A chapter-by-chapter synopsis of Benjamin Graham's original edition of The Intelligent Investor, which according to Warren Buffett is "the best book about investing ever written".
Preface to the Fourth Edition, by Warren E. Buffett
The preface is only two pages long, and is well worth reading in full.
Buffett explains why Graham's book is essential reading, and why Graham's framework is so powerful. He specifically recommends chapters 8 and 20. He also includes his remembrance of Graham from the time of Graham's passing.
The preface is simply too short and full of valuable information to summarize here without copying verbatim.
Introduction: What This Book Expects to Accomplish
Here, Graham sets the stage for the content he will be presenting in the rest of the book. He talk about speculation, dollar cost averaging, the importance of quantifying, and how successful investment is as psychological as it is analytical and mathematical.
It is here that Graham gives his famous analogy to buying groceries, first mentions the possibility of simply buying into an index, and the general lackluster performance of investment funds.
The introduction too is probably best read in full, as summarizing it here would be an attempt to write a summary of a summary.
Chapter 1. Investment versus Speculation: Results to Be Expected by the Intelligent Investor
Graham gives examples of what constitutes speculation and investment in the stock market. He also gives the results and recommendations for defensive and enterprising investors during the time, the recommended distribution across stocks and bonds etc.
The three main areas of activity for enterprising investors — trading, short term selectivity and long term selectivity — are also discussed. Special situations, the CAPE ratio and bargain issues are also touched upon for the first time.
All of Graham's investment analyses include taxation as an integral part of the final performance calculation, as it should be.
Chapter 2. The Investor and Inflation
Again, Graham uses very specific historical numbers and data to discuss rates of inflation and their effect on investment performance, the relative merits of investing in stocks vs bonds when keeping inflation in mind, and so on.
After questioning the wisdom of investing in alternative commodities and items of rarity which provide little income and intrinsic value, Graham reiterates his original policy of having one's investment distributed across both equity and debt regardless of market conditions.
Chapter 3. A Century of Stock-Market History: The Level of Stock Prices in Early 1972
This chapter is almost completely historical. Graham compares stock prices, earnings and dividends for the preceding 100 years using ten year averages.
He then discusses recommendations he made in previous editions in the book, to how things actually panned out afterwards.
He concludes with the same recommendations that he made in the previous 1964 edition; that is to not increase stock holdings in one's portfolio, and to reduce them if required to bring proportions back to 50%.
Chapter 4. General Portfolio Policy: The Defensive Investor
Graham first alludes to his central maxim of how returns are not proportional to risk.
Graham then discusses allocation in stocks vs bonds.
The remainder of the chapter is dedicated to the bond component and similar instruments such as savings deposits, preferred stocks and income bonds.
Chapter 5. The Defensive Investor and Common Stocks
Graham reiterates the need for a common stock holding in the investor's portfolio during all market conditions. He then lays out a rudimentary set of rules that the defensive investor will need to follow in selecting common stocks. Graham then discusses growth stocks and why he thinks they are unsuitable for Defensive investors.
In this chapter, Graham addresses the need for the defensive investors to revisit their portfolios once a year; while explaining that well selected portfolios will not need frequent changes.
The practical utility of dollar cost averaging is addressed. Various types of investors and their specific situations are discussed. The subtle yet important difference between risk and volatility is also explained here.
Chapter 6. Portfolio Policy for the Enterprising Investor: Negative Approach
Graham starts this chapter with various generalizations for Enterprising Investors, specifically on what to avoid. The first part of the chapter focuses on bonds and preferred stock.
The latter part of the chapter focuses on new issues or Initial Public Offerings (IPOs), with various examples to illustrate the need for the caution advised.
Chapter 7. Portfolio Policy for the Enterprising Investor: The Positive Side
The chapter first discusses various strategies that an enterprising investor may employ, formula plans and growth stocks. The pitfalls of typical methods of investing in growth stocks are explained with historical data.
Graham then suggests three fields of activity for the enterprising investor — the large unpopular company, bargain issues and Special Situations — and concludes with the implications of his various suggested strategies.
The chapter also discusses some of the tactical aspects of value investing, as well as Cyclical Stocks.
Chapter 8. The Investor and Market Fluctuations
The first of the two most chapters most highly recommended by Buffett (the second being chapter 20), this chapter introduces the subject of Timing vs Pricing.
Graham again mentions the CAPE (Cyclically Adjusted P/E) Ratio, and the necessity of being passive but alert about one's investments.
It's also in this chapter that Graham introduces the famous parable of a Mr. Market who comes to the investor every day with a different price, to be heeded or ignored.
