How to Invest in stock market? – As an Intelligent Investor.
Benjamin Graham -“The Intelligent Investor” Key Points
Fruitful money management doesn’t need stratospheric IQ, insider data, or karma for that matter Instead what’s required is a sound scholarly system for deciding, joined with a capacity to hold feelings back from demolishing it. In “The Intelligent Investor”, Benjamin Graham presents such a structure along with rationale that will assist with monitoring your feelings. Seemingly, he’s effective financial planning system has been one of the best ones during the most recent hundred years. The great records, of Graham himself, yet in addition of various of his followers are difficult to overlook. Among these, the most splendid sparkling star is Warren Buffett, is the third richest man on the planet. Warren Buffett alludes to this book as “by a wide margin, the best book on financial planning at any point composed”.Following are the five main key takeaways from the book.
Meet Mr. Market
Takeaway number 1: Meet Mr. Market Imagine that you own a part of a business that you paid $1000 for. Every day, a certain bipolar person called Mr. Market comes to your home with an opinion about how much you’re part of that business is worth. Furthermore, he offers to buy your share or sell you an additional one on that basis. History has shown that Mr. Market’s opinion about how much your part of the business is worth, can be pure gibberish. For instance, back in March 2000, he estimated the value of your share to be $2600. Only one year later, in March 2001, he thought it was worth $500. Even though the income of the company increased with 50% and the profit increased by 20% during the same period. Should you let this guy decide how much your $1000 of interest in that business is worth? Of course not! One of Graham’s core principles, is that a stock is not just a ticker symbol combined with a price tag, it’s an ownership interest in a business. And because Mr. Market isn’t always rational, the underlying value of the business can differ from the price he is willing to pay for it. In fact, it frequently is over- or underpriced as Mr. Market easily becomes over optimistic, or conversely too pessimistic.
Graham advises you to invest only if you would feel comfortable to hold the stock in the future without seeing the fluctuating prices that Mr. Market presents you with. But for the investor who can keep his head cool, Mr. Market presents a great possibility of making money, for he doesn’t force you to strike a deal with him, he merely presents you with an opportunity of doing so! You should be happy to sell to him when he offers prices that are ridiculously high, and similarly, you should be happy to buy from him when he presents you with bargains. We must consider that, at the time when Graham wrote this book, people were far less bombarded with news, forecasts, stock quotes, and so on than we are today. Back in the 1970s, Mr. Market arrived maybe once a day, together with the morning newspaper. Today, he wants to do business with us every time we open our phone. Which, if you’re anything like me, is more than 100 times every day, Just because Mr. Market visits you more often, it doesn’t mean that you must trade with him any more frequently than people had to in the 1970s. If he doesn’t present you with an offer that meets your standards, ignore him, and move on with your day!
How to invest as a defensive investor
Takeaway number 2: How to invest as a defensive investor. There are two types of investors according to Graham – the defensive (or passive) one and the enterprising (or active one). Most people are better suited for the defensive strategy, as the time they are willing to dedicate to investing is limited. The defensive investor should create a portfolio with a mixture of bonds and stocks, say 50% stocks and 50% bonds. Note that how much you should devote to each asset category depends on your life situation and the current difference in the average yield of stocks versus bonds. Restore this allocation once or twice every year, so that if stocks suddenly make up 60% of the portfolio compared to only 40% in bonds, sell stocks and buy bonds, until 50/50 is restored. Invest a fixed amount of capital at regular intervals. For instance, straight after you get your salary. This is called dollar-cost averaging, and will allow for a fair average price of stocks and bonds. Most of all, it will assure that you don’t concentrate your buying at the wrong time.
For the stock component of the portfolio, the defensive investor should aim for the following 8:
1: Diversification in the companies he invests in. 10 to 30 companies should be adequate. Also, make sure that you are not overexposed to a single industry.
2: The companies should be large, which Graham defined as generating more than a $100 million in yearly sales. After inflation, this equals approximately to $700 million in today’s value.
3: Look for companies that are conservatively financed. Such a company has a so called “current ratio” of at least 200%. This means that its current assets are at least twice as big as its current liabilities.
4: Dividend should have been paid to shareholders for at least the last 20 years.
5: No earnings deficit in the last ten years.
6: At least 33% growth in earnings during the last ten years. This translates to a conservative growth of 2.9% annually.
7. Don’t overpay for assets. The price of the stock should not be higher than 1.5 times its net asset value. The net asset value can be calculated by subtracting the company’s liabilities from its assets.
8: Don’t overpay for earnings (either). Don’t let the p/e ratio be higher than 15 when using the last 12-month earnings.
An alternative today is to invest in an index fund, which by definition will have returns similar to the average of the market. If you are satisfied with an average reward through your investing, you only need these two first takeaways.
However, if you thirst for more, you will also need to consider:
How to invest as an enterprising investor
Takeaway number 3: How to invest as an enterprising investor. As it’s so easy for the defensive investor to get the average return of the market, it would seem a simple matter to beat the market. You just devote a little more time to investing than these average investors do, right?
To be an enterprising investor, and to beat the market, is much more demanding as such a logic suggests. It requires patience, discipline, an eagerness to learn and a lot of time. Many professionals and private investors alike aren’t suited for this. It’s easier to fall victim to the price quotations of Mr. Market than one could possibly imagine. Just listen to these two statements from the early 2000s, at the peak of the dot-com bubble, made by the chief investment strategist at 2 large mutual funds: “It’s a new world order….” “We see people discard all the right companies, with all the right people, with the right visions, because their stock price is too high.” “That’s the worst mistake an investor can make.” “Is the stock market riskier today than two years ago simply because the prices are higher? The answer is no!” But the answer is yes, yes, YES! Of course, both statements turned out to be costly for the investors who put their money in these funds. Since the profits that companies can earn are finite, the price the intelligent investor should be willing to pay for these companies must also be finite.
