The Intelligent Investor by Benjamin Graham

Buy the Book: Print | eBook

Benjamin Graham’s classic was first published in 1949. Graham wanted to teach investors the basic principles needed to navigate markets. In doing so, he taught investors how to manage themselves.

The Notes

Based on the Revised 4th Edition 1973.

• Warren Buffett opens the preface with this: “If you follow the behavioral and business principles that Graham advocates – and if you pay special attention to the invaluable advice in Ch. 8 and 20 – you will not get a poor result from your investments… The sillier the market’s behavior, the greater the opportunity for the business-like investor. Follow Graham and you will profit from folly rather than participate in it.”
• The key to the book is to provide a basic understanding of investment principles and investor behavior.
• “To invest intelligently in securities one should be forearmed with an adequate knowledge of how the various types of bonds and stocks have actually behaved under varying conditions – some of which, at least, one is likely to meet again in one’s own experience.”
• The book is not for speculators or about trading in the markets: “The one principle that applies to nearly all these so-called “technical approaches” is that one should buy because a stock or the market has gone up and one should sell because it has declined. This is the exact opposite of sound business sense everywhere else, and it is most unlikely that it can lead to lasting success in Wall Street.”
• The markets are always changing. Sound investment principles are the basis of every investment strategy. Given enough time, the intelligent investor will recognize patterns in history around investor behavior and know how to put those sound principles into practice. Not every strategy works in every climate. The strategy is rewritten – based on sound investment principles – for the environment.
• “The underlying principles of sound investment should not alter from decade to decade, but the application of these principles must be adapted to significant changes in the financial mechanisms and climate.”
• 1969 – 70: Leading up to 1969-70, investors regained the idea that stocks “could be bought at any time and at any price, with the assurance not only of ultimate profit but also that any intervening loss would soon be recouped by a renewed advance of the market to new high levels. That was too good to be true. At long last the stock market has “returned to normal”, in the sense that both speculators and stock investors must again be prepared to experience significant and perhaps protracted falls as well as rises in the value of the holdings.”
• “Evidently it is not only the tyro who needs to be warned that while enthusiasm may be necessary for great accomplishments elsewhere, in Wall Street it almost invariably leads to disaster.”
• Graham recommended at least 25% of a portfolio be in stocks and bonds, with the other 50% divided between the two based on the market climate, risk, and investor type.
• The two types of investors — Defensive and Enterprising: “The defensive (or passive) investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions. The determining trait of the enterprising (or active, or aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort, in the form of a better average return than that realized by the passive investor. We have some doubt whether a really substantial extra recompense is promised to the active investor under today’s conditions. But next year or the years after may well be different. We shall accordingly continue to devote attention to the possibilities for enterprising investment, as they existed in former periods and may return.”
• Two lessons from a top-down investment strategy that looks for fast-growing industries and picks the best companies in those industries:
  1. “Obvious prospects for physical growth in a business do not translate into obvious profits for investors.”
  2. “the experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries.”
• Graham’s Main Objectives:
  1. Better Behavior: “Our main objective will be to guide the reader against the areas of possible substantial error and to develop policies with which he will be comfortable. We shall say quite a bit about the psychology of investors. For indeed, the investor’s chief problem – and even his worst enemy – is likely to be himself. (“The fault, dear investor, is not on our stars – and not in our stocks – but in ourselves…”)… We have seen much more money 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 had an extensive knowledge of finance, accounting, and stock market lore.”
  2. Quantifying Price and Value: “Additionally, we hope to implant in the reader a tendency to measure or quantify. For 99 issues out of 100 we could say that at some price they are cheap enough to buy and at some other price they would be so dear that they should be sold. The habit of relating what is paid to what is being offered is an invaluable trait in investment. In an article in a women’s magazine many years ago we advised the readers to buy their stocks as they bought their groceries, not as they bought their perfume. The really dreadful losses of the past few years (and on many similar occasions before) were realized in those common-stock issues where the buyer forgot to ask ‘How much?'”
  3. Policy Built Around Value Over Growth: “The reason for this outmoded counsel is both practical and psychological. Experience has taught us that, while there are many good growth companies worth several times net assets, the buyer of such shares will be too dependent on the vagaries and fluctuations of the stock market. By contrast, the investor in shares, say, of public-utility companies at about their net-asset value can always consider himself the owner of an interest in sound and expanding businesses, acquired at a rational price – regardless of what the stock market might say to the contrary. The ultimate result of such a conservative policy is likely to work out better than exciting adventures into the glamorous and dangerous fields of anticipated growth.”
• Matching the market return is very possible without much effort but beating the market with very little effort is nearly impossible: “The art of investment has one characteristic that is not generally appreciated. A creditable, if unspectacular, result can be achieved by the lay investor with a minimum of effort and capability; but to improve this easily attainable standard requires much application and more than a trace of wisdom. If you merely try to bring just a little extra knowledge and cleverness to bear upon your investment program, instead of realizing a little better than normal results, you may well find that you have done worse.”
• Graham points to the few investment funds that beat the market as evidence of how hard it is, even for smart professionals. He also cites the unreliable predictions and forecasts of brokerage houses being worse than tossing a coin.
• “A strong-minded approach to investment, firmly based on the margin of safety principle, can yield handsome rewards.”
• Graham explains the ups and downs and uncertainty of the market. Despite not knowing the future — two World Wars, Great Depression, etc. — history shows that sound principles won out. We can only assume it will continue to work. “Through all the vicissitudes and casualties, as earth-shaking, as they were unforeseen, it remained true that sound investment principles produced generally sound results. We must act on the assumption that they will continue to do so.”
• The difference between investing versus speculating: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
• The term “investor” has changed over time depending on how stocks are viewed. When people like stocks “investor” takes a broader meaning and can include trading/speculating. When people hate stocks – like after the ’29 crash – any ownership of stocks is speculation. The media does a good job of misrepresenting both words depending on sentiment at the time. But if sentiment is to be believed, people consistently avoid stocks due to “speculative nature” when stocks are cheapest, and dive into the markets when stocks are most expensive (speculative).
• “It is indeed ironical (though not surprising) that common stock purchases of all kinds were quite generally regarded as highly speculative or risky at a time when they were selling on a most attractive basis, and due soon to begin their greatest advance in history; conversely the very fact they had advanced to what were undoubtedly dangerous levels as judged by past experience later transformed them into “investments”, and the entire stock buying public into “investors”.”
• “The distinction between investment and speculation in common stocks has always been a useful one and its disappearance is a cause for concern.”
• The Speculative Factor: Every stock has a speculative factor built into its price. Driven by sentiment, it pushes prices above or below intrinsic value. Investors should be prepared, financially and psychologically, for periods where the speculative factor stays wildly in one direction or the other for an extended length of time.
• You can’t get away from speculation – there is always some amount of speculation – since with every investment both the buyer and seller assume they’re right. They both can’t be right. And in most situations, there is some chance of both profit and loss. The intelligent investor must keep the speculation to a minimum by relying on the most probable outcomes.
• “There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.”
• Graham adds investing on margin and chasing hot stocks to that list of speculative endeavors.
• Graham advises an allocation of no more than 75% and no less than 25% of your money in high-grade bonds and common stocks, with the simplest choice being 50-50. Rebalance as necessary and re-allocate whenever changes in risk in the market environment warrants.
• In 1965 the average taxable high-grade bond yield was 4.5%, and 3.25% for tax-free bonds, while the average dividend yield was 3.2%. Graham viewed the small spread between the bond yield and dividend yield warranted caution.
• Between 1949 and 1965, stocks returned on average better than 10%. People “generally regarded as a sort of guarantee that similarly satisfactory results could be counted on the future. Few people were willing to consider seriously the possibility that the high rate of advance in the past means that stock prices are ‘now too high,’ and hence that ‘the wonderful results since 1949 would imply not very good but bad results for the future.'”
• Between 1949 and 1969, the Dow increased 5x while its earnings and dividends only doubled (i.e. P/E expansion): “Hence the greater part of the impressive market record for that period was based on a change in investors’ and speculators’ attitudes rather than in underlying corporate values. To that extent, it might well be called a ‘bootstrap operation.'”
• Stocks outperform bonds over time because of two important factors: earnings paid out over time (dividend yield), plus retained earnings reinvested at a reasonable rate of return (capital appreciation).
• Periods, where expected returns for bonds exceed expected returns for stocks, should be viewed as a possible warning of an inflection point — most likely with stocks — where bonds are the less risky play until expectations revert to favor stocks again. Put another way, if you can get the same expected return from bonds as you can with stocks, it’s better to own more bonds until stocks offer a significantly favorable return.
