Transcript for:
The Intelligent Investor Chapter 1 - Investment vs. Speculation

the intelligent investor by benjamin graham the definitive book on value investing warren buffet says the intelligent investor is the best book written on investing he also says that it is the bible of investing and now the intelligent investor chapter one investment versus speculation results to be expected by the intelligent investor this chapter will outline the viewpoints that will be set forth in the remainder of the book in particular we wish to develop at the outset our concept of appropriate portfolio policy for the individual non-professional investor versus speculation what do we mean by investor throughout this book the term will be used in contra distinction to speculator dot as far back as 1934 in our textbook security analysis one we attempted a precise formulation of the difference between the two as follows an investment operation is one which upon thorough analysis promises safety of principle and an adequate return operations not meeting these requirements are speculative dot while we have clung tenaciously to this definition over the ensuing 38 years it is worthwhile noting the radical changes that have occurred in the use of the term investor during this period after the great market decline of 1929 1932 all common stocks were widely regarded as speculative by nature a leading authority stated flatly that only bonds could be bought for investment.2 thus we had then to defend our definition against the charge that it gave too wide scope to the concept of investment now our concern is of the opposite sort we must prevent our readers from accepting the common jargon which applies the term investor to anybody and everybody in the stock market in our last edition we cited the following headline of a front-page article of our leading financial journal in june 1962. small investors bearish they are selling odd lots short in october 1970 the same journal had an editorial critical of what it called reckless investors comma who this time were rushing in on the buying side these quotations well illustrate the confusion that has been dominant for many years in the use of the words investment and speculation think of our suggested definition of investment given above and compare it with the sale of a few shares of stock by an inexperienced member of the public who does not even own what he is selling and has some a largely emotional conviction that he will be able to buy them back at a much lower price it is not irrelevant to point out that when the 1962 article appeared the market had already experienced a decline of major size and was now getting ready for an even greater upswing it was about as poor a time as possible for selling short in a more general sense the later used phrase reckless investors could be regarded as a laughable contradiction in terms something like spendthriftmisers were this misuse of language not so mischievous the newspaper employed the word investor in these instances because in the easy language of wall street everyone who buys or sells a security has become an investor regardless of what he buys or for what purpose or at what price or whether for cash or on margin compare this with the attitude of the public toward common stocks in 1948 when over 90 percent of those queried expressed themselves as opposed to the purchase of common stocks.three about half gave as their reason not safe a gamble comma and about half the reason not familiar with dotted is indeed ironical though not surprising that common stock purchases of all kinds were quite generally regarded as highly speculative or risky at a time when they were selling on a most attractive basis and due soon to begin their greatest advance in history conversely the very fact they had advanced to what were undoubtedly dangerous levels as judged by past experience later transformed them into investments comma and the entire stock buying public into investors. the distinction between investment and speculation in common stocks has always been a useful one and its disappearance is a cause for concern we have often said that wall street as an institution would be well advised to reinstate this distinction and to emphasize it in all its dealings with the public otherwise the stock exchanges may someday be blamed for heavy speculative losses which those who suffered them had not been properly warned against ironically once more much of the recent financial embarrassment of some stock exchange firms seems to have come from the inclusion of speculative common stocks in their own capital funds we trust that the reader of this book will gain a reasonably clear idea of the risks that are inherent in common stock commitments risks which are inseparable from the opportunities of profit that they offer and both of which must be allowed for in the investor s calculations what we have just said indicates that there may no longer be such a thing as a simon pure investment policy comprising representative common stocks in the sense that one can always wait to buy them at a price that involves no risk of a market or quotational loss large enough to be disquieting in most periods the investor must recognize the existence of a speculative factor in his common stock holdings it is his task to keep this component within minor limits and to be prepared financially and psychologically for adverse results that may be of short or long duration two paragraphs should be added about stock speculation per se as distinguished from the speculative component now inherent in most representative common stocks outright speculation is neither a legal immoral nor for most people fattening to the pocketbook more than that some speculation is necessary and unavoidable for in many common stock situations there are substantial possibilities of both profit and loss and the risks therein must be assumed by someone there is intelligent speculation as there is intelligent investing but there are many ways in which speculation may be unintelligent of these the foremost are 1. speculating when you think you are investing 2. speculating seriously instead of as a pastime when you lack proper knowledge and skill for it and 3 risking more money in speculation than you can afford to lose in our conservative view every non-professional who operates on margin should recognize that he is ipso facto speculating and it is his broker s duty so to advise him and everyone who buys a so-called hot common stock issue or makes a purchase in any way similar thereto is either speculating or gambling speculation is always fascinating and it can be a lot of fun while you are ahead of the game if you want to try your luck at it put aside a portion the smaller the better of your capital in a separate fund for this purpose never add more money to this account just because the market has gone up and profits are rolling in that s the time to think of taking money out of your speculative fund never mingle your speculative and investment operations in the same account nor in any part of your thinking results to be expected by the defensive investor we have already defined the defensive investor as one interested chiefly in safety plus freedom from bother in general what course should he follow and what return can he expect under average normal conditions if such conditions really exist to answer these questions we shall consider first what we wrote on the subject seven years ago next what significant changes have occurred since then in the underlying factors governing the investor s expectable return and finally what he should do and what he should expect under present day early 1972 conditions 1. what we said six years ago we recommended that the investor divide his holdings between high grade bonds and leading common stocks that the proportion held in bonds b never less than 25 percent or more than 75 percent with the converse being necessarily true for the common stock component that his simplest choice would be to maintain a 50 50 proportion between the two with adjustments to restore the equality when market developments had disturbed it by as much as say 5 as an alternative policy he might choose to reduce his common stock component to 25 if he felt the market was dangerously high comma and conversely to advance it toward the maximum of 75 if he felt that a decline in stock prices was making them increasingly attractive. in 1965 the investor could obtain about 41. 2 on high-grade taxable bonds and 31. four percent on good tax-free bonds the dividend return on leading common stocks with the dow jones industrial average at 892 was only about 3.2 percent this fact and others suggested caution we implied that at normal levels of the market the investor should be able to obtain an initial dividend return of between 2 and 41 2 on his stock purchases to which should be added a steady increase in underlying value and in the normal market price of a representative stock list of about the same amount giving a return from dividends and appreciation combined of about 71 2 per year the half and half division between bonds and stocks would yield about 6 before income tax we added that the stock component should carry a fair degree of protection against a loss of purchasing power caused by large-scale inflation it should be pointed out that the above arithmetic indicated expectation of a much lower rate of advance in the stock market than had been realized between 1949 and 1964. that rate had averaged a good deal better than 10 for listed stocks as a whole and it was quite generally regarded as a sort of guarantee that similarly satisfactory results could be counted on in the future few people were willing to consider seriously the possibility that the high rate of advance in the past means that stock prices are now too high comma and hence that the wonderful results since 1949 would imply not very good but bad results for the future.4 2. what has happened since 1964. the major change since 1964 has been the rise in interest rates on first grade bonds to record high levels although there has since been a considerable recovery from the lowest prices of 1970. the obtainable return on good corporate issues is now about 71 2 and even more against 41. 2 in 1964. in the meantime the dividend return on dow jones industrial average type stocks had a fair advance also during the market decline of 1969.70 but as we write with the dow at 900 it is less than 3.5 against 3.2 at the end of 1964. the change in going interest rates produced a maximum decline of about 38 in the market price of medium-term say 20-year bonds during this period there is a paradoxical aspect to these developments in 1964 we discussed at length the possibility that the price of stocks might be too high and subject ultimately to a serious decline but we did not consider specifically the possibility that the same might happen to the price of high grade bonds neither did anyone else that we know of we did warn on p 90 that a long-term bond may vary widely in price in response to changes in interest rates.in the light of what has since happened we think that this warning with attendant examples was insufficiently stressed for the fact is that if the investor had a given sum in the dow jones industrial average at its closing price of 874 in 1964 he would have had a small profit thereon in late 1971 even at the lowest level 630 in 1970 his indicated loss would have been less than that shown on good long-term bonds on the other hand if he had confined his bond type investments to u.s savings bonds short-term corporate issues or savings accounts he would have had no loss in market value of his principal during this period and he would have enjoyed a higher income return than was offered by good stocks it turned out therefore that true cash equivalents proved to be better investments in 1964 than common stocks in spite of the inflation experience that in theory should have favored stocks over cash the decline and quoted principal value of good longer-term bonds was due to developments in the money market an abstruse area which ordinarily does not have an important bearing on the investment policy of individuals this is just another of an endless series of experiences over time that have demonstrated that the future of security prices is never predictable almost always bonds have fluctuated much less than stock prices and investors generally could buy good bonds of any maturity without having to worry about changes in their market value there were a few exceptions to this rule and the period after 1964 proved to be one of them we shall have more to say about change in bond prices in a later chapter 3. expectations and policy in late 1971 and early 1972. toward the end of 1971 it was possible to obtain 8 taxable interest on good medium-term corporate bonds and 5.7 tax-free on good state or municipal securities in the shorter term field the investor could realize about 6 on u.s government issues due in five years in the latter case the buyer need not be concerned about a possible loss in market value since he is sure of full repayment including the 6 interest return at the end of a comparatively short holding period the dow jones industrial average at its recurrent price level of 900 in 1971 yields only 3.5 percent let us assume that now as in the past the basic policy decision to be made is how to divide the fund between high grade bonds or other so-called cash equivalents and leading dow jones industrial average type stocks what course should the investor follow under present conditions if we have no strong reason to predict either a significant upward or a significant downward movement for some time in the future first let us point out that if there is no serious adverse change the defensive investor should be able to count on the current 3.5 dividend return on his stocks and also on an average annual appreciation of about 4 as we shall explain later this appreciation is based essentially on the reinvestment by the various companies of a corresponding amount annually out of undistributed profits on a before tax basis the combined return of his stocks would then average say 7.5 somewhat less than his interest on high-grade bonds on an after-tax basis the average return on stocks would work out at some 5.3 0.5 this would be about the same as is now obtainable on good tax-free medium-term bonds these expectations are much less favorable for stocks against bonds than they were in our 1964 analysis that conclusion follows inevitably from the basic fact that bond yields have gone up much more than stock yields since 1964. we must never lose sight of the fact that the interest and principal payments on good bonds are much better protected and therefore more certain than the dividends and price appreciation on stocks consequently we are forced to the conclusion that now toward the end of 1971 bond investment appears clearly preferable to stock investment if we could be sure that this conclusion is right we would have to advise the defensive investor to put all his money in bonds and none in common stocks until the current yield relationship changes significantly in favor of stocks but of course we cannot be certain that bonds will work out better than stocks from today s levels the reader will immediately think of the inflation factor as a potent reason on the other side in the next chapter we shall argue that our considerable experience with inflation in the united states during this century would not support the choice of stocks against bonds at present differentials in yield but there is always the possibility though we consider it remote of an accelerating inflation which in one way or another would have to make stock equities preferable to bonds payable in a fixed amount of dollars there is the alternative possibility which we also consider highly unlikely that american business will become so profitable without stepped-up inflation as to justify a large increase in common stock values in the next few years finally there is the more familiar possibility that we shall witness another great speculative rise in the stock market without a real justification in the underlying values any of these reasons and perhaps others we haven't thought of might cause the investor to regret a 100 concentration on bonds even at their more favorable yield levels hence after this foreshortened discussion of the major considerations we once again enunciate the same basic compromise policy for defensive investors namely that at all times they have a significant part of their funds in bond type holdings and a significant part also in equities it is still true that they may choose between maintaining a simple 50 50 division between the two components or a ratio dependent on their judgment varying between a minimum of 25 and a maximum of 75 of either we shall give our more detailed view of these alternative policies in a later chapter since at present the overall return envisaged from common stocks is nearly the same as that from bonds the presently expectable return including growth of stock values for the investor would change little regardless of how he divides his fund between the two components as calculated above the aggregate return from both parts should be about 7.8 percent before taxes or 5.5 percent on a tax-free or estimated tax paid basis a return of this order is appreciably higher than that realized by the typical conservative investor over most of the long-term past it may not seem attractive in relation to the 14 or so return shown by common stocks during the 20 years of the predominantly bull market after 1949 but it should be remembered that between 1949 and 1969 the price of the dow jones industrial average had advanced more than fivefold while its earnings and dividends had about doubled hence the greater part of the impressive market record for that period was based on a change in investors and speculators attitudes rather than in underlying corporate values to that extent it might well be called a bootstrap operation. in discussing the common stock portfolio of the defensive investor we have spoken only of leading issues of the type included in the 30 components of the dow jones industrial average we have done this for convenience and not to imply that these 30 issues alone are suitable for purchase by him actually there are many other companies of quality equal to or excelling the average of the dow jones list these would include a host of public utilities which have a separate dow jones average to represent them but the major point here is that the defensive investor s overall results are not likely to be decisively different from one diversified or representative list than from another or more accurately that neither he nor his advisors could predict with certainty whatever differences would ultimately develop it is true that the art of skillful or shrewd investment is supposed to lie particularly in the selection of issues that will give better results than the general market for reasons to be developed elsewhere we are skeptical of the ability of defensive investors generally to get better than average results which in fact would mean to beat their own overall performance our skepticism extends to the management of large funds by experts let us illustrate our point by an example that at first may seem to prove the opposite between december 1960 and december 1970 the dow jones industrial average advanced from 616 to 839 or 36 but in the same period the much larger standard and poorest weighted index of 500 stocks rose from 58.11 to 92.15 or 58 obviously the second group had proved a better buy than the first but who would have been so rash as to predict in 1960 that what seemed like a miscellaneous assortment of all sorts of common stocks would definitely outperform the aristocratic 30 tyrants of the dao all this proves we insist that only rarely can one make dependable predictions about price changes absolute or relative we shall repeat here without apology for the warning cannot be given too often that the investor cannot hope for better than average results by buying new offerings or hot issues of any sort meaning thereby those recommended for a quick profit.the contrary is almost certain to be true in the long run the defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition any security analyst worth his salt could make up such a list aggressive investors may buy other types of common stocks but they should be on a definitely attractive basis as established by intelligent analysis to conclude this section let us mention briefly three supplementary concepts or practices for the defensive investor the first is the purchase of the shares of well-established investment funds as an alternative to creating his own common stock portfolio he might also utilize one of the common trust funds comma or commingled funds comma operated by trust companies and banks in many states or if his funds are substantial use the services of a recognized investment council firm this will give him professional administration of his investment program along standard lines the third is the divisive dollar cost averaging comma which means simply that the practitioner invests in common stocks the same number of dollars each month or each quarter in this way he buys more shares when the market is lower than when it is high and he is likely to end up with a satisfactory overall price for all his holdings strictly speaking this method is an application of a broader approach known as formula investing.the latter was already alluded to in our suggestion that the investor may vary his holdings of common stocks between the 25 minimum and the 75 maximum in inverse relationship to the action of the market these ideas have merit for the defensive investor and they will be discussed more amply in later chapters results to be expected by the aggressive investor our enterprising security buyer of course will desire and expect to attain better overall results than his defensive or passive companion but first he must make sure that his results will not be worse it is no difficult trick to bring a great deal of energy study and native ability into wall street and to end up with losses instead of profits these virtues if channeled in the wrong directions become indistinguishable from handicaps thus it is most essential that the enterprising investor start with a clear conception as to which courses of action offer reasonable chances of success and which do not first let us consider several ways in which investors and speculators generally have endeavoured to obtain better than average results these include 1. trading in the market this usually means buying stocks when the market has been advancing and selling them after it has turned downward the stocks selected are likely to be among those which have been behaving better than the market average a small number of professionals frequently engage in short selling here they will sell issues they do not own but borrow through the established mechanism of the stock exchanges their object is to benefit from a subsequent decline in the price of these issues by buying them back at a price lower than they sold them for as our quotation from the wall street journal on p 19 indicates even small investors perish the term exclamation mark sometimes try their unskilled hand at short selling 2. short-term selectivity this means buying stocks of companies which are reporting or expected to report increased earnings or for which some other favorable development is anticipated 3. long-term selectivity here the usual emphasis is on an excellent record of past growth which is considered likely to continue in the future in some cases also the investor may choose companies which have not yet shown impressive results but are expected to establish a high earning power later such companies belong frequently in some technological area e.g computers drugs electronics and they often are developing new processes or products that are deemed to be especially promising we have already expressed a negative view about the investor s overall chances of success in these areas of activity the first we have ruled out on both theoretical and realistic grounds from the domain of investment stock trading is not an operation which on thorough analysis offers safety of principle and a satisfactory return.more will be said on stock trading in the later chapter in his endeavor to select the most promising stocks either for the near-term or the longer future the investor faces obstacles of two kinds the first stemming from human fallibility and the second from the nature of his competition he may be wrong in his estimate of the future or even if he is right the current market price may already fully reflect what he is anticipating in the area of near-term selectivity the current year s results of the company are generally common property on wall street next year s results to the extent they are predictable are already being carefully considered hence the investor who selects issues chiefly on the basis of this year s superior results or on what he is told he may expect for next year is likely to find that others have done the same thing for the same reason in choosing stocks for their long-term prospects the investor s handicaps are basically the same the possibility of outright error in the prediction which we illustrated by our airlines example on p six is no doubt greater than when dealing with near-term earnings because the experts frequently go astray in such forecasts it is theoretically possible for an investor to benefit greatly by making correct predictions when wall street as a whole is making incorrect ones but that is only theoretical how many enterprising investors could count on having the acumen or prophetic gift to beat the professional analysts at their favorite game of estimating long-term future earnings we are thus led to the following logical if disconcerting conclusion to enjoy a reasonable chance for continued better than average results the investor must follow policies which are 1. inherently sound and promising and 2. not popular on wall street are there any such policies available for the enterprising investor in theory once again the answer should be yes and there are broad reasons to think that the answer should be affirmative in practice as well everyone knows that speculative stock movements are carried too far in both directions frequently in the general market and at all times in at least some of the individual issues furthermore a common stock may be undervalued because of lack of interest or unjustified popular prejudice we can go further and assert that in an astonishingly large proportion of the trading in common stocks those engaged there in dante appear to know in polite terms one part of their anatomy from another in this book we shall point out numerous examples of past dis crippenses between price and value thus it seems that any intelligent person with a good head for figures should have a veritable picnic on wall street batoning off other people's foolishness so it seems but somehow it doesn't he work out that simply buying a neglected and therefore undervalued issue for profit generally proves a protracted and patience trying experience and selling shorter too popular and therefore overvalued issue is apt to be a test not only of 1s courage and stamina but also of the depth of 1s pocketbook the principle is sound its successful application is not impossible but it is distinctly not an easy art to master there is also a fairly wide group of special situations comma which over many years could be counted on to bring a nice annual return of 20 or better with a minimum of overall risk to those who knew their way around in this field they include inter-security arbitrages payouts or workouts in liquidations protected hedges of certain kinds the most typical case is a projected merger or acquisition which offers a substantially higher value for certain shares than their price on the date of the announcement the number of such deals increased greatly in recent years and it should have been a highly profitable period for the cognoscenti but with the multiplication of merger announcements came a multiplication of obstacles to mergers and of deals that didn't ego through quite a few individual losses were thus realized in these once reliable operations perhaps too the overall rate of profit was diminished by too much competition. the lessened profitability of these special situations appears one manifestation of a kind of self-destructive process akin to the law of diminishing returns which is developed during the lifetime of this book in 1949 we could present a study of stock market fluctuations over the preceding 75 years which supported a formula based on earnings and current interest rates for determining a level to buy the dow jones industrial average below its central or intrinsic value and to sell out above such value it was an application of the governing maxim of the rothschilds by cheap and cell dear dot and it had the advantage of running directly counter to the ingrained and pernicious maxim of wall street that stocks should be bought because they have gone up and sold because they have gone down alas after 1949 this formula no longer worked a second illustration is provided by the famous dow theory of stock market movements in a comparison of its indicated splendid results for 1897 1930 and its much more questionable performance since 1934. a third and final example of the golden opportunities not recently available a good part of our own operations on wall street had been concentrated on the purchase of bargain issues highly identified as such by the fact that they were selling at less than their share in the net current assets working capital alone not counting the plant account and other assets and after deducting all liabilities ahead of the stock it is clear that these issues were selling at a price well below the value of the enterprise as a private business no proprietor or majority holder would think of selling what he owned at so ridiculously lower figure strangely enough such anomalies were not hard to find in 1957 a list was published showing nearly 200 issues of this type available in the market in various ways practically all these bargain issues turned out to be profitable and the average annual result proved much more remunerative than most other investments but they too virtually disappeared from the stock market in the next decade and with them a dependable area for shrewd and successful operation by the enterprising investor however at the low prices of 1970 there again appeared a considerable number of such sub-working capital issues and despite the strong recovery of the market enough of them remained at the end of the year to make up a full-sized portfolio the enterprising investor under today s conditions still has various possibilities of achieving better than average results the huge list of marketable securities must include a fair number that can be identified as undervalued by logical and reasonably dependable standards these should yield more satisfactory results on the average than will the dow jones industrial average or any similarly representative list in our view the search for these would not be worth the investor s effort unless he could hope to add say 5 before taxes to the average annual return from the stock portion of his portfolio we shall try to develop one or more such approaches to stock selection for use by the active investor chapter 2 the investor and inflation inflation and the fight against it has been very much in the public s mind in recent years the shrinkage in the purchasing power of the dollar in the past and particularly the fear or hope by speculators of a serious further decline in the future has greatly influenced the thinking of wall street it is clear that those with a fixed dollar income will suffer when the cost of living advances and the same applies to a fixed amount of dollar principal holders of stocks on the other hand have the possibility that a loss of the dollar s purchasing power may be offset by advances in their dividends and the prices of their shares on the basis of these undeniable facts many financial authorities have concluded that one bonds are an inherently undesirable form of investment and two consequently common stocks are by their very nature more desirable investments than bonds we have heard of charitable institutions being advised that their portfolios should consist 100 of stocks and 0 of bonds this is quite a reversal from the earlier days when trust investments were restricted by law to high-grade bonds and a few choice preferred stocks our readers must have enough intelligence to recognize that even high quality stocks cannot be a better purchase than bonds under all conditions i.t regardless of how high the stock market may be and how low the current dividend return compared with the rates available on bonds a statement of this kind would be as absurd as was the contrary one too often heard years ago that any bond is safer than any stock in this chapter we shall try to apply various measurements to the inflation factor in order to reach some conclusions as to the extent to which the investor may wisely be influenced by expectations regarding future rises in the price level in this matter as in so many others in finance we must base our views of future policy on a knowledge of past experience is inflation something new for this country at least in the serious form it has taken since 1965. if we have seen comparable or worse inflations in living experience what lessons can be learned from them in confronting the inflation of today let us start with table 2 1 a condensed historical tabulation that contains much information about changes in the general price level and can comet and changes in the earnings and market value of common stocks our figures will begin with 1915 and thus cover 55 years presented at five-year intervals we use 1946 instead of 1945 to avoid the last year of wartime price controls the first thing we notice is that we have had inflation in the past lots of it the largest five-year dose was between 1915 and 1920 when the cost of living nearly doubled this compares with the advance of 15 between 1965 and 1970. in between we have had three periods of declining prices and then six of advances at varying rates some rather small on this showing the investor should clearly allow for the probability of continuing or a current inflation to come can we tell what the rate of inflation is likely to be no clear answer is suggested by our table it shows variations of all sorts it would seem sensible however to take rq from the rather consistent record of the past 20 years the average annual rise in the consumer price level for this period has been 2.5 but for 1965 1970 was 4.5 that for 1970 alone was 5.4 percent official governor meant policy has been strongly against large-scale inflation and there are some reasons to believe that federal policies will be more effective in the future than in recent years we think it would be reasonable for an investor at this point to base his thinking and decisions on a probable far from certain rate of future inflation of say 3 percent per annum this would compare with an annual rate of about 21. 