Chapter 1: Investment vs. Speculation

Key points:

• Investors are those who invest their money, seeking to effectively balance risk and suredness-of-return, whereas speculators seek to predict future fluctuations and achieve massive returns.
• The thought processes behind investment and speculation are different, and the two "disciplines" ought to be separated
• Buying common stock was seldom considered a safe investment until after the 1949-1958 boom.
• Results to be expected by the defensive investor:
  • The defensive investor, per classic Graham and Dodd wisdom, holds 25-75% in common stocks and an inverse 25-75% in bonds.
  • We cannot be sure that bonds will work out better than stocks, but either way, they both have different risk profiles
  • Note the advent of TIPS, where bonds are automatically protected against inflation by force of contract
• Results to be expected by the aggressive investor:
  • What are some strategies speculators and investors use to beat the market?
    • Trading in the market
    • Short-term selectivity
    • Long-term selectivity
  • p34, "In our view the search for these would not be worth the investor’s effort unless he could hope to add, say, 5% before taxes to the average annual return from the stock portion of his portfolio."

Commentary on Chapter 1

• p35, "Investing, to Graham, consists equally of three elements"
  • you must thoroughly analyze a company, and the soundness of its underlying businesses, before you buy its stock;
  • you must deliberately protect against serious losses
  • you must aspire to "adequate," not extraordinary, performance
• Speculators, of course, do none of these things
• p36, "People who invest make money for themselves; people who speculate make money for their brokers. And that, in turn, is why Wall Street perennially downplays the durable virtues of investing and hypes the gaudy appeal of speculation."
• The story of finance as a "nonstop national videogame," which caused people to forget its underlying value-base, and the story of "financial strategies" which "worked" until they were disseminated (either because widespread practice "breaks" them, or because they only "worked" due to correlation, and not causation)

Chapter 2: The Investor and Inflation

• "Cash is trash" - holders of stocks, however, can hope that a weakening of the dollar correlates with a strengthening in stocks
• Cash has the same problem as bonds (even with interest?)
• Even high-quality stocks cannot be better than bonds under all conditions; any financial instrument x cannot be better than y under all conditions
• Ultimately, inflation is not an independent factor which increases the value of common stocks — while common stocks tend to go up over time (and may go down at any time), they don't go up "with" inflation; an aggregate of other factors make it appear that way
• Footnotes recommend not investing in gold directly, but rather a well-priced mutual fund made of a composite of natural resource / mineral firms

Commentary on Chapter 2

• Most of this commentary seems irrelevant; it was written at a time when inflation was hovering around 1%!
• Most of the advice amounts to "always be prepared"
• REITs and TIPS

Chapter 3: A Century of Stock Market History

• In the first edition (1949), it seemed as though the inclusion of common stocks in a portfolio needed to be intensively justified
• "Rules for the Common Stock Component"
  • Adequate, though not excessive diversification (10-30)
    • One wonders whether more diversification is possible/desirable after the advent of the internet and ways to check financials on the fly
  • Each company selected should be large, prominent, and conservatively financed
  • Each company should have a long record of continuous divident payments. (All the issues in the DJIA met this requirement in 1971.)
    • Footnotes suggest 10-20 years of continuous dividends
    • It seems as though value investing is aided by reminding oneself that the purpose of a stock is to return dividends, at least historically, even though the return through a change in value might make a much bigger impact on one's portfolio

Commentary on Chapter 3

Nothing from the commentary seems particularly noteworthy here, except for this statement, p. 81:

In the April 10, 2000, issue of BusinessWeek, Jeffrey M. Apple- gate, then the chief investment strategist at Lehman Brothers, asked rhetorically: “Is the stock market riskier today than two years ago simply because prices are higher? The answer is no.” — But the answer is yes. It always has been. It always will be.

Chapter 4: Portfolio Policy for the Defensive Investor

• "It has been an old and sound principle that those who cannot afford to take risks should be content with a relatively low return on their invested funds."
• Bond-stock allocation — the 25-75 ratio discussed earlier
  • p. 89, "These copybook maxims have always been easy to enunciate and always difficult to follow—because they go against that very human nature which produces that excesses of bull and bear markets."
• Yale had a 50-50 endowment after 1937; this has since advanced to 61% in equity
• The bond component
  • Everything seems to be issue-by-issue based; tax-free municipal bonds are a better choice for higher tax brackets, taxed corporate bonds for lower brackets.
  • Longer and shorter maturities: "Does the investor want to assure himself against a decline in the price of his bonds, but at the cost of (1) a lower annual yield and (2) loss of the possibility of an appreciable gain in principal value?"
  • Note on high yield bonds: higher-yield bonds are usually such because the issues are of lower quality; the price of the bond might decline, and there is a higher chance of default.
  • Call provisions: when only slightly higher than the issue price, "heads I win, tails you lose."
• Nonconvertible preferred stocks: Not as safe as it might initially seems; if the company is unable to pay dividends on its common stock, the preferred stock is already precarious. Buy at a bargain.
  • Other security forms besides stocks and bonds: many securities, like income bonds, offer better contractual protection than these forms, but yet are seldom used (and thus their value says low.)
    • Interest on income bonds is tax deductible!

