2 tips from Graham

The Fool.com has an excellent little summary of two of the key concepts from the Intelligent Investor: 1) Buying stocks makes you an owner and 2) Always buy with a margin of safety.

The author expands on 1), saying that as an owner of a stock you have a right to get answers from management about their performance and to demand better. Doing this kind of thing is not out of the reach of people like Buffett or Bill Ackman who own significant portions in common stocks. But I think it is important to think about buying stocks as ownership in a company and not just a randomly fluctuating ticker symbol. It’s helpful to ask, as Graham often does, if this business were a private business, would you buy it at the current market price? 2) Always buy with a margin of safety, is extremely important. The article says,

Graham details just how to buy with a margin of safety, which he calls the “central concept” of investing. Put simply, the “margin of safety” is the difference between the intrinsic value and the price at which a stock trades. For example, a security worth $50 per share but trading at $25 per share enjoys a massive 100% margin of safety. Buying in that situation heavily stacks the odds in favour of the investor.

The margin of safety concept is very important. The term “safety” reminds me that buying low not only improves the odds of a greater return in the future, but ensures greater “safety” against a significant loss, compared to a stock which is trading at a high price. After all, this is the main purpose of investing, as Graham defines it at the beginning of Chapter 1 of the Intelligent Investor, where Graham quotes himself, from the 1934 edition of Security Analysis: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” How can one ensure a margin of safety? Graham hints at this early on, in the Introduction, entitled, What This Book Expects to Accomplish: “we shall suggest as one of our chief requirements here that our readers limit themselves to issues selling not far above their tangible-asset value [book-value, or net-asset value] . . . The ultimate result of such a conservative policy is likely to work out better than exciting adventures into the glamorous and dangerous fields of anticipated growth.”

Clearly, Graham was not about speculation, and he favoured a conservative and boring approach to investing. In the Appendixes, written by Buffet, he tells about a man named Walter Schloss. Walter never went to college but took one course taught by Ben Graham at Columbia and later worked at Graham-Newman. His strategy? Buffett recalls Adam Smith wrote about him in Supermoney,

He has no connection or access to useful information. Practically no one in Wall Street knows him and he is not fed any ideas. He looks up the numbers in the manuals and sends for the annual reports, and that’s about it. . . Money is real to him and stocks are real–and from this flows an attraction to the “margin of safety” principle.

Buffet continues,

Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does. . . He simply says, if a business is worth a dollar land I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again. [italics his]

Looking at Walter Schloss’s returns in the Appendixes show some pretty amazing returns. From 1956 to 1984, WJS Limited Partners had a 16.1% annual compound return and WJS Partnership had a 21.3% annual compound return. That compares to an 8.4% return for the S&P500 over the same period. Pretty impressive returns for what sounds like a very simple approach to investing, on the surface. We cannot forget of course that Walter J. Schloss probably spent his entire day pouring over annual reports for many companies, which is no small chore.

Finally, the author of the Fool article offers a glowing recommendation for the Intelligently Investor:

I’ve read and re-read my copy of The Intelligent Investor. It is lined with yellow highlighter ink. Reading that book was one of the most important steps I took toward developing a lucid investment strategy. And I believe Buffett was right when he called it the “best book on investing ever written.”

I second his comments, and that reading this book was one of the best investments I ever made, after getting a university education. I am just now going through it for the second time, only now I am covering it in yellow highlighter ink as well. I’ve had to take a short break this week as I need to buy a new highlighter already, after just the first two chapters!