When the most successful investor of the world, Mr. Warren Buffett, read “The Intelligent Investor” by Benjamin Graham at the age of 19, he called it “the best book about investing ever written”. He was so impressed by the author of the book that when he got to know that Benjamin Graham was a professor at Columbia University he decided to get enrolled in the college just for him. And we’re here to provide you with the summary of “The Intelligent Investor” by Benjamin Graham.
Benjamin Graham – The Father of Value Investing
Benjamin Graham, known as the “Father of Value Investing” was an American investor, economist, and professor. He wrote two books “Security Analysis” and “The Intelligent Investor” which is said to be the founding texts in neo-classical investing. And today we’ll give you a summary of The Intelligent Investor.
Summary of 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.
There are three main points in this definition of investment given by Benjamin Graham. Firstly, an investor should analyze a company properly before investing. Secondly, he should save the principal investment from any kind of losses. And lastly, he should get an adequate return on his investment. We can not call everyone an investor. The people who fall within the constraints of this definition can only be called an investor. So, if you’re investing ask yourself this question – do I fall within the constraints of this definition? Am I actually investing or just speculating?
What is speculation?
Speculation is very fascinating. It can attract anyone towards it very easily. Some people like to speculate so if you want to try your luck in speculation then take a small amount and handle it through a separate Demat account. When you get good profit out of speculation don’t think about investing more money in that account. When you’re speculating, only think about speculation and when you’re investing, only think about investment. Never mix the two.
Rule One: The difference between speculating and investing
Investors determine the value of the stock through the value of the business whereas speculators think that the value of the share will increase because someone will be willing to pay more price for that stock. An intelligent investor never sells the share because its price is falling, they check if there have been any changes in the value of the business.
Rule Two: Never judge the future from the past
According to Benjamin Graham, an intelligent investor must not forecast the future of a company from its past. When all the investors think that a stock is going to fetch them guaranteed returns they start buying that stock heavily. Because of which the share price increases and the share becomes overvalued. There’s a simple logic behind this, a company earns a limited profit similarly the price paid by the investors for a particular share should also be limited. Otherwise, the share will be overvalued and the investors will have to bear heavy losses. A lot of people make the same mistake. They buy the shares seeing the splendid performance of the market and have to bear losses later.
Rule Three: The rate of return depends on the intelligent efforts
The investors know that to gain success in their investments they have to follow the rule of buy low, sell high. Even then they do the opposite. Generally, in investing, it is believed the higher risk you take the higher profit you make and if you take fewer risks you’ll get fewer returns. But Benjamin Graham defies this and says that the rate of return depends on the intelligent efforts taken by the investors. The investors who are alert and use more skills get more returns which require a lot of time and energy.
Rule Four: Be careful while investing in IPO
One of Benjamin Franklin’s rule is that an investor has to be very careful while investing in an IPO. This is because they are promoted very promptly and secondly most of the IPOs are issued when the market is in good condition. And such a condition is more convenient for the company issuing the IPO as compared to the investors. If we observe we’ll know that most of the IPOs are issued when the market is experiencing a Bull run. During 1968-69 when the USA was experiencing a Bull run, 781 companies issued their IPOs. Whereas when there was a Bear run then only 9 companies issued their IPOs in 1974, and 14 companies issued IPOs in 1975. An intelligent investor should be able to recognize such promotions and stay away from it.
Difference between the stock price in the IPO and stock market
If you’re going to invest in IPOs then you must analyze them very carefully. The share price in IPOs is decided by Investment Banks. Whereas the stock price of the same company is decided by people once it’s listed in the Stock Market. That’s why when an Investment Bank decides the share price it’s very hard to get a bargain. On the other hand, due to people’s greed and fear, it’s easier to gain bargain opportunities in the secondary market. That’s why an investor has to be more careful while investing in IPOs.
What is a Bargain?
When the value of a stock is more than its selling price then it’s called a Bargain issue. According to Graham, a stock is a good bargain when its value is at least 50% more than its selling price. For example, if the selling price of a stock is 100 and its value is 150 then it is a good bargain. Another way of determining a bargain is when a stock is sold at a lower price than its Net Working Capital.
Net Working Capital = Current Assets – Total Liabilites
When you are investing in stock then you have to assume as if you’re going to buy the whole company. So, when you buy a company at a price lower than its Net Working Capital, it means that you’re not paying for the fixed assets of the company like its building, machinery, etc. If the market capitalization of the company is lower than its Net Working Capital then it can be a Bargain issue. There are very few companies that can be bought at a lower price than its Net Working Capital but there’ll surely be some. Usually, such opportunities are found during Bear Market, and at a time of recession.
Whether a stock is overvalued or undervalued?
