[00:02:47] Patrick Donley: Last week, we discussed the essays of Warren Buffett written by Larry Cunningham. Today, we’re going to get into what’s arguably the seminal, most important value investing book, which is The Intelligent Investor by Ben Graham. Graham is better known for his, well, he’s known for a lot of things, but his protege Warren Buffett called him the second most influential person in his life, aside from his own father, which is pretty high praise.

[00:03:13] Patrick Donley: I think Buffett read The Intelligent Investor at 19 and at that point said it was the most important investing book he’d ever read and still is today. So we’re going to dive into it. The book was first written in 1949 and Graham updated it throughout his life, did some revisions. Graham died in 1976 and about 21 years after that, Jason Zweig of the Wall Street Journal, who is one of the best financial writers on the planet today, as far as I’m concerned, did a commentary after each chapter to update it for the 21st century. So I just wanted to get into what principles stood out for you as you read the book and then in what ways can we translate the book into today’s 2024 world?

[00:03:59] Shawn O’Malley: It’s definitely a book most people will be familiar with, even if they’ve never sat down to read it, start to finish.

[00:04:05] Shawn O’Malley: It’s kind of like a value investor’s bible. It’s definitely not a short read. And I know that my first time going through it to your point. I was itching for another revised edition because as you said, it’s been several decades since we had an updated version of it by Jason Zweig and Warren Buffett actually wrote a preface for the Intelligent Investor where he argues that years on from Graham’s first writing, he has yet to find anyone with more enduring principles for investors and that’s because the book is just practical.

[00:04:38] Shawn O’Malley: It’s an extremely sober assessment of what it means to be an investor, what we should expect from our efforts in investing and the pitfalls that many fall into. Since Graham first wrote the book, a ton of brilliant investors have taken a stab distilling his ideas into more digestible formats. But there’s something special about the original work and seeing it for yourself.

[00:05:02] Shawn O’Malley: I kind of compare it to seeing pictures of some famous masterpiece or artwork for years. And then the difference in actually finally venturing to see it for yourself in person in a museum or a gallery, it’s just a different thing. So, much of the common sense you’ve probably heard in life about finance and investing stems pretty directly from Graham’s original insights about investing in this book, but it’s in a more raw form, since the ideas to him were newer.

[00:05:32] Shawn O’Malley: And there’s been a lot of time to distill those ideas into more digestible formats. I think it’s safe to say the book doesn’t really flow as smoothly as, some hit book you might find on investing in finance at the bookstore today, but whether you’ve actually read the book offers a pretty good litmus test about how serious of an investor you are, someone who’s read the intelligent investor cover to cover when I meet people like that, it just, it signals something about their willingness and interest to dive into kind of the foundations of investing.

[00:06:02] Shawn O’Malley: As you said in the last edition of the book, which is already more than 20 years old, Jason Zweig tries to modernize Graham’s original writings and carry his legacy into the 21st century. And in his first comments in the revised 2003 edition, Zweig argues that money managers before Graham were like this medieval guild guided by mostly superstition, guesswork, and rituals.

[00:06:26] Shawn O’Malley: But Graham’s lifetime of work helped transform the investment management industry into a serious, more respected profession. And after the speculative mania of the 1920s and then the great depression stock investing fell out of favor in a way that I think would be unrecognizable now to most people today, sort of people just assume that they can plow money into the 401k and to stock index funds.

[00:06:50] Shawn O’Malley: And they’re going to reliably get this eight to 10 percent annual return and nothing about that is really that controversial, but to kind of step back in time for years after the Great Depression, there was a stigma around stock investing, and it was very mainstream to see stock investing as hugely risk, risky and very speculative after the losses.

[00:07:10] Shawn O’Malley: that’s how famously happened in 1929. And in that stock market crash, it was almost seen as kind of a gentlemanly thing, no respectable gentleman would be caught dead rolling the dice on stocks. It would be like being caught in the casino. There was this popular bias against stock investing.

[00:07:27] Shawn O’Malley: In part, because there weren’t established ways to, to value a company stock. So, of course your average person thought stock investing was gambling. If you couldn’t imagine a way to determine whether you were paying fair value for stock. And I think that’s partly why this book was so impactful.

[00:07:43] Shawn O’Malley: It creates this blueprint for intuitively and logically thinking about valuing stocks and what it even means to be a shareholder and a company. What’s also special about Graham is that he’s such a gifted thinker in so many ways beyond investing. He’s very multidisciplinary, as Charlie Munger would say, which I think explains how he brought order to this industry that was really in disarray after the Great Depression and during World War II.