This chapter too then discusses some of the tactical aspects of value investing.
Graham finally discusses fluctuations in prices of bonds, how they're even harder to predict than those of stocks, and finally makes suggestions for a bond structure with flexible payments that would suit both borrower and lender better.
Chapter 9. Investing in Investment Funds
Graham broadly explains the various types of funds in existence, with some of the specific characteristics of each type.
Graham then gets into the more complex part of discussing the choices before the investor and how they could affect him. He first starts with discussing the performance of funds as a whole, and then specifically with that of performance funds.
Graham also elaborates on the new types of manipulations taking place in the markets after those of the last generation were made illegal.
In the next next section on open vs closed end funds, Graham makes one of his first actual recommendations for investors in funds; to buy closed-end funds at a discount.
The last section discusses balanced funds and ends with a recommendation to buy bonds directly instead.
Chapter 10. The Investor and His Advisers
Graham first explains why the concept of investment advice is in itself somewhat paradoxical. He describes work of the various types of advisors — Investment Counsels, Trust Services, Financial Services, Brokerage Houses, Investment Bankers and other advisers — and what the investor must expect from (and the contradictions inherent in) each of them.
Graham also explains the differences between account executives and financial analysts, and how the investor is to deal with each; as well as with the brokerage houses themselves when considering their own shortcomings.
After a sage warning of "Much bad advice is given free", Graham closes with some general advice for investors to restrict their dealings to members of the NYSE and to have their security deliveries handled by their banks.
Chapter 11. Security Analysis for the Lay Investor: General Approach
Graham begins by differentiating between the fields and practitioners of security analysis and financial analysis, including rather interesting statements such as "mathematical techniques of a rather sophisticated sort have perforce been invoked".
The chapter first addresses tests of safety for corporate bonds and preferred stocks.
Graham then moves on to the more detailed topic of security analyses of stocks, and the factors involved in calculating the required capitalization rates; such as Long-Term Prospects, Management, Capital Structure, Dividend Record and Dividend Rate.
He also explains how individual forecasts of companies and industries are rarely reliable, with extensive use of data.
This is also the chapter in which the controversial Benjamin Graham Formula is described, along with its intended insights and warnings.
Graham then discusses the subject of industry analysis, ending with an enigmatic — and possibly uncharacteristic — note on finding a balance between the conservative and imaginative approaches.
The chapter ends with a practical strategy for achieving the above; and the reasons for and the advantages of the same.
Chapter 12. Things to Consider About Per-Share Earnings
Graham begins by advising the investor not to pay too much attention to short-term earnings figures. He then explains four types of manipulation that can be done to a single year's earnings figures, using ALCOA and other companies as examples.
The chapter ends with a suggestion to use the average of the annual figures over periods of three years when evaluating a stock's intrinsic worth or its past earning growth, and reiterating the less than average reliability of security analysis of industrial companies in general.
Chapter 13. A Comparison of Four Listed Companies
Graham gives an example of security analysis using four consecutively listed companies picked at random from the NYSE. He then evaluates the four firms against six performance metrics - Profitability, Stability, Growth, Financial Position, Dividends and Price History.
Finally, Graham explains why the average investor would prefer two of the four firms and why he would recommend the other two to the conservative investor instead. Graham also introduces his seven statistical requirements for defensive investment for the first time, and explains how the investor should focus on his portfolio as a whole and not on individual issues.
He concludes by explaining how such individual choices are hard to explain based on commonly accepted principles of investment, and depend a lot on the investor having a conservative attitude.
Chapter 14. Stock Selection for the Defensive Investor
This is the chapter where Graham first describes the strategy that would go on to become the now common concept of Index funds. Graham also describes in further detail the seven criteria for defensive investment from the previous chapter, the last two of which would go on to become the now famous Graham Number.
Graham remarks on how the criteria work better in aggregate over a portfolio, since not many individual stocks would meet them all. He also mentions that public utilities are more likely to clear the defensive criteria, and that even even defensive portfolios need to be churned occasionally; ending on a tongue-in-cheek note on rather paying taxes than losing gains. Recommendations on financial enterprises and railroads are then discussed.
Graham ends the chapter with the pitfalls of selectivity, especially the differences in attitudes between prediction and protection; which in turn become a choice between the qualitative and quantitative approaches.
Chapter 15. Stock Selection for the Enterprising Investor
The chapter opens by stating that the task for the Enterprising investor is one of individual selection, unlike that for the Defensive investor which is one of individual exclusion. But then Graham describes how the attempt for superior performance has proven statistically to be elusive.
