The Intelligent Investor and the Not So Intelligent Me
A brief commentary on Benjamin Graham’s value investing principles
I’m a big shopper and in the last few weeks, the stock market has been having a giant sale. Unfortunately, I had dumped almost all of my working capital into the stock market at its peak last year. My terrible timing combined with poor investing acumen has resulted in tremendous losses across my entire portfolio. Newly motivated to minimize the damage, I dug into The Intelligent Investor last week. The book, originally published in 1949 and republished 1973, is today widely regarded as Warren Buffet’s favorite, one of the greatest works of investing literature ever published. Below is a summary of the high level takeaways for other novices like me. Note that I’ve skipped over the book’s lengthy discussion of bonds and options, since I generally don’t have these asset classes in my portfolio.
The investor’s chief problem is himself. Success relies on the personal discipline inherent in managing your own psychology.
This is the most important concept in the book. We are prone to buying high and selling low. Often, we buy because we see the price of an issue going up, or we sell because we see the price beginning to point downwards. This is a terrible strategy since markets are cyclical. By following the herd and trading irrationally in the face of volatility, we’re likely to lose more money in the short term than we would make in the long term by detaching our emotions from the current state of the market. Volatility is expected and should be considered the price to play. In any 5 year period, expect swings upwards of 50% or more in gains and declines of 30% or more.
The better a business performs, the more likely it is to come untethered from its stock price.
The better a company’s record and future prospects, the less of a relationship the value of the business has to the stock price. Speculation drives prices up, putting a premium on its book value. The game then becomes how large of a premium is warranted, which depends much more heavily on the mood of the market over actual performance. This explains the erratic price behavior of successful companies like Amazon and Google. If you invest in these larger enterprises, it becomes all the more important to heed the first point above — do not be unduly worried by the market’s vicissitudes. You will never be forced to sell your stocks, so, by virtue, you will always have the option to ignore its current price.
For stock investments, examine company size, dividend history, price, financial condition, and earnings stability/growth
Graham outlines various thresholds for the defensive vs. the enterprising investor. The difference between the two is the time allocation to your stock portfolio. If you don’t want to be bothered, you’re probably a defensive investor. If you have some time each week to do some research and rebalance your portfolio, you might classify yourself as the latter. The investment criteria remain the same, but the thresholds look different. The criteria for defensive investing encompasses the following — if you are an enterprising investor, you will want to relax these constraints:
- Company size: ≥$2B market cap
- Dividend history: consistent dividend payout over the past 20 years
- Price: current price should be no more than 15x average earnings of the past 3 years
- Financial condition: 2x current ratio (current assets to current liabilities)
- Earnings stability and growth: 10 years of positive earnings (EPS) and a minimum increase of 33% in per-share earnings over the past 10 years using 3-year averages over the beginning and end
Reflecting, I decided to take a closer look at some popular stock picks. I threw together some common technology, commerce, real estate, and biotech stocks, only to realize with great disappointment that almost none of the stocks met the thresholds for either the defensive or enterprising investor. Only 1 managed to satisfy all the requirements: Gilead Sciences.
Unsurprisingly, the splashy stocks covered by mainstream media don’t actually make great investments in the long term. But, despite the rules of the game, it’s up to each of us to define the degree of risk we are willing to accept.
- Where you can, try dollar cost averaging. If done consistently, you will buy more when stocks are cheap, and less when stocks are more expensive, ensuring your cost basis ends up somewhere in the middle and preventing you from concentrating your buying at the wrong time. Graham acknowledges that this is difficult to do in practice — most people don’t have the capital or time to re-invest on regular intervals.
- Invest in what you know well and conversely, don’t invest in businesses you don’t deeply understand
- Diversify your portfolio, across asset classes, geographies, and industries.
- Many people (myself included) use a top down investment strategy that looks for fast-growing industries and picks the best companies in those industries. This strategy tends to fail for 2 main reasons: 1. obvious prospects for physical growth in a business do not translate into obvious profits for investors, and 2. even experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries.
- Stay away from IPOs, most don’t have long enough history of earnings to draw any reasonable conclusion.
- In most cases, it’s best to stick to index funds. You’ll come away with the most diversification and will probably be better off than picking individual stocks yourself.
- Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it — even if others balk or differ.
Perhaps the most poignant takeaway is that it’s never too late to start. After all, a crisis is a terrible thing to waste.