Notes – The Intelligent Investor Commentary By Jason Zweig (@jasonzweigwsj, #valueinvesting, #bengraham)

The Intelligent Investor

by Benjamin Graham, Jason Zweig, published 1949, 2003

The Modern Day Intelligent Investor

The following note outline was rescued from my personal document archive. The outline consists of a summary of the end-chapter commentary written by Jason Zweig. Zweig did such a good job of reviewing Graham’s lessons in each chapter and practically applying them that I find you can get most of the major principles of The Intelligent Investor by reading the combined commentary chapters as if they were a standalone investment book.

Of course, Graham’s original work is a classic in the value investing tradition and it should be read and savored on its own, as well.

Chapter 1, JZ commentary

  1. What is investing?
    1. You must thoroughly analyze a company, and the soundness of its underlying businesses, before you buy its stock
    2. You must deliberately protect yourself against serious losses
    3. You must aspire to “adequate”, not extraordinary, performance
  2. How to invest
    1. An investor calculates what a stock is worth, based on the value of the underlying business
    2. A speculator gambles that a stock will go up in price because somebody will pay even more for it
    3. You should be comfortable owning the underlying business even if you couldn’t get timely, regular quotes of its market price
    4. Price is what the business is selling for, not what it’s worth. Value is what the business is worth. Money is sometimes made in the arbitraging of the two, but price does not dictate value; in the long-term, value dictates price
  3. Limit your risk
    1. Never mingle speculative accounts and investment accounts
    2. Never allow your speculative thinking to spill over into your investing activities
    3. Never put more than 10% of your assets into your “mad money” account

Chapter 2, JZ commentary

  1. Stocks have not had a perfect record of keeping up with inflation, as measured by the CPI
  2. 20% of the 5year periods from 50s today in which inflation dominated saw falling stocks
  3. Two strategies for branching out beyond stocks during inflation:
    1. REITs (Real Estate Investment Trusts)
    2. TIPS (Treasury Inflation Protected Securities)
      1. IRS considers an increase in TIPS value to be taxable income

Chapter 3, JZ commentary

  1. “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.”
  2. The stock market’s performance depends on three factors:
    1. real growth in earnings and dividends
    2. inflation(-expectations) within the general economy
    3. speculative appetite for stocks/risk (increase/decrease)
  3. In the long run, you can reasonably expect stocks to average a 6% nominal return, 4% real return (with inflation calculated at 2% historical rate)
  4. Be humble about your ability to forecast future stock returns– don’t risk too much on a forecast that could turn out to be wrong.

Chapter 4, JZ commentary

  1. Two kinds of intelligent investors:
    1. active/enterprising – continual research, selection and monitoring of a dynamic mix of stocks, bonds or mutual funds (intellectually/physically demanding)
    2. passive/defensive – create a permanent portfolio that runs on autopilot and requires no further effort but generates very little excitement (emotionally demanding)
  2. How to allocate amongst stocks and bonds for defensive investors?
    1. “Age” is arbitrary and pointless
    2. Instead, consider the fundamental circumstances of your life and the financial needs you’ll have for the foreseeable future
    3. For the aggressive investor, 25% in bonds and cash, 75% in stocks
    4. For the defensive investor, 25% in stocks and 75% in bonds and cash
    5. Rebalancing should be done on a predictable, disciplined basis– not when the market dictates, but when the “calendar” or schedule does
  3. Income investing (bond choices)
    1. Taxable or tax free? Choose tax free (municipal) unless you are in the lowest income bracket
    2. Short-term or long-term? Intermediate term bonds of 5-10yrs allow you to avoid the guessing game and see-saw risks of short and long-term bonds
    3. Bonds or bond funds? Unless you have a lot of capital to make minimum purchases, probably more cost effective to buy a bond fund
    4. Watch out for preferred stock, the worst of both worlds
      1. Secondary claim on assets in bankruptcies (junior to bonds)
      2. Offer less potential profit than common equity because they are often forcibly called by businesses when interest rates drop or credit ratings improve
      3. Companies can not deduct the interest payments like they can with bond issuance, ask yourself, “Why would a company that is healthy issue preferred rather than bonds?” Answer is, probably because they aren’t healthy
    5. Sometimes, stocks can offer competitive yields with Treasuries, which can increase income yield while raising potential return (as well as increasing potential risk of loss)

Chapter 5, JZ commentary

  1. Markets are least risky after a crash, most risky at the top
  2. Should you buy what you know? Psychological studies say that we tend to discount risk inappropriately when we feel we are experts on something due to familiarity
  3. Dollar-cost averaging can be a disciplined way to force oneself to invest through bear and bull markets

