Sunday, 22 January 2012

Book Summary: The Intelligent Investor by Benjamin Graham

As shocking as this may sound to some of you, I just finished reading The Intelligent Investor by Benjamin Graham. The shocking part for many of you may be why I only read it now. Well, the answer is a dumb one but it's the truth. I remember looking at some excerpt of the book 5 or 10 years ago and saw something about railroads (or something like that). Back then, being the young, dumb, person I was, I was like "What the hell is a railroad? Aren't those some ancient relics of the past? I know there is a train that goes by my house but so what? Does anyone even make money on them?" Obviously my youthful arrogance, not to mention lack of time, made the worst of me. Little did I realize that, although the examples are somewhat dated, the concepts behind the book were quite insightful. I do have to admit that I have read most of Graham's principles in articles, websites, reports, and so forth, so I basically knew most of Graham's philsophies (I just didn't get around the reading his actual book).

I think it's quite fitting to pick the best value investing book of all time as my first book review on this "young" site. Since this book has been beaten to death by many (i.e. talked about, quoted, reviewed, etc), I probably won't provide much insight. I think my future book commentaries may be more interesting given that my interests are diverse and I may pick something less commonly talked about.

For most of the books I'll be looking at, I won't necessarily write a review but instead talk about insightful elements from the book, while adding some thoughts regarding my investments. If you find anything I say interesting, purchase the book or sign it out at the library or something (written knowledge is one of the cheapest things in life).

(All errors in quotations are mine. Please do point them out to me. All italics and bolds are mine.)

(image courtesy

The Intelligent Investor: A Book of Practical Counsel
By Benjamin Graham
2003 Revised Edition (based on the 1973 4th edition)

You know you are reading something great when the book you signed out from the library is worn out even though it is only a 2003 book. In fact, I had to sign out multiple times (didn't finish in time) and each book was worn out. Warren Buffett even considers The Intelligent Investor the best investing book ever written.

The edition I read was the 2003 revised edition with commentary by Jason Zweig (of Fortune)--this edition happens to be based on the 1973 edition. Although I haven't read the other editions, and some think the earlier editions are better, I think this one is best for newbies such as myself. The problem with investment books is that the market environment changes so rapidly that some of the concepts may not be relevant--and in fact wrong. Jason Zweig does a fine job giving modern examples (from the 2000s), as well as elaborating on Graham's points at the end of each chapter. However, Jason Zweig mainly addresses Graham's defensive investors (definition below) so I found most of what he said to be not too insightful.

If there is a weakness in the book, it is the fact that the prose isn't necessarily easy to understand, and that some things aren't as significant nowadays. For instance, it would be difficult to find many securities in a stock market in a developed country satisfying Graham's requirements. Criteria such as high dividend yield and price below book value are rare nowadays. A bear market will result in more securities fitting Graham's requirements but, even then, the selection will likely be small. Some of the things that Graham talks about, such as warrant dilution, is also less of an issue now, as Jason Zweig points out (although warrant dilution has been replaced with option dilution so human behaviour is still the same).

The Intelligent Investor is written for lay investors and is relatively easy to read. Being the so-called father of value investing, Graham defines the core terms that are important to value investors. In the paragraphs below, I will talk about items that I personally find useful (this means that I will skip over many other things that you may find benefitial).

Some Categorization

The first thing an investor needs to understand is the difference between an investor and a speculator. Graham cites the following:

An investment operation is one which, upon thorough analysis promises safety of principal and an adquate return. Operations not meeting these requirements are speculative.

Note that I emphasized the notion of safety of principal. Graham's definition has nothing to do with volatility or inherent risk in an asset. In contrast, the Wall Street view keeps changing with time. At one time, all stocks were considered speculative; while at other times, almost all stocks were investments.

Graham also goes on to seperate intelligent investors into two camps:

  • Defensive Investor: One who wants safety and less involvement
  • Enterprising Investor: One who wants higher returns that he/she is willing to work for

In contrast to the conventional view, an enterprising investor is not one who is more risky or aggressive; instead, it is one who has an interest in investing and is willing to work hard for it. I think it is important for investors to figure out which category they fall into. I, as well as nearly all readers of this blog, will be considered enterprising investors. Therefore, I will only talk about concepts inThe Intelligent Investor that apply to enterprising investors. Make sure you understand that most of what I reference below is not suitable for defensive investors.

