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.