Benjamin Graham is one of the most influential educators in modern finance.
Considered the “Father of Value Investing,” his books The Intelligent Investor and Security Analysis have influenced a whole generations of both professional money managers and novice investors.
In fact, after reading The Intelligent Investor, Warren Buffett credits Graham’s influence in shaping his career and investing mindset. Graham’s philosophies even inspired Buffett to attend Columbia Business School where he taught as a professor.
While you will probably never be as successful of an investor as the “Oracle of Omaha,” applying the same principles that Graham outlines in these books will undoubtedly reap long-term financial success.
While The Intelligent Investor is certainly a “must-read” among the investing community, Security Analysis is another wonderful book on investing.
This article will help you decide which to buy and read first!
The Intelligent Investor Summary
The overall purpose of The Intelligent Investor is to provide you with the tools to analyze potential investments. The main purpose is to help you adopt a proper mindset and attitude as you research investment ideas.
After reading The Intelligent Investor, you’ll be well equipped and have a solid foundation as an investor. By applying Graham’s framework, you can scour the market for lucrative investment opportunities in confidence.
You will no longer be a “speculator” or “reckless investor” as Graham outlines in the first chapter. Instead, you’ll be able to make educated investment decisions.
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.
Investing and Risk
Graham 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 after readin gthe book and can apply his thoughts on each to your own portfolio’s composition.
1. The Defensive Investor
The defensive investor is “one chiefly concerned with safety plus freedom from bother.”
In essence, the defensive investor doesn’t want the “hassle factor” and stress of investment analysis in their life. If you’re in this category, you probably don’t want to invest hours into picking individual stocks, funds, or bonds.
Maybe, your time is be better spent earning more money or enjoying life. Perhaps, this class of investors does not 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.
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, the income generated from a bond portfolio tends to be relatively more stable.
However, the overall returns would certainly underperform a 100% equity portfolio over the long-term.
2. The Enterprising (Aggressive) Investor
“Aggressive Investors” are willing to assume more risk in their portfolio. Therefore, they expect to achieve higher overall returns.
However, Graham asserts this class of investors must also bring more energy and study to markets. After all, investing in 75%+ equities requires a commitment of time and research.
Who may fall into the “Enterprising Investor” category?
More than likely, you fall into this category if you’re investing books on investing.
If you have a longer time horizon and the stomach to take market swings for greater overall returns, you can probably assume some level of risk in your portfolio.
Many investors in this category “think” they are enterprising until the bottom falls out of the market. 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.”
Graham provides historical markers and examples
Enough about the two types of investors Graham discusses! He goes much deeper in the book.
The Intelligent Investor isn’t meant to be a history book on financial markets. However, Graham provides historical references to support his philosophies.
After all, markets tend to be cyclical and their behaviors mimic past patterns.
Graham “back-tests” his suggestions and theories to provide the results of his thesis. Then, he provides guidance on how to navigate markets going forward.
Even if today’s market is different than his examples, understanding historical context will almost certainly allow you to make a more educated investment decisions today.
Assessing Intrinsic Value
The assessment of intrinsic value represents another prevalent theme in The Intelligent Investor.
According to Graham’s theories on intrinsic value, the stock price of certain companies may not be reflective of their true, total value. These differences could offer an opportunity to buy or sell the security.
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.
Graham explains how intrinsic equity value can be estimated through cash flows, earnings, and dividends that companies generate.
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.
Even in downturns, the fact that the company is already “cheap” relative to the market should provide 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 another primary concept to apply alongside the margin of safety. This should help 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 made up of different kinds of assets will generally yield higher long-term returns. Plus, it will reduce the risk of any individual holding or security.
Meet Mr. Market
Another visual that Graham helps to explain the the stock market is “Mr. Market.”
In his allegory, Graham personifies market fluctuations as a genial, unstable man. Every day, Mr. Market 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 Mr. Market knocks 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.
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).
Security Analysis Summary
Security Analysis was first published in 1934. However, the principles outlined still shape those interested in value investing – even today.
This writing offers investors investors a window into one of the greatest investment philosophers of modern times, and introduces many key concepts central to picking undervalued securities.
One of the most widely known principles he discusses is called “margin of safety.”
Graham’s book Security Analysis outlines a value-investing approach that will help new and experienced investors identify which stocks represent the best investments.
