The Intelligent Investor

This book is not addressed to speculators. The speculator is not our concern, and if he reads these pages at all, he reads them in vain — for the speculator’s purpose is to divine how other men will value things tomorrow, and no book can reliably teach that. Our purpose is different: to establish principles by which the private investor may behave soundly and profitably. The two enterprises are not the same, and confusing them has cost the public dearly.

The intelligence we ask of the investor is not measured in points on an examination. It is a trait more of character than of the brain. The man who panics in a falling market may have a first-rate mind; the man who buys calmly when others flee may be unremarkable in every other respect. We have observed both kinds across half a century on Wall Street. The decisive quality is temperament.

We entered Wall Street in June 1914. No one then had any inkling of what the next half-century held in store — two world wars, a depression of catastrophic scope, an inflationary spiral, and a bull market of dimensions that would have seemed impossible. What we bring the reader, then, is not prophecy. It is something more durable: a set of principles that have survived those upheavals.

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative. This definition was set down in our textbook Security Analysis in 1934, and we have seen no reason in the intervening decades to soften it. The distinction matters enormously — not as an academic exercise but as a practical safeguard against loss.

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. Market movements concern him chiefly as they create opportunities to buy well or, occasionally, to sell at an advantage.

The distinction between investment and speculation in common stocks has always been a useful one, and its disappearance is a cause for concern. We have often said that Wall Street as an institution would be well advised to reinstate it and to emphasize it in all its dealings with the public. Otherwise the stock exchanges may some day be blamed for the losses of speculating customers who believe themselves to be investing.

Three things are dangerous to the non-professional who enters the speculative arena: speculating when you think you are investing; speculating seriously instead of as a pastime, when you lack proper knowledge and skill; and risking more money than you can afford to lose. Every nonprofessional who operates on margin is ipso facto speculating, and his broker has a duty to tell him so. We say this not harshly, but as a matter of plain arithmetic.

There is one further distinction we must press upon the reader. The defensive investor, and the enterprising investor — these are not personalities assigned at birth. They are roles chosen by the investor according to his situation, his temperament, and the time he is willing to devote. The defensive investor seeks safety and freedom from effort. The enterprising investor seeks superior results and is willing to apply the work required to earn them.

Inflation, and the fight against it, has been very much in the public’s mind. The shrinkage in the purchasing power of the dollar, and the fear of further decline, has greatly influenced the thinking of Wall Street. It is clear that those with fixed-income investments have been seriously hurt by this trend. The question is whether common stocks protect the investor against inflation better than bonds do.

The argument that stocks are an inflation hedge is superficially plausible: a company owns factories and inventories whose prices rise with the cost of living. But the actual record is disappointing. The connection between inflation and corporate earnings is far less reliable than the theory suggests. Periods of sharp inflation have often been accompanied by poor stock returns. The stock market is not the simple repository of real value that its partisans claim.

What the investor can do is maintain a mixed portfolio of bonds and stocks, maintaining the proportion that suits his situation, and hold to it without excitement as prices move. If inflation turns out to be serious, his stocks will have given him some protection. If it proves mild, his bonds will have served him well. The mixture itself is the hedge — not a prediction but a precaution, the oldest financial virtue.

The investor’s portfolio of common stocks represents a small cross-section of that immense and formidable institution known as the stock market. Prudence suggests that he have an adequate idea of stock-market history — in terms particularly of the major fluctuations in its price level, and of the varying relationships between stock prices and earnings and dividends. Without this knowledge he cannot form the indispensable historical perspective.

Nearly all the bull markets have had a number of well-defined characteristics in common: a historically high price level, high price-to-earnings ratios, low dividend yields against bond yields, much speculation on margin, and many new common-stock issues of poor quality. These are the signs of an overheated market. It would appear that the intelligent investor should be able to recognize them. Whether he can act on that recognition with discipline is another matter entirely.

At the end of 1971 we found the market level high by historical standards — by earnings, by dividends, by book value. The Dow yielded only 3.5%. We cannot predict whether prices will fall or continue to rise. But we can say with confidence that common stocks purchased at the levels prevailing in early 1972 contain a significant speculative element. The investor who neglects this fact will find it impossible to distinguish investment from speculation.

In 1949, when the first edition of this book appeared, we were able to recommend a formula: buy when the market is selling at a reasonable multiple of earnings and a good dividend yield; sell when neither condition obtains. This formula worked for thirty years. Then the market changed its behavior. What once were reliable signals are no longer reliable. This is the great humiliation of market forecasting — the mechanism fails precisely when most people have learned to trust it.

We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range in bonds. There is an implication here that the standard division should be a 50–50 split. The advantage of this simplest of programs is that it will give him something to do as the market moves — selling stocks after they have risen, adding to them after they have fallen.

