Warren Buffett is generally considered the greatest modern investor. He managed to parlay his initial investment in troubled textile manufacturer Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) into a multibillion-dollar fortune. Yet once, even Warren Buffett had to learn to invest. He was an A+ student, of course -- but the professor who taught his class launched an investing revolution. That professor was none other than Benjamin Graham, the founder of value investing.
Fortunately for the rest of us, Graham was kind enough to capture the essence of his strategy in writing. His classic text, The Intelligent Investor, lays out the foundation of value investing. Buffett himself has called it "the best book on investing ever written."
What's it about?
It's a wide-ranging book, covering such topics as portfolio policy, asset allocation, inflation, diversification, market fluctuation, dividends, and of course Graham's famous margin of safety. Data-rich and numbers-heavy, it's not exactly recreational reading. But nestled among the tables of data reaching as far back as 1871 are key lessons that every investor really needs to know in order to be successful. Had I learned these lessons a decade ago, I'd have escaped much suffering at the hands of my former stockbroker.
Chief among Graham's lessons are the twin anchors of valuation and patience. You must do the research to estimate a company's true worth. With that value in mind, successful investing becomes as simple as refusing to overpay for a company. Additionally, once you've bought a stake in a bargain-priced business, you must be patient enough to wait for the market to realize its mistake and bid up the company's shares.
These days, we also often forget that total return also includes dividends. In stark contrast to modern practices, Graham argues that "stockholders should demand of their managements a normal payout of earnings -- on the order, say, of two-thirds -- or else a clear-cut demonstration that the reinvested profits have produced a satisfactory increase in per-share earnings."
The keys to investing success
Beyond a shadow of a doubt, the last chapter of The Intelligent Investor is a must-read for anyone looking to make money in the stock market. In it, Graham describes the concept of the margin of safety -- three magical words that let investors absolutely slaughter the market.
Graham explains that companies slip up, that projections are estimates at best, and that believing in overly rosy projections can drive stock prices too high. On the flip side, companies can be priced well below their true value, too, if the prevailing market projections are too pessimistic. If you buy only those firms trading for well below their true worth, even if their business suffers, their shares simply have that much less room to fall. That's the safety provided by value-priced stocks.
Of course, even a margin of safety in one investment, Graham councils, is not enough. You must diversify appropriately to improve your chances of making money across a portfolio. To illustrate, Graham likened diversification to playing roulette, with the casino's odds rather than the gambler's. With each spin of the wheel, the casino has a margin of safety that provides it an edge over time. Yet on any given spin, the gambler may win. Even so, the casino's margin of safety on each spin helps assure it will end up ahead, in the long run.
Value investing made simple
The lessons embedded in The Intelligent Investor are an absolute must for anyone with money in the stock market. They can be boiled down to these four simple points:
- Estimate a fair value for a company.
- Buy only if the price is safely below that value.
- Look for a strong dividend policy as a signal of financial strength.
- Diversify appropriately to spread the risks.
If you invest based on those four key principles, the odds are quite high that you'll do fine. All in all, The Intelligent Investor is a superb reference book, and one with which every investor should be acquainted.
Graham's teachings on value investing form the basis of our strategy at Motley Fool Inside Value. Our market-beating returns show that Graham's value-centric strategy still works today. We're such strong believers in Graham's teachings that if you join today, we'll send you a free copy of The Intelligent Investor as part of your membership. Want to look around first? Try it free for 30 days.
At the time of publication, Fool contributor and Inside Value team member Chuck Saletta had no ownership stake in any company mentioned in this article, though he certainly follows Graham's strategy. The Fool has a disclosure policy.