The Intelligent Investor
Part 1 - A Summary of the Principles of Benjamin Graham
1. Speculation vs. Realistic Results
Investment vs. Speculation
Investing, as defined by Benjamin Graham, promises Safety of Principal and an adequate return by thoroughly analyzing investment opportunities. Investing may be contrasted to Speculating. Speculation includes any activity that unduly risks principal. Speculation is acceptable only if the speculator acknowledges that such behavior will result in losses over the long run. If the speculator confuses his activity for investing, undertakes it seriously, or risks more than he can afford to lose, then the speculator is acting foolishly.
The Defensive Investor
The Defensive Investor seeks Safety of Principal and freedom from bother. Without exertion, the defensive investor cannot expect to achieve better than average results. Yet achieving results that are better than average is itself uncommon. In fact, most mutual funds fail to achieve better than average results.
The Defensive Investor’s portfolio is comprised of 1st quality common stocks and bonds, of which neither comprises less than 25% of the portfolio at any one time. Thus, the defensive investor may hold as much as 75% stock at the end of a recession and as little as 25% stock at the end of a bull market. Notwithstanding, market timing itself is speculation. Stocks provide a hedge against inflation. 1st quality bonds are less subject to severe price fluctuations in turbulent markets.
The Defensive Compromise
Investment quality bonds are always safer than stock except during periods of inflation. Inflation causes interest rates to rise, and this devalues fixed income securities. A business that can raise prices has protection against inflation. Appreciation of common stocks is based largely on reinvestment of earnings, which usually increases during periods of inflation (albeit maybe not during periods of stagflation). Thus, a conservative investor should keep at least 25% of his portfolio in stock as a hedge against inflation. As stated, the defensive investor can expect no more than average results. The defensive investor can not do better by purchasing new offerings or “hot” issues to make a quick profit. In fact, the contrary is almost certain.
Three alternatives for the Defensive Investor
1. Buy shares of established investment funds.
2. Utilize a trust company, bank, or certified investment counselor.
3. Use Dollar-Cost-Averaging, which means placing equal monetary amounts into a fund regardless of the current economy. However, this assumes that the investor will have the same resources available to him in all economies, regardless of his employment status, and that the investor has the courage to continue investing during turbulent times.
The Enterprising Investor
Although the enterprising investor should expect to do better than the defensive investor, he is likely to do worse. Three speculative areas that the investor should avoid are:
1. Trading in the market – short selling and betting against trends. This neither offers safety of principal nor a satisfactory return.
2. Short-term selectivity – buying stock of firms that are expected to report increased earnings. Not only may the investor be wrong in his selection, but also the issue may be fully valued due to a relatively efficient market.
3. Long term selectivity – Choosing companies that show great promise. The same arguments apply for short and long term selectivity based upon expected favorable results.
To achieve success, an investor must follow policies that are sound and not popular on Wall Street. There are large discrepancies between market price and actual value. Often, speculative stock movements are at unreasonably high or low levels. Nonetheless, buying neglected and undervalued issues can prove both protracted and frustrating.
The ingrained, long-standing and seemingly insane maxim of Wall Street is to buy stocks when they have gone up and to sell them when they have gone down. This is as opposed to the cliché of buying low and selling high. One may take advantage of this contradiction by concentrating on bargain issues, that is, those possessing a market price less than their net current asset value (i.e. working capital less long term liabilities).
The search for these types of issues, and the diligence required to investigate them, is not worth an investor’s time unless the investor can add at least 5% before taxes to the average annual return. Thus, the aggressive investor seeks a 5% return over the market average.
2. Inflation
Fixed income investments fare worse during inflationary periods than do common stocks. During inflationary periods, firms can increase prices, profits, and dividends causing their share price to increase and offsetting declines in purchasing power. In 1970, the most probable average future rate of inflation was 3%.
The investor can not count on more than a 10% return above the net tangible assets of the DJIA. This is consistent with the suggestion that the average investor may earn a dividend return of 3.6% on their market value and 4% on reinvested profits.
There is no underlying connection between inflation and the movement of common stock earnings and prices. Appreciation does not result from inflation, but rather from the re-investment of profits. The only way for inflation to increase common stock values is to raise the rate of earnings on capital investment, which it has not done historically.