Graham then suggests two possible reasons why superior performance has been so rare: market efficiency and professional bias. He then remarks that the latter has proven to be the primary cause in his experience, and that there are ways around it for his readers.
He gives a summary of the various operations of the Graham-Newman Corporation during its 30 years of existence — Arbitrages, Liquidations, Related Hedges, Net-Current-Asset Issues etc — as well the operations that are now irrelevant or were discontinued.
Some of the operations Graham recommends for his readers are undervalued cyclical enterprises and secondary issues. He remarks on the usefulness of the S&P stock guide for finding such stocks; lamenting on the missing asset value information in it, but also elaborating on all its extraordinarily useful features.
Graham then explains his selectivity and diversification criteria for Enterprising investors in great detail. He describes his most popular strategy — Net-Current-Asset Issues — and gives a comparison of various other such single criteria strategies; including the positive effects of S&P rankings, and of the momentum of individual issues. He then devotes an entire section to Net-Current-Asset Issues.
The last part of this rather long chapter is dedicated to special situations, which Graham classifies specifically as a business. Graham gives three detailed examples, using them to explain why such operations would not be suitable for the average Enterprising investor.
Chapter 16. Convertible Issues and Warrants
Graham starts by calling warrants a "fabrication".
He also points out that convertible issues themselves are like any other security, their attractiveness depends on the factors pertaining to the individual issue; and that a lot of them are issued during bull markets when their convertibility may not prove to be of much use, and in a lot of cases, the convertibility was used to compensate for the lack of genuine investment worthiness.
Graham then illustrates the various conundrums of owning and dealing with convertible issues using examples, and explains the reasoning behind the Wall Street maxim of "never convert a convertible bond". The chapter includes various historical examples and explanations of how the common stock fared against the preferred.
Again, Graham starts the section on Warrants by calling them a fraud in no uncertain terms; and explains the various problems associated with their issue for investors. But he ends the chapter on a more forgiving note saying that they may have their uses in moderation with bonds, and are only a problem when they become large in size relative to the common stock.
Chapter 17. Four Extremely Instructive Case Histories
Graham uses four examples to illustrate the kind of extremes that prevail in financial markets to everyone who may be involved directly or indirectly in them.
The examples used are Penn Central (Railroad) Co for neglect and overvaluation, Ling-Temco-Vought Inc for empire building and bank lending, NVF Corp for corporate acquisition, and AAA Enterprises for franchising.
Graham uses Penn Central to admonish any security analysts involved; especially on how the company was invested into despite failing all conservative measures, including Graham's own documented ones, by a considerable margin.
Ling-Temco-Vought Inc is used to show the perils of unsustainable expansion financed by debt. Graham includes notes on the accounting tricks and extremes of valuation that prevailed in the case, the losses from which eventually wiped out all equity and asset values. The section ends with a question on how the firm was able to secure such loans from commercial banks in the first place.
The NVF Takeover of Sharon Steel is used as an example of a company taking over a much larger one, using debt to finance the acquisition. The various accounting gimmicks used in this case are discussed in detail, particularly the excesses involving warrants, and the dismal end of the saga at the end of 1970 with the stock listed on the S&P guide as selling at a PE ratio of 2.
AAA Enterprises, a company selling mobile homes, is finally used as an example of "hot issues" sold by underwriting firms to their gullible clients. Graham then uses the subsequent rise of the stock, its relatively slow devaluation when compared to its operating conditions, and its eventual near demise, to remark on the mindlessness and vagaries that prevail in the stock market.
Graham ends with several remarks on the speculative excesses that prevail in the market and what role, if any, regulation may play in mitigating them.
Chapter 18. A Comparison of Eight Pairs of Companies
Graham compares eight pairs of consecutively listed to illustrate some of the peculiarities of financial markets.
The first is a pair or real estate companies — Real Estate Investment Trust and Realty Equities Corp. The former is an example of a conservatively run enterprise and the later, that of the usual irresponsible NY based growth stock. The story ends with the former following the tough but safe path through the difficult times of the late 60s, while the later is wiped out as expected.
The second pair — Air Products and Chemicals and Air Reduction Co — is again shown as an example of where a newer company is given preference by the market over a more established and profitable one. Again, the comparison ends with the lower multiplier stock showing better long term results.
The third pair — American Home Products Co and American Hospital Supply Co — is a slightly more balanced comparison. The former, which showed better historical profitability despite a lower book value, eventually outperforms the latter.
Graham then uses H & R Block Inc and Blue Bell Inc as a comparison of a highly overvalued company against a very undervalued one. Even though the latter eventually outperforms the former, the former is used as an example of how difficult it is to successfully short-sell an overvalued company.
