The Investment Policies based on Benjamin Graham.

 The Investment Policies based on Benjamin Graham.

Elaboration of Section 1

This section is the cornerstone of the entire article, establishing the fundamental philosophy that guides all subsequent advice. It is based directly on the work of Benjamin Graham, the father of value investing and the intellectual mentor of Warren Buffett.

The core of this section can be broken down into three critical concepts:

1. The Categorization of Investment Policies
Graham doesn't believe in a one-size-fits-all approach. Instead, he provides a clear menu of options based on an investor's goals. The policies are structured from most conservative to most aggressive:

• Policy A: Investment for Fixed Income: This is the safest tier, focused entirely on capital preservation. It includes instruments like fixed deposits (FDs) and government bonds. The primary goal is safety, not growth.

• Policy B: Investment for Income & Moderate Appreciation: This tier introduces a balance. It aims for a reasonable income (e.g., dividends) and some protection against inflation. This is achieved through:

  • Investment Funds: Diversified mutual funds or unit trusts.

  • Blue-Chip Stocks: Shares of large, well-established, and financially sound companies, but only when bought at a "reasonable price."

• Policy C: Investment Chiefly for Profit: This is for investors seeking higher returns and who are willing to do more work. It outlines several "enterprising" approaches:

  • Buying general stocks when the overall market is low.

  • Buying growth stocks at a reasonable price relative to their current performance (not future hype).

  • Value Investing: The core Graham strategy—buying securities that are selling for significantly less than their intrinsic value (a "bargain").

  • Buying high-grade bonds and preferred shares.

  • Exploiting "special situations" like mergers or arbitrage.

• Policy D: Speculation: Graham is very clear to distinguish this from investing. Speculation includes:

  • Buying IPOs (new ventures).

  • Active trading.

  • Buying "growth stocks" at inflated, "generous" prices. He warns that this should be done with a separate pool of money one can afford to lose.

2. The Two Types of Investors: Defensive vs. Enterprising
This is a psychological and practical classification, not one based on wealth.

• The Defensive Investor: This investor seeks safety and freedom from effort. Graham includes in this category people who lack the time (e.g., a busy professional) or the inclination to deeply analyze investments. Their strategy should be simple and safe, sticking to Policy A and B.

• The Enterprising (or Aggressive) Investor: This investor is willing to devote significant time and "intelligent effort" to the task of investing. They have the interest and temperament to research and analyze securities. They can pursue the strategies in Policy A, B, and C.

3. The Crucial Difference Between Investment and Speculation
This is the most important philosophical point in the section. Graham provides a precise, three-part definition:

"An INVESTMENT OPERATION is one which, upon THOROUGH ANALYSIS, promises SAFETY OF PRINCIPAL and a SATISFACTORY RETURN. Operations NOT meeting these requirements are speculative."

Let's break down the definition:

• Thorough Analysis: This means a detailed, fact-based study of the asset, not a tip from a friend or a gut feeling.

• Safety of Principal: The primary goal is to not lose your initial capital. The investment must have a low risk of permanent loss.

• Satisfactory Return: The return should be reasonable and aligned with the level of risk. It doesn't have to be spectacular.

Graham adds that an investment must be justifiable on both qualitative and quantitative grounds (the nature of the business and its numbers) and that price is always a critical factor. A great company can be a terrible investment if you pay too much for it.

He concludes by distinguishing speculation from gambling:

• Intelligent Speculation: Taking a calculated risk after careful study of the pros and cons.

• Unintelligent Speculation: Taking a risk without any real analysis.

• Gambling: Creating a risk that didn't exist before (e.g., betting on a horse race).

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Summary of Section 1

Section 1 lays the foundational philosophy for intelligent investing by defining clear policies, investor profiles, and the critical line between investing and speculation.

• Investment Policies: It outlines a spectrum of strategies, from safe fixed-income (Policy A) to more profitable but riskier value and growth investing (Policy C), while clearly labeling speculation (Policy D) as a separate, dangerous activity.

• Investor Profiles: It distinguishes between the Defensive Investor, who should adopt a simple, low-effort strategy focused on safety, and the Enterprising Investor, who can pursue higher returns through active analysis and strategies like value investing.

• Core Definition: The section's most vital lesson is Graham's definition of an investment operation: it must be based on thorough analysis, prioritize safety of principal, and only then seek a satisfactory return. Any activity failing to meet these three criteria is considered speculation.

In essence, this section teaches you to first know who you are as an investor (Defensive or Enterprising), then choose an appropriate strategy from Graham's menu, and finally, to always ensure your actions qualify as true investment and not speculation. This disciplined framework is the first and most important step toward managing risk and achieving long-term financial success.

SUMMARY OF A SOUND INVESTMENT POLICY (BENJAMIN GRAHAM & QMV METHOD).

 SUMMARY OF A SOUND INVESTMENT POLICY (BENJAMIN GRAHAM & QMV METHOD).

Elaboration of Section 31

This section serves as a powerful recap and synthesis, bringing the entire discussion full circle. It consolidates the foundational wisdom from the beginning with the practical framework developed throughout the document. It's designed to be a quick-reference guide for the intelligent investor.

