The Intelligent Investor

1-Page Summary

Investing well over the long term does not require incredible intelligence or deep insight. Instead, it requires two things:

A rational framework for making decisions
Preventing your emotions, and other people’s emotions, from overriding your framework

With these two elements, and without extensive trading experience, you can do better than more financially-educated people who lack patience, discipline, and emotional control.

Investing successfully in stocks requires keeping a few key principles in mind:

A stock is not just a mere object you trade. It is a piece of ownership in a business. Therefore, the stock has a fundamental value that is often not the share price. Understand the business, and you understand the fundamental value.
Pay attention to the price at which you buy stock. The more you pay for a stock, the lower your return will be. Buying stock carelessly, with the expectation that you can buy anytime at any price and still profit, is a mistake. As Graham says, “buy your stocks like you buy your groceries, not like you buy your perfume.”
The market has constant mood swings. At times, it is over-optimistic, which makes stocks too expensive. At other times, it is pessimistic, which makes stocks cheap. The key is to buy from pessimists and sell to optimists.
Keep a “margin of safety”—don’t get carried away and overpay for a stock, or a downturn can cause irrevocable losses.

This book covers two major types of intelligent investors—defensive investors and aggressive investors—and advises how each should invest. It also covers general investment principles and market behavior, popularizing Graham’s famous concepts of Mr. Market and Margin of Safety.

Let’s begin by discussing what investment is.

Investors vs. Speculators

What are investors? The term is thrown about loosely to describe anyone who buys or sells securities in the market. But since many people trade irresponsibly and by their emotions, describing them as “investors” seems too generous. For instance, if the stock market suffers a major drop, the media will report, “investors became bearish and pulled out of the market.” Yet these moments are precisely when sound investors would be buying stocks on the cheap.

Offering a more robust definition, Graham defines investment as an operation that, through extensive analysis, provides an adequate return and safety of principal. Everything that doesn’t fit this definition is speculation.

Investors and speculators therefore behave very differently.

Speculators trade on market movements of stock price They buy stocks as they move up, hoping to sell to someone who will pay more for it. When the price goes down, they sell to capture their gains or cap their losses. In all this, they ignore the fundamental value of what the company is worth.

Investors look at the fundamental value of the stock, independent of the stock price. In fact, Graham suggests that investors should be comfortable buying stock even if they could receive zero future information about its daily stock price. Investors also trade oppositely to speculators—they buy when the market is down, since stocks are cheap. Investors dread bull markets since it makes everything overpriced.

Speculators are swayed by popular opinion. They hear optimistic estimates from analysts and buy stock, without questioning the underlying value. They buy when everyone else is buying, and sell when everyone else is selling.

Investors are independent thinkers. They use a dependable system for decision-making.

Don’t Believe the Active Trading Hype

You’ve likely seen commercials for stock brokerages that let you trade more conveniently and with lower fees than ever before. Beware: brokerages make money when you trade, and not when you make money. Therefore, brokerages hype up speculation for common investors in their marketing, promising riches at unprecedented speed.

In reality, active trading worsens your performance. A 2000 study by finance professors found that the most active traders (who turned over more than 20% of their holdings each month) underperformed the market by 6.4% per year, while the least active traders (trading less than 0.2% of holdings each month) matched the market.

Defensive vs. Aggressive Investors

Having distinguished investors from speculators, Graham defines two different types of intelligent investors: defensive investors and aggressive (or enterprising) investors.

Defensive investors want to avoid spending too much time on investing. They like simplicity and don’t love thinking about investments or money. Their goal is to perform on average, in line with the market, and to avoid serious mistakes.

Aggressive investors are willing to devote serious time and energy to research stocks and select good ones. They enjoy thinking about money and see smart investing as a competitive game they want to win. Their goal is to achieve better returns than the passive investor (Graham says an extra 5% per year, before taxes, is necessary to justify all the effort.)

Both approaches can be intelligent and can perform well. The key is choosing the right type of investment for your temperament and goals, to stick with it over your entire investment timeline, and to keep your emotions well under control.

The Defensive Investor

How Should Defensive Investors Invest?

Graham’s recommendation is to split investments between stocks and bonds. The default split is 50-50 between stocks and bonds. This allows you to participate in both the gains of stocks as well as the relative safety of bonds.

At times, you can shift your balance in favor of stocks or bonds. If you feel stocks are overpriced and due for a downturn, you can shift your investment to 25% in stocks and 75% in bonds. Likewise, after a steep market downturn or when stocks are cheap, you might shift to 75% in stocks and 25% in bonds. But Graham advises no more than a 75-25 imbalance.

Why not 100% into either bonds or stocks?

Stocks on average rise faster than inflation, whereas bonds might not, so holding stocks better protects against inflation.
However, stocks don’t always outperform bonds at all times. At the time of Graham’s last revision in 1973, bonds were outperforming stocks. Keeping a balance helps you weather a variety of economic conditions.
Stocks fluctuate much more than bonds do, and the wild oscillations of a 100% stock portfolio will test your psychology.

Dollar-Cost Averaging

If you have a lump sum of money, how would you invest it? Some investors, tempted to get higher than market returns, might choose to “time the market,” waiting until a market dip to invest. The very likely risk is that the investor turns out to be entirely wrong, either losing out on gains as the market rises, or mistiming the bottom.

In contrast, Graham recommends dollar-cost averaging—split up the lump sum into multiple investments of equal amounts, distributed over a longer period of time (such as every month or quarter). This is a straightforward strategy that requires minimum thinking and emotional investment.

Dollar-cost averaging carries psychological benefits: you remain emotionally detached from the swings of the market. Regardless of whether prices are up or down, you invest the same amount.

It also helps you avoid the delusion that you can predict the market. Zweig notes that your response to any question about the market should be “I don’t know and I don’t care.”

Low-Cost Index Funds are the Default Option

In the book, Graham spends a few chapters giving advice on choosing specific individual bonds and stocks because, in the mid-20th century, those were the only options available to investors.

Since then, a large number of low-cost index funds have become popular (such as those by Vanguard). These funds hold a wide basket of assets, such as stocks and bonds, thus providing diversification with minimal effort. Near the end of his life, Graham noted that index funds should be the default choice of most everyday investors, rather than picking individual stocks (his protege Warren Buffett agrees).

Choosing Individual Stocks

If you do want to choose your own stocks, as a defensive investor you should buy only stocks of high-quality companies at reasonable prices. Use these seven criteria to filter the options:

Size: More than $100 million in revenue
- Small companies face more volatility and may be unable to survive bad events.
- Graham’s criterion was set in 1970, and $100 million in revenue may be too small today. Nowadays, sufficient size might mean a market value of at least $2 billion.
Strong financials: Assets at least double liabilities, and working capital more than long-term debt
Dividends: Paid continuously over the last 20 years, without interruption
Earnings: Positive in each of the past 10 years; no unprofitable years
Earnings growth: At least 33% total growth in per-share earnings in the past 10 years (a bit less than 3% annually)
- A company that is shrinking over time will not be a good long-term investment.
- Use 3-year average earnings at both the beginning and end of the 10-year period.
Price-to-earnings ratio: No more than 15 times the average past 3-year earnings
- Beware of analysts who calculate a “forward P/E ratio” using not historical earnings but “next-year’s earnings.” Predictions are notoriously unreliable, and often the forward P/E ratio is used merely to justify an overpriced stock.
Price-to-book value ratio: No more than 150% of book value (also known as net asset value; calculated by subtracting total liabilities from total assets)
- In his commentary, Zweig notes that many companies today have a greater amount of value in intangible assets such as brand value and intellectual property, which don’t show up in book value. Thus, more companies are priced at higher price-to-book ratios.

These seven criteria are stringent and often cut away the majority of stocks. This is deliberate—at any time, most stocks are likely not good choices for the defensive investor.

The Aggressive Investor

In contrast to defensive investors, who want to minimize time and get acceptable results, aggressive investors want to devote serious time to investment research to achieve better returns than average.

When describing these investors as “aggressive,” Graham is not urging any carelessness or impulsiveness, despite general connotations of the term “aggressive.” In stark contrast, aggressive investors should methodically value potential investments, be patient for bargains, and maintain level-headedness when the market is reactive in either direction.

Expectations for the Aggressive Investor

How much in gains should a successful aggressive investor expect? An additional 5% per year, before taxes, is necessary to be worth the effort of all the research and work. (Graham notes repeatedly that good investors should not aim for stratospheric results, but rather modest and consistent returns over the long term.)

Beating the market is difficult, and Graham cautions—most professional money managers do not beat the overall market in the long term, after deducting fees. These funds employ highly intelligent and motivated people who dedicate their entire working days to researching and choosing individual securities. If they can’t outperform the S&P 500, do you think you realistically can?

Find Bargain Stocks

Graham’s core strategy is to find companies that are priced lower than their fair value. In other words, try to buy a dollar for far less than a dollar.

Why would this continue to work, despite the claims of the efficient market hypothesis? Because of human psychology. Markets are made up of people who are impulsive and follow each other. This can cause major fluctuations in price (both up and down) that are irrational relative to the stock’s underlying value.

When a company has fallen out of favor, its price will drop below what the fundamentals of the company would warrant. The stock has now become a bargain—if you buy them, they may later recover their prices and be good investments. Graham defines a bargain as a stock with a price that is below two-thirds of its value.

Bargains may occur when a large company endures a temporary setback, or when an entire industry falls out of favor. The market may overreact, moving certain stock prices into bargain territory.

Aggressive Investor Criteria

Like the defensive investor, start with statistical criteria for filtering all the stocks available. However, you can relax the criteria to include more companies:

Size: No requirement for size. You can limit your risk with small companies by carefully identifying good companies and diversifying.
Financials: Assets at least 1.5 times liabilities, and debt less than 110% of net current assets
Dividends: Some dividends paid recently
Earnings: Last 12 months’ earnings is positive
Earnings growth: Last 12 months earnings’ more than earnings from 4 years ago.
Price-to-earnings ratio: No more than 9 times earnings from the last 12 months
Price-to-book value ratio: No more than 120% of book value.

To decide whether a stock is a good investment, you must do your own reasoned analysis. There is no such thing as good stocks and bad stocks—only cheap stocks and overpriced stocks.

A strong company is not a good investment if its stock is overpriced.
A stock at a low price is not a good investment if the company has poor future prospects.
A stock with tremendous hype around growth, and high prices to match, is likely too speculative for intelligent investors.
Yet a once-hyped stock that falls dramatically in value can then turn into a bargain stock worth buying.

Market Fluctuations and Mr. Market

When asked to predict what the market would do, the financier J.P. Morgan said, “it will fluctuate.”

You can be sure that the market will fluctuate. In all likelihood, you will not be able to predict when and how the market fluctuates. You can, however, respond to fluctuations in two critical ways:

Steel yourself mentally for the fluctuations. Prepare for the idea that your portfolio may decline by 30% from its high point, and don’t tie your emotions to these fluctuations.
Watch patiently and prepare to spot opportunities when they do appear. When the market sours on a stock, it can be an overreaction and present a bargain buying opportunity.

Mr. Market

You are not obligated to trade and sell with the market. You should use market pricing merely as an indicator for whether a stock is over- or under-priced, taking advantage of opportunities in your favor.

This sounds like common sense, yet countless traders behave as the market demands they do. They buy when stocks are going up and sell when they have gone down.

To illustrate how silly this is, Graham introduces his famous idea of Mr. Market. Say you own a piece of a business worth $1,000. Imagine a fellow named Mr. Market who is a manic-depressive sort of person and visits you once a day, asking to buy and sell your interest.

When the market is up, he asks to sell another piece to you at exorbitant prices: $1,500, $2,000.
When the market is down, he comes by asking to buy your stake for a steeply discounted $600.

Should you go along with this odd person, feeling exactly what he feels at every moment and doing what he demands?

Of course not. You know the piece of business is worth $1,000. You’d maintain your own rationality and politely ask this oddly behaving person to leave your house.

Mr. Market represents the whims and folly of other traders. His behavior should not influence yours. If you know the fundamental value of a business, why should the mistakes of other people influence your behavior? Behaving this way is like having your emotions and behavior dictated by other people.

You have no obligation to act according to market fluctuations. You should deliberately choose to transact only when it is in your favor. You shouldn’t ignore Mr. Market entirely, nor should you blindly follow whatever he tells you, but rather use his prices only when it is to your advantage. You are not obligated to trade with him.

Margin of Safety

In seeking good investments, Graham always made sure to build in enough margin of safety. In simple terms, margin of safety is a measure of how much can go wrong before an investment goes bad. If you make investments with a larger margin of safety, you have a greater likelihood of prevailing in the end.

Warren Buffett offers an analogy: If you’re designing a bridge that tends to support 10,000 pounds in everyday traffic, you should design it to carry 30,000 pounds.

Many of Graham’s investment criteria we’ve covered have margin of safety built into them:

Interest coverage ratio: If a company’s earnings covers 5 times its interest expenses, then even if it suffers a sudden 20% drop in earnings, it has more than enough earnings remaining to continue paying interest and thus avoiding defaulting on debt. In contrast, a company that can only cover 1 times its interest expense is in danger of defaulting with just small setbacks to earnings.
Price to book value: If you buy stock in a company when its market value is two-thirds of book value, the company’s book value can shrink by one-third before your investment becomes negative (relative to book value).
Asset to liabilities ratio: If a company has assets at multiple times its liabilities, it can lose significant value before its bondholders suffer a loss.

A larger margin of safety prevents you from needing to be clairvoyant or unusually clever. You may not be able to predict market downturns or company setbacks, but with a large margin of safety, that doesn’t matter—your investment can still be successful.

As Warren Buffett has said about value investing, “if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me.”

Introduction

Investing well over the long term does not require incredible intelligence or deep insight. Instead, it requires two things:

A rational framework for making decisions
Preventing your emotions, and other people’s emotions, from overriding your framework

With these two elements, and without extensive trading experience, you can do better than more financially-educated people who lack patience, discipline, and emotional control.

Investing successfully in stocks requires keeping a few key principles in mind:

A stock is not just a mere object you trade. It is a piece of ownership in a business. Therefore, the stock has a fundamental value that is often not the share price. Understand the business, and you understand the fundamental value.
Pay attention to the price at which you buy stock. The more you pay for a stock, the lower your return will be. Buying stock carelessly, with the expectation that you can buy anytime at any price and still profit, is a mistake. As Graham says, “buy your stocks like you buy your groceries, not like you buy your perfume.”
The market has constant mood swings. At times, it is over-optimistic, which makes stocks too expensive. At other times, it is pessimistic, which makes stocks cheap. The key is to buy from pessimists and sell to optimists.
Keep a “margin of safety”—don’t get carried away and overpay for a stock, or a downturn can cause irrevocable losses.

Warren Buffet read this book when he was 19 years old, and he still calls this “by far the best book about investing ever written.

Brief Biography of Benjamin Graham

Graham was born in 1894 and lived his childhood in New York. His father died when he was 9, the family business failed, and the family became poor. Her mother traded stocks on margin and became bankrupt in the stock market panic of 1907. This incident deeply influenced Graham’s thinking on the importance of not suffering grave losses in investing.

Graham attended Columbia for college and entered Wall Street. Here he obsessed over analyzing stocks and companies in minute detail. He eventually founded his investment firm, the Graham-Newman Partnership, where he employed a young Warren Buffett. Over 20 years, his firm returned 14.7% annually (after fees), compared to 12.2% for the stock market.

In 1956, Graham Graham retired and closed his partnership and continued teaching and writing, sharing his principles of value investing worldwide. He died in 1976, a few years after his last revision of this book.

Graham led the movement of “value investing” and deeply influenced some of the world’s most successful investors, most notably Warren Buffett and Charlie Munger of Berkshire Hathaway.

Shortform Introduction

This book was first published in 1949, but it’s gone through multiple revisions since then. We’re summarizing the latest edition, which was published in 2003. Each of the 20 chapters in the book has two parts: 1) the original by Ben Graham, from his last revision in 1973, and 2) modern commentary by Jason Zweig, a finance columnist for the Wall Street Journal.

In his section, Graham often discusses the contemporary market of 1973, giving advice to the 1970s reader on how to invest based on the market conditions then. We’ll largely skim over these details to focus on the timeless principles, but we’ll keep the best examples.

Zweig’s modern commentary points out how Graham’s advice has been timeless through major stock market events, such as Black Monday in 1987 and the dot-com bubble in 2000. Since the book was written in 2003, it doesn’t address the great financial crisis of 2008 or the decade-long bull market following that, but disciples of Graham’s value investing would have little doubt the principles still hold.

Throughout the summary, by default the ideas come from Graham’s writing; we note which ideas and updates come from Zweig. Any mention of history after 1973 should be assumed to come from Zweig.

The book is written for investors in the United States investing in United States securities, but the ideas are likely applicable to any modern financial market.

Chapter 1: What Is Investment?

