The Intelligent Investor: Book Notes

I. Summary

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“The Intelligent Investor” is a seminal work in the field of investment, authored by Benjamin Graham, widely regarded as the “father of value investing”. The book aims to provide guidance on investment strategies for the layman, with the following core ideas:

• Rational Investment: Investment decisions should be based on thorough analysis of a security’s value, not on market sentiment or speculative behavior.
• Margin of Safety: The core of investing is the margin of safety, which means buying securities at a price significantly below their intrinsic value, thus reducing risk and enhancing potential returns.
• Defensive and Enterprising Investors: Based on risk tolerance and investment objectives, investors are classified as either defensive or enterprising, each employing different investment strategies.
• Investors and the Market: Investors should view market fluctuations rationally, seeing them as opportunities rather than sources of risk.
• Company Owner Mentality: Investors should adopt the mindset of a company owner, paying attention to corporate management and governance and safeguarding their own interests.

II. Chapter Summaries

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Chapter 1: What Intelligent Investors Get

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This chapter introduces fundamental concepts of investing, including:

• Investing vs. Speculation: Investing is an operation based on analysis, aiming for safety of principal and a satisfactory return; speculation is hoping for profit from market fluctuations and carries higher risk.
• Defensive Investors: Seeking safety and steady returns, they can adopt a simple portfolio strategy, allocating funds between high-grade bonds and a diversified selection of leading common stocks.
• Enterprising Investors: Willing to take on more risk for greater returns, they can employ more aggressive strategies, such as selecting growth stocks and seeking undervalued securities.

Chapter 2: The Investor and Market Fluctuations

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This chapter explores how investors should view market fluctuations:

• Price Fluctuations as a Measure of Investment Success: In the long run, investment success depends on the long-term returns of the portfolio, not short-term price movements.
• Market Fluctuations as a Guide for Investment Decisions: Investors can capitalize on market volatility to create opportunities for buying low and selling high, but should avoid excessive focus on short-term market trends.
• Market Fluctuations of Individual Stocks: Focusing on undervalued individual stocks is more meaningful than attempting to predict overall market movements.

Chapter 3: A Review of the 1964 Market

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This chapter analyzes the stock market conditions at the time of writing (1964):

• Comparison with Previous Years: The stock market was at a historical high, rendering traditional valuation methods no longer applicable.
• New Standards for a “New Era”: New valuation methods had not yet been tested by time, and the market was characterized by a high degree of uncertainty.
• Investment Strategy Recommendation: Adopt a cautious investment strategy and avoid excessive risk-taking.

Chapter 4: The Investor and His Advisers

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This chapter discusses the relationship between investors and their advisors:

• Sources of Investment Advice: Investors can obtain investment guidance from various avenues, including family and friends, banks, brokerage firms, and professional investment advisors.
• Selecting Investment Advisors: Choosing the right advisor is crucial, requiring careful assessment of their expertise, experience, and ethical standards.
• Independent Thinking: Even when seeking professional advice, investors should maintain their own independent judgment and be responsible for their investment decisions.

Chapter 5: The Defensive Investor’s Portfolio Policy

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This chapter details the strategies for defensive investors:

• Bond and Stock Allocation: Allocate funds between high-grade bonds and a diversified selection of leading common stocks. The ratio can be adjusted based on market conditions, but generally maintain a 50:50 split.
• Bond Portfolio Composition: Introduces characteristics of different types of bonds, such as US Savings Bonds, state and municipal bonds, and corporate bonds.
• Principles for Common Stock Selection: Choose large, prominent, and conservatively financed companies with a long history of dividend payments, and purchase them at reasonable price-earnings ratios.

Chapter 6: Portfolio Policy for the Enterprising Investor: Negative Approach

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This chapter presents a “negative list” of what enterprising investors should avoid:

• Second-Grade Bonds and Preferred Stocks: Avoid buying securities lacking sufficient safety merely for the allure of high yields.
• Foreign Government Bonds: Higher risk and difficulty in enforcing claims in case of default.
• New Issues: Require careful evaluation and avoidance of excessive hype surrounding them.
• Convertible Issues: Their advantages often come at the expense of quality or income, and they present investors with decision-making dilemmas.
• New-Issue Mania: During bull markets, many smaller companies go public, and their stock pricing is often unattractive or even excessive. Investors should be wary of the hype surrounding new issues and avoid blindly following the crowd.

Chapter 7: Portfolio Policy for the Enterprising Investor: The Positive Side

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This chapter discusses positive strategies enterprising investors can employ:

• Market Timing Limitations: While the strategy of buying low in depressed markets and selling high in booming markets could be profitable in the past, recent market dynamics have made this approach less viable.
• Considerations for Growth Stocks: Selecting growth stocks requires diligent assessment of future growth potential, avoiding overpaying for lofty expectations.
• Three Recommended Areas for Enterprising Investment:
  1. Investing in Large Companies during Unpopular Periods: When large companies are experiencing unpopular periods, their stock prices may be undervalued, presenting opportunities for investors.
  2. Bargain Issues: Seek securities whose intrinsic value is demonstrably understated and buy them at prices significantly below this value.
  3. Special Situations: Focus on events like mergers, reorganizations, and liquidations where the price fluctuations can offer substantial profit opportunities.
• Broad Application of Investment Rules: Enterprising investors should approach investing as a business endeavor, adhering to sound business principles, such as knowing their investment domain, choosing partners carefully, and managing risk.