The summary is structured in two clear parts:

Part 1: The Foundational Policies of Benjamin Graham (A Direct Reprise of Section 1)
This part reiterates the core menu of strategies from Benjamin Graham, reminding the investor of the different paths available based on their goals and temperament.

• Policy A: Investment for Fixed Income. The safest tier, for capital preservation (e.g., FDs, bonds).

• Policy B: Investment for Income & Moderate Appreciation. A balanced approach using investment funds and blue-chip stocks for income and some growth.

• Policy C: Investment Chiefly for Profit. The enterprising investor's path. This includes:

  • Buying in low markets.

  • Buying growth stocks at reasonable prices.

  • VALUE INVESTING: Buying securities below intrinsic value.

  • Special situations (arbitrage, etc.).

• Policy D: Speculation. Clearly labeled as a separate, high-risk activity (IPOs, trading, overpaying for growth).

This is then mapped directly to the two investor profiles:

• Defensive Investor: Should stick to Portfolio A & B.

• Enterprising Investor: Can pursue Portfolio A, B, & C.

Part 2: The Practical Execution Framework (The KISS Strategy from Section 6)
This part summarizes the actionable, day-to-day methodology for implementing the policies above, particularly for the enterprising investor following Policy C.

It condenses the process into two easy-to-remember acronyms:

• For BUYING, remember "ABC":

  • Assess Quality, Management, and Valuation (QMV).

  • Buy only good quality stocks.

  • Buy at a Conservative price (Margin of Safety).

• For SELLING, remember "1, 2, 3, 4":

  • 1. (To be avoided) Need cash for an emergency.

  • 2. (Urgent - Defensive) The company's fundamentals have permanently deteriorated. SELL.

  • 3. (Offensive) The stock is significantly overvalued.

  • 4. (Offensive) You found a much better bargain.

The selling strategy is further refined into:

• Defensive Portfolio Management (Reason 2): Aimed at preventing harm. This is urgent.

• Offensive Portfolio Management (Reasons 3 & 4): Aimed at optimizing returns. This can be done at leisure.

---

Summary of Section 31

Section 31 is a master summary that combines Benjamin Graham's strategic policies with a simple, actionable framework for making buy and sell decisions, providing a complete blueprint for intelligent investing.

• The Strategic Foundation (Graham's Policies): Defines the spectrum from safe, defensive investing (A & B) to profitable, enterprising investing (C), while clearly isolating speculation (D).

• The Tactical Execution (The KISS Framework): Provides a disciplined, repeatable process:

  • Buy using "ABC": Assess (QMV), Buy (Quality), Conservative (Price).

  • Sell using "1,2,3,4": Based on emergency needs, deteriorating fundamentals, overvaluation, or a better opportunity.

In essence, this section is the ultimate takeaway. It ensures that an investor is never without a guiding principle. They first choose their overarching strategy (Am I defensive or enterprising?) and then apply the simple "ABC" and "1,2,3,4" rules to execute that strategy with discipline. It perfectly captures the document's goal: to provide a sound, business-like philosophy that is also practical and safe to implement.

Chapter 1 & 2: Scope and Limitations of Security Analysis (Security Analysis 6th Edition)

Chapter 1: Introduction – Scope and Limitations of Security Analysis

Introduction. Scope and limitations of security analysis. 

Every science has its limits. Even the most advanced tools cannot guarantee perfection. Security analysis is no different. It offers investors a way to think clearly about financial decisions, but it cannot eliminate uncertainty.

Benjamin Graham and David Dodd open their classic by warning us. Do not expect analysis to predict the future with certainty. Instead, expect it to create a logical foundation for making decisions. The role of the analyst is not fortunetelling. It is interpretation.  It is careful judgment built on facts, not on wishes. 

The first step is to understand what security analysis is meant to do. 

It studies financial statements, balance sheets, income accounts, and company reports. It searches for the real strength and weaknesses of a business. Its goal is to find the truth behind the numbers. 

But here comes the limitation. Even the best analysis cannot foresee wars, political revolutions, sudden economic crisis, or natural disasters. These unknowns are beyond the reach of numbers. So the analyst must remain humble. He must remember that markets can surprise anyone. 

Still, analysis has great value.  It allows the investor to avoid blind speculation. It helps in separating companies with solid foundations from those built on illusions. It gives the investor a rational anchor in a sea of market emotions. 

Graham and Dodd emphasize discipline. The analyst cannot be swayed by hope, fear, or market noise. Instead, he must ask, "Is the company truly able to protect the investor's money? Does it have a record of stable earnings? Are its assets real and strong?" If the answer is yes, then the security deserves attention. 

At the same time, analysis must remain flexible. The world changes. Industries rise and fall. Methods that worked in the past may not always work in the future. So the intelligent analyst adapts, but he never abandons the principles of logic, evidence, and caution. 

The authors also point out another important truth. Most mistakes in investing come not from lack of intelligence, but from overconfidence.  People believe they can outsmart the market. They trust predictions that sound certain, but are built on weak foundations. Here security analysis acts as a defense. It keeps the investor grounded in facts rather than fantasies. 

So what should we take from this first chapter? That security analysis is both powerful and limited. It cannot promise wealth but it can prevent disaster. It cannot predict the future but it can prepare us for it. And above all it gives us the discipline to remain rational when others lose control. 

