by Benjamin Graham, published 2006
What follows are the notes from my third (lifetime) re-reading of Graham’s classic investment treatise. I had planned to re-read this book after a market sell-off, but I realized this was a futile act of meta-market timing self-delusion and decided since I was interested in it I should just re-read it now. I am glad I did!
Developing knowledge about past market experience with stock and bond investments is key to intelligent investment; surveying the past with its ups and downs not only makes the future more predictable but helps to create a rational baseline for our own expectations about what is possible with our investment portfolios. Experience shows that enthusiasm almost always leads to disaster. Market conditions can reward, on a relative basis, a passive versus an active approach– sometimes the effort to reward ratio of active management is not worth the trouble.
The investor’s chief problem is likely to be himself. Mastering oneself is a necessary part of mastering one’s investment program.
The future is uncertain. Nonetheless, we must act on the assumption that sound principles will see us through a variety of conditions over time, just as they have in the past.
In most periods of market experience there is a “speculative factor” in common stock prices due to the enthusiasm of the marketplace. We must keep it within limits and be prepared for short and long-term adverse results in terms of both financial and psychological experience whenever this speculative factor is present. Acknowledging this reality, it’s extremely important to keep speculative and investment positions in separate accounts and never to let them mingle financially or in our thoughts.
Better than average results require promising prospects (in terms of risk versus reward) and a lack of popular following of certain portfolio holdings when purchased.
There is no close, time-causal relation between inflationary or deflationary conditions and stock earnings and prices (likely because of Cantillon effects). Earnings rates have shown no general tendency to advance with wholesale price increases. The best result to expect from one’s investment program over long periods of time is approximately an 8% per annum return from a combination of dividends and price increases.
It is the uncertainty of the future that makes the lack of diversification (between common equity and cash/fixed income in a portfolio) folly. At one extreme, one might allocate 25% to stocks and 75% to cash or fixed income, and at the other extreme the inverse. The “happy medium” is 50%/50% between the two. Never should one have 100% of one’s capital in stocks or cash/fixed income– the former suggests an irrational optimism about the future and a total disregard for the risk of adverse conditions, and the former suggests an overly pessimistic view that has given in to the unknowable temptation to time the markets.
Rather than try to time the market, it is more important to follow a consistent and controlled common stock policy and to discourage the impulse to “beat the market” and to “pick the winners”. The work of a financial analyst falls somewhere in the middle of a mathematician and an orator, in that he must be exact where he can, and qualify where he can’t.
The rate of return sought from one’s investment portfolio should be dependent upon the amount of intelligent effort one is willing (and able) to bring to bear on the task. Passive indexing requires the least intelligent effort and should bring the lowest return expectation; active value strategies entail the most intelligent effort and should have commensurately higher return expectations.
Long experience shows that the average investor should stay away from high yield (junk) bonds. Experience also teaches that the time to buy preferred shares is when prices are depressed by temporary adversity.
With every new wave of optimism or pessimism, we are ready to abandon history and time-tested principles, but we cling tenaciously and unquestioningly to our prejudices. This is a bias of human psychology which must be overcome if one is to have a successful long-term investment record.
Common stocks have an added degree of security when the average dividend yield exceeds the yield over that which can be obtained from good bonds.
Rules for common stock portfolios for the defensive investor:
- Minimum of ten different issues
- Large, prominent and conservatively financed companies
- Long record of continuous dividend payments
- 25x past 7yr average earnings (4% earnings yield) and 20x LTM earnings, at a maximum
Experience shows that large, relatively unpopular companies offer a good hunting ground for the defensive investor to search in.
Avoid inferior bonds and preferred stocks at prices greater than a 30% discount to pay value; never buy yield without safety. Owners of foreign debt issues have limited legal recourse, which increases their risk. IPOs can be good purchases… years after the fact, at small fractions of their true worth; let others make the quick profits and experience the harrowing losses of recently issued stocks.
Danger lies in market/public price enthusiasm outstripping earnings growth. Confidence in your investments is a function of proximity and control.
