Considered the “Father of Value Investing,” Benjamin Graham’s book The Intelligent Investor was first published in 1949. Ever since, Graham’s philosophies have influenced a whole generation of both professional money managers and novice investors.
In fact, this book has made such an impact on the investing community that Warren Buffett credits The Intelligent Investor with changing his life. After reading the book at age 19, Graham’s philosophies inspired Buffett to attend Columbia Business School where Graham taught. Not only did Buffett take Graham’s classes, but he even worked under his mentor at Graham’s investment fund.
While you will probably never be as successful of an investor as the “Oracle of Omaha,” applying the principles outlined in this book will no doubt reap financial successes over the long-term.
Even if you consider yourself a growth-oriented investor, Graham’s principles provide a valuable lens to understand and value individual securities and construct your portfolio. As you understand how the life cycle of companies progresses from infancy to maturity, you can examine the potential those growth companies can present.
For this reason The Intelligent Investor is a “must read” for experienced and novice investors alike – regardless of investment philosophy.
Learning Graham’s theories that have shaped some of the greatest investors’ mindsets can provide the greatest ROI you will ever achieve.
An overall glimpse of what you’ll learn by reading The Intelligent Investor
If you’re looking for a book that tells you which individual stocks you should pick, you will be disappointed.
This book is by no means an encyclopedia of “buy now” stocks. Sure, The Intelligent Investor has undergone many iterations to keep up with modern markets. In many chapters, Graham references prominent companies of the time as examples of what he looks for and how he executes his analysis. The revised edition provides commentary for how the chapter relates to today’s market.
However, the underlying goal of Graham’s writing isn’t to hand investors an updated list of stocks to buy. It goes beyond “hot stock tips” to teach you to determine the best securities for yourself.
You’ll learn Graham’s proven philosophies on investment analysis regardless of risk tolerance
The overall purpose of Graham’s book is to provide the tools to analyze potential investments. Further, the book teaches investors how to adopt a proper mindset and attitude when making investment decisions.
After reading this book, you will have ample information to form the foundation of your investment philosophy. You can then apply this framework as you scour the market for lucrative investment opportunities.
By applying these principles, you will no longer be a “speculator” or “reckless investor” as Graham outlines in his first chapter.
Instead, you will be on the path to learning to view markets and investing while properly valuing individual securities.
Is there still an element of speculation in investing even for “value investors?” Absolutely. Your potential investment opportunities will range from extremely speculative (and potentially reckless) to relatively stable with inherently less risk. However, there will almost always be a speculative element assumed at some level.
By increasing your knowledge through reading The Intelligent Investor, you can ensure your portfolio has the proper amount of speculation relative to your risk-tolerance.
Applying Graham’s teachings based on your risk tolerance
Graham’s further distinguishes investor categories beyond “speculators” and “investors.”
He breaks down the “investor” category into two sub-categories: 1) The “defensive investor” and 2) The “enterprising (aggressive) investor”
More than likely, you’ll be able to self-identify with which category you belong. Then, you can apply his respective thoughts on each to your own portfolio’s composition.
1. The Defensive Investor
According to Graham, the defensive investor is “one chiefly concerned with safety plus freedom from bother.”
Ok… But, what does this mean?
In essence, the defensive investor doesn’t want the “hassle factor” and stress of investment analysis in their life. This class of investor may not wish to invest hours into picking individual stocks, funds, or bonds. Maybe, their time can be better spent elsewhere either earning more money or enjoying life.
Further, they don’t want a decline in their portfolio to have a meaningful impact on their daily life.
Instead, they are content to passively track the market and earn a reasonable 5%-7% annually. They may not experience the upside of equities that appreciate 15%+ in a given year. However, they also avoid 15%+ declines in market corrections. Plus, once they select their funds and blue-chip, dividend-paying stocks, they probably don’t need to invest a ton of time monitoring their portfolio going forward.
This makes defensive investing much more passive and stable. However, a defensive investor won’t achievable returns capable of building wealth faster.
