The Intelligent Investor Notes
Written in: November 2019 Notes
Last updated on: December 24, 2019
Notes on The Intelligent Investor by Benjamin Graham.
- The pendulum always swings from irrational exuberance to unjustified pessimism
- The intelligent investor dreads a bull market since it makes stocks more expensive to buy
- Risk goes up as prices goes up, not the other way around
1 Investment vs. Speculation
- You do the same thing when you invest and speculate, it’s the reasons why you are doing it that makes the difference.
- There can be intelligent speculation, you just need to acknowledge that it’s speculation and not investment. And you need to size your speculation accordingly
- An intelligent investor keeps both stocks and bonds, swinging more towards bonds when equity prices are high, and more towards stocks when bond prices are high
2 The Investor and Inflation
- You can count on a long-term average of 2.5% inflation
- Much of your bond return usually is eaten by inflation, especially since high yields are seen in times when inflation is high
- Everyone’s portfolio should have inflation risk mitigation–companies or assets that will benefit from inflation
3 Stock Market History
- Be fearful when everyone else is greedy and greedy when everyone else is fearful
- You can expect about 6% return in stocks in the long run, 4% real return after inflation
- Bonds usually yield more than stocks at the end of a cycle, and less at the beginning
- Usually if everyone is predicting something to happen in the market, the exact opposite happens
4 General Portfolio Policy
- How you allocation should be based on your time horizon, more stocks if longer
- Stock allocation should be between 25-75%, bonds the complementary percent
- Bonds don’t offer inflation protection
5 The Defensive Investor and Common Stock
- You should have between 10 and 30 holdings
- Each stock should be large, prominent, and conservatively financed
- Each stock should have a long record of dividend payments
- You shouldn’t pay more than 20-25 PE for a stock
6 Negative Approach to Investing
- Don’t invest in junk bonds
- Don’t day trade
- IPOs can be a trap and there are typically a lot at the end of a business cycle as everyone cashes out
- Even if you buy IPOs, you don’t get the good “initial offering” price. If you bought all the hot IPOs in the dot-com bubble at the price of the first day close, you would have underperformed the market by 23%.
7 Positive Approach to Investing
- Buy big companies that are out of favor
- Growth companies look most appealing when they are expensive, but most tank when bubbles burst
8 The Investor and Market Fluctuations
- You have to be financially and psychologically ready for big market fluctuations
- Timing the stock market is very hard, even if you sell out near the top, you’ll likely miss some of the run up and dividends in the meantime
- The only timing approach that seems to make sense is to slowly transition from stocks to bonds when the market is high, and the other way around when it’s low (or at least what you perceive to be high and low)
- Even steady performance companies will see unreasonable times of optimism and pessimism. The investor who take a long approach will benefit most. And they can even double down on their bet when the price goes down. Some prudence is required. You should look at the tangible value of a company when the share price is depressed. Is the price a reflection of the company, or is the public just overreacting. Likewise, when the market gets high, you can incrementally sell off your position so long as you still think it’s worth being in for the long term
- An intelligent investor is never forced to sell. You should track the price and performance of your investments only to the extent that you remain solvent and are never forced to sell. If you sell, it should be based on a change in your beliefs about the intrinsic value of the company
- Pay attention to your dividend results and the financial/operating results of your companies
9 -> Skip
10 -> Skip
11 Securities for the Lay Investor
- There are both quantitative and qualitative aspects to consider
- Quantitatively, it’s a good idea to use past performance and then project future performance based on your ideas about how the world, industry of the company, etc. will change. You can adjust other things too, like margins, sales, etc.
- Graham offers an easy calculation for value: x (8.5 + 2*)
- Qualitatively, you want good management that have proper incentives, are invested for the long-haul, have personal skin in the game, etc.
- Industry analysis can be useful for coming up with the future growth rate value
- You should prefer companies with sound capital structure and a proven track record when possible
- Dividend record is one of the most important indicators–do they have many years of solid dividend payments.
- Current dividend rate–is it still paying out well to shareholders
12 Things to consider about per-share earnings
- Ordinary earnings are what you see reported in per-share earnings, but there are actually several types of earnings and accountants sometimes use them to mislead investors.
