Friday, February 22, 2008

Book Review: The Intelligent Investor

Synopsis: This book is a true investment classic. It relates in simple, plain English the key concepts behind investing. Graham artfully distinguishes between investing and speculating (the presence of a “margin of safety” against loss) and explains the essence of “intrinsic value” and shares his famous depiction of “Mr Market”. While not a “reference” book or a textbook (for that, one needs to read his other seminal work, Security Analysis, written with David Dodd in 1934), it is a book to which one can return many times, as there are always new nuggets and perspective to consider. This book is simply a must read for anyone who intends to make money investing.

My take on Graham is that he believes that investing is about knowing what one is looking for: this, I think is the true sense of “businesslike investing”. Different investors, facing different circumstances with different strengths and weaknesses must think about how they want to approach the market. The key is to understand clearly what one is looking for and then seek to exploit the opportunities the market offers, when it offers them. This is very much like a firm must approach the market for its goods and services. The firm must be selective and targeted. So must the investor. Picking a good target is important, but then the investor must train his ability to see and to be patient if that which he seeks is not readily available. What many (un)intelligent investors choose to do is change their strategy to fit the market, making them slaves to Mr Market and his whims.

Full version: When Warren Buffett was 19 he read a book published by Columbia University professor and money-manager Benjamin Graham. Buffett was so impressed, he decided to attend business school at Columbia and subsequently to work for Professor Graham at his hedge fund, the Graham-Newman Company. Buffett, of course, was no ordinary student. In fact, Graham later remarked that Buffett was the best student he ever had. Certainly, he is the most successful. The book is titled “The Intelligent Investor” and it has recently been republished with commentary by Jason Zweig and an introduction by none other than Graham’s famous student.

Graham’s views of investing were heavily informed by his experience in the Great Depression. Graham had been a successful speculator in the late 1920’s boom, before losing his entire fortune. That experience was an eye-opener, though. He came to realize that his purchase decisions had been driven by entirely the wrong set of measures. He resolved to revise his principles and make investing based only on the “fundamental” value of a business. This was a fortuitous decision for two reasons: a major change in the information available to investors in securities and an extremely inexpensive market. Just at the time that he resolved to make decisions based on the financial condition of a company, the US government was passing landmark securities legislation, the Securities Act of 1933 and Securities Exchange Act of 1934. These two laws dramatically increased the amount and quality of information that public companies were forced to share with outsiders and investors. At the same time, stocks were trading at multi-decade lows. Many stocks were not only trading at significant discounts to book value but were actually trading below liquidation value.

Graham seized this opportunity to begin purchasing stocks at bargain basement prices. Together with his textbook, which was the first systematic approach to using the newly standardized financial statements required by the SEC, his professorship at Columbia and his success as an investor led to the creation of his hedge fund.

By the early 1950s Graham was again a wealthy man and was something of a legend. He decided to write a book that would encapsulate his investing philosophy. Graham’s philosophy is often distilled into two basic concepts: Margin of Safety and the irrationality of the Market in short term price decisions. In spite of the efficient market hypothesis and its heralds (many of whom are professors at my alma mater on the shores of Lake Michigan), the Intelligent Investor takes both of these factors into consideration in order to maximize his returns.

In my opinion, his system can be boiled down to two factors: know your strategy and exploit market conditions to when they are favourable to your strategy (either in the purchasing or selling). This would be good enough advice (it is often not followed), but he broke down the elements of these two investing rules into more practical factors

  • Know what you are looking for. “Value” does not inhere exclusively in an investment. Aninvestment’s value is also based on the objectives and skills of the investor
  • ·Leave room for error. Investing is too uncertain to haggle over small differentials. The amount of time some firms spend determining (and arguing) about small changes in discount rates never fails to amaze me. Technical wizardry often trumps common sense, with disastrous results (think LTCM). Better to be approximately correct than precisely wrong, as Buffett says.
  • Use market error in your favour. If you know what you are looking for, and you can distinguish value from irrational swings, you can have the confidence necessary to make significant capital allocation (or significant reduction of capital allocation) and achieve fantastic returns.

In short, this is one of my favourite books on the topic. It is readable, enjoyable, sensible and practical, which is more than one has a right to expect from most books on finance. It is available for $9.99 from Amazon.

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