My Key Takeaways From Chapter 1 and Commentary 1 of the Intelligent Investor. Part 2/16. To Be Continued.

Chapter 1 investment versus Speculation

An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

Results to Be Expected by the Defensive Investor

In general, what course should he follow and what return can he expect under “average normal conditions” – if such conditions really exist? To answer these questions, we shall consider first what we wrote on the subject 7 years ago, next what significant changes have occurred since then in the underlying factors governing the investor’s expectable return, and finally what he should do and what he should expect under present-day (early 1972) conditions.

To conclude this section, let us mention briefly 3 supplementary concepts or practices for the defensive investor. The 1st is the purchase of the shares of well-established investment funds as an alternative to creating his own common stock-portfolio. He might also utilize one of the “common trust funds,” or “commingled funds,” operated by trust companies and banks in many states; o, if his funds are substantial, use the services of a recognized investment-counsel firm. The 3rd is the device of “dollar-cost averaging,” which means simply that the practitioner invests in common stocks the same number of dollars each month or each quarter.

Results to Be Expected by the Aggressive Investor

We are thus led to the following logical if disconcerting conclusion: To enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising, and (2) not popular on Wall Street.

Policies available for the enterprising investor. Everyone knows that speculative stock movements are carried too far in both directions, frequently in the general market and at all times in at least some of the individual issues. Furthermore, a common stock may be undervalued because of lack of interest or unjustified popular prejudice.

A 3rd and final example of the golden opportunities not recently available: A good part of our own operations on Wall Street had been concentrated on the purchase of bargain issues easily identified as such by the fact that they were selling at less than their share in the net current assets (working capital) alone, not accounting the plant account and other assets, and after deducting all liabilities ahead of the stock. It is clear that these issues were selling at a price well below the value of the enterprise as a private business.

Commentary on Chapter 1

Note that investing, according to Graham, consists equally of 3 elements:

• You must thoroughly analyze a company, and the soundness of its underlying business, before you buy its stock;
• You must deliberately protect yourself against serious losses;
• You must aspire to “adequate,” not extraordinary, performance

As Graham once put it, investors judge “the market price by established standards of value,” while speculators “base [their] standards of value upon the market price.”

Graham urges you to invest only if you would be comfortable owning a stock even if you had no way of knowing its daily share price.

The techniques that became so trendy in the 1990s-day trading, ignoring diversification, flipping hot mutual funds, following stock-picking “systems”- seemed to work. But they had no chance of prevailing in the long run, because they failed to meet all 3 of Graham’s criteria for investing.

In 1973, the annual turnover rate on the NYSE was 20% meaning that the typical shareholder held a stock for 5 years before selling it. By 2002, the turnover rate hit 105%-a holding period of only 11.4 months. Back in 1973, the average mutual fund held on to a stock for nearly 3 years; by 2002, the ownership period had shrunk to just 10.9 months.

As Graham never stops reminding us, stocks do well or poorly in the future because the businesses behind them do well or poorly-nothing more, and nothing less.

All mechanical formulas for earning higher stock performance are “a kind of self-destructive process-akin to the law of diminishing returns.” There are 2 reasons the returns fade away. If the formula was just based on random statistical flukes, the mere passage of time will expose that it made no sense in the 1st place. On the other hand, if the formula actually did work in the past (like the January effect), then by publicizing it, market pundits always erode-and usually eliminate-its ability to do so in the future.