The Intelligent Investor

Investment, speculation and two kinds of investor

Benjamin Graham was a Columbia professor, a money manager and the teacher of Warren Buffett. He first published The Intelligent Investor in 1949 and revised it several times. The last edition he worked on came out in 1973. Most readers today use the revised edition with commentary by the financial journalist Jason Zweig, who adds a modern chapter after each of Graham's original chapters.

The book opens with a definition that frames everything after it. An investment operation is one that, after thorough analysis, promises safety of principal and an adequate return. Anything that fails these tests is speculation. Graham does not say speculation is wrong. He says you must know which one you are doing. The danger is speculation that you mistake for investment, or speculation done with money you cannot afford to lose.

Graham also says the book is not about how to beat the market. It is about how to avoid serious mistakes and how to build a policy you can keep for life. In his view, the intelligent investor needs no special genius. He or she needs a sound framework for decisions and the discipline to keep emotions from wrecking it.

Graham splits readers into two groups. The split depends on how much time and effort you will give to investing, not on how much money you have.

• The defensive investor (also called the passive investor) wants safety and freedom from bother. This person accepts an ordinary return in exchange for little work.
• The enterprising investor (also called the active or aggressive investor) is willing to spend serious time and effort to get a better return than average.

Graham's key point is that there is no comfortable middle. Many people try to get above-average results with half the effort. That usually produces below-average results. Choose one role, and act like it.

The defensive investor's policy

For the defensive investor, Graham gives a simple structure. Split your money between high-grade bonds and high-grade common stocks. Never hold less than 25% or more than 75% in either. The standard split is 50-50. When the stock part grows past the target because prices rise, sell some stocks and buy bonds. When it shrinks, do the opposite. This rebalancing forces you to sell a little when prices are high and buy a little when prices are low.

For the stock portion, Graham suggests:

• Adequate but not excessive diversification: roughly ten to thirty different stocks.
• Large, prominent companies with conservative financing.
• A long record of continuous dividend payments.
• A price limit tied to earnings, so you do not overpay.

He also recommends dollar-cost averaging: investing the same amount of money at regular intervals, whatever the market does. This way you buy more shares when prices are low and fewer when prices are high, and you never need to guess the right moment.

In his commentary, Zweig points out that the defensive investor today can meet most of Graham's goals with a low-cost index fund. Graham himself, late in life, came to favor simpler approaches for most people.

Later in the book, Graham turns the defensive policy into a checklist for picking individual stocks. The main tests are:

• Adequate size of the company.
• Strong financial condition: current assets at least twice current liabilities, and long-term debt no more than net current assets.
• Earnings stability: some earnings in each of the past ten years.
• Dividend record: uninterrupted payments for at least the past twenty years.
• Earnings growth: at least a one-third increase in per-share earnings over ten years.
• Moderate price to earnings: no more than 15 times average earnings of the past three years.
• Moderate price to assets: no more than 1.5 times book value, or a combined test where price-to-earnings multiplied by price-to-book stays at or under 22.5.

The checklist is strict on purpose. It keeps the defensive investor away from glamour stocks that need everything to go right.

The enterprising investor

The enterprising investor has more room, but Graham starts with what to avoid. He calls this the negative approach. The enterprising investor should usually avoid second-grade bonds and preferred stocks bought at full price, foreign government bonds, and new issues. He is especially sharp about new issues (what we now call IPOs). They tend to appear in bull markets, when sellers can get the best price, and they often come with heavy promotion.

On the positive side, Graham describes several fields where effort can pay:

• Relatively unpopular large companies. The market often overreacts to bad news at big, solid firms. They have the resources to recover.
• Bargain issues. These are stocks that sell well below their conservative value. The clearest case is a stock that trades below its net current asset value: current assets minus all liabilities, ignoring the value of the plant and other fixed assets. Graham suggests buying such stocks at no more than two-thirds of that figure. Investors now call these "net-nets."
• Special situations, such as mergers, reorganizations and liquidations, where a careful analyst can estimate an outcome.

The enterprising investor still uses rules. The difference is that he or she does the extra analysis and accepts more mistakes, as long as the group of purchases has a good average outcome.

Mr. Market and price swings

Chapter 8 is the most famous part of the book. Graham asks you to imagine that you own a small share in a private business. One of your partners is Mr. Market. Every day he tells you what he thinks your share is worth and offers to buy you out or sell you more at that price.

Sometimes his price makes sense. Often it does not. Mr. Market is moody. When he is excited, he quotes a very high price. When he is depressed, he quotes a very low one. You are under no obligation to trade with him. You can ignore him, sell to him when he is too cheerful, or buy from him when he is too gloomy.

The lesson is that a falling price is not, by itself, a reason to sell. It may be a chance to buy. The market exists to serve you, not to guide you. If you let the daily price tell you what your holdings are worth, you hand control of your decisions to the least stable partner you have.

Graham warns that the investor's main problem is usually his or her own behavior. People buy after prices rise because it feels safe, and sell after prices fall because it feels dangerous. A sound policy, written down in advance, protects you from yourself.

Funds, advisers and analysis

Graham reviews investment funds and finds that most do not beat the market by enough to justify their costs. He favors funds with low expenses and a steady record over funds that chase hot performance. Zweig's commentary adds data from later decades that supports this and makes the case for index funds even stronger.

On advisers, Graham says a good adviser helps you avoid mistakes. A good adviser does not promise to make you rich. Be wary of anyone who claims to forecast the market.

Graham also gives a short course in security analysis for nonprofessionals. He warns readers not to take reported per-share earnings at face value. Companies can shift charges and gains between years to make results look smoother or better. He suggests using average earnings over several years. He then compares real companies side by side, in pairs, to show how two businesses that look similar can deserve very different prices. He also tells several case histories of companies whose shares were wildly mispriced, to show how promotion and enthusiasm can break the link between price and value.

Margin of safety

The final chapter names what Graham calls the central idea of sound investing: the margin of safety. The idea comes from engineering. A bridge built to carry 30,000 pounds should not be used for loads near that limit. It should carry 10,000.

In investing, the margin of safety is the gap between what you pay and what the asset is conservatively worth. For a bond, it is the extra earning power the company has above what it needs to pay interest. For a stock bought at a low price relative to earnings or assets, it is the cushion that protects you if your estimate is too optimistic or if bad luck hits.

The margin of safety does not guarantee that each purchase will work. It makes it likely that a diversified group of purchases will work, because the cushion absorbs errors. Graham ties it to diversification: with a margin of safety in each position, a few failures do not sink the whole portfolio.

He ends with the idea that investing is most intelligent when it is most like running a business. Know what you own. Do not let others run your affairs unless you can supervise them. Do not act unless the numbers give you a fair chance of a profit. Trust your own judgment when you have the facts and have reasoned well, even if the crowd disagrees.

What the critics say

Many of Graham's specific screens are hard to use now. Stocks trading below net current asset value are rare in large markets, and modern companies hold much of their value in brands, software and other assets that book value misses. Critics also note that Graham's later view leaned toward simple methods and that most readers will do best with a low-cost index fund, which is a policy the defensive section already points toward.

Who should read it

This book suits anyone who owns, or plans to own, stocks and bonds for the long term. It is most useful for people who feel pulled by market swings and want a calm, rule-based policy. Expect dense passages and dated numbers; Zweig's commentary makes it far easier to apply today.