International Flavors & Fragrances and International Harvester Co is a slightly different comparison, where a newer and smaller company was actually being run better but was also valued much higher. Graham uses this as an example where neither is a good investment despite one being a good performer and the other being sold at a discount.
McGraw Edison and McGraw-Hill Inc is another typical example of when a good company is undervalued when compared to a similar one with a better story. The latter eventually goes through a correction as expected, while the former performs well.
National General Corp and National Presto Industries is again an example of a complex and aggressively run conglomerate, compared against a conservatively run concern with a few diverse operations. The former eventually loses almost three quarters of its market value, while the latter improves its performance while still remaining substantially undervalued.
The last pair — Whiting Corp and Willcox & Gibbs — is a comparison of a small conservatively run enterprise, against an aggressively run conglomerate of similar size. Again, the heavily overvalued concern gives a bad showing accompanied by a market correction, while the better run firm continues to perform and grow while being undervalued.
Graham then explains his choices for comparisons and the clear lessons that can be learnt from some of them; specifically those of clear undervaluation and overvaluation. He ends the chapter advising the analyst to look for undervaluations rather than high performers.
Chapter 19. Shareholders and Managements: Dividend Policy
Graham begins the chapter by exhorting investors to take a more active role in policing their company managements. He then explains that this duty of shareholders has been involuntarily delegated, to a certain extent, due to the proliferation of take over bids of poorly run enterprises. However, Graham beseeches investors to pay more attention to any activism by their fellow shareholders nevertheless.
The next section of the chapter deals with how the market has changed its attitude towards dividend payout ratios. The section also explains the prevailing paradoxical dividend expectations from high growth versus low growth companies. Graham points out that earnings should only be retained when a company has clearly demonstrated growth resulting from such retention in the past.
Graham then explains the symbolic and accounting differences between stock dividends and splits, as well as the psychological and taxation benefits of the former. The chapter closes with a suggestion for public utilities to modernize by migrating to such a tax-friendly dividend policy.
Chapter 20. “Margin of Safety” as the Central Concept of Investment
This is perhaps the most important chapter of the book, and one of the two chapters — along with chapter 8 — specifically recommended by Buffett in his preface.
Graham starts by explaining the central concept of investment, in the straightforward way that it applies to fixed value investments; in terms of market value over debt, enterprise value over debt, and earning over interest charges.
He then discusses how the margin of safety applies differently to stocks under depressed and normal conditions; very similar to that of bonds under the former, and by way of higher earnings power — both distributed and retained — under the latter.
Graham discusses the poorer choice of stocks available to the investor at the time — 1972 — and also the various types of investments that carry a higher than average risk, such as reasonably priced fair-weather stocks rather than obviously overvalued ones.
The higher difficulty in maintaining a margin of safety with growth stocks is covered next; with Graham first uncharacteristically accepting conservative estimates of future earnings as possibly being as reliable as records of the past, but then dismissing the stock prices themselves as not conservative enough. The last part of the section addresses how undervalued securities are the most suitable to be invested in within such a margin.
The correlation between diversification and the margin of safety is explained using roulette as an example. The margin of safety is now presented as the defining factor in differentiating between investment and speculation, requiring objective statistical proof.
Graham then provides various examples of conventional and unconventional investments, including an allusion to buying secondary issues under two-thirds of their indicated value that is uncharacteristically not included in the stock selection chapters.
He then gives another unconventional view of how many opportunities perceived as speculative because of poor quality, can actually be investment opportunities because of low prices; many of which are simply fair-weather securities favorites that have since taken a beating. Graham even gives a "shocker" of a special situation where stock option warrants may be used as an investment.
The last section sums up by saying that investment is a business and needs to be treated as one, without expectations in excess of interest and dividend incomes. The second principle addresses the rare conditions under which one may entrust the management of one's investments to someone else. A third principle cautions the investor against entering into enterprises where the potential for loss is high, and to remain within the territory of conservative returns. The fourth rule is more positive and advises courage, if knowledge and judgment have been applied in an investment operation.
The chapter ends on an reassuring note for defensive investors, while again cautioning those in pursuit of superior returns.
Postscript
The postscript uses Graham's own experience with GEICO — but anonymously — as an example of how one investment can sometimes outperform all others in a short period of time. But again, Graham advises his readers that such opportunities usually only come to those with the requisite knowledge, experience and discipline. The book ends on a somewhat humorous note that while profits may be restricted to the intelligent and enterprising investor, excitement in the field is guaranteed to everyone.
Note: While Graham's investment principles are timeless, it may be helpful to remember that The Intelligent Investor is a textbook and reference guide; and does not need to be read cover to cover.