The Intelligent Investor

Introduction

Since its original publication in 1949, Benjamin Graham's revered classic, The Intelligent Investor, has remained the most respected guide to the financial markets.

• While it is not a technical manual for stock picking or a step-by-step handbook for business evaluation, Benjamin Graham’s timeless philosophy of "value investing" shields investors from the common pitfalls of market volatility.
• Indeed, the investor's chief problem - and even his worst enemy - is likely to be himself. Millions of investors spend their entire lives fooling themselves: taking risks they do not understand, chasing the phantoms of past performance, selling their winning assets too soon, holding their losers too long, paying outlandish fees in pursuit of the unobtainable, bragging about beating the market without even measuring their returns.
• By teaching readers how to resist the influence of "Mr. Market" with the proper mental and emotional attitude, he provides an indispensable foundation for long-term investment success.
• In fact, Warren Buffett famously regarded it as "by far the best book on investing ever written", advising readers to pay special attention to the invaluable lessons found in Chapters 8 (Market Fluctuations) and 20 (Margin of Safety).

Benjamin Graham argues that while most traders are guided by charts or mechanical methods to "time" the market, these approaches are fundamentally flawed.

• Technical analysis encourages people to buy simply because a stock has gone up and sell because it has declined.
• However, this is the exact opposite of sound business logic. In any other field, you want to buy an asset when it is cheaper and sell it when it is worth more. Following price trends blindly is a form of speculation that rarely leads to lasting success in investing.

Furthermore, Benjamin Graham observes that even "experts" lack dependable ways of selecting and concentrating on the most promising companies within the most promising industries.

• To illustrate, the majority of investment funds - despite their experienced personnel and vast resources - have failed to outperform the general market over the long term.

Investment versus Speculation

Investors must clearly distinguish between investment and speculation, and between market price and underlying value.

• Investment: An operation which, upon thorough analysis, promises safety of principal and an adequate return.
• Speculation: Any operation that does not meet these requirements.

An investor looks beyond short-term market behavior to evaluate the long-term health of the business.

• A stock is not just a price on a screen; it is an ownership stake in an underlying enterprise.
• The sources of return for an investment are internal to the asset: the interest income from bonds, or the earnings and dividends produced by a company.
• The selection of securities and the target rate of return - whether one chooses to be a defensive or enterprising investor - depend less on an individual’s financial resources and more on their financial equipment: their knowledge, experience, and, above all, their temperament.

On the other hand, if you gamble instead of investing, you turn the stock market into a negative-sum game.

• You miss the rewards of long-term ownership, create unnecessary trading costs, and generate punitive tax bills.
• Joining the "herd" to buy a soaring stock provides a false sense of safety - it feels right because you are not acting alone. However, the crowd is often wrong, and "social validation" can lead to the massive overvaluation of a worthless business.
• Modern investors must also be especially wary of the gamification of trading apps. Features like bright displays, sign-up rewards, badges, and leaderboards are designed to trigger dopamine and encourage frequent, speculative trading. The intelligent investor ignores these "trophies" and remains focused on the underlying business.

The investor must recognize that a speculative factor exists in almost every stock holding.

• The task is to keep this component limited and to remain prepared - both financially and psychologically - for adverse results that may last for short or long durations.

NOTE: Speculation is an endless cycle of emotional swings. It begins in doubt, progresses through hope and confidence to complacency and greed, before falling into fear and despair, only to fade back into doubt and start all over again.

The Defensive Investor

The defensive (or passive) investor emphasizes the avoidance of serious mistakes. Their secondary aim is freedom from effort, annoyance, and the need for frequent decision-making.

Strategy and asset allocation

• The 50-50 Rule: Maintain a simple division of 50% bonds and 50% equities. This ratio can vary between 25% and 75% based on market conditions and personal judgment.
• Quality over Hype: Avoid "hot" issues or new offerings recommended for quick profit. Stick to well-established companies with long records of profitable operations and strong financial standing.

