The Four Investing Secrets Of Benjamin Graham’s The Intelligent Investor

Although I strongly encourage any of you to read Benjamin Graham’s classic “The Intelligent Investor” if you have not done so already, I do know that “life happens” and it’s a lot easier to find fifteen minutes to read an article than it is to hunker down and read a dry, detailed text for 4-5 hours straight. So for those of you don’t have the time to read The Intelligent Investor or simply want to get a summary to help you determine whether the book is worth reading, I’ll try and share with you the four general principles that I took away from reading the book.

(1)    Price Matters. A lot.

(2)    Stock Represents An Ownership Interest In A Real Business.

(3)    The Prices Of The Stock, However, Fluctuate Between Irrational Lows and Equally Irrational Highs.

(4)    You need a “Margin of Safety” in the form of price to guarantee satisfactory long-term results, even if your initial predictions prove too optimistic.

In a nutshell, that is what Benjamin Graham’s teachings are about. As we sit here in 2013, I think it is quite easy to overlook and forget a lot of those basic principles.

First of all, technology advances in how we trade stock make it easy to disregard the underlying businesses represented by the stock. When we just see squiggly ticker symbols on a screen, it can be easy to forget about the real business and profits they represent. Some people will look at a stock like Amazon and say, “It was $242 per share this time last year. Now it is over $399. Maybe I should buy it because it keeps going up.”

Someone following Benjamin Graham’s principles will say, “Wait a minute. Tell me about the underlying business. Why is the share price going up 50-75% in a year? Did profits grow that much? Did the future earnings growth projections grow that much? Let’s talk about the business side of the equation.” Then, that person will look to see that Amazon is generating $0.80 per share in current profits and see that the company is trading at a rate of $487 for every dollar in profit that the company generates.

That is, frankly, insane. With large-cap companies worth hundreds of billions of dollars, the company can usually trade between 20 and 25x earnings, if the profits are especially high quality or the future prospects especially bright. To justify a share price of $399, even under the most optimistic scenarios, Amazon would need to be posting around $15.96 in current per share profits. But that is nowhere near the case. Until then, an intelligent investor would politely pass, like a 1927 American banker that saw certain banks trading at 8x book value, and decided that is not a game worth playing.

The rest of the lessons from Benjamin Graham are all about price. It is the price you pay that is the fixed determinant for one part of the equation for all the future returns that you achieve. It is getting a good price on a stock that can protect you if the business performance falls short of your expectations. And lastly, Graham includes a reminder that prices will fluctuate between overvaluations and undervaluations, and it is your job as an investor to keep your head cool in both situations.

Hershey makes $3.45 in profits. I could understand why stock market participants value the company at 20x earnings similar to Coca-Cola, believing that both companies enjoy similar balance sheet strengths, brand equity, and future growth prospects. That means I could understand why intelligent investors would pay $69 per share to make their investment. What I do not understand is why an investor would pay $95+ to make an investment right now. Even with excellent companies, it is my job to say, “Thanks, but no thanks, right now.”

With a company like Hershey, your safety comes the further and further the price falls below $69 per share. That’s what puts Benjamin Graham’s theories at odds with some modern-day statisticians: if you make decisions based on a stock’s “beta” or other such factor, then you believe that the more Hershey falls in price, the riskier it is. Graham would conclude the opposite—as long as the earnings power is still intact, the lower the price of the stock, the safer it is. If Hershey stock fell to $40 per share, Graham would consider it quite safe because it would have an earnings yield of 8.62%. That means that Hershey could, theoretically, give their investors an 8.62% annual return in perpetuity by ceasing to use retained earnings to grow and returning all the profits to shareholders (it’s a little more complicated than that because Hershey could theoretically raise the price of existing chocolate bars in excess of inflation, but you get the general concept).

If you get nothing else from Benjamin Graham’s life work, I hope you understand that the more a stock price falls, the safer it becomes. It can be somewhat counterintuitive emotionally. If you see something you hold falling in stock price quickly each day,  it can be fertile ground for freaking out, and CNBC will provide you plenty of fodder. But Graham’s life teachings reach the opposite conclusion.  Graham understood that the future returns you experience are a combination of the current earnings yield mixed to the earnings per share growth rate of the firm (that’s a crude simplification). When prices go down, the earnings yield go up, and the higher the earnings yield, the lower the growth rate necessary to achieve high total returns.