[2007-04-25] “The Intelligent Investor”

Benjamin Graham, known as “The Dean of Wall Street” and as “The Father of Value Investing”, was one of the greatest investors and teachers of investing principles. His disciples include some of the most famous investors, including Warren Buffett, and his approach of “value investing” still retains a dedicated following despite the advent of fancier and more popular approaches like “Modern Portfolio Theory”. He is credited with bringing discipline to the field of investing via the influential textbook “Security Analysis” that he co-authored with David Dodd and that was first published in 1934.

For the laymen, he wrote “The Intelligent Investor”, first published in 1949, that lays out the principles of value investing and that has proved to be quite popular ever since. In 2003, about 27 years after his death, the fourth edition of this book was published along with extensive commentaries by Jason Zweig, a senior writer at “Money” magazine, and a preface and an appendix by Warren Buffett. The commentaries serve the useful purpose of putting Graham's text in today's perspective, mostly illustrating just how relevant Graham's words remain even today, adapting them for the type of securities currently available and the prevailing taxation laws (in the US).

Graham clarifies right in the beginning that the book is not about how you can “beat the market” (since there is no reliable way of doing that). It is about how you can minimise the chances of suffering losses, maximise the chances of getting sustainable returns and control your behaviour in the face of market fluctuations. It is a conservative approach rooted in common sense that is not likely to fare well with people used to the sustained bull markets of recent years (in the US and much more so in India). Graham makes a distinction between “investment” and “speculation” and bemoans the use of the former term, even in his day, for activities that are really described by the latter. He says that “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return”. Anything else is speculation. He divides investors into two categories - defensive and aggressive - based their appetite for risk and willingness to thoroughly research investment opportunities. Much of the book is devoted to the techniques that each of these types of investors can use to identify suitable investment opportunities. He also advocates a reasonable diversification of the investor's portfolio to guard against errors of judgement and bad luck, at the cost of the chance of achieving spectacular returns.

The core idea of the book is to judge an investment opportunity by comparing the value of the underlying business with the price being offered for it in the market, rather than trying to predict the movements of the price over time. Contrast this with how most of us deal with the stock market. Consequently Graham places much more emphasis on sustained profits and dividend payouts than is the current fashion. He derides Initial Public Offerings (IPOs) as being almost always overpriced relative to the value of the business, especially when it is difficult for the public to judge the value of the business without publicly available and audited financial results for a reasonable period. IPOs are also almost always introduced during a bull market so that the market eagerly buys the issue even at the inflated prices. Graham also cautions against unscrupulous accounting practices used in juggling numbers in financial statements to show profits in some years even when the business really suffered a loss or to transfer losses to lean years so as to mark a profit in other years. He shows how to spot some of these shenanigans. He also favours keeping a reasonable “margin of safety” while investing to minimise the chances of a loss. There are quite a few case studies and comparative analyses throughout the book that illustrate these principles.

To help one deal with the market, Graham uses the allegory of “Mr Market”, an obliging and persistent person who turns up every day and offers to trade with you. You trade with him only if you find him offering a good deal and ignore him otherwise. Since there are a lot of very smart people constantly analysing securities and trading in them, most securities are already priced at levels that reflect their past performance and future potential for earnings. It is foolish to think that you can always outwit them, especially if it is not a full-time job for you. That said, the market tends to move as a whole at many times - overpricing securities during a bull market and underpricing them during a bear market - and gets caught up in fads (for example, the recent obsession with computer and telecommunication companies). It is up to the intelligent investor to spot such opportunities and profit from them.

Jason Zweig's commentaries on each chapter review the lessons learnt in that chapter and illustrate the principles with examples from the recent past. Through numerous footnotes, he also provides references for the studies quoted by Graham, spells out the names of the companies and individuals omitted by Graham and provides a brief history of a company used in a case study since the time Graham wrote about it. Graham's own footnotes have been moved to an “Endnotes” section towards the end of the book. This makes it a bit difficult to find a footnote when you see a superscripted number, asterisk, dagger or a double-dagger. Some times Zweig's footnotes take up more than half of a page or overflow into the next page, both of which were a bit irritating for me. Some times Zweig also provides additional comments for Graham's footnotes. Since these comments are printed in a sans-serif font (as are his commentaries), while Graham's text and footnotes are printed in a serif font, it becomes a bit difficult to separate the two.

Graham's text is slightly verbose and the language is a bit too stuffy for today. The text could have been made shorter and simpler if there were not so many references to and quotes from the text of the previous editions of the book. Graham does come across as pretty honest. He does not shy from admitting to his mistakes and analysing his words from the previous editions in the light of subsequent developments. Zweig uses a much simpler and more friendly language. He does not seem to be able to hold back his glee at the miseries inflicted on bombastic analysts and speculators when the markets crashed spectacularly after the heady boom fuelled by the enthusiasm for computer and telecommunication companies.

Graham bemoaned that his books were read by everybody on Wall Street but followed by nobody. As Warren Buffett illustrates in an appendix, those who have diligently followed the principles of value investing have consistently profited from it. The great thing about Graham's text is that all his principles follow from common sense. Sadly, common sense is not a defining characteristic of either Wall Street or Dalal Street.

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