Ever since its publication in 1949, The Intelligent Investor has been considered the value investor’s bible. At the time of publication, not only were readers blessed with a thick book written by the best financial mind of its time; they were blessed with the fact that Graham wrote directly to the layman.
Buffett has said you either get the idea of value investing in the first five minutes, or you don’t get it at all. That statement is likely true only if you have a mental tree to hang Graham’s ideas on—an understanding of how the market works and have dabbled in it yourself. If your slate is blank, reading the book more than once is your road to enlightenment.
I won’t bother diving into the technical details of how Graham analyzed securities or what metrics he advised the “defensive” and “enterprising” investor to focus on. There are many brief recommendations sprinkled throughout the book in terms of D/Es, P/Es, and P/TBVs. Other summaries cover these things. You should read the whole book to pick this stuff up anyway.
The idea of the book is the distinction of what makes an investment intelligent or unintelligent: The price you pay for something is the sole determinant of how risky it is and the return you can expect to make on the investment. This is a truism, yet easily forgotten amid market volatility and waning emotional discipline. To give you an intellectual framework, aiming to combat creeping emotions when attempting to invest rationally, Graham introduces three overarching concepts in chapter 1, 8, and 20 that are never to be forgotten.
A stock represents part ownership of a business
A stock isn’t just a piece of paper to be traded, a number bobbing up and down, or a blip on a computer screen. It represents ownership in a business with underlying value independent of its share price. Any business can be an attractive investment at a certain price.
For 99 issues out of 100, we could say that at some price they are cheap enough to buy and at some other price they would be so dear that they should be sold. The habit of relating what is paid to what is being offered is an invaluable trait in investment.
Viewing a stock as a part-ownership of a business is as much a psychological concept as it is theory. And it’s often only when you buy it that this feeling comes to life. This is because of the endowment effect. But the key to successfully analyzing investments is to get into this mindset before entering.
Graham uses the word “investor” as a direct contrast to “speculator”. However, whether people see themselves as investors or speculators often depends on how the market is pricing stocks—either attractively or unattractively. Ironically, yet predictably, most investors mix up the two.
…common-stock purchases of all kinds were quite generally regarded as highly speculative or risky at a time when they were selling on a most attractive basis, and due soon to begin their greatest advance in history; conversely the very fact they had advanced to what were undoubtedly dangerous levels as judged by past experience later transformed them into “investments”, and the entire stock-buying public into “investors”.
Speculation is neither illegal, immoral, nor necessarily detrimental to the speculator’s wallet. There’s even such a thing as intelligent speculation. But danger arrives when you speculate, thinking you’re investing. Graham recognized that there’s no such thing as a simon-pure investment policy in which an investor can buy an investment at a price that incurs no risk of a paper loss. A speculative factor is inherent in how stock markets work. However, it’s the investor’s task to keep this component within limits. The way to do that is to only dabble with a certain gentleman when he gives you an offer you can’t refuse.
Mr. Market
The idea of Mr. Market is that he’s a manic-depressive partner in a private company who comes to you regularly and offers to buy your stock or sell his stock every day, depending on his mood. Mr. Market is not too intelligent, nor is he malicious. He doesn’t care if you’re interested, but he will come enthusiastically every day to cry his wares. There’ll be times when he’s optimistic about the future and so his prices will be high. There will be times when he’s pessimistic and so his prices will be low. For the most part, you can just ignore him. But when he gets extremely worked up, either excited or depressed, you can use him to buy and sell around the intrinsic value of the investment in question.
This is easier said than done. Everyone understands Mr. Market but fewer practice it as Graham intended.
Think of it this way: Shortly after you get your head handed to you in the market for the first time, you’ll realize there are real people on the other side of every transaction. And because the majority of the market is institutional, these people are well-educated and have more money, experience, and power than you. When transacting with these people, you’ll often look wrong. You’ll feel like the sucker at the poker table and you’ll start to doubt everything you once believed.
Once experienced firsthand, many investors unconsciously start to invest based on what they think Mr. Market will do. But you can’t predict what Mr. Market will do or when he’ll do it. And when you buy a value stock, there’s no guarantee he will ever come around and get excited about it.
Protecting capital is therefore the most important thing when dealing with Mr. Market, rather than trying to profit from him. Which leads to:
Margin of safety
Value is a fluid thing. Your perception of it changes over time and depends on the sensibility of your future assumptions.
All investments have just one intrinsic value. But no matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on the margin of safety can you minimize your odds of error.
The margin of safety is the difference between price and your estimate of value. The larger the margin, the larger the safety. Graham emphasizes that the hallmark of a sound philosophy isn’t profit maximization but loss minimization.
This isn’t any different from when a credit rating agency rates a bond and demands a certain interest coverage to justify the bond as investment grade. The bond investor doesn’t expect future average earnings to work out the same as in the past. If he did, the margin demanded would be small. The margin of safety renders the bond investor’s accurate estimate of the future unnecessary.
As applied to stock investing, the key to understanding the margin of safety is being unreasonable. You shouldn’t buy a company worth $100mn for $95mn. Buffett’s analogy for the margin of safety is that you wouldn’t drive a 9,800-pound truck over a bridge with a 10,000-pound capacity.
The margin of safety is there to make outcomes tolerable when the future fails to live up to your expectations. It’s the secret to sound investing.
The 4th pillar: circle of competence
The concept of the circle of competence wasn’t Graham’s idea. But it deserves a spot here since it completes the pillars that underlie a sound intellectual framework for value investing.
Buffett uses the circle of competence to describe limiting your investments in areas you know best. The size of the circle is unimportant but knowing the boundaries is vital.
An investment operation is one which, on thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
You use fundamental analysis to forecast a company’s future economics. To do that, you got to understand the business, what makes it tick, how it converts earnings to cash, and its competition and place in the industry. To answer such questions, that business would have to be within your circle of competence. And you would have to look at it with an owner’s mindset.
Now the question: How can you prove that you understand something?
The answer lies in intellectual honesty. Developing and expanding your circle of competence is a question of compounding knowledge, intertwining your studies with your passions and experiences to develop firm grasps of pockets of businesses.
Slow and steady wins the race. Compounding is akin to running a marathon. Since you must understand everything you invest in, expect results to take a while.
None of the four pillars for intelligent investing are hard to understand. They’re not even slightly complicated. But even so, Mr. Market is an interesting fellow who can sometimes shuffle your ability to apply Graham’s teachings as intended.
Character and temperament are solutions. To get it, you must have innate traits that keep emotions from corroding the intellectual framework.
You must be independent and judge yourself not by the opinion of others but by your own.
You must remain objective and rational. Those who seek rationality as a moral goal are well suited to value investing.
You must be patient. Business is a long-term game. Why would stock investing be any different when what you invest in are businesses?
You must be decisive. When Mr. Market gives you an opportunity, act fiercely. Because he’s unpredictable, you never know when he will give you another one.
You must be intensely curious. A natural passion for business pushes you to the bottom of the most important questions to ask.
“The fault, dear investor, is not in our stars—and not in our stocks—but in ourselves.”—Ben Graham
In the end, how your investments behave is less important than how you behave.
