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Book summary - Intelligent Investor By Benjamin Graham

Recently I have gone through this interesting book on value investing. And I can truly say that this is a masterpiece and need to reread it again and again over the period  of time. I got bitten by this concept of value investing in my late 20s and I have started reading about value investing on lot of blogs and books. In almost all the blogs everyone has mentioned about this book. So here is book summary for intelligent investor.

First advise that Ben has given is avoid speculations. Well as a beginner I have used speculations and paid the price for that. Until and unless I burn my fingers, I can not learn. Company should sound promising inherently, and should not be popular on social media, news or  any other platform. One should not delude himself into thinking that he is investing while actually he is speculating. Speculations are harmful to investment. Biggest advantage or disadvantage of stock market is, it will always overreact. Or on other words market is more volatile  and there is no way to control it. But we can gain skills that can be make gains in this volatility.

Inflation has huge effect on portfolio. If we do not beat inflation then it will reduce the returns on investment. If we have High Inflation and low share markets  then its a good opportunity to enter markets. If we have High Inflation and high share markets then its a bubble and need to be avoided. If we have Low Inflation and low share market then it is a good opportunity to enter. If we have low inflation and high share market then avoid as prices are already overvalued.

Price of an issue should justify underlying assets, earning and dividends. Ben has provided significance of price to earning ratio, price to book ratio and earning per share(supported by inflation) throughout this book. Also he has provided basic background checks of investment. These checks need to be fulfilled then only we can start our investment journey. 

  • No borrowing to buy or hold securities 
  • Have set aside enough case to support your family for at least 1 year
  • Ask yourself it this company deserve my investment or why should I buy this security at this price and at this time?
For companies which are paying high dividends, Ben asked a question why company is paying fat dividends on its stock instead of issuing bonds and getting tax break? The likely answer is that the company is not healthy. the market for its bonds glutted and you should approach stock of the company in a same way that you approve for unrefrigerated dead fish. In Buffett's words while buying a stock one should write at least a page about why I should buy this issues of this company.

Ben has set different verticals for defensive investor and enterprise investor. For defensive investor who can not spend more time on portfolio, he has suggested to go for common stocks (stock with less risk such as  blue chip, or performed very well over period of time) with diversification to reduce the risk. These common stocks should be large, financially sound and should have a good track record. And for enterprise investor he has suggested to hunt for growth stocks. Stocks which has potential to grow. But to hunt these stocks lot of work need to be done.

There are some don't that Ben suggested for retail investor,

  • Never apply for IPO - IPO are generally get registered when markets are at their peak and economy is in good shape. IPO's are more favored to promoters then retail investors. Promoters want to raise money they will always choose to raise it in bull market and not in bear market. So they are not favoring retail investors. 
  • Never trade
  • Never go for high return mutual funds or bonds - To my understanding, mutual fund industry is not good way of investment. I will prefer to go with index funds instead of these mutual funds or bonds.
I have burned my fingers in all of  them ☝.

These growth stock should meet the underlying criteria for underlying soundness.
Growth stock are generally unpopular companies which has capital and man power that will sustain a bear market. What I have understood is growth stock must has strong management, margin of safety, deep moat as qualitative requirement and strong balance sheet , cashflow and earning over a long period of time as quantitative requirement. Earning should sustain over period of time. These growth stocks should be undervalued may be due to temporary disappointed results or neglected over period of time. But one should verify why there is reason of undervaluation before jumping to stock.  Never take position on company having court room battles or if the management has some legal cases filed against.

There is another interesting observations that he has shared company should earn over the period of time. Company should be marathoner and not sprinter. If it provides high earning which leads to high growth and become more expensive in small period of time, it has maximum probability of defaulting. Also no one can time the market correctly.

