Probably the best book out there for long term investors is Benjamin Graham’s book, The Intelligent investor. However, the most recent publication is from the 1970s, so I’ll go through the book in a series of articles in order to extract what is still relevant.
Believe me, there’s still plenty of relevant material, especially in this market. This will allow us to compare the current market with essential value investing wisdom and perhaps improve our risk reward perspective on things.
Let’s start with chapter 1, Investment Versus Speculation: Results to be expected by the Intelligent Investor. This chapter discusses the appropriate portfolio policy for the individual investor, an everlasting topic.
Chapter 1 – Distinction Between Investor & Speculator
“An investment operation is one in which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
The key to Graham, as later with Buffett and Klarman, is safety of principal which is the leading rule with value investors. Never lose money.
As it is now, so it was in the 1970s. That’s a big misunderstanding of who is an investor and who is a speculator.
Graham wouldn’t have been happy about hearing the notion of “investing in cryptocurrencies.” Therefore, if you’re an investor, you invest in the business and take little risk, everything else is speculation. In this market, that means that 98% of all assets are speculations.
After the next crash, the stock market will again be called a casino and all things related as speculations, even though right now everything seems to be an investment. As long as the market goes up, it is. The same things were going on towards the end of the 1940s when stocks were considered a gamble, thus cheap, and in the 1960s when the entire stock buying public called themselves investors.
Graham puts it very simply:
“Speculating is always fascinating, and it can be a lot of fun while you are ahead of the game…never add money to this account just because the market has gone up…(That’s the time to think of taking money out of your speculative fund).”
To whom should we listen, Benjamin Graham and his school of investors who outperformed the market for eternity, or the new Wall Street index fund set?
Chapter 1 – Results To Be Expected By The Defensive Investor
The defensive investor is one who is interested in safety plus freedom from bother. Graham’s advice is simple, hold between 25% and 75% of your portfolio in bonds or stocks and rebalance when the market is dangerously high. Remember, Buffett has about 40% of his portfolio in cash right now.
The market in 1971 was similar to what we have now where stocks had a 3.5% dividend yield and an additional 4% earnings yield at their 1971 valuation but bonds yielded 8%, medium term government bonds. So the advice from Graham was easy then, towards a mixture of bonds and stocks.
What’s the case now? The earnings yield is around 4% while medium term bonds yield is from 2% to 3%. Given the relatively flat yield curve, you don’t risk anything by holding short term bonds if you’re a conservative investor.
An interesting thing discussed is how the DJIA increased 6 fold in the 1949 – 1969 period but earnings only doubled, a big warning sigh for Graham. In the last 30 years, S&P 500 earnings also just doubled while the S&P 500 index is up 6 times, depending on what year we pick.
If you are a defensive investor, I would really be defensive now and wait for the potential storm to pass. Don’t be greedy now if you have to use your funds in the future. If you are afraid of inflation, you can invest in TIPS.
Chapter 2 – Results To Be Expected By The Aggressive Investor
There are 3 ways one can beat the market according to Graham as the goal of the aggressive investor is to beat the market:
- Short-term selectivity – i.e. buying stocks of companies reporting or expected to report increased earnings or where there are other catalysts.
- Long-term selectivity – Buying great businesses, even tech companies.
Graham is against trading as it’s a negative sum game, he is also against short-term selectivity as next year’s results are priced in by far already. So the only option an aggressive investor has in this market is long-term selectivity. Something I would agree with 100% today. However, I quote “to enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising, and (2) not popular on Wall Street.”
According to Graham, investors should also look for arbitrage opportunities, mergers and acquisitions, hedges, liquidations, etc., to reach satisfying returns. As we go through the whole book, there will be plenty on how to find stocks that will outperform.
I’ll finish with a quote that’s perfect for the current environment. In 1971, Graham wrote: “a final example of golden opportunities not recently available: A good part of our own operations On Wall Street has been concentrated on the purchase of bargain issues…selling at less than their share in the net current assets (working capital) alone.” Just as it was back then in the 1970s, it’s hard now to find such stocks, but the reader should be reminded that just 10 years later, the market was full of such bargains.
Next time, an interesting and timely topic, Chapter 2 – The investor and inflation.