The Intelligent Investors by Benjamin Graham
Wall Street is “in business to make commissions, and that the way to succeed in business is to give customers what they want, trying hard to make money in a field where they are condemned almost by mathematical law to lose.”
IN 1993, Warren Buffet wrote, “By periodically investing in an index fund, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.” A decade later, he reaffirmed that advice: “those index funds that are very low cost… are investor-friendly by definition and are the best selection for most of those who wish to own equities.”
If you speculate you will (most probably) lost your money in the end. Buy when most people are pessimistic and sell when they are actively optimistic. Investigate, then invest. Rely on the time-tested principle of insurance, with wide diversification of risk.”
In his 1976 interview, he confirmed on change, and it was a landmark change: “I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, forty years ago, but the situation has changed a great deal since then. In the old days, any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies, but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior elections to justify their cost. To that very limited extent, I’m on the side of the ‘efficient market’ school of thought now generally accepted by the professors.”
For the Enterprising InvestorI: “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgement is sound, act on it—even though others may hesitate or differ. (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.) Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.”
For the Defensive Investor: “Fortunately for the typical investor, it is by no means necessary for his success that he bring these qualities to bear upon his program—provided he limits his ambition to his capacity and confines his activities within the safe and narrow path of standard, defensive investment. To achieve satisfactory investments results is easier than most people realize, to achieve super results is harder than it looks.”
- If you speculate you will (most probably) lost your money in the end.
- Buy when most people (including experts) are pessimistic; and sell when they are actively optimistic.
- Investigate, then invest.
What this means is that, though business conditions may change, corporations and securities may change, and financial institutions and regulations may change, human nature remains essentially the same. Thus the important and difficult part of sound investment, which hinges upon the investor’s own temperament and attitude, is not much affected by the passing years.
When we contemplate the immense financial changes of the past it seems at first that the main requisite for successful investment is foresight in anticipating new conditions. But that is a quality vouchsafed only to the few, and no one individual can rely with safety on the foresight of another. The everyday investor, we believe, can deal best with the factor of change by safeguarding himself against it—that is, by requiring his securities to meet specific standard of strength which will carry them through possible adversity. Thus investment can be grounded largely on the time-tested principle of insurance—which combines an adequate safety factor in each individual commitment with a wide diversification of risk. Thus, also successful investment may become substantially a matter of technique and criteria that are learnable, rather than the product of unique and incommunicable mental powers.
One thing badly needed by investors—and a quality they rarely seem to have—is a sense of financial history.
Investments may be soundly made with either of two alternative intentions: (a) to carry them determinedly through the fluctuations that are reasonably to be expected in the future; or (b) to take advantage of such fluctuations by buying when confidence and prices are low and by selling when both are high. Neither policy can be followed with intelligence unless the investor, or his adviser, has a broad comprehension of the effects of the economic alternations of the past, and unless he takes them fully into account in planning to meet the future.
The first rule of intelligent action by the enterprising investor must be that he will never embark on a security purchase which he does not fully comprehend and which he cannot justify by reference to the results of his personal study or experience.
The history of the past fifty years, and longer, indicates that a diversified holding of representative common stocks will prove more profitable over a stretch of years than a bond portfolio, with one important proviso—that the shares must be purchased at reasonable market levels, that is, levels that are reasonable in the light of fairly well-defined standards derived from the past experience.
Although common stocks are by no means a perfect protection or hedge against inflationary developments, they are certain to do more for the investor in that direction than bonds or money in the bank—which will do nothing at all. This reasoning supplies a strong logical basis for the inclusion of a fair-sized proportion of common stocks in any substantial investment portfolio. (The logic is less compelling if the investor has other types of assets—for example, his own business, or commercial real-estate holdings—which themselves are partial inflation hedges.)
The buyer of common stocks must assure himself that he is not making his purchases at a time when the general market level is a definitely high one, as judged by established standards of common-stock values.
In fact, our reasoning leads us to the rather extreme conclusion that the only kinds of corporate bonds and preferreds suitable for the investor under present conditions are those which are depressed in price to the point of being definitely undervalued.
Intelligent investors should not support new security financing except on terms which offer them proportionally as attractive a combination of income and safety as is obtainable by the purchase of United States Savings Bonds plus common stocks of leading corporations at normal market prices.
If you don’t like management, sell your stock.
Intelligent investment is more a matter of mental approach than it is of technique. A sound mental approach toward stock fluctuations is the touchstone of all successful investment under present-day conditions.
When the general market declines or advances substantially, nearly all investors will have somewhat similar changes in their portfolio values. We do not believe that the investor should pay serious attention to such price developments unless they fit into a previously established program of buying at low levels and selling at high levels. He is neither a smart investor nor a richer one when he buys in an advancing market and the market continues to rise.
There is a vital difference here between temporary and permanent influences. A price decline is of no real importance to the bona fide investor unless it is either very substantial—say, more than a third from cost—or unless it reflects a known deterioration of consequence in the company’s position. In a well-defined bear market many sound common stocks sell temporarily at extraordinary low prices. It is possible that the investor may then have a paper loss of fully 50 percent on some of his holdings, without any convincing indication that the underlying values have been permanently affected.
There are two possible ways by which he may try to do this: the way of timing and the way of pricing. By timing we mean the endeavor to anticipate the action of the stock market—to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rice above such value. A less ambitious form of pricing is the simple effort to make sure that when you buy you do not pay too much for your stocks.
There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he is himself a part.
Timing is of no real value to the investor unless it coincides with pricing—that is, unless it enables him to repurchase his shares at substantially under his previous selling price.
