Lessons from the "Intelligent Investor" (Part 2)

This is the second post in a mini-series on one of the greatest investment books ever written by a world famous investor, Benjamin Graham. To read the first part of this mini-series follow the link to part one.

The Intelligent Investor

This post is part two of a seriesthat outlines some of the key lessons that I took away from reading "The Intelligent Investor". Once again I must stress that anyone with an interest in investment MUST read this book. The lessons are invaluable and I will not do them justice here. However, I will try to outline some more of the key guidelines (although some might say "commandments") so as to share the wisdom if this great man with a wider audience.

Where to start your investment research?

I believe that almost everyone should be investing for the future. I regularly find myself discussing investments with my friends. I am always surprised that although people show an interest in the stock market, they complain that they wouldn't know where to start when investing. It is my belief that the best way to learn is to do! If you've never seen Niagra Falls before you don't gain much insight from someone describing it to you. Conclusively, won't fully understand the experience until you actually go. It's the same with investing. You have to have some money set aside, that you can afford to lose, and give it a go. That's the best way to learn how to invest. It forces you to constantly research and learn. It's the reason I write blog posts such as these; that I may learn about investing and share that knowledge with others.

The next step to investing is the two Rs: that's Research and Reading, and lots of it! You want to read market data, newspapers, company websites, Annual Reports, and company announcements. An investor should be asking themselves - where do the profits come from? Where is the future growth of the Company going to come from? What is the intrinsic value of the Company today? How does that intrinsic value compare the the current Market Capitalisation (Stock market price multiplied by the number of shares)?

Red Flags for investing

An investor should also be on the look out for red flag, warning signs. If an investor becomes aware of any of the following when researching then do not consider investment:

If the Company appears to be making lots of acquisitions each year then this should be a big red flag warning sign. Successful companies can put their capital to good use and grow their earnings internally. If a Company is regularly having to go to the market place to boost it's revenues you should be asking yourself why. Obviously, some acquisitions are a good thing. In the UK WM Morrisons, the supermarket, took a 10% stake in an American online grocer to give them experience in online grocery shopping before considering expansion onto the net. This was a relatively cheap way to test online shopping before diving straight in. Generally, more than 2 "large" acquisitions per year should be a signal of possible underlying problems.

If the Company regularly finds itself approaching its shareholders for extra financing, or borrowing from another financial institution, this could be a cause for concern. These sorts of cash inflows will be written under "cash from financing activities" on a Company's Statement of Cash Flows. Regularly borrowing money from external sources generally means that the Company does not produce enough cash flow from its operating activities. If the Company always needs to borrow to grow then this it is not a share in a Company that you are investing; it is debt.

If a Company has only a few customers, this should be a concern to the investor. Whilst those one or two customers may provide plenty of revenue, there may be limited scope for scaling the business. Furthermore, an investor would want more comfort than provided by only a few customers. For example, should one customer 'go bust' and close for whatever reason then there may be problems for your investment as your Company relied too heavily on the list business.

Gaining confidence in investing

Apart from having a market price below intrinsic value there are a couple of indicators that a Company is or will be a successful one. Here are a few ideas:

Graham also encouraged looking for businesses with a "wide moat". In economics we call it "barriers to entry". Essentially, we mean factors that would prevent competitors from entering the market place. A business is in a good position if it has something inherent in the business that deters/ prevents other businesses from competing for market share. Examples of factors that provide a wide moat: brands such as coca cola, legal factors such as patents in drug companies, and technological factors such as Microsoft creating an operating system whereby consumers would have to busy Microsoft products to be compatible.

A management who's interests are aligned with the shareholders is extremely desirable. Graham believed that you should have confidence in management who own a lot of the shares within a Company. Managers sell shares for many reasons e.g. kids are going to University, the manager is moving house, the manager is going through a divorce etc, however, if the management are buying shares in the Company that they manage then that is a hugely encouraging sign to invest within the Company. Essentially, management share buying is the person(s) that knows the business best is endorsing it. I apologise for not having the exact statistics but I recently read an article in City am that suggested that those Companies that have employee share ownership tend to perform better over the long run.

For more on this series:

Lessons from the Intelligent Investor Part 1
Lessons from the Intelligent Investor Part 3

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