Hi friends,
Let me start off today with a story:
Imagine you bought a house, worth $300,000. You have a neighbor, Mr. Market, who comes by every day. Each time he comes, he will quote you a price on your house. Some days, he is in a good mood, he quotes you $500,000. Others, he is a bit moody and quotes you $100,000.
When you hear his quotations, will you sell your house just because he quotes you a price way lower than what you bought your house at? If the answer is NO, why are we selling when we see our stock prices fall?
This is the mindset that Benjamin Graham is trying to convey in his book - The Intelligent Investor. An intelligent investor does not let the market define the values of his portfolio. Some facts about Benjamin Graham, he was the mentor of Warren Buffett, he is known as the creator of value- investing. The Intelligent Investor was also commented by Warren Buffett to be "The best book written on investing, ever!" Let me start off by going straight into my thoughts and comments about the book.
Thoughts and comments:
This book isn't an easy read. definitely. But I felt that the book is significantly harder in the beginning chapters. But with the help of the commentaries, it eased the difficulties in trying to understand what Benjamin Graham was trying to convey. Also, this book does not have much calculation/formulas. It serves more like a principle-based approach to value-investing along with some guidelines that we can follow to filter out companies that have a better chance of delivering better value.
I felt that, after reading this book, I have a better understanding of what a stock is, and what are the expectations if I were to be an active investor. Therefore, I have decided that I am going to be a passive investor, with a small amount of my money (5%) invested in speculative assets as part of my "fun money"
Let's move on to the 6 principles that I have derived from the book:
1. A stock is a business, not a ticker symbol or lines in a chart:
When we want to buy a stock, we should evaluate it from the POV of a business owner. How much money would you pay to own a business that isn't profitable? How much money are you willing to pay for a business with sustained profit growth of 8% every year?
Hence, it is important for us, as an intelligent investor, to view stocks as ownership of businesses, with the objective of producing and sustaining as much profit as possible. Since we are partial owners of this business, we should expect to benefit from this growth in business.
2. A great business can be either a good buy or a bad buy at a certain price:
Stocks with a high PE (price to earnings ratio) tend to do worse than their counterparts. Hence, even a good company (like Coke, Raytheon, General Electric) would be a bad buy when you buy into it at a high PE ratio (>25).
What this means for us is that there isn't any point in trying to copy the portfolio of successful investors. This is as the price that he bought his portfolio (his entry price) is significantly different from yours. Hence, both of your returns would be significantly different.
3. Crises are great for the intelligent investor:
In a typical bull market scenario, it would be hard to find undervalued stocks. This is even worse in the ending period of the bull market, there would be a lot of bad quality new issues out in the market.
However, when there is a crisis, fear would be the one ruling the market. There would be a lot of pessimism too. Hence, great companies' stock prices would also be affected negatively, these great companies which are previously too expensive would become a bargain. But the important thing is: You need to learn how to determine great companies, also you need the guts to do the opposite of what everyone is doing.
4. Businesses can swing from being undervalued to widely overvalued:
Throughout history, there are phases where certain industries are favored (Right now, it is the technological companies, previously it was the internet companies, even further back was the conglomerates). Hence, when certain industries are favored, they would highly be overvalued. In these times, there would be companies of neglected industries that are undervalued and would be a good bargain.
5. Passive (or Defensive) investors have a radically different investing approach compared to Active (or Enterprising) investors:
The main difference between the passive and the active investor is the amount of time, effort, the energy that both parties are willing to put into analysing stocks and bonds.
For the defensive investor:
It would be better for him to invest in a market index fund (US) and diversify using index funds of other countries (Emerging Markets) and bond funds (US Treasury). He would invest it by DCA-ing into his portfolio and rebalance on an annual basis.
For the enterprising investor:
As he is expected to put in significantly more effort and time in analysing stocks and bonds compared to the defensive investor. He will attempt to beat the market's return through the careful selection of stocks.
He should think of his actions as a business (similar to a mutual fund) and manage his returns as such. This would mean that he would be doing it full-time, with an expected salary and all that. The approach of the enterprising investor will be elaborated in the next point.
6. The enterprising investor has a lot of things to do:
The enterprising investor should treat what he is doing as a full-time business that deals with investment. For every stock that he looks at, there will be an entry price, exit strategy, and participation strategy. His portfolio should also not consist of more than 30 stocks
Here is a rough run-through of how the enterprising investor can arrive at his 30 stocks:
a. From a list of all the stocks in that market, filter out using 6 criteria (read the book if you are interested). You should expect to find about 40-50 stocks.
b. From the 40-50 stocks, further, filter it by an additional set of criteria that is defined as important by the investor.
c. This should filter to 20-30 stocks. This is where the fun part begins, the enterprising investor would then read the annual reports of these companies for the past 5 years and look for red-flags in the companies' reports. Benjamin Graham gave a few examples of the red-flags (They can be frequent changes of management teams, recurring special payments, etc)
d. From these, he will choose around 4-5 stocks that he is satisfied with (especially those with a moat against its competitors) and buy it.
THAT'S NOT ALL. THAT'S FOR THE ENTRANCE INTO THE STOCKS. There is still the exit and participation strategy.
Exit Strategy:
The enterprising investor should cash out when there is a change in the quality of the management team or when the objective of the managers no longer aligns with the investors. The enterprising investor can also exit when the stock price goes into the speculative regions (high PE ratio) and this would produce a decent returns
Participation Strategy:
For this portion, Benjamin Graham recommended to actively look at the yearly distributions of the company to gauge the effectiveness of the managers. The managers should serve to increase shareholder returns. This can be done through participation in AGMs.
From these principles, I have decided that I am going to be a passive investor as I do not plan to have invested as a full-time career, But if you do, here are some of the action plans that you can do:
1. Learn about the rationales and exact figures on how to do stock evaluations (Can be found in the book. I did not include it as it will be too technical).
2. Treat investing as a real business that you are doing for 1-2 years, take note of your mentality, and some of the emotional pitfalls that you can make mistakes in.
3. Measure your returns against the market index. If you do well, then MAYBE, you can do it full time.
Conclusion:
I can understand why Warren Buffett had such high praise for this book. If you are familiar with Buffett's investing approach, it is highly similar to Benjamin Graham. Especially in terms of treating stocks for the things that they truly are: Ownership of a business and that there is a price that we should be willing to pay for. I hope to read this book again soon as I truly feel that I have not understood everything about the book.
Whether or not I will be an active investor, maybe I will do it with my fun money in the future. But for now, no.
Till then,
Stay vested, stay frugal my friends,
Dionysius
Source:
The Intelligent Investor
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