Most investors follow the crowd. That’s why if a stock is selling at a bargain then they also stay away from such stocks because rest of them are not investing in such stocks either. They invest in the stocks which are already overvalued because others are also investing in them. Whereas the intelligent investor buys a stock when it is undervalued and sells it when it is highly overvalued. Some people think that a stock is overvalued if its price is very high and undervalued if its price is very low. They determine the value of a stock from its price.
To determine whether a business is overvalued or undervalued we have to determine the value of the business. That is, we’ll have to compare the business value with its share price.
Rule Five: Don’t Try to Time the Market
Fluctuations are a part of the Stock Market and investors try to take advantage of such fluctuations. And for that investors try to time the market, that is, they try to determine whether the price of a stock will go up or down in coming time. When they think the market trend is on the upper side, they purchase the shares. If you try to time the market then you will become a speculator. Many people have experienced huge losses in an attempt to time the market.
Don’t try to time the market because the market loves to surprise us. Brokerage firm and market analysts try to time the market continuously. They try to forecast it because it is their business and they get money for it. An intelligent investor should never get involved with timing the market. Every investor should understand that fluctuations in the share market are a part of investing. Market fluctuations help the investors to find good opportunities.
A&P Case Study
Let’s understand this with an example. A&P got listed on American Stock Exchange (now New York Stock Exchange) in 1929. It’s share price rose to $494 after getting listed. Due to 1929’s Great Depression, its share price went down to $104 by 1932. By 1938 its share price fell down to $36. At that time, the market capitalization of that company was $126mn. Whereas the company had $85mn in cash and $134mn as working capital. A&P was America’s biggest retail company at that time and the business performance of the company was also very impressive and outstanding then also it was selling at such a low price.
There were mainly three reasons behind this. First, it was in talks that the Govt. might levy extra taxes on chain stores. Secondly, the net profit of the company in the previous year was low. And thirdly that the whole market was facing depression at that time. Mr. Benjamin Graham says that the first reason was merely a fear. Whereas the second and third reasons were just temporary influences.
Increase in Share Price of A&P
In 1938, the share price of A&P was $36 as compared to $80 in 1937 and its P/E Ratio was 12. Even at the price of $80 Benjamin Graham considered it as a bargain and an attractive stock. Even if an investor had purchased the shares of A&P at $80 in 1937 it won’t have been an issue when the price fell to $36 in 1938 as its share price fell but its business value remained the same. If that investor had courage and money then he could have purchased more shares of A&P in 1938.
In 1939, A&P’s share price went up to $117 and by 1961 its share price rose to $705 and its P/E ratio became 30. At that time people were very optimistic about A&P but did not have any justification for that optimism. People were optimistic even when the company’s financial condition was deteriorating and its stock was overvalued. In 1962, its share price went down to $340 but was not a bargain price like it was in 1937-38. Its share price fell down even more and reached $180 by 1972. So this is how optimism and pessimism go on in the stock market.
In 1938 people were not ready to buy A&P’s share even at a bargain price whereas were ready to give more money even when its share was overvalued in 1961. 1961’s A&P was a bigger company than 1938’s A&P but was not been executed properly like the 1938’s A&P and wasn’t even that attractive as per its valuation. This teaches us that share price fluctuates and an investor can show courage and make use of such opportunities. And secondly that the quality and character of most businesses change over a long period. That’s why it’s important to review our investments.
Let’s understand how we can get benefitted by market fluctuations with another example. Assume that you have purchased the share of an unlisted company for $1000. In that company, you have a very helpful partner named Mr. Market who tells you about the price of various shares and helps you with the purchase and sales of the stock at that particular price. Sometimes, the price quoted by Mr. Market seems correct seeing the performance of a particular business but also seems silly at other times. If you are a sensible investor, would you consider the price told by Mr. Market as that share’s actual price?
If you agree with the price quoted by Mr. Market then only you’ll buy the shares of that particular business. And rest of the time you won’t pay attention to the price quoted by Mr. Market. When Mr. Market quotes you a very low price then you happily buy the shares and when he quotes you a very high price you sell the shares. Rest of the time you don’t pay attention to the market fluctuations.
The stock market works on an auction basis. Which makes fluctuation a very important part of the stock market. In fact, we can say that fluctuation is the beauty of the stock market. Because of fluctuations only, stocks get over/undervalued sometimes and provide good buying and selling opportunities for the investors. If you are investing in a company on the basis of its value then you should not worry about the fall in the share price of the company nor you should get very excited with an increase. That’s why Mr. Benjamin Graham says you should not sell a share just because its price is falling and vice versa.
Credits/Pic Courtesy: Finnovationz
This was the first part of the Summary of The Intelligent Investor by Benjamin Graham. Stay tuned for the next part of the summary of The Intelligent Investor. And let us know in the comments below if you have read The Intelligent Investor and how did you like it?