Price is truly an important factor for the enterprising investor. Just like the market tends to overvalue companies when they have been growing fast or is glamorous for some other reason, it tends to undervalue the ones with unsatisfactory development. The intelligent investor should therefore try to avoid so-called “growth stocks” as much as possible. Why? Simply because the investment decision is based relatively more on future earnings, and future earnings are less reliable than current valuations. If you, on the other hand, can find a company which is valued lower than its net working capital, you essentially pay nothing for all the fixed assets, such as buildings, machinery goodwill, etc. The net working capital can be calculated by subtracting total liabilities from current assets. Such companies were proven truly profitable during Graham’s investment career. Unfortunately, they are rare today except during tough bear markets.
Luckily, Graham suggests an additional method of finding investments for the enterprising investor. These criteria are similar to the ones that the defensive investors should use, but the constraints are looser, allowing for the enterprising investor to consider more companies. Note that there is no constraint at all regarding company size. Also, some diversification should be applied, but the number of companies held isn’t carved in stone for the active investor. In analyzing a company, the enterprising investor should also study its annual financial reports. Graham has written a whole book on this subject called “The Interpretation of Financial Statements.” You can read the book to get more insight.
Insist on a margin of safety
Takeaway number 4: Insist on a margin of safety. There’s one risk that no careful consideration can truly eliminate: the risk of being wrong. You can, however, minimize this risk. To do this, you must insist that every investment you make has a “margin of safety”. As mentioned before, the price and value of a company is not always the same. When the price is at most two thirds of its calculated value, the investor has found a company with enough margin of safety. You wouldn’t construct a ship that sinks if 31 Viking boarded it, if you know that it regularly will be used to transport 30 of them. Neither should you invest in stock that you think is worth, say, $31 if it currently is priced at $30. It might be that your calculation is wrong. In the first case, a group of angry (and wet) Vikings might hunt you down. In the second, you might postpone your financial freedom by a couple of years. I don’t know which situation that I’d consider to be worse: Use margins of safety!
A formula used in the book can give you some heads up regarding what the value of a company is, and therefore also if it can be bought with a margin of safety. Value = current (normal) earnings x 8.5 + 2 x expected annual growth rate The growth rate should be equal to the expected yearly growth rate of earnings for the next 7 to 10 years. Here’s how much the three largest companies of the S&P 500 are worth according to the formula in September 2018: Note that we can use the formula backwards too, to trace how much these companies must grow in the coming 7 to 10 years for today’s stock prices to be rational. There’s a huge discrepancy here! Amazon is expected to grow at 74% per year according to its stock price, while Apple is expected to grow at a mere 5.8%. Do you think that this is reasonable?
Risk and reward are not always correlated
Takeaway number 5: Risk and reward are not always correlated. According to academic theory, the rate of return which an investor can expect must be proportional to the degree of risk that he’s willing to accept. Risk is then measured as the volatility of the returns on the investment, meaning, how much it has differed historically from its expected value.
Graham doesn’t agree with this statement. Instead, he argues that the price and value of assets often are disconnected. Therefore, the return that an investor can expect is a function of how much time and effort he brings in his pursuit of finding bargain assets. The minimum return goes to the defensive (or passive) investor, while the maximum goes to the enterprising investor who exercises maximum intelligence and skill. Consider this: It’s 4:00 a.m in the morning, and you’ve been out drinking in the streets of Moscow together with your friends. You decide that it’s too early to call it a night, and therefore you end up in the more obscure parts of town. At a particularly ambiguous bar you’re approached by a man who asks: “Do you want to play a game?” “Well, of course, games are fun!” your bravest least sober friend replies. The man puts a revolving in front of you, which is loaded with a single bullet. “I’ll give you $10,000 if you dare to take a shot, Russian Roulette.” Your drunk friend reaches out for the gun, but you stop him. “I think we’ll pass on this one ” you politely inform the man. “I thought so” he replies … “What about $100,000 for taking two shots?” Now, this story represents the academic way of demanding a higher potential reward for taking a higher risk. In the first offer, you were to receive $10,000 at a 16.7% risk of blowing your brains out. In the second offer, the reward is $100,000 because the risk of putting a hole through your head has increased to 33.3%. Seems logical, right? But stock market investing doesn’t have to be like that!
Remember that price and value are not the same. When you buy a company at 60 cents on the dollar, you have a great potential reward, and a low risk. Furthermore, if you can find another company that you can buy at 40 cents on the dollar, you have found a better potential reward, combined with an even lower risk! How could anyone in their right mind argue that it’s riskier to buy a dollar at the price of 40 cents than to buy a dollar at 60 cents, just because the potential reward is higher?
Quick recap of the five takeaways:
Firstly the market tends to be over-optimistic and too pessimistic from time to time. Don’t let this influence what you think the true value of your assets are. Instead, see it as a business opportunity, where you get to deal with a person who has no idea of what he’s doing!
Secondly, the defensive investor should go for a diversified portfolio of stocks and bonds, where the stock category consists of primarily low-priced issues.
Thirdly, the enterprising investor should also aim for stocks that show lower price tendencies. If he can find a company that is trading below its net working capital, he might have found his El Dorado.
The fourth takeaway Is that the intelligent investor should insist on a margin of safety when acquiring an asset.
And finally, takeaway number 5 is that risk and reward aren’t necessarily correlated.
What do you think of Graham’s advice? Are they still as applicable today, as they were back in the 1970s? Comment below in the section