- Diluted earnings includes any new shares that are likely to be issued in the future via convertible debt, convertible preferred shares, stock options, etc. It’s very rare that a company doesn’t have at least some unissued shares, which makes the diluted EPS strictly less that ordinary EPS in the vast majority of cases.
- There is also the concept of “special charges,” which don’t need to be reported in a company’s earnings. These are expenses that the company arbitrarily gets to decide is “special” or “out of the ordinary” that will occur in the future. This essentially fattens future earnings and results in these special charges not being included in the earnings of any year. In essence, it allows a company to only show investors it’s most profitable segments and write off the bad parts as “special.”
- Sometimes when you take into account dilution and special charges, EPS can significantly decrease.
- There is no real way to determine the “correct” earnings since the companies don’t provide it to you. You don’t know what tax losses they might get from special charges, or when those expenses will actually have to be paid for. They may choose to take special charges in down years in order to pump up their stock in later years.
- Averaging earnings over many years is a good way to get a sense for the earnings power of non-growth companies. In this case, you should include special charges and dilution, as these will approximately average out their effects over time.
- Here are some other ways modern companies obscure earnings:
- Pro-forma earnings: this allows accounts to ignore GAAP and report and earnings number that is what the company deems as “long-term earnings,” taking out any “short-term anomalies” that affects the GAAP ordinary earnings. This is wildly abused though, as companies write off huge expenses as “extraordinary.” It allows the company to say how well they could have done looking back with 20/20 hindsight and is mostly used by executives with stock options to boost the stock price in time for their options to vest
- Abuse of realizing revenue: companies will sometimes try to recognize revenue before it’s actually in their account. One example is Qwest in the early 2000s. They put it on their books as if all of their phone books that were printed for the entire year were immediately sold. When companies do stuff like this, it’s usually a sign of larger issues underneath the hood and to come
- Capital expense or operating expense?: operating expenses are normal costs that a company incurs to do business–office supplies, insurance, licensing fees, etc. Capital expenses are considered investments in the company’s future–buildings, patents, equipment,…–and are not counted in the net income as an expense. Instead, they are counted as an asset on the books and are depreciated over time. Companies can claim operating expenses as capital expenses to boost the perception of their profitability. The example given in the book was a fiber company laying lines across oceans to connect the world. The initially counted the cost of their lines as operating expenses, but then suddenly claimed all of those lines were actually capital expenses, boosting their assets. Capital expenditures are reported as “cost of sales.” An intelligent investor should always understand why companies they are investing in are capitalizing
- Non-recurring costs that keep recurring: companies are allowed to write off certain costs as non-recurring on their books. Many analysts will simply gloss over these and write them off, assuming the company did in fact have a one-time large cost. But sometimes companies will keep items that recur indefinitely under non-recurring costs. The example given in the book is Micron, which listed it’s assets assuming a given price for the electronics it had in inventory. But when those electronics didn’t sell, they claimed a non-recurring cost by writing down the value of their inventory. This was in the dot-com bubble, so nobody asked questions. But over time, they kept overvaluing their electronics and then writing off the difference as non-recurring costs.
- Pension plans: If a company’s pension plan is expected to have more than what they will need to pay employee benefits, they can write off the difference as current income, boosting earnings. This can be abused, though, as companies can arbitrarily say they are raising the expected return of their portfolio x%, which will result in excess pension funds, thus allowing them to claim earnings today.
- How to spot accounting misconducts and avoid investing in companies that abuse them:
- Read reports backwards, things the company doesn’t want you to know will always be at the back
- Read the notes and footnotes of all financial statements, especially “summary of significant accounting policies.” Here you can also spot things mentioned that might have a big effect on future earnings, like stock options, debt, etc.
