The Intelligent Investor
This installment of The Matt Allen Letter is free for everyone. If you would like to read about stock analysis, stock market analysis, and much more.
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Dear Friends,
In this newsletter, we will go over some of the best points from the book that changed Warren Buffet’s life. It will help you as well! The example at the end is my favorite!
The Intelligent Investor by Benjamin Graham is the best book ever written on investing. Warren Buffett calls it “the Bible of investing.”
When Buffett was 19, he picked up the book to read it, and the book completely changed his life.
Warren loved the book so much that he went to Columbia University to be taught by Professor Benjamin Graham. When Buffett graduated, he spent a few years working for him before he went back to Omaha to start Buffett partners.
I read The Intelligent Investor once a year, I started reading it when I was 20 years old. The book has been a foundation for my long-term investment strategy.
The book will help you build a foundation for your investment thought process. It will not teach you how to beat the market. However, it will teach you how to reduce risk, protect your capital from loss and reliably generate sustainable returns over the long run.
1. Mr. Market
“Mr. Market's job is to provide you with prices; your job is to decide whether it is to your advantage to act on them. You no not have to trade with him just because he constantly begs you to.”
Most people look at a stock as a ticker symbol with a price on it. This is completely wrong. A stock is ownership of a business even if you just have 1 share.
Enter in Mr. Market:
Think of Mr. Market as an irrational investor in a business you also invested in. He frequently changes his mind and quotes wildly different prices for your shares. (Everyday on the stock market)
When you invest in a stock, you have to remember that value is what the stock is worth while price is what you pay for the stock.
Why would you pay $75 per share of a company that is worth $50 a share?
For the investor that can stay calm, Mr. Market never forces you to buy or sell a stock from him. Mr. Market just gives you the opportunity each day to do so.
You should be happy to sell to him, when he gives you prices that are incredibly high.
You should be happy to buy from him, when he gives you prices that are are on a big discount.
We have to keep in mind that people back in 1928 were not bombarded with news and stock quotes everyday. However, this is not an excuse for us to trade our long term account even more frequently. I am a firm believer in not leaving your long term account on your cell phone because of this reason.
In Matt Allen terms: Let’s say that you buy a business/home for $300,000. You got a GREAT deal on it because the business/home is really worth $500,000. You are pumped about it!
On Monday morning at 9:30 am, Mr. Market shows up at your doorstep and offers you $100,000 for your business/home. You would tell them that they are insane and to leave.
On Tuesday morning at 9:30 am, Mr. Market shows up at your doorstep and offers you $1,000,000. You would tell them that they are insane BUT you would sell right then and there.
A stock is not any different. Do not get distracted by the daily quotes.
2. Insist on a Margin of Safety
No matter how smart or great of an investment idea that we have there is always that chance that we could be wrong. In the stock market, you will have events that dictate the outcome of what happens.
However, we can minimize this risk by insisting that every investment has a margin of safety on it.
As I said before, you have to remember that value is what the stock is worth while price is what you pay for the stock.
Graham suggests that you want to invest in a stock that is 2/3 of it’s true value. (However, Buffett has changed this up some when he met Charlie Munger)
When you find a stock that is on sale by 66%, you have found a massive margin of safety. The stock has nowhere to go but up at this point.
The book gives a formula for finding true value:
value=current (normal) earnings x (8.5+2 x expected annual growth rate)
The growth rate should be equal to the expected growth of earnings in the next 7-10 years
Please note that I use a DCF Model along with Warren Buffett. I am working on a spreadsheet for our premium investors that does everything for you.
When I invest, I base my margin of safety based on how right I believe that I am in my thesis.
For example, when I sent out Mara to our premium subscribers at 95 cents, I believed that the stock would go to $50 (it went to $88.) So does it really matter, if you buy at $5? It does not. I was very confident in my thesis. However, I will send out some stocks that I am not as confident about and the margin of safety needs to be much higher.
In Matt Allen Terms:
Would you get on a cruise ship that boards 100 people, but it would sink if 101 people were on the ship? Absolutely not!
My ass is only getting on that ship, if only 40 people are on board.
You should look at stocks the same way, do not invest in a stock that is valued at $100 but it is priced at $101.
3. IPOs
Benjamin Graham is not a fan of Initial Public Offerings. IPOs often happen in bull markets and lead to the prices of stocks being way overvalued. When the bear market begins, these overpriced growth stocks are the first to crash and cause severe losses.
This is what has happened from 2020 to now. We have seen a bunch of IPOs and SPAC that sent the prices of these assets soaring. However, they were the first to come back to reality when the tide started to turn.
A sure way to predict the end of a bull market is when the stocks of new small businesses are priced higher than blue-chip medium-sized companies. (This might sound familiar)
An investor who bought every IPO at its public closing price and held on for three years, from 1980 to 2001, would have underperformed the market by 23% annually.
4. Risk and Reward are not always correlated
According to academic theory, the rate of return which an investor can expect must be proportional to the degree of risk that he is willing to accept. Risk is then measured as the volatility of the returns on the investment.
In Matt Allen terms: the higher the risk, the higher the reward.
(Why can’t academics just say the simple explanation? lol)
Benjamin Graham does not agree with this statement.
Instead, he argues that the price and value of assets are often disconnected. Therefore, the return that an investor can expect is a function of how much time and effort that he brings in his pursuit of finding bargains.
Let’s say that we have found a stock that is worth $25 a share, but Mr. Market has it being sold for $5 a share. This means that in time, Mr. Market will eventually realize his mistake and sell it to us for $25. This is a 400% gain.
The person who researches and works hard to find a stock like this is taking less risk for a higher reward.
I actually sent out a stock to our premium investors that reminded me of this scenario that you can read about here.
In Matt Allen terms: Let’s say that you and a group of friends are out drinking at bar at 2:00 am. The bar closes, but you guys decide that it is to early to call it a night.
You end up going to a more sketch part of town.
A man walks up to the group and asks in a Russian accent: “Do you want to play a game?”
The friend that always talks to strangers replies: “Absolutely. I love games! What is it?”
The Russian man puts a gun on the table that is loaded with one bullet. “I will give you $10,000, if you dare to take a shot, Russian Roulette style.”
The entire group says absolutely not, and the Russian man doubles down on his offer.
“What about $100,000 for 2 shots of Russian Roulette style?”
This story represents the academic style way of demanding a higher risk for a higher reward.
In the first offer, you were going to receive a reward of $10,000 at a risk of 16.7% chance of blowing your brains out.
In the second offer, you were going to receive a reward of $100,000 at a risk of 33.3% chance of blowing your brains out.
Seems logical, right? However, the stock market does not have to be like this!
Remember: Price and value are not the same! When you buy a company for 60 cents on the dollar, you have a great chance at a big reward for small risk.
When you buy a company for 40 cents on the dollar, you have an even bigger chance at a bigger reward for a smaller risk.
I hope everyone has a great rest of the week!
If you have any questions, feedback, or just wanna say hey, email me at mattallenletter@gmail.com
Stay Hungry, Stay Long
Matt Allen
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