And now comes the natural question.  If analysis is both powerful and limited, how exactly do we define its scope? What areas of finance can it truly master? And where must we admit its boundaries?

Chapter 2: The Scope and Limitations of Security Analysis Continued

The second chapter deepens the discussion of what security analysis can and cannot do. Graham and Dodd remind us that the analyst is not a prophet. He is more like a doctor. A doctor cannot guarantee life, but he can diagnose, prevent, and improve chances of survival. In the same way, an analyst cannot guarantee profits, but he can diagnose weaknesses, avoid risks, and improve chances of success.

The scope of security analysis lies in facts. Numbers do not lie, but they can be misread. The analyst's job is to test those numbers, compare them with reality, and build a logical conclusion.

For example, if a company's earnings cover its interest many times over, that is a strong sign of safety. If assets are greater than debts, that provides protection. These are within the scope of analysis, but there are strict limitations. Analysis cannot account for political revolutions, sudden natural disasters, or unexpected human behavior. It cannot forecast the timing of booms or crashes.

No formula can predict exactly when optimism will turn to panic. Therefore, the wise analyst does not try to predict everything. He accepts uncertainty and builds a margin of safety. 

The authors stress another key point. Security analysis works best when applied to groups of securities rather than single bets. Looking at one company may lead to mistakes, but examining a wide group gives a more reliable picture. Patterns and averages are more dependable than isolated cases. This is why Graham often relied on statistical studies of many companies, not just one. 

Another limitation is human emotion. Even when analysis shows danger, people often ignore it. During market bubbles, investors dismiss logic. They believe this time is different. In truth, no amount of analysis can protect someone who refuses to listen to reason. Yet, despite all these boundaries, analysis remains essential. It is the compass that keeps investors from drifting aimlessly. It cannot guarantee the destination, but it can keep the ship away from rocks. 

So, what is the lesson of this chapter? That security analysis has clear power but only within defined territory. It is like a flashlight. It cannot light the whole forest but it can guide you safely along the path in front of you. With this foundation, Graham and Dodd prepare us for the next step. 

If analysis is about finding the truth of a business, then we need a central guiding star. Something that helps us measure whether a security is really worth buying. That guiding star is the concept of intrinsic value. And it is in chapter 3 that the authors introduce this core idea. The very heart of security analysis. Chapter 3, the concept of intrinsic value.

Audio Summary of Security Analysis (6th Edition)

Summary of Security Analysis by Benjamin Graham (6th Edition)

Individual summary of each chapter in Benjamin Graham's *Security Analysis* (6th Edition). This classic text is divided into parts; we'll follow that structure.

---

### **Introduction & Part One: Survey and Approach**

#### **Chapter 1: The Scope and Limitations of Security Analysis**

*   **Core Focus:** Defining the very essence of security analysis and its boundaries.

*   **Key Takeaways:**

    *   Security analysis is the detailed examination of facts to form a reasoned judgment on a security's attractiveness and intrinsic value.

    *   It involves three functions: **Descriptive** (gathering facts), **Critical** (evaluating facts), and **Selective** (making a buy/sell judgment).

    *   The central concept is **Intrinsic Value**—the value justified by a company's assets, earnings, and dividends—which is distinct from its often-irrational market price.

    *   The famous analogy: the market is a **"voting machine"** (driven by sentiment) in the short run, but a **"weighing machine"** (reflecting intrinsic value) in the long run.

    *   The critical principle to combat uncertainty is the **"Margin of Safety"**—only investing when the price is significantly below the calculated intrinsic value.

#### **Chapter 2: Fundamental Elements in the Problem of Analysis**

*   **Core Focus:** Identifying the four relative factors that define any analytical decision.

*   **Key Takeaways:**

    *   No security is good or bad in isolation. Its merit depends on the interplay of four elements: **The Security, The Price, The Time, and The Person** (the investor).

    *   **Price is paramount.** A superb company can be a poor investment at an inflated price, and a mediocre company can be excellent at a deep discount.

    *   Analysis must prioritize **Quantitative Factors** (measurable data like assets and earnings) over **Qualitative Factors** (subjective assessments like management quality), as the latter are often speculative and already reflected in the price.

#### **Chapter 3: Sources of Information**

*   **Core Focus:** Outlining the essential sources of reliable data for analysis.

*   **Key Takeaways:**

    *   The analyst must be a thorough investigator, relying on **official and verifiable sources**.

    *   The most important documents are **Annual Reports** and **SEC Filings (10-K, 10-Q)**, which contain audited financial statements.

    *   Understanding the specific **terms of a security** (from its indenture or charter) is crucial.

    *   Additional sources include financial manuals (e.g., Moody's) and trade publications for industry context.

    *   The analyst's role is **critical**: they must read the fine print and verify figures, not just accept information at face value.

---

### **Part Two: Fixed-Value Investments**

*This section focuses on bonds and preferred stocks, investments intended to preserve capital and provide steady income.*

#### **Chapter 4: The Unsecured Bond and the Selection of Fixed-Value Investments (Summary)**

*   **Core Focus:** Establishing the criteria for selecting safe fixed-income investments.

