“By far the best book on investing ever written.” – Warren Buffett
After Benjamin Graham published ‘Security Analysis’, a very big, technical and advanced textbook, he decided to write a layman’s version that would be more accessible to average investors. The first edition of ‘The Intelligent Investor’ was published in 1949 (15 years after the first edition of Security Analysis). Warren read it in 1950, at the age of 19, and it changed his life.
The most recent edition available was printed in 2003, uses the text from the fourth edition published in 1973, and includes updated commentary by Jason Zweig, a financial writer and journalist. This makes their commentary about the stock market a bit out of date, but still educational, and the principles taught in the book remain precious and timeless. I’ve owned my copy for about 10 years now, have read it several times, and I learn something new every time.
The first golden nugget that I took from the book, one that really gave me confidence to start learning and investing on my own, was written by Warren on the preface to the fourth edition: “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.” It’s not about intelligence, it’s about temperament.
This book provides the sound intellectual framework. The right temperament is dependant on the individual but is also addressed throughout, with the most important chapters (according to Warren) being ‘Chapter 8 – The Investor and Market Fluctuations’ and ‘Chapter 20 – Margin of Safety as the Central Concept of Investment’.
In Chapter 8 we are introduced to Mr. Market, one of the partners in a private business (and a parable of the general stock market) where one owns a small share that cost $1,000. Every day he tells us what he thinks our share is worth and offers to either buy our share or sell us his at that price. Sometimes this price seems reasonable and justified by business developments; other times Mr. Market lets his enthusiasm or fear get the best of him, and the price he quotes seems ridiculous.
Would you judge the value of your share based on the price he gives you? If you are a prudent investor or a sensible businessman, you will make up your own opinion based on the company’s reports about the business and financial position. When his quote is way out of wack, you will be happy to sell out to him if the price is ridiculously high, and equally happy to buy from him if the price is extremely low.
A real investor is in this position when he owns shares: he can take advantage of the share price fluctuations or do nothing at all, depending on his own judgment. Basically, price fluctuations “provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”
In Chapter 20 we learn the secret of sound investment: margin of safety. A real investor does not sell shares simply because they went up, or buy shares simply because they went down. He does it by considering his own valuation of the company, after researching it thoroughly by reading its financial reports and news, maybe also speaking with clients and suppliers, perhaps attending the annual general meeting, etc. If the shares are selling for much less than their estimated value, we have a margin of safety (aka discount to fair value). Its main function is to make an accurate estimate of future earnings unnecessary and provide a measure of protection in case our assessment is way off.
The bigger the margin of safety, the more protection the investor will have against a major drop in earnings or other unforeseen negative future developments, and the more upside there will be when the market finally realises the fair value of the company. For example, if we buy a company for a third less that what we think it’s worth, there’s a possible 50% upside. If we buy it for a 50% discount, there’s a possible 100% profit once the share price reaches our fair value estimate. By refusing to pay too much for an investment, we minimise the chances of losing money.
Other chapters in ‘The Intelligent Investor’ deal with: Investment versus Speculation, Portfolio Policy, Security Analysis for the Lay Investor, Things to Consider About Per-Share Earnings, Stock Selection for the Enterprising Investor, Four Extremely Instructive Case Histories, A Comparison of Eight Pairs of Companies, and more.
One of the biggest gems of the book is ‘Appendix 1 – The Superinvestors of Graham-and-Doddsville’, an edited transcript of a talk given by Warren at Columbia University in 1984, where he discusses how several of Graham’s disciples used his principles to achieve amazing returns in the stock market. Priceless!
As Warren says: “The most important investment you can make is in yourself.” Do yourself a gigantic favor and buy this book.