After all, we all have a finite amount of capital (money). The idea is to put our constrained capital to work in the investments that will do BEST over our investment horizon.
Graham explains that an investment is not without risk; however, the goal is to preserve the principal and generate returns through stock appreciation and dividends.
Any kind of “investment” that does not preserve the principle and generate returns is not an investment at all. Instead, these “investments” would actually just be speculation which is akin to gambling.
Market Analysis vs Security Analysis
Graham discusses a few different approaches most professional investors use in picking stocks.
There is the “top-down approach” which looks at the market as a whole. These analysts try and anticipate the action of the overall market.
There are variations and sub-categories within “market analysis.”
One of the most popular varieties is known as technical analysis. Chartists or market technicians uses past market performance to anticipate future performance.
The underlying philosophy that drives technical analysis is that the market encompasses all information known at the time. Therefore the price reflects the fair value of the companies at the time which is reflected in the stock performance. As history tends to rhyme, chartists are able to identify trends in the stocks’ past behaviors and are able to pick which stocks will outperform.
The other variation of market analysis indexes economic activity. Generally, a country’s economic output (GDP) has a great influence over the prices of the securities. The theory is that as overall economic growth increases, markets tend to rise.
However, Graham asserts that past experience indicated neither of these theories based on market analysis will lead to outperformance. Instead, they promote speculation rather than fundamental investing.
Conversely, there’s a more “bottoms-up approach.” These investors seek to pick individual stocks by examining the underlying company fundamentals – without regard for the market overall.
As you would expect, Graham’s fundamental philosophies fall into the latter camp.
Graham indicates that intrinsic value is the key driver in identifying underpriced securities.
Intrinsic value may be a difficult theory to understand at first. However, the overall concept is that value is determined by a company’s assets, earnings, dividends, and prospects future prospects to increase these items over time. All of these items encompass the true “value” of a company as a whole.
However, investors are not able to calculate an exact intrinsic value as there are too many variables.
Even though intrinsic value is not calculated by an exact formula, careful study can help investors determine if the price quoted by the market is near to the intrinsic value of a company. If the price is substantially below the intrinsic value, the stock is likely undervalued and would represent a good buy.
Stocks and Bonds
There are generally two types of investments most investors evaluate – stocks vs. bonds.
Graham asserts that conventional thought is inappropriate given it focuses on the type and form of the security rather than the purpose and relative risk.
Instead, he likes to group securities into three groups:
- Fixed value securities (includes preferred stocks and high-grade bonds);
- Variable-value senior securities (preferred shares and speculative bonds); and
- Common stocks.
Each of these have different risk profiles based on where they stand in a company’s capital structure.
However, no company is bankruptcy-proof, but there are a couple of factors that contribute to a company’s risk:
- A dominant size within its industry
- Sufficient earnings to cover its bond interest by a large margin
Graham believes that companies that do not have a wide moat to protect from competition or that are over-levered do not make good investments.
Remember that there is no such thing as a permanent investment. You will need to continually re-evaluate as economics and industries evolve.
Risk vs. Reward
To decrease the risk associated with the volatility and potential bankruptcy of common stocks, Graham states investors should always hold a diversified portfolio.
In Security Analysis, you will also dive into learning these 3 key areas when evaluating individual stocks:
- Dividend rate
- Earnings
- Asset Value
If you’re looking for a technical book that will teach you moderate to advanced techniques to estimate fundamental value, Security Analysis: Sixth Edition, Foreword by Warren Buffett (Security Analysis Prior Editions) is a great option that any investor can understand!
So… Which book should you read first?
After reading both Security Analysis and The Intelligent Investor, you honestly can’t go wrong with either. If fact, you should seriously consider reading BOTH books.
However, for most investors, I would lean towards recommending The Intelligent Investor FIRST. Both books are chalked full of incredible knowledge that is sure to take your value investing to the next level; however, Security Analysis reads a bit more like an investing manual (which is certainly great if you want to go above and beyond after forming a foundation from The Intelligent Investor.
Plus, Warren Buffett has given his stamp of approval to The Intelligent Investor, stating it was the single most influential piece of literature that changed his life. In latter versions, he even wrote a foreword expressing the influence The Intelligent Investor and Benjamin Graham had on his life.
In conclusion, both books should be within reach of any investor’s nightstand. However, you won’t regreat with reading the classic The Intelligent Investor first!