Economic prosperity usually is accompanied by slight inflation, which does not affect returns. Offsetting factors include rising wage rates that exceed productivity gains and additional capital needs that cause interest rates to increase. The investor has no reason to believe that he can achieve average annual returns better than 8% on DJIA type investments.
Graham describes alternatives to common stocks as a hedge against inflation. These alternatives range from gold and diamonds to rare paintings, stamps, and coins. Gold has performed poorly, far worse than returns from savings in a bank account. The latter categories, such as paying thousands of dollars for a rare coin, can not qualify as an “investment operation.” Real Estate is still another alternative; however, its value fluctuates widely, and serious errors may be made when purchasing individual locations. Again, the defensive investor is best served by purchasing a portfolio of carefully chosen common stocks and bonds.
3. Stock Market History
During the last 100 years, stocks have made an underlying advance through numerous market cycles. These cycles can be divided into 10 year periods.
The period from 1900 to 1968 can be subdivided into three segments. From 1900 to 1929, market cycles lasted 3 to 5 years. From 1929 to 1949, the DJIA barely moved, rising a mere 1.5% per year, evidencing the public disdain for common stocks. Then, from 1949 to 1968, there was mostly one single bull market punctuated by only several short recessions. During this 20 year period the DJIA advanced 6 times, averaging an annual 11% compounded rate of return not including average dividend returns of 3.5%, for a total return of 14% per annum. Just when the market seemed its rosiest, the DJIA fell 36% between 1968 and 1970, then returned to an all time high in 1972. 1970 marked a definite deterioration in the health of American firms. The average ROIC fell to its lowest level since WWII, and a number of important bankruptcies occurred. Measuring market performance in 10 year increments smoothes annual fluctuations.
Only 2 of the last 8 decades had a decrease in common stock earnings and prices. However, shorter term fluctuations have been more severe. For example, during the period from 1959 to 1961, many “hot” issues went public at astoundingly high valuations. These valuations were further elevated by speculation. By 1962, many of these same issues had lost as much as 90% of their value.
In the 1964 writing of the “Intelligent Investor”, Graham believed that the market was overvalued. He stated that the old standards of valuation were inapplicable and major investing uncertainties existed. He stated that if the current market level was not too high, then no price was too high. When markets are overvalued, Graham recommends the following actions:
1) Do not borrow to buy or hold securities.
2) Do not increase the proportion of stocks held in funds.
3) Reduce common stock holdings to no more than 50% of the overall portfolio.
4) Suspend contributions to any “dollar-cost averaging” stock contribution plan.
4. The Defensive Investor’s Portfolio Policy
Those who can not afford to take risks should be content with a relatively low return. The rate of return is dependent upon the amount of effort put forth by an investor. As previously stated, the defensive investor’s portfolio should consist of no less than 25% high grade bonds and no less than 25% large stocks. Yet these maxims are difficult to follow, because like the herd of Wall Street, when the market has been advancing, the temptation is strong to bet heavily on stocks. This is the same facet of human nature that produces bear markets. The time to invest in the stock market is after it has suffered a large loss.
A 50% ratio of stocks and bonds was a prudent choice except during periods of excessive increases or decreases in stock value. This simple formula guards against the mistakes caused by human nature even if it does not provide for the best returns. Again, Safety of Principal is Graham’s chief concern.
Bonds
The decision between purchasing taxable and tax-free bonds depends mainly on the difference in income to the investor after taxes. Those in a higher bracket have a greater incentive to closely examine this issue. For example, in 1972, an investor may have lost 30% of his income from investing in municipal issues (“munis”) as opposed to taxable issues.
Bonds come in many types, a description of which follows:
US Savings Bonds are a great choice. In 1972, they came in two series: E and H. The Series H Bond paid semi-annual interest. Series E Bonds did not pay interest, but rather sold at a discount to their coupon rate. In 1972, Series E bonds provided the right to defer income tax payments until the bond was redeemed, which in some cases increased the value by as much as one-third. Both E and H Series Bonds are redeemable at any time providing bondholders protection from shrinkage of principal during periods of rising interest rates (or rather, the ability to benefit from rising rates). Both series paid in or around 5% in 1972. Federal, but not state, income tax was payable on both series. Graham recommends US Bonds due to their assurance of transferability, coupon rate, and security.