For the most part, Graham outlines that the defensive investor relies on a portfolio that consists of 25%-75% bonds. While bonds still pose risk to investors (interest rate, credit risk, inflation risk, risk of default, etc.), the income generated from a bond portfolio tends to be relatively more stable.
However, the overall returns should certainly underperform a 100% equity portfolio. After all, equity investors assume more risk!
Who is “defensive investing” right for?
If you rely on your portfolio to support your lifestyle (i.e. in retirement) or you take greater risk in how you earn income (i.e. your income source is relatively risky), you may categorize yourself as a “defensive investor.”
A relatively more defensive portfolio may provide stability to your overall financial situation. For the defensive investor, Graham outlines both expectations and strategies for the defensive investor while providing historical references, actual and forecasted performance for defensive investors who have a 25%-75% bond portfolio.
Throughout his book, Graham offers examples and outcomes on how to apply his concepts for those relatively more risk-averse.
2. The Enterprising (Aggressive) Investor
As you would anticipate, “Aggressive Investors” are willing to assume more risk in their portfolio. Therefore, they expect to attain better overall returns when compared with their defensive investor counterparts.
However, Graham asserts this class of investors must also bring more energy and study to markets when assessing investment opportunities. After all, active investing in 75%+ equities requires more research than sitting back and collecting interest and dividends like the defensive investor does.
If you self-identify as an “Enterprising Investor,” Graham similarly provides historical context for those who assume more risk in their portfolio.
Who may fall into the “Enterprising Investor” category?
If you have the stomach to endure market swings in hopes of greater overall equity returns, you can probably take more risk in your portfolio.
To achieve outperformance over the long run, you’ll want to ensure you have an adequate time horizon (5+ years). Historically, markets experience corrections (10% declines) at some point nearly every year. A bear market (20%+ declines) happens every 3-4 years on average. However, declining markets often rebound rather quickly.
Even though markets generally bound higher 2 out of every 3 years, many investors can’t tolerate the declines.
They fall victim to the news media’s embellishment of the negative situation. Ultimately, many investors end up “buying high” when all is good. Then, they “sell low” when short-term issues cause other investors panic.
Instead, the aggressive investor should implement a “buy and hold” strategy of diversified equities. When markets decline, continue to buy more “on sale.”
If you do not believe you have the discipline to be “fearful when others are greedy and greedy when others are fearful,” you may not have the necessary mindset to be a successful “Enterprising Investor.”
Enterprising vs. Defensive Investor
More than likely, you’re probably somewhere between the two classes of investors Graham discusses in his book.
When compiling your own portfolio, you should first assess your purpose for investing, the timeline, and risk-tolerance. Depending on these factors, you may lean one way or another depending upon your goals.
For instance, maybe your goal is retirement. If you have 20+ years until retirement, you can certainly lean towards a more aggressive portfolio. Historically, this time horizon would allow plenty of time to ride out the market waves. In return, you would be rewarded with a larger 401(k) or IRA that substantially outpaces inflation and outperforms bonds.
Alternatively, maybe your goal is to invest for a house in ~5 years. You’d probably be best served taking a more defensive approach. Your goal would probably be to earn enough after-tax returns to beat general economic inflation and offset much of the appreciation in housing prices. To accomplish this particular goal, Graham would probably argue you’ll want an element of equity appreciation in more stable dividend-paying companies, the security of bonds, and an ample cash cushion.
You must determine for yourself how far along the scale between “defensive investing” and “aggressive investing” you fall.
Graham provides historical markers and examples
The Intelligent Investor isn’t meant to be a history book on financial markets. However, Graham provides historical references and instances as support for his philosophies.
Often, markets are cyclical and their behaviors provide a patterns that can be anticipated. Instead of reacting negatively, understanding past behavior could provide valuable insight on how to proceed in volatile markets. This information could allow you to make profitable decisions in the long run.
Graham “back-tests” his suggestions and theories to provide the results of his thesis. Then, he provides applicable guidance on how to navigate going forward.
