Benjamin Graham - The Intelligent Investor Part 2

For part 1 of my review, please head here. I will now analyze and review part 2 of The Intelligent Investor by Benjamin Graham. Part 1 was just 10% of the book and I was immensely pleased to gain new wisdom and knowledge that I have missed out a year ago while reading the book. With no further ado, I present part 2 of The Intelligent Investor by Benjamin Graham.

Stocks and bonds should be assessed accordingly for varying market conditions
There is no sure asset class to be carrying. Under certain conditions, bonds might be a safer bet even though historically, equities have been proven to generate higher returns. The intelligent investor recognizes that even high quality stocks cannot be a better purchase than bonds all the time.

Alternatives to equities as hedges against inflation
Gold has been presented as a possible hedge against inflation. However, gold does not generate any income for the investor. Moreover, storage expenses are also incurred if it is stored in a secure location. However, recent years have shown that gold can be a tool of speculation, which might generate profits for the investor due to capital gains. In addition, investment in other "things" such as diamonds, paintings by masters, coins are not covered in this book though it could be a good hedge against inflation as well. Real estate is also something not covered in this book. Personally, I feel that with the introduction of REITs into the market, the intelligent investor can actually benefit materially by understanding the various different asset classes he can invest in.

Diversification is key to an investor's life
Do not put all your eggs into one basket. Moderate diversification should be practised as an ill investment might very well wipe out your entire investments. In the book, one is advised to have a balance between the percentages of equities and bonds holdings. Of course, with the introduction of ETFs, REITs, the modern investor has more choices.

When in doubt over the market, choose the path of caution:

1. No buying or holding securities on margin
2. Fix the percentage of equities held in your portfolio
3. A possible reduction of stock holdings to 50%

Never forecast the future solely based on the past
Even though history tends to repeat itself, we should never ever consider only the past in our forecast for the future. This is because conditions change, inventions are made, the world become more connected etc. All these few factors influence the present to an extent as well.

Stocks does not always outperform bonds
When calculating returns, companies which are bankrupt are usually not accounted into the index. Therefore, there is selection bias and the returns from stocks can tend to be overestimated. It is up to the enterprising investor to do his research on the composition of his own portfolio.

The value of any investment is, and always a function of the price you pay for it
Mentioned in part 1 as well, the heading is self explanatory. When you invests in something, the value you get is always inclusive of the initial price that you paid for the investment.

The stock market's performance depends on these few factors:

• Real growth of the company (earnings and dividends)
• Inflationary growth (rise in general price level of goods and services)
• Speculative growth or decline (the mass public's appetite for investing)

For the equities component of a defensive investor's portfolio, these factors are important:

• Adequate but not excessive diversification, minimum of 10 and maximum of 30 (personally, I feel that absolute figures are at best a rough guide)
• Companies behind the equities should be large, prominent and conservatively financed (think along the line of investing in blue chip stocks)
• Companies should have a history of dividends payment
• Limit for the equities should be set at a P/E ratio of 25 for the average of its earnings over 7 years, and not more than 20 than the last 12 month period. This excludes growth stocks and reasons will be discussed later.

The reasons for avoiding growth stocks is that these stocks tend to be sold at a high prices in relation to current earnings and at much higher multiples of their average profits over a past period. As a result, there tend to be a speculative element behind these stocks and has made successful investing in this field a difficult task. Moreover, growth stocks tend to go high in price before tumbling down, just like International Business Machines (IBM) from 1961-62 and 1969-70 in which 50% of its market value is lost and Texas Instruments.

Dollar Cost Averaging is useful for a defensive investor's returns as well
Dollar Cost Averaging is an extension of a formula investment. By buying during periods of boom and bust, it is said that the investor will eventually walk off with a profit provided that the companies they invested in are sound and fit the 4 bullet point factors above. Of course, one has to be cautious that there will inevitably be periods where the market value of one's portfolio might decrease and not sell in panic. After a long period like 20 years, the investor will actually be profitable. I currently have an Investment Linked Policy with AXA that does just that.

The investor's personal situation determines what type of investor he should be
To become a successful enterprising investor, one has to take the required time to instill in himself the time and discipline, as well as the knowledge to prevail over the market. Moreover, intelligent people who does not treat investing as a skill and does not learn it well might fail at investing profitably as well. Most people would be more apt being defensive investors.

Risk should be limited to these few factors:

• Loss of value realized through actual sale of an investment
• Significant deterioration in the company's position
• High payment for an investment above its intrinsic value

Therefore, market fluctuations cannot really be categorized as real risk. Risk of true loss in value can only come from actual sale. Of course, paying too high a price for an investment is risky as well.

Attributes of large, prominent and conservatively financed companies:

• Book value of stocks at least half of market capitalization, including bank debts
• $50 million of assets or do $50 million of business (these are the figures given in early 1970s, current figures should be $10 billion)
• Rank among first quarter or first third in size within the industry group (personally, i feel that market capitalization, net asset values are good indications of size)

However, all these attributes are just rough guidelines and it would be most foolish to stick to them mechanically.

Buy what you know
This slogan is advocated by Mr Peter Lynch, who from 1977 to 1990 led the fund he managed, Fidelity Magellan to the best track record ever recorded by a mutual fund. If you have discovered a great new product or service that Wall Street professionals are oblivious to, it might be a good time to cash in. Of course, you have to thoroughly analyse their financial statements as well. Moreover, you have to guard against the phenomenon of "home bias" in which one stick to an investment in which one is comfortable with. This is because more often than not, familiarity breeds complacency.

With that, I will end off part 2 of my review of The Intelligent Investor by Benjamin Graham. As a summary, I would just say that this part of the review is more for the defensive investor so do take another quick glance if you do not want the headache of managing an active portfolio. Dollar Cost Averaging remains one of the most powerful weapon that a defensive investor can have for the guarding and building of his wealth.