What to Avoid

There are many roads that lead to the Kingdom of Financial Success. You can become wealthy by pursuing a multitude of methods, but if you choose to follow Graham's techniques, you should avoid the following:

  • Trading
  • Short-term selection (buying based on near-term expected earnings results)
  • Long-term selection (buying based on expected future growth (typically in computers, drugs, etc))

Graham suggests that any successful strategy be "sound and promising" and "not popular on Wall Street". In the book, he develops some strategies that fit those desired conditions. For enterprising investors, Graham tells them to avoid:

  • High quality preferred stocks: These are mainly advantageous for cross-corporation purchases because corporations supposedly don't pay taxes on them
  • Bonds and lower quality preferreds: Never buy lower quality bonds at par.Only purchase if they are trading 30% below par for the high coupon ones, and a bit lower for the lower coupon ones
  • Foreign government bonds: These generally do poorly, and right now many emerging market bonds are priced as if they will never default--something I find unlikely
  • New issues (IPOs) and new stock offerings (by existing companies): A lot of statistical evidence from other sources against this idea
  • Common stocks with short history of good earnings

Since I'm looking at the Pulte Homes exchange-traded bonds (PHA), I'm going to delve into Graham's comments about bonds for a bit. I'm not sure if PHA would be considered second grade or not. Moody's has Pulte's bonds on watch for a potential downgrade, which will put them into junk territory so you are looking at a very low quality bond. But Pulte is one of the largest homebuilders in USA so it is a leading company (secondary companies are not leaders). Graham essentially says never to buy second grade bonds at par value! Graham points out that practically all bonds trade below par when economic conditions are poor, so should be patient and wait. In fact, in an ideal situation, first grade bonds of high quality corporations can trade at a big discount at times (Graham points to railroad bonds early on and utility bonds later on).

If one if interested in bonds, best place to look is in out of favour sectors. Recall that Warren Buffett and Mohnish Pabri bought Level 3 Communications convertibles back in 2002 (I believe), when technology stocks were totally out of favour. Right now homebuilders are totally out of favour and that's why I'm looking at them. Right now PHA is trading 20% below par (with a yield of around 8.4%), and I'm waiting until price drops even further to, say, 40% below par (and yield of around 10%). If Moody's downgrades the bonds (a possibility if Pulte posts weak earnings this quarter), I think they will drop to my target range.

If you ever thought stocks were volatile, wait until you check out foreign bonds (on a side note, I think a lot of emerging market bond buyers are going to suffer greatly when the commodities boom ends within a few years). Anyone up for a rollercoaster ride:

How many readers have any idea of the repeated vicissitudes of the 8% bonds of Czechoslovakia, since they were first offered in this country in 1922 at 96.5? They advanced to 112 in 1928, declined to 67.75 in 1932, recovered to 106 in 1936, collapsed to 6 in 1939, recovered (unbelievably) to 117 in 1946, fell promptly to 35 in 1948, and sold as low as 8 in 1970!

Strategies to Use

For the enterprising investor, Graham recommends the following strategies:

  • Relatively unpopular large company: This would entail buying unpopular S&P500-type companies in a group
  • Bargain Issues: Graham says to buy securities 50% below their true value. You determine the actual worth by (i) appraisal, where you discount future earnings, or (ii) business value to a private buyer, where you look at future earnings but also seriously consider net current asset
  • Special situation or "workout": This involves things like merger arbitrage, takeovers, bankruptcy investing, and so forth. Graham says only a small percentage of enterprising investors are likely to use this method so this book does not go into this strategy.

Graham strongly suggests that one needs to be dedicated if they are to follow the enterprising investor 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 in 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 dissapointment than achievment.

The Intelligent Investor elaborates on some tools to be used in analyzing securities. It is quite brief but it gives enough of a starting point for the lay investor to pursue. One of the insightful items I found was the following simplified formula for valuing growth stocks:

value = current_(normal)_earnings x [8.5 + 2 x expected_annual_growth_rate]

So at 0% growth, P/E is 8.5, and growth in 10 years is 0.
At 2.5% growth rate, P/E is 13.5, and growth in 10 years is 28%.
At 5% growth rate, P/E is 18.5, and growth in 10 years is 63%.

I was always uncertain when it came to pricing future growth and this rough formula provides some help to me. It isn't accurate but one should keep in mind that projecting the future can be misleading so a rough guide is all that I want.

