“By far the best book on investing ever written.” - Warren Buffet.
This book has been on my reading list for quite some time, often regarded as the ultimate guide to investing. This edition includes additional commentary from Jason Zweig, who provides insights into how Graham’s strategies held up during and after the dot-com bubble of 2000. What makes it truly remarkable is that, despite being originally published in 1949, it remains highly relevant today, even 75 years later.
🖊️ Benjamin Graham (1894-1976) was a British-born American financial analyst, investor and professor. He is widely known as the "father of value investing". His investment philosophy consisted of independent thinking, emotional detachment, and careful security analysis, emphasizing the importance of distinguishing the price of a stock from the value of its underlying business. After graduation, Warren Buffett worked for Graham's company, Graham-Newman Corporation, until Graham retired.
Graham's largest gain was from GEICO, in which the firm Graham-Newman purchased a 50% interest in 1948 for $712,500. To comply with a regulatory limitation, Graham-Newman was ordered by the U.S. Securities and Exchange Commission to distribute its GEICO stock to the fund's investors. An investor who owned 100 shares of the Graham-Newman fund in 1948 (worth $11,413) and who held on to the GEICO distribution would have had $1.66 million by 1972. Graham-Newman Corp. closed in 1956 when Graham retired from active investing. GEICO was eventually acquired in whole by Berkshire Hathaway in 1996.
My 🔑 takeaways:
This book won't teach you how to outperform the market, but it will offer lessons that are just as valuable, if not more so. Mainly:
- How you can minimize the odds of suffering irreversible losses.
- How you can maximize the chances of achieving sustainable gains.
- How you can control the self-defeating behavior that keeps most investors from reaching their full potential.
According to Graham, an intelligent investor has more than a high IQ. One must be patient, disciplined, and eager to learn. Even Sir Isaac Newton, one of the world’s leading scientists made bad investment decisions and let his emotions influence his rational decisions (link).
Speculation
Graham also describes how an intelligent investor must know when they are speculating or when they are investing. One of the key risks are:
- Speculating when you think you are investing.
- Speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it.
- Risking more money in speculation than you can afford to lose.
These principles may seem simple, but when a stock you bought on speculation rises significantly, it’s easy to forget you were speculating and start viewing it as an investment. This is often when people add more money or see large unrealized gains disappear quickly. It's crucial to always remember the original reason for buying the stock.
Types of investors
The book describes two types of investors. Defensive investors focus on protecting their capital, earning reasonable returns, and minimizing decision-making. Enterprising investors, on the other hand, actively manage their portfolios, dedicating significant time to stock selection. However, they don’t necessarily take on more risk than defensive investors, they simply invest more effort in choosing stocks. Part-time investors are advised to stick to passive, long-term strategies, with low-cost index ETFs now offering an easy way to track the market with minimal effort. Achieving even slight market outperformance demands exceptional knowledge and skill, and trying to outsmart the market with just a bit of extra time usually leads to below-average results.
Speculation worsened after the rise of the internet, and by 1999, six million people were trading online. Anyone engaged in short-term trading, whether intraday or swing trading, knows that it takes countless hours just to have a chance of success. Frequent stock traders often end up losing money, which is why Graham clearly advocates passive investing for those unwilling or unable to commit the substantial time and effort needed to consider active trading seriously.
Defensive investors
So how should you invest? For the defensive investor, Graham uses his famous 75/25 rule, where the intelligent investor should never have less than 25% or more than 75% of his funds in common stocks, the rest should be in high-grade bonds. In general he recommends investors to have no more than 50% in equities unless they have strong confidence in their stock position and are sure that they can handle a 1969-1970 decline. This is when the S&P 500 fell by more than 35% (link) and some single stocks even more. Investing in equities is only close to reasonable if one is able to handle significant declines. For bonds, Graham highlights U.S. savings bonds, state and municipal bonds, or high-grade corporate bonds of large corporations with a good track record.
But what if one wants to invest fully in stocks? 100% in stocks may seem like something highly against Graham’s view, but it is highlighted that this may only make sense when:
Furthermore, if the defensive investor is to buy single stocks, they must satisfy seven statistical requirements:
- Adequate size.