• The Defensive Investor:
  • “…the major point here is that the defensive investor’s overall results are not likely to be decisively different from one diversified or representative list than from another, or — more accurately — that neither he nor his advisers could predict with certainty whatever differences would ultimately develop…we are skeptical of the ability of defensive investors generally to get better than average results — which in fact would mean to beat their own overall performance. (Our skepticism extends to the management of large funds by experts.)”
  • “All this proves, we insist, that only rarely can one make dependable predictions about price changes, absolute or relative.”
  • “The defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial conditions.”
  • Graham advocates for dollar-cost averaging because it systematically causes you to buy more shares when the market is low than when the market high.
• The Enterprising Investor:
  • The enterprising investors are most likely trying to beat the market. “But first he must make sure that his results will not be worse.”
  • “It is no difficult trick to bring a great deal of energy, study, and native ability into Wall Street and to end up with losses instead of profits.”
  • Ways investors/speculators try to beat the market:
    • Trading in the market: chasing/picking stocks that seem to behave better than the rest or short selling those behaving the worst
    • Short term selectivity: picking stocks based on some anticipated change in earnings, sales, etc., or good news.
    • Long term selectivity: picking stocks with hopes of continued excellent growth in earnings or improvement in earnings.
  • Investors face two obstacles in picking stocks:
    • Human Fallibility: wrong about future estimates or expectations.
    • Nature of Competition: right, but the market already reflects it in the price.
  • “In his endeavor to select the most promising stocks either for the near term or the longer future, the investor faces obstacles of two kinds – the first stemming from human fallibility and the second from the nature of his competition. He may be wrong in his estimate of the future; or even if he is right, the current market price may already fully reflect what he is anticipating.”
  • The potential for human error is highest when trying to predict earnings — long term earnings being harder to predict than short term earnings.
  • “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) are not popular in Wall Street.”
  • “Everyone knows that speculative stock movements are carried too far in both directions, frequently in the general market and at all times in at least some of the individual issues. Furthermore, a common stock may be undervalued because of lack of interest or unjustified popular prejudice. We can go further and assert that in an astonishingly large proportion of the trading in common stocks, those engaged therein don’t appear to know — in polite terms — one part of their anatomy from another… Thus it seems that any intelligent person, with a good head for figures, should have a veritable picnic in Wall Street, battening off other people’s foolishness. So it seems, but somehow it doesn’t work out that simply. Buying a neglected and therefore undervalued issue for profit generally proves a protracted and patience-trying experience. And selling short a too popular and therefore overvalued issue is apt to be a test not only of one’s courage and stamina but also of the depth of one’s pocketbook. The principle is sound, its successful application is not impossible, but it is distinctly not an easy art to master.”
  • “Buy cheap and sell dear,” is the Rothschilds maxim. As a strategy, it worked great — until about 1949 — then it didn’t. Strategies, like stocks, can be become popular, perform great for a period of time (diminishing future returns), then stop. Strategies go in and out of favor because investors chase strategies like they chase stocks.
  • Graham’s Net Current Assets (NCAV) strategy: Bargains selling below the net current asset value (working capital), not counting plant and other assets and minus liabilities. Often, you’re buying the cash on the balance sheet and getting the business for free. Or you’re buying the assets and getting the earnings for free. The strategy goes through long dry spells where none are available, only reappearing after the worst market drawdowns.
  • Graham believes that stock selection of the enterprising kind is only worth the effort if you can add “5% before taxes to the average annual return from the stock portion of his portfolio.”
• Investors are in a constant fight against inflation, to protect from loss of purchasing power. When dealing with high inflation: the rule of thumb is: stocks offer more protection than bonds.
• Stocks offer a possibility that rising dividends and prices may offset inflation, whereas most bonds offer a fixed income that can be outpaced by inflation. But only on average, over time. There is no short-term correlation between stock price movements and inflation (or deflation).
• Beware of thinking stocks are always better (fear often drives thinking on Wall Street to extremes).
• “Our readers must have enough intelligence to recognize that even high-quality stocks cannot be a better purchase than bonds under all conditions — i.e., regardless of how high the stock market may be and how low the current dividend return compared with the rates available on bonds. A statement of this kind would be as absurd as was the contrary one — too often heard years ago — that any bond is safer than any stock.”
• Beware of thinking, planning, and acting in terms of years, instead of decades: “We must deal here with two different time elements in investment results. The first covers what is likely to occur over the long-term future — say, the next 25 years. The second applies to what is likely to happen to the investor — both financially and psychologically — over short or intermediate periods, say five years or less. His frame of mind, his hopes and apprehensions, his satisfaction or discontent with what he has done, above all his decisions what to do next, are all determined not in the retrospect of a lifetime of investment but rather by his experience from year to year.”
• At the corporate level, periods of high inflation can cause costs (wages, debt, new capital) to grow faster than rising production rates, sales/earnings. It’s harder to raise prices to keep up with the rising costs. Heavy debt-laden companies are worse off due to the higher cost to borrow new debt at much higher rates, directing impacts earnings.
• Graham’s Views on Alternative Inflation Hedges:
  • Gold: “The standard policy of people all over the world who mistrust their currency has been to buy and hold gold…But during all this time the holder of gold has received no income return on his capital, and instead has incurred some annual expense for storage.” and “The near-complete failure of gold to protect against a loss in the purchasing power of the dollar must cast grave doubt on the stability of the ordinary investor to protect himself against inflation by putting his money in ‘things’.”
  • Collectibles like paints, books, stamps, coins: “But in many, perhaps, most of these cases there seems to be an element of the artificial or the precarious or even the unreal about the quoted prices.” With all of these, the only chance of profit is in hoping a greater fool comes along.
  • Real Estate: can suffer from wide price swings, potential errors due to location and price paid, and diversification is difficult to practically impossible.
• “Just because of the uncertainties of the future the investor cannot afford to put all his funds into one basket — neither in the bond basket…nor in the stock basket… The more the investor depends on his portfolio and the income therefrom, the more necessary it is for him to guard against the unexpected and the disconcerting in this part of his life.”
• Know Stock Market History: Graham believed investors should know market history to better inform their decisions, particularly when the market looked attractive or dangerous.
  • Have an idea of swings in price levels — how stocks acted — during the past market cycles. Mid-year swings included.
  • Understand the relationship between prices, earnings, and dividends and how it varied during different periods of the past. Look at it on a year-to-year and multi-year basis.
  • Examples:
    • 1949 – 1961 (the change in the P/E ratio of the S&P went from 6.3 to 22.9): “This is certainly the most remarkable turnabout in the public’s attitude in all stock-market history.”
    • 1961 – June 1962: The Dow declines 27%. “Growth stocks” got hit harder. IPOs launched at high prices in ’61, saw losses of 90% or more. But the market turned after that.
    • June 1962 – 1964: The Dow was up 66%. Sentiment swung just as wildly as the market from 1961 to 1964, it also followed prices.
    • 1964 – 1970: The Dow rose 11% then fell, ending below where it was in ’64. IPOs hit again with 90%+ losses.
    • Dividend Yield/Bond Yield relationship reversed between 1948 and 1972. Stocks yielded twice that of bonds in ’48, bonds twice that of stocks in ’72.
• Return is not based on risk taken, but by intelligent effort and skill: “It has been an old and sound principle that those who cannot afford to take risks should be content with a relatively low return on their invested funds. From this there has been developed the general notion that the rate of return which the investor should aim for is more or less proportionate to the degree of risk he is ready to run. Our view is different. The rate of return sought should be dependent, rather, on the amount of intelligent effort the investor is willing and able to bring to bear on his task. The minimum return goes to our passive investor, who wants both safety and freedom from concern. The maximum return would be realized by the alert and enterprising investor who exercises maximum intelligence and skill.”
• Graham calls for a diversified portfolio divided between stocks and bonds, never going above 75% or below 25% for either. He refers to a 50:50 split with regular rebalance when it shifts to 55/45 in either direction.
• Graham also offers a tactical approach for those with the right temperament: “According to tradition the sound reason for increasing their percentage in common stocks would be the appearance of the ‘bargain price’ levels created in a protracted bear market. Conversely, sound procedure would call for reducing the common-stock component below 50% when in the judgment of the investor the market level has become dangerously high.”
