The intelligent investor

Introduction: What this book expects to Accomplish

We must now consider whether the current great advantage of bond yields over stock yields would justify an all-bond policy until a more sensible relationship returns, as we expect it will. Naturally the question of continued inflation will be of great importance in reaching our decision here. A chapter will be devoted to this discussion.

Two morals for our readers:

1. Obvious prospects for physical growth in a business do not translate into obvious profits for investors.
2. The experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries.

The investor’s chief problem – and even his worst enemy – is likely to be himself. («The fault, dear investor, is not in our starts – and not in our stocks – but in ourselves…»).

The habit of relating what is paid to what is being offered is an invaluable trait in investment. In an article in a women’s magazine many years ago we advised the readers to buy their stocks as they bought their groceries, not as they bought their perfume.

A comparatively simple matter to «beat the averages»; but as a matter of fact the proportion of smart people who try this and fail is surprisingly large. Even the majority of the investment funds, with all their experienced personnel, have not performed so well over the years.

They have a clear concept of the differences between investment and speculation and between market price and underlying value.

A strong-minded approach to investment, firmly based on the margin-of-safety principle, can yield handsome rewards. But a decision to try for these emoluments rather than for the assured fruits of defensive investment should not be made without much self-examination.

Consequently we do not discuss such important media as savings and time deposits, savings-and-loan-assassination accounts, life insurance, annuities, and real-estate mortgages or equity ownership. The reader should bear in mind that when he finds the word «now,» or the equivalent, in the text, it refers to late 1971.

Commentary on the introduction

Are you an intelligent investor?

There’s proof that high IQ and higher education are not enough to make an investor intelligent. In 1998, Long-Term Capital Management L.P., a hedge fund run by a battalion of mathematicians, computer scientists, and two Nobel Prize-winning economists, lost more than $2 billion in a matter of weeks on a huge bet that the bond market would return to «normal.»

The sure thing that wasn’t

The people who now claim that the next «sure thing» will be health care, or energy, or real estate, or gold, are no more likely to be right in the end than the hypesters of high tech turned out to be.

The silver lining

The intelligent investor realizes that stocks become more risky, not less, as their prices rise – and less risky, not more, as their prices fall.

Chapter 1: Investment versus speculation: results to be expected by the intelligent investor

Investment versus Speculation

«An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.»

«There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation that you can afford to lose.

Everyone who buys a so-called «hot» common-stock issue, or makes a purchase in any way similar thereto, is either speculating or gambling.

Results to be expected by the defensive investor

1. What we said six years ago
   We recommended that the investor divide his holdings between high-grade bonds and leading common stocks; that the proportion held in bonds be never less than 25% or more than 75%, with the converse being necessarily true for the common-stock component; that his simplest choice would to be maintain a 50-50 proportion between the two, with adjustments to restore the equality when market developments had disturbed it by as much as, say, 5%. As an alternative policy he might choose to reduce his common-stock component to 25% «if he felt the market was dangerously high,» and conversely to advance it toward the maximum of 75% «if he felt that a decline in stock prices was making them increasingly attractive.»
2. What has happened since 1964
   The major change since 1964 has been the rise in interest rates on first-grade bonds to record high levels, although there has since been a considerable recovery from the lowest prices in 1970.  Future of security prices is never predictable. Almost always bonds have fluctuated much less than stock prices, and investors generally could buy good bonds of any maturity without having to worry about changes in their market value. There were a few exceptions, and the period after 1964 proved to be one of them.
3. Expectations and policy in late 1971 and early 1972
   The defensive investor should be able to count on the current 3.5% dividend return on his stocks and also on an average annual appreciation of about 4%.

Results to be expected by the aggressive investor

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.

Commentary on Chapter 1

Investing, according to Graham consists equally of three elements:

• You must thoroughly analyze a company, and the soundness of its underlying businesses, before you buy its stock;
• You must deliberately protect yourself against serious losses;
• You must aspire to «adequate,» not extraordinary, performance.

Graham urges you to invest only if you would be comfortable owning a stock even if you had no way of knowing its daily share price.

From formula to fiasco

• Cash in on the calendar. As more people learned about the January effect, more traders bought small stocks in December, making them less of a bargain and this reducing their returns. Also, the January effect is biggest among the smallest stocks – but according to Plexus Group, the leading authority on brokerage expenses, the total cost of buying and selling such tiny stocks can run up to 8% of your investment. Sadly, by the time you’re done paying your broker, all your gains on the January effect will melt away.
• Just do «what works».  James O´Shaughnessy published a book called What Works on Wall Street. In it, he argued that «investors can do much better than the market.» O´Shaughnessy made a stunning claim: From 1954 through 1994, you could have turned $10.000 into $8.074.504, beating the market by more than 10-fold – a towering 18.2% average annual return. How? By buying a basket  of 50 stocks with the highest one-year returns, five straight years of rising earnings, and share prices less than 1.5 times their corporate revenues. As if he were the Edison of Wall Street, O´Shaughnessy obtained U.S. Patent No. 5.978.778 for his «automated strategies» and launched a group of four mutual funds based on his findings. By late 1999 the funds had sucked in more than $175 million from the public – and, in his annual letter to shareholders, O´Shaughnessy stated grandly: «As always, I hope that together, we can reach our long-term goals by staying the course and sticking with our time-tested investment strategies.» But «what works on Wall Street» stopped working right after O´Shaughnessy publicized it.
• Follow «The foolish four». You would have «trashed the market averages over the last 25 years» and could «crush your mutual funds» by spending «only 15 minutes a year».

The Fools made the same mistake as O´Shaughnessy; if you look at a large quantity of data long enough, a huge number of patterns will emerge – if only by chance. By random luck alone, the companies that produce above-average stock returns will have plenty of things in common.

On the other hand, if the formula actually did work in the past (like the January effect), then by publicizing it, market pundits always erode – and usually eliminate – its ability to do so in the future.

The intelligent investor designates a tiny portion of her total portfolio as a «mad money» account. For most of us, 10% of our overall wealth is the maximum permissible amount to put at speculative risk. Never mingle the money in your speculative account with what’s in your investment accounts; never allow your speculative thinking to spill over into your investing activities; and never put more than 10% of your assets into your mad money account, no matter what happens.

Chapter 2: The investor and inflation

On the basis of these undeniable facts many financial authorities have concluded that (1) bonds are an inherently undesirable form of investment, and (2) consequently, common stocks are by their very nature more desirable investments than bonds.

Our readers must have enough intelligence to recognize that even high-quality stocks cannot be a better purchase than bonds under all conditions.

We think it would be reasonable for an investor at this point to base his thinking and decisions on a probable (far from certain) rate of future inflation of say, 3% per annum. (This would compare with an annual rate of about 2.5% for the entire period 1915-1970.)

Commentary on Chapter 2

The money illusion

There’s another reason investors overlook the importance of inflation: what psychologists call the «money illusion.» If you receive a 2% raise in a year when inflation runs at 4%, you will almost certainly feel better than you will if you take a 2% pay cut during a year when inflation is zero. Yet both changes in your salary leave you in a virtually identical position – 2% worse off after inflation.

Two acronyms to the rescue

REITs. Real Estate Investment Trusts, or REITs (pronounced «reets»), are companies that own and collect rent from commercial and residential properties. Bundled into real-estate mutual funds, REITs do a decent job of combating inflation.

TIPS. Treasury Inflation-Protected Securities, or TIPS, are U.S. government bonds, that automatically go up in value when inflation rises.

You can buy TIPS directly from the U.S. government at www.publicdebt.treas.gov/of/ofinflin.htm, or in a low-cost mutual fund like Vanguard Inflation-Protected Securities or Fidelity Inflation-Protected Bond Fund.

Chapter 3: A century of stock-market history: the level of stock prices in early 1972

The stock-market level in early 1972

WHAT COURSE TO FOLLOW

Investors should not conclude that the 1964 market level in dangerous merely because they read it in this book. The principles of investment, as set forth herein, would call for the following policy under 1964 conditions, in order of urgency:

1. No borrowing to buy or hold securities.
2. No increase in the proportion of funds held in common stocks.
3. A reduction in common-stock holdings where needed to bring it down to a maximum of 50% of the total portfolio. The capital-gains tax must be paid with as good grace as possible, and the proceeds investment in first-quality bonds or held as a savings deposit.

All of these judgements could be defended even today by adroit arguments. Discouraging endeavors to «beat the market» or to «pick the winners» on the other.

There is a fine passage near the beginning of Aristotle’s Ethics that goes: «It is the mark of an educated mind to expect that amount of exactness which the nature of the particular subject admits. It is equally unreasonable to accept merely probable conclusions from a mathematician and to demand strict demonstration from an orator.» The work of a financial analyst falls somewhere in the middle between that of a mathematician and of an orator.

Commentary on Chapter 3

Bull-market Baloney

The heart of Graham’s argument is that the intelligent investor must never frecast the future exclusively by extrapolating the past.

Some bulls went further. Since stocks had «always» beated bonds over any period of at least 30 years, stocks must be less risky than bonds or even cash in the bank.

The higher they go, the harder they fall

The value of any investment is, and always must be, a function of the price you pay for it. By the late 1990s, inflation was withering away, corporate profits appeared to be booming, and most of the world was at peace. But that did not mean – nor could it ever mean – that stocks were worth buying at any price. Since the profits that companies can earn are finite, the price that investors should be willing to pay for stocks must also be finite.

What’s next?