Three supplementary practices

• Investment Funds: Purchasing shares of well-established funds rather than managing a personal portfolio.
• Trust Funds: Utilizing "commingled funds" operated by banks or trust companies.
• Dollar-Cost Averaging: Investing a fixed dollar amount into common stocks at regular intervals (monthly or quarterly), regardless of price.

Four rules for common stocks selection

• There should be adequate though not excessive diversification.
• This might mean a minimum of 10 different issues and a maximum of about 30.
• Each company selected should be large, prominent and conservatively financed.
• Debt no greater than equity (50% or less of total capital)
• No earning deficits in the past 10 years.
• Ten-year growth of at least one-third in per-share earnings.
• Each company should have a long record of continuous dividend payments (ideally for at least the past 20 years).
• The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past seven years.
• Price of stock no more than 1.5 times net asset value (i.e. P/B ≤1.5).
• Price no more than 15 times average earnings of the past three years (i.e. P/E ≤15).
• Importantly, the product of the P/B and P/E should not exceed 22.5 (1.5 x 15 = 22.5).

NOTE: While growth stocks are attractive, they are often dangerous for the defensive investor because they sell at high multiples of past earnings. If the anticipated growth does not materialize, the price can drop drastically. The defensive investor should only buy growth-oriented companies if the price is not excessive, which is rarely the case in a bull market.

The Enterprising Investor

The defining trait of the enterprising (or aggressive) investor is the willingness to devote time and care to selecting securities that are both sound and more attractive than the average.

• However, simply applying energy and study is not enough; many talented people bring "native ability" to Wall Street only to end up with losses.
• The enterprising investor must understand which courses of action offer a reasonable chance of success.

The obstacles to outperformance

• Stock trading is not an operation which, on thorough analysis, offers safety of principal and a satisfactory return.
• Human Fallibility: The inherent difficulty of predicting an unpredictable future.
• Competition: By the time you identify a "promising" stock, the market price usually already reflects that anticipation. If you select a stock based on this year's superior results, you will likely find that everyone else has done the same.

To achieve better-than-average results, the investor must follow policies that are inherently sound but unpopular.

• A stock may be undervalued simply due to a lack of interest or unjustified popular prejudice.
• Success comes from making correct predictions when Wall Street as a whole is making incorrect ones.

However, while this principle is logically sound, it rarely unfolds simply in practice. Benjamin Graham warns of two primary challenges:

• The Test of Patience: Buying a neglected, undervalued issue for profit generally proves to be a protracted and patient-trying experience. The market can remain irrational and ignore a good company for years.
• The Danger of Overvaluation: Selling short a popular, overvalued issue is a brutal test. It requires not only immense courage and stamina but also a deep pocketbook.

The Negative Approach

Nonetheless, before branching out into more complex security commitments (such as second-grade bonds or special situations), the enterprising investor must start from the same base as the defensive investor: a balanced division of funds between high-grade bonds and high-grade common stocks bought at reasonable prices.

• You must master the basics of safety before seeking the rewards of aggression.

Experience clearly shows that it is unwise to buy a second-grade bond or preferred stock that lacks adequate safety merely because the yield is attractive.

• These "second-grade" securities are highly susceptible to severe sinking spells and suspended interest or dividends payment during market volatility.
• In search of higher returns, you are no longer just risking a lower return; you are literally risking the loss of a substantial part of your principal.
• For practical purposes, it is mere common sense to abstain from buying securities at "full prices". By insisting on a bargain or a reasonable valuation, you protect yourself from the "discommodity" and worry that occur when prices inevitably decline.

While they often come with excitement and high expectations, the enterprising investor must be especially wary of "new issues" (IPOs). An IPO is the only time a stock is sold with a predetermined marketing campagin behind it.

