Profit between the cover

The classics never go out of style. That applies to books about investing as much as other creative endeavours.

Rather than tomes about thriving in or surviving prevailing market conditions, it's the books based on time-tested principles such as value that give investors the quickest route to a healthy portfolio. The classics never go out of style. That applies to books about investing as much as other creative endeavours. Investment guides are, like most things, subject to fashion. Manuals with titles like "How to Survive the Coming ... " (fill in the blank with any scary word you can think of - Collapse, Apocalypse, Depression) are usually published near or after the end of a recession as the stock market is bottoming.

Books with titles like "How to Profit From the Coming ... " (fill in the blank with a hopeful term like Boom or Golden Age) populate the shelves just as a long bull market is topping out and giving way to, well, the coming apocalypse. A notorious example in this genre is Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market by James K Glassman and Kevin A Hassett. It was published in 1999, just in time for the tech crash and a few other crashes after that. "Dow 6,000" would have been a better title.

A book such as Dow 36,000 seems anachronistic only a decade after its publication, even downright comical, except perhaps for readers who used its ideas as a rationale for sinking their life savings into tech stocks 10 minutes before the bubble popped. Two older books seem much fresher today because they focus on a timeless truth: investors have brains susceptible to the same flaws - faulty logic and faulty temperament - as anyone else. Indeed, they may be more prone to these flaws, because investing involves throwing money around, and money has a way of magnifying our ability to act foolish.

One Up on Wall Street by Peter Lynch, the former manager of the Fidelity Magellan Fund, and Benjamin Graham's The Intelligent Investor don't tell you what the market is about to do. They don't pretend to know and they're not all that interested. But they do explain what investors - including you, most likely - do in certain circumstances, highlighting some common, costly errors. By holding a mirror up to readers, they offer them a way to avoid the errors. Just as important, they provide the means to exploit the same weaknesses present in other investors not yet blessed with self-awareness and an understanding of how markets work.

It's not a coincidence that both books were written soon after extraordinary periods in stock market history, when human frailties were so spectacularly on display. Mr Graham's book was published in 1934, at roughly the midpoint of the Great Depression and two years after US stocks ended a cascade of nearly 90 per cent. One Up on Wall Street hit shelves two years after the 1987 crash. A key message of both authors is that retail investors have the ability to beat the pros on Wall Street (Mr Lynch and Mr Graham focus on US markets, but their observations and lessons also seem applicable to the City or the financial Establishment anywhere else).

Fund managers and analysts tend to use the same pieces of data to form judgements about companies and are required to keep their portfolios from deviating far from benchmark indices. That makes them susceptible to the malaise of "groupthink". Mr Lynch is a big believer in what he calls "the power of common knowledge", meaning inferences about companies that can be gleaned by ordinary people making ordinary observations. What makes such knowledge so powerful is that it's not all that common, especially among professional investors, and neither is the sense needed to fathom its significance.

"Any normal person ... can pick stocks just as well [as], if not better than, the average Wall Street expert," he writes. "The amateur investor has numerous built-in advantages that, if exploited, should result in his or her outperforming the experts and also the market in general." Mr Lynch is anything but an average Wall Street expert. His long-term outperformance at the helm of Magellan has won him a justified reputation as one of the greatest stock pickers ever.

Much of his book is spent spelling out his methods so that small investors can press those built-in advantages he believes they have: how to determine whether a company is a fast grower, a cyclical, a turnaround play etc; how to spot when a metamorphosis has begun that will move it from one category into another; how to compare an impression of a company with the way Wall Street sees it and how to reconcile the differences.

Mr Lynch recommends a "two-minute drill". That's a term from American football, but as he uses it, it's more like a pitch to a Hollywood mogul - a quick rationale for buying a stock, something along the lines of: the retailer's earnings are down, but it hired a new head buyer and the merchandise hitting the shelves is far more popular with my kid than the old stuff. Mr Lynch is an aggressive, growth-oriented stock picker, and his book plays to his strength and reputation. Mr Graham in many ways is the antithesis; he is less interested in what to buy than when and for how much, and his focus is on value rather than growth and on playing defence rather than offence.

His defensive game plan relies on the twin pillars of time and quality. While stock-picking is secondary to Mr Graham, he urges investors to choose blue chips and other companies with such traits as a sound balance sheet and consistent earnings growth. To avoid overpaying for these top-notch businesses, he would buy when there is what he calls "a margin of safety". Say long-term government bonds are yielding three per cent and a stock is trading at a point at which the company's profits amount to eight per cent of the price (this figure is the inverse of the price-earnings ratio, which for this stock would be 12.5).

That discrepancy of five percentage points is Mr Graham's safety margin. He also counsels buying when the broad market is cheap by historical standards in the expectation that it won't remain so. This is where time comes in. He was well aware of the tendency of prices to go to extremes and later come back to normal levels. He was also aware that ordinary investors get swept up in events and ignore this basic tenet. Mr Graham expressed bemusement at the way stocks attract more buyers as they become more expensive and are shunned as their prices fall. He (in a 1972 revision) and Mr Lynch both made note of the fact that investors were nearly universally averse to owning stocks just ahead of, and then during, the great post-war bull markets.

Neither book is completely immune from the ravages of time. Mr Graham makes frequent references to book value when discussing how to assess a stock's worth, but that yardstick is less valid in an increasingly service-oriented, post-industrial economy. The evolution of the Western economy creates a problem for Mr Lynch, too. He fancies high-growth companies, while also encouraging investors to stick with what they're familiar with. These days the fast growers are concentrated in industries that barely existed a few years ago and whose workings remain obscure to common folk.

In all substantive respects, though, investors should find the books valuable evergreens that can improve long-term returns. Recalling other classics, they show how the little guy can beat the odds and beat the system by working within it and turning it to his advantage.