BOOK REVIEW: THE INTELLIGENT INVESTOR

Benjamin Graham, in his book – The Intelligent Investor, precisely starts with explaining the title of
the book. He has mentioned that everyone can be an investor in the market but what it takes to
stand out of the crowd from the routine investors is, what kind of mindset does one possess.

The book starts with explaining what essence does the word “Investor” carry and how is it different
from “Speculator”. People used these two words interchangeably in the 1960’s and it went on for a
decade or two. However, it was also supported with the opinion that with the absence of any of
these two parties, it is impossible to imagine a freely tradeable market where people can buy/sell
securities any time they want to. The book brings out the profiles of the two types of stock market
participants mentioned above and highlighted a contrast with what were people’s perception about
it. For instance, anyone who operates on Margin or anyone who buys a so-called “hot” common-
stock issue is either speculating or gambling and anyone who invests in any stock after undergoing a
regressive Fundamental and Technical analysis and thereby takes an informed decision is an
Investor. The book continues by stating the types of investors namely, Aggressive (Risk Seeking) and
Conservative (Risk Averse), and connected these with the intentions of various other participants of
the financial market – Mutual Funds, Debt Funds, Exchange Traded Funds (ETF’s), Index Funds etc.
Talking about these participants, the author brings various types of financial instruments into the
picture for ex. Equity, Debt, G-Secs, Bonds etc.

Moving forward, the author mentions about the various possibilities of price movements in a stock
market which lead to emergence of different types of traders with time. One such category of
traders that evolved were the Short Sellers who were again introduced in the market as being one of
those speculators who just took positions to book profits and exit.

Taking the discussion towards the next chapter, the author discussed about the rates of return of
investments and how are they affected by Inflation. This is the part where the author referred the
relationship between Inflation and Investment as the Real Rate of Return. Real Rate of Return means
that return earned over and above the on-going Inflation rate. For instance, if any investor earns a
nominal rate of return of say, 12%, in the last year and the Inflation during that similar time period
was say, 3.5%, then the real rate of return earned by the investor is approximately 9.5%. Following
this concept, the author came up with different scenarios while connecting Inflation and Investment
namely,

 Nominal rate of return > Inflation – Investor earns a real return

 Nominal rate of return = Inflation – Investor earns no real return
 Nominal rate of return < Inflation – Investor is at a loss in terms of real returns
 Nominal rate of return is negative – The effect of loss gets magnified due to presence of
inflation.

Considering these scenarios, the author elaborated that, in case of negative real returns, the
investor motive of choosing the Common-Stock portfolio over the Fixed-Income Securities portfolio
would get defeated. It is due to the reasons that, though both the portfolios will be affected to
similar extent, but the Stock portfolio’s cost of active management would further drag down the
figures. This was evident in the late 1960’s, when the rise in the cost of living was almost 22%, the
largest in a five-year period since the late 1940’s, but both the stock earnings and stock prices as a
whole have declined since 1965. In contrast to this, Common-Stock portfolios have enormous upside
potential as compared to Bond portfolio and hence, if the markets turn out to be positive, the
common stocks could make the portfolio a Multibagger. The various facts and figures presented by
the author in the book indicate that so far from inflation having benefited the corporations and their
shareholders, its effect has been quite the opposite. This double – faceted effect of inflation was
sharply seen in public – utility enterprises, being caught from one side between a great advance in
the cost of money borrowed and the difficulty of raising the rates charged under regulatory process.
But, looking at the contrasting side to this, remarking the very fact that the unit costs of electricity,
gas, and telephone services have advanced so much less than the general price index puts these
companies in a strong strategic position for the future.

Talking of hedging the inflation risks, the author introduces the concept of investing in Safe Heaven –
Gold and many other Metals, Precious Gems, Commodities etc. and even Real Estate for the sake of
it, so as to hedge inflation risk. Since, as mentioned earlier, every investment comes with certain
costs to be incurred upon, such as the cost of no fixed recurring income and storage costs when
invested in Gold or the real estate valuations being subject to wide fluctuations, it is not every
investor’s cup of tea to Diversify his/her portfolio in order to hedge various market risks. However,
just because of the costs involved and the uncertainties of the future, the investor cannot afford to
put all his funds into one basket.

