- Investment = thorough analysis + safety of principal + adequate return.
- Speculation isn't wrong in itself; it is unintelligent when mistaken for investing, done without skill, or done with money you can't afford to lose.
- Defensive investor: avoid serious losses, minimise effort. Enterprising: put in time and care.
- What you buy doesn't decide it; how you decide does.
- investment operation
- Graham: one that, on thorough analysis, promises safety of principal and an adequate return
- speculation
- any operation that fails Graham's test
- defensive investor
- aims to avoid serious losses and wants freedom from effort
- enterprising investor
- willing to put in time and care to find better-than-average opportunities
- margin
- buying with borrowed money; Graham counts it as speculation
Watch out: Calling anyone who buys shares an "investor". Graham complained that newspapers used the word for everyone in the market, even people making emotional short-term bets. The word should describe how you decide, not what you own.
- Inflation erodes fixed payments; stocks can keep up, but not reliably.
- Graham, 1915–1970: stocks about 8% a year in all, no better than bonds paid in 1972.
- Short term: no close link between inflation and stock prices.
- Real return = (1 + return) ÷ (1 + inflation) − 1.
- inflation
- a general rise in prices, which shrinks what money buys
- real return
- the return after inflation: (1 + return) ÷ (1 + inflation) − 1
- fixed income
- payments set in money terms, like bond interest, which inflation erodes
- inflation-protected bond
- a government bond whose value is adjusted for inflation (Zweig discusses the U.S. version)
Watch out: Treating stocks as a perfect inflation shield. In Zweig's data, stocks did badly in years of very high inflation (and in deflation). Graham's advice is to expect inflation, but to protect against it with a mix, not with one asset.
- Earnings yield = 1 ÷ P/E.
- Graham compared stocks' yields with bond yields to judge whether the market was high.
- In early 1972 he judged it no bargain; the 1973–74 fall followed.
- Never assume past returns will simply continue: the price you pay changes what you can expect.
- earnings yield
- earnings ÷ price; the P/E ratio upside down
- bond yield
- the yearly return on a bond at its current price
- bear market
- a large, lasting fall in prices
- extrapolation
- assuming a past trend will simply continue
Watch out: "Stocks have returned 7% after inflation for two centuries, so I'll get 7% from here." Graham's point is that the price you pay changes the return you can expect: the same companies bought at a higher P/E leave less room for return, and for error.
- Stocks between 25% and 75%; the simplest default is 50–50.
- Graham: restore 50–50 when the mix drifts (his example: by about 5 points). Zweig: rebalance every six months.
- Rebalancing sells some of what rose and buys what fell.
- Graham ties return to effort, not risk; Zweig adds that circumstances matter more than age.
- asset allocation
- how money is split between stocks, bonds and cash
- rebalancing
- trading back to your target mix after prices have moved
- high-grade bond
- a bond from a very creditworthy borrower
- defensive investor
- Graham: wants safety and freedom from concern (a passive, low-effort approach)
Watch out: Letting the winners run until they dominate. After a long rise, an unrebalanced 50–50 portfolio can become 70–30 or more: much riskier than intended, often after prices have risen a long way. Rebalancing sells a little of what rose and buys what fell.
- Mr. Market quotes a price daily; you can trade with him or ignore him.
- Prices are offers, not verdicts on value.
- Timing (forecasting) leads to speculation; pricing (value versus price) is the investor's approach.
- Watch the businesses, and use extreme prices when they come.
- Mr. Market
- Graham's moody partner who quotes a price every day
- timing
- trying to forecast market moves and act ahead of them
- pricing
- buying below fair value, selling above it, or at least never overpaying
- fair value
- what a business is worth, judged from its earnings and assets
Watch out: Letting the daily price tell you how to feel. Zweig points out that the average contribution to U.S. workplace retirement (401(k)) plans fell from 8.6% of pay in 1999, when stocks were soaring, to 7% in 2002, after three years of falling prices: the cheaper stocks got, the less eager people were to buy them.
- Even safe bonds change price when interest rates change; longer bonds change more.
- A shareholder is both a part-owner and the holder of a tradable share.
- Graham: being stampeded by falls turns your advantage into a disadvantage.
- Zweig: control your costs, expectations, risk, taxes and above all your behaviour.
