PDF Summary:The Intelligent Investor, by Benjamin Graham

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Graham attended Columbia for college and entered Wall Street. Here he obsessed over analyzing stocks and companies in minute detail. He eventually founded his investment firm, the Graham-Newman Partnership, where he employed a young Warren Buffett. Over 20 years, his firm returned 14.7% annually (after fees), compared to 12.2% for the stock market.

In 1956, Graham Graham retired and closed his partnership and continued teaching and writing, sharing his principles of value investing worldwide. He died in 1976, a few years after his last revision of this book.

Graham led the movement of “value investing” and deeply influenced some of the world’s most successful investors, most notably Warren Buffett and Charlie Munger of Berkshire Hathaway.

Shortform Introduction

This book was first published in 1949, but it’s gone through multiple revisions since then. We’re summarizing the latest edition, which was published in 2003. Each of the 20 chapters in the book has two parts: 1) the original by Ben Graham, from his last revision in 1973, and 2) modern commentary by Jason Zweig, a finance columnist for the Wall Street Journal.

In his section, Graham often discusses the...

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Speculators are swayed by popular opinion. They hear optimistic estimates from analysts and buy stock, without questioning the underlying value. They buy when everyone else is buying, and sell when everyone else is selling.

Investors are independent thinkers. They use a dependable system for decision-making.

Speculators have erratic mood swings, and are impatient. Their feelings govern their behavior, and they don’t act by any methodical, reliable system.

Investors control their psychology through ups and downs. They rely on their dependable framework for decision-making and don’t act impulsively.

Speculation Disguised as Investment

In addition to trading based on market movements, Graham cautions against these common methods of speculation that masquerade as investment:

• Trading based on short-term earnings reports: estimating future earnings accurately is already difficult in itself. But studying earnings is so common and competitive, with legions of analysts on Wall Street, that even if you get it right, the stock price probably already reflects those earnings.
• Trading based on long-term growth prospects: here you may have a more...

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• In periods of steady mild inflation, stock returns outperformed inflation.
• In periods of high (above 6%) inflation, stocks performed poorly. This might be because high inflation disrupts the economy—consumers purchase less, and businesses suffer.

Why Do Stocks Resist Inflation?

(Shortform note: This is a technical section we’ve included to be comprehensive; it’s not too relevant for the typical defensive investor.)

One theory of why stocks resist inflation is that during a time of inflation, a business’s costs increase, but it can also increase its prices at the same time, thus preserving its profits. In theory, a business can grow its revenues and profits at the same rate as inflation, and its stock price rises with inflation as well. In other words, a business can pass on the costs of inflation to its customers.

Graham analyzes these claims and finds that they fall short. Looking back on the 20th century, he agrees that stock prices have risen faster than inflation, but not because inflation had a direct effect on company financials. If the theory above were true, then companies would show higher earnings on capital during inflation (because the earnings...

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While the general trend is up and to the right, in the short-term, stocks fluctuate. Look more closely at the chart, and you’ll see more detail:

• A major collapse in 1929, followed by fluctuations up until 1950. The S&P 500 would not reach the heights of 1929 until 25 years later.
• A strong growth period from 1950 to 1965.
• A period of relative flatness from 1965 to 1975.
• Generally strong growth from 1975 to the 2000 dotcom crash, with periodic recessions in between.

As we think about investments today, we don’t have the benefit of future information, and so it becomes important to assess whether the stock market is expensive or cheap.

Shortform Exclusive: Inflation-Adjusted Returns

The book doesn’t address inflation in this chapter, but the inflation-adjusted stock returns have a significantly different shape:

Notably, during the highly inflationary 1970s and early 1980s, the stock market halved in real value, even though the absolute price stayed relatively flat. After adjusting for inflation, the annual return of the S&P 500 decreases from 10%...

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• Stocks fluctuate much more than bonds do, and the wild oscillations of a 100% stock portfolio may test the investor’s equanimity. A terrible mistake you can make as an investor is to sell as the stock market craters, and buy at the peak of its hype. Holding a minimum 25% in bonds gives some psychological cushion against stock market falls.

In short, keeping a standard split is simple, provides adequate returns, and prevents your emotions from sabotaging yourself.

The Myth of Age

There’s a common rule of thumb that your split between stocks and bonds should depend on your age: subtract your age from 100, and that is the percentage that should be held in stocks.

But Graham never mentions age in his advice, for good reason. Zweig supports this point, arguing age shouldn’t affect your investment decisions—your personal circumstances are what matter.

In particular, you can feel more comfortable holding more stocks if:

• You do not need to sell your stocks at inopportune times to support your living costs.
• You can withstand severe drops in the stock market.
• You do not need your investments to provide cash income. Generally, bonds provide more in...

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The task of beating the market is a difficult one, and Graham issues a caution—the evidence strongly suggests that most professional money managers do not beat the overall market in the long term, after deducting fees. These funds employ highly intelligent and motivated people who dedicate their entire working days to researching and choosing individual securities. Yet even they can’t outperform the S&P 500.