• On portfolio models: “These copybook maxims have always been easy to enunciate and always difficult to follow — because they go against that very human nature which produces that excesses of bull and bear markets. It is almost a contradiction in terms to suggest as a feasible policy for the average stockowner that he lighten his holdings when the market advances beyond a certain point and add to them after a corresponding decline. It is because the average man operates, and apparently must operate, in opposite fashion that we have had the great advances and collapses of the past; and — this writer believes — we are likely to have them in the future.”
• The risk that comes with any portfolio model is being too aggressive, too conservative, and sticking to it.
• Two Bond Questions:
  • Taxable vs Tax-Free: It’s come down to math. Whichever produces the yield based on the current taxable rate.
  • Short vs Long Term Maturity: Do you want protection from price declines but at the cost of lower yield and loss of possible gains.
• High Yield Bonds: May produce a higher yield on average but present more risks, via default and price declines. Graham doesn’t believe its worth the potentially higher yield unless you have the extra study and skill to find bargain opportunities.
• Preferred Stocks: “Experience teaches that the time to buy preferred stocks is when their price is unduly depressed by temporary adversity.”
• On the bias for types of investments on Wall Street: “The acceptance by everybody of the inherently weak preferred-stock form and the rejection of the stronger income-bond form is a fascinating illustration of the way in which traditional institutions and habits often tend to persist in Wall Street despite new conditions calling for a fresh point of view. With every new wave of optimism or pessimism, we are ready to abandon history and time-tested principles, but we cling tenaciously and unquestioningly to our prejudices.”
• The Defensive Investor
  • The appearance of safety or risk is inversely driven by price direction.
  • You should have some exposure to stocks at all times, even if stocks are “expensive”: “For reasons already given we feel that the defensive investor cannot afford to be without an appreciable proportion of common stocks in his portfolio, even if he must regard them as the lesser of two evils — the greater being the risks attached to an all-bond holding.”
  • 4 Rules for the Stock Portion of the Portfolio
    1. “There should be adequate though not excessive diversification” — 10 to 30 stocks
    2. “Each company selected should be large, prominent, and conservatively financed.”
    3. “Each company should have a long record of continuous dividend payments” — 20+ years of dividends
    4. “The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past seven years.” — 25x earnings and not more than 20x last year’s earnings.
  • Growth Stocks: “Obviously, stocks of this kind are attractive to buy and to own, provided the price paid is not excessive. The problem lies there, of course, since growth stocks have long sold at high prices in relation to current earnings and at much higher multiples of their average profits over a past period. This has introduced a speculative element of considerable weight in the growth-stock picture and has made successful operations in this field a far from simple matter… Of course, wonders can be accomplished with the right individual selections, bought at the right levels, and later sold after a huge rise and before the probable decline. But the average investor can no more expect to accomplish this than to find money growing on trees. “
  • The “best of” growth stocks tend to be the worst performers when the market turns.
  • Unpopular Stocks: “In contrast we think that the group of large companies that are relatively unpopular, and therefore obtainable at reasonable earnings multipliers, offers a sound if unspectacular area of choice by the general public.”
  • Portfolio Turnover: If the list of stocks is well selected using the rules above, there should be no reason for constant turnover.
  • The benefit of Dollar-Cost Averaging: “…prevented the practitioner from concentrating his buying at the wrong times.”
  • “No one has yet discovered any other formula for investing which can be used with so much confidence of ultimate success, regardless of what may happen to security prices, as Dollar Cost Averaging.” — Lucile Tomlinson via Practical Formulas for Successful Investing
  • Graham recommends the stock allocation of a portfolio to fall between 25% and 75% (the opposite for the bond allocation) depending on the price of stocks.
  • On why highly intelligent people are often unsuccessful: “…they usually have an ample confidence in their own intelligence and a strong desire to make a good return on their money, without the realization that to do so successfully requires both considerable attention to the matter and something a professional approach to security values.” (in reference to doctors, but probably not limited only to them.)
  • Graham’s advice for the beginner: “There is a great advantage for the young capitalist to begin his financial education and experience early. If he is going to operate as an aggressive investor he is certain to make some mistakes and to take some losses. Youth can stand these disappointments and profit by them. We urge the beginner in security buying not to waste his efforts and his money in trying to beat the market. Let him study security values and initially test out his judgment on price versus value with the smallest possible sums.”
  • “…the kind of securities to be purchased and the rate of return to be sought depend not on the investor’s financial resources but on his financial equipment in terms of knowledge, experience, and temperament.”
  • Note on “Risk” 
    • “…the idea of risk is often extended to apply to a possible decline in the price of a security, even though the decline may be of a cyclical and temporary nature and even though the holder is unlikely to be forced to sell at such times. These chances are present in all securities… But we believe that what is here involved is not a true risk in the useful sense of the term. The man who holds a mortgage on a building might have to take a substantial loss if he were forced to sell it at an unfavorable time. That element is not taken into account in judging the safety or risk of ordinary real-estate mortgages, the only criterion being the certainty of punctual payments. In the same way the risk attached to an ordinary commercial business is measured by the chance of its losing money, not by what would happen if the owner were forced to sell.”
    • “…the bona fide investor does not lose money merely because the market price of his holdings declines; hence the fact that a decline may occur does not mean that he is running a true risk of loss. If a group of well-selected common-stock investments shows a satisfactory overall return, as measured through a fair number of years, then this group investment has proved to be “safe.” During that period its market value is bound to fluctuate, and as likely as not it will sell for a while under buyer’s cost. If that fact makes the investment “risky”, it would then have to be called both risky and safe at the same time. This confusion may be avoided if we apply the concept of risk solely to a loss of value which either is realized through actual sale, or is caused by a significant deterioration in the company’s position — or, more frequently perhaps, is the result of the payment of an excessive price in relation to the intrinsic worth of the security.”
    • “Many common stocks do involve risks of deterioration. But it is our thesis that a properly executed group investment in common stocks does not carry any substantial risk of this sort and that therefore it should not be termed “risky” merely because of the element of price fluctuation. But such risk is present if there is danger that the price may prove to have been clearly too high by intrinsic-value standards — even if any subsequent severe market decline may be recouped many years later.”
    • “In current mathematical approaches to investment decisions, it has become standard practice to define “risk” in terms of average price variations or “volatility”… We find this use of the word “risk” more harmful than useful for sound investment decisions — because it places too much emphasis on market fluctuations.”
• The Enterprising Investor
  • Circle of competence: “The field of choice is wide; the selection should depend not only on the individual’s competence and equipment but perhaps equally well upon his interests and preferences.”
  • Graham suggests the “aggressive” investor take a negative approach, by first knowing what to avoid.
  • Beware of buying “high-yield” bonds and preferreds for the income because the yield looks attractive. In bad times, “high-yield” securities fall when the business or market falls on hard times. You risk loss income from suspended dividend/interest and loss of capital from price weakness.
  • The opportunity is buying high-yield (junk) bonds or preferreds well below par, that are temporarily unpopular and surprise on the upside.
  • All bonds are just as susceptible to short-term uncertainty. They can fall in price despite “good” business.
  • The fallacy of a “businessman’s investment”: “That involves the purchase of a security showing a larger yield than is obtainable on a high-grade issue and carrying a corresponding greater risk. It is bad business to accept an acknowledged possibility of a loss of principal in exchange for a mere 1 or 2% of additional yearly income. If you are willing to assume some risk you should be certain that you can realize a really substantial gain in principal value if things go well.”
  • On “New Issues”: “Our own recommendation is that all investors should be wary of new issues… 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 “favorable market conditions” — which means favorable for the seller and consequently less favorable for the buyer.”
  • New issues look safe but only if you assume recent earnings will continue without any setbacks. Most don’t have a long enough history of earnings to draw a conclusion.
  • The Cycle of IPOs: “This activity follows a well-defined pattern, which by the nature of the security markets must bring many losses and disappointments to the public. The dangers arise both from the character of the businesses that are thus financed and from the market conditions that make the financing possible… By an unfortunate correlation, during the same period the stock-buying public has been developing an ingrained preference for the major companies and a similar prejudice against the minor ones. This prejudice, like many others, tends to become weaker as bull markets are built up; the large and quick profits shown by common stocks are sufficient to dull the public’s critical faculty, just as they sharpen its acquisitive instinct… Somewhere in the middle of the bull market the first common stock flotations make their appearance. These are priced not unattractively, and some large profits are made by the buyers of the early issues. As the market rise continues, this brand of financing grows more frequent; the quality of the companies becomes steadily poorer; the prices asked and obtained verge on exorbitant. One fairly dependable sign of the approaching end of a bull swing is the fact that new common stocks of small and nondescript companies are offered at prices somewhat higher than the current level for many medium-sized companies with a long market history… The heedlessness of the public and the willingness of selling organizations to sell whatever may be profitably sold can have only one result — price collapse… The situation is worsened by the aforementioned fact that, at bottom, the public has a real aversion to the very kind of small issue that it bought so readily in its careless moments. Many of these issues fall, proportionately, as much below their true value as they formerly sold above it… But all this is part of the speculative atmosphere. It is easy money. For every dollar you make in this way you will be lucky if you end up by losing only two. Some of these issues may prove excellent buys — a few years later, when nobody wants them and they can be had at a small fraction of their true worth.”
