Posted by: Susan Vollmer | 11 April 2008

The Intelligent Investor

This book, written by Benjamin Graham, originally appeared in 1949, and Graham during his lifetime was known as one of the major teachers for Warren Buffett, regarding value investing.  The book, reissued in 2003, had commentary added after each chapter by Jason Zwieg.

 

The commentary providing modern-day examples is much appreciated.  While Graham’s concepts are excellent, the examples can sometimes be hard to follow.  In a future edition, the publisher might consider updating the charts beyond 1970 or leaving those out, which cannot be updated.

 

The concepts in the book are much appreciated, and here is a synopsis of the points I found most helpful.

 

Zwieg wrote, “Only by insisting on what Graham called the ‘margin of safety’ – never overpaying, no matter how exciting an investment seems to be – can you minimize your odds of error.”

 

The term intelligent investor does “not” refer to IQ or the SAT scores for entrance to college.  “The intelligent investor dreads a bull market, since it makes stocks more costly to buy. … You should welcome a bear market, since it puts stocks back on sale.”

 

Three practices recommended for investing include:

 

  1. Purchase investment funds which are well established.
  2. Utilize a common-trust fund.
  3. Use dollar-cost averaging to invest in the same stocks per month or per quarter.

 

Graham did not consider real estate as a protection against inflation.  “Unfortunately, real-estate values are also subject to wide fluctuations, serious errors can be made in location, price paid, etc.”

 

In the commentary section, Zweig recommends using Treasury Inflation-Protected Securities (TIPS).  When the value of a TIPS bond increases, the IRS considers it taxable income, even if only on paper.  This is best used in a tax-deferred environment, if possible.  TIPS can be purchased direct from the U.S. government at:

 

http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm

 

Or, if preferred, you can use a low-cost mutual fund for the proportion of your retirement funds that you would keep in cash.

 

The performance of stocks in the market depends on these factors:

 

  • Growth of earnings and dividends
  • Inflationary growth in the economy
  • Speculative increase or decrease by the public in stocks

 

“Because so few investors have the guts to cling to stocks in a falling market, Graham insists that everyone should keep a minimum of 25% in bonds.”  That gives you the courage to stay in the market even when it’s performing poorly.

 

What are some of the guidelines offered, when selecting stocks?

 

  • Adequate but not excessive diversification.
  • Companies selected should be large
  • Companies need a long record of continuous dividend payments.
  • Set a limit on the price you will pay for a stock.  (For example, “Twenty-five times such average earnings and not more than 20 times those of the last 12-month period.”)

 

In regard to selection, Graham looked at large companies that were relatively unpopular and could be purchased at a good price.  He wrote, “Earnings multiplier is a synonym for P/E or price/earnings ratios, which measure how much investors are willing to pay for a stock compared to the profitability of the underlying business.”

 

The guidelines on the price/earnings ratios given included:

 

Below 10 = low P/E

10 to 20 = moderate P/E

> 20 = expensive P/E

 

To be considered a large company, the recommend stock value (market capitalization) for 2003 needs to be at least $10 billion.  A resource for checking this is:

 

http://screen.yahoo.com/stocks.html

 

To be prominent, a company should be in the top three or top four spots in its industry group.  Graham wrote that, “The key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity.”  Larger companies have the advantages of resources in capital and brainpower to carry them through.

 

In Zweig’s commentary, he stated that, “Growth stocks are worth buying when their prices are reasonable, but when their price / earnings ratio go much above 25 or 30, the odds get ugly.”

 

To arrive at a book value per share, look at the balance sheet in a company’s annual report.  Take the shareholder’s equity and subtract from that the following. 

 

Shareholder’s equity minus

         Goodwill

         Trademarks

         Other intangibles

 

(Then divide the fully diluted number of outstanding shares to determine the book value per share.)

 

To help maintain perspective as an investor, Graham suggests the following.  “Price fluctuations have only one significant meaning for the true investor.  They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.  At other times, he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”

 

Would you describe yourself as an investor or a speculator in stocks?  To help you decide, Graham offers these definitions.

 

“The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements.  The speculator’s primary interest lies in anticipating and profiting from market fluctuations.  The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices.”

 

Even if you can’t control the market, there are some factors within your control.  You can decide what is acceptable for:

 

  • Brokerage costs
  • Ownership costs
  • Expectation of returns
  • Risk tolerance
  • Tax obligation (such as holding for a year before selling)
  • Your own behavior

 

Graham identified the following factors as affecting the capitalization rate:

 

  • General long-term prospects – can reflect the view of the price / earnings ratio.
  • Management – this may be useful where new management has taken over
  • Financial strength – company with a lot of surplus cash is preferred.
  • Dividend record – has the company paid dividends regularly?  (If 20 years or more of continuous payment, that is a plus.)
  • Current dividend rate

 

In regard to the long-term prospects, obtain and read at least five years worth of annual reports from the company or from (http://www.sec.gov).  See if you can answer these questions:

 

  1. “What makes this company grow?”
  2. “Where do (and where will) its profits come from?”

 

Possible signs of problems to watch for include a company with more than two acquisitions in a year might be in trouble.  Another possible problem are companies who take write-off / or accounting charges from past acquisitions.  In a company’s 10-K, you can check the “Management’s Discussion and Analysis” for any information on acquisitions. 

