The Intelligent Investor series (Chapter 3)


Welcome back to the Intelligent Investor series. This chapter is all about letting the Intelligent Investor review prior market data in an attempt to learn why the market acted the way it did, and determine how it may act in the future. The goal is to use this as yet another datapoint when making a decision as to whether or not the market is trending at a level that would warrant positive results. Here’s the list of preceding posts if you’d like to get caught up:

Before we really get into the meat of this, I think it’s important to reiterate that Graham and Zweig both focus on leveraging the past data of the market not to try and predict what will happen, but to help give context to any potential current market analysis.


Graham begins his lesson by speaking directly about the business cycle. Noting without bias that the market has represented itself at both very high (dangerous) and very low (more favorable) levels to the value investor. By taking a look at 10 year averages we begin to get a better feel for how the business cycle has influenced, or been influenced by the thoughts and feelings of investors and speculators alike. He notes that the Intelligent Investor would do well to pay attention to how the price, earnings and dividends of issues has changed with the business cycle but that the changes may not even show correlation to the business cycle, much less causation. What past data can suggests is, typically, mega-rises have tended to disappoint,while major crashes have usually evened out at a higher level than the “experts” had forecasted.

“One extreme to another carried a strong warning of trouble ahead”

After reviewing the nearly 100 years of market data he had at the time, Graham gives the 1964 Intelligent Investor some advice for the future:

No borrowing to buy or hold securities

No Increases in the promotion of funds held in common stocks

A reduction in common-stock holdings where needed to bring it down to a maximum of 50 per cent of the total portfolio. The capital-gains tax must be paid with as good grace as possible, and the proceeds invested in first-quality bonds or held as a savings deposit

Taking a look at 1964 compared to our 2016 current situation, we can draw on the following comparison between then and now.

1964
2016

Graham typically argues that the price of the S&P 500 and DJIA is too high and that investors need to care for their capital by comprising at least half their portfolios with safer alternatives to stocks. Comparing this to today, with both indexes at their high, I feel that he’d recommend the same advice. This time however, the bond rates aren’t the cushy 3–4% they were in ’64. The safe haven of a bond now comes at the price of 4% , versus the 1–2% of the past. It seems we get put in a bit of a precarious situation given that the price of the stock market doesn’t seem based in reality and bond offerings are less than dismal.

Some advice Graham may continue to reiterate is to develop a consistent and controlled common stock policy. Discouraging the “beat the market / pick the winners” mentality. Recall defining the investor and incorporating principles of investing for value.


Graham turns his attention to reflecting on the the price of stock offerings versus their earnings and dividend yields. Using the table below he explains how we see the multiples of EPS and dividend growth failing to match that of an issue’s price growth.

In this case, you’re paying more for less, which highlights that the price you pay is not equal to the value of the issue.


Zweig’s commentary again offers insight and strengthens Graham’s arguments.

One of his most insightful pieces comes on page 83:

“When every investor comes to believe that stocks are guaranteed to make money in the long run, won’t the market end up being wildly overpriced? And once that happens, how can future returns possibly be high?”

Zweig also returns the investor to basic value principles by stating that a cheaper issue does not equal 7% stock returns. You still need to be selective about the companies that you buy, which will be the focus of the remaining chapters. Zweig builds on Graham’s advice from before by offering what an issue’s future growth is dependent on the following three factors:

Real Growth (the rise of companies’ earnings and dividends)

Inflationary Growth (the general rise of prices throughout the economy) ** For an analysis of Inflationary Growth check out Chapter 2**

Speculative Growth — or decline (any increase or decrease in the investing public’s appetite for stocks)

The Chapter and commentary did a good job of describing valuable ways of evaluating data from the market’s past. It also declared that stocks were still preferred to bonds overall. Finally we are oriented to develop our investment techniques as investors , not speculators as we are reminded:

The only thing you can be confident about while forecasting future stock returns is that you will probably turn out to be wrong

As I continue to work through the chapters, my goal is to post on each chapter’s central tenants. If you find something out of place, or care to strike up a discussion feel free to comment or find me on twitter @DavidCappelucci.

Recommend the article if you found value in it and would like to follow along.

-David

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