This is the second 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 first chapter, which is on pages 18 to 34, and the Jason Zweig commentary, on pages 35 to 46.
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.