I wanted to continue a series I started a couple weeks ago on the Intelligent Investor. The last post covered some of Ben Graham’s wisdom from the first four chapters of the book.
The next four chapters cover the two types of investors – defensive or enterprising – according to Graham, where to find bargains or value, and how you should look at market fluctuations (one of the most important chapters according to Buffett). Like the first few chapters, this section is light on filler and heavy on timeless wisdom. Below, you’ll find some random bits of wisdom from chapters five through eight.
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.
Graham’s take on risk:
Nevertheless, 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…But we believe that what is here involved is not a true risk in the useful sense of the term…
…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.
On the risk of buying only for yield:
Many investors buy securities of this kind because they “need income” and cannot get along with the meager return offered by top-grade issues. Experience clearly shows that it is unwise to buy a bond or a preferred which lacks adequate safety merely because the yield is attractive. (Hence the word “merely” implies that the issue is not selling at a large discount and thus does not offer an opportunity for a substantial gain in principle value.) Where such securities are bought at full prices – that is, not many points under 100 – the chances are very great that at some future time the holder will see much lower quotations. For when bad business comes, or just a bad market, issues of this kind prove highly susceptible to severe sinking spells; often interest or dividends are suspended or at least endangered, and frequently there is a pronounced weakness even though the operating results are not at all bad.
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 growth stocks and the difficulty of picking the top performers:
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.
The striking things about growth stocks as a class is their tendency toward wide swings in market price…The investment caliber of such a company may not change over a long span of years, but the risk characteristics of its stock will depend on what happens to it in the stock market. The more enthusiastic the public grows about it, and the faster its advance as compared with the actual growth in its earnings, the riskier a proposition it becomes.
On buying the unloved instead:
If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue – relatively, at least – companies that are out of favor because of unsatisfactory developments of a temporary nature. This may be set down as a fundamental law of the stock market, and it suggests an investment approach that should prove both conservative and promising.
But in considering individual companies a special factor of opposite import must sometimes be taken into account. Companies that are inherently speculative because of widely varying earnings tend to sell both at a relatively high price and at a relatively low multiplier in the good years, and conversely at low prices and high multipliers in their bad years.
The same vagaries of the market place that recurrently establish a bargain condition in the general list account for the existence of many individual bargains at almost all market levels. The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks. Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels. Thus we have what appear to be two major sources of undervaluation: (1) currently disappointing results and (2) protracted neglect or unpopularity.
The many experiences of this type suggest that the investor would need more than a mere falling off in both earnings and price to give him a sound basis for purchase. He should require an indication of at least reasonable stability of earnings over the past decade or more – i.e., no year of earnings deficit – plus sufficient size and financial strength to meet possible setbacks in the future. The ideal combination here is thus that of a large and prominent company selling both well below its past average price and its past average price/earnings multiplier.
On formula investing:
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.
The moral seems to be that any approach to moneymaking 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.”
On predictions and forecasts:
The investor can scarcely take seriously the innumerable predictions which appear almost daily and are his for the asking. Yet in many cases he pays attention to them and even acts upon them. Why? Because he has been persuaded that it is important for him to form some opinion of the future course of the stock market, and because he feels that the brokerage or service forecast is at least more dependable than his own.
If it is virtually impossible to make worthwhile predictions about the price movements of stocks, it is completely impossible to do so for bonds.
On market fluctuations and being prepared for wide swings in price:
In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.
A serious investor is not likely to believe that the day-to-day or even month-to-month fluctuations of the stock market make him richer or poorer. But what about the longer-term and wider changes? Here practical questions present themselves, and the psychological problems are likely to grow complicated. A substantial rise in the market is at once a legitimate reason for satisfaction and a cause for prudent concern, but it may also bring a strong temptation toward imprudent action. Your shares have advanced, good! You are richer than you were, good! But has the price risen too high, and should you think of selling? Or should you kick yourself for not having bought more shares when the level was lower? Or – worst thought of all – should you now give way to the bull market atmosphere, become infected with the enthusiasm, the overconfidence, and the greed of the great public (of which, after all, you are a part), and make larger and dangerous commitments? Presented thus in print, the answer to the last question is a self-evident no, but even the intelligent investor is likely to need considerable will power to keep from following the crowd.
It is for these reasons of human nature, even more than by calculation of financial gain or loss, that we favor some kind of mechanical method for varying the proportion of bonds to stocks in the investor’s portfolio. The chief advantage, perhaps, is that such a formula will give him something to do. As the market advances he will from time to time make sales out of his stockholdings, putting the proceeds into bonds; as it declines he will reverse the procedure.
As long as the earning power of his holdings remains satisfactory, he can give as little attention as he pleases to the vagaries of the stock market. More than that, at times he can use these vagaries to play the master game of buying low and selling high.
But note this important fact: 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.
Source: The Intelligent Investor, 4th revised edition