[00:08:10] Shawn O’Malley: Graham attended Columbia University on scholarship, and I mean, this is just really astonishing. It stood out to me when I first read the book. By his senior year at 20 years old, three different departments, English, mathematics, and philosophy had asked him to join as a PhD faculty member after graduation.

[00:08:30] Shawn O’Malley: I don’t know about you, but when I wrapped up college, I definitely did not have multiple professors from different departments begging me to stay around. I just, no one has that kind of impact. So he’s just a very special thinker across a range of disciplines. And that logic carries with him.

[00:08:46] Shawn O’Malley: When he starts his career on wall street, but that logic I don’t think is necessarily born out of a high IQ. The life experience for him played a major role in shaping how he thought about investing. Graham was born into this wealthy family that lost everything in the early 20th century when his father died.

[00:09:04] Shawn O’Malley: We’re talking about maids and servants on 5th Avenue, kind of wealthy, only to completely 180 and become dirt poor. And that fixation for him on never wanting to lose everything again, really stuck with him. So much of Graham’s writings are focused on being as conservative as possible and ensuring that you have no illusions about investing that could cause you to lose everything as his family once did.

[00:09:29] Shawn O’Malley: For him to have survived the Great Depression and World War II as an investor and continue to build his wealth and beat the market averages over that period is A testament to how enduring his approaches through, really any headwind imaginable. I don’t think I could imagine bigger headwinds than those two events, essentially back to back.

[00:09:49] Shawn O’Malley: And for example, when we look at 1949, the Dow Jones was one third lower than its level in 1939. So if you think about that in today’s context, that would be like the S and P 500 is sitting at a fraction of its 2004 level. Which I think is just extremely difficult for people to even imagine and realize that is actually precedented in stock market history to watch the stock market, not just be flat over several decades, but to actually decline.

[00:10:18] Shawn O’Malley: And yet Graham’s pragmatic advice is pretty familiar to us today still. He writes it by simply dollar cost averaging with a small fraction of your income each month into these large established businesses for 20 years, starting in 1929, you would have earned an 8 percent compounded annual return over that period, despite the broader index being down 33 percent from the 1929 peak.

[00:10:42] Shawn O’Malley: The takeaway being that, with this simple approach of dollar cost averaging, the market averages following, don’t have to be a death sentence for the returns that you earn. And when I think about translating the book to today, it’s mostly about putting his lessons in a context that resonate with the world we’ve grown up with and world wars and great depressions can seem very distant, which can make his writings feel less relevant.

[00:11:09] Shawn O’Malley: But in the grand scheme of history, in the 80 years since World War II, things have been very quiet and tame, yet that almost certainly will not be the case forever, right? We’ve, we saw that with the COVID 19 pandemic in 2020. I think that was kind of this first wake up call for people that the society around us is not as stable as we might think it is or want it to be.

[00:11:30] Shawn O’Malley: And that unimaginable shocks can still emerge to disrupt their lives. So some people will read Graham’s book as overly cautious. But the point is really that if you want to be an intelligent investor, who can survive any period in markets as he did, you should study grant because of, instead of just speculating that the future will offer a smooth ride with excellent returns, similar to a better than the past, by being conservative as he was, we can prepare ourselves for any different environment.

[00:12:01] Patrick Donley: One of the things that really surprised me as I was reviewing the book, I’ve got my original copy here that I bought in 2008 during the great financial crisis that I still have and it’s a Bible of sorts But the story that you were telling about his family being super wealthy his father died His mother had a boarding room house that she did just to kind of keep the money and coming in and a little food on the table But she started trading stocks on margin and was completely wiped out in the 1907 financial crisis that happened that year.

[00:12:31] Patrick Donley: So it’s really shocking to me that he ended up in a career on Wall Street after those kinds of experiences of getting just blown out. Really horrible traumatic experiences. I would have been surprised or not surprised. Had he just pursued a career in academia. I mean, he clearly had a path and he did to some degree, but like just a full-fledged ignore wall street altogether. So I just wanted to touch on the title of the book, The Intelligent Investor. What does that mean to you? How would you define what is an intelligent investor?

[00:13:01] Shawn O’Malley: I’d say it has almost nothing to do with being intelligent and academic or high IQ way. That’s something Graham actually tells us pretty explicitly and Buffett builds on it later and invalidates this idea as well.