The stock market’s performance depends on three factors:

• real growth (the rise of companies’ earnings and dividends)
• inflationary growth (the general rise of prices throughout the economy)
• speculative growth – or decline (any increase or decrease in the investing public’s appetite for stocks)

Chapter 4: General portfolio policy: the defensive investor

The bond component

The choice of issues in the bond component of the investor’s portfolio will turn about two main questions: should he buy taxable or tax-free bonds, and should he buy shorter – or longer-term maturities? The tax decision should be mainly a matter of arithmetic, turning on the difference in yields as compared with the investor’s tax bracket.

List a few major types of bonds that deserve investor consideration, and discuss them briefly with respect to general description, safety, yield, market price, risk, income-tax status, and other features.

1. U.S. Savings bonds, series E and series H.: There is no other investment that combines (1) absolute assurance of principal and interest payments, (2) the right to demand full «money back» at any time, and (3) guarantee of at least a 5% interest rate for at least ten years. Holders of the earlier issues of series E bonds have had the right to extend their bonds at maturity, and this to continue to accumulate annual values at successively higher rates.
2. Other united states bonds: A profusion of these issues exists, covering a wide variety of coupon rates of maturity dates. All of them are completely safe with respect to payment of interest and principal. They are subject to Federal income taxes but free from state income tax.
3. State and municipal bonds: These enjoy exemption from Federal income tax. They are also ordinarily free of income tax in the state of issue but not elsewhere. They are either direct obligations of a state or subdivision, or «revenue bonds» dependent for interest payments on receipts from a toll road, bridge, building lease, etc. Not all tax-free bonds are strongly enough protected to justify their purchase by a defensive investor. He may be guided in his selection by the rating given to each issue by Moody’s or Standard & Poor’s. One of three highest ratings by both services – Aaa (AAA), Aa (AA), or A – should constitute a sufficient indication of adequate safety. The yield on these bonds will vary both with the quality and the maturity, with the shorter maturities giving the lower return.
4. Corporation bonds: These bonds are subject to both Federal and state tax.

Higher-yielding bond investments

By sacrificing quality an investor can obtain a higher income return from his bonds. Long experience has demonstrated that the ordinary investor is wiser to keep away from such high-yield bonds.

Savings deposits in Lieu of bonds

An investor may now obtain as high an interest rate from a savings deposit in a commercial or savings bank (or from a bank certificate of deposit) as he can from a first-grade bond of short maturity. The interest rate on bank savings accounts may be lowered in the future, but under present conditions they are a suitable substitute for short-term bond investment by the individual.

Security Forms

The bond form and the preferred-stock form, are well-understood and relatively simple matters. A bond-holder is entitled to receive fixed interest and payment of principal on a definite date. The owner of a preferred stock is entitled to a fixed dividend, and no more, which must be paid before any common dividend. His principal value does not come due on any specified date. (The dividend may be cumulative or noncumulative. He may or may not have a vote.)

From the investor’s standpoint it is probably best for him in most cases that he should have (1) an unconditional right to receive interest payments when they are earned by the company, and (2) a right to other forms of protection than bankruptcy proceedings if interest is not earned and paid.

Commentary on Chapter 4

N/A

Chapter 5: The defensive investor and common stocks

If you had invested $1 in U.S. stocks in 1900 and spent all your dividends, your stock portfolio would have grown to $198 by 2000. But if you had reinvested all your dividends, your stock portfolio would have been worth $16.797! Far from being an afterthought, dividends are the greatest force in stock investing.

Why do the «high prices» of stocks affect their dividend yields? A stock’s yield is the ratio of its cash dividend to the price of one share of common stock. If a company pays a $2 annual dividend when its stock price is $100 per share, its yield is 2%. But if the stock price doubles while the dividend stay constant, the dividend yield will drop to 1%.

Rules for the common-stock component

The selection of common stocks for the portfolio of the defensive investor should be a relatively simple matter. Suggest 4 rules to be followed:

1. There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.
2. Each company selected should be large, prominent, and conservatively financed.
3. Each company should have a long record of continuous dividend payments.
4. The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past 7 years. We suggest that this limit be set at 25 times such average earnings, and not more than 20 times those f the last 12 month period. But such a restriction would eliminate nearly all the strongest and most popular companies from the portfolio. In particular, it would ban virtually the entire category of «growth stocks,» which have for some years past been the favorites of both speculators and institutional investors.

Portfolio changes

Presumably our defensive investor should obtain – at least once a year – the same kind of advice regardging changes in his portfolio as he sought when his funds were first committed.

Investors can now set up their own automated system to monitor the quality of their holdings by using interactive «portfolio trackers» at such websites as www.quicken.com, moneycentral.msn.com, finance.yahoo.com and www.morningstar.com.

Dollar-cost averaging

The NYSE has put considerable effort into popularizing its «monthly purchase plan,» under which an investor devotes the same dollar amount each month to buying one or more common stocks. This is an application of a special type of «formula investment» known as dollar-cost averaging. During the predominantly rising-market experience since 1949 the results from such a procedure were certain to be highly satisfactory, especially since they prevented the practitioner from concentrating his buying at the wrong times.

The investor’s personal situation

We urge the beginner in security buying not to waste his efforts and his money in trying to beat the market. Let him study security values and initially test out his judgment on price versus value with the smallest possible sums.

Note on the concept of «Risk»

We should like to point out that the words «risk» and «safety» are applied to securities in two different senses, with a resultant confusion in thought.

A bond is clearly proved unsafe when it defaults its interest or principal payments. Similarly, if a preferred stock or even a common stock is bought with the expectation that a given rate of dividend will be continued, then a reduction or passing of the dividend means that it has proved unsafe. It is also true that an investment contains a risk if there is a fair possibility that the holder may have to sell at a time when the price is well below cost.

Commentary on Chapter 5

Should you «buy what you know»?

Lynch insists that o one should ever invest in a company, no matter how great its products or how crowded its parking lot, without studying its financial statements and estimating its business value.

Psychologists led by Baruch Fischhoff of Carnegie Mellon University have documented a disturbing fact: becoming more familiar with a subject does not significantly reduce people’s tendency to exaggerate how much they actually know about it. That’s why «investing in what you know» can be so dangerous; the more you know going in, the less likely you are to probe a stock for weaknesses. This pernicious form of overconfidence is called «home bias».

The more familiar a stock is, the more likely it is to turn a defensive investor into a lazy one who thinks there’s no need to do any homework.

Can you roll your own?

Fortunately, for a defensive investor who is willing to do the required homework for assembling a stock portfolio, this is the Golden Age: never before in financial history has owning stocks been so cheap and convenient.

Be warned, however, that buying stocks in tiny increments for years on end can set off big tax headaches. If you are not prepared to keep a permanent and exhaustively detailed record of your purchases, do not buy in the first place.

Filling in the potholes

Let’s say you can spare $500 a month. By owning and dollar-cost averaging into just three index funds – $300 into one that holds the total U.S. stock market, $100 into one that holds foreign stocks, and $100 into one that holds U.S. bonds – you can ensure that you own almost every investment on the planet that’s worth owning.

If you had invested $12.000 in the Standard & Poor’s 500 – stock index at the beginning of September 1929, 10 years later you would have had only $7.223 left. But if you had started with a paltry $100 and simply invested another $100 every single month, then by August 1939, your money would have grown to $15.571! That’s the power of disciplined buying – even in the face of the Great Depression and  the worst bear market of all time.

Every little bit helps

From the end of 1999 through the end of 2002, the S&P500 – stock average fell relentlessly. But if you had opened an index-fund account with a $3.000 minimum investment and added $100 every month, your total outlay of $6.600 would have lost 30.2% – considerably less than the 41.3% plunge in the market. Better yet, your steady buying at lower prices would build the base for an explosive recovery when the market rebounds.

Chapter 6: Portfolio policy for the enterprising investor: negative approach

Second-grade bonds and preferred stocks

Since in late-1971 it is possible to find first-rate corporate bonds to yield 7.25%, and even more, it would not make much sense to buy second-grade issues merely for the higher return they offer. In fact corporations with relatively poor credit standing have found it virtually impossible to sell «straight bonds» – i.e., nonconvertibles – to the public in the past two years.

Foreign government bonds

Foreign bonds, as a whole, have had a bad investment history since 1914.

We do know that, if and when trouble should come, the owner of foreign obligations has no legal or other means of enforcing his claim.

Years ago an argument of sorts was made for the purchase of foreign bonds here on the grounds that a rich creditor nation such as ours was under moral obligation to lend abroad. Time, which brings so many revenges, now finds us dealing with an intractable balance-of-payments problem of our own, part of which is ascribable to the large-scale purchase of foreign bonds by American investors seeking a small advantage in yield. For many years past we have questioned the inherent attractiveness of such investments from the standpoint of the buyer; perhaps we should add now that the latter would benefit both his country and himself if he declined these opportunities.

New issues generally

They cover the widest possible range of quality and attractiveness. Certainly there will be exceptions to any suggested rule. Our one recommendation is that all investors should be wary of new issues – which means, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased.

There are two reasons for this double caveat. The first is that new issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance. The second is that most new issues are sold under «favorable market conditions» – which means favorable for the seller and consequently less favorable for the buyer.

New common-stock offerings

In the case of companies already listed, additional shares are offered pro rata to the existing stockholders. The subscription price is set below the current market, and the «rights» to subscribe have an initial money value. The sale of the new shares is almost always underwritten by one or more investment banking houses, but it is the general hope and expectation that all the new shares will be taken by the exercise of the subscription rights.

