely based on past performance) and then add a modification for new conditions (or growth prospects)
  • Strive to make decisions that are not dependent on the accuracy of anyone’s forecasts, including your own
Chapter 12: Things to consider about per-share earnings
  • Don’t take a single year’s earnings seriously
  • Look out for booby traps in per share figures (which include the dilution effects of options/warrants and “non-recurring” charges among others)
  • The market is often unkindest to rapidly growing companies that suddenly report a fall in earnings. The risk in owning growth stocks is not that their growth will stop, but merely that it will slow down
Chapter 13: A comparison of four listed companies
  • Similar companies can be compared based on profitability, stability, growth, financial position, dividends, price history
  • Price momentum (especially for high quality companies) can sustain for long periods, making expensive valuations even more expensive
Chapter 14: Stock selection for the defensive investor
  • A defensive investor must ensure that they obtain (1) minimum quality in terms of past performance and current financial position of a company and (2) minimum quantity in terms of earnings and assets per dollar of price
  • 7 things an investor should look out for: Adequate size of enterprise, Sufficiently strong financial condition, Earnings stability, Dividend record, Earnings growth, Moderate P/E, Moderate Price to Assets
  • It is worth comparing the earnings yield (inverse of P/E) to the high grade bond yield
  • One can approach the future by way of prediction or protection i.e. one can endeavour to anticipate what a company will accomplish in the future (prediction) or endeavour to assure oneself of a substantial margin of safety which could absorb unfavourable developments of the future (protection)
Chapter 15: Stock selection for the Enterprising Investor
  • Beating the market is tough even for the brightest minds in the investment business
  • This could be because either 1) The market is efficient – so many intelligent analysts spend so much time analysing companies in detail that the market price generally reflects the fair value of the company or 2) Many of the investors are handicapped by a flaw in their approach to stock selection – they search for the best possible company in the best industry and purchase it at any price
  • Therefore an investor must look for approaches that are sound but unpopular
  • Graham-Newman methods include 1) Arbitrages 2) Liquidations 3) Related Hedges and 4) Net-Current Assets (or “Bargain”) issues
  • Smaller issues of inferior quality tend to get overvalued in bull markets and subsequently suffer serious price declines
Chapter 16: Convertible Issues and Warrants
  • Convertible bonds are often sold as the best of both worlds. But this is not necessarily true and the attractiveness of a convertible issue depends a lot on the individual issue
  • A convertible preferred issue is often safer than the common stock of the same company, however often the common stock itself is unattractive (and hence the conversion privilege is not very attractive)
  • The ideal combination is a strongly secured convertible issue, exchangeable for a common stock that itself is attractive and convertible at a price only slightly higher than the current market price
  • Warrants are often highly volatile, they reduce the value of common shares and have limited value to the company or investors
Chapter 17: Four extremely instructive case histories
  • Graham highlights four cases: 
    1. An overpriced tottering giant: An example of neglect of the most elementary signs of financial weakness 
    2. An empire building conglomerate: Rapid and unsound expansion backed by indiscriminate borrowing and creative + confusing accounting
    3. A merger in which a tiny firm took over a big one: Debt fuelled expansion and creative accounting can often confuse investors
    4. An IPO in a worthless company: Rapid rise and eventual collapse of a worthless but hot stock
  • No regulatory reform can prevent investors from overdosing on their own greed and such examples are likely to repeat over time
Chapter 18: A comparison of eight pairs of companies
  • You should buy a company because its underlying value is increasing, not just because its stock price is going up
  • Market panics can create great prices for good companies. The positive news in an individual company can get lost if the market sentiment is bad
  • In speculative bubbles you often get absurd reasons for overvaluation – “70x sales is cheap because a competitor is valued at 400x sales” i.e. an absurdly expensive stock is cheap simply because another stock’s valuation is even more absurd. In the tech bubble several of these ended up losing 95%+ of their value
  • Usually a giant company can not deserve a giant P/E ratio. Because of its large size it will be difficult for a giant company to grow earnings at very large rates
  • A great company is not necessarily a great investment
  • Although there are good and bad companies, there is no such thing as a good stock. There are good stock prices, which come and go
  • Don’t invest in places just because you think there will be market action. Invest in places where you can form a reasonable judgement about where price is less than value
  • Beware of companies where there is rapid expansion, complex capital structures, high debt, strong share price movement but limited growth in per share earnings power
  • A mediocre company selling at a discount is not necessarily a good investment
  • An overvalued stock can remain overvalued for a long time especially if it is a great company. Even if it is expensive, it is possible that it will become even more expensive.
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Chapter 19: Shareholders and Managements – Dividend Policy
  • As an investor, one should take interest in monitoring the behaviour of managers, demand explanations for sub-par performance and support movements to improve management
  • Companies should either pay a substantial dividend (as a % of net income) or clearly demonstrate that retained profits are providing a satisfactory increase in EPS
  • Two questions that investors should play close attention to:
    1. Operational efficiency: Is the management efficient in conducting business operations?
    2. Capital efficiency: Are the interests of the outside shareholder receiving proper recognition? Is the stockholder’s money working in the form to best suit their interest? Are the financing decisions and use of cash efficient?
  • Stock buybacks are often done to counter the effect of dilution from the exercise of ESOPs. Investors should be vigilant when such buybacks are done at a high price
  • ESOPS should align the interests of managers with that of shareholders but most managers sell their stock immediately after exercising the options (thus defeating their purpose). Additionally there is often an asymmetric payoff for the manager (if the strike price on the options is low, even a moderate increase in prices leads to a large return for the managers)
  • Any option grant should be contingent on a fair and enduring measure of superior results
Chapter 20: “Margin of Safety” as the central concept of Investment  
  • Investing with a margin of safety renders unnecessary an accurate estimate of the future
  • Having a margin of safety allows you to absorb any unexpected unsatisfactory developments
  • Often large losses come to investors when buying low quality securities when business conditions are favourable. Buyers mistakenly view the current good earnings as indications of long term earnings power
  • A basic rule of prudent investment is that all estimates, when they differ from past performance, must err on the side of understatement
  • You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right
Conclusion

