We’ve reached the end of the trail.

This chapter closes out The Intelligent investor by discussing the true message behind the book: companies that provide a great value are quiet, solid, and able to resist competition. They just pay out their dividends and keep doing what works.

Graham sums this up in one concept: the “margin of safety.” Simply put, it’s the idea that a company has established such a stable business that the company can succeed through many environmental changes. The economy goes up or it goes down – either way, the company is safe and stable. Competitors come and competitors go – the company survives. Management changes – the company rolls right through it.

Companies that have established themselves with such steadiness are the real value stocks. Quite often, companies like this are actually seen as boring (particularly if the company’s business is not in an exciting sector) and thus are often ignored in the “hype” talk on CNBC and the like. That means there aren’t a whole lot of buyers, even though the company is very strong, and that results in an undervalued stock. You buy it for cheap, ride the stability, and collect dividends along the way.

Sounds like a great plan to me.

Chapter 20 – “Margin of Safety” as the Central Concept of Investment
A single quote by Graham on page 516 struck me:

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

This seems obvious on the surface, but it’s actually a great argument for thinking more carefully about your individual stock investments. If most of your losses come from buying companies that seem healthy but really aren’t, isn’t that a profound argument for carefully studying any company you might invest in?

Graham takes this point a step further, arguing that diversification is strongly correlated with margin of safety. In effect, Graham states that you introduce some additional margin of safety into your portfolio when you own a widely diverse array of value stocks that each have significant margin of safety.

Graham’s final note is pretty simple: investors get in trouble when they abandon their basic principles in the heat of the moment. One must approach investing with a set of fundamental principles and not abandon them in the heat of the moment.

Commentary on Chapter 20
Zweig closes out this final chapter by arguing that psychology is a major part of investing, one that many people overlook in the rush to find the big bargain. He goes so far as to argue that people are the primary risk in their own investing – poor decision making and abandonment of principles results in far more loss than an investment gone wrong.

Zweig actually ties this to Pascal’s wager, a famous suggestion by the French philosopher Blaise Pascal in which he argues that, since God’s existence cannot be determined through reason, one should behave as though God does exist, since living in that way (as opposed to living as though God does not exist) provides much more gain than loss. Similarly, since one cannot prove what will happen in the future with investments, we’re better off living by our investing principles than playing it by ear.

This is the final entry in the book club reading of The Intelligent investor. I hope you enjoyed it as much as I did.

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There’s an eight hundred pound gorilla in the room when it comes to value investing: the corrupt company.

When you go through a filtered list of companies that might represent great value investments, many of those companies actually are values. They’re simply boring companies – ones that are well established, grow slowly, and dominate a niche that doesn’t get people excited.

At the same time, that list is going to contain at least a few companies that got there because of shady business practices. The company appears to be worth a lot on paper, but in truth it’s all a house of cards. It’s only an illusion of a value, not a real value.

Some of these are easy to detect. Companies like Enron wind up, years after their corruption is exposed, appearing to be a value stock, but a careful evaluation of the history of the company shows it to be a bad investment. Other companies, though, are much more difficult to see – mismanagement isn’t always immediately clear in the hottest companies, let alone the ones that lurk in the quieter parts of the market.

Chapter 19 – Shareholders and Managements: Dividend Policy
Here, Graham seems to indicate that if a stock that otherwise appears to be a value stock isn’t paying out dividends, something is afoot. If there’s not a very clear and concrete reason for no dividends (and the overly simplistic “we’re investing in the company” isn’t satisfactory), then there’s something afoot.

This is not true for companies that would be considered “growth” investments. Quite often, the absence of a dividend (or the presence of only a small dividend) in a growth company is a sign that the company is actually doing what they claim – investing in the company with the intent of maintaining the impressive rate of growth.

The big difference is in why you invest in these different types of stocks. You invest in growth stocks to enjoy the increase in stock price – dividends aren’t really a part of the equation. You intend to ride that wave of growth until it runs out, then sell the stock somewhere near the peak (when the stock is still selling at a premium because of its “growth” status, but the growth is slowing).

However, the typical reason for owning a value stock is income. You don’t expect that the price of a value stock will jump greatly over time. Instead, you own it for that dividend – it’ll keep putting money in your pocket over the long haul. This isn’t a good enough reason for speculators to own the stock – dividend earnings are a long term thing – so good value stocks tend to be forgotten in the mad rush.

If you see a stock that’s undervalued, it should either be paying out a good dividend, have a stellar reason for not doing so, or it should be avoided.

Commentary on Chapter 19
Zweig offers up one nugget that really caught my attention. From page 506:

Research by money managers Robert Arnott and Clifford Asness found that when current dividends are low, future corporate earnings also turn out to be low. And when current dividends are high, so are future earnings. Over 10-year periods, the average rate of earnings growth was 3.9 points greater when dividends were high than when they were low.

What does that mean? Good, strong companies can afford to pay out dividends. Thus, to an extent, a company paying solid dividends – particularly over a lot of years – is likely a company that’s on very solid footing and sure of their future.

Companies that pay good dividends don’t need to hoard money. They don’t need to invest in themselves. Instead, they’re able to provide direct value to their stockholders.

It’s a pretty good argument for value stocks, I must say.

Next Friday, we’ll take a look at the final chapter, Chapter 20: “Margin of Safety” as the Central Concept of Investment.

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This is really a “put the principles into practice” chapter, above all else. The premise is really simple: Graham simply picks eight pairs of companies off of a list of stocks available on the stock exchange. He simply chose ones that were adjacent to each other in name on a long list of publicly traded stocks.

The problem with this method is that many of the companies that Graham evaluates are either no longer in business or are completely different entities than they were in 1972. So what’s the value in reading these comparisons?

The value comes in seeing what things Graham looks for when comparing two companies. If you carefully read this chapter, you can tease out a lot of interesting basic concepts that Graham seems to rely on in his analysis. Let’s dig in.

Chapter 18 – A Comparison of Eight Pairs of Companies
So, what “basic concepts” am I talking about? Here are five things that stood out to me in Graham’s comparisons.

Companies that stick to their core businesses are generally better values. Companies that dive into mergers and make big splashes into other businesses get all the attention, but if you’re looking for value, look for companies that focus in one area and do it well.

Investing on what you think will happen in the future is almost always a bad idea. No one can predict the future. If you’re investing for value, don’t bet on a company because of what they’ve done very recently. Look for a long track record.

Overvalued stocks tend to stay overvalued, while undervalued stocks tend to stay undervalued. Why? Conventional wisdom tends to rule the day. If a company is seen as “hot,” it takes a lot for that facade to go away. Similarly, if a company is seen as “boring,” it’s very hard to lose that stigma. That’s why selling short really only works well in certain specific situations where a company is clearly losing something of value, not just merely the fact that it seems overvalued.

A company in a highly competitive market is almost never a value. If a company has a lot of strong competitors, you should never view that stock as a value stock. Most good values sell products in niches where there isn’t much competition – hence the perception that such stocks are boring.

Price volatility is usually a bad sign. If a company is experiencing far greater price fluctuations than the market as a whole is seeing, particularly when it alternates between going up rapidly and going down rapidly, avoid the stock. Such events happen only in companies that are either unstable or are involved in something else going on in the market, both of which are good to avoid.

Commentary on Chapter 18
Zweig attempts to do eight similar comparisons with more modern companies, looking at them as they sat in 2002 and early 2003.

Again, most of these comparisons are really products of their times – they aren’t valid looks at the companies today. However, these comparisons do reinforce most of the principles taught in this book – nice, quiet, steady, stable companies with steady dividends and earnings growth are the ones that make for a great value.

Most importantly, it establishes that Graham’s principles are all about the long term, not the short term. If you’re interested in day trading and selling short, Ben Graham’s philosophy isn’t the right one for you.

Next Friday, we’ll take a look at Chapter 19: Shareholders and Managements: Dividend Policy.

The post The Intelligent Investor: Four Extremely Instructive Case Histories appeared first on The Simple Dollar.

The real question in value investing is how do you identify the lemons that are mixed in with the ‘values’?

Obviously, when you’re digging into “value” companies, you’re seeking out companies that are currently undervalued by the stock market. This can happen for a lot of reasons: these companies are boring, these companies are not experiencing rapid growth, or, more ominously, something nasty is afoot with this business.

The problem with teasing out companies that are up to shenanigans is that there’s no ready made recipe for identifying them. This is where homework comes into play. You need to study the individual companies you invest in. Careful study of a company will often identify fundamental problems in their business plan – and if you see those things, you can stay away.