It seems obvious nowadays but it's worth mentioning the point from Graham about earnings manipulation. Graham says to read the fine point (footnotes) and think about charges and other one-time items. He recommends that one should use average earnings over a period of time, rather that the present one year earnings. (Instead of earnings, it is prudent to look at ROIC and book value per share growth--this is not Graham's suggestion).

Based on his experience at his firm, Graham-Newman, Graham suggests the following for enterprising investors:

  • Arbitrages: True arbitrage is risk-free but most so-called "arbitrage" strategies carried out by most people are single-sided bets. For instance, when Warren Buffett recently took a stake in Dow Jones, before it was acquired by News Corporation, there was no way to hedge the transaction*.
  • Liquidations: This involves buying shares where you will receive cash payments from liquidations. This sounds interesting but I am not sure how to search for these stocks (if anyone has some ideas, leave comments or e-mail me please).
  • Related hedges: Graham talks about buying covertibles and selling the underlying stock
  • Net current asset (bargain) issues: Buying below 2/3 net current asset value. Graham suggests wide diversification (his firm had 100 securities at once).

(* On a side note, I thought that deal was risky (before hearing about Buffett's move) but Buffett clearly thought otherwise. The risk I saw was that the family that controlled Dow Jones may not accept the deal but Buffett correctly predicted the deal consummation.)

One strategy is to look at beaten down cyclicals:

If he [enterprising investor] followed our philosophy in this field he would more likely be the buyer of important cyclical enterprises--such as steel shares perhaps--when the current situation is unfavourable, the near-term prospects are poor, and the low price fully reflects the current pessimissm.

The above is what being a contrarian is all about!

Graham suggests the following screen to narrow down stocks:

  • (a) current assets greater than 1.5 x liabilities; (b) debt less than 110% of net current assets (for industrial companies)
  • no earnings deficit in last 5 years
  • some current dividend
  • earnings greater today than 5(?) years ago
  • stock price less than 120% of net tangible assets

There are very few stocks that will pass that screen right now (the screen for a defensive investor is even more stricter than what is given above). To satisfy Graham's filter, one either needs to wait for a market correction or look at ignored places like foreign stocks, smallcap stocks, pink sheet stocks, and so forth.

The Most Important Lessons

Even if one doesn't follow everything else that was covered in the book, there are two important insights for any investor.

The first is the God-like entity that we all love and hate, Mr. Market. The ever-emotional Mr. Market has a habit of offering prices higher than the true worth of a firm, and at other times, a price lower than what a company is worth. The lesson to learn is that one should take advantage of the market and sell when the offering price is higher than a company's true value, and buy when the price is clearly below the worth of a company. The choice to act is yours and, in general, one should just ignore the quoted prices. Investing is as simple as that!

The second important point can be summed up in a few words--perhaps the most important in all of investing--by Graham: margin of safety. Those three words are just as immortal as the old saying that applies to all situations: "this too shall pass". If there is something that seperates value investors from other investing styles, it is this concept of margin of safety.

Graham suggests that an investor only buy securities with a big margin, where the price paid is far below the value of the business. He also recommends diversification in addition to a margin of safety (although I should note that Graham at one time had 25% of his portfolio in one stock, GEICO--he made more money on this than all his other investments combined).

Ultimately, Graham says that investors should think like a businessperson. He gives some principles to act like a businessperson:

  • Know what you are doing--know your business: Just like a businessperson knows the details of the product or service he/she is selling, so should you.
  • Do note 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.: Only let others manage your money if they fit these suggestions.
  • 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.: Graham says the an investment decision should be based on arithmetic rather than optimism.
  • 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.): Graham is basically saying that one needs to act on their convictions after a solid case can be made.

The above suggestions are the hardest for me. I need to start thinking like as if I'm running a real business.

Final Opinion

Overall, I think this is a remarkable book--Benjamin Graham isn't called the father of value investing for nothing. Since a lot of the concepts have been repeated in other books or covered in magazines, I did not find this book as mindblowing as some others may have. I highly recommend this book to any investor that has some knowledge of investing (if you are total newbie and doesn't know what a bond or preferred share is then you should read an introductory book before this one). Even if you are not a value investor, you should check out this book to see what value investing is all about. Contrarians will find a lot of insight from an experienced master who lived and breathed Wall Street for almost half a century.

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