The selection of common stocks for the portfolio of the defensive investor should be a relatively simple matter. The rules: adequate though not excessive diversification — ten to thirty issues. Each company large, prominent, and conservatively financed. A long record of continuous dividends. A price not more than 25 times average earnings of the past seven years, and not more than 20 times the earnings of the last twelve months. These are not secrets. They are the basics.

There is a basic principle of investment which is old, sound, and often forgotten: those who cannot afford to take risks should be content with a relatively low return on their invested funds. The rate of return which the investor should aim for is more or less proportionate to the effort and intelligence he brings to the enterprise, and to the risk he can genuinely afford. There are no high returns without correspondingly serious risks. The investor who forgets this is soon reminded.

We regard growth stocks as a class as too uncertain and risky for the defensive investor. The growth-stock buyer depends on the market’s continuing to value his stock at a high multiple, which requires that the company continue to grow at a high rate. When the rate of growth slows — as it always eventually does — the multiple contracts, and the investor finds that the price advance which seemed certain has become a price decline. The error was paying for hope.

Our enterprising security buyer will desire and expect to attain better overall results than his defensive companion. But first he must make sure that his results will not be worse. It is no difficult trick to bring a great deal of energy, study, and native ability into Wall Street and to end up with losses instead of profits. These virtues, if channeled in the wrong directions, become indistinguishable from handicaps. The intelligent investor must know what not to do.

We lay out what operations are not available to the enterprising investor — that is, what appears promising but, on examination, offers no genuine advantage. The high-grade preferred stock, the inferior bond, the foreign-government issue, the new common-stock offering at its height of enthusiasm, the stock recommended by the brokerage house with a financial interest in recommending it — these are not opportunities. They are traps in the clothing of opportunities.

The enterprising investor may properly seek bargain issues: common stocks that are selling below their net current assets — what they would fetch in liquidation. In good times such issues are scarce. In 1970 a good number appeared. Our own operations on Wall Street concentrated for many years on exactly this ground: stocks selling for less than their share in the net current assets, with no weight given to plant, equipment, or goodwill. The results over time were gratifying.

Bargains come into existence because of neglect, because of temporary disappointments, because of corporate structures that obscure true earning power. They do not come into existence because the market is ignorant. They come into existence because the market is impatient. The investor must be the opposite. He must be willing to wait, without excitement, for the price to recognize the value that the balance sheet already declares. This is not glamorous work. It is sound work.

Our criteria for the enterprising investor’s common-stock list are less severe than those for the defensive investor, but they still constitute a disciplined screen. Financial condition: current assets at least one and a half times current liabilities, and debt not more than 110% of net current assets. Earnings stability: no deficit in the last five years. Some current dividend. Earnings no lower last year than ten years ago. Price not more than 120% of tangible book value.

Secondary companies — well-established smaller concerns — are not to be dismissed. The aggressive investor may properly consider those priced at a discount from their fair value, knowing that the market’s prejudice against them holds their prices low. The prejudice is a structural fact; the smart investor exploits it rather than sharing it. What the crowd avoids, the intelligent buyer examines. What the crowd prizes, the intelligent buyer holds at arm’s length.

The speculative public is incorrigible. In financial terms it cannot count beyond 3. It will buy anything, at any price, if there seems to be some “action” in progress. It will fall for any company identified with franchising, computers, electronics, science, technology — whatever the particular fashion happens to be at the moment. Our readers, sensible investors all, are of course above such foolishness. But the question remains: should not the responsible investment houses refuse to sell it to them?

Imagine that in some private business you have a thousand-dollar interest. 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 an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments. Often, however, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems 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 your thousand-dollar interest in the enterprise? Only if you agree with him, or if 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 do better to form your own ideas of value, based on the reports the company sends you about its operations and financial position.

The intelligent investor should be perfectly comfortable owning a stock even if the market stopped supplying daily prices for the next ten years. If you cannot face that thought, you are not an investor — you are a speculator of the mildest sort, someone who has let himself be managed by a quotation rather than managing it. Mr. Market is there to serve you, not to guide you. The moment he becomes your guide, you have handed him a power he has not earned and you have not conferred wisely.

We are convinced that the average investor cannot deal successfully with price movements by endeavoring to forecast them. Can he benefit from them after they have taken place — by buying after each major decline and selling out after each major advance? For thirty years prior to 1950 the record seemed favorable to that approach. Since then the pattern has changed. The best we can say is: be prepared to buy when prices are low, and do not be lured into selling when they rise. Patience is not a policy, but it is the indispensable companion of one.