To paint the bigger picture, Benjamin Graham wants the investors to think about the stock market
with a macro view i.e. outside their portfolio and by looking into the past of the market. An
individual portfolio is a small ship on a big ocean, so investors should get to know something about
that ocean as well as their ship. Specifically, he is interested in major fluctuations in the price levels
of the market, as well as the varying relationships among prices, earnings and dividends.

 1900 – 1924: a series of generally similar, three- to five-year cycles, with an average
annual advance of about 3%.

 1924 – 1949: starts with the New Era bull market, which collapsed in 1929 and was
followed with what Graham calls “quite irregular fluctuations" until 1949. The average annual
advance was about 1.5%.

 1950 – 1970: The greatest bull market in history (up until 1970), as Graham calls it.
There were a couple of notable corrections, but the markets recovered quickly from them and
experienced an average annual advance of 9%.

Graham offered three principles, in what he calls the “order of urgency”:

1. Do not borrow to buy or hold securities.

2. Do not increase the common stock proportion of your portfolio
3. Reduce your common stock exposure to a maximum of 50% of your portfolio. Proceeds from
selling stocks should be invested in Investment grade bonds or in a savings account.

Speaking of the investing principles, Graham also brought the phenomenon of ‘Dollar – Cost
Averaging’ and stated that investors need to understand the motive behind Dollar – Cost Averaging
and when you should do it because it can have magnified effects on the losses suffered by the
market participants.

Three factors always determine the future of the stock market’s performance, he says:

 Real growth (increasing earnings and dividends).

 Inflationary growth (increasing prices throughout the economy).

 Speculative growth (or decline) because of the varying demand for stocks.
From my perspective, the most important message of this chapter is there is no constant tomorrow,
just random walks down economic boulevards. We can never be sure of the future, and so the best
we can do is follow a program of caution and common sense.

Graham now talks about the general Portfolio Policy for the defensive investors. It has been an old
and sound principle that that those who cannot afford to take risks should be content with a
relatively low return on their investment. From this, there has developed the general notion that the
rate of return which the investor should aim for is more or less proportionate to the degree of risk
he is ready to run. The perspective that the author puts forward here is that, the rate of return
sought should be dependent, rather, on the amount of intelligent effort the investor is willing and
able to bring to bear on his task.

In this way, the minimum return goes to the passive investors, who want both safety and freedom
from concern and the maximum return would be realized by the alert and enterprising investor who
exercises maximum intelligence and skill.

The author then addresses the basic problem of fund allocation for defensive investors. Graham
suggests that a risk averse investor should follow the 25-75 Rule i.e. not less than 25% or more than
75% of the available funds should be allocated to the equity segment of the portfolio and hence not
less than 75% or more than 25% to bonds. However, some investors also feel that the ratio of 50 –
50 for investment in Stocks and Bonds is rather less complex, aiming unquestionably in the right
direction, gives the follower the feeling that he is at least making some moves in response to the
market developments and most important of all it will restrain him from being drawn more and
more heavily into common stocks as the market rises to more and more dangerous heights.

Furthermore, a truly conservative investor will be satisfied with the gains shown on half his portfolio
in a rising market, while in a declining market he may derive much solace from reflecting how much
better off he is than many of his more venturesome friends.

Graham uses the concept of rebalancing when values shift to 55-45 or greater. For example, if stocks
increase by 10 % and are now 55%, you would sell 5% of your stocks and buy 5% more bonds to
achieve the desired 50-50 split. Now, the choice of bond raises two main questions in front of the
investor, should he buy taxable or tax – free bonds and whether they should be of shorter or longer
duration? Graham states that the tax decision should be mainly a matter of arithmetic, turning on
the difference in yields as compared with the investor’s tax bracket and the question of maturities
should be based on the investor’s perceived need for yield and risk/opportunity of a change in
principal value. Graham then presents some major types of bond investments that deserve investor
consideration and various features that these bonds carry (Callable and Putable Bonds).