- interest-rate risk
- the chance that rising rates lower a bond's market price
- maturity
- when a bond is repaid; longer maturity means bigger price swings
- present value
- what future payments are worth today at a given rate
- behaviour
- the control Zweig stresses "most of all"
Watch out: Treating a fall in price as a loss you have to act on. Unless you need to sell, a lower price changes what Mr. Market offers. If the business or the borrower hasn't deteriorated, it doesn't change what you're paid; Graham says to check that first.
- Open-end funds trade at NAV; closed-end funds trade on an exchange, often at a discount.
- Graham: funds were useful, but no better than the market, and may have cost more.
- His rule: discounted closed-end funds gave about one-fifth more for the money than mutual funds bought with a 9% charge.
- Zweig: start with low cost and good stewardship; treat past returns as the weakest reason to buy, and look at them last.
- net asset value (NAV)
- the value of a fund's holdings per share
- open-end (mutual) fund
- issues and redeems shares at NAV
- closed-end fund
- has a fixed number of shares that trade on an exchange, often at a discount or premium to NAV
- sales charge (load)
- a fee paid when buying (or selling) some funds
- discount
- a closed-end fund's price below its NAV
Watch out: Buying a fund because it was last year's top performer. In Zweig's account, a fund at the top often attracts a flood of new money, swells in size, loses its manager to a rival, or simply had luck that runs out. A good past return is the weakest reason to buy.
- Advisers can help with planning, taxes and behaviour; neither Bogle nor Graham expects them to beat the market reliably.
- Commission and fee-only pay create different conflicts; both are costs.
- A 1% yearly fee can take around 30% of 30 years' gains.
- Help is most worth having after big losses, budget trouble, chaotic portfolios or big life changes. Trust, then verify.
- commission
- pay an adviser receives from a product provider for a sale
- fee-only adviser
- an adviser paid only by the client, not by product providers
- conflict of interest
- when an adviser's pay depends on what they recommend
- advice fee
- a yearly charge, often a % of the money advised on
- investment counsel
- a professional adviser paid a fee to manage or advise on investments
- due diligence
- checking someone's background before trusting them
Watch out: Treating a recommendation as free. If an adviser is paid by commission, the product price includes their pay; if fee-only, it's on your statement. Either way, ask how much it is in money per year, and what you get for it.
- Assets = liabilities + equity, always.
- Every transaction changes two things, so the sheet still balances.
- Swapping one asset for another leaves totals unchanged.
- Profit raises equity; it is not the same as cash.
- assets
- what a business owns or controls
- liabilities
- what it owes others
- equity
- what belongs to the owners: money put in plus profits kept
- balance sheet
- a snapshot, on one date, of assets, liabilities and equity
- statement of financial position
- the name used in international accounting standards (and by ACCA) for the balance sheet
- capital
- another name for the owner's equity, used especially for small businesses; profit adds to it and drawings reduce it
- drawings
- money or goods the owner takes out of the business for personal use
- current and non-current
- assets and liabilities are split by whether they turn into cash, or fall due, within about a year
Watch out: Treating profit as cash. Profit raises equity; it does not always mean more cash. A sale on credit, for example, raises profit while the money is still owed by the customer.
- Four rules: 10–30 companies; large, prominent, conservatively financed; long dividend record; price limits (25× seven-year average earnings, 20× last year's).
- The price rule excludes most growth stocks.
- Dollar-cost averaging: same amount, regular intervals; average cost below average price.
- Zweig: a broad index fund can now do much of this work with less effort.
- diversification
- spreading money across many holdings
- growth stock
- a company expected to grow earnings much faster than average
- dollar-cost averaging
- investing a fixed amount at regular intervals
- earnings multiplier
- another name for the P/E ratio
- conservatively financed
- not heavily in debt
Watch out: Treating a famous, fast-growing company as safe. Growth that's already in the price leaves no room for disappointment. Graham notes that some authorities define a "true growth stock" as one expected to at least double its earnings in ten years (a compounded rate of over 7.1% a year), and that growth stocks were the favourites of speculators and big institutions alike in his day.
- Graham's enterprising "don'ts": high-grade preferreds (leave to companies), second-grade bonds and preferreds unless at bargain prices (for high-coupon issues, 30%+ below par), foreign government bonds, new issues.
- New issues come with salesmanship and are sold when conditions favour sellers.
- Zweig: IPO booms repeat, and buyers usually pay too much.
