The Intelligent Investor: A General Approach to Security Analysis for the Lay Investor

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intelligentThis 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.

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6 thoughts on “The Intelligent Investor: A General Approach to Security Analysis for the Lay Investor

  1. Revenue figures that jump around are scary, but earnings are often volatile due to capex, tax charges, mark to market, etc. Depending on the industry that’s not a problem.

  2. Trent,

    A really good book.

    Your right many people/investors want to quickly know HOW to pick stocks or for someone to give them the picks.

    One of the hardest things in investing is sitting on the sidelines waiting and being patient, most people want action and this can get them in trouble.

  3. @Michael I would like to note that ‘earnings’ in the form it has been referenced here refers to net income, in that case cap ex is not included in the calculation; and mark to market mainly effects financial firms. Tax charges? Well those are real costs aren’t they? An huge swings in tax charges year to year over 10 years is suspect.

    @Trent, I agree that Graham liked to earn dividends on his investments. However to say he looked at dividend income and not price appreciation as the main way to profit from his investments is inaccurate. The largest thing Graham paid attention to when buying was ‘Margin of Safety’ (Ch. 20) whether it was bonds, preferred or common stock. For the most obvious reasons of protecting his initial capital, but also to hopefully see the business rise back close to its intrinsic value i.e. capital appreciation. Graham figured if he bought enough issues with a healthy MOS, held over long periods of time, even with some failures, the entire portfolio earn quite a nice return.

    Finally EDGAR is extremely powerful but yet quite cumbersome for the layman. The SEC is currently in the process of transitioning to a more user friendly electronic database. Currently only a few companies have opted in to submit these new electronic reports. Once it become mandatory, it will be sweeet.

    Happy Holidays!

    Ethan

  4. While net income is the most commonly used figure for profitability of a company, Ethan is right in saying it doesn’t include capital expenditures. The only easily found number that does do that is free cash flow, which is equal to operating income (income after subtracting all operating expenses) and deducting capital expenditures. Free cash flow is a much better measure of the company’s ability to grow, pay dividends, or buy back shares consistently.

    I’m not sure if Graham got there yet, but he advocates taking the average earnings over a long period of time (up to 10 years) to even out the fluctuations that companies sometimes show in their earnings.

    I read this book because I’d heard good things about it, and because Buffett often calls it the best book on investing. I found a good amount of it boring at the beginning, since I too wanted to fast forward to Graham’s specific methodology for picking stocks.

    However, I later appreciated Graham’s constant urging of buying stocks below intrinsic value and understanding the psychology of bull/bear markets. Much of what he wrote on how the public acts in such markets is so accurate that it sounds like it could’ve been written today. The Intelligent Investor was the book that helped me become numb to market fluctuations and the ensuing coverage by the media.

    Trent, have you started picking individual stocks yet? You mentioned in a post a few weeks ago that your wife was urging you to do so. I’m sure you could outperform the market, as long as you consistently followed a value-oriented strategy. One thing I’ve found is that many of the legends identify that the only way to consistently beat the market is to always pay less than a company is worth. In my own experience, the margin of safety concept is priceless. I don’t follow Graham’s investing style, but I have definitely incorporated the margin of safety concept.

  5. Graham seemed to prefer bonds to stocks because the rate of return was so high. Even the dividend payout from stocks was much greater than it is today.

  6. I agree that management buying shares of the company is a good thing, but remember that when they’re selling, it doesn’t necessarily follow that “something’s amiss”; there are MANY reasons that an insider is selling stock (e.g. paying for a child’s college education, buying a boat or a house), but there’s only one reason why management buys, and that is that they believe in the company.

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