The second type is the placement with the public of common stock of what were formerly privately owned enterprises. Most of this stock is sold for the account of the controlling interests to enable them to cash in on a favorable market and to diversify their own finances.

Commentary on Chapter 6

The early bird gets wormed

You can get access to IPOs only after their shares have rocketed above the exclusive initial price.

But that gain was earned by only a handful of institutional traders; individual investors were almost entirely frozen out.

Buying IPOs is a bad idea because it flagrantly violates one of Graham’s most fundamental rules: no matter how many other people want to buy a stock, you should buy only if the stock is a cheap way to own a desirable business.

Chapter 7: Portfolio policy for the enterprising investor: the positive side

Broader implications of our rules for investment

Between the passive and aggressive status. Many, perhaps most, investors seek to place themselves in such an intermediate category; in our opinion that is a compromise that is more likely to produce disappointment than achievement.

As an investor you cannot soundly become «half a businessman,» expecting thereby to achieve half the normal rate of business profits on your funds.

Commentary on Chapter 7

Timing is nothing

As the Danish philosopher Soren Kierkegaard noted, life can only be understood backwards – but it must be lived forwards. Looking back, you can always see exactly when you should have bought and sold your stocks. But don’t let that fool you into thinking you can see, in real time, just when to get in and out. In the financial markets, hindsight is forever 20/20, but foresight is legally blind. And thus, for most investors, market timing is a practical and emotional impossibility.

What goes up…

A great company is ot a great investment if you pay too much for the stock.

The more a stock has gone up, the more it seems likely to keep going up. But that instinctive belief is flatly contradicted by a fundamental law of financial physics: The bigger they get, the slower they grow. A $1 – billion company can double its sales fairly easily; but where can a $50 – billion company turn to find another $50 billion in business?

Growth stocks are worth buying when their prices are reasonable, but when their price/earnings ratios go much above 25 or 30 the odds get ugly.

Even many corporate leaders fail to understad these odds (see sidebar on p. 184). The intelligent investor, however, gets interested in big growth stocks not when they are at their most popular – but when something goes wrong.

Should you put all your eggs in one basket?

Nearly all the richest people in America trace their wealth to a concentrated investment in a single industry or even a single company (think Bill Gates and Microsoft, Sam Walton and Wal-Mart, or the Rockefellers and Standard Oil). The Forbes 400 list of the richest Americans, for example, has been dominated by undiversified fortunes ever since it was first compiled in 1982.

Almost no small fortunes have been made this way – and not many big fortunes have been kept this way.

So how many of the Forbes 400 fortunes from 1982 remained on the list 20 years later? Only 6 of the original members – a measly 16% – were still on the list in 2002. By keeping all their eggs in the one basket that had gotten them onto the list in the first place – once – booming industries like oil and gas, or computer hardware, or basic manufacturing – all the other original members fell away. When hard times hit, none of these people – despite all the huge advantages that great wealth can bring – where properly prepared.

The bargain bin

A quick and easy way to search for companies that might pass Graham’s net-working-capital tests. http://quote.morningstar.com/highlow.html?msection=HighLow

To see whether a stock is selling for less than the value of net working capital (what Graham’s followers call «net nets»), download or request the most recent quarterly or annual report from the company’s website or from the EDGAR database at www.sec.gov. From the company’s current assets, subtract its total liabilities, including any preferred stock and long-term debt.

What’s your foreign policy?

Put all your money in Japanese stocks.

The result? Over the next decade, you lose roughly two-birds of your money.

The lesson? It’s not that you should never invest in foreign markets like Japan; it’s that the Japanese should never have kept all their money at home. And neither should you. If you live in the United States, work in the United States, and get paid in U.S. dollars, you are already making a multilayered bet on the U.S. economy. To be prudent, you should put some of your investment portfolio elsewhere – simply because no one, anywhere, can ever know what the future will bring at home or abroad.

Chapter 8: The Investor and the Market Fluctuations

Let us repeat what we said at the outset: if you want to speculate do so with your eyes open, knowing that you will probably lose money in the end; be sure to limit the amount at the risk and to separate it completely from your investment program.

Market Fluctuations as a Guide to Investment Decisions

Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. 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 upwards, 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 rise 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.

The Dow theory may seem to create its own vindication, since it would make the market advance or decline by the very action of its followers when a buying or selling signal is given. A «stampede» of this kind is, of course, much more of a danger than an advantage to the public trader.

Buy-Low-Sell-High Approach

We are convinced that the average investor cannot deal successfully with price movements by endeavoring to forecast them. Can he benefit from them after they have take place – i.e., by buying after each major decline and selling out after each major advance? The fluctuations of the market over a period of many years prior to 1950 lent considerable encouragement to that idea. In fact, a classic definition of a «shrewd investor» was «one who bought in a bear market when everyone else was selling, and sold out in a bull market when everyone else was buying».

Nearly all the bull markets had a number of well-defined characteristics in common, such as (1) a historically high prices level, (2) high price / earning ratios, (3) low dividend yields as against bond yields, (4) much speculation on margin, and (5) many offerings of new common-stock issues of poor quality. This to the student of stock-market history it appeared that the intelligent investor should have been able to identify the recurrent bear and bull markets, to buy in the former and sell in the latter, and to do so for the most part of reasonably short intervals of time.

The market’s behaviour in the past 20 years has not followed the former pattern, nor obeyed what once were well-established danger signals, nor permitted its successful exploitation by applying old rules for buying low and selling high.

Formula Plans

In the early years of the stock-market rise that began in 1949-50 considerable interest was attracted to various methods of taking advantage of the stock market’s cycles. These have been known as «formula investment plans.» The essence of all such plans – except the simple case of dollar averaging – is that the investor automatically does some selling of common stocks when the market advances substantially. In many of them a very large rise in the market level would result in the sale of all common-stock holdings; others provided for retention of a minor proportion of equities under all circumstances.

This approach had the double appeal of sounding logical (and conservative) and of showing excellent results when applied retrospectively to the stcok market over many years in the past. True, they had realized excellent profits, but in a broad sense the market «ran away» from them thereafter, and their formulas gave them little opportunity to buy back a common-stock position.

Market Fluctuations of the Investor’s Portfolio

A serious investor is not likely to believe that the day-to-day or even month-to-month fluctuations of the stock market make him richer or poorer.

Business Valuations versus Stock-Market Valuations

Net Asset Value, book value, balance-sheet value, and tangible-asset value are all synonyms for net worth, or the total value of a company’s physical and financial assets minus all its liabilities. It can be calculated using the balance sheets in a company’s annual and quartely reports; from total shareholders’ equity; subtract all «soft» assets such as goodwill, trademarks, and other intangibles. Divide by the fully diluted number of shares outstanding to arrive at book value per share.

What we have said applies to a comparison of the leading growth companies with the bulk of well-established concerns; we exclude from our purview here those issues which are highly speculative because the businesses themselves are speculative.

The price of its shares fell from 607 to 300 in seven months in 1962-63; after two splits its price fells from 389 to 219 in 1970. Similarly, Xerox – an even more impressive earnings gainer in recent decades – fell from 171 to 87 in 1962-63, and from 116 to 65 in 1970. These striking losses did not indicate any doubt about the future long-term grwoth of IBM or Xerox; they reflected instead a lack of confidence in the premium valuation that the stock market itself had placed on these excellent prospects.

A stock does not become a sound investment merely because it can be bought at close to its asset value. 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 at least be maintained over the years.

The A. & P. Example

There are two chief morals to this story. The first is that the stock market often goes far wrong, and sometimes an alert and courageous investor can take advantage of its patent errors. The other is that most businesses change in character and quality over the years, sometimes for the better, perhaps more often for the worse. The investor need not watch his companies’ performance like a hawk; but he should give it a good, hard look from time to time.

But note this important fact: The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more.

«Only to the extent that it suits his book» means «only to the extent that the price is favorable enough to justifiy selling the stock.» In traditional brokerage lingo, the «book» is an investor’s ledger of holdings and trades.

Summary

The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell.

That market quotations are there for his convenience, either to be taken advantage of or to be ignored. He should never buy a stock becuase 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.»

Fluctuations in Bond Prices

Note that bond prices do not fluctuate in the same (inverse) proportion as the calculated yields, because their fixed maturity value of 100% exerts a moderating influence. However, for very long maturities, as in our Northern Pacific example, prices and yields change at close to the same rate.

The price fluctuations of convertible bonds and preferred stocks are the resultant of three different factors: (1) variations in the price of the related common stock, (2) variations in the credit standing of the company, and (3) variations in general interest rates. A good many of the convertible issues have been sold by companies that have credit ratings well below the best.

This may be a good place to make a suggestion about the «long-term bond of the future.» Why should not the effects of changing interest rates be divided on some practical and equitable basis between the borrower and the lender? One possibility would be to sell long-term bonds with interest payments that vary with an appropriate index of the going rate. The main results of such an arrangement would be: (1) the investor’s bond would always have a principal value of about 100, if the company maintains its credit rating, but the interest received will vary, say, with the rate offered on conventional new issues; (2) the corporation would have the advantages of long-term debt – being spared problems and costs of frequent renewals of refinancing – but its interest costs would change from year to year.

Commentary on Chapter 8

Think for yourself

The intelligent investor shouldn´t ignore Mr. Market entirely. Instead, you should do business with him – but only to the extent that it serves your interests. Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them. You do not have to trade with him just because he constantly begs you to.

By refusing to let Mr. Market be your master, you transform him into your servant. After all, even when he seems to be destroying values, he is creating them elsewhere.

Can you beat the pros at their own game?

