It would be difficult to name a more-significant book about investing than Benjamin Graham's "The Intelligent Investor." Graham formally introduces a new style of investing, called 'value investing.' This book has guided professional investors, such as Warren Buffett, who said it was "by far the best book on investing ever written" for innumerable individuals who invest based on the principles outlined within its pages.
"The Intelligent Investor" was published in 1949, and its author is a professional fund manager who became a professor at Columbia University's business school. His most famous student was Buffett himself, the legendary "Oracle of Omaha." "The Intelligent Investor" is fairly complex and probably not user-friendly for the novice. The core principles in the book, however, are relevant to any investor, regardless of experience. The book's title, naturally, is a clue to what its content may be about. Unlike most investment books or financial 'experts' that promise viewers the ability to make easy money, this book is about intelligent investing. Not flashy investing, not investing in hot stocks, not complex merger/arbitrage trades. Just clean, simple value investing.
In the first chapter, Graham makes important distinctions between an investor and a speculator. An investor researches extensively to determine which securities to purchase, whereas a speculator buys or sells based on popular notions or fluctuations in the price of a security, and he does so without reflecting on the underlying fundamentals of the business whose securities he is buying. Graham further breaks down investors into defensive and enterprising categories.
Defensive investors buy fairly 'safe' stocks, mainly of the 30 companies in the Dow Jones Index, or high-quality bonds. The goal for defensive investors is to have a steady rate of return. Defense investing is a good strategy for people without a lot of research time - for example, university students, although young investors are usually advised to select stocks for growth potential in lieu of fixed-income securities like bonds.
As for non-government bonds, one has a choice between corporate and municipal bonds. Corporate bonds are issued by companies to raise capital. Municipal bonds are issued by states or localities. These are revenue bonds that pay interest from revenue sources, such as tolls and user fees, and general obligation bonds in which interest is guaranteed by the general taxing power of the issuer.
In addition to buying individual bonds, you can buy bond funds that are like mutual funds and are diversified pools of bonds. Because most municipal bonds are federal and state tax-free, they bear a lower interest rate as compared to their corporate brethren.
The type of bond you buy depends on your tax bracket. Investors in a high tax bracket should buy more municipal bonds to save on taxes, even though the interest rate is lower. Conversely, those in a lower tax bracket should buy more corporate bonds because the higher interest rate offsets the burden of having to pay the tax.
Enterprising investors have to do far more work. They actively look for all kinds of securities or investments that will give them the best returns.
The enterprising investor faces obstacles, however. To justify all the time put in, he naturally expects a better-than-average return. But beating the market is very hard to do. Graham provides examples of numerous funds that under-performed the market, even with many experts hard at work. The challenge then becomes that of finding a better investment strategy - incongruent with Wall Street's formulas - that will outperform the market.
From the above discussion, Graham makes several key points. First, it is important to know your limits and not try to invest in a complex portfolio if you do not have the time, the understanding or the stomach for losses. In reality, it is perfectly acceptable to generate a small, steady return by investing defensively rather than burning out with enterprising investing. Often, investors who take on too much risk will fail, become discouraged from future investing, which will cause them to lose the profits they would have made in the future. This leads directly to Graham's next principal, 'value investing.'
Value investing is like buying a juicy steak dinner for the price of a Quarter Pounder. Market prices, because they are determined by the decisions of people, are inherently imperfect; people make mistakes in valuing stocks. Graham says the wisest financial decisions are to invest in undervalued companies, trading at a low price-to-earnings ratio. P/E is determined by dividing the stock price by the earnings during the last year. Although P/E is a relative measure based on a given industry, Graham pays special attention to companies with a low P/E. Such a figure means the company is undervalued. It is important to be careful - some companies are undervalued because they really are unworthy companies. But what Graham explains is that it is important to try to find underappreciated companies with relatively low valuations as compared to their industries - "diamonds in the rough" - and invest in them. He makes an example with GEICO. At one point Graham threw away all notions of diversification and put 25 percent of his fund's money into shares of GEICO. Why? Because he saw it as a company whose stock price was cheap compared to its earnings, cash flow and other factors.
There are plenty of stocks that have attractive valuations, so with a bit of effort, you can spot them and take advantage of the eventual upswing.\n\nHarrison's column runs biweekly Wednesdays. He can be reached at h.freund@cavalierdaily.com.
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