• New issues have special salesmanship behind them (i.e. a fee hive of intermediaries - underwrites, bankers, placement agents, brokerages and media outlets - all of whom are incentivized to generate "buzz").
• Also, most new issues are sold under "favourable market conditions" - which means favourable for the seller and consequently less favourable for the buyer.
• Because new issues lack a public track record and are often sold during periods of irrational exuberance, they should be subjected to unusually severe tests and careful examination before any purchase is considered.
• Bull-market periods are characterized by the transformation of a large number of private businesses into public companies with quoted shares. The heedleness of the public and the willingness of selling organizations to sell whatever may be profitably sold can have only one result - price collapse. In many cases, the new issues lose 75% and more of their offering price.

The Positive Side

The activities specifically characteristic of the enterprising investor in the common-stock field may be classified under four strategic heads

• Buying in low markets and selling in high markets
• This is the attempt to take advantage of the market's psychological cycles - purchasing when "Mr. Market" is in a fit of depression and lightening holdings when he is in a state of euphoria.
• Buying carefully chosen "growth stocks"
• A growth stock is defined as one that has performed better than average in the past and is expected to continue doing so.
• However, common stocks with good records and apparently good prospects sell at corresponding high prices. Hence, the investor may have paid in full (and perhaps overpaid) for the expected prosperity. Moreover, unusually rapid growth cannot continue forever. As a company expands, the growth curve eventually flattens out or turns inward. If the investor paid for infinite growth that suddenly slows, the price collapse is often devastating.
• For the average intelligent investor, even with devoted effort, it is notoriously difficult to derive better results in the growth sector than specialized investment companies or index funds.
• Buying bargain issues of various types
• Large, established companies that are temporarily "out of favor" due to unsatisfactory developments of a temporary nature.
• Medium-sized firms that are not the "leaders" but are strong enough to weather storms. Because they lack "glamour", they are often undervalued by the herd.
• Bonds and preferred stocks selling well under par, where the underlying assets (net current assets or working capital) far exceed the price.
• Buying into "special situations"
• These are operations involving corporate developments such as reorganizations, mergers, liquidations, or lawsuits.
• These require a high degree of technical skill and legal knowledge, as the profit depends on the outcome of a specific event rather than the general movement of the stock market.

NOTE: "Golden opportunities" - specifically the purchase of bargain issues where companies sell for less than their net working capital (after accounting for all liabilities) - are largely a thing of the past.

The Inflation

Inflation, and the constant struggle against it, has been a central concern throughout human history.

• The historical shrinkage in the purchasing power of the dollar - and the fear (or the speculators' hope) of a further decline - has profoundly influenced the thinking of Wall Street.

There are two opposing views that Benjamin Graham considers equally absurd:

• The Stock Extremist: The belief that high-quality stocks are always better investments than bonds under any condition.
• The Bond Extremist: The belief that any bond is inherently safer than any stock.

The reality is more nuanced.

• Contrary to popular belief, inflation does not automatically increase the value of previously existing capital or the rate of corporate earnings.
• In the economic cycles of the past, price levels rose and fell based on business activity.
• The real profitability of corporations has often been limited by two major factors:
• Labor Costs: Wage rates often rise faster than gains in productivity during inflationary periods, squeezing profit margins.
• Capital Intensity: The need for huge amounts of new capital to replace aging equipment or inventory at much higher prices can drain a company's cash reserves.

Alternatives to common stocks as inflation hedges

• Gold: The standard policy for those who mistrust their currency has been to buy and hold gold. However, the holder of gold receives no income return on their capital. Instead, they incur annual expenses for storage and insurance. From an investment standpoint, gold is a "dead" asset that relies entirely on price appreciation rather than internal growth.
• Tangible Collectibles: Categories of valuable objects - such as diamonds, paintings by masters, first editions, and rare stamps or coins - have seen striking advances in market value over the years. However, there is an element of the artificial, the precarious, and even the unreal about their quoted prices.
• Real Estate: While the outright ownership of real estate has long been considered a sound long-term investment, it is not without risk. Real estate values are subject to wide fluctuations, and investors can make serious errors regarding location, the price paid, and the costs of maintenance and taxes.