- Don't buy anything only for its yield.
- par
- a bond's face value, the amount repaid at maturity
- preferred stock
- shares that pay a fixed dividend before ordinary shareholders get anything
- second-grade (junk) bond
- a bond from a borrower with weaker credit, paying more interest
- new issue / IPO
- shares or bonds sold to the public for the first time (IPO: initial public offering)
Watch out: Buying a bond or preferred stock only for its high yield. Zweig puts it bluntly: when the yield dries up, there's nothing else there. A higher yield usually means a higher risk that the payments stop.
- Bond safety: interest coverage, averaged over years; Graham's minimums vary by type of company (industrials: 7× average or 5× in the worst year, before tax).
- Graham's growth formula: value ≈ earnings × (8.5 + 2g): a shortcut, not a precise truth.
- Work backwards from the price to see what growth it assumes.
- Zweig: watch for serial acquisitions, reliance on outside money and dependence on one customer; look for moats and steady growth.
- interest coverage
- earnings ÷ interest charges: how many times the company can pay its interest
- investment-grade
- judged safe enough for a conservative investor
- capitalisation rate (multiplier)
- the number earnings are multiplied by to estimate value
- implied growth
- the growth rate a price assumes, worked backwards
- moat
- the term Zweig uses for a lasting competitive advantage
Watch out: Trusting a precise-looking valuation. Every formula depends on the growth figure you put in, and growth forecasts are where analysts are most often wrong. Zweig warns that a growth rate of around 10% a year before tax may be sustainable for a long time, but that companies promising much more, or showing a sudden burst, usually fade.
- Don't judge a company on one year's earnings.
- Watch for special charges and dilution; fully diluted EPS allows for new shares.
- Graham: average earnings over 7–10 years, including special items.
- Growth: compare the last three years' average with the same three years a decade earlier.
- Zweig: ignore "pro forma" earnings.
- earnings per share (EPS)
- net profit ÷ number of shares
- special charge
- a cost reported as unusual or one-off
- dilution
- earnings spread over more shares, from conversions or warrants
- fully diluted EPS
- earnings per share allowing for all possible new shares
- pro forma earnings
- a company's figure for what it "would have" earned without certain costs
Watch out: Taking the headline figure. Zweig adds a modern version: "pro forma" earnings, in which a company shows what it would have earned if certain costs hadn't happened. His advice for the intelligent investor: ignore them.
- Enterprising options: unpopular large companies, bargain issues, special situations.
- Bargain = worth at least 50% more than the price (price ≤ about two-thirds of value).
- Net current asset value = current assets − all liabilities (incl. preferred), per share.
- Buy bargains as a diversified group; any single one can fail.
- net current asset value
- current assets minus all liabilities (including preferred stock)
- working capital
- current assets minus current liabilities; Graham's "net working capital" here deducts all liabilities, including long-term debt and preferred stock
- bargain issue
- Graham: worth at least 50% more than its price
- special situation
- a share whose price depends on a specific event, such as a takeover
- unpopular large company
- a big company temporarily out of favour with the market
Watch out: Treating "cheap" as "safe" for one company. Graham's evidence is for groups of bargain stocks. A single company priced below its working capital may be losing money fast, so the working capital shrinks before the market recovers.
- Compare companies on profitability, stability, growth, financial position, dividends and price history.
- Graham's 1970 four: P/E ratios varied far more than business results.
- High valuations entail high risks.
- Rising prices ("market action") aren't a reason for a conservative investor to buy.
- book value
- a company's net assets per share, from its balance sheet
- return on book value
- earnings ÷ book value
- current ratio
- current assets ÷ current liabilities
- dividend yield
- dividend per share ÷ share price
- price/book ratio
- share price ÷ book value per share
Watch out: Choosing the company with the more exciting share price. Graham notes that many analysts preferred the two dear companies mainly for their "market action" (rising prices), which he calls something for speculators, not a valid reason for a conservative investor.
- Seven tests: size, financial strength, ten years of earnings, 20 years of dividends, one-third EPS growth, P/E ≤ 15, price ≤ 1.5 × book or P/E × P/B ≤ 22.5.
- They exclude weak companies and expensive popular ones.
- They are minimums, not a buy list; the 1972 size figure needs updating.
- Zweig: an index fund now does much of the defensive job.
