In This Market, What's An Intelligent Investor To Do?
By all accounts, it looks like we are in for a wild week. A lot of factors are coming into play at once giving rise to a lot of uncertainty in the markets:
- The U.S. debt ceiling debacle
- S&P's downgrade of U.S.'s credit rating
- Europe's soveign debt crisis
With so much uncertainty, it's a good time to reflect on what makes an "intelligent investor." It's been a while since I've posted some reading notes (the last were for Born To Run) and the timing worked out well since I just finished reading The Intelligent Investor by Benjamin Graham. I recommend getting the version with updated commentary by Jason Zweig.
The Intelligent Investor is the one, must-read book that Warren Buffet recommends to any beginner investor. And for good reason. Anyone serious about investing in stocks should give it a read. It gives a great overview of "value investing" -- which shields investors from error during downturns as well as from their greatest enemy, themselves.
It is also a timely book to keep in mind since this is the year of Internet IPOs. Graham makes the clear distinction between investing and speculating (see below) and regards IPOs in the clear camp of speculating as the companies don't yet have a history of strong performance. It's a challenge I routinely have to remind myself on (see related post: Why I'm Buying LinkedIn).
The markets are in for a bumpy ride this week (and months?) but as with all downturns there will be some very real buying opportunities presented to us. As Warren Buffet famously said,
We should simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
I think if you stick to the basic tenets of Graham (high value, strong financial history, low P/E ratio, good dividend, etc.) then you will be fine in the long run. And if you invest intelligently in this downturn, then well, you could even make out like a bandit.
Here are my notes:
- The investor’s chief problem-and even his worst enemy-is likely to be himself
- The Intelligent Investor dreads a bull market and welcomes a bear market
- An investment operation is one in which, upon thorough analysis promises safety of principle and an adequate return.
- The defensive investor should allocate his holdings 50-50 between equities and high-grade bonds, unless one asset class has a better outlook and/or valuation
- If proper market conditions exist, this 50-50 ratio can be altered up to 25-75 for either equities or high-grade bonds
- Note that investing, according to Benjamin Graham, consists equally of three elements: you must thoroughly analyze a company, and the soundness of its underlying business, before you buy its stock; you must deliberately protect yourself against serious losses; and you must aspire to “adequate”, not extraordinary, performance
- An investor calculates what a stock is worth, based on the value of its businesses. A speculator gambles that a stock will go up in price because someone else is willing to pay more for it
- Benjamin Graham’s rules for speculating are that you must never delude yourself into thinking that you’re investing when you’re speculating, speculating becomes more dangerous the moment you begin to take it seriously, and you must put strict limits on the amount that you are willing to wager. And ALWAYS keep it to a separate account
- Bond funds are great way to get bond exposure with keeping a diversified approach
- On defensive investing: Benjamin Graham’s four rules for defensive investors are there should be adequate diversification of between ten and thirty stocks, each company selected should be large, prominent, and conservatively financed, each company should have a long record of continuous dividend payment, and the investor should impose some limit on the price he will pay for an issue in relation to its average past earnings
- One must make a clear choice on whether to be a defensive or enterprising investor
- Enterprising investors must (1) must meet objective or rational tests of underlying soundness and (2) must follow strategies different from those followed by most investors or speculators in order to obtain better than average results
- Buying relatively large companies that are currently unpopular is one way to make large returns
- The only certainty in the markets are that there will be large and volatile swings in pricing
- Two ways to take advantage of the price swings are through timing and pricing
- What this means is that timing is of no real value to the investor unless it coincides with pricing - that is, unless it enables him to repurchase his shares at substantially under his previous selling price
- Focus on companies that are trading at or close to tangible-asset value
- Additionally, desirable stocks must also have a satisfactory P/E ratio, strong financial position, and the prospect that its earnings will be maintained over the years
- Portfolios of strong companies trading around book value can neglect the day-to-day changes in market pricing and may even put let the manager take advantage of pricing irregularities
- 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 he would be spared the mental anguish caused him by other persons, mistakes of judgement.
- True investors use price fluctuations to either purchase or sell shares of a company
- Stock quotations are there for convenience and can either be taken advantage of or ignored
- Mr. Market is like a partner that tells you every day what he thinks your interest is worth. Imagine he is manic depressive and lets his enthusiasms AND fears run away with him
- Mr. Market’s wild pricing inconsistencies can wildly undervalue or overvalue equities
- You do not have to trade with Mr. Market just because he constantly begs you to
- But investing isn’t about beating others at their game. It’s about controlling yourself at your own game
- Later in his life, Graham praised index funds as the best choice for individual investors, as does Warren Buffet
- When finding the right fund, first evaluate its expenses, then evaluate its risk using a prospectus, and then look at the manager’s reputation and past performance of the fund
- Low-cost ETF’s are worth looking at for investors looking to gain exposure to specific areas
- Look for companies with large competitive advantages, companies that consistently grow earnings at a steady pace (10% pre-tax long-term), and that spend on R&D
- For the defensive investor, Jason Zweig advocates they should keep at least 90% of his money in an index fund: “By owning the entire haystack you can be sure to find every needle, thus capturing returns of all the superstocks. Especially if you are a defensive investor, why look for the needles when you can own the whole haystack”
- The seven quality and quantity criteria that Graham for picking individual equities are (1) adequate size, (2) strong financial condition, (3) earnings stability, (4) consistent dividnd record, (5) continued earnings growth, (6) moderate P/E, and (7) moderate price/assets ratio
- 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
- Although there are good and bad companies, there is no such thing as a good stock; there are only good stock prices, which come and go
- 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 likelihood. It’s a certainty
- The amount that companies are giving out in dividends has greatly decreased from the publication of the book to the modern day. Graham believes that a company should definitely pay a dividend if it has the means to
- No wonder, when he was asked to sum up everything he had learned in his long career about how to get rich, the legendary financier J.K. Klingenstein of Wertheim & Co. answered simply: DON’T LOSE
- Graham averaged a return of close to 20% per year, an amazing feat for anyone during anytime
- Investing, too, is an adventure; the financial future is always an uncharted world. With Graham as your guide, your lifelong investing voyage should be as safe and confident as it is adventuruous
Also: Why Apple Even Now Is Still Very Cheap