One possible weapon is indifference to market fluctuations; such as investor buys carefully when he has money to place and then lets prices take care of themselves.
The mechanical formulas for varying the proportion of capital invested in common stocks, in a ratio opposite to the movements of prices, are predicated on the theory that sales made at historically high levels can always be replaced later on more advantageous terms. It is interesting to observe from our chart that this simple principle has he’d true in the market for the past fifty years and possibly much longer. A concrete way of expressing the point is as follows: Whenever the investor sold out in an upswing as soon as the top level of the previous well-recognized bull market was reached, he had a chance in the next bear market to buy back at one-third (or better) below his selling price.
“There is an age-old tradition, still firmly believe in by many, that the current market price always represents a better-informed view of sound value than any individual could arrive at by himself; the knowledge, the expectations, and the judgement of every interested party are said to play their appropriate part in reaching what long ago was termed “the bloodless verdict of the marketplace.” Thus it would seem that modesty and plain common sense should restrain the investor from any presumption that he knows better than the market.
It is our firm conviction that investors cannot soundly base their operations on indications afforded by the market action of individual stocks.
The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored. He should never buy a stock because it has gone up or sell one because it has gone down. He would not be far wrong if this motto read more simply: “Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop.”
Most stock-exchange houses, however, still adhere to the old-time slogans that they are in business to make commissions and that the way to succeed in business is to give customers what they want.
It is an old and sound principle that those who cannot afford to take risks should be content with a low return on their invested funds.
Good bonds carry no protection against inflation. The bondholder suffers the full effect of any loss in purchasing power of the dollar that he lent.
Good common stocks provide a better degree of protection against inflation than do high-grade bonds.
The price paid for each should be reasonable in relation to its average earnings for the last five years or longer. We would recommend a price not to exceed twenty times such earnings.
We would emphasize our conviction that the bona fide investor does not lose money merely because the market price of his holdings decline; the fact that a decline may occur does not mean that he is running a true risk of loss. If a group of well-selected common-stock investments shows a satisfactory over-all return, as measured through a fair number of years, then this group investment has proved to be “safe.”
An elementary requirement for the intelligent investor is an ability to resist the blandishments of salesmen offering new common-stock issues during bull markets. Even if one or two can be found that can pass severe tests of quality and value, it is probably bad policy to get mixed up in this sort of business.
A growth stock may be defined as one which has done this in the past and is expected to do so in the future.
Note that the five stocks most frequently suggested were the favorite selections of well-informed students of securities. The trouble with them was that they were too obvious a choice: Their future was already being paid for in the 1939 price.
Never consider any investment principle proved by the mere citing of a few examples.
Let us suggest that an issue is not a true “bargain” unless the indicated value is at least 50 per cent more than the price.
There are two tests by which a bargain common stock is detected. The first is by our method of appraisal. As already noted, this relies largely on estimating future earnings and then multiplying these by a factor appropriate to the particular issue. If the resultant value is sufficiently above the market price—and if the investor has condense in the technique employed—he can tag the stock as a margin. The second test is the value of the business to a private owner. This value also is often determined chiefly by expected future earnings—in which case the result may be identical with the first. But in the second test more attention is likely to be paid to the realizable value of the assets, with particular emphasis on the net current assets or working capital.
Value-to-a-Private-Owner Test. The private-owner test would ordinarily start with the net worth as shown in the balance sheet. The question then arises as to whether the indicated earning power is sufficient to validate the net worth as a measure of what a private buyer would be justified in paying for the business as a whole. If the answer is definitely yes, we suggest that an ordinary investor should find the common stock attractive at a price one-third or more below such a figure. If instead of using all the net worth as a starting point the investor considered only the working capital and applied his test to that, he would have a more convincing demonstration of the existence of a bargain opportunity. For it is something of an axiom that a business is worth to any private owner at least the amount of its working capital, since could ordinarily be sold or liquidated for more than this figure. Hence, if a common stock can be bought at no more than two-thirds of the working-capital value alone-disregarding all the other assets—and if the earnings record and prospects are reasonably satisfactory, there is strong reason to believe that the investor is getting substantially more than his money’s worth. Peculiarly enough, many such opportunities present themselves in ordinary markets.
Bargain-Issue Pattern in Secondary Companies. We have defined a secondary company as one which is not a leader in a fairly important industry. Thus it is usually one of the smaller concerns in its field, but it may equally well be the chief unit in an unimportant line. By way of exception, any company that has established itself as a growth stock is not ordinarily considered as “secondary.”
Substantial profits from the purchase of secondary companies at bargain prices arise in a variety of ways. First, the dividend return is high. Second, the reinvested earnings are substantial in relation to the price paid and will ultimately affect the price. In a five- to seven-year period these advantages can bulk quite large in a well-selected list. Third, when a bull market appears it is most generous to low-priced issues; thus it tends to raise the typical bargain issue to at least a reasonable level. Fourth, even during relatively featureless market periods a continuous process of price adjustment goes on, under which secondary issues that were undervalued may rise at least to the normal level for their type of security.
We have advised against the purchase at “full prices” of three important categories of securities: (a) foreign bonds; (b) ordinary corporate bonds and preferred stocks, under present conditions of relative yield; and (c) secondary common stocks, including, or course, original offerings of such issues. By “full price” we mean prices close to par for bonds or preferred stocks, and prices that represent about the fair business value of the enterprise in the case of common stocks. The greater number of defensive investors are to avoid these categories regardless of price; the enterprising investor is to buy them only when obtainable at bargain prices—which we define as prices not more than two-thirds of the appraisal value of the securities.