Let’s begin by defining who investors are, in the context of this book.

Investors vs. Speculators

Likewise, people describe “speculation” loosely. Yet after a stock market crash, when sentiment is poor and all stocks are considered too risky, they’re often the most attractive for investment.

Investors and speculators therefore behave very differently.

Investors are independent thinkers. They use a dependable system for decision-making.

Speculators have erratic mood swings, and are impatient. Their feelings govern their behavior, and they don’t act by any methodical, reliable system.

Investors control their psychology through ups and downs. They rely on their dependable framework for decision-making and don’t act impulsively.

Speculation Disguised as Investment

In addition to trading based on market movements, Graham cautions against these common methods of speculation that masquerade as investment:

Trading based on short-term earnings reports: estimating future earnings accurately is already difficult in itself. But studying earnings is so common and competitive, with legions of analysts on Wall Street, that even if you get it right, the stock price probably already reflects those earnings.
Trading based on long-term growth prospects: here you may have a more optimistic view of certain companies than the overall market. But Graham is once again skeptical that an individual investor has the insight and vision needed to consistently outperform the market on these predictions.

In his commentary, Zweig shares examples of popular formulas that failed to perform:

The “January effect”: A strategy published in the 1980s that claimed that small stocks dip at the end of the year and rise at the beginning of the year. The explanation is that investors sell their worst stocks by the end of the year to reduce taxes; investment firms also sell falling stocks by year-end to make their annual performance look better. The January effect looked strong up until the 1980s, after which it began disappearing.
In 1996, a money manager named James O’Shaughnessy published a simple strategy in his book What Works on Wall Street: Buy 50 stocks with the highest one-year returns, 5 years of rising earnings, and share prices less than 1.5x revenues. He created funds based around this strategy, but they underperformed the S&P 500 through 2000, and some of those funds promptly shut down.
The Motley Fool’s “Foolish Four”: Take the five stocks in the Dow Jones with the lowest price and highest dividend yields; discard the one with the lowest price; invest 40% in the stock with the second-lowest price, and put 20% in the other three. Repeat each year. When published, the technique claimed to produce a 10.1% annual return above market in a back-test over 25 years. But when applied going forward, this failed to perform any better than random stock picking.

The takeaways:

Strategies that seem to work when back-tested against historical data may be illusory. If you look for enough patterns, you will find some that seem to work, by mere chance, but they will fail to deliver consistent performance over time.
Even if the strategy really does work, if it becomes popular, the competitive market will adopt the strategy, thus erasing its possibility for profit. We’ll discuss this more in the last section of the chapter.
Any simplistic strategy that mechanically picks stocks, without thorough consideration of the company’s underlying value, does not qualify as investment under Graham’s definition.

Speculation isn’t immoral or necessarily bad for society. Speculation based on the promise of future growth fuels innovation—new upstarts like Google or Amazon needed optimistic speculators to provide capital. But for most people, speculation is a poor way to attain wealth.

Don’t Believe the Active Trading Hype

(Shortform note: With the advent of mobile apps for trading and zero-commission trading, the barrier to trading is lower than ever. How do brokerages with zero commissions make money through trading? By selling order flow to market makers, who profit from inexperienced investors.)

As a result of these tools, trading activity has increased dramatically, as well as impatience—in 1973, a shareholder kept a stock for 5 years before selling it; by 2002, that shrunk over 80%, to 11 months. During frenzied periods, like the dotcom bubble in 1999, a share might be held an average of a few days.

Beyond just making poor investment decisions, active trading has other punishing drawbacks:

A frenetic speculator who is desperate to buy or sell a stock may accept unfavorable prices for the sake of speed. For instance, someone who wants to trade 1,000 shares of a stock and misprices by 20 cents per share gives up $200.
If you hold a stock for less than a year, any gains on that stock are taxed at ordinary income rates, rather than the lower long-term capital gains rate.
(Shortform note: Recent research suggests that individual active traders even tend to earn below-market returns before accounting for fees—individual investors simply trade stocks poorly.)

Thus, accounting for small losses and taxes, an active trader might need to gain at least 5% just to break even.

A 2000 study by finance professors found that the most active traders (who turned over more than 20% of their holdings each month) underperformed the market by 6.4% per year, while the least active traders (trading less than 0.2% of holdings each month) matched the market.

The message is clear: “active trading is hazardous to your wealth.”

Shortform Exclusive: Why Do Individual Investors Do Worse?

There is ample evidence that individual investors do worse than the market. Why is this? Here are reasons borne out by research:

Overconfidence: In general throughout much of life, people are overconfident about how much they know and how accurate they are. People who rate themselves as smarter than average trade more actively. Men tend to be more overconfident than women, and they trade more and perform worse than women do.
Sensation seeking: Trading stocks is entertaining and provides emotional, visceral engagement the same way gambling does. In this way, trading can be seen to compete with other entertaining activities; when alternatives such as legal gambling and lotteries are introduced, active trading drops.
Familiarity: Traders tend to over-invest in companies close to where they live or in the industry or company in which they’re employed. This leads to under-diversification and can have grave consequences when the employer goes bankrupt, as in Enron and Kmart.
Disposition effect: Individual traders strongly prefer to sell stocks that have risen in value, and hold stocks that have fallen in value. In other words, they sell winners and hold losers. This is largely the opposite of what is prudent—the stocks that rise tend to rise even further, and likewise for falling stocks. (In turn, the reason traders do this can do with loss aversion, narrow accounting, and self-control issues. For more on these topics, see our summary of Thinking, Fast and Slow.)

If investors knew this, they would rationally invest in an index fund and stop trading. Still, many are attracted by the siren song and continue suffering poor returns.

Warnings for Speculators

At its most irresponsible, speculation should be seen as gambling. It can be entertaining and instructional, but it should never be confused for investing. Here are warnings for speculators:

Don’t confuse your actions as investing when you’re really speculating. If your actions don’t require extensive analysis, don’t provide an adequate return over time, or don’t provide safety of principal, you’re speculating.
Don’t be deluded by a speculative method that works in the short term. Good investing frameworks sustain over the long term. Day trading, chart analysis, and stock-picking systems may work for a short period, but they fail in the long run.
Don’t speculate without knowledge or skill. Be humble about understanding your experience and track record. Study the results of other people with similar experience and skill.
Don’t speculate with more money than you can afford to completely lose. If you really want to speculate, set aside some money for a speculation account (say, a max of 10% of your assets), and never add money to it.

Defensive vs. Aggressive Investors

Having distinguished investors from speculators, Graham then defines two different types of intelligent investors: defensive investors and aggressive (or enterprising) investors.

Defensive investors want to avoid spending too much time on investing. They like simplicity and don’t love thinking about investments or money. Their goal is to perform on average in line with the market, and to avoid serious mistakes.

In later chapters, we’ll dive much deeper into both defensive and aggressive investment strategies.

Exercise: What Kind of Investor Are You?

Define what kind of investor you should be.

Are you currently an investor or a speculator? Remember that investment is an “operation that, through extensive analysis, provides an adequate return and safety of principal.” investors always consider the underlying value of what they’re buying.
Have you ever speculated before? What did you do, and what was the result?
Going forward, how much time are you willing to spend on investment?
What are your expectations of returns, relative to the market average?
What kind of investor should you be? Why would you not want to be the other kind of investor?

Chapter 2: Inflation

Inflation is an increase in prices over time. A dollar today buys a lot less than a dollar did 20 years ago: the purchasing power of a dollar has decreased.

Inflation is an insidious problem, because it doesn’t change the actual balance of your bank account, it only changes the purchasing power of how much money you have. If 2% of your bank balance were deducted per year, you’d take notice and be alarmed. But when the same amount of money can buy 2% less in goods and services each year, it’s nearly undetectable.

Therefore, if you were to hold all of your savings simply in cash, it would gradually lose value because of inflation. In contrast, holding stocks in your portfolio reduces the effect of inflation. Even if inflation occurs in a given period, increases in the stock’s dividends and price may offset inflation. Bonds, being loans with fixed terms, don’t have the same flexible resistance to inflation.

We’ll discuss inflation in more detail and why stocks protect against it.

Measuring Inflation

How bad can inflation get? During certain periods, inflation can be rapid:

In the US, in the 6 years from 1915 to 1920, cost of living nearly doubled.
Also in the US, in the 10 years from 1973 to 1982, cost of living more than doubled.
Zweig notes that since 1960, two-thirds of market economies have experienced inflation of at least 25% per year for at least a year. The US hasn’t yet experienced this, but it’d be unwise to assume it could never happen.

Averaging across much of the 20th century, Graham predicts that a reasonable assumption around inflation is 3% per year. (Shortform note: Since the start of the 21st century, inflation has stayed at a relatively steady 2% per year.)

Inflation and Stocks

How do stocks and businesses perform during inflation? There’s a lot of variability and plenty of exceptions to any rule, but, in his commentary looking back over the 20th century, Zweig notes in general:

In periods of steady mild inflation, stock returns outperformed inflation.
In periods of high (above 6%) inflation, stocks performed poorly. This might be because high inflation disrupts the economy—consumers purchase less, and businesses suffer.

Why Do Stocks Resist Inflation?

(Shortform note: This is a technical section we’ve included to be comprehensive; it’s not too relevant for the typical defensive investor.)

One theory of why stocks resist inflation is that during a time of inflation, a business’s costs increase, but it can also increase its prices at the same time, thus preserving its profits. In theory, a business can grow its revenues and profits at the same rate as inflation, and its stock price rises with inflation as well. In other words, a business can pass on the costs of inflation to its customers.

Graham analyzes these claims and finds that they fall short. Looking back on the 20th century, he agrees that stock prices have risen faster than inflation, but not because inflation had a direct effect on company financials. If the theory above were true, then companies would show higher earnings on capital during inflation (because the earnings should rise with inflation while the old capital investment stays the same). But this hasn’t appeared—earnings on capital have not kept pace with consumer prices.

Instead, much of the gain in earnings and stock price from 1950 to 1970 was due to two factors:

Reinvestment of profits into the business
Increasing corporate debt, used to grow the company faster

Protecting Against Inflation

Other than stocks, these two asset classes can also help protect against inflation:

Real estate: Prices of real estate tend to rise with inflation. However, Graham warns that real estate prices can be volatile, and you can easily make mistakes buying the wrong property for the wrong price. In his commentary, Zweig recommends Real Estate Investment Trusts (REITs), which are tradable securities that hold a diversified basket of real estate properties.
Treasury Inflation-Protected Securities (TIPS): Introduced in 1997, TIPS are inflation-indexed bonds, meaning the value adjusts to inflation. You can buy them from the US government or from a fund as offered by Vanguard. Oddly, increases in TIPS principal value are taxed as income, so consider buying TIPS in a tax-deferred retirement account like an IRA or 401(k).

Other assets are commonly considered to protect against inflation, but Graham is skeptical:

Gold: Gold’s supply doesn’t change much over time, as opposed to central banks creating more paper money, so it’s theoretically less subject to inflation. However, the price of gold has historically had a poor correlation with inflation, since gold prices fluctuate based on other factors.
Exotic assets, like art or diamonds. Graham says he’s out of his depth here, and most readers likely are too.

Chapter 3: Is It a Good Time to Buy Stocks?

Is it a good time to buy stocks? This is a perennially difficult question to answer. Investment professionals, whose job is to figure this out, constantly get it wrong.

Public sentiment is even less reliable—when a large crash occurs, most people, having incurred large losses, declare stocks too risky; in reality, this is the time of greatest opportunity to buy. Conversely, when people expect growth to continue perpetually, they’re willing to buy at any price; this ebullience is inviting a steep crash to more reasonable levels.

In each edition of The Intelligent Investor, revised roughly every 5 years from 1949 to 1973, Graham gave an assessment of whether stocks were undervalued or overvalued, and thus whether investors should choose to invest or sit on the sidelines. In this chapter, he reflects on those predictions and the general method of evaluating the stock market. (Shortform note: For today’s readers, this is of course less relevant for its actual predictions and more to illustrate Graham’s thinking.)

Stock Market History

In hindsight, over the past 75 years, stocks have trended consistently upwards. Here’s a chart showing the S&P 500 on a log scale:

(Shortform note: Long-term stock charts are often shown in log scale since they better reflect percentage changes and compounded growth, as opposed to changes in absolute values.)

Over the long term, stocks have tended to rise—in the history of the S&P 500, the annual return is roughly 10%, without adjusting for inflation. Graham suggests this consistent long-term performance supports his advice that all portfolios should have a portion in stocks.

However, he heavily cautions against simplistically extrapolating from the past, and against the delusion that stocks will always increase and so are worth investing in at any time, at any price. These conditions tend to breed wanton overpricing, which tends to invite a steep correction downward.

While the general trend is up and to the right, in the short-term, stocks fluctuate. Look more closely at the chart, and you’ll see more detail:

A major collapse in 1929, followed by fluctuations up until 1950. The S&P 500 would not reach the heights of 1929 until 25 years later.
A strong growth period from 1950 to 1965.
A period of relative flatness from 1965 to 1975.
Generally strong growth from 1975 to the 2000 dotcom crash, with periodic recessions in between.

As we think about investments today, we don’t have the benefit of future information, and so it becomes important to assess whether the stock market is expensive or cheap.

Shortform Exclusive: Inflation-Adjusted Returns

The book doesn’t address inflation in this chapter, but the inflation-adjusted stock returns have a significantly different shape:

Notably, during the highly inflationary 1970s and early 1980s, the stock market halved in real value, even though the absolute price stayed relatively flat. After adjusting for inflation, the annual return of the S&P 500 decreases from 10% to 7%.

Metrics for Evaluating the Stock Market

Of course, when investing today, you don’t have a stock chart for the future. You’ll need to assess the market to decide whether it’s cheap or expensive. Graham uses two major indicators of stocks in this discussion:

1) Price to Earnings ratio (P/E ratio)

This is the ratio of the stock price to the company’s earnings. If a company has earnings per share of $1, and its stock is selling at $10 per share, the P/E ratio is 10.

In general, a P/E ratio of 10 or below is low, and the stock is considered cheap. A P/E ratio of 20 or above is high (or the stock is expensive). (Shortform note: However, as discussed later, the P/E ratio is not by itself a good indicator of whether to buy a stock, since a failing company with poor future prospects will also have a low P/E ratio.)

2) Dividend yield, relative to bond yield

A stock’s dividend yield is the amount paid in annual dividends per share of stock, divided by its stock price. If a company pays $1 in dividends per share, and the stock price is $20, the dividend yield is 5%.

The bond yield is the return on a bond. Simplistically, if a bond costs $1,000 and pays $100 per year, the yield is 10%.

Comparing the stock’s dividend yield to the bond yield suggests whether stocks are likely to outperform bonds in the short-term, or vice versa. If the bond yield is notably higher than the stock’s dividend yield, it might indicate that stocks are overpriced.

Both of these indicators can be calculated for individual stocks, as well as for a collection of stocks or the stock market as a whole.

Graham’s Predictions

In each edition of The Intelligent Investor, Graham assessed then-current market conditions and declared whether the market was cheap or expensive. We’ll discuss his reasoning and how his predictions matched reality. (Shortform note: We’ve included stock charts of the Dow Jones Industrial Average up to each prediction time, to better show what was available to Graham at each point in writing.)

1948

Prediction: Stocks are not at too high a level.

The ratio of stock price to the last 3 years of earnings is at 9.2x.
The yield of stock dividend yield to bond yield is 2.1x.

Reality: From 1949 to 1953, the Dow gained 50%.

1953

Prediction: Stock prices are favorable, but prices have grown for longer than in most previous bull markets, and the price is historically high. Be cautious.

P/E ratio is 10.2x.
Dividend yield to bond yield is 1.8x.

Reality: The stock market grew 100% in the following five years. Graham admits they were too conservative in this edition.

1959

Prediction: The market is at an all-time high, and investors’ enthusiasm and momentum is likely to carry it to even greater heights. We’re in dangerous territory. Don’t delude yourself into thinking there will never be a downturn, and buying stocks is always profitable.

P/E ratio is 17.6x
Dividend yield to bond yield is 0.8x.

Reality: These were mixed results. The market grew to 1961, then fell rapidly in 1962, but quickly recovered into 1963 and grew from then on.

1964

Prediction: Be cautious. It appears the market is no longer held to traditional methods of valuation. We can’t rule out either extreme, that prices will continue growing by 50% or will suddenly collapse by 50%. If in doubt, reduce stocks to 50% of your portfolio.

P/E ratio is 20.7x.
Dividend yield to bond yield is 0.7x

Reality: The market fell to a notably low in 1970, then spent 1972 relatively close to 1965 levels. Graham feels this was appropriately cautious.

1971

Prediction: Stocks are still overvalued. There will likely be a major setback in stock value, or a brief bull market followed by an even larger setback.

P/E ratio is 18.1x. This is lower than the recent high of 20.7x in 1963.
However, the dividend yield to bond yield ratio is a dismal 0.41x, down from 2.1x in 1948. The situation has inverted, so that bonds are a much better investment than stocks.

Reality: The stock market suffered a major drop in 1973-1974, down 37% from the peak. Here’s a chart showing what happened after his last assessment:

Takeaways

Now that we’ve covered multiple historical data points, what’s important to take away from this?

1) Even experts like Graham have trouble picturing exactly what will happen in the future. At times Graham was too conservative in estimating how strongly stocks would grow; at others, he predicted a major setback that didn’t occur for quite some time. Beware of relying on so-called experts; make up your own mind through independent thinking.

2) Beware of relying too strongly on extrapolating from the past. Graham himself cautioned in 1953 that the market was at a historical high. The market grew by 100% in the following five years.

In commentary, Zweig notes that during the dotcom bubble, a slew of investment managers claimed this was an unprecedented new era of limitless growth, and they piled on each other with higher and higher price targets for the stock market. The stock market eventually fell over 30%, with some stocks losing over 99% of its value.

3) Practice contrarian thinking. If someone says stocks will always go up, ask, “why? If everyone buys stock according to this belief, then won’t stock prices be unreasonably high? And if companies can only earn finite amounts of profit, won’t the stock price at some point exceed a reasonable value for the company?”

In fact, Zweig suggests, the more enthusiastic investors are, the more likely a setback is to occur. And the more that stocks fall out of favor after a large shock, the more likely it’s a buying opportunity.

Chapter 4-5: The Defensive Investor

With some market fundamentals covered, we’ll now discuss the two major types of investors: defensive investors in this chapter, and aggressive investors in the next.

Defensive investors want to avoid spending too much time on investing. They like simplicity and don’t love thinking about investments or money. Their goal is to perform on average in line with the market, and to avoid serious mistakes.

We’ll cover how the defensive investor should invest, both from a philosophical point of view on how to behave and a tactical point of view on what stocks and bonds to buy.

How Should Defensive Investors Invest?

Why is this? Why not put 100% of your investment into bonds? Three reasons:

Stocks on average rise faster than inflation, whereas bonds might not, so holding stocks better protects against inflation.
Stocks tend to have better returns (though this isn’t always true; if interest rates are very high, as they were in parts of the 1970s and early 80s, bonds may provide better returns).
If you invest 100% into bonds, but the stock market grows tremendously, you’d feel regret on missing out.

And why not 100% into stocks?

Stocks don’t always outperform bonds at all times. At the time of Graham’s last revision in 1973, bonds were outperforming stocks. Keeping a balance helps you weather a variety of economic conditions.
Stocks fluctuate much more than bonds do, and the wild oscillations of a 100% stock portfolio may test the investor’s equanimity. A terrible mistake you can make as an investor is to sell as the stock market craters, and buy at the peak of its hype. Holding a minimum 25% in bonds gives some psychological cushion against stock market falls.

In short, keeping a standard split is simple, provides adequate returns, and prevents your emotions from sabotaging yourself.

The Myth of Age

There’s a common rule of thumb that your split between stocks and bonds should depend on your age: subtract your age from 100, and that is the percentage that should be held in stocks.

But Graham never mentions age in his advice, for good reason. Zweig supports this point, arguing age shouldn’t affect your investment decisions—your personal circumstances are what matter.

In particular, you can feel more comfortable holding more stocks if:

You do not need to sell your stocks at inopportune times to support your living costs.
You can withstand severe drops in the stock market.
You do not need your investments to provide cash income. Generally, bonds provide more in interest payments than stocks do in dividends.

Consider two different situations that buck the common wisdom:

A retired 80-year-old who has a pension to cover all her living expenses, $2 million in assets, and grandchildren. Investing mostly in bonds is a mistake—she doesn’t need to rely on investments for income. Furthermore, her descendants, who will inherit her assets, have decades of investment in their timeline, and stocks will provide better returns on that timeline.
A working 30-year-old who has $50,000 and is saving up for his down payment on a house. It’d be silly to put all of that in the stock market—if the stock market fell, he’d have to change his life plans.

Portfolio Rebalancing

Over time, as your investment values fluctuate, the proportion between stocks and bonds will deviate from your desired ratio. For example, if you start with $10,000 and a 50-50 split between stocks and bonds, over time you may end up with $6,500 in stocks and $5,500 in bonds, leading to a 54:46 split. At this time, you should “rebalance” your portfolio to return to 50-50. You can do this by selling stocks and buying bonds, or if you have more money to invest, you would buy relatively more bonds than stocks in this round of investment to return to a 50-50 split.

You shouldn’t rebalance more frequently than once or twice a year. If you’re checking your investments on a daily basis and spending hours per week, you’re getting too involved to be a defensive investor, and your emotions will likely start ruling your decisions.

Dollar-Cost Averaging

Graham argues for the psychological benefits of dollar-cost averaging: you remain emotionally detached from the swings of the market. Regardless of whether prices are up or down, you invest the same amount.

Practically, this prevents you from overreacting in bad directions:

When the stock market crashes, most people become fearful about investing, yet this is the point at which stocks are cheapest. Dollar-cost averaging forces you to invest the same amount.
Likewise, in a strong bull market, you might be tempted to buy stocks at steep prices. Dollar-cost averaging prevents you from getting carried away and investing more than is wise.

Psychologically, dollar-cost averaging helps you avoid the delusion that you can predict the market. Zweig notes that your response to any investment question should be “I don’t know and I don’t care.”

Are technology stocks worth doubling down on? Is this hot new company worth investing in at its premium price? “I don’t know and I don’t care”—if you invest in mutual funds, they already capture a large part of most industries, and any hot company that succeeds will be a part of your portfolio soon enough.
Is the stock market going to rise or fall in the next month? “I don’t know and I don’t care”—if it rises, your existing investments will capture that gain; if it falls, you will invest more later at a lower price.

(Shortform note: Dollar-cost averaging has been studied extensively, with both strong advocates and critics. Critics argue that it leads to subpar performance—in short, if the expected value of your investment is positive, then you should invest as early as possible to capture that expected value. Proponents of dollar-cost averaging suggest that, even if it doesn’t yield superior returns, it carries benefits in psychological ease and simplicity.)

What Stocks and Bonds to Buy?

Now that you understand the general split between stocks and bonds, what do you actually buy? Graham spends a few chapters giving advice on choosing specific individual bonds and stocks because, in the mid-20th century, those were the only options available to investors.

Since then, a large number of low-cost mutual funds have become popular. These funds hold a wide basket of assets, such as stocks and bonds, thus providing diversification with minimal effort. (Shortform note: For instance, Vanguard has a fund for the entire US stock market, as well as a fund for short-term Treasury bills. When you buy a share of such a fund, you essentially hold a small piece of everything the fund holds.) Such diversification makes dollar-cost averaging and rebalancing easy to execute, since you only need to buy one fund instead of balancing across dozens of stocks.

And in contrast to high-cost mutual funds in the 20th century, where annual fees might be as high as 1-2% of your investment, these days competition has driven the fees down to the range of 0.05% (a $10,000 investment would cost just $5 per year).

Graham was a big fan of index funds, and the modern defensive investor may do well simply by investing in index funds at Graham’s recommended split. But for comprehensiveness, we’ll cover his advice to the defensive investor for choosing specific stocks and bonds.

What Stocks to Buy?

For any investor, the classic mistakes in buying stocks are:

Paying too high a price for a stock: This is especially risky in 1) strong bull markets, when the market seems like it can only rise with no possibility of a downturn, or 2) for hot stocks, where speculators drive up the price expecting the company to outperform in the long term.
Withdrawing from the stock market after a steep crash, when most people view stocks as too risky. At this time, stocks are especially cheap.

To counter these mistakes, Graham issues four simple rules for choosing stocks:

1. Diversify, but not excessively.

Graham advises holding at least 10 and at most 30 stocks.

2. Buy large, prominent companies with conservative financing.

Let’s define each of the three terms:

Large: In 1973, Graham defined large as having at least $50 million in assets or revenue. In modern commentary, Zweig suggests the bar is companies with at least $10 billion in market capitalization.
Prominent: The company should be a leader in its industry, and be in the top 25% by size.
Conservative financing: The company’s market capitalization should be no more than double its book value.

(Shortform note: Critics argue that book value is unreliable in modern times, since book value excludes the value of intangible assets like intellectual property or brand value. Thus, relying on book value alone would eliminate a swath of promising investments.)

3. Buy companies with a record of continuous dividend payments.

In 1973, Graham argued for companies that regularly paid dividends over the past 20 years. In recent times, companies have paid dividends much less regularly, so Zweig adjusts the time frame to the past 10 years.

4. Impose a price maximum on stocks you buy.

Graham argues for a maximum per-share price of 25 times average earnings over the past 7 years, or 20 times earnings over the past 12 months.

Notably, this rule excludes hot “growth stocks,” for good reason. Growth stocks often represent new companies that are growing rapidly but are unprofitable or have only meager earnings. Thus, their price-to-earnings ratio may be far above 20 times. Graham argues that these stocks are too risky for the defensive investor—without thorough analysis, a defensive investor is very unlikely to repeatedly pick the right stocks at the right times.

Finally, don’t buy common stock for its dividend income alone. The stock price must still be reasonable, and the company should be fundamentally sound.

We’ll return to more technical guidance on how to pick stocks in Chapters 14-15, after we cover more fundamentals of stock analysis and market mindset.

Don’t “Buy What You Know”

In his commentary, Zweig cautions against the common wisdom of “buy what you know.” The premise of “buy what you know” is that, as an ordinary consumer, you know what brands and products you like, and in this sense you might know more about the company than professional stock analysts. Thus, you should buy stocks of companies you like.

Of course, this simple-minded view violates Graham’s universal principles of considering the underlying value of the stock, and the stock price in relation to its value. If you were a disciplined investor, you would consider whether the stock was overpriced, regardless of how much you liked the company emotionally.

This applies generally to being complacent about what you’re familiar with. The more you think you know about something, the less you are to probe for real weaknesses.

Notably, this applies to people owning their own company’s stock in their retirement portfolios. Does it ever make sense to have a third of your entire stock portfolio in a single company? If not, then why would it make sense to invest it in your employer?

What Bonds Should You Buy?

Shortform Exclusive: Introduction to Bonds

(Graham skips over explaining what bonds are, assuming the reader already has knowledge. We wrote this introduction in case you’re unfamiliar.)

Bonds represent loans made by an investor to a borrower. As an investor, you can buy bonds from companies, municipalities, states, and national governments. When you buy a bond, you become a creditor—the bond issuer owes you money.

A bond consists of a few components:

The principal: the amount of money that is borrowed, also known as the “face value”
The coupon: the interest rate that is paid to bondholders.
The maturity date: the date at which the principal will be paid back.

For example, say today you buy a treasury bond from the US federal government with a principal of $10,000. The term is 20 years, with a coupon rate of 4%. Every year, you will receive $400 in interest payments. In 20 years, the government will pay you back $10,000.

The bond is also tradeable. You can buy the bond from the government, then sell it to another investor. You aren’t required to hold onto a bond until the maturity date.

The bond therefore has a market price that depends on outside circumstances, particularly the market interest rates. Once it’s issued, a bond is a fixed instrument with defined terms—it will pay certain amounts at certain dates. The fixed amount that bond pays can have changing values in different periods:

If the interest rate in the larger market declines, the price of a bond increases. For example, say you have a bond with a 4% coupon while overall interest rates are at 2%. The bond is paying out more than current interest rates, and it thus becomes more valuable. The price of this bond might significantly exceed the $10,000 in face value.
Likewise, if the overall interest rate increases, the price of a bond decreases. For example, if interest rates rise to 6%, there are better opportunities to invest elsewhere than in the 4% bond. The price of a bond might fall much lower than the $10,000 in face value.

There are many more complexities to bonds, but this should suffice to build an intuition for how bonds work.

Zweig’s Commentary on Bonds

In his modern commentary, Zweig offers the following additional tips:

Most bonds are sold in $10,000 lots, and you need at least 10 bonds to diversify away the risk of default. Therefore, unless you have $100,000 to invest in bonds, you should invest in bond funds instead. These diversify over a wide basket of bonds without your needing to do individual research.
If you really want to buy individual bonds, instead of buying short-term or long-term bonds, strike the middle: 5-10 year maturity dates. These have more dampened fluctuations than long-term bond prices, while they capture more upside than short-term bonds.

Types of Bonds

When deciding what bonds to buy, there are more considerations:

Tax status: some bonds provide tax-free coupon income, while others are taxable.
Maturity date: are bonds with shorter terms or longer terms better?
Risk of default: a borrower defaults when it’s unable to make payments on its loans. The borrower may ultimately declare bankruptcy, and the bond may lose a substantial part of its value. Thus, higher-risk borrowers can only issue bonds at higher interest rates—its lenders demand the extra payments to compensate for the higher risk of bankruptcy.

For tax status, the question is straightforward—a taxable bond should compensate for your income tax bracket with a higher coupon. For example, if your tax bracket is 30%, then a tax-free bond with a 7% coupon and a taxable bond with a 10% coupon are equivalent. Thus, a tax-free bond with a coupon rate higher than 7% would be relatively more attractive, and likewise for a taxable bond with a coupon higher than 10%.

Don’t buy tax-free bonds in your retirement accounts, like your 401(k) or IRA. In these tax-advantaged accounts, you should hold taxable bonds instead.

To address the other issues, Graham provides an overview of the major types of bonds. While the yields for all types of bonds fluctuate over time, the general properties stay consistent.

US Savings Bonds (Series E)

Maturity: Up to 30 years
Federal tax: Yes | State tax: No
Risk of default: Very low

Notes:

Allows for redemption at any time. Graham notes that this unique flexibility could compensate for lower returns.
Graham discusses Series H bonds, but these were discontinued in the early 2000s.

Treasury Bonds

Maturity:
- Treasury bills: Up to one year
- Treasury notes: Between 2 and 10 years
- Treasury bonds: 30 years
Federal tax: Yes | State tax: No
Risk of default: Very low

State and Municipal Bonds

Maturity: 1 to 30 years or more
Federal tax: No | State tax: Yes (unless in state of issue)
Risk of default: Moderate (check credit ratings—AAA to A is safe)

Corporation Bonds

Maturity: 1 to 10 years or more
Federal tax: Yes | State tax: Yes
Risk of default: Moderate to high (check credit ratings)

Notes:

Higher-yielding “junk bonds” provide a higher return with higher risk of default. Graham advises defensive investors to steer clear of these, since they require detailed study to find bargains.

Preferred Stocks

Like corporation bonds, preferred stocks are issued by companies, but they’re a hybrid of common stock and bonds:

They pay a fixed dividend rate, but only if the company decides to pay a dividend. If the company can’t or doesn’t pay dividends, the preferred stock doesn’t produce any payments.
Because the dividend is fixed, it caps the profits available to the preferred stock holder. Common stock does not have this cap.
In a company’s liquidation, preferred stock has more senior rights than common stock, but lower than bonds and creditors.

In Graham’s view, this is the worst of both worlds: limited upside combined with higher risk. Thus, he advises defensive investors to stay away from preferred stock. He does note that other corporations might consider buying preferred stock, since corporations pay a lower tax rate on dividends than on income payments from bonds.

Income Bonds

Income bonds are issued by companies. With income bonds, interest isn’t guaranteed to be paid, unless the company has enough earnings to pay it. A company that pays interest on these bonds can deduct it from its taxable income, which makes it an especially cheap form of capital.

Graham notes that these should be used more often by corporations, but still have a historical stigma as being issued by financially weak companies.

Chapter 6: The Aggressive Investor, Generally

(Shortform note: Graham uses the terms “enterprising investor” and “aggressive investor” interchangeably—we use “aggressive” since it’s the more well-known of the two terms.)

Expectations for the Aggressive Investor

Effort Required of the Aggressive Investor

To be successful as an aggressive investor, you must devote your full effort and attention to the task. You should view your investing as equivalent to operating a full business—just as you can’t be half a business operator, you can’t be half an aggressive investor and half a passive investor.

Since most people can’t put in this effort, they should become defensive investors instead.

Expected Gains of the Aggressive Investor

How much in gains should a successful aggressive investor expect? The author says that an additional 5% per year, before taxes, is necessary to be worth the effort of all the research and work. (Shortform note: Graham notes repeatedly that good investors should not aim for stratospheric results, but rather modest and consistent returns over the long term. Due to compounding returns, an extra 5% a year makes a huge difference over time.)

A Warning from Graham

(Shortform note: This section originally came from Chapter 15.)

The task of beating the market is a difficult one, and Graham issues a caution—the evidence strongly suggests that most professional money managers do not beat the overall market in the long term, after deducting fees. These funds employ highly intelligent and motivated people who dedicate their entire working days to researching and choosing individual securities. Yet even they can’t outperform the S&P 500.

Why is it so difficult to beat the market? Graham offers two possible reasons:

Reason 1: The current stock price already has all existing information “priced in,” and from this point stock market movements are essentially unpredictable.

There are countless opportunistic investors and investment firms that behave like an aggressive investor—they study a company’s historical performance and future prospects, try to identify bargains and overpriced stocks, and invest accordingly. When the market is made up of many thousands of such people, the market price for a security already reflects the consensus opinion of the company’s value.

From this point on, any developments that affect stock price are unpredictable. When you try to predict the unpredictable, your chances of succeeding in the long term are slim.

Reason 2: Most investors have a bad strategy. If you adopt a non-consensus strategy, you might be able to beat them.

Most money managers might have a consistent problem in how they make investments. For instance, they might believe that a promising company’s stock is worth buying, no matter how high the price. They might also believe that certain industries and companies are toxic wastelands to be avoided, no matter how low the price.

In practice, no company’s stock price rises perpetually, and many companies that have fallen into temporary misfortune recover company performance and stock price.

If most traders in the market believe such ideas, then there can exist opportunities that are ignored by the rest of the market. Graham’s personal record as a consistently successful investor, as well as the records of his students such as Warren Buffett, suggests that such opportunities do exist.

How Should Aggressive Investors Invest, Generally?

To beat the overall market, the aggressive investor needs to practice a disciplined approach that is unpopular in the larger market.

Why unpopular? Investing is so competitive that any straightforward strategy that actually works consistently will quickly be adopted by the rest of the market, and the profits will evaporate. Graham cites an example from 1949, where buying the Dow Jones index below its intrinsic value and selling it above intrinsic value provided consistent returns over much of the past century. After 1949, this no longer worked—either because people adopted the strategy and thus bid up stock prices past the point where the strategy worked; or the strategy was illusory to begin with.

After all these warnings, what strategy can be used, then? In essence, Graham’s strategy is to use a framework to value companies reliably, then identify companies that are priced lower than their fair value. In other words, buy a company when it’s priced more cheaply than it’s worth. That’s what most of the remainder of the book is about.

Why does this strategy not lose its advantage over time, like other strategies? Graham suggests a few reasons:

Speculators trade so erratically that, at any time, there will always be stocks that are overvalued and undervalued.
Companies and entire industries may be undervalued simply because they fall out of fashion.
Despite the claims of the efficient market hypothesis, there will remain pricing inefficiencies in the market, particularly because market movements are made of people following their own flawed psychology and of such people mimicking each other.

(Shortform note: The implication is that the patient, methodical, emotionally composed method suggested by Graham will continue to be unpopular. Most speculators are swayed by popular opinion, have mood swings, look for simple solutions, and are impatient for riches. Few will have calm control over their psychology and take on the burdensome task of thorough research, and so few will enjoy the fruits of the strategy.)

Enthusiasm is great for endeavors outside of investing. In investing, it will ruin you. Here you need self-control. You cannot let other people’s opinions and emotions sway your own.

Chapter 7: The Aggressive Investor, Specifically

With the general mindset established, we can now cover the specific choices of the aggressive investor. While the defensive investor can earn market returns simply by investing in general mutual funds, the aggressive investor needs to seek pointed opportunities to be above average.

Asset Classes to Avoid

An aggressive investor willing to do a lot of work will likely be more interested in a broad array of asset classes. If you know what you’re doing and can find good opportunities, you’ll likely enter areas that defensive investors should stay clear of.

However, Graham cautions against a set of instruments that even aggressive investors should be skeptical of. An investor’s success is defined just as much by what he chooses not to do as by what he does.

For the below issues, the aggressive investor should be cautious and scrutinize the security before investing.

Be careful not to get carried away by the promise of higher returns while ignoring the risk and inadequate margin of safety.
Avoid buying each of these securities at full prices. Consider buying them only at steep discounts (where prices are below two-thirds of their fundamental value).

In any of these classes, you may find clear bargains, but you need to be more careful than usual.

Defensive investors should avoid these entirely.

Second-Grade Bonds (Junk Bonds)

Companies with a sound position offer first-rate corporate bonds. More precarious companies with lower credit ratings issue lower-grade bonds (also known as “junk bonds”) with a higher interest rate.

One heuristic Graham uses to determine the grade of a bond is the ratio of company earnings to interest charges.

In the railroad industry, for instance, he prefers that a company earn at least 5 times the annual interest charge; less healthy companies might only have enough earnings to cover 1 times the interest charge.
In modern times, WorldCom sold $11.9 billion of bonds in 2001. However, its pretax income fell short of covering its interest charges by $4 billion. It could only pay off its interest by borrowing even more money. While its bonds did offer 8% yields for a few months, WorldCom went bankrupt in 2002.

It may be tempting to buy these lower-grade bonds purely for the sake of a higher yield. But Graham cautions that it’s unwise to seek attractive yield without adequate safety. The companies issuing lower-grade bonds have a higher chance of default and you may actually lose your entire principal, merely for an extra 1-2% of yield.

Therefore, a second-grade bond selling at par value is usually a bad investment. It’s better to buy lower-grade bonds at steep discounts. Because these bonds tend to rise and fall with markets, a patient investor will be able to find good deals.

In his modern commentary, Zweig mentions there are now junk-bond funds that allow more diversification across dozens of different junk bonds. While they do outperform Treasury bonds on paper, they tend to charge high fees.

Foreign Government Bonds

The trouble with owning foreign government bonds is that the owner of these bonds has no legal way of enforcing them. Unlike domestic companies, foreign governments are outside the domestic legal system.

Historically, foreign bonds have also had a poor history for much of the 20th century until at least when Graham wrote this book. For instance, Cuba issued bonds that reached a high of 117 in 1953, then defaulted on those bonds and brought the price down to 20 in 1963.

In his commentary, Zweig mentions there are now emerging-market mutual funds that, once again, allow diversification across foreign bonds. He notes that these have the useful property of not correlating strongly with the US stock market and may be useful as diversification, but don’t put more than 10% of total bond holdings into them.

New Stock Offerings (IPOs) and New Issues

In an initial public offering (IPO) or a new stock offering, privately owned companies “go public” and sell their stock to the public. This allows the company to sell their stock for cash, raising funds for further investment and allowing stockholders to cash out.

Not all new issues should categorically be dismissed, but they deserve extra scrutiny for two reasons:

The underwriters of the IPO (commonly investment banks) own a large portion of shares, so they have a passionate interest in painting the best picture of the company to pump up the price.
New issues are opportunistically sold under good market conditions (typically bullish), which means worse conditions for the buyer.

When considering IPOs, we tend to fixate on the landmark examples of the past—the Microsofts and the Apples—while forgetting that most other IPOs were bad investments. Zweig notes that, between 1980 to 2001, if you had bought each IPO and kept it for 3 years, you would have underperformed the market by 23% annually.

The IPO Cycle

IPO hype occurs in a cycle. History has shown a regular cycle of 1) a bullish period, during which private companies go public with soaring stock prices, followed by 2) steep declines in a market contraction. This occurred in 1945, then in 1960, then in 1967, the dotcom boom in the late 1990s, and so on.

In more detail, the bullish period has a repeatable sequence that brings stocks to unfathomable heights:

In the middle of the bull market, the first IPOs are priced reasonably, and its early buyers make large profits.
As the market continues to rise, more companies seek to cash out through IPOs, and the pace of new issues increases. At the same time, the quality of the companies going public deteriorates, and the prices soar to unreasonable heights.
During the bullish period, the fast rise of the new stock prices causes a greedy complacency that dulls the public’s critical skepticism.
A sign of the coming end of the bull market appears when the new IPO stocks are priced comparably to mid-sized companies with a much longer track record.
As the bull market turns downward, the new public stocks may lose 75% or more of their initial price.

For a notable example, AAA Enterprises IPO’d at $14 a share in 1968, reached a peak of $28, then dropped to $0.25 in 1971 (a 98% drop). (We’ll cover this company more in Chapter 17.)

An intelligent investor needs to maintain his critical faculties during bull markets and avoid buying overpriced shares that are far outside the underlying value of the business. If you’re patient, you can pick up steeply discounted shares just years later when the hot stocks fall out of fashion.

Convertible Issues

(Shortform note: This material comes from Chapter 16.)

Convertible issues are bonds or preferred shares that have a conversion option—they allow the holder to convert the bonds or shares into common stock at a particular conversion ratio.

The sales pitch is that convertible issues are presumably a “best of both worlds” for everyone:

The investor gets the stability of a bond, while having the option of participating in the rise in a company’s stock price by converting.
The issuer gets to raise capital through a debt-like instrument—because of the value of the conversion option, the interest rate is usually lower. And if the company succeeds and the investor converts, the issuer gets rid of a senior creditor; in the meantime, the company isn’t diluted as much as if it issued new shares.

Despite these positive arguments, Graham believes convertible issues are the worst of both worlds for the investor:

By having the conversion option, the investor accepts a lower interest rate than would be available through standard bonds. Thus, in bear markets, they underperform bonds, yet they carry more risk by being more junior in debt obligations.
The value of convertible issues rises and falls with the company stock price. An investor with typical psychology would convert the shares when the stock is rising, but that’s precisely when the stock is likely overpriced.
Companies that issue convertible securities tend to be of lower quality with worse long-term prospects. Instead of buying stock in these companies, investors think convertible issues are safer. But if you wouldn’t buy stock in these companies, why would you want to hold convertible securities?

In other words, if a company is strong, you should invest in its stock directly. If you want the security of bonds, then just buy bonds. The middle ground of convertible issues is usually an unnecessary compromise. (As with any of the securities in this section, there may be exceptions where a convertible issue is more attractive than the common stock or bonds, but you will have to search for them.)

How to Choose Stocks

With these cautionary notes out of the way, which stocks should the aggressive investor choose? Graham describes four general strategies that aggressive investors take and offers his opinion on each:

Market timing: buying in bear markets and selling in bull markets
Growth stocks: identifying stocks with high potential to growth
Bargain stocks: finding that have fallen out of favor of the market and are trading well under a reasonable price (this is Graham’s preferred strategy)
Special situations: idiosyncratic situations, such as acquisitions, bankruptcy, and legal proceedings

One strong general theme runs through: when you consider the wisdom of investing in a stock, you cannot ignore its price.

A very promising company with bright prospects may still be a bad investment, if its high price already reflects the market’s enthusiasm for the stock.
“Buy your stocks like you buy your groceries, not like you buy perfume.”

(Shortform note: While Graham focuses his advice on choosing stocks, the principles for choosing specific bonds are analogous.)

Market Timing

Market timing has a strong allure: buy when the market is down, and sell when the market is up. The trouble is determining when exactly the bottom or the peak of a market is. This often seems obvious in retrospect but is exceedingly difficult to predict in the future.

Graham notes that markets have resisted any reliable mathematical diagnosis of when a market is poised to collapse or to boom. In his commentary, Zweig adds that even professionals who spend their entire careers attempting market timing are empirically unsuccessful at it. So think carefully: why should you do any better?

We’ll cover more of market timing in Chapter 8, when discussing Graham’s famous Mr. Market idea.

Growth Stocks

Growth stocks are stocks that have grown earnings well in the recent past and are expected to continue growing them into the future.

The simplistic strategy is to choose a basket of stocks that have recently outperformed the market, expecting them to continue outperforming. However, growth funds specializing in this strategy have not been shown to outperform the market and often do worse.

Why doesn’t this work reliably? There are two major issues:

Because the company has already outperformed in the past, the market has already developed an optimism for the stock, and so the stock may already have its current price inflated. Buying in at this point is risky: If the company fails to meet the market’s lofty expectations, its stock price may tumble.
- Graham suggests that stocks with a price-to-earnings ratio of over 20 already have significant growth accounted for in the stock price.
It’s difficult to extrapolate future growth from recent history. In practice, growth cannot continue forever. The larger the company, the harder it is to grow at the same rate. Beware of breathless enthusiasm for infinite growth possibilities.
- In the 2000 dotcom bust, countless reputable investors forecast unlimited growth and considered traditional investing principles obsolete. Some stocks reached a price/earnings ratio of over 100! In hindsight, this was a gross overestimation of growth prospects, and the stocks crashed back to earth.

Graham also advises against buying stocks based merely on industry growth. It’s hard to consistently pick the best companies in the best industries—even experts fail at it.

In the 1950s, airline traffic was poised to grow by multiples. But investing in airlines would have been a mistake—despite rising revenues, airlines were chronically unprofitable.

Beware the Fantasy Stories

Investing history is rife with fantastical stories of early investors in companies such as Microsoft and Apple, who grew their initial stakes 100-fold into fortunes.

While it’s tempting to find opportunities like this as a public outsider, Graham notes that these fortunes are usually made only by people with a close tie to the company, such as the founders, employees, or family members of either. These insiders have stronger reasons to hold onto the stock than you would as an outsider; they held onto the stock through its fluctuations, while you would face significantly more psychological pressure to capture your gains or stem your losses.

In his commentary, Zweig adds that many of these fortunes were made by heavy concentration in one stock, as with Bill Gates and Microsoft. However, history is unkind to people who concentrate so heavily. Take the 400 richest people on the Forbes list in 1982 and look 20 years later—only 64 (or 16%) remained on the list in 2002. The rest had most of their worth tied to their business and enjoyed a temporary fortune; when their businesses went south, their worth followed.

Bargain Stocks

Finding bargain stocks is Graham’s preferred method. Here’s the general idea: markets are made up of people who are impulsive and follow each other. This can cause major fluctuations in price (both up and down) that are irrational, based on the stock’s underlying value.

When a company has fallen out of favor, its price will drop below what the fundamentals of the company would warrant. The stock has now become a bargain—if you buy them, they may later recover their prices and be good investments.

Graham defines a bargain as a stock that has a real value of at least 50% more than the current price. In other words, the price is below two-thirds of the stock’s value.

How do you calculate the stock’s value, then? Two methods:

Take the company’s future earnings and multiply these by a factor relevant to the company and industry. (Shortform note: a related method is discounted cash flow.)
Estimate the value of the business to a buyer. This value might generally be similar to the future earnings method, but more attention might be paid to the value of assets.

To be more concrete, Graham shares a few flavors of bargain stocks.

The Unpopular Large Company

Large companies with a history of good performance and a sound position are like large, steady ships: they can weather many storms, since they have the resources to work through sudden problems and bad macroeconomic conditions.

However, these companies might fall out of favor in the market because of bad news (like a small scandal or a news report). The market may overreact, thinking that the news reflects a permanent, irrecoverable loss in the value of the company. In reality, the large companies can recover quickly, and the market may regain confidence in it quickly given the company’s strong track record.

Here are a few examples:

In October 1982, seven people in Chicago died from Tylenol laced with cyanide. The parent company Johnson & Johnson (J&J) saw its stock fall by 17.5%, but within the year it introduced new tamper-proof packaging. Tylenol regained its market leader status, and J&J quickly regained its share price and became a strong growth stock through the 1980s.
Similarly, in July 2002, J&J announced a federal investigation into record keeping at one of its factories, and its stock price fell 16% in a day (taking its price-to-earnings ratio from 24 to 20). It recovered its price within a few weeks.
In 2002, the cruise ship operator Carnival lost 10% of its value when news came out of tourists getting sick on the ships of other companies.

Beware, however, that not all companies can recover from bad news. Some companies may start trading at an apparent discount and indeed show a permanent loss in stock price.

How do you identify companies that can weather the storm?

It should have stable earnings over the past 10 years or more.
It should be large enough and have strong enough finances to overcome future problems.

Untraditional Earnings

Some companies may have accounting idiosyncrasies that obscure its real earnings potential. Graham cites Northern Pacific Railway, which had real earnings in 1947 of $10 per share but had a stock price of $13.50, because railroad companies used accounting methods that underestimated its earnings potential.

Value Less Than Net Working Capital

At times, a company’s market capitalization may be lower than its net working capital (current assets minus current liabilities). This is an odd situation, since it suggests a buyer could buy the company and get all its fixed assets (property, equipment) and goodwill for free.

Very few companies are truly in such a poor situation that it should be worth less than net working capital, so more likely it has simply fallen temporarily out of the market’s favor.

Secondary, Non-market Leader Companies

The large market leader of an industry tends to be a “blue chip” type of stock, with relatively predictable stock price performance. The secondary companies, or companies who are not market leaders, have a more lopsided potential—they are smaller and thus more at risk of failing, but, being smaller, they are able to grow faster than large companies.

Therefore, secondary companies are more susceptible to the current market fashion. The fashion has oscillated over time:

The Great Depression in the early 1930s was especially harsh to secondary companies, so the market avoided them for decades, preferring the stability of large market leaders.
After World War II, the economic boom benefited all companies but was especially kind to smaller companies, which had more room to grow. Thus small company stocks grew faster than large company stocks, and they became fashionable.
Each boom and bust cycle tends to show this pattern. In times of technological hype, as in the 1960s with electronics and computer companies, the small startup companies tend to have wildly inflated values.

The key, then, is to invest when secondary companies are out of fashion, when the market believes they are headed to extinction. In reality, this is an overreaction—secondary companies are often solid businesses on their own right, and they may be comparable in size to leaders in smaller industries. Thus there’s no general reason they shouldn’t have an equal chance of longevity as larger companies.

Special Situations

These are special idiosyncratic situations that require considerable insight. Thus even most aggressive investors may be wise to avoid them unless they really know what they’re doing.

Acquisitions

At the time of Graham’s writing, large corporations favored the strategy of diversification by acquiring smaller companies. When buying public companies, a buyer often needs to persuade the target’s shareholders by offering a price well above its current trading stock price. If you expect a company is soon to be approached by a suitor, then you might invest in the seller’s stock.

Even after an acquisition is announced, it may represent an arbitrage opportunity.

For example, Acme Corp. may propose acquiring Beta Corp. by giving 1 Acme’s shares for 2 of Beta’s shares. If the transaction were certain to close, then Beta’s stock price should be half of Acme’s—for instance, Acme might be priced at $40 and Beta at $20.
If Beta’s shares are priced less than this ratio, then the market believes the transaction is not certain to consummate. This presents an arbitrage opportunity—if you understood this transaction well and held a non-consensus view of its likelihood of consummating, you could earn a fairly quick return. This of course is subject to the risk of the deal not consummating, at which point you’d likely suffer a loss.

Bankruptcy

Companies going through bankruptcy reorganization may have old bonds that can be exchanged for new securities after the reorganization, producing a kind of arbitrage. There’s a risk that the company doesn’t reorganize successfully.

Legal Proceedings

There’s an investing maxim that goes, “Never buy into a lawsuit.” If most of the market believes this, then a company running into legal issues may have an underpriced stock. Some of these companies may indeed face permanent damage, but others may recover.

Closely Held Companies

Graham’s definition of a bargain (two-thirds of its underlying value) pertains to outside investors who do not control a company. If you do control a company, then you can consider buying shares at a value above Graham’s bargain price, at a fair value in the private market.

With this overview of which types of stocks to buy and avoid, we’ll return to picking stocks in Chapters 14-15, after we cover more fundamentals of stock analysis and market mindset.

Chapter 8: Market Fluctuations and Mr. Market

When asked to predict what the market would do, the financier J.P. Morgan said, “it will fluctuate.”

You can be sure that the market will fluctuate. In all likelihood, you will not be able to predict when and how the market fluctuates. You can, however, respond in two critical ways:

Steel yourself mentally for the fluctuations. Prepare for the idea that your portfolio may decline by 30% from its high point, and don’t tie your emotions to these fluctuations.
Watch patiently and prepare to spot opportunities when they do appear. When the market sours on a stock, it can be an overreaction and present a bargain buying opportunity.

We cover two trading strategies that deal with market fluctuations: market timing and stock pricing. Graham is sour on the former as a reliable investment strategy, but, as we’ve seen, he believes in the latter.

Market Timing Doesn’t Work

Market timing has a strong allure: buy when the market is down, and sell when the market is up. The trouble is determining when exactly the bottom or the peak of a market is. This often seems obvious in retrospect but is exceedingly difficult to predict in the future.

Graham argues that market timing is so unreliable that it should be considered speculation. There is little evidence that any individual investor should be able to beat the overall market at market timing.

Why Do People Like Market Timing?

Speculators are drawn to market timing for a variety of reasons:

They are impatient to do something in the market and to have some opinion about the market. It’s less entertaining to sit idly until stocks fall under your criteria for a bargain.
They have an arrogant presumption that if you’re smart enough, you can predict how the market will move. Investment “experts” profess to have these clairvoyant powers and put out endless predictions daily, but in reality they are woefully inaccurate.
Compared to the hard work of evaluating a business’s fundamental value, market timing is relatively simple—guess whether the market is too high or too low, and sell accordingly.

Why Doesn’t Market Timing Work?

Simple mathematical formulas to determine whether the market is at a peak or bottom (such as relying on overall price-to-earnings ratios) tend not to work. There are two major reasons why:

A formula may seem to work when backtesting across past years or decades. However, it may simply have been illusory—a pattern fitting due to random chance, or a strategy that worked in an idiosyncratic period—and provide no predictive power going forward.
The formula may indeed have worked in history, but if a strategy provides a real advantage in the market and is simple to execute, it will be adopted so quickly and widely that it loses its advantage. (Shortform note: The advantage disappears because if enough people adopt the formula, market prices will adjust in an unfavorable way. For example, a formula may predict when a market’s bottom is and thus when to buy. If enough people buy at that point, prices will rise, meaning the stocks are no longer a bargain and there is less room for the price to appreciate.)

Any simple formula that can be easily adopted by the market most likely does not present an advantage over the long term.

Graham comments on how, in the first half of the 20th century, there were ten market cycles running from high to low and back again. Most bull markets fit a certain pattern, such as having a high price level, high price/earnings ratios, and a high number of low-quality stock offerings. Seeing these warning signs of the top of a bull market, an investor might reasonably sell and wait for the market to turn.

However, this pattern didn’t fit all cycles, such as the bull market of the late 1920s or the postwar market from 1950 to 1970. During these times, the market soared beyond warning signs that applied in previous cycles. An investor trusting these signals would have sat out much of the market’s growth. Even worse, an investor might get so uncomfortable seeing the market leave him behind that he abandons all caution and buys into the market, right at the point at which it is overvalued and really due for a downturn.

Stock Price Fluctuations

In a narrow sense, a stock price should be considered an indication of the value of a business. If you examined a private business and tried to estimate its value, you might consider its book value (or its assets minus liabilities), as well as its current earnings.

However, in public markets, a high-quality company tends to have its stock price inflated well above book value. This is due to the market’s expectation that the company will continue growing (and so today’s stock price might represent the company’s book value 10 or 20 years from now).

The more a stock price deviates from the company’s current book value, the more speculative the stock is, and the more volatile the price will be. When the stock price well exceeds the appraisal value of the business, the movements of the stock price are not really based around whether the fundamental value of the business has changed, but more around the enthusiasm of speculators.

This is why fundamentally sound companies can see their stock price change dramatically, even when the underlying business hasn’t changed much at all. For instance, in 1963 IBM stock fell by half, from 607 to 300, even though its long-term growth prospects hadn’t materially changed.

Graham thus cautions the conservative investor to concentrate on stocks trading at no more than one-third above the company’s book value. Investments in these stocks can be justified on solid financial grounds and will be less subject to the whimsies of stock speculators.

Example: A&P

To illustrate the wild fluctuations of stocks, Graham gives the example of A&P, a grocery store chain. From 1915 to 1965, A&P was the largest retailer in the US. Durings its lifetime, its shares went from tremendous bargain to alarmingly overpriced.

A&P Stock Reaches a Low

In 1929, A&P started trading publicly, with stocks as high as 494. By 1932 the price had fallen to 104, and in the recession of 1938 it plummeted to a low of 36.

This low price was remarkable. The market valued the company at $126 million, less than its current assets: $85 million in cash and working capital of $134 million. At this time, A&P was the largest retailer in the country, if not the world, yet the market believed it was worth less than if the company were liquidated that day.

Why would the market believe this? Partially because of the overall depressed bear market, and partially because of temporary fears (chain stores might have new taxes levied against them, and earnings had declined).

Any investor holding stock in A&P would have felt the emotional pull of the stock’s collapse, but on inspection he might find that A&P was still a sound company with strong future prospects. Instead of selling in a panic with the rest of the market, he would judiciously hold onto his stock or even buy even more stock at a bargain. He would find himself vindicated. In 1939, A&P shares rose to 117.5, triple the low the previous year.

A&P Stock Reaches a High

In 1961, the price soared to the equivalent of 705 (the stock had a 10-for-1 split, so its literal price was 70.5). This represented a price-to-earnings ratio of 30, compared to 23 for the Dow Jones index.

This rich price implied bright growth prospects. In reality, A&P was headed for an irrecoverable decline in earnings and revenue. The company was larger than it was 30 years ago, but it was not managed as well, was not as profitable, and could not ward off competition. Within a year, the stock price halved to 34, then over ten years halved again to 18 in 1972.

The example illustrates the vacillations of the stock market in relation to the fundamental prospects of the business. When A&P was in its prime and poised for growth, the market wouldn’t touch the stock. Inversely, when A&P was headed for obsolescence, the market was breathlessly enthusiastic about its future.

A patient, alert investor will watch for gross aberrations like these and take advantage.

Don’t Be Pressured to Act

Now that you know stock prices vary, you should prepare yourself psychologically for this reality.

It’s human nature to have your emotions pulled with the market.

When you haven’t bought stock and the price rises, you fear missing out and regret not having bought earlier.
When you hold stock and the price rises, you wonder whether growth might indeed be limitless. Should you buy more at this inflated price and be overcome with greed like everyone else?
When you hold a stock and the price falls, you worry whether you‘ve missed something. You may believe the business had sound prospects, but perhaps other people know something you don’t? Maybe you should sell to cap your losses?

Beyond simply feeling these emotions, an even worse decision is to act on the emotions—to buy greedily right when the stock is too high, to sell in a panic right when it is a bargain.

Objectively, this is silly. If you know the fundamental value of a business, why should the mistakes of other people influence your behavior? Behaving this way is like having your emotions and behavior dictated by other people. You have no obligation to act according to market fluctuations. You should deliberately choose to transact only when it is in your favor.

In fact, you might largely be better off by pretending there is no quoted market for the shares day to day. If you don’t check the value of your home on an hourly basis, why should you do the same for stock prices?

To make this idea concrete, Graham gives his famous parable of Mr. Market.

Mr. Market

Say you own a piece of a business worth $1,000. Imagine a fellow named Mr. Market who is a manic-depressive sort of person and visits you once a day, asking to buy and sell your interest.

When the market is up, he asks to sell another piece to you at exorbitant prices: $1,500, $2,000.
When the market is down, he comes by asking to buy your stake for $600.

Should you go along with this odd person, feeling exactly what he feels at every moment and doing what he demands?

Of course not. You know the piece of business is worth $1,000. You’d maintain your own rationality and politely ask this oddly behaving person to leave your house.

(Shortform note: To make the analogy even more concrete, imagine Mr. Market quoting you the price of a hard asset, like your home or car,. If your house is worth $200,000 and someone comes by asking you to sell it for $100,000, would you? Likely not, because you expect the future value to rise again. The same thinking should apply to stocks.)

Yet countless traders behave as Mr. Market demands they do. They buy when stocks are going up and sell when they have gone down.

You shouldn’t ignore Mr. Market entirely, nor should you blindly follow whatever he tells you, but rather use his prices only when it is to your advantage. You are not obligated to trade with him.

Your Psychological Advantage

In his commentary, Zweig notes that your psychology is your advantage in the market. As an investor, you compete with lots of other traders, including professional money managers. In most dimensions, you are outclassed by professional money managers—they have more resources, people, and experience than you.

The one advantage you have over money managers is that you do not need to follow Mr. Market. Money managers do, because they represent the interests of people (who themselves follow Mr. Market):

When the market rises, investors get greedy and put in more money, forcing money managers to buy more stocks (which drives price up more).
Likewise, when the market falls and investors withdraw money in a panic, money managers are forced to sell just as stocks are cheap.

This is essentially behaving as Mr. Market demands. You do not need to suffer the same obligation.

Invert the News

One manifestation of Mr. Market is the way that financial news is commonly related. When stock prices go up, there is jubilation; when it falls, there is doom and gloom. These daily mood swings don’t really make sense—if you’re investing for an outcome 20 or 30 years from now, why should the movements on a single day (one ten-thousandth of your time span) make any difference?

In his commentary, Zweig proposes an interesting inversion of normal financial news.

When the stock market has fallen, frame this as the positive. “Stocks became even more of a bargain today, adding a 5% discount to its already steeply discounted price. This is an unprecedented buying opportunity for affordable stocks.”
Likewise, when the market is raging to new heights, sound loud warnings. “Markets soared to dangerous heights today, with stocks at a 180% premium over their fair value. These stocks have become a certifiable rip-off and may get worse in the coming months.”

Inverting news this way may help you counter the natural effects of Mr. Market.

Exercise: Prepare for Fluctuations

Your investments will fluctuate. Prepare for them.

Have you ever committed the mistake of following Mr. Market, buying when the market was rising and selling as it was falling? What was your thinking during that time?
Now armed with better knowledge, how will you prepare yourself for future fluctuations in your investments?

Chapter 9: Investment Funds

While much of the book is about choosing individual securities (stocks or bonds), there is a simpler way to invest—through mutual funds. Mutual funds pool together money from many investors, then invest those funds along the fund’s strategy. Therefore, when you buy a share of the fund, you hold a portion of the fund’s underlying securities, including a wide array of stocks and bonds.

At the time of Graham’s writing in the early 1970s, mutual funds were a rising force in finance, with roughly $50 billion under management. Since that time, mutual funds have become a juggernaut, with nearly $20 trillion under management (for context, the total market capitalization of the US stock market is around $40 trillion).

This chapter discusses what expectations to have on fund performance, how to choose funds, and which funds to avoid.

Which Funds to Choose?

Mutual funds come in many flavors:

In scope, with some representing the entire stock market and others focused on particular industries such as Internet companies
In location, with some focusing on the United States to those focused internationally
In strategy, with some actively trading through proprietary strategies and others simply following an index like the S&P 500
In degree of marketing, with some actively advertised and with an enthusiastic sales force, and others quietly operating with little marketing presence
In fee amounts, with some charging, say, 3% of your holdings in annual fees, and others charging just 0.1%

With thousands of funds in existence, choosing the right one can be as perplexing as choosing the right stocks.

In summary, Graham urges the following cautions:

When you invest in a fund, expect only returns in line with the overall market. Over history, the vast majority of funds do not outperform the broader market (especially after deducting fees). If you delude yourself into thinking you can vastly exceed market returns by choosing the right fund, you’ll seek out risky funds and deceptive marketing.
Do not choose a fund simply because it has a recent hot streak. Most often, funds with outstanding recent performance are using risky strategies that have performed well recently but will falter in the long term. (We’ll cover why
Be skeptical of funds that charge high fees. The higher the fees, the more the fund has to outperform the market for you to be in line with the market. For example, if the market returns 5%, then a fund that charges 1% in fees has to return 6% to be in line with the market.
Be skeptical of funds that have aggressive marketing or salespeople. Salespeople are part of the fund’s operating costs, and thus you’ll be paying for their salaries and commissions with your fees.

Near the end of his life, Graham noted that index funds should be the default choice of most everyday investors (his protege Warren Buffett agrees). It’s the “boring” way to invest—you won’t be able to indulge in hot stock tips and boast about your own landmark stock win—but you will reliably accumulate wealth over time and beat most speculators.

Funds That Are “Too Good to Be True”

Graham comments on the recurring appearance of “performance funds” in history. Like clockwork, the cycle works like this:

Certain funds appear with remarkable short-term performance (say, in the previous 1-3 years). Often they claim to have a special strategy or a young, genius stock picker in its leadership.
The funds market themselves aggressively to get more investor money, and they balloon in size. Even reputable investors, such as pension funds and universities, may invest in these funds.
In reality, the performance funds’ gains were achieved with risky strategies that simply got lucky in the recent past. These strategies are untenable in the long-term, and they quickly underperform the market, sometimes severely (say, by 30 or more percentage points).
For some time, people become skeptical of these funds. But then they appear a few decades later, with the same promises.

Each time in history, funds appear with new tactics and marketing messaging:

In the 1929 boom and bust, money managers often resorted to outright fraud and misleading reporting. These tactics were outlawed by the SEC.
In the 1965-1969 period, new funds appeared with newer gimmicks, such as focusing on small stocks and misleading accounting.
In the dotcom boom of the late 1990s, Internet funds appeared promising limitless growth but soon crashed more severely than the rest of the market.

(Zweig notes that major boom and busts seem to occur every 30 years, roughly the length of a human generation. By the end of a generation, people who have suffered major losses in previous crashes become less influential, and so societal memory becomes lost and naive optimism reigns again. If true, the next major boom and bust may occur around 2030.)

While most funds tend not to outperform the market, there is a small minority that do outperform over the long term. These tend to be small funds that don’t manage vast amounts of capital, suggesting that more capital causes funds to shift closer to market returns. Furthermore, these highly-performing funds tend to be closed to the public and thus out of your reach.

(Shortform note: A notable example is the Medallion fund of Renaissance Technologies, which has produced staggering annualized returns of 66% between 1988 to 2018, before fees, compared to roughly 10% for the S&P 500 in the same period. The Medallion Fund manages just $10 billion and is available only to the firm’s employees and their families.)

Why Most Funds Don’t Outperform the Market

Why is it so hard for funds to outperform the market? With so many smart, highly compensated people at their helm, surely they must harbor some secret to do better than average?

This presumption comes from our everyday perception of skill. There are certain baseball players who hit more home runs than others; there are certain restaurants that prepare better food than others. Surely there must be better fund managers than others. However, the empirical evidence shows overwhelming evidence against this idea.

In his commentary, Zweig explains multiple reasons that funds that were once-promising tend to be mediocre in the long-term. In short, larger size causes new problems.

Forced deployment of capital: When a fund takes on more money, it is forced to mobilize this money in investments. (If it simply kept the money as cash, it would produce a lower return as a percentage of its assets under management.) A fund might take in money at the peak of the market, when greedy investors pile in, and thus have to invest precisely when the market is overpriced.

More difficult investment choices: Funds managing low amounts of money can take small positions in small companies—say, spending $5 million to buy 1% of a $500 million company. Large funds that have to deploy money have two bad choices: 1) they can either buy more of the company, which might cause them to shift the market and thus lower the profits, or 2) they have to invest in many more companies, which dilutes their focus and requires taking on investments they have lower conviction about.

Rising fees: Fees may rise with size because it has to make more trades and its trades become more complex. Buying 0.1% of a company is relatively easy; buying 10% of a company is complex and will shift the price.

Talent exodus: If the fund has a truly good investment manager, its success may cause the manager to leave for a competitor or to start her own fund.

Changing incentives toward stability: When funds take on more money, they can earn a substantial amount in fees. This shifts the incentive from fund performance to simply having a large amount of assets under management. In turn, this causes fund strategies to become more conservative to avoid an outflow of money. Thus, they may adopt the same strategies as the rest of the market, causing them to match overall market performance.

Choosing the Few Outperforming Funds

Thus, Zweig offers the following criteria for choosing the minority of funds that might outperform the market:

The managers of the fund should be its largest shareholders. If true, they will be incentivized to achieve fund returns, rather than just collect fees.
They should offer low fees. High fees simply make it more difficult for you to beat the market after fees.
They use non-consensus strategies. If a fund simply follows the market, it will perform in line with the market.
They tend to close their funds to new investors. This means they’re optimizing for fund performance, not for fund size. While you might not be able to make it into already-closed funds, you might identify fund managers with a history of closing funds to new investors and invest in their new funds.
They don’t advertise or market themselves.

However, selecting funds that outperform is as difficult as selecting individual stocks that outperform. If you’re a defensive investor, by and large you should resign yourself to choosing funds that represent the entire market.

Chapter 10: Financial Advisors

If you’re not trained in treating medical conditions, you consult a doctor for medical advice. Likewise, if you’re not trained in finance, it’s natural to feel like you need advice from financial experts. Choosing the right advisors is important for you to keep your money.

Finance offers a wide range of advisors, including banks, financial information providers, brokerages, and investment banks. We’ll cover generalities of how to distinguish good advisors from bad ones and how each specific advisor works.

General Advice on Finding Advisors

Now that you know how much effort it takes to earn above-average returns, and how few people successfully do it, you should be skeptical of anyone who promises to do this for you. When finding financial advisors, have grounded expectations for what they should do for you.

If you owned a business, you could find consultants for specific aspects of the business (such as marketing or legal compliance), but you should not expect to find a consultant to do the main work of building a profitable business. That is the business owner’s concern and responsibility.
Likewise, you should not hire an advisor with the expectation that she can make you outlandish amounts of money without your involvement.

What distinguishes good advisors from bad advisors?

Good financial advisors are scrupulous and don’t overpromise. When you communicate your goals and the type of help you’re looking for, they customize what they do for you. Your interests are aligned—they see your financial success as their success.
Bad financial advisors seek to pad their own pockets, regardless of what happens to you. They prey on your greed and impulsiveness and will try to override your best judgment. Their incentives may overlap minorly with yours or even be in direct opposition.

Do you actually need an advisor? Graham doesn’t advise much on this, but Zweig suggests that you should seek an advisor in these cases:

If you habitually underperform the market
If your personal finance budget is out of control—you can’t pay your bills, and you don’t save any money
If you experience any major changes or crises, such as leaving steady employment or being unable to plan for college tuition or retirement

Defensive and aggressive investors should look for different things from investors.

Defensive investors should find advisors who will help them achieve average market returns—no better, and no worse. Typically, advisors help defensive investors by protecting them against themselves and the worst of their own psychology.
Aggressive investors should find advisors who will be useful sounding boards for their investment ideas. Aggressive investors should examine the advice they receive and form their own conclusions, rather than simply taking opinions on faith.

Beware of these common pitfalls when seeking advisors:

Don’t rely on advisors to make above-average returns for you without your involvement. Finding advisors who can do this is as difficult as finding individual stocks that will outperform. Before hiring someone who can achieve this, you should be able to independently assess the validity of their recommendations, which means you have already become an aggressive investor.
Don’t hire advisors simply to have someone to blame for your own mistakes. Some speculators make up their mind on what they want to do and hire an advisor to approve their decisions; when these go poorly, they blame the advisors instead of themselves.
In his commentary, Zweig cautions against advisors who use these red flags in their speech:
- Guarantees: “It’s a sure thing.” “You can’t lose.” “There’s no downside.”
- Overpromises: “We can beat the market.” “You’ll retire early.”
- Secrets only they have: “Our proprietary system.” “No one else can do this.” “Exclusive.”
- Unfamiliar jargon they aren’t willing to explain: “Commodities trading.” “Options strategy.”
- Urgency: “You have to act now.” “Opportunity of a lifetime.” “Once-in-a-decade.”

With these generalities in mind, we’ll discuss the spread of financial advisors.

Investment Counsel and Bank Services

Investment counsel firms manage your money for you in exchange for fees. They can be independent firms or arms of larger banks (often called private banking or wealth management).

According to Graham, the best investment advisors tend to be conservative in their actions and promises. They want to deliver acceptable returns and preserve your principal over the long term.

They may also help you meet your financial goals in general, including managing your budget, planning for retirement, and customizing an investment approach for your goals.

The primary role of such advisors may be to protect you from yourself. In times of financial duress, they act as a stabilizer, helping you avoid unwise decisions that you might indulge in alone.

In his commentary, Zweig suggests questions to vet such an advisor:

How do you define success? What would a good outcome with me be like in 10 years?
What’s your investment philosophy?
How many clients do you have? What do you do for them? How often do you talk?
What returns are realistic for my investments?
Have you ever received a formal complaint?

Financial Information

These services provide financial information to be used by customers to make their own financial decisions. They often exist as organizations that send out newsletters or provide databases of information. These services cost less than the investment advisors above.

The services vary in how opinionated they are about the information they put out, which then determines how you should approach them.

On the most objective end, organizations produce merely statistical data on securities, which is the cornerstone for securities analysis. Examples of reputable firms from Graham’s time include Moody’s and Standard & Poor’s.
On the more opinionated end, services may issue forecasts on the direction of the market or of individual stocks. There is a large demand from investors for oracle-like advice, and businesses will always exist to supply it. Graham has a dim view of these types of forecasts and often finds them inaccurate, technically unsound, or short-sighted.

For any financial information you receive, do your own research instead of relying solely on recommendations.

Stockbrokers and Brokerages

The key point to remember about stock brokerages is that they make money when you trade, not when you make money. Therefore, brokerages try to make trading as easy and fast as possible, regardless of whether this is actually good for you.

In fact, since speculators nearly certainly lose money on average and in the long-term, if brokerages had their customers’ best interests in mind, they would make trading more cumbersome. But the least they often do is avoid outright encouraging speculation; otherwise, they throw up their hands, saying, “If customers want to trade using our tools, so be it.”

If you deal with any individual brokers, remember that they typically make their money on commissions, so beware of anyone promoting what smells of speculation. (Earlier in this chapter we’ve discussed red flags for language.)

Investment Banks

Investment banks help companies “go public,” or offer shares to the public for sale. They typically serve as underwriters, meaning they buy the company’s newly issued stocks at a discount, then sell them to the public (thus offering a guarantee to the company that all their stock will be sold, and that the company will raise a certain amount of funds). They also provide marketing and regulatory services.

Investment banking is often seen as the most respected profession in finance, since they accomplish a goal of material societal value—helping companies procure investment to grow.

Today, you likely won’t deal directly with investment banks (unless they directly promote new stocks to you), but you are subject to their marketing. Like many financial advisors, the incentive of investment banks only overlaps partially with yours—they make money when the stock price goes up. Therefore, they will paint the most optimistic picture of future company performance.

Graham has already expressed his skepticism of new issues in general, given the enthusiastic salesmanship and that IPOs tend to happen when the environment is most favorable to the company. Resist the ebullient marketing and do your own analysis.

Other Advisors

Not that you know how much effort it takes to earn above-average returns, you should be skeptical of anyone who promises the same, whether they be your local banker, friends, or relatives. If they don’t have a long track record of strong performance and don’t put in the hard work to be judicious about investments, they shouldn’t be trusted anymore than you trust yourself.

Chapters 11-13: Security Analysis

If you want to choose individual stocks and bonds, you will need to understand the company’s financial position and future growth prospects. This work is called “security analysis” and it involves diving into the company’s financial statements. It also involves reading between the lines to infer what is really going on behind the numbers.

While no one has a crystal ball and can foresee the future with complete accuracy, certain indicators help you understand whether a company is situated for long-term growth or whether it’s likely to collapse within a few years.

Security analysis tries to answer two basic questions:

How safe is this bond or stock?
What is the value of this stock?

Stock Analysis

The chief question when buying stocks is whether the stock’s current price is too high or too low relative to its underlying value.

The current price is easy to determine since it’s quoted as market prices on stock tickers. The stock’s underlying value is more difficult, since it involves predicting how the company will perform in the future.

While Graham doesn’t give precise formulas for calculating company value (that’s more complex and out of the scope of this book), he discusses the general factors that determine a company’s value. This should be sufficient for nonprofessional investors to understand what professional analysts are saying.

Valuing Companies in General

The traditional way to calculate a company’s value is to estimate its earnings over a range of years in the future, then to multiply that by a “capitalization rate.” The capitalization rate depends on the company’s stability and future performance; the better a company will do, the higher the capitalization rate.

For example, after analysis, you may decide that a company with earnings per share of $5 deserves a capitalization rate of 10, implying a stock value of $50. However, this rate is subjective; another investor may decide it deserves a rate of 20, implying a stock value of $100.

Another measure of stock value that is more common today is price-to-earnings ratio (P/E ratio), which is the current stock price divided by the company’s current earnings per share. A stock with a higher P/E multiple implies a faster earnings growth rate than a stock with a lower multiple.

In general, Graham suggests a few major factors that affect the capitalization rate:

Future long-term prospects
Management
Financial strength
Dividend record and rate

Future Long-term Prospects

How well will the company do in the future? Is it growing or shrinking? Will it be a market leader or a minor player?

Graham doesn’t provide more specifics on evaluating this, but in his commentary Zweig adds a few factors:

Competitive advantage or “moat”: The company has a strong position that will endure over time. These include strong brand loyalty, monopoly status, or economies of scale. (Shortform note: For more on competitive advantage, see our summary of Understanding Michael Porter.)
Consistent historical growth: The company should have grown revenues and earnings steadily over the past 10 years. Be skeptical of a company that promises 20% growth without a track record of such growth.
Research and development budget: A reasonable amount or R&D suggests the company will retain its competitive edge and introduce new product lines instead of becoming obsolete. The average budget is different depending on industry (consumer packaged goods companies may spend 5-10% while technology companies may spend more).
Real growth: The company doesn’t grow merely on the backs of debt. On their cash flow statement, look out for “cash from financing activities”—this is cash flow from raising money and shouldn’t be confused with real sales growth.
Lack of customer concentration: A company relying solely on a single customer is in a very precarious position.

Graham also cautions that it’s easier for smaller companies to grow fast, and it gets harder to grow as the company gets larger. Thus, a company that started with just $100 million in revenue might have grown 40% each year for the past 3 years, causing market enthusiasm for boundless growth and a high P/E multiple. However, the company might find that once it reaches, say, $250 million in revenue, it starts stagnating, and its early investors that bought in at a high multiple may be disappointed as the stock price drops.

Management

How capable is the management team? Will they lead the company to success or ruin?

While financial analysts often include management as an explicit factor, Graham believes management capability is already reflected in the company’s track record and future prospects, so including it again is “double counting” and leads to overvaluations.

However, he notes that sudden changes in management have yet to play out and might thus not show up in the track record. Changes in management can be both positive and negative. For instance, in 1921, Walter Chrysler took over a dying Maxwell Motors and revitalized it into an automobile powerhouse.

In his commentary, Zweig adds a few other warnings signs of bad management:

High executive pay: Management may be running a company to benefit themselves and not shareholders.
Repricing stock options: When companies cancel existing stock options (that are often “out of the money” and worthless) to issue more options to employees at better prices, it suggests a lack of responsibility and refusal to accept consequences.
Repeated insider sales: Management that repeatedly sells big parcels of stock have less incentive alignment with you as a shareholder.
More talk than action: Management should spend time managing the company privately, not on managing relations with Wall Street and press.
Distorted accounting: Opaque financial reports may suggest management is hiding something.
Buying back shares at high prices: This suggests management is propping up stock prices using cash (thus benefiting the value of their own stock prices), when that cash would be better paid as dividends.

Financial Strength

A company with a large stockpile of cash and little debt is in a better position than one with little cash and significant debt. If these two companies with the same earnings and the same stock price, the first is clearly a better buy than the second.

Graham recommends an assets to liabilities ratio of 2:1 or better.

In his commentary, Zweig adds:

On the balance sheet, long-term debt should be under 50% of total capital.
Calculate “owner earnings,” or what a 100% owner would take home in cash each year. This is calculated by net income plus amortization and depreciation minus capital expenditures. Owner earnings more sensibly relates company profits than the reported net income, which can be subject to accounting manipulation. (Warren Buffett popularized this metric.)

Beware of companies that are growing revenue quickly but showing increasing losses and a precarious financial position.

A dotcom company, Exodus Communications, had a market capitalization of $14 billion in 1999, with just $242 million in revenue. Compare this to a “boring” industrial company, Emerson Electric, which had a market capitalization of $25 billion for $14 billion in revenues. While Exodus had grown revenue by nearly 400% that year, it had doubled losses to $130 million and had $2.6 billion in debt. In 2001, Exodus filed for bankruptcy.

Dividends

A company with a long history of paying substantial dividends (over the past 20 years or more) is a positive sign for stock quality.

In Graham’s day, it was standard for companies to distribute around 55% of its dividends. However, since then dividend payouts have dropped significantly to 30-40%, because of beliefs that reinvesting in the company was better than paying dividends. We’ll return to dividends when discussing company management in Chapter 19.

Formulas for Valuing Growth Stocks

Growth stocks are growing rapidly, and using their historical performance may underestimate the company’s value in the future.

Graham thus proposes the following formula for growth stocks:

Company Value = Current Earnings x (8.5 + 2x expected annual growth rate over next 10 years)

(Shortform note: This simple formula became popular and is now known as the Benjamin Graham formula.)

This formula represents the company’s total market capitalization in dollars. The current earnings is factual and found through the company’s financial statements. The expected annual growth rate is a prediction about the future and thus subjective. (Graham doesn’t give specific guidance on figuring out a company’s growth rate, other than considering the general factors in the last section.)

The formula can also be rearranged to figure out the company’s proper value to earnings ratio (also known as price to earnings ratio, or P/E):

Value / Earnings = 8.5 + 2x expected annual growth rate

For example:

A company with an expected annual growth rate of 20% could justify a P/E ratio of 48.5 (8.5 + 2*20).
A company with an expected annual growth rate of 10% could justify a P/E ratio of 28.5.
A company with an expected annual growth rate of 0% could justify a P/E ratio of 8.5.

The formula can be reordered to figure out what the market believes the company’s growth rate will be, based on its current stock price:

Expected annual growth rate = (P/E ratio - 8.5) / 2

For example, if the market prices a company’s stock at a P/E ratio of 20, it believes the company will grow earnings by 5.75% every year.

These formulas help you determine whether a company’s stock is over- or undervalued.

If, through your analysis, you find that a company’s fair value is $500 million, but its current market capitalization is lower at $400 million, the stock may be a bargain.
Likewise, if you believe a company’s value is $500 million but its market value is $1 billion, the stock may be highly overpriced and need to achieve incredible growth to earn its valuation.

(Shortform note: Graham doesn’t discuss situations where the company’s earnings are currently negative, as is the case with many public companies today. They likely wouldn’t meet his criterion for safety and would see investing in these companies as too speculative for most investors.)

Accounting Shenanigans

While we’ve treated earnings to be a fairly dependable number, in practice companies may use accounting sleight of hand to make their financials look more promising.