  • “The enterprising investor, by definition, will devote a fair amount of his attention and efforts toward obtaining a better than run-of-the-mill investment result.”
  • Activity should be limited to these areas:
    1. Buying low markets, selling high markets.
    2. Buying carefully chosen “growth stocks.”
    3. Buying various bargain stocks.
    4. Buying special situations.
  • On picking “growth stocks” based on past performance alone: “There are two catches to this simple idea. The first is that common stocks with good records and apparently good prospects sell at correspondingly high prices. The investor may be right in his judgment of their prospects and still not fare particularly well, merely because he has paid in full (and perhaps overpaid) for the expected prosperity. The second is that his judgment as to the future may prove wrong. Unusually rapid growth cannot keep up forever; when a company has already registered a brilliant expansion, its very increase in size makes a repetition of its achievement more difficult. At some point the growth curve flattens out, and in many cases turns downward.”
  • On the risk of buying a single company stock: “But the big fortunes from single-company investments are almost always realized by persons who have a close relationship with the particular company — through employment, family connections, etc. — which justifies them in placing a large part of their resources in one medium and holding on to this commitment through all vicissitudes, despite numerous temptations to sell out at apparently high prices along the way. An investor without such close personal contact will constantly be faced with the question whether too large a portion of his funds are in this medium. Each decline — however temporary it proves in the sequel — will accentuate his problem; and internal and external pressures are likely to force him to take what seems to be a goodly profit, but one far less than the ultimate bonanza.”
  • Obtaining better than average investment results, the required investment policy must be:
    1. It must be objective, rational, and sound.
    2. It must be different from the policy followed by most investors.
  • Graham recommends three investment approaches:
    1. Unpopular Large Caps: the stock market regularly undervalues and overvalues stocks on a temporary basis. Undervalued large caps fill a conservative approach when bought out of favor or experiencing temporary business setbacks. Graham sites the Dogs of the Dow Theory – investing in the 10 worst-performing Dow stocks based on P/E multiple and switched out each year. The 10 “unpopular” lowest P/E Dow stocks beat the average and the 10 highest multiple stocks from 1937-1969. But don’t expect it to outperform every year.
    2. Bargain Issues: Graham defines a bargain as an issue valued at 50% more than it’s current price. Bargains are due to disappointing results and protracted neglect or unpopularity. But that’s not enough to warrant buying. Look for a history of stable past earnings, plus have the size and financial strength to cover future setbacks.
    3. Special Situations: Merger arbitrage, spinoffs, and reorganizations. “The underlying factor here is the tendency of the security markets to undervalue issues that are involved in any sort of complicated legal proceedings.”
  • Companies showing inconsistent earnings can look cheap, but be expensive or look expensive but be cheap on a P/E basis. Because of this, a test for cheapness would be to compare the current price to past average earnings.
  • “Perhaps the aggressive investor should start with the “low-multiplier” idea, but add other quantitative and qualitative requirements thereto in making up his portfolio.”
  • “The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.”
  • Sentiment moves prices and price direction fuels sentiment further. This happens for the entire market and individual stocks. But sentiment alone won’t guarantee a stock will recover. A hint of improving results or some other good news is needed to swing sentiment.
  • “It is true that current earnings and the immediate prospects may both be poor, but a levelheaded appraisal of average future conditions would indicate values far above ruling prices. Thus the wisdom of having courage in depressed markets is vindicated not only by the voice of experience but also by application of plausible techniques of value analysis.”
  • “…there is a world of difference between “hindsight profits” and “real-money profits.””
  • Dividends can hold down a stock’s price and accounting methods can hide earnings and lead the market to undervalue a stock.
  • Net-Net Strategy:  Stocks trading below their net working capital. NWC stocks – on average – rise to its net-current-asset value in about 2 years times and few show significant further losses. The appearance of net-nets are cyclical (they’re rare).
  • “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. This would mean that the buyer would pay nothing at all for the fixed assets – buildings, machinery, etc., or any good-will items that might exist. Very few companies turn out to have an ultimate value less than the working capital alone, although scattered instances may be found. The surprising thing, rather, is that there have been so many enterprises obtainable which have been valued in the market on this bargain basis.”
  • Industry Leaders vs Secondary Companies: a pattern exists in the markets where investors overweight leaders and underweight secondary companies that create bargains. Numerous periods in market history percieved leaders had limitless possibilities and secondaries were doomed for extinction.
  • Ways to profit from secondary companies bought at bargain prices:
    1. The dividend return tends to be high.
    2. Reinvested earnings are high in relation to the price paid and ultimately grow the business and affect the price.
    3. Bull markets impact low priced stocks the most, driving it to a fairer value.
    4. Regular “price adjustment” happens at all times…even when the market goes nowhere.
    5. Factors driving poor performance can be corrected via new policies or management.
    6. Merger or Acquisition.
  • “The average well-selected secondary company may be fully as promising as the average industrial leader. What the smaller concern lacks in inherent stability it may readily make up in superior possibilities of growth. Consequently it may appear illogical to many readers to term “unintelligent” the purchase of such secondary issues at their full “enterprise value.” We think that the strongest logic is that of experience. Financial history says clearly that the investor may expect satisfactory results, on the average, from secondary common stocks only if he buys them for less than their value to a private owner, that is, on a bargain basis.”
• Defensive or Enterprising Investor? “Investment policy, as it has been developed here, depends in the first place on a choice by the investor of either the defensive (passive) or aggressive (enterprising) role. The aggressive investor must have a considerable knowledge of security values — enough, in fact, to warrant viewing his security operations as equivalent to a business enterprise. There is no room is this philosophy for a middle ground, or a series of gradations, between the passive and aggressive status. Many, perhaps most, investors seek to place themselves in such an intermediate category; in our opinion that is a compromise that is more likely to produce disappointment than achievement… It follows from this reasoning that the majority of security owners should elect the defensive classification. They do not have the time, or the determination, or the mental equipment to embark upon investing as a quasi-business. They should therefore be satisfied with the excellent return now obtainable from a defensive portfolio (and with even less), and they should stoutly resist the recurrent temptation to increase this return be deviating into other paths.”
• “It is easy for us to tell you not to speculate; the hard thing will be for you to follow this advice… If you want to speculate do so with your eyes open, knowing that you will probably lose money in the end; be sure to limit the amount at risk and to separate it completely from your investment program.”
• On timing versus pricing the market: “Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which he may try to do this: the way of timing and the way of pricing. By timing we mean the endeavor to anticipate the action of the stock market — to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value. A less ambitious form of pricing is the simple effort to make sure that when you buy you do not pay too much for your stocks. We are convinced that the intelligent investor can derive satisfactory results from pricing or either type. We are equally sure that if he places his emphasis on timing, in the sense of forecasting, he will end up as a speculator and with a speculator’s financial results.”
• Timing the market is pointless unless pricing lets you buy at lower prices or sell at higher prices.
• Wall Street has fooled investors into thinking they must have an opinion on the future direction of the stock market. We’re now awash in market predictions and forecasts. Of course, some will be right by sheer chance. Good luck figuring out which one.
• Why some “strategies” stop working: “Those formulas that gain adherents and importance do so because they worked well over a period, or sometimes merely because they have been plausibly adapted to the statistical record of the past. But as their acceptance increases, their reliability tends to diminish. This happens for two reasons: First, the passage of time brings new conditions which the old formula no longer fits. Second, in stock market affairs the popularity of a trading theory has itself an influence on the market’s behavior which detracts in the long run from its profit-making possibilities.”
•  Popularity, ultimately, decides a strategy’s future results. Expect strategies to go out of favor.
• “The moral seems to be that any approach to money making in the stock market which can be easily described and followed by a lot of people is by its terms too simple and too easy to last. Spinoza’s concluding remark applies to Wall Street as well as to philosophy: “All things excellent are as difficult as they are rare.””
• Investors should expect volatility in their portfolio — swings upwards of 50% or more in gains and declines of 30% or more over any five year period.