Chapter 8: Security Analysis for the Lay Investor: General Approach

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This chapter introduces basic methods of security analysis for non-professional investors:

• Bond Analysis:
  • Focus on the ratio of earnings to interest expenses, ensuring it meets certain standards (4x for utilities, 5x for railroads, 7x for industrials).
  • Consider factors like company size, equity ratio, and asset value.
  • Understand the risk characteristics of different bond types, like the relatively higher risk of railroad bonds compared to the safer utility company bonds.
• Common Stock Analysis:
  • Analyze company profitability, including projected future earnings, sales margins, and return on net worth.
  • Assess capitalization rates, considering factors like long-term prospects, management quality, financial condition, and dividend record.
  • Pay attention to the impact of non-recurring gains and losses, making adjustments to earnings data.
• Industrial Stock Analysis: Focus on industry trends and individual companies’ competitive positions within their respective sectors.

Chapter 9: Stock Selection for the Defensive Investor

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Using Dow Jones Industrial Average stocks as an example, this chapter explains how defensive investors can select securities:

• Choose a Representative Sample: For instance, buy equal amounts of all 30 Dow Jones industrial stocks.
• Exclude Stocks with Excessive Price-Earnings Ratios: Avoid overpaying for speculative growth.
• Select Relatively Unpopular Stocks with Reasonable Valuations: Capitalize on the market’s neglect of certain stocks, finding undervalued investment opportunities.

Chapter 10: Stock Selection for the Enterprising Investor: General Approach

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This chapter introduces methods for enterprising investors to select securities:

• The Valuation Approach: Estimate a company’s future earnings and select a suitable multiplier to determine its intrinsic value.
• Factors Affecting Asset Value: Pay attention to net tangible asset value, especially net current asset value. Add half the excess of net current asset value over earnings power value to the earnings power value for a more comprehensive assessment.
• Growth Stock Valuation: Consider the expected growth rate, but be cautious in assessing its reasonableness. The author provides a simplified formula for growth stock valuation: Value = Current (normal) earnings x (8.5 + 2 x expected annual growth rate).
• First-Grade vs. Second-Grade Common Stocks: Enterprising investors can consider buying second-grade common stocks, but only at bargain prices, namely when their price is less than two-thirds of the indicated intrinsic value.

Chapter 11: Security Analysis for the Lay Investor: Six Illustrative Cases

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This chapter uses six real-world cases to illustrate how to apply security analysis techniques to uncover undervalued investment opportunities:

• Case 1: Northern Pacific Railroad common stock (1947): The company’s stock price was undervalued due to a combination of a low dividend payout and the non-inclusion of certain earnings in its income statement.
• Case 2: Standard Gas and Electric (SP&L) $7 preferred (1947): Analyzed the complex capital structure of SP&L, pointing out the undervaluation of its preferred stock.
• Case 3: American-Hawaiian Steamship (AHS) (1947): The company held substantial cash assets that were not reflected in its market price.
• Case 4: Royal Dutch Petroleum (RDP) (1953): Pointed out that the market value of RDP was undervalued relative to its earnings power.
• Case 5: Hoover Company Class A (1957): The company’s stock was undervalued because the net worth of its British subsidiary was not fully reflected.
• Case 6: Chicago, Terre Haute & Southeastern Railway (TH) bonds (1964): Analyzed the value of TH bonds, indicating their undervaluation compared to comparable bonds.

Chapter 12: Stock Market Fluctuations: The Pattern of Behavior

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This chapter analyzes the patterns of earnings and price fluctuations for different types of stocks:

• Pattern 1: Relatively Stable Earnings, Wide Price Fluctuations: Using S.H. Kress as an example, the chapter demonstrates how even with stable earnings, market prices can fluctuate greatly, primarily driven by market sentiment.
• Pattern 2: Earnings Fluctuate Moderately, Stock Prices Fluctuate Widely: Using General Motors as an example, it illustrates how stock price volatility often exceeds earnings volatility and advises investors to view such fluctuations rationally.
• Pattern 3: Extreme Ups and Downs: Taking examples like Brunswick Corporation and St. Louis Southwestern Railway, the chapter highlights the substantial uncertainties in company development and stock price movements. Investors should be wary of companies experiencing extreme volatility.
• Pattern 4: Growth Stocks: Using examples like 3M and Philip Morris, the chapter shows that even growth stocks face risks, and investors should carefully evaluate their growth potential and avoid overpaying for lofty expectations.