- Be skeptical anytime there is “deferred,” “restructuring,” or “capitalized” used in the footnotes. This isn’t necessarily a bad sign, but it can be a red flag
- Compare the annual reports to at least one other competitor to see how aggressive their books are
- Read books on financial statements:
- Financial statement analysis
- The financial numbers game
- Financial shenanigans
13 & 14 Stock selection for the defensive investor
- Graham suggest the following criteria when selecting stocks as a defensive investor
- They should be adequately large in market cap/sales
- They should be in strong financial condition
- They should have strong earnings for the past 10 years
- Should have earnings increases over the last 10 years when looking at 3 year averages
- The P/E ration should generally not be more that 15. There is a most business cycle specific recommendation of taking the current AA corporate bond rate, taking 1/that rate, we get a suggested PE ratio. He suggests taking a 20% reduction on that value to get a max PE ratio you should pay
- Moderate price/assets: product of PE and price/book should not exceed 22.5
- If you’re confident in the companies you choose and you’ve done solid analysis, diversification actually hurts you, it doesn’t help you
- One thing to note is that book value is less useful today than it used to be because intangible assets make up a large portion of many companies–brand, patents, trademarks, etc. So companies usually trade at a higher price to book value than they used to
- Look at SEC filings that show who owns the stock. If large institutions own >60%, it’s usually good to stay away. As these institutions sell their position, they can significantly move the price and usually with disastrous effects.
15 Stock selection for the enterprising investor
- Good managers put considerable work and thought into investments, but pay little attention to the broader market.
- Buffet likes to buy stocks that meet Grahams requirements, but that are also consumer brands, easily understandable, robust financial health, and have near monopolies in their markets.
16 Convertible issues and warrants
- Convertible bonds can be a good balance of risk and reward, but they are usually only issued by companies near the end of a business cycle, and because of the psychology of investing, when bonds are converted into stock at all-time highs, investors usually don’t like to sell. They think the stock will go even higher. But this is often the exact wrong time to get into the market, and often the stock tanks after that. The only rule they offer is that you should never convert a convertible bond, and if you do, you sell the stock immediately for the profit.
- Preferred stock is equity a company can issue that usually pays a higher, steadier dividend, but that doesn’t have voting rights. In the event of liquidation, preferred stock has priority to assets over commons stock, but after credit holders. It’s kinda a hybrid between the two. If the company fails to pay the promised dividend on a preferred stock, it does not go into default like it would if it failed to pay creditors. So yields are usually higher to compensate. If shares are callable, the issuing company can buy back the preferred shares at a predetermined price.Thus, they have less price appreciation potential than common stock, if any. Some preferred stock is convertible, which means that it either converts into common stock on a set date or the issuer or purchaser (depending on the specific stock) has the right to convert their shares to common stock. Private or pre-public companies will issue these commonly to raise money. Institutional investors are usually the purchasers because of the tax advantages they get that aren’t available to retail investors. Sometimes the issuance of preferred stock limits the company from raising further debt.
- Common stock holders have “pre-emptive right” to have right of first purchase when the company they are invested in is going to issue more shares
- Convertible warrants give holders the option to buy newly issued shares at a set price by a certain date. The author says these are mostly used to cook the books. At the time of writing, it was not uncommon for companies to issue common stock bundled with a warrant. This, in effect, let them raise the price, and thus the amount of capital they could raise on that day without any dilution. And then when they report earnings, they don’t have to take into account outstanding warrants that could be exercised at any time. If you are buying OTC stock and the broker offers to sell you a “unit” you can be 95% certain they are a thief who is selling you a package like this to make a quick buck.
- There is an example of how these warrants can be used to make EPS after special charges greater and reduce P/E ratio. The way this works is that the company assumes after dilution of all warrants exercised that the share price will stay the same. Thus, the ordinary EPS decreases and P/E goes up. But the kicker here is that without dilution, the company can claim the warrants as special charges, thus after dilution those special charges don’t exist. So the EPS goes up! Tricky! The author suggests that instead of this method, companies should be required to report warrants as an increase in share price equal to the total value of warrants. And that they shouldn’t be able to be counted as special charges. This would result in a drastic increase in P/E ratio after dilution and special charges, like it should be.
- The author says warrants can in special circumstances be good investments, but that it’s much too complicated of an analysis for this book.
- In modern day there are all types of convertible bonds–LYONS, ELKS, etc. They are different because they cap losses, cap gains, etc.