Why is it so difficult to beat the market? Graham offers two possible reasons:

Reason 1: The current stock price already has all existing information “priced in,” and from this point stock market movements are essentially unpredictable.

There are countless opportunistic investors and investment firms that behave like an aggressive investor—they study a company’s historical performance and future prospects, try to identify bargains and overpriced stocks, and invest accordingly. When the market is made up of many thousands of such people, the market price for a security already reflects the consensus opinion of the company’s value.

From this point on, any developments that affect stock price are unpredictable. When you try to predict the unpredictable, your...

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• In modern times, WorldCom sold $11.9 billion of bonds in 2001. However, its pretax income fell short of covering its interest charges by $4 billion. It could only pay off its interest by borrowing even more money. While its bonds did offer 8% yields for a few months, WorldCom went bankrupt in 2002.

It may be tempting to buy these lower-grade bonds purely for the sake of a higher yield. But Graham cautions that it’s unwise to seek attractive yield without adequate safety. The companies issuing lower-grade bonds have a higher chance of default and you may actually lose your entire principal, merely for an extra 1-2% of yield.

Therefore, a second-grade bond selling at par value is usually a bad investment. It’s better to buy lower-grade bonds at steep discounts. Because these bonds tend to rise and fall with markets, a patient investor will be able to find good deals.

In his modern commentary, Zweig mentions there are now junk-bond funds that allow more diversification across dozens of different junk bonds. While they do outperform Treasury bonds on paper, they tend to charge high fees.

Foreign Government Bonds

The trouble with owning foreign government bonds is...

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• Compared to the hard work of evaluating a business’s fundamental value, market timing is relatively simple—guess whether the market is too high or too low, and sell accordingly.

Why Doesn’t Market Timing Work?

Simple mathematical formulas to determine whether the market is at a peak or bottom (such as relying on overall price-to-earnings ratios) tend not to work. There are two major reasons why:

• A formula may seem to work when backtesting across past years or decades. However, it may simply have been illusory—a pattern fitting due to random chance, or a strategy that worked in an idiosyncratic period—and provide no predictive power going forward.
• The formula may indeed have worked in history, but if a strategy provides a real advantage in the market and is simple to execute, it will be adopted so quickly and widely that it loses its advantage. (Shortform note: The advantage disappears because if enough people adopt the formula, market prices will adjust in an unfavorable way. For example, a formula may predict when a market’s bottom is and thus when to buy. If enough people buy at that point, prices will rise, meaning the stocks are no longer a...

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In summary, Graham urges the following cautions:

• When you invest in a fund, expect only returns in line with the overall market. Over history, the vast majority of funds do not outperform the broader market (especially after deducting fees). If you delude yourself into thinking you can vastly exceed market returns by choosing the right fund, you’ll seek out risky funds and deceptive marketing.
• Do not choose a fund simply because it has a recent hot streak. Most often, funds with outstanding recent performance are using risky strategies that have performed well recently but will falter in the long term. (We’ll cover why
• Be skeptical of funds that charge high fees. The higher the fees, the more the fund has to outperform the market for you to be in line with the market. For example, if the market returns 5%, then a fund that charges 1% in fees has to return 6% to be in line with the market.
• Be skeptical of funds that have aggressive marketing or salespeople. Salespeople are part of the fund’s operating costs, and thus you’ll be paying for their salaries and commissions with your fees.

Near the end of his life, Graham noted that **index funds...

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Do you actually need an advisor? Graham doesn’t advise much on this, but Zweig suggests that you should seek an advisor in these cases:

• If you habitually underperform the market
• If your personal finance budget is out of control—you can’t pay your bills, and you don’t save any money
• If you experience any major changes or crises, such as leaving steady employment or being unable to plan for college tuition or retirement

Defensive and aggressive investors should look for different things from investors.

• Defensive investors should find advisors who will help them achieve average market returns—no better, and no worse. Typically, advisors help defensive investors by protecting them against themselves and the worst of their own psychology.
• Aggressive investors should find advisors who will be useful sounding boards for their investment ideas. Aggressive investors should examine the advice they receive and form their own conclusions, rather than simply taking opinions on faith.

Beware of these common pitfalls when seeking advisors:

• Don’t rely on advisors to make above-average returns for you without your involvement. Finding advisors who can...

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Another measure of stock value that is more common today is price-to-earnings ratio (P/E ratio), which is the current stock price divided by the company’s current earnings per share. A stock with a higher P/E multiple implies a faster earnings growth rate than a stock with a lower multiple.

In general, Graham suggests a few major factors that affect the capitalization rate:

• Future long-term prospects
• Management
• Financial strength
• Dividend record and rate

Future Long-term Prospects

How well will the company do in the future? Is it growing or shrinking? Will it be a market leader or a minor player?