Chapter 13: A Comparison of Eight Pairs of Companies

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This chapter uses comparative analysis of various stock portfolios to further investigate factors impacting stock prices:

• Four Groups of Randomly Selected Cases and the Dow Jones Industrial Average: By contrasting the performance of stocks in different market standings and comparing their initial trading dates, the chapter suggests that choosing large, strong companies often yields more consistent results. New stocks of smaller companies carry higher risk.
• Secular Changes in the Quality of a Company Group: Taking railroad stocks as an example, the chapter highlights how the standing and investment merit of companies within a group can shift significantly over time.
• The Results of a Policy of Quality Improvement: Using the Dow Jones Industrial Average as an example, the chapter illustrates that merely replacing underperforming components with more popular ones does not necessarily lead to sustained investment gains. Stock selection should be based on a combination of company quality and price.

Chapter 14: Stockholders and Management

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This chapter explores the relationship between stockholders and company management:

• Management Efficiency:
  • How to assess Management efficiency: By comparing key indicators like profitability, sales margin, and return on net worth to industry averages.
  • How to improve inefficient management: Stockholders can take actions like raising questions at shareholder meetings, hiring independent management consultants for assessment, and electing more independent board members.
• The Board of Directors:
  • Role in Corporate Governance: The board represents shareholder interests, oversees management, sets company strategy, and reviews and approves significant decisions.
  • Stockholder Oversight of the Board: Stockholders can exercise their influence by electing board members and voting on proposals at shareholder meetings.
• Fair Treatment of the General Stockholder:
  • Management’s responsibility to protect outside stockholder interests: Management should set a fair dividend policy, avoid repurchasing stock at excessively low prices, and prioritize shareholder interests.
• Holding Companies:
  • Disadvantageous position of outside stockholders within holding companies: Holding companies often present conflicts between controlling shareholder interests and those of outside stockholders, leading to potential harm to the latter.
• The Securities and Exchange Commission and Investor Protection:
  • SEC’s functions and limitations: The SEC oversees the securities market and protects investor interests. However, its powers and functions are limited and cannot fully guarantee investor rights.

Chapter 15: “Margin of Safety” as the Central Concept of Investment

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This chapter summarizes the core concept of the book - the Margin of Safety:

• Definition of Margin of Safety: Purchasing securities at a price significantly below their intrinsic value, thereby mitigating risk and enhancing potential returns.
• Application in Different Investment Types: Bonds, common stocks, growth stocks, bargain issues, and other asset classes.
• Margin of Safety and Diversification: Diversification can reduce the overall risk of a portfolio and therefore enhances the margin of safety.
• Distinguishing Investment from Speculation: The margin of safety is a key criterion for differentiating investment operations from speculative ones. Investment operations should be based on a clear and demonstrably justifiable analysis of value, while speculative operations rely more heavily on subjective judgment and market sentiment.
• Generalization of the Investment Concept: The idea of margin of safety can be applied to broader investment domains, such as when purchasing real estate, art, or other assets.

III. Key Quotes

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“In Wall Street, if you’re always doing what’s obvious or what everyone else is doing, you’re not going to make money.”

Analysis: This emphasizes that to achieve above-average returns, investors require independent thinking and must seek value that is overlooked by the market.

“For rational investment, mental attitude is more important than technique.”

Analysis: Investment success necessitates not just skills and tools, but also the right investment philosophy and mindset, including rationality, patience, and discipline.

“Don’t buy after a stock has surged and don’t sell after it has plummeted.”

Analysis: Avoid chasing rising prices and panicking during market dips. Focus on rational valuation and don’t be swayed by market emotions.

“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.”

Analysis: Investment requires independent judgment. Investors need to be confident and courageous in their convictions, even when facing dissenting opinions. Stay true to your well-researched investment principles.

“Many that are first shall be last, and the last shall be first.”

Analysis: The business landscape is dynamic. Company strength and investment merit can shift over time, requiring investors to maintain a dynamic outlook and avoid fixed biases.

“Margin of Safety”

Analysis: This succinct phrase encapsulates the core of Graham’s approach. Investing should be grounded in acquiring assets at a price that provides a buffer against uncertainty and potential errors in judgment.

IV. Guiding Significance

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• Establish a Sound Investment Philosophy: Investing should be based on value analysis, not on speculation.
• Emphasize Margin of Safety: Purchase securities at prices significantly below their intrinsic value to minimize risk and enhance potential returns.
• Choose a Suitable Investment Strategy: Opt for a strategy—defensive or enterprising—that aligns with your risk tolerance and investment objectives.
• View Market Fluctuations Rationally: Don’t be swayed by emotional reactions to market volatility. Instead, view such fluctuations as potential opportunities.
• Continuously Learn and Improve Investment Knowledge: Investing requires ongoing study and practice.
• Maintain Patience and Discipline: Investment success often requires a long-term perspective, avoiding impulsive reactions to market movements.