2 for the entire period 1915 19970 1. what would be the implications of such an advance it would eat up in higher living costs about one half the income now obtainable on good medium-term tax-free bonds or are assumed after tax equivalent from high-grade corporate bonds this would be a serious shrinkage but it should not be exaggerated it would not mean that the true value or the purchasing power of the investor s fortune need be reduced over the years if he spent half his interest income after taxes he would maintain this buying power intact even against a three percent annual inflation but the next question naturally is can the investor be reasonably sure of doing better by buying and holding other things than high-grade bonds even at the unprecedented rate of return offered in 1971 971 question mark would not for example an all-stock program be preferable to a part bond part-stop program do not common stocks have a built-in protection against inflation and are they not almost certain to give a better return over the years than will bonds have not in fact stocks treated the investor far better than have bonds over the 55-year period of our study the answer to these questions is somewhat complicated common stocks have indeed done better than bombs over a long period of time in the past the rise of the dow jones industrial average from an average of 77 in 1915 to an average of 753 in 1970 works out at an annual compounded rate of just about four percent to which we may add another four percent for average dividend return the corresponding figures for the s and p composite are about the same these combined figures of eight percent per year are of course much better than the return enjoyed from bonds over the same 55-year period but they do not exceed that now offered by high-grade bonds this brings us to the next logical question is there a persuasive reason to believe that common stocks are likely to do much better in future years than they have in the last five and one-half decades our answer to this crucial question must be a flat no common stocks may do better in the future than in the past but they are far from certain to do so we must deal here with two different time elements in investment results the first covers what is likely to occur over the long term future say the next 25 years the second applies to what is likely to happen to the investor both financially and psychologically over short or intermediate periods say five years or less his frame of mind his helps and apprehensions his satisfaction or discontent with what he has done above all his desi sons what to do next are all determined not in the retrospect of a lifetime of investment but rather by his experience from year to year on this point we can be categorical there is no close time connection between inflationary or deflationary conditions and the movement of common stock earnings and prices the obvious example is the recent period 1966 1970. the rise in the cost of lifting was 22 the largest in a five-year period since 1946 1950 but both stock earnings and stock prices as a whole have declined since 1965. there are similar contradictions in both directions in the record of previous five-year periods inflation and corporate earnings another and highly important approach to the subject is by a study of the earnings rate on capital shown by american business this has fluctuated of course with the general rate of economic activity but it has shown no general tendency to advance with wholesale prices or the cost of living actually this rate has fallen rather markedly in the past 20 years in spite of the inflation of the period to some degree the decline was due to the charging of more liberal depreciation rates see table 2 2 our extended studies have led to the conclusion that the investor cannot count on much above the recent five-year rate earned on the dow jones industrial average group about 10 percent on net tangible assets book value behind the shares.2 since the market value of these issues is well above their book value say 900 market versus 560 book in mid 1971 the earnings on current market price work out only at some 61. four percent this relationship is generally expressed in the reverse or times earnings commentary.g that's the dow jones industrial average price of 900 equals 18 times the actual earnings for the 12 months ended june 1971. our figures gear indirectly with the suggestion in the previous chapter that the investor may assume an average dividend return of about 3.5 percent on the market value of his stocks plus an appreciation of say four percent annually resulting from reinvested profits note that each dollar added to book value is here assumed to increase the market price by about 1 dollar and 60 cents the reader will object that in the end our calculations make no allowance for an increase in common stock earnings and values to result from our projected three percent annual inflation our justification is the absence of any sign that the inflation of a comparable amount in the past has had any direct effect on reported per share earnings the cold figures demonstrate that all the large gain in the earnings of the dow jones industrial average unit in the past 20 years was due to a proportionately large growth of invested capital coming from reinvested profits if inflation had operated as a separate favorable factor its effect would have been to increase the value of previously existing capital this in turn should increase the rate of earnings on such old capital and therefore on the old and new capital combined but nothing of the kind actually happened in the past 20 years during which the wholesale price level has advanced nearly 40 business earnings should be influenced more by wholesale prices than by consumer prices dot the only way that inflation can add to common stock values is by raising the rate of earnings on capital investment on the basis of the past record this has not been the case in the economic cycles of the past good business was accompanied by a rising price level and poor business by falling prices it was generally felt that a little inflation was helpful to business profits this view is not contradicted by the history of 1951 970 which reveals a combination of generally continued prosperity and generally rising prices but the figures indicate that the effect of all this on the earning power of common stock capital equity capital has been quite limited in fact it has not even served to maintain the rate of earnings on the investment clearly there have been important offsetting influences which have prevented any increase in the real profitability of american corporations as a whole perhaps the most important of these have been 1. a rise in wage rates exceeding the gains in productivity and 2. the need for huge amounts of new capital thus holding down the ratio of sales to capital employed our figures in table 2 2 indicate that so far from inflation having benefited our corporations and their shareholders its effect has been quite the opposite the most striking figures in our table are those for the growth of corporate debt between 1950 and 1969. it is surprising how little attention has been paid by economists and by wall street to this development the debt of corporations has expanded nearly five-fold while their profits before taxes are little more than doubled with the great rise in interest rates during this period it is evident that the aggregate corporate debt is now an adverse economic factor of some magnitude and a real problem for many individual enterprises note that in 1950 net earnings after interest but before income tax were about 30 of corporate debt while in 1969 there were only 13.2 percent of debt the 1970 ratio must have been even less satisfactory in some it appears that a significant part of the 11 being earned on corporate equities as a whole is accomplished by the use of a large amount of new debt costing 4 or less after tax credit if our corporations had maintained the debt ratio of 1950 their earnings rate on stock capital would have fallen still lower in spite of the inflation the stock market has considered that the public utility enterprises have been a chief victim of inflation being caught between a great advance in the cost of borrowed money and the difficulty of raising the rates charged under the regulatory process but this may be the place to remark that the very fact that the unit costs of electricity gas and telephone services have advanced so much less than the general price index puts these companies in a strong strategic position for the future.3 they are entitled by law to charge rates sufficient for an adequate return on their invested capital and this will probably protect their shareholders in the future as it has in the inflations of the past all of the above brings us back to our conclusion that the investor has no sound basis for expecting more than an average overall return of say eight percent on a portfolio of dow jones industrial average type common stocks purchased at the late 1971 price level but even if these expectations should prove to be understated by a substantial amount the case would not be made for an all stock investment program if there is one thing guaranteed for the future it is that the earnings and average annual market value of a stock portfolio will not grow at the uniform rate of four percent or any other figure in the memorable words of the elder jp morgan they will fluctuate.this means first that the common stock buyer at today s prices or tomorrow s will be running a real risk of having unsatisfactory results there from over a period of years it took 25 years for general electric and the dow jones industrial average itself to recover the ground lost in the 1929 1932 debacle besides that if the investor concentrates his portfolio on common stocks he is very likely to be led astray either by exhilarating advances or by distressing declines this is particularly true if his reasoning is geared closely to expectations of further inflation for then if another bull market comes along he will take the big rise not as a danger signal of an inevitable fall not as a chance to cash in on his hands or profits but rather as of indication of the inflation hypothesis and as a reason to keep on buying common stocks no matter how high the market level nor how low the dividend return that way lies sorrow alternatives to common stocks as inflation hedges the standard policy of people all over the world who mistrust their currency has been to buy and hold gold this has been against the law for american citizens since 1900 1935 locally for them in the past 35 years the price of gold in the open market has advanced from 35 per ounce to 48 in early 1972 rise of only 35 but during all this time the holder of gold has received no income return on his capital and instead has incurred some annual expense for storage obviously he would have done much better with his money at interest in a savings bank in spite of the rise in the general price level the near-complete failure of gold to protect against a loss in the purchasing power of the dollar must cast graved doubt on the ability of the ordinary investor to protect himself against inflation by putting his money in things.quite a few categories of valuable objects have had striking advances in market value over the years such as diamonds paintings by masters first editions of books rare stamps and coins etc but in many perhaps most of these cases the seems to be an element of the artificial or the precarious or even the unreal about the quoted prices somehow it is hard to think of paying 67 500 for a u.s silver dollar dated 1804 but not even minted that year as an investment operation.4 we acknowledge we are out of our depth in this area very few of our readers will find the swimming safe and easy there the outright ownership of real estate has long been considered as a sound long-term investment carrying with it a goodly amount of protection against inflation unfortunately real estate values are also subject to wide fluctuations serious errors can be made in location price paid etc there are pitfalls in salesmen airs whiles finally diversification is not practical for the investor of moderate means except by various types of participations with others and with the special hazards that attach to new flotations not too different from common stock ownership this too is not our field all we should say to the investor is be sure it has yours before you go into it dot conclusion naturally we return to the policy recommended in our previous chapter just because of the uncertainties of the future the investor cannot afford to put all his funds into one basket neither in the bond basket despite the unprecedentedly high returns that bonds have recently offered nor in the stock basket despite the prospect of continuing inflation the more the investor depends on his portfolio and the income they're from the more necessary it is for him to guard against their unexpected and the disconcerting in this part of his life it is axiomatic that the conservative investor should seek to minimize his risks we think strongly that the risks involved in buying say a telephone company bond at yields of nearly 71. two percent are much less than those involved in buying the dow jones industrial averages 900 or any stock list equivalent there too but the possibility of large-scale inflation remains and the investor must carry some insurance against it there is no certainty that a stock component will ensure adequately against such inflation but it should carry more protection than the bombed component this is what we said on the subject in our 1965 edition p 97 and we would write the same today it must be evident to the reader that we have no enthusiasm for common stocks at these levels 892 for the dow jones industrial average for reasons already given we feel that the defensive investor cannot afford to be without an appreciable proportion of common stocks in his portfolio even if we regard them as the lesser of two evils the greater being the risks in an all bondholding chapter three colon the level of stock prices in early 1972. the investors portfolio of common stocks will represent a small cross-section of that immense and formidable institution known as the stock market prudence suggests that he have an adequate idea of stock market history in terms particularly of the major fluctuations in its price level and of the varying relationships between stock prices as a whole and their earnings and dividends with this background he may be in a position to form some worthwhile judgment of the attractiveness or dangers of the level of the market as it presents itself at different times by a coincidence useful statistical data on prices earnings and dividends go back just 100 years to 1871. the material is not nearly as full or dependable in the first half period as in the second but it will serve in this chapter we shall present the figures in highly condensed form with two objects in view the first is to show the general manner in which stocks have made their underlying advance through the many cycles of the past century the second is to view the picture in terms of successive 10-year averages not only of stock prices but of earnings and dividends as well to bring out the varying relationship between the three important factors with this wealth of material as a background we shall pass to a consideration of the level of stock prices of the beginning of 1972. the long-term history of the stock market is summarized in two tables and a chart table three one sets fourth the low and high points of 19 bear and bull market cycles in the past 100 years we have used two indexes here the first represents a combination of an early study by the cowell's commission going back to 1870 which has been spliced onto and continued to date in the well known standard and pause composite index of 500 stocks the second one is the even more celebrated dow jones industrial average the dow jones industrial average or the dao which dates back to 1897 it contains 30 companies of which one is american telephone and telegraph and the other 29 are large industrial enterprises dot one chart i presented by courtesy of standard and pause depicts the market fluctuations of its 425 industrial stock index from 1900 through 1970. a corresponding chart available for the dow jones industrial average will look very much the same the reader will note three quite distinct patterns each covering about a third of the 70 years the first runs from 1900 to 1924 and shows for the most part a series of rather similar market cycles lasting from three to five years the annual advance in this period averaged just about three percent we move on to the new era bull market culminating in 1929 with its terrible aftermath of collapse followed by quite irregular fluctuations until 1949. comparing the average level of 1949 with that of 1924 we find the annual rate of advance to be a mere 11 halves of a percent hence the close of our second period found the public with no enthusiasm at all for common stocks by the rule of opposites the time was ripe for the beginning of the greatest bull market in our history presented in the last third of our chart this phenomenon may have reached its culmination in december 1968 at 118 for standard and poor's 425 industrials and 108 for its 500 stock composite as table 3 1 shows there were fairly important setbacks between 1949 and 1968 especially in 1956 to 57 and 1961-62 but the recoveries there from were so rapid that they had to be denominated in the long-accepted semantics as recessions in a single bull market rather than as separate market cycles between the low level of 162 for the dow in mid 1949 and the high of 995 in early 1966 the advance had been more than six-fold in 17 years which is at the average compounded rate of 11 per year not counting dividends of say 31 halves of a percent per annum the advance for the standard and poor's composite index was somewhat greater than that of the dow jones industrial average actually from 14 to 96 these 14 and better returns were documented in 1963 and later in a much publicized study too it created a natural satisfaction on wall street with such fine achievements and a quite a logical and dangerous conviction that equally marvelous results could be expected for common stocks in the future few people seem to have been bothered by the thought that the very extent of the rise might indicate that it had been overdone the subsequent decline from the 1968 high to the 1970 low was 36 for the standard and poor's composite and 37 for the dow jones industrial average the largest since the 44 suffered in 1939 to 1942 which had reflected the perils and uncertainties after pearl harbor in the dramatic manner so characteristic of wall street the low level of may 1970 was followed by a massive and speedy recovery of both averages and the establishment of a new all-time high for the standard and poor's industrials in early 1972. the annual rate of price advance between 1949 and 1970 works out at about nine percent for the s p composite or the industrial index using the average figures for both years that rate of climb was of course much greater than for any similar period before 1950 but in the last decade the rate of advance was much lower 51 fourths of a percent for the s and p composite index and only the ones familiar 3 for the dow jones industrial average the record of price movements should be supplemented by corresponding figures for earnings and dividends in order to provide an overall view of what has happened to our share economy over the 10 decades we present a conspectus of this kind in our table 3 2 p 71 it is a good deal to expect from the reader that he study all these figures with care but for some we hope they will be interesting and instructive let us comment on them as follows the full decade figures smooth out the year-to-year fluctuations and leave a general picture of persistent growth only two of the nine decades after the first show a decrease in earnings and average prices in 1891 to 1900 and 1931-1940 and no decade after 1900 shows a decrease in average dividends but the rates of growth in all three categories are quite variable in general the performance since world war ii has been superior to that of earlier decades but the advance in the 1960s was less pronounced than that of the 1950s today's investor cannot tell from this record what percentage gain in earnings dividends and prices he may expect in the next 10 years but it does supply all the encouragement he needs for a consistent policy of common stock investment however a point should be made here that is not disclosed in our table the year 1970 was marked by a definite deterioration in the overall earnings posture of our corporations the rate of profit on invested capital fell to the lowest percentage since the world war years equally striking is the fact that a considerable number of companies reported net losses for the year many became financially troubled and for the first time in three decades there were quite a few important bankruptcy proceedings these facts as much as any others have prompted the statement made above that the great boom era may have come to an end in 1969 to 1970. a striking feature of table 3 2 is the change in the price earnings ratios since world war 2. in june 1949 the s and p composite index sold at only 6.3 times the applicable earnings of the past 12 months in march 1961 the ratio was 22.9 times similarly the dividend yield on the s and p index had fallen from over 7 in 1949 to only 3.0 percent in 1961 a contrast heightened by the fact that interest rates on high-grade bonds had meanwhile risen from 2.60 to 4.50 this is certainly the most remarkable turnabout in the public's attitude in all stock market history to people of long experience and innate caution the passage from one extreme to another carried a strong warning of trouble ahead they could not help thinking apprehensively of the 1926 to 1929 bull market and its tragic aftermath but these fears have not been confirmed by the event true the closing price of the dow jones industrial average bcd in 1970 was the same as it was 61 halves years earlier and the much her ordered soaring 60s proved to be mainly a march up a series of high hills and then down again but nothing has happened either to business or to stop prices that can compare with the bear market and depression of 1929 to 1932 the stock market level in early 1972. with a century-long conspectus of stock prices earnings and dividends before our eyes let us try to draw some conclusions about the level of 900 for the dow jones industrial average and 100 for the s p composite index in january 1972. in each of our former editions we have discussed the level of the stock market at the time of writing and endeavoured to answer the question whether it was too high for conservative purchase the reader may find it informing to review the conclusions we reached on these earlier occasions this is not entirely an exercise in self-punishment it will supply a sort of connecting tissue that links the various stages of the stock market in the past 20 years and also a taken from life picture of the difficulties facing anyone who tries to reach an informed and critical judgment of current market levels let us first reproduce the summary of the 1948 1953 and 1959 analyzes that we gave in the 1965 edition in 1948 we applied conservative standards to the dow jones level of 180 and found no difficulty in reaching the conclusion that it was not too high in relation to underlying values when we approached this problem in 1953 the average market level for that year had reached 275 a gain of over 50 percent in five years we asked ourselves the same question namely whether in our opinion the level of 275 for the dow jones industrials was or was not too high for sound investment in the light of the subsequent spectacular advance it may seem strange to have to report that it was by no means easy for us to reach a definitive conclusion as to the attractiveness of the 1953 level we did say positively enough that from the standpoint of value indications our chief investment guide the conclusion about 1953 stock prices must be favorable but we were concerned about the fact that in 1953 the averages had advanced for a longer period than in most bull markets of the 73 past and that its absolute level was historically high setting these factors against our favorable value judgment we advised a cautious or compromise policy as it turned out this was not a particularly brilliant council a good profit would have foreseen that the market level was due to advance an additional 100 in the next five years perhaps we should add in self-defense that few if any of those whose business was stock market forecasting as ours was not had any better inkling than we did of what lay ahead at the beginning of 1959 we found the dow jones industrial average at an all-time high of 584. our lengthy analysis made from all points of view may be summarized in the following from page 59 of the 1959 edition in sum we feel compelled to express the conclusion that the present level of stock prices is a dangerous one it may well be perilous because prices are already far too high but even if this is not the case the market's momentum is such as inevitably to carry it to unjustifiable heights frankly we cannot imagine a market of the future in which there will never be any serious losses and in which every tyro will be guaranteed a large profit on his stock purchases the caution we expressed in 1959 was somewhat better justifed by the sequel than was our corresponding attitude in 1954 yet it was far from fully vindicated the dow jones industrial average advanced to 685 in 1961 then fell a little below our 584 level to 566 later in the year advanced again to 735 in late 1961 and then declined in near panic to 536 in may 1962 showing a loss of 27 within a brief period of six months at the same time there was a far more serious shrinkage in the most popular growth stocks as evidenced by the striking fall of the indisputable leader international business machines from a high of 607 in december 1961 to a low of 300 in june 1962. this period saw a complete debacle in a host of newly launched common stocks of small enterprises the so-called hot issues which had been offered to the public at ridiculously high prices and then had been further pushed up by needless speculation to levels little short of insane many of these lost 90 and more of the quotations in just a few months the collapse in the first half of 1962 was disconcerting if not disastrous to many self-acknowledged speculators and perhaps 74. to many more imprudent people who called themselves investors but the turnabout that came later that year was equally unsuspected by the financial community the stock market averages resumed their upward course producing the following sequence the recovery and new ascent of common stock prices was indeed remarkable and created a corresponding revision of wall street sentiment at the low level of june 1962 predictions had appeared predominantly bearish and after the partial recovery to the end of that year they were mixed leaning to the skeptical side but at the outset of 1964 the natural optimism of brokerage firms was again manifest nearly all the forecasts were on the bullish side and they so continued through the 1964 advance we then approached the task of appraising the november 1964 levels of the stock market 892 for the dow jones industrial average after discussing it learnedly from numerous angles we reached three main conclusions the first was that old standards evaluation appear inapplicable new standards have not yet been tested by time the second was that the investor must base his policy on the existence of major uncertainties the possibilities compass the extremes on the one hand of a protracted and further advance in the markets level say by 50 or to 1350 for the dow jones industrial average or on the other hand of a largely unheralded collapse of the same magnitude bringing the average in the neighborhood of say 450 p 63 the third was expressed in much more definite terms we said speaking bluntly if the 1964 price level is not too high how could we say that any price level is too high and the chapter closed as follows what course to follow investors should not conclude that the 1964 market level is dangerous merely because they read it in this book they must weigh our reasoning against the contrary reasoning they will hear from most competent and experienced people on wall street in the end each one must make his own decision and accept responsibility therefore we suggest however that if the investor is in doubt as to which course to pursue he should choose the path of caution the principles of investment as set forth herein would call for the following policy under 1964 conditions in order of urgency 1. no borrowing to buy or hold securities 2. no increase in the proportion of funds held in common stocks 3. a reduction in common stock holdings where needed to bring it down to a maximum of 50 of the total portfolio the capital gains tax must be paid with as good grace as possible and the proceeds invested in first quality bonds or held as a savings deposit investors who for some time have been following a bona fide dollar cost averaging plan canon logic elect either to continue their periodic purchases unchanged or to suspend them until they feel the market level is no longer dangerous we should advise rather strongly against the initiation of a new dollar averaging plan at the late 1964 levels since many investors would not have the stamina to pursue such a scheme if the results soon after initiation should appear highly unfavorable this time we can say that our caution was vindicated the dow jones industrial average advanced about 11 further to 995 but then fell irregularly to a low of 632 in 1970. and finished that year at 839 the same kind of debacle took place in the price of hot issues that is with declines running as much as 90 as had happened in the 1961-60 setback and as pointed out in the introduction the whole financial picture appeared to have changed in the direction of less enthusiasm and greater doubts a single fact may summarize the story the dow jones industrial average closed 1970 at a level lower than six years before the first time such a thing had happened since 1944. such were our efforts to evaluate former stock market levels is there anything we and our readers can learn from them we considered the market level favorable for investment in 1948 and 1953 but too cautiously in the latter year dangerous in 1959 at 584 for dow jones industrial average and too high at 892 in 1964. all of these judgments could be defended even today by adroit arguments but it is doubtful if they have been as useful as our more pedestrian councils in favor of a consistent and controlled common stock policy on the one hand and discouraging endeavors to beat the market or to pick the winners on the other nonetheless we think our readers may derive some benefit from a renewed consideration of the level of the stock market this time as of late 1971 even if what we have to say will prove more interesting than practically useful or more indicative than conclusive there is a fine passage near the beginning of aristotle's ethics that goes it is the mark of an educated mind to expect that amount of exactness which the nature of the particular subject admits it is equally unreasonable to accept merely probable conclusions from a mathematician and to demand strict demonstration from an orator the work of a financial analyst falls somewhere in the middle between that of a mathematician and of an orator at various times in 1971 the dow jones industrial average stood at the 892 level of november 1964 that we considered in our previous edition but in the present statistical study we have decided to use the price level and the related data for the standard and pause composite index or s and p 500 because it is more comprehensive and representative of the general market than the 30 stock dow jones industrial average we shall concentrate on a comparison of this material near the four dates of our former editions namely the year ends of 1948 1953 1958 and 1963 plus 1968 for the current price level we shall take the convenient figure of 100 which was registered at various times in 1971 and in early 1972. the salient data are set forth in table 3-3 for our earnings figures we present both the last year's showing and the average of three calendar years for 1971 dividends we use the last 12 months figures and for 1971 bond interest and wholesale prices those of august 1971. the three-year price earnings ratio for the market was lower in october 1971 than at year end 1963 and 1968. it was about the same as in 1958 but much higher than in the early years of the long ball market this important indicator taken by itself could not be construed to indicate that the market was especially high in january 1972 but when the interest yield on high-grade bonds is brought into the picture the implications become much less favorable the reader will note from our table that the ratio of stock returns earnings slash price to bond returns has grown worse during the entire period so that the january 1972 figure was less favorable to stocks by this criterion than in any of the previous years examined when dividend yields are compared with bond yields we find that the relationship was completely reversed between 1948 and 1972. in the early year stocks yielded twice as much as bonds now bonds yield twice as much and more than stocks our final judgment is that the adverse change in the bond yield stock yield ratio fully offsets the better price earnings ratio for late 1971 based on the three-year earnings figures hence our view of the early 1972 market level would tend to be the same as it was some seven years ago that is that it is an unattractive one from the standpoint of conservative investment this would apply to most of the 1971 price range of the dow jones industrial average between say 800 and 950 in terms of historical market swings the 1971 picture would still appear to be one of irregular recovery from the bad setbacks you faired in 1969 to 1970. in the past such recoveries have ushered in a new stage of the recurrent and persistent bull market that began in 1949. this was the expectation of wall street generally during 1971 after the terrible experience suffered by the public buyers of low-grade common stock offerings in the 1968-1970 cycle it is too early in 1971 for another twirl of the new issue merry-go-round hence that dependable sign of imminent danger in the market is lacking now as it was at the 892 level of the dow jones industrial average in november 1964. considered in our previous edition technically then the outlook would appear to favor another substantial rise far beyond the 900 dow jones industrial average level before the next serious setback or collapse but we cannot quite leave the matter there as perhaps we should to us the early 1971 markets disregard of the harrowing experiences of less than a year before is a disquieting sign can such heedlessness go unpunished we think the investor must be prepared for difficult times ahead perhaps in the form of a fairly quick replay of the the 1969-1970 decline or perhaps in the form of another bull market fling to be followed by a more catastrophic collapse.3 what course to follow turn back to what we said in the last edition reproduced on p 75 this is our view at the same price level say 900 for the dow jones industrial average in early 1972 as it was in late 1964 chapter 4 general portfolio policy the defensive investor the basic characteristics of an investment portfolio are usually determined by the position and characteristics of the owner or owners at one extreme we have had savings banks life insurance companies and so-called legal trust funds a generation ago their investments were limited by law in many states to high-grade bonds and in some cases high-grade preferred stocks at the other extreme we have the well-to-do and experienced businessman who will include any kind of bond or stock in his security list provided he considers it an attractive purchase it has been an old and sound principle that those who cannot afford to take risks should be content with a relatively low return on their invested funds from this though has developed the general notion that the rate of return which the investor should aim for is more or less proportionate to the degree of risk he is ready to run our view is different the rate of return sort should be dependent rather on the amount of intelligent effort the investor is willing and able to bring to bear on his task the minimum return goes to our passive investor who wants both safety and freedom from concern the maximum return would be realized by the alert and enterprising investor who exercises maximum intelligence and skill in 1965 we added in many cases there may be less real risk associated with buying a bargain issue offering the chance of a large profit than with a conventional bond purchase yielding about 41 halves of a percent this statement had more truth in it than we ourselves suspected since in subsequent years even the best long-term bonds lost a substantial part of their market value because of the rise in interest rates the basic problem of bond stock allocation we have already outlined in briefest form the portfolio policy of the defensive investor he should divide his funds between high-grade bonds and high-grade common stocks we have suggested as a fundamental guiding rule that the investor should never have less than 25 percent or more than 75 of his funds in common stocks with a consequent inverse range of between 75 and 25 in bonds there is an implication here that the standard division should be an equal one or 50 to 50 between the two major investment mediums according to tradition the sound reason for increasing the percentage in common stocks would be the appearance of the bargain price levels created in a protracted bear market conversely sound procedure would call for reducing the common stock component below 50 percent when in the judgment of the investor the market level has become dangerously high these copybook maxims have always been easy to enunciate and always difficult to follow because they go against that very human nature which produces that excesses of bull and bear markets it is almost a contradiction in terms to suggest as a feasible policy for the average stock owner that he lighten his holdings when the market advances beyond a certain point and add to them after a corresponding decline it is because the average man operates and apparently must operate in opposite fashion that we have had the great advances and collapses of the past and this writer believes we are likely to have them in the future if the division between investment and speculative operations were as clear now as once it was we might be able to envisage investors as a shrewd experienced group who sell out to the heedless hapless speculators at high prices and buy back from them at depressed levels this picture may have had some verisimilitude in bygone days but it is hard to identify it with financial developments since 1949. there is no indication that such professional operations as those of the mutual funds have been conducted in this fashion the percentage of the portfolio held in equities by the two major types of funds balanced and common stock has changed very little from year to year their selling activities have been largely related to endeavors to switch from less to more promising holdings if as we have long believed the stock market has lost contact with its old bounds and if new ones have not yet been established then we can give the investor no reliable rules by which to reduce his common stock holdings toward the 25 minimum and rebuild them later to the 75 maximum we can urge that in general the investor should not have more than one half inequities unless he has strong confidence in the soundness of his stock position and is sure that he could view a market decline of the 1969-70 type with equanimity it is hard for us to see how such strong confidence can be justified at the levels existing in early 1972. thus we would counsel against a greater than 50 apportionment to common stocks at this time but for