Book Notes: Benjamin Graham
The Intelligent Investor (1973) + Security Analysis (1934), by Benjamin Graham
As with my other book notes, some passages are direct quotes and others are my own paraphrasing/summaries. Any footnotes or [brackets] are my personal comments.
The Intelligent Investor (1973) + Security Analysis (1934), by Benjamin Graham
To invest intelligently in securities one should be forearmed with an adequate knowledge of how the various types of bonds and stocks have actually behaved under varying conditions—some of which, at least, one is likely to meet again in one’s own experience.
An investment operation is one which, upon thorough analysis promises safety of principle and an adequate return. Operations not meeting these requirements are speculative. An investment operation is one that can be justified on both qualitative and quantitative grounds.
We speak of an investment operation rather than an issue or a purchase, for several reasons. An investment might be justified in a group of issues, which would not be sufficiently safe if made in any one of them singly. In our view it is also proper to consider as investment operations certain types of arbitrage and hedging commitments which involve the sale of one security against the purchase of another. The safety sought in investment is not absolute or complete; the word means, rather, protection against loss under all normal or reasonably likely conditions or variations. A safe stock is one which holds every prospect of being worth the price paid except under quite unlikely contingencies.
Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook. There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.
The defensive (or passive) investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions. The determining trait of the enterprising (or active, aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than average.
Obvious prospects for physical growth in a business do not translate into obvious profits for investors. The future of security prices is never predictable.
In his endeavor to select the most promising stocks wither for the near term or the longer future, the investor faces obstacles of two kinds—the first stemming from human fallibility and the second from the nature of his competition. He may be wrong in his estimate of the future; or even if he is right, the current market price may already fully reflect what he is anticipating. In the area of near-term selectivity, the current year’s results of the company are generally common property on Wall Street; the next year’s results, to the extent they are predictable, are already being carefully considered. Hence the investor who selects issues chiefly on the basis of this year’s superior results, or on what he is told he may expect for next year, is likely to find that others have done the same thing for the same reason. To enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising, and (2) not popular on Wall Street.
Survey and Approach
The intelligent investor should confine himself to either businesses in which the future appears reasonably predictable, or where the margin of safety of past-performance value over current price is so large that he can take his chances on future variations.
Security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish either that the value is adequate or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. It is quite possible to know that a woman is old enough to vote without knowing her age or that a man is fat without knowing his exact weight.
We might say that it was difficult to determine whether the intrinsic value of a company was nearer $30 or $130. Yet if the stock had been selling as low as $10, the analyst would undoubtedly have been justified in declaring that it was worth more than the market price. The degree of indistinctness may be expressed by a very hypothetical “range of approximate value,” which would grow wider as the uncertainty of the picture increased. It would follow that even a very indefinite idea of the value may still justify a conclusion if the current price falls far outside either the maximum or minimum appraisal.
Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by overenthusiasm or artificial stimulants. The particular danger to the analyst is that, because of such delay, new determining factors may supervene before the market price adjusts itself to the value as he found it. In other words, by the time the price finally does reflect the value, this value may have changed considerably and the facts and reasoning on which his decision was based may no longer be applicable. [“Time is the friend of the wonderful business, and the enemy of the mediocre one.” -- Warren Buffett]
Let us assume that, through some sort of analysis, a roulette player is able to reverse the odds so that they are now 18 to 19 in his favor. If he distributes his wagers evenly over all the numbers, then whichever one turns up he is certain to win a moderate amount. This operation may be likened to an investment program based upon sound analysis and carried on under favorable general conditions.
There are three recommended fields for “enterprising investment”:
The Relatively Unpopular Large Company—the key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity. There are two advantages here: they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base; and the market is likely to respond with reasonable speed to any improvement shown.
Purchase of Bargain Issues—which, on the basis of facts established by analysis, appears to be worth considerable more than it is selling for. This relies largely on estimating future earnings and then multiplying these by a factor appropriate to the issue. There are two major sources of undervaluation: (1) currently disappointing results and (2) protracted neglect or unpopularity.
Special Situations or “Workouts”—arbitrages, bankrupt securities, liquidations, etc. The exploitation of special situations is a technical branch of investment which requires a somewhat unusual mentality and equipment.
Anyone who can control a secondary company, or who is part of a cohesive group with such control, is fully justified in buying the shares on the same basis as if he were investing in a “close corporation” or other private business. In secondary companies the average market value of a detached share is substantially less than it’s worth to a controlling owner. Because of this fact, the matter of shareholder-management relations and of those between inside and outside shareholders tends to be much more important and controversial.
The market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.
Every investor who owns common stocks must expect to see them fluctuate in value over the years. A serious investor is not likely to believe that the day-to-day or even month-to-month fluctuations of the stock market make him richer or poorer. But even the intelligent investor is likely to need considerable will power to keep from following the crowd.
We see in history how wide can be the vicissitudes of a major American enterprise in little more than a single generation, and also with what miscalculations and excesses of optimism and pessimism the public has valued its shares. The stock market often goes far wrong, and sometimes an alert and courageous investor can take advantage of its patent errors. Most businesses change in character and quality over the years, sometimes for the better, perhaps more often for the worse. The investor need not watch his companies’ performance like a hawk; but he should give it a good, hard look from time to time.
The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment.
Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.
The true investor is in that very position when he owns listed common stock. Price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.
Margin of Safety
In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “this too will pass.” Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.
In the ordinary common stock, bought for investment under normal conditions, the margin of safety lies in an expected earning power considerably above the going rate for bonds. Assume in a typical case that the earning power is 9% on the price and that the bond rate is 4%; then the stockbuyer will have an average annual margin of 5% accruing in his favor.
The margin of safety is always dependent on the price paid. The margin is available for absorbing the effect of miscalculations or worse than average luck. It guarantees only that he has a better chance for profit than for loss—not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. [Diversify--but not too much.]
It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity—provided that the buyer is informed and experienced and that he practices adequate diversification.
In security analysis the prime stress is laid upon protection against untoward events. We obtain this protection by insisting on margins of safety, or values well in excess of the price paid. The underlying idea is that even if the security turns out to be less attractive than it appeared, the commitment might still prove a satisfactory one. In market analysis there are no margins of safety; you are either right or wrong, and, if you are wrong, you lose money.
Investment is most intelligent when it is most businesslike. If a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles. The first of these principles is, “Know what you are doing—know your business.” For the investor that means: do not try to make “business profits” out of securities—that is, returns in excess of normal dividends—unless you know as much about security values as you would need to know about the value of merchandise that you proposed to manufacture or deal in.
A second principle: “Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.” A third principle: “Do not enter upon an operation—that is, manufacturing or trading an item—unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. Stay away from ventures with little to gain and much to lose.” Profit should be based not on optimism, but on arithmetic. And the fourth and final principle: “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 though others may hesitate or differ.” You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.