In this chapter, Graham discusses four examples of this kind of careful study:
Penn Central (Railroad) Co., which is an example of a corporate giant that’s rotting from the inside
Ling-Temco-Vought, Inc., which is a company that builds an empire on paper, but is actually pretty fragile
NVF Corp., which is an example of corporate acquisitions gone bad
AAA Enterprises, which is an example of a “hot” stock that’s getting elevated beyond all reason

Chapter 17: Four Extremely Instructive Case Histories
Here’s how Graham sniffed out the rat in each company.

Penn Central (Railroad) Co.
A careful reading of the company’s annual reports reveals that the company had been paying virtually no income tax for a decade. That’s a huge warning sign – if they’re not paying income tax, they’re either taking advantage of a ton of tax breaks (which you should be able to discover easily) or they’re not really earning much income at all.

How did they do it? They were reporting earnings without “charges” that were going to be taken several years down the road. These “charges,” however, were merely disguising that the company wasn’t really bringing in any income.

What can you do to avoid this? If you see a company reporting good earnings but also talking about “charges” for mysterious reasons that will be dealt with in future years, be very careful. They could be just extending the life of the company on paper when it’s actually in serious trouble.

Ling-Temco-Vought, Inc.
The warning signs? In 1966, the company stated that their assets were less than 5% of the stock value of the company. This means that if the company went bankrupt, the common stocks would pretty much be worthless – something to avoid like the plague if you’re investing for value.

Another warning sign: large investors started dumping the stock in droves. If you see big investors selling all of their stock in a company, you might want to consider doing the same. Watch out for big changes in institutional investing in the public reports on the company.

In 1969, the company reported a loss far bigger than the total profits in the history of the company. In one year, it lost more money than it ever earned – a sure sign something’s seriously wrong.

The way to avoid this is simple: avoid any stocks that are valued far beyond their asset value. Avoid any stocks that are being sold in droves by institutional investors. Avoid stocks that suddenly report a huge loss seemingly out of nowhere.

NVF Corp.
Here, NVF used a number of accounting gimmicks to hide the fact that they were acquiring companies with a huge amount of debt and unsteady business.

How did they do that? The most flagrant sign was that the company claimed an “asset” called “deferred debt expense” that was actually larger than the entire equity of the company. If you started digging into the annual report and figuring out what the items are, you soon realized that the company was actually claiming some debts as assets – and when you got that all straightened out, it became clear that the company was worthless.

You can avoid this by avoiding any company that has unexplainable items on their annual report. If you can’t get a rational explanation of what an element of a company’s annual report is, avoid that company.

AAA Enterprises
If you can’t determine why exactly people are investing in a company, don’t invest. That’s basically the story here, in which a tiny company played a hype game and wound up being valued at 115 times earnings – a number that’s not realistic no matter what the company.

This was all based on potential – much like the “dot com” stocks of 1999 and 2000. Graham’s point? Avoid companies that are selling nothing more than potential. If you can’t see real assets and real business there, don’t invest.

Commentary on Chapter 17
Zweig spends his commentary making modern analogies for each of these disasters.

Zweig compared Penn Central (Railroad) Co. to Lucent. Both companies were among the largest in America, but once you started digging into the books, it became clear that the large company was rotting from the inside, with apparent earnings that weren’t actually based in reality.

He compared Ling-Temco-Vought, Inc. to Tyco, both of which built a big paper empire that wasn’t really based on real-world assets, but instead based on mergers and shuffling.

He compared NVF Corp. to AOL-Time Warner, the best modern example of a merger that completely made no sense in which the minnow swallowed the whale.

Finally, the easy one: AAA Enterprises could have been compared to a lot of dot-com companies (my favorite disaster was Boo.com), but Zweig analogized it to eToys, another classic dot-com disaster.

What’s the lesson? These same tactics keep getting used and keep fooling investors. Be careful.

Next Friday, we’ll take a look at Chapter 18: A Comparison of Eight Pairs of Companies.

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The final five chapters of The Intelligent Investor (of which this is the first) really serve as a “wind-down” for the entire book. Graham spends the chapters looking at examples, special cases, and special topics that really almost serve as a supplement to the real meat of the book – the earlier chapters.

This chapter is a particularly interesting one, as it focuses on an area of investing that very few people in mainstream life are even aware of – convertible issues and warrants.

What are they? Convertible issues refer to financial instruments (usually bonds) issued by companies that can be converted into other financial instruments. The most common example of this is a convertible bond issued by a company in order to raise money. A convertible bond is just like any other bond – you buy it for a certain price, it pays a certain amount every so often, and when it’s finished, the bond has a face value. You might, for example, pay $9,800 for a bond that pays $400 a year for five years, then can be redeemed for $10,000. A convertible bond adds another option – you can, at any time, convert it into stock of the company that issued the bond at whatever rate was specified when the bond was issued. So, let’s say you have that $10,000 face value bond and it can be “converted” into 500 shares of stock in the company. If the stock’s value goes much above $20, it might be worthwhile to convert it.

A warrant is a long-term option to buy shares of stock at a certain price. For example, you might have a warrant for company A that lasts ten years that allows you to buy 1,000 shares of their stock at $10 a pop. If the company’s stock goes up to $20, that warrant itself has some significant value to it.

While I doubt I’ll ever find direct use for knowing how to find value when buying warrants or convertible issues, one can still garner useful principles from reading this information. So let’s dig in.

Chapter 16: Convertible Issues and Warrants
In short, Graham seems pretty wary of both of these types of investments. For the most part, throughout The Intelligent Investor, Graham seems to totally eschew the complex in favor of the simple.

For convertible issues, Graham points out that convertible issues that are issued late in a bull market are almost always an awful investment. Why? The bonds themselves usually aren’t a very good investment – your hope is usually that you’ll be able to convert the bond (or sell the bond when the conversion is good). At the end of a bull market, prices are usually inflated and are about to sink. Thus, convertible issues bought late in a bull market are usually not able to be converted at a profit, making them a terrible investment.

Here’s the kicker: the latter stages of a bull market are when most convertible issues are created and sold. Companies are usually seeking to fund expansion and big spending projects when the economy seems to be roaring and that’s when they issue things like convertible bonds.

So, in a nutshell, Graham is very wary of all convertible issues – he all but encourages individual investors to simply leave them out of their investing plans.

What about warrants? He’s pretty clear about them on page 413: “We consider the recent development of stock-option warrants as a near fraud, an existing menace, and a potential disaster.” That’s about as clear as one can be – stay away from these as well.

Commentary on Chapter 16
Zweig’s commentary here is very short, and he focuses exclusively on convertible bonds. His primary point about such investments is that, if you choose to invest in convertible bonds, don’t think of them as bonds. Instead, think of them as rather stable stocks, since the performance of convertible bonds mirrors the stock market, not the bond market.

Next Friday, we’ll take a look at Chapter 17: Four Extremely Instructive Case Histories.

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As I mentioned last week, this chapter (and the one preceding it) form what I consider to be the heart of The Intelligent Investor.

What I found most interesting about the previous chapter – Stock Selection for the Defensive Investor – is that Graham basically advocates for index funds if you’re a defensive investor. The interesting part is that Graham wrote that chapter in 1972 – years before index funds appeared for people to invest in. They simply didn’t exist in 1972 – the only mutual funds around at that time were heavily managed by active investors.

This chapter, though, sees Graham talking about individuals who aren’t simply defensive in their investing. How does one seek out and find value stocks, not just ones listed in the S&P 500? Graham really answers that question here.

Chapter 15 – Stock Selection for the Enterprising Investor
So, how do you find a value stock? That’s really the question Graham strives to answer in this chapter.

The first factor to look for is a low price to earnings ratio – information you can easily get from a good stock tracking software like the Yahoo Stock Screener (that’s the tool I use). Graham suggests looking for stocks that have a price-to-earnings ratio of 9 or lower.

Graham immediately points out that simply screening based on a P/E ratio of less than 9 will get you a lot of stocks – and he’s right. I found 909 stocks that had a P/E ratio of 9 or less – a mix of big companies and little ones, ones I’d heard of and ones that I hadn’t.

Graham then suggests five additional factors to screen for:
1. Good financial conditions – assets that are at least 1 1/2 times current liabilities
2. Earnings stability – no losses in the last five years
3. Dividends – some current dividend is being paid
4. Earnings growth – last year’s earnings are more than those of five years ago
5. Price – a stock price less than 120% of the company’s assets

I entered some of these criteria into the tool and found that these factors quickly eliminated hundreds of stocks, leaving me with a much tighter list with companies like Exxon and Chevron to investigate.

Much of the rest of this chapter deals with special situations, most of which Graham encourages people to avoid (“special” issues) or has a lot of caveats about (buying stocks with a stock price lower than the company’s assets – probably meaning the company is in fairly serious trouble).