• Graham recommends a mechanical method toward investing to avoid human nature infecting portfolio decisions. The main advantage is it still gives investors something to do (as the stock market advances, sell stocks to buy bonds, as it declines sell bonds to buy stocks). But the actions taken will be opposite the crowd.
• On Business Value versus Market Value: “The whole structure of stock market quotations contains a built-in contradiction. The better a company’s record and prospects, the less relationship the price of its shares will have to their book value. But the greater the premium above book value, the less certain the basis of determining its intrinsic value — i.e., the more this “value” will depend on the changing moods and measurements of the stock market. Thus we reach the final paradox, that the more successful the company, the greater are likely to be the fluctuations in the price of its shares. This really means that, in a very real sense, the better the quality of a common stock, the more speculative it is likely to be…”
• “The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. 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.”
• Mr. Market: Imagine a you have a partner named Mr. Market. Every day he quotes what you’re investments are worth and offers to buy you out or sell you more at his price. Some days his quoted prices seem justified. Other days his emotions — excitement or fears — get the best of him and his quoted prices seem crazy. You can get caught up in daily mood swings, letting his prices persuade your views. Or you can come to your own conclusions on the value of your investments. Only then can take advantage of Mr. Market’s crazier price quotes and ignore him the rest of the time.
• “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.”
• “The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell.”
• Market quotations are a convenience. Take advantage of it or ignore. But don’t let fluctuations in the quotes influence actions. Don’t buy a stock because its price rose or sell because its price fell. Buy because the price offers an opportunity in relation to its value and sell because the opportunity is gone.
• “Good management produce a good average market price, and bad management produce bad market prices.”
• “Those of us with a long experience in Wall Street had seen Newton’s law of “action and reaction, equal and opposite” work itself out repeatedly in the stock market… “
• “Nothing important in Wall Street can be counted on to occur exactly in the same way as it happened before. This represents the first half of our favorite dictum: “The more it changes, the more it’s the same thing.”
• “If it is virtually impossible to make worthwhile predictions about the price movements of stocks, it is completely impossible to do so for bonds.”
• Mutual funds are an option for the defensive investor, but bring with it a “large and somewhat bewildering variety of choices before him – not too different from those offered in direct investment.”
• Graham offers three questions to consider about mutual funds:
  1. Can investors pick funds that ensure better than average results?
  2. If not, how can investors avoid funds that earn worse than average results?
  3. Can investors make smart choices between the different types of funds?
• As a whole, Graham believes the mutual funds are a net positive for investors — in that investors in mutual funds have probably faired better than those who choose individual stocks. But the real choice is not between choosing funds or no funds, it’s falling prey to fund salesmen or brokers pushing risky stocks offerings. Or an investor chooses a conservative stock strategy (over owning mutual funds) but ends up speculating and losing.
• But…Graham cautions that the performance of funds fared no better than common stocks as a whole. In other words, the average fund didn’t beat the market. “We do not think the mutual fund industry can be criticized for doing no better than the market as a whole. Their managers and their professional competitors administer so large a portion of all marketable common stocks that what happens to the market as a whole must necessarily happen (approximately) to the sum of their funds.”
• Moral of the 1960s Go-Go Fund frenzy: “Bright, energetic people — usually quite young — have promised to perform miracles with “other people’s money” since time immemorial. They have usually been able to do it for a while — or at least to appear to have done it — and they have inevitably brought losses to their public in the end… The operations of the new “money managers” in 1965-1969 came a little more than one full generation after the shenanigans of 1926-1929. The specific malpractices banned after 1929 were no longer resorted to — they involved the risk of jail sentences. But in many corners of Wall Street they were replaced by newer gadgets and gimmicks that produced very similar results in the end. Outright manipulation of prices disappeared, but there were many other methods of drawing the gullible public’s attention to the profit possibilities in “hot” issues… It is amazing how, in a completely different atmosphere of regulation and prohibitions, Wall Street was able to duplicate so much of the excesses and errors of the 1920s. No doubt there will be new regulations and new prohibitions. The specific abuses of the late 1960s will be fairly adequately banned from Wall Street. But it is probably too much to expect that the urge to speculate will ever disappear, or that the exploitation of that urge can ever be abolished. It is part of the armament of the intelligent investor to know about these “Extraordinary Popular Delusions,” and to keep as far away from them as possible.”
• “…there is a strong indication that smaller size is a necessary factor for obtaining continued outstanding results.”
• History suggests that funds showing spectacular market-beating returns, come with spectacular risks, since, with so many, what follows is calamitous losses.
• Closed-end funds: If buying closed-end funds,  buy at a discount to NAV, not a premium.
• The role of the financial adviser is to protect you from mistakes and to earn a normal return on your money. “It is when the investor demands more than an average return on his money, or when his adviser undertakes to do better for him, that the question arises whether more is being asked or promised than is likely to be delivered.”
• On financial services and market forecasts: “In our view — perhaps a prejudiced one — this segment of their work has no real significance except for the light it throws on human nature in the securities markets. Nearly everyone interested in common stocks wants to be told by someone else what he thinks the market is going to do. The demand being there, it must be supplied.”
• “We take a more critical attitude toward the widespread custom of asking investment advice from relatives or friends. The inquirer always thinks he has good reason for assuming that the person consulted has superior knowledge or experience. Our own observation indicates that it is almost as difficult to select satisfactory lay advisers as it is to select the proper securities unaided. Much bad advice is given free.”
• The job of the security analyst:
  • Deals with the past, present, and future of a security.
  • Describes the business.
  • Summarizes the operating results and financial position.
  • Sets the pros and cons; possibilities and risks.
  • Estimates the range of future earnings power under various assumptions.
  • Compares various companies or one company over various times.
  • Modifies the annual statement in order to find items that mean more or less than they say.
  • Uses past average earnings, capital structure, working capital, and asset values to determine the soundness of a security.
  • Opines on the safety of the security.
• A common error in analyzing “growth” stocks: “Certain mathematical techniques of a rather sophisticated sort have perforce been invoked to support the valuations arrived at… We must point out a troublesome paradox here, which is that the mathematical valuations have become most prevalent precisely in those areas where one might consider them least reliable. For the more dependent the valuation becomes on anticipations of the future — and the less it is tied to a figure demonstrated by past performance — the more vulnerable it becomes to possible miscalculation and serious error. 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.”
• When analyzing bonds and preferred stocks:
  • Bonds: what’s the number of times the total interest charges have been covered by earnings over the past several years?
  • Preferred stocks: what’s the number of times the bond interest and preferred dividends combined been covered by earnings over the past several years?
  • Beyond earnings coverage, look at: the size of the company, the Stock/Equity Ratio, and property value (in the case of utilities, real estate, and investment companies).
  • “Investment history shows that bonds and preferred stocks that have met stringent tests of safety, based on the past, have in the great majority of cases been able to face the vicissitudes of the future successfully.”
  • In most cases where securities were deemed unsafe, after the fact, there were clear signs of excessive debt and mismanagement. To take it a step further, when comparing average earnings make sure a portion of those earnings were achieved during an economic downturn.
  • A lack of bond defaults, in an industry or overall market, over a long period does not mean mass defaults are a thing of the past! Relaxing standards of analysis during these times could end badly.
• When analyzing common stocks:
  • “…valuation…would ordinarily be found by estimating the average earnings over a period of years in the future and then multiplying that estimate by an appropriate “capitalization factor.””
  • Future earnings estimates start with average past data — sales volume, prices received, and operating margin — then grounded using economic and industry estimates.
  • Composite estimates of future earnings should be more dependable than individual estimates.
  • “Unfortunately, it appears to be almost impossible to distinguish between those individual forecasts which can be relied upon and those which are subject to a large chance of error.”
  • To the few analysts exceptional enough to reliably estimate future earnings, Graham recommends Common Stocks and Uncommon Profits in a footnote.
  • “No one really knows anything about what will happen in the distant future, but analysts and investors have strong views on the subject just the same.”
  • Factors Affecting Capitalization Rate:
    • General long-term prospects: Hard to predict the future, which can be seen in differences between the P/E ratios of companies and industry groups.
    • Management: No reliable quantitative tests exists for evaluating management. It’s largely subjective. It stands to reason that great companies have good management and because of this investors will mistakenly use that as another reason to pay a higher multiple “The management factor is most useful, we think, in those cases in which a recent change has taken place that has not yet had the time to show its significance in the actual figures.”
    • Financial Strength and Capital Structure: The amount of debt or leverage “in front of the common” must be weighed. Account for the amount of cash, bonds, preferreds, and bank loans. Heavy debt can be seen as speculative.