complementary reasons it is almost equally difficult to advise a reduction of the figure well below 50 unless the investor is disquieted in his own mind about the current market level and will be satisfied also to limit his participation in any further rise to say 25 of his total funds we are thus led to put forward for most of our readers what may appear to be an oversimplified 50 to 50 formula under this plan the guiding rule is to maintain as nearly as practicable and equal division between bond and stockholdings when changes in the market level have raised the common stock component to say 55 the balance would be restored by a sale of 1 11 of the stock portfolio and the transfer of the proceeds to bonds conversely a fall in the common stock proportion to 45 would call for the use of 1 11th of the bond fund to buy additional equities yale university followed a somewhat similar plan for a number of years after 1937 but it was geared around a 35 normal holding in common stocks in the early 1950s however yale seems to have given up its once-famous formula and in 1969 held 61 percent of its portfolio inequities including some convertibles at that time the endowment funds of 71 such institutions totaling 7.6 billion dollars held 60.3 in common stocks the yale example illustrates the almost lethal effect of the great market advance upon the once popular formula approach to investment nonetheless we are convinced that our 50 to 50 version of this approach makes good sense for their defensive investor it is extremely simple it aims unquestionably in the right direction it gives the follower the feeling that he is at least making some moves in response to market developments most important of all it will restrain him from being drawn more and more heavily into common stocks as the market rises to more and more dangerous heights furthermore a truly conservative investor will be satisfied with the gains shown on half his portfolio in a rising market while in a severe decline he may derive much solace from reflecting how much better off he is than many of his more venturesome friends while our proposed 50-50 division is undoubtedly the simplest all-purpose program devisable it may not turn out to be the best in terms of results achieved of course no approach mechanical or otherwise can be advanced with any assurance that it will work out better than another the much larger income return now offered by good bonds than by representative stocks is a potent argument for favoring the bond component the investor's choice between 50 or a lower figure in stocks may well rest mainly on his own temperament and attitude if he can act as a cold-blooded wearer of the odds he would be likely to favor the low 25 stock component at this time with the idea of waiting until the dow jones industrial average dividend yield was say two-thirds of the bond yield before he would establish his median 50-50 division between bonds and stocks starting from 900 for the dow jones industrial average and dividends of 36. on the unit this would require either a fall in taxable bond yields from 71 halves of a percent to about 5.5 without any change in the present return on leading stocks or a fall in the dow jones industrial average to as low as 660 if there is no reduction in bond yields and no increase in dividends a combination of intermediate changes could produce the same buying point a program of that kind is not especially complicated the hard part is to adopt it and to stick to it not to mention the possibility that it may turn out to have been much too conservative the bond component the choice of issues in the bond component of the investor's portfolio will turn about two main questions should he buy taxable or tax-free bonds and should he buy shorter or longer-term maturities the tax decision should be mainly a matter of arith matic turning on the difference in yields as compared with the investors tax bracket in january 1972 the choice in 20-year maturity ties was between obtaining say 71 halves of a percent on grade a a corporate bonds and 5.3 percent on prime tax-free issues the term municipals is generally applied to all species of tax-exempt bonds including state obligations there was thus for this maturity a loss in income of some 30 in passing from the corporate to the municipal field hence if the investor was in a maximum tax bracket higher than 30 he would have a net saving after taxes by choosing the municipal bonds the opposite if his maximum tax was less than 30 a single person starts paying a 30 rate when his income after deductions passes ten thousand dollars for a married couple their rate applies when combined taxable income passes twenty thousand dollars it is evident that a large proportion of individual investors would obtain a higher return after taxes from good municipals than from good corporate bonds the choice of longer versus shorter maturities involves quite a different question viz does the investor want to assure himself against a decline in the price of his bonds but at the cost of one a lower annual yield and two loss of the possibility of an appreciable gain in principal value we think it best to discuss this question in chapter eight the investor and market fluctuations for a period of many years in the past the only sensible bond purchases for individuals were the u.s savings issues their safety was and is unquestioned they gave a higher return than other bond investments of first quality they had a money back option and other privileges which added greatly to their attractiveness in our earlier editions we had an entire chapter entitled u.s savings bonds a boon to investors as we shall point out u.s savings bonds still possess certain unique merits that make them a suitable purchase by any individual investor for the man of modest capital with say not more than ten thousand dollars to put into bonds we think they are still the easiest and the best choice but those with larger funds may find other mediums more desirable let us list a few major types of bonds that deserve investor consideration and discuss them briefly with respect to general description safety yield market price risk income tax status and other features 1. u.s savings bonds series e and series h we shall first some memorize their important provisions and then discuss briefly the numerous advantages of these unique attractive and exceedingly convenient investments the series h bonds pay interest semi-annually as do other bonds the rate is 4.29 for the first year and then a flat 5.10 for the next nine years to maturity interest on the series e-bonds is not paid out but accrues to the holder through increase in redemption value the bonds are sold at 75 of their face value and mature at 100 in five years 10 months after purchase if held to maturity the yield works out at five percent compounded semi-annually if redeemed earlier the yield moves up from a minimum of 4.01 in the first year to an average of 5.20 in the next 45 6 years interest on the bonds is subject to federal income tax but is exempt from state income tax however federal income tax on the series e bonds may be paid at the holders option either annually as the interest accrues through higher redemption value or not until the bond is actually disposed of owners of series e-bonds may cash them in at any time shortly after purchase at their current redemption value holders of series h bonds have similar rights to cash them in at par value cost series e bonds are exchangeable for series h bonds with certain tax advantages bonds lost destroyed or stolen may be replaced without cost there are limitations on annual purchases but liberal provisions for co-ownership by family members make it possible for most investors to buy as many as they can afford comment there is no other investment that combines 1. absolute assurance of principal and interest payments 2. the right to demand full money back at any time and 3 guarantee of at least a 5 interest rate for at least 10 years holders of the earlier issues of series e bonds have had the right to extend their bonds at maturity and thus to continue to accumulate annual values at successively higher rates the deferral of income tax payments over these long periods has been of great dollar advantage we calculate it has increased the effective net after tax rate received by as much as a third in typical cases conversely the right to cash in the bonds at cost price or better has given the purchasers in former years of low interest rates complete protection against the shrinkage in principal value that befell many bond investors otherwise stated it gave them the possibility of benefiting from the rise in interest rates by switching their low interest holdings into very high coupon issues on an even money basis in our view the special advantages enjoyed by owners of safing's bonds now will more than compensate for their lower current return as compared with other direct government obligations 2. other united states bonds a profusion of these issues exists covering a wide variety of coupon rates and maturity dates all of them are completely safe with respect to payment of interest and principle they are subject to federal income taxes but free from state income tax in late 1971 the long-term issues over 10 years showed an average yield of 6.09 intermediate issues three to five years returned 6.35 and short issues returned 6.03 in 1970 it was possible to buy a number of old issues at large discounts some of these are accepted at par in settlement of estate taxes example the u.s treasury due 1990 are in this category they sold at 60 in 1970 but closed 1970 above 77. it is interesting to note also that in many cases the indirect obligations of the u.s government yield appreciably more than its direct obligations of the same maturity as we write an offering appears of 7.05 of certificates fully guaranteed by the secretary of transportation of the department of transportation of the united states the yield was fully one percent more than that on direct obligations of the u.s maturing the same year 1986 the certificates were actually issued in the name of the trustees of the penn central transportation go but they were sold on the basis of a statement by the u.s attorney general that the guarantee brings into being a general obligation of the united states backed by its full faith and credit quite a number of indirect obligations of this sort have been assumed by the u.s government in the past and all of them have been scrupulously honoured the reader may wonder why all this hoku spoke focus involving an apparently personal guarantee by our secretary of transportation and a higher cost to the taxpayer in the end the chief reason for the indirection has been the debt limit imposed on government borrowing by the congress apparently guarantees by the government are not regarded as debts a semantic windfall for shredder investors perhaps the chief impact of this situation has been the creation of tax-free housing authority bonds enjoying the equivalent of a u.s guarantee and virtually the only tax-exempt issues that are equivalent to government bonds another type of government practice uses the recently created new community debentures offered to yield 7.60 in september 1971. three state and municipal bonds these enjoy exemption from federal income tax they are also ordinarily free of income tax in the state of issue but not elsewhere they are either direct obligations of a state or subdivision or revenue bonds dependent for interest payments on receipts from a toll road bridge building lease etc not all tax-free bonds are strongly enough protected to justify their purchase by a defensive investor he may be guided in his selection by the rating given to each issue by moody's or standard and pause one of three highest ratings by both services aaa aaa aaaa or a should constitute a sufficient indication of adequate safety the yield on these bonds will vary both with the quality and the maturity with the shorter maturities giving the lower return in late 1971 the issues represented in standard and poor's municipal bond index averaged a a in quality rating 20 years in maturity and 5.78 in yield a typical offering of vineland new jersey bonds rated afraid and gave a yield of only three percent on the one-year maturity rising to 5.8 per cent to the 1995 and 1996 maturities.1 for corporation bonds these bonds are subject to both federal and state tax in early 1972 those of highest quality yielded 7.19 for a 25-year maturity as reflected in the published yield of moody's aaa corporate bond index the so-called lower medium grade issues rated bar returned 8.23 for long maturities in each class shorter term issues would yield somewhat less than longer-term obligations comment the above summaries indicate that the average investor has several choices among high-grade bonds those in high-income tax brackets can undoubtedly obtain a better net yield from good tax-free issues than from taxable ones for others the early 1972 range of taxable yield would seem to be from 5.00 on u.s savings bonds with their special options to about 71 halves of a percent on high-grade corporate issues higher yielding bond investments by sacrificing quality an investor can obtain a higher income return from his bonds long experience has demonstrated that the ordinary investor is wiser to keep away from such high-yield bonds while taken as a whole they may work out somewhat better in terms of overall return than the first quality issues they expose the owner to too many individual risks of untoward developments ranging from disquieting price declines to actual default it is true that bargain opportunities occur fairly often in lower grade bonds but these require special study and skill to exploit successfully perhaps we should add here that the limits imposed by congress on direct bond issues of the united states have produced at least two sorts of bargain opportunities for investors in the purchase of government-backed obligations one is provided by the tax-exempt new housing issues and the other by the recently created taxable new community debentures an offering of new housing issues in july 1971 yielded as high as 5.8 free from both federal and state taxes while an issue of taxable new community debentures sold in september 1971 yielded 7.60 both obligations have the full faith and credit of the united states government behind them and hence are safe without question and on a net basis they yield considerably more than ordinary united states bonds savings deposits in lieu of bonds an investor may now obtain as high an interest rate from a savings deposit in a commercial or savings bank or from a bank certificate of deposit as he can from a first grade bond of short maturity the interest rate on bank savings accounts may be lowered in the future but under present conditions they are a suitable substitute for short-term bond investment by the individual convertible issues these are discussed in chapter 16. the price variability of bonds in general is treated in chapter 8 the investor and market fluctuations call provisions in previous editions we had a fairly long discussion of this aspect of bond financing because it involved a serious but little noticed injustice to the investor in the typical case bonds were callable fairly soon after issuance and at modest premiums say 5 above the issue price this meant that during a period of wide fluctuations in the underlying interest rates the investor had to bear the full brunt of unfavorable changes and was deprived of all but omega participation in favorable ones example our standard example has been the issue of american gas and electric 100 year 5 debentures sold to the public at 101 in 1928. four years later under near panic conditions the price of these good bonds fell to 621 halves yielding eight percent by 1946 in a great river sal bonds of this type could be sold to yield only three percent and the five percent issue should have been quoted at close to 160 but at that point the company took advantage of the call provision and redeemed the issue at a mere 106. the call feature in these bond contracts was a thinly disguised instance of heads i win tales you lose at long last the bond buying institutions refused to accept this unfair arrangement in recent years most long-term high coupon issues have been protected against redemption for 10 years or more after issuance this still limits their possible price rise but not inequitably in practical terms we advise the investor in long term is used to sacrifice a small amount of yield to obtain the assurance of non-callability say for 20 or 25 years similarly there is an advantage in buying a low coupon bonder to discount rather than a high coupon bond selling at about par and callable in a few years for the discount for example over 31 halves of a percent bond of 631 halves of a percent yielding 7.85 percent carries full protection against adverse call action straight that is non-convertible preferred stocks certain general observations should be made here on the subject of preferred stocks really good preferred stocks can ends do exist but they are good in spite of their investment form which is an inherently bad one the typical preferred shareholder is dependent for his safety on the ability and desire of the company to pay dividends on its common stock once the common dividends are amid dead or even in danger his own position becomes precarious for the directors are under no obligation to continue paying him unless they also pay on the common on the other hand the typical preferred stock carries no share in the company's profits beyond the fixed dividend rate thus the preferred holder lacks both the legal claim of the bondholder or creditor and the profit possibilities of a common shareholder or partner these weaknesses in the legal position of preferred stocks tend to come to the foreign currently in periods of depression only a small percentage of all preferred issues are so strongly entrenched as to maintain an unquestioned investment status through all vicissitudes experience teaches that the time to buy preferred stocks is when their price is unduly depressed by temporary adversity at such times they may be well suited to the aggressive investor but too unconventional for the defensive investor in other words they should be bought on a bargain basis or not at all we shall refer later to convertible and similarly privileged issues which carry some special possibilities of profits these are not ordinarily selected for a conservative portfolio another peculiarity in the general position of preferred stocks deserves mention they have a much better tax status for corporation buyers than for individual investors corporations pay income tax on only 15 of the income they receive in dividends but on the full amount of their ordinary interest income since the 1972 corporate rate is 48 this means that 100 received as preferred stock dividends is taxed only 7.20 whereas 100 received as bond interest is taxed 48 on the other hand individual investors pay exactly the same tax on preferred stock investments as on bond interest except for a recent minor exemption thus in strict logic all investment grade preferred stocks should be bought by corporations just as all tax-exempt bonds should be bought by investors who pay income tax security forms the bond form and the preferred stock form as hitherto discussed are well understood and relatively simple matters a bondholder is entitled to receive fixed interest and payment of principal on a definite date the owner of a preferred stock is entitled to a fixed dividend and no more which must be paid before any common dividend his principal value does not come due on any specified date the dividend may be cumulative or non-cumulative he may or may not have a vote the above describes the standard provisions and no doubt the majority of bond and preferred issues but there are innumerable departures from these forms the best known types are convertible and similar issues and income bonds in the latter type interest does not have to be paid unless it is earned by the company unpaid interest may accumulate as a charge against future earnings but the period is often limited to three years income bonds should be used by corporations much more extensively than they are their avoidance apparently arises from a mere accident of economic history namely that they were first employed in quantity in connection with railroad reorganizations and hence they have been associated from the start with financial weakness and poor investment status but the form itself has separate practical advantages especially in comparison with and in substitution for the numerous convertible preferred stock issues of recent years chief of these is the deductibility of the interest paid from the company's taxable income which in effect cuts the cost of that form of capital in half from the investors standpoint it is probably best for him in most cases that he should have one an unconditional right to receive interest payments when they are earned by the company and two a right to other forms of protection than bankruptcy proceedings if interest is not earned and paid the terms of income bonds can be tailored to the advantage of both the borrower and the lender in the manner best suited to both conversion privileges can of course be included the acceptance by everybody of the inherently weak preferred stock form and the rejection of the stronger income bond form is a fascinating illustration of the way in which traditional institutions and habits often tend to persist on wall street despite new conditions calling for a fresh point of view with every new wave of optimism or pessimism we are ready to abandon history and time-tested principles but we cling tenaciously and unquestioningly to our prejudices chapter five the defensive investor and common stocks investment merits of common stocks in our first edition 1949 we found it necessary at this point to insert a long exposition of the case for including a substantial common stock component in all investment portfolios common stocks were generally viewed as highly speculative and therefore unsafe they had declined fairly substantially from the high levels of 1946 but instead of attracting investors to them because of their reasonable prices this fall had had the opposite effect of undermining confidence in equity securities we have commented on the converse situation that has developed in the ensuing 20 years whereby the big advance in stock prices made them appear safe and profitable investments at record high levels which might act to ally carry with them a considerable degree of risk the argument we made for common stocks in 1949 turned on two main points the first was that they had offered a considerable degree of protection against the erosion of the investors dollar caused by inflation whereas bonds offered no protection at all the second advantage of common stocks lay in their higher average return to investors over the years this was produced both by an average dividend income exceeding the yield on good bonds and by an underlying tendency for market value to increase over the years in consequence of the reinvestment of undistributed profits while these two advantages have been of major importance and had given common stocks a far better record than bonds over the long-term past we have consistently warned that these benefits could be lost by the stock buyer if he pays too high a price for his shares this was clearly the case in 1929 and it took 25 years for the market level to climb back to the ledge from which it had abysmally fallen in 1929 to 1932. since 1957 common stocks have once again through their high prices lost their traditional advantage in dividend yield over bombed interest rates it remains to be seen whether the inflation factor and the economic growth factor will make up in the future for this significantly adverse development it should be evident to the reader that we have no enthusiasm for common stocks in general at the 900 dow jones industrial average level of late 1971 for reasons already given we feel that the defensive investor cannot afford to be without an appreciable proportion of common stocks in his portfolio even if he must regard them as the lesser of two evils the greater being the risks attached to an all bondholding rules for the common stock component the selection of common stocks for the portfolio of the defensive investor should be a relatively simple matter here we would suggest four rules to be followed 1. there should be adequate though not excessive diversification this might mean a minimum of 10 different issues and a maximum of about 30. 2. each company selected should be large prominent and conservatively financed indefinite as these adjectives must be their general sense is clear observations on this point are added at the end of the chapter 3. each company should have a long record of continuous dividend payments all the issues in the dow jones industrial over age met this dividend requirement in 1971 to be specific on this point we would suggest the requirement of continuous dividend payments beginning at least in 1950 4. the investor should impose some limit on the price he will pay for an issue in relation to its average earnings over say the past seven years we suggest that this limit be set at 25 times such average earnings and not more than 20 times those of the last 12-month period but such a restriction would eliminate nearly all the strongest and most popular companies from the portfolio in particular it would ban virtually the entire category of growth stocks which have for some years past been the favorites of both speculators and institutional investors we must give our reasons for proposing so drastic in exclusion growth stocks and the defensive investor the term growth stock is applied to one which has increased its per share earnings in the past at well above the rate for common stocks generally and is expected to continue to do so in the future some authorities would say that a true growth stock should be expected at least to double its per share earnings in 10 years that is to increase them at a compounded annual rate of over 7.1 percent obviously stocks of this kind are attractive to buy and to own provided the price paid is not excessive the problem lies there of 116. course since growth stocks have long sold at high prices in relation to current earnings and at much higher multiples of their average profits over a past period this has introduced a speculative element of considerable weight in the growth stock picture and has made successful operations in this field are far from simple matter the leading growth issue has long been international business machines and it has brought phenomenal rewards to those who bought it years ago and held on to it tenaciously but we have already pointed out that this best of common stocks actually lost 50 of its market price in a six months decline during 1961-62 and nearly the same percentage in 1969-70 other growth stocks have been even more vulnerable to adverse developments in some cases not only has the price fallen back but the earnings as well thus causing a double discomforture to those who owned them a good second example for our purpose is texas instruments which in six years rose from five to 256 without paying a dividend while its earnings increased from 40 cents to 3.91 per share note that the price advanced five times as fast as the profits this is characteristic of popular common stocks but two years later the earnings had dropped off by nearly 50 percent and the price by four-fifths to forty nine the reader will understand from these instances why we regard growth stocks as a whole as two uncertain and riskier vehicle for the defensive investor of course wonders can be accomplished with the right individual selections bought at the right levels and later sold after a huge rise and before the probable decline but the average investor can no more expect to accomplish this than to find money growing on trees in contrast we think that the group of large companies that are relatively unpopular and therefore obtainable at reasonable earnings multipliers offers a sound if unspectacular area of choice by the general public we shall illustrate this idea in our chapter on portfolio selection portfolio changes it is now standard practice to submit all security lists for periodic inspection in order to see whether their quality can be improved this of course is a major part of the service provided for clients by investment counselors nearly all brokerage houses are ready to make corresponding suggestions without special fee in return for the commission business involved some brokerage houses maintain investment services on a fee basis presumably our defensive investor should obtain at least once a year the same kind of advice regarding changes in his portfolio as he sought when his funds were first committed since he will have little expertness of his own on which to rely it is essential that he entrust himself only to firms of the highest reputation otherwise he may easily fall into incompetent or unscrupulous hands it is important in any case that at every such consultation he make clear to his advisor that he wishes to adhere closely to the four rules of common stock selection given earlier in this chapter incidentally if his list has been competently selected in the first instance there should be no need for frequent or numerous changes dollar cost averaging the new york stock exchange has put considerable effort into popularizing its monthly purchase plan under which an investor devotes the same dollar amount each month to buying one or more common stocks this is an application of a special type of formula investment known as dollar cost averaging during the predominantly rising market experience since 1949 the results from such a procedure were certain to be highly satisfactory especially since they prevented the practitioner from concentrating his buying at the wrong times in lucile tomlinson's comprehensive study of formula investment plans one the author presented a calculation of the results of dollar cost averaging in the group of stocks making up the dow jones industrial index tests were made covering 23 10-year purchase periods the first ending in 1929 the last in 1952 every test showed a profit either at the close of the purchase period or within five years thereafter the average indicated profit at the end of the 23 buying periods was 21.5 exclusive of dividends received needless to say in some instances there was a substantial temporary depreciation at market value miss tomlinson ends her discus sign of this ultra simple investment formula with the striking sentence no one has yet discovered any other formula for investing which can be used with so much confidence of ultimate success regardless of what may happen to security prices as dollar cost averaging it may be objected that dollar cost averaging while sound in principle is rather unrealistic in practice because few people are so situated that they can have available for common stock investment the same amount of money each year for say 20 years it seems to me that this apparent objection has lost much of its force in recent years common stocks are becoming generally accepted as a necessary component of a sound savings investment program thus systematic and uniform purchases of common stocks may present no more psychological and financial difficulties than similar continuous payments for united states savings bonds and for life insurance to which they should be complementary the monthly amount may be small but the results after 20 or more years can be impressive and important to the saver the investor's personal situation at the beginning of this chapter we referred briefly to the position of the individual portfolio owner let us return to this matter in the light of our subsequent discussion of general policy to what extent should the type of securities selected by the investor vary with his circumstances as concrete examples representing widely different conditions we shall take one their widow left 200 000 with which to support herself and her children 2. a successful doctor in mid-career with savings of 100 thousand dollars and yearly accretions of ten thousand dollars and three a young man earning two hundred dollars per week and saving one thousand dollars a year for the widow the problem of living on her income is a very difficult one on the other hand the need for conservatism in her investments is paramount a division of her fund about equally between united states bonds and first grade common stocks is a compromise between these objectives and corresponds to our general prescription for the defensive investor the stock component may be placed as high as 75 if the investor is psychologically prepared for this decision and if she can be almost certain she is not buying a too higher level assuredly this is not the case in early 1972. we do not preclude the possibility that the widow may qualify as an enterprising investor in which case her objectives and methods will be quite different the one thing the widow must not do is to take speculative chances in order to make some extra income by this we mean trying for profits or high income without the necessary equipment to warrant full confidence in overall success it would be far better for her to draw two thousand dollars per year out of her principle in order to make both ends meet than to risk half of it in poorly grounded and therefore speculative ventures the prosperous doctor has none of the widow's pressures and compulsions yet we believe that his choices are pretty much the same is he willing to take a serious interest in the business of investment if he lacks the impulse or the flare he will do best to accept the easy role of the defensive investor the division of his portfolio should then be no different from that of the typical widow and there would be the same area of personal choice in fixing the size of the stock component the annual savings should be invested in about the same proportions as the total fund the average doctor may be more likely than the average widow to elect to become an enterprising investor and he is perhaps more likely to succeed in the undertaking he has one important handicap however the fact that he has less time available to give to his investment education and to the administration of his funds in fact medical men have been notoriously unsuccessful in their security dealings the reason for this is that they usually have an ample confidence in their own intelligence and a strong desire to make a good return on their money without the realization that to do so successfully requires both considerable attention to the matter and something of a professional approach to security values finally the young man who saves 1 000 a year and expects to do better gradually finds himself with the same choices though for still different reasons some of his savings should go automatically into series e bonds the balance is so modest that it seems hardly worthwhile for him to undergo a tough educational and temperamental discipline in order to qualify as an aggressive investor thus a simple resort to our standard program for the defensive investor would be at once the easiest and the most low guy cal policy let us not ignore human nature at this point finance has a fascination for many bright young people with limited means they would like to be both intelligent and enterprising in the placement of their savings even though investment income is much less important to them than their salaries this attitude is all to the good there is a great advantage for the young capitalist to begin his financial education and experience early if he is going to operate as an aggressive investor he is certain to make some mistakes and to take some losses youth can stand these disappointments and profit by them we urge the beginner in security buying not to waste his efforts and his money in trying to beat the market let him study security values and initially test out his judgment on price versus value with the smallest possible sums thus we return to the statement made at the outset that their kind of securities to be purchased and the rate of return to be sought depend not on the investor's financial resources but on his financial equipment in terms of knowledge experience and temperament note on the concept of risk it is conventional to speak of good bonds as less risky than good preferred stocks end of the latter as less risky than good common stocks from this was derived the popular prejudice against common stocks because they are not safe which was demonstrated in the federal reserve board survey of 1948. we should like to point out that the words risk and safety are applied to security ties in two different senses with a resultant confusion in thought a bond is clearly proved unsafe when it defaults its interest or principal payments similarly if a preferred stock or even a common stock is bought with the expectation that a given rate of dividend will be continued then a reduction or passing of the dividend means that it has proved unsafe it is also true that an investment contains a risk if there is a fair possibility that the holder may have to sell at a time when the price is well below cost nevertheless the idea of risk is often extended to apply to oppose civil decline in the price of a security even though the decline may be of a cyclical and temporary nature and even though the holder is unlikely to be forced to sell at such times these chances are present in all securities other than united states savings bonds and to a greater extent in the general run of common stocks than in senior issues as a class but we believe that what is here involved is not a true risk in the useful sense of the term the man who