Other US Bonds come in many varieties. Federal taxes, but not state taxes, are charged on other US Bonds. Some of these issues are discounted heavily. Others bonds are guaranteed, but not issued, by the US US
State and Municipal Bonds are exempt from federal and state tax in the State of their issue. However, not all of these bonds possess sufficient protection to be considered worthy of investment. To be worthy of investment, a bond should possess a minimum rating of “A”.
Corporate Bonds are taxable and offer higher yields than all types of government issues bonds.
Junk Bonds are those that are less than investment grade. Their title is aptly given. The investor should steer clear of these issues. The additional yield that junk bonds provide is rarely worth their risk.
Savings and Money Market Accounts are a viable substitute for US Bonds. They usually pay interest rates close to rates paid on short-term US
Preferred Stocks should be avoided. Not only does the preferred holder lack the legal claim of a bondholder (as a creditor), but also he lacks the profit possibilities of the common stock holder (as a partner). The only time to purchase preferred stock, if ever, is when its price is unduly depressed during times of temporary adversity.
Early redemption of bonds by issuers was commonplace before 1970, and resulted in an unfair advantage for the issuer by not allowing the investor to participate in significant upside values if interest rates fell. However, this practice largely stopped. The investor should sacrifice a small amount of yield to ensure that his bonds are not callable.
5. The Defensive Investor and Common Stock
Common Stocks offer protection against inflation and provide a better than average return to investors. This higher return results from a combination of the dividend yield and the reinvestment of earnings (undistributed profits), which increases value. However, these benefits are lost when the investor pays too high a price. One should recall that prices did not recover again to their 1929 highs for another 25 years. However, the defensive investor can not do without a common stock component.
4 Rules for the Defensive Investor Accumulating Common Stock:
1. There should be adequate, although not excessive, diversification; that is, between 10 and thirty stocks.
2. Each stock should be large, prominent, and conservatively financed. Conservatively financed means a debt to capital ratio no greater than 30%. Large and prominent means that the firm, in 1972 dollars, has at least $50 million in assets and annual sales, and it should at least in the top third of its industry group. Each of the 30 DJIA firms met this criteria in 1972.
3. Each firm should have a long record of continuous dividend payments.
4. Each stock should cost no more than 25 times the average of the last 7 years of earnings, and no more than 20 times the last 12 months earnings.
This last rule virtually bans all growth and other “in-favor” stocks. Due to the fact that these issues sell at high price, they necessarily possess a speculative element. A “growth stock” should at least double its earnings per share every 10 years for a minimum compounded rate of return of 7.1%.
The best of the growth stocks, IBM, lost 50% of its value during the declines of 1961 and 1962. Texas Instruments went from $5 to $256 (a 50x increase) in six years without a dividend payment as its earnings rose from $0.40 to $3.94 (a 10x increase); 2 years later TI’s earnings fell 50% while its stock price fell 80% to $50.
The temptations here are great, as growth stocks chosen at the correct prices provide enormous results. However boring, large firms that are unpopular will invariably perform better for the defensive investor.
Dollar Cost Averaging (“DCA”) often is popular during rising markets. If DCA is adhered to over many years, then this formula should work. The difficulty is that few people are so situated that they can invest the same amount each year. Economic downturns often constrain one’s ability to invest just when stocks are trading at their lowest valuations. Furthermore, when prosperity for the average investor returns, so too do high valuations.
Most people fall into the “defensive investor” category. Graham provides examples such as a widow who cannot afford unnecessary risks, a physician who cannot devote the time for proper analysis, and a young man whose small investment will not return enough gain to justify the extra effort. The beginning investor should not try to beat the market.
The investor only realizes a loss in value through the sale of the asset or the significant deterioration of the firm’s underlying value. Careful selection and diversification helps to avoid these risks. A more common and difficult problem is overpaying for securities; that is, paying more for a security than its intrinsic value warrants.
6. Portfolio Policy for the Enterprising Investor – the Negative Side
What to Avoid
The aggressive investor should start with the same base as the defensive investor, dividing the portfolio more or less equally between stocks and bonds. To avoid losses or returns lower than that of the defensive investor, the aggressive investor should steer clear of the following pitfalls:
1. Avoid all preferred stocks. Preferred stock rarely possesses upside component that is the basis for owning common stock. Yet compared to debt, preferred stock affords little protection. Since dividends can be suspended at anytime, unlike debt, why not just own debt instead?