The author here mentions another category of investment for defensive investors – Preferred Stock.
On one hand, these prove to be attractive for the investors as these are fixed income investments
whereas, on the other hand, investors resist investing in these securities as preferred stocks do not
bear any kind of rights of the investor on the company other than dividend.

Solving the query of the defensive investors, Graham digs deeper into common stocks. Starting with
the merits of investing in common stocks he mentions that they offered a considerable degree of
protection against the erosion of investor wealth caused by inflation, whereas bonds offered no
protection at all. Common stocks have the potential to deliver higher than average returns to the
investors produced both by an average dividend income and underlying tendency for the market
value to increase over the investment horizon in consequence to reinvestment of the undistributed
profits.
Considering the concerns of defensive investors along with the merits of equity investing, Graham
laid down four rules to be followed:

1. There should be adequate though not excessive diversification. (Min 10 – Max 30 different
scripts)

2. Each company selected should be large, prominent, and conservatively financed.

3. Each company should have a long record of continuous dividend payments.

4. A suggested limit of a price not over 25 times average earnings, and not more than 20 times
those of the last twelve-month period. The goal here being to eliminate “growth stocks” from
the defensive investor’s portfolio.

Graham tried to engage the defensive investors into the area of common stocks by putting forward a
category of common stocks called “Growth Stocks”, meaning stocks whose per – share earnings have
increased in the past at well above the rate for common stocks generally and is expected to do so in
the future. However, the author expects, from the instances mentioned in the book, that the
defensive investors understand that growth stocks, of course, can create wonders with the right
individual selections, bought at the right levels and later sold after a huge rise and before the
probable decline.

Graham comments on the pros and cons of attending annual consultations through which to receive
feedback on one’s investment portfolio. On the “pro” side lies the fact that most investors lack
expertise; on the “con” side lies the fact that many consulting firms are no better than most
investors (and, moreover, charge fees and/or commissions for their services).

The phrase “dollar-cost averaging” refers to the practice of investing a pre-determined sum of
money (say, $100) routinely at a pre-determined length of time (say, once per month) in a pre-
determined company or set of companies. Graham notes that this method, if genuinely followed,
does indeed offer a convenient and straightforward way for the investor to guard herself from the
all-too-human impulse of buying high and selling low. He notes, though, that such monthly
purchases should be complementary to similar monthly purchases in bonds.

Graham also takes in to consideration the investor’s personal situation while taking an investment
decision. He notes that “the kind of securities to be purchased and the rate of return to be sought
depend not on the investor’s financial resources but on his financial equipment in terms
of knowledge, experience, and temperament.”

Graham distinguishes between the notion of risk as it ought to be understood by the intelligent
investor, and risk as it is in fact understood by most market participants.
Risk as it ought to be understood Risk as it is commonly (mis)understood

False: An investment is proved unsafe if its price

True: “A bond is proved unsafe when it defaults its declines, “even though the decline may be of a cyclical
interest or principal payments.” and temporary nature and even though the holder is
unlikely to be forced to sell at such times.”

True: A company is proved unsafe if it fails to pay its

stock’s declared dividend.

True: A company is proved unsafe if it reduces its

stock’s dividend in a manner contrary to the
reasonable expectations of its investors.

True: “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.”

Moving forward and shifting his concentration to the aggressive investors, the author highlights
negative v/s positive approach of an enterprising investor, the ones who have some expertise in that
area and hence want better-than-average returns. He recommends the same portfolio approach as
he did to defensive investors just for the sake of stating a starting point to their investments and
moving forward, he will be prepared to branch out into other kinds of securities with proper
justification.

The author, here, points out that the most useful generalizations for the enterprising investor are of
a negative sort. The general belief is that, let the investor leave the high-grade preferred stocks to
the corporate buyers, avoid inferior types of bonds and preferred stocks unless they can be bought
at prices at least 30% under par for high-coupon issues and much less for the lower coupon issues,
letting other participants buy foreign-government bond issues irrespective of the attractive yield and
will also be cautious of all kinds of new issues, including convertible bonds and preferreds that seem
quite tempting and common stocks with excellent earnings confined to the recent past.