holds a mortgage on a building might have to take a substantial loss if you are forced to sell it at an unfavorable time that element is not taken into account in judging the safety or risk of ordinary real estate mortgages the only criterion being the certainty of punctual payments in the same way a risk attached to an ordinary commercial business is measured by the chance of its losing money not by what would happen if the owner were forced to sell in chapter 8 we shall set forth our conviction that the bona fide investor does not lose money merely because the market price of his holdings declines hence the fact that a decline may occur does not mean that he is running a true risk of loss if a group of well-selected common stock investments shows a satisfactory overall return as measured through a fair number of years then this group investment has proved to be safe during that period its market value is bound to fluctuate and as likely as not it will sell for a while under the buyer's cost if that fact makes the investment risky it would then have to be called both risky and safe at the same time this confusion may be avoided if we apply the concept of risk solely to a loss of value which either is realized through actual sale or is caused by a significant deterioration in the company's position or more frequently perhaps is the result of the payment of an excessive price in relation to the intrinsic worth of the security.2 many common stocks do involve risks of such deterioration but it is our thesis that a properly executed group investment in common stocks does not carry any substantial risk of this sort and that therefore it should not be termed risky merely because of the element of price fluctuation but such risk is present if there is danger that the price may prove to have been clearly too high by intrinsic value standards even if any subsequent severe market decline may be recouped many years later note on the category of large prominent and conservatively financed corporations the quoted phrase in our caption was used earlier in the chapter to describe the kind of common stocks to which defensive investors should limit their purchases provided also that they had paid continuous dividends for a considerable number of years a based on adjectives is always ambiguous where is the dividing line for size for prominence and for conservatism of financial structure on the last point we can suggest a specific standard that though arbitrary is in line with accepted thinking an industrial company's finances are not conservative unless the common stock at book value represents at least half of the total capitalization including all bank debt.3 for a railroad or public utility the figure should be at least 30 the words large and prominent carry the notion of substantial size combined with a leading position in the industry such companies are often referred to as primary all other common stocks are then called secondary except that growth stocks are ordinarily placed in a separate class by those who buy them as such to supply an element of concreteness here let us suggest that to be large in present day terms a company should have 50 mil line of assets or do 50 million dollars of business again to be pro mean and a company should rank among the first quarter or first third in size within its industry group it would be foolish however to insist upon such arbitrary criteria they are offered merely as guides to those who may ask for guidance but any rule which the investor may set for himself and which does no violence to the common sense meanings of large and prominent should be acceptable by the very nature of the case there must be a large group of companies that some will and others will not include among those suitable for defensive investment there is no harm in such diversity of opinion and action in fact it has a salutary effect upon stock market conditions because it permits a gradual differentiation or transition between the categories of primary and secondary stock issues chapter 6 portfolio policy for the enterprising investor negative approach the aggressive investor should start from the same base as the defensive investor namely a division of his funds between high-grade bonds and high-grade common stock sport at reasonable prices he will be prepared to branch out into other kinds of security commitments but in each case he will want a well-reasoned justification for the departure there is a difficulty in discussing this topic in orderly fashion because there is no single or ideal pattern for aggressive operations the field of choice is wide the selection should depend not only on the individual's competence and equipment but perhaps equally well upon his interests and preferences the most useful generalizations for the enterprising investor are of a negative sort let him leave high-grade preferred stocks to corporate buyers let him also avoid inferior types of bonds and preferred stocks unless they can be bought at bargain levels which means ordinarily at prices at least 30 under par for high coupon issues and much less for the lower coupons he will let someone else buy foreign government bond issues even though the yield may be attractive he will also be wary of all kinds of new issues including convertible bonds and preferreds that seem quite tempting and common stocks with excellent earnings confined to the recent past for standard bond investments the aggressive investor would do well to follow the patterns suggested to his defensive confrare and make his choice between high-grade taxable issues which can now be selected to yield about 71 fourths of a percent and good quality tax-free bonds which yield up to 5.30 on longer maturities second-grade bonds and preferred stocks since in late 1971 it is possible to find first-rate corporate bonds to yield 71 fourths of a percent and even more it would not make much sense to buy second-grade issues merely for the higher return they offer in fact corporations with relatively poor credit standing have found it virtually impossible to sell straight bonds that is non-convertibles to the public in the past two years hence their debt financing has been done by the sale of convertible bonds or bonds with warrants attached which place them in a separate category it follows that virtually all the non-convertible bonds of inferior rating represent older issues which are selling at a large discount thus they offer the possibility of a substantial gain in principal value under favorable future conditions which would mean here a combination of an improved credit rating for the company and lower general interest rates but even in the matter of price discounts and resultant chance of principal gain the second grade bonds are in competition with better issues some of the well-entrenched obligations with older style coupon rates 21 halves of a percent to 4 percent sold at about 50 cents on the dollar in 1970. examples american telephone and telegraph 25 25-8s due 1986 sold at 51 atchison topeka and santa fe are affords due 1995 sold at 51 mcgraw hill 37-8 s due 1992 sold at 501 halves hence under conditions of late 1971 the enterprising investors can probably get from good grade bonds selling at a large discount all that he should reasonably desire in the form of both income and chance of appreciation throughout this book we refer to the possibility that any well-defined and protracted market situation of the past may return in the future hence we should consider what policy the aggressive investor might have to choose in the bond field if prices and yields of high grade issues should return to former normals for this reason we shall reprint here our observations on that point made in the 1965 edition when high-grade bonds yielded only 41 halves of a percent something should be said now about investing in second-grade issues which can readily be found to yield any specified return up to 8 or more the main difference between first and second grade bonds is usually found in the number of times the interest charges have been covered by earnings example in early 1964 chicago milwaukee sent poor and pacific 5 income debenture bonds at 68 yielded 7.35 but the total interest charges of the road before income taxes were earned only 1.5 times in 1963 against our requirement of five times for a well-protected railroad issue many investors buy securities of this kind because they need income and cannot get along with the meager return offered by top grade issues experience clearly shows that it is unwise to buy a bond or a preferred which lacks adequate safety merely because the yield is attractive here the word merely implies that the issue is not selling at a large discount and thus does not offer an opportunity for a substantial gain in principal value where such securities are bought at full prices that is not many points under 100 the chances are very great that at some future time the holder will see much lower quotations for when bad business comes or just a bad market issues of this kind prove highly susceptible to severe sinking spells often interest or dividends are suspended or at least endangered and frequently there is a pronounced price weakness even though the operating results are not at all bad as a specific illustration of this characteristic of second quality senior issues let us summarize the price behavior of a group of 10 railroad income bonds in 1946 to 47. these comprise all of those which sold at 96 or more in 1946 their high prices averaging 1021 halves by the following year the group had registered low prices averaging only 68 a loss of one-third of the market value in a very short time peculiarly enough the railroads of the country were showing much better earnings in 1947 than in 1946 hence the drastic price decline ran counter to the business picture and was a reflection of the sell-off in the general market but it should be pointed out that the shrinkage in these income bonds was proportionately larger than that in the common stocks in the dow jones industrial list about 23 obviously the purchaser of these bonds at a cost above 100 could not have expected to participate to any extent in a further rise in the securities market the only attractive feature was the income yield averaging about 4.25 against 2.50 for first grade bonds an advantage of 1.75 in annual income yet the sequel showed all too soon and too plainly that for the minor advantage in annual income the buyer of these second grade bonds was risking the loss of a substantial part of his principle the above example permits us to pay our respects to the popular fallacy that goes under the sobriquet of a businessman's investment that involves the purchase of a security showing a larger yield than is obtainable on a high grade issue and carrying a correspondingly greater risk it is bad business to accept an acknowledged possibility of a loss of principle in exchange for a mere one or two percent of additional yearly income if you are willing to assume some risk you should be certain that you can realize a really substantial gain in principal value if things go well hence a second grade 5.5 or 6 bond selling at par is almost always a bad purchase the same issue at 70 might make more sense and if you are patient you will probably be able to buy it at that level second grade bonds and preferred stocks possess two contradictory attributes which the intelligent investor must bear clearly in mind nearly all suffer severe sinking spells in bad markets on the other hand a large proportion recover their position when favorable conditions return and these ultimately work out all right this is true even of cumulative preferred stocks that failed to pay dividends for many years there were a number of such issues in the early 1940s as a consequence of the long depression of the 1930s during the post-war boom period of 1945 to 1947 many of these large accumulations were paid off either in cash or in new securities and the principle was often discharged as well as a result large profits were made by people who a few years previously had bought these issues when they were friendless and sold at low prices.two it may well be true that in an overall accounting the higher yields obtainable on second grade senior issues will prove to have offset those principal losses that were irrecoverable in other words an investor who bought all such issues at their offering prices might conceivably fare as well in the long run as one who limited himself to first quality securities or even somewhat better.3 but for practical purposes the question is largely irrelevant regardless of the outcome the buyer of second grade issues at full prices will be worried and discommoded when their price declines precipitately furthermore he cannot buy enough issues to assure an average result nor is he in a position to set aside a portion of his larger income to offset or amortize those principal losses which prove to be permanent finally it is mere common sense to abstain from buying securities at around 100 if long experience indicates that they can probably be bought at 70 or less in the next week market foreign government bonds all investors with even small experience know that foreign bonds as a whole have had a bad investment history since 1914. this was inevitable in the light of two world wars and an intervening world depression of unexample depth yet every few years market conditions are sufficiently favorable to permit the sale of some new foreign issues at a price of about par this phenomenon tells us a good deal about the working of the average investor's mind and not only in the field of bonds we have no concrete reason to be concerned about the future history of well-regarded foreign bonds such as those of australia or norway but we do know that if and when trouble should come the owner of foreign obligations has no legal or other means of enforcing his claim those who bought republic of cuba 41-2s as high as 117 in 1953 saw them default their interest and then sell as low as 20 cents on the dollar in 1963. the new york stock exchange bond list in that year also included belgian congo 51-4 essa 36 greek sevens at 30 and various issues of poland as low as seven how many readers have any idea of the repeated vicissitudes of the eight percent bonds of czechoslovakia since they were first offered in this country in 1922 it's 961 halves they advanced to 112 in 1928 declined to 673 fourths in 1932 recovered to 106 in 1936 collapsed to six in 1939 recovered unbelievably to 117 in 1946 fell promptly to 35 in 1948 and sold as low as eight in 1970. years ago an argument of sorts was made for the purchase of foreign bonds here on the grounds that a rich creditor nation such as ours was under moral obligation to lend abroad time which brings so many revenges now finds us dealing with an intractable balance of payments problem of our own part of which is ascribable to the large-scale purchase of foreign bonds by american investors seeking a small advantage in yield for many years past we have questioned the inherent attractiveness of such investments from the standpoint of the buyer perhaps we should add now that the latter would benefit both his country and himself if he declined these opportunities new issues generally it might seem ill-advised to attempt any broad statements about new issues as a class since they cover the widest possible range of quality and attractiveness certainly there will be exceptions to any suggested rule our one recommendation is that all investors should be wary of new issues which means simply that these should be subjected to careful examination and unusually severe tests before they are purchased there are two reasons for this double caveat the first is that new issues have special salesmanship behind them which calls therefore for a special degree of sales resistance the second is that most new issues are sold under favorable market conditions which means favorable for the seller and consequently less favorable for the buyer the effect of these considerations becomes steadily more important as we go down the scale from the highest quality bonds through second grade senior issues to common stock flotations at the bottom a tremendous amount of financing consisting of the repayment of existing bonds at call price and their replacement by new issues with lower coupons was done in the past most of this was in the category of high grade bonds and preferred stocks the buyers were largely financial institutions amply qualified to protect their interests hence these offerings were carefully priced to meet the going rate for comparable issues and high-powered salesmanship had little effect on the outcome as interest rates fell lower and lower the buyers finally came to pay too high a price for these issues and many of them later declined appreciably in the market this is one aspect of the general tendency to sell new securities of all types when conditions are most favorable to the issuer but in the case of first quality issues the ill effects to the purchaser are likely to be unpleasant rather than serious the situation proves somewhat different when we study the lower grade bonds and preferred stocks sold during the 1945-46 and 1960-61 periods here the effect of the selling effort is more apparent because most of these issues were probably placed with individual and inexpert investors it was characteristic of these offerings that they did not make an adequate showing when judged by the performance of the companies over a sufficient number of years they did look safe enough for the most part if it could be assumed that the recent earnings would continue without a serious setback the investment bankers who brought out these issues presumably accepted this assumption and their salesmen had little difficulty in persuading themselves and their customers to a like effect nevertheless it was an unsound approach to investment and one likely to prove costly bull market periods are usually characterized by the transformation of a large number of privately owned businesses into companies with quoted shares this was the case in 1945-46 and again beginning in 1960 the process then reached extraordinary progressions until brought to a catastrophic close in may 1962. after the usual swearing-off period of several years the whole tragicom eddy was repeated step-by-step in 1967 new common stock offerings the following paragraphs are reproduced unchanged from the 1959 edition with comment added common stock financing takes two different forms in the case of companies already listed additional shares are offered pro rata to the existing stockholders the subscription price is set below the current market and the rights to subscribe have an initial money value the sale of the new shares is almost always underwritten by one or more investment banking houses but it is the general hope and expectation that all the new shares will be taken by the exercise of the subscription rights thus the sale of additional common stock of listed companies does not ordinarily call for active selling effort on the part of distributing firms the second type is the placement with the public of common stock of what were formerly privately owned enterprises most of this stock is sold for the account of the controlling interests to enable them to cash in on a favorable market and to diversify their own finances when new money is raised for the business it comes often via the sale of preferred stock as previously noted this activity follows a well-defined pattern which by the nature of the security markets must bring many losses and disappointments to the public the dangers arise both from the character of the businesses that are thus financed and from the market conditions that make the financing possible in the early part of the century a large proportion of our leading companies were introduced to public trading as time went on the number of enterprises of first rank that remained closely held steadily diminished hence original common stock flotations have tended to be concentrated more and more on relatively small concerns by an unfortunate correlation during the same period the stock buying public has been developing an ingrained preference for the major companies and a similar prejudice against the minor ones this prejudice like many others tends to become weaker as bull markets are built up the large and quick profits shown by common stocks as a whole are sufficient to dull the public's critical faculty just as they sharpen its acquisitive instinct during these periods also quite a number of privately owned concerns can be found that are enjoying excellent results although most of these would not present too impressive a record if the figures were car ride back say 10 years or more when these factors are put together the following consequences emerge somewhere in the middle of the bull market the first common stock flotations make their appearance these are priced not unattractively and some large profits are made by the buyers of the early issues as the market rise continues this brand of financing grows more frequent the quality of the companies becomes steadily poorer the price is asked and obtained verge on the exorbitant one fairly dependable sign of the approaching end of a bull swing is the fact that new common stocks of small and non-descript companies are offered at prices somewhat higher than the current level for many medium-sized companies with a long market history it should be added that very little of this common stock financing is ordinarily done by banking houses of prime size and reputation the heedlessness of the public and the willingness of selling organizations to sell whatever may be profitably sold can have only one result price collapse in many cases the new issues lose 75 and more of their offering price the situation is worsened by the aforementioned fact that at bottom the public has a real ever sign to the very kind of small issue that it bought so readily in its careless moments many of these issues fall proportionately as much below their true value as they formally sold above it an elementary requirement for the intelligent investor is an ability to resist the blandishments of salesmen offering new common stock issues during bull markets even if one or two can be found that can pass severe tests of quality and value it is probably bad policy to get mixed up in this sort of business of course the salesman will point to many such issues which have had good sized market advances including some that go up spectacularly the very day they are sold but all this is part of the speculative atmosphere it is easy money for every dollar you make in this way you will be lucky if you end up by losing only two some of these issues may prove excellent buys a few years later when nobody wants them and they can be had at a small fraction of their true worth in the 1965 edition we continued our discussion of this subject as follows while the broader aspects of the stock market's behavior since 1949 have not lent themselves well to analysis based on long experience the development of new common stock flotations proceeded exactly in accordance with ancient prescription it is doubtful whether we ever before had so many new issues offered of such low quality and with such extreme price collapses as we experienced in 1960 to 1960 the ability of the stock market as a whole to disengage itself rapidly from that disaster is indeed an extraordinary phenomenon bringing back long-buried memories of the similar invulnerability it showed to the great florida real estate collapse in 1925. must there be a return of the new stock offering madness before the present bull market can come to its definitive close who knows but we do know that an intelligent investor will not forget what happened in 1962 and will let others make the next batch of quick profits in this area and experience the consequent harrowing losses we followed these paragraphs in the 1965 edition by citing a horrible example namely the sale of stock of etna maintenance company at nine dollars in november 1961. in typical fashion the shares promptly advanced to 15 the next year they fell to 23 eighths and in 1964 to seven eighths the later history of this company was on the extraordinary side and illustrates some of the strange metamorphoses that have taken place in american business great and small in recent years the curious reader will find the older and newer history of this enterprise in appendix 5. it is by no means difficult to provide even more harrowing examples taken from the more recent version of the same old story which covered the years 1967 to 1970. nothing could be more passed to our purpose than the case of aaa enterprises which happens to be the first company then listed in standard and poor's stock guide the shares were sold to the public at 14 in 1968 promptly advanced to 28 but in early 1971 were quoted at a dismal 25 cents even this price represented a gross overvaluation of the enterprise since it had just entered the bankruptcy court in a hopeless condition there is so much to be learned and such important warnings to be gleaned from the story of this flotation that we have reserved it for detailed treatment below in chapter 17 chapter 7 portfolio policy for the enterprising investor the positive side the enterprising investor by definition will devote a fair amount of his attention and efforts toward obtaining a better than run-of-the-mill investment result in our discussion of general investment policy we have made some suggestions regarding bond investments that are addressed chiefly to the enterprising investor he might be interested in special opportunities of the following kinds 1. tax-free new housing authority bonds effectively guaranteed by the united states government 2. taxable but high-yielding new community bonds also guaranteed by the united states government 3 tax-free industrial bonds issued by municipalities but serviced by lease payments made by strong corporations references have been made to these unusual types of bond issues in chapter four at the other end of the spectrum there may be lower quality bonds obtainable at such low prices as to constitute true bargain opportunities but these would belong in the special situation area where no true distinction exists between bonds and common stocks operations in common stocks the activities specially characteristic of the enterprising investor in the common stock field may be classified under foreheads 1. buying in low markets and selling in high markets 2. buying carefully chosen growth stocks 3. buying bargain issues of various types 4. buying into special situations general market policy formula timing we reserve for the next chapter our discussion of the possibilities and limitations of a policy of entering the market when it is depressed and selling out in the advanced stages of a boom for many years in the past this bright idea appeared both simple and feasible at least from first inspection of a market chart covering its periodic fluctuations we have already admitted ruefully that the market's action in the past 20 years has not lent itself to operations of this sort on any mathematical basis the fluctuations that have taken place while not inconsiderable in extent would have required a special talent or feel for trading to take advantage of them this is something quite different from the intelligence which we are assuming in our readers and we must exclude operations based on such skill from our terms of reference the 50 to 50 plan which we proposed to the defensive investor and described on p 90 is about the best specific or automatic formula we can recommend to all investors under the conditions of 1972 but we have retained a broad leeway between the 25 mini mum and the 75 maximum in common stocks which we allow to those investors who have strong convictions about either the danger or the attractiveness of the general market level some 20 years ago it was possible to discuss in great detail a number of clear-cut formulas for varying the percentage held in common stocks with confidence that these plans had practical utility dots one the times seemed to have passed such approaches by and there would be little point in trying to determine new levels for buying and selling out of the market patterns since 1949. that is too short a period to furnish any reliable guide to the future growth stock approach every investor would like to select the stocks of companies that will do better than the average over a period of years a growth stock may be defined as one that has done this in the past and is expected to do so in the future.2 thus it seems only logical that the intelligent investor should concentrate upon the selection of growth stocks actually the matter is more complicated as we shall try to show it is a mere statistical chore to identify companies that have outperformed the averages in the past the investor can obtain a list of 50 or 100 such enterprises from his broker why then should he not merely pick out the 15 or 20 most likely looking issues of this group and low he has a guaranteed successful stock portfolio there are two catches to this simple idea the first is that common stocks with good records and apparently good prospects sell at correspondingly high prices the investor may be right in his judgment of their prospects and still not fare particularly well merely because he has paid in full and perhaps overpaid for the expected prosperity the second is that his judgment is to the future may prove wrong unusually rapid growth cannot keep up forever when a company has already registered a brilliance x-band scion its very increase in size makes a repetition of its achievement more difficult at some point the growth curve flattens out and in many cases it turns downward it is obvious that if one confines himself to a few chosen instances based on hindsight he could demonstrate that fortunes can readily be either made or lost in the growth stock field how can one judge fairly of the overall results obtainable here we think that reasonably sound conclusions can be drawn from a study of the results achieved by the investment funds specializing in the growth stock approach the authoritative manual entitled investment companies published annually by arthur wiesenberger and company members of the new york stock exchange computes the annual performance of some 120 such growth funds over a period of years of these 45 have records covering 10 years or more the average overall gain for these companies unweighted for size of fund works out at 108 for the decade 1961-1970 compared with 105 for the s and p composite and 83 for the dow jones industrial average.3 in the two years 1969 and 1970 the majority of the 126 growth funds did worse than either index similar results were found in our earlier studies the implication here is that no outstanding rewards came from diversified investment in growth companies as compared with that in common stocks generally there is no reason at all for thinking that the average intelligent investor even with much devoted effort can derive better results over the years from the purchase of growth stocks than the investment companies specializing in this area surely these organizations have more brains and better research facilities at their disposal than you do consequently we should advise against the usual type of growth stock commitment for the enterprising investor this is one in which the excellent prospects are fully recognized in the market and already reflected in a current price earnings ratio of say higher than 20 for the defensive investor we suggested an upper limit of purchase price at 25 times average earnings of the past seven years the two criteria would be about equivalent in most cases 160 the striking thing about growth stocks as a class is their tendency toward wide swings in market price this is true of the largest and longest established companies such as general electric and international business machines and even more so of newer and smaller successful companies they illustrate our thesis that the main characteristic of the stock market since 1949 has been the injection of a highly speculative element into the shares of companies which have scored the most brilliant successes and which themselves would be entitled to a high investment rating their credit standing is of the best and they pay the lowest interest rates on their borrowings the investment caliber of such a company may not change over a long span of years but the risk characteristics of its stock will depend on what happens to it in the stock market the more enthusiastic the public grows about it and the faster its advance as compared with the actual growth in its earnings the riskier a proposition it becomes but is it not true the reader may ask that the really big fortunes from common stocks have been garnered by those who made a substantial commitment in the early years of a company in whose future they had great confidence and who held their original shares unwaveringly while they increased 100 fold or more in value the answer is yes but the big fortunes from single company investments are almost always realized by persons who a 162 a close relationship with the particular company through employment family connection etc dot which justifies them in placking a large part of their resources in one medium and holding on to this commitment through all this institutes despite numerous temptations to sell out at apparently high prices along the way an investor without such close personal contact will constantly be faced with the question of whether too large a portion of his funds are in this one medium each decline however temporary it proves in the sequel will accentuate his problem and internal and external pressures are likely to force him to take what seems to be a goodly profit but one far less than the ultimate bonanza.4 three recommended fields for enterprising investment to obtain better than average investment results over a long poll requires a policy of selection or operation possessing a two-fold merit one it must meet objective or rational tests of underlying soundness and two it must be different from the policy followed by most investors or speculators our experience and study leads us to recommend three investment approaches that meet these criteria they differ rather widely from one another and each may require a different type of knowledge and temperament on the part of those who are say it the relatively unpopular large company if we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason it is logical to expect that it will undervalue relatively at least companies that are out of favor because of unsatisfactory developments of a temporary nature this may be set down as a fundamental law of the stock market and it suggests an investment approach that should prove both conservative and promising the key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity while small companies may also be undervalued for similar reasons and in many cases may later increase their earnings and share price they entail the risk of a definitive loss of profitability and also of protracted neglect by the market in spite of better earnings the large companies thus have a double advantage over the others first they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base second the market is likely to respond with reasonable speed to any improvement shown a remarkable demonstration of the soundness of this thesis is found in studies of the price behavior of the unpopular issues in the dow jones industrial average in these it was assumed that an investment was made each year in either the six or the ten issues in the dow jones industrial average which were selling at the lowest multipliers of their current or previous year's earnings these could be called the cheapest stocks in the list and their cheapness was evidently the reflection of relative unpopularity with investors or traders it was assumed further that these purchases were sold out at the end of holding periods ranging from one to five years the results of these investments were then compared with the results shown in either the dow jones industrial average as a whole or in the highest multiplier that is the most popular group the detailed material we have available covers the results of annual purchases assumed in each of the past 53 years.5 in the early period 1917-1913 this approach proved unprofitable but since 1933 the method has shown highly successful results in 34 tests made by drexel and company now drexel firestone of one year holding from 1937 through 1969 the cheap stocks did definitely worse than the dow jones industrial average in only three instances the results were about the same in six cases and the cheap stocks clearly outperformed the average in 25 years the consistently better performance of the low multiplier stocks is shown table 7 2 by the average results for successive five-year periods when compared with those of the dow jones industrial average and of the 10 high multipliers the drexel computation shows further that an original investment of ten thousand dollars made in the low multiplier issues in 1936 and switched each year in accordance with the principal would you have grown to 66 900 by 1962. the same operations in high multiplier stocks would have ended with a value of only 25 300 while an operation in all 30 stocks would have increased the original fund to 44 000 the concept of buying unpopular large companies and its execution on a group basis as described above are both quite simple but in considering individual companies a special factor of opposite import must sometimes to be taken into account companies that are inherently speculative because of widely varying earnings tend to sell both at a relatively high price and at a relatively low multiplier in their good years and conversely at low