[00:13:15] Shawn O’Malley: People with a strong ability to defer gratification, as in having patience and discipline, are far likelier to succeed in investing than a highly emotional but ultra intelligent person. Right. You can imagine this genius type who just has no control over their emotional impulses. And it’s not hard to imagine that they’re not going to succeed despite being so brilliantly intelligent.

[00:13:39] Shawn O’Malley: And to quote Graham directly here, he says this type of investment intelligence is a trait more of the character than of the brain, meaning the behavioral side of investing is as important or more than your ability to solve problems, which is, the classic definition of brain intelligence. I love Jason’s wags commentary for this section.

[00:14:01] Shawn O’Malley: He cites the infamous story of the hedge fund, long term capital management, which employed this huge team of mathematicians, physicists, and Nobel prize winners. And despite all that brainpower, they suffered a massive 2 billion blow up in 1998 that disrupted the entire financial system. So being too book smart and investing without any grounding in the real world can work against you.

[00:14:23] Shawn O’Malley: And another great example of that is with Isaac Newton and the, the South Sea bubble, where he’s quoted as saying he could calculate the motion of the heavenly bodies, but not the madness of the people. This is a guy who invented calculus invented, and he fell victim to the mania of financial bubbles and just the collective excitement that was in the air.

[00:14:46] Shawn O’Malley: And after he actually initially made a profit, he bought in again at the market top, essentially lost everything or everything that he had invested. And I just think it’s such a powerful example for us. Because if Isaac Newton can fail to remain logical when managing his own money, I think it’s a risk that can impact anyone.

[00:15:06] Shawn O’Malley: And it’s not to say that having a low IQ is better, but more than a stratospheric IQ without the right Emotional prerequisites does not necessarily give you the advantages that people think it does.

[00:15:20] Patrick Donley: I think it’s funny. The Isaac Newton story, like he said, he invented calculus. He ended up losing, I think the equivalent of 3 million in the South Sea bubble.

[00:15:27] Patrick Donley: And after that, he would not let people even mention the South Sea company at all in his presence. So it’s just funny how like investing attracts so much intellectualization. And yet that can be completely counterproductive. It’s not like low IQ people are going to work on Wall Street, but at the same time, there’s all these complex formulas that these PhDs have, and yet you still have these blow up crises like 2008. I wanted to hear a little bit about your thoughts on just how common sense is so vital and is an advantage in investing.

[00:15:59] Shawn O’Malley: This is something Buffett has long talked about, but one obvious area where intellectualism has gone too far in finances is what the efficient markets hypothesis. It’s the belief that markets perfectly reflect all information in stock prices and therefore perfectly discount each stock on level ground.

[00:16:17] Shawn O’Malley: Even back in Graham’s Day, he acknowledged and saw that this was mostly true. Most of the time, stocks do a pretty good job of responding to changes in the real world. If Walmart reports a blowout quarter, it’s probably going to rise. If Meta reveals that people are using its social networks less, its stock is probably going to fall.

[00:16:37] Shawn O’Malley: But there’s a big difference in prices always and mostly. Being accurate. It’s like saying most of the time I remember to drive on the right side of the road. That’s a pretty consequential distinction and that differential between always and mostly and investing has enabled history’s best investors to earn the kind of mind numbing returns that you see across their lifetimes.

[00:16:58] Shawn O’Malley: And again, I think the academics are too smart for their own good here. the typical response would be to say, well. Statistical outliers are to be expected and that the Buffett’s or Graham’s of the world are natural occurrences that we can mathematically expect with implication being that they’re just two random statistical outliers.

[00:17:16] Shawn O’Malley: I think we can reject that with a little bit of common sense, right? Graham’s framework for common sense investing has worked since the Great Depression and his best student, Warren Buffett. Embrace those teachings and turn them into an even more impressive career spending almost 70 years. Is that really just random?

[00:17:33] Shawn O’Malley: If it is and Graham has no secret sauce, what are the odds that another one of these one in a million statistical outliers and investment returns would be a direct disciple of his? I think it just doesn’t pass the smell test. In theory, based on randomly occurring standard deviations from the average, somebody is bound to have market beating investment returns.

[00:17:56] Shawn O’Malley: And that would be more due to luck than their philosophy and if that’s the case, obviously there’d be no substance that we could learn from them by trying to study them. But again, what are the odds that one investor with three or four standard deviation returns from the mean would produce another investor who is even more of a statistical outlier?

