Be An Intelligent Investor in 15 minutes (..... well depends on your IQ)

Preface:
After spending months reading, exploring and researching the so-called stock market Bible, I've decided to summarize the Bible to make everyone a little more intelligent at investing in stock market.

This Bible is none other than the book written by the investment Guru, Benjamin Graham (click for more info). For those who are not familiar with his name, in brief, he is Warren Buffet's mentor. Enough being said!!!! And for those who are not familiar with Warren Buffet's name, just STOP reading this post, I won't blame you......

I. Investments vs Speculations
Always, investing in stock market is seen as a zero-sum game. For those who think that stock market is zero-sum game, for certain, remain in a negative-sum game (after tax and brokerage) in the long run because they do not understand the gist of investing.

The reason stock market is seen as a zero-sum game is because these people make their money in stock market by assuming that other "fools" will pay higher price to acquire their stocks. However, this is not investing, this is speculation. Like thieves and robbers, these speculators take risks and make money out others' pocket.

On the other hand, investing is an art - like planting a seed (money) into the ground (stock market) and wait for the return (fruits). In a perfect world where the world population remains constant, yes, then stock market will be a zero-sum game. But we are not living in a perfect world. Therefore, investing is a positive-sum game. A business makes profit because

1. Increase in demand (growing world population, outperforming competitors)
2. Inflation (Increase in profit but not in real profit)
3. Decrease in supply (laws and regulation, war, environment, less natural resources etc.)
   

And hence, through investing our money in a business, we can make profits with the growth of the business, but not out of others' pocket.

Investing, by Graham's definition, is an investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. This means that investors need to do the following in order to invest in a business

1. Analyze the company BEFORE we buy the stocks.
   
2. Protect ourselves from any losses and risks.
3. Expect a moderate and satisfactory returns.

When putting your money in an investment, timing does not matter at all. Timing only matters to speculators but not investors. The only thing matter to an investor is the price, and how to determine if the stock price is cheap is through analysis.

Why timing does not matter? Because if you plan to keep the stock for a long period of time (let's say 5 years), would it matter to you if you buy the stock at 1% cheaper? The difference would be diluted by the long period of time. And investors always plan to keep the stock for long period of time unless the company is no longer performing or the stock is way too expensive now.

In short:
Speculation - buying on the hope that a stock's price will keep going up.
Investment - buying on the basis of what the underlying business is worth.

II. Inflation
As mentioned, inflation can increase profit but it does not increase wealth as the living cost is higher due to inflation too. Inflation is a very important element in investing as it

1. Eliminates our profit without our knowing
2. Is out of our control
3. Is the main reason why we invest - to secure our wealth from inflation
   

Because inflation can hurt us in many ways without being noticed, Benjamin Graham put extra emphasis on inflation. Therefore, as an investor, we should always safeguard our capitals and profits with bonds and money market to guard ourselves from inflation.

III. Margin of Safety
We invest in the present, but we invest for the future. And unfortunately the future is always uncertain - wars, recessions, natural disasters, terrorist attacks, natural resources shortage, inflation, interest rate etc. Therefore, investing on the basis of projection and forecasts does not make sense. However, the current price reflects not only the past and present performance of the company and the important facts about the company, but also reflects the expectation of the public on the company's future. And this is where we can exploit the inefficiency of the market.

What is certain is the past and the present. Benjamin Graham suggests that we should use past and present information to generate an estimate of how much the business is worth (the value of the business). Then, compare the "value" with the current price of acquiring the business:

• Value > Price - the larger difference between value and price, the larger "margin of safety", the better buy it is. Benjamin Graham suggests at least 30% margin of safety.
  
• Value <>
• Value = Price - there is no margin of safety too. Thus, it is bad buy.
  

Remember, margin of safety does not prevent a loss because losing some money is an inevitable part of investing. Nevertheless, investing with a "margin of safety" prevents us from taking unnecessary risk and from overpaying. We must be extremely risk adverse in order to survive and to be successful in stock market because we cannot afford to lose in stock market. Let me illustrate as follow:

Stock A grows 10% annually while the market average grows 5% annually. However, Mr. X pays too high the price for the stock A, stock A loses 50% of its value in the first year and generates 10% annually as it supposed to. It would take Mr. X's stock A to grow 10% for 16 years to reach the market average gain.

The morals of the story are:

1. Never overpay
2. Always keep some chips in your hand, rather than losing most of them in the beginning to the market.

And by using "margin of safety", we prevent overpaying for one stock and reduce the risk of losing. The most important reasoning behind "margin of safety" is gain more by taking less risk. This might seem confusing because "the teachers in school say high risk high return" and it contradicts to most of our understanding of stock market. Well, this leads us to the next topic "Risk".

IV. Risk
We are told: High risk, high return. Low risk, low return.
The fact: High risk, less return. Low risk, high return.

This is why:
Let's say I'm selling you a bottle of Guinness for $2. You think it's cheap because you know a bottle of Guinness is worth $5. (You have a margin of safety of 60% for buying this bottle of Guinness). Would you buy the bottle of Guinness from me?