*   **Key Takeaways:**

    *   Safety is not determined by the *name* of the security (e.g., "bond") but by the **issuer's financial capacity to pay**.

    *   The primary test for safety is a **history of substantial earnings** above interest requirements, not the presence of physical collateral.

    *   Graham introduces quantitative standards (e.g., earnings coverage ratios) to measure this safety buffer.

#### **Chapter 5: The Selection of Fixed-Value Investments: Second and Third Principles (Summary)**

*   **Core Focus:** Introducing additional, qualitative principles for bond selection.

*   **Key Takeaways:**

    *   **Second Principle: The "Human Factor":** The competence and integrity of the management team matter, though this is difficult to quantify.

    *   **Third Principle: The "Margin of Safety":** This principle is just as critical for bonds as for stocks. The investor must ensure the company's value is well in excess of its debt.

#### **Chapters 6-9: Specific Applications (Summary)**

*   **Core Focus:** Applying the core principles to various types of fixed-income securities.

*   **Key Takeaways:**

    *   These chapters analyze **high-yield bonds**, **preferred stocks**, and other senior securities.

    *   They demonstrate how to apply earnings coverage tests and asset-value tests in different scenarios.

    *   A key insight is that a **preferred stock** should be analyzed with the same rigor as a bond, as it is also a fixed-value investment.

---

### **Part Three: Senior Securities with Speculative Features**

*This section covers securities that are a hybrid, having both fixed-income and speculative characteristics.*

#### **Chapters 10-13: Convertible and Privileged Issues (Summary)**

*   **Core Focus:** Analyzing securities that offer conversion rights or other privileges (e.g., warrants).

*   **Key Takeaways:**

    *   The value of a convertible security has two components: its **value as a senior security** (bond or preferred stock) and its **value from the conversion option**.

    *   Graham warns against overpaying for the conversion privilege. The **Margin of Safety** should be based on the security's fixed-income value first and foremost.

    *   These securities are often issued when straight debt would be difficult to place, signaling potential weakness.

---

### **Part Four: Theory of Common Stock Investment**

#### **Chapter 14: Stock and Stock Profits (Summary)**

*   **Core Focus:** Exploring the fundamental nature of common stock and the sources of stockholder profits.

*   **Key Takeaways:**

    *   Challenges the old view that common stocks are inherently speculative.

    *   Identifies two sources of return: **Dividends** and **Reinvested Earnings** (which boost future earnings and intrinsic value).

    *   Argues that the intelligent stock investor is a **business owner**, not a share price speculator.

#### **Chapter 15: The Dividend Factor in Common-Stock Analysis (Summary)**

*   **Core Focus:** Examining the role of dividend policy in valuation.

*   **Key Takeaways:**

    *   Dividend policy is a major point of analytical controversy.

    *   Graham analyzes the cases for and against liberal dividend payouts versus profit retention.

    *   For the analyst, the key is to understand the company's policy and its impact on the stock's intrinsic value and investor appeal.

#### **Chapter 16: The Role of Earnings and the P/E Ratio (Summary)**

*   **Core Focus:** Establishing a sound framework for analyzing earnings and valuation multiples.

*   **Key Takeaways:**

    *   **Average Earnings** over a period (e.g., 5-10 years) are more important than a single year's results. This smooths out the business cycle.

    *   The **Price-to-Earnings (P/E) Ratio** must be examined in the context of average earnings, not just current earnings.

    *   Warns against projecting recent growth trends far into the future, a common and dangerous speculative practice.

---

### **Part Five: Analysis of the Income Account**

*This section dives into the critical details of the income statement.*

#### **Chapters 17-20: Income-Statement Analysis (Summary)**

*   **Core Focus:** Teaching the analyst how to critically dissect a company's profit and loss statement.

*   **Key Takeaways:**

    *   Emphasizes the need to identify and exclude **non-recurring items** (e.g., one-time gains or losses) to discern the true, repeatable earnings power.

    *   Discusses the impact of **depreciation and amortization** policies on reported earnings.

    *   Stresses the importance of analyzing a company's results **relative to its industry** and the overall economy.

---

### **Part Six: Balance-Sheet Analysis**

*This section focuses on the importance of asset values.*

#### **Chapters 21-24: Asset-Value Analysis (Summary)**

*   **Core Focus:** Explaining how to interpret the balance sheet and the significance of asset values.

*   **Key Takeaways:**

    *   **Book Value** (asset value per share) is a crucial benchmark, especially for identifying "bargain issues."

    *   The analyst must calculate **Liquidating Value** or **Net-Net Working Capital** (current assets minus all liabilities) to find the ultimate margin of safety.

    *   A stock selling for significantly less than its net current asset value is, in Graham's view, a compelling statistical bargain.

---

### **Part Seven: Additional Aspects of Security Analysis**

#### **Chapters 25-28: Diversification, Comparison, and Discretion (Summary)**

*   **Core Focus:** Covering the final, practical elements of portfolio management and analyst judgment.

*   **Key Takeaways:**

    *   **Diversification** is a cornerstone of risk management, even for undervalued securities.

    *   Analysts should use **comparison** to rank potential investments against each other.