What does Graham mean by those words «basic advantage»? He means that the intelligent individual investor has the full freedom to choose whether or not to follow Mr. Market. You have the luxury of being able to think for yourself.

Some of the handicaps mutualfund managers and other professional investors are saddled with:

• With billions of dollars under management, they must gravitate toward the biggest stocks – the only ones they can buy in the multimillion-dollar quantities they need to fill their portfolios. This many funds end up owning the same few overpriced giants.
• Investors tend to pour more money into funds as the market rises. The managers use that new cash to buy more of the stocks they already own, driving prices to even more dangerous heights.
• If fund investors ask for their money back when the market drops, the managers may need to sell stocks to cash them out. Just as the funds are forced to buy stocks at inflated prices in a rising market, they become forced sellers as stocks get cheap again.
• Many portfolio managers get bonuses for beating the market, so they obsessively measure their returns against benchmarks like the S&P500 index. If a company gets added to an index, hundreds of funds compulsively buy it. (If they don´t, and that stock then does well, the managers look foolish; on the other hand, if they buy it and it does poorly, no one will blame them.)
• Increasingly, fund managers are expected to specialize, Just as in medicine the general practitioner has given way to the pediatric allergist and the geriatric otolaryngologist, fund managers must buy only «small growth» stocks, or only «mid-sized value» stocks, or nothing but «large blend» stocks. If a company gets too big, or too small, or too cheap, or an itty bit too expensive, the fund has to sell it – even if the manager loves the stock.

Your returns will always be hostage to Mr. Market and his whims. But you can control:

• your brokerage costs, by trading rarely, patiently, and cheaply
• your ownership costs, by refusing to buy mutual funds with excessive annual expenses
• your expectations, by using realism, not fantasy, to forecast your returns
• your risk, by deciding how much of your total assets to put at hazard in the stock market, by diversifying, and the rebalacing
• your tax bills, by holding stocks for at least one year and, whenever possible, for at least five years, to lower your capital-gains liability
• and, most of all, your own behaviour.

If you listen to financial TV, or read most market columnists, you-d think that investing is some kind of sport, or a war, or a struggle for survival in a hostile wilderness. But investing isn´t about beating others at their game. It’s about controlling yourself at your own game. The challenge for the intelligent investor is not to find the stocks that will go up the most and down the least, but rather to prevent yourself from being your own worst enemy – from buying high just because Mr. Market says «Buy!» and from selling low just because Mr. Market says «Sell!».

If your investment horizon is long – at least 25 or 30 years – there is only one sensible approach: Buy every month, automatically, and whenever else you can spare some money.

After all, the whole point of investing is not to earn more money than average, but to earn enough money to meet your own needs. The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.

Chapter 9: Investing in Investment Funds

Those that are redeemable on demand by the holder, at net asset value, are commonly known as «mutual funds» (or»open-end funds»). Most of these are actively selling additional shares through a corps of salesmen. Those with nonredeemable shares are called «closed-end» companies or funds; the number of their shares remains relatively constant. All of the funds of any importance are registered with the Securities & Exchange Commission (SEC), and are subject to its regulations controls.

Commentary on Chapter 9

Top of the charts

Most investors simply buy a fund that has been going up fast, on the assumption that it will keep on going. And why not? Psychologists have shown that humans have an inborn tendency to believe that the long run can be predicted from even a short series of outcomes. What’s more, we know from our own experience that some plumbers are far better than others, that some baseball players are much more likely to hit home runs, that our favorite restaurant serves consistently superior food, and that smart kids get consistently good grades. Skill and brains and hard work are recognized, rewarded – and consistently repeated – all around us. So, if a fund beats the market, our intuiton tells us to expect it to keep right on outperforming.

Financial scholars have been studying mutual-fund performance for at least a half century, and they are virtually unanimous on several points:

• the average fund does not pick stocks well enough to overcome its costs of researching and trading them;
• the higher a fund’s expenses, the lower its returns;
• the more frequently a fund trades its stocks, the less it tends to earn;
• highly volatile funds, which bounce up and down more than average, are likely to stay volatile;
• funds with high past returns are unlikely to remain winners for long.

First of all, understanding why it’s so hard to find a good fund will help you become a more intelligent investor. Second, while past performance is a poor predictor of future returns, there are other factors that you can use to increase your odds of finding a good fund. Finally, a fund can offer excellent value even if it doesn´t beat the market – by providing an economical way to diversify your holdings and by freeing up your time for all the other things you would rather be doing than picking your own stocks.

The first shall be last

The more obstacles its investors face:

Migrating managers. When a stock picker seems to have the Midas touch, everyone wants him-including rival fund companies.

Asset elephantiasis. When a fund earns high returns, investors notice – often puring in hundreds of millions of dollars in a matter of weeks. That leaves the fund manager with few choices – all of them bad.

No more fancy footwork. Some companies specialize in «incubating» their funds-test driving them privately before selling them publicly.

Rising expenses. It often costs more to trade stocks in very large blocks than in small ones; with fewer buyers and sellers, it’s harder to make a match.

Sheepish behavior. Finally, once a fund becomes successful, its managers tend to become timid and imitative. As a fund grows, its fees become more lucrative – making its managers reluctant to rock the boat. Without any pretense of being able to select the «best» and avoid the «worst» – will beat most funds over the long run. Index funds have only one significant flaw: They are boring. You’ll never be able to go to a barbecue and brag about how you own the top-performing fund in the country. You’ll never be able to boast that you beat the market, because the job of an index fund is to match the market’s return.

Tilting the tables

Add up all their handicaps. What qualities do they have in common?

Their managers are the biggest shareholders. The conflict of interest between what’s best for the fund’s managers and what’s best for its investors is mitigated when the managers are among the biggest owners of the fund’s shares.

They are cheap. One of the most common myths in the fund business is that «you get what you pay for» – that high returns are the best justification for higher fees.

They dare to be different. When Peter Lynch ran Fidelity Magellan, he bought whatever seemed cheap to him – regardless of what other fund managers owned.

They shut the door. The best funds often close to new investors – permiting only their existing shareholders to buy more.

They don’t advertise. Just as Plato says in The Republic that the ideal rulers are those who do not want to govern, the best fund managers often behave as if they don’t want your money.

What else should you watch for? Most fund buyers look at past performance first, then at the manager’s reputation, then at the riskiness of the fund, and finally (if ever) at the fund’s expenses.

Next, evaluate risk, In its prospectus (or buyer’s guide), every fund must show a bar graph displaying its worst loss over a calendar quarter. If you can’t stand losing at least that much money in three months, go elsewhere. It’s also worth checking a fund’s Morningstar rating. Find a low-cost fund whose managers are major shareholders, dare to be different, don’t hype their returns, and have shown a willingness to shut down before they get too big for their britches. Then, and only then, consult their Morningstar rating. Finally, look at past performance.

Know when to fold’em

So when should you sell? Here a few definite red flags:

• a sharp and unexpected change in strategy, such as a «value» fund loading up on technology stocks in 1999 or a «growth» fund buying tons of insurance stocks in 2002;
• an increase in expenses, suggesting that the managers are lining their own pockets;
• large and frequent tax bills generated by excessive trading;
• suddenly erratic returns, as when a formerly conservative fund generates a big loss (or even produces a giant gain).

«If you’re not prepared to stay married, you shouldn’t get married». Fund investing is no different. If you’re not prepared to stick with a fund through at least three lean years, you shouldn’t buy it i the first place. Patience is the fund investor’s single most powerful ally.

Chapter 10: The investor and his advisers

Investment Counsel and Trust Services of Banks

The truly professional investment advisers – that is, the well-established investment counsel firms, who charge substantial annual fees – are quite modest in their promises and pretentions. For the most part they place their clients’ funds in standard interest – and dividend-paying securities, and they rely mainly or normal investment experience for their overall results.

Advice from Brokerage Houses

The Wall Street brokerage fraternity has probably the highest ethical standards of any business, but it is still feeling its way toward the standards and standing of a true profession.

Stock-market speculators as a class were almost certain to lose money.

The investor obtains advice and information from stock-exchange houses through two types of employees, now known officially as «customers’ brokers» (or account executives») and financial analysts.

The customer’s broker, also called a «registered representative,» formerly bore the less dignified title of «customer’s man.» Today he is for the most part an individual of good character and considerable knowledge of securities, who operates under a rigid code of right conduct. Nevertheless, since his business is to ear commisions, he can hardly avoid being speculation-minded. This the security buyer who wants to avoid being influenced by speculative considerations will ordinarily have to be careful and explicit in his dealing with his customer’s broker; he will have to show clearly, by word and deed, that he is not interested in anything faintly resembling a stock-market «top.». Once the customer’s broker understands clearly that he has a real investor on his hands, he will respect this point of view and cooperate with it.

The financial analyst, formerly known chiefly as security analyst, is a person of particular concern to the author, who has been one himself for more than five decades and has helped educate countless others. At this stage we refer only to the financial analysts employed by brokerage houses. The function of the security analyst is clear enough from his title. It is he who works up the detailed studies of individual securities, develops careful comparisons of various issues in the same field, and forms an expert opinion of the safety or attractiveness or intrinsic value of all the different kinds of stocks and bonds.

The CFA Certificate for Financial Analysts

Chartered Financial Analyst (CFA) is now awarded to those senior practitioners who pass required examinations and meet other tests of fitness.

Commentary on Chapter 10

Do you need help?

Big losses. If your portfolio lost more than 40% of its value from the beginning of 2000 through the end of 2002, then you did even worse than the dismal performance of the stock market itself.