Even if today’s market differs from historical examples in the book, understanding the historical context will almost certainly allow you to make a more educated investment today. Plus, the education Graham provides allows you to confidently invest through down markets and avoid panic selling.
As the philosopher George Santayana once said, “Those who do not remember the past are condemned to repeat it.”
Why not avoid past investors’ mistakes by brushing up on your market history?
Basic but profound message
In his book, Graham introduces many investing theories primarily centered around investors’ behavior.
While he compares certain securities and discusses technical aspects, Graham’s primary focus lies investors’ behavior. After all, our own discipline is one of the few controllable aspects for investors.
Most of us do not have the capital to acquire enough company stock to have any sort of control or influence. For many of us, our goal is to simply rely on management to continue moving the company to increased profitability and growing our equity position.
However, in a competitive market, growth isn’t always guaranteed. The overall economy may enter a recession. Particular industries experience cycles that ebb and flow with supply and demand. Certain companies may have inherent issues that threaten their future prospects.
Disciplined investors understand that management’s job is to apply their past experience and knowledge to weather these issues. By contrast, a savvy investor’s goal is to identify which companies and managers have the potential to outperform.
Instead of speculating on which companies have the potential to outperform, Graham provides the knowledge base necessary to make educated investment decisions. This can provide concrete support for your investment thesis.
Once value investors perform their due diligence and make the decision to invest, we should be content to rely on management, monitor their performance relative to other companies, and aim to hold for the long-term.
In The Intelligent Investor, Graham provides both the basics and detail of performing comparative company analysis. Armed with this knowledge, you can discern among companies in similar industries as you determine where to best allocate your dollars.
Assessing Intrinsic Value
The assessment of intrinsic value represents another prevalent theme in Graham’s must read book.
According to Graham’s theories on intrinsic value, the stock price of certain companies may not be reflective of their true, total value. This could offer an opportunity to buy or sell depending upon the situation.
Unlike technical analysis which relies on stock charts and indicators, intrinsic value takes a more fundamental view of the actual operations of the business and the profits generated.
Quantitative and fundamental analysis determines the intrinsic value of a company. The results are then compared to the overall price or market capitalization of the company.
According to Graham, intrinsic equity value can be determined through the cash flows, earnings, and dividends that companies generate. Not only should historical results be analyzed, potential growth opportunities should be assessed.
Margin of Safety
If the overall equity value is substantially below the “appraised value” calculated for the company, Graham contends the difference provides a wide “margin of safety.”
Essentially, a margin of safety means the equity value of the company is well below what it SHOULD be relative to earnings.
Therefore, an investment with a wide margin of safety has the potential to outperform other stocks. Even in an economic decline, the fact that the company is already “cheap” relative to the market should offer downside protection. In Graham’s words, the investment has the ability to “withstand adverse developments.” Even if earnings decline, the margin of safety may still allow for a satisfactory return.
Theory of Diversification
However, a portfolio of stocks with wide margins of safety can still produce negative investment returns. Therefore, diversification is a key concept to apply to Graham’s margin of safety to increase the probability of positive returns.
In portfolio theory, diversification allows investors to mitigate risks by investing their portfolio across distinct asset types and investment vehicles to limit exposure to any single asset or risk. The rationale behind diversification is that a portfolio constructed of different kinds of assets will generally yield higher long-term returns while reducing the risk of any individual holding or security.
Graham intertwines diversification and margin of safety with the analogy of a roulette wheel.
In once instance, a man bets $1 on a single number and is paid $35 profit when he wins. His odds are 37 to 1. In this example, he has a “negative margin of safety” of $2. The more numbers he bets on, the smaller his chance of profit.
In another instance, a man bets $1 on a single number but is paid a $39 profit if he wins. Just like the last example, his odds are 37 to 1. In this example, he has a margin of safety of $2. Therefore, the more numbers he wages on, the better his odds of winning. In fact, he could achieve a guaranteed $2 win with each spin if he bets on every number.