    *   The analyst must exercise **informed discretion**, recognizing that quantitative rules are a guide, not a substitute for thinking.

---

### **Part Eight: Global Value Investing (6th Edition Addition)**

*This section, added in the 6th edition, applies Graham's principles in a modern, global context.*

#### **Chapters 29-33: Modern Applications (Summary)**

*   **Core Focus:** Demonstrating the enduring relevance of value investing in today's global markets.

*   **Key Takeaways:**

    *   The fundamental principles of **Margin of Safety** and **Intrinsic Value** are timeless and universally applicable.

    *   Applies the value framework to **emerging markets**, **arbitrage**, and **corporate restructuring** situations.

    *   Concludes that while markets and instruments have evolved, the disciplined psychology of the value investor remains the key to long-term success.

This comprehensive chapter-by-chapter summary provides a valuable roadmap to this foundational text.

Things changed. Is detailed analysis of individual stocks necessary?

Just before he died, Graham was asked whether detailed analysis of individual stocks - a tactic he became famous for - remained a strategy he favoured.  He answered:

"In general, no.  I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities.  This was a rewarding activity, say, 40 years ago, when our textbook was first published.  But the situation has changed a great deal since then."

What changed was:   Competition grew as opportunities became well known; technology made information more accessible; and industries changed as the economy shifted from industrial to technology sectors, which have different business cycles and capital uses.

Things changed.

Recognise the phenomenal long-term wealth-creating power of a company that possesses a durable competitive advantage over its competitors.

History of investment analysis

Benjamin Graham

Benjamin Graham had adopted early bond analysis techniques to common stocks analysis.

He focused primarily on determining a company's solvency and earning power for the purposes of bond analysis.  

Graham never made the distinction between a company that held a long-term competitive advantage over its competitors and one that didn't.

He was only interested in whether or not the company had sufficient earning power to get it out of the economic trouble that sent its stock price spiraling downward.  

He wasn't interested in owning a position in a company for ten or twenty years.  If it didn't move after two years, he was out of it.

Warren Buffett

Warren Buffett discovered, after starting his career with Graham,  the tremendous wealth-creating economics of a company that possessed a long-term competitive advantage over its competitors.

He realized that the longer you held one of these fantastic businesses, the richer it made you.

While Graham would have argued that these super businesses were overpriced, Warren realized that he didn't have to wait for the stock market to serve up a bargain price, that even if he paid a fair price, he could still get superrich off of those businesses.

Warren developed a unique set of analytical tools to help identify these special kinds of businesses.  

His new ways of looking at things enabled him to determine whether the company could survive its current problems (recall Washington Post at the time when he first bought into this company).

Warren's way also told him whether or not the company in question possessed a long-term competitive advantage that would make him superrich over the long run.  

Warren's two simple and stunning revelations:  

(1) How to identify an exceptional company with a durable competitive advantage?

(2) How to value a company with a durable competitive advantage?

Behavioural Finance: We are hardwired to be lousy investors.

1.  We are hardwired from birth to be lousy investors.

Our survival instincts make us fear loss much more than we enjoy gain.  We run from danger first and ask questions later.  We panic out of our investments when things look bleakest - we are just trying to survive!  We have a herd mentality that makes us feel more comfortable staying with the pack.  So buying high when everyone else is buying and selling low when everyone else is selling comes quite naturally - it just makes us feel better!

We use our primitive instincts to make quick decisions based on limited data and we weight most heavily what has just happened.  We run from managers who performed poorly most recently and into the arms of last year's winners - that just seems like the right thing to do!  We all think we are above average!  We consistently overestimate our ability to pick good stocks or to find above-average managers.  It is also this outsized ego that likely gives us the confidence to keep trading too much.  We keep making the same investing mistakes over and over - we just figure this time we will get it right!

We are busy surviving, herding, fixating on what just happened and being overconfident!  Maybe it helps explain why Mr. Market acts crazy at times.

2.  So, how do we deal with all these primitive emotions and lousy investing instincts?  

The answer is really quite simple:  we don't!

Let's admit that we will probably keep making the same investing mistakes no matter how many books on behavioural investing we read.

3.  How to invest in the stock market?

Traditionally, stocks have provided high returns and have been a mainstay of most investors’ portfolios. Since a share of stock merely represents an ownership interest in an actual business, owning a portfolio of stocks just means we’re entitled to a share in the future income of all those businesses. If we can buy good businesses that grow over time and we can buy them at bargain prices, this should continue to be a good way to invest a portion of our savings over the long term. Following a similar strategy with international stocks (companies based outside of the United States) for some of our savings would also seem to make sense (in this way, we could own businesses whose profits might not be as dependent on the U.S. economy or the U.S. currency)

4.  These words of wisdom from Benjamin Graham

In an interview shortly before he passed away, Graham provided us with these words of wisdom:

The main point is to have the right general principles and the character to stick to them.… The thing that I have been emphasizing in my own work for the last few years has been the group approach.  To try to buy groups of stocks that meet some simple criterion for being undervalued—regardless of the industry and with very little attention to the individual company.… Imagine—there seems to be practically a foolproof way of getting good results out of common stock investment with a minimum of work. It seems too good to be true. But all I can tell you after 60 years of experience, it seems to stand up under any of the tests that I would make up.