Graham doesn’t provide more specifics on evaluating this, but in his commentary Zweig adds a few factors:

• Competitive advantage or “moat”: The company has a strong position that will endure over time. These include strong brand loyalty, monopoly status, or economies of scale. (Shortform note: For more on competitive advantage, see our summary of Understanding Michael Porter.)
• Consistent historical growth: The company should have grown revenues and earnings steadily over...

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1. Price-to-earnings ratio: No more than 15 times the average past 3-year earnings
   • Beware of analysts who calculate a “forward P/E ratio” using not historical earnings but “next-year’s earnings.” Predictions are notoriously unreliable, and often the forward P/E ratio is used merely to justify an overpriced stock.
2. Price-to-book value ratio: No more than 150% of book value (also known as net asset value; calculated by subtracting total liabilities from total assets)
   • The last two measures can be combined to form a multiplier no more than 22.5 times. For example, a stock at 10 times earnings can have a price-to-book value ratio of 2.25 or lower.
   • In his commentary, Zweig notes that many companies today have a greater amount of value in intangible assets such as brand value and intellectual property, which don’t show up in book value. Thus, more companies are priced at higher price-to-book ratios.

These seven criteria are stringent and often cut away the majority of stocks. In 1970, Graham found that the 30 stocks on the Dow Jones index met the criteria in aggregate, but as individual stocks only 5 of the 30 stocks passed all the...

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Lucent

In 2000, Lucent Technologies had a valuation of $193 billion on roughly $32 billion in revenue. It was in a precarious position:

• It had acquired a company for $4.8 billion—this company had zero revenue and no customers, and a book value of just $600 million.
• Lucent had lent $1.5 billion to its customers to buy its products, under “customer financings.” How safe are your revenues if your customers need financial help buying your products?
• It accounted for software development as a “capital asset,” not as an expense.
• (Shortform note: In 2000, Lucent also reported a $125 million accounting error and a $700 million overstatement in revenues.)

By 2002, Lucent reported losses of $28 billion in two years; its stock fell 97%. (Shortform note: It later merged with Alcatel in 2006, forming Alcatel-Lucent, which was then acquired by Nokia).

Archetype 2: An Empire-Builder that Falters

Ling-Temco-Vought

Ling-Temco-Vought was a conglomerate involved in industries as wide as aerospace, sporting goods, and pharmaceuticals.

(Shortform note: The conglomerate began with a young entrepreneur James Ling, who took his electrical contracting business...

... </td> $222 million </tr> Net income $20.3 million $13.6 million Earnings per share $1.80 $2.40 5-year change in per-share earnings +19% +59% Dividends paid since 1917 1954 Price-to-earnings ratio 9.1x 16.5x Assets-to-liabilities ratio 3.8x 1.5x Price-to-book value 75% 165% </table>

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Air Products had a valuation of $231 million on $222 million in revenue and $13.6 million in net income. It had grown per-share earnings by 59% in the past 5 years. It was now trading at a price-to-earnings ratio of 16.5 times.

In comparison, Air Reduction had a valuation of just $185 million (nearly $50 million less), but had over double the revenue at $488 million. It also had higher net income, at $20.3 million. It had...

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Dividend Policy

In the first half of the 20th century, it was common for businesses to pay out the majority of profits to shareholders. This seems like common sense—the purpose of a business is to make money, and that money should belong to shareholders. Successful businesses therefore paid high dividends, while faltering businesses paid only a paltry amount.

However, over time the opposite fashion emerged—businesses began retaining more of their profits and reduced dividend payments. (Shortform note: In the 1960s, companies paid 55-60% of its profits; in recent years, the payout ratio is closer to 30%.)

The theoretical justification was that the business could use the profits to further grow the business, and so the money was better retained in the business than paying shareholders. For a set of growing businesses that clearly could deploy capital to achieve growth, this made sense.

This trend inverted how successful businesses behaved—the more successful, growing businesses paid less in dividends (as a percentage of profits); shareholders, enthusiastic about the growth in stock price,...

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Likewise, many of Graham’s investment criteria we’ve covered have margin of safety built into them:

• Interest coverage ratio: If a company’s earnings covers 5 times its interest expenses, then even if it suffers a sudden 20% drop in earnings, it has more than enough earnings remaining to continue paying interest and thus avoiding defaulting on debt. In contrast, a company that can only cover 1 times its interest expense is in danger of defaulting with just small setbacks to earnings.
• Price to book value: If you buy stock in a company when its market value is two-thirds of book value, the company’s book value can shrink by one-third before your investment becomes negative (relative to book value).
• Asset to liabilities ratio: If a company has assets at multiple times its liabilities, it can lose significant value before its bondholders suffer a loss.
• Long history of dividends and positive earnings: A company that has a long history of paying dividends suggests consistent profitability, thus providing a cushion in recessions. In contrast, a company that has never paid dividends and is currently unprofitable may be on the edge of collapsing.

Margin...