The Intelligent Investor - Euclidean's Five Key Takeaways
Benjamin Graham wrote what is arguably the seminal text on value investing. The Intelligent Investor is dense with enduring insight. Warren Buffett refers to it as “by far, the best book on investing ever written.”
Graham’s masterpiece deftly employs Occam’s Razor to cut out all the aspirations, distractions, and misconceptions that lie outside the realm of intelligent investment. What remains is timeless wisdom.
However, as easy-to-understand as Graham’s wisdom may be, it has proven to be anything but easy to adopt in practice. The Intelligent Investor’s secrets have been accessible to all since its first printing 65 years ago. Moreover, the impressive track records of Graham’s disciples have been impossible to ignore. Nonetheless, his principles have not been widely embraced. The human mind seems hard-wired to cling to the aspirations and misconceptions that lead investors astray. But, for those investors willing to devote the energy and cultivate a certain mindset, the opportunity endures to generate good long-term investment returns by adhering to Graham’s teachings.
“Though business conditions may change, corporations and securities may change and financial institutions and regulations may change, human nature remains essentially the same. Thus the important and difficult part of sound investment, which hinges upon the investor’s own temperament and attitude, is not much affected by the passing years.” - Introduction, page XXIV*
We encourage you to buy a copy and enjoy The Intelligent Investor in its entirety. In the meantime, we share with you some takeaways from the book that you may find helpful in reflecting on your own approach to long-term investing.
* All references to the book are based on the 2005 hardcover reissue of Benjamin Graham’s 1949 classic, The Intelligent Investor.
Takeaway 1: Price & Value Are Two Entirely Different Concepts
Within our own investment operations, we have observed that inherent worth of a company does not fluctuate nearly as rapidly as public equity prices might have one think. In this sense, price and value appear to be two very different concepts. In The Intelligent Investor, Graham provides the best analogy we have seen for appreciating this observation and its importance. We believe that this point is the cornerstone of any sound long-term investment program because, when price and value diverge, attractive investment opportunities often present themselves.
“Imagine that in some private business you own a small share which cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers to either buy you out or sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or fears run away with him, and the value he proposes seems to you a little short of silly.
If you are a prudent investor or a sensible businessman will you let Mr. Market’s daily communication determine your view as the value of your $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.” - Page 32
From the standpoint of a value investor, these two paragraphs are the most important ever written. They summarize the cause-and-effect relationship that explains why value investing has historically been a sound approach to long-term capital appreciation.
These words, however, also carry with them some important implications regarding the concept of risk and the importance of cultivating a mindset that allows for successful investing.
Takeaway 2: Risk Is Not The Short-Term Volatility Of Returns
Many people in the investment world associate risk with price volatility, but Benjamin Graham would not have been one of them. Relating to the Mr. Market analogy, Graham views price volatility as a relevant topic only insofar as it provides an investor with an attractive opportunity to purchase shares at low prices or sell them at fulsome values. He writes,
“The idea of risk is often extended to apply to a possible decline in the price of a security, even though the decline may be of a cyclical and temporary nature and even though the holder is unlikely to be forced to sell it at such times…. But we believe that what is here involved is not a true risk in the useful sense of the term…. We would emphasize our conviction that the bona fide investor does not lose money merely because the market price of his holdings decline...” - Pages 72-73
“The true investor scarcely ever has 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. The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for then he would be spared the mental anguish caused him by other persons’ mistakes of judgment." - Page 40
So then, the concept of risk to Benjamin Graham is really a behavioral one. That is, risk emerges when an investor fails to cultivate the mental disposition that prevents him from being unduly influenced by Mr. Market.
Takeaway 3: To Be Successful, You Must Be Psychologically Prepared
The big risk Graham articulates in The Intelligent Investor is the one that comes when investors fail to control their minds and allow their behavioral biases to lead them into bad investment decisions.
Graham wrote during a time when investors were far less bombarded then they are today by news, economic forecasts and others’ views. Even so, he saw clearly that investors were prone to attach too much meaning to information that often proved to have little to do with the long-term value of their investments.
“A sound mental approach toward stock fluctuations is the touchstone of all successful investment…” - Page 21
“Nearly everyone interested in common stocks wants to be told by someone else what he thinks the market is going to do. The demand being there, it must be supplied.” - Page 48
“If an investor intends to buy and sell recurrently, his weapons must be a frame of mind and a principle of action which are basically different from those of the trader and speculator. He must deal in values, not in price movements…. In a word, he must be psychologically prepared to be a true investor and not a speculator masquerading as an investor." - Page 34
The behavioral traits that Graham calls out seem to be timeless ones, in that they are as recognizable among today’s investors as they were 65 years ago when he wrote The Intelligent Investor. As Jason Zwieg wrote in 2009:
“It is sometimes said that to be an intelligent investor, you must be unemotional. That isn't true; instead, you should be inversely emotional.”
Developing this type of investment character is very difficult, which may be a reason you do not see widespread adherence to, and success from, value-minded investment principles.
Takeaway 4: You Can’t Predict The Future
Although he believed (or, we might say, knew) that companies’ future earnings ultimately drive their future market values, Benjamin Graham was skeptical of investors’ ability to predict the future.
“The long-term future of a company is at best an ‘educated guess.’ Some of the best-educated guesses, derived from the most painstaking research, have turned out to be abysmally wrong. Furthermore, the chief obstacle to success lies in the stubborn fact that if the favorable prospects of a concern are clearly apparent they are almost always reflected already – and often over discounted – in the current price of the stock. Buying such an issue is like betting on a top-heavy favorite in a horse race. The chances may be on your side, but the real odds are against you." - Page 14
Takeaway 5: Investing With A Margin Of Safety Increases Probabilities Of Success
With takeaway number four in mind, Graham advocated buying companies at very low prices in relation to their existing bodies of work. He believed that doing so provided a margin of safety that provided an attractive probability of long-term success.
“Even the rather crude assumption that past average earnings will be repeated in the future may be found a more reliable basis of valuation than some other figure plucked out of the air of either optimism or pessimism.” - Page 127
“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." - Page 245
Indeed, we have seen considerable evidence that buying companies at low prices in relation to prior earnings would have been a successful investing strategy during the many decades following the publishing of The Intelligent Investor.
At Euclidean, we do not believe sound investing needs to be complex. Rather, we believe sound investing requires only disciplined adherence to sound principles over long periods of time. In this context, The Intelligent Investor is truly a masterpiece. Graham highlights the aspirations, distractions, and misconceptions that are outside the realm of intelligent investment and, with the concepts of Mr. Market and Margin of Safety, provides the foundation for a successful and timeless investment program.
Moreover, he rightly highlights that the real risk to investors is not the volatility of returns, as commonly viewed in the fund world, but rather that investors fail to cultivate the mental disposition necessary to productively embrace Mr. Market’s tendency to sometimes offer good companies priced low enough that a level a margin of safety emerges.
We hope you find these notes helpful and that you find time to revisit The Intelligent Investor during 2015!
Mike & John