Chapter 6, JZ commentary

  1. Junk bonds
    1. Graham warned against them because they were difficult to diversify away the risks of default; today, many junk bond funds exist which allow an investor to diversify
    2. While junk bonds have outperformed 10yr UST even with historical default rates factored in, many junk bond funds charge high fees which reduces their appeal
  2. Emerging market bonds
    1. Typically not correlated with US equity markets
    2. Restrict holdings in bond portfolio to 10% (published 2003)
  3. Day trading
    1. The increased transaction costs of day trading is a surefire way to bomb a portfolio
    2. Day trading raises transaction costs to the point where returns must be beyond what one could reasonably expect to make with a conservative estimation of returns, just to break even
  4. IPOs
    1. Most people who have bought-and-held IPOs have been decimated over time
    2. Hard to find value in the mania buying of an IPO
    3. The public excitement of an IPO often leads investors to forget about valuing the underlying business; many investors have paid ridiculous sums for businesses that were not profitable and never had a chance of being profitable
    4. “It’s Probably Overpriced”

Chapter 7, JZ commentary

  1. Market timing is essentially a fools errand: Life can only be understood looking backwards, but it is lived forwards.
  2. Growth stocks– the faster the companies grow, the higher goes their stock multiples
    1. A $1B company can double its business fairly easily, but how will a $50B company double itself?
    2. A great company is not a great investment if you pay too much for it
    3. When growth companies expand beyond 25-30 times earnings, they’re expensive and should not be bought
    4. One way growth companies could become temporarily attractive is when they suffer a setback or disclosure of upsetting information, creating “the relatively unpopular large company.”
  3. Most great fortunes in the world are made through concentration into one industry or business idea; similarly, most great fortunes are lost this way as well
    1. Because markets are sometimes cyclical, people who got rich in one industry as it boomed will likely lose their fortunes in that same industry when it busts
  4. Bargain hunting for stocks can be a winning strategy; consider stocks that are selling at or for less than their net working capital (Current Assets – Total Liabilities, including preferred stock and long-term debt)
    1. One way to quickly find these stocks can be to search for companies that have recently hit new lows for the past 52 weeks
  5. Diversifying outside the US (or home market) is adviseable because national economies suffer booms and busts as well as specific industries do
    1. If you had been Japanese in 1989, you would probably think it foolish to invest in America; however, you would lose 2/3 of your equity value over the ensuing decade as a result
    2. The country that you live and work in is already a multilayered bet on the economic prospects of that country’s economy; buying foreign stocks (including emerging markets) provides insurance against the possibility that your home market might be a laggard

Chapter 8, JZ commentary

  1. Do not let the movement of Mr. Market, up or down, affect your decision on whether to buy or sell a particular company or stock at a particular time
    1. Don’t buy just because the market is going up
    2. Don’t sell just because the market is going down
  2. Graham: “The primary cause of failure is that they pay too much attention to what the stock market is doing currently.”
  3. Investing intelligently is about controlling the uncontrollable
    1. your brokerage costs
    2. your ownership costs (mutual fund fees)
    3. your expectations (keep them reasonable)
    4. your risk (how much of your total assets do you put into each investment)
    5. your tax bills (short vs. long term cap gains)
    6. your own behavior
  4. “To be an intelligent investor, you must also refuse to judge your financial success by how a bunch of total strangers are doing”
    1. You haven’t lost if everyone else has won
    2. You haven’t won if everyone else has lost
    3. Focus on your own absolute performance
  5. Remember: market quotations are what other people think the value of a stock is– not what the true value of the stock is in relation to underlying intrinsic value
  6. Selling into a bear market can occasionally make sense in relation to taking a realized loss for tax purposes; consult a tax professional before doing so