2. Avoid inferior (“high yield” or “junk”) bonds unless such bonds are purchased at least 30% below their par value for high coupon issues, or 50% below par value for other issues. The risk of these issues is rarely worth the interest premium that they offer.
3. Avoid all new issues.
4. Avoid firms with “excellent” earnings limited to the recent past.
Quality bonds should have “Times Interest Earned” ratio, that is EBIT/net interest, of at least 5x.
Preferred stocks, convertible bonds, and other high yield or “junk” bonds often trade significantly below par during their issue, so purchasing them at par is unwise. During economic downturns, lower quality bonds and preferred stocks often experience “severe sinking spells” where they trade below 70% of their par value. For the minor advantage in annual income of 1%-2%, the buyer risks losing a substantial amount of capital, which is bad business. Yet purchasing these issues at par value provides no ability to achieve capital gains. Therefore, unless second grade bonds can be purchased at a substantial discount, they are bad deals!
Foreign Government Bonds are worse than domestic high yield junk, for the owner of foreign obligations has no legal or other means of enforcing their claims. This has been true since 1914. Foreign bonds should be avoided at all costs.
Investors should be wary of all new issues. New issues are best left for speculators. In addition to the usual risks, new issues have salesmanship behind them, which artificially raises the price and requires an additional level of resistance. Aversion becomes paramount as the quality of these issues decrease.
During favorable periods, many firms trade in their debt for new bonds with lower coupons. This inevitably results in too high a price paid for these new issues, which then experience significant declines in principal value.
Common stock issues take two forms - - those that are already traded publicly (secondary issues) and those that are not already traded publicly (IPOs). Stock that is already publicly traded does not ordinarily call for active selling by investment houses, whereas the issue of new stock requires an active selling effort. Most new issues are sold for account of the controlling interests, which allows them to cash-in their equity during the next several years and to diversify their own finances. Not only does danger arise from the poor character of businesses brought public, but also from the favorable market conditions that permit initial public offerings.
New issues during a bull market usually follow the same cycle. As a bull market is established, new issues are brought public at reasonable prices, from which adequate profits may be made. As the market rise continues, the quality of new issues wanes. In fact, one important signal of a market downturn is that new common stocks of small, nondescript firms are offered at prices higher than the current level for those of medium sizes with long market histories.
In many cases, new issues of common stock lose 75% or more of their initial value. Thus, the investor should avoid new issues and their salespeople. These issues may be excellent values several years after their initial offering, but that will be when nobody else wants them.
7. Portfolio Policy for the Enterprising Investor - the positive side
Selection of Bonds
In addition to the US Bonds described in previous chapters, US guaranteed bonds like “New Housing Authority Bonds” and “New Community Bonds” (both of which were widely available in 1972), as well as tax free municipal bonds serviced by lease payments of A rated corporations, are good investments. Lower quality bonds may be attainable at true bargains in “special situations”, however these have characteristics that are more similar to common stocks.
Selection of Stocks
The enterprising investor usually conducts 4 activities:
1. Buying in low markets and selling in high markets.
2. Buying carefully chosen growth stocks.
3. Buying bargain issues.
4. Buying into “special situations”.
1. Market timing - This is a difficult proposition at best. Market timing is more of a speculative activity.
2. Growth Stocks – This also is difficult. These issues are already fully priced. In fact, their growth may cease at any time. As a firm grows, its very size inhibits further growth at the same rate. Therefore, the investor risks not only overpaying for growth stocks, but also choosing the wrong ones. In fact, the average growth fund does not fair much better than the indexes. Also, growth stocks fluctuate widely in price over time, which introduces a speculative element. The more enthusiastic the public becomes, the more speculative the stock becomes as its price rises in comparison to the firm’s earnings.
3. Special Situations – This is a specialty field that includes workouts in bankruptcy and risk arbitrage arising from mergers and acquisitions. However, since the 1970s, this field has become increasingly risky with available returns less than were previously realizable. In addition, this field requires a special mentality as well as special equipment. Thus, to the common investor, this area is highly speculative.
4. Bargain Issues – This is the area in which the common investor has the enterprising investor has the greatest chance for long term success.
