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.