[00:18:15] Shawn O’Malley: And the main reason for that is because Graham isn’t giving an exact formula to replicate and expect the same success. Being an intelligent investor is more of a way of life than a formula. In my opinion, it’s a framework for instilling discipline into a medium where the pursuit of profit is blinding for the vast majority of people.

[00:18:34] Shawn O’Malley: So becoming an intelligent investor is in part, recognizing that markets aren’t perfectly intelligent a hundred percent of the time. And everyone likes to reference the 2000 tech bubble to show this, which we talked about in our episode about the essays of Warren Buffett. But it was such a crazy time that I do think it is worth revisiting.

[00:18:54] Shawn O’Malley: And Cisco at the time was supposed to be this big beneficiary of the internet revolution. And it has been, but the stock has never recovered from its peak in 2000. And it’s the same with micro strategy. To the intelligent investor, it’s pretty clear that this was a classic case of stock prices just getting way ahead of any plausible business outlook that could be expected.

[00:19:16] Shawn O’Malley: And Cisco by no means is the most egregious example from that period either. Most of those 2000 era tech bubble darlings faded into oblivion and just got completely wiped out. And some of them lived on and traded a fraction of their peaks and are kind of haunted. By those crazy past valuations of just 24 years ago.

[00:19:36] Shawn O’Malley: And we all know this intuitively too, because of 2021 stock market. When, how recent of an illustration of what mania and markets can look like, right? we saw this with GameStop, AMC, Tesla, crypto alt coins and SPACs. None of this makes a particularly compelling case for the efficient markets hypothesis being believable, right?

[00:19:56] Shawn O’Malley: And being an intelligent investor is to recognize when markets have gotten out of whack and to have the discipline to, to swallow your FOMO and to spring into action when financial asset prices are excessively discounted in a bear market on the flip side of that. It’s one of those things that sounds tantalizingly easy.

[00:20:15] Shawn O’Malley: But when you look at yourself in the mirror and ask, how did I respond in 2021 when everyone was getting rich trading on stock tips from neighbors, and you saw people getting rich on Dogecoin, did you really have the restraint to sidestep that speculation? You’re probably thinking, well, yes, of course, I’m a disciplined and rational person.

[00:20:35] Shawn O’Malley: But again, if you answer that, honestly, most of us, I think in one way or another, fell victim to speculation and failed to behave like an intelligent investor at some point in 2021, which is okay. But that honesty with yourself is the key part. If you can’t be honest that you fell into those speculations.

[00:20:54] Shawn O’Malley: Then I don’t think there’s really any hope that you can avoid those solutions in the future. And you’re probably going to be destined to be in an average investor, as opposed to being an intelligent investor.

[00:21:05] Patrick Donley: I wanted to just take a moment to just revisit the idea of updating and translating Graham’s writings dating back to before 1950 for us to today. I just wanted to hear your thoughts on what stands out as items or maybe chapters that need revision or more context.

[00:21:23] Shawn O’Malley: One of the biggest for me is Graham’s focus on dividends. When you look at some of his rules of thumb for filtering down intelligent investments, much of that focus relates to dividends, either the dividend yields available and how they compare to available bond yields or investing only in companies with proven track records of stability measured by their history of steady growth of their dividend payments over at least two decades.

[00:21:48] Shawn O’Malley: This largely has to do with the reality that cash dividends were seen very differently back then the best companies were those who could afford to pay massive and growing dividends because that was a sign of their profitability and weaker businesses were thought to be those that couldn’t afford to pay dividends at all.

[00:22:05] Shawn O’Malley: Today, it kind of goes without saying that people see that differently, right? If a business is paying out large and growing dividends. People sort of think that they either have limited meaningful channels to continue growing their business through, or they’re forsaking that growth to pay dividends. And either way is going to be problematic.

[00:22:23] Shawn O’Malley: If a company today is a leader in its industry and can reinvest its profits to confidently earn, say a 10 or 20 percent return on that capital. That is a far better use for the money than paying out that cash instead to investors who are going to have to allocate it somewhere else and probably earn a lower return to say nothing of the double taxation that occurs when dividends are paid out.

[00:22:45] Shawn O’Malley: In the decades since for better or worse, a lack of dividends has come to mean that a company has compelling future business prospects it can be reinvesting into and channeling cash into as opposed to paying out the rewards to shareholders. And to Graham’s credit and his 1972 revision, he observes how investors preferences were changing, where they increasingly preferred companies to reinvest profits toward future growth.

