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The Intelligent Investor - summary

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The Intelligent Investor is considered by Warren Buffett to be "By far the best book on investing ever written", so if you're going to get serious about your investing it should be on your shopping list. But if you don't have time to read it, here's a summary of my learnings from it.

To invest successfully what's needed is:

Investment results depend on the quality of your decision-making framework and the amplitudes of stock-market folly that prevail during your investing career.

Intellectual framework for making decisions

Dollar-cost averaging

Investing the same number of dollars each month or quarter.

Share/bond split

Compare expected return of shares against that of bonds, and then the defensive investor would vary the proportion of shares in his portfolio from 25% to 75% (the remainder being invested in high-grade bonds):

The investor should have an adequate knowledge of the historic relationshipo between the price level of the stock market, dividends and earnings.

"One fairly dependable sign of the approaching end of a bull swing is the fact that new common stock of small and nondescript companies are offered at prices somewhat higher than the current level for many medium-sized companies with a long market history."

Share investments

For the defensive investor Graham suggests restricting himself to "leading issues of the type included in the 30 components of the Dow Jones Industrial Average" (for convience, as he was skeptical of the ability of defensive investors to beat the average results - today this could be achieved by investing in low cost ETFs or mutual funds/unit trusts). "The defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition. Aggressive investors may buy other types of common stock, but they should be on a definitely attractive basis as established by intelligent analysis."

Recommended fields for enterprising investment:

  1. Buy unpopular large companies: The market tends to undervalue "companies that are out of favour because of unsatisfactory developments of a temporary nature." "The key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity. While small companies may also be undervalued for similar reasons, and in many cases may later increase their earnings and share price, they entail the risk of a definitive loss of profitability (large companies have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base) and also of protracted neglect by the market in spite of better earnings." Set up a low-multiplier list of companies, with reference to average earnings over a period of time.

  2. It may be best to focus on "issues selling at a reasonably close approximation to their tangible asset value, say at not more than a third above that figure". "The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will be at least maintained over the years."

  3. Purchase of bargain issues, where the estimated value is at least 50% greater than the price. Check value by (1) estimating future earnings and multiplying them by an appropriate factor, (2) calculate the realisable value of the assets, with particular emphasis on the net current assets or working capital. "The type of bargain issue that can be most readily identified is a common stock that sells for less than the company's net working capital alone, after deducting all prior obligations. Net working capital means a company's current assets (such as cash, marketable securities and inventories) minus its total liabilities (including preferred stock and long-term debt)."

The enterprising investor will be wary of all new issues, including convertible bonds and preferred stock, and common stock with excellent earnings confined to the recent past. The enterprising investor is advised against the purchase at full prices of "(1) foreign bonds, (2) ordinary preferred stock, and (3) secondary common stocks". "By full prices 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 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." "Secondary issues, for the most part, do fluctuate about a central level which is well below their fair value."

Have a way of calculating the underlying value of a stock, so that it plus or minus the required margin of safety can be compared with the market price:

A 2-part appraisal process:

Eventually the intelligent analyst will confine himself to those groups in which the future appears reasonably predictable (these industry groups, ideally, would not be overly dependent on such unforeseeable factors as fluctuating interest rates or the direction of prices for raw materials like oil or metals. Possibilities might be industries like gaming, cosmetics, alcoholic beverages, nursing homes, or waste management), or where the margin of safety of past performance value over current price is so large that he can take his chances on future variations - as he does in selecting well-secured senior securities.

For growth stocks, Graham suggests a formula: value = Current (normal) earnings * (8.5 + 2*expected annual growth rate)....but this depends on interest rates.

In particular know how to calculate the tangible net asset value of a stock, and limit yourself to issues selling not far above it. Tangible assets include a company's physical property - like real estate, factories, equipment and inventories - as well as its financial balances - such as cash, short-term investments, and accounts receivable. Among the elements not included in tangible assets are brands, copyrights, patents, franchises, goodwill & trademarks.

Don't take a single year's earnings seriously. Pay attention to booby traps in the per-share figures:

One important advantage of such an averaging process is that it will solve the problem of what to do about nearly all the special charges and credits - they should be included in the average earnings.