 

Be suspicious of anyone who seems addicted to “Other People’s Money.”  This can be labeled as “cash from financing activities” in an annual report.  When examining the “Statement of Cash Flows” in the financial statement, be suspicious of companies where the cash from “operating activities” is consistently negative.

 

Read the forecast from management in the annual report.  Check to see if previous forecasts in earlier annual reports were met.  If not, it’s better if the management accepts responsibility rather than blaming “the economy, uncertainty or weak demand.”

 

On the Form 4, available through the Edgar database, this shows up if a firm’s executives are buying or selling shares.  Be watchful if they are selling a lot of their own stock in the company.

 

Check to see if “Nonrecurring” charges keep happening often in a company.  Look for acronyms like EBITDA, which may cloak losses.

 

In the commentary, it was suggested to also watch for positive signs, which a company may demonstrate, including:

 

  • Competitive advantage
  • Economies of scale
  • Customers who resist substitution (such as electricity)
  • Revenues and net earning have increased over the past 10 years on the income statement.  (However, huge increases already achieved may not realistically continue.)
  • Research and development – companies need to invest but not so much that they are at risk

 

In the commentary, it discusses the concept of owner earnings, which has been made popular by Warren Buffett.  This includes the following:

 

            Owner earnings calculation:

 

            Net income + amortization + depreciation

 

                        Subtract from that

         Capital expenditures

         Costs of granting stock options

         Nonrecurring / extraordinary charges

         Income from the company’s pension fund

 

There are also items to consider about the true earnings of a company, according to Graham.  In the price per share, it’s better if the company has already deducted any special charges from ordinary earnings.

 

In regard to calculating the growth rate, compare the average of the last three years with the same figures from 10 years before.  For example:

 

                                                                                    Stock

 

            Average earnings (2005-2007)                Price

            Average earnings (1995-1997)                Price

            Growth                                                          ____ %

            Annual rate                                                     ____ % (compounded)

 

(In the commentary, Zweig advises to ignore any pro forma earnings that a company might show as not being valid.)

 

Here are some tips for reading an annual report:

 

  • Start at the back page work your way forward.  (Bad news will be buried.)
  • Read all of the footnotes to the financial statements.  Compare the footnotes to a competitor in the same industry.

 

When comparing companies, Graham offers these suggestions to look for:

 

  • Profitability – check the “net per share / book value.”
  • Stability – compare the average earnings of the past three years with the preceding 10 years.  (No decline means the stock is stable.)
  • Growth
  • Financial position – does the company keep long-term debt low?  (For example $2 of current assets for each $1 of current liabilities?)
  • Dividends – has the company paid one without interruption?
  • Price history – divide the high price of a stock by the low price to create a ratio of:  (Example of 66 high divided by 1/8 low = 528 or a ratio of 528 to 1.)

 

 

Graham offered the following criteria to be used by the defensive investor in the selection of stocks:

 

  1. Adequate size of the enterprise – exclude small companies.  At one time, this was defined as not less than $100 million is sales.  It has been updated to $2 billion in sales.
  2. Strong financially  — long term debt cannot exceed working capital.
  3. Earnings stability  — past 10 years earnings for the stock.
  4. Dividend record – payments for the 20 consecutive years.
  5. Earnings growth – increase of at least 1/3 in per-share earnings over past 10 years.
  6. Moderate price / earnings ratio – the price of the stock is not “more than 15 times average earnings of the past three years.” 
  7. Moderate ratio of price to assets – Multiply the price / earnings ratio by the price-to-book ratio to see if below 22.5.  “Current price should not be more than 1 ½ times the book value last reported.”

 

A simple way to invest is to buy every stock in the Dow Jones Industrial average; there are 30.  Or, use a low-cost index fund.

 

You can check to see who the big owners of a stock company are, such as Berkshire Hathaway.

 

To help identify stock which you might want to analyze and consider for purchase, check the Wall Street Journal for the “52-Week Lows” or the “Market Week” section of Barrons.

 

Before purchasing and after buying stock, Zweig encourages reading the proxy statement for the company.  Use common sense when reading it, to see if it seems logical.

 

Graham wrote, “We suggest that the margin-of-safety concept may be used to advantage as the touchstone to distinguish an investment operation from a speculative one.”

 

The legacy of Graham’s writing continues today beyond his lifetime.  His teaching have helped many become true investors rather than speculators, and his most well-known pupil remains Warren Buffet, the founder of the investment company, Berkshire Hathaway.

 

 

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Responses

  1. My book is “The Four Filters Invention of Warren Buffett and Charlie Munger. Two Friends Transformed Behavioral Finance.”
    ISBN 978-0-6152-4129-6
    http://www.lulu.com/content/3215722

    “The Four Filters Invention of Warren Buffett and Charlie Munger” examines each of the basic steps they perform in “framing and making” an investment decision. This book is a focused look into this amazing invention within “Behavioral Finance.” The genius of Buffett and Munger’s parsimonious four filters process was to “capture all the important stakeholders” in a “multi-variable” equation or formula. Imagine…Products, Enduring Customers, Managers, and Margin-of-Safety… all in one mixed “qual + quant” formula. Other important ideas are embedded in each chapter. The book can be used as a supplemental textbook in a Valuation or Decision Sciences course.


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