Busted budgets. Have no idea where your money goes, find it impossible to save on a regular schedule, and chronically fail to pay your bills on time, then your finances are out of control. An adviser can help you get a grip on your money by designing a comprehensive financial plan that will outline how -and how much- you should spend, borrow, save, and invest.

Trust, then verify

Internet search engine like Google to see if anything comes up (watch for terms like «fine,» «complaint,» «lawsuit,» «disciplinary action,» or «suspension»). www.nasaa.org, www.advisorinfo.sec.gov, www.iard.com, or the website of your state securities regulator. Pay special attention to the Disclosure Reporting Pages, where the adviser must disclose any disciplinary actions by regulators. (Because unscrupulous advisers have been known to remove those pages before handing an ADV to a prospective client, you should independently obtain your own complete copy), www-cfp-board.org.

Words of warning

Here’s the kind of lingo that should set off warming bells: offshore, exclusive, opportunity, focus performance not fees, want to be rich, can’t lose, upside is huge, there is no downside, trust me, commodities trading, monthly returns, guaranteed, you need to hurry, sure thing, computer model, smart money is buying it, options strategy, no-brainer, you cannot afford not to own it, we can beat the market, you’ll be sorry if you don’t, no one else knows how to do this.

Getting to know you

If fees will consume more than 1% of your assets annually, you should probably shop for another adviser.

Anything over 8% or 10% is unrealistic.

Defeating your own worst enemy

So they will ask you some tough questions as well, which might include:

Why do you feel you need a financial adviser?
What are your long-term goals?
What has been your greatest frustration in dealing with other advisers (including yourself)?
Do you have a budget? Do you live within your means? What percentage of your assets do you spend each year?
When we look back a year from now, what will I need to have accomplished in order for you to be happy with your progress?
How do you handle conflicts or disagreements?
How did you respond emotionally to the bear market that began in 2000?
What are your worst financial fears? Your greatest financial hopes?
What rate of return on your investments do you consider reasonable? (Base your answer on Chapter 3.)

Chapter 11: Security Analysis for the Lay Investor: General Approach

The security analyst deals with the past, the present, and the future of any given security issue. He describes the business; he summarizes its operating results and financial position; he sets forth its strong and weak points, its possibilities and risks; he estimates its future earning power under various assumptions, or as a «best guess.» He makes elaborate comparisons of various companies, or of the same company at various times. Finally, he expresses an opinion as to the safety of the issue, if it is a bond or investment-grade preferred stock, or as to its attractiveness as a purchase, if it is a common stock.

Bond Analysis

The most dependable and hence the most respectable branch of security analysis concerns itself with the safety, or quality, of bond issues and investment-grade preferred stocks. The chief criterion used for corporate bonds is the number of times that total interest charges have been covered by available earnings for some years in the past. In the case of preferred stocks, it is the number of times that bond interest and preferred dividends combined have been covered.

We approve a «poorest-year» test as an alternative to the seven-year-average test; it would be sufficient if the bond or preferred stock met either of these criteria.

In addition to the earnings-coverage test, a number of others are generally applied. These include the following:

1. Size of Enterprise. There is a minimum standard in terms of volume of business for a corporation – varying as between industrials, utilities, and railroads – and the population for a municipality.
2. Stock/Equity Ratio. This is the ratio of the market price of the junior stock issues (shares of common stock) to the total face amount of the debt, or the debt plus preferred stock.
3. Property Value. The asset values, as shown on the balance sheet or as appraised, were formerly considered the chief security and protection for a bond issue.

Common-Stock Analysis

The ideal form of common-stock analysis leads to a valuation of the issue which can be compared with the current price to determine whether or not the security is an attractive purchase. This valuation, in turn, would ordinarily be found by estimating the average earnings over a period of years in the future and then multiplying that estimate by an appropriate «capitalization factor.»

Factors Affecting the Capitalization Rate

1. General Long-Term Prospects. These views are reflected in the substantial differentials between the price/earnings ratios of individual companies and of industry groups.
2. Management. On Wall Street a great deal is constantly said on this subject, but little that is really helpful.
3. Financial Strength and Capital Structure. Stock of a company with a lot of surplus cash and nothing ahead of the common is clearly a better purchase (at the same price) than another one with the same per share earnings but large bank loans and senior securities.
4. Dividend Record. One of the most persuasive test of high quality is an uninterrumpted record of dividend payments going back over many years.
5. Current Dividend Rate.

A Two-Part Appraisal Process

The work between senior and junior analysts: (1) The senior analyst would set up the formula to apply to all companies generally for determining past-performance value. (2) The junior analysts would work up such factors for the designated companies – pretty much in mechanical fashion. (3) The senior analyst would then determine to what extent a company’s performance – absolute or relative – is likely to differ from its pats record, and what change should be made in the value to reflect such anticipated changes. It would be best if the senior analyst’s report showed both the original valuation and the modified one, with his reasons for the change.

Commentary on Chapter 11

Putting a Price on the Future

Which factors determine how much you should be willing to pay for a stock?

• the company’s «general long-term prospects»
• the quality of its management
• its financial strength and capital structure
• its dividend record
• and its current dividend rate.

The long-term prospects. Nowadays, the intelligent investor should begin by downloading at least five years’ worth of annual reports (Form 10-K) from the company’s website or from the EDGAR database at www.sec.gov. Then comb through the financial statements, gathering evidence.

Among the problems watch for:

• The company is a «serial acquirer.» An average of more than two or three acquisitions a year is a sign of potential trouble.
• The company is an OPM addict, borrowing debt or selling stock to raise boatloads of Other People’s Money. These fat infusons of OPM are labeled «cash from financing activities» on the statement of cash flows in the annual report. They can make a sick company appear to be growing even if its underlying businesses are not generating enough.
• The company is a Johnny-One-Note, relying on one customer (or a handful) for most of its revenues.

Sources of growth and profit, the good signs:

• The company has a wide «moat,» or competitive advantage. A monopoly or near-monopoly on the market; economies of scale, or the ability to supply huge  amounts of goods or services cheaply; a unique intangible asset; a resistance to substitution.
• The company is a marathoner, not a sprinter. By looking back at the income statements, you can see whether revenues and net earnings have grown smoothly and steadily over the previous 10 years.
• The company sows and reaps. No matter how good its products or how powerful its brands, a company must spend some money to develop new business.

The quality and conduct of management. A company’s executives should say what they will do, then do what they said. Read the past annual reports to see what forecasts the managers made and if they fulfilled them or fell short. Managers should forthrightly admit their failures and take responsibility for them, rather than blaming all-purpose scapegoats like «the economy,» «uncertainty,» or «weak demand.» Check whether the tone and substance of the chairman’s letter stay constant, or fluctuate with the latest fads on Wall Street.

Question to help you determine whether the people who run the company will act in the interests of the people who own the company:

• Are they looking out for No. 1?
  • A firm that pays its CEO $100 million in a year had better have a very good reason.
  • «Form 4», available through the EDGAR database at www.sec.gov, shows whether a firm’s senior executives and directors have been buying or shelling shares. There can be legitimate reasons for an insider to sell-diversification, a bigger house, a diver settlement – but repeated big sales are a bright red flag. A manager can’t legitimately be your partner if he keeps selling while you’re buying.
• Are they managers or promoters?
  • Executives should spend most of their time managing their company in private, not promoting it to the investing public.

Financial strength and capital structure. The most basic possible definition of a good business is this: it generates more cash than it consumes. Good managers keep finding ways of putting that cash to productive use. In the long run, companies that meet this definition are virtually certain to grow in value, no matter what the stock market does.

Start by reading the statement of cash flows in the company’s annual report. See whether cash from operations has grow steadily throughout the past 10 years.

You should substract from reported net income:

• any costs of granting stock options, which divert earnings way from existing shareholders into the hands of new inside owners
• any «unusual», «nonrecurring,» or «extraordinary» charges
• any «income» from the company’s pension fund.

If owner earnings per share have grown at a steady average of at least 6% or 7% over the past 10 years, the company is a stable generator of cash, and its prospects for growth are good.

A few words on dividends and stock policy:

• The burden of proof is on the company to show that you are better off if it does not pay a dividend.
• Companies that repeatedly split their shares – and hype those.
• Companies should buy back their shares when they are cheap – not when they are at or near record highs.

Chapter 12: Things to Consider About Per-Share Earnings

Don’t take a single year’s earnings seriously. The second is: If you do pay attention to short-term earnings, look out for booby traps in the per-share figures.

Commentary on Chapter 12

The numbers game

Companies and their accountants pushed the limits of propriety in the past few years. Compensated heavily through stock options, top executives realized that they could become fabulously rich merely by increasing their company’s earnings for just a few years running. Hundreds of companies violated the spirit, if not the letter, of accounting principles – turning their financial reports into gibberish, tarting up ugly results with cosmetic fixes, cloaking expenses, or manufacturing earnings out of thin air.

An inventory story

One thing is clear: The intelligent investor must always be on guard for «nonrecurring» costs that, like the Energizer bunny, just keep on going.

Caveat investor

When you research a company’s financial reports, start reading on the last page and slowly work your way toward the front. Anything that the company doesn’t want you to find is buried in the back.