prices and high multipliers in their bad years these relationships are illustrated in table 7 3 covering fluctuations of cries like operation common in these cases the market has sufficient skepticism as to the continuation of the unusually high profits to value them conservatively and conversely when earnings are low or non-existent note that by the arithmetic if a company earns next to nothing its shares must sell at a high multiplier of these minuscule profits as it happens chrysler has been quite exceptional in the dow jones industrial average list of leading companies and hence it did not greatly affect the the low multiplier calculations it would be quite easy to avoid inclusion of such anomalous issues in a low multiplier list by requiring also that the price be low in relation to past average earnings or by some similar test while writing this revision we tested the results of the dow jones industrial average low multiplier method applied to a group assumed to be bought at the end of 1968 and revalued on june 30 1971. this time the figures proved quite disappointing showing a sharp loss for the low multiplier 6 or 10 and a good profit for the high multiplier selections this one bad instance should not officiate conclusions based on 30 odd experiments but its recent happening gives it a special adverse weight perhaps the aggressive investor should start with the low multiplier idea but add other quantitative and qualitative requirements thereto in making up his portfolio purchase of bargain issues we define a bargain issue as one which on the basis of facts established by analysis appears to be worth considerably more than it is selling for the genus includes bonds and preferred stocks selling well under par as well as common stocks to be as concrete as possible let us suggest that an issue is not a true bargain unless the indicated value is at least 50 percent more than the price what kind of facts would warrant the conclusion that so greater discrepancy exists how do bargains come into existence and how does the investor profit from them there are two tests by which a bargain common stock is detected the first is by the method of appraisal this relies largely on estimating future earnings and then multiplying these by a factor appropriate to the particular issue if the resultant value is sufficiently above the market price and if the investor has confidence in the technique employed he can tag the stock as a bargain the second test is the value of the business to a private owner this value also is often determined chiefly by expected future earnings in which case the result may be identical with the first but in the second test more attention is likely to be paid to the realizable value of the assets with particular emphasis on the net current assets or working capital at low points in the general market a large proportion of common stocks are bargain issues as measured by these standards a typical example was general motors when it sold at less than 30 in 1941 equivalent to only 5 for the 1971 shares it had been earning in excess of four dollars and paying three dollars and fifty cents or more in dividends it is true that current earnings and the immediate prospects may both be poor but a level-headed appraisal of average future conditions would indicate values far above ruling prices thus the wisdom of having courage in depressed markets is vindicated not only by the voice of experience but also by application of plausible techniques of value analysis the same vagaries of the marketplace 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 mole hills and exaggerating ordinary vicissitudes into major setbacks even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels thus we have what appear to be two major sources of undervaluation one currently disappointing results and two protracted neglect or and popularity however neither of these causes if considered by itself alone can be relied on as a guide to successful common stock investment how can we be sure that the currently disappointing results are indeed going to be only temporary true we can supply excellent examples of that happening the steel stocks used to be famous for their cyclical quality and the shrewd buyer could acquire them at low prices when earnings were low and sell them out in boom years at a fine profit a spectacular example is supplied by chrysler corporation as shown by the data in table 7 3. if this were the standard behavior of stocks with fluctuating earnings then making profits in the stock market would be an easy matter unfortunately we could cite many examples of declines in earnings and price which were not followed automatically by a handsome recovery of both one such was anaconda wire and cable which had large earnings up to 1956 with a high price of 85 in that year the earnings then declined irregularly for six years the price fell to 231 halves in 1962 and the following year it was taken over by its parent enterprise anaconda corporation at the equivalent of only 33. the many experiences of this type suggest that the investor would need more than a mere falling off in both earnings and price to give him a sound basis for purchase he should require an indie cation of at least reasonable stability of earnings over the past decade or more that is 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 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 we have mentioned protracted neglect or unpopularity as a second on cause of price declines to unduly low levels a current case of this kind would appear to be national press to industries in the bull market of 1968 it sold at a high of 45 which was only eight times the 5.61 earnings for that year the per share profits increased in both 1969 and 1970 but the price declined to only 21 in 1970. this was less than four times their record earnings in that year and less than its net current asset value in march 1972 it was selling at 34 still only 51 halves times the last reported earnings and at about its enlarged net current asset value another example of this type is provided currently by standard oil of california a concern of major importance in early 1972 it was selling at about the same price as 13 years before say 56. its earnings had been remarkably steady with relatively small growth but with only one small decline over the entire period its book value was about equal to the market price with this conservatively favorable 1958-71 record the company has never shown an average annual price as high as 15 times its current earnings in early 1972 the price earnings ratio was only about 10. a third cause for an unduly low price for a common stock may be the market's failure to recognize its true earnings picture our classic example here is northern pacific railway which in 1946 to 47 declined from 36 to 131 halves the true earnings of the road in 1947 were close to 10 per share the price of the stock was held down in great part by its one dollar dividend it was neglected also because much of its earnings power was concealed by accounting methods peculiar to railroads the type of bargain issue that can be most readily identified is a common stock that sells for less than the company's networking 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 goodwill 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 the surprising thing rather is that there have been so many enterprises obtainable which have been valued in the market on this bargain basis a compilation made in 1957 when the market's level was by no means low disclosed about 150 of such common stocks in table 74 we summarize the result of buying on december 31 1957 one share of each of the 85 companies in that list for which day two appeared in standard and poor's monthly stock guide and holding them for two years by something of a coincidence each of the groups advanced in the two years to somewhere in the neighborhood of the aggregate net current asset value the gain for the entire portfolio in that period was 75 against 50 for standard and poor's 425 industrials what is more remarkable is that none of the issues showed significant losses seven held about even and 78 showed appreciable gains our experience with this type of investment selection on our 170 diversified basis was uniformly good for many years prior to 1957. it can probably be affirmed without hesitation that it constitutes a safe and profitable method of determining and taking advantage of undervalued situations however during the general market advance after 1957 the number of such opportunities became extremely limited and many of those available were showing small operating profits or even losses the market decline of 1969-70 produced a new crop of these sub-working capital stocks we discuss this group in chapter 15 on stock selection for the enterprising investor bargain issue pattern and secondary companies we have defined a secondary company as one that is not a leader in a fairly important industry thus it is usually one of the smaller concerns in its field but it may equally well be the chief unit in an unimportant line by way of exception any company that has established itself as a growth stock is not ordinarily considered secondary in the great bull market of the 1920s relatively little distinction was drawn between industry leaders and other listed issues provided the latter were of a respectable size the public felt that a middle-sized company was strong enough to weather storms and that it had a better chance for really spectacular expansion than one that was already of major dimensions the depression years 1931-32 however had a particularly devastating impact on the companies below the first rank either in size or in inherent stability as a result of that experience investors have since developed a pro announced preference for industry leaders and a corresponding lack of interest most of the time in the ordinary company of secondary importance this has meant that the latter group have usually sold at much lower prices in relation to earnings and assets than have the former it has meant further that in many instances the price has fallen so low as to establish the issue in the bargain class when investors rejected the stocks of secondary companies even though these sold at relatively low prices they were expressing a belief or fear that such companies faced a dismal future in fact at least subconsciously they calculated that any price was too high for them because they were heading for extinction just as in 1929 the companion theory for the blue chips was that no price was too high for them because their future possibilities were limitless both of these views were exaggerations and were productive of serious investment errors actually the typical middle-sized listed company is a large one when compared with the average privately owned business there is no sound reason why such companies should not continue indefinitely in operation undergoing the vicissitudes characteristic of our economy but earning on the whole affair return on their invested capital this brief review indicates that the stock market's attitude towards secondary companies tends to be unrealistic and consequently to create in normal times innumerable instances of major undervaluation as it happens the world war ii period and the post-war boom were more beneficial to the smaller concerns than to the larger ones because then the normal competition for sales was suspended and the former could expand sales and profit margins more spectacularly thus by 1946 the market's pattern had completely reversed itself from that before the war whereas the leading stocks in the dow jones industrial average had advanced only 40 from the end of 1938 to the 1946 high standard and poor's index of low-priced stocks had shot up no less than 280 per cent in the same period speculators and many self-styled investors with the proverbial short memories of people in the stock market were eager to buy both old and new issues of unimportant companies at inflated levels thus the pendulum had swung clear to the opposite extreme the very class of secondary issues that had formally supplied by far the largest proportion of bargain opportunities was now presenting the greatest number of examples of over enthusiasm and overvaluation in a different way this phenomenon was repeated in 1961 and 1968 the emphasis now being placed on new offerings of the shares of small companies of less than secondary character and on nearly all companies in certain favored fields such as electronics computers franchise concerns and authors as was to be expected the ensuing market declines fell most heavily on these overvaluations in some cases the pendulum swing may have gone as far as definite undervaluation 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 rain vested earnings are substantial in relation to the price paid and will ultimately affect the price in a five to seven year period these advantages can bulk quite large in a well-selected list third a bull market is ordinarily most generous to low-priced issues thus it tends to raise the typical bargain issue to at least a reasonable level fourth even during relatively featureless market periods a continue house process of price adjustment goes on under which secondary issues that were undervalued may rise at least to the normal level for their type of security fifth the specific factors that in many cases made for a disappointing record of earnings may be corrected by the advent of new conditions or the adoption of new policies or by a change in management an important new factor in recent years has been the acquisition of smaller companies by larger ones usually as part of a diversification program in these cases the consideration paid has almost always been relatively generous and much in excess of the bargain levels existing not long before when interest rates were much lower than in 1970 the field of bargain issues extended to bonds and preferred stocks that sold at large discounts from the amount of their claim currently we have a different situation in which even well-secured issues sell at large discounts if carrying coupon rates of say 41 halves of a percent or less example american telephone and telegraph 25 8s due 1986 sold as low as 51 in 1970 deer and company 41-2s due 1983 sold as low as 62. these may well turn out to have been bargain opportunities before very long if ruling interest rates should decline substantially for a bargain-bombed issue in the more traditional sense perhaps we shall have to turn once more to the first mortgage bombs of railroads now in financial difficulties which sell in the 20s or 30s such situations are not for the an expert investor lacking a real sense of values in this area he may burn his fingers but there is an underlying tendency for market decline in this field to be overdone consequently the group as a whole offers an especially rewarding invitation to careful and courageous analysis in the decade ending in 1948 the billion-dollar group of defaulted railroad bonds presented numerous and spectacular opportunities in this area such opportunities have been quite scarce since then but they seem likely to return in the 1970s special situations or workouts not so long ago this was a field which could almost guarantee an attractive rate of return to those who knew their way around in it and this was true under almost any sort of general market situation it was not actually forbidden territory to members of the general public some who had a flare for this sort of thing could learn the ropes and become pretty capable practitioners without the necessity of long academic study or apprenticeship others have been keen enough to recognize the underlying soundness of this approach and to attach themselves to bright young men who handled funds devoted chiefly to these special situations but in recent years for reasons we shall develop later the field of arbitrages and workouts became riskier and less profitable it may be that in years to come conditions in this field will become more propitious in any case it is worthwhile outlining the general nature and origin of these operations with one or two illustrative examples the typical special situation has grown out of the increasing number of acquisitions of smaller firms by large ones as the gospel of diversification of products has been adopted by more and more managements it often appears good business for such an enterprise to acquire an existing company in the field it wishes to enter rather than to start a new venture from scratch in order to make such acquisition possible and to obtain acceptance of the deal by the required large majority of shareholders of the smaller company it is almost always necessary to offer a price considerably above the current level such corporate moves have been producing interesting profit making opportunities for those who have made a study of this field and have good judgment fortified by ample experience a great deal of money was made by shrewd investors not so many years ago through the purchase of bonds of railroads in bankruptcy bonds which they knew would be worth much more than their cost when the railroads were finally reorganized after promulgation of the plans of reorganization a when issued market for the new securities appeared these could almost always be sold for considerably more than the cost of the old issues which were to be exchanged therefore there were risks of non-consumer shin of the plans or of unexpected delays but on the whole such arbitrage operations proved highly profitable there were similar opportunities growing out of the breakup of public utility holding companies pursuant to 1935 legislation nearly all these enterprises proved to be worth considerably more when changed from holding companies to a group of separate operating companies the underlying factor here is the tendency of the security markets to undervalue issues that are involved in any sort of complicated legal proceedings an old wall street motto has been never buy into a lawsuit this may be sound advice to the speculators seeking quick action on his holdings but the adoption of this attitude by the general public is bound to create bargain opportunities in the securities affected by it since the prejudice against them holds their prices down to unduly low levels the exploitation of special situations is a technical branch of investment which requires a somewhat unusual mentality and equipment probably only a small percentage of our enterprising investors are likely to engage in it and this book is not the appropriate medium for expounding its complications.6 broader implications of our rules for investment investment policy as it has been developed here depends in the first place on a choice by the investor of either the defensive passive or aggressive enterprising role the aggressive investor must have a considerable knowledge of security values enough in fact to warrant viewing his security operations as equivalent to a business enterprise there is no room in this philosophy for a middle ground or a series of gradations between the passive and aggressive status many perhaps most investors seek to place themselves in such an intermediate category in our opinion that is a compromise that is more likely to produce disappointment than achievement as an investor you cannot soundly become half a businessman expecting thereby to achieve half the normal rate of business profits on your funds it follows from this reasoning that the majority of security owners should elect the defensive classification they do not have the time or the determination or the mental equipment to embark upon investing as a quasi business they should therefore be satisfied with the excellent return now obtainable from a defensive portfolio and with even less and they should stoutly resist the recurrent temptation to increase this return by deviating into other paths the enterprising investor may properly embark upon any security operation for which his training and judgment are adequate and which appears sufficiently promising when measured by established business standards in our recommendations and caveats for this group of investors we have attempted to apply such business standards in those for the defensive investor we have been guided largely by the three requirements of underlying safety simplicity of choice and promise of satisfactory results in terms of psychology as well as arithmetic the use of these criteria has led us to exclude from the field of recommended investment a number of security classes that are normally regarded as suitable for various kinds of investors these prohibitions were listed in our first chapter on p 30. let us consider a little more fully than before what is implied in these exclusions we have advised against the purchase at full prices of three important categories of securities one foreign bonds two ordinary preferred stocks and 3 secondary common stocks including of course original offerings of such issues by full prices we mean prices close to par for bonds or preferred stocks and prices that represent about the fair business value of the enterprise in the case of common stocks the greater number of defensive investors are to avoid these categories regardless of price the enterprising investor is to buy them only when obtained able at bargain prices which we define as price is not more than two-thirds of the appraisal value of the securities what would happen if all investors were guided by our advice in these matters that question was considered in regard to foreign bonds on p 138 and we have nothing to add at this point investment grade preferred stocks would be bought solely by corporations such as insurance companies which would benefit from the special income tax status of stock issues owned by them the most troublesome consequence of our policy of exclusion is in the field of secondary common stocks if the majority of investors being in the defensive class are not to buy them at all the field of possible buyers becomes seriously restricted furthermore if aggressive investors are to buy them only at bargain levels then these issues would be doomed to sell for less than their fair value except to the extent that they were purchased unintelligently this may sound severe and even vaguely unethical yet in truth we are merely recognizing what has actually happened in this area for the greater part of the past 40 years secondary issues for the most part do fluctuate about a central level which is well below their fair value they reach and even surpass that value at times but this occurs in the upper reaches of bull markets when the lay sons of practical experience would argue against the soundness of paying the prevailing prices for common stocks thus we are suggesting only that the aggressive investor recognized the facts of life as it is lived by secondary issues and that they accept the central market levels that are normal for that class as their guide in fixing their own levels for purchase there is a paradox here nevertheless the average well-selected secondary company may be fully as promising as the average industrial leader what the smaller concern lacks in inherent stability it may readily make up in superior possibilities of growth consequently it may appear illogical to many readers to term unintelligent the purchase of such secondary issues at their full enterprise value we think that the strongest logic is that of experience financial history says clearly that the investor may expect satisfactory results on the average from secondary common stocks only if he buys them for less than their value to a private owner that is on a bargain basis the last sentence indicates that this principle relates to the ordinary outside investor anyone who can control a secondary company or who is part of a cohesive group with such control is fully justified in buying the shares on the same basis as if he were investing in a close corporation or other private business 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 at the end of chapter five we commented on the difficulty of making any hard and fast distinction between primary and secondary companies the many common stocks in the boundary area may properly exhibit an intermediate price behavior it would not be illogical for an investor to buy such an issue at a small discount from its indicated or appraisal value on the theory that it is only a small distance away from a primary classification and that it may acquire such a rating unqualifiedly in the not too distant future thus the distinction between primary and secondary issues need not be made too precise for if it were then a small difference in quality must produce a large differential in justified purchase price in saying this we are admitting a middle ground in the classification of common stocks although we councilled against such a middle ground in the classification of investors our reason for this apparent inconsistency is as follows no great harm comes from some uncertainty of viewpoint regarding a single security because such cases are exceptional and not a great deal is at stake in the matter but the investors choices between the defensive or the aggressive status is of major consequence to him and he should not allow himself to be confused or compromised in this basic decision chapter 8 the investor and market fluctuations to the extent that the investors 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 his longer-term bonds may have relatively wide price swings during their lifetimes and his common stock portfolio is almost certain to fluctuate in value over any period of several years the investor should know about these possibilities and should be prepared for them both financially and psychologically he will want to benefit from changes in market levels certainly through an advance in the value of his stock holdings as time goes on and perhaps also by making purchases and sales at advantageous prices this interest on his part is inevitable and legitimate enough but it involves the very real danger that it will lead him into speculative attitudes and activities it is easy for us to tell you not to speculate the hard thing will be for you to follow this advice let us repeat what we said at the outset 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 we shall deal first with the more important subject of price changes in common stocks and pass later to the area of bonds in chapter 3 we supplied a historical survey of the stock market's action over the past hundred years in this section we shall return to that material from time to time in order to see what the past record promises the investor in either the form of long-term appreciation of a portfolio held relatively unchanged through successive rises and declines or in the possibilities of buying near bear market lows and selling not too far below bull market highs market fluctuations as a guide to investment decisions since common stocks even of investment grade are subject to recurrent and wide fluctuations in their prices the intelligent investor should be interested in the possibilities of profiting from these pendulum swings 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 we are convinced that the intelligent investor can derive satisfactory results from pricing of either type we are equally sure that if he places his emphasis on timing in the sense of forecasting he will end up as a speculator and with a speculator's financial results this distinction may seem rather tenuous to the layman and it is not commonly accepted on wall street as a matter of business practice or perhaps a thorough going conviction the stock brokers and the investment services seem wedded to the principle that both investors and speculators in common stocks should devote careful attention to market forecasts the farther one gets from wall street the more skepticism one will find we believe as to the pretensions of stock market forecasting or timing the investor can scarcely take seriously the innumerable predictions which appear almost daily and are his for the asking yet in many cases he pays attention to them and even acts upon them why because he has been persuaded that it is important for him to form some opinion of the future course of the stock market and because he feels that the brokerage or service forecast is at least more dependable than his own we lack space here to discuss in detail the pros and cons of market forecasting a great deal of brain power goes into this field and undoubtedly some people can make money by being good stock market analysts but it is absurd to think that the general public can ever make money out of market forecasts for who will buy when the general public at a given signal rushes to sell out at a profit if you the reader expect to get rich over the years by following some system or leadership in market forecasting you must be expecting to try to do what countless others are aiming at and to be able to do it better than your numerous competitors in the market there is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public of which he is himself apart there is one aspect of the timing philosophy which seems to have escaped everyone's notice timing is of great psychological importance to the speculator because he wants to make his profit in a hurry the idea of waiting a year before his stock moves up is repugnant to him but a waiting period as such is of no consequence to the investor what advantage is that to him in having his money uninvested until he receives some presumably trustworthy signal that the time has come to buy 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 in this respect the famous dow theory for timing purchases and sales has had an unusual history briefly this technique takes its signal to buy from a special kind of breakthrough if the stock averages on the upside and it's selling signal from a similar breakthrough on the downside the calculated not necessarily actual results of using this method showed an almost unbroken series of profits in operations from 1897 to the early 1960s on the basis of this presentation the practical value of the dow theory would have appeared firmly established the doubt if any would apply to the dependability of this published record as a picture of what a dow theorist would actually have done in the market a closer study of the figures indicates that the quality of the results shown by the dow theory changed radically after 1938 a few years after the theory had begun to be taken seriously on wall street its spectacular achievement had been in giving a sell signal at 306 about a month before the 1929 crash and in keeping its followers out of the long bear market until things had pretty well righted themselves at 84 in 1933 but from 1938 on the dow theory operated mainly by taking its practitioners out at a pretty good price but then putting them back in again at a higher price finally 30 years thereafter one would have done appreciably better by just buying and holding the dow jones industrial average.2 in our view based on much study of this problem the change in the dow theory results is not accidental it demonstrates an inherent characteristic of forecasting and trading formulas in the fields of business and finance those formulas that gain adherence and importance do so because they have worked well over a period or sometimes merely because they have been plausibly adapted to the statistical record of the past 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 the popularity of something like the dow theory may seem to credit its own vindication since it would make the market advance or decline by the very action of its followers when a buying or selling signal is given a stampede of this kind is of course much more of a danger than an advantage to the public trader by a low sell high approach we are convinced that the average investor cannot deal successfully with price movements by endeavoring to forecast them can he benefit from them after they have taken place i.t by buying after each major decline and selling out after each major advance the fluctuations of the market over a period of many years prior to 1950 lent considerable encouragement to that idea in fact a classic definition of a shrewd investor was one who bought in a bear market when everyone else was selling and sold out in a bull market when everyone else was buying.if we examine our chart i covering the fluctuations of the standard in poorest composite index between 1900 and 1970 and the supporting figures in table 3 1 p 66 we can readily see why this viewpoint appeared valid until fairly recent years between 1897 and 1949 there were 10 complete market cycles running from bear market low to bull market high and back to bear market low six of these took no longer than four years four ran for six or seven years and won the famous new era cycle of 1921 1932 lasted 11 years the percentage of advance from the lows to highs ranged from 44 to 500 percent with most between about 50 and 100 the percentage of subsequent declines ranged from 24 to 89 with most found between 40 and 50 it should be remembered that a decline of 50 fully offsets a preceding advance of 100 the investor and market fluctuations 193 nearly all the bull markets had a number of well-defined characteristics in common such as one a historically high price level two high price earnings ratios 3 low dividend yields as against bond yields 4 much speculation on margin and 5 many offerings of new common stock issues of poor quality thus to the student of stock market history it appeared that the intelligent investor should have been able to identify the recurrent bear and bull markets to buy in the former and cell in the latter and to do so for the most part at reasonably short intervals of time various methods were developed for determining buying and selling levels of the general market based on either value factors or percentage movements of prices or both but we must point out that even prior to the unprecedented bull market that began in 1949 there were sufficient variations in the successive market cycles to complicate and sometimes frustrate the desirable process of buying low and selling high the most notable of these departures of course was the great bull market of the late 1920s which threw all calculations badly out of gear even in 1949 therefore it was by no means a certainty that the investor could base his financial policies and procedures mainly on the endeavor to buy at low levels in bear markets and to sell out at high levels in bull markets it turned out in the sequel that the opposite was true there 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 patent 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.t 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 standarts formula plans in the early years of the stock market rise that began in 1949.50 considerable interest was attracted to various methods of taking advantage of the stock market s cycles these have been known as formula investment plans.the essence of all such plans except the simple case of dollar averaging is that the investor automatically does some selling of common stocks when the market advances substantially in many of them a very large rise in the market level would result in the sale of all common stock holdings others provided for retention of a minor proportion of equities under all circumstances this approach had the double appeal of sounding logical and conservative and of showing excellent results when applied retrospectively to the stock market over many years in the past unfortunately its vote grew greatest at the very time when it was destined to work least well many of the formula planners found themselves entirely or nearly out of the stock market at some level in the middle 1950s true they had realized excellent profits but in a broad sense the market ran away from them thereafter and their formulas gave them little opportunity to buy back a common stock position there is a similarity between the experience of those adopting the formula investing approach in the early 1950s and those who embraced the purely mechanical version of the dow theory some 20 years earlier in both cases the advent of popularity marked almost the exact moment when the system ceased to work well we have had a like discomfiting experience with our own central value method of determining indicated buying and selling levels of the dow jones industrial average the moral seems to be that any approach to money making in the stock market which can be easily described and followed by a lot of people is by its terms too simple and too easy to last.spinoza s concluding remark applies to wall street as well as to philosophy all things excellent are as difficult as they are rare dot market fluctuations of the investor s portfolio every investor who owns common stocks must expect to see them fluctuate in value over the years the behavior of the dow jones industrial average since our last edition was written in 1964 probably reflects pretty well what has happened to the stock portfolio of a conservative investor who limited his stock holdings to those of large promenent and conservatively financed corporations the overall value advanced from an average level of about 890 to a high of 995 in 1966 and 985 again in 1968 fell to 631 in 1970 and made an almost full recovery to 940 in early 1971. since the individual issues set their high and low marks at different times the fluctuations in the dow jones group as a whole are less severe than those in the separate components we have traced through the price fluctuations of other types of diversified and conservative common stock portfolios and we find that the overall results are not likely to be markedly different from the above in general the shares of second line companies fluctuate more widely than the major ones but this does not necessarily