The market often undervalues large companies undergoing short-term adversity. The market also will undervalue small firms in similar circumstances. Large firms generally possess the capital and intellectual resources necessary to carry the firm through adversity; plus, the market recognizes the recovery of large firms faster than it does for small firms. Small firms are more likely to lose profitability that is never to be regained, and when earnings do improve, they may go unnoticed by the market.
One way to profit from this strategy is to purchase those issues of the DJIA that have either the highest dividend yields or the lowest earnings multiples. The investment returns using this method should result in a return approximately 50% better than purchasing equal amounts of all 30 DJIA issues. This is a sound starting point for the enterprising investor.
Caution must be paid not to purchase companies that are inherently speculative due to economic swings, such as the Big 3 automakers. These firms have high prices and low multipliers in their good years, and low prices and high multipliers in their bad years. When earnings are significantly low, the P/E is high to adjust for the underlying value of the firm during all economic periods. To avoid this mistake, the stock selected should have a low price in reference to past average earnings.
Bargain issues are defined as those that worth considerably more than their market price based upon a thorough analysis of the facts. To be a true bargain, an issue’s price must be at least 50% below its real value. This includes bonds and preferred stocks when they sell far under par.
There are two ways to determine the true value of a stock. Both methods rely upon estimating future earnings. In the first method, the cumulative future earnings are discounted at an appropriate discount rate, or in the alternative, the earnings are multiplied by an appropriate p/e multiple. In the second method, more attention is paid to the realizable value of the assets with particular emphasis on the net current assets or working capital.
During bear markets, many issues are bargains by this definition. Courage to purchase these issues in depressed markets often is later vindicated. In any case, bargains can be found in almost all market conditions (except for the highest) due to the market’s vagaries. The market often makes mountains out of molehills. In addition to currently disappointing results, a lack of interest also can cause an issue to plummet.
Many stocks, however, never recover. Determining which stocks have temporary problems from those that have chronic woes is not easy. Earnings should be proximately stable for a minimum of 10 years with no earnings deficit in any year. In addition, the firm should have sufficient financial strength to meet future possible setbacks. Ideally, the large and prominent company should be selling below both its average price and its past average price/earnings multiple. This rule usually disqualifies from investment companies like Chrysler, whose low price years are accompanied by high price earnings ratios. The Chrysler type of roller coaster is not a suitable investment activity.
The easiest value to recognize is one where the firm sells for the price of its net working capital after all long-term obligations. This means that the buyer pays nothing for fixed assets like buildings and machinery. In 1957, 150 common stocks were considered bargain issues. Of these, 85 issues appeared in the S & P Monthly Guide. The gain for these issues in two years was 75%, compared to 50% for the S & P industrials. This constitutes a good investment operation. During market advances bargain issues are difficult to find.
Secondary issues, those that are not the largest firms in the most important industries, but that otherwise possess large market positions, may be purchased profitably under the conditions that follow. Secondary issues should have a high dividend yield, their reinvested earnings should be substantial compared to their price, and the issues should purchased well below their market highs. Regardless of the circumstance, purchasing a firm’s issue prior to its acquisition usually results in a realized gain for the investor.
General Rules for Investment
The aggressive investor must have a considerable knowledge of security values and must devote enough time to the pursuit as to consider it a business enterprise. Those who place themselves in an intermediate category between defensive and aggressive are likely to produce only disappointment. There is no middle ground. Thus, a majority of security owners should position themselves as defensive investors who seek safety, simplicity, and satisfactory results.
As stated earlier, all investors should avoid purchase at full price of all foreign bonds, ordinary preferred stocks, and secondary issues. “Full price” is defined to be the fair value of a common stock or the par value of a bond.
Most secondary issues fluctuate below fair value and only surpass their value in the upper reaches of a bull market. Thus, the only logic for owning common secondary issues is that they are purchased far below their worth to a private owner, that is, on a bargain basis. In secondary companies, the average common share is worth much less to an outside investor than the share is worth to a controlling owner. In any case, the distinction between a primary and secondary issue often is difficult to determine.
8. Market Fluctuations
Fluctuations of Common Stock Prices
Since common stocks are subject to wide price swings, the investor should seek to profit from these opportunities. However, attempting to time the market usually ends in unsatisfactory results. Graham believes that market timing is pure speculation and is not an investing activity. The best an investor can do is the change the bond and stock proportions in his portfolio after major market swings.