    • Dividend Record: Look for a track record of continuous dividend payments over may years — 20 years or more is a good sign of quality.
    • Current Dividend Rate: The dividend payout ratio is enough to not maintain growth without wasting capital.
  • “There is really no way of valuing a high-growth company, in which the analyst can make realistic assumptions of both the proper multiplier for the current earnings and the expectable multiplier for the future earnings.”
  • Interest Rates: “We should point out that any “scientific,” or at least reasonably dependable, stock evaluation based on anticipated future results must take future interest rates into account. A given schedule of expected earnings, or dividends, would have a smaller present value if we assume a higher than if we assume a lower interest structure. “
  • Problems can arise when relying too heavily on just a qualitative or just a quantitative analysis.
  • “The investor cannot have it both ways. He can be imaginative and play for the big profits that are the reward for vision proved sound by the event; but then he must run a substantial risk of major or minor miscalculation. Or he can be conservative, and refuse to pay more than a minor premium for possibilities as yet unproved; but in that case he must be prepared for the later contemplation of golden opportunities foregone.”
• Diversification: “For it is undoubtedly better to concentrate on one stock that you know is going to prove highly profitable, rather than dilute your results to a mediocre figure, merely for diversification’s sake. But this is not done, because it cannot be done dependably. The prevalence of wide diversification is in itself pragmatic repudiation of the fetish of “selectivity,” to which Wall Street constantly pays lips service.”
• Graham suggests a two-part valuation process:
  • Part 1: Value the company based only on past performance and assume the past growth rate won’t change.
  • Part 2: Decide how much that past performance valuation might change based on any new conditions in the future.
  • He suggests this not because it will be more reliable in any way — it won’t — but because the repetitive practice of valuing companies offers useful experience and insight to improve your valuation process.
• Per-share earnings aren’t always what it seems.
• Long-term decisions should be made using long-term records. Short-term decisions should be made using short-term records.
• Graham offers two pieces of advice:
  1. Don’t take a single year’s earnings seriously.
  2. If you pay attention to short-term earnings, watch out for traps in per-share figures.
• Because quarterly and annual figures get a lot of press and can be misleading. It’s hard not to let it infect your thinking. Education is paramount to avoid being misled.
• To find these traps, check the footnotes of the financial statement for:
  • Share dilution – look for convertible issues, stock options, etc. that could dilute future earnings per share numbers.
  • Special charges – look for special items that might not fit “extraordinary and nonrecurring” but rather fit better in “regular operating results.” Misappropriated special charges put future losses on the books today and in turn lower current earnings but inflate future earnings.
  • Income tax deduction – tax credits from special charges also impact current and future earnings.
  • Depreciation – switching from “straight line” to an “accelerated” schedule or back.
  • Amortization – charging off R&D in a single year versus a period of years.
  • Inventories – switching from LIFO to FIFO or back.
  • Sometimes “special charges” have a way of showing earnings to be smoother and more consistent than they actually are.
• The more seriously investors take the per-share earnings figures as published, the more necessary it is to be on guard against true accounting factors of one kind or another that may impair the comparability of the numbers.
• Don’t take small amounts on financial statements too seriously.
• “Corporate accounting is often tricky; security analysis can be complicated; stock valuations are really dependable only in exceptional cases. For most investors it would be probably best to assure themselves that they are getting good value for the prices they pay, and let it go at that.”
• Graham uses average earnings over a 7 to 10-year period to the judge growth and stability of earnings. It’s long enough to look at over the full swing in the business cycle.
• Average earnings over a longer period would include any special charges and tax credits anyways so no need to uncover those.
• Calculating Growth Rate: compare the average of the last three years against the three year average from 10 years earlier.
• Optimism or pessimism around recent earnings can have a bigger impact on stock price than the true growth rate in earnings. This is why it’s so important to look at average earnings over multiple years instead of the current year only.
• “High multipliers have been maintained in the stock market only if the company has maintained better than average profitability.”
• Graham looks at 6 areas to judge a company’s prospects:
  • Profitability – look for satisfactory earnings per book value. Also, a high rate of return on invested capital often equates to a high growth rate in earnings per share. For manufacturing companies, operating income to sales may indicate strength or weakness.
  • Stability – measure any single year earnings decline in 1 of the past 10 years versus average earnings in the preceding 3 years (then compare it against the Dow or S&P 500 decline).
  • Growth – compare growth in earnings over 10 year period, then compare growth against the P/E ratio.
  • Financial Position – sound finances (not excessively debt-heavy and low long term debt) with better than 2x current ratio ($2 current assets to $1 current liabilities). Treat convertible issues (preferred and bonds) as if it were converted into common, to see how it impacts earnings per share.
  • Dividends – Check for suspensions or cuts.
  • Price History – should see a gradual increase over the past decade(s). Price history also shows any excess advances and declines during previous bull and bear markets. And if fundamentally sound, might see it repeated in the future.
• Growth is limited by the size of the market and/or the ability to raise prices.
• There’s no reason to expect to low multiple stocks to outperform high multiple stocks over any short term period. In other words, momentum can drive high multiple stocks higher and low multiple stocks lower for a lot longer than investors expect.
• The defensive investors should stick with high-quality bonds and a diversified basket of leading stocks. The basket of stocks can be chosen one of two ways:
  • A basket of stocks found in an index (like the Dow or S&P 500), or
  • A basket of quantitatively-selected stocks.
• Graham’s Criteria for the Defensive Investor:
  • Adequate Size – exclude small companies at greater risk of industry or economic downturn.
  • Strong Financial Condition – 2x current ratio (current assets to current liabilities). Also, long-term debt should be less than the current assets (or working capital). (Note: Graham excludes the current ratio for public utilities. He replaces it with an adequate stock capital to debt.)
  • Earnings Stability – actual earnings over the past 10 years.
  • Dividend Record – consistent dividend payout over the past 20 years.
  • Earnings Growth – a minimum increase of 33% in per-share earnings over the past 10 years using 3-year averages over the beginning and end.
  • Moderate P/E Ratio – the current price should be no more than 15x average earnings of the past 3 years.
  • Moderate Price/Assets – the current price should be no more than 1.5x book value. (rule of thumb – the product of the P/E ratio times the P/B value should not exceed 22.5 (which corresponds to 15x earnings and 1.5x book value)).
  • These criteria will eliminate companies that are too small, in weak financial condition, with proven losses in the past, inconsistent dividend history but with proven earnings growth while paying a more conservative price per dollar of assets.
  • Graham notes that his criteria won’t beat the market all the time: “…no system or formula will guarantee superior market results. Our requirements “guarantee” only that the portfolio-buyer is getting his money’s worth.”
• Graham suggests the defensive investor’s portfolio should have an average E/P ratio >= to the high-grade bond interest rate (he uses AA bond rates).
• On portfolio turnover and paying taxes: “…even defensive portfolios should be changed from time to time, especially if the securities purchased have an apparently excessive advance and can be replaced by issues much more reasonably priced. Alas! there will be capital-gains taxes to pay — which for the typical investor seems to be about the same as the Devil to pay. Our old ally, experience, tells us here that it is better to sell and pay the tax than to not sell and repent.”
• Beware of projecting one company’s performance onto an entire industry or group of stocks. (Graham uses the example of the Penn Central bankruptcy to show how the big bankruptcy of a popular company depressed shares of the entire industry).
• “…the current price of each prominent stock pretty well reflects the salient factors in its financial record plus the general opinion as to its future prospects…” or “…the current price reflects both known facts and future expectations…”
• “To be sure, every competent analyst looks forward to the future rather than backward to the past, and he realizes that his work will prove good or bad depending on what will happen and not on what has happened.”
• Analysts can handle the future in two ways:
  • Prediction (Qualitative): attempt to accurately predict what the company will accomplish, what earnings growth will be, in the future. A naive take: just continue the past growth into the future (can lead to any price being attractive).
  • Protection (Quantitative): look for a margin between present value and current price, where the margin (of safety) cushions from unfavorable future events.
• Graham’s approach: “In our own attitude and professional work we were always committed to the quantitative approach. From the first we wanted to make sure that we were getting ample value for our money in concrete, demonstrable terms. We were not willing to accept the prospects and promises of the future as compensation for a lack of sufficient value in hand.”
• The defensive investors should emphasize diversification over selection. If the defensive investor could select the “best” stocks, they wouldn’t need to diversify.
• On diversification: “Incidentally, the universally accepted idea of diversification is, in part at least, the negation of the ambitious pretensions of selectivity. If one could select the best stocks unerringly, one would only lose by diversifying.”