Commentary on Chapter 15
Zweig actually extracted different lessons from this chapter than I did, which speaks to the density of information in Graham’s writing – and probably indicates why many people have a hard time trudging through the book.

Zweig argues that the biggest lesson here is the value of practice. Graham’s pointers seem straightforward at first glance, but they really only help you find a group of stocks which you’ll have to dig through on your own. The process of digging through those stocks, picking a few, seeing how they do, and learning some of the patterns is something that can’t really be taught in a book – it requires a lot of experience.

How can you get that experience? Zweig strongly encourages people to spend some serious time (he suggests at least a year of practice) using an online portfolio tracker like the one at Yahoo. Study stocks, add some to your virtual portfolio, and watch them. See what works and what doesn’t. If you enjoyed this process and earned a decent return, start investing with real money – but if you just wind up confused and bored, stick with index funds.

Next Friday, we’ll take a look at Chapter 16: Convertible Issues and Warrants.

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I’ve been writing these chapter-by-chapter discussions of The Intelligent Investor on my second read-through of the book.

The first time I read the book was roughly a year ago. To me, it came across quite like most good books – it built to a climax that contained the key portion of the book, which occurred about two-thirds of the way through. Prior to that climax was a ton of “setup” material – putting all the pieces in place so that the climax could be understood, processed, and enjoyed. The material after the climax was largely clarification and continuation – a bit more detail.

From my perspective, this chapter and the next (Stock Selection for the Enterprising Investor) serve as the climax of The Intelligent Investor. These chapters really outline what exactly Graham’s stock selection philosophy is in great detail.

This first chapter in the pair focuses on a more conservative philosophy for picking individual stocks, which personally appeals to me more than aggressive strategies. My personal philosophy for stock investing tends to stick pretty strongly to broad-based index funds – I have very little confidence that I can regularly pick stocks that will do substantially better than comparable index funds.

Chapter 14 – Stock Selection for the Defensive Investor
Graham’s strategy for defensive investors is actually pretty straightforward. He recommends that you start off with a broad index of funds – he uses the Dow Jones Industrial Average for his example, but the philosophy would work just as well with the S&P 500 or the Wilshire if you so wanted (and you could easily do that with computer-based tools).

Once you have this list, Graham suggests applying seven criteria to each stock on that list, in this order:

1. Adequate size of the enterprise Don’t invest in small companies, in other words. A defensive investor avoids stocks that would be considered small-cap.

2. A sufficiently strong financial condition The assets of any good defensive company should be at least twice the debts of that company.

3. Earnings stability The company must have had positive earnings each of the last ten years.

4. Dividend record The company must have made uninterrupted dividend payments each year for the past twenty years.

5. Earnings growth The company must have seen an increase of at least 33% in per-share earnings as compared to ten years ago.

6. Moderate price/earnings ratio The stock’s price must be nome more than 15 times the company’s earnings over the past three years.

7. Moderate ratio of price to assets The company shouldn’t have a stock value 50% greater than the total value of the company’s assets.

If you apply all of these criteria, even to every stock available, you’ll find the list of acceptable stocks at the end to be very, very small – if you find any at all. If you do find a stock that matches these criteria, it’s almost assuredly going to be a very steady value.

If you want to play around with these criteria using all publicly available stocks, it’s pretty easy to set up Yahoo’s Stock Screener. I used all of these criteria and didn’t find a single matching stock, but when I experimented a bit and loosened some of the criteria just a touch, I did find quite a few matches. This would be a great place to start for a defensive investor looking to jump into individual stocks.

Commentary on Chapter 14
Zweig’s message is simple: the easiest method for a defensive investor to invest in stocks today is by buying a broad-based index fund and simply sitting on it. This broad-based fund will match the stock market, have very little cost, and require very little effort from the buyer.

He does walk through each of Graham’s seven criteria for good defensive stocks and uses them to analyze the S&P 500 as it sat in early 2003 (when prices were pretty low). Zweig actually found that a sizable percentage of the S&P 500 passed each individual criteria, but he doesn’t mention how many companies pass all of the criteria – I’m willing to bet that it’s a very low number, if any at all.

Next Friday, we’ll take a look at Chapter 15: Stock Selection for the Enterprising Investor.

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Over the past few chapters, Graham finally began to lay out some of the specifics of how to implement his concept of value investing.

It only took him ten chapters to reach the supposed “meat” of the book. I wouldn’t hesitate a bit to speculate that Graham’s “slow start” to the book is the reason many people have a hard time picking it up and going with it – it’s simply a slow starter, especially if you just want to know specifically how Graham values stocks.

But that’s not the point of the book.

What does it say on the front? The Intelligent Investor. That doesn’t mean “The Guy Who Can Price Value Stocks Really Well” – and the fact that many people believe that the two are the one and the same is actually a real problem.

Investing isn’t just about knowing how to evaluate a company properly or how to seek out huge values on Wall Street – that’s only one small part of the bigger picture. Investing is about knowing yourself (how much risk you can tolerate, for one), knowing the people around you, setting goals, defining a broader portfolio than just stocks, and so on.

Here’s the problem – those topics are boring to a lot of people. Yet Graham devoted the first nine or ten chapters of The Intelligent Investor to just these issues.

Graham views these elements as the bedrock of what it means to be an intelligent investor, and that’s why he devoted the first third of his book to it. Those who would skip it or not “waste their time” paying attention to it are missing a key part of Graham’s message.

Chapter 13 – A Comparison of Four Listed Companies
This chapter, however, does focus on evaluating companies in terms of finding ones that offer significant value to the investor. Graham does this by actually running through how he would evaluate four different companies given their situation in early 1972 – ELTRA, Emerson Electric, Emery Air Freight, and Emhart Corp.

What companies? If you looked at those names and shrugged your shoulders, there’s good reason – only Emerson still actually exists as a distinct company and brand. The other three were subject to mergers and buyouts from other firms – ELTRA merged with Bunker Ramo and that operation was eventually purchased by Honeywell, Emery Air Freight is now a part of CNF, and Emhart was bought by Black and Decker. Remember, though, the point here isn’t to point out good stock buys. Graham’s discussion here is about how he would evaluate these companies from his position in early 1972.

Graham walks through all four companies, considering their profitability (he looks at the past decade of results), stability (he looks at their worst year over the past decade), growth (compared over multiple time frames, not just the last year), financial position (they must have $2 in assets for every $1 in debt), dividends (years of dividends paid without interruption), and price history (evaluated over the companies’ entire histories).

Graham concludes a few things here: Emerson and Emery are both overpriced – or at least aren’t value stocks at the moment. He thinks Emerson has better long term potential, but seems fairly gold on buying Emery as a value stock. The other two companies, though, are undervalued, and he believes they would be good buys for a defensive investor.

What exactly constitutes a “good buy”? Graham just begins to touch on that, indicating “seven statistical tests,” but then holds off on delving into those tests until the next chapter.

Commentary on Chapter 13
Zweig basically does the same analysis as Graham, except Zweig focuses on four modern companies – Emerson (again), EMC, Expeditor’s International, and Exodus Communications.

Why those four? Together, they actually provide a very nice history of the stock market during the 1980s, 1990s, and early 2000s, highlighting all of the ups and downs along the way.

What did Zweig conclude from his evaluation? Companies that aren’t stable on paper aren’t stable investments. Exodus Communication was his “dot-com” stock and it went belly-up before 2003 was out. On the other hand, Emerson was Zweig’s stable old horse – and it weathered the dot-com bust just fine.

There’s a lesson here – value investors don’t buy the flashy stocks. The flashy stocks are almost always overvalued compared to what the company is really worth on paper. Instead, value investors tend to look for the boring – Emerson’s shop-vacs aren’t glamorous, but the company does provide a good value for the shareholders.

Next Friday, we’ll take a look at Chapter 14: Stock Selection for the Defensive Investor.

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This version of The Intelligent Investor was written by Ben Graham in 1972, yet time and time again I am practically convinced that Ben is actually writing about today’s stock market.

It’s not so much that Graham is some sort of prophet. You can tell from some of the specific examples that he’s clearly writing from the perspective of thirty five years ago. He vastly overestimates the value of bonds, at least in terms of how people today would invest. His specific examples of dominant companies are rather laughable in today’s market – some are completely out of business, while others are shells of their former selves.

What’s amazing about Graham’s writing is that he really understands the basic principles that underline all of this stuff – and those principles are largely still true. Then, as now, greedy businesspeople will try to cook the books. Then, as now, investors have something of a herd mentality and will overlook some serious values if that’s not where the herd is. Then, as now, salesmen and charlatans pose as legitimate investment advisors, peddling dubious advice and collecting kickbacks all along the way.

