by Benjamin Graham, published 1973, 2003, 2006
A “valueprax” review always serves two purposes: to inform the reader, and to remind the writer. Find more reviews by visiting the Virtual Library.
All you need to know about intelligent investing
Graham’s layman’s manual for thoughtful investing in common stocks and bonds is a long book, chock full of useful theory and wisdom-gained-by-experience as well as numerous “case studies” which serve to illustrate Graham’s points. While it’s all worth considering, the truth is that certain parts of the book shine more brightly than others and, following the 80/20 principle, are clearly more valuable overall. Having earlier posted a reference item containing a summary of the major points made in the outstanding commentary by Jason Zweig which covers the entire breadth of the book, my purpose this time is to hone in on that key info at the expense of the totality of the book.
The Intelligent Investor is of course a practical guide to sound investment, but it is also a work of philosophy. Buried throughout the book are invaluable caveats that are easy to overlook yet deserve to get full billing because they can spare an amateur a lot of headaches down the road. In the book’s introduction, there are two such provisos quite nearby one another, the first being,
and the second being,
be prepared to experience significant and perhaps protracted falls as well as rises in the value of [your] holdings
Subtle, but profound, these two warnings are Graham’s opening salvo on the subject of investor psychology, or more accurately, the investor’s own psychology. It will be a common thread running throughout TII– your biggest risk in investing is yourself and your psychological reaction to events impacting your portfolio.
while enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster
Translating the first message, Graham is trying to gird the investor for the inevitabilities of the market, where volatility is constant in both directions. The key, as you will see, is to master volatility by recognizing that the upward variety is not necessarily proof of a good decision and the downward variety is not punishment but an opportunity to buy at bargain prices.
The second message is even more important– successful investing requires an even-keeled temperament and reasonable expectations about long-term success. The game is about expecting little and learning to be pleasantly surprised, rather than expecting a lot and constantly being disappointed. Most of your fellow market participants are excitable folks and their optimistic expectations will work with yours to crowd out any chance at realizing value, while you’ll always have plenty of room to maneuver on your own if you seek out the waters everyone of which everyone else has become bored.
The last warning is to be consistent and disciplined, to never abandon your principles in dire times because that is in fact when they become most valuable:
This is again a psychological appeal. When everyone else is losing their shirts, and their minds, forgetting what they’re doing and why, it will pay the long-term investor great dividends to be mindful of who he is and by what principles he invests as his conservatism is always in due time rewarded.
Through all their vicissitudes and casualties, as earth-shaking as they were unforeseen, it remained true that sound investment principles produced generally sound results
Security analysis 101
While the best treatment of Graham’s principles of security analysis are given in great detail in his treatise of the same name, Security Analysis, The Intelligent Investor does come with several basic recommendations on how to perform basic security analysis for issues under consideration for inclusion in one’s portfolio.
The key to bond investing is interest coverage, as without it a bond is in default and its principal value is imperiled. Therefore, the primary analytical factor is the number of times total interest charges have been covered by available earnings in years past. Typically two values are consulted:
- average coverage for a period of years (7)
- minimum coverage in the poorest year
On an after-tax basis, Graham recommends 2.65x for public utilities, 3.2x for transportation companies, 4.3x for industrials, and 3.2x for retail companies on an average of 7 years basis, and 2.1x, 2.65x, 3.2x and 2.65x, respectively, measured by the poorest year.
Additional factors for consideration are:
- size of the enterprise – something large and robust, so that depletions in revenue do not imperil the business as a whole
- equity ratio – the market price of equity versus the total debt, which shows the amount of “cushion” for losses standing in front of the debt
- property value – this is the asset value on the balance sheet, though “experience has shown that in most cases safety resides in the earning power”
Some basic principles of stock selection and analysis are considered in more detail below, based upon whether one is determined to be a defensive or an enterprising investor. For now, it is sufficient to quote Graham on the subject in the following manner:
In essence, Graham is outlining the philosophy of “growth” versus “value” investing and stock analysis– attempting to forecast the future, or being content one is not paying too much for what he’s got based on an assessment of the past.
The investor can not have it both ways. He can be imaginative and play for the big profits that are the reward for the vision proved sound by the event; but then he must run a substantial risk of major or minor miscalculation. Or he can be conservative, and refuse to pay more than a minor premium for possibilities as yet unproved; but in that case he must be prepared for the later contemplation of golden opportunities for gone
Keeping the shirt you have: the defensive investor
In Graham’s mind, there are two kinds of investors– the defensive investor, who is passive and seeks primarily to protect his capital, and the enterprising investor, who treats his investing like a professional business and expects similarly profitable results for his efforts. First, let’s talk about the defensive investor.
Specifically, Graham lists 4 criteria for selecting common stocks for the defensive investor’s portfolio:
The defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition
- diversification – minimum of 10, maximum of 30 separate issues
- standing – companies which are large, prominent and conservatively financed (over $10B mkt cap and in the top third or quarter of their industry by market share or some other competitive metric)
- dividends – a long record of continuous payments
- price – no more than 25x avg earnings of past 7 yrs, nor 20x LTM earnings
Graham also defines risk early on, saying,
if his list has been competently selected in the first instance, there should be no need for frequent or numerous changes
and that further, a defensive investor should never compromise their standards of safety and quality in order to “make some extra income.” Safety first, income/returns second, or you’re likely to wind up with neither in the long run.
the risk attached to an ordinary commercial business is measured by the chance of its losing money
In terms of selecting individual stocks for the defensive investor’s portfolio, Graham suggests 7 criteria: