by Benjamin Graham
The Intelligent Investor outlines what it means to be a patient, disciplined, and unemotional investor. An intelligent investor is one who confines him- or herself to quality investments that promise safety of principal and an adequate return. This limits the defensive investor to the shares of important, large companies with a strong financial position and a long record of profitable operations. Stocks only do poorly, after all, because the businesses behind them do poorly. An investor should never dump a stock, therefore, simply because the share price has fallen. One must first ask whether the value of the company’s underlying businesses has deteriorated.
Given the uncertainties of the future, the investor cannot afford to put his or her funds all in stocks or bonds. Graham’s recommendation is never to have less than 25% or more than 75% in common stocks. Protracted bear markets justify increasing the common-stock component when prices are at bargain levels. Conversely, the percentage in common stocks should be lower when market levels have become dangerously high. Asset allocations should be re-balanced on a predictable schedule every six months.
There are two ways to be an intelligent investor. The first type is a passive investor. This involves creating a permanent portfolio that runs on autopilot and doesn’t require any additional effort, namely by investing through index funds (e.g. 1/3 U.S. stocks, 1/3 foreign stocks, and 1/3 U.S. bonds). This typically includes committing a set dollar amount to be invested each month, known as dollar-cost averaging. As many empirical studies have confirmed, following this strategy is all but certain to outperform the vast majority of professional investors.
The second type of intelligent investor is one who is considered active or aggressive. The mindset of the active investor is one who thinks of buying common stock as a cheap way to own a desirable business. This style of investing requires dedicating a large part of your life to stock picking and an ability to live with the fact that most of your stocks will gain at least 50% from their lowest price and lose at least 33% from their highest price.
A good starting point is to own between 10 and 30 stocks, preferably in different industries. Better yet, start off by picking and tracking stocks for a year using an online portfolio tracker (but not with real money) and then compare your results to the returns on the S&P 500 index over the same period. After a year, keep 90% of your money in an index fund and pick your own stocks with the remainder before venturing further.
Companies should be large, which in today’s markets means having a market capitalization of at least $10 billion. Large companies have the double advantage of holding capital resources to carry them through adversity and an attentive crowd that will respond quickly to any improvements shown. Issues for such companies are best purchased when prices are unduly depressed during periods of temporary adversity caused by, say, complicated legal proceedings. Disappointing short-term results or protracted unpopularity can also be sources of undervaluation. A stock issue is not a bargain, however, unless the estimated intrinsic value is at least 50% more than the market price. The most readily identifiable bargains are stocks selling for less than a company’s current assets net of total liabilities.
Additional qualities to look for include current assets at least 1.5 to 2 times current liabilities. Debt should not be more than 110% of net current assets. Long-term debt should be under 50% of total capital, preferably fixed-rate. The investor should also require no year of earnings deficit over the past decade or more. Per-share earnings should have seen growth of at least one-third in the past ten years or an average annual increase of 3%. (Graham recommends calculating growth using three-year averages at both ends of the time period). Institutional ownership above 60% should be avoided. The investor should further require continued dividends for the past 20 years and a stock price of no more than 1.5 times net asset value.
When it comes to calculating the price-to-earnings ratio, Graham insists on his own formula of current price divided by average earnings over the past three years. A reasonable multiple should never be more than 25 times average earnings over three years and no more than 15 or 20 times those of the last twelve-month period. Attractive P/E ratios can also be calculated by taking the inverse of a 10-year AA-rated corporate bond and then decreasing that ratio by 20 percent. Price-to-book ratios should not be more than roughly 1.3, after subtracting all soft assets such as goodwill, trademarks, and other intangibles from net asset value.
The intelligent investor should begin researching a company by downloading the annual reports (Form 10-K) for the past 10 years and one year’s worth of quarterly reports (Form 10-Q) from the company’s website or SEC EDGAR database. Look to the financial statements to see whether revenues, net earnings, and cash from operations have growth smoothly and steadily over time. Never buy a stock without reading the footnotes to the financial statements and be sure to compare them to the footnotes in the annual reports of at least one close competitor.
After purchasing a stock, the investor need not closely track the company’s performance. Better to treat the investment like an owned interest in a private business with no publicly quoted price. This requires taking a good, hard look at one’s investments from time to time. The intelligent investor watches price fluctuations only insofar as they provide an opportunity to acquire more issues when prices fall sharply and sell when they increase a great deal above fair value.