Saturday, 14 December 2013

Benjamin Graham - The Intelligent Investor Part 1

As mentioned in my previous post, I am now going to do a review of The Intelligent Investor by Benjamin Graham now. I will split the review into 5 parts as there is too much wisdom in the book to summarize it into a single post. I used to read this book till page 100 before I was too engrossed with other things and eventually, gave up on reading it a year ago. However, after my failed bulge bracket interview, I understand that I am still lacking in many areas and have decided to reread all my trading and investing materials, as well as acquire new skills such as the discounted cash flow analysis and an in depth knowledge on the oil and gas sector. To proceed, I feel that it is imperative that I tackle one of the best investment classics ever written and gain new knowledge from it. I will attempt to finish this book in 5 days, while jotting down all the lessons that I personally receive from this book.

Benjamin Graham was one of the best investment managers in the world, past and present. He was able to generate consistent returns above market. For example, from 1936 to 1956, his Graham-Newman Corp. has an annual return of 14.7% vs 12.2% for the stock market as a whole. The core principles of his investment style are as followed:
  • A stock is an ownership in actual business, with a fundamental value that does not depend on its share price
  • The market is a pendulum that swings from unsustainable optimism (which makes stocks expensive) and unjustified pessimism (which makes stocks cheap). The intelligent investor is a realist who sells to optimists and buy from pessimists
  • The future value of every investment is a function of its present value. Therefore, an expensive price paid now for the investment might lead to lower returns in the future
  • The risk of being wrong cannot be eliminated no matter how careful one is. Only by insisting on a “margin of safety”, in which one does not overpay for an investment, can the odds of making a wrong investment be minimized
  • The secret to financial success lies within oneself. Invest with patient confidence, and one can take on even the worst slumps in the market. Developing one’s courage and discipline and one will be in control of their own financial destiny. The way one behaves in the market is more important than how the investments behave in the market
The book aims to teach one about the adoption and execution of an investment strategy. To do that, past historical market movements will be explored as well. I will skip through all the history lessons that might only be able to help the reader marginally and seek to convey the essence of the book. Of course, if the reader feels that something is missing, they can always add on in the comments session. Since this is just my own interpretation of the valuable lessons from the book, different perspectives can arise from the same paragraph or section and this review is only my own personal enlightenment from the book.

Inflation is an investor’s worst enemy
If one simply keeps the money he had now for a one year period, would his wealth be higher, lower or the same? The fact is, his wealth will actually decrease due to inflation. Therefore, to build wealth, one has to invest intelligently so as to prevail over inflation.

Those who do not remember the past are doomed to repeat it
This is one of the first lessons outlaid in the book. It mentioned about knowing the past and how different asset markets like bonds and equities react to varying conditions in order to not make the same mistakes.

There is 2 types of investors – defensive (passive) and enterprising (active or aggressive)
The defensive investor will seek to avoid serious mistakes or losses and then a freedom of effort from making frequent decisions. In contrast, the enterprising investor devotes time and care to the selection of equities that are more sound and attractive than the average. Historical trends imply that the enterprising investor has above average returns and one should seek to be that.

Recognize industry, then the company that is most likely to grow
Successful investors first identify the industry that is growing, then the company that is most likely to grow in order for profitable returns. However, this is not as easy as it looks in retrospect. This is because obvious prospects for physical growth does not necessarily translates into higher returns for the investors and a way to select the most attractive company in the most attractive industry is not widely available.

There is a right price to pay for any investment
If one forgets to ask the question of price when making an investment, he might be incurring possible losses later on. There is always a suitable price for any asset. A price too high for an asset could be a good time to sell while a price too low for the very same asset could be a signal to buy.

Stocks become more risky as their prices rise, and less risky as their prices fall
The intelligent investor is cautious about a bull market, as it makes stocks more costly to buy. Conversely, a bear market might present several buying opportunities for the investor. Therefore, a bear market might be a good time to build wealth.

Speculation vs Investing
Investment operation is something which promises safety of initial capital and an adequate return upon careful analysis whereas speculation is anything other than the above requirements.

There is always a speculative factor in holding common stocks
When one holds common stocks, there is always a speculative factor. As an intelligent investor, it is our duty to recognize this factor and keep it within a minimum limit, and be prepared for both the short and long term financial or psychological costs.

Unintelligent speculation consists of these few factors:
  1. Speculating when one think they are investing
  2. Speculating seriously when one lacks proper knowledge or skills
  3. Risking more money in speculation than one can afford to lose
Keep a separate account for speculation and investing
There should always be two accounts, one for speculation and one for investing. Put aside a specific amount of capital for speculation and never add more money into this account when the market is going up. Instead, it might be a good time to turn the paper profits into real profits by cashing out.

Be cautious about hot investments or tips
An investor cannot hope for above average results by buying new offerings, or hot issues of any sort, meaning those which imply a quick profit to be reaped.

A defensive investor should be aware of these concepts or practices:
  1. Purchase of the shares of well established investment funds as an alternative to creating one’s own common-stock portfolio
  2. Investment can also be targeted at trust funds, exchange traded funds, or if one has substantial capital, make use of the service of an established recognized investment counsel firm like Blackrock etc
  3. Using the concept of “dollar-cost averaging”, the investor invests in common stocks the same amount of money each month or quarter. This method is an application of a broader approach known as “formula investing”
There are various dangers to an enterprising investor’s investment strategy
The strategies are split into trading in the market, short-term selectivity, and long-term selectivity respectively:
Trading in the market
Buying when the market is advancing and selling when the market is turning downwards
Short-term selectivity
Buying or selling a company’s stock in advance of earning reports, future developments or press announcements
Long-term selectivity
Historical trends of past growth leading to future growth in the company

Stock trading as mentioned in the book is not very profitable as it does not on thorough analysis, offers safety of principal and a satisfactory return. In selecting a stock for future growth in the short or long term, the investor faces various dangers, one from human fallibility and the other from his competition. The fact is, expected earnings or future news might already be factored into the share price and other competitors might have already bought or sold the targeted equities, making the share price a fair indicator of the company’s performance.

Therefore, an enterprising investor must follow an investment strategy that is inherently sound and promising and not popular on Wall Street, or any other stock exchanges in the world.

There is always undervaluation and overvaluation in the market
A common stock might be valued unfairly because of a lack of interest or just intense prejudice whereas it might be overvalued due to foolish speculation and beautiful stories. Therefore, a person who is patient, courageous, and disciplined will have a much higher chance of beating the market (getting return above the market’s average).

Investing according to Mr Benjamin Graham
Investing consists of 3 important elements according to Benjamin Graham:
  • A company and its underlying business must be thoroughly analyzed before buying the company’s stock
  • Deliberately protect oneself against serious losses
  • Investors should aspire to adequate and not supernormal performance
The share price of a company is dependent on the performance of the underlying business
In the long run, stocks go up in price because the business behind the stock is doing well and stocks go down in price because the business is performing badly, nothing more nothing less.

With that, I conclude the first part of The Intelligent Investor by Benjamin Graham.

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