- A sufficiently strong financial condition.
- Continued dividend for at least the past twenty years.
- No earnings deficit in the past ten years.
- Ten-year growth of at least one-third in per-share earnings.
- Price of stock no more than 1.5 times net asset value.
- Price no more than 15 times average earnings of the past three years.
With these conditions in place one will realize that few stocks remain. Passive investing might be the better path if one does not have enough time to analyze these points.
Enterprising investors
The aggressive investor should start with the same foundation as the defensive investor but may explore other investment opportunities, provided they are well-reasoned and justified. Graham outlines specific investments that should be avoided, even if they appear to promise high returns. These include second-grade bonds and preferred stocks, foreign government bonds, new issues, and common stock offerings. As Jason Zweig notes, IPO stands for: "It’s Probably Overpriced, Imaginary Profits Only, Insiders’ Private Opportunity, or Idiotic, Preposterous, and Outrageous." While skilled traders might navigate these speculative securities, Graham advises that such investments should be avoided by any intelligent investor.
So which securities can one branch out into? Graham covers three recommended fields:
- The relatively unpopular large company: Larger companies going through a period of unpopularity. They often have the capital and brain power to recover, and markets will eventually respond.
- Purchase of bargain issues: Stocks worth considerably more than they are selling for, often during panics or overselling. Example: a stock selling for less than its net working capital (assets – liabilities).
- Special situations, or “workouts”: Mergers, acquisitions, liquidations, or arbitrages where prices are temporarily misaligned. These can offer substantial gains but are difficult to identify in modern efficient markets.
Price versus value
"The stock market is filled with individuals who know the price of everything, but the value of nothing." - Philip Fisher.
Graham explains this concept in terms of a fictional case. Assume you own a small share in a private business that cost you $1,000. Now every day, Mr. Market, one of your partners, tells you how much it is worth and offers to buy you out or sell you more. Some days he is rational, other days he is silly and may offer you ridiculous prices.
The value of a company should therefore not be determined by the price Mr. Market offers, but by:
- Company’s general long-term prospects.
- Quality of its management.
- Financial strength and capital structure.
- Dividend record.
- Current dividend rate.
And always remember, the market goes into extremes on both ends. Sometimes Mr. Market offers you way too much, other times way too little. Value is not the same as price, and it is up to you whether to take his offer.
Margin of safety
Once you have established the skill and understanding of differentiating price from value, a margin of safety can be built into your investments. If one buys a security at a significant discount to its intrinsic value, high-return opportunities are created with lower downside risk.
"The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price. If, as we suggest, the average market level of most growth stocks is too high to provide an adequate margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily. A special degree of foresight and judgment will be needed, in order that wise individual selections may overcome the hazards inherent in the customary market level of such issues as a whole.”
Other lessons
- Ordinary investors should not try to time the market. Rather they should look for great assets with a reliable track record that they can buy for a good price.
- Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop.
- What if you don’t beat the market? Zweig writes: “I once interviewed a group of retirees in Boca Raton... The best way to measure your investing success is not by whether you're beating the market but by whether you've put in place a financial plan and a behavioral discipline that are likely to get you where you want to go. In the end, what matters isn't crossing the finish line before anybody else but just making sure that you do cross it.”
- Zweig writes: “Although there are good and bad companies, there is no such thing as a good stock; there are only good stock prices which come and go.” Even premium companies can make poor investments if bought at the wrong price.
💭 “When you leave it to chance, then all of a sudden you don't have any more luck.” - Pat Riley
Investing is not the same as speculating, though speculation is more common among ordinary investors. This is especially true when Mr. Market behaves irrationally, offering absurd prices for little value or panicking and selling at rock-bottom prices. Human nature will persist, and opportunities will continue to arise, but knowing when to act and when to hold back is crucial. Graham emphasizes the distinction between the defensive and enterprising investor, and it is important to know which category you fall into. If you are willing to put in the effort, remain calm during market panics and crashes, and resist the whims of Mr. Market, you can achieve significant investment success. If not, passive investing is the wiser path. Above all, always build a margin of safety by recognizing the difference between value and price.