Graham's "extended studies" lead him to conclude that an investor cannot count on an earnings rate much above about 10% on net tangible assets (this ties in with research by Adam Barth, published in 2005, that shows that "average earnings for the 30 companies included in the Dow Jones Industrial Average (DJIA) are 11% of the company's book value in any 20-year period between 1920 and 1986 (1920-39, 1921-40, 1922-41, etc.). 'Average earnings as a function of book value barely varies in the slightest, and has remained basically immune to inflation, wars, massive changes in the tax code or any other external facto.'").

"The current year's results of the company are generally common property on Wall Street; next year's results, to the extent they are predictable, are already being carefully considered. Hence the investor who selects issues chiefly on the basis of this year's superior results, or on what he is told he may expect for next year, is likely to find that others have done the same thing for the same reason."

Market value is different to book value, as the 10% return on book value can be adjusted to get a (lower) return on market value.

 

The defensive investor should have adequate but not excessive diversification, this might mean holding 10 to 30 stocks. Statistical requirements for inclusion in a defensive investor's portfolio:

Process for finding cheap stocks for the enterprising investor
  1. Make a list of stocks selling at PE ratios of 9 or less

  2. remove industrial companies with current assets less than 1.5 times current liabilities, or debt more than 110% of net current assets

  3. Remove companies which had negative earnings at any time in the last 5 years

  4. Remove companies which are not paying a dividend at the moment

  5. Removes companies which have not seen an increase in earnings in the last 5 years

  6. Remove companies whose price is greater than 120% of net tangible assets

52 week lows

Also look at the daily list of stocks hitting 52-week-lows (subscribe to the mailing list at www.sharenet.co.za to get this sent to you for free)

Graham-Newman methods

Arbitrage & liquidation operations on the twin basis of (a) a calculated annual return of 20% or more, and (b) our judgement that the chance of a successful outcome was at least 4 out of 5:

Purchase of convertible bonds or convertible preferred shares and the simultaneous sale of the common stock into which they were interchangeable.

Net current asset (or bargain) issues - acquire as many issues as possible at a cost for each of less than their book value in terms of net-current assets alone - i.e. giving no value to the plant account and other assets (i.e. current assets - total liabilities). Purchases were typically made at 2 thirds or less of the stripped down asset value. If you can choose, look for those which reported a net profit in the last 12 month period.

Tips for reading financial reports
Bonds

Two main questions:

Government-backed securities offer the most safety from a credit risk perspective, but Graham warns not to purchase foreign bonds, as the owner has no legal means of enforcing his claim. New issues have a "special salesmanship behind them, which calls therefore for a special degree of sales resistance...Most new issues are sold under 'favourable market conditions' - which means favourable for the seller and consequently less favourable for the buyer."

"The typical preferred shareholder is dependent for his safety on the ability and desire of the company to pay dividends on its common stock. Once the common dividends are omitted, or even in danger, his own position becomes precarious, for the directors are under no obligation to continue paying him unless they also pay on the common. On the other hand the typical preferred stock carries no share in the company's profits beyond the fixed dividend rate...Experience teaches that the time to buy preferred stocks is when their price is unduly depressed by temporary adversity...In other words, they should be bought on a bargain basis or not at all."

Whilst the defensive investor will avoid inferior types of bonds and preferred stock, the enterprising investor will also avoid them "unless they can be bought at bargain levels - which means ordinarily at prices at least 30% under par for high coupon issues and much less for the lower coupons".

"It is unwise to buy a bond or a preferred which lacks adequate safety merely because the yield is attractive (Here the word 'merely' implies that the issue is not selling at a large discount)."

"It is more common sense to abstain from buying securities at around 100 if long experience indicates that they can probably be bought at 70 or less in the next weak market."

The chief criterion used to test the safety of corporate bonds is the number of times that available earnings has covered total interest charges over 7 years in the past. "We approve a 'poorest-year' test as an alternative to the 7-year average test. It would be sufficient if the bond or preferred stock met either of these criteria." It's recommended that the ratio of before tax earnings to total fixed charges over the last 7 years has averaged at least 4x for a public utility operating company, 5x for railroad, 7x for industrial and 5x for a retail concern (for preferred stock these ratios should cover twice the preferred dividends).

Look market value of junior stock (including common stock) to the total face amount of the debt, and asset values should also be tested.

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