The Intelligent Investor

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

The term “investor” has changed throughout the decades, confusing many people. An investor is someone who:

1. Executes a thorough analysis: judges a company based on the facts rather than based on the market sentiment;
2. Looks for the safety of principal: high-risk (potential) high-reward ventures are not considered an “investment” but are considered “speculation”;
3. Looks for adequate returns: the highest returns are in high-risk ventures, but these are not investments.

There are two types of investors: defensive and aggressive.

The defensive investor looks for safety and freedom from any bother. Generally, they confine themselves to the shares of important companies with a long record of profitable operations and in strong financial condition. Since their goal is to outperform the market while avoiding major errors, this is ideal for people who want to maximize returns while minimizing losses.

Aggressive investors, on the other hand, look for above-average market returns. They’re willing to put in effort and time to research and select good stocks. They see investments as a game to win. Their aim is to outperform the passive investor by earning at least an extra 5% per year.

To achieve these above-average market returns, aggressive investors must be careful not to lose more money than they gain.

“The rate of return sought should be dependent on the amount of intelligent effort the investor is willing and able to bring to bear on his task.”

The passive investor, who seeks both safety and freedom from fear, receives the minimum return on investment. On the other hand, the alert and enterprising investor who exercises maximum intelligence and skill would realize the maximum return.

A fundamental guiding rule for the defensive or passive investor is to split the investment into two: 50% in common stocks and 50% in bonds. Stocks and bonds differ in terms of security and returns—bonds are safer to invest in but produce lesser returns, while stocks, on the other hand, are riskier but produce greater returns. By diversifying your investments this way, you’ll feel more secure while also receiving minimum returns.

However, if you’re more risk-averse, you may consider investing 75% in bonds and the remaining 25% in stocks. There are different types of bonds; some are taxable, and some are tax-free. The investment decision should be made based on the investor’s tax bracket.

“The selection of common stocks for the portfolio of the defensive investor should be a relatively simple matter.”

While growth stocks provide significantly larger returns than common stocks, they are considered too uncertain for defensive investors. Therefore, investors should still hold common stocks. Not only it offers higher certainty against growth stocks, but it also provides better protection against inflation than bonds.

To avoid the risk of buying stocks at the wrong time, it’s best to use the "dollar-cost averaging” technique, in which you’ll invest a fixed amount of your money in stocks each month.

“The “aggressive” investor should start from the same base as the defensive investor, namely, a division of his funds between high-grade bonds and high-grade common stocks bought at reasonable prices.”

The advice for the active investor is mainly of a negative sort: avoid high-grade preferred stocks, foreign-government bonds, and new issues.

There is no reason at all to think that the average intelligent investor, even with much-devoted effort, can derive better results over the years from the purchase of growth stocks than the investment companies specializing in this area.

Obtaining better-than-average investment results requires that the investment passes rational and objective tests and that the investment choice differs from the policy adopted by most investors (and, especially, speculators).

“His longer-term bonds may have relatively wide price swings during their lifetimes, and his common-stock portfolio is almost certain to fluctuate in value over any period of several years.”

Market fluctuations are to be expected, but it is difficult to make predictions.

The market can be seen as a somewhat irrational and emotional mechanism that overreacts to events. This will create fluctuations and also allows active investors to outperform those investors/speculators who do not maintain their rational judgment.

“We do not think the mutual-fund industry can be criticized for doing no better than the market as a whole.”

Mutual funds are investment-company shares that can be traded on demand by the holder. There are also closed-end funds, where shares can’t be continuously traded.

Funds vary largely in the makeup of their portfolio: some hold a majority of bonds, others a majority of stocks.

Historically, many funds haven’t been able to outperform the market.

“If the reason people invest is to make money, then in seeking advice, they are asking others to tell them how to make money. That idea has some element of naïveté.”

Truly professional investment advisors are modest in their promises and usually employ a quite conservative strategy.

Common types of advisors are trust services of banks, financial service institutions, brokerage houses, and investment bankers. As an intelligent investor, it’s important to weigh all these advisors down and be selective in whom you’ll ask for advice.

“The security analyst deals with the past, the present, and the future of any given security issue.”

Security analysis is the examination and evaluation of stocks and bonds. While financial analysis includes that, it’s way more complex as it also involves the determination of investment policy (portfolio selection) plus a substantial amount of general economic analysis.