A good answer is NO because you should examine that particular bottle of Guinness first. Maybe it's expired, maybe it's fake etc.

After examining, you are certain that the bottle of Guinness is genuine and I'm selling it to you under goodwill. Would you buy from me? This should be a yes answer because you are paying less price for its value. You could easily make a profit from reselling the bottle of Guinness at $5 to the market. Also, you have little risk of reselling it because you can sell below market price and still profit from it.

What if now I'm selling you another bottle of genuine Guinness at $4.75 (5% margin of safety), would you still buy from me? It should be a yes answer too because it's 5% cheaper than the market price but you might consider other factors too. Do you plan to resell it? Do you plan to drink it? If you plan to resell it, probably you won't buy it from me because the profit margin is less and the risk of not getting it sold is higher.

Put the story in stock market:
1. Someone is selling a stock at a very low price (low PE ratio)
2. You analyze it (like you examine the bottle of Guinness)
3. You make decision to buy or not, based on the resales value of the stock in the future (like you're reselling the bottle of Guinness to make profit).

And how would paying less for the bottle of Guinness is more risky than paying more? It does not make sense because paying less is obviously less risky and is generating more profit as we have a higher profit margin. On the other hand, paying more is more risky and is also generating less profit. Therefore, we should forget what know about risk/return before and embrace Benjamin Graham's philosophy of "less risk, high return".

V. Defensive Investors vs Enterprising Investors
Defensive Investors create a permanent portfolio that runs on autopilot and requires no further effort. On the other hand, Enterprising Investors continually research, select and monitor a portfolio. Both types of investors are intelligent investors. And to be which type of investors, it all depends on your:

• Personality
• Effort you wanna put into your portfolio
• Current financial status and employment etc.
  
• Current marital status, family size etc.
  
• Long term goal and short term goal

But please remember this, it NEVER depends on your age. I agree age changes your mentality but age is NOT a factor. Never too old to learn, never too young to learn, and if you are willingly to learn, wealth is what you'll earn.

VI. Guideline for Defensive Investor
In his portfolio, a defensive investors should never have less than 25% or more than 75% of his fund in stocks, and vice versa in bonds. By doing this, we can

1. Secure our funds from inflation (by holding bonds)
2. Outperform the inflation (by investing stock market)
3. Survive bear market (by holding bonds)

For the bonds component, an investor can choose either one or a mixture of the following:

1. Taxable or Tax Free Bonds
2. Short term or Long term Bonds
3. Bonds or Bond Funds
4. Treasury securities (in USA, T-bill; in Malaysia, MGS)
5. Saving bonds/Fixed Deposit

For the stock component, an investor can choose either one or a mixture of the following:

1. Mortgage securities
2. Annuities (Insurance-like investment)
   
3. Preferred Stock
4. Common Stock
5. Mutual Funds
   
6. REIT
7. TIPS (Treasury Inflation-Protected Securities)

Mortgage Securities are considered safe investment during Graham's days but the financial crisis in 2008 showed us that most of the mortgage securities are just junk. You must examine these securities with EXTRA care if you choose to buy as some of these securities are way underpriced after the crisis. Yet, if you buy wrongly, it's just a piece of worthless paper.

Some rules to follow for a defensive investor:

1. Adequate diversification but NOT excessively diversify the portfolio. Over-diversify can almost ensure you NEVER be able to outperform the market.
2. Investor should impose limit, in terms of PE ratio, on the price he will pay for the stock
3. Avoiding growth stock as they are almost overpriced and financially unstable.
4. Avoid changing your portfolio too often unless you have a very good reason to change it or a very bad reason to keep it (losing money is not a valid reason to change).
5. Practice Dollar-Cost Averaging: Invest a constant amount of money in your portfolio every month, regardless how's the stock market is performing.

Before going into the company's financial structure, an investor must understand:

1. The company's general long term prospects
2. The quality of the management

Then, examine if the company purchased possess the following quality:

1. Adequate size
2. In a sufficiently strong financial condition
3. Earning stability for at least past 10 years
4. Uninterrupted dividend payment for past 20 years
5. Earning growth
6. Moderate PE Ratio (~15x average earnings of past 3 years)
   
7. Moderate Ratio of Price to Assets (not more than 1.5 times of book value)

VII. Guideline for Enterprising Investor
Also, in his portfolio, an enterprising investors should never have less than 25% or more than 75% of his fund in stocks, and vice versa in bonds.

What to Avoid in Portfolio:

1. Junk Bonds (high default rate)
   
2. Preferred Stocks (constant coupon yet taxable and less protected than bonds)
   
3. Foreign Bonds (high default rate)
   
4. New Issues of Bonds (uncertain return)
   
5. Initial Public Offering (overpriced)
   
6. Day Trading (<-- avoid at all cost because highly speculated with high trading expenses
7. Hot Stocks (probably way overpriced)
   

Foreign bonds are considered junk bonds in Graham's days because of the post-war financial situation in the world, USA became the financially strongest country and there was no reason to invest in other risky countries (China was considered risky country for the cold war reason). However, in our time, investing in third world country bonds are as safe as buying T-bills. Also, third world country bonds, that do not sync with US market can provide us a comfort zone when the US market is not performing (as we have seen during the financial crisis in 2008).