In summary, because of the uncertainties of the future, the investor cannot afford to put all his funds into one basket - neither in the bond basket nor the stock basket - but must remain flexible.

NOTE: The price of gold has historically swung up and down almost as erratically as stocks; as a result, gold often lagged behind inflation instead of beating it.

Stock Market

Over multidecade periods, stocks generally trend upward, but their course is seldom smooth and never predictable.

• This inherent uncertainty creates a "double-edged sword" for investors depending on their stage in life.
• For the long-term investor who is still in their earning years, a falling stock market can act like rocket fuel for wealth creation. Lower prices allow you to accumulate more shares through "Dollar-Cost Averaging", significantly boosting your future returns when the market eventually recovers.
• Conversely, market drops are detrimental when you are no longer earning a salary. If you have to pay your daily expenses by selling stocks during a downturn, you are forced to "sell low", which permanently depletes your principal and undercuts your portfolio's ability to recover.

Stock investment is fundamentally risky because of this uncertainty.

• In a perfect world, if you could determine exactly when a crash would strike, you could sell at the top, move into the safety of cash, and buy back at the bottom.
• However, the reality is if stocks seemed certain to outperform bonds, everyone would buy them simultaneously. This would drive prices so high that there would be no room left for future growth, making a crash inevitable.
• Remember, the profitability of stocks over bonds depends heavily on the starting price. If the price is too high, the future return will be low, regardless of how well the business performs.

General Portfolio Policy

A long-standing and sound principle of finance suggests that those who cannot afford to take risks should be content with a relatively low return on their invested funds.

• From this, a general notion has developed: that the rate of return an investor aims for should be more or less proportionate to the degree of risk they are willing to run.

Benjamin Graham famously disagrees with this standard "risk vs. reward" model. He argues that the rate of return sought should be dependent, instead, on the amount of intelligent effort the investor is willing and able to bring to bear on the task.

• The minimum return goes to the passive (defensive) investor, who prioritizes safety and freedom from concern. Their return is limited by their desire for simplicity and low involvement.
• The maximum return is realized by the alert and enterprising investor, who exercises maximum intelligence and skill. Their higher potential return is not a reward for taking "more risk" (in the sense of gambling), but a reward for their diligent research and professional-grade analysis.

Benjamin Graham offers another counterintuitive point regarding the timing of investments.

• He suggests a feasible policy for the average stockowner: lighten holdings when the market advances beyond a certain point and add to them after a corresponding decline.
• While most people feel the urge to buy more when the market is rising (greed) and sell when it is falling (fear), Graham’s policy forces the investor to do the opposite.
• This mechanical approach ensures that the investor harvests profits during periods of irrational exuberance and deploys capital when the market offers bargains.

The bona fide investor does not lose money simply because the market price of his holdings declines.

• In any given period, market value is bound to fluctuate.
• To maintain psychological clarity, we should apply the concept of "Risk" solely to a loss of value that occurs in one of three ways:
• Actual Sale: When an investor panics or is forced to sell at a price lower than their cost basis.
• Business Deterioration: When a significant decline in the company’s underlying financial position or competitive standing occurs.
• Excessive Entry Price: When a loss is caused by the payment of a price so high in relation to the intrinsic worth of the security that the investment was doomed from the start.

Market Fluctuations

Since even investment-grade common stocks are subject to wide, recurrent fluctuations, the intelligent investor naturally seeks to profit from these "pendulum swings".

There are two distinct methods to approach this:

• The Trap of Timing (Forecasting)
• Timing is the endeavor to anticipate the action of the stock market - buying or holding because you believe the market is going up, or selling or refrain from buying because you believe it is going down.
• The Logic of Pricing (Valuation)
• Pricing is the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value.
• In pricing, you are not guessing what the market will do next; you are measuring what the business is worth right now compared to its price tag.

However, if an investor emphasizes timing, he will end up as a speculator with a speculator’s financial results.

