The Intelligent Investor - by Benjamin Graham

Introduction

It has long been the prevalent view that the art of successful investment lies first in the choice of those industries that are most likely to grow in the future and then in identifying the most promising companies in these industries. For example, smart investors- or their smart advisers-would long ago have recognized the great possibilities of the computer industry as a whole and of International Business Machine (IBM) in particular. And similarly for a number of other growth industries and growth companies. But this is not as easy as it always looks in retrospect. To bring this point home at the outset let us add here a paragraph that we included in the 1949 edition of this book.

Such and investor may for example be a buyer of air-transport stocks because he believes their future is even more brilliant than the trend the market already reflects. For this class of investor the value of our book will lie more in its warnings against pitcalls lurking in this favorite investment approach than in any positive technique that will help him along his path.

The pitfalls have proved particularly dangerous in the industry we mentioned. It was, of course, easy to forecast that the volume of air traffic would grow spectacularly over the years. Because of this factor their shares became a favorite choice in the investment funds. But despite the expansion of revenues-at a pace even greater than in the computer industry-a combination of technological problems and over expansion of capacity made for fluctuating and even disastrous profit figures. In the year 1970, despite a new high in traffic figures, the airlines sustained a loss of some $200 million for their shareholders. (They has shown losses also in 1945 and 1961.) The stocks of these companies once again showed a greater decline in 1969-70 than did the general market. The record shows that even the highly paid full-time experts of the mutual funds were completely wrong about the fair short-term future of a major and non-esoteric industry.

On the other hand, whole the investment funds had substantial investments and substantial gains in IBM, the combination of its apparently high price and impossibility of being certain about its rate of growth prevented them from having more than, say, 3%, of their funds in this wonderful performer. Hence the effect of this excellent choice on their overall results was by no means decisive. Furthermore, many-if not most-of their investments in computer-industry companies other than IBM appear to have been unprofitable. From these two broad examples we draw 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.

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Chapter 1. Investment versus Speculation: Results to be Expected by the Intelligent Investor

Results to be expected by the Defensive Investor

We have already defined the defensive investor as one interested chiefly in safety plus freedom to bother. In general what course should he follow and what return can he expect under "average normal conditions" - if such conditions really exist? To answer these questions we shall consider first what we wrote on the subject seven ears ago, next what significant changes have occured since then in the underlying factors governing the investor's expectable return, and finally what he should do and what he should expect under present-day (early 1972) conditions.

1. What we said six years ago

We recommended that the investor divide his holdings between high-grade bonds and leading commons stocks; that the proportion held in bonds be never less than 25% or more than 75%, with the converse being necessarily true for common-stock component; that his simplest choice would be to 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."

...

Results to be expected by the aggressive investor

Our enterprising security buyer, of course, will desire and expect to attain better overall results than his defensive or passive companion. But first he must make sure that his results will not be worse. It is no difficult trick to bring a great deal of energy, study, and native ability into Wall Street and to end up with losses instead of profits. These virtues, if channeled in the wrong directions, become indistinguishable from handicaps. Thus it is most essential that the enterprising investor start with a clear conception as to which courses of action offer reasonable chances of success and which do not.

First let us consider several ways in which investors and speculators generally have endeavored to obtain better than average results. These include:

1. Trading in the market. This usually means buying stocks when the market has been advancing and selling them after it has turned downward. The stocks selected are likely to be among those which have been "behaving" better than the market average. A small number of professionals frequently engage in short selling. Here they will sell issues they do not own but borrow through the established mechanisms of stock exchanges...

2. Short-term selectivity. This means buying stocks or companies which are reporting or expected to report increased earnings, or for which some other favorable development is anticipated.

3. Long-term selectivity. Here the usual emphasis is on an excellent record of past growth, which is considered likely to continue in the future. In some cases also the "investor" may choose companies which have not yet shown impressive results, but are expected to establish a high earning power later. (Such companies belong frequently in some technological area-e.g., computers, drugs, electronics-and they often are developing new processes or products that are deemed to be especially promising.)