[00:23:14] Shawn O’Malley: I think it’s cool to see a snapshot in time during this transition period and investors priorities from an era where people felt more strongly that as owners in the business. They’re entitled to income from their investments, irrespective of whether that capital could be used to drive greater price appreciation through profitable reinvestment, that’s one really clear area, right for revision.

[00:23:38] Shawn O’Malley: Graham’s intent by focusing on companies dividends was to say that the intelligent investor looks for opportunities and well established but growing businesses. And whether a company has missed dividend payments or cut the dividend or doesn’t pay one at all are pretty easy to use indicators of business quality, especially at that time.

[00:23:59] Shawn O’Malley: And as I said, that has changed a bit now, but I don’t think you would go wrong by any means by focusing on companies with strong dividend track records. Ironically, if you strictly followed Graham’s advice, you’d have never invested in Warren Buffett’s Berkshire Hathaway because Berkshire doesn’t pay dividends.

[00:24:14] Shawn O’Malley: Buffett has proven pretty capable of converting a dollar of retained earnings into more than a dollar of market value, suggesting that he can compound those dollars at better rates than most investors would with their dividends. And another glaring example, and this is one Jason Zweig touches on in his commentary for the book, is that Graham’s formulas for valuation use pretty conservative ratios of price to book value by today’s standards.

[00:24:40] Shawn O’Malley: That has a lot to do with accounting rules and the fact that the value of intangible assets have proliferated on companies balance sheets without being perfectly captured in accounting calculations of equity value. Proprietary software, R& D, patents and trademarks, all that stuff, and all the other aspects of intangible assets and accounting are just really hard to accurately reflect.

[00:25:03] Shawn O’Malley: What happens then is that the generally accepted accounting principles calculations of book value fall pretty far short. Of what most analysts would agree is a more accurate calculation for companies in today’s digital economy. It’s a technical point with the idea being that you can’t just read the intelligent investor and exactly copy the formulas Ben Graham uses.

[00:25:27] Shawn O’Malley: The point is to have some basic calculations we can use to assess whether a stock is fairly valued. But we also have to be mindful of how financial accounting has changed since Graham’s era. And this is a pretty good illustration of that. Following Graham’s rule that you should never pay more than 1. 5 times book value for a stock wouldn’t be a bad idea.

[00:25:46] Shawn O’Malley: At the same time, you’d unnecessarily filter out some excellent businesses that have large sets of intangible assets by doing so. The last thing I probably mentioned too, is that Graham was fairly skeptical of investing in international stocks and bonds. And given the era that he grew up in, I think that makes perfect sense.

[00:26:05] Shawn O’Malley: If you live through World War II and then saw America’s economic ascendance thereafter. You are probably very skeptical of allocating your dollars beyond America’s shores, but we just live in a different world now, right? The U. S. isn’t at the forefront of global economic growth. It used to be and international markets have developed in a way that I think makes them much worthier alternatives to investing solely in the U.

[00:26:30] Shawn O’Malley: S. So when you read the book, Graham’s comments can feel very outdated there for sure using ETFs, for example, we can invest in dozens of foreign countries at once or invest in a bundle of companies within a given country or region. So that gives us a much more appropriate margin of safety for venturing outside of the U.S. than was available during Graham’s time.

[00:26:52] Patrick Donley: It just makes sense that as a global playing field has leveled out, an intelligent investor would be wise to just seek out overseas opportunities and not rule those out. You touched on margin of safety and chapter eight and chapter 20, Buffett says are the two most important chapters to him of the book.

[00:27:09] Patrick Donley: Chapter 20 is on margin of safety and Graham has called those three words the three most important words in investing. I want to hear a little bit about how investors in 2024 can embrace the margin of safety concept.

[00:27:23] Shawn O’Malley: The margin of safety is as much a tangible price discount you can calculate on stock values as I think it is an idea and tool for managing our emotions while investing.

[00:27:34] Shawn O’Malley: Jason’s Zweig gives us this great quote where he says, in the end, how your investments behave is much less important than how you behave. And I think that is really at the core of this idea. The classic way of thinking about having a margin of safety is to determine the intrinsic value of a business based on the cash flows it’ll produce in its lifetime discounted to a present value today, and then waiting patiently.

[00:27:58] Shawn O’Malley: For the market to offer you shares in that business at a discount to your assessment of its intrinsic value. This gives you a cushion to absorb the chance that your calculations of intrinsic value were overly generous or that the company will hit a rough patch that seriously reduces its intrinsic value.

