Financial markets are different now than what they were in 1949. This was when Benjamin Graham wrote The Intelligent Investor book. Stock valuations are quite higher, and saving bonds which Graham recommended aren’t appealing anymore. Benjamin explained the market using the image of a character he named “Mr. Market.” It was a mythical person who offered investors a price he would purchase their shares every day. He would then sell more of that stock. The investors were always advised by Benjamin to overlook Mr. Markets. Today, however, investors are more involved with Mr. Markets than before 2000 times. This nice piece of advice has thus been ignored by most investors.
Benjamin may give a skeptical look at the amount of speculative trading today. He would criticize the shift to renting stocks than owning them. This’s because short-term ownership of stocks gives little benefit to investors. But, Benjamin ’s take on “enterprising” and “defensive” investors still hold. He even predicted the inability of money managers to earn a return higher than the market average. His emphasis was strongly on long-run ownership. This suggests that he would have promoted the concept of index mutual fund. In an interview, he said, “investors must try to earn at least average market return from their fund.” Only index funds can assure such returns.
The Intelligent Investor
Investors are of two broad types:
- Defensive: They intend to save cash, make the least errors and get a good return. They are also safe from hazards. Defensive investors want liberty as well as security. Therefore, 40% of their assets should be placed on savings bonds. They can also stock a good deal in common stocks. This is a cover for inflation. They can also receive dividend earnings from any stock price increases.
- Aggressive: Such investors want to purchase lower-value securities. Their trading on the market average could help these individuals. They choose stocks and growth stocks that match market conditions. They purchase when the market falls and sell when it’s up-and-coming. When investors try, then speculation is not investment, if they try to overcome the market average and pick winning stocks. However, true investment strategies are other methods. The safest way to gain wealth is to purchase undervalued securities.
Investors ought to have a sense of the past. This way they can place market shifts in hindsight. As most investors do not have such reflection, trends become permanent. Investors must treat investing as a business. Many people in business who’re wise in their work tend to lose sight when they see Mr. Market. Smart investors are not uncommonly insightful or intelligent. Instead, they treat the market as a business. Success in investing is dependent more on character than the mind. The investor should have the courage to avoid urges to speculate, follow the crows and make fast money.
Speculators try making money on how market shifts. In contrast, Investor seeks to buy great stocks at decent prices and hold them. Market shifts matter just because they give prices at which it’s wise to buy or sell. An average investor must not wait for the market to fall to buy stocks. Unless prices are very high, you must build a stock portfolio via wise buying patterns. Averaging is one of them. Most investors try identifying stocks which will beat the market in near-term. This is like speculation and is not recommended. The stock price entails information on predictions of lower or higher prices. It shows the net effect of such opinions. A value investor may neglect daily shifts in prices.
Portfolio Policies: Defensive, Aggressive and Enterprising
Investment advisors could be helpful. But don’t depend on them for guidance on how to earn a profit. Such professionals can help you get a low-risk level with conservative income. They can also give you market & economic information. But, do not rely on their market predictions. Brokers are at the end businesses. They are nowhere close to professional companies like a law company or investment banker. Hence, they do not see consumers as likely buyers for the securities.
How investors use advisors and bits of advice relies on whether they’re enterprising or defensive. The former work with advisors and want in-depth discussions & suggestions. But, the latter must confine their purchase to high-quality bonds with low risk. They only need straightforward and straightforward advice about which shares meet their needs. Also, they need to know if prices are in tune with the earlier averages. For a defensive investor, a well-built equity portfolio is not very dangerous. While stock prices are changing, the investor will not lose cash just because the industry is falling. Only when they sell less than the purchase price do they lose value.
Enterprising investors must believe in their own decisions. They should seek advice only for knowledge to add to their skills. Never for any direction. Two principles of portfolio management are the application to such investors. Firstly, don’t buy corporate bonds as US saving bonds give equal returns at much less risk. Secondly, do not purchase high-cadre preferred stocks. It’s wise to invest in low-quality corporate bonds & preferred shares if prices are one-third below average. Foreign bonds should be left alone. Same applies for common stocks and convertibles with recent great earning performance. New issues are appealing only when they are way below their intrinsic value.