mean that a group of well-established but smaller companies will make a poorer showing over a fairly long period in any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance say 50 or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years. a serious investor is not likely to believe that the day-to-day or even month-to-month fluctuations of the stock market make him richer or poorer but what about the longer-term and wider changes here practical questions present themselves and the psychological problems are likely to grow complicated a substantial rise in the market is at once a legitimate reason for satisfaction and a cause for prudent concern but it may also bring a strong temptation toward imprudent action your shares have advanced good you are richer than you were good but has the price risen too high and should you think of selling or should you kick yourself for not having bought more shares when the level was lower or worst thought of all should you now give way to the bull market atmosphere become infected with the enthusiasm the over-confidence and the greed of the great public of which after all you are apart and make larger and dangerous commitments presented thus in print the answer to the last question is a self-evident no but even the intelligent investor is likely to need considerable willpower to keep from following the crowd it is for these reasons of human nature even more than by calculation of financial gain or loss that we favor some kind of mechanical method for varying the proportion of bonds to stocks in the investor s portfolio the chief advantage perhaps is that such a formula will give him something to do as the market advances he will from time to time make sales out of his stock holdings putting the proceeds into bonds as it declines he will reverse the procedure these activities will provide some outlet for his otherwise two pent-up energies if he is the right kind of investor he will take added satisfaction from the thought that his operations are exactly opposite from those of the crowd business valuations versus stock market valuations the impact of market fluctuations upon the investor s true situation may be considered also from the standpoint of the shareholder as the part owner of various businesses the holder of marketable shares actually has a double status and with it the privilege of taking advantage of either at his choice on the one hand his position is analogous to that of a minority shareholder or silent partner in a private business here his results are entirely dependent on the profits of the enterprise or on a change in the underlying value of its assets he would usually determine the value of such a private business interest by calculating his share of the net worth as shown in the most recent balance sheet on there other hand the common stock investor holds a piece of paper an engraved stock certificate which can be sold in a matter of minutes at a price which varies from moment to moment when the market is open that is and often is far removed from the balance sheet value the development of the stock market in recent decades has made a typical investor more dependent on the course of price quotations and less free than formerly to consider himself merely a business owner the reason is that the successful enterprises in which he is likely to concentrate his holdings sell almost constantly at prices well above their net asset value or book value or balance sheet value in paying these market premiums the investor gives precious hostages to fortune for he must depend on the stock market itself to validate his commitment stocks this is a factor of prime importance in present-day investing and it has received less attention than it deserves the whole structure of stock market quotations contains a built-in contradiction the better a company s record and prospects the less relationship the price of its shares will have to their book value but the greater the premium above book value the less certain the basis of determining its intrinsic value i dot e the more this value will depend on the changing moods and measurements of the stock market thus we reach the final paradox that the more successful the company the greater are likely to be the fluctuations in the price of its shares this really means that in a very real sense the better the quality of a common stock the more speculative it is likely to be at least as compared with the unspectacular middle-grade issues what we have said applies to a comparison of the leading growth companies with the bulk of well-established concerns we exclude from our purview here those issues which are highly speculative because the businesses themselves are speculative the argument made above should explain the often erratic price behavior of our most successful and impressive enterprises our favorite example is the monarch of the mall international business machines the price of its shares fell from 607 to 300 in seven months in 1962-63 after two splits its price fell from 387 to 219 in 1970. similarly xerox and even more impressive earnings gainer in recent decades fell from 171 to 87 in 1962-63 and from 116 to 65 in 1970. these striking losses did not indicate any doubt about the future long-term growth of ibm or xerox they reflected instead a lack of confidence in the premium valuation that the stock market itself had placed on these excellent prospects the previous discussion leads us to a conclusion of practical importance to the conservative investor in common stocks if he is to pay some special attention to the selection of his portfolio it might be best for him to concentrate on issues selling at a reasonably close approximation to their tangible asset value say at not more than one-third above that figure purchases made at such levels or lower may with logic be regarded as related to their company s balance sheet and as having a justification or support independent of the fluctuating market prices the premium overbook value that may be involved can be considered as a kind of extra fee paid for the advantage of stock exchange listing and the marketability that goes with it a caution is needed here a stock does not become a sound investment merely because it can be bought at close to its asset value the investor should demand in addition a satisfactory ratio of earnings to price a sufficiently strong financial position and the prospect that its earnings will at least be maintained over the years this may appear like demanding a lot from a modestly priced stock but the prescription is not hard to fill under all but dangerously high market conditions once the investor is willing to forego a brilliant prospects i.t better than average expected growth he will have no difficulty in finding a wide selection of issues meeting these criteria in our chapters on the selection of common stocks chapters 14 and 15 we shall give data showing that more than half of the dow jones industrial average issues met our asset value criterion at the end of 1970. the most widely held investment of all american telephone and tel dot actually sells below its tangible asset value as we write most of the light and power shares in addition to their other advantages are now early 1972. available at prices reasonably close to their asset values the investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock market fluctuations than those who have paid high multipliers of both earnings and tangible assets as long as the earning power of his holdings remains satisfactory he can give as little attention as he pleases to the vagaries of the stock market more than that at times he can use these vagaries to play the master game of buying low and selling high the a and p example at this point we shall introduce one of our original examples which dates back many years but which has a certain fascination for us because it combines so many aspects of corporate and investment experience it involves the great atlantic and pacific t company here is the story a and p shares were introduced to trading on the curb market now the american stock exchange in 1929 and sold as high as 494 by 1932 they had declined to 104 although the company s earnings were nearly as large in that generally catastrophic year as previously in 1936 the range was between 111 and 131 then in the business recession and bear market of 1938 the shares fell to a new low of 36. that price was extraordinary it meant that the preferred and common were together selling for 126 million dollars although the company had just reported that it held 85 million dollars in cash alone and a working capital or net current assets of 134 million dollars and p was the largest retail enterprise in america if not in the world with a continuous and impressive record of large earnings for many years yet in 1938 this outstanding business was considered on wall street to be worth less than its current assets alone which means less as a going concern than if it were liquidated why first because there were threats of special taxes on chain stores second because net profits had fallen off in the previous year and third because the general market was depressed the first of these reasons was an exaggerated and eventually groundless fear the other two were typical of temporary influences let us assume that the investor had bought a and p common in 1937 at say 12 times its five-year average earnings or about 80. we are far from asserting that the ensuing decline to 36 was of no importance to him he would have been well advised to scrutinize the picture with some care to see whether he had made any miscalculations but if the results of his study were reassuring as they should have been he was entitled then to disregard the market decline as a temporary vagary of finance unless he had the funds and the courage to take advantage of it by buying more on the bargain basis offered sequel and reflections the following year 1939 a and p shares advanced to 1171 question mark 2 or 3 times the low price of 1938 and well above the average of 1937. such a turnabout in the behavior of common stocks is by no means uncommon but in the case of a and p it was more striking than most in the years after 1949 the grocery chain s shares rose with the general market until in 1961 the split up stock 10 for 1 reached a high of 701 question mark 2 which was equivalent to 705 for the 1938 shares this price of 701 question mark 2 was remarkable for the fact it was 30 times the earnings of 1961. such a price earnings ratio which compares with 23 times for the dow jones industrial average in that year must have implied expectations of a brilliant growth in earnings this optimism had no justification in the company s earnings record in the preceding years and it proved completely wrong instead of advancing rapidly the course of earnings in the ensuing period was generally downward the year after the 701 question mark too high the price fell by more than half to 34. but this time the shares did not have the bargain quality that they showed at the low quotation in 1938. after varying sorts of fluctuations the price fell to another low of 211 question mark 2 in 1970 and 18 in 1972 having reported the first quarterly deficit in its history we see in this history how wide can be the vicissitudes of a major american enterprise in little more than a single generation and also with what miscalculations and excesses of optimism and pessimism the public has valued its shares in 1938 the business was really being given away with no takers in 1961 the public was clamoring for the shares at a ridiculously high price after that came a quick loss of half the market value and some years later a substantial further decline in the meantime the company was to turn from an outstanding to a mediocre earnings performer its profit in the boom year 1968 was to be less than in 1958 it had paid a series of confusing small stock dividends not warranted by the current additions to surplus and so forth a p was a larger company in 1961 and 1972 than in 1938 but not as well run not as profitable and not as attractive there are two chief morals to this story the first is that the stock market often goes far wrong and sometimes an alert and corer jess investor can take advantage of its patent errors the other is that most businesses change in character and quality over the years sometimes for the better perhaps more often for the worse the investor need not watch his company's performance like a hawk but he should give it a good hard look from time to time let us return to our comparison between the holder of marketable shares and the man with an interest in a private business we have said that the former has the option of considering himself merely as the part owner of the various businesses he has invested in or as the holder of shares which are saleable at any time he wishes at their quoted market price but note this important fact the true investor scarcely ever is forced to sell his shares and at all other times he is free to disregard the current price quotation he need pay attention to it and act upon it only to the extent that it suits his book and no more thus the investor who permits himself to be stampeded or unduly were ride by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage that man would be better off if his stocks had no market quotation at all for he would then be spared the mental anguish caused him by other person's mistakes of judgment. incidentally a widespread situation of this kind actually existed during the dark depression days of 1009 1933 there was then a psychological advantage in owning business interests that had no quoted market for example people who owned first mortgages on real estate that continued to pay interest were able to tell themselves that their investments had kept their full value there being no market quotations to indicate otherwise on the other hand many listed corporation bonds of even better quality and greater underlying strength suffered severe shrinkages in their market quotations thus making their owners believe they were growing distinctly poorer in reality the owners were better off with the listed securities despite the low prices of these for if they had wanted to or were compelled to they could at least have sold the issues possibly to exchange them for even better bargains or they could just as logically have ignored the market s action as temporary and basically meaningless but it is self-deception to tell yourself that you have suffered no shrinkage in value merely because your securities have no quoted market at all returning to ra and p shareholder in 1938 we assert that as long as he held on to his shares he suffered no loss in their price decline beyond what his own judgment may have told him was occasioned by a shrinkage in their underlying or intrinsic value if no such shrinkage had occurred he had a right to expect that in due course the market quotation would return to the 1937 level or better as in fact it did the following year in this respect his position was at least as good as if he had owned an interest in a private business with no quoted market for its shares for in that case too he might or might not have been justified in mentally lopping off part of the cost of his holdings because of the impact of the 1938 recession depending on what had happened to his company critics of the value approach to stock investment argue that listed common stocks cannot properly be regarded or appraised in the same way as an interest in a similar private enterprise because the presence of an organized security market injects into equity ownership the new and extremely important attribute of liquidity dot but what this liquidity really means is first that the investor has the benefit of the stock market s daily and changing appraisal of his holdings for whatever that appraisal may be worth and second that the investor is able to increase or decrease his investment at the market s daily figure if he chooses thus the existence of a quoted market gives the investor certain options that he does not have if his security is unquoted but it does not impose the current quotation on an investor who prefers to take his idea of value from some other source let us close this section with something in the nature of a parable imagine that in some private business you own a small chair that cost you one thousand dollars 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 one thousand dollars 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 summary the most realistic distinction between the investor and the speculator is found in their attitude towards stock market movements the speculator s primary interest lies in anticipating and profiting from market fluctuations the investor s primary interest lies in acquiring and holding suitable securities at suitable prices market movements are important to him in a practical sense because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell it is far from certain that the typical investor should regularly hold off buying until low market levels appear because this may involve a long wait very likely the loss of income and the possible missing of investment opportunities on the whole it may be better for the investor to do his stock buying whenever he has money to put in stocks except when the general market level is much higher than can be justified by well-established standards of value if he wants to be shrewd he can look for the ever-present bargain opportunities in individual securities aside from forecasting the movements of the general market much effort and ability are directed on wall street toward selecting stocks or industrial groups that in matter of price will do better than the rest over a fairly short period in the future logical as this endeavor may seem we do not believe it is suited to the needs or temperament of the true investor particularly since he would be competing with a large number of stock market traders and first-class financial analysts who are trying to do the same thing as in all other activities that emphasize price movements first and underlying values second the work of many intelligent minds constantly engaged in this field tends to be self-neutralizing and self-defeating over the years the investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances he should always remember that market quotations are there for his convents either to be taken advantage of or to be ignored he should never buy a stock because it has gone up or sell one because it has gone down he would not be far wrong if this motto read more simply never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop dot an added consideration something should be said about the significance of average market prices as a measure of managerial competence the shareholder judges whether his own investment has been successful in terms both of dividends received and of the long range trend of the average market value the same criteria should logically be applied in testing the effectiveness of a company s management and the soundness of its attitude toward the owners of the business this statement may sound like a truism but it needs to be emphasized for as yet there is no accepted technique or approach by which management is brought to the bar of market opinion on the contrary managements have always insisted that they have no responsibility of any kind for what happens to the market value of their shares it is true of course that they are not accountable for those fluctuations in price which as we have been insisting bear no relationship to underlying conditions and values but it is only the lack of alertness and intelligence among the rank and file of shareholders that permits this immunity to extend to the entire realm of market quotations including the permanent establishment of a depreciated and unsatisfactory price level good managements produce a good average market price and bad managements produce bad market prices fluctuations in bond prices the investor should be aware that even though safety of its principle and interest may be unquestioned a long-term bond could vary widely in market price in response to changes in interest rates in table 8 1 we give data for various years back to 1902 covering yields for high-grade corporate and tax-free issues as individual illustrations we add the price fluctuations of two representative railroad issues for a similar period these are the atchison topeka and santa fe general mortgage fours due 1995 for generations one of our premier non-callable bond issues and the northern pacific re threes due 2047 originally a 150-year maturity exclamation mark long a typical bar-rated bond because of their inverse relationship the low yields correspond to the high prices and vice versa the decline in the northern pacific threes in 1940 represented mainly doubts as to the safety of the issue it is extraordinary that the price recovered to an all-time high in the next few years and then lost two-thirds of its price chiefly because of the rise in general interest rates there have been startling variations as well in the price of even the highest grade bonds in the past 40 years note that bond prices do not fluctuate in the same inverse proportion as the calculated yields because their fixed maturity value of 100 exerts a moderating influence however for very long maturities as in our northern pacific example prices and yields change at close to the same rate since 1964 record movements in both directions have taken place in the high grade bond market taking prime municipals tax-free as an example their yield more than doubled from 3.2 in january 1965 to 7 in june 1970. their price index declined correspondingly from 110.8 to 67.5 in mid 1970 the yields on high-grade long-term bonds were higher than at any time in the nearly 200 years of this country s economic history 25 years earlier just before our protracted bull market began bond yields were at their lowest point in history long-term municipals returned as little as 1 and industrials gave 2.40 compared with the 41 question mark 2 to 5 formerly considered normal.those of us with a long experience on wall street had seen newton s law of action and reaction equal and opposite work itself out repeatedly in the stock market the most noteworthy example being the rise in the dow jones industrial average from 64 in 1921 to 381 in 1929 followed by a record collapsed to 41 in 1932 but this time the widest pendulum swings took place in the usually stayed and slow-moving array of high-grade bond prices and yields moral nothing important on wall street can be counted on to occur exactly in the same way as it happened before this repairer sends the first half of our favorite dictum the more it changes the more it s the same thing dot if it is virtually impossible to make worthwhile predictions about the price movements of stocks it is completely impossible to do so for bonds in the old days at least one could often find a useful clue to the coming end of a bull or bear market by studying the prior action of bonds but no similar clues were given to a coming change in interest rates and bond prices hence the investor must choose between long-term and short-term bond investments on the basis chiefly of his personal preferences if he wants to be certain that the market values will not decrease his best choices are probably u.s savings bonds series e or h which were described above p 93 either issue will give him a five percent yield after the first year the series e for up to 55 question marks six years the series h for up to 10 years with a guaranteed resale value of cost or better if the investor wants the 7.5 now available on good long-term corporate bonds or the 5.3 percent on tax-free municipals he must be prepared to see them fluctuate in price banks and insurance companies have the privilege of valuing high-rated bonds of this type on the mathematical basis of amortized cost comma which disregards market prices it would not be a bad idea for the individual investor to do something similar the price fluctuations of convertible bonds and preferred stocks are the resultant of three different factors one variations in the price of the related common stock 2. variations in the credit standing of the company and 3. variations in general interest rates a good many of the convertible issues have been sold by companies that have credit ratings well below the best.3 some of these were badly affected by the financial squeeze in 1970. as a result convertible issues as a whole have been subjected to triply unsettling influences in recent years and price variations have been unusually wide in the typical case therefore the investor would delude himself if he expected to find in convertible issues that ideal combination of the safety of a high-grade bond and price protection plus a chance to benefit from an advance in the price of the common this may be a good place to make a suggestion about the long-term bond of the future.why should not the effects of changing interest rates be divided on some practical and equitable basis between the borrower and the lender one possibility would be to sell long-term bonds with interest payments that vary with an appropriate index of the going rate the main results of such an arrangement would be 1. the investor s bond would always have a principal value of about 100 if the company maintains its credit rating but the interest received will vary say with the rate offered on conventional new issues too the corporation would have the advantages of long-term debt being spared problems and costs of frequent renewals of refinancing but its interest costs would change from year to year.4 over the past decade the bond investor has been confronted by an increasingly serious dilemma shall he choose complete stability of principal value but with varying and usually low short-term interest rates or shall he choose a fixed interest income with considerable variations usually downward it seems in his principal value it would be good for most investors if they could compromise between these extremes and be assured that neither their interest return or their principal value will fall below a stated minimum over say a 20-year period this could be arranged without great difficulty in an appropriate bond contract of a new form important note in effect the u.s government has done a similar thing in its combination of the original savings bonds contracts with their extensions at higher interest rates the suggestion we make here would cover a longer fixed investment period than the savings bonds and would introduce more flexibility in the interest rate provisions it is hardly worthwhile to talk about non-convertible preferred stocks since their special tax status makes the safe ones much more desirable holdings by corporations e.g insurance companies than by individuals the poorer quality ones almost always fluctuate over a wide range percentage-wise not too differently from common stocks we can offer no other useful remark about them table 16 2 below p 406 gives some information on the price changes of lower grade non-convertible preference between december 1968 and december 1970 the average decline was 17 against 11.3 for the s and p composite index of common stocks chapter 9 investing in investment funds one course open to the defensive investor is to put his money into investment company shares those that are redeemable on demand by the holder at net asset value are commonly known as mutual funds or open end funds most of these are actively selling additional shares through a core of salesmen those with non-redeemable shares are called closed-end companies or funds the number of their shares remains relatively constant all of the funds of any importance are registered with the securities and exchange commission sec and are subject to its regulations and controls the industry is a very large one at the end of 1970 there were 383 funds registered with the sec having assets totaling 54.60 bill lions of these 356 companies with 50 dollars and 60 cents billions were mutual funds and 27 companies with four dollars billions were closed and dot there are different ways of classifying the funds one is by the broad division of their portfolio they are balanced funds if they have a significant generally about one-third component of bonds or stock funds if their holdings are nearly all common stocks there are some other varieties here such as bond funds comma hedge funds comma letter stock funds comma etc another is by their objectives as their primary aim is for income price stability or capital appreciation growth another distinction is by their method of sale load funds add a selling charge generally about nine percent of asset value and minimum purchases to the value before charge.1 others known as no load funds make no such charge the managements are content with the usual investment council fees for handling the capital since they cannot pay salesman s commissions the size of the no load funds tends to be on the low side.the buying and selling prices of the closed end funds are not fixed by the companies but fluctuate in the open market as does the ordinary corporate stock most of the companies operate under special provisions of the income tax law designed to relieve the shareholders from double taxation on their earnings in effect the funds must pay out to ali all their ordinary income i.t dividends and interest received less expenses in addition they can pay out their realized long-term profits on sales of investments in the form of capital gains dividends which are treated by the shareholder as if they were his own security profits there is another option here which we omit to avoid clutter nearly all the funds have but one class of security outstanding a new wrinkle introduced in 1967 divides the capitalization into a preferred issue which will receive all the ordinary income and a capital issue or common stock which will receive all the profits on security sales these are called dual purpose funds dot many of the companies that state their primary aim is for capital gains concentrate on the purchase of the so-called growth stocks comma and they often have the word growth in their name some specialize in a designated area such as chemicals aviation overseas investments this is usually indicated in their titles the investor who wants to make an intelligent commitment in funds shares has thus a large and somewhat bewildering variety of choices before him not too different from those offered in direct investment in this chapter we shall deal with some major questions viz 1. is there any way by which the investor can assure himself of better than average results by choosing the right funds subction what about the performance funds 2. if not how can he avoid choosing funds that will give him worse than average results 3. can he make intelligent choices between different types of funds e.g balanced versus all stock open end versus closed end load versus no load investment fund performance as a whole before trying to answer these questions we should say something about the performance of the fund industry as a whole has it done a good job for its shareholders in the most general way how have fund investors fed us against those who made their investments directly we are quite certain that the funds in the aggregate have served a useful purpose they have promoted good habits of savings and investment they have protected countless individuals against costly mistakes in the stock market they have brought their participants income and profits commensurate with the overall returns from common stocks on a comparative basis we would hazard the guess that the average individual who put his money exclusively in investment fund shares in the past 10 years has fared better than the average person who made his common stock purchases directly the last point is probably true even though the actual performance of the funds seems to have been no better than that of common stocks as a whole and even though the cost of investing in mutual funds may have been greater than that of direct purchases the real choice of the average individual has not been between constructing and acquiring a well-balanced common stock portfolio or doing the same thing a bit more expensively by buying into the funds more likely his choice has been between succumbing to the wiles of the doorbell ringing mutual fund salesman on the one hand as against succumbing to the even wiley or and much more dangerous peddlers of second and third-rate new offerings we cannot help thinking too that the average individual who opens a brokerage account with the idea of making conservative common stock investments is likely to find himself beset by untoward influences in the direction of speculation and speculative losses these temptations should be much less for the mutual fund buyer but how have the investment funds performed as against the general market this is a somewhat controversial subject but we shall try to deal with it in simple but adequate fashion table 9-1 gives some calculated results for 1961 1970 of our 10 largest stock funds at the end of 1970 but choosing only the largest one from each management group it summarizes the overall return of each of these funds for 1961 1965 1966 1907 and for the single years 1969 and 1970 we also give average results based on the sum of one share of each of the 10 funds these companies had combined assets of over 15 billion dollars at the end of 1969 or about one-third of all the common stock funds thus they should be fairly representative of the industry as a whole in theory there should be a bias in this list on the side of better than industry performance since these bet tour companies should have been entitled to more rapid expansion than the others but this may not be the case in practice some interesting facts can be gathered from this table first we find that the overall results of these 10 funds for 1961 1970 were not appreciably different from those of the standard and poor s 500 stock composite average or the s and p 425 industrial stock average but they were definitely better than those of the dow jones industrial average this raises the intriguing question as to why the 30 giants in the dow jones industrial average did worse than the much more numerous and apparently rather miscellaneous list used by standard and poorest a second point is that the fund's aggregate performances against the s and p index has improved somewhat in the last five years compared with the preceding five the funds gain ran a little lower than s and ps in 1961 1965 and a little higher than s and ps in 1966 1970. the third point is that a wide difference exists between the results of the individual funds we do not think the mutual fund industry can be criticized for doing no better than the market as a whole their managers and their professional competitors administer so large a portion of all marketable common stocks that what happens to the market as a whole must necessarily happen approximately to the sum of their funds note that the trust assets of insured commercial banks included 181 billion dollars of common stocks at the end of 1969 if we add to this the common stocks in accounts handled by investment advisors plus the 56 billion dollars of mutual and similar funds we must conclude that the combined decisions of these professionals pretty well determine the movements of the stock averages and that their movement of the stock averages pretty well determines the fund's aggregate results are the better than average funds and can the investor select these so as to obtain superior results for himself obviously all investors could not do this since in that case we would soon be back where we started with no one doing better than anyone else let us consider the question first in a simplified fashion why shouldn't the investor find out what fund has made the best showing of the lot over a period of sufficient years in the past assume from this that its management is the most capable and will therefore do better than average in the future and put his money in that fund this idea appears the more practicable because in the case of the mutual funds he could obtain this most capable management without paying any special premium for it as against the other funds by contrast among non-investment corporations the best managed companies sell at correspondingly high prices in relation to their current earnings and assets the evidence on this point has been conflicting over the years but our table 9 1 covering the 10 largest funds indicates that the results shown by the top five performers of 1961 1965 carried over on the whole through 1966 1970 even though two of this set did not do as well as two of the other five our studies indicate that the investor in mutual fund shares may properly consider comparative performance over a period of years in the past say at least five provided the data do not represent a large net upward movement of the market as a whole in the latter case spectacularly favorable results may be achieved in unorthodox ways as will be demonstrated in our following section on performance funds such results in themselves may indicate only that the fund managers are taking undue speculative risks and getting away with same for the time being performance funds one of the new phenomena of recent years was the appearance of the cult of performance in the management of investment funds and even of many trust funds we must start this section with the important disclaimer that it does not apply to the large majority of well-established funds but only to a relatively small section of the industry which has attracted a disproportionate amount of attention the story is simple enough some of those in charge set out to get much better than average or dow jones industrial average results they succeeded in doing this for a while garnering considerable