The investor with a stock portfolio resting on sound asset 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 and assets. As long as the earning power of his holdings remains satisfactory, he can give as little attention as he pleases to the market’s gyrations. He need not be beguiled into buying when the market is high, nor panicked into selling when it is low.

The investment fund offers the small investor something genuinely useful: diversification at modest cost, professional management, and freedom from the labor of choosing individual securities. We approve the purchase of well-managed investment funds as an alternative to creating one’s own portfolio, particularly for the defensive investor who by definition is an amateur. These are genuine advantages, and we do not wish to belittle them.

But the evidence on the subject is not flattering to the professionals. Studies covering 1960 through 1968 show that random portfolios of New York Stock Exchange stocks with equal investment in each performed on the average better than mutual funds in the same risk class. The differences were not trivial for low- and medium-risk portfolios. If the experts cannot beat random selection, the investor should ask himself what it is he is paying for.

As the investment manager’s fund grows, its fees become more lucrative — making the manager reluctant to rock the boat. The very risks he took to generate his initial high returns could now drive investors away. The result is a kind of institutional timidity masquerading as prudence. The fund that made its name by being different becomes, with success, indistinguishable from the herd. Excellence in investment management has a natural tendency to become self-defeating.

The relationship between the investment banker and the investor is basically that of salesman to prospective buyer. This is a fact so obvious that one might expect it to be universally known. Yet investors in every generation appear astonished when their brokers turn out to have their own interests — in commissions, in the securities their houses are selling — somewhat ahead of the investor’s. It is imprudent for the buyer to trust himself entirely to the judgment of the seller.

The investor should use his intelligence not only in formulating his financial policies but also in choosing who advises him. He should entrust himself only to firms of the highest reputation. The function of the advisory service is not to make him rich quickly, but to ensure that his financial policy is sound and that he obtains the normal result to which a sound policy entitles him. Expectations of superior performance from a financial counselor are almost invariably disappointed.

The aggressive investor will work in active cooperation with his advisers. He will want their recommendations explained in detail, and he will insist on passing his own judgment on them. This means that he will gear his expectations and his criteria to some extent along with those of his adviser, and then apply his own common sense to their recommendations. Delegating investment judgment entirely, without review, is not intelligent investment — it is abdication.

The security analyst deals with the past, the present, and the future of any given security issue. He describes the business; he summarizes its operating results and financial position; he sets forth its strong and weak points, its possibilities and risks; he estimates its future earning power under various assumptions. His conclusions emerge as a valuation — an estimate of what the security is worth — and the investor either acts on that valuation or learns why he need not.

In dealing with common stocks the security analyst must now work with standards less precise than those he applies to bonds. The standard for bonds asks whether earnings cover interest by an adequate margin over a period of years including times of adversity. For common stocks the analyst must ask whether the company’s earning power is likely to be maintained, and at what level. This is partly science and partly judgment — and the part that is judgment will sometimes be wrong.

The more seriously investors take per-share earnings figures as published, the more necessary it is for them to be on guard against accounting factors that impair true comparability. Special charges written off in a given year may never recur, but they represent real losses to the company’s owners. The analyst must reconstruct the true earnings history before he can evaluate the current price. A figure that management has put forward is not automatically the figure that matters.

We caution the investor not to judge any company’s value primarily on the earnings of a single year. Average earnings over a period of five to ten years give a far more reliable picture of a company’s true earning power than any single year’s figure — particularly when that year happens to be a very good one. The market will capitalize a boom year’s earnings as if they were permanent. The investor should decline to do the same, knowing that cycles are not abolished by their own peaks.

We present four companies to illustrate the different extremes found in the market’s behavior. Penn Central: an extreme example of the neglect of the most elementary warning signals of financial weakness. Ling-Temco-Vought: quick and unsound empire-building with collapse practically guaranteed. NVF Corporation: a small company acquiring a larger one, burdening itself with debt while using accounting changes to disguise the deterioration. These are not anomalies. They are cautionary types.

The defensive investor’s criteria — and we repeat them here because they bear repeating — are: adequate size, a strong financial condition, continued dividends for at least the past twenty years, no earnings deficit in the past ten years, some growth in earnings per share, price not more than fifteen times average earnings of the past three years, and price not more than one and a half times the book value last reported. A stock passing all seven tests is not glamorous. It is sound.

The enterprising investor who seeks bargain issues finds them by a different method: identifying stocks selling at less than their working capital — current assets minus all liabilities. We called these net-net stocks. In December 1957 we compiled a list of 85 such issues. By the end of 1959 the average gain of the group was 75%, against 50% for the Standard & Poor’s 425 industrials. More remarkably, not a single issue in the group showed a significant loss. The method is tedious. It works.

