The Intelligent Investor: The Summary You Should’ve Read
Article image (Creative Commons) by Horia Varlan, edited by Net Net Hunter.
The Intelligent Investor is a true roadmap to beat the market — and yet, most people miss three important implications of Benjamin Graham’s teachings.
Failing to understand Graham’s simple lessons eventually leads to financial disaster.
That’s right. The average investor underperforms the market by more than 50% every year, earning returns below the rate of inflation.
While we think you should read the book in detail, there are three takeaways that you should learn by heart to do well in the stock market. Lucky for you, we’re going to walk you through them below in this summary of The Intelligent Investor.
Why You Need to Re-Think Margin of Safety
Every value investor thinks they know what “margin of safety” means, but few actually get the concept right.
When engineers build a structure, they make sure that it can stand a couple of times the actual weight it will normally endure. The difference between the structure’s weight capacity and the actual weight it endures is its margin of safety.
For investors, the margin of safety is the difference between price and value. A stock bought for a price 50% below its intrinsic value has a margin of safety because your estimation of value could be wrong by 50%, and you still didn’t overpay.
While this is the most obvious use of the concept, Graham also used margin of safety in other critically important ways.
First, think diversification. So, your estimation of the value of a stock was wrong. Is your margin of safety gone? Not as long as you own a group of stocks bought at discounts to intrinsic value. Graham liked a stock with a margin of safety, but he liked a portfolio with a margin of safety even better.
Also, take debt. Graham always focused on finding firms with little debt because this guarded them against future negative events. By demanding a debt to equity ratio of less than 25%, Graham was forcing his investments to conform to a basic margin of safety on the balance sheet.
Graham stayed away from companies that burned cash every year as well, because their margin of safety just shrank as time passed.
A group of stocks bought at huge discounts to intrinsic value, with an adequate earnings record, and very low debt has a very high margin of safety — i.e., it has very low probability of loss, plus high potential for profit.
However, in this summary of The Intelligent Investor we give you one additional angle to the margin of safety.
The Intelligent Investor Summary: Stop Trying to Outguess Mr. Market
Any value investor knows Mr. Market is like this manic-depressive partner in a private company who offers to buy or sell his stock to you every day, depending on his mood swings.
One day he’s depressed and sells his shares to you at a price well below the real business value. A couple of days later, he’s in a manic episode and offers to buy your shares for a very high price — one above the business’ intrinsic value.
What Graham meant with the “parable” of Mr. Market is very simple: you can’t predict what Mr. Market will do, or when he’ll do it.
Yet, most value investors invest based on what they think Mr. Market will do.
Take investing in cyclical companies. The idea here is to buy stocks of companies in cyclical industries (like shipping or steel) when prices are depressed and then sell when they recover in the future — it all depends on when Mr. Market decides it’s time to recover.
Or think about moat investing, where investors try to buy businesses that will grow earnings at above-average rates in hopes that the market will pay higher earnings multiples for them in the future.
What most value investors fail to realize is that Mr. Market is unpredictable.
Graham’s investing strategies aimed at protecting his capital against Mr. Market’s unpredictability, not at profiting from it.
The Intelligent Investor Summary: Is the Bond-Stock Split Outdated?
Here’s yet another angle to the margin of safety found in The Intelligent Investor.
For both defensive and enterprising investors, Graham recommended a bond-stock split, meaning they should have a portion of their portfolio in stocks and the other portion in high-grade bonds at all times.
Does this make sense under current market conditions?
Well, Warren Buffett believes you shouldn’t own long-term government bonds. With yields around 3% for 30-year government bonds and the Fed’s 2% inflation target, your real returns will be negative in this field.
But, we shouldn’t discard Graham’s advice so fast.
Let’s say you’ve invested all your life savings in the S&P 500 for the last 20 years.
Then, all of a sudden, the stock market falls 50%. Think you have the stomach for that?
Now, let’s say 30% of your savings were in government bonds — or even just cash — when the market tanked.
It feels different, right? In times of turmoil, you can act more rationally if you’re not risking it all.
The bond-stock split was just another way of saying investors shouldn’t keep all their eggs in the same basket. There’s your margin of safety again.
The Intelligent Investor Summary: Here’s What Enterprising Investors Usually Get Wrong
Most value investors want to believe they are enterprising investors, but few actually follow Graham’s advice on these matters.
What was Graham’s advice for enterprising investors?
“To obtain better than average investment returns over a long pull requires a policy selection or operation possessing a twofold merit: (1) It must meet objective or rational tests of underlying soundness; and (2) it must be different from the policy followed by most investors or speculators.” [P. 162. The Intelligent Investor]
Think moat investing matches these criteria? Think twice.
Don’t get me wrong — investing in companies with durable competitive advantages at fair prices works. Just look at Buffett’s track record.
The thing is, your chances of actually finding them and buying them at fair prices are very low. Buffett’s unique ability makes it look easier than it actually is. Also, given the massive amounts of capital he manages, he’s got no option.
What I can assure you is that “wonderful businesses at fair prices” is what most professional investors are looking for all the time. I’ve yet to find one value investor who’s consciously looking for overpriced stocks.
So, which stock selection policy actually matches Graham’s criteria?
Net nets. These are dirt cheap stocks trading below liquidation value. Essentially, if you bought the entire company, you could double your money immediately by closing the business.
Net net investing is clearly different from what most investors do. Even among value investors, only a minority actually look for these kinds of “sub-asset” stocks.
Graham kept a very detailed record of the results of his various investing strategies over the course of his career — arbitrages, hedges, workouts, and net nets — and eventually came to the conclusion that a group of net nets outperformed all the other strategies.
He said the returns were around 20% per year on average for nearly 30 years.
Academic research supports Graham’s conclusions as well. Given that this is a summary of The Intelligent investor, we are not going to detail all of the studies available on the topic, but you can find them at Net Net Hunter.
The most famous is study came from Oppenheimer, who ran a test over a 12-year period starting in 1970 and found that a basket of net nets yielded a 31% compounded annual growth rate.
The Intelligent Investor Summary: Here’s What Enterprising Investors Should Actually Do
If this summary of The Intelligent Investor convinced you about the long-term benefits of implementing a net net strategy, that’s great!
The bad news is, net nets have almost disappeared since the ’80s … from the US stock markets.
But, they are alive and well in Japan, South Korea, the UK, and Europe.
How can you find these international net nets, though?
At Net Net Hunter, we have access to a database from which we extract net nets from around the world. This is called the Raw Screen.
Each month, we spend several hours combing through the approximately 1,000 stocks on the Raw Screen in order to come up with the best net net stocks available.
The result is a monthly Shortlist that our members receive, where they can start their bargain hunt.
We’ve also developed a unique net net selection criteria based on Graham’s advice to find the best quality net nets available around the world.
For example, we have a minimum debt to equity ratio cutoff. We also look for companies with adequate past earnings, just like Graham did.
Based on Graham’s late years’ research, we also came up with a mechanical investing strategy called Ansan. It consists of buying the cheapest 20 net nets on the Shortlist — plus other criteria — and rebalancing after one year.
This mechanical strategy helps investors sidestep common behavioural biases that destroy their returns in the long term.
Want to learn more? Join Net Net Hunter now and find high-quality net nets to stock your portfolio and boost your long-term returns.
Download our net checklist right now for free. Click Here.
