Key Ideas for the Intelligent Investor

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"Investing is foregoing consumption now in order to have the ability to consume more at a later date." - Warren Buffett

When we invest we are setting out money now with the hopes of receiving more money in the future. In order to maintain buying power our investment must generate a post-tax return equal to the rate of inflation. Any investment return beyond the rate of inflation increases our buying power and allows us to increase our consumption.

"A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price." - Benjamin Graham

A stock is not just a ticker symbol. Shares of stock represent ownership rights in the underlying company, which entitle you to a share of the profits in the form of dividends, and voting rights on key issues such as election of the board of directors. If you purchased all of the outstanding shares of a company you would have complete ownership and control, just as if it were a privately-owned business.

"I don't think people understand there's 100% correlation with what happens to a company's earnings over several years and what happens to the stock." - Peter Lynch

As Ben Graham explained, the market is a voting machine in the short term and a weighing machine in the long term. The intelligent investor focuses on the quality and performance of the underlying business, knowing that business returns will translate into stock returns in the long term.

"The value of any stock, bond or business today is determined by the cash inflows and outflows — discounted at an appropriate interest rate — that can be expected to occur during the remaining life of the asset." - Warren Buffett

Intrinsic value is a dollar value assigned to the underlying business that is estimated by the investor based on the company's financial statements, a forecast of future prospects, and interest rate assumptions. Intrinsic value is completely independent from the market price, and when the two values diverge materially the intelligent investor takes action. Intrinsic value is not something that can be calculated with precision and is therefore a rough range of values. For many companies an investor may not be able to estimate intrinsic value at all. This is perfectly fine; the intelligent investor simply moves on to the next idea.

"There’s no such thing as a good or bad idea regardless of price." - Howard Marks

Simply finding a terrific business is not enough; if you considerably overpay for a great business you may never see an adequate return. Although the underlying business may be generating strong and growing earnings relative to invested capital, if you pay a high multiple of current earnings it's going to take a lot of earnings growth to achieve adequate earnings relative to the cost of your investment. There is always a price that is too high, even for the strongest of companies. And if the price is low enough, even a terrible company can be a great investment.

"In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, "This too will pass." Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto - Margin of Safety." - Benjamin Graham

Margin of safety is a concept that comes from the field of engineering. The idea is that if you need to build a bridge that will hold 1,000 pounds, you should design one that can handle 2,000 pounds, to account for any unexpected loads. In investing, since it is impossible to calculate intrinsic value with precision, you need a margin of safety to avoid catastrophe if your estimate is off. You get a margin of safety by demanding a price that is significantly lower than your estimate of intrinsic value.

"The intelligent investor is a realist who sells to optimists and buys from pessimists." - Benjamin Graham

Ben Graham famously compared the stock market to a neighbor and business partner named Mr. Market who is prone to erratic swings of optimism and pessimism. Mr. Market offers up a price each day at which he will either buy your share of the business or sell you his. Oftentimes his price seems reasonable, but occasionally it is ridiculously high or absurdly low. As an intelligent investor you must learn to ignore Mr. Market's daily quotations, except when they offer the opportunity to buy or sell at obviously attractive prices, focusing instead on the long-term outlook for your businesses.

"Several things go together for those who view the world as an uncertain place: healthy respect for risk; awareness that we don’t know what the future holds; an understanding that the best we can do is view the future as a probability distribution and invest accordingly." - Howard Marks

Every decision has a probability distribution of potential outcomes associated with it. For investment decisions each possible outcome has a corresponding investment return. However, it is impossible to know the full range of possible outcomes, probabilities, or corresponding returns with any precision. Instead we have to make rational decisions based on our best estimate of the general shape of the underlying distribution.

"Never invest in a business you cannot understand." - Warren Buffett

A company's financial statements and metrics are just imperfect tools to help you understand the underlying business, and taken alone are a grossly inadequate basis upon which to make an investment. Qualitative factors - like product quality, brand strength, competitive moat, and management quality - must be considered as well. Only by a thorough analysis of both the quantitative and qualitative factors can you hope to get an idea of a what a company may look like in 5-10 years, which is what matters for long-term investments.

"The ideal business is one that takes no capital, but yet grows." - Warren Buffett

The ideal business isn’t capital intensive and can grow very large. If you have a business that grows, and does so while spitting out a lot of money every year that it doesn't need, you get a double barreled effect from the internal earnings growth plus the returned capital which you can use for new investments. Some businesses can actually be run with negative capital, i.e. businesses where the customer pays you in advance. The low capital long term grower is the holy grail; the trick is finding such a high quality business where this isn't reflected in the stock price.

"Everybody's got a different circle of competence. The important thing is not how big the circle is. The important thing is staying inside the circle." - Warren Buffett

It's absolutely crucial to correctly identify your circle of competence and stay within it. For many nonprofessional investors this may mean sticking to dollar-cost averaging into index funds, with the aid of tax advantaged accounts. For the more industrious this means investing only in industries and companies where you have done your homework and truly understand the underlying economics. The key is knowing the edges of your circle of competence and staying away from them.