Convertible bonds and preferred stocks are regularly promoted to investors as offering the best of both worlds — the safety of a bond and the appreciation potential of a stock. Our experience teaches otherwise. They generally give you the worst of both worlds. When the stock advances, the convertible lags behind. When the stock declines, the convertible falls with it. The only case for the convertible is when the company is strong enough to make the bond worth holding, and cheap enough to make the conversion option genuinely valuable.

Stock-option warrants we regard as a near fraud, an existing menace, and a potential disaster. They have created huge aggregate dollar “values” out of thin air. They have no excuse for existence except to the extent that they mislead the speculator. They give him the hope of large gain without the substance of business ownership. When the underlying stock declines sharply, the warrant becomes worthless faster — but not before it has extracted its toll from those who purchased hope at a premium.

We have compared pairs of companies side by side in the stock exchange list to show that the market’s judgments are not always consistent. Two companies in similar businesses can sell at vastly different multiples of earnings and book value, without any corresponding difference in their records or their prospects. The market does not price things correctly in any universal sense. It prices things according to the prevailing mood, the promotional acumen of management, and the accidents of timing.

In the past the dividend policy was a fairly frequent subject of argument between public shareholders and management. Management preferred to keep earnings in the business, asking shareholders to sacrifice present income for future benefit. In recent years this argument has gone quiet — investors have accepted management’s judgment on this question more readily than is perhaps wise. The burden of proof should be on management to justify the withholding of the dividend.

A company’s management may run the business well and yet not give the outside stockholders the right results for them — because its efficiency is confined to operations and does not extend to the best use of capital. The objective of management should be to obtain as good results as possible for the outside investors. A manager who enriches himself while leaving the stockholder behind has not managed well, whatever the operating efficiency he can demonstrate.

The shareholder who has a poorly managed company should not, in most cases, expect to improve matters by protesting at annual meetings or organizing stockholder revolts. The realistic remedy is to sell the shares and invest elsewhere. But the investor who bought on value, and who finds that the management has not served him well, is entitled to remember this fact when next management asks him for his proxy. His vote, cast with knowledge and deliberateness, is not meaningless.

In the old Wall Street phrase, there are two requirements for success in the stock market: to think correctly, and to think independently. Both are necessary; neither alone is sufficient. The analyst who thinks correctly but follows the crowd will be right only when the crowd is right. The analyst who thinks independently but arrives at wrong conclusions will be independent and wrong. The margin of safety, properly applied, is the instrument that converts correct and independent thinking into actual results.

There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss — not that loss is impossible. But as the number of such commitments is increased, the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses.

The margin of safety for bonds and investment-grade preferred stocks may be calculated from the historical record of interest coverage during periods of business adversity. If a company has earned its interest charges by four or five times over many years, including a bad recession, the bondholder has a substantial margin. For common stocks the concept applies differently: the margin is the excess of the stock’s intrinsic value over its price. This margin is established by calculation, not by feeling.

We greatly doubt whether the man who stakes money on his view that the market is heading up or down can ever be said to be protected by a margin of safety in any useful sense of the phrase. By contrast, the investor’s concept of the margin of safety rests on simple and definite arithmetical reasoning from statistical data. This is the dividing line between investment and speculation stated in another form. The speculator relies on price movement. The investor relies on value.

A strong-minded approach to investment, firmly based on the margin-of-safety principle, can yield handsome rewards. But the decision to try for these rewards rather than the assured fruits of defensive investment should not be made without much self-examination. The enterprising investor who does not know himself as well as he knows his balance sheet will find, in the first serious decline, that he does not have the temperament he thought he had. The margin of safety in the portfolio cannot compensate for the absence of a margin of safety in the character.

If the intellectual foundation is flawed — if the Graham-and-Dodd approach is obsolete — one would expect its practitioners, spread across decades and geographies, to produce results no better than chance. What one finds instead is a group of investors who have in common not a single industry, not a single source of information, not a single portfolio construction technique, but one intellectual approach: looking for discrepancies between the value of a business and the price of small pieces of that business in the market.

These investors have achieved superior results over many years not by taking more risk — the conventional explanation of excess returns — but by paying less than the business is worth. Their coin flips have come up heads not because they are lucky but because they began with an intellectual framework that the market has not yet made self-defeating. When enough people practice the method, it will erode its own advantage. For now it survives in part because the market’s institutions cannot be bothered to think this way.

In this little waking vigil that still remains to our senses, consider the seeds from which you sprang — you were made not to live as brutes, but to follow virtue and knowledge. The art of investing is not the art of predicting the next quarter’s earnings. It is the art of forming a sound judgment about a business and its price, then having the character to act on that judgment and the patience to wait for the market to agree. Intelligence is indispensable. Temperament is everything.