The Intelligent Investor

Benjamin Graham’s masterpiece, The Intelligent Investor, is a great starting point for anyone wishing to begin investing in the stock or bond markets.

I’ve recently wanted to turn some attention to investing surplus cash rather than accumulating it in a low interest savings account. I turned to this book having read quotes from Warren Buffet, one of the world’s greatest investors, that Graham helped shape the investor that he became.

The volume was originally written in the 1949 and had revisions released every five or so years up to the death of the author, Benjamin Graham, in 1976. The version I read was based on the last revision with added commentary covering the span of years from then up to just after the collapse of the dot-com boom early this century.

The first key lesson is to understand the difference between a speculator and an investor. The two terms are separate and do no overlap. An investor expects to guarantee the safety of his investment, but targets moderate returns. A speculator does not protect his capital, hoping to strike it lucky.

Speculators expect to get rich from their schemes soon whereas investors are in it for the long haul. The book is aimed only at those who wish to follow the long term approach.

Graham devotes a lot of time to banishing myths about the investment process and returns to the difference between sensible investing and reckless speculation throughout. He does see a middle ground between the two extremes.

Two alternate forms of intelligent investing strategy are explained. One is for the passive investor who should make his investment decision once, with annual reviews, and invest using a regular investment plan. The idea is to avoid watching the market price of the basket of funds so that the temptation to sell or buy in extreme markets is removed.

The active investor, on the other hand, is one who is willing to spend time regularly assessing securities, looking for new stocks or bonds to add to their portfolio. They need to assess a wide range of companies and sectors and to understand the companies they invest in thoroughly.

Graham has a set of guidelines to follow that appear to be tried and tested. For example he suggests only purchasing large companies that are in the leading group for their industry. They should have a solid record of paying dividends and meet certain earning to price ratios.

The key is to identifying valuable businesses that are under priced in the market. Sounds easy, but understanding why the price is suppressed and being sure that the potential for growth is real, takes a lot of work.

The suggestion is to read several years of annual statements, available from the Edgar database at www.sec.gov. Read them thoroughly, paying particular attention to the multitude of footnotes, which sometimes outweigh the actual text of the report.

Graham gives a number of cases where odd accounting practices have been spotted in these annual reports. For example, he stresses that you should look for one-off charges that appear to repeat for a number of years.

He is critical of many of the accounting practices that were used in the late 1960s that enabled management teams to earn huge bonuses while their companies started a path to decline. The commentary suggests that some of the practices that helped fuel the dot-com bubble would have infuriated Graham had he lived to see them.

An overall principle that he tries to get across to the reader is that you should take a lot of care before purchasing a stock or bond. Take time to do the due diligence required to ensure you are buying quality at a fair (or better than fair) price.

Graham describes a metaphor, Mr. Market, that comes to you everyday to tell you the price of the stocks you own and ones you do not. But he is manic depressive. Some days he will be full of optimism and try to persuade you to buy a stock at absurdly high prices. Another day he will be completely pessimistic and try to sell you stocks at rock bottom prices.

You must, if you are to become an intelligent investor, ignore Mr. Market as much as possible, and don’t feel the hype or despair from market swings. Take advantage to allow the purchase of low priced stocks, or to sell out when the market becomes dangerously high (read “ready for a crash”) and you will do all right.

How should we put all this good advice into an investment strategy? My take aways from the book are to use index trackers, dollar cost averaging and to take a long term view of investing.

Index Trackers

Picking good quality stocks is difficult. Graham suggests that anywhere from twenty-five to seventy-five per cent of your portfolio should be in equities, depending both on you own personal circumstances and also on market conditions, and a good ratio to aim for is fifty-fifty; the rest should be in high quality bonds.

Doing this would appear to be quite difficult. Picking a single stock, reading the reports, checking rival companies and reviewing regularly is hard enough without having to follow the advice to diversify over a number of companies and sectors. Graham suggests between ten and thirty stocks to have a decent protection against the collapse of one industry.

I want to invest now, but the analysis of all these companies is going to take forever. What do I?

The answer given by the commentary is to find a low cost index tracking fund and invest in that. There are many around, with Vanguard offered as a typical example. Their S%P500 ETF (IE00B3XXRP09) has an annual charge of 0.07% and depending on the brokerage you use to purchase, should have low or no entry and exit fees.

The benefit of doing this is not having to spend time figuring out the best stocks to purchase, you will simply be buying a little of them all. When the markets drop the value will go down, but think of that as the time when you start buying stocks at bargain prices. Not all of them will be true bargains but a significant proportion will probably be undervalued.

Another advantage is the wide diversification this gives across all the industries and companies collected in the index you choose to follow. There are index trackers for all the major markets and for investing in high grade bonds also.

