The Intelligent Investor

The Intelligent Investor — Benjamin Graham on fallibility, competition, and the margin of safety

Two morals from Ben Graham

In The Intelligent Investor, Benjamin Graham recalls the hype that surrounded air-transport stocks in the late 1940s. Back then, it was easy to foresee growth in the commercial and personal air travel industry. Future profitability, however, was not as clear-cut given the impact that competition tends to have on expenditures in marketing, research, assets, and expansion.

Graham draws “two morals” from this experience. Firstly, “obvious prospects for physical growth in a business do not translate into obvious profits for investors”. Secondly, “experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries”.

Both morals, I suspect, will find detractors. But I’m reminded similarly of Facebook’s growth. The early days of social media were filled with many upstarts. Teenagers ran multiple accounts on Bebo, Myspace, Facebook, and whatnot. Social media was the next big thing. How much luck then should we attribute to the winning and losing bets?

Investing and speculation

As we know, Graham and his disciples were conservative investors. To Graham, the defensive investor prioritizes the: (1) “avoidance of serious mistakes”; and (2) protection over projections. They seek “freedom from effort, annoyance, and the need for making frequent decisions”. This contrasts with the enterprising investor who has the time, ability, and inclination to pursue a portfolio of opportunities that they believe will earn better returns.

Graham also makes an important distinction between investment and speculation. An investment, he notes, requires “thorough analysis”, “safety of principal”, and “an adequate return”. Everything else is speculation. (Of course, who’s to say what’s adequate in the ecology of finance. Investors vary greatly in their philosophy, risk tolerance, and worldviews.)

“There is intelligent speculation as there is intelligent investing”, Graham says. But some behaviors can make speculation unintelligent. This includes: “speculating when you think you are investing”; speculating without adequate knowledge or skill; and “risking more money… than you can afford to lose” (often by way of leverage).

Fallibility and competition

The intelligent investor, Graham says, must recognize two barriers to out-performance: fallibility and competition. Fallibility is a matter of degree. Nobody can estimate the quality of protection or project the future with absolute precision and accuracy. The goal then is in reducing the likelihood and severity of catastrophic mistakes.

I’m reminded also of Burton Malkeil’s note in A Random Walk Down Wall Street on the four common sources of error: (1) unknowable and unintended consequences; (2) poor data and accounting; (3) analytical and computational error; and (4) incentives and systematic biases. Multiple small errors can compound in unfortunate ways.

But even if your estimates are correct, the price system may already reflect everything you know. Competition, we have to remember, tends to lead to “diminishing returns” — “a kind of self-destructive process”. Many of Graham’s own filters and methods are no longer as viable today, due in part to imitation and replication.

Sound and unpopular

What’s more, fallibility and competition, Graham says, leads to a “disconcerting conclusion”. That is, to improve one’s chances of beating the market average, the investor must pursue “inherently sound and promising” opportunities that are “not popular on Wall Street”.

The principle is easy to understand, but difficult to apply. After all, finding and buying neglected, undervalued securities is “a protracted and patience-trying experience”. And shorting popular, overvalued assets, Graham reminds, requires “courage”, “stamina, … [and a deep] pocketbook”.

Margin of safety

This brings us, of course, to Graham’s fundamental tenet of investing: the margin of safety. Sound investing, ultimately, involves buying assets at a healthy discount to our estimate of intrinsic value (which is inherently fuzzy by nature).

As Graham writes:

“We advised the readers to buy their stocks as they bought their groceries, not as they bought their perfume. The really dreadful losses… were realized in those common-stock issues where the buyer forgot to ask “How much?”
Ben Graham. (1973). The Intelligent Investor.

The middle ground

An adequate margin of safety eliminates the need for the investor to predict the future perfectly. Like engineering, it provides room for error and worse-than-anticipated conditions — it provides “[protection] against the vicissitudes of time”.

The “chief hazard”, Graham observes, is paying too high a price for poor quality during upbeat conditions and euphoric sentiment. During these episodes, the investor risks conflating abnormal results with safety.

“Because of the present tendency of investors… to concentrate on more glamorous issues, I should hazard the statement that these middle-ground stocks tend to sell on the whole rather below their independently determinable values. They thus have a margin-of-safety factor supplied by the same market preferences and prejudices which tend to destroy the margin of safety in the more promising issues. Furthermore, …there is plenty of room for penetrating analysis…, to which can be added the higher assurance of safety conferred by diversification.” .
Ben Graham. (1973). The Intelligent Investor

Value and growth

Do not mistake Graham, however, for saying that investing in growth is speculative and unwise. The distinction between investing and speculation, he reminds, is in the margin of safety. Prudent investors may find safety in current earnings and/or conservative estimates of growth.

“The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price. … Thus, the growth-stock approach may supply as dependable a margin of safety… provided the calculation of the future is conservatively made, and provided it shows a satisfactory margin in relation to the price paid.”
Ben Graham. (1973). The Intelligent Investor.

Safety and diversification

The margin of safety and the principle of diversification are closely related. It is only a matter of probability and time until one or more of our individual holdings performs poorly. This is true no matter how wide our original margin of safety. Diversification helps to minimize the chances of catastrophic losses, and to produce profitability in the overall portfolio.

One distinction, however, between the tenets of value investing and that of modern portfolio theory is the limits of diversification. The prudent investor recognizes that search is costly and investments with a wide margin of safety are not abundant. While diversification is helpful, we do not want to dilute our portfolio with expensive, low-quality assets that we do not fully understand.

Ultimately, “investment is most intelligent when it is most businesslike”, Graham says. We have to “know what [we] are doing”. It isn’t that hard to achieve satisfactory results with indices abound. Trouble arises, however, when the optimistic, self-confident majority believes that market-beating results are their domain. As I’ve noted before, intellectual honesty is important.

“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”
Warren Buffett. In Ben Graham. (1973). The Intelligent Investor.

Sources and further reading

Graham, Benjamin. (1973). The Intelligent Investor: The Definitive Book on Value Investing. 4th Revised Edition.
Malkiel, Burton. (1973). A Random Walk Down Wall Street: Including a Life-Cycle Guide to Personal Investing.
Buffett, Warren. (1984). The Superinvestors of Graham-and-Doddsville.

The Intelligent Investor — Benjamin Graham on Fallibility, Competition, and the Margin of Safety