That interview took place thirty-five years ago. Yet we still have an opportunity to benefit from Graham’s sage advice today.

I wish you all—the patience to succeed and the time to enjoy it. Good luck.

Book:  Joel Greenblatt:  The Big Secret for the Small Investor (2001)

General Portfolio Policy (Benjamin Graham)

General Portfolio Policy: The Defensive Investor

Graham opens the chapter defining two different kinds of investors: the “active” investor, which is the kind of investor that actively seeks new investments and invests serious time into studying investments, and the “passive” or “defensive” investor, the kind of investor that wants to invest once (or on a highly regular basis) and just let his or her portfolio run on autopilot.

Regardless of the activity that you apply to your investments, Graham sticks hard with his recommendation from the earlier chapter: 50% stocks, 50% bonds (or a close approximation thereof, with an absolute maximum of 75% in either side). It’s important to remember with a recommendation like that that Graham is very conservative in his investing, dreading the idea of an actual loss in capital. Only in the most dire of down markets (like 2008, for example) would such a portfolio actually deliver a loss to the investor.

Things that enterprising investors should focus on. (Benjamin Graham) 2

Portfolio Policy for the Enterprising Investor: The Positive Side

Graham says that there are four clear areas of activity that an enterprising investor (read: not an ultra-conservative investor) should focus on:

1. Buying in low markets and selling in high markets.
Graham says, in essence, that this is a good strategy in theory, but that it’s essentially impossible to accurately predict (on a mathematical basis) when the market is truly “low” and when it’s truly “high.” Why? Graham says that there’s inadequate data available to be able to accurately predict such situations – he basically believes fifty years of data is needed to make such claims, and as of the book’s writing, he did not believe adequate data was available in the post-1949 modern era. 

2. Buying carefully chosen “growth stocks.”
What about growth stocks – ones that are clearly showing rampant growth? Graham isn’t opposed to buying these, but says that one should look for growth stocks that have a reasonable P/E ratio. He wouldn’t buy a “growth stock” if it had a price-to-earnings ratio higher than 20 over the last year and would avoid stocks that have a price-to-earnings ratio over 25 on average over the last several years. In short, this is a way to filter out “bubble” stocks (one where irrational exuberance is going on) when looking at growth stocks.

3. Buying bargain issues of various types.
Here, Graham finally gets around to the idea of buying so-called “value stocks.” For the most part, Graham focuses on market conditions as they existed in 1959, pointing towards what would constitute value stocks then. A brief bit on page 169, Graham discusses “filtering” the stocks listed by Standard and Poor’s (essentially a 1950s precursor to the S&P 500) and identifying 85 stocks that meet basic value criteria, then buying them and finding that, over the next two years, most of them beat the overall market.

That’s an index fund. Graham had basically conceived of the idea in the 1950s – it worked then, and it works now.

4. Buying into “special situations.”
Graham largely suggests avoiding “topical” news as a reason to buy or sell, mostly because it’s hard for investors to gauge how exactly such news will truly affect the stock’s price. Instead, one should simply file away interesting long-term news for later use if you’re going to evaluate the stock. For example, recalling that a company is still paying off an incurred debt from ten years ago and that debt is about to be paid off might be an indication of an upcoming jump in profit for the company – and a possible sign of a good value.

Things that enterprising investors should focus on. (Benjamin Graham) 1

Ben Graham has a lot of ideas about what you should avoid.  Defensive investors should avoid everything but large, prominent companies with a long history of paying dividends. Even enterprising investors should avoid junk bonds, foreign bonds, preferred stocks, and IPOs.

To put it simply, Graham doesn’t like risk. It comes through time and time again in every chapter of the book – do the footwork, minimize risk, and don’t swing for the fences.

So what kind of real-world investing does that lead to? Graham finally gets down to actual tactics here, finally pointing toward some specific investment choices that he actually supports! At last!

Things that even enterprising investors should avoid. (Benjamin Graham) 2

Portfolio Policy for the Enterprising Investor: Negative Approach

So, what should you avoid?

First, avoid junk bonds. If they have anything less than a stellar bond rating, don’t bother, even if they appear to return very well. Junk bonds put your principal at risk, and the point of buying bonds is to have a safe portion of your portfolio.

Second, avoid foreign bonds. Here, there are stability issues, and it’s often hard to adequately judge the risk of buying bonds from government and private entities operating under rules unfamiliar to you. 

Third, avoid preferred stocks. Preferred stocks are ones that have a higher priority in the event of a liquidation of the business, but often come at a premium price. Almost always, Graham doesn’t feel these are worth any sort of premium. Of course, in the United States, preferred stock is generally not sold directly to individual investors, only to large institutions, so it’s largely a moot point.

Finally, avoid IPOs. To put it simply, new issues do not have any track record upon which to adequately judge the company. The “hype” of an IPO is all you really have to judge the issue on. Instead, let others jump into that feeding frenzy and wait until time has shown which companies swim and which ones sink.

Those are some good rules for anyone to follow, particularly if you’re concerned about not losing the money you invest. Most of these investments have a pretty significant amount of risk and in Graham’s world, one shouldn’t put the principal at undue risk.