If you just want to get investing right away, an index tracker is a good choice to get started. I suggest investing what you can afford after other expenses monthly and try to build up a sizeable investment. Later, when you have completed the stock investigation, you can switch the amount into your chosen stock or direct the monthly investment, holding the amount already invested where it is.

Dollar (or Unit) Cost Averaging

By investing every month, through ups and downs, you remove the risks involved with investing a lump sum at a single point in time. When the prices dip, continue investing, and you will ultimately be getting more units for your money.

The book sites evidence that dollar cost averaging is one of the most efficient ways to build up investments and is used by most pension funds including personal ones for millions of salaried workers all over the world.

Protection comes from the lows, but also from getting too excited about the high markets. Simply decide that you are going to invest monthly (or more frequently if you have the resources) in a small set of funds or stocks, no matter what the market says. By removing Mr. Market from the conversation and focusing on the long term picture, you will avoid making mistakes.

Graham constantly reminds us throughout the book that there is no point in trying to pretend that you can tell the future. Anyone else that tries to tell you that they can, should be ignored or avoided. Also, don’t use past performance as the basis for expectation about the future.

No one fund or stock’s past performance can really help you tell its future. But there is one trend that seems to be consistent: the gradual rise in value of the stock market as a whole.

Sometimes is surges ahead only to collapse. During other periods it languishes in the low figures until suddenly catching up. But if you average it out, it trends upwards.

Use dollar cost averaging to get the benefits of that gradual increase, smoothing out all the market jitters that come along the way.

Long Term View

Making share purchases means that you are buying a part of a company. Assuming that you have done all the research and due diligence that Graham advises, this is not a purchase that you make lightly. The aim should be an investment that will stand the test of time.

The book is full of warnings that an intelligent investor should not heed what the market says the stock is worth. This is simply the price tag that is determined by the current popularity of the stock or sector. As demand grows, the price tends to go up and as it wanes, the price goes down.

The underlying value of a company does not change so widely as that, so looking at the daily price of the stock will only lead to an investor being tempted to but or sell without the analysis required. Graham advises holding stocks through both bear and bull markets, until such a time when careful analysis shows that they are overheated. It may be possible, at that stage, to sell some or all.

If you take the advice for the passive investor, choosing a spread of stocks across different industries or an index based fund, and spread the purchases over time using dollar cost averaging, then you should be focusing on the five to ten year time line. The effect of this investment style will smooth out the jitters of the stock market.

The book includes a contract between you, the aspiring intelligent investor, and yourself — in paper versions of the book, you can cut it out, sign and date it. This serves as a reminder of all the best advise from the book, but basically boils down to steadily investing in the right companies and not reacting to the wild fluctuations of Mr. Market.

Other Advice

I won’t try to repeat all the strategies that the book covers. The most basic is to compare the sum of net assets of the company less liabilities with its total market capitalisation (the number of shares times the price). If the market values the company less than the underlying value (i.e. things that can be sold off if the company goes bankrupt) then you will probably get at least your money back in case of collapse.

There are a number of similar tests for financial strength including forecasting growth, that will help strike companies off the list of possible choices if they don’t pass Graham’s strict tests. At the end, and if you are willing to spend the time, you can get a short-list of companies to investigate further using the criteria in the book.

Then the hard work starts. You must read annual statements, concentrating on the footnotes and small print. Read the report from the end, because that is where clever accountants like to put all their trickery.

The book outlines a number of cases where the health of the company was clearly in a poor state, and this would have been obvious from reading the reports, but the market as a combined entity did not heed the warnings.

It becomes even murkier in cases where the accounting was misleading and even deliberately wrong. It takes a thorough, alert security analyst to spot these discrepancies. If something does not feel right, don’t buy the stock.

Conclusion

While I have little experience investing, this book was reasonably easy to read and digest. It is aimed at someone like me that wants to get started but does not exactly know where to start.

The main thing I got from it is that I should start now. But how? To invest the way Graham wants people to invest takes times, involves searching for companies, analysing their financial history, reading statements, predicting growth and coming up with some idea of current intrinsic value. If it is less than the market price then it may be a good purchase.

The other suggestion is to use an index fund to get investing straight away. I can spread my money across the entire S&P 500 with one click on Degiro. I can even use a bond fund to place some of my investments into bonds.

Degiro is the on-line exchange I have chosen (it operates in most European countries) due to its low charges. To encourage regular investing, they allow a single purchase of selected electronically traded funds (ETF) per month. This will allow me to begin dollar cost average investing into the market immediately.

Small amounts invested regularly into funds with low annual charges can build up over time. I will print out the investor’s contract from the book and stick to it. Over time I will try my hand at security analysis, perhaps venture into the world of stock ownership at some point. But for now I can be comfortable that at least I am doing something with my money.