I just finished reading Benjamin Graham’s The Intelligent Investor for the second time. My first read was in 2004 when I finally had enough money to invest and was looking for guidance. At the time, I found the investing world crowded with so-called pundits who advocated strategies that conflicted with one another.

So I focused my attention on the person who has had the most successful investment career — Warren Buffett. Frequently in his interviews and essays he cites The Intelligent Investor as “by far the best book about investing ever written” and Benjamin Graham as the man that influenced his life more than any other except his father.

After reading it, I, too, was captivated by its insights and strategies due to their simplicity and time-tested correctness. The book is as relevant today as it was at the time of its first publication in 1949. It surely would have kept its readers out of the recent dot-com crash.

Although I must concede that I am a speculator rather than an investor, I keep Graham’s emphasis on value and margin of safety in my mind when engaging in any speculation. And as I become older, I intend to adhere to the principles offered by The Intelligent Investor to a greater degree as preservation of capital becomes my chief concern.

I often find myself wanting to re-read the book, but my lack of spare time dissuades me. So I thought it would be useful after my recent reading to compile a brief summary of the book for easy reference. Others might also find this abbreviation useful, but I must warn, this doesn’t replace reading the book in its entirety — especially if one has never read it.

Outline of The Intelligent Investor

What is Investing?

• “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
• “To have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.”
• A margin of safety when applied to bonds is the ability of a company to earn in excess of interest requirements that is counted on to protect the investor against loss from possible future deterioration in earnings.
• A security of low-quality can be a good investment if it can be demonstrated that it is cheap enough.
• Speculation can be intelligent or unintelligent. Unintelligent speculation arises when (1) speculating when you think you are investing, (2) speculating in a field where you lack proper knowledge and skill, and (3) risking more money than you can afford to lose.

Investing Psychology

• “The investor’s chief problem — and even his worst enemy — is likely to be himself.”
• “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it — even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”
• “The kind of securities to be purchased and the rate of return to be sought depend not on the investor’s financial resources but on his financial equipment in terms of knowledge, experience, and temperament.”

General Portfolio Policy

• An investor should have between 25% and 75% of his portfolio in stocks, and the balance in bonds. During bear markets when valuations become attractive he may increase the stock weighting up to 75%. In bull markets, when market levels become dangerously high, he may reduce his stock allocation to as low as 25%.
• Continuous and uniform purchases of common stocks have proven to be rewarding over time.
• Investors in high tax brackets would be better off by selecting municipal bonds, which are tax free, rather than corporates.
• Foreign government bonds should be avoided because the investor has no legal or other means of enforcing his claim.
• Investors should be weary of new issues because they have a strong sales force behind them which can make them appear more attractive than otherwise they would be. Also, new issues are usually sold under favorable market conditions which means favorable for the seller and unfavorable for the buyer.
• When considering a company’s earnings, the average earnings of the past 7 to 10 years should be considered to iron out the ups and downs of the business cycle. It also reduces the problem of accounting for special charges and credits. They should be included in the average earnings.

Portfolio Policy for the Defensive Investor

• The defensive (or passive) investor aims to avoid making mistakes and losing capital. He will also seek to minimize his effort in accomplishing this.
• Defensive investors can choose from federal, municipal, and corporate bonds. Only investment grade municipals and corporates need be considered.
• Preferred shares lack both the legal claim of the bondholder and the profit possibilities of the common shareholder. Thus, they are too unconventional for the defensive investor.
• Criteria for bond selection by the conservative investor:
  1. Earnings-Coverage Test. Examining the past 7 years should reveal that the industrial company has earned before taxes during its worst year at least 33% of principal amount of debt. This figure could be as low as 20% for a public utility and 25% for a railroad.
  2. Size of Enterprise. The volume of business should be very large, or in the case of municipalities, the population should be of a significant number.
  3. Debt/Market Cap Ratio. A low ratio indicates that senior issues will have substantial cushion from future adverse developments since the large equity base will have to first bear the brunt.
  4. Asset Value. While this number in relation to the total debt is generally not nearly as important as a company’s earnings power, it is the chief protection for bonds of public utilities, real estate businesses, and investment companies.
• Rules for common stock selection for the defensive investor:
  1. The portfolio should be diversified with a minimum of 10 issues, but not more than 30.
  2. “Each company selected should be large, prominent, and conservatively financed”. A company is conservatively financed if its net current assets exceeds its total debt. Also, current assets should be twice the current liabilities.
  3. Each company should have a uninterrupted dividend payment record of at least 20 years.
  4. The purchase price of the share should not exceed 25 times average earnings, and not more than 20 times the earnings over the past 12 months.
  5. The issue should not cost more than one-third over its tangible asset value. A small premium over book value can be viewed as the price for marketability of the security.
  6. There should be some earnings for each of the past 10 years.
  7. A minimum increase of at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end.
  8. Current price should not be more than 15 times average earnings of the past three years. Also the earnings/price ratio should be at least as high as the yield currently obtainable on a high-grade bond.

