Wow, it has been quite a week for us observers of stock markets! The recent volatility in the markets has recently moved to the largest stocks in the market.
First, we had Facebook (now called Meta) dropping 26% on Thursday, erasing $250B of market value for the largest single-day drop of market cap ever by a company. Then the very next day, we had Amazon (still called Amazon) rise 13.5% and add $190B in market value for the most significant gain by a company in a single day.
I have been kicking it into high gear during the recent stock volatility by spending most of my free time learning about companies. This extra time researching coupled with an increased workload at my job and suddenly months have passed since my last post. This recent period has really shown me that I’m an employee first, an investor second, and a blogger third.
Doing deep stock research is the most important thing for those picking individual stocks. You can’t consistently be a market-beating investor without getting the reps in, just like how you can’t be a body builder without working out.
Nevertheless, understanding investing philosophy is essential for focusing on what truly matters while doing the work. What better way to do that than by recounting the lessons from The Intelligent Investor, an investing classic?
The Intelligent Investor Categorizes the Investing Landscape
There are several ways The Intelligent Investor categorizes market behavior and market participants. These categorizations are incredibly helpful because the standard term “investing” can seem confusing.
For example, if someone is willing to put all their net worth on some not well thought out call option, like what was happening on Reddit during the GameStop mania, news outlets would call those folks investors. Ben Graham wouldn’t, though, so let’s get into his categorizations.
Investment vs Speculation
- Investment: a purchase which, upon thorough analysis, provides safety of principal and a satisfactory return
- Speculation: a purchase which doesn’t fulfil the requirements of an investment
What does this mean in simpler terms? Well, if you are considering your alternatives by conducting research, determining factors that allow you not to lose the money you put in, and calculating the expected returns, congratulations, you’re investing.
Alternatively, if you aren’t putting in the time to study where you put your money, you’re speculating. If you are entering into a transaction with a good likelihood of losing all the money you put in, you’re speculating. Lastly, if you haven’t determined reasonable expected returns and instead are thinking, “it will go up because it has to,” you’re speculating. Let’s look at some more definitions.
Defensive Investors vs Enterprising Investors
- Defensive investor: an investor focused on consistently applying simple & proven investment principles to avoid serious mistakes
- Enterprising investor: an investor willing to devote substantial time to selection of attractive investments
In the 1949 edition of this book, Ben defined these two types of investors and good practices for each of them.
For the defensive investor, he recommended purchases of US Savings Bonds, purchasing a widely diversified set of leading companies, and shares of leading mutual funds.
Current day, as the forward by John Bogle stated, he’d most likely be a big proponent of defensive investors investing in index funds, like an S&P 500 index fund. As far as bonds (you know where I stand on treasuries), I’d imagine he would advocate for the purchase of inflation-protected I-bonds in today’s market. Because of current inflation rates, these bonds pay about 7% and are set to match inflation rates to maintain purchasing power.
For the enterprising investor, he has a more extensive range of recommendations – as they are more willing to put in the work to navigate the alternatives. The proposals include investments a defensive investor would purchase, cautiously identified fast-growing companies, and undervalued common stocks/bonds/preferred stocks.
I imagine these recommendations would remain unchanged in today’s environment, though the nature of how to identify today’s opportunities would.
The Intelligent Investor Describes Timeless Philosophies for Investing
There are three fundamental philosophies for intelligent investing that Ben detailed in 1949 that have stood the test of time. Even if you haven’t read this book yet, it’s likely you’ve heard these concepts or have been influenced by them indirectly. So let’s dive into it.
Mr. Market is to be Taken Advantage of
Sometimes the best way to learn a lesson is to develop powerful analogies. In the Intelligent Investor, Ben Graham described a constructive way to think about the market overall. Honestly, I can’t think of a better way to describe this other than by just typing out exactly what he said – so that’s what I’ll do.
“Imagine that in some private business you own a small share which cost you $1000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis.
Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
If you are a prudent investor or a sensible businessman will you let Mr. Market’s daily communication determine your view as the value of your $1000 interest in the enterprise? …
Basically 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 dividend returns and to the operating results of his companies.”