We have already expressed negative view about the investor's overall chances of success in these areas of activity. The first we have ruled out, on both theoretical and realistic grounds, from the domain of investment. Stock trading is not an operation "which, on thorough analysis, offers safety of principal and a satisfactory return." More will be said on stock trading in a later chapter.

In his endeavor to select the most promising stocks either for the near term or the longer future, the investor faces obstacles of two kinds- the first stemming from human fallibility and the second from the nature of his competition. He may be wrong in his estimate of the future; or even if he is right, the current market price may already fully reflect what he is anticipating. In the area of near-term selectivity, the current year's results of the company are generally common property on Wall Street; next years' results, to the extent they are predictable, are already being carefully considered. Hence the investor who selects issues chiefly on the basis of this year's superior results, or on what he is told he may expect for next year, is likely to find that others have done the same thing for the same reason.

In choosing stocks for their long-term prospects, the investor's handicap is basically the same. The possibility of outright error in the prediction-which we illustrated by our airlines example on p.6- is no doubt greater than when dealing with near-term earnings. Because the experts frequently go astray in such forecasts, it is theoretically possible for an investor to benefit greatly by making correct predictions when Wall Street as a whole is making incorrect ones. But that is only theoretical. How many enterprising investors could count on having the acumen or prophetic gift to beat the professional analysts at their favorite game of estimating long-term future earnings?

We are thus led to the following logical if disconcerting conclusion: 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.

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Commentary on Chapter 1

Graham's definition of investing could not be clearer: "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return." Note that 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.

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 somebody else will pay even more for it. As Graham once put it, investors judge "the market price by established standards of value," while speculators, "base [their] standards of value upon the market price." For a speculator, the incessant stream of stock quotes is like oxygen; cut it off and he dies. For an investor, what Graham called "quotational" values matter much less. 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.

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Commentary on Chapter 3

Even though investors all know they're supposed to buy low and sell high, in practice they often end up getting it backwards. Graham's warning in this chapter is simple: "By the rule of opposites," the more enthusiastic investors become about the stock market in the long run, the more certain they are to be proved wrong in the short run. On March 24, 2000, the total value of the U.S. stock market peaked at $14.75 trillion. By October 9, 2002, just 30 months later, the total U.S. stock market was worth $7.34 trillion, or 50.2% less -a loss of &7.41 trillion. Meanwhile, many market pundits turned sourly bearish, predicting flat or even negative market returns for years-even decades to come.

At this point, Graham would ask one simple question: Considering how calamitously wrong the "experts" were the last time they agreed on something, why on earth should the intelligent investor believe them now?

What's Next?

Instead, let's tune out the noise and think about future returns as Graham might. 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)

In the long run, the yearly growth in corporate earnings per share has averaged 1.5% to 2% (not counting inflation). As of early 2003, inflation was running around 2.4% annually; the dividend yield on stocks was 1.9%. So,

1.5% to 2%

+ 2.4%

+ 1.9%

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= 5.8% to 6.3%

In the long run, that means you can reasonably expect stocks to average roughly a 6% return (or 4% after inflation). If the investing public gets greedy again and send stocks back into orbit, then that speculative fever will temporarily drive returns high. If instead, investors are full of fear, as they were in the 1930s and 1970s, the returns on stocks will go temporarily lower. (That's where we are in 2003).

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Commentary on Chapter 4

Once you set these target percentages, change them only as your life circumstances change. Do not buy more stocks because the stock market has gone up; do not sell them because it has gone down. The very heart of Graham's approach is to replace guesswork with discipline. Fortunately, through your 401(k), it's easy to put your portfolio on permanent autopilot. Let's say you are comfortable with a fairly high level of risk-say, 70% of your assets in stocks and 30% in bonds. If the stock market rises 25% (but bonds stay steady), you will now have just under 75% in stocks and only 25% in bonds.

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Chapter 5. The Defensive investor and common stock

Rules for common-stock component

The selection of common stocks for the portfolio of the defensive investor should be a relatively simple matter. Here we would suggest four 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 thirty.

2. Each company selected should be large, prominent, and conservatively financed. Indefinite as these adjectives must be, their general sense is clear. Observations on this point are added at the end of the chapter.