Formulas do not work, although they have been in vogue since the 1950s. When the market reached new highs in the mid-1950s, many formula investors sold their equities according to formula only to witness the market grow increasingly higher. Any approach to the market that is easily described is sure to fail (except for Graham’s method).
The investor also can focus on the price of a security. Graham recommends this practice. Short-term fluctuations should not matter. Over a period of 5 years, the investor should not be surprised if the average value of his portfolio increases more than 50% from its low point or decreases 1/3 from its high point
Market advances and declines tempt investors to make foolish decisions. Varying the proportion of stocks and bonds between the 25%-75% ratio occupies an investor’s time during turbulent markets and prevents him from making gross errors in judgement. The true investor takes comfort that his actions are opposite from the actions of the crowd.
The better a firm’s record and its prospects, the less relationship that its price will have to its book value. The more successful the company, the more likely its share price is to fluctuate. More often than not, a fast growing firm’s market price will exceed its intrinsic value. So, the better the quality of the stock, the more speculative it will be. This explains the erratic price behavior of some of the most successful and impressive enterprises, such as IBM and Xerox.
The investor should purchase issues close to their tangible asset values and at no more than 33% above that figure. These purchases logically are related to a company’s balance sheet and not to its earnings. Any premium over book value may be thought of as a fee for liquidity that accompanies any publicly traded stock.
Just because a stock sells at or below its net asset value does not warrant that it is a sound purchase. In addition to below market values, the investor also must demand a strong financial position, a satisfactory p/e ratio, and an assurance that the firm’s earnings will be sustained over the years. This is not an entirely difficult bill to fill except under dangerously high market conditions. At the end of 1970 more than half of the DJIA met these investment criteria. However, the investor will forgo the most brilliant, high growth prospects.
With a portfolio purchased at close to book value, the investor can take a more detached view of market fluctuations. In fact, so long as the earning power of the portfolio remains satisfactory, the investor can use these market vagaries to buy low and sell high.
As seen with the stock fluctuations of A & P over many years, the market often goes wrong. Although the stock market may fall, a true investor is rarely forced to sell his shares. Rather, the investor is free to disregard the market quotes. Thus, the investor who allows himself to be unduly worried about the market transforms his basic advantage into a disadvantage. In fact, the investor who owns common stock owns a piece of these companies as a private owner would, and a private owner would not sell his business when it is undervalued by the market. A quoted stock provides an option for the investor to sell at a given price and nothing more. The investor with a diversified portfolio of good stocks should neither worry about sizeable declines nor become excited about sizeable advances. An investor never should sell a stock just because it has gone down or purchase it because it has gone up.
Graham provides the parable of “Mr. Market”, who like the stock market, quotes you a price for your shares each and every day. Mr. Market will either buy your shares or sell you his. The price will depend upon Mr. Market’s mood. You can ignore his efforts, or you can take advantage of him when he quotes you a price that you believe is priced advantageously. Finally, one should not forget the effect of management on a firm’s results. Good management produces acceptable results and bad management does not.
Fluctuation of Bond Prices
Short-term bonds, defined as those with a duration of less than 7 years, are not significantly affected by changes in the market. This applies to US Savings Bonds, which can be redeemed at anytime. Long term bonds, however, may experience wide price swings as a result of fluctuations in the interest rate. Thus, long term bonds may seem attractive when discounted, but this practice often leads to speculation and losses.
Low yields correspond with high bond prices and vice versa; prices and yields are inversely related. The period from 1960 to 1975 is marked by reversing swings in the price of bonds so much so that it reminded Graham of Newton’s law: “every action has an opposite and equal reaction.” Of course, nothing on Wall Street actually occurs the same way twice.
Graham acknowledges the impossibility of attempting to predict bond prices, even if common stock prices were predictable. Therefore, the investor must choose between long- term and short-term bonds chiefly on the basis of personal preference. If the investor wishes to ensure that his market values will not decrease, then the investor is best served by US Savings Bonds. With higher yield long term bonds, the investor must be prepared to see their market values fluctuate.
Convertible issues should be avoided. Their prices fluctuate widely and unpredictably based upon the price of the underlying common stock, the credit standing of the firm, and the market interest rate. Because convertible issues experience huge swings in market value, they are largely speculative investments.
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