Chapter 9, JZ commentary

  1. The pitfalls of mutual funds:
    1. avg fund does not pick stocks well enough to overcome the costs of researching and trading them
    2. the higher a fund’s expenses, the lower its returns
    3. the more frequently a fund trades, the less it tends to earn
    4. highly volatile funds tends to stay volatile
    5. funds with high past returns are unlikely to remain winners for long
  2. Why don’t more winning funds stay winners?
    1. migrating managers; top mgrs get picked off by higher paying companies or go on to start their own funds
    2. asset elephantitis; when a fund is too large, it reduces the types and size of investments it can possibly make, reducing its nimbleness
    3. no more fancy footwork; many fund “incubate” before going public and whatever advantages they had during incubation are generally lost afterward, yet they use the incubation period performance to promote the fund
    4. rising expenses; it often costs more to trade in size than to trade smaller because markets become illiquid when trading in size
    5. sheepishness/herding; fund mgrs who have been successful and attract higher fees grow accustomed to these fees and their reputation and don’t want to take any risks that might jeopardize either one, so they trade like other fund mgrs
  3. The solution for the individual investor is boring, low cost index funds– they won’t beat the market, but they won’t get beaten by it either
  4. How to pick good mutual funds?
    1. managers should be the biggest shareholders
    2. they should be cheap/low fee; high returns are temporary, high fees are permanent
    3. they should be run creatively and “dare to be different”
    4. they shut the door before they get too big
    5. they don’t advertise much if at all
  5. Expense fee guidelines:
    1. taxable and muni bonds, .75%
    2. US equities, 1%
    3. high-yield bonds, 1%
    4. US equities (small stocks), 1.25%
    5. foreign equities, 1.5%
  6. When to sell a mutual fund?
    1. a sharp and unexpected change in strategy
    2. an increase in expenses
    3. large and frequent tax bills (caused by excessive trading)
    4. suddenly erratic returns (big gains or big losses)

Chapter 11, JZ commentary

  1. Five decisive elements for determining price multiples
    1. the company’s “general long-term prospects”
      1. Warning flags
        1. the company is a serial acquirer, gaining revenues and profit growth through the acquisition of other businesses
        2. the company is addicted to OPM and is continually floating debt or issuing new stock
          1. cash from operating activities negative, while cash from financing activities positive, on a general or recurring basis, means the company is not profitable in its own line of industry
        3. the company relies on one or only a handful of important customers to generate a significant share of its revenues and profits
      2. Positives in company analysis
        1. the company has a wide “moat” to competition
          1. brand identity
          2. monopoly or near-monopoly
          3. economies of scale
          4. unique intangible asset
          5. resistance to substitution
        2. the company is a marathoner, not sprinter
          1. revenues and income should grow steadily, not in spurts
          2. less likely to attract and then offend “hot stock” money
        3. the company sows and reaps
          1. the company should be spending on R&D to develop new lines of growth in the future
          2. 3-6% of revenues by industry is a typical measure
    2. the quality of its management
      1. is it looking out for #1?
        1. executives should not be paid too much
        2. company should not be reissuing or repricing stock options constantly
        3. use fully-diluted share totals when calculating EPS
        4. insiders should not be selling the company
      2. are they managers or promoters?
        1. mgrs should spend most of their time managing, not being in the media promoting the company’s stock
        2. watch out for accounting opaqueness, recurring non-recurring charges, ordinary extraordinary items and the focus on EBITDA rather than net income, etc.
    3. the financial strength and capital structure
      1. it should generate more cash than it consumes
      2. cash from operations should grow steadily over time
        1. use “owner earnings” (Net Income + Amortization + Depreciation – Cost of Stock Options – Unusual/Nonrecurring Charges – Company Pension Fund “Income”)
      3. capital structure considerations
        1. total debt ( + preferred stock) should be under 50% of total capital
        2. is debt fixed-rate or variable, exposing the company to interest rate risk (check footnotes)?
        3. check annual reports for “ratio of earnings to fixed costs” which can demonstrate if the company is able to make interest payments
    4. its dividend record
      1. the burden of proof is on the company to prove they shouldn’t issue you a dividend because they can grow the company better with the retained earnings
      2. the stock should not be split constantly
      3. stock buybacks should occur when the company’s shares are cheap, not at record highs
    5. its current dividend rate

Chapter 12, JZ commentary

  1. Accounting gimmickery
    1. make sure capitalized expenses really ought to be capitalized
    2. watch out for firms realizing revenues on their accounting statements that they have not actually earned
    3. inventory write-downs should not be occurring regularly if the company is using proper inventory accounting methods
    4. “net pension benefit” should not be more than 5% of the company’s net income
  2. How to avoid accounting fraud
    1. read backwards; the dirty secrets are buried at the end
    2. read the notes; never buy a stock without reading the footnotes in the annual report
      1. look for terms like “capitalized”, “deferred” and “restructuring”
    3. read more; check out Financial Statement Analysis (Fridson and Alvarez), The Financial Number’s Game (Comiskey), Financial Shenanigans (Schilit)