The investing world has changed a lot since the time Graham wrote this book. We now have instant access to information, powerful screening tools and algorithmic trading among a plethora of other things. This is why some of the specific Graham-Newman techniques such as arbitrages, hedges and Net Current Assets issues may not be accessible to the common investor today. However, the temperamental framework and some of the principles that Graham prescribes  are truly timeless and are likely to serve investors well for generations.

Often theories and approaches are wildly popularised and they make much money in the short term. Often you get the impression that this is the only way to invest as people claim that this is the “new world order”. Wild popularity and extraordinary returns over a significant period of time (12-18 months or more) does not mean that it is the right approach. Stocks that had gone up a few 1000% and signified a “new approach to investing” during the tech bubble subsequently went on to collapse by >99%. One needs to have extraordinary mental strength during this period (when everyone around you is getting wildly rich) to stick to your principles. Ultimately buying quality companies at reasonable valuations is the only way to make sustained wealth (over 5-10 years). Having the mental strength to not get swayed by the latest trend is difficult but rewarding.

My 2 cents on the value vs growth debate

I think a lot of debates and even academic papers often misunderstand value investing and the distinction between growth and value investing. I’ve heard in debates and research something along the lines of “Low P/E stocks have done poorly. This shows that value investing doesn’t work anymore”. A low P/E (or low P/B) ratio does not necessarily make a stock a “value stock”. I think a value stock is one whose price is lower than the intrinsic value assessed by the investor. A careful reading and understanding of The Intelligent Investor shows that Graham never really advocates buying stocks just because they are trading at a low P/E. In fact he explicitly states that purchasing mediocre companies at a discounted price may not yield good results. He advocates wholistic analysis of the company, its growth prospects, its management among other things and advocates purchasing at a reasonable valuation and never overpaying even for a very strong company. To me, value and growth investing aren’t starkly different concepts. As a “value investor” if I find a fantastic, fast growing company and I can be reasonably confident about its growth prospects, my intrinsic value calculation will reflect that and I may be willing to pay a reasonable (not necessary low) P/E for that. If I find a poorly run company with mediocre prospects, I may not purchase it even if it is trading at a single digit P/E. Similarly, even if I am a “growth investor” I will not pay an unreasonably high multiple even if I find a wonderfully fast growing company. As Warren Buffett himself says, “Value and growth are part of the same equation” (Warren Buffett & Charlie Munger: Growth stocks vs Value stocks (2001))

Please note that this is not investment advice. I am not a financial advisor. Please do your own research or consult a financial advisor before making any investment decision. Please assume that I have a position in any stock that I write about. 



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Purav Shah
Purav analyses a company/sector and ends by asking the key questions that are likely to determine the success of the investment. He tries to answer these questions and decides that they should go (in the words of Charlie Munger) in the “too hard (to answer) pile”.
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