Never buy a stock without reading the footnotes to the financial statement in the annual report. Usually labeled «summary of significant accounting policies,» one key note describes how the company recognizes revenue, records inventories, treats installment or contract sales, expenses its marketing costs, and accounts for the other major aspects of its business. In the other footnotes watch for disclosures about debt, stock options, loans to customers, reserves against losses, and other «risk factors» that can take a big chomp out of earnings. Among the things that should make your antennae twitch are technical terms like «capitalized,» «deferred,» and «restructuring» – and plain-English words signaling that the company has altered its accounting practices, like «began,» «charge,» and «however.» None of those words mean you should not buy the stock, but all mean that you need to investigate further. Be sure to compare the footnotes with those in the financial statements of at least one firm that’s a close competitor, to see how aggressive your company’s accountants are.

Chapter 13: A Comparison of Four Listed Companies

1. Profitability. a) A high rate of return on invested capital often goes along with a high annual growth rate in earnings per share. b) For manufacturing companies, the profit figure per dollar of sales is usually an indication of comparative strength or weakness.
2. Stability. We measure by the maximum decline in per-share earnings in any one of the past ten years, as against the average of the three preceding years. No decline translates into 100% stability.
3. Growth. Satisfactory growth rates.
4. Financial Position. Having better than standard ratio of $2 of current assets for $1 of current liabilities. Have a relatively low long-term debt.
5. Dividends. What really counts is the history of continuance without interruption. The variations in payout percentage do not seem especially significant. The current dividend yield is twice as high on the «cheap pair» as on the «dear pair,» corresponding to the price / earnings ratios.
6. Price History.

Commentary on Chapter 13

The promised land?

Just the news that a stock would be splitting 2-for-1 could instantly drive its shares up 20% or more.

Why? Because getting more shares makes people feel richer. Someone who bought 100 shares of Exodus in January watched them turn into 200 when the stock split in April; then those 200 turned into 400 in August; then the 400 became 800 in December. It was thrilling for these people to realize that they had gotten 700 more shares just for owning 100 in the first place. To them, that felt like «found money» – never mind that the price per share had been cut in half with each split. In December, 1999, one elated Exodus shareholder, who went by the handle «givemeadollar,» exulted on an online message board: «I’m going to hold these shares until I’m 80, [because] after it splits hundreds of times over the next years, I’ll be close to becoming CEO.»

What about Exodus the business? Graham wouldn’t have touched it with a 10-foot pole.

Exodus’s stock lost 55% in 2000 and 99.8% in 2001. On September 26, 2001, Exodus filed for Chapter 11 bankruptcy protection. Most of the company’s assets were bought by Cable & Wireless, the British telecommunications giant. Instead of delivering its shareholders to the promised land, Exodus left them exiled in the wilderness. As of early 2003, the last trade in Exodus’s stock was at one penny a share.

Chapter 14: Stock Selection for the Defensive Investor

1. Adequate size of the enterprise
   Our idea is to exclude small companies which may be subject to more than average vicissitudes especially in the industrial field. Not less than $100 million of annual sales for an industrial company and, not less than $50 million of total assets for a public utility.
2. A sufficiently strong financial condition
   For industrial companies current assets should be at least twice current liabilities – a so – called two-to-one current ratio. Also, long-term debt should not exceed the net current assets (or «working capital»). For public utilities the debt should not exceed twice the stock equity (at book value).
3. Earnings stability
   Some earnings for the common stock in each of the past ten years.
4. Dividend record
   Uninterrupted payments for at least the past 20 years.
5. Earnings growth
   A minimum increase of at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end.
6. Moderate price/earnings ratio
   Current price should not be more than 15 times average earnings of the past three years.
7. Moderate ratio of price to assets
   Current price should not be more than 1.5 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5. (This figure corresponds to 15 times earnings and 1.5 times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.)

General comments:

Will exclude companies that are (1) too small, (2) in relatively weak financial condition, (3) with a deficit stigma in their ten-year record, and (4) not having a long history of continuous dividends.

Our last two criteria are exclusive in the opposite direction, by demanding more earnings and more assets per dollar of price than the popular issues will supply. This is by no means the standard viewpoint of financial analysts; in fact most will insist that even conservative investors should be prepared to pay generous prices for stocks of the choice companies. We have expounded our contrary view above; it rests largely on the absence of an adequate factor of safety when too large a portion of the price must depend on ever-increasing earnings in the future. The reader will have to decide this important question for himself – after weighing the arguments on both sides.

Inclusion of a modest requirement of growth over the past decade.

Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings/price ratio – the reverse of the P/E ratio – at least as high as the current high-grade bond rate. This would mean a P/E ratio no higher than 13.3 against an AA bond yield of 7.5%.

Application of our criteria to the DJIA at the end of 1970

1. Size is more than ample for each company.
2. Financial condition is adequate in the aggregate, but not for every company.
3. Some dividend has been paid by every company since at least 1940. Five of the dividend records go back to the last century.
4. The aggregate earnings have been quite stable in the past decade. None of the companies reported a definit during the prosperious period 1961-69, but Chrysler showed a small deficit in 1970.
5. The total growth – comparing three-year averages a decade apart – was 77%, or about 6% per year. But five of the firms did not grow by one-third.
6. The ratio of year-end price to three-year average earnings was 839 to $55.5 or 15 to 1 – right at our suggested upper limit.
7. The ratio of price to net asset value was 839 to 562 – also just within our suggested limit of 1.5 to 1.

The public-utility «solution»

We exclude one criterion from our tests of public-utility stocks – namely, the ratio of current assets to current liabilities. The working-capital factor takes care of itself in this industry as part of the continuous financing of its growth by sales of bonds and shares. We do require an adequate proportion of stock capital to debt.

Even defensive portfolios should be changed from time to time, especially if the securities purchased have an apparently excessive advance and can be replaced by issues much more reasonably priced.

Investing in stocks of financial enterprises

All these enterprises that they have a relatively small part of their assets in the form of material things – such as fixed assets and merchandise inventories – but on the other hand most categories have short-term obligations well in excess of their stock capital. The question of financial soundness is, therefore, more relevant here than in the case of the typical manufacturing  or commercial enterprise.

The shares of financial concerns have produced investment results similar to those of other types of common shares.

Raiload issues

The carriers have suffered severely from a combination of severe competition and strict regulation.

Automobiles, buses, and airlines have drawn off most of their passenger business and left the rest highly unprofitable; the trucks have taken a good deal of their freight traffic. More than half of the railroad mileage of the country has been in bankruptcy (or «trusteeship») at various times during the past 50 years.

There have been prosperious periods for the industry, especially the war years.

There is no compelling reason for the investor to own railroad shares.

Selectivity for the defensive investor

The future itself can be approached in two different ways, which may be called the way of prediction (or projection) and the way of protection.

The first, or predictive, approach could also be called the qualitative approach, since it emphasizes prospects, management, and other nonmeasurable, albeit highly important, factors that go under the heading of quality. The second, or protective, approach may be called the quantitative or statistical approach, since it emphasizes the measurable relationships between selling price and earnings, assets, dividends, and so forth.

Emphasize diversification more than individual selection. Incidentally, the universally accepted idea of diversification is, in part at least, the negation of the ambitious pretensions of selectivity. If one could select the best stocks unerringly, one would only lose by diversifying. There is room for a rather considerable freedom of preference.

Commentary on Chapter 14

Getting started

Buy every stock in the DowJones Industrial Average. Today’s defensive investor can do even better – by buying a total stock-market index fund that holds essentially every stock worth having. A low-cost index fund is the best tool ever created for low-maintenance stock investing -.

Keep 90% of your stock money in an index fund, leaving 10% with which to try picking your own socks. Only after you build that solid core should you explore.

Why diversify?

Keeping your money spread across many stocks and industries is the only reliable insurance against the risk of being wrong.

But diversification doesn’t just minimize your odds of being wrong. It also maximizes your chances of being right. Over long periods of time, a handful of stocks turn into «superstocks» that go up 10.000% or more.

Testing, testing

• Adequate size
• Strong financial condition
• Earnings stability. According to Morgan Stanley, 86% of all the companies in the S&P 500 index have had positive earnings in every year from 1993 through 2002.
• Dividend record. 354 companies in the S&P 500 (or 71% of the total) paid a dividend.
• Earnings growth. 264 companies in the S&P 500 met that test. But here, it seems, Graham set a very low hurdle; 33% cumulative growth over a decade is less than a 3% average annual increase. Cumulative growth in earnings per share of at least 50% – or a 4% average annual rise -.
• Moderate P/E ratio. Graham recommends limiting yourself to stocks wose current price is no more than 15 times average earnings over the past three years.
• Moderate price-to-book ratio. Graham recommends a «ratio of price to assets» (or price-to-book-value ratio) of no more than 1.5. In recent years, an increasing proportion of the value of companies has come from intangible assets like franchises, brand names, and patents and trademarks. All told 273 companies (or 55% of the index) have price-to-book ratios of less than 2.5.

At least 142 stocks in the S&P 500 could pass that test as of early 2003.

Due diligence

Do your homework. Through the EDGAR database at www.sec.gov, you get instant access to a company’s annual and quarterly reports, along with the proxy statement that discloses the manager’ compensation, ownership, and potential conflicts of interest. Read at least five years’ worth.

Check out the neighborhood. Websites like http://quicktake.morningstar.com, http://finance.yahoo.com and www.quicken.com can readily tell you what percentage of a company’s shares are owned by institutions.

Chapter 15: Stock selection for the enterprising investor

The stock market does in fact reflect in the current prices not only all the important facts about the companies’ past and current performance, but also whatever expectations can be reasonably formed as to their future.

A summary of the Graham-Newman methods

Arbitrages: the purchase of a security and the simultaneous sale of one or more other securities into which it was to be exchanged under a plan of reorganization, merger, or the like.