- Covered calls are another new type of investment vehicle. If you own shares of a company, you can sell a call option, which allows some other investor the right to buy your shares at some premium by a certain date. They pay you an upfront cost, and then the set price if they exercise their shares. This caps your floor, but it also caps your ceiling since in the case a stock does well the option owner will exercise their option. The author says this is not worth it, why are you invested in a company you want to cover the downside of? The only thing that can happen if you’re intelligently invested is that you’ll lose your upside on a good stock pick.
17 & 18 Case Studies
- The Penn Central case (over-priced giant company)
- This was the largest railroad in assets in the world. It filed for bankruptcy out of nowhere in 1970 and shocked the world, but as far back as just 1968, the stock was at an all-time high. This analysis shows how you could have easily seen the financial calamity coming in 1968
- The interest payments of the railroad bonds were paid by earnings before taxes 1.91 and 1.98 times in 1968 and 1969 respectively. The minimum coverage ascribed to railroad bonds in Securities Analysis is 5, and other competitors at the time were around 4-5. So their earnings were barely covering interest payments, let alone other expenses.
- The railroad had been paying no income taxes for 11 years!
- In 1968 they reported earnings of $3.8 on share price of 86.5–a 24 P/E. This should have raised serious concerns. How are they making earnings this high when they pay no income taxes and barely make enough revenue to cover interest payments on their bonds?
- In 1966 they reported earnings of $6.8 after a merger with another company. But that merged incurred significant costs for the company that weren’t included in the earnings. Instead of being marked as a cost, they were marked as special charges, which changes the earnings from $6.8 to -$12/share.
- The transportation ratio (cost of running railroad divided by revenue) was 47.5% compared to 35% for other railroads. Note that today 70% would be excellent, railroads have deteriorated significantly
- Along the way there were other strange accounting results that should have been red flags
- Ling-Temco-Vought Inc. (empire-building conglomerate)
- Started by an electrical contractor who sold $1mm worth of shares as his own investment banker at a Texas fair. He then used that money to acquire more companies, which rose share price and afforded him the opportunity to sell more shares and acquire more companies. These types of companies are called “serial acquirerers” when they primarily grow through acquisition, and they almost always end poorly.
- Had one year of large deficits as it wrote off a lot of special charges to boost price in years to come
- Bank loans and long-term debt had skyrocketed in recent years
- NVF Corp (merger where a tiny firm took over a big one)
- Listed $58mm of “deferred debt expense” as an asset, which was greater than all shareholder equity at $48mm
- $20mm of “excess of equity over cost of investment” was not included in the balance sheet
- Taking these into account, actual shareholder book value per share decreased by almost 90%
- Several mysterious items in accounting that the author had never seen before
- Had a huge amount of warrants that could be converted into common stock
- AAA Enterprises (IPO of a basically worthless company)
- Went public selling at 110 time earnings and several times book value.
- Mostly went up in value because it was first in the phone book, which happened intentionally because of the name chosen
- The company made $600k one quarter and then lost $4.5mm the next. Something was off
- No public company has ever grown fast enough to justify a PE greater than 60 according to Jeremy Seigel.
- Total stock options granted to executives should never total more than 3% of outstanding shares. And the shares shouldn’t be handed over free, they should be earned on a performance basis
19 -> skip
20 Margin of Safety
- Purchase stocks that give solid track record of dividends and have assets near or greater than what you’ll pay for it.
- The most common way to lose money is purchasing low-quality securities in times of favorable business conditions
- Growth stocks can still supply a margin of safety if their financials are sound and if you conservatively project future growth and determine it has high return prospects. These are hard to find though, as investors usually price growth stocks so high there is no way they will meet your conservative estimates
- Company should be able to withstand any adverse developments
- There is no such thing as a good or bad stock–only stocks at good or bad prices. All large stocks at one time or another were blue-chip stocks with high future growth expectations. Business conditions and public sentiment sway back and forth, making any stock sold at a good or bad price depending on timing.
- More diversification leads to a higher margin of safety only if each component itself has a solid margin of safety
- Investment is most intelligent when it’s most business-like
- View every stock you own a ownership in a business. You should only purchase if you’d be willing to own the entire company (given you had the capital). And only if you would own it in illiquid times/situations. This means you must know the business very well