The Intelligent Investor by Benjamin Graham summary

The Intelligent Investor by Benjamin Graham summary

Successful investing does not necessitate a high IQ, insider information, or even luck. Instead, a good conceptual foundation for making judgments is required, as well as the ability to resist emotions from getting in the way. Benjamin Graham gives such a framework, along with reasoning, in The Intelligent Investor, which will help you keep your emotions under control. It is regarded as one of the best business books, such as Peter Theil’s Zero to One. In this post, we will tell you the takeaways and summary of The Intelligent Investor by Benjamin Graham.

The summary of The Intelligent Investor by Benjamin Graham

In this book, he argues that his investment technique is one of the most successful in the last century. The excellent records of not only Graham but also many of his pupils are tough to overlook. Among these, the brightest shining star is Warren Buffett- one of the wealthiest men in the world. Warren Buffett refers to this book as “by far, the best book on investing ever written”. In this post, I will present the, in my opinion, greatest takeaways from the book.

Takeaway number 1: Meet Mr. Market

Imagine that you own a part of a business that you paid $1000 for. Every day, a certain bipolar person called Mr. Market comes to your home. He comes with an opinion about how much your part of that business is worth. Furthermore, he offers to buy your share or sell you an additional one on that basis. History has shown that Mr. Market’s opinion about how much your part of the business is worth, can be pure gibberish. For instance, back in March 2000, he estimated the value of your share to be $2600. Only one year later, in March 2001, he thought it was worth $500. Even though the income of the company increased by 50% and the profit increased by 20% during the same period. Should you let this guy decide how much your $1000 of interest in that business is worth? Of course not!

One of Graham’s key beliefs is that a stock is more than a ticker symbol and a price tag; it’s an ownership stake in a company. Because Mr. Market isn’t always reasonable, the business’s fundamental value may differ from the price he is ready to pay for it. It is frequently overpriced or underpriced, since Mr. Market is prone to becoming overly optimistic or, conversely, very pessimistic.

Graham recommends investing only if you can imagine yourself holding the stock in the future without witnessing the fluctuating values that Mr. Market brings you. Mr. Market, on the other hand, gives a tremendous prospect for profit for the investor who can keep his calm, because he doesn’t compel you to do business with him; he simply offers you the chance! You should be pleased to sell to him when he offers absurdly high prices, and you should also be happy to buy from him when he offers you great deals.

We must remember that when Graham wrote this book, people were not as overwhelmed with news, forecasts, stock prices, and other information as they are today.  Back in the 1970s, Mr. Market arrived maybe once a day, together with the morning newspaper. Today, he wants to do business with us every time we open our phones. Which, if you’re anything like me, is more than 100 times every day. Just because Mr. Market visits you more often it doesn’t mean that you must trade with him any more frequently than people had to in the 1970s. If he doesn’t present you with an offer that meets your standards, ignore him, and move on with your day!

Takeaway number 2: How to invest as a defensive investor.

There are two types of investors according to Graham – the defensive (or passive) one and the enterprising (or active one). Most people are better suited for the defensive strategy, as the time they are willing to dedicate to investing is limited. The defensive investor should create a portfolio with a mixture of bonds and stocks, say 50% stocks and 50% bonds.

Note that how much you should devote to each asset category depends on your life situation and the current difference in the average yield of stocks versus bonds. Restore this allocation once or twice every year, so that if stocks suddenly make up 60% of the portfolio compared to only 40% in bonds, sell stocks and buy bonds, until 50/50 is restored. Invest a fixed amount of capital at regular intervals. For instance, straight after you get your salary. This is called dollar-cost averaging and will allow for a fair average price of stocks and bonds.

Most of all, it will assure that you don’t concentrate your buying at the wrong time. For the stock component of the portfolio, the defensive investor should aim for the following eights:

  • Diversification in the companies he invests in. 10 to 30 companies should be adequate. Also, make sure that you are not overexposed to a single industry.
  • The companies should be large, which Graham defined as generating more than $100 million in yearly sales. After inflation, this equals approximately $700 million in today’s value.
  • Look for companies that are conservatively financed. Such a company has a so-called “current ratio” of at least 200%. This means that its current assets are at least twice as big as its current liabilities.
  • Dividend should have been paid to shareholders for at least the last 20 years.
  • No earnings deficit in the last ten years.
  • At least 33% growth in earnings during the last ten years. This translates to a conservative growth of 2.9% annually.
  • Don’t overpay for assets. The price of the stock should not be higher than 1.5 times its net asset value. The net asset value can be calculated by subtracting the company’s liabilities from its assets.
  • Don’t overpay for earnings (either). Don’t let the p/e ratio be higher than 15 when using the last 12-month earnings. An alternative today is to invest in an index fund, which by definition will have returns similar to the average of the market.