It’s because of Graham’s deep understanding of this that The Intelligent Investor is still such a valuable book. Gloss over the specifics and look at the principles. You’ll find that they’re incredibly accurate.

If a thirty-five year old book can be so prescient, one can’t help but wonder what value all of the modern information flood has when it comes to investing.

Chapter 12 – Things to Consider About Per-Share Earnings
This is actually a pretty short chapter. Graham really only has two major points to discuss about per-share earnings – the amount of money a company earns on paper for every single share of their stock.

First, don’t take a single year’s earnings seriously. There are many, many reasons why a company’s single-year earnings can be completely out of whack with the true reality of the health of a company. For example, many of the companies affected by the subprime lending crisis had extremely anomalous single years for 2008 in terms of earnings because they wrote down those losses all at once. Similarly, a company can have very nice returns in a single year thanks to a short-term effect – a big fad or something like that.

What should you do instead? You should look at earnings over as many years as you possibly can and attempt to get a real bead on the direction the company is going over the long term. A single year is not enough to accurately judge the direction of the company.

That leads directly into Graham’s second principle, if you do pay attention to short term earnings, look out for booby traps in the per-share figures. In other words, if a number looks too good to be true, it probably is.

What can you do here? If you use that short-term number for anything important, you need to do some serious research into the stock. Read the annual report. Read the SEC filings. Dig into the details of what is actually included in the earnings number being used here. What’s being included in it? Are there “one time charges” all over the place? What are those charges, and how would the number change without those charges?

What’s the real lesson that Graham is teaching? There is no single number that you can use to really evaluate a stock or a company. There are so many tricks that a company can use to manipulate their numbers, both legitimately and otherwise, that relying on a single number to judge a company is a fool’s game. You’re begging for a company to trick you if you rely on minimal information.

Commentary on Chapter 12
Zweig spends his commentary arguing that Graham’s principles on per-share earnings are actually more true today than ever before, and he uses the chicanery of the past decade to make his case. Enron. Adelphia. WorldCom. Global Crossing. These companies looked great on paper if you took an extremely superficial view, but if you started digging into the data, it started to look a little more shaky. And, of course, we know what happened over the long run.

Zweig offers a few general principles for today’s world.

First, read financial reports in reverse. Often, the nastiest stuff a company has to report is hidden in the back in footnotes. When you want to know how a company is doing, start digging in there to get the real story.

Next, read all notes. If you see a number in a financial report followed by a comment like “see Note 1″ … immediately read Note 1. It’s usually an indication that the number you see there has been cooked in some fashion.

Finally, read more. If you’re actually going to get into individual investing to the point that you’re devouring financial reports, know how to read them. Get geared up on basic accounting principles. Read books on financial statement analysis (Zweig recommends Financial Statement Analysis by Fridson and Alvarez).

All around, it’s good advice. Never trust a single number, and never trust that the company is going to make the skeletons in their closet immediately clear to you.

Next Friday, we’ll take a look at Chapter 13: A Comparison of Four Listed Companies.

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And now (finally) we get down to the meat of the matter.

Most people who have heard about The Intelligent Investor immediately associate it with a method for specifically identifying value stocks. Graham’s method is known for identifying stocks where the value of the company’s stocks is significantly lower than what it should be.

Yet, here we are at page 280 and there’s been essentially no mention of how exactly to go about this. Instead, Graham spends most of the first half of the book focusing on general advice for individual investors: play it conservative, be careful with your advisors, and so on.

For some readers, this is undoubtedly frustrating. They don’t want to hear about anything other than Graham’s methods for pricing stocks. Knowing that the material on stock pricing begins on page 280, some readers will immediately skip all that comes before it and jump straight into the later chapters.

To them I say, hold on.

Graham opens the book with a lot of chapters about the actual mechanics of how to be an intelligent individual investor. Merely knowing how to price stocks is only one piece of the pie. If you’re focused on nothing else but trying to find the “real” value of a given company, you’re likely overlooking many more important things. Is your overall investment plan sensible? Are you actually utilizing a balanced portfolio?

It doesn’t matter how good you are with pricing individual stocks, eventually you’re going to pick a dud and eventually you’ll be caught in a hard place if you don’t have an adequately balanced investment portfolio.

So, if you’re reading The Intelligent Investor for the first time, don’t just skip ahead to the chapters on individual stock investing. Instead, take in Graham’s complete message – I actually think the earlier chapters are more important than this stuff.

Chapter 11 – Security Analysis for the Lay Investor: General Approach
How exactly can an individual estimate what a reasonable value of a given stock should be? Graham identifies five key factors that basically define the value of a stock.

The company’s “general long-term prospects” Ignore what the talking heads are saying and look at the books. Is the company growing steadily? Is this growth actually in line with the stock price, or is the stock price jumping up and down seemingly out of touch with the actual business of the company? If the books are steady, the company is steady, and the prices jumping up and down is the result of talking heads. Be sure to look at a lot of data, though – at least five years, and ten is better.

The quality of the management It’s hard to judge this. One way to effectively judge it is to watch the annual reports of the company over a long period and see if the management actually does what they say they’re going to do as well as frankly discuss the moves they’ve made. If the management commentary seems not well related to the business of the company, that’s a big red flag.

Its financial strength and capital structure The less debt, the better, but a little bit of debt isn’t a big scary red flag. Again, look at the long term and see how the company has handled debt over the long term – it should always be low (or steadily going down).

Its dividend record Graham believes that a company should be paying a pretty steady investment for at least twenty years. If the company you’re investing in doesn’t have this kind of history, that’s something of a negative.

Its current dividend rate Since Graham wrote this book, companies have gradually shrunk their dividend payments, making the current dividend rate much less of a factor. When Graham was writing, companies typically paid around 60% of earnings out as dividends – today, 25-30% is fairly typical.

One important thing to note about Graham’s five factors is that he’s looking at these stocks as a long term investment that he hopes will return a healthy pile of dividends over that time. He’s not necessarily looking for a big ramp-up in stock price over that period – his “value” comes primarily from the dividends. That’s quite a bit different than how CNBC often talks about about stocks.

Commentary on Chapter 11
Zweig spends the commentary basically taking Graham’s five key factors and putting them in a modern context. For example, for evaluating a company’s long term prospects, Zweig encourages people to visit EDGAR (at sec.gov) and download at least five years’ worth of annual reports. That’s not exactly something that could be done in Graham’s day.

In fact, most of Zweig’s recommendations point people towards using EDGAR, which is an incredible tool for getting straightforward factual information about the status of companies you’re investing in. Zweig points out lots of things you should look for in all that data, but here’s three that stood out to me:

Form 4, which shows what a firm’s senior management has been doing in terms of buying and selling stock. If they’re buying, they believe in what they’re doing. If they’re all selling quite a bit, something’s amiss.

Statement of cash flows, which shows where the money is coming from. If you see a lot of “cash from financing activities,” that means they’re borrowing Peter to pay Paul – not a healthy long term solution.

Revenue and earnings each year for as many years as you can, which can show whether the earnings growth is smooth (good) or very bumpy (bad). No company is perfectly smooth, but if you see a 120% jump in growth followed by a 4% growth followed by a 19% growth followed by 2% shrinkage, consider that a red flag.

Next Friday, we’ll take a look at Chapter 12: Things to Consider About Per-Share Earnings.

The post The Intelligent Investor: A General Approach to Security Analysis for the Lay Investor appeared first on The Simple Dollar.

I found it very refreshing that in this chapter, Graham didn’t just focus on professional investment advisors when using the term “advisor.” Instead, under this umbrella, Graham included relatives, friends, local bankers, brokerage firms and other investment houses, financial service providers of all stripes, and professional finance advisors.

Why is this distinction important? We don’t just get our financial advice from “financial advisors.”

Take this blog (and countless others like it). We’re not financial advisors. I tend to think of myself as closer to the definition of “friend” than of financial advisor. I’m simply out here sharing my own reflections and experiences, letting people know where I succeed and where I fail.

Take the talking heads on CNBC. Those people may be financial advisors, but they’re speaking in a role where they’re not actually providing financial advice. They’re actually just being entertainers. Have you ever seen the disclaimer that precedes or follows any segment with Jim Cramer?

Yet there’s all this advice out there, and we do incorporate it into our knowledge, whether consciously and directly or not. The question is how can we know what knowledge is actually worthwhile and what isn’t? What advice is worth paying for and what isn’t? That’s really what Graham is seeking here.

Chapter 10 – The Investor and His Advisers
Even though this chapter is fairly long, Graham’s principles for how to deal with personal finance advisors – and personal finance advice – are pretty simple.

Be wary of all advice. You should never absolutely trust anyone with your money. Couple their recommendations with your own research and have an idea of what you want. Don’t just follow blindly with whatever an advisor says.