• “Our emphasis in selection has been chiefly on exclusions — advising on the one hand against all issues of recognizably poor quality, and on the other against highest-quality issues if their price is so high as to involve a considerable speculative risk.”
• Is it possible to beat the market? Graham cites the track record of stock funds that fail to beat the S&P 500 over many years. “…to the objective observer the failure of the funds to better the performance of a broad average is a pretty conclusive indication that such an achievement, instead of being easy, is in fact extremely difficult.”
• Beating the market is indeed hard. Despite the average fund’s inability to even match the market, funds still provide easier access to the market and better results than the average person would get picking stocks. It’s safe to say, Graham would stand behind the use of index funds today.
• Luck vs. Skill: “We have often thought of the analogy between the work of the host of security analysts in Wall Street and the performance of the master bridge players at a duplicate-bridge tournament. The former try to pick the stocks “most likely to succeed”; the latter to get top score for each hand played. Only a limited few can accomplish either aim. To the extent that all bridge players have about the same level of expertness, the winners are likely to be determined by “breaks” of various sorts rather than superior skill. In Wall Street the leveling process is helped along by the freemasonry that exists in the profession, under which ideas and discoveries are quite freely shared at the numerous get-togethers of various sorts. It is almost as if, at the analogous bridge tournament, the various experts were looking over each other’s shoulders and arguing out each hand as it was played.”
• Graham offers up 2 possible reasons why it’s so difficult for professionals to beat the market:
  1. Price moves are truely random: That stock prices do reflect all relevant information, including whatever expectations that can be reasonably formed about the future (extreme market movements are then due to unforeseeable events or probabilities) making price moves random. If true, trying to predict the unpredictable with any consistency, would be impossible.
  2. Analysts are biased: They look for companies with the best growth, the best management, and the best advantages, and buy at any price while avoiding the worst companies at any price. It’s the ideal strategy if the best companies saw infinite growth and the worst companies went extinct. But the facts suggest the opposite — companies are subject to mean reversion. “Extremely few companies have been able to show a high rate of uninterrupted growth for long periods. Remarkably few, also, of the larger companies suffer ultimate extinction. For most, their history is one of vicissitudes, of ups and downs, of change in their relative standing. In some the variations “from rags to riches and back” have been repeated on almost a cyclical basis — the phrase used to be a standard one applied to the steel industry — for others spectacular changes have been identified with deterioration or improvement of management.”
• Seriously, is it possible to beat the market? “Readers of this book, however intelligent and knowing, could scarcely expect to do a better job of portfolio selection than the top analysts of the country. But if it is true that a fairly large segment of the stock market is often discriminated against or entirely neglected in the standard analytical selections, then the intelligent investor may be in a position to profit from the resultant undervaluations. But to do so he must follow specific methods that are not generally accepted in Wall Street, since those that are so accepted do not seem to produce the results that everyone would like to achieve. It would be rather strange if — with all the brains at work professionally in the stock market — there could be approaches which are both sound and relatively unpopular. Yet our own career and reputation have been based on this unlikely fact.”
• Summary of the Graham-Newman Methods:
  • Arbitrages: the simultaneous purchase of one security and the sale of another where both are related to a merger, acquisition, or reorganization.
  • Liquidations: selected company liquidations for the cash payout on the basis of a) potential annual return of 20% or more and b) chance of success was at least 4 out of 5.
  • Related Hedges: hedges on convertible bonds and preferreds by buying convertible issues and selling short the common stock. The related hedges produced good results during bear markets where bargain issues faired worse.
  • Net-Current-Asset or Bargain Issues: buy stocks selling below book value — at 2/3’s or less of net current assets (excluding plant and other assets). Typically carried more than 100 different issues.
• “The enterprising investor may confine his choice to industries and companies about which he holds an optimistic view, but we counsel strongly against paying a high price for a stock (in relation to earnings and assets) because of such enthusiasm.”
• Graham’s Criteria for the Enterprising Investor:
  • P/E Ratio – less than 10.
  • Financial Condition – current ratio >= 1.5 (current assets at least 1.5x current liabilities) and debt not more than 110% of current assets.
  • Earnings Stability – no losses in the past five years.
  • Dividend Record – some current dividends.
  • Earnings Growth – current earnings more than that of 5 years ago.
  • Price – less than 120% of net tangible assets.
  • Filter the resulting list down to a basket of at least 15 stocks based on personal judgment.
• Why not use a single metric for choosing stocks? Graham cited only two metrics “single metrics” that produce consistently good results:
  1. Buying low multiple stocks.
  2. Buying stocks selling below NCAV — net current asset value (or working capital).
• Net Current Asset Value (NCAV) stocks:
  • Requires a diversified basket and time (patience).
  • “The record of common-stock purchases made at a price below their working capital value has no such mark against it; the drawback here has been the drying up of such opportunities during most of the past decade.”
  • “It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone — after deducting all prior claims, and counting as zero the fixed and other assets — the results should be quite satisfactory.”
• Convertible Issues:
  • Convertible bonds and convertible preferreds — senior debt issues that can be converted into common stock at a predetermined price.
  • Convertible issues are only attractive when it can outperform the common stock, otherwise, just own the common.
  • Beware of new convertible issues floated in late bull markets when optimism is high because they often produce poor returns and conversion “privilege” becomes moot.
  • “…the addition of the conversion privilege often – perhaps generally – betrays an absence of genuine investment quality for the issue.”
  • Beware of converting too early. In doing so, you remove the strategic optionality embedded in the issue and lose the interest/dividend yield.
  • “The ideal combination, of course, is a strongly secured convertible, exchangeable for a common stock which itself is attractive, and at a price only slightly higher than the current market.”
  • Often ignored is the potential dilution of earnings per share as a result of exercised conversion rights. Worth figuring out what earnings per share would look like assuming all convertibles issues are converted when analyzing a company.
• “Wall Street has a few prudent principles; the trouble is that they are always forgotten when they are most needed. Hence that other famous dictum of the old-timers: “Do as I say, not as I do.””
• Warrants:
  • Warrants – issues offering the long-term right to buy common stock at a predetermined price.
  • “We consider the recent development of stock-option warrants as a near fraud, an existing menace, and a potential disaster. They created huge aggregate dollar “values” out of thin air. They have no excuse for existence except to the extent that they mislead speculators and investors. They should be prohibited by law, or at least strictly limited to a minor part of the total capitalization of a company.”
  • “Once more we assert that large issues of stock-option warrants serve no purpose, except to fabricate imaginary market values.”
  • Usually common stock comes with the first right to buy additional common shares when a company raises capital. It’s part of the value inherent in common stock (like dividends, voting rights, etc.). Warrants remove that value, transferring it to a separate certificate.
  • “If the warrant total is relatively small there is no point in taking its theoretical aspect too seriously; if the warrant issue is large relative to the outstanding stock, that would probably indicate that the company has a top-heavy senior capitalization. It should be selling additional common stock instead. Thus the main objective of our attack on warrants as a financial mechanism is not to condemn their use in connection with moderate-size bond issues, but to argue against the wanton creation of huge “paper-money” monstrosities of this genre.”
• Case Histories — four companies that present extremes that often repeat in market history.
  • All of the examples — expanded on below — show a company’s ability to disguise the true financial nature with “adjusted earnings” and other accounting gimmicks.
  • Penn Central Co. – financial weakness gone wrong
    • A financially weak company, with a high stock price and a huge amount of debt via bonds, that ultimately collapsed under bankruptcy.
    • The company paid no income taxes over a long period, which should have been a giant red flag to investigate the accuracy of the reported earnings.
    • Reported earnings of $6.80 per share in 1966, before a special charge of $12 per share to be taken in 1971!
    • “O wonderful fairyland of Wall Street where a company can announce “profits” of $6.80 per share in one place and special “costs and losses” of $12 in another, and stockholders and speculators rub their hands with glee!”
    • “Moral: Security analysts should do their elementary jobs before they study stock-market movements, gaze into crystal balls, make elaborate mathematical calculations, or go on all-expense-paid field trips.”
  • Ling-Temco-Vought Inc. – quick and unsound empire-building gone wrong
    • The case of the acquisition spree gone awry. Fast expansion led by too much debt, helped by bank lenders, can end badly for shareholders.
    • In 1961 the company showed a small loss because they “decided to throw all possible charges and reserves into the one bad year. These amounted to a round $13 million, which was more than the combined net profits of the preceding three years. It was now ready to show “record earnings” in 1962, etc.”
    • The Heyday years (1967-1968): sales grew 20x to $2.8 billion, debt grew from $44 million to $1.7 billion.