• Over time, investors are often persuaded that they must form an opinion on the future course of the market.
• They listen to brokerage forecasts and daily predictions, and act upon them.
• Yet, there is no basis in logic or experience to suggest the average investor can successfully anticipate market movements.
• History shows the market does not obey old "danger signals" or follow patterns predictably enough for forecasting to work consistently.

Importantly, as long as the earning power of his stock holdings remains satisfactory, the investor can afford to give as little attention as he pleases to the vagaries of the stock market.

• Remember the story of the moody 'Mr. Market,' who every day tells you what he thinks your private business is worth, and furthermore, offers either to buy you out or sell you an additional interest on that basis. Sometimes, his quoted price may be justified; at other times, it may be nothing short of silly.
• The true investor can take advantage of the daily fluctuating market price - buying wisely when prices fall sharply and selling wisely when they advance a great deal - but he never allows the market to dictate his own judgment or inclination. At all other times, he focuses his attention on his dividend returns and the operating results of his companies.

It is far from certain that the typical investor should hold off on buying until 'low market levels' appear.

• Such a strategy may involve a long wait, very likely the loss of income, and the possible missing of investment opportunities.
• On the whole, it is better for the investor to purchase stocks whenever he has the funds available - except when the general market level is significantly higher than can be justified by well-established standards of value.

Security Analysis for the Lay Investor

While financial analysis is now a well-established and flourishing profession, mathematical valuations have become most prevalent precisely in those areas where they are least reliable.

• The more a valuation depends on anticipations of the future - and the less it is tied to figures demonstrated by past performance - the more vulnerable it becomes to miscalculation and serious error.
• When we make future projections for a high-multiplier growth stock based on an annual financial report, we must realize the future may differ markedly from the past.

Nonetheless, the ideal form of common-stock analysis leads to an intrinsic valuation that can be compared with the current market price to determine whether a security is an attractive purchase.

• Unfortunately, it is nearly impossible to distinguish in advance between forecasts that are reliable and those subject to a high margin of error.
• While general long-term prospects are inherently uncertain, it is fair to assume that an outstandingly successful company possesses unusually capable management likely to continue their performance.

Two Key Factors for Better Investment:

• Financial Strength: Prioritize companies with surplus cash and minimal debt (loans).
• Dividend History: Look for an uninterrupted record of dividend payments spanning many years (e.g., more than 20 years).

Benjamin Graham suggested a simplified for valuing growth stocks:

Value = Current (Normal) Earnings * (8.5 + 2 x Expected Annual Growth Rate (%) over the Next 7-10 years)

It must be noted that such projections do not possess a high degree of reliability.

• One cannot count on future prices to behave exactly as prophecies are realized, surpassed, or disappointed.

There are hazards in deriving investment conclusions chiefly from glimpses into the future that are not supported by presently demonstrable value. Yet, there are perhaps equal hazards in sticking strictly to value limits set by sober calculations based only on past results.

The investor cannot have it both ways:

• The Imaginative Approach: One can play for big profits - the reward for a vision proved sound by events - but must accept the substantial risk of major miscalculation.
• The Conservative Approach: One can refuse to pay more than a minor premium for unproved possibilities, but must then be prepared to watch "golden opportunities" pass by.

Per-Share Earnings

When a company announces its earnings, one question matters above all: Do the reported numbers fairly represent the underlying profitability of the business?

• Often, companies spin "financial fairy tales" because their audience - the market - does not want the spell to be broken.
• When investors are eager to believe in magic, management will find ways to make wishes seem to come true through creative accounting.

Two pieces of crucial advice

• Avoid the "Single-Year" Trap
• Never take a single year’s earnings at face value.
• A single snapshot is insufficient to capture the true health of a business.
• Watch for Accounting "Booby Traps"
• If you must look at short-term figures, remain vigilant for factors that impair the comparability of the numbers, such as
• The special charges that may never be reflected in hte per-share earnings
• The reduction in the normal income-tax deduction by reason of past losses
• The dilution factor implicit in the existence of substantial amounts of convertible securities or warrants.
• The method of treating depreciations of its assets
• The choice between charging off research and development costs in the year they are incurred or amortizing them over a period of years.
• Ask: Is an expediture or a gain an one-time or recurruring event?

