The Intelligent Investor
If you haven’t heard the phrase “the price and value of a company is not always the same” then this is a must read.
Instead what's needed is a sound intellectual framework for making decisions, combined with an ability to keep emotions from ruining it.
In "The Intelligent Investor", Benjamin Graham presents such a framework together with logic that will help to keep your emotions under control.
Arguably, his investing strategy has been one of the most successful ones during the last hundred years.
The impressive records from not just Graham himself, but also of numerous of his disciples are impossible to ignore. Among these, the brightest shining star is Warren Buffett, the third wealthiest man in the world. (Read a summary of his biography)
Warren Buffett refers to this book as "by far, the best book on investing ever written".
In this summary, you will discover the 5 greatest takeaways from the book.
Takeaway 1: Meet Mr. Market
Imagine that you own a part of a business that you paid $1000 for.
Every day, a certain bipolar person called Mr. Market comes to your home with an opinion about how much you're part of that business is worth. Furthermore, he offers to buy your share or sell you an additional one on that basis.
History has shown that Mr. Market's opinion about how much your part of the business is worth, can be pure gibberish.
For instance, back in March 2000, he estimated the value of your share to be $2600.
Only one year later, in March 2001, he thought it was worth $500.
Even though the income of the company increased with 50% and the profit increased by 20% during the same period.
Should you let this guy decide how much your $1000 of interest in that business is worth?
Of course not!
One of Graham's core principles, is that a stock is not just a ticker symbol combined with a price tag.
It is an ownership interest in a business.
A stock is not just a ticker symbol combined with a price tag. It is an ownership interest in a business.
And because Mr. Market isn't always rational, the underlying value of the business can differ from the price he is willing to pay for it.
In fact, it frequently is over- or underpriced as Mr. Market easily becomes over optimistic, or conversely too pessimistic.
Graham advises you to invest only if you would feel comfortable to hold the stock in the future without seeing the fluctuating prices that Mr. Market presents you with.
But for the investor who can keep their head cool, Mr. Market presents a great possibility of making money, for he doesn't force you to strike a deal with him, he merely presents you with an opportunity of doing so!
You should be happy to sell to him when he offers prices that are ridiculously high, and similarly, you should be happy to buy from him when he presents you with bargains.
We must consider that, at the time when Graham wrote this book, people were far less bombarded with news, forecasts, stock quotes, and so on than we are today.
Back in the 1970s, Mr. Market arrived maybe once a day, together with the morning newspaper. Today, he wants to do business with us every time we open our phone.
Just because Mr. Market visits you more often, it doesn't mean that you must trade with him any more frequently than people had to in the 1970s.
If he doesn't present you with an offer that meets your standards, ignore him, and move on with your day!
Takeaway 2: How to invest as a defensive investor.
There are two types of investors according to Graham – the defensive (or passive) one and the enterprising (or active one).
Most people are better suited for the defensive strategy, as the time they are willing to dedicate to investing is limited.
The defensive investor should create a portfolio with a mixture of bonds and stocks, say 50% stocks and 50% bonds.
Note that how much you should devote to each asset category depends on your life situation and the current difference in the average yield of stocks versus bonds.
Restore this allocation once or twice every year, so that if stocks suddenly make up 60% of the portfolio compared to only 40% in bonds, sell stocks and buy bonds, until 50/50 is restored.
Invest a fixed amount of capital at regular intervals. For instance, straight after you get your salary.
This is called dollar-cost averaging, and will allow for a fair average price of stocks and bonds.
Most of all, it will assure that you don't concentrate your buying at the wrong time.
For the stock component of the portfolio, the defensive investor should aim for the following 8:
- Diversification in the companies – 10 to 30 companies should be adequate. Also, make sure that you are not overexposed to a single industry.
- The companies should be large, which Graham defined as generating more than a $100 million in yearly sales. After inflation, this equals approximately to $700 million in today's value.
- Look for companies that are conservatively financed. Such a company has a so called "current ratio" of at least 200%. This means that its current assets are at least twice as big as its current liabilities.