For instance, a company might present a business expense such as taxes on stock options as an “extraordinary nonrecurring event,” saying that it’s not part of normal business. It then shows “pro forma” earnings that ignore this expense.

Using techniques like this usually isn’t outright illegal; rather, it takes accounting tools that have reasonable intended purposes and stretches them to the edge of plausibility.

Graham and Zweig highlight some common tricks to be aware of:

Timing of losses: When a company’s project fails, it typically reports a loss on it in the year that it actually takes the loss (such as when it closes down a factory). However, some companies may report a loss early under the guise of “anticipating future losses,” reporting the loss well before it actually happens.
- Why would a company do this? To take advantage of investor expectations—if the stock market has had a bad year and investors have already resigned their expectations for the company, it’s a good time to declare possible future losses. In essence, this shifts the loss from future years to the current year, thus making future years’ earnings higher.
“Special”, “extraordinary” or “one-time” items: These are one-time charges or revenues that the company believes is not indicative of normal operations and won’t recur in future years. Examples of legitimate extraordinary items include a regulatory fine or eliminating debt. However, some companies may improperly report regular business expenses as “one-time charges,” which makes company earnings look better than they really are. A regular pattern of “one-time” items appearing more than one time is a red flag.
Choice of depreciation: How a company chooses to depreciate assets will affect its earnings. In particular, if a company changes its choice of depreciation from one year to another, it can cause a short-term change in earnings that doesn’t represent any material differences in the business.
Pro forma financials: While GAAP accounting (Generally Accepted Accounting Principles) is the standard for financial reporting, companies may report alternative “pro forma” financials, which pretend as though certain items are not part of normal operations. One legitimate use of pro forma financials is during a business acquisition, to show the acquirer how the business would operate when acquired. However, during the dotcom bubble, many companies improperly used pro forma financials to inflate their earnings.
Aggressive revenue recognition: Say a company sells a product that the customer pays for over the course of months or years. Realistically, the cash goes from the customer over this long period of time. However, the company may “recognize” the revenue over years as having been collected instantaneously at the moment of the sale. This inflates revenues and can overestimate the solidity of the business, particularly if the customer later stops paying.
Treating normal expenses as capital expenditures: A company may report normal operating expenses as capital expenditures. This allows the company to boost assets on its balance sheet and take less of a hit on its net income.
Over-optimistic pension projections: A company with a pension will estimate how much money it needs to pay future pensions. When a company earns more than this estimated amount, it can report the difference as net income. However, a company can also artificially change this number by changing its estimations.
- For instance, a company might previously estimate its pension plan would grow at 6% per year. If it suddenly improved the estimate to 8% per year, it would need less money today to meet future obligations. This presents an artificial “gain” that can be reported as net income.
- Pay attention if the “net pension benefit” is a big portion of the company’s net income—say, over 5%.

The details of corporate accounting can be abstruse and difficult to unpack. One reliable way around these shenanigans is to use a long period of earnings, say 10 years, with all the adjustments added in. Don’t rely solely on a single year’s earnings for your investment decisions.

When studying a company’s financials, beware of any reported changes in the company’s accounting methods. These are opportunities for companies to inflate performance over previous years.

(Shortform note: Accounting regulation is an ever-changing field. In reaction to major accounting frauds such as Enron and Worldcom as well as the dotcom crash, the Sarbanes-Oxley Act of 2002 was passed in the United States to standardize financial reporting and decrease flexibility of some of the tools mentioned here. However, as Graham notes, companies will always find creative ways to toe the line of regulation.)

Bond Analysis

The chief risk of buying bonds is that the issuing company defaults and goes bankrupt. By studying certain criteria of safety for a bond issuer, you can avoid risky bonds that might become worthless. This is particularly important as the historical trend has been for companies to take on large loans even as they struggle to show profits.

(Shortform note: In his commentary, Zweig issues a reminder that since bonds are sold in large increments (say, $5,000), an investor buying bonds herself would need $100,000 to properly diversify. Instead, modern investors are likely better suited by bond funds, which do the hard work of bond research and diversification for you.)

Interest Coverage Ratio

The major metric for bond safety is the ratio of earnings to total interest charges, also known as the “Interest Coverage Ratio.” This is a measure of how well the company can pay the interest on its loans.

If the ratio is below 1, then the company isn’t generating enough profits to pay off its loans; this can in turn mean the company may default on its loans, which can then lead to bankruptcy and a reorganization of the company.

To be more precise, the ratio can be calculated in a few different ways:

The earnings can be before taxes or after taxes
The window of time can change. Graham proposes using either the average ratio of the past 7 years, or the single worst year in the past 7 years.

Different industries have different minimum coverage ratios. For example, Graham proposes that retail and railroad companies should have a minimum interest coverage ratio of 5 averaged over the past 7 years, while utility companies can have a lower minimum of 4 due to its relative stability.

Other Safety Factors

Beyond the interest coverage test, study other factors of the company:

Size of business
Asset values, particularly in real estate, utilities, and investment companies. In other industries, the value of the assets may fall while the company’s earnings power falls.
Ratio of earnings to the total debt principal, as opposed to total interest charges. This is useful particularly in high interest rate periods, when it becomes more difficult for companies to cover multiples of their interest charges

Chapters 14-15: How To Choose Stocks, In More Detail

We now have a general understanding of how to think about a company’s long-term prospects, and also how the market prices the company’s stocks. We can now think about how to choose specific stocks. We’ll start with defensive investors, then cover aggressive investors.

How Defensive Investors Should Choose Stocks

Let’s begin by questioning the premise. Should a defensive investor choose stocks at all? Nowadays, the answer is likely no—defensive investors might best be served by not choosing individual stocks, instead buying an index fund representing a broad swath of the stock market. This will provide broad diversification, and your performance will be in line with the overall market.

But if you want to choose your own stocks, as a defensive investor you should buy only high-quality stocks at reasonable prices. In practice, defensive investors should look for stocks with these seven criteria:

Size: More than $100 million in revenue
- Small companies face more volatility and may be unable to survive bad events.
- Graham’s criterion was set in 1970, and $100 million in revenue may be too small today. In his commentary, Zweig defines sufficient size as having a market value of at least $2 billion.
Strong financials: Assets at least double liabilities, and working capital more than long-term debt
Dividends: Paid continuously over the last 20 years, without interruption
Earnings: Positive in each of the past 10 years; no unprofitable year
Earnings growth: At least 33% total growth in per-share earnings in the past 10 years (a bit less than 3% annually)
- A company that is shrinking over time will not be a good long-term investment.
- Use 3-year average earnings at both the beginning and end of the 10-year period.
Price-to-earnings ratio: No more than 15 times the average past 3-year earnings
- Beware of analysts who calculate a “forward P/E ratio” using not historical earnings but “next-year’s earnings.” Predictions are notoriously unreliable, and often the forward P/E ratio is used merely to justify an overpriced stock.
Price-to-book value ratio: No more than 150% of book value (also known as net asset value; calculated by subtracting total liabilities from total assets)
- The last two measures can be combined to form a multiplier no more than 22.5 times. For example, a stock at 10 times earnings can have a price-to-book value ratio of 2.25 or lower.
- In his commentary, Zweig notes that many companies today have a greater amount of value in intangible assets such as brand value and intellectual property, which don’t show up in book value. Thus, more companies are priced at higher price-to-book ratios.

These seven criteria are stringent and often cut away the majority of stocks. In 1970, Graham found that the 30 stocks on the Dow Jones index met the criteria in aggregate, but as individual stocks only 5 of the 30 stocks passed all the criteria.

(Shortform note: At times, particularly in bull markets, there theoretically could be zero companies in the market that pass all seven criteria. Graham doesn’t comment on what to do in this situation, since in his time there remained plenty of stocks to choose from.)

In his commentary, Zweig cautions that defensive investors should treat stock picking as just an entertaining intellectual pursuit and not their core investment strategy. As a defensive investor, if you really want to pick your own stocks, allocate only 10% of your stock value to individual stocks; 90% should go into an index fund.

How Aggressive Investors Should Choose Stocks

Unlike defensive investors, aggressive investors who want an above-average return will need to make investments out of line with the overall market. This often means choosing individual securities, using a strategy that is unpopular in the market.

Graham starts with a reminder that the task is difficult—most professional money managers who are intelligent and diligent fail to beat the market. But his own investment record shows that opportunities do exist—if you adopt a rigorous method to invest in select bargain securities, and if you are in firm control of your own psychology, you can earn above-average returns. (Shortform note: Review chapter 9 in this summary if you’d like a reminder of these ideas.)

Graham cautions that new investors should practice investing first before putting their real money at stake. There are plenty of online virtual portfolios you can use to make fictional trades. This will let you exercise your judgment and make mistakes without losing real money. Then, you can measure your returns against the S&P 500 and decide whether you want to pick stocks with real money.

Graham’s Criteria

How should you choose stocks? Like the defensive investor, start with statistical criteria for filtering all the stocks available. However, you can relax the criteria to include more companies:

Size: No requirement for size. You can limit your risk with small companies by carefully identifying good companies and diversifying.
Financials: Assets at least 1.5 times liabilities, and debt less than 110% of net current assets
Dividends: Some dividends paid recently
Earnings: Last 12 months’ earnings is positive
Earnings growth: Last 12 months earnings’ more than earnings from 4 years ago.
Price-to-earnings ratio: No more than 9 times earnings from the last 12 months
Price-to-book value ratio: No more than 120% of book value.
- (Shortform note: While all other criteria here are looser than their analogue for defensive investors, this ratio is more restrictive compared than the “no more than 150%” criterion above. This is not explained.)

After applying this filter, you’ll be left with companies that are more likely to be bargains and out of favor with the market, but still with a good position and with possible good long-term prospects.

Additional Criteria

From here, how do you choose? This is where a subjective understanding of the company comes into play. There are many roads.

Graham covers one special situation: Stocks selling below working capital value (net current assets). This means the market believes the stock is worth well less than what the company would gain if liquidated today. Sometimes this means the company is actually headed for a permanent downturn (and will burn cash to get there), but often it simply means the company has fallen out of favor with the market and will recover soon. (To calculate net current assets, take current assets, deduct current liabilities, and count fixed and other assets as zero).

(Shortform note: In the Chapters 6-7 summary, we covered other opportunities for the aggressive investor, such as unpopular large companies, secondary companies, and acquisition arbitrages.)

In his commentary, Zweig offers other criteria from value investors who are adherents of Benjamin Graham:

Warren Buffett’s criteria: Buffett likes choosing solid businesses that will continue to grow. Specifically, this often means companies with consumer brand loyalty, business models that are easy to understand, in strong financial positions, and have monopolist positions in their markets. Notably, he’s patient to wait to buy when the stock is undervalued, such as after a scandal or temporary setbacks.
Return on invested capital (ROIC): This measures how well the company used its money to generate its returns. ROIC is calculated by taking Owner Earnings and dividing by Invested Capital.
- Owner Earnings = Operating profit, plus (depreciation and amortization of goodwill), minus (federal income tax, cost of stock options, essential capital expenditures, income generated by unsustainable returns on pension funds)
- Invested Capital = Total assets, plus (past accounting charges that reduced invested capital), minus (cash and short-term investments)
- An ROIC above 10% is noteworthy. An ROIC above 6% is acceptable if the company is well managed and has a competitive advantage.
Study the value of subsidiaries: Dice up a company into its subsidiaries or business segments. Then compare the financials of that subsidiary with comparable companies that have been acquired recently. You can then estimate what that subsidiary might be worth to an acquirer, and invest if it’s a bargain.
Assess management: While Graham thinks assessing management is too unscientific to be reliable, some investors look for certain signs of good management:
- Their financial statements are easy to understand and don’t obscure the truth.
- They focus more on managing the business than on messaging expectations of Wall Street.
- They have sizable investments in the company, ideally by purchasing stock with their own money rather than being awarded stock or options.
- They have a consistent message about what they will do, and they execute on it.
- They do not have high executive turnover.

Chapter 17: Case Studies in Failed Companies

(Shortform note: Chapter 16 discussed convertible issues; we covered this in Chapter 7 on what the Aggressive Investor should avoid.)

When choosing investments, it’s as important to avoid overhyped companies on the brink of failure as it is to choose bargain stocks. Graham shows four case studies of companies that had astronomical stock prices but showed clear warning signs of their impending demise. Moreover, to detect their weak conditions, you wouldn’t have needed to understand their intricate workings—you could have used the basic financial metrics we’ve covered already.

Then, in his commentary, Zweig adds modern examples of each archetype.

The four archetypes shown are:

A giant company with signs of poor operating performance
An empire-building conglomerate that grows unwisely through acquisition
An acquisition where a small company absorbs a giant
A company with little substance riding a speculative wave

Archetype 1: A Poorly Operating Giant

Penn Central

In 1970, the nation’s largest railroad company Penn Central filed for bankruptcy. This was shocking to the finance world, but Graham argues its demise could have been predicted well in advance:

The company had not paid income taxes for 11 years, yet it was regularly reporting earnings. How would this have been possible?
The standard interest coverage ratio (the ratio of earnings to interest charges) for railroads was 5:1 before taxes. In 1967 and 1968, Penn Central showed a ratio of just 1.9.
It was operationally inefficient. Railroad expenses made up 47.5% of its income in 1968, compared to 35.2% for a more efficient competitor.
Its accounting was fishy, with strange transactions that didn’t make much sense. Graham declines to go into detail.

Graham argues that anyone paying attention to the simple fundamentals of the business could have noticed that Penn Central was in deep trouble. At that time, they should have pulled their stock and bonds out of the company and exchanged them for more robust competitors.

Lucent

In 2000, Lucent Technologies had a valuation of $193 billion on roughly $32 billion in revenue. It was in a precarious position:

It had acquired a company for $4.8 billion—this company had zero revenue and no customers, and a book value of just $600 million.
Lucent had lent $1.5 billion to its customers to buy its products, under “customer financings.” How safe are your revenues if your customers need financial help buying your products?
It accounted for software development as a “capital asset,” not as an expense.
(Shortform note: In 2000, Lucent also reported a $125 million accounting error and a $700 million overstatement in revenues.)

By 2002, Lucent reported losses of $28 billion in two years; its stock fell 97%. (Shortform note: It later merged with Alcatel in 2006, forming Alcatel-Lucent, which was then acquired by Nokia).

Archetype 2: An Empire-Builder that Falters

Ling-Temco-Vought

Ling-Temco-Vought was a conglomerate involved in industries as wide as aerospace, sporting goods, and pharmaceuticals.

(Shortform note: The conglomerate began with a young entrepreneur James Ling, who took his electrical contracting business public in 1955. From that point he began a blistering pace of acquisitions in a staggering array of industries. Taking advantage of low interest rates in the 1960s, Ling-Temco-Vought raised huge sums of debt to fund acquisitions. The strategy was relatively simple—as long as an acquired company’s earnings could cover the interest on debt used to acquire the company, the acquisition was profitable.)

The nominal growth in the company was staggering—revenue began at $7 million in 1958, grew twenty-fold within 2 years to $143 million, then grew again twenty-fold again to $2.8 billion by 1968.

Yet warning signs appeared through this steady rise:

The acquisitions required debt, which ballooned to $1.5 billion by 1969. This was a near-record amount across all companies in history (Shortform note: On the financial tables shown, its assets to liabilities ratio generally remained between 1.0 and 2.0.)
Its ratio of earnings to interest didn’t pass the conservative benchmark of 5.
Its market price in 1967 was a remarkable 22 times net tangible assets.

In 1969, at its peak in sales, Ling-Temco-Vought reported a loss of $70 million (it had earned $124 million before taxes and interest, but interest charges were $122 million, swallowing up nearly all the profits; additional taxes and special items caused further losses).

Over the next few years, the stock price fell from its peak by over 95%.

(Shortform note: Graham doesn’t comment on the company’s fundamental business issues. It appears Ling-Temco-Vought suffered from:

A general market downturn in 1970
Investors’ realization that its acquired companies weren’t growing any faster as part of the conglomerate than before they were acquired, thus weakening the conglomeration strategy
Antitrust concerns of conglomerates)

Tyco

In the late 1990s, Tyco was an acquisition machine. Over 4 years, it spent $37 billion buying hundreds of companies—in 2000, it acquired 200 companies, or more than one every two days.

The high-level results were impressive: by 2001, revenue had grown from $7 billion 5 years earlier to $34 billion. It showed operating income of $6.2 billion, and its valuation reached $114 billion.

However, the fundamental success of these acquisitions was questionable. In its financial statements, Tyco repeatedly wrote off acquisition-related charges of over $750 million per year. In 2002, it showed a $9 billion loss. (Shortform note: The same year, it suffered a corporate scandal in which the former CEO and CFO were convicted of stealing $150 million.)

