A Book Review: By George M. Hiller, JD, LLM, MBA, CFP®
What is the best book on investing ever written? According to Warren Buffett, recently ranked #2 on the Forbes 400 list of the wealthiest people in America, that accolade goes to a book entitled,The Intelligent Investor, by Benjamin Graham. Benjamin Graham (1894-1976) was a professor of finance at Columbia University School of Business in New York. He was also the co-author of the landmark textbook, Security Analysis, by Benjamin Graham and David L. Dodd, first published in 1934.
The first edition of The Intelligent Investor was published in 1949. Warren Buffett read it in 1950 when he was nineteen years old. Buffett later went to Coumbia School of Business so that he could be personally taught by Benjamin Graham. After graduation, Buffett offered to work for free at Graham’s investment firm, Graham-Newman Corp., but Graham turned Buffett down. However, Buffett continued to seek employment at the firm and was eventually hired. Buffett later went on to found his own investment partnerships and what is now known as Berkshire Hathaway. It is fair to say that the country’s greatest investor was mentored by Benjamin Graham and heavily influenced by Graham’s teachings.
A revised edition of The Intelligent Investor is the First Collins Business Essentials edition published in 2006. It is updated with new and helpful commentary by Jason Zweig. Jason Zweig is a personal finance columnist for “The Wall Street Journal” and was formerly a senior writer for “Money” magazine. Before that Zweig was a mutual fund editor for “Forbes.” This edition also contains a preface and appendix written by Warren Buffet.
The Intelligent Investor has been described as the definitive book on value investing. Value investing is an approach that focuses on the price that is paid for a security relative to its estimated intrinsic value as opposed to its market value. The market value of a security changes from day-to-day and may be influenced by temporary or psychological and emotional factors that at times translate into prices that are either too high or too low relative to its intrinsic value.
Graham refers to the stock market as Mr. Market. Mr. Market is a very emotional fellow that sometimes gets too optimistic and other times becomes too pessimistic. When Mr. Market is optimistic stock prices climb, when he is pessimistic they fall. In other words, the market is like a pendulum that swings from unsustainable highs (stocks are too expensive) to unjustified lows (stocks are too cheap). Graham believes that it is possible to take advantage of Mr. Market’s volatile nature and buy stocks when they are unreasonably low because of Mr. Market’s erratic behavior.
A basic investment principle that could be used to dictate when to buy stocks is to be fearful when others are greedy and greedy when others are fearful. In the short-run the market is a voting machine and much buying and selling is done on the basis of short-term emotions driven by economic conditions and the popularity or unpopularity of stocks. In the long-run, the market is a weighing machine. Stocks that continue to grow earnings will increase in value as the market weighs the worth of owning those earnings and expected future cash flows.
Because the market swings from highs to lows the long-term investor must be prepared for and expect this market behavior. That means that there will be times when the value of security holdings may rise or fall precipitously and such periods may at times be of a protracted nature. The investor must be willing to buy securities even when experiencing protracted lows in the market with the expectation that securities that were purchased at deep discounts to their intrinsic value will eventually reap returns that reflect their real value.
Graham says that stocks generally become riskier as their prices go up and less risky as their prices go down. Therefore, when stocks are very low is the best time to be buying them. He says investors must follow policies that are inherently sound and promising, and not popular on Wall Street. Graham could perhaps be called a contrarian investor.
The hypothesis that stocks at times swing from unrealistic highs to unrealistic lows runs contrary to an alternate viewpoint called the efficient market hypothesis (EMH). The efficient market hypothesis states that an investor can not reliably and consistently beat the market because the market is very efficient in factoring all known information about a security into its price. In other words, knowledge, experience and understanding about a security or the market will not allow you to get a better return than a market return.
In fact, EMH proposes that stock prices appear to follow a random walk and there is no method, analysis, business judgment or skill that can be applied as a way to reliably outperform the market. Anyone that does manage to outperform the market is simply lucky or part of a small statistical sample in which a certain number of participants will appear to outperform the averages for a period of time. In the Appendix to The Intelligent Investor, Warren Buffett does an excellent job of refuting the efficient market hypothesis, in large part by showing how consistently Benjamin Graham, Warren Buffett, and others have been able to significantly outperform the market by using value investing principles that Graham taught and wrote about in his book.
At the core of the value based approach to investing advocated by Graham is a concept called Margin of Safety. The Margin of Safety concept is that stocks should be bought only when there is a sufficient margin of safety (discount) relative to the intrinsic value of the stock. A way to think of margin of safety would be to only buy stocks when you can buy them at a deep discount (such as 50 cents on the dollar) to the stock’s intrinsic value. By buying stocks at a deep discount to their real value your downside risk is greatly reduced. If you are properly diversified the margin of safety principle helps to assure that your overall results over time are acceptable.
Determining when a stock is selling at a deep discount to its intrinsic or real value is the most complicated part of the process of value investing, but Graham says that although it does require some measure of study, analysis and effort, that it is not all that complicated. Graham says that when you are buying a stock you are not buying a piece of paper or a stock symbol, but you are buying a part of a business. You should only consider buying a stock if you would be willing to consider buying and owning the business. You should be comfortable owning the business even if you could not get a daily price quote for the stock.
When you own stock you own a small part of the company. You want to make sure that you are not over paying and that you are getting a good value for your purchase. In order to make sure that you are getting a good value for your purchase you must go through a process of security analysis and appraisal.
The security analysis and appraisal process involves reviewing the company’s revenues, its net income, it’s earning per share (EPS), its price to earnings (PE) ratio, the amount of debt on it’s books, it’s book value, it’s historical earnings record and other factors. The book helps the reader to understand security analysis by comparing the financial data on different stocks side-by-side and noting comparative differences that might indicate why one stock might be a better investment than another and why one stock might have a higher margin of safety than another.
Graham urges that a conservative investor maintain at least 25% of his portfolio in common stocks. Graham tends to recommend a general asset allocation of 50% equities and 50% fixed income for most people. Graham generally recommends that an aggressive investor not have more than 75% of his portfolio in stocks.
Graham defines an investment operation as “one which, upon thorough analysis promises safety of principal and an adequate return.” He would advise only buying securities that have a long history of profitable operations and a strong financial condition.
I recommend The Intelligent Investor by Benjamin Graham, although it is not an especially easy book to read and it requires study and thought. The content of the book and the specific examples cited is now decades old, but the extensive commentary by Jason Zweig updates the book with examples as recent as 2002. In the end I found it to be a fascinating book. Any person who wishes to do well in the stock market would do well to read it. I find that I must agree with Warren Buffett that it is the best book on investing ever written.