Benjamin Graham

Chapter 8 – The Investor and Market Fluctuations

Summary and Discussion – Chapter 8 – The Investor and Market Fluctuations
Notes on The Intelligent Investor by Benjamin Graham
Notes by Jason Fernando
Created December 13th, 2013
Last updated December 19th, 2013
Reference document: Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003.

50-Word Recap

  • Do not try to time the market. Instead, focus on acquiring high-quality securities at reasonable prices.
  • Quantitative criteria can be used to aid investors in determining what constitutes a “reasonable price”, but this is far from an exact science.
  • Investors should be comfortable waiting for such prices to present themselves.

Price ≠ Value

Speculation ≠ Investment

The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices.[1]

It is easy for us to tell you not to speculate; the hard thing will be for you to follow this advice. Let us repeat what we said at the outset: If you want to speculate do so with your eyes open, knowing that you will probably lose money in the end; be sure to limit the amount at risk and to separate it entirely from your investment program.” [2]

Graham begins this chapter by critiquing the pseudoscience of market forecasting. The notion that “experts” and “strategists”, much less honest amateurs, can accurately forecast the future patterns of the stock market with any degree of consistency has been thoroughly throughout the decades (and, indeed, through the centuries and millennia as well, if one takes a liberal definition of “markets”). Graham does so by distinguishing, here again, between the psychology of the speculator versus that of the investor. He writes:

“There is one aspect of the “timing” philosophy which seems to have escaped everyone’s notice. Timing is of great psychological importance to the speculator because he wants to make his profit in a hurry. The idea of waiting a year before his stock  moves up is repugnant to him. But a waiting period, as such, is of no consequence to the investor. What advantage is there to him in having his money uninvested until he receives some (presumably) trust-worthy signal that the time has come to buy? He enjoys an advantage only if by waiting he succeeds in buying later at a sufficiently lower price to offset his loss of dividend income. What this means is that timing is of no real value to the investor unless it coincides with pricing—that is, unless it enables him to repurchase his shares at substantially under the previous selling price.” [3]

Or, as summarized eloquently by Jason Zweig in his commentary on Chapter 7,

“TIMING IS NOTHING” [4]

How, then, ought one to navigate financial markets? Essentially, Graham’s recommendations break down into two categories:

  1. Buying individual securities on the basis of their valuation, as outlined in Chapter 7. This means buying those companies whose shares are priced at significantly below their value, relative to their industry and to the stock market as a whole.
  2. Modifying the composition (also known as “allocation,” or “weighting”) of your portfolio with regard to its ratio between stocks and bonds in accordance with perceived valuation levels of the stock and bond markets. This means reducing the proportion of your portfolio dedicated to stocks/bonds under conditions when the stock/bond market is expensive, and increasing it when it is priced at bargain levels.

The rules for #1 differ depending on whether one is a defensive or enterprising investor, as can rule #2. These nuances are discussed in chapter 7 and 4, respectively.

Formula Plans

Over the years, several methods of investing have been developed which purport to offer investors a straightforward and logical way  of inferring high or low general prices in the broad market, thereby providing sound indications of when to sell securities and when to buy. Despite their often successful beginnings, the effectiveness of such “formula investment plans” have the tendency to gradually diminish over time. A parsimonious explanation for this phenomenon is that such formulae become victims of their own popularity: If a sufficient number of people defer their investment decision-making to identical “formulas”, then the decisions made by those formulas will become self-defeating. Consider, for example, a formula which states that the Dow Jones Industrial Average (DJIA) had best be sold once it reaches the 13,000 threshold, based on the premise that such a level constitutes a high price for which investors can secure a handy profit on the sale of their securities. Yet, if a sufficient number of investors adhere to this view, their combined selling pressure will reflect negatively on the market prices for the DJIA, thus undermining their ability to profit from the sale of their shares. To borrow from Keynes (albeit in an altogether different context): “What is individually rational is collectively irrational.” This holds true for many investment formulae.