[00:28:16] Shawn O’Malley: As in, if you think a company is worth 90 per share and it trades at 75 or lower, you’ve got a pretty substantial margin of safety that gives you some breathing room in that investment thesis. Thanks. And at its core, I think this is about reducing the odds that we’ll suffer permanent losses on our investments.

[00:28:33] Shawn O’Malley: Tying back to that idea of Graham being very conservative and wanting to preserve capital while investing. And that is avoiding cases where we invest a thousand dollars and get 800 back or whatever the numbers are. It’s about trying to have much more upside than downside. There are also other ways to think about margin of safety though.

[00:28:52] Shawn O’Malley: If you’re a pro at calculating intrinsic value and finding stocks with large margins of safety but panic out of the investment. The first time it falls below your purchase price, then you’re still going to have a terrible track record. And that gets back to our conversation about having really high IQ and not having the emotional discipline to really follow through on your calculations of intrinsic value.

[00:29:13] Shawn O’Malley: I see efforts to hedge against our own worst behavior as actually a way of forming our own margin of safety. Maybe that means deleting your stock apps off of your phone so you don’t have easy access to prices and you can’t obsessively check them, or maybe it even means removing your brokerage app if you’re going to be tempted to make impulsive trades.

[00:29:34] Shawn O’Malley: You say what you want about financial advisors, but they’re a built in margin of safety in a way for a lot of people. They’re a protective layer between you and bad financial decisions. And this is where I think everybody and honestly, almost everyone gets it really wrong about financial advisors or wealth managers or whatever the word you want to call them is.

[00:29:53] Shawn O’Malley: It’s something Graham even talks about too. Their job isn’t to help you beat the market averages or become rich from their advice. That would be crazy. Thank you. If a financial advisor knew what the next Amazon was going to be, they’d be way better off running a hedge fund than they would be by helping you manage your money.

[00:30:12] Shawn O’Malley: Their job is to ensure that you earn an appropriate return for the amount of risk that you’re comfortable taking. And then to help you manage the emotional side of investing for you and make it hard for you to do something really dumb, like liquidate your portfolio at the bottom of a bear market. And Graham makes the point that investment management is the only business where we ask for advice in making money.

[00:30:36] Shawn O’Malley: Not only do we expect professionals to deliver us financial salvation with their advice, we’ll happily act on advice from complete strangers. Some people have no second thoughts trading on a stock tip from their golf buddy, just kind of assuming that they know better. I feel like I’m on a tangent, but the idea is to be realistic about what we expect from investment advice.

[00:30:58] Shawn O’Malley: Your financial advisor is more of a behavioral investment manager than a stock guru. And that’s perfectly okay because they offer you a margin of safety in your personal life. And you could embrace this idea of having a margin of safety in so many other ways too. It’s having an emergency fund. So you don’t have to sell your stocks to pay for a car repair.

[00:31:19] Shawn O’Malley: It’s having life insurance, which gives your family some margin of safety in case they’re dependent on your income. And something happens to you prematurely. It’s even reducing stress and noise in our daily lives. So we can think more clearly about investing and how to spend our time. It can be really anything that I think tilts the odds of success in your favor, especially with regard to investing in managing your personal finances.

[00:31:42] Patrick Donley: So we’ve talked kind of generally about intrinsic value, which is a key tenant in value investing. I wanted to dive a little deeper and see what kind of formulas that Benjamin Graham provides in the Intelligent Investor. Can you touch on that a little bit?

[00:31:57] Shawn O’Malley: Graham actually does give some more quantitative ways to approximate intrinsic value. In the 1962 edition of Graham’s other famous investment book, Security Analysis, the formula is pretty basic. It’s the earnings per share from the last 12 months multiplied by the sum of 8.5 plus two times the expected growth rate for the company over the next seven to 10 years. The basic idea being that 8.5 represents the price to earnings ratio that an investor should demand for a dollar of earnings from a company with no growth prospects. So it’s hard to say exactly how Graham landed on that 8. 5 number, because there’s probably a lot of research that went into it. But another way to think of it more simply is using the earnings yield, which is actually the inverse of the price to earnings ratio.

[00:32:45] Shawn O’Malley: So, if we divide one by 8. 5, we get an earnings yield of almost 12%. And if a company were to never grow its earnings again, and we bought in at a price to earnings ratio of 8.5, it would take you eight and a half years to earn back your investment. That is the payback period for buying the stock at that multiple.

