Book Review: The Intelligent Investor

The Intelligent Investor (1973) by Benjamin Graham
with commentary (2003) by Jason Zweig

In this classic book, which Warren Buffett called "the best book on investing ever written," Graham lays out the basic principles of an approach that has come to be known as value investing. He argues that investors in common stocks should strive to build a fairly diversified portfolio consisting of large, prominent, conservatively financed, and well-managed companies that have stable and growing earnings (and good prospects for continued growth), strong dividend records, and attractive valuations (e.g., low P/E ratios). Regarding valuation, one should seek out stocks that are trading at a discount to their companies' intrinsic values, where value is determined independently of the market through analysis of a company's earning power, assets, liabilities, and other fundamentals. These undervalued stocks provide what Graham calls a "margin of safety," which can be defined as the difference between a company's intrinsic value and the price you pay for its stock. A large margin of safety leaves room for error in valuation and is likely to produce a satisfactory return when the market eventually prices the stock at a level closer to its company's intrinsic value.

Graham succeeds in establishing that value investing is a sensible approach not just in principle, but also in practice. There are several case histories and comparisons between companies throughout the book that make clear the benefits of buying undervalued stocks and the follies of buying overvalued or "growth" stocks. In his chapter commentaries, Zweig provides more recent examples from the height of the dot-com boom in the late 20th century, showing that Graham's observations are timeless. In addition, a reprint of Buffett's classic speech "The Superinvestors of Graham-and-Doddsville" is presented in an Appendix and highlights the actual records of several individual investors who were successful by following the principles of value investing.

The discussion of value investing is augmented in several places throughout the book by Graham's thoughts on the nature and the psychology of investing. In Chapter 1, Graham makes a clear distinction between an "investor" and a "speculator," arguing that one should strive to be the former by only making investments that are judged by thorough analysis to offer safety of principal and a satisfactory return. In Chapter 8, which I think is the most important chapter in the entire book, Graham discusses how an investor should deal with market fluctuations. I feel compelled to quote two segments of text that made a strong impression on me. The first quote is from p. 203, where Graham writes:

The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage [the flexibility of being a shareholder of a public company] into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgment.

Graham refers to "other persons' mistakes of judgment" because if you have bought a stock that is priced below its company's intrinsic value, then other people are making a mistake by selling it and driving the price down further. That's right -- it is critical to realize that you have not necessarily made a mistake if your stocks go down in price after you buy them. Your investment decisions may have been sound, but the market may be acting irrationally at the moment. The second quote is from p. 205 and comes after Graham's classic parable about the manic-depressive Mr. Market:

Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.

I think this is sound advice that can help an investor stay disciplined and protect himself from emotionally driven reactions to market fluctuations.

I have largely restricted this review to Graham's discussion of common stocks, but he also covers preferred stocks, bonds, investment funds, advisors, and other topics. His writing style is very readable and engaging, which is quite an accomplishment for a book that is over 500 pages. (If you are interested in this book but do not want to read it all, I recommend at least reading Chapters 1, 8, and 20.) The chapter commentaries by Zweig are very good, enhancing Graham's main points and providing modern-day examples of their continued relevance. The reprinted speech by Buffett is a great bonus.

Even though I had already incorporated many aspects of value investing into my own investing approach prior to reading this book, I still learned a lot from it, especially with respect to understanding the characteristics and psychological make-up of an intelligent investor.

Note: I read this book in March 2012.