Q&A: The Intelligent Investor – Chapter 8: The Investor and Market Fluctuations

Below are my reflections and answers to the discussion questions posted at Modern Graham for chapter 8 – The Investor and Market Fluctuations – of the Intelligent Investor written by Benjamin Graham. The Intelligent Investor

But first a short note, before I go on to discuss the questions.

So, here it comes, the infamous chapter eight about Mr. Market that Buffett has been mentioned so many times over the years. In his most recent letter to shareholders Warren wrote “In contrast, Ben’s ideas were explained logically in elegant, easy-to-understand prose (without Greek letters or complicated formulas). For me, the key points were laid out in what later editions labeled Chapters 8 and 20. (The original 1949 edition numbered its chapters differently.) These points guide my investing decisions today.”

Another quote I picked from Warren is “If you understand chapters 8 and 20 of The Intelligent Investor (Benjamin Graham, 1949) and chapter 12 of the General Theory (John Maynard Keynes, 1936), you don’t need to read anything else and you can turn off your TV.”

In the preface to the fourth edition of the Intelligent Investor Warren writes “If you follow the behavioral and business principles that Graham advocates—and if you pay special attention to the invaluable advice in Chapters 8 and 20 you will not get a poor result from your investments. (That represents more of an accomplishment than you might think.) Whether you achieve outstanding results will depend on the effort and intellect you apply to your investments, as well as on the amplitudes of stock-market folly that prevail during your investing career. The sillier the market’s behavior, the greater the opportunity for the business-like investor. Follow Graham and you will profit from folly rather than participate in it.”

So here it is, the much talked about “Chapter 8”. Read it, learn from it, and get back to it every now and then.

1. What quote from this chapter do you think best summarizes the point Graham is making?

“Let us close this section with something in the nature of a parable. Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. 

If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed—this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such signals are misleading at least as often as they are helpful. Basically,
price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”

2. How have you seen the parable of Mr. Market play out in your experience?  Any examples of a company that has been grossly mispriced at some point?

One example that comes to mind at the moment is American Express (AXP) back in the financial crisis in 2008-09. Looking at the fundamentals of the business in the years before the financial crisis hit, it’s pretty clear that what we have here is a great business that faced some difficulties due to the financial crisis. The question was the severity of these problems.

See financials below. Source: Morningstar

AXP2

The AXP price per share, see below (Source: Morningstar), took a dive from $65 in April 2007 to $9.71 in June 2009, a fall of 85%. Having reached this low the share price started to climb up to where it’s trading today, at a price per share of $86, a gain of 686%. If I had had a better understanding of the business I might have had the courage to buy.

AXP1

3. On page 192 Graham notes that as investing formulas have gained popularity their reliability dwindles due to new market conditions and the widespread use of the formula undermining its previously held advantage. In what ways has Graham’s formula lost reliability? How has it managed to stay useful?

Graham’s formula is still of value. The formula focuses on businesses that has demonstrated an ability to grow earnings without taking on too much risk to do this. In the end, this is what counts, the value creation in a certain business. Then it’s all about paying a fair price for this value creation based on a reasonable and conservative assumption about the intrinsic business value.

4. Graham mentions that one issue with the formula plans is that they leave the potential for the market to “run away” from investors. What steps do you take to ensure that the market doesn’t run away from you, while also protecting yourself from a steep drop in prices such as the bear market of the early 2000s?

Always be on the look out for great businesses selling at fair prices. The most important thing is to never pay too much for a business.

5. Graham seems to advocate that the Intelligent Investor find a way to have “something to do” as an outlet of pent-up energy as the market advances, rather than allowing oneself to become entangled with the market movements.  Do you have any example of what you could do in that regard?

Read about as many businesses as possible to prepare for less good times and for Mr. Market to offer some of them at a good price.

6. What did you think of the chapter overall?

The highlight of the chapter is the parable of Mr. Market. The final section “Fluctuations in bond prices” I read only briefly. Overall a great chapter.

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