Lessons from the "Intelligent Investor" (Issue 1)

This is the first of what I hope will be a mini-series on one of the greatest investment books ever written by a world famous investor, Benjamin Graham.

The brilliant intelligent investor

Recently, while on vacation, I read the greatest investment book that was ever written - The Intelligent Investor. Benjamin Graham, one of Warren Buffett's investment tutors wrote this Bible after decades of investment experience and success. I read a 1970s edition of the book and thought that I would share what I consider to be the key aspects of this Investment Bible. I must stress that anyone with an interest in investment MUST read this book. The lessons are invaluable and I will not be able to do them justice here. However, I will try to outline some key guidelines (although some might say "commandments") so as to share the wisdom if this great man with a wider audience.

7 Principles of Valuation

Graham sites 7 key filters for ascertaining whether a particular company is a worthwhile consideration as an investment. I have tried to offer some explanation to assist the reader:

1. Size - the general suggestion seems to be that the company should be large. In today's terms in GBP this should equate to about £70million in annual sales for a company.

2. Financial Condition - There should be a 2:1 ratio of current assets to current liabilities. This is to ensure that if the company faces financial difficulties it has enough current assets to help it through difficult times. Furthermore, Graham specifies that long term debt should not exceed net current assets. Once again this should ensure liquidity of the company if it should hit rough times.

3. Earnings stability - there should be positive earnings for at least the last 10 years. Clearly, you only want to invest in a company that has a proven track record to generate earnings. Whilst, Graham is not denying that there will be companies out there that have made large profits after several years of losses, he requires a certain level of safety that can only be gained by specifying certain criteria. It is that "margin of safety" that Graham is trying to establish with these 7 investing principles.

4. Dividends - Graham requires that an investment should offer a tangible return. He isn't interested in company that doesn't yet pay a dividend but may do in future. A return in the form of a dividend allows Graham to reinvest as he sees fit. This allows compound interest to take effect. Graham recommends that investors should look for companies with a dividend record of at least 20 years.

5. Earnings growth - an investor should require at least a 33% increase in per share earnings over the last 10 years. You should use a three year moving average of the first and last year. This should help to smooth out any unusual spikes in per share earnings over these periods. Similar to the 3rd point, this is to ensure that you are only investing in a company with a track record of growth.

6. Moderate PE - Graham suggests that the current share price should not be more than 15 times the average earnings of past 3 years. However, this rule is flexible, as is explained in point 7, below. 

7. Moderate ratio of price to assets - the suggestion here is that you should look for companies whose current price is less than 1.5 times the book value (total assets). If we combine the ideas in points 6 and 7, if the product of the multiplier of 3 year average earnings and the ratio of price to book value is below 22.5 then this is acceptable. Of course, this means that there will be instances either the multiplier or the ratio of price to book value is greater than what Graham had specified earlier but this caveat adds flexibility to Graham's "rules".

Investing Principles Notes

Graham himself made a point of admitting that if you find a company that meeting all of these criteria, there is still risk in investment. The sort of numerical analysis adopted here does not account for the fact that there may be qualitative disasters that will affect the future price of the shares. For example, Graham makes no mention of the management of the company, nor even that you should know what the function of the company even is. Furthermore, it has been noted that there are extremely few companies that will meet all of these criteria that exists today.

Whilst, Buffett was one of Graham's greatest disciples, and is now worth on excess of $50billion, he learnt that Graham's method is a solid base of knowledge and should be considered in investment. It is not, however, the only points to be considered in investment.


For more on this series:

Lessons from the Intelligent Investor Part 2
Lessons from the Intelligent Investor Part 3

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