Best lines that I would like to copy from this book are as follows,

"The true investor scarcely(something is unlikely to be or certainly not the case) ever is forced to sell his shares, and all the other time he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by justified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would better off if his stocks has no market quotation at all, for he would then be spared the mental anguish caused by another persons mistakes of judgement

Generally there is an saying on investment in stock market provide less return then that of investment in private enterprise, because stock market is organized security market (injects into equity ownership the new and extremely important attribute of liquidity). But what is liquidity means is, first, the investor has benefit of the stock market's daily and changing appraisal of his holding, for whatever 
the appraisal may  be worth of, second the investor can increase/decrease the his investment based on the markets daily figures. Thus the existence of a quoted market gives the investor certain options that he does not have his securities unquoted. But it does not imposes the current quotation on a investor who prefers to take his idea of value from other source. Imagine that in some private business you have investment of $1000. One of your partner Mr. Market is very obliging(works on ethics). Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you additional interest on that basis. Sometimes his idea seems plausible and justified by business developments and prospects you as you know them. Often, on the other hand, Mr.  Market let his enthusiasm or his fears let run away this him, and values he proposes seems short of silly. If you are prudent investor or a sensible business man, will you  let Mr. Market's daily quotes determine your view of value of $1000 interest in that enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him if he quotes you ridiculously high price and equally happy to buy from him when the prices are low. But rest of the time you are wiser to form your own ideas of your holding, based on the full reports from the company about its operations and financial positions."

Ben is not happy with all the stock advisors. He treats ethical standard of these advisor are worst then some businesses like smuggling, prostitution or politician's who are lobbying. These advisors are liars, cheaters and thieves. This includes discount brokers also who spend lot of money on advertisement on trading. Moral I understand by reading this chapter is  "Never ever ever seek any advise for security investment and better safe and late than sorry"

Most of the writing in this book is for layman investors. There are 5 main elements that an investor should go through which are as follows,
  • Long Term prospect
  • Quality of management
  • Financial strength and capital structure
  • Dividend Record
  • Current dividend rate
Every highlighted points that I have mentioned above can be analyzed from balance sheet, annual report and cashflow. Long term prospect can be found by looking at the cashflow, check if operations cashflows is negative and cash from financial activities are always positive indicates company has habit of cash carving from other people and can not generate cash for its own operation. We need to avoid such companies. By looking at the income statement we can see if revenues and net earning have grown smoothly and steadily over 10 years period of time.

Quality of management can be viewed by using annual report. If we read the past annual report and see what management has promised and what management has actually delivered over period of time. We can also check if management is playing any blame game for poor performance in the past. Company can pay high salary to management but that need be justified with high gains and profits. Executives of cement or underware companies should not declare, they are on the verge of software revolution. Management should not sell their stocks. If management is reissuing stocks to insiders then we need to stay away from these companies. Also if they are issues new stocks, their generated profits will be shared by existing and new share holder. Also any established company that reprices options - as dozens of high tech firms did is a disgrace. Any investor who buys stock in such a company is sheep begging to be sheared. Executives must spend more time on managing and not promoting their investment. Also accounting practices need to be designed in such a that financial results must be transparent. If "nonrecurring" charges keep recurring, "extraordinary" items crop up often that they seem ordinary. Like EBITDA take priority over net income, or "pro forma" earnings are used to clock actual losses, you may be looking at a firm that not yet learned how to put shareholders long term interests first.

Financial strength and capital structure can be seen by looking at the cashflow and balance sheet carefully. Company should generate more cash then it consumes. We can calculate margin of safety by using Bruce Greenwald book.
Ben suggested that we need look cashflow, balance sheet over the period of time and not for single year. For industrial company, current assets should be at least twice  as that of current liabilities or so called two is to one ratio and long term debt should not exceed the net current assets. 

As per Graham selection criteria for common stocks must be,

Debt to equity <0.4 AND
Free cash flow 10years > 10 AND
Price to Earning < 15 AND
Profit growth 10Years > 10 AND
Price to book value < 0.5 AND
Current assets  > 2*Current liabilities AND
Debt < 2*(Book value * Number of equity shares) AND
Working capital >Debt

These common stock can not outperform growth stock. For growth stock we need to apply qualitative and quantitative approach. Case studies in the last section to compare equities are also important to get a clear idea on how we can apply basic criteria to identify stocks.

In the last part of the book Ben has provided significance of margin of safety. But I will prefer the calculation of margin of safety suggested by Bruce Greenwald. Also Ben is more focused on  diversification. But diversification is for those who do not know what they are doing. Highest rewards can be obtained by concentrations only. But to do concentration in portfolio we need to be more focused.