If you are satisfied with an average reward through your investment, you only need these two first takeaways. However, if you thirst for more, you will also need to consider more.

Takeaway number 3: How to invest as an enterprising investor.

As it’s so easy for the defensive investor to get the average return of the market, it would seem a simple matter to beat the market. You just devote a little more time to investing than these average investors do, right? To be an enterprising investor, and to beat the market, is much more demanding as such a logic suggests. It requires patience, discipline, an eagerness to learn, and a lot of time. Many professionals and private investors alike aren’t suited for this. It’s easier to fall victim to the price quotations of Mr. Market than one could imagine. Just read these two statements from the early 2000s, at the peak of the dot-com bubble, made by the chief investment strategist at 2 large mutual funds:

– “It’s a new world order”. We see people discard all the right companies, with all the right people, with the right visions, because their stock price is too high. That’s the worst mistake an investor can make”.

– “Is the stock market riskier today than two years ago simply because the prices are higher? The answer is no”.

But the answer is yes, yes, YES!

Of course, both statements turned out to be costly for the investors who put their money in these funds. Since the profits that companies can earn are finite, the price the intelligent investor should be willing to pay for these companies must also be finite.

For the entrepreneurial investor, price is a critical consideration. Similarly, to how the market likes to overvalue companies that have been developing quickly or are glamorous for some other reason, it tends to undervalue companies that have had a poor performance. As a result, the wise investor should aim to stay away from so-called “growth stocks” as much as possible. Why? Because the investment decision is based on future earnings rather than present prices, future earnings are less predictable. If you can identify a company that is worth less than its net working capital, you will effectively pay nothing for all of the fixed assets, such as buildings, machinery, goodwill, and so on.

The net working capital can be calculated by subtracting total liabilities from current assets. Such companies were proven truly profitable during Graham’s investment career. Unfortunately, they are rare today except during tough bear markets. Luckily, Graham suggests an additional method of finding investments for the enterprising investor. These criteria are similar to the ones that the defensive investors should use, but the constraints are looser, allowing for the enterprising investor to consider more companies. Note that there is no constraint at all regarding company size.

Also, some diversification should be applied, but the number of companies held isn’t carved in stone for the active investor. In analyzing a company, the enterprising investor should also study its annual financial reports. Graham has written a whole book on this subject called “The Interpretation of Financial Statements.”

Takeaway number 4: Insist on a margin of safety.

There’s one risk that no careful consideration can truly eliminate: the risk of being wrong. You can, however, minimize this risk. To do this, you must insist that every investment you make has a “margin of safety”. As mentioned before, the price and value of a company are not always the same. When the price is at most two-thirds of its calculated value, the investor has found a company with enough margin of safety. You wouldn’t construct a ship that sinks if 31 Vikings boarded it if you know that it regularly will be used to transport 30 of them. Neither should you invest in a stock that you think is worth, say, $31 if it currently is priced at $30.

It might be that your calculation is wrong. In the first case, a group of angry (and wet) Vikings might hunt you down. In the second, you might postpone your financial freedom by a couple of years. I don’t know which situation I’d consider being worse: Use margins of safety!

A formula used in the book can give you some heads up regarding what the value of a company is, and therefore also if it can be bought with a margin of safety.

Value = current (normal) earnings x 8.5 + 2 x expected annual growth rate

The growth rate should be equal to the expected yearly growth rate of earnings for the next 7 to 10 years. Note that we can use the formula backward too, to trace how much these companies must grow in the coming 7 to 10 years for today’s stock prices to be rational. There’s a huge discrepancy here!

Amazon is expected to grow at 74% per year according to its stock price, while Apple is expected to grow at a mere 5.8%. Do you think that this is reasonable?

Takeaway number 5: Risk and reward are not always correlated.

According to academic theory, the rate of return that an investor can expect must be proportional to the degree of risk that he’s willing to accept. Risk is then measured as the volatility of the returns on the investment, meaning, how much it has differed historically from its expected value. Graham doesn’t agree with this statement. Instead, he argues that the price and value of assets often are disconnected. Therefore, the return that an investor can expect is a function of how much time and effort he brings in his pursuit of finding bargain assets.