Buffett is known for applying Graham’s concepts of intrinsic valuation and identifying stocks with a wide “margins of safety”
If you have ever listened to interviews with Graham’s protege, Warren Buffett touts the laurels of identifying intrinsic value. Throughout his career, Buffett has recognized the spread in the intrinsic value of a company and the market. This has allowed for immense profitability in many of his investment decisions.
Because value investors look for undervalued opportunities relative to the current earnings, cash flow, and comparable stocks, learning the basics of intrinsic value identification helps the reader on their journey to becoming a better investor.
Meet Mr. Market
Another key concept that Graham outlines relates to introducing the stock market as “Mr. Market.”
In his allegory, Graham personifies market fluctuations as a genial, unstable gentleman. Every day, he knocks on investors’ doors and offers to buy their shares for a specific price.
On some days, Mr. Market offers a fair price. However, Mr. Market’s quoted price on other days is ridiculously out of line with the intrinsic value of the business.
Graham explains that Mr. Market’s behavior is totally unpredictable and suffers from drastic mood swings.
Investors have the opportunity to buy or sell on a daily basis. However, investors do not have to sell just because the market beckons on a particular day. Instead, frequent trading is often detrimental to total returns. In fact, Graham argues patient investors who hold a portfolio of stocks for the long run will outperform investors who react to market fluctuations.
The overarching principle of Graham’s philosophy teaches investors the best investing methods ignore Mr. Market.
As a savvy investor, simply refrain from participating in the market’s daily fluctuations. Instead, enjoy the dividends and returns that your investments pay and continue holding despite volatility.
Only take advantage of Mr. Market when his quoted price both overvalues the intrinsic value of your stock and you need the money in the near future (i.e. <5 years).
Invest for the Long Run
Just like investors should not answer the door each time Mr. Market knocks, plan to hold your stocks for the long run.
Graham contends investors should provide time for compounding returns. Therefore, investors should buy stock in great companies with a trustworthy management team.
Remember, management may not always be motivated by long-term outperformance. Because management’s compensation may be tied to quarterly measures, they may make decisions that are beneficial only in the short-term.
However, the best management teams implement strategies geared to provide long-term rewards. Even short-term sacrifices are necessary, investors should look for managers with long-term agendas.
As an example, Warren Buffett offers a perfect example for this strategy.
Part of Buffett’s investment thesis centers on owning the stock of companies with experienced management. Before he purchases equity in a company, he determines if he would like to own 100% of the business.
While owning 100% of a particular company’s stock may not be possible (even for Berkshire Hathaway), when Buffett does buy entire companies, he often allows current management to continue operating as usual. Even though Buffett certainly has the reputation (and financial ammunition) to influence his portfolio companies’ decisions, Buffett usually takes a passive approach to his investments.
The Intelligent Investor: A MUST read for EVERY investor
If The Intelligent Investor takes the title of a “must read” from the greatest investor of all time, you should seriously consider the value this book will bring to your own portfolio.
If you are just now starting your investing journey, The Intelligent Investor provides a wonderful introduction to equity valuation. More importantly, Graham teaches you how to THINK like an investor.
Some of the concepts Graham discusses are quite detailed and advanced. However, Graham does an exceptional job of breaking down complex investing theories into “layman’s terms” that novice investors can comprehend.
Even if you are a growth-oriented investor, the fundamental analysis Graham provides can give you an advantage in identifying companies that will one day become the next blue-chip stock.
For new investors, The Intelligent Investor should be akin to your “investing Bible.”
If you’ve been investing for years and consider yourself a pro, Graham’s book is full of concepts to take your investing game to the next level. His perspectives stemming from decades of research and testing of portfolio theory can certainly complement your own investment strategy.
Even if applying one or two of Graham’s theories results in 1% or 2% in additional returns, the investment of purchasing The Intelligent Investor can be well-worth the small monetary and time investment.
While some of the examples Graham provides may appear outdated, the philosophies Graham developed can still be applied today.
Do yourself and your portfolio a service by learning financial analysis from the “Father of Value Investing.”
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