What to Include in Portfolio:

1. T-bills, Saving Bonds (riskless)
   
2. Rated A Municipal Bonds (tax free)
3. Rated A Corporation Bonds
   
4. Common Stocks of Unpopular Large Company (usually cheap)
   
5. Common Stocks of Secondary Company at Bargain Level (undervalued stocks)
6. Mutual Funds

Also look for:

1. Arbitrages
2. Liquidations
3. Related Hedges
4. Net-Current-Asset Issues
   

Some rules to follow:

1. Be consistent with your investing strategy and refuse to change even when it is unfashionable.
2. Less diversify and take very specific high risk (i.e. do put all eggs in one basket)
3. Pay little attention to what the market is doing (i.e. switch off the Blomberg news).

Before going into the company's financial structure, an investor must understand:

1. The company's general long term prospects
2. The quality of the management

Then, examine if the company purchased possess the following quality:

1. In an acceptable financial condition
   i. Current Ratio >1.5
   ii. Debt <>
2. Earning stability for at least past 5 years (no deficit for 5 years)
   
3. Some dividend payments
   
4. Earning growth
5. Price: Less than 120% Net Tangible Assets

VIII. Management
Notice that how important the company's long term prospect and the quality of management are when making decision to buy a stock. The company's long term prospect and the quality of management always come before the capital structure of the company. The manager manages the company and determine the future prospect of the company.

One extreme example can be that Company A has a very strong capital structure, grown 20% annually in the past, beat the competitors by miles and yet you are able to acquire it at very a fair price. Let's say despite his ability to make the company so profitable, the manager is a hermit-crab-like person and plans to leave Company A for its competitor Company B in very near future. Company A's future prospect can be in danger because of the attitude of the manager and as a shareholder (investor) should avoid such situation.

In theory, investors are shareholders and they have absolute power over the managers as the cash, the business property and the employees belong to the investors. However, in practice, because many of the investors who buy stocks in the intention of selling them to make profit, do not plan to own the stocks, they give little attention to the managers.

As an intelligent investor, you should know your rights as a shareholder of the company by reading the proxy materials. Understanding and voting your proxy is very important to you as an investor. If the manager do not work at the best interest of the shareholder (such as unfavorable dividend policy without justification), you have the rights to get someone else to work at the best interest of you.

IX. Other Important Financial Knowledge

PE Ratio - To determine how expensive/cheap of the given company. The lower PE Ratio, the cheaper the company is.

Return on Invested Capital (ROIC) - To show how efficiently the company has used the shareholder's money to generate return. Generally, 10% is attractive and 6-7% is tempting if the company has good brand names, focused management, or is under a temporary cloud.

Current Ratio - To determine the company's ability to meet its short term obligation. Usually >1 indicate the company is financially okay to meet its short term debts However, companies like Coca-Cola and HP which have very high earning power usually have current ratio lower than 1. The reasoning behind this is that such companies keep very low cash for other investments and keep very low inventory for more efficient manufacturing operation.

X. Conclusion
The problem we face today is not that many financial analysts/investors are idiots, but rather that so many of them are so damn freaking smart (thanks to the teaching of Graham for more than 60 years).

Under Efficient Market Hypothesis, millions of financial analysts and investors scouring the market every day, it is unlikely that severe mispricings can persist for long. As more and more smart people search the market for bargains, the chances of getting bargains are getting rarer. The market's valuation of a given stock is the result of a vast, continuous, real-time operation of collective intelligence. Most of the time, for most stocks, that collective intelligences gets the valuation approximately correct.

Nevertheless, investment still enables us to beat the inflation and secure our wealth from inflation. To some, it provides excitement. To some, it provides wealth. And unfortunately, to some, it destroys wealth. To prevent the third situation from happening, we shall follow three core principal of investing:

1. Know your business - Do not try to make "business profit" out of securities but out of the business you own through securities (read more under investment vs speculation).
   
2. Do not let anyone run your business, unless you can supervise him or you have confidence in his ability and integrity (read more under management).
   
3. Do not enter upon an operation unless it has a fair chance to yield reasonable profit (read more under margin of safety and risk).

Remember that we cannot control uncertainty but we can control:

1. Our own behavior - do not panic to sell if your portfolio loses some money and do not panic to buy if some other stocks are performing so well.
2. Brokerage Cost - trade rarely, patiently and cheaply
   
3. Ownership Cost - do not buy mutual funds with excessive annual expenses
   
4. Expectations - use realism to forecast returns
   
5. Tax Bills - hold stocks for long term to lower the capital-gains liability
   

And lastly, I hope this summary of Benjamin Graham's "The Intelligent Investor" will help you to understand more about investing in capital market. Remember, this is just one brief summary of one of his great books and I strongly recommend you to read more of his books. And start investing as early as you can because you'd rather learn how to invest now than later.


p/s: The order of the contents in the book is different from mine because I reorganized them according to its importance (in my opinion).
p/p/s: Good luck to those who think they are ready to get into the securities market after reading this post. This is not being sarcastic =)