- Dividend should have been paid to shareholders for at least the last 20 years.
- No earnings deficit in the last ten years.
- At least 33% growth in earnings during the last ten years. This translates to a conservative growth of 2.9% annually.
- Don't overpay for assets. The price of the stock should not be higher than 1.5 times its net asset value. The net asset value can be calculated by subtracting the company's liabilities from its assets.
- Don't overpay for earnings. Don't let the p/e ratio be higher than 15 when using the last 12-month earnings. An alternative today is to invest in an index fund (or for Malaysians, robo advisors such as Stashaway and Wahed Invest), which by definition will have returns similar to the average of the market.
If you are satisfied with an average reward through your investing, you only need these two first takeaways.
However, if you want more, you will also need to consider the rest of the takeaways ….
Takeaway 3: How to invest as an enterprising investor
As it's so easy for the defensive investor to get the average return of the market, it would seem a simple matter to beat the market.
You just devote a little more time to investing than these average investors do, right?
To be an enterprising investor, and to beat the market, is much more demanding as such a logic suggests. It requires patience, discipline, an eagerness to learn and a lot of time.
Many professionals and private investors alike aren't suited for this.
It's easier to fall victim to the price quotations of Mr. Market than one could possibly imagine. Just listen to these two statements from the early 2000s, at the peak of the dot-com bubble, made by the chief investment strategist at 2 large mutual funds (also known as unit trusts):
"It's a new world order…."
"We see people discard all the right companies, with all the right people, with the right visions, because their stock price is too high."
"That's the worst mistake an investor can make."
Since the profits that companies can earn are finite, the price the intelligent investor should be willing to pay for these companies must also be finite.
Price is truly an important factor for the enterprising investor.
Just like the market tends to overvalue companies when they have been growing fast or is glamorous for some other reason, it tends to undervalue the ones with unsatisfactory development.
The intelligent investor should therefore try to avoid so-called "growth stocks" as much as possible.
Simply because the investment decision is based relatively more on future earnings, and future earnings are less reliable than current valuations.
If you, on the other hand, can find a company which is valued lower than its net working capital, you essentially pay nothing for all the fixed assets, such as buildings, machinery goodwill, etc.
The net working capital can be calculated by subtracting total liabilities from current assets.
Such companies were proven truly profitable during Graham's investment career.
Unfortunately, they are rare today except during tough bear markets.
Luckily, Graham suggests an additional method of finding investments for the enterprising investor.
These criteria are similar to the ones that the defensive investors should use, but the constraints are looser, allowing for the enterprising investor to consider more companies.
Note that there is no constraint at all regarding company size.
Also, some diversification should be applied, but the number of companies held isn't carved in stone for the active investor.
In analyzing a company, the enterprising investor should also study its annual financial reports.
Takeaway 4: Insist on a margin of safety
There's one risk that no careful consideration can truly eliminate: the risk of being wrong.
You can, however, minimize this risk. To do this, you must insist that every investment you make has a "margin of safety".
As mentioned before,
the price and value of a company is not always the same.
When the price is at most two thirds of its calculated value, the investor has found a company with enough margin of safety.
Let's pretend that you're a construction engineer. You've been assigned with the task to build a bridge. The bridge is a very complex one, especially the calculations regarding the carrying capacity.
You've been told that the trucks passing your bridge sometimes will weigh as much as 40 tons.
Will you build a bridge so that your calculations say that it supports 40 tons, or 60 tons?
If you picked 41 tons, this could be a possible scenario:
You made a small mistake in your calculations. So your bridge could only carry 38 tons in reality. Now this really heavy truck tries to drive across it …
Not so nice, right?
Sure, this could happen if you try to build one which supports 60 tons as well, but the risk is reduced.
Let's face it – our estimations when trying to predict the future of a stock or often … wrong.
Therefore, we need plenty of room for error – a margin of safety.
If you think that a stock is worth $50, you don't buy it if it also costs $50 in the market.
In this situation, you might want to wait until the stock costs $40 instead, assuming that you still think its value remains the same at that point, of course.
