I am currently reading The Intelligent Investor by Benjamin Graham for the third or fourth time — I can’t quite remember. Every time I read through I pick up more and more of his teachings. This book is widely considered one of the best books ever written for value investors, and it’s easy to see why.
This post will be the first of a series. I plan to share my learnings, thoughts, and ideas with you here as I read through this book one more time. Specifically I am reading the revised edition with commentary by Jason Zweig. This edition contains the full fourth edition updated by Graham in 1971/72 and since this was quite some time ago now, Jason does an excellent job of translating some of the ideas to the present day. If you have a copy of this book, I encourage you to read along and share your comments below!
Stocks or Bonds?
Chapter 1 deals with the idea that investment and speculation are two very different things. Investment refers to the process of careful analysis and selection of a security, and the realization that risk and profit go hand-in-hand and are inseparable from one another – to achieve a profit, a risk must be taken. Speculation by contrast is unavoidable but should be minimized to the greatest possible extent.
Graham goes through an interesting review of capital allocation strategy, and outlines key ideas to look at with respect to investment in stocks or bonds in particular. He points out that at any given time, the expected return on an investment in company stock is equal to the dividend return plus the average annual appreciation of the stock, and that this should be compared to the interest rate on bonds. Bond yields are much better protected, and therefore more certain than the dividends on stocks.
For example, let’s assume a stock has an annual dividend yield of 2.5% and on average over the past 10 years, the stock’s price is appreciating 4% per year. The return would then work out to be roughly 6.5% per year before taxes. After tax, the return would be reduced, possibly to lets say 5%. This should be compared to the return on high-grade bonds before making an investment. High-grade bonds are generally considered to be U.S. Treasuries, and it’s typical to look at 5 or 10 year terms.
Back in the 70s, 10-yr treasury bonds were yielding around 7-8% and were worth considering as an alternative to stock. Today, however a quick look at yahoo finance shows that the 10-yr yield is only 1.9%. Since this will barely keep up with inflation, I typically have my entire portfolio invested in stocks.
Avoid Hot Issues
Graham doesn’t hold back in showing his dislike for new offerings or hot stock issues, stating that defensive investors must only invest in companies with a long record of profitable operations and in strong financial condition. This theory is actually the underlying basis behind most of the stock screens I conduct to search for appropriate value investments, such as my Predictable Growth, Low Debt screen. It makes sense. Since the underlying core idea of value investing is the determination of a company’s intrinsic value before making a purchase, how can this possibly be done on a company with no history? There is no data from which to derive a value!
Also frowned upon by Graham are strategies that involve buying or selling on momentum and trying to buy in the short or long term based on speculation about increased earnings. These are all very common strategies that I would argue are employed by the vast majority of the investing public.
To enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising, and (2) not popular on Wall Street.
This quote sets the basis for many of Graham’s ideas — which are essentially contrarian in style — the idea that stock movements generally swing too far in either direction, whether that be for the market as a whole, or for an individual stock, and that this presents buying or selling opportunities. Graham’s traditional (and most famous) method of selecting stocks was to identify those which were trading at a price less than the value of the company’s net current assets (essentially cash & cash equivalents). These are now nearly impossible to find, but there are still stocks that do represent good value to the investor. A portion of the remainder of the book dedicates itself to identifying these methods.
- Buy The Intelligent Investor from Amazon