What this phenomenon points to is that investment strategies which are easy to practice are likely to have their effects diminished by overuse. As Graham writes: “The moral seems to be that any approach to moneymaking in the stock market which can be easily described and followed by a lot of people is by its terms too simple and too easy to last. Spinoza’s concluding remark applies to Wall Street as well as to philosophy: “All things excellent are as difficult as they are rare.”” [5]

Market Fluctuations of the Investor’s Portfolio

“Every investor who owns common stocks must expect to see them fluctuate… over the years.” Specifically, “…the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.” [6]

Paradoxically, one of the greatest dangers which face the investor is the psychological pressure which accompanies superficial success:

“A serious investor is not likely to believe that the day-to-day or even month-to-month fluctuations of the stock market make him richer or poorer. But what about the longer-term and wider changes? Here practical questions present themselves, and the psychological problems are likely to grow complicated. A substantial rise in the market is at once a legitimate reason for satisfaction and a cause for prudent concern, but it may also bring a strong temptation toward imprudent action. Your shares have advanced, good! You are richer than you were, good! But has the price risen too high, and should you think of selling? Or should you kick yourself for not having bought more shares when the level was lower? Or—worst thought of all—should you now give way to the bull-market atmosphere, become infected with the enthusiasm, the overconfidence and the greed of the great public (of which, after all, you are a part), and make larger and dangerous commitments? Presented thus in print, the answer to the last question is a self-evident no, but even the intelligent investor is likely to need considerable will power to keep from following the crowd.” [7]

Business Valuations versus Stock-Market Valuations

When you buy shares of a company’s stock, you are becoming a partial owner of that company. In theory, buying 100% of a company’s stock would make you its sole and complete owner, effectively taking the company off of the market. Yet buying 0.000001% of a company is not fundamentally different from buying a much larger stake; in both cases, you gain a legal claim of ownership to the profits generated from the company’s business operations. In the past, the concept that buying shares equates to buying a stake of ownership in a company was made clear by the fact that shares bought and sold as physical certificates containing the relevant logos, signatures, and engravings of the company in question. Today, shares are almost exclusively digital in nature, with no visible relation to their issuing company other than the small and abbreviated “ticker symbol” (such as “BB” for Blackberry). This dematerialization of shares has made it all too likely for investors to forget what the act of buying shares actually entails; it can become, at least subjectively, more like a bet in a casino than a decision to become a partial owner in an actual business.

Graham attributes this shift in part to the often exuberant valuations of publicly traded companies:

“The development of the stock market in recent decades has made the typical investor more dependent on the course of price quotations [8] and less free than formerly to consider himself merely a business owner. The reason is that the successful enterprises in which he is likely to concentrate his holdings sell almost constantly at prices well above their net asset value (or book value, or “balance-sheet value”). In paying these market premiums the investor gives precious hostage to fortune, for he must depend on the stock market itself to validate his commitments.” [9]

Jason Zweig’s footnote to the above is worth including as well:

Net asset value, book value, balance-sheet value, and tangible-asset value are all synonyms for net worth, or the total value of a company’s physical and financial assets minus all its liabilities. It can be calculated using the balance sheets in a company’s annual and quarterly reports; from total shareholders’ equity, subtract all “soft” assets such as goodwill, trademarks, and other intangibles. Divide by the fully diluted number of shares outstanding to arrive at book value per share.

Rephrasing the above, we arrive at the following formula for calculating net worth:

Book Value per Share = (Total Shareholders’ Equity – All “Soft” Assets) / (Fully Diluted Shares Outstanding)

In light of the above, Graham notes that companies which attract significant levels of investment often experience more volatile changes in price than their comparatively small counterparts:

“The whole structure of stock-market quotations [meaning, stock market prices] contains a built-in contradiction. The better a company’s record and prospects, the less relationship the price of its shares will have to their book value. But the greater the premium above book value, the less certain the basis of determining its intrinsic value—i.e., the more this “value” will depend on the changing moods and measurements of the stock market. Thus we reach the final paradox, that the more successful the company, the greater are likely to be the fluctuations in the price of its shares. This really means that, in a very real sense, the better the quality of a common stock, the more speculative it is likely to be—at least as compared with the unspectacular middle-grade issues.”

