The Intelligent Investor by Benjamin Graham Book Summary. Chapter 1: Investment versus Speculation. Results to Be Expected by the Intelligent Investor
Let’s develop an appropriate portfolio policy
The definition of an investor is well defined: using thorough analysis to promise safety of principal and an adequate return. Anything else is speculation. You can't be an ill-informed or reckless investor because the activity of investor requires good analysis and control of emotion.
Investing, according to Graham consists of:
- thorough analysis of a company, of its underlying business
- deliberate protection against serious losses
- aspire for adequate, not extraordinary performance
Graham has is own definitions, be cognisant of them:
- safety of principal = protection of loss under all normal and likely conditions
- adequate/ satisfactory = any rate of return that the investor is willing to accept (amount doesn’t matter!), if he acts with reasonable intelligence
Gone are the days of pure investment policies. The market has speculative factor. It’s unavoidable, as someone has to take the risk (read: profit and loss). A speculator values based on what everyone else will pay.
🧪 A test to see if you’re a speculator
Would you be comfortable owning a stock if you didn’t know its daily share price?
If there was no market for these shares, would you invest privately on these terms?
Speculation is important though, else who invests in untested companies and startups?
But some types of speculation are unintelligent:
- thinking you’re investing, but you’re actually speculating
- speculating seriously (when it should just be a past time)
- risking more than you can lose in the act of speculation
💡 Recommendation: don’t mingle your speculative investments into the same account as your investment operations account.
Some recommendations from 1964:
- High grade bonds never less than 25% or more than 75%
- Thus common stocks never more than 75% or less than 25%
- Simplest choice is 50/50
- Adjustments to be 5%
- If stock market is highly priced, reduce it toward 25, and vice versa
- Example: in 1965, an investor can obtain about 4.5% in high grade taxable bonds and 3.25% on good tax free bonds. Dividend return was 3.2%. An estimated return of a 50/50 portfolio was 6% a year before tax.
- The stock component should carry a fair degree of protection versus a loss of PP from large scale inflation
But what has happened since 1964:
- Record high IR for first grade bonds, good corporate issues are at 7.5%
- Dividend return on DIJA type stocks had a good advance but now at a point lower than 3.5% (similar to end of 1964)
- The change in IR produced a max decline of 38% during this period (?)
- A paradoxical aspect to these developments! They discussed that stocks may be too high and subject to a serious decline; but didn’t consider the same could happy to high-grade bonds. The warning on this wasn’t enough.
- Cash equivalents would have performed better than the common stock
Cash and cash equivalents refers to the line item on the balance sheet that reports the value of a company’s assets that are cash or can be converted into cash immediately.
Cash equivalents include bank accounts and marketable securities, which are debt securities with maturities of less than 90 days. However, oftentimes cash equivalents do not include equity or stock holdings because they can fluctuate in value.
Examples of cash equivalents include commercial paper, Treasury bills, and short-term government bonds with a maturity date of three months or less. Marketable securities and money market holdings are considered cash equivalents because they are liquid and not subject to material fluctuations in value.
🥡 Takeaway: the future of security prices is never predictable, but your own behaviour is!
- Don’t forget that increases in price can be nominal (driven by inflation!). So account for inflation!
In this section Graham is summarising Gordon’s Equation (aka Dividend Discount Model): the stock market’s future return is a sum of the current dividend yield plus expected earnings growth. Worked example: a stock of 2% and long-term earnings growth of 2% plus inflation at 2% gives a future return of 6%.
🔗 Understanding Gordon Growth Model
Limitations of the Gordon equation:
- Assumes a company exists forever
- Assumes constant growth in dividends per share (there are business cycles!)
The interest and principal payments on good bonds are much better protected and certain than dividends and price appreciation on stocks.
Interest payments are fixed amounts, and erode in real value with inflation, so keep an eye on inflation.
In 1997, Treasury Inflation-Protected Securities (TIPS) were introduced which immunise against inflation (they adjust to CPI). These are superior to stocks in the function of hedging against inflation.
Bonds sound great! But there may be a regrettable situation: if American businesses become so great, away from underlying value, pushed up by speculation, that you lost out on the uptick.
Thus the rule remains — have a balance of stocks & bonds.
Between 1949 and 1969 the DIJA advanced 5x whereas earnings and dividends had only doubled — see this as a change in investors’ and speculators’ attitudes, rather than underlying values.
Graham is skeptical of defensive investors to do better than average results.
The investor cannot hope for better than average results by buying new or hot offerings (recommendations for quick profit). Instead, confine yourself to shares of important companies with a long record of profitable operations and in strong financial condition.
Practices for the defensive investor:
- buy well established investment funds (vs. building your own common stock portfolio)
- dollar cost averaging — investing the same number of dollars each period (month / quarter). This way you buy more shares when the market is low vs when it is high, and you will likely end up with a good price. This is a type of Formula Investing.
🔗 Dollar-Cost Averaging (DCA) Definition
Before you want to become an aggressive investor, make sure you perform better than a defensive investor. Some ways investors and speculators have tried to better the market:
- market trading — buy low, sell high
- short term selectivity — buying when a company has recently released (or will release) increased earnings
- long term selectivity — past growth which is considered to continue or when a company is expected to establish a high earning power (tech stocks)
Graham takes a negative view on the above. Firstly market trading is unrealistic, as it doesn’t protect principal nor give a satisfactory return.
Selectivity has two obstacles:
- human fallibility
- you may be wrong, or market is has already priced that inc
- your competition (wall st)
- do you have enough acumen to beat them?
💡 Recommendation: follow policies which are inherently sound and not popular on Wall St.
But it’s not to say an enterprising investor cannot succeed. Speculations go up and down (= arbitrage opportunity), some stocks don’t get the attention, people just don’t understand the anatomy of companies.
The book then describes the ebb and flow of arbitrage corporate events (as ways of fulfilling the enterprising investor), and as an example refers to the spike in leverage buy outs (LBOs) in the 80s and how Wall St set up desks to take advantage of merger/event arbitrage.
Don’t short sell unless you really want to test your courage, stamina and wallet.
Sell if the fundamentals have changes, not the price.
Further Research Areas
- Turn over rates (average time a stock is held for)
- Publications by Schwert @ Rochester University
Originally published on my blog, find more book summaries there!