Liquidations: purchase of shares which where to receive one or more cash payments in liquidation of the company’s assets.

Related Hedges: the purchase of convertible bonds or convertible preferred shares, and the simultaneous sale of the common stock into which they were exchangeable. The position was established at close to a parity basis.

Net-Current-Asset (or «Bargain») issues: the idea here was to acquire as many issues as possible at a cost for each of less than their book value in terms of net-current-assets alone.

Secondary companies

It is Standard & Poor’s Stock Guide, published monthly, and made available to the general public under annual subscription. In addition many brokerage firms distribute the Guide to their clients (on request).

A Winnowing of the stock guide

We suggest the following:

1. Financial condition: (a) Current assets at least 1.5 times current liabilities, and (b) debt not more than 110% of net current assets (for industrial companies).
2. Earnings stability: no deficit in the last five years covered in the Stock Guide.
3. Dividend record: some current dividend.
4. Earnings growth: last year’s earnings more than those of 1966.
5. Price: less than 120% net tangible assets.

The Stock Guide material includes «Earnings and Dividend Rankings,» which are based on stability and growth of these factors for the past 8 years. (Thus price attractiveness does not enter here.) We include the S&P rankings in our Table-1. Ten of the 15 issues are ranked B+ (=average) and one (American Maize) is given the «high» rating of A. If our enterprising investor wanted to add a seventh mechanical criterion to his choice, by considering only issues ranked by Standard & Poor’s as average or better in quality, he might still have about 100 such issues to choose from. One might say that a group of issues, of at least average quality, meeting criteria of financial condition as well, purchasable at a low multiplier of current earnings and below asset value, should offer good promise of satisfactory investment results.

Commentary on Chapter 15

Practice, practice, practice

The fact that most professionals do a poor job of stock picking does not mean that most amateurs can do better. The vast majority of people who try to pick stocks learn that they are not as good at it as they thought; the luckiest ones discover this early on, while the less fortunate take years to learn it. A small percentage of investors can excel at picking their own stocks. Everyone else would be better off getting help, ideally through an index fund.

You can use «portfolio trackers» at websites like www.morningstar.com, http://finance.yahoo.com, http://money.cnn.com/services/portfolio/ or www.marketocracy.com (at the last site, ignore the «market-beating» hype on its funds and other services).

Looking under the right rocks

Start by looking at the «Business Segments» footnote in the company´s annual report, which typically lists the industrial sector, revenues, and earnings of each subsidiary. (The «Management Discussion and Analysis» may also be helpful.) Then search a news database like Factiva, ProQuest, or LexisNexis for examples of other firms in the same industries that have recently been acquired. Using the EDGAR database at www.sec.gove to locate their past annual reports, you may be able to determine the ratio of purchase price to the earnings of those acquired companies. You can then apply that ratio to estimate how much a corporate acquirer might pay for a similar division of the company you are investing.

From EPS to ROIC

Net income or earnings per share (EPS) has been distorted in recent years by factors like stock-option grants and accounting gains and charges. To see how much a company is truly earning on the capital it deploys in its businesses, look beyond EPS to ROIC, or return on invested capital. Christopher Davis of the Davis Funds defines it with this formula:

ROIC = Owner Earnings % Invested Capital

where Owner Earnings is equal to:

Operating profit
plus depreciation
plus amortization of goodwill
minus Federal income tax (paid at the company’s average rate)
minus cost of stock options
minus «maintenance» (or essential) capital expenditures
minus any income generated by unsustainable rates of return on pension funds (as of 2003, anything greater than 6.5%)

where Invested Capital is equal to:

Total assets
minus cash (as well as short-term investments and non-interest-bearing current liabilities)
plus past accounting charges that reduced invested capital.

ROIC has the virtue of showing, after all legitimate expenses, what the company earns from its operating businesses – and how efficiently it has used the shareholders’ money to generate that return. An ROIC of at least 10% is attractive; even 6% or 7% can be tempting if the company has good brand names, focused management, or is under a temporary cloud.

Who’s the boss?

Want to see not only whether managements are honest with shareholders but also whether they’re honest with themselves.» (If a company boss insists that all is hunky-dory when business is sputtering, watch out!) Nowadays, you can listen in on a company’s regularly scheduled conference calls even if you own only  a few shares; to find out the schedule, call the investor relations department at corporate headquarters or visit the company’s website.

Robert Rodriguez of FPA Capital Fund turns to the back page of the company’s annual report, where the heads of its operating divisions are listed. If there’s a lot of turnower  in those names in the first one or two years of a new CEO’s regime, that’s probably a good sign; he’s cleaning out the dead wood. But if high turnover continues, the turnaround has probably devolved into turmoil.

Chapter 16: Convertible issues and warrants

Convertible bonds are preferred stocks have been taking on a predominant importance in recent years in the field of senior financing. As a parallel development, stock-option warrants – which are long-term rights to buy common shares at stipulated prices – have become more and more numerous.

Convertible issues are claimed to be especially advantageous to both the investor and the issuing corporation. The investor receives the superior protection of a bond or preferred stock, plus the opportunity to participate in any substantial rise in the value of the common stock.

The issuer is able to raise capital at a moderate interest or preferred dividend cost, and if the expected prosperity materializes the issuer will get rid of the senior obligation by having it exchanged into common stock.

In exchange for the conversion privilege the investor usually gives up something important in quality or yield, or both. Conversely, if the company gets its money at lower cost because of the conversion feature, it is surrendering in return part of the common shareholders’ claim to future enhancement. On this subject there are a number of tricky arguments to be advanced both pro and con.

Convertible securities as a whole have relatively poor quality as senior issues and also are tied to common stocks that do worse than the general market except during a speculative upsurge.

A convertible preferred is safer than the common stock of the same company – that is to say, it carries smaller risk of eventual loss of principal. Buying of convertibles was done by investors who had no special interest or confidence in the common stock.

«Never convert a convertible bond.» Why this advice? Because once you convert you have lost your strategic combination of prior claimant to interest plus a chance for an attractive profit. You have probably turned from investor into speculator, and quite often at an unpropitious time (because the stock has already had a large advance).

The investor should look more than twice before he buys them. After such hostile scrutiny he may find some exceptional offerings that are too good to refuse. The ideal combination, of course, is a strongly secured convertible, exchangeable for a common stock which itself is attractive, and at a price only slightly higher than the current market. Every now and then a new offering appears that meets these requirements.

Stock-option warrants

We consider the recent development of stock-option warrants as a near fraud. They have created huge aggregate dollar «values» out of thin air. They have no excuse for existence except to the extent that they mislead speculators and investors.

«Premptive right» is one of the elements of value entering into the ownership of common stock – along with the right to receive dividends, to participate in the company’s growth, and to vote for directors. When separate warrants are issued for the right to subscribe additional capital, that action takes away part of the value inherent in an ordinary common share and transfers it to a separate certificate. An analogous thing could be done by issuing separate certificate. An analogous thing could be done by issuing a separate certificates for the right to receive dividends (for a limited or unlimited period), or the right to share in the proceeds of sale or liquidation of the enterprise, or the right to vote the shares. Why then are these subscription warrants created as part of the original capital structure? simply because people are inexpert in financial matters. They don’t realize that the common stock is worth less with warrants outstanding than otherwise. Hence the package of stock and warrants usually commands a better price in the market than would the stock alone. Note that in the usual company reports the per-share earnings are (or have been) computed without proper allowance for the effect of outstanding warrants. The result is, of course, to overstate the true relationship between the earnings and the market value of the company’s capitalization.

Large issues of stock-option warrants serve no purpose, except to fabricate imaginary market values.

Commentary on Chapter 16

The zeal of the convert

It’s expensive to trade small lots of convertible bonds, and diversification is impractical unless you have well over $100.000 to invest in this sector alone. Fortunately, today’s intelligent investor has the convenient recourse of buying a low-cost convertible bond fund. Fidelity and Vanguard offer mutual funds with annual expenses comfortably under 1%, while several closed-end funds are also available at a reasonable cost (and, occasionally, at discounts to net asset value).

Chapter 17: Four Extremely instructive case histories

Commentary on Chapter 17

The more things change…

Graham highlights four extremes:

• an overpriced «tottering giant»
• an empire-building conglomerate
• a merger in which a tiny firm took over a big one
• an initial public offering of shares in a basically worthless company

Chapter 18: A comparison of 8 pairs of companies

Commentary on Chapter 18

The market scoffs at Graham’s principles in the short run, but they are always revalidated in the end. If you buy a stock purely because its price has been going up – instead of asking whether the underlying company’s value is increasing – then sooner or later you will be extremely sorry. That’s not a likelihood. It is a certainty.

Chapter 19: Shareholders and managements: dividend policy

Shareholders and dividend policy

There were several strong counter-arguments, such as: The profits «belong» to the shareholders, and they are entitled to have them paid out within the limits of product management; many of the shareholders need their dividend income to live on.

Stock dividends and stock splits

What we should call a proper stock dividend is one that is paid to shareholders to give them a tangible evidence or representation of specific earnings which have been reinvested in the business for their account over some relatively short period in the recent past. A stright stock dividend has an important tax advantage over the otherwise equivalent combination of cash dividends with stock subscription rights.