3. Each company should have a long record of continuous dividend payments. (All the issues in the Dow Jones Industrial Average met this dividend requirement in 1971.) To be specific on this point we would suggest the requirement of continuous dividend payments beginning at least in 1950.

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 seven years. We suggest that this limit be set at 25 times such average earnings, and not more than 20 times those of the last twelve-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. We must give our reasons for proposing so drastic an exclusion.

...

The leading growth issue has long been International Business Machines, and it has brought phenomenal rewards to those who bought it years ago and held on to it tenaciously. But we have already pointed out that this "best of common stocks" actually lost 50% of its market price in six-months' decline during 1961-1962 and nearly the same percentage in 1969-70. Other growth stocks have been even more vulnerable to adverse developments; in some cases not only has the price fallen back but the earnings as well, thus causing double discomfiture to those who owned them. A good second example for our purpose is Texas Instruments, which in six years rose from 5 to 256, without paying dividend, while its earnings increased form 40 cents to $3.91 per share. (Note that the price advance five times as fast as profits; this is characteristic of popular common stocks.) But two years later the earnings had dropped off by nearly 50% and the price by four-fifths, to 49.

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Chapter 7: Portfolio Policy for the Enterprising Investor: The Positive Side

Purchase of Bargain Issues

We define a bargain issue as one which, on the basis of facts established by analysis, appears to be worth considerably more than it is selling more. The genus includes bonds and preferred stocks selling well under par, as well as common stocks. To be as concrete as possible, let us suggest that an issue is not a true "bargain" unless the indicated value is at least 50% more than the price. What kind of facts would arrant the conclusion that so great a discrepancy exists? How do bargains come into existence, and how does the investor profit from them?

There are two tests by which a bargain common stock is detected. The first is by the method of appraisal. This relies largely on estimating future earnings and then multiplying these by a factor appropriate to the particular issue. If the resultant value is sufficiently above the market price - and if the investor has confidence in the technique employed- he can tag the stock as a bargain. The second test is the value of the business to a private owner. This value also is often determined chiefly by expected future earnings-in which case the result may be identical with the first. But in the second test more attention is likely to be paid to the realizable value of the assets, with particular emphasis on the net current assets or working capital.

At low points in the general market a large proportion of common stocks are bargain issues, as measured by these standards. (A typical example was General Motors when it sold at less than 30 in 1941, equivalent to only 5 for the 1971 shares. It had been earning in excess of $4 and paying $3.50, or more, in dividends.) It is true that current earnings and the immediate prospects may be poor, but a levelheaded appraisal of average conditions would indicate values far above ruling prices. Thus the wisdom of having courage in depressed markets is vindicated not only by the voice of experience but also by application of plausible techniques of value analysis.

The same vagaries of the market place that recurrently establish a bargain condition in the general list account for the existence of many individual bargains at almost all market levels. The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks. Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels. Thus we have what appear to be two major sources of undervaluation: (1) currently disappointing results and (2) protracted neglect or unpopularity.

However, neither of these causes, if considered by itself alone, can be relied on as a guide to successful common-stock investment.

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Chapter 8: The Investor and Market Fluctuations

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 taken place- i.e., by buying after each major decline and selling out after each major advance?

...

Between 1897 and 1949 there were ten complete market cycles, running from bear-market low to bull-market high and back to bear-market low. Six of these took no longer than four years, four ran for six or seven years, and one-the famous "new-era" cycle of 1921-1932- lasted eleven years. The percentage of advance from the lows to highs range from 44% to 500%, with most between about 50% to 100%. The percentage of subsequent declines ranged from 24% to 89%, with most found between 40% and 50%. (It should be remembered that a decline of 50% fully offsets a preceding advance of 100%)

Nearly all the bull markets had a number of well-defined characteristics in common, such as (1) a historically high price level, (2) high price/earnings 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.

Business Valuations versus Stock-Market Valuations

The impact of market fluctuations upon the investor's true situation may be considered also from the standpoint of the shareholder as the part owner of various businesses.

...

(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 quarterly reports; from total shareholder's equity, subtract all "soft" assets such as goodwill, trademarks, and other tangibles. Divide by the fully diluted number of share outstanding to arrive at book value per share.