The Intelligent Investor
Warren Buffet (a student of Ben Graham) also has some great quotes about Mr. Market, which I’ll share due to his ability to describe this better (and with more grandfatherly flavor) than I can.
“Mr. Market is kind of a drunken psycho. Some days he get’s very enthused, some days he gets very depressed. And when he gets really enthused you sell to him, and if he gets depressed, you buy from him.”
Warren Buffett
Investing with a Margin of Safety
The 1949 version ends the book with a chapter that summed up his investing policy. If it had to come down to three words, it would be having a margin of safety. Having a reasonable margin of safety protects investors from the surprises that inevitably come up in investing.
He gives an example of owning a railroad bond, where a railroad had to have earned 2X more than its interest expenses to qualify as being investment-grade (a safe investment). This is because if the earnings of the railroad company suddenly get halved, they will still be able to meet their debt obligations.
For stocks, his first example in the chapter on the margin of safety is a company that can safely issue bonds for the value of its total outstanding stock.
Let’s think about Meta (Facebook) stock for a modern-day example. Meta’s market cap now is about $660 billion; can they safely issue that amount of bonds based on their earnings? Yes and here’s why. At an interest rate of say 5%, $660 billion of bonds would have interest expenses of $33B a year.
Meanwhile, Meta had a free cash flow of $39B last year. By Graham’s definition, this would be a slim margin of safety, as there isn’t much in the way of present earnings power above the amount that could be expensed in bond interest.
Ben Graham was also a big proponent of using diversification to have a margin of safety in a portfolio of stocks. Having a diverse portfolio is a way to decrease the reliance on single investments and serves to protect against negative surprises that come with them.
There are other ways to have a margin of safety that are not discussed in this book; though that’s the power of solid philosophy, it can adapt with the times.
Other ways to have margins of safety in stock picking include: buying businesses with sound economics, buying companies with great capital allocators as managers, buying companies protected from competition, buying businesses with innovative cultures, buying companies with products that have strong psychological positioning in the minds of customers, etc.
The Intelligent Investor Contains Great Historical Stock Analysis Examples
What do companies like Bethlehem Steel, Woolworth, Allied Chemical, Goodyear, New York Central Railroad, American Smelting, Swift & Company, National Department Stores, Stewart Warner, and White Dental Manufacturing have in common?
They are all referenced in The Intelligent Investor and have significantly declined in importance/relative standing in the US economy. Some have merged with other companies, some have taken on new names (ahem, Woolworth or should I say Foot Locker), and some have wholly stopped existing.
Reading this book and learning about the leading stocks of the day is a great lesson in the transitory nature of business in capitalism.
Inadvertently, Ben Graham teaches about the margin of safety just by the actual company names he brings up in the book. Having a margin of safety, while getting the protection of principal and an adequate return is crucial if you want to build wealth through stocks in a capitalist society.
This book has a lot of examples of how to analyze stocks, bonds, and the like. So here, I’ll share one brief example of what that looks like.
One of the most interesting parts I found about the book when I first read it years ago was the focus on company balance sheet analysis. The book has an excellent example of this type of analysis when Ben Graham works out the net asset value for American Hawaiian Steamship Company and compares it to the market cap.
In the example, he finds the company had reported liquid assets (current assets – current liabilities) of $22M, actual liquid assets of $29M, and total net assets of $31M. Yet, the company was trading in the public market for $16M. Mr. Market was definitely up to his old tricks with that one in 1949.
The Intelligent Investor and the Cypher Investor
Cracking open my old copy of this book and giving myself a breather from the stock analysis was fun. I really do think this is a book that every enterprising investor should read, so I’ll link to it one more time.
If you’re a defensive investor, then reading this blog may suffice. After all, I imagine you want reasonably good results without all the work and headaches. I hope you took away valuable lessons from this.
Disclaimer: I am an Amazon affiliate and thus may receive compensation if you buy items through my provided links. I take this responsibility seriously and will never review books I didn’t read (and often re-read), enjoy, and find incredibly valuable.