A formula used in the book can give you some heads up regarding what the value of a company is, and therefore also if it can be bought with a margin of safety.
Takeaway 5: Risk and reward are not always correlated
According to academic theory, the rate of return which an investor can expect must be proportional to the degree of risk that he's willing to accept.
Risk is then measured as the volatility of the returns on the investment, meaning, how much it has differed historically from its expected value.
Graham doesn't agree with this statement. Instead, he argues that the price and value of assets often are disconnected. Therefore, the return that an investor can expect is a function of how much time and effort he brings in his pursuit of finding bargain assets.
The minimum return goes to the defensive (or passive) investor, while the maximum goes to the enterprising investor who exercises maximum intelligence and skill.
It's 4:00 a.m in the morning, and you've been out smoking shisha in the streets of KL together with your friends.
You decide that it's too early to call it a night, and therefore you end up in the more obscure parts of town.
At a particularly ambiguous bar you're approached by a man who asks: "Do you want to play a game?"
"Well, of course, games are fun!" your bravest friend replies.
The man puts a revolver in front of you, which is loaded with a single bullet.
"I'll give you $10,000 if you dare to take a shot, Russian Roulette."
Your drunk friend reaches out for the gun, but you stop him.
"I think we'll pass on this one " you politely inform the man.
"I thought so" he replies …
"What about $100,000 for taking two shots?"
Now, this story represents the academic way of demanding a higher potential reward for taking a higher risk.
In the first offer, you were to receive $10,000 at a 16.7% risk of blowing your brains out.
In the second offer, the reward is $100,000 because the risk of putting a hole through your head has increased to 33.3%.
But stock market investing doesn't have to be like that!
Remember that price and value are not the same.
When you buy a company at 60 cents on the dollar,
you have a great potential reward, and a low risk.
Furthermore, if you can find another company that you can buy at 40 cents on the dollar, you have found a better potential reward,
combined with an even lower risk!
How could anyone in their right mind argue that it's riskier to buy a dollar at the price of 40 cents than to buy a dollar at 60 cents, just because the potential reward is higher?
The Intelligent Investor Recap
Firstly the market tends to be over-optimistic and too pessimistic from time to time.
Don't let this influence what you think the true value of your assets are.
Instead, see it as a business opportunity, where you get to deal with a person who has no idea of what he's doing!
Secondly, the defensive investor should go for a diversified portfolio of stocks and bonds, where the stock category consists of primarily low-priced issues.
Thirdly, the enterprising investor should also aim for stocks that show lower price tendencies.
If he can find a company that is trading below its net working capital, he might have found his El Dorado.
The fourth takeaway is that the intelligent investor should insist on a margin of safety when acquiring an asset.
And finally, takeaway number 5 is that risk and reward aren't necessarily correlated.
Our Thoughts at More Money Malaysia.
We are a huge fan of The Intelligent Investor and the concept of value investing.
We do believe that risk is being defined incorrectly and therefore everyday people like us are able to become very rich if we learn how to become a value investor.
However, value investing is a very active thing. You have to spend months, if not years learning value investing properly.
And most importantly, you must buy the company's shares at a discounted rate compared to its current value.
If however, spending hours each day for over a year to learn value investing is not for you, we would suggest using a robo advisor (such as Stashaway or Wahed Invest <- especially for those who are looking for islamic investing options) or investing yourself in index funds.
Now that you have an understanding of what The Intelligent Investor is about, here are some next steps.
Step 1: Remember that the price of a stock is not the value of the stock.
Mr Market is always going to over valuing the company or under valuing the company. It's up to you to understand where it's at by understanding the company.
And the only way you can understand the company is by…
Step 2: Determine whether you will spend the time required to learn value investing.
Learning value investing will take hours each day for the next year before you are ready to invest like a pro.
Are you willing to put that time in or would you rather spend your time doing other things?
If you are interested in learning value investing, then go through all our videos around investing and start reading the books.
Otherwise, invest using robo advisors (such as Stashaway or Wahed Invest <- especially for those who are looking for islamic investing options) or by yourself with index funds but always remember lesson 1.