Graham, here, states that the investors often face a dangerous trap named “Secondary-Grade”
Bonds or either Preferred Stocks. Secondary denotes the inferior quality of the bond and the trap
that investors face is the high yield that the bond offers which is nothing but a compensation against
the higher risk factor. Some investors just look at the return perspective here and the risk
component goes into vain. This is the reason why the bonds are trading at heavily discounted rates
and hence offer a higher yield. Many investors get along with such securities because they are in
need of a regular income (bonds as well as preferred stocks provide regular income in the form of
interest payments). According to Graham, experience clearly shows that it is unwise to buy a bond or
a preferred stock which lacks adequate safety merely because the yield is attractive as against the
top-grade issues because in times of a bad market such high grade issues prove to be susceptible to
severe sinking spells. The author presents an example depicting the phenomena and hence
concluding that if an investor is willing to accept risk, he should be certain that a substantial gain in
the principal value can be realised if things go well.

Same is the case with the foreign government bonds that the purchaser does not have any legal
recourse in the event that the issuing government defaults on said bonds.

About the new issues in general, Graham advised investors to carefully examine before newly issued
securities are purchased. Reasons for this are two-fold – First is that the new issues have special
salesmanship behind them, which therefore calls for a special degree of sales resistance and the
Second being that most new issues are sold under favourable market conditions, which means
favourable for the seller and consequently less favourable for the buyer. This prescient observation
bears an important implication, which is that periods during which new issues / IPOs are especially
frequent are a likely indication that the market is reaching its peak. More specifically, it is a likely
indication that Wall Street has come to the conclusion that the market is trading at or near a high-
point in prices. Therefore, investors should be wary of participating in new issues if for no other
reason than the high likelihood that they will pay too elevated a price for their shares.

It would, of course, be profitable to purchase some shares of IPOs provided that they are purchased
at the right time and for the right price. Nonetheless, for those investors who are inclined to roll the
dice of the IPO market, Graham offers the following recommendations:

 If you can, aim for the middle

 Keep your eye on the exit
 Get out while you can
 Slow and steady wins the race

Graham offers positive recommendations to enterprising investors who are branching out. After
briefly referencing some special situations for bond investments, he moves on to common stocks. He
breaks stock operations into four categories:

1. Buying low and selling high.

2. Buying growth stocks (but only those that are carefully chosen).
 3. Buying bargains of various kinds.

4. Buying into “special situations.”

The one with buying low and selling high is what Graham describes as “Formula Timing “. Graham’s
adherents continue to reject market timing on the simple but profound basis that it requires
knowing the future, which is impossible. Timing may return above-average returns, but it may also
return worse-than-average returns. Number two, buying carefully chosen growth stocks also
presents problems (he defines a growth stock as one that has grown quickly in the past and is
expected to deliver above-average returns in the future). Graham has two objections: first, investors
may pay too much for the growth and, second, that the investor’s judgment of the future may be
wrong. Moving on to number three, Graham addresses what he really likes – Bargain Stocks, for
which he sets out certain categories:

 The Relatively Unpopular Large Company: While small companies also go through bouts of
unpopularity, large companies have a double advantage. Resources, including finances and
management talent, to get them through tough times and, second, because the market
responds to recovering big companies faster.

 True Bargains: Graham is referring to stocks, bonds or preferred stocks that sell for a
discount of 50% or more. To determine if a stock is a bargain, the investor can estimate future
earnings and then multiply by an appropriate factor, or by estimating what the business would
be worth to a private owner. This second test may end up being the same as the first, but if
assessed as a private business, then there will be extra emphasis on net current assets or
working capital.

