This is the thirteenth in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the twelfth chapter, which is on pages 310 to 321, and the Jason Zweig commentary, on pages 322 to 329.

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.

This is the twelfth in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the eleventh chapter, which is on pages 280 to 301, and the Jason Zweig commentary, on pages 302 to 309.

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.

This is the eleventh in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the tenth chapter, which is on pages 257 to 271, and the Jason Zweig commentary, on pages 272 to 279.

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.

This is the tenth in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the ninth chapter, which is on pages 226 to 241, and the Jason Zweig commentary, on pages 242 to 256.

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.

This is the ninth in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the eighth chapter, which is on pages 188 to 212, and the Jason Zweig commentary, on pages 213 to 225.

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.

This is the eighth in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the seventh chapter, which is on pages 155 to 178, and the Jason Zweig commentary, on pages 179 to 187.

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.

This is the seventh in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the sixth chapter, which is on pages 133 to 144, and the Jason Zweig commentary, on pages 145 to 154.

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.

This is the sixth in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the fifth chapter, which is on pages 112 to 123, and the Jason Zweig commentary, on pages 124 to 132.

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.