Ever since its publication in 1949, The Intelligent Investor has widely been considered the stock market bible.
Not only were readers of the book blessed with a thick book written from arguably the greatest financial minds of the time. They were blessed with the fact that Graham wrote the words directly to the layman.
Of course, The Intelligent Investor is destined to be in the Junto book notes. After all, the lessons that Ben Graham puts forth are the epitome of what Junto is all about.
This is the fifth or sixth time I have blazed through The Intelligent Investor. When I read the book for the first time at the age of twelve, I obviously did not understand one bit.
The second time I read it—probably by the age of 15—I was marginally wiser but too dumb to grasp the caliber to which Ben Graham’s words should hit home. I made foolish mistakes in the market and gained lots of valuable experiences.
The third time around is perhaps when Graham’s ideas started to enlighten me with a sound intellectual framework of navigating investments. It’s been a joy ever since.
Warren Buffett has said that
you either get the idea in the first five minutes, or you don’t get it at all. I think that statement is only true if you have a mental tree to hang Graham’s lessons on. That you have a preconception of how the stock market works or have dabbled in it yourself. If your slate is blank, reading the book at least more than once is your road to comprehension.
As you are reading this, I’m guessing that there is a good probability that you have already read the book or know its contents.
For this reason, I will not bother diving into the technical details of how Graham analyzed securities or what metrics he advised the defensive investor and enterprising investor to focus on. There are loads of brief recommendations sprinkled throughout the book in terms of the debt to equity ratio, the price to earnings ratio, the price to net tangible assets ratio, and so on. Lots of other summaries cover these things. And, one should read the entire book to pick this stuff up anyway.
No, I will rather mention the one core idea that lies behind everything Graham teaches in The Intelligent Investor and Security Analysis. (I am sure you already know what I’m talking about.) Each sub-lesson, concept, and analogy that Graham puts forth in the book flows from this one idea.
The key idea pertains mainly to the enterprising investor and is the distinction of what makes an investment an intelligent one or an unintelligent one. And for this, the price an investor pays for something is the sole determinant for how risky that something is and for the return the investor can expect to make on the investment.
An investment is intelligent if the investor pays less than the investment’s intrinsic worth. Doing the opposite is foolish. The higher the price of a stock is, ceteris paribus, the riskier it is.
This is a logical truism. And yet, it is so easily forgotten by market participants in the midst of fluctuations and waning emotional discipline.
Therefore, to provide an intellectual framework that aims to combat creeping emotions when attempting to invest rationally, Graham came up with three basic concepts that are introduced in chapters 1, 8, and 20. These include that stocks confer part-ownerships of businesses, the concept of Mr. Market, and the concept of the margin of safety.
To value investors, these concepts are—or at least should be—as commonly encountered as the occasional family dinner.
A stock represents part-ownership of a business
A stock is not just a piece of paper to be traded, a number bobbing up and down, or a blip on a computer screen.
A stock represents ownership in an actual business that has an underlying value that is independent of its share price. This is simply a question of personal property rights and the extent to which those rights are protected in a country.
Because this is true, any business could compose an attractive investment at a certain price.
As Graham writes:
For 99 issues out of 100, we could say that at some price they are cheap enough to buy and at some other price they would be so dear that they should be sold. The habit of relating what is paid to what is being offered is an invaluable trait in investment.
Viewing a stock as a part-ownership of a business is as much a psychological concept as it is theory. And it is often only when you buy into the business that this feeling comes to life. This is due to the endowment effect. But the key to successfully analyze investments is to get into this mindset before entering.
Throughout the book, Graham uses the word “investor” as a direct contradiction to “speculator”. But how the majority of investors perceive themselves of the two can differ widely depending on whether the market is pricing stocks attractively or unattractively. Ironically—though not surprisingly—the majority of investors got it the wrong way around.
…common-stock purchases of all kinds were quite generally regarded as highly speculative or risky at a time when they were selling on a most attractive basis, and due soon to begin their greatest advance in history; conversely the very fact they had advanced to what were undoubtedly dangerous levels as judged by past experience later transformed them into “investments”, and the entire stock-buying public into “investors”.
Speculation is neither illegal, immoral, nor necessarily detrimental to the speculator’s wallet. There is even such a thing as intelligent speculation. But the real danger arrives when you speculate when you think you are investing.
Graham did recognize that there is no such a thing as a simon-pure investment policy in which an investor can buy an investment at a price that incurs no risk of a quotational loss. A speculative factor is therefore inherent in how stock markets work. But it is the investor’s task to keep this component within minor limits.
And the way to do that is to only dabble with a certain gentleman when he gives you an offer you cannot refuse.
The idea of Mr. Market is that he is the manic-depressive partner in a private company who comes to you from time to time and offers to buy your stock or sell his stock every day, depending on his mood.