Avoid people who claim absurd returns. If returns seem to excessively beat the market, stay away. Almost always, it’s either a scam or it’s a person playing a very short term game that’s likely not to work next year. In either case, you don’t need their advice.

Stick with certified advisors or advisors from large, reputable houses. You’ll have to pay for both of these, of course, but the advice here is pretty good if you’re just seeking what a well-informed and cautious investor might be doing.

Truly defensive investors may not need advice at all. Defensive investors stick with high-grade bonds and common stocks of large, stable corporations and are likely to want to know exactly what they’re buying. In that case, you should be doing the research yourself – advisors might only be helpful in special situations (like a giant windfall, for example).

Make your advisors prove themselves to you. Just because someone has some impressive accomplishments in their past doesn’t mean that they’re guaranteed to be a great advisor. Be limiting in your trust until they show you repeatedly that they’re providing great advice for you.

Commentary on Chapter 10
Zweig puts more of a modern spin on Graham’s advice in the commentary. He seems to be even less inclined to recommend financial advisors than Graham is, arguing that one should only hit a financial advisor if you’ve tried things yourself and are experiencing waters that are far more turbulent than you’d like.

Zweig’s mantra? Research, research, research. Find out everything you can about your potential advisor before you even begin taking advice. Google them, find out about any complaints (using http://www.advisorinfo.sec.gov/), and ask around about them.

When you decide to give one a shot, don’t just dive into their advice. Zweig offers two long pages of questions you might want to ask a new advisor in order to get to know where they stand on things.

The biggest flag of a good advisor (from Zweig’s perspective) is interest in your specific situation. Are they asking about your budget? Your goals? Your frustrations? Your psychological makeup (asking about how you handle conflicts)? A good advisor will want to know all of these. If they’re not asking, they don’t care, and that’s dangerous.

Next Friday, we’ll take a look at Chapter 11: Security Analysis for the Lay Investor: General Approach.

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It’s worth noting that Graham wrote this chapter in 1972, predating the advent of the index fund. When Graham discusses the idea of investment funds, Graham is largely talking about traditional-style mutual funds – ones managed by a fund manager who makes the decisions about what investments should be held by the fund.

An index fund, on the other hand, isn’t actively managed by anyone. Instead, it’s managed by a handful of very straightforward rules on what should and should not be held by the fund. For example, an index fund of the S&P 500 (like the Vanguard 500) holds only stocks that are listed on the S&P 500 index, a statistic used widely to gauge the market health of large domestic companies. Here’s more information about index funds.

Unsurprisingly, Graham isn’t particularly a big cheerleader of traditional mutual funds. One of Graham’s big requirements for investing is that you know exactly what you’re invested in, and by buying into a fund, you cede that control to someone else. Yet it was just a few chapters earlier that Graham basically outlined the idea behind an index fund and spoke very positively of the idea.

One can’t help but wonder what Graham might have said today about the proliferation of index funds and the rise of Vanguard.

Chapter 9 – Investing in Investment Funds
Graham basically says that there are three questions you need to answer before investing in any fund.

1. Is there any way by which the investor can assure himself better than average results by choosing the right funds? [...]

2. If not, how can he avoid choosing funds that will give him worse than average results?

3. Can he make intelligent choices between different types of funds – e.g., balanced versus all-stock, open-end versus closed-end, load versus no-load?

Graham states that in general, individuals who invest in balanced funds tend to do better than individuals who invest in individual common stocks. The reason is simple: a person who is not an expert at picking individual stocks and balancing a portfolio is usually better off in the hands of a professional money manager even after the costs.

However (and this is big), Graham largely seems to suggest that the fees in a typical mutual fund are far too high and the time invested in finding a bargain fund (one with good results with limited costs) is well worth the time. He also believes that you should not expect to ever radically beat the market with a fund, and that funds who have astounding short term gains are usually not playing a healthy long-term gain – something that’s been shown over and over again over the history of investing.

Much of Graham’s specific commentary in this chapter deals with the specifics of mutual funds as they existed in the late 1960s, an era in which index funds did not yet exist and legal constraints on funds were substantially different than they are now. As a result, it’s much more sensible to look at the big picture here and not get bogged down in specifics.

Commentary on Chapter 9
Zweig has the advantage of knowledge of three more decades of investing history and he definitely uses it here. For the most part, Zweig applies Graham’s three big questions to modern mutual funds – and the results aren’t pretty.

Zweig seems to conclude that managed mutual funds are not a good investment for the typical investor. Over a long period, very few funds even manage to match the market, let alone beat the market. Why is this? Assuming there were no fees or costs, a truly average fund would match the market and (in theory) half of all funds would do that well or better. However, once you add in fees and costs, this sinks many of those market-beaters to a rate of return worse than the overall market.

Given that, though, Zweig is a big fan of index funds, as they overcome several of the problems with managed funds. They’re designed merely to match the market with an extremely low cost, which means that a typical index fund should beat a solid majority of mutual funds covering the same area.

Of course, Zweig advises that even if you’re using an index fund strategy, you still need to pay attention to diversification and should not have all of your eggs in one basket. Just because you’re invested with index funds doesn’t mean you shouldn’t balance your portfolio between stocks, bonds, and cash.

Next Friday, we’ll take a look at Chapter 10: The Investor and His Advisers.

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If there’s ever been a year where strong market fluctuations have been the rule rather than exception, 2008 is that year. It’s been a roller coaster ride, with triple digit gains and losses in the Dow Jones Industrial Average becoming the norm instead of the exception.

Because of this, I really looked forward to reading this chapter, even though I already had some idea of what Graham would say about market fluctuations. Given his earlier commentary, I completely expected Graham to advocate for sitting back, letting the fluctuations simply happen, and watch for bargains in quality companies when their stock prices are being tugged downward due to momentary fluctuations outside of the company’s control.

And that’s largely what I got, with some nuances. Graham’s philosophy throughout this book is consistent and logical, even if it might be a bit too conservative for more gung-ho investors.

Chapter 8 – The Investor and Market Fluctuations
Right off the bat, Graham argues that attempting to play market timing games is a fool’s game. One can never predict true market bottoms or peaks in advance – they can only be seen through hindsight. Graham also points out that some of the “markers” of a bottoming-out market won’t necessarily hold true for the next bottom, and that same effect holds true for peaks as well. In a nutshell, don’t bother trying to time things based on what you think the overall stock market is going to do.

However, for individual stocks, Graham thinks that timing can actually work well. In this case, though, Graham is referring to detailed study of a company: knowing that the company is sound, knowing how it compares to the competition, and knowing what a reasonable value of the stock should be. Once you’ve identified a good, quality company, then you should keep your eye out for the right price on that stock – when it goes below a certain number without any change in the nature of the company itself, then you buy.

This, in essence, is the key of the “buy low, sell high” idea. You don’t try to time the market at all. Instead, you merely seek out bargains in the things that you know, and you wait for them patiently.

What about selling? For the most part, Graham encourages people not to sell into fluctuations, either, and instead hold onto those steady, dividend-paying stocks. The only time Graham seems to encourage selling based on market conditions is if the prices you would get today are significantly out of whack with the long term history of the stock. For example, if the stock has pretty consistently held near a 12 P/E ratio, but is suddenly selling for 20, it’s probably a good time to sell it.

What’s the end result of all of this? A person who diligently follows Graham’s advice is going to almost always be doing the opposite of what everyone else is doing. When the bull market is roaring and everyone is buying, you’re likely to be holding or selling stocks. When the bear market is afoot and everyone is selling, you’re likely to buy up those value stocks.

What about bonds? Graham generally advocates buying bonds when there are no values to be had in the stock market. In other words, if you have money to invest and the stock market is roaring like a freight train, Graham suggests increasing the portion of bonds in your portfolio. Similarly, when the market is down, one may want to decrease the portion of their portfolio that is in bonds if there are appropriate value stocks out there for purchase. Again, it’s the opposite of what seems to be the convention on Wall Street.

Commentary on Chapter 8
Zweig spends most of the commentary ruminating on Graham’s “Mr. Market.” For those unfamiliar, Graham often liked to imagine the stock market as a person he called Mr. Market. This individual was essentially a manic depressive – when the stock market was rocketing, he’d offer to buy or sell you stocks at a price way beyond what the company was worth, but when the stock market was down, he’d only buy or sell at prices far below what the company should fetch. Graham argued that the way to deal with Mr. Market was patience – wait until he quoted you prices you liked.

Zweig uses several modern examples of irrational exuberance to show this “Mr. Market” phenomenon at work – and the dot-com boom certainly gave us a lot of examples. Zweig discusses Inktomi, which went from a peak well over $200 in 2000 to being worth a quarter a share in 2002, even though the fundamentals of the business actually improved over that time frame. In 2002, it was a bargain, and eventually Yahoo bought the company lock, stock, and barrel for roughly seven times that much.