Chapter 14, JZ commentary

  1. Investing for the defensive investor
    1. Substantially all of ones stock picks should be limited to a total stock market index fund; or, 90% total stock market index fund and 10% individual stock picks
  2. Graham’s criteria for stock selection:
    1. adequate size; market cap > $2B, unless owned through a “small cap mutual fund” that allows for diversification
    2. strong financial condition; 2:1 current assets:current liabilities ratio
    3. earnings stability; some earnings for the common stock in each of the past ten years
    4. dividend record; the company should pay a dividend, even better if it increases over time
    5. earnings growth; 33% cumulative EPS growth over ten years, or essentially, 3% annual EPS growth
    6. moderate p/e ratio; current price should be no more than 15x avg earnings over past 3 yrs
    7. moderate price-to-book ratio; price-to-assets/price-to-book-value ratio of no more than 1.5
    8. alternatively, multiply p/e ratio by price-to-book and the number should be below 22.5
  3. Do the due diligence
    1. do your homework; read at least 5 yrs worth of annual and qtrly reports and proxy statements disclosing managers’ compensation, ownership, and potential conflicts of interest
    2. check out the neighborhood; check for institutional ownership ratios, over 60% probably means the company is overowned and overpriced
      1. if one sells, they’ll all sell; could be a time to find bargains in that stock
      2. check who the biggest holders are, if they’re money mgrs that invest like you, you could be in good hands

Chapter 15, JZ commentary

  1. You can practice stock-picking for a year, without investing any real money, and see how you do
    1. if you beat the S&P500, maybe you are good enough to pick stocks
    2. if you don’t, stick to index funds
  2. How to pick stocks for the enterprising investor
    1. Start with stocks that have recently hit 52 week lows
    2. use the ROIC method of analysis; ROIC = Owner Earnings / Invested Capital, where Owner Earnings is:
      1. Operating Profit + Depreciation + Amortization of Goodwill – Federal Income Tax – Cost of Stock Options – Maintenance (Essential CapEx) – Income Generated By Pension Funds
      2. Invested Capital = Total Assets – Cash and ST Investments + Past Accounting Charges That Reduced Invested Capital
      3. ROIC can demonstrate, after legitimate expenses, what the company earns from its operating businesses and how efficiently it has used shareholders’ money to generate that return
      4. ROIC of 10% is attractive, 6-7% in special occasions with strong brand name, focused management or the company being temporarily unpopular
    3. you can also look for comparable companies that have been acquired recently for valuations for the company you are looking at
      1. check the “Business Segments” (or “Management Discussion and Analysis”) section of the company’s annual report for industrial sector, revenues and earnings of each subsidiary
      2. then, check Factiva, ProQuest or LexisNexis for examples of other firms in the same industry that have been acquired
      3. then, look at past ARs for these companies for information about purchase price to earnings for those companies before acquisition
      4. this might reveal a “60-cent dollar”, a company whose assets and earnings are selling for 60% or less than the businesses might be worth to an acquirer

Chapter 20, JZ commentary

  1. The first objective of investing: “Don’t lose.”; this is Graham’s “margin of safety” concept in a nutshell
  2. Consider a market that is returning 5% a year, while you have found a stock that you think can grow at 10%; if you overpay for it and suffer a capital loss of 50% in the first year, it will take you 16 years to overtake the market, and nearly 10 years just to break even again
  3. The biggest financial risk we face is ourselves; ask yourself the following questions:
    1. How much experience do I have? What is my track record with similar decisions in the past?
    2. What is the typical track record of other people who have tried this in the past?
    3. If I am buying, someone is selling. How likely is it that I know something they don’t know?
    4. If I am selling, someone else is buying. How likely is it that I know something they don’t know?
    5. Have I calculated how much this investment needs to go up to cover my taxes and trading expenses?
  4. Then, make sure you have considered the consequences of being wrong by asking yourself:
    1. How much could I lose if I am wrong?
    2. Do I have other investments that will tide me over if this decision turns out to be wrong? Am I putting too much capital at risk?
    3. Have I demonstrated a high tolerance for risk by continuing to invest after large losses in the past?
    4. Am I relying on willpower alone to prevent me from panicking or have I made preparations in advance by diversifying and dollar-cost averaging?
  5. “In making decisions under conditions of uncertainty, the consequences must dominate the probabilities. We never know the future.”
  6. Never make the mistake of following investment crazes or putting all your eggs in one basket; if you make one error, you will have wiped yourself out
  7. Instead, diversify, and always protect yourself from the consequences of being wrong just as much as you hope and plan to enjoy the benefits of being right