Mr. Market is not too intelligent nor is he malicious. He does not care if you are interested or not but he will come enthusiastically every day to cry his wares.
There will be times when he is optimistic about the future and so his prices will be high. There will be times when he is pessimistic about the future and so his prices will be low. For the most part, though, you can just ignore him. But when Mr. Market becomes extremely worked up – either excited or depressed – you can use him to buy and sell around the intrinsic value of the investment in question.
This is easier said than done. A lot of people understand the concept of Mr. Market but few practice it as Graham intended.
Think of it this way. As you actually begin to enter the market, you will realize that there are real people on the other side of every transaction. And because the majority of the market is institutional, there is a high probability that these people are well-educated, have more money and power than you, and are much more experienced. In the process of transacting with these people, you will often look wrong—at least in the short-term. You begin to feel like the sucker at the table and you will start to doubt everything you once believed.
The result is that once this is experienced first hand, many investors, perhaps unconsciously, start to invest based on what they think Mr. Market will do.
But Graham’s simple point about Mr. Market is that you can’t predict what he will do or when he will do it. And when you buy a value investment, there is no guarantee that Mr. Market will ever come around and get excited about it.
Protecting capital is therefore the most important thing when dealing with Mr. Market rather than trying to profit from him. Which leads to the next concept.
Margin of Safety
Value is a fluid thing. Your perception of it changes from time to time and depending on the sensibility of your future assumptions about the investment.
In theory, an investment only has one intrinsic value. But no matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. And only by insisting on the margin of safety can you minimize your odds of error.
The margin of safety thus comprises the difference between price and your estimate of value. The bigger the margin, the bigger the safety. Throughout The Intelligent Investor, Graham emphasizes that the hallmark of a sound philosophy is not profit maximization but loss minimization.
The concept is not any different from when a credit rating agency rates a bond and demands a certain interest coverage to justify the bond as investment grade. The bond investor does not expect future average earnings to work out the same as in the past. If he did, the margin demanded would be small. The concept of margin of safety renders the bond investor’s accurate estimate of the future unnecessary.
Therefore, as applied to stock investing, the key to understanding the margin of safety is by being unreasonable. You should not attempt to buy a company worth $100 million for $95 million. Buffett’s famous analogy for the margin of safety is that you would not try to drive a 9,800 pound truck over a bridge with a 10,000-pound capacity.
The margin of safety is there to make outcomes tolerable when the future does not live up to your expectations. In that way, it is the secret to sound investing.
The Fourth Pillar: Circle of Competence
The concept of the circle of competence was not Graham’s invention. However, the concept of the circle of competence deserves its spot here because it completes the pillars that underlie a sound intellectual framework for practicing value investing.
It was introduced by Warren Buffett to describe limiting your investments in areas where you know best. The size of the circle is unimportant but knowing the boundaries is vital.
You can only truly know the intrinsic value of something that is within your circle of competence. Again, this is a logical truism.
Graham’s well-known distinction of investing and speculation goes as follows.
An investment operation is one which, on thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
To conduct a thorough analysis, you use fundamental analysis to forecast a company’s future economic performance. In order to do that, you have to understand the business; what makes it tick, how it converts earnings to cash; and its competition and place in the industry’s value chain. In order to answer such questions, that business would have to be within your circle of competence. And you would have to look at things truly with an owner’s mindset.
Now comes the question of how you can prove that you really understand something.
The answer lies in intellectual honesty. Developing and expanding your circle of competence is a question of compounding knowledge, intertwining your studies with your passions and past experiences to develop firm grasps of pockets of businesses.
Slow and steady wins the race. Compounding things is akin to running a marathon. Because you must understand everything you invest in, you can expect it to take a long time.
None of the four pillars underlying intelligent value investing are hard to understand. They are not even slightly complicated. But even so, Mr. Market is an interesting fellow that can at times shuffle your ability to apply Graham’s teachings as intended.
Character and temperament are the solutions. In order to get it, you must have innate traits that keep emotions from corroding the intellectual framework.
You must be relatively independent and judge yourself not by the opinion of others but by your own.
You must remain objective and rational. Those who seek rationality as a moral goal in itself are generally well suited to value investing.
You must be very patient. Business is a long-term game. Why would stock investing be any different when what you invest in are businesses?
You must be decisive. When Mr. Market provides an opportunity, you must act fiercely. Because Mr. Market is unpredictable, you never know when he will provide another one.
You must be intensely curious. A natural passion for business influences you to get to the bottom of the most important questions to ask.
“The fault, dear investor, is not in our stars—and not in our stocks—but in ourselves.”Ben Graham
In the end, how your investments behave is much less important than how you behave.