    • Market price reached 22x reported asset value at about $77 per share. But deduct preferred stock, goodwill items, and bond asset, it comes to $3 per share for the common.
    • In 1969, new acquisitions increased debt to 1.9 billion, and the beginning of trouble (likely the largest debt figure of any company at the time except Standard Oil).
    • The stock price got as high as $169.50 in 1967. By 1970 it was about $7.
    • “The losses in 1969 and 1970 far exceeded the total profits since the formation of the company.”
    • “Moral: The primary question raised in our mind by the Ling-Temco-Vought story is how the commercial bankers could have been persuaded to lend the company such huge amounts of money during its expansion period. In 1966 and earlier the company’s coverage of interest charges did not meet conservative standards, and the same was true of the ratio of current assets to current liabilities, and or stock equity to total debt.”
  • NVF Corp. – corporate acquisition gone wrong
    • NVF Company bought out Sharon Steel, which was 7x its size. To do so, it took on a pile of debt that led to its downfall (Sharon Steel shareholders received bonds and warrants in exchange for their shares).
    • In taking on the new debt, NVF “changed its calculated 1968 earnings from a profit to a loss into a bargain. A measure of the impairment of the company’s financial position by this step is found in the fact that the new 5% bonds did not sell higher than 42 cents on the dollar during the year of issuance.”
    • Changed its method for arriving at pension costs and adopted lower depreciation rates in 1969. The accounting changes added $1 per share earnings.
    • The S&P stock guide reported NFV Co. had a P/E of 2 in 1970. “But this ratio did not allow for the large dilution factor, nor for the adverse results actually realized in the last quarter of 1970.”
    • Accuracy of the P/E ratio depends on the amount of “adjustment” to earnings and any potential dilution to shares from warrants, options, and convertible preferreds/bonds.
    • Accounting gimmicks were so widespread that even a well-trained analyst would have a hard time making sense of it.
  • AAA Enterprises – public stock financing gone wrong
    • Was a franchise business that allowed others the right to sell mobile homes — later included tax prep — under the AAA name.
    • In taking the company public, the IPO ended selling for 115x current earnings. The hyped IPO eventually led to the company’s downfall.
    • With the excess cash from an above-average IPO price, the company went into the retail carpet store business and bought a mobile home manufacturing plant.
    • Moral: “The speculative public is incorrigible. In financial terms it cannot count beyond 3. It will buy anything, at any price, if there seems to be some “action” in progress. It will fall for any company identified with “franchising,” computers, electronics, science, technology, or what have you, when the particular fashion is raging. Our readers, sensible investors all, are of course above such foolishness.”
    • “It will be difficult to impose worthwhile changes in the field of new offerings, because the abuses are so largely the result of the public’s own heedlessness and greed.”
• “Most security analysts try to select the issues that will give the best account of themselves in the future, in terms chiefly of market action but considering also the development of earnings. We are frankly skeptical as to whether this can be done with satisfactory results. Our preference for the analyst’s work would be rather that he should seek the exceptional or minority cases in which he can form a reasonably confident judgment that the price is well below value. He should be able to do this work with sufficient expertness to produce satisfactory average results over the years.”
• Stockholders should question management competence whenever results are unsatisfactory, results are worse than other similar companies, and the stock price languishes for a long time. But most shareholders don’t.
• On Dividends: “It is our belief that stockholders should demand of their managements either a normal payout of earnings — on the order, say, of two-thirds — or else a clear-cut demonstration that the reinvested profits have produced a satisfactory increase in per-share earnings.”
• 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.”
  • Graham borrowed the concept of margin of safety from bond and preferred stock investing. Basically, a company should earn multiple times the cost of interest on its debt to be considered “safe” from bankruptcy and protect the investor against a future decline in earnings.
  • “The bond investor does not expect future average earnings to work out the same as in the past; if he were sure of that, the margin demanded might be small. Nor does he rely to any controlling extent on his judgement as to whether future earnings will be materially better or poorer than in the past; if he did that, he would have to measure his margin in terms of a carefully projected income account, instead of emphasizing the margin shown in the past record. 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 any vicissitudes of time.”
  • The margin of safety in stocks: “In the ordinary common stock, bought for investment under normal conditions, the margin of safety lies in an expected earnings power considerably above the going rate for bonds.”
  • Graham offers an example: Assume a company’s earning power is 9% on the stock price and the bond rate is 4%, then the investor has average margin of safety of 5%. Over a 10 year period, the stock’s excess earning power over bonds could add up to 50% of the price paid. “This figure is sufficient to provide a very real margin of safety — which, under favorable conditions, will prevent or minimize a loss. If such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favorable result under “fairly normal conditions” becomes very large. That is why the policy of investing in representative common stocks does not require high qualities of insight and foresight to work out successfully. If the purchases are made at the average level of the market over a span of years, the prices paid should carry with them assurances of an adequate margin of safety. The danger to investors lies in concentrating their purchases in the upper levels of the market, or in buying nonrepresentative common stocks that carry more than average risk of diminishing earning power.” Here: “earning power is 9%” where x% is the inverse the P/E ratio (so E/P). So a stock with a P/E of 11 — it’s E/P is 1/11 — has an earning power of 9.1%. The bond rate it’s compared to, I believe, is the AAA bond rate at the time.
  • Graham notes that during periods when a low or no margin of safety exists, an investor must weigh the risk of having little to no margin or losing to inflation by investing in bonds.
  • Graham warns of buying cyclical stocks at the peak of the business cycle: “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.”
  • Using a margin of safety with growth stocks only works if the future earnings estimates are made competently and conservatively and the margin is reasonable compared to the price. The problem: the markets sets growth stock prices too high to offer any protection based on conservative estimates.
  • “The margin of safety is always dependent on price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price.”
  • Diversification won’t work when you pay too high a price for every stock.
  • Using a margin of safety with bargains: “The margin of safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities. We have here, by definition, a favorable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck. The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments… If these are bought on a bargain basis, even a moderate decline in the earning power need not prevent the investment from showing a satisfactory results. The margin of safety will then have served its proper purpose.”
  • On diversification: “There is close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss — not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.”
  • On speculation and margin of safety:
  • Timing, “skill,” instinct, or other subjective views on the future are not a margin of safety. Margin of safety only exists through facts and data.
  • “It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity — provided that the buyer is informed and experienced and that he practices adequate diversification. For, if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment.”
  • Price depreciation can make what seems like a “risky” stock, relatively safe. Because if a stock price falls low enough, carefully study “might well yield the conclusion that there is much more to be gained in such an operation than to be lost and that the chances of an ultimate profit are much better than those of an ultimate loss.”
• “Investment is most intelligent when it is most businesslike.”
• Graham offers four principles to live by:
  1. “Know what you are doing – know your business.” Or, don’t invest in what you don’t understand and don’t try to earn a return in excess of what your knowledge allows.
  2. “Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.”
  3. “Do not enter upon an operation — that is, manufacturing or trading in an item — unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular, keep away from ventures in which you have little to gain and much to lose.” Or, investments should be based on facts, not feelings and done so without risking a large part of your portfolio.
  4. “Have the courage of your knowledge and experience. 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.)” Or, “Similar, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.”
• “To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.”
• In the postscript, Graham refers to an experience he had at Graham-Newmann with GEICO stock:
  • “We know very well two partners who spent a good part of their lives handling their own and other people’s funds in Wall Street. Some hard experience taught them it was better to be safe and careful rather than to try to make all the money in the world.”
  • Graham-Newman averaged about 20% annual returns avoiding anything that looked overpriced and quickly sold anything that looked fairly priced. They did it with a diversified portfolio of over 100 issues using strategies discussed earlier.
  • Graham-Newman was offered 50% of GEICO in 1949 (GEICO was privately held at the time).
  • They bought even though it didn’t meet their investment standards at the time (the deal almost fell through because they insisted the price be covered 100% by asset value).
  • Their GEICO stock advanced 200x the price paid (and exceeded the profits of all other investments over the 20-year life of the firm).
  • “Are there morals to this story of value to the intelligent investor? An obvious one is that there are several different ways to make and keep money in Wall Street. Another, not so obvious, is that one lucky break, or one supremely shrewd decision — can we tell them apart? — may count for more than a lifetime of journeyman efforts. But behind the luck, or the crucial decision, there must usually exist a background of preparation and disciplined capacity. One needs to be sufficiently established and recognized so that these opportunities will knock at his particular door. One must have the means, the judgment, and the courage to take advantage of them.”

Buy the Book: Print | eBook

Or read other book notes.