So how can you avoid situations like Inktomi? Know what you’re buying, be patient, and only buy when the getting is good. Not only does this ensure that you get actual bargains, it also reduces the brokerage fees that a more frenetic buyer and seller would accumulate.

Zweig picks out a great quote from Graham that I think bears repeating here.

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, right there, is most of the lesson of this chapter in one sentence.

Next Friday, we’ll take a look at Chapter 9: Investing in Investment Funds.

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If you’ve been paying attention the last few weeks, you’ve probably observed that Ben Graham has a lot of ideas about what you should avoid. Defensive investors should avoid everything but large, prominent companies with a long history of paying dividends. Even enterprising investors should avoid junk bonds, foreign bonds, preferred stocks, and IPOs.

To put it simply, Graham doesn’t like risk. It comes through time and time again in every chapter of the book – do the footwork, minimize risk, and don’t swing for the fences.

So what kind of real-world investing does that lead to? Graham finally gets down to actual tactics here, finally pointing toward some specific investment choices that he actually supports! At last!

Chapter 7 – Portfolio Policy for the Enterprising Investor: The Positive Side
Graham says that there are four clear areas of activity that an enterprising investor (read: not an ultra-conservative investor) should focus on:

1. Buying in low markets and selling in high markets.
Graham says, in essence, that this is a good strategy in theory, but that it’s essentially impossible to accurately predict (on a mathematical basis) when the market is truly “low” and when it’s truly “high.” Why? Graham says that there’s inadequate data available to be able to accurately predict such situations – he basically believes fifty years of data is needed to make such claims, and as of the book’s writing, he did not believe adequate data was available in the post-1949 modern era. Note, though, that Graham returns to the notion of high and low markets in the next chapter.

2. Buying carefully chosen “growth stocks.”
What about growth stocks – ones that are clearly showing rampant growth? Graham isn’t opposed to buying these, but says that one should look for growth stocks that have a reasonable P/E ratio. He wouldn’t buy a “growth stock” if it had a price-to-earnings ratio higher than 20 over the last year and would avoid stocks that have a price-to-earnings ratio over 25 on average over the last several years. In short, this is a way to filter out “bubble” stocks (one where irrational exuberance is going on) when looking at growth stocks.

3. Buying bargain issues of various types.
Here, Graham finally gets around to the idea of buying so-called “value stocks.” For the most part, Graham focuses on market conditions as they existed in 1959, pointing towards what would constitute value stocks then. What I found most profound, though, is a brief bit on page 169. Here, Graham discusses “filtering” the stocks listed by Standard and Poor’s (essentially a 1950s precursor to the S&P 500) and identifying 85 stocks that meet basic value criteria, then buying them and finding that, over the next two years, most of them beat the overall market.

That’s an index fund, my friends. Graham had basically conceived of the idea in the 1950s – it worked then, and it works now.

4. Buying into “special situations.”
Graham largely suggests avoiding “topical” news as a reason to buy or sell, mostly because it’s hard for investors to gauge how exactly such news will truly affect the stock’s price. Instead, one should simply file away interesting long-term news for later use if you’re going to evaluate the stock. For example, recalling that a company is still paying off an incurred debt from ten years ago and that debt is about to be paid off might be an indication of an upcoming jump in profit for the company – and a possible sign of a good value.

Commentary on Chapter 7
Zweig provides a ton of supporting evidence that market timing doesn’t really work, and that “examples” of market timing that are often used to show how good it can be are cherry picked using the amazing power of hindsight.

He makes a similar argument about growth stocks, saying that there are often periods where growth stocks appear to be taking off like a rocket, but that it’s impossible to know where the top of that rocket ride is. He provides several examples of this and largely seems to agree with Graham that the only growth stocks a person should invest in are ones that are truly sound as a business and not merely the beneficiaries of a lot of hype. How can you do this? Keep a very close eye on the real business numbers of any growth stock you own.

In the end, Zweig argues that the best solution for most investors is pretty simple: diversify, diversify, diversify. Don’t put all your eggs in one basket, ever. Instead, buy lots of different stocks from lots of different industries and from lots of different markets (foreign and domestic).

Next Friday, we’ll take a look at Chapter 8: The Investor and Market Fluctuations.

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As we’ve learned over the past two weeks, Graham’s view of a conservative investor is very conservative. Focus primarily on big, blue chip stocks that pay a dividend and counterbalance that with roughly an equal amount of bonds. Very conservative, indeed.

But what about those of us who are less conservative and want to seek out other investments? After all, isn’t The Intelligent Investor supposed to be a guide to value investing, not just “buy blue chips and wait”?

Graham starts to head down this path here as he turns his sights from the very conservative investor to the … less conservative investor, the type of person who would actually follow value investing principles and seek out investments that show every sign of being undervalued – and then invest in them.

But first, a chapter of cautionary advice. Graham is nothing if not cautious, after all. The focus here is on things that even enterprising investors should avoid.

Chapter 6 – Portfolio Policy for the Enterprising Investor: Negative Approach
So, what should you avoid?

First, avoid junk bonds. If they have anything less than a stellar bond rating, don’t bother, even if they appear to return very well. Junk bonds put your principal at risk, and the point of buying bonds is to have a safe portion of your portfolio.

Second, avoid foreign bonds. Here, there are stability issues, and it’s often hard to adequately judge the risk of buying bonds from government and private entities operating under rules unfamiliar to you. Today, arguably, Graham would be okay with buying bonds within the European Union, but I would guess Graham would avoid anything outside of that.

Third, avoid preferred stocks. Preferred stocks are ones that have a higher priority in the event of a liquidation of the business, but often come at a premium price. Almost always, Graham doesn’t feel these are worth any sort of premium. Of course, in the United States, preferred stock is generally not sold directly to individual investors, only to large institutions, so it’s largely a moot point.

Finally, avoid IPOs. To put it simply, new issues do not have any track record upon which to adequately judge the company. The “hype” of an IPO is all you really have to judge the issue on. Instead, let others jump into that feeding frenzy and wait until time has shown which companies swim and which ones sink.

Those are some good rules for anyone to follow, particularly if you’re concerned about not losing the money you invest. Most of these investments have a pretty significant amount of risk and in Graham’s world, one shouldn’t put the principal at undue risk.

Commentary on Chapter 6
Zweig looks at modern examples of all four of these cases and largely comes to the same conclusions as Graham: they’re quite risky and probably not worth it for the average investor. The only caveat that Zweig makes is that there could be room for a mutual fund of junk bonds in a large and diverse portfolio, but it should be considered risky and not be considered anywhere close to a “safe” portion of the portfolio.

Zweig also covers day trading here, describing it as something for most people to avoid. Why? In a world where trading is completely free and trades could be always executed without delay, many people could make a solid income from day trading.

But that’s not the real world. Brokerage fees can eat up a lot of one’s gains, as can trading delays. This forces day traders to walk a tightrope – it becomes a high risk game, and that’s not a game for an investor with any conservative streak. Zweig almost writes it off as gambling, in fact.

So, in short, avoid junk bonds, foreign bonds, IPOs, and day trading and you’re off to a good start in Graham’s world.

Next Friday, we’ll take a look at Chapter 7: Portfolio Policy for the Enterprising Investor: The Positive Side.

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There’s one big underlying theme to this book that I didn’t expect. Yet, it keeps coming to the forefront again and again. It’s the one point that I believe Graham wants people to take home from this book.

Strong, thorough research is the most important part about owning stocks.

If you can’t – or aren’t willing to – put in a lot of time studying individual stocks, identifying ones that genuinely have potential to return good value to you over time, and keep careful tabs on those individual stocks, then you shouldn’t be investing in stocks.

Over and over again, Graham makes this point, in both obvious and subtle ways. He’s a strong, strong believer in knowing the company. If you don’t have clear, concrete reasons for buying a stock, then you shouldn’t be buying that stock, period.

What if you don’t have that time? This book was written before the advent of index funds, but I tend to think that broad-based index funds can be a reasonable replacement for the stock portion of your portfolio.

Chapter 5 – The Defensive Investor and Common Stocks
Graham’s advice, then, tends to focus on people who are willing to put in that extra time – and if you’re willing to do that, he has a lot of wisdom to share.

First of all, diversify. You should own at least ten different stocks, but more than thirty might be a mistake, as it becomes difficult to follow all of them carefully and also seek out new potential stock investments.

Second, invest in only large, prominent, and conservatively financed companies. Look for ones with little debt on the books and ones with a large market capitalization.