"Investment management, as it's now taught... say the whole secret of investment is diversification. That's the mantra. They've got it exactly back-asswards. The whole secret of investment is to find places where it's safe and wise to non-diversify... Diversification is for the know-nothing investor; it's not for the professional." - Charlie Munger

The enterprising investor selecting individual securities is not going to have hundreds of equally good ideas. You're going to have a handful of great ideas at most and should focus on these rather than "diworsifying" into lower conviction ideas. If you're an amateur investor taking the passive index approach you don't need to own every stock, bond, commodity, currency and piece of land on the planet. An S&P 500 index fund, some Treasury Bills, a house and a good career is plenty of diversification.

"If the job has been correctly done when a common stock is purchased, the time to sell it is - almost never." - Philip Fisher

It isn't possible to value a business with precision, so when you find a business you understand your valuation will be a rough range rather than an exact figure. You also need a margin of safety to insure against errors in your analysis and unlucky developments. Consider buying when the stock price is lower than the lower bound of your valuation minus a margin of safety, and consider selling when the price is higher than the upper bound of your valuation. In the case where you are fortunate enough to own a truly great business in which you have strong conviction, default to holding rather than selling, even when you feel the price has become rich, as such investments are incredibly rare.

"There are huge advantages for an individual to get into a position where you make a few great investments and just sit on your ass: You are paying less to brokers. You are listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded." - Charlie Munger

In taxable accounts, holding investments long term has tax advantages. When you hold an investment that has accrued capital gains you are essentially getting an interest-free loan from the government by deferring paying taxes until you sell. You get to pocket any future returns on this "loan" minus the taxes owed on the additional gains.

"Always be saving something. Put it into a tax-deferred account. Over time, it will begin to amount to something. This is such a no-brainer!" - Charlie Munger

Both Traditional and Roth retirement accounts provide significant tax advantages and should be fully utilized before investing in taxable brokerage accounts. A Roth completely shields your investments from taxes; neither dividends, capital gains, nor qualified distributions are taxed. The downside is that most retirement account funds aren't available for distribution without penalty prior to age 59 ½, but this should be of little concern to the long term investor.

"[Treasury Bills are] a parking place. It's an unattractive parking place, but it's a parking place where we know we'll get our car back when we want it." - Warren Buffett

You need some cash for personal emergencies and will inevitably have extra laying around from time to time when you are unable to find suitable uses for new capital. Bank accounts and Certificate of Deposits are only insured up to the FDIC limit of $250,000. Money Markets run the risk of credit drying up under extreme circumstances. Treasury Notes and Treasury Bonds have long maturities which means losses if you need the money in a rising interest rate environment. Treasury Bills, with short maturities of 4 - 52 weeks, have none of these problems. They are short term loans to the federal government, and since the government has the ability to tax its citizens and print money on demand, there is near zero risk of losing your money. You can purchase treasuries directly using the Treasury Direct website to eliminate brokerage firm risk, and can change which bank your maturing Treasury Bills are deposited into post-purchase, enabling you to divert funds as desired in the event of bank failures.

"Before costs, beating the market is a zero-sum game. After costs, it is a loser's game." - John Bogle

U.S. equity investors as a whole, by definition, have to receive the total U.S. stock market return before any fees or taxes are paid. In order for your investments to outperform the market someone else's investments have to underperform the market. It is therefore important to ask yourself whether you really possess the skill and diligence required to be an above-average investor. If the answer is clearly no then there is no shame in admitting that and embracing the passive approach of dollar-cost averaging into index funds.

"The stock market is filled with individuals who know the price of everything, but the value of nothing." - Phillip Fisher

Of all the money sloshing around the stock market, the portion following a value investing approach is relatively small. Therefore it's important to understand the viewpoint of the majority, which largely falls into two categories: the index crowd and those concerned with short term stock price movements rather than underlying business performance. The index view ranges from the rational realization that one lacks the knowledge or time to select individual stocks to the false belief that markets are perfectly efficient and no one can beat the index. The other prevailing view, focused on stock price movements rather than business performance, acknowledges that stocks represent ownership in companies, but argues that there is more money to be made in predicting short term stock price swings. Unfortunately for this group, with the exception of a few ultra-high-IQ mathematicians armed with supercomputers (think Jim Simons), consistently predicting short-term stock price movements proves impossible, whereas predicting long term business performance is merely difficult.

"Risk means more things can happen than will happen." - Howard Marks

A desirable outcome does not indicate a wise investment decision was made and an undesirable outcome does not indicate a poor investment decision was made. Any decision has a probability distribution of potential outcomes associated with it. For investments, these outcomes have corresponding investment returns. Therefore, If your investment does well, you don't know if this was an unlikely outcome - in which case you got lucky despite making a poor decision, or if this was a likely outcome - in which case you made a wise investment choice. The only way to know whether you made a good decision is through careful examination of the logic used in making the decision. Unless the outcome wasn't even on your radar as a possibility, it provides no information regarding the probability distribution associated with the decision. Only cumulative results, over a long period of time, begin to provide evidence of the quality of your investment strategy, in the same way that a series of coin tosses will eventually converge on a 50/50 distribution of heads and tails.