Things that even enterprising investors should avoid. (Benjamin Graham) 1

Graham’s view of a conservative investor is very conservative. Focus primarily on big, blue chip stocks that pay a dividend and counterbalance that with roughly an equal amount of bonds. Very conservative, indeed.

But what about those of us who are less conservative and want to seek out other investments? After all, isn’t The Intelligent Investor supposed to be a guide to value investing, not just “buy blue chips and wait”?

Graham starts to head down this path here as he turns his sights from the very conservative investor to the … less conservative investor, the type of person who would actually follow value investing principles and seek out investments that show every sign of being undervalued – and then invest in them.

But first, a chapter of cautionary advice. Graham is nothing if not cautious, after all. The focus here is on things that even enterprising investors should avoid.

The Defensive Investor and Common Stocks (Benjamin Graham)

The Defensive Investor and Common Stocks

Graham’s advice, tends to focus on people who are willing to put in that extra time – and if you’re willing to do that, he has a lot of wisdom to share.

First of all, diversify. You should own at least ten different stocks, but more than thirty might be a mistake, as it becomes difficult to follow all of them carefully and also seek out new potential stock investments.

Second, invest in only large, prominent, and conservatively financed companies. Look for ones with little debt on the books and ones with a large market capitalization.

Third, invest only in companies with a long history of paying dividends. If a company rarely pays dividends, your only way to earn money from that company is if the market deems the stock to be valuable, and you shouldn’t trust that the market will do so.

Graham seems to point strongly towards the thirty stocks that make up the Dow Jones Industrial Average as a good place to start looking, as they usually match all of these criteria. I’d personally stretch that to include stocks that make up the S&P 500, but the Dow is a great place to find very large blue chip companies that are very stable and have paid dividends for a long time.

Other than that, Graham pooh-poohs many other common strategies. Buying growth stocks? Nope. Dollar-cost averaging? Good in theory, not great in practice. Portfolio adjustments? Be very, very careful – and only do annual evaluations. In short, be very, very wary and play it very, very cool.

Remember, this is Graham’s advice for the defensive, very conservative investor.

Strong, thorough research is the most important part about owning stocks. (Benjamin Graham)

The Intelligent Investor by Benjamin Graham

There’s one big underlying theme to this book. Yet, it keeps coming to the forefront again and again. It’s the one point that I believe Graham wants people to take home from this book.

Strong, thorough research is the most important part about owning stocks.

If you can’t – or aren’t willing to – put in a lot of time studying individual stocks, identifying ones that genuinely have potential to return good value to you over time, and keep careful tabs on those individual stocks, then you shouldn’t be investing in stocks.

Over and over again, Graham makes this point, in both obvious and subtle ways. He’s a strong, strong believer in knowing the company. If you don’t have clear, concrete reasons for buying a stock, then you shouldn’t be buying that stock, period.

What if you don’t have that time? This book was written before the advent of index funds, but I tend to think that broad-based index funds can be a reasonable replacement for the stock portion of your portfolio.

The Future of Common Stocks

https://www8.gsb.columbia.edu/sites/valueinvesting/files/files/DOC004.pdf

http://www.firstavenue.co.za/sites/default/files/downloads/the_evolution_of_valuation_22112011.pdf

https://en.wikipedia.org/wiki/Edgar_Lawrence_Smith

http://www.firstavenue.co.za/sites/default/files/downloads/the_evolution_of_valuation_22112011.pdf

Bargains in Bonds and Preferred Stocks: How to profit from these bargains?

Bargains in Bonds and Preferred Stocks

The field of bargain issues extends to bonds and preferred stocks which sell at large discounts from the amount of their claim.

It is far from true that every low-priced senior issue is a bargain (there are default risks on non payment of interest and/or  principals).

The inexpert investor is well advised to eschew or stay away these completely, for they can easily burn his fingers.

There is an underlying tendency for market declines in this field to be overdone; consequently the group as a whole offers an especially rewarding invitation to careful and courageous analysis.

In the decade ending in 1948, the billion-dollar group of defaulted railroad bonds presented numerous and spectacular opportunities in this area.

Bargain-Issue Pattern in Secondary Companies (1): What led to creating these bargains?

Definition of Secondary Companies

A secondary company is one which is not a leader in a fairly important industry.

It is usually one of the smaller concerns in the field.

It may also equally be the chief unit in an unimportant line.

Any company that has established itself as a growth stock is not ordinarily considered as "secondary" company.



Stock Market's Attitude toward Secondary Companies

(a)  1920

In 1920, relatively little distinction was drawn between industry leaders and other listed issues, provided the latter were of respectable size.

The public felt that a middle-sized company

• was strong enough to weather storms and 
• that it had a better chance for really spectacular expansion than one which was already of major dimension.

(b)  Post 1931 -1933 depression

The 1931 - 1933 depression had a particularly devastating impact on companies below the first rank either in size or inherent stability.

As a result of that experience, investors have since developed a pronounced preference for industry leaders and a corresponding lack of interest in the ordinary company of secondary importance.

This has meant that the latter group has usually sold at much lower prices in relation to earnings and assets than have the former.