Security analysts are generally on the lookout for the companies’ strong and weak points, possibilities, and risks and assume their future earning power based on various factors. They also compare companies and evaluate the safety of the issue.

“The more seriously investors take the per-share earnings figures as published, the more necessary it is for them to be on their guard against accounting factors of one kind and another that may impair the true comparability of the numbers.”

Per-share earnings cannot always be compared accurately because accounting factors can hide certain facts or events. For example, if warrants and stock options are considered in these calculations, they can change the earnings per share (EPS) drastically.

To calculate EPS, simply divide the company’s net profit by the number of outstanding shares. This greatly indicates the company’s capacity for shareholder value creation.

It’s crucial to have several metrics to compare industries and companies. There are six key metrics we must focus on: profitability, stability, growth, financial position, dividends, and price history.

By comparing industries and companies within those industries, it’s easy to understand what a well-performing company looks like.

“If all analysts were agreed that one particular stock was better than all the rest, that issue would quickly advance to a price which would offset all of its previous advantages.”

The defensive investor will purchase only high-grade bonds plus a diversified list of leading common stocks. One might buy all stocks from an index or use quantitative methods to assess diversification to attain a diversified portfolio.

Here are the specifics of some industries:
- Public utility stocks are highly available and relatively low risk.
- Financial enterprises have produced results comparable to those of common stocks.
- Railroad stocks differ from regular public utility stocks, as these have largely fluctuated in the past.

When assessing stocks, it’s important to consider the following criteria:

• Adequate size of enterprise: Exclude small companies with a huge potential for experiencing unpleasant circumstances, as they are too risky for defensive investors.
• Strong financial condition: The current assets of industrial companies should be at least twice their current liabilities, and their long-term debt should not surpass their current net assets.
• Earnings stability: Companies must have at least some earnings for the common stock for the past ten years.
• Dividend record: There should be uninterrupted dividend payments for at least the previous 20 years.
• Earnings growth: There should be a minimum increase of at least one-third in per-share earnings over the last ten years, calculated using three-year averages for the beginning and end tails.
• Fair price/earnings ratio: The current price should not be more than 15 times the three-year average earnings.
• Fair ratio of price to assets: The current price should not be more than 1.5 times the book value last reported. A good rule of thumb is to ensure that the product of the multiplier, when multiplied by the price-to-book value ratio, should not exceed 22.5.

By following these criteria, we are avoiding issues that we don’t want in common stocks. These include companies that are too small, have weak financial conditions, don’t have a long history of uninterrupted dividends, and those with a financial shortfall in their ten-year record.

“Obviously, the professional techniques we have followed are not suitable for the defensive investor, who by definition is an amateur. As for the aggressive investor, perhaps only a small minority of them would have the type of temperament needed to limit themselves so severely to only a relatively small part of the world of securities.”

The enterprising investor will consider stocks that could be more profitable than the index average. However, this is extremely difficult to do so successfully.

As a result, extremely few companies have been able to show a high rate of uninterrupted growth for long periods of time. The good news is that we can identify some trend opportunities that are more profitable than average using the Graham-Newman methods:
- Arbitrages - buying security and selling another one into which it was to be exchanged under a plan of a merger or some other reorganization.
- Liquidations - purchase of shares that were to receive one or more cash payments in liquidation of the company’s assets.
- Related hedges - the purchase of convertible bonds or convertible preferred shares and the simultaneous sale of the common stock into which they were exchangeable.
- Net-Current Asset Issues - acquire as many issues as possible at a cost for each of less than their book value in terms of net-current assets alone.

When evaluating stocks, keep your risk tolerance and goals in mind. Remember not to pay too high for a stock merely because you are enthusiastic about an industry or speculation.

Convertible issues are bonds issued by companies that can be converted to company stocks. They are typically favorable in a downturn market but not in an upturn market. Here, the risk of losing the principal is lowered.

As convertible issues become more dominant, stock-option warrants also become more prevalent. Simply defined, a stock warrant represents the right to purchase a company's stock at a specific price and date.

“Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.”

The past performance will determine the margin of safety that can be expected for the future. The margin of safety is the inverse of risk. Each investment will have a certain amount of risk attached to it. The lower the risk, the higher the margin of safety is.

Individual securities may fail, so investing in different issues, known as “diversification,” is crucial.