Third, invest only in companies with a long history of paying dividends. If a company rarely pays dividends, your only way to earn money from that company is if the market deems the stock to be valuable, and you shouldn’t trust that the market will do so.

Graham seems to point strongly towards the thirty stocks that make up the Dow Jones Industrial Average as a good place to start looking, as they usually match all of these criteria. I’d personally stretch that to include stocks that make up the S&P 500, but the Dow is a great place to find very large blue chip companies that are very stable and have paid dividends for a long time.

Other than that, Graham pooh-poohs many other common strategies. Buying growth stocks? Nope. Dollar-cost averaging? Good in theory, not great in practice. Portfolio adjustments? Be very, very careful – and only do annual evaluations. In short, be very, very wary and play it very, very cool.

Remember, this is Graham’s advice for the defensive, very conservative investor.

Commentary on Chapter 5
So, what does Jason Zweig have to say about all of this?

His big point is that simply “buying what you know” isn’t enough. You shouldn’t buy Starbucks’ stock simply because you drink their coffee. You need to spend the time to analyze the company’s situation, both internally and in the marketplace, and determine whether or not it’s a reasonable value. You can’t get there just by knowing the products they produce.

Zweig seems to generally feel that most people on the ground that are defensive investors are better off just buying mutual funds (preferably index funds) or seeking help from investment advisors, because the work needed to adequately study enough companies to build a good defensive portfolio is beyond what’s available to most people in their busy lives.

For me? I might tinker with individual stock buying, but I think I’d prefer to keep most of my money in index funds, simply because I, too, don’t feel like I have adequate time to really study enough stocks to build a good defensive stock portfolio.

Next Friday, we’ll look at Chapter 6: Portfolio Policy for the Enterprising Investor: Negative Approach.

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A lot of people like to argue that the rate of return you can expect from an investment is directly related to the amount of risk you take on. The more risk you have, the greater the potential return – but also the greater risk if you suddenly need to pull out your money.

I’ve always felt that this is a very limited view of things and that it ignores the effort and intelligence of the investor. An investor who can invest a lot of time studying the market and specific investments and can apply cool reasoning and behavior to his or her investments can get a better return than an investor who just wants to stick his or her money somewhere.

Take index funds, for example. Stock index funds are made up of all of the stocks that meet a certain criteria. If you buy into an index fund, it’ll essentially do as well as the average of all of those stocks. That actually also lowers your risk a fair amount because you’re not tied to the ups and downs of a specific company.

For an investor with limited time to research and understand specific investments – such as me – that’s a great way to invest. However, I know that if I had adequate time to actually study the market and played it cool, I could often (not always, but often) pick specific stocks that would beat this return.

Why don’t I do that? With the amount of money I have to invest (relatively small) and the time it would take to actually do the research and pick the investments (relatively large), it’s not a cost-effective use of my time. Give me index funds or give me death!

This is much the same logic that this chapter provides. Graham also buys into the idea that an intelligent and patient investor has a big advantage over the “gambler”-investor.

Chapter 4 – General Portfolio Policy: The Defensive Investor
Graham opens the chapter defining two different kinds of investors: the “active” investor, which is the kind of investor that actively seeks new investments and invests serious time into studying investments, and the “passive” or “defensive” investor, the kind of investor that wants to invest once (or on a highly regular basis) and just let his or her portfolio run on autopilot.

Regardless of the activity that you apply to your investments, Graham sticks hard with his recommendation from the earlier chapter: 50% stocks, 50% bonds (or a close approximation thereof, with an absolute maximum of 75% in either side). It’s important to remember with a recommendation like that that Graham is very conservative in his investing, dreading the idea of an actual loss in capital. Only in the most dire of down markets (like 2008, for example) would such a portfolio actually deliver a loss to the investor.

Much of this chapter is spent talking about the various types of bonds that a person can buy: savings bonds, treasury notes/bills, municipal bonds, and corporate bonds dominate most of the chapter, with most of their ins and outs described. Graham doesn’t really come to a conclusion about any of them, merely pointing out that there is a huge diversity of options when it comes to the bond portion of your portfolio – some short term, some long term, some free from taxes, some not.

Commentary on Chapter 4
So, how can you tell whether you should be 75% stock and 25% bonds or 50/50 or 25/75? Or somewhere in between? Zweig argues that it mostly comes down to your goals, the stability in your life, your other savings, and your tolerance for risk. The more stable things are and the longer term your goals are, the higher your proportion of stocks can (and probably should) be.

Zweig also covers several additional options for the bond portion that didn’t exist in Graham’s day, such as bond funds, mortgage securities (no, no, no, no, NO!), and annuities. More importantly, Zweig actually looked at holding cash as an investment option in such things as high-interest online savings accounts and CDs. All of these can be a big part of the conservative half of one’s portfolio, sharing space with (or replacing) bonds.

Most interestingly, though, Zweig suggested that buying stocks solely for the dividends might be considered something that could be a part of the conservative side of a portfolio. Zweig points out that many common stocks pay out 3% or more of their value in dividends each year, so if you select a high-dividend stock from a very stable company, it could potentially serve as part of the conservative side of a defensive investor’s portfolio. I don’t know if I agree with this, given the inherent riskiness of owning individual stocks, that companies reset their dividends annually, and that even the most stable of companies can fall apart quicker than you might expect.

Next Friday, we’ll look at Chapter 5: The Defensive Investor and Common Stocks.

The post The Intelligent Investor: General Portfolio Policy for the Defensive Investor appeared first on The Simple Dollar.

“Past performance is not a guarantee of future results.”

That phrase (or variations on it) is something you read over and over and over again if you read much about specific investments in the modern era. In fact, it’s printed so often that many people simply breeze on past it, not giving the phrase a second thought.

Yet virtually everything we can know about the stock market comes from past performance. Believing that the stock market will jump when the Federal Reserve cuts rates? It’s based on past performance. Believing that the stock market will fall on poor economic numbers? It’s based on past performance. Believing that a certain stock is undervalued compared to the rest of the market? It’s based on past performance.

That’s why it’s so valuable to look in detail at the history of the stock market. How has the market typically reacted to certain events? How have individual stocks reacted to certain events? How have things gone when the economy is thriving … and when the economy is slow?

This study is never a guarantee of what will happen, but it’s a pretty good guide. And that’s why Graham spends twenty pages or so delving into the past here.

Chapter 3 – A Century of Stock Market History
Graham spends this chapter drawing on a century’s worth of stock market history to come up with some general investment principles as to how to invest in the stock market in early 1972.

Now, at first glance, that might seem incredibly boring. “Why do I need to know how to invest in the 1972 stock market? Tell me what I need to know now.” If that’s your perspective and you’re merely seeking a specific investing recipe to follow, I suggest that you put this book down immediately and pick up a good book of investing recipes, like The Lazy Person’s Guide to Investing.

What’s actually worth studying here is the process. How does Graham come to the conclusions that he does about the stock market in 1972? He walks step by step through the logic, showing how the market in 1972 is very similar to earlier bull markets and patterns. He concluded that the bull run was likely somewhat near the top – he didn’t worry too much about actually guessing the specific top – and thus one should invest with that situation in mind.

Another thing worth noting is that Graham’s advice for the 1972 market really applies well to any stock market that’s riding a year-plus long bull market. His advice is basically don’t go into debt to invest right now and also don’t have more than half of your investment money in stocks – the rest should be in bonds, cash, real estate, etc.

Graham’s advice is conservative, but he doesn’t hide the fact that he doesn’t want investors to lose principal – that’s a constant theme throughout the book. Graham vastly prefers very conservative moves and patience, waiting carefully for a great investment opportunity instead of throwing the farm at any old piece of fool’s gold.

Commentary on Chapter 3
Zweig deftly takes Graham’s arguments about the 1971-1972 stock market and applies them to the stock market of 1999 and 2000. In both cases, that peak was followed by a drop and, if one had followed Graham’s general advice of how to invest conservatively at the peak of a stock market, you would have rolled right through it without much loss.

Zweig also makes the argument that, based on Graham’s calculations and the numbers in the stock market from 1993 to 2003, one could reasonably expect the 2003 to 2013 stock market to return roughly 6% – or 4% after inflation. Looking at the first half of that range, from January 2003 to October 2008, the stock market (by most metrics) is roughly back to where it started, with most of the gains coming in the form of dividends.

I couldn’t help but speculate, while reading this chapter and Zweig’s commentary, that this same exact “peak investing” philosophy applies very well to 2006 and 2007. I know that if I had gone very conservative in late 2007 with my investments – even if I just left what I had in stocks and merely started buying bonds instead – I’d be in a much better place financially right now. My retirement accounts wouldn’t be hurting nearly as much.

Next Friday, we’ll look at Chapter 4: General Portfolio Policy: The Defensive Investor.

