In our latest Five Minute Read, we review the book Warren Buffett called “the best book about investing ever written”, Benjamin Graham’s The Intelligent Investor.
We’ve been on a bit of a Buffett buzz in Rubicoin HQ these past few weeks. Last month’s Five-Minute Read was The Little Book of Value Investing, which I suppose it would be fair to say is the crib notes to today’s outing – the “bible of value investing” – The Intelligent Investor by Benjamin Graham.
About the Author
Benjamin Graham was a British-born American investor and professor, often called the “father of value investing”. Having moved to America with his parents in 1895, Graham graduated from Columbia University at the age of 20 and went on to work on Wall Street, establishing the Graham-Newman Partnership.
In 1934, Graham published his first book, Security Analysis, which he co-authored with David Dodd. His second book, The Intelligent Investor, was published in 1949.
Graham is best known as the professor who taught Warren Buffett during his time at Columbia. Buffett went on to briefly work for Graham, and that relationship inspired Buffett to invest in Geico – one of his most profitable investments. Buffett has described The Intelligent Investor as “the best book about investing ever written”.
The Intelligent Investor
Graham’s mission with this book is to inspire people to become more intelligent about their investments. There is a level of knowledge to be acquired and a level of discipline to be maintained if you expect to become successful.
Graham says, “An investment operation is one which, upon thorough analysis, promises safety of principal and adequate return. Operations not meeting these requirements are speculative.”
This is the overarching theme of Graham’s book. All stocks have an intrinsic value, and the goal of every investor should be to determine that value and buy the stock for cheaper than that. If that’s not possible – either because you can’t determine the value or you can’t buy the stock cheaper – then no investment should be made.
To ensure you do not fail as an investor, the only action that you must take is to not overpay for stocks. Plain and simple. To become successful at investing, all you must do is patiently hold those stocks you buy (for below their intrinsic value of course) until the market comes to its senses.
We’ll explain why the market makes mistakes later on…
Graham groups investors into two buckets – the ‘Defensive Investor’ and the ‘Enterprising Investor’. Today, we’d use the terms “passive” and “active”.
The ‘Defensive Investor’ is one who isn’t too interested in the bother of evaluating the stock market on a regular basis. They want healthy returns without the risk of large capital losses.
Meanwhile, an ‘Enterprising Investor’ is someone who views the stock market as an intellectual challenge and is willing to put a large amount of time and effort into evaluating companies in order to secure the best possible returns.
You don’t have to just become one or the other though. A healthy mix is possible, depending on your goals and attitude to risk.
For ‘Defensive Investors’, some key principles are:
- Keep a minimum of 25% of your money in bonds. This will give you a cushion for when stocks take a downturn. This percentage can fluctuate depending on your attitude towards risk. It could end up being 50% of your portfolio if you are particularly pessimistic.
- Companies you own should be large and with solid financials. They should have stable positive earnings over the last ten years.
- Every company you own should have a long track record of paying dividends (so no technology companies for Graham).
- Own between 10 and 30 stocks to diversify your holdings, and ensure you not overly exposed to one industry.
For ‘Enterprising Investors’:
- Avoid day trading and IPO’s.
- No matter how good a business is, it’s not a good investment unless it’s at a good price.
- Be contrarian. Don’t buy into a company because it is popular. Look out for great businesses that suddenly become unpopular, allowing you to purchase it at a good price.
Probably the most famous metaphor Graham has left us with is the idea of Mr. Market.
Graham asks the reader to imagine that he is part owner of a business with someone called Mr. Market.
Every day, Mr. Market approaches you and offers to buy some of your shares in the business (or sell you some of his) at a certain price. Mr. Market is quite fickle however, and the price changes depending on how Mr. Market is feeling that day. Some days, he’ll be feeling pessimistic and set the price low. Other days, he’ll feel optimistic and set the price high.
So every time you talk to Mr. Market, you have a choice.
You can decide that Mr. Market is overly pessimistic. In this scenario, you wouldn’t sell your shares to him because the price is too low but, you may decide to buy some of his shares.
Or you may decide the opposite – that he is overly optimistic. On days like that, you may decide to sell some of your shares to him, but you probably wouldn’t buy any off him.
Most importantly, on any given day you can just decide to ignore him as he’ll come back the next day and make another offer.
This simple allegory has been with us for over half a century, but to this day investors fail to understand it and do the exact opposite. A rational investor (what Graham would call an ‘Intelligent Investor’) would only sell if he thought the price was high and only buy if the price was low. Yet these days, if the price of a stock drops, investors panic and sell. When the price skyrockets, investors start buying it again.
This is as a result of people speculating rather than investing. Without having gone through the steps of assigning an intrinsic value to the company they are investing in, speculators listen to what Mr. Market thinks. When Mr. Market turns negative on a stock, so do the speculators, and they sell off for a loss rather than riding out his mood swings.
Margin of Safety
As much as Graham entreats readers to carefully determine the intrinsic value of a company, he accepts that errors will occur and that you must take measures to protect against this. And so he introduces the ‘Margin of Safety’ – probably his longest lasting and best-known idea.
‘Margin of safety’ says an investor should only purchase shares in a company when the stock price is significantly below its intrinsic value. This will limit the downside risk of an investment.
For example, if you think a stock is worth $100, but its current share price is $120, you certainly wouldn’t buy it.
But according to Graham, even if the stock were to fall to $100, you still shouldn’t buy it. That’s because you could be wrong about the stock in the first place. So you need to give yourself a margin of safety that will protect you from that risk. Depending on how confident you are in your analysis of a company, that might be anywhere from 20%-50%, meaning you wouldn’t buy until the stock was in the $50 – $80 range.
Of course, you could be wrong on the other side. If the stock was really worth $140, failing to buy at $100 was a big mistake. But the margin of safety principle means you’re at least protected from capital loss and can possibly make another good investment somewhere down the line.
This seems rather logical these days, but in 1949 was this was quite a new principal in the world of investing. Moreover, it refocused the investor on price, and not the company itself. You may really love a stock, but unless it falls into the realm where you have a margin of safety, you may never end up buying it.
Should I Buy This Book?
This is often cited as the very first book anyone should read before they start investing.
But I have to disagree. I would imagine that this book has probably turned a lot of would-be investors off over the years with its data-centric philosophy and archaic language. To get people started, I would recommend reading Peter Lynch’s One Up On Wall Street instead.
However, if you’re serious about improving as an investor and learning about the core principles of value investing, then this is a must-buy. There are chapters that you will find completely irrelevant and big chunks that you could easily skip over, but the central themes and philosophy are still as important today as they were nearly 70 years ago.
I would strongly recommend you pick up the revised edition with commentary from Jason Zweig, who breaks down each chapter in more modern terms and makes the whole experience more accessible.
If the thought of a 70-year-old, 640-page investment manual turns you off, Buffett himself has said a solid understanding of chapters 8 and 14 will put you miles ahead of most investors.
That alone is worth shelling out for.