...

The striking losses did not indicate any doubt about the future long-term growth 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.

The previous discussion leads us to conclusion of practical importance of the conservative investor in common stocks. If he is to pay some special attention to the selection of his portfolio, it might be best for him to concentrate on issues selling at a reasonably close approximation to their tangible-asset value - say, not more than one-third above that figure. Purchases made at such levels, or lower, may with logic be regarded as related to the company's balance sheet, and having a justification or support independent of the fluctuating market prices. The premium over book value that may be involved can be considered as a kind of extra fee paid for the advantage of stock-exchange listing and the marketability that goes wit it.

A caution is needed here. 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 earning to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years.

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Commentary on Chapter 9

This is another reminder that the market's hottest market sector-in 1999, that was technology-often turns as cold as liquid nitrogen, with blinding speed and utterly no warning. And it's a reminder that buying funds based purely on their past performance is one of the stupidest things an investor can do. 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.

...

If you're not prepared to stick with a fund through at least three lean years, you shouldn't buy it in the first place. Patience is the fund investor's single most powerful ally.

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Chapter 10. The Investor and His Advisers

Here are some of the questions that prominent financial planners recommended any prospective client should ask:

Why are you in this business? What is the mission statement of your firm? Besides your alarm clock, what makes you get up in the morning?

What is your investing philosophy? Do you use stocks or mutual funds? Do you use technical analysis? Do you use market timing? (A "yes" to either of the last two questions is a "no" signal to you.)

...

How do you choose investments? What investing approach do you believe is most successful, and what evidence can you show me that you have achieved that kind of success for your clients? What do you do when an investment performs poorly for an entire year? (Any adviser who answers "sell" is not worth hiring.)

How much, in actual dollars, do you estimate I would pay for your services the first year? What would make that number go up or down over time? (If fees will consume more than 1% of your assets annually, you should probably shop for another adviser.)

Can I see a sample account statement? (If you can't understand it, ask the adviser to explain it. If you can't understand his explanation, he's not right for you.)

How high an average annual return do you think is feasible on my investments? (Anything over 8% to 10% is unrealistic.)

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Chapter 11. Security analysis for the lay investor: general approach

Factors Affecting the Capitalization Rate

1. General Long-Term Prospects...

2. Management...

3. Financial Strength and Capital Structure...

4. Dividend Record...

5. Current Dividend Rate.

This, our last additional factor, is the most difficult one to deal with in satisfactory fashion. Fortunately, the majority of companies have come to follow what may be called a standard dividend policy. This has meant that distribution of about two-thirds of their average earnings, except that in the recent period of high profits and inflationary demands for more capital the figure tended to be lower. (In 1969 it was 59.5% for the stocks in the Dow Jones average, and 55% for all American corporations.)

Capitalization Rates for Growth Stocks

Most of the writing of security analysts on formal appraisals relates to the valuation of growth stocks. Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the valuation of growth stocks, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations. Our formula is:

Value = Current (Normal) Earnings x (8.5 plus twice the expected annual growth rate)

The growth figure should be that expected over the next seven to ten years.

The difference between the implicit 32-4% annual growth for Xerox and the extremely modest 2.8% for General Motors is indeed striking- It is explainable in part by the stock ma ing that General Motors' 1963 earnings-the largest for any corporation in history-can be maintained with difficulty and exceeded only modestly at best. The price-earnings ratio of Xerox, on the other hand, is quite representative of speculative enthusiasm fastened upon a company of great achievement and perhaps still greater promise.

COMMENTARY ON CHAPTER 11

Putting a Price on the Future

Which factors determine how much you should be willing to pay for a stock"? What makes one company worth 1 0 times esarnings and -another worth 2O times? How can you be reasonably sure that you are not overpaying for an apparently rosy future that turns out to be a murky nightmare*? Graham feels that five elements are decisive. He summarizes them as:

-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 database at www.sec.gov.3 Then comb through the financial statements, gathering evidence to help you answer two overriding questions. What makes this company grow? Where do (and where will) it’s profits come from? Among the problems to 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. After all, if the company itself would rather buy the stock of other businesses than invest in its own, shouldn’t you take the hint and look elsewhere too? And check the company’s track record as an acquirer. Watch out for corporate bulimics-firms that wolf down big acquisitions, only to end up vomiting them back out. Lucent, Mattel, Quaker Oats, and tyco International are among the com- panies that have had to disgorge acquisitions at sickening losses. Other firms take chronic write-offs, or accounting charges proving that they overpaid for their past acquisitions. That's a bad omen for future deal making.