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Inflation.

It’s a word I’ve never liked. It represents an erosion in everything we work hard for. It naturally devalues our investments, working against growth. It causes items on the grocery store shelves to inch up in price, completely out of our control.

When my father was a boy, he would go to the gas station and fill up tanks of gas for his boat motor. The cost? Sixteen cents a gallon. Right now, I can buy a gallon for about $2.70 – that’s a sixteenfold increase. Over those sixty years, the price of a gallon of gas doubled, doubled again, doubled again, and doubled yet again.

In other words, the value of a 1940s dollar is roughly sixteen times the value of a dollar today.

It’s inflation that makes putting dollar bills under your mattress a completely worthless investment. Even if you did nothing more with your money than put it in a savings account bearing 2% interest, you’d still be protected at least a little bit against inflation. A dollar put away in that 2% interest savings account for sixty years would be worth $3.28 – better, but still not that sixteenfold increase we’d need to keep up.

The other solution would be to just invest everything in the stock market, but if 2008 has shown us anything, the stock market is a huge roller coaster. You might be way ahead of inflation a few years, then lose most of those gains the next.

How can an investor simultaneously protect themselves against risk and at the same time keep up with (or ahead of) inflation? That’s Graham’s topic here.

Chapter 2 – The Investor and Inflation
The biggest point that Graham makes in the chapter is that there really is no true hedge against inflation. He mostly looks at stocks, pointing out that ups and downs in the stock market are largely uncorrelated with the onward march of inflation. He also looks at the history of other assets and finds much the same – gold isn’t a great long-term hedge against inflation, either.

Another point I found really interesting: Graham suggests that, for your own calculations, you assume 3% annual inflation. He made this prediction in 1972 based on historical data, so I was curious to see how it stacked up. Lo and behold, he’s not that far off. Except for a rough patch at the end of the 1970s, annual inflation rates indeed average out to right around 3% over the long haul. There are some patches that are lower, with percentages in the 2s and even the 1s, and some higher, but the average isn’t all that far off since 1972.

I think it’s fairly reasonable to use that 3% number – or 3.5%, if you want to be conservative and guess a strong inflationary rate. It’s what Graham called almost four decades ago and it’s been pretty accurate over the long haul since then.

What about investment choices? Graham’s conclusion is that diversification is key. You shouldn’t put all your money into stocks (because of the volatility risk), nor should you put everything into bonds or cash (because they usually don’t earn enough to beat inflation). Balancing these two is the right way to go. In Graham’s words:

Just because of the uncertainties of the future the investor cannot afford to put all of his funds into one basket – neither the bond basket [...] nor in the stock basket, despite the prospect of continuing inflation.

Commentary on Chapter 2
Zweig does a great job of pointing out why inflation is sneaky.

There’s another reason investors overlook the importance of inflation: what psychologists call the “money illusion.” If you receive a 2% raise in a year when inflation runs at 4%, you will almost certainly feel better that you will if you take a 2% pay cut during a year when inflation is zero. Yet both changes in your salary leave you in a virtually identical position – 2% worse off after inflation.

A great return is nice, but it’s not all that great if it happens during a period of high inflation. Zweig immediately points to the late 1970s and early 1980s, where you could get a CD at 11% and it still wouldn’t even keep up with inflation.

As I write this, inflation is at roughly 5 to 6%, depending on the figure you use. The CPI (a common measure of inflation) actually fell from August to September 2008, so that rate of inflation may actually be going down. In comparison, as Zweig points out, we were barely at 2% inflation from 1997 to 2002.

The point? Inflation is not constant. And it’s not something you can predict, either. Instead, it’s a constant reminder that your dollar today will be worth less than a dollar tomorrow, slowly but surely. That’s a big reason why investing is worthwhile – investing helps your dollars keep pace with that growth, usually ahead of it, sometimes behind it, but always moving against that force.

One avenue that Zweig explores as a hedge against inflation are TIPS – treasury inflation-protected securities. These increase in value directly with inflation – if inflation is high, these return well. However, Zweig encourages you only to buy them in retirement accounts where you won’t be whacked with a tax penalty, because the taxation on TIPS can keep you on your toes otherwise.

Next Friday, we’ll look at Chapter 3: A Century of Stock-Market History: The Level of Stock Prices in Early 1972.

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I have a friend who keeps cajoling me that I should become a day trader. “Come on!” he says. “You could write the stuff for The Simple Dollar while daytrading! It’s easy as pie!”

So one day I asked him to explain to me what he was doing. He offered up a bunch of explanations that basically amounted to technical analysis using a bunch of online tools.

Then I asked the $64,000 question: “Do you actually know anything about the companies whose stocks you’re buying and selling?” He responds, “Not too much, but I don’t need to.”

My friend is a speculator. That’s fine – it works for him. But it only works because he devotes his life to figuring out small inefficiencies in the market. He’s really passionate about finding them.

For most of us, though, we don’t have the time, patience, or interest to engage in that minutiae. We are investors.

Chapter 1 – Investment Versus Speculation: Results to Be Expected by the Intelligent Investor
Graham gets down to business. In only the second paragraph of the chapter, he specifies the difference between investors and speculators:

An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

In Graham’s view, an investment is something that you’ve analyzed carefully. You know exactly what you’re buying. You know it’s stable for the long haul. You also know that it will give you an adequate return, either through an increase in share value or through healthy dividends for the price you pay.

The ones that scream “BUY! BUY! BUY! WE’RE ALL GETTING RICH!” when the stock market is high and then scream “SELL! SELL! WE’RE ALL GOING BANKRUPT!” when the market is low are speculators. The people that look for undervalued companies no matter what the market is doing, buy them, then only sell them if they actually need the money or if they’re not undervalued any more, those people are investors.

Graham argues that one of the biggest dangers for investors is that they’re speculating when they believe they’re investing. They buy a stock, for instance, based on a hot tip that, if true, might make it a good investment. Or they purchase a mutual fund based on a television ad or magazine ad, without really doing the due diligence to see whether it’s a quality investment based on sound principles that ensures quite a bit of safety in the investment and some sort of decent return.

Furthermore, Graham states that the only way you can be an investor (and not a speculator) that beats the market is by having an investment philosophy that’s based on sound logic that’s not popular on Wall Street at the moment.

I immediately thought of Jim Cramer’s comment on Graham during the peak of the 2000 stock market bubble, which Zweig mentioned in his commentary in the introduction:

In February 2000, hedge-fund manager James J. Cramer proclaimed that Internet-related companies “are the only ones worth owning right now.” These “winners of the new world,” as he called them, “are the only ones that are going higher consistently in good days and bad.” Cramer even took a potshot at Graham: “You have to throw out all of the matrices and formulas and texts that existed before the Web … If we used any of what Graham and Dodd teach us, we wouldn’t have a dime under management.”

[...]

By year-end 2002, [...] a $10,000 investment spread equally across Cramer’s picks would have lost 94%, leaving you with a grand total of $597.44.

Interestingly, most of the internet stocks during the dot com bubble wouldn’t have passed the Graham test. Not even close. Score one for the unpopular method.

So, what can we learn here? Don’t invest without knowing what you’re buying. Study it very carefully before you buy. If you want to speculate, that’s fine, but don’t speculate with any money you’ll actually need for the future.

Commentary on Chapter 1
Zweig does a good job of boiling down Graham’s view on what investment is, summarizing it in three points:

* you must thoroughly analyze a company, and the soundness of the underlying businesses, before you buy its stock;
* you must deliberately protect yourself against serious losses;
* you must aspire to “adequate,” not extraordinary, performance.

If you want an absurd return that’s going to blow away the market over the short term, value investing probably isn’t for you. Having said that, though, Graham’s principles are intended to avoid huge losses as well. That’s because the entire idea is to seek out undervalued companies – ones that, for some reason, the market has overlooked. Maybe they’re boring. Maybe they have an undeserved bad reputation.

Zweig makes that point again a bit later:

If they beat the market over any period, no matter how dangerous or dumb their tactics, people boasted that they were “right.” But the intelligent investor has no interest in being temporarily right.

In short, investing fads are a joke. Just a few weeks ago, I scathed the book Millionaire by Thirty because it was just that – an investing fad with short term success that the author tried to parlay into this great investing strategy that was timeless. It wasn’t. Zweig points out at least a dozen more similar investing fads or shortcut formulas, all of which worked over the short term, and none of which work over the long term.

What does work, then? Knowing in detail what you’re investing in. Is it a good, stable, safe company? Is it undervalued? Does it pay solid dividends? Those are where the real values are at. They’re not glamorous, but if you can find them, you’ll always do well, no matter how the market changes.

Next Friday, we’ll look at Chapter 2: The Investor and Inflation.

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