Written by the founding father of value investing, Benjamin Graham, The Intelligent Investor has been considered the bible of stock investing ever since it was first published. While some ideas are may no longer be relevant today, many have withstood the test of time. Here are 7 timeless concepts from The Intelligent Investor.
1. What is investing?
Let us start of with Graham’s definition of investing. In The Intelligent Investor he wrote that “an investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return”. This definition can be segmented into 3 parts. First, “upon thorough analysis” suggests that investing requires you to commit sufficient time to do research and your due diligence. Next, “promises safety of principal” means that investing involves protecting our capital from losses. Lastly, “an adequate return” implies that investing provides a fair return for our time and effort, not a windfall. This definition thus draws a clear distinction between investing and the likes of gambling and speculation. Investing serves to protect our capital while providing a decent rate of return. Gambling, on the other hand, provides the possibility of a windfall but also a high chance of losing everything.
2. Behind every stock is a business
This brings me to my next point: a stock is not just a ticker symbol, it is an ownership in an actual business, with an underlying value that does not depend on its share price. With stock prices continuously hitting all time highs today, it is easy to forget that there is an underlying business behind each stock ticker.
A litmus test to check whether we are buying a stock because of the underlying business is to ask ourselves this question: if there was no market for these shares, would I still be willing to have an investment in this company on these terms? If the lack of a market would mean that you will be unwilling to make this investment, you are playing a fool’s game, where you are hoping that the next fool will come along and take these shares off your hands for a higher price.
After all, before the creation of the stock market, investing in a business entails putting up capital for a stake in a company with no way to consistently track the price of that ownership. The creation of the stock market has made it possible to have all the quotations at our fingertips. Whether this is for the better or worse depends on how we use it (more on this later).
3. Share price and value will often deviate
The third concept is that deviation between the share price and the value of a company is a natural phenomenon. Sometimes, this deviation will last a week or two but other times, it can go on for many months. Graham wrote: “The market is a pendulum that forever swings between unsustainable optimism and unjustified pessimism. The intelligent investor is a realist who sells to the optimists and buys from the pessimists”. This quote reminds me that volatility is part and parcel of investing. The sadness we feel when we see our holdings dip is the cost we have to pay in order to take part in this machine of wealth creation. However, if you believe that the market is at least somewhat efficient, prices and intrinsic value will eventually converge in the long run. Thus, looking at the market levels today where prices seem to be running way ahead of value, there are only a few possibilities that can follow: stock prices come down, value of businesses goes up, or both.
4. Future returns of every investment is a function of its present price
Another implication of the relationship between price and value is that the future returns of every investment is a function of its present price. The higher the price you pay, the lower your return will be. This is because for a company with an extremely high valuation, their future growth is already priced in. This means that this future growth is to be expected of them. If future earnings turn out to be worse than expected, this valuation is no longer justified and their share price will tumble. An implication of this is that a great company is only a great investment at the right price. For instance, despite improving fundamentals, Amazon did not break it’s dotcom bubble peak of USD$105 until 9 years later in 2009! This is because in 2000, Amazon’s share price ran so far ahead of its value that it took almost a decade for its fundamentals to “catch up”. As Warren Buffet so aptly put it: “Price is what you pay; value is what you get”. When investing, we are looking to get more while paying less.
5. Volatility does not equate to risk
Building on the previous two points, Graham argued that risk is not fluctuations in price but rather the loss of value which either is realized through actual sale, or is caused by a significant deterioration in the company’s position – or, more frequently, is the payment of a price greater than the intrinsic value of the stock. When investing, we are putting up our capital for potential appreciation. Due to the uncertain nature of the future, there is always a chance of losing our capital due to misjudgement, competition, a recession or a multitude of other reasons. These are the risks that we are undertaking when investing in a company, not the day to day fluctuations in the company’s share price. In other words, risk is the chance of a permanent loss of capital, while volatility is the temporary losses on our investments. Graham also wrote that “The intelligent investor realises that stocks become more risky, not less, as their prices rise – and less risky, not more, when their prices fall”. This is because a company’s share price is a reflection of its expected future earnings. With lower prices, a company has lower expectations of future earnings and is hence less likely to fall short. Thus, volatility can potentially provide opportunities to accumulate even more shares in great businesses at cheaper prices.
6. Margin of safety
Next, is the need for a margin of safety. Graham argues that no matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. In today’s VUCA world, this is more true than ever. With so many factors affecting the outcome, no one can be 100% certain which companies will thrive 10-20 years from now. Furthermore, luck and risk are also factors out of our control. There is always a chance that a business can do everything in its power but still lose out to its competitors. Therefore, there is a need for a “margin of safety”. This gives us assurance that even if we are wrong, we don’t suffer crippling losses and are able to continue investing (aka capital preservation). This is one of the ways to effectively deal with luck and risk; stay in the game long enough until luck becomes on our side.
7. Mr. Market
Finally, there is Mr. Market. This, in my opinion, is a powerful way to view the stock market and price quotations. Imagine that you have a business partner called Mr. Market. Everyday, Mr. Market gives you quotations on a list of businesses. These are prices that Mr. Market is willing to sell you shares of a business at or buy shares of the business from you. However, the quotations that Mr. Market gives us are subjected to his rapidly changing emotions and the news he reads. Some days, he may be overly pessimistic and sell you shares in wonderful businesses for extremely low prices. On other days, he may be overly optimistic and quote insane prices. While Mr. Market may give you many different prices on many different businesses, we need not need to act on it every single time. Our job is to be discerning. If Mr. Market quotes us a low price on a wonderful business, do not sell your stake and consider seizing the opportunity by accumulating more shares. If Mr. Market offers to sell his stake in a business for an insane price, we can ignore it or consider selling him some of our shares. This concept helps me worry less about the daily stock prices and focus on the underlying businesses.
These are the 7 timeless investing concepts I have learnt from The Intelligent Investor. Hope that it may benefit all and help us stay rooted in today’s volatile and uncertain market. For more articles and resources like this, click here to join The Dollar Sapling telegram channel!