- The company is an OPM addict, borrowing debt or selling stock to raise boatloads of Other Peoples Money. These fat infusions 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 cash-as Global Crossing and WorldCom showed not long ago.

As you study the sources of growth and profit, stay on the lookout for positives as well as negatives. Among the good signs:

-the company has a wide moat or competitive advantage. Like castles, some companies can easily be stormed by marauding competitors, while others are almost impregnable. Several forces can widen a company's moat: a strong brand identity (think of Harley Davidson, whose buyers tattoo the company's logo onto their bodies); a monopoly or near-monopoly on the market; economies of scale, or the ability to supply huge amounts of goods or services cheaply (consider Gillette, which churns our razor blades by the billion); a unique intangible asset (think of coca-cola, whose secret formula for flavored syrup has no real physical value but maintains a priceless hold on consumers); a resistance to substitution (most businesses have no alternative to electricity, so utility companies are unlikely to be supplanted any time soon).

-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. A recent article in the Financial Analysts Journal confirmed what other studies (and the sad experience of many investors) have shown: that the fastest:growing companies tend to overheat and flame out. If earnings are growing at a long-term rate of 10% pretax (or 6% to 7% after-tax) that may be sustainable. But the 15% growth hurdle that many companies set for themselves is delusional. And an even higher rate "or a sudden burst of growth in orieoflwo years-is all but certain to fade, just like an inexperienced marathoner who tries to run the whole race as if it were a 100-meter dash.

-The company sows and reaps. No matter how good its products or how powerful it’s brand, a company must spend some money to develop new business. While research and development spending is not a source of growth today, it may well be tomorrow-particularly if a firm has a proven record of rejuvenating its businesses with new ideas and equipment. The average budget for research and development varies across indusjfies and companies. In 2002, Procter & Gamble spent 4% of its net sales on R&D, while 3M spent 6.5% and Johnson and Johnson 10.9%. In the long run, a company that spends nothing on R&D is at least as vulnerable as one that spends too much.

The quality and conduct of management.

A company's executives should say what they will do, then do what they said. Read theoast annual reports to see what forecasts the manager 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. (Pay special attention to boom years like 1999.)

Financial strength and capital structure.

The most basic possible definition of a good business is this: It generates more cash than it consumes.

See whether cash from operations has grown steadily throughout the past 10 years.

In general, long-term debt should be under 50% of total capital. In the footnotes to the financial statements, determine whether the long-term debt is fixed-rate (with constant interest payments) or variable (with payments that fluctuate, which could be come costly if interest rates rise).

CHAPTER 13 A Comparison of Four Listed Companies

1. Profitability...

2. Stability...

3. Growth...

4. Financial position...

5. Dividends...

6. Price history...

The two companies will meet our seven statistical requirements for inclusion in a defensive investors portfolio. These will be developed in the next chapter, but we summarize them as follows:

1. Adequate size.

2. A sufficiently strong financial condition.

3. Continued dividends for at least the past 20 years.

4. No earnings deficit in the past ten years.

5. Ten-year growth of at least one-third in per-share earnings.

6. Price of stock no more than 1.5 times net asset value.

7. Price no more than 15 times average earnings of the past three years.

CHAPTER 20 "Margin of Safety" as the Central Concept of Investment

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to “earning power” and assume that prosperity is synonymous with safety.

Extension of the Concept of Investment

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.

For, if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment.

To Sum Up

Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings. Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or claim against, a specific business enterprise.

The first and most obvious of these principals is, “Know what you are doing-know your business.”

A second business principle:”Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.”

A third business principle: “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.”

For enterprising investors this means that his operations for profits should be based not on optimism but on arithmetic.