There are 3 primary sources of selection for the enterprising investor’s portfolio:
- Large, out of favor companies due to temporary developments; large companies are safer than small companies because they’re more likely to weather the storm; always judge average past earnings, not LTM
- 50% discount to BV or greater, due to currently disappointing results or protracted neglect/lack of popularity
- require reasonable stability of earnings over past decade
- no earnings deficit in the company’s history
- sufficient size and strength to meet possible future setbacks
- NCAV bargains are safe and profitable method for finding bargains
- “Special situations”
The reasons why bargain issues lead to good performance:
- dividend returns are relatively high
- reinvested earnings, which are substantial relative to price paid (BV grows rapidly)
- bull markets are more generous to low-priced issues
- specific factors contributing to poor earnings may be resolved in the interim
One must choose to engage in either active (enterprising) or passive (defensive) investing, there is no room to do both without becoming speculative in one’s thoughts and actions, ie, can’t be “half a businessman”.
Bargain pricing territory begins at 66% of appraised value, as a return to 100% or fair value indicates a 50% potential upside at purchase price.
If you can control a company, you can safely pay closer to fair value for it.
The investor’s choice as between the defensive or the aggressive status is of major consequence to him and he should not allow himself to be confused or compromised in this basic decision.
Investment formulas are ephemeral and their popularity is their undoing. Rather than market timing, commit to proportional exposure to stocks and cash/fixed income. Every investor who owns common stocks must expect to see them fluctuate in value over the years. Most holdings will advance as much as 50% above the lows, and fall 33% from highs, so set your expectations accordingly.
The virtue of the proportionality formula is that it gives the investor something to do; often it is the inability to sit still and the propensity to tinker that leads to risky novelty. Ironically, higher quality common stocks have more of a speculative element in their price which contributes to their volatility; it is their very popularity and perceived safety which invites unscrupulous risk-takers to dabble in the trading at the margin where the price is set.
Stocks bought closer to book value allow for greater detachment from price fluctuations. Try to be in a position to buy more, including what you already own, when prices fall, assuming value remains in tact. The stock market is often wrong, far wrong, creating opportunity for courageous and alert investors.
All business quality changes with time, sometimes for better and sometimes for worse. Everything is a trade given circumstances and time. Allowing unjustified price action in one’s holdings to influence one’s actions is to turn the basic advantage of liquidity into a disadvantage. True investors see price fluctuations one way: as opportunity to buy what is cheap and sell what is dear. Therefore, the litmus test for investment versus speculation is this, Do you try to anticipate and profit from market fluctuations, or do you look for suitable securities to acquire and hold at suitable prices?
Good managements produce good average market prices and bad managements produce bad market prices.
Businessmen seek professional advice on various elements of their business, but they do not expect to be told how to make a profit; investors must be similarly responsible.
The behavior of a security analyst includes:
- examine past, present and future of a security
- describe the business
- summarize its operating results and financial position
- explain the strengths and weaknesses of the business, its possibilities and risks
- estimate future earnings power under various assumptions
- compare companies, or the same company at different times in its history
- provide an opinion as to the safety of the security
The more dependent valuation is on an assumption about the future, the more vulnerable that valuation is to miscalculation and error.
When evaluating corporate bond safety, judge it by the total interest charges as a multiple of past average earnings (7yrs) or against the “poorest year” of earnings.
No one really knows anything about the future. A company with a high valuation for good performance is already getting a premium for good management, don’t double count management value separately.
One test of quality is an uninterrupted record of dividends going back a number of years. Dividends can’t be forged.
The multiple on earnings is an implied growth rate, pay attention to this fact. There is no way to value a high growth company in which the analyst makes realistic assumptions of both the proper multiple for current earnings and the expected multiple for future earnings.
An analyst can be imaginative and play for big profits as a reward for his vision (entrepreneurship) or he can be conservative and refuse to pay more than a minor premium for possibilities as yet unproved; but do one or the other.
As an exercise, do a valuation based on past performance and another on expected future performance and compare the two. This can be beneficial because it:
- provides useful experience
- creates a record of the experience (allowing for self-evalution)
- may lead to improved methods of analysis in examining the record
Don’t take a single year’s earnings seriously, it’s too easy to fudge the numbers with special charges and one-off items. Sometimes large losses in the past create tax advantages which boost earnings unfairly in the present, so remember to adjust earnings for the average tax impact. Using average earnings smooths out special charges and other one-time items which is another reason to use an average as it reduces the work of trying to “normalize” earnings over time.
High valuations entail high risks.