publicity and additional funds to manage the aim was legitimate enough unfortunately it appears that in the context of investing really sizable funds the aim cannot be accomplished without incurring sizeable risks and in a comparatively short time the risks came home to roost several of the circumstances surrounding the performance phenomenon caused dominance headshaking by those of us whose experience went far back even to the 1920s and his views for that very reason were considered old-fashioned and irrelevant to this second new era in the first place and on this very point nearly all these brilliant performers were young men in their 30s and 40s whose direct financial experience was limited to the all but continuous bull market of 1948 to 1968. secondly they often acted as if the definition of a sound investment was a stock that was likely to have a good rise in the market in the next few months this led to large commitments in new ventures at prices completely disproportionate to their assets or recorded earnings they could be justified only by a combination of naive help in the future accomplishments of these enterprises with an apparent shrewdness in exploiting the speculative enthusiasms of the uninformed and greedy public this section will not mention people's names but we have every reason to give concrete examples of companies the performance fund most in the public's eye was undoubtedly manhattan fund incorporated organized at the end of 1965 its first offering was of 27 million shares at 9.25 to 10 per share the company started out with 247 million dollars of capital its emphasis was of course on capital gains most of its funds were invested in issues selling at high multipliers of current earnings paying no dividends or very small ones with a large speculative following and spectacular price movements the fund showed an overall gain of 38.6 in 1967 against 11 for the s and p composite index but thereafter its performance left much to be desired as is shown in table 9 2. the portfolio of manhattan fund at the end of 1969 was unorthodox to say the least it is an extraordinary fact that two of its largest investments were in companies that filed for bankruptcy within six months thereafter and a third faced creditors actions in 1971. it is another extraordinary fact that shares of at least one of these doomed companies were bought not only by investment funds but by university endowment funds the trust departments of large banking institutions and the like a third extraordinary fact was that the founder manager of manhattan fund sold his stock in a separately organized management company to another large concern for over 20 million dollars in its stock at that time the management company sold had less than 1 million dollars in assets this is undoubtedly one of the greatest disparities of all times between the results for the manager and the managees a book published at the end of 1969 2 provided profiles of 19 men who are tops at the demanding game of managing billions of dollars of other people's money the summary told us further that they are young some earn more than a million dollars a year they are a new financial breed they all have a total fascination with the market and a spectacular knack for coming up with winners a fairly good idea of the accomplishments of this top group can be obtained by examining the published results of the funds they manage such results are available for funds directed by 12 of the 19 persons described in the money managers typically enough they showed up well in 1966 and brilliantly in 1967. in 1968 their performance was still good in the aggregate but mixed as to individual funds in 1969 they all showed losses with only one managing to do a bit better than the s p composite index in 1970 their comparative performance was even worse than in 1969. we have presented this picture in order to point a moral which perhaps can best be expressed by the old french proverb plus sir change plus quest lame chose bright energetic people usually quite young have promised to perform miracles with other people's money since time immemorial they have usually been able to do it for a while or at least to appear to have done it and they have inevitably brought losses to their public in the end about a half century ago the miracles were often accompanied by flagrant manipulation misleading corporate reporting outrageous capitalization structures and other semi-fraudulent financial practices all this brought on an elaborate system of financial controls by the sec as well as a cautious attitude toward common stocks on the part of the general public the operations of the new money managers in 1965 to 1969 came a little more than one full generation after the shenanigans of 1926-1929.the specific malpractices banned after the 1929 crash were no longer resorted to they involved the risk of jail sentences but in many corners of wall street they were replaced by newer gadgets and gimmicks that produced very similar results in the end outright manipulation of prices disappeared but there were many other methods of drawing the gullible public's attention to the profit possibilities in hot issues blocks of letter stock 3 could be bought well below the quoted market price subject to undisclosed restrictions on their sale they could immediately be carried in the reports at their full market value showing a lovely and illusory profit and so on it is amazing how in a completely different atmosphere of regulation and prohibitions wall street was able to duplicate so much of the excesses and errors of the 1920s no doubt there will be new regulations and new prohibitions the specific abuses of the late 1960s will be fairly adequately banned from wall street but it is probably too much to expect that the urge to speculate will ever disappear or that the exploitation of that urge can never be abolished it is part of the armament of the intelligent investor to know about these extraordinary popular delusions for and to keep as far away from them as possible the picture of most of the performance funds is a poor one if we start after their spectacular record in 1967. with the 1967 figures included their overall showing is not at all disastrous on that basis one of the money managers operators did quite a bit better than the s and p composite index 3 did distinctly worse and 6 did about the same let us take as a check another group of performance funds the 10 that made the best showing in 1967 with gains ranging from 84 up to 301 percent in that single year of these four gave a better overall four-year performance than the s and p index if the 1967 gains are included and two xld index in 1968-1970 none of these funds was large and the average size was about 60 million dollars thus there is a strong indication that smaller size is a necessary factor for obtaining continued outstanding results the foregoing account contains the implicit conclusion that there may be special risks involved in looking for superior performance by investment fund managers all financial experience up to now indicates that large funds soundly managed can produce at best only slightly better than average results over the years if they are unsoundly managed they can produce spectacular but largely illusory profits for a while followed inevitably by kalami taos losses there have been instances of funds that have consistently outperformed the market averages for say 10 years or more but these have been scarce exceptions having most of their operations in specialized fields with self-imposed limits on the capital employed and not actively sold to the public closed end versus open end funds almost all the mutual funds or open-end funds which offer their holders the right to cash in their shares at each day's valuation of the portfolio have a corresponding machinery for selling new shares by this means most of them have grown in size over the years the closed end companies nearly all of which were organized a long time ago have a fixed capital structure and thus have diminished in relative dollar importance open end companies are being sold by many thousands of energetic and persuasive salesmen the closed end shares have no one especially interested in distributing them consequently it has been possible to sell most mutual funds to the public at a fixed premium of about nine percent above net asset value to cover salesman's commissions etc while the majority of close end shares have been consistently obtainable at less than their asset value this price discount has vied among individual companies and the average discount for the group as a whole has also varied from one date to another figures on this point for 1961 to 1970 are given in table 9 3. it does not take much rudeness to suspect that the lower relative price for closed enders against open end shares has very little to do with the difference in the overall investment results between the two groups that this is true is indicated by the comparison of the annual results from 1961 to 1970 of the two groups included in table 9-3 thus we arrive at one of the few clearly evident rules for investors choices if you want to put money in investment funds buy a group of closed n shares at a discount of say 10 to 15 from asset value instead of paying a premium of about 9 above asset value for shares of an open end company assuming that the future dividends and changes in asset values continue to be about the same for the two groups you will thus obtain about one fifth more for your money from the closed end shares the mutual fund salesman will be quick to counter with the argument ah but if you own closed 10 shares you can never be sure what price you can sell them for the discount can be greater than it is today and you will suffer from the wider spread with our shares you are guaranteed the right to turn in your shares at 100 of asset value nevertheless let us examine this argument a bit it will be a good exercise in logic and plain common sense question assuming that the discount on closed end shares does widen how likely is it that you will be worse off with those shares than with an otherwise equivalent purchase of open end shares this calls for a little arithmetic assume that investor buys some open-end shares at 109 of asset value and investor b buys closed 10 shares at 85 thereof plus 11 halves of a percent commission both sets of shares earn and pay 30 of this asset value in say four years and end up with the same value as at the beginning investor redeems his shares at one hundred percent of value losing the 9 premium he paid his overall return for the period is 30 less 9 or 21 on asset value this in turn is 19 on his investment how much must investor b realize on his closed 10 shares to obtain the same return on his investment as investor a the answer is 73 or a discount of 27 from asset value in other words the closed end man could suffer a widening of 12 points in the market discount about double before his return would get down to that of the open end investor an adverse change of this magnitude has happened rarely if ever in the history of closed end shares hence it is very unlikely that you will obtain a lower overall return from a representative closed end company bought at a discount if its investment performance is about equal to that of a representative mutual fund if a small load or no load fund is substituted for one with the usual 81 halves of a percent load the advantage of the closed end investment is of course reduced but it remains an advantage the fact that a few closed-end funds are selling at premiums greater than the true 9 charge on most mutual funds introduces a separate question for the investor do these premium companies enjoy superior management of sufficient proven worth to warrant their elevated prices if the answer is sought in the comparative results for the past 5 or 10 years the answer would appear to be no three of the six premium companies have mainly foreign investments a striking feature of these is the large variation in prices in a few years time at the end of 1971 sold at only one quarter of its high another at a third another at less than half if we consider the three domestic companies selling above asset value we find that the average of their 10-year overall returns was somewhat better than that of 10 discount funds but the opposite was true in the last five years a comparison of the 1961-1970 record of lehman corporation and of general american investors two of our oldest and largest closed end companies is given in table nine five one of these sold 14 above and the other 7.6 below its net asset value at the end of 1970. the difference in price to net asset relationships did not appear warranted by these figures investment in balanced funds the 23 balanced funds covered in the wiesenberger report had between 25 and 59 of their assets in preferred stocks and bonds the average being just 40 the balance was held in common stocks it would appear more logical for the typical investor to make his bond type investments directly rather than to have them form part of a mutual fund commitment the average income return shown by these balanced funds in 1970 was only 3.9 percent per annum on asset value or say 3.6 on the offering price the better choice for the bond component would be the purchase of united states savings bonds or corporate bonds rated a or better or tax-free bonds for the investor's bond portfolio chapter 10. the investor and his advisors the investment of money in securities is unique among business operations in that it is almost always based in some degree on advice received from others the great bulk of investors aromats naturally they feel that in choosing their securities they can profit by professional guidance yet there are peculiarities inherent in the very concept of investment advice if the reason people invest is to make money then in seeking advice they are asking others to tell them how to make money that idea has some element of naivete businessmen seek professional advice on various elements of their business but they do not expect to be told how to make a profit that is their own bailiwick when they or non-business people rely on others to make investment profits for them they are expecting a kind of result for which there is no true counterpart in ordinary business affairs if we assume that there are normal or standard income results to be obtained from investing money in securities then the role of the advisor can be more readily established he will use his superior training and experience to protect his clients against mistakes and to make sure that they obtain the results to which their money is entitled it is when the investor demands more than an average return on his money or when his advisor undertakes to do better for him that the question arises whether more is being asked or promised than is likely to be delivered advice on investments may be obtained from a variety of sources these include one a relative or friend presumably no legible insecurities 2. a local commercial banker 3 a brokerage firm or investment banking house 4. a financial service or periodical and five an investment counsellor the miscellaneous character of this list suggests that no logical or systematic approach in this matter has crystallized as yet in the minds of investors certain common sense considerations relate to the criterion of normal or standard results mentioned above our basic thesis is this if the investor is to rely chiefly on the advice of others in handling his funds then either he must limit himself and his advisers strictly to standard conservative and even unimaginative forms of investment or he must have an unusually intimate and favorable knowledge of the person who is going to direct his funds into other channels but if the ordinary business or professional relationship exists between the investor and his advisors he can be receptive to less conventional suggestions only to the extent that he himself has grown in knowledge and experience and has therefore become competent to pass independent judgment on the recommendations of others he has then passed from the category of defensive or unenterprising investor into that of aggressive or enterprising investor investment council and trust services of banks the truly professional investment advisors that is the well-established investment council firms who charge substantial annual fees are quite modest in their promises and pretensions for the most part they place their clients funds in standard in terrorist and dividend-paying securities and they rely mainly on normal investment experience for their overall results in the typical case it is doubtful whether more than 10 of the total fund is ever invested in securities other than those of leading companies plus government bonds including state and municipal issues nor do they make a serious effort to take advantage of swings in the general market the leading investment council firms make no claim to being brilliant they do pride themselves on being careful conservative and competent their primary aim is to conserve the principal value over the years and produce a conservatively acceptable rate of income any accomplishment beyond that and they do strive to better the goal they regard in the nature of extra service rendered perhaps their chief value to their clients lies in shielding them from costly mistakes they offer as much as the defensive investor has the right to expect from any councillor serving the general public what we have said about the well-established investment council firms applies generally to the trust and advisory services of the larger banks financial services the so-called financial services are organizations that send out uniform bulletins sometimes in the form of telegrams to their subscribers the subjects covered may include the state and prospects of business the behavior and prospect of the securities markets and information and advice regarding individual issues there is often an inquiry department which will answer case students affecting an individual subscriber the cost of the service average is much less than the fee that investment councillors charge their individual clients some organizations notably babson's and standard and poor's operate on separate levels as a financial service and as investment council incidentally other organizer nations such as scudder stevens and clark operate separately as investment council and as one or more investment funds the financial services direct themselves on the whole to a quite different segment of the public than do the investment council firms the latter's clients generally wish to be relieved of bother and the need for making decisions the financial services offer information and guidance to those who are directing their own financial affairs or are themselves advising others many of these services confine themselves exclusively or nearly so to forecasting market movements by various technical methods we shall dismiss these with the observation that their work does not concern investors as the term is used in this book on the other hand some of the best known such as moody's investment service and standard and pause are identified with statistical organizations that compile the voluminous statistical data that form the basis for all serious security analysis these services have a varied clientele ranging from the most conservative-minded investor to the rankest speculator as a result they must find it difficult to adhere to any clear-cut or fundamental fellow sophie in arriving at their opinions and recommendations an old established service of the type of moody's and the others must obviously provide something worthwhile to a broad class of investors what is it basically they address themselves to the matters in which the average active investor speculator is interested and their views on these either command some measure of authority or at least appear more reliable than those of the unaided client for years the financial services have been making stock market forecasts without anyone taking this activity very seriously like everyone else in the field they are sometimes right and sometimes wrong wherever possible they hedge their opinions so as to avoid the risk of being proved completely wrong there is a well-developed art of delphic phrasing that adjusts itself successfully to whatever the future brings in our view perhaps a prejudiced one this segment of their work has no real significance except for the light it throws on human nature in the securities markets nearly everyone interested in common stocks wants to be told by someone else what he thinks the market is going to do the demand being there it must be supplied their interpretations and forecasts of business conditions of course are much more authoritative and informing these are an important part of the great body of economic intelligence which is spread continuously among buyers and sellers of securities and tends to create fairly rational prices for stocks and bonds under most circumstances undoubtedly the material published by the financial services adds to the store of information available and fortifies the investment judgment of their clients it is difficult to evaluate their recommendations of individual securities each service is entitled to be judged separately and the verdict could properly be based only on an elaborate and inclusive study covering many years in our own experience we have noted among them a pervasive attitude which we think tends to impair what could otherwise be more useful advisory work this is their general view that a stock should be bought if the near-term prospects of the business are favorable and should be sold if these are unfavorable regardless of the current price such a superficial principle often prevents the services from doing the sound analytical job of which their staffs are capable namely to ascertain whether a given stock appears over or undervalued at the current price in the light of its indicated long-term future earning power the intelligent investor will not do his buying and selling solely on the basis of recommendations received from a financial service once this point is established the role of the financial service then becomes the useful one of supplying information and offering suggestions advice from brokerage houses probably the largest volume of information and advice to the security-owning public comes from stockbrokers these are members of the new york stock exchange and of other exchanges who execute buying and selling orders for a standard commission practically all the houses that deal with the public maintain a statistical or analytical department which answers inquiries and makes recommendations a great deal of analytical literature some of it elaborate and expensive is distributed gratis to the firm's customers more impressively referred to as clients a great deal is at stake in the innocent appearing question whether customers or clients is the more appropriate name a business has customers a professional person or organization has clients the wall street brokerage fraternity has probably the highest ethical standards of any business but it is still feeling its way toward the standards and standing of a true profession in the past wall street has thrived mainly on speculation and stock market speculators as a class were almost certain to lose money hence it has been logically impossible for brokerage houses to operate on a thoroughly professional basis to do that would have required them to direct their efforts toward reducing rather than increasing their business the farthest that certain brokerage houses have gone in that direction and could have been expected to go is to refrain from inducing or encouraging anyone to speculate such houses have confined themselves to executing orders given them to supplying financial information and analyzes and to rendering opinions on the investment merits of securities thus in theory at least they are devoid of all responsibility for either the profits or the losses of their speculative customers most stock exchange houses however still adhere to the old-time slogans that they are in business to make commissions and that the way to succeed in business is to give the customers what they want since the most profitable customers want speculative advice and suggestions the thinking and activities of the typical firm are pretty closely geared to day-to-day trading in the market thus it tries hard to help its customers make money in a field where they are condemned almost by mathematical law to lose in the end by this we mean that the speculative part of their operations cannot be profitable over the long run for most brokerage house customers but to the extent that their operations resemble true investing they may produce investment gains that more than offset the speculative losses the investor obtains advice and information from stock exchange houses through two types of employees now known officially as customers brokers or account executives and financial analysts the customers broker also called a registered representative formerly bore the less dignified title of customers man today he is for the most part an individual of good character and considerable knowledge of securities who operates under a rigid code of right conduct nevertheless since his business is to earn kim as sons he can hardly avoid being speculation-minded thus the security buyer who wants to avoid being influenced by speculative considerations will ordinarily have to be careful and explicit in his dealing with his customers broker he will have to show clearly by word and deed that he is not interested in anything faintly resembling a stock market tip once the customers broker understands clearly that he has a real investor on his hands he will respect this point of view and cooperate with it the financial analyst formerly known chiefly as security analyst is a person of particular concern to the author who has been one himself for more than five decades and has helped educate countless others at this stage we refer only to the financial analysts employed by brokerage houses the function of the security analyst is clear enough from his title it is he who works up the detailed studies of individual securities develops careful comparisons of various issues in the same field and forms an expert opinion of the safety or attractiveness or intrinsic value of all the different kinds of stocks and bonds by what must seem quirk to the outsider there are no formal requirements for being a security analyst contrast with this the facts that a customer's broker must pass an examination meet the required character tests and be duly accepted and registered by the new york stock exchange as a practical matter nearly all the younger analysts have had extensive business school training and the old stars have acquired at least the equivalent in the school of long experience in the great majority of cases the employing brokerage house can be counted on to assure itself of the qualifications and competence of its analysts the customer of the brokerage firm may deal with the security analysts directly or his contact may be an indirect one via the customer's broker in either case the analyst is available to the client for a considerable amount of information and advice let us make an emphatic statement here the value of the security analyst to the investor depends largely on the investor's own attitude if the investor asks the analyst the right questions he is likely to get the right or at least valuable answers the analysts hired by brokerage houses we are convinced are greatly handicapped by the general feeling that they are supposed to be market analysts as well when they are asked whether a given common stock is sound the question often means is this stock likely to advance during the next few months as a result many of them are com pellet to analyze with one eye on the stock ticker oppose not conducive to sound thinking or worthwhile conclusions in the next section of this book we shall deal with some of the concepts and possible achievements of security analysis a great many analysts working for stock exchange firms could be of promises tense to the bona fide investor who wants to be sure that he gets full value for his money and possibly a little more as in the case of the customer's brokers what is needed at the beginning is a clear understanding by the analyst of the investors attitude and objectives once the analyst is convinced that he is dealing with a man who is value-minded rather than quotation-minded there is an excellent chance that his recommendations will prove of real overall benefit the cfa certificate for financial analysts an important step was taken in 1963 toward giving professional standing and responsibility to financial analysts the official title of chartered financial analyst cfa is now awarded to those senior practitioners who pass required examinations and meet other tests of fitness.1 the subjects covered include security analysis and portfolio management the analogy with the long-established proofs on title of certified public accountant cpa is evident and intentional this relatively new apparatus of recognition and control should serve to elevate the standards of financial analysts and eventually to place their work on a truly professional basis dealings with brokerage houses one of the most disquieting developments of the period in which we write this revision has been the financial embarrassment in plain words bankruptcy or near bankruptcy of quite a few new york stock exchange firms including at least two of considerable size this is the first time in half a century or more that such a thing has happened and it is startling for more than one reason for many decades the new york stock exchange has been moving in the direction of closer and stricter controls over the operations and financial condition of its members including minimum capital requirements surprise audits and the like besides this we have had 37 years of control over the exchanges and their members by the securities and exchange commission finally the stock brokerage industry itself has operated under favorable conditions namely a huge increase in volume fixed minimum commission rates largely eliminating competitive fees and a limited number of member firms the first financial troubles of the brokerage houses in 1969 were attributed to the increase in volume itself this it was claimed over taxed their facilities increased their overhead and produced many troubles in making financial settlements it should be pointed out this was probably the first time in history that important enterprises have gone broke because they had more business than they could handle in 1970 as brokerage failures increased they were blamed chiefly on the falling off in volume a strange complaint when one reflects that the turnover of their nyse in 1970 totaled 2937 million shares the largest volume in its history and well over twice as large as in any year before 1965. during the 15 years of the bull market ending in 1964 the annual volume had averaged only 712 million shares one quarter of the 1970 figure but the brokerage business had enjoyed the greatest prosperity in its history if as it appears the member firms as a whole had allowed their overhead and other expenses to increase at a rate that could not sustain even a mild reduction in volume during part of a year this does not speak well for either their business acumen or their financial conservatism a third explanation of the financial trouble finally emerged out of a mist of concealment and we suspect that it is the most plausible and significant of the three it seems that a good part of the capital of certain brokerage houses was held in the form of common stocks owned by the individual partners some of these seem to have been highly speculative and carried at inflated values when the market declined in 1969 the quotations of such securities fell drastically and a substantial part of the capital of the firms vanished with them.two in effect the partners were speculating with the capital that was supposed to protect the customers against the ordinary financial hazards of the brokerage business in order to make a double profit thereon this was inexcusable we refrain from saying more the investor should use his intelligence not only in formulating his financial policies but also in the associated details these include the choice of a reputable broker to execute his orders up to now it was sufficient to counsel our readers to deal only with a member of the new york stock exchange unless he had compelling reasons to use a non-member firm reluctantly we must add some further advice in this area we think that people who do not carry margin accounts and in our vocabulary this means all non-professional investors should have the delivery and receipt of their securities handled by their bank when giving a buying order to your brokers you can instruct them to deliver the securities bought to your bank against payment therefore by the bank conversely when selling you can instruct your bank to deliver the securities to the broker against payment of the proceeds these services will cost a little extra but they should be well worth the expense in terms of safety and peace of mind this advice may be disregarded as no longer called for after the investor is sure that all the problems of stock exchange firms have been disposed of but not before investment bankers the term investment banker is applied to a firm that engages to an important extent in originating underwriting and selling new issues of stocks and bonds to underwrite means to guarantee to the issuing corporation or other issuer that the security will be fully sold a number of the brokerage houses carry on a certain amount of underwriting activity generally this is confined to participating in underwriting groups formed by leading investment bankers there is an additional tendency for brokerage firms to originate and sponsor a minor amount of new issue financing particularly in the form of smaller issues of common stocks when a bull market is in full swing investment banking is perhaps the most respectable department of the wall street community because it is here that finance plays its constructive role of supplying new capital for the expansion of industry in fact much of the theoretical justification for maintaining active stock markets notwithstanding their frequent speculative excesses lies in the fact that organized security exchanges facilitate the sale of new issues of bonds and stocks if investors or speculators could not expect to see a ready market for a new security offered them they might well refuse to buy it the relationship between the investment banker and their investor is basically that of the salesman to the prospective buyer for many years past the great bulk of the new offerings in dollar value has consisted of bond issues that were purchased in the main by financial institutions such as banks and insurance companies in this business the security salesmen have been dealing with shrewd and experienced buyers hence any recommendations made by the investment bankers to these customers have had to pass careful and skeptical scrutiny thus these transactions are almost always affected on a business-like footing but a different situation obtains in a relationship between the individual security buyer and the investment banking firms including the stock brokers acting as underwriters here the purchaser is frequently inexperienced and seldom shrewd he is easily influenced by what the salesman tells him especially in the case of common stock issues since often his unconfessed desire in buying is chiefly to make a quick profit the effect of all this is that the public investors protection lies less in his own critical faculty than in the scruples and ethics of the offering houses.3 it is a tribute to the honesty and competence of the underwriting firms that they are able to combine fairly well the discordant roles of advisor and salesmen but it is important for the buyer to trust himself to the judgment of the seller in 1959 we stated at this point the bad results of this unsound attitude show themselves recurrently in the underwriting field and with notable effects in the sale of new common stock issues during periods of active speculation shortly thereafter this warning proved urgently needed as already pointed out the years 1960-1961 and again 1968-69 were marked by an unprecedented outpouring of issues of lowest quality sold to the public at absurdly high offering prices and in many cases pushed much higher by heedless speculation and some semi-manipulation a number of the more important wall street houses have participated to some degree in these less than creditable activities which demonstrates that the familiar combination of greed folly and irresponsibility has not been exorcised from the financial scene the intelligent investor will pay attention to the advice and recommendations received from investment banking houses especially those known by him to have an excellent reputation but he will be sure to bring sound and independent judgment to bear upon these suggestions either his own if he is competent or that of some other type of advisor other advisers it is a good old custom especially in the smaller towns to consult one's local banker about investments a commercial banker may not be a thorough going expert on security values but he is experienced and conservative he is especially useful to the unskilled investor who is often tempted to stray from the straight and unexciting path of a defensive policy and needs the steadying influence of a prudent mind the more alert and aggressive investor seeking counsel in the selection of security bargains will not ordinarily find the commercial banker's viewpoint to be especially suited to his own