[00:33:04] Shawn O’Malley: That’s what that means, essentially. And in 1974, Graham revises this formula a bit to include a discount rate or what some people call that the required rate of return. And this accounts for the opportunity cost of owning stock, which you can measure by looking at the interest rate offered on bonds. And to do that, people usually use the yields on U.S. treasury bonds but Graham actually looks at the average yield of triple a corporate bonds over time. And the current yield on triple a corporate bonds being offered. It’s a subtle difference because triple a corporate bonds are debts issued by the most credit worthy companies that should have a very low risk of defaulting.

[00:33:43] Shawn O’Malley: But there is of course, some risk because unlike the U S government, companies cannot print money to pay off what they owe. So you basically end up multiplying the original formula by the average yield on these corporate bonds over the past decade or so, and then divide the whole thing by the current yield offered on those bonds.

[00:34:01] Shawn O’Malley: And that would give you at least one very rough way to assess. Intrinsic value. And once you have that estimate of intrinsic value, you’d want to be very conservative to hedge against what you don’t know and embrace that margin of safety. So you would probably reduce your estimate by something like 20 or 30 percent to give yourself a buffer room against any overly optimistic expectations in that calculation.

[00:34:25] Shawn O’Malley: And you can get really technical on a lot of these points, especially around how to estimate companies growth rates or in adjusting the accounting that goes into earnings per share. Okay. But Graham himself will tell you to be very careful about using these calculations. Don’t have any illusions that you can reliably predict how a company will grow and even what it’s worth and this will just be one reference point in a much broader assessment of the valuation of a company.

[00:34:54] Patrick Donley: We’ll put those formulas in the show notes for people that are curious about diving deeper into the math behind what you just went into, but I want to go into Chapter 8. we’ve talked about Chapter 20, which is about margin of safety.

[00:35:07] Patrick Donley: Chapter 8 is about another really famous concept, from the book, which is Mr. Market. Can you go into the Mr. Market metaphor for us and share a little bit your thoughts about that idea?

[00:35:18] Shawn O’Malley: Yeah. If you’re not familiar with the reference, the idea is that because stock prices represent ownership and real businesses, which don’t change that much day to day, right?

[00:35:28] Shawn O’Malley: It’s irrational to offer price quotes for stocks every second, seven and a half hours per day, five days per week. And it’s even less rational how much stock prices swing on that intraday basis. It just doesn’t make sense that on Tuesday, the entire value of a multibillion dollar company is suddenly worth.

[00:35:46] Shawn O’Malley: 3 percent less than it was on Monday and then by Friday, maybe it’s worth 5 percent more, but what those fluctuations and stock prices are telling us, and at least in theory, is that those are real changes and the company’s value and Graham uses this metaphor of having a manic depressive neighbor named Mr. Market, who shows up every day, offering you a price for your private business. But I actually think it’s easier to imagine this with your house. So Mr. Market shows up every day, offering you a price for your house, similar to how every day the stock market gives you quotes for the businesses you own. And most of the time you’re just going to find them annoying and ignore the prices he’s offering you.

[00:36:26] Shawn O’Malley: But every now and then he might give you some crazy high price for your house that you’d actually consider, or maybe he offers to sell you his house at some crazy low price and you’d be a fool not to take it. And Graham basically tells us to use Mr. Market’s mood swings to our advantage in this way.

[00:36:43] Shawn O’Malley: The first step in this process is to know what your investments are worth. Maybe, the, what the value of your home is and what price you’d be willing to sell it at. And that positions you to capitalize on the deals that Mr. Market offers you making the markets work for you instead of you being a victim to their fluctuations.

[00:37:01] Patrick Donley: So we’ve talked about two of the key concepts at this point, margin of safety and Mr. Market. Were there any lesser known nuggets of wisdom in the book that you came across that you’d like to talk a little bit about today?

[00:37:14] Shawn O’Malley: Graham touches on this point briefly, but it’s something Jason Zweig builds on more in his commentary, and it’s this question of whether we should invest in what we know. Peter Lynch popularized this idea and his book went up on wall street. Where he suggested we can have an advantage over wall street and our daily lives by just noticing what services we rely on or what brands we interact with. You can imagine that if you went to Chipotle early on, you might have noticed, hey, this is high quality food at a decent price.