The minimum return goes to the defensive (or passive) investor, while the maximum goes to the enterprising investor who exercises maximum intelligence and skill. Consider this:

It’s 4:00 a.m, and you’ve been out drinking in the streets of Moscow together with your friends. You decide that it’s too early to call it a night, and therefore you end up in the more obscure parts of town. At a particularly ambiguous bar, you’re approached by a man who asks, “Do you want to play a game?”. “Well, of course, games are fun!”, your bravest least sober friend replies. The man puts a revolving in front of you, which is loaded with a single bullet. “I’ll give you $10,000 if you dare to take a shot, Russian Roulette”. Your drunk friend reaches out for the gun, but you stop him. “I think we’ll pass on this one”, you politely inform the man. “I thought so”, he replies. “What about $100,000 for taking two shots?”

Now, this story represents the academic way of demanding a higher potential reward for taking a higher risk. In the first offer, you were to receive $10,000 at a 16.7% risk of blowing your brains out. In the second offer, the reward is $100,000 because the risk of putting a hole through your head has increased to 33.3%. Seems logical, right? But stock market investing doesn’t have to be like that! Remember that price and value are not the same. When you buy a company at 60 cents on the dollar, you have a great potential reward and a low risk.

Furthermore, if you can find another company that you can buy at 40 cents on the dollar, you have found a better potential reward, combined with even lower risk! How could anyone in their right mind argue that it’s riskier to buy a dollar at the price of 40 cents than to buy a dollar at 60 cents, just because the potential reward is higher?

Takeaway number 5: Risk and reward are not always correlated

According to academic theory, the rate of return that an investor can expect must be proportional to the degree of risk that he’s willing to accept. Risk is then measured as the volatility of the returns on the investment, meaning, how much it has differed historically from its expected value. Graham doesn’t agree with this statement. Instead, he argues that the price and value of assets often are disconnected. Therefore, the return that an investor can expect is a function of how much time and effort he brings in his pursuit of finding bargain assets.

The minimum return goes to the defensive (or passive) investor, while the maximum goes to the enterprising investor who exercises maximum intelligence and skill. Consider this:

It’s 4:00 a.m, and you’ve been out drinking in the streets of Moscow together with your friends. You decide that it’s too early to call it a night, and therefore you end up in the more obscure parts of town. At a particularly ambiguous bar, you’re approached by a man who asks, “Do you want to play a game?”. “Well, of course, games are fun!”, your bravest least sober friend replies. The man puts a revolving in front of you, which is loaded with a single bullet. “I’ll give you $10,000 if you dare to take a shot, Russian Roulette”. Your drunk friend reaches out for the gun, but you stop him. “I think we’ll pass on this one”, you politely inform the man. “I thought so”, he replies. “What about $100,000 for taking two shots?”

Now, this story represents the academic way of demanding a higher potential reward for taking a higher risk. In the first offer, you were to receive $10,000 at a 16.7% risk of blowing your brains out. In the second offer, the reward is $100,000 because the risk of putting a hole through your head has increased to 33.3%. Seems logical, right? But stock market investing doesn’t have to be like that! Remember that price and value are not the same. When you buy a company at 60 cents on the dollar, you have a great potential reward and a low risk.

Furthermore, if you can find another company that you can buy at 40 cents on the dollar, you have found a better potential reward, combined with even lower risk! How could anyone in their right mind argue that it’s riskier to buy a dollar at the price of 40 cents than to buy a dollar at 60 cents, just because the potential reward is higher?

A quick recap of the five takeaways: The Intelligent Investor Summary

  • For starters, the market can be both overly enthusiastic and gloomy at times. Don’t allow this affect your perception of the genuine value of your assets. Instead, consider it a business opportunity to work with someone who has no idea what he’s doing!
  • Second, the defensive investor should opt for a diverse stock and bond portfolio, with the stock category dominated by low-cost issues.
  • Thirdly, stocks with lower price inclinations should also be sought by the astute investor. He might have found his El Dorado if he can find a company that is trading below its net working capital.
  • The fourth takeaway is that when purchasing an asset, the intelligent investor should insist on a margin of safety.
  • And finally, takeaway number 5 is that risk and profit aren’t always linked.

What do you think of Graham’s advice? Are they still as applicable today, as they were back in the 1970s?

So this was the summary of The Intelligent Investor by Benjamin Graham. I hope you enjoyed the summary. For more book summaries, visit our website.

 Note: Must read Summary of The Four Agreements by Don Miguel Ruiz

By

Leave a Reply

Your email address will not be published. Required fields are marked *

Subscribe To Our Newsletter

Subscribe to our newsletter below and never miss the latest articles or an exclusive offer.