 Special situations or “Workouts”: In this section, Graham points out special situations come
and go according to the nature of the times. They include corporate acquisitions involving the
payment of a premium from a large company to a smaller company; bonds of railroads in
bankruptcy (these examples from 1973); and the breakup of public utility holding companies
(also a big deal in the 1970s). He says what these situations have in common is the tendency of
markets to undervalue issues caught up in complicated legal proceedings. Hence, he believes
only a small number of enterprising investors have the knowledge and skills to take advantage
of special situations.

Graham reiterates that investors in these three categories must be proficient. He makes a point of
saying there is no compromise between not knowing and knowing. Defensive investors should not
be involved in these categories at all, and enterprising investors should have enough knowledge to
be able to treat their securities as an actual business.

In all, Graham sets out four areas of opportunities out of which only one gets Graham’s approval:
Bargain Stocks. He is against the philosophies of Formula Timing, Growth Stocks and any kind of
special situation and stresses on an enterprising investor’s knowledge to calculate the intrinsic value
of any stock and hence accurately judge and pick up stocks selling at a significant discount to their
intrinsic value (Bargain Stocks).

After suggesting the portfolio policy approach to specific categories of investors, Graham takes one
step forward and introduces the investors to what he termed as “Mr. Market”. By this, he means to
make investors aware of all the uncertainties and fluctuations that the market is made up of. About
the fluctuations, Graham told that investors holding high-grade securities with short maturities (less
than 7 years) need not worry about these uncertainties. However, investors holding longer-term
securities should be prepared for such events, both financially and psychologically. Fluctuations
would, of course, lead to speculations which, according to Graham, would inevitably lead to losses
and if one is determined to speculate, he should risk a small amount and separate from his portfolio.

Since common stocks are highly vulnerable to fluctuations, Graham points out two ways to profit
from the market swings – The way of timing and the way of pricing. Speculators being the ones who
opt for the way of timing and investors being the ones who opt for the way of pricing. Timing is of
great psychological importance to the speculator because he just wants to make profit and exit.
However, timing is of no real value to an investor unless it coincides with pricing. Speaking of market
forecasting, it is absurd to think that general public can ever make money out of forecasting. There is
no basis either in logic or in experience for assuming that any typical or average investor can
anticipate market movements more successfully than the general public, of which he himself is a
part.

Graham says “formula plans,” except for dollar-cost averaging, push investors out of the market too
soon during advancing markets. This approach had the double appeal of sounding logical and of
showing excellent results when applied retrospectively to the stock market over many years in the
past. General day to day or even month to month fluctuations of the stock market would most likely
not be considered by any serious investor but any longer-term or wider fluctuations would be taken
into account. For instance, there is a significant positive change in the stock prices, the crowd would
think of either selling the holdings and exiting the bull market or would regret not buying more
shares when prices were low. In such a situation, what differentiates the intelligent investor from
the crowd is the will power that he is carrying to stick with his own mindset and not fall into the trap
that the general public is into.

The stock market is paradoxical in that the highest-grade stocks are often the most speculative
because they gain great premiums over book value and are based more on the changing moods of
the market and its confidence in the premium valuation it had put on the company in the first place.
Thus, for conservative investors, they would be best to focus on companies with relatively low
premiums placed upon them - a market rate no more than 1/3 above the net tangible-asset value.

However, a stock does not become sound because it can be bought close to asset value. The
intelligent investor must also demand a satisfactory price-earnings ratio, sufficiently strong financial
position, and the prospect of earnings being maintained over the years.

Intelligent Investors with portfolios close to the net tangible asset valuation of the underlying
companies need worry less about stock market fluctuations than those who paid high multiples of
earnings and assets. The intelligent investor should disregard the market price and not allow the
mistakes that the market will make in its valuation to affect his feelings about the business. Do not
let the market’s madness fool you into selling your shares at a loss - such a move requires reasoned
judgment independent of the market price.