The following sentence bears repeating: “[T]he greater the premium above book value, the less certain the basis of determining [the] intrinsic value [of a company]… [and] the more this “value” will depend on the changing moods and measurements of the stock market.” [10]

What is “the intelligent investor” to do with such information? It leads, Graham argues, “to a conclusion of practical importance to the conservative investor in common stocks.” This “conclusion” consists of Graham’s recommendation that “conservative investor[s]” should “concentrate on issues selling at a reasonably close approximation of their tangible-asset value—say, not at more than one-third above that figure. Purchases made at such levels, or lower, may with logic be regarded as related to the company’s balance sheet, and as having a justification or support independent of the fluctuating market prices. The premium over book value that may be involved can be considered as a kind of extra fe paid for the advantage of stock-exchange listing and the marketability that goes with it.” [11] Yet valuation should not be taken as the sole basis on which to assess the attractiveness of a given investment; other factors, such as the ongoing profitability of the business, must also be taken into consideration. Graham writes, therefore, that “[t]he investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that [the company’s] earnings will be maintained over the years.” [12]

The above recommendations can be summarized as follows:

  1. Price 133% of book value.
  2. “Satisfactory” price-to-earnings ratio.
  3. “Sufficiently strong financial position”
  4. Stable earnings which seem likely to be “maintained over the years”.

“The investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipliers of both earnings [“price-to-earnings”] and tangible assets [“price-to-book value”]. As long as the earning power [read: dividend income] of his holdings remains satisfactory, he can give as little attention as he pleases to the vagaries of the stock market. More than that, at times he can use these vagaries to play the master game of buying low and selling high.” [13]

Graham provides a valuable example of these principles in action in a section entitled “The A. & P. Example,” between pages 200 and 202. I will not transcribe this example, but its conclusion is worth printing out and permanently taping to whatever computer monitor, interface, or telephone through which you make your brokerage transactions. As Zweig notes in his footnote on page 203, “You cannot read these words too often; they are like Kryptonite for bear markets. If you keep them close at hand and let them guide you throughout your investing life, you will survive whatever the markets throw at you”:

“…[N]ote this important fact: 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 [by this Graham means “only to the extent that doing so is in his interest,” such as in the case that selling his shares would secure him an attractive profit under appropriate conditions]. 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 into a basic disadvantage. [14] 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.” [15]

Of course, Graham in that last sentence is being partly facetious. As he notes latterly on page 204, “it is self-deception to tell yourself that you have suffered no shrinkage in value merely because your securities have no quoted market at all.”

Let’s move back to the notion of the “basic advantage” afforded to the common-stock investor. There is another dimension of this advantage viz. private business owners which has not yet been mentioned explicitly, and that is the liquidity of the equity market:

“Critics of the value approach to stock investment argue that listed common stocks cannot be properly regarded or appraised in the same way as an interest in a similar private enterprise, because the presence of an organized security market “injects into equity ownership the new and extremely important attribute of liquidity.” But what this liquidity really means is, first, that the investor has the benefit of the stock market’s daily and changing appraisal of his holdings, for whatever that appraisal may be worth, and, second, that the investor is able to increase or decrease his investment at the market’s daily figure—if he chooses. Thus the existence of a quoted market gives the investor certain options that he does not have if his security is unquoted. But it does not impose the current quotation on an investor who prefers to take his idea of value from some other source.” [16]

Usually my intention is to summarize more aggressively so as to reduce the overall wordage of these documents for ease of reading. However, Graham includes a famous analogy in this chapter, the exclusion of which ultimately be against the interests of the reader:

Mr. Market

“Let us close this section with something in the nature of a parable. Imagine that in some private business you own a small share cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you can additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away from him, and the value he proposes seems to you a little short of silly.