Portfolio Policy for the Aggressive Investor

• The enterprising (or active, or aggressive) investor is more willing to devote time to the selection of sound securities which could deliver a better than average return.
• An enterprising investor should also divide his portfolio between high-grade bonds and high-grade stocks. He could purchase other types of securities if their is well-reasoned justification for the purchase. He should avoid purchasing preferred stocks and low-grade bonds (unless they can be bought for at least 30% under par for high-coupon issues and much less for the lower coupons). Also, he should avoid new issues, foreign government bonds, and common stocks with excellent earnings confined to the recent past.
• It is dangerous to purchase a security with a greater yield and, a correspondingly greater risk attached to it, than is obtainable in a high-grade issue. If more risk is assumed then there should be a higher likelihood of gain in principal value. Hence, a low-coupon issue selling at par has more downside risk than if it were priced well-below par.
• Second-grade bonds and preferred stocks can suffer a severe declines in value during bear markets, but can significantly appreciate during bull markets.
• Four activities that enterprising investors tend to engage in are:
  1. Buying in low markets and selling in high markets. This is an extremely difficult practice and can lead to speculation. Investors can limit this through the flexible 25% to 75% weighting that can be given to stocks.
  2. Buying carefully chosen growth stocks. There are two problems with this approach. Growth stocks sell at a premium to account for its future growth prospects. So even if the company were to satisfy the market’s future expectations the share price may still not rise. Another problem is that one could be wrong and the company may not achieve the expected growth targets. After all, no company can out pace the growth of the economy forever. There are many investment growth funds, but very few of them have consistently earned a rate of return above the market indexes. Therefore, it is unreasonable to expect most individual investors to beat the indexes, where most professionals have failed.
  3. Buying bargain issues of various types.
  4. Buying into special situations.
• To obtain better than average results over a long period requires an approach that is (1) able to pass objective and rational tests of underlying soundness, and (2) different from what is undertaken by most investors and speculators.
• Rules for common stock selection for the aggressive investor:
  1. Financial Condition: (a) current assets at least 1.5 times current liabilities, and (b) debt not more than 110% of net current assets (for industrial companies)
  2. Earnings stability: No deficit in the last five years.
  3. Dividend record: Some current dividend.
  4. Earnings growth: Last year’s earnings more than than those of five years ago.
  5. Price: less than 120% of net tangible assets.

Regarding gold, Graham urges investors to disregard it as an investment due to its historically disappointing performance:

The standard policy of people all over the world who mistrust their currency has been to buy and hold gold. This has been against the law for American citizens since 1935 — luckily for them. In the past 35 years the price of gold in the open market has advanced from $35 per ounce to $48 in early 1972 — a rise of only 35%. But during all this time the holder of gold has received no income return on his capital, and instead has incurred some annual expense for storage. Obviously, he would have done much better with his money at interest in a savings bank, in spite of the rise in the general price level.

As a gold bug, I of course, strongly disagree with his view. Although gold only increased 35% in the 35 years prior to 1972, it has performed much better since then. In fact, in the 35 years since 1972 gold has returned 8% per year matching the 7.7% gain in the Dow Jones Industrial Average (ignoring dividends).

When screening for stocks using Graham’s criteria in today’s market one will find it difficult to find anything (aside from some troubled homebuilders and financial companies) that satisfies each condition. Perhaps this is a reflection of the dangerous overvaluation US stocks are currently enjoying.

The ideas put forth by The Intelligent Investor seem to be forgotten by today’s investors who are more concerned about the return on their capital rather than the return of their capital. Unfortunately, the next painful bear market should serve to bring Graham’s classic to prominence once again.