Archetype 3: A Tiny Company Swallows a Giant

NVF and Sharon Steel

In 1968, NVF, a company with $31 million in sales, acquired a company seven times its size: Sharon Steel Corp, a company with $219 million in sales.

To fund this acquisition, NVF issued $102 million of bonds with stock warrants attached. Warning signs then appeared:

Its financial reporting showed incomprehensible entries relating to debt expenses, cost of investment in Sharon Steel, and fair market value of warrants. The overall effect was to disguise the severity of the debt and of the dilution from the stock warrants.
The newly issued bonds soon traded at a steep discount (42 cents on the dollar), suggesting the market had deep concerns about its financial position.
In 1969 Sharon Steel adjusted its calculations for pension costs and lowered depreciation rates, thus artificially boosting earnings by $1 per share.

(Shortform note: Graham doesn’t discuss the stock performance of NVF, but Sharon Steel began defaulting on debt in 1985 and filed for bankruptcy in 1987. The chairman of NVF, Victor Posner, was a famed “corporate raider” and pioneer of leveraged buyout and hostile takeover strategies.)

America Online (AOL) and Time Warner

In 2001, AOL, a company with $6 billion in revenue, merged with Time Warner, a company with $27 billion in revenue. This was signaled as a “merger of equals,” but AOL was clearly the smaller company. The rationalization was that AOL, the hot Internet company, was going to revitalize the old media company Time Warner.

AOL was already on shaky ground:

The SEC had opened investigations into whether AOL had misleadingly represented marketing costs.
Half of AOL’s assets ($5 billion worth) consisted of stock in other companies; if the stock market fell, its asset base would also fall.

The eventual result: AOL Time Warner reported a $99 billion loss in 2002, to date still the largest corporate loss of all time (after accounting for inflation), and an 80% loss in stock price.

(Shortform note: The book doesn’t go further into fundamental reasons for the business’s failure, but general consensus points to 1) the bursting of the dotcom bubble, 2) the disruption of AOL’s dial-up Internet service by broadband Internet providers, 3) a clash of cultures between new AOL and old Time Warner that prevented real cooperation from materializing.)

Archetype 4: An Illusory Company Riding a Speculative Wave

AAA Enterprises

In the late 1960s, the markets enjoyed a “franchising” craze—anything in the market with “franchising” in its strategy received hype and heady valuations.

In this environment, AAA Enterprises entered the stock market. Its historical business was selling mobile homes; it seized on the idea of franchising this business, allowing others to sell mobile homes with its corporate name. It had another business of preparing tax returns (using mobile homes as offices); this business too was turned into a franchise business.

In 1969, AAA Enterprises sold 500,000 shares to the investing public, at $13 per share. The stock soon more than doubled to 28, producing a valuation of $84 million. For the company’s financial performance, this price was astronomical—this price was ten times book value; at earnings of $690,000, the price-to-earnings ratio was 115 times!

By this point in the book, an intelligent investor knows to be skeptical of overhyped stocks that are driven by wild speculation and promises of limitless future growth. AAA Enterprises soon fell to the ground:

The company grew quickly, opening retail carpet stores and acquiring a manufacturer of mobile homes. These appeared to be poor ventures—in the fourth quarter of 1969, the company lost $4.4 million, dwarfing all the money it raised in the stock offering and its earnings to date.
Through 1970, the company continued to lose money and was supported by loans from the company’s founder.
In 1971, AAA filed for bankruptcy.

Graham isn’t shy about blaming the parties involved for such a clear failure:

The underwriters clearly profited from the jump in share price, not just for this company but in encouraging imitator IPOs who also wanted to cash in on the exuberant times.
Speculators are “incorrigible” and will “fall for” any company spouting the latest buzzwords, regardless of actual company performance.
AAA Enterprises designed itself to take advantage of the franchising hype—it even likely chose the name “AAA” so that it’d appear first in listings of stocks, thus being a beneficiary of speculative energy.

eToys

In 1999, Internet retailer eToys went public at a valuation of $7.8 billion. It was a tiny company with sales of just $30 million and assets of $31 million; in comparison, Toys “R” Us was worth $2 billion less at $5.6 billion, with 70-fold more revenue ($2.1 billion) and total assets of $8 billion.

How did this make any sense? eToys showed an astounding growth rate of 4,261% in the past year. However, as Graham has cautioned us, smaller companies are able to grow at astounding rates that they cannot sustain (a 42-fold growth in revenue suggests eToys had just $700,000 in revenue the previous year).

Even worse, while it showed revenue of $30 million, eToys suffered a loss of an equal size, at $31 million—it was losing a dollar for every dollar it brought in.

In 2001, eToys filed for bankruptcy, and its stock fell from $86 per share to zero.

Chapter 18: Contrasting Bargain Stocks and Overpriced Stocks

Graham extends his security analysis to comparing eight pairs of publicly traded businesses. The overall purpose was to illustrate how the market reacts differently to two types of companies:

The value stock: a solid, steady performer with reliable growth, but that might have fallen out of fashion with the market. At low prices, the stock would be a bargain.
The growth stock: a flashy company that showed faster recent growth or higher net margins, thus having its stock price bid up to high multiples of earnings. These stocks are speculative and likely overpriced, by Graham’s standards.

In some pairs, the companies were chosen from the same industry (such as Real Estate Investment Trust vs. Realty Equities Corp. of New York) while in other pairs, the companies were in very different industries and were chosen merely because they had similar names (International Flavors & Fragrances vs. International Harvester Co., a machinery manufacturer).

In most pairs, the market valued the growth stock at much higher multiples of earnings. In some cases, the growth company even had a higher total valuation than the value company, even though the value company showed multiples higher revenue, earnings, and assets.

Take this comparison of the value stock Air Reduction Co. and the over-valued Air Products and Chemicals (both in the industrial gases industry) at the same point in time in 1969:

	Air Reduction	Air Products
Price per Share	16.375	39.5
Valuation	$185 million	$231 million
Revenue	$488 million	$222 million
Net income	$20.3 million	$13.6 million
Earnings per share	$1.80	$2.40
5-year change in per-share earnings	+19%	+59%
Dividends paid since	1917	1954
Price-to-earnings ratio	9.1x	16.5x
Assets-to-liabilities ratio	3.8x	1.5x
Price-to-book value	75%	165%

Here, the market was clearly enthusiastic about the higher growth rate of Air Products and its higher earnings per share, thus valuing it higher than Air Reduction, even though the latter was over twice the size and had a longer dividend history. Possibly Air Products had higher long-term prospects as a business, but Air Reduction was a better prospect as a stock investment. By 1971, Air Reduction showed a 50% increase in stock price, compared to the lower 30% for Air Products.

Some valuations were simply nonsensical, where a company had high valuations despite showing poor profitability and growth rates. Take this comparison of the stable Whiting Corp. (an industrial equipment manufacturer) and the ludicrously priced Willcox & Gibbs (a small conglomerate):

	Whiting	Willcox & Gibbs
Price per Share	17.75	15.5
Valuation	$11.2 million	$44.6 million
Revenue	$42.2 million	$29 million
Net income before special item	$1.01 million	$0.35 million
Earnings per share	$1.91	$0.08
10-year change in earnings	+354%	decrease
Dividends paid since	1954	None since 1957
Price-to-earnings ratio	9.3x	127x
Assets-to-liabilities ratio	3.0x	1.55x
Price-to-book value	70%	470%

Whiting was clearly the superior performing company and a bargain buy. Willcox was the relative darling of the market, sporting a valuation it didn’t deserve by Graham’s criteria.

In his commentary, Zweig takes the pair-comparison strategy into the dotcom era, highlighting even more drastic discrepancies. At the end of 1999, Internet company Yahoo! had a market value of $114 billion—263 times its revenues of $433 million, and 3,264 times its earnings of $34.9 million. In comparison, fast-food franchise company Yum! had a valuation of $6 billion on revenues of $8 billion. Despite being 17 times the size of Yahoo! In revenue, it was 1/19th of its market value. Ultimately, Yum! enjoyed a stock price rise of 25% by 2002, while Yahoo! suffered a 92% loss in the same period.

Reminder: even if a stock is cheap, it may not be a sound investment. Graham’s criteria of growth and profitability still apply. International Harvester Co. was a large company with $2.6 billion in sales but had a tepid total growth of 9% over 5 years and poor profitability of 2.6% net income over revenue. Despite its large size, Harvester was growing too slowly and showed too little profitability to meet Graham’s investment criteria.

The overall point: to decide whether a stock is a good investment, you must do your own reasoned analysis. There is no such thing as good stocks and bad stocks—only cheap stocks and overpriced stocks.

A strong company is not a good investment if its stock is overpriced.
A stock at a low price is not a good investment if the company has poor future prospects.
A stock with tremendous hype around growth, and high prices to match, is likely too speculative for intelligent investors.
Yet a once-hyped stock that falls dramatically in value can then turn into a bargain stock worth buying.

Chapter 19: A Stock Owner is a Business Owner

When most people buy a share of stock in a company, they see it as an item of abstract value, rising and falling with the whims of the market. In turn, they see themselves as passive observers of a business, content to let management do whatever it thinks is best.

Graham urges you to see a stock in a much more concrete way: as a piece of ownership in a real business. If you owned 100% of stock in a business, you’d see yourself as a business owner. Similarly, even if you own only 0.001% of a company, you should still see yourself a legitimate part-owner of a business. The CEO of the company works for you, and its board of directors answers to you.

As a business owner, you should actively monitor the business’s performance and the decisions of its management. If you are disappointed by this performance, you should actively demand that management do a better job. Should management continue to perform poorly, you should actively demand that current management be fired and new management be installed. You have a voting right in how the company is run, and you should see this duty nearly as important as voting in your national election.

Most individual investors do none of this. The majority of individual investors don’t vote in company proceedings. Graham was visibly disheartened by this indifference and urged investors to take stronger action.

(Shortform note: Since Graham’s times, “activist investors” have taken a larger role in steering companies. These are often investment firms that take sizable minority stakes—say, 1-10% of a company—and vocally demand certain directions by management. This is no substitute for an individual’s active involvement, but Graham might have seen these movements as directionally positive.)

Beyond general stewardship of a business, Graham focuses on one particular issue related to management duties: dividend payout policy.

Dividend Policy

In the first half of the 20th century, it was common for businesses to pay out the majority of profits to shareholders. This seems like common sense—the purpose of a business is to make money, and that money should belong to shareholders. Successful businesses therefore paid high dividends, while faltering businesses paid only a paltry amount.

However, over time the opposite fashion emerged—businesses began retaining more of their profits and reduced dividend payments. (Shortform note: In the 1960s, companies paid 55-60% of its profits; in recent years, the payout ratio is closer to 30%.)

The theoretical justification was that the business could use the profits to further grow the business, and so the money was better retained in the business than paying shareholders. For a set of growing businesses that clearly could deploy capital to achieve growth, this made sense.

This trend inverted how successful businesses behaved—the more successful, growing businesses paid less in dividends (as a percentage of profits); shareholders, enthusiastic about the growth in stock price, happily accepted this situation. In contrast, faltering businesses couldn’t lift their stock price through growth, so they had to pay dividends instead.

Over time, as this habit became the new normal, the dividend policy morphed into a signal about future company prospects. If a profitable, growing company with no history of paying dividends suddenly began doing so, it might suggest that the company had run out of good ideas to reinvest its profits. Counter-intuitively, paying dividends might lead to a decrease in stock price, since shareholders would worry that the company’s growth was soon to stop. Guided by this fear, companies refrained from paying dividends.

Why should the shareholder care if the company doesn’t pay dividends? Wouldn’t this cash simply be stored up to be paid at some later time? Not if the company wastes the cash on unprofitable projects. It might fund expensive acquisitions or costly expansions into industries in which it has no competence. This wasted cash would have been better put into the pockets of shareholders.

As an active investor, you should not take the dividend payout policy of management on faith. Every company that earns money should by default pay it out to its investors. If management decides not to pay dividends, it is their responsibility to argue that it can deploy this money profitably. If it fails to meet its promises, dividends should be paid in the future, or management should be replaced.

Chapter 20: Margin of Safety

Graham ends The Intelligent Investor with one of his most famous concepts: margin of safety. The concept underlies much of what we’ve covered in this summary; here, we can explicitly discuss it as a satisfying conclusion.

In simple terms, margin of safety is a measure of how much can go wrong before an investment goes bad. If you make investments with a larger margin of safety, you have a greater likelihood of prevailing in the end.

Warren Buffett offers an analogy: If you’re designing a bridge that tends to support 10,000 pounds in everyday traffic, you should design it to carry 30,000 pounds.

For a concrete example, consider how the margin of safety varies based on a stock’s price-to-earnings ratio.

A stock with a high price-to-earnings ratio has extraordinary expectations from the market—the company is expected to grow quickly over an extended future period. A high valuation today therefore is strongly dependent on its future outcomes. The higher the price-to-earnings ratio, the lower the margin of safety: everything expected of the company must go right. Its growth prospects need to materialize, it cannot be stifled by competition or regulation, management must continue to be excellent, and so on. If any linchpin falters, the company’s value will drop sharply, as will the value of the investment. (Shortform note: This is why stocks in speculative price ranges tend to be more volatile to bad news—the current high price already assumes most things will work out, so news that contradicts this belief shatters the current valuation.)
In contrast, a stock with a low price-to-earnings ratio has a high margin of safety. Your investment can endure a range of conditions before it clearly turns south. For example, the macroeconomic environment can turn bearish, and the company may suffer a temporary setback. But because the stock was a bargain to begin with, it may not have much more to fall; but in good times, it has much room to grow.

Likewise, many of Graham’s investment criteria we’ve covered have margin of safety built into them:

Interest coverage ratio: If a company’s earnings covers 5 times its interest expenses, then even if it suffers a sudden 20% drop in earnings, it has more than enough earnings remaining to continue paying interest and thus avoiding defaulting on debt. In contrast, a company that can only cover 1 times its interest expense is in danger of defaulting with just small setbacks to earnings.
Price to book value: If you buy stock in a company when its market value is two-thirds of book value, the company’s book value can shrink by one-third before your investment becomes negative (relative to book value).
Asset to liabilities ratio: If a company has assets at multiple times its liabilities, it can lose significant value before its bondholders suffer a loss.
Long history of dividends and positive earnings: A company that has a long history of paying dividends suggests consistent profitability, thus providing a cushion in recessions. In contrast, a company that has never paid dividends and is currently unprofitable may be on the edge of collapsing.

Margin of safety explains why a high-functioning company may still be a bad investment at too high of a stock price. The margin of safety evaporates as the price rises well above the company’s fair value. Likewise, a bargain company that is otherwise ignored by the market can be a great investment—there is significant margin of safety before your investment turns sour.

Earning Power and Bond Rate

To define the margin of safety of a stock more technically, compare the earnings yield of the company with the current going bond rate.

Earnings yield is the inverse of the P/E ratio: the company’s earnings per share divided by the stock price.
The bond rate is the interest rate, representing a low-risk investment return.

The larger the difference, the larger the margin of safety.

For example, if the earnings yield is 9% (implying a P/E multiple of around 11), and the bond rate is 4%, the margin is 5%.
In contrast, at a high P/E multiple of 30, the earnings yield is 3.3%, which is below the bond rate and thus indicative of a low margin of safety.

(Shortform note: Graham refers to earnings yield as “earning power,” but in modern times this has a different definition.)

Diversification Provides Margin of Safety

We can generalize the concept of margin of safety from one security to considering a portfolio of securities.

Putting all your investment funds into a single stock has a low margin of safety—that stock must perform well, or your investment will fail.

In contrast, by diversifying your stock portfolio, you spread the risk across a large number of stocks. The probability that all of them will fail spectacularly at the same time is quite low. With a high margin of safety, more things can go wrong while your investment continues to be successful.

Margin of Safety for Speculators vs. Investors

One way to distinguish speculators from investors is to understand each group’s conception of margin of safety.

Speculators base their margin of safety on shaky ground. For instance, they might think, “the market still has quite a lot of room to go up, so buying now means I can withstand quite a fall before my investment goes negative.” We already know that no one can predict whether the market will move up or down with any long-term consistency; thus, this margin of safety is illusory.

In contrast, investors define their margin of safety from simple mathematical metrics, such as price-to-earnings ratio and assets-to-liabilities. These metrics have proved their reliability over decades of investment experience and are not subject to the whims of human psychology.

A Higher Margin of Safety Makes Investing Easier

Margin of safety applies not just to outside conditions and company performance, but also to your own analytical accuracy. You might misprice a company through your calculations, but with a wide enough margin of safety, your minor mistakes don’t matter.

If you can find a legitimate bargain, then it’s likely to be a good investment. It doesn’t matter what investment analysts are saying, whether the stock went up or down on the last day, what next year’s earnings projections are, what complicated “discounted cash flow” models show, and so on. A bargain is a bargain. You can ignore the noise.

As Warren Buffett has said about value investing, “if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me.”