The aggressive investors might seek profit by:
- Market timing: Buying when the market is low and selling while it’s up. This is appealing yet risky. Future shifts in the market may not match earlier changes. One benefit of this formula is that it encourages investors to act as contrarians. They purchase and sell against the crowd in this manner. That’s a smart way. But the timing of the market has little other advantages.
- Buying bargains: Preferred stocks and bonds could be bargains when their price is less than average. Common stocks could be a great deal if their internal value is higher than the market price. At times, some stocks sell at less than their working capital value. The secondary stocks of the industry can also be great deals. Market inflates the risk of stocks which aren’t dominant in the industry. But, people buying bargain stocks can benefit from the high returns on the dividend. Besides, they can also profit from reinvesting earnings and price increases over a time-period.
- Growth stocks: Most investors want to select stocks which will beat the market in the future. Finding stocks which outdid in the past is easy. But predicting upcoming performance is hard. Do not end up overpaying for growth.
- Special situations: Situations like mergers, bankruptcy, reorganization, etc. provide opportunities to make a profit. Stocks are often available at discounts during such events.
Rules for Appraising Stocks
These rules can help both analysts and investors:
- Estimate a company’s profitability for measuring value. Recognize the asset value properly and multiply this.
- Earning capacity is an estimate of the company’s earnings over five years.
- Adjust previous years’ numbers to show any changes in capitalization.
- Guess a company’s average earnings over this period. You can do this by averaging bad and good in previous years. Then estimate margins and revenues for the future.
- You should use a maximum multiplier of 20 and a minimum of 8. This allows for changes in earning in the long-run.
- If the value arrived at from earning power is higher than the fixed assets’ value, subtract from the earnings value change. We suggest: subtract a quarter of the sum by which the earning-power value is higher than two-times the asset value. This allows for a 100% premium on tangible assets sans penalty.
- If such value is lower than the net current assets’ value, add 50% of the variance to the value measured on earning-power.
- In unusual events, like war short-term royalties or rentals, adjust the value accordingly.
- Assign value among bondholders, stockholders or preferred shareholders. Before this step, compute the company value as though it is a capital structure had only common stock.
- The more debt & preferred stock in the capital structure, the less you can rely on the appraised value. Decisions should not be taken on this value.
- When the appraisal is one-third greater or less than the current value of the market, you can base your decision on this. If the difference is less, then the appraisal is just a factor to consider in the assessment.
Managers and Stockholders
Though stockholders possess legal rights over management, practically they’re impotent. Stockholders follow the management irrespective of how it performs. Though management is usually decent, there are many cases of dishonest and incompetent management. Stockholders must get serious about using their rights as owners. To be specific, they must do the following:
- Management efficiency: In the performance of stock investments, management is very important. However, investors have little interest in quality control. Incompetent executives are even less removed. The interest in management efficiency should be developed by Stockholders. They have to objectively monitor the quality of leadership. If, while the industry booms, the return to shareholders falls, they must look for justifications. The necessary information is available for such an analysis. Shareholders could believe that selected managers defending their interests. But remember that executives choose executives. Many biases occur and managers tend to be in the favor.
- Outside stockholders: Shareholders external to the company are outside stockholders. They are not involved in managing or controlling the firm. Insiders often handle companies in order to serve their interests. Many times, even at the cost of outside stockholders. Such bias is most visible in holding companies. In such firms, the stocks are decidedly less valued in comparison to the asset values behind them. Insiders can eliminate this partiality by breaking the holding company, although outsiders benefit. Hence, stockholders of holding companies continue agreeing with the management that does not act for their interests.
Shareholders have both responsibilities and rights of control. They must use them wisely.
The Intelligent Investor Summary