[00:37:44] Shawn O’Malley: The line is out the door and maybe this is a stock that’s worth looking into. Unfortunately, this is too often taken to mean that you should invest in the stocks of companies that you like. If you love wearing Lululemon shorts, why not buy some Lulu stock, order everything from Amazon, buy some shares on it.

[00:38:02] Shawn O’Malley: that is actually not what Lynch wants us to think though. Lynch actually meant that as consumers, we can find great brands before wall street analysts do, which can be a starting point in assessing intelligent investment opportunities. The most common example I’ve seen of this is actually with people’s employers and their 401k.

[00:38:22] Shawn O’Malley: If you work at a publicly listed company, they probably offer you a chance to buy their shares and your retirement plan. And people often feel like they should either out of loyalty to their company or because they feel like they know their company best because they work there and they think it’s doing pretty well and therefore they want to invest in it.

[00:38:40] Shawn O’Malley: And generally that is a terrible idea. First off, if you’re at a big company, even if you’ve worked there for years, you probably have an overconfidence bias and how well you really know it. And you probably don’t know it as well as you think you do. Lots of employees at Enron, for example, put their life savings into Enron stock only to find out that the company was a fraud.

[00:39:01] Shawn O’Malley: Right. It shouldn’t, they have known better than anyone. If they couldn’t recognize that. I’m not sure that any of us stand a better chance necessarily. And beyond that, you’re just over concentrating your life to be very dependent on a single company. In the US, at least your employer facilitates your retirement, pays for your healthcare, of course, provides your monthly income.

[00:39:19] Shawn O’Malley: So you’re already hugely exposed to them and you have very little margin of safety. If you load up on your employer’s stock too, you’re just making yourself even more financially vulnerable to how your company does. If your company goes under or even just has to do layoffs, you’d not only lose your income and healthcare, but now your retirement portfolio is going to take a hit if the stock falls too.

[00:39:41] Shawn O’Malley: And in most cases, it’s just better and a lot cleaner to have that divide. Don’t put all of your 401k and your employer stock. I would say you probably shouldn’t even put 5 or 10 percent in. Just use the standard low fee, broad index funds that your 401k should hopefully offer. And that diversification will give you a margin of safety.

[00:40:01] Shawn O’Malley: And in a similar way, in Chapter 9, Graham talks about investing in investment funds and how there will always be a new generation of hotshot investors who claim to have found the formula for success. Today, that’s probably anyone who promises to beat the market each year by investing in things like AI or robotics or gene editing or any of those other buzzwords.

[00:40:23] Shawn O’Malley: But for one, these people are probably earning high returns by taking risks. They might not even realize they’re taking. We saw that in 2022, lots of funds making bold promises about blockchains and web three in 2021 got wiped out in 2022 because the timeline for these advancements was just unrealistic.

[00:40:42] Shawn O’Malley: The other problem too, going back to 401ks is that people often just look up the fund with the best performance in the last decade and think it will continue to be the best and select that one. By definition, these funds’ investments are now more expensive, though, which reduces the odds they’ll continue to do well.

[00:41:00] Shawn O’Malley: It also means their strategy will probably soon fall out of favor because no market or industry can outperform forever. The other problem is that truly great investment managers who generate outperformance for one fund will probably get poached to work somewhere else. So when you buy into the best performing fund in your retirement plan or offered in your retirement plan, you’re actually probably buying into the most expensive investment option with the highest likelihood of falling out of favor because it’s already been popular for a while and it may not even be managed by the same people anymore.

[00:41:35] Shawn O’Malley: Sort of as today’s theme, a lot of this is just common sense, logical stuff, but it takes some extra effort to think objectively and not chase our impulses, like putting a bunch of our portfolio and the hot mutual fund that all of our coworkers selected for their 401ks.

[00:41:53] Patrick Donley: It’s funny is it’s May 16th as we record this and the Dow is hitting 40,000 for the first time. It’d be really fascinating to get Graham’s take on today’s market. Shawn, I just wanted to thank you for sharing these key takeaways with us on what’s definitely one of the most important books on value investing ever written. I also wanted to share just before we close out one of my favorite quotes, from Ben Graham.

[00:42:14] Patrick Donley: He said that the intelligent investor is a realist who sells to optimists and buys from pessimists. With that, we’re going to close out for our second edition here of our book studies, but I really appreciate your time and thoughts, Shawn.

[00:42:28] Shawn O’Malley: Thanks for having me on.

[00:42:30] Patrick Donley: Okay, folks, that’s all I had for today’s episode. I hope you enjoyed the show and I’ll see you back here real soon.

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