Commentary on Chapter 4

• Why should age deteremine the amount of risk you take?
  • Graham concurs
• Risk is a choice, and the advisable choice depends on the specific situation
• Bonds are generally sold in $10,000 lots; you'd need more than $100,000 to diversify, so just buy into a bond fund.
• This chapter also predates inflation adjusted treasury securities
• Other securities
  • Mortgage securities
  • Annuities

Chapter 5: The Defensive Investor and Common Stocks- In the first edition (1949), it seemed as though the inclusion of common stocks in a portfolio needed to be intensively justified

• "Rules for the Common Stock Component"
  • Adequate, though not excessive diversification (10-30)
    • One wonders whether more diversification is possible/desirable after the advent of the internet and ways to check financials on the fly
  • Each company selected should be large, prominent, and conservatively financed
  • Each company should have a long record of continuous divident payments. (All the issues in the DJIA met this requirement in 1971.)
    • Footnotes suggest 10-20 years of continuous dividends
    • It seems as though value investing is aided by reminding oneself that the purpose of a stock is to return dividends, at least historically, even though the return through a change in value might make a much bigger impact on one's portfolio

Commentary on Chapter 5

Nothing from the commentary seems particularly noteworthy here, except for this statement, p. 81:

In the April 10, 2000, issue of BusinessWeek, Jeffrey M. Apple- gate, then the chief investment strategist at Lehman Brothers, asked rhetorically: “Is the stock market riskier today than two years ago simply because prices are higher? The answer is no.” — But the answer is yes. It always has been. It always will be.

Chapter 6: Portfolio Policy for the Enterprising Investor, Negative Approach

• "The “aggressive” investor should start from the same base as the defensive investor, namely, a division of his funds between high-grade bonds and high-grade common stocks bought at reasonable prices.*"
  • This is an abstruse way to say enterprising/aggressive does not depend on risk but on effort
• Second-grade bonds: nonconvertible bonds sold at a discount since the issues are often older, these might offer substantial return if they deliver on their yield. Graham calls them too risky.
• New issues generally are sold under "favourable market conditions," i.e. favourable for the seller.

Commentary on Chapter 6

• Bond funds mitigate quite a bit of the risk of second-rate (now called "junk") bonds
• Foreign bonds are, of course, less risky now, and can still (as always) hedge against the Dow being down.
• Buying IPOs violates one of Graham's most fundamental rules: No matter how many other people want to buy a stock, you should buy only if the stock is a cheap way to own a desirable business.

Chapter 7: Portfolio Policy for the Enterprising Investor, The Positive Side

• The enterprising investor might be interested in the following "special" opportunity [these are all American, and maybe not relevant for me]
  • Tax-free New Housing Authority bonds
  • Taxable but high-yielding New Community bonds
  • Tax-free industrial bonds issued by municipalities
• There are low-quality bonds
  • Distressed/defaulted bonds: Bonds of a default company which has a chance of recovering from bankruptcy
    • Under the right conditions, can perform as well as common stocks
• Operations in common stocks
  • Buying in low markets and selling in high markets (arbitrage)
  • Buying "growth stocks"
  • Buying bargain issues of various types
  • Buying into special situations
• "the market’s action in the past 20 years has not lent itself to operations of this sort on any mathematical basis."
  • Malkiel
• 1949-1972 is still too short of a span to draw "objective" conclusions
  • This makes most of technical analysis pseudoscience then, no?
• Investment Companies, Arthur Wiesenburger and Co — growth fund annual performance analysis
• For growth stocks, Graham insists on calculating P/E based on a multiyear average of past earnings
• Three recommended fields for "enterprising investment"
  • To obtain better than average investment results, some policy must (1) meet rational rests of underlying soundness, (2) be different than the policy followed by most investors or speculators.
  • 1. The Relatively Unpopular Large Company
  • 2. Purchase of Bargain Issues
    • "An issue that is worth more than it is selling for"
      • There are two tests for this
        • Appraisal, estimation of future earnings…
        • Value of a business to a private owner, which is also determined by future earnings, but more attention to assets will be paid here
  • 3. Special Situations
    • Buy into lawsuits?