- current ratio
- current assets ÷ current liabilities
- net current assets
- current assets minus current liabilities (working capital)
- book value
- net assets per share, from the balance sheet
- 22.5 rule
- P/E × price-to-book should not exceed 22.5 (15 × 1.5)
- screen
- a set of tests used to rule shares in or out
Watch out: Treating the screen as a list of things to buy. Graham's tests are minimums to exclude risky or expensive shares; a company that passes still needs diversification around it, and the 1972 size figure needs updating for inflation.
- Graham: beating the averages is hard, even for professionals; look where others don't.
- His enterprising screen: P/E of 9 or less, current ratio 1.5, debt ≤ 110% of net current assets, five years without a loss, some dividend, earnings above four years earlier, price below 120% of net tangible assets.
- Random stocks fell 22%; good-will giants did best, but Graham kept his preference for asset value.
- Bargain issues need diversification and patience; workouts are for professionals.
- Practise on paper for a year (Graham's advice, via Zweig); Zweig limits stock picking to 10% of the portfolio.
- net tangible assets
- net assets excluding intangibles such as goodwill
- bargain issue
- a stock priced below its net current asset value
- workout
- a holding whose profit depends on a merger, liquidation or similar deal going through
- good-will component
- the part of a share price above book value
- 52-week low
- the lowest price of the past year
Watch out: Reading the "good-will giants" result as Graham's advice to buy popular, expensive companies. He reports the finding because it was true over that period, says momentum may carry such stocks along, and still prefers stocks with substantial asset value behind the price.
- A convertible's conversion value is shares × price; its premium is how far its price is above that.
- Graham: the buyer pays for conversion with quality or yield; new convertibles cluster late in bull markets and fall hard afterwards.
- "Never convert a convertible bond": Eversharp holders who did lost three-quarters.
- Warrants reduce the value of the common; add their market value when judging the price.
- Zweig (2003): convertibles act like stocks, are safer than in Graham's day, and are best held through a low-cost fund.
- convertible
- a bond or preferred share the holder can exchange for common shares
- conversion ratio
- the number of shares received for one convertible
- conversion value
- conversion ratio × share price
- conversion premium
- how far a convertible's price is above its conversion value
- warrant
- a long-term right to buy new shares from the company at a set price
- call
- the company paying off a bond early
Watch out: Buying a new convertible because it "can't lose much and might gain a lot". Graham's records show new convertibles doing worse than straight issues in falling markets, because they are often issued by weaker companies near market tops. The convertible form alone makes an issue neither good nor bad; the facts of each issue decide.
- Four patterns: the tottering giant, empire building on debt, the small firm swallowing a big one, the hot new issue.
- Each showed a simple warning sign in the published figures: coverage, debt, taxes paid, price against earnings.
- Graham faulted the lenders and questioned the sponsors, not only the buyers.
- Zweig (2003): Lucent, Tyco, AOL–Time Warner and eToys repeat the patterns.
- interest coverage
- earnings before interest and tax ÷ interest charges
- conglomerate
- a company built by buying businesses in many unrelated fields
- hot issue
- a new share issue whose price jumps soon after sale
- non-recurring charge
- a cost reported as a one-off, outside normal earnings
- tangible equity
- shareholders' equity minus goodwill and other intangibles
Watch out: Treating size, a famous name or a respected sponsor as proof of safety. Penn Central was the country's largest railroad, and AAA's shares were sold by a leading firm. Graham's point is that the figures decide, whoever stands behind the company.
- Graham's method: set two companies' figures side by side and ask which gives more per dollar of price.
- Whiting vs Willcox & Gibbs and Blue Bell vs Block: the bigger, better-backed business was the cheaper stock.
- Popular, fast-growing companies can be fine businesses and still overpriced.
- The analyst should look for the minority of cases where price is clearly below value.
- Zweig: there are no good stocks, only good prices.
- price / book
- share price ÷ net assets per share (book value)
- tangible assets
- assets other than intangibles such as goodwill
- dividend yield
- yearly dividend ÷ share price
- current ratio
- current assets ÷ current liabilities
- overvalued
- priced above what the facts reasonably support
Watch out: Judging the company instead of the price. Graham calls Block an "excellent business". The question he asks is whether 300 million dollars for it already paid for everything it might reasonably achieve. A fine company at too high a price can be a worse holding than an ordinary company at a low one.
