Highlights: The Intelligent Investor, Rev. Ed, by Benjamin Graham;Jason Zweig;Warren E. Buffett

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That extra cost, called “market impact,” never shows up on your brokerage statement, but it’s real. If you’re overeager to buy 1,000 shares of a stock and you drive its price up by just five cents, you’ve just cost yourself an invisible but very real $50. On the flip side, when panicky investors are frantic to sell a stock and they dump it for less than the most recent price, market impact hits home again. The costs

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Oh, yes—there’s one other thing. When you trade instead of invest, you turn long-term gains (taxed at a maximum capital-gains rate of 20%) into ordinary income (taxed at a maximum rate of 38.6%).

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The same vagaries of the market place that recurrently establish a bargain condition in the general list account for the existence of many individual bargains at almost all market levels. The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.*

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Thus we have what appear to be two major sources of undervaluation: (1) currently disappointing results and (2) protracted neglect or unpopularity.

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He should require an indication of at least reasonable stability of earnings over the past decade or more—i.e., no year of earnings deficit—plus sufficient size and financial strength to meet possible setbacks in the future. The ideal combination here is thus that of a large and prominent company selling both well below its past average price and its past average price/earnings multiplier. This would no doubt have ruled out most of the profitable opportunities in companies such as Chrysler, since their low-price years are generally accompanied by high price/earnings ratios. But let us assure the reader now—and no doubt we shall do it again—that there is a world of difference between “hindsight profits” and “real-money profits.” We doubt seriously whether the Chrysler type of roller coaster is a suitable medium for operations by our enterprising investor.

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The type of bargain issue that can be most readily identified is a common stock that sells for less than the company’s net working capital alone, after deducting all prior obligations.* This would mean that the buyer would pay nothing at all for the fixed assets—buildings, machinery, etc., or any good-will items that might exist. Very few companies turn out to have an ultimate value less than the working capital alone, although scattered instances may be found.

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BARGAIN-ISSUE PATTERN IN SECONDARY COMPANIES. We have defined a secondary company as one that is not a leader in a fairly important industry.

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If most secondary issues tend normally to be undervalued, what reason has the investor to believe that he can profit from such a situation? For if it persists indefinitely, will he not always be in the same market position as when he bought the issue? The answer here is somewhat complicated. Substantial profits from the purchase of secondary companies at bargain prices arise in a variety of ways. First, the dividend return is relatively high. Second, the reinvested earnings are substantial in relation to the price paid and will ultimately affect the price.

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The greater number of defensive investors are to avoid these categories regardless of price; the enterprising investor is to buy them only when obtainable at bargain prices—which we define as prices not more than two-thirds of the appraisal value of the securities.

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The distinction between the position, and consequent investment policy, of insiders and of outsiders becomes more important as the enterprise itself becomes less important. It is a basic characteristic of a primary or leading company that a single detached share is ordinarily worth as much as a share in a controlling block. In secondary companies the average market value of a detached share is substantially less than its worth to a controlling owner. Because of this fact, the matter of shareholder-management relations and of those between inside and outside shareholders tends to be much more important and controversial in the case of secondary than in that of primary companies.

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As the Danish philosopher Søren Kierkegaard noted, life can only be understood backwards—but it must be lived forwards.

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great company is not a great investment if you pay too much for the stock.

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Growth stocks are worth buying when their prices are reasonable, but when their price/earnings ratios go much above 25 or 30 the odds get ugly:

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However, almost no small fortunes have been made this way—and not many big fortunes have been kept this way. What Carnegie neglected to mention is that concentration also makes most of the great failures of life. Look again at the Forbes “Rich List.” Back in 1982, the average net worth of a Forbes 400 member was $230 million. To make it onto the 2002 Forbes 400, the average 1982 member needed to earn only a 4.5% average annual return on his wealth—during a period when even bank accounts yielded far more than that and the stock market gained an annual average of 13.2%.

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If you live in the United States, work in the United States, and get paid in U.S. dollars, you are already making a multilayered bet on the U.S. economy. To be prudent, you should put some of your investment portfolio elsewhere—simply because no one, anywhere, can ever know what the future will bring at home or abroad. Putting up to a third of your stock money in mutual funds that hold foreign stocks (including those in emerging markets) helps insure against the risk that our own backyard may not always be the best place in the world to invest.

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o the extent that the investor’s funds are placed in high-grade bonds of relatively short maturity—say, of seven years or less—he will not be affected significantly by changes in market prices and need not take them into account. (This applies also to his holdings of U.S. savings bonds, which he can always turn in at his cost price or more.)

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If you want to speculate do so with your eyes open, knowing that you will probably lose money in the end; be sure to limit the amount at risk and to separate it completely from your investment program.

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There are two possible ways by which he may try to do this: the way of timing and the way of pricing. By timing we mean the endeavor to anticipate the action of the stock market—to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value. A less ambitious form of pricing is the simple effort to make sure that when you buy you do not pay too much for your stocks. This may suffice for the defensive investor, whose emphasis is on long-pull holding; but as such it represents an essential minimum of attention to market levels.1

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He enjoys an advantage only if by waiting he succeeds in buying later at a sufficiently lower price to offset his loss of dividend income. What this means is that timing is of no real value to the investor unless it coincides with pricing—that is, unless it enables him to repurchase his shares at substantially under his previous selling price.

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But as their acceptance increases, their reliability tends to diminish. This happens for two reasons: First, the passage of time brings new conditions which the old formula no longer fits. Second, in stock-market affairs the popularity of a trading theory has itself an influence on the market’s behavior which detracts in the long run from its profit-making possibilities.

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The market’s behavior in the past 20 years has not followed the former pattern, nor obeyed what once were well-established danger signals, nor permitted its successful exploitation by applying old rules for buying low and selling high. Whether the old, fairly regular bull-and-bear-market pattern will eventually return we do not know. But it seems unrealistic to us for the investor to endeavor to base his present policy on the classic formula—i.e., to wait for demonstrable bear-market levels before buying any common stocks. Our recommended policy has, however, made provision for changes in the proportion of common stocks to bonds in the portfolio, if the investor chooses to do so, according as the level of stock prices appears less or more attractive by value standards.