It is in this chapter that Graham creates the oft-cited Parable of Mr. Market. Essentially, you are a
private business owner. You own a share that you purchased for $1,000. Your partner is Mr. Market.
Every day, Mr. Market quotes you a price for your interest and also offers to sell you his interest for
the same price. Sometimes the quote is rationally connected with the business. On other days, it is
clear that Mr. Market’s enthusiasm or fear has gotten to him, and the value he has placed is
irrational. Graham says the Intelligent Investor would only let Mr. Market’s daily quote affect him if
the Intelligent Investor agrees with the price (due to his own analysis of the value of the company),
or he wants to buy from or sell to Mr. Market. Unless you want to transact with Mr. Market, you
would be wiser to make your own analysis of the value of the company.  If you want to transact, then
you must compare Mr. Market’s value to the value you reached independently. This parable reflects
the way a stock market investor should treat his relationship with the stock market.
Benjamin Graham brings together defensive investors and investment funds in chapter nine of "The
Intelligent Investor." He says the benefits of funds include the promotion of savings and investment,
protecting individuals from costly mistakes and generating returns reasonably comparable with
direct investments.

To get started, he addresses the distinction between two types of funds that comprise “investment
funds”

 Open-end funds, or mutual funds, can be redeemed on demand by the holder, at net asset
value.

 Closed-end funds cannot be redeemed on demand, and they have a relatively constant
number of shares outstanding.

Beyond that, there are other classifications:

 By the content of their portfolios, including stock funds, bond funds and balanced funds.

 By objective, including income, capital growth and defensive positioning.

 By sales commissions, in which there are load funds that charge investors a sales fee when
the funds are bought or sold, and no-load funds that charge no sales fees.

 Split funds, in which the securities are split into a preferred issue which receives ordinary
income, and a second issue that collects capital gains (if any).

Getting into specifics, Graham looks at the what was then a relatively new product: “performance
funds.”  He points to funds that reached for yield, got temporarily better returns, which attracted
more inflows, and then found it was harder to get the same outperformance when investing larger
sums. He offers this warning:

“The foregoing account contains the implicit conclusion that there may be special risks involved in
looking for superior performance by investment-fund managers. All financial experience up to now
indicates that large funds, soundly managed, can produce at best only slightly better than average
results over the years.”

Graham adds that these large funds, if not soundly managed, can produce spectacular, but mostly
illusory, profits for a while, but then impose “calamitous” losses.

Next, he tackles the issue of closed-end funds versus open-end funds. Open-end, or mutual, funds
give their holders the right to sell at the daily valuation and they make new shares available. This has
allowed them to grow. Closed-end funds have a fixed capital structure and, consequently, have
diminished in relative dollar importance. The environment was different in 1973, and Graham had
“clearly evident” rules for investors. Buy closed-end shares at a discount of 10% to 15% of asset
value, rather than buying open-end shares at a premium of 9%. Doing this should give investors
about one-fifth more for their money.

Finally, Graham takes a quick look at balanced funds, i.e., those that combine a specific proportion of
bonds and a specific proportion of stocks. Referring to the bonds in these funds, he suggests it would
be “more logical” for typical investors to buy their bond investments directly, rather than through a
mutual fund. I find that a curious suggestion in that typical investors (who presumably have invested
little time and effort in learning the ways of the markets) would be able to successfully buy bonds.
Indeed, developing expertise in bonds would be no less difficult than gaining knowledge about
stocks.

In conclusion, Graham has provided an option for defensive investors and less ambitious
enterprising investors: mutual funds. While his discussion is tailored to his times, investors of 2018
can take away several lessons.

 First, there is no such thing as just a mutual fund. They come in many forms and
combinations of features; to Graham’s list of categories we can add even more, including index
funds and ETFs.

 Second, stay away from growth funds because to get extra growth (alpha), fund managers
may have to stretch. As a result, growth funds don’t always deliver as well as their managers
might hope.

 Third, balanced funds seem to fit the needs of many defensive investors, with their pre-
determined allocations of bonds and stocks.

Finally, I will weigh in against load funds, which can almost preordain underperformance. Choosing a
front- or back-load fund means giving up a significant amount of your capital before or after you own
it. Losing 5% (for example) to a front-load fund means it is unlikely you would achieve even average
performance.

- AYUSH JAIN (B007) – TY BCOM(H) - 74011017071