If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

The true investor is in that very position when he owns a listed common stocks. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed—this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such signals are misleading at least as often as they are helpful. 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.

Summary

I) Under what conditions should one invest?

“It is far from certain that the typical investor should regularly hold off buying until low market levels appear, because this may involve a long wait, very likely the loss of [dividend] income, and the possible missing of investment opportunities. On the whole it may be better for the investor to do his stock buying wherever he has money to put in stocks, except when the general market level is much higher than can be justified by well-established standards of value [such as the price-to-earnings ratio, other valuation metrics, and the Shiller P/E, discussed below]. If he wants to be shrewd he can look for the ever-present bargain opportunities in individual securities.

→ Note what Graham is saying here. In considering whether or not one should invest in the equity market, he proposes asking oneself the following three questions:

1) What is the opportunity cost associated with the dividend income which you would stand to gain by investing? In simpler terms, what percentage of dividend income would you gain by investing in the companies under consideration?

2) If you are hesitant to invest (presumably based on certain apparently unfavourable conditions), how long do you anticipate refraining in this manner? In other words, how long do you anticipate these “unfavourable conditions” to persist? By multiplying this period of time by the dividend income mentioned above, you arrive at a rough estimation of what income is forfeited by not investing.

3) What is the “general market level”, and do these prices bode well for the prospects of current investment? An overvalued “general market” (as expressed through such major indices as the Dow Jones Industrial Average and/or the S&P500 in the United States) indicates elevated risk for investors and should therefore weigh in favour of delaying one’s equity purchases. Conversely, of course, an undervalued market weighs in favour of the decision to invest. A natural question which arises is How does one determine whether the general market is overvalued or undervalued? Doing so should by no stretch of the imagination be regarded as an exact science. However, the various valuation methods which Graham discusses throughout The Intelligent Investor can be applied just as effectively to the general market as to individual companies. Investors should also take note of the Shiller Price-to-Earnings Ratio, a method of valuing the broad market which has shown impressive predictive capacity when back-tested (that is, applied retroactively to determine what valuation the Ratio would have yielded at particular points in the past, in advance of the ensuing market activity). The Shiller Ratio is, of course, after Graham’s time, but it should be part of the modern investor’s toolkit of resources. I will focus on the Shiller Ratio in a separate article.

Summary

This passage from Jason Zweig’s commentary on Chapter 8 does a good job of synthesizing the essential gist of the chapter:

“The intelligent investor shouldn’t ignore Mr. Market entirely. Instead, you should do business with him—but only to the extent that it serves your interests. Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them. You do not have to trade with him because he constantly begs you to.” [17]

 

At the time of publication, Jason Fernando held shares in one of the securities mentioned in this article. Specifically, he held shares in Blackberry, Ltd. He does not intend to trade any of these shares within 48 hours of publication.

 

Footnotes
[1] 205.
[2] 188.
[3] 190-191.
[4] 179.
[5] 195.
[6] 196.
[7] 197.
[8] By “price quotations,” Graham is referring to the average price being paid for a given share at a given time on the public markets. These prices are often referred to as “quotes” or “price quotes”. For example, electronic brokerage services (through which shares are often bought and sold by individual investors) allow users to “quote” the price of a given stock (meaning, they display the current average market price of the stock).
[9] 198.
[10] 198-199.
[11] 199-200.
[12] 200.
[13] 200.
[14] By “basic advantage”, Graham is referring to the fact that owners of common stock are partial owners in the businesses whose stock they purchase while also having the ability to sell the stock at their discretion. Private business owners or majority stakeholders, on the other hand, have less freedom in this regard as such a sale would likely be scrutinized by other shareholders and may bear a significant impact on the company as a whole. As Graham notes earlier on page 203, the ordinary (non-insider) shareholder “has the option of considering himself merely as the part owner of the various businesses he has invested in, or as the holder of shares which are salable at any time he wishes at their quoted price.” This flexibility is the “basic advantage” which Graham refers to latterly.
[15] 203.
[16] 204.
[17] 215.

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