You should reject from your consideration companies which:
- are too small
- have a relatively weak financial condition
- have a stigma of earnings deficit in their 10 year record
- do not possess a long history of continuous dividends
There is an absence of safety when too large a portion of the price is dependent on ever-increasing future earnings. Stock portfolio earnings overall should be at least as high as the rate on high grade bonds.
Even defensive portfolios should be turned over occasionally, if a holding has seen excessive advance and this is a more reasonably priced issue available. It’s better to sell and pay the tax than not to sell and repent the foregone profits.
Do not be willing to accept prospects and promises of the future as compensation for the lack of sufficient value in hand. Leave the “best” stock alone, instead emphasize diversification more than individual selection. If one could select the best unerringly, one would only lose by diversification.
There are extremely few companies which have been able to show a high rate of uninterrupted growth for long periods of time; conversely, remarkably few of the larger companies suffer ultimate extinction. Competitive advantage in investing lays in focusing one’s efforts on the part of the market systematically overlooked by everyone else.
When Graham owned net-nets, he owned about 100 at a time– “extreme” diversification.
The Graham-Newman playbook included:
- self-liquidations and related hedges (performed well in bear markets)
- working-capital bargains (NCAVs)
- a few control operations
The right time to buy a cyclical enterprise is when:
- the current situation is unfavorable (macro)
- near-term prospects are poor
- the low price fully reflects the pessimism of the market
When browsing the stock guides for opportunity, look for the following characteristics:
- P/E of 9x or less
- financial condition
- current assets >= 1.5x current liabilities
- debt <= 1.1x net current assets
- earnings, no deficit in the last 5 yrs
- some history of dividends
- earnings growth, last years earnings > 5 yrs ago
- price < 1.2x BV
You can use ValueLine, stock screeners or Google Finance-linked GSheets to filter.
If you were to use a single criteria to pick stocks, two items have worked successfully in the past:
- important companies (S&P 500) trading at a low multiplier
- a diversified list of net-nets have performed “quite satisfactorily”
When the going is good and new issues are readily saleable, stock offerings of no quality at all make their appearance.
Special situations are the realm of the pro and require focus and dedication to yield results. Do not do them as one-offs.
The addition of a conversion privilege on a security betrays the absence of investment quality.
If a company pays no taxes for a long time, it throws into question the validity of reported earnings. Watch out also for “channel stuffing” of special charges into a single year on the income statement.
When to raise questions with management:
- unsatisfactory results
- results which are poor compared to competitors
- long discrepancy between price and value
As a rule, poor managers are changed not by activism, but by a change of control.
Dividends can be valuable to the owner of a poorly-run company because they allow some value to escape from the clutches of bad management.
There is no reason to believe expansion moves by a bad management will deliver anything other than more poor results.
The function of the Margin of Safety is to render unnecessary an accurate estimate of the future. In stocks, the Margin of Safety lies in the expected earning power being considerably above the going bond rate. Chief losses come from low quality businesses bought in favorable times. Margin of Safety is totally dependent on the price paid; it is largest at one price, smaller at another and non-existent at a third.
The insurance underwriting process can be thought of as Margin of Safety applied to diversification of bets.
There is no Margin of Safety available in staking money on a market call.
There is no valid reason for optimism or pessimism of the continued function of quantitative methods of analysis.
The Margin of Safety is demonstrated by figures, persuasive reasoning and reference to actual experience.
Do not try to make “business profits” out of securities unless you know as much about their value as you’d need to know about the value of merchandise you proposed to manufacture and deal in. Do not enter into an operation unless a reliable calculation shows it has a fair chance of a reasonable profit. Stay away from situations where you have little to gain and much to lose. Have courage in your knowledge and experience; act on your judgment even when it differs from others. Courage is the supreme virtue when adequate knowledge and tested judgment are at hand.
To achieve satisfactory results is easier than most people realize; to achieve superior results is harder than it looks.
One lucky break, or shrewd decision, may count more than a lifetime of journeyman efforts; but those efforts — preparation and disciplined capacity — are what expose you to the good fortune in the first place.
The Superinvestors of Graham-and-Doddsville
Think always of price and value.
With a significant Margin of Safety in place, something good might happen to me.
Size is the anchor of performance.
Always buy the business, not the stock, mentally speaking.
The greater the potential for reward, the less risk there is.
Don’t make easy things difficult.
Potential for profit will exist as long as price and value diverge in the market.