Stock dividends of all types seem to be disapproved of by most academic writers on the subject. They insist that they are nothing but pieces of paper, that they give the shareholders nothing they did not have before, and that they entail needless expense and inconvenience. On our side we consider this a completely doctrinaire view, which fails to take into account the practical and psychological realities of investment. True, a periodic stock dividend – say of 5% – changes only the «form» of the owners’ investment. He has 105 shares in place of 100; but without the stock dividend the original 100 shares would have represented the same ownership interest now embodied in his 105 shares. Nonetheless, the change of form is actually one of real importance and value to him. If he wishes to cash in his share of the reinvested profits he can do so by selling the new certificate sent him, instead of having to break up his original certificate. He can count on receiving the same cash-dividend rate on 105 shares as formerly on his 100 shares; a 5% rise in the cash-dividend rate without the stock dividend would not be nearly as probable.

Commentary on Chapter 19

Theory versus practice

Graham wants you to realize something basic but incredibly profound: When you buy a stock, you become an owner of the company its managers, all the way up to the CEO, work for you. Its board of directors must answer to you. Its cash belongs to you. Its businesses are your property. If you don’t like how your company is being managed, you have the right to demand that the managers be fired, the directors be changed, or the property be sold. «Shareholders,» declares Graham, «should wake up.»

The intelligent owner

Toda’s investors have forgotten Graham’s message. They put most of their effort into buying a stock, a little into selling it – but none into owning it. Graham starts telling us that «there are just two basic questions to which stockholders should turn their attention:

1. Is the management reasonably efficient?
2. Are the interests of the average outside shareholder receiving proper recognition?»

You should judge the efficiency of management by comparing each company’s profitability, size, and competitiveness against similar firms in its industry. What if you conclude that the managers are no good? Then, urges Graham,

A few of the more substantial stockholders should become convinced that a change is needed and should be willing to work toward that end. Second, the rank and file of the stockholders should be open-minded enough to read the proxy material and too weigh the arguments on both sides. They must at least be able to known when their company has been unsuccessful and be ready to demand more than artful platitudes as a indication of the incumbent management. Third, it would be most helpful, when the figures clearly show that the results are well below average, if it became the custom to call in outside business engineers to pass upon the policies and competence of the management.

What is «proxy material» and why does Graham insist that you read it? in its proxy statement, which it sends to every shareholder, a company announces the agenda for its annual meeting and discloses details about the compensation and stock ownership of managers and directors, along with transactions between insiders and the company. Shareholders are asked to vote on which accounting firm should audit the books and who should serve on the board of directors.

If you do read the proxy and see things that disturb you, then:

• vote against every director to let them know you disapprove
• attend the annual meeting and speak up for the rights
• find an online message board devoed to the stock (like those at http://finance.yahoo.com) and rally other investors to join your cause.

Whose money is it, anyway?

Graham saw right through this managerial malarkey:

The objective of efficient operation is to produce at low cost and to find the most profitable articles to sell. Efficient finance requires that the stockholders’ money be working in forms most suitable to their interest.

Selling low, buying high

When a company repurchases some of its stock, that reduces the number of its shares outstanding. Even if its net income stays flat, the company’s earnings per share will rise, since its total earninigs will be spread across fewer shares. That, in turn, should lift the stock price. Better yet, unlike a dividend, a buyback is tax-free to investors who don’t sell their shares. This it increases the value of their stock without raising their tax bill. And if the shares are cheap, then spending spare cash to repurchase them in an excellent use of the company’s capital.

All this is true in theory. Unfortunately, in the real world, stock buy-backs have come to serve a purpose that can only be described as sinister. Now that grants of stock options have become such a large part of executive compensation, many companies – especially in high-tech industries – must issue hundreds of millions of shares to give to the managers who exercise those stock options. But that would jack up the number of shares outstanding and shrink earnings per share. To counteract that dilution, the companies must turn right back around and repurchase millions of shares in the open market. By 2000, companies were spending as astounding 41.8% of their total net income to repurchase their own shares – up from 4.8% in 1980.

Keeping their options open

In 1997, Steve Jobs, the cofounder of Apple Computer Inc., returned to the company as its «interim» chief executive officer. Already a wealthy man, Jobs insisted on taking a cash salary of $1 per year. At year-end 1999, to thank Jobs for serving as CEO «for the previous 2.5 years without compensation,» the board presented him with his very own Gulfstream jet, at a cost to the company of a mere 90$ million. The next month Jobs agreed to drop «interim» from his job title, and the board rewarded him with options on 20 million shares. (Until then, Jobs had held a grand total of two shares of Apple stock.)

The principle behind such options grants is to align the interests of managers with outside investors. If you are an outside Apple shareholder, you want its managers to be rewarded only if Apple’s stock earns superior returns. Nothing else could possibly be fair to you and the other owners of the company. But, as John Bogle, former chairman of the Vanguard funds, points out, nearly all managers sell the stock they receive immediately after exercising their options. How could dumping millions of shares for an instant profit possibly align their interests with those of the company’s loyal long-term shareholders?

In Jobs’ case, if Apple stock rise by just 5% annually through the beginning of 2010, he will be able to cash in his options for 548.3$ million. In other words, even if Apple’s stock earns no better than half the long-term average return of the overall stock market, Jobs will land a half-a-billion dollar windfall. Does that align his interests with those of Apple’s shareholders – or malign the trust that Apple’s shareholders have placed in the board of directors?

Reading proxy statements vigilantly, the intelligent owner will vote against any executive compensation plan that uses option grants to turn more than 3% of the company’s share outstanding over the managers.

Chapter 20: «Margin of Safety» as the central concept of investment

There is a reasonably close connection between the growth of corporate surpluses through reinvested earnings and the growth of corporate values.

The danger in a growth-stock program lies precisely here. For such favored issues the market has a tendency to set prices that will not be adequately protected by a conservative projection of future earnings. (It is a basic rule of prudent investment that all estimates, when they differ from past performance, must err at least slightly on the side of understatement.) The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price. If, as we suggest, the average market level of most growth stocks is too high to provide an adequate margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily.

The margin-of-safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities. We have here, by definition, a favorable difference between price on the one hand and indicated  or appraised value on the other. That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck.

Theory of diversification

There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better change for profit than for loss – not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses.

Extension of the concept of investments

Conventional investments are appropriate for the typical portfolio.

Unconventional investments are those that are suitable only for the enterprising investor. They cover a wide range. The broadest category is that of undervalued common stocks of secondary companies, which we recommend for purchase when they can be bought at two-thirds or less of their indicated value.

To sum up

«Know what you are doing – know your business.» For the investor this means: Do not try to make «business profits» out of securities – that is, returns in excess of normal interest and dividend income – unless you know about security values as you would need to kow about the value of merchandise that you proposed to manufacture or deal in.

«Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusally strong reasons for placing implicit confidence in his integrity and ability.» For the investor this rule should determine the conditions under which he will permit someone else to decide what is done with his money.

«Do not enter upon an operation – that is, manufacturing or trading in an item – unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular, keep away from ventures in which you have little to gain and much to lose.»

«Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even though others may hesitate or differ.»

Commentary on Chapter 20

First, don’t lose

Risk didn’t mean losing money; it meant making less money than someone else.

Losing some money is an inevitable part of investing, and there’s a nothing you can do to prevent it. But, to be an intelligent investor, you must take responsibility for ensuring that you never lose most or all of your money. Graham’s «margin of safety» performs the same function: By refusing to pay oo much for an investment, you minimize the chances that your wealth will ever disappear or suddenly be destroyed.

The risk is not in our stocks, but in ourselves

Financial risk resides not in what kinds of investments you have, but in what kind of investor you are.

Factors that characterize good decisions:

• «well-calibrated confidence» (do I understand this investment as well as I think I do?)
• «correctly-anticipated regret» (how will I react if my analysis turns out to be wrong?).

Think carefully through these questions:

• How much experience do I have? what is my track record with similar decisions in the past?
• What is the typical track record of other people who had tried this in the past?
• If I am buying, someone else is selling. How likely is it that I know something that this other person (or company) does not know?
• If I am selling, someone else is buying. How likely is it that I know something that this other person (or company) does not know?
• Have I calculated how much this investment needs to go up for me to break even after my taxes and costs of trading?

«Do I fully understand the consequences if my analysis turns out to be wrong?» Answer that question by considering these points:

• If I’m right, I could make a lot of money. But what if I’m wrong? based on the historical performance of similar investments, how much could I lose?
• Do I have other investments that will tide me over if this decision turns out to be wrong? Do I already hold stocks, bonds, or funds with a proven record of going up when the kind of investment I’m considering goes down? Am I putting too much of my capital at risk with this new investment?
• When I tell myself, «You have ea high tolerance for risk,» how do I known? Have I ever lost a lot of money on an investment? How did it feel? Did I buy more, or did I bail out?
• Am I relying on my willpower alone to prevent me from panicking at the wrong time? Or have I controlled my own behavior advance by diversifying, signing an investment contract, and dollar-cost averaging?

Pascal’s Wager

As Bernstein explains;

Suppose you act as through God is and [you] lead a life of virtue and abstinence, when in fact there is no god. You will have passed up some goodies in life, but there will be rewards as well. Now suppose you act as through God is not and spend a life of sin, selfishness, and lust when in fact God is. You may have had fun and thrills during the relatively brief duration of your lifetime, but when the day of judgment rolls around you are in big trouble.

Concludes Bernstein: «In making decision under conditions of uncertainty, the consequences must dominate the probabilities. We never know the future.» This, as Graham has reminded you in every chapter of this book, the intelligent investor must focus not just on getting the analysis righ. You must also ensure against loss if your analysis turns out to be wrong – as even the best analyses will be at least some of the time. The probability of making at least one mistake at some point in your investing lifetime is virtually 100%, and those odds are entirely out of your control. However, you do have control over the consequences of being wrong.