In previous eras, astute analysts and investors paid considerable attention to average earnings over a long period - usually seven to ten years.

• This "mean figure" serves as a vital tool for "ironing out" the frequent fluctuations of the business cycle.
• It provides a much more accurate representation of a company’s true earning power than the results of the latest year alone.

Margin of Safety

All experienced investors recognize that the 'Margin of Safety' concept is essential to the choice of sound bonds and preferred stocks.

• Its purpose is to provide a buffer for absorbing the effects of miscalculations, worse-than-average luck, or adverse developments. To illustrate, most large passenger jets have two engines, but can safely fly for extended periods if one fails, and a bridge required to bear a load of 40 tons is built to hold 70 or 80 tons.
• In bonds, the margin of safety is found in the company's past ability to earn significantly more than its interest requirements - protecting the investor against loss or discomfiture in the event of a future decline in net income. Alternatively, this margin can be calculated by comparing the total value of the enterprise to the amount of its debt.
• In common stocks, the margin of safety lies in an expected earning power that is considerably higher than the prevailing interest rate on bonds. Alternatively, the simplest measure of safety is the value of the business minus the price of the stock.

While the risk of paying too high a price for a high-quality stock is real, it is not the chief hazard confronting the average investor.

• Observation over many years has taught us that the greatest losses come from the purchase of low-quality securities during "favourable" business conditions.
• When investors buy inferior-grade bonds or preferred stocks at prices near par, the margin of safety is non-existent.
• These "fair-weather" investments are destined to suffer disturbing price declines the moment the economic horizon clouds over.

Diversification is the necessary companion to the margin-of-safety principle in conservative investing.

• While a margin of safety provides a buffer for an individual security, it does not make a loss impossible; a specific investment may still perform poorly.
• Diversification ensures that even if an individual security works out badly, the overall portfolio remains protected.

NOTE: A sufficiently low price can turn a security of mediocore quality into a sound investment opportunity - provided that the buyer is informed and experienced and that he practices adequate diversification.

Summary

In the world of investing, stories often triumph over statistics.

• We are constantly bombarded by the boasting of winners, while the evidence of those who have been wiped out rarely comes to our attention.
• Most "losers" are too embarrassed to speak of their losses, creating a skewed reality for the beginner.

To navigate this, Benjamin Graham’s teachings provide four fundamental principles to ground the investor in reality:

• Investing vs. Speculating
• Trading is a necessary part of investing, but trading alone does not make you an investor.
• If you buy a stock simply because its price is rising or because "everyone else" is buying it, you are speculating, not investing. The intelligent investor conducts thorough research and makes deliberate, consistent and measurable decisions.
• The Business Behind the Ticker
• A stock is not merely a ticker symbol or a flickering price on a smartphone screen; it represents an ownership interest in an actual business.
• This business has a fundamental value that exists independently of its daily share price.
• Consequently, the intelligent investor studies the underlying business rather than the stock chart.
• Mastering "Mr. Market"
• While market prices are usually accurate, they can occasionally be wildly irrational.
• Graham illustrated this through the character of Mr. Market - a mythical partner who swings between extreme euphoria when prices rise and deep misery when they fall.
• The intelligent investor is a realist who buys from pessimists and sells to optimists, refusing to let their emotions be taken hostage by the market's mood swings.
• The Margin of Safety
• Many investors fail because they focus solely on potential gains while ignoring potential losses.
• Graham argued that the most vital tool for any investor is the "margin of safety". This is a cushion of humility - a gap between the price paid and the intrinsic value of the business - that allows you to survive and stay solvent even if your initial analysis proves to be incorrect.