- Graham: shareholders should act as owners; in practice, takeovers did more to change poor managements.
- Dividend test: about two-thirds paid out, or proof that retained earnings raised earnings per share.
- Zweig: read the proxy statement; dividends discipline managers; buybacks are good only at sensible prices; vote against option plans over 3% of shares.
- payout ratio
- dividends ÷ earnings
- retained earnings
- earnings kept in the business instead of paid out
- buyback
- a company buying its own shares, reducing the number outstanding
- proxy statement
- the document sent to shareholders before the annual meeting, covering votes, pay and insider dealings
- stock option
- a right given to employees to buy shares at a set price
Watch out: Assuming a buyback always benefits shareholders. A buyback reduces the number of shares, so earnings per share rise. But if the company pays more than the shares are worth, or is mainly buying back shares it just issued to executives cheaply, the remaining owners lose.
- Margin of safety: the cushion between price and value, or earnings and charges, that absorbs error.
- Bonds: earnings well above interest, or value well above debt.
- Stocks: earnings yield well above the bond rate; Graham's typical ten-year excess was about 50% of the price.
- It always depends on the price; growth estimates must be conservative.
- Bargains: price two-thirds of value or less.
- margin of safety
- the cushion between price and value, or earnings and charges, that absorbs error
- earning power
- what a company can be expected to earn year after year under normal conditions
- earnings yield
- earnings per share ÷ price (the inverse of the P/E)
- enterprise value
- here, the total fair value of a business, against which its debt is compared
- bargain issue
- a security priced well below its appraised value
Watch out: Treating a margin of safety as a guarantee. Graham says the margin gives a better chance of profit than of loss, not certainty: any single holding can still go wrong. That is why he pairs it with diversification (the next lesson).
- A margin of safety improves the odds; diversification makes an overall gain more and more likely.
- Graham's test of investment: a margin shown by figures, reasoning and experience.
- A low enough price can make even a mediocre security an investment, for an informed, diversified buyer.
- Four principles: know your business, supervise anyone who runs it, use arithmetic not optimism, have the courage of your knowledge.
- Zweig: avoid big losses (a 50% loss needs a 100% gain to recover).
- diversification
- spreading money over many holdings so no single one decides the result
- negative margin of safety
- odds or prices set against you, as in a casino game
- speculation
- buying on judgement or hope without a margin of safety shown by figures
- well-calibrated confidence
- being as sure as the evidence justifies, no more
- Pascal's wager
- Bernstein's point that consequences should outweigh probabilities under uncertainty
Watch out: Thinking diversification can fix a bad bet. Graham's roulette example shows the reverse: spreading money over many bets with a negative margin only makes the loss more certain. Diversification helps only when each holding has a margin in your favour.
- Buffett's coin contest: chance alone creates impressive winners.
- His case: winners concentrated in one method, named in advance, audited, with little overlap.
- In value investing, a lower price means less risk and more reward.
- Cautions: a small chosen sample, survivorship, a value premium that has varied, and shrinking edges with size.
- efficient market
- the view that prices already reflect all available information, so beating the market is luck
- survivorship bias
- judging from the records that survived and are known, while failures drop out of sight
- value investing
- buying a business, or shares in it, for clearly less than it is worth
- value premium
- the extra return, if any, of value stocks over other stocks
- pre-identified
- named in advance, before the results were known
Watch out: Concluding from a few famous winners that anyone who follows a method will win, or, the other way round, dismissing every long record as luck. Buffett's test is whether success is concentrated among people named in advance who share a method; the counter-arguments are about how strong that evidence can be.
- Graham's postscript: one well-prepared decision (GEICO) outweighed 20 years of careful work; luck and shrewdness are hard to tell apart.
- Zweig: Graham's risk was small because of the asset value behind the price; most of us should diversify.
- What holds up: investment versus speculation, Mr. Market, the margin of safety, simple defensive plans, elementary checks.
- What has dated: the 1972 figures, some instruments, some of Graham's own views.
- postscript
- Graham's closing story about one decisive investment
- preparation
- the knowledge, standing and means that let a person act on an opportunity
- concentration
- putting a large share of money into one holding
- earnings yield
- earnings per share ÷ price
Watch out: Taking the GEICO story as permission to concentrate everything in one idea. Graham himself does not know whether it was luck or shrewdness, and Zweig draws the opposite lesson for most investors: diversify.