Commentary on Chapter 7

• Nobody can find out the worst days of the market before they arrive.
  • The commentator notes that the word "truth" in investment articles is often a sign of imminent lies.
• Finding bargains is work.

Chapter 8: The Investor and Market Fluctuations

• Market fluctuations as a guide to investment decisions
  • Investors who place stock in the future short-term price (unpredictable) are in danger of becoming speculators
  • It is probably better to just embrace not having the knowledge
  • "Undoubtedly some people can make money by being good stock market analysts. But it is absurd to think that the general public can ever make money out of market forecasts. For who will buy when the general public rushes to sell at a profit?"
• BLSH Approach
  • "Without bear markets to take stock prices down, any one looking to buy low will be left behind"
  • There is not really a bull-bear pattern in the modern day, and there is not appropriate signalling when these shift
• Formula Plans
  • A good way to put logical principles on rails
• Business valuations
  • In essence, market price vs. NAV.
  • "The whole structure of stock-market quotations 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."
• "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."
  • "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. 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."
• Fluctuations in bond prices
  • Basically, the same
    • A lot of what bond advice Graham gives is outmoded by TIPS

Commentary on Chapter 8

• You don't have to agree with Mr. Market — only take advantage of his offers when it benefits you.

Chapter 9, Reflection

[at this point, I stop taking notes and start writing reflections.]

Here, Graham delineates the different types of funds available to investors, in addition to things worthy of watching out for. Graham reminds us that, while the market may be an aggregate of buy-sell operations that serve to create a subjective assessment of value with NAV, earnings, etc. as mere inputs, there is still a logic to it. Namely, the assertion that it is highly improbable that a "proven methodology" — a "nobody else knows how to do this" — will routinely beat the market.

Other useful information:

• The difference between closed and open-ended investment funds

Zweig's commentary goes over the value of managers being shareholders, avoiding BS from management, and those who take an unorthodox approach derived from educated experience.

Chapter 10, Reflection

Basically, Graham wants us to make sure that our advisors are not leveraging the power of storytelling, short-term high returns (which will inevitably collapse), or the notion that they have some sort of "special sauce." The commentary on the professionalisation of financial analysis is interesting — professionalisation implies a certain objectivity, but the mechanics of the market are going to by nature be a compound of people's subjective assessment of securities.

Chapter 11, Reflection

This is a minified guide to security analysis; presumably a watered-down version of the advice given in Security Analysis. It goes over how to read financial statements. Graham lists some basic factors which go into analysing a security:

• General Long-term Prospects
• Management
• Financial Strength and Capital Structure
• Dividend Record
• Current Divident Rate

There is some corrections offered to the conventional wisdom that you should "buy what you know" — just because you're familiar with an industry doesn't mean you don't need to do due dilligence to analyse its prospects. Moreover, if you are very into mechanical keyboards, you might overestimate the amount of people who care about mechanical keyboards.

Zweig's commentary: Management may also play tricks to make their company appear more valuable, and make it appear as if they are serving shareholders and not themselves — share-splitting, buying back shares when they are more expensive (as a way for execs to sell off their own stock options), and, of course, overpaying management in the name of facilitating their increasing shareholder value.

Chapter 12, Reflection

Here, Graham gives some basic advice on how to read per-share earnings. Which figures should be paid attention to — primary earnings, net income after special charges, diluted w/ SP, diluted w/o SP? Graham argues that diluted shares (i.e., those held up in convertible bonds or preferred stock, in a company trust, or otherwise not held by shareholders). Graham discusses how special charges can be weaponised to obscure a company's true expenses, or at least create "good years" out of whole cloth by time-shifting those expenses.

Zweig's commentary goes into some aspects of creative accounting, e.g., pro forma earnings.

Chapter 13, Reflection

Graham analyses four firms and finds one which has managed to weather market downturns and grow at a rapid pace — and makes the observation that, while this firm seems a trailblazer, it is often hard to sustain growth at a certain size, and "high valuations (i.e., P:E) entail high risks."

Zweig's commentary provides similar, modern examples. Each failure is a company which, in spite of high revenue, is strapped for cash and in increasing levels of debt in an effort to grow itself beyond reasonability. The point from the beginning of the book is re-emphasised: for every stock, there is a company, and confusing a stock for a company is confusing a map for its territory.

Chapter 14, Reflection

Or, "just buy an index fund." In essence, Graham wants the defensive investor, when picking common stocks, to "build their own DJIA." Factors of note include:

• Adequate size
• A strong financial condition
• Earnings stability
• Dividend record
• Earnings growth
• Moderate P:E, i.e., not overvalued
• Moderate ratio of price to NAV

Zweig notes how it is important to make an index fund the "foundation" of one's portfolio - that some enjoy individual stock-picking, but for the defensive investor at least, this ought to be supplemental.