It has meant further that in many instances the price has fallen so low as to establish the issue in the bargain class.



No sound rational reasons for rejecting stocks of secondary companies

When investors rejected the stocks of secondary companies, even though these sold at a relatively low prices, they were expressing a belief or fear that such companies faced a dismal future.

In fact, at least subconsciously, they calculated that ANY price was too high for them because they were heading for extinction - just as in 1999 the companion theory for the "blue chips" was that no price was too high for them because their future possibilities were limitless.

Both of these views were exaggerations and were productive of serious investment errors.  

Actually, a typical middle-sized listed company is a large one when compared with the average privately-owned business.

There is no sound reason why such companies should not continue indefinitely in operation, undergoing the vicissitudes characteristic of our economy but earning n the whole a fair return on their invested capital.



The stock market's attitude toward secondary companies create instances of major undervaluation.

The stock market's attitude toward secondary companies tends to be unrealistic and consequently to create in normal times innumerable instances of major undervaluation.


As it happens, the war period and the post-war boom were more beneficial to the smaller concerns than to the larger ones, because then the normal competition for sales was suspended and the former could expand sales and profit margins more spectacularly.

• Thus by 1946 the market's pattern had completely reversed itself.  
• Whereas the leading stocks in the Dow-Jones Industrial Average had advanced only 40 percent from the end of 1938 to the 1946 high, Standard & Poor's Index of low-priced stocks had shot up no less than 280 per cent in the same period.  
• Speculators and many self-styled investors - with the proverbial short memories of people in the stock market - were eager to buy both old and new issues of unimportant companies at inflated levels.   

Thus, the pendulum had swung clear to the opposite extreme.

• The very class of secondary issues which had formerly supplied by far the largest proportion of bargain opportunities was now presenting the greatest number of examples of over-enthusiasm and overvaluation.
• If past experience can be relied upon, the post-war bull market will itself prove to have created an enlarged crop of bargain opportunities.
• For in all probability a large proportion of the new common stock offerings of that period will fall into disfavour, and they will join many secondary companies of older vintage in entering the limbo of chronic undervaluation.

The Intelligent Investor
Benjamin Graham

Value of a Business to a Private Owner

Value of a Business to a Private Owner Test

The private-owner test would ordinarily start with the net worth as shown in the balance sheet.


How to search for a bargain opportunity?

1.  Using the net worth as the starting point

The question to ask is:  Is the indicated earnings power sufficient to validate the net worth as a measure of what a private buyer would be justified in paying for the business as a whole?

If the answer is definitely yes, an ordinary investor should find the common stock attractive at a price one-third or more below such a figure.  


2.  Using the working capital as the starting point

If instead of using all the net worth as a starting point, the investor considered only the working capital and applied his test to that, he would have a more convincing demonstration of the existence of a bargain opportunity.

For it is something of an axiom or is self evident, that a business is worth to any private owner AT LEAST the amount of its working capital, since it could ordinarily be sold or liquidated for more than this figure.

If a common stock can be bought at no more than two-thirds of the working capital value alone - disregarding all the other assets - and if the earnings record and prospects are reasonably satisfactory, there is strong reason to believe that the investor is getting substantially more than his money's worth.



An example of how to find a bargain common stock:

[Peculiarly, in 1947, many such opportunities present themselves in ordinary markets.  Benjamin Graham]

National Department Stores as of January 31, 1948, the close of its fiscal year.
The price of the stock was 16 1/2.
The working capital was no less than $26.60 per share.
The total asset value was $33.30.
Deducting contingency reserves - mainly to mark down the inventory to a "LIFO" (last in first out) basis, these figures would be reduced by $2.20 per share.

The company had earned $4.12 per share in the year just closed.  The seven-year average was $3.43; the twelve-year average was $2.29.  (Growing earnings)
The year's dividend had been $1.50.  (Paying dividends)
Compared with a decade before,
-  the working-capital value had risen from $7.40 per share to $26.60,
-  the sales had doubled and (Increasing sales)
-  the net after taxes had risen from $654,000 to $3,224,000.  (Increasing profits)


Thus, we had a business
-  selling for $13 million,
-  with $25 million of assets, mostly current.  (Price < Net Assets)
-  Its sales were $88 million.  A fair estimate of average future earnings might be $2 million. (earnings record and prospects are reasonably satisfactory  or Not gruesome)

The average earnings prior to 1941 had been unimpressive, and the company was regarded as a "marginal" one in its field - that is, it could earn a reasonably good return only under favourable business conditions.  (Qualitative assessment)

In the past eight years, however, it has improved both in financial strength and in the quality of its management.  (Qualitative assessment - earnings record and prospects are reasonably satisfactory or improving quality of business and management)

Let us grant that Wall Street would still consider the company as belonging in the second rank of department-store enterprises.  (Investor sentiment/Market sentiment/Neglected by market)

Even after proper allowance is made for such an unfavourable factor, we may still conclude that on the basis of the figures the stock is intrinsically worth well above its market price.  (Worse case scenario, still Value > Price)


Conclusion:  At 16 1/2, the conclusion in the case of National Department Stores remains, whether we apply the appraisal test or the test of value to a private owner.  (Undervalued / A bargain)