objectives we take a more critical attitude toward the widespread custom of asking investment advice from relatives or friends the inquirer always thinks he has good reason for assuming that the person consulted has superior knowledge or experience our own observation indicates that it is almost as difficult to select satisfactory lay advisors as it is to select the proper securities unaided much bad advice is given free summary investors who are prepared to pay a fee for the management of their funds may wisely select some well-established and well-recommended investment council firm alternatively they may use the investment department of a large trust company or the supervisory service supplied on a fee basis by a few of the leading new york stock exchange houses the results to be expected are in no wise exceptional but they are commensurate with those of the average well-informed and cautious investor most security buyers obtain advice without paying for it specifically it stands to reason therefore that in the majority of cases they are not entitled to and should not expect better than average results they should be wary of all persons whether customers brokers or security salesmen who promise spectacular income or profits this applies both to the selection of securities and to guidance in the elusive and perhaps elusive art of trading in the market defensive investors as we have defined them will not ordinarily be equipped to pass independent judgment on the security recommendations made by their advisors but they can be explicit and even repetitiously so in stating the kind of security ties they want to buy if they follow our prescription they will confine themselves to high-grade bonds and the common stocks of leading corporations preferably those that can be purchased at individual price levels that are not high in the light of experience and analysis the security analyst of any reputable stock exchange house can make up a suitable list of such common stocks and can certify to the investor whether or not the existing price level therefore is a reasonably conservative one as judged by past experience the aggressive investor will ordinarily work in active cooperation with his advisors he will want their recommendations explained in detail and he will insist on passing his own judgment upon them this means that the investor will gear his expectations and the character of his security operations to the development of his own knowledge and experience in the field only in the exceptional case where the integrity and competence of the advisors have been thoroughly demonstrated should the investor act upon the advice of others without understanding and approving the decision made they have always been on principled stock salesmen and fly-by-night stock brokers and as a matter of course we have advised our readers to confine their dealings if possible to members of the new york stock exchange but we are reluctantly compelled to and the extra cautious council that security deliveries and payments be made through the intermediary of the investors bank the distressing wall street brokerage house picture may have cleared up completely in a few years but in late 1971 we still suggest better safe than sorry chapter 11 security analysis for the lay investor financial analysis is now a well-established and flourishing profession or semi-profession the various societies of analysts that make up the national federation of financial analysts have over 13 000 members most of whom make their living out of this branch of mental activity financial analysts have textbooks a code of ethics and a quarterly journal they also have their share of unresolved problems in recent years there has been a tendency to replace the general concept of security analysis by that of financial analysis the latter phrase has a broader implication and is better suited to describe the work of most senior analysts on wall street it would be useful to think of security analysis as limiting itself pretty much to the examination and evaluation of stocks and bonds whereas financial analysis would comprise that work plus the determination of investment policy portfolio selection plus a substantial amount of general economic analysis.1 in this chapter we shall use whatever designation is most applicable with chief emphasis on the work of the security analyst proper the security analyst deals with the past the present and the future of any given security issue he describes the business he summarizes its operating results and financial position he sets forth its strong and weak points its possibilities and risks he estimates its future earning power under various assumptions or as a best guess he makes elaborate comparisons of various companies or of the same company at various times finally he expresses an opinion as to the safety of the issue if it is a bond or investment grade preferred stock or as to its attractiveness as a purchase if it is a common stock in doing all these things the security analyst avails himself of a number of techniques ranging from the elementary to the most abstruse he may modify substantially the figures in the company's annual statements even though they bear the sacred imprimatur of the certified public accountant he is on the lookout particularly for items in these reports that may mean a good deal more or less than they say the security analyst develops and applies standards of safety by which we can conclude whether a given bond or preferred stock may be termed sound enough to justify purchase for investment these standards relate primarily to past average earnings but they are concerned also with capital structure working capital asset values and other matters in dealing with common stocks the security analyst until recently has only rarely applied standards of value as well defined as were his standards of safety for bombs and preferred stocks most of the time he contended himself with a summary of past performances a more or less general forecast of the future with particular emphasis on the next 12 months and a rather arbitrary conclusion the latter was and still is often drawn with one eye on the stock ticker or the market charts in the past few years however much attention has been given by practicing analysts to the problem of valuing growth stocks many of these have sold at such high prices in relation to past and current earnings that those recommending them have felt a special obligation to justify their purchase by fairly definite projections of expected earnings running fairly far into the future certain mathematical techniques of a rather sophisticated sort have perforce been invoked to support the valuations arrived at we shall deal with these techniques in foreshortened form a little later however we must point out a troublesome paradox here which is that the mathematical valuations have become most prevalent precisely in those areas where one might consider them least reliable for the more dependent the valuation becomes on anticipations of the future unless it is tied to a figure demonstrated by past performance the more vulnerable it becomes to possible miscalculation and serious error a large part of the value found for a high multiplier growth stock is derived from future projections which differ markedly from past performance except perhaps in the growth rate itself thus it may be said that security analysts today find themselves compelled to become most mathematical and scientific in the very situations which lend themselves least auspiciously to exact treatment let us proceed nonetheless with our discussion of the more important elements and techniques of security analysis the present highly condensed treatment is directed to the needs of the non-professional investor at the minimum he should understand what the security analyst is talking about and driving at beyond that he should be equipped if possible to distinguish between superficial and sound analysis security analysis for the lay investor is thought of as beginning with the interpretation of a company's annual financial report this is a subject which we have covered for layman in a separate book entitled the interpretation of financial statements.2 we do not consider it necessary or appropriate to traverse the same ground in this chapter especially since the emphasis in the present book is on principles and attitudes rather than on information and description let us pass on to two basic questions underlying the selection of investments what are the primary tests of safety of a corporate bond or preferred stock what are the chief factors entering into the valuation of a common stock bond analysis the most dependable and hence the most respectable branch of security analysis concerns itself with the safety or quality of bond issues and investment grade preferred stocks the chief criteria news for corporate bonds is the number of times the total interest charges have been covered by available earnings for some years in the past in the case of preferred stocks it is the number of times that bond interest and preferred dividends combined have been covered the exact standards applied will vary with different authorities since the tests are at bottom arbitrary there is no way to determine precisely the most suitable criteria in the 1961 revision of our textbook security analysis we recommend certain coverage standards which appear in table 11 1. our basic test is applied only to the average results for a period of years other authorities require also that a minimum coverage be shown for every year considered we approve a poorest year test a for investment grade preferred stocks the same minimum figures as above are required to be shown by the ratio of earnings before income taxes to the sum of fixed charges plus twice preferred dividends note the inclusion of twice the preferred dividends allows for the fact that preferred dividends are not income tax deductible whereas interest charges are so deductible b other categories of bonds and preference the standards given above are not applicable to one public utility holding companies two financial companies three real estate companies requirements for these special groups are omitted here as an alternative to the seven-year average test it would be sufficient if the bond or preferred stock met either of these criteria it may be objected that the large increase in bond interest rates since 1961 would justify some offsetting reduction in the coverage of charges required obviously it would be much harder for an industrial company to show a seven times coverage of interest charges at eight percent than at 41 halves of a percent to meet this changed situation we now suggest an alternative requirement related to the percent earned on the principal amount of the debt these figures might be 33 before taxes for an industrial company 20 for a public utility and 25 for a railroad it should be borne in mind here that the rate actually paid by most companies on their total debt is considerably less than the current eight percent figures since they have the benefit of older issues bearing lower coupons the poorest year requirement could be set at about two-thirds of the seven-year requirement in addition to the earnings coverage test a number of others are generally applied these include the following 1. size of enterprise there is a minimum standard in terms of volume of business for a corporation varying as between indus trials utilities and railroads and of population from municipality 2. stock equity ratio this is the ratio of the market price of the junior stock issues to the total face amount of the debt or the debt plus preferred stock it is a rough measure of the protection or cushion afforded by the presence of a junior investment that must first bear the brunt of unfavorable developments this factor includes the market's appraisal of the future prospects of the enterprise 3. property value the asset values as shown on the balance sheet or as appraised were formerly considered the chief security and protection for a bomb disu experience has shown that in most cases safety resides in the earning power and if this is deficient the assets lose most of their reputed value asset values however retain importance as a separate test of ample security for bonds and preferred stocks in three enterprise groups public utilities because rates may depend largely on the property investment real estate concerns and investment companies at this point the alert investor should ask how dependable are tests of safety that are measured by past and present performance in view of the fact that payment of interest and principle depends upon what the future will bring forth the answer can be founded only on experience investment history shows that bonds and preferred stocks that have met stringent tests of safety based on the past have in a great majority of cases been able to face the vicissitudes of the future successfully this has been strikingly demonstrated in the major field of railroad bonds a field that has been marked by a calamitous frequency of bankruptcies and serious losses in nearly every case the roads that got into trouble had long been overbended had shown an inadequate coverage of fixed charges in periods of average prosperity and would thus have been ruled out by investors who applied strict tests of safety conversely practically every road that has met such tests has escaped financial embarrassment our premise was strikingly vindicated by the financial history of the numerous railroads reorganized in the 1940s and in 1950. all of these with one exception started their careers with fixed charges reduced to a point where the current coverage of fixed interest requirements was ample or at least respectable the exception was the new haven railroad which in its reorganization year 1947 earned its new charges only about 1.1 times in consequence while all the other roads were able to come through rather difficult times with solvency unimpaired the new haven relapsed into trusteeship for the third time in 1961. in chapter 17 below we shall consider some aspects of the bankruptcy of the penn central railroad which shook the financial community in 1970. an elementary fact in this case was that the coverage of fixed charges did not meet conservative standards as early as 1965. hence a prudent bond investor would have avoided or disposed of the bond issues of the system long before its financial collapse our observations on the adequacy of the past record to judge future safety apply and to an even greater degree to the public utilities which constitute a major area for bond investment receivership of a soundly capitalized electric utility company or system is almost impossible since securities and exchange commission control was instituted along with the breakup of most of the holding company systems public utility financing has been sound and bankruptcies unknown the financial troubles of electric and gas utilities in the 1930s were traceable almost 100 to financial excesses and mismanagement which left their imprint clearly on the company's capitalization structures simple but stringent tests of safety therefore would have warned the investor away from the issues that were later to default among industrial bond issues the long-term record has been different although the industrial group as a whole has shown a better growth of earning power than either the railroads or the utilities it has revealed a lesser degree of inherent stability for individual companies and lines of business thus in the past at least there have been persuasive reasons for confining the purchase of indus trial bonds and preferred stocks to companies that not only are of major size but also have shown an ability in the past to withstand a serious depression few defaults of industrial bonds have occurred since 1950 but this fact is attributable in part to the absence of a major depression during this long period since 1966 there have been adverse developments in the financial position of many industrial companies considerable difficulties have developed as the result of unwise expansion on the one hand this has involved large additions to both bank loans and long-term debt on the other it has frequently produced operating losses instead of the expected profits at the beginning of 1971 it was calculated that in the past seven years the interest payments of all non-financial firms had grown from 9.8 billion dollars in 1963 to 26.1 billion dollars in 1970 and that interest payments had taken 29 of the aggregate profits before interest and taxes in 1971 against only 16 in 1963.3 obviously the burden on many individual firms had increased much more than this overbunded companies have become all too familiar there is every reason to repeat the caution expressed in our 1965 edition we are not quite ready to suggest that the investor may count on an indefinite continuance of this favorable situation and hence relax his standards of bond selection in the industrial or any other group common stock analysis the ideal form of common stock analysis leads to evaluation of the issue which can be compared with the current price to determine whether or not the security is an attractive purchase this valuation in turn would ordinarily be found by estimating the average earnings over a period of years in the future and then multiplying that estimate by an appropriate capitalization factor the now standard procedure for estimating future earning power starts with average past data for physical volume prices received and operating margin future sales in dollars are then projected on the basis of assumptions as to the amount of change in volume and price level over the previous space these estimates in turn are grounded first on general economic forecasts of gross national product and then on special calculations applicable to the industry and company in question an illustration of this method of valuation may be taken from our 1965 edition and brought up to date by adding the sequel the value line a leading investment service makes forecasts of future earnings and dividends by the procedure outlined above and then derives a figure of price potentiality or projected market value by applying evaluation formula to each issue based largely on certain past relationships in table 11 2 we reproduce the projections for 1967-1969 made in june 1964 and compare them with the earnings and average market price actually realized in 1968 which approximates the 1967-1969 period the combined forecasts proved to be somewhat on the low side but not seriously so the corresponding predictions made six years before had turned out to be over optimistic on earnings and dividends but this had been offset by use of a low multiplier with the result that the price potentiality figure proved to be about the same as the actual average price for 1963. the reader will note that quite a number of the individual forecasts were wide of the mark this is an instance in support of our general view that composite or group estimates are likely to be a good deal more dependable than those for individual companies ideally perhaps the security analyst should pick out the three or four companies whose future he thinks he knows the best and concentrate his own and his clients interest on what he forecasts for them unfortunately it appears to be almost impossible to distinguish an advance between those individual forecasts which can be relied upon and those which are subject to a large chance of error at bottom this is the reason for the wide diversification practiced by the investment funds for it is undoubtedly better to concentrate on one stock that you know is going to prove highly profitable rather than dilute your results to a mediocre figure merely for diversification's sake but this is not done because it cannot be done dependably.4 the prevalence of wide diversification is in itself a pragmatic repudiation of the fetish of selectivity to which wall street constantly pays lip service factors affecting the capitalization rate though average future earnings are supposed to be the chief determinant of value the security analyst takes into account a number of other factors of a more or less definite nature most of these will enter into his capitalization rate which can vary over a wide range depending upon the quality of the stock issue thus although two companies may have the same figure of expected earnings per share in 1973 to 1975 say four dollars the analyst may value one as low as 40 and the other as high as 100. let us deal briefly with some of the considerations that enter into these divergent multipliers 1. general long-term prospects no one really knows anything about what will happen in the distant future but analysts and investors have strong views on the subjects just the same these views are reflected in the substantial differentials between the price earnings ratios of individual companies and of industry groups at this point we added in our 1965 edition for example at the end of 1963 the chemical companies in the dow jones industrial average were selling at considerably higher multipliers than the oil companies indicating stronger confidence in the prospects of the former than of the latter such distinctions made by the market are often soundly based but when dictated mainly by past performance they are as likely to be wrong as right we shall supply here in table 11 3 the 1963 year-end material on the chemical and oil company issues in the dow jones industrial average and carry their earnings to the end of 1970. it will be seen that the chemical companies despite their high multipliers made practically no gain in earnings in the period after 1963. the oil companies did much better than the chemicals and about in line with the growth implied in their 1963 multipliers.5 thus our chemical stock example proved to be one of the cases in which the market multipliers were proven wrong b 2. management on wall street a great deal is constantly said on this subject but little that is really helpful until objective quantitative and reasonably reliable tests of managerial competence are devised and applied this factor will continue to be looked at through a fog it is fair to assume that an outstandingly successful company has unusually good management this will have shown itself already in the past record it will show up again in the estimates for the next five years and once more in the previously discussed factor of long-term prospects the tendency to count it still another time as a separate bullish consideration can easily lead to expensive overvaluations the management factor is most useful we think in those cases in which a recent change has taken place that has not yet had the time to show its significance in the actual figures two spectacular occurrences of this kind were associated with the chrysler motor corporation the first took place as far back as 1921 when walter chrysler took command of the almost moribund maxwell motors and in a few years made it a large and highly profitable enterprise while numerous other automobile companies were forced out of business the second happened as recently as 1962 when chrysler had fallen far from its once higher state and the stock was selling at its lowest price in many years then new interests associated with consolidation coal took over the reigns the earnings advanced from the 1961 figure of 1.24 cents per share to the equivalent of 17 in 1963 and the price rose from a low of 381 halves in 1962 to the equivalent of nearly 200 the very next year.6 3. financial strength and capital structure stock of a company with a lot of surplus cash and nothing ahead of the common is clearly a better purchase at the same price than another one with the same per share earnings but large bank loans and senior security ties such factors are properly and carefully taken into account by security analysts a modest amount of bonds or preferred stock however is not necessarily a disadvantage to the common nor is the moderate use of seasonal bank credit incidentally a top-heavy structure too little common stock in relation to bonds and preferred may under favorable conditions make for a huge speculative profit in the common this is the factor known as leverage 4. dividend record one of the most persuasive tests of high quality is an uninterrupted record of dividend payments going back over many years we think that a record of continuous dividend payments for the last 20 years or more is an important plus factor in the company's quality rating indeed the defensive investor might be justified in limiting his purchases to those meeting this test 5. current dividend rate this our last additional factor is the most difficult one to deal with in satisfactory fashion fortunately the majority of companies have come to follow what may be called a standard dividend policy this has meant the distribution of about two-thirds of their average earnings except that in the recent period of high profits and inflationary demands for more capital the figure has tended to be lower in 1969 it was 59.5 for the stocks in the dow jones average and 55 for all american corporations where the dividend bears a normal relationship to the earnings the valuation may be made on either basis without substantially affecting the result for example a typical secondary company with expected average earnings of three dollars and an expected dividend of dollar the second of may be valued at either 12 times its earnings or 18 times its dividend to yield a value of 36 in both cases however an increasing number of growth companies are departing from the once standard policy of paying out 60 or more of earnings in dividends on the grounds that the shareholders interests will be better served by retaining nearly all the profits to finance expansion the issue presents problems and requires careful distinctions we have decided to defer our discussion of the vital question of proper dividend policy to a later section chapter 19 where we shall deal with it as a part of the general problem of management shareholder relations capitalization rates for growth stocks most of the writing of security analysts on formal appraisals relates to the valuation of growth stocks our study of the various methods has led us to suggest a foreshortened and quite simple formula for the valuation of growth stocks which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations our formula is value equals current normal earnings 8.5 plus twice the expected annual growth rate the growth figure should be that expected over the next 7 to 10 years.7 we show how our formula works out for various rates of assumed growth it is easy to make the converse calculation and to determine what rate of growth is anticipated by the current market price assuming our formula is valid in our last edition we made that calculation for the dow jones industrial average and for six important stock issues these figures are reproduced in table 11 5. we commented at the time the difference between the implicit 32.4 annual growth rate for xerox and the extremely modest 2.8 percent for general motors is indeed striking it is explainable in part by the stock markets feeling that general motors 1963 earnings the largest for any corporation in history can be maintained with difficulty and exceeded only modestly at best the price earnings ratio of xerox on the other hand is quite representative of speculative enthusiasm fastened upon a company of great achievement and perhaps still greater promise the implicit or expected growth rate of 5.1 percent for the dow jones industrial average com bc pairs with an actual annual increase of 3.4 percent compounded between 1951 to 1953 and 1961 to 1963. we should have added a caution somewhat as follows the valuations of expected high growth stocks are necessarily on the low side if we were to assume these growth rates will actually be realized in fact according to the arithmetic if our company could be assumed to grow at a rate of 8 or more indefinitely in the future its value would be infinite and no price would be too high to pay for the shares what the valuer actually does in these cases is to introduce a margin of safety into his calculations somewhat as an engineer does in his specifications for a structure on this basis the purchasers would realize his assigned objective in 1963 a future overall return of 71 halves of a percent per annum even if the growth rate actually realized proved substantially less than that projected in the formula of course then if that rate were actually realized the investor would be sure to enjoy a handsome additional return there is really no way of valuing a high growth company with an expected rate above say eight percent annually in which the analyst can make realistic assumptions of both the proper multiplier for the current earnings and the expectable multiplier for the future earnings as it happened the actual growth for xerox and ibm proved very close to the high rates implied from our formula as just explained this fine showing inevitably produced a large advance in the price of both issues the growth of the dow jones industrial average itself was also about as projected by the 1963 closing market price but the moderate rate of 5 did not involve the mathematical dilemma of xerox and ibm it turned out that the 23 price rise to the end of 1970 plus the 28 in aggregate dividend return received gave not far from the 71 halves of a percent annual overall gain posited in our formula in the case of the other four companies it may suffice to say that their growth did not equal the expectations implied in the 1963 price and that their quotations failed to rise as much as the dow jones industrial average warning this material is supplied for illustrative purposes only and because of the inescapable necessity in security analysis to project the future growth rate for most companies studied let the reader not be misled into thinking that such projections have any high degree of reliability or conversely that future prices can be counted on to behave accordingly as the prophecies are realized surpassed or disappointed we should point out that any scientific or at least reasonably dependable stock evaluation based on anticipated future results must take future interest rates into account a given schedule of expected earnings or dividends would have a smaller present value if we assume a higher than if we assume a lower interest structure such assumptions have always been difficult to make with any degree of confidence and the recent violent swings in long-term interest rates render forecasts of this sort almost pre-sumptuous hence we have retained our old formula above simply because no new one would appear more plausible industry analysis because the general prospects of the enterprise carry major weight in the establishment of market prices it is natural for the security analyst to devote a great deal of attention to the economic position of the industry and of the individual company in its industry studies of this kind can go into unlimited detail they are sometimes productive of valuable insights into important factors that will be operative in the future and are insufficiently appreciated by the current market where a conclusion of that kind can be drawn with a fair degree of confidence it affords a sound basis for investment decisions our own observation however leads us to minimize somewhat the practical value of most of the industry studies that are made available to investors the material developed is ordinarily of a kind with which the public is already fairly familiar and that has already exerted considerable influence on market quotations rarely does one find a brokerage house study that points out with a convincing array of facts that a popular industry is heading for a fall or that an unpopular one is due to prosper wall street's view of the longer future is notoriously fallible and this necessarily applies to that important part of its investigations which is directed toward the forecasting of the course of profits in various industries we must recognize however that the rapid and pervasive growth of technology in recent years is not without major effect on the attitude and the labors of the security analyst more so than in the past the progress or retrogression of the typical company in the coming decade may depend on its relation to new products and new processes which the analyst may have a chance to study and evaluate in advance thus there is doubtless a promising area for effective work by the analyst based on field trips interviews with research men and an intensive technological investigation on his own there are hazards connected with investment conclusions derived chiefly from such glimpses into the future and not supported by presently demonstrable value yet there are perhaps equal hazards in sticking closely to the limits of value set by sober calculations resting on actual results the investor cannot have it both ways he can be imaginative and play for the big profits that are the reward for vision proved sound by the event but then he must run a substantial risk of major or minor miscalculation or he can be conservative and refuse to pay more than a minor premium for possibilities as yet unproved but in that case he must be prepared for the later contemplation of golden opportunities foregone a two-part appraisal process let us return for a moment to the idea of valuation or appraisal of a common stock which we began to discuss above on p 288 a great deal of reflection on the subject has led us to conclude that this better be done quite differently than is now the established practice we suggest that analysts work out first what we call the past performance value which is based solely on the past record this would indicate what the stock would be worth absolutely or as a percentage of the dow jones industrial average or of the s p composite if it is assumed that its relative past performance will continue unchanged in the future this includes the assumption that its relative growth rate as shown in the last seven years will also continue unchanged over the next seven years this process could be carried out mechanically by applying a formula that gives individual weights to past figures for profitability stability and growth and also for current financial condition the second part of the analysis should consider to what extent the value based solely on past performance should be modified because of new conditions expected in the future such a procedure would divide the work between senior and junior analysts as follows 1. the senior analyst would set up the formula to apply to all companies generally for determining past performance value two the junior analysts would work up such factors for the designated companies pretty much in mechanical fashion three the senior analyst would then determine to what extent a company's performance absolute or relative is likely to differ from its past record and what change should be made in the value to reflect such anticipated changes it would be best if the senior analysts report showed both the original valuation and the modified one with his reasons for the change is a job of this kind worth doing our answer is in the affirmative but our reasons may appear somewhat cynical to the reader we doubt whether the valuations so reached will prove sufficiently dependable in the case of the typical industrial company great or small we shall illustrate the difficulties of this job in our discus cyan of aluminium company of america alcoa in the next chapter nonetheless it should be done for such common stocks why first many security analysts are bound to make current or projected valuations as part of their daily work the method we propose should be an improvement on those generally followed today secondly because it should give useful experience and insight to the analysts who practice this method thirdly because work of this kind could produce an invaluable body of recorded experience as has long been the case in medicine that may lead to better methods of procedure and a useful knowledge of its possibilities and limitations the public utility stocks might well prove an important area in which this approach will show real pragmatic value eventually the intelligent analyst will confine himself to those groups in which the future appears reasonably predictable or where the margin of safety of past performance value over current price is so large that he can take his chances on future variations as he does in selecting well-secured senior securities in subsequent chapters we shall supply concrete examples of the application of analytical techniques but they will only be illustrations if the reader finds the subject interesting he should pursue it systematically and thoroughly before he considers himself qualifed to pass a final buy or sell judgment of his own on a security issue these industry groups ideally would not be overly dependent on such unforeseeable factors as fluctuating interest rates or the future direction of prices for raw materials like oil or metals possibilities might be industries like gaming cosmetics alcoholic beverages nursing homes or waste management chapter 12 things to consider about per share earnings this chapter will begin with two pieces of advice to the investor that cannot avoid being contradictory in their implications the first is don't take a single year's earnings seriously the second is if you do pay attention to short term earnings look out for booby traps in the per share figures if our first warning were followed strictly the second would be unnecessary but it is too much to expect that most shareholders can relate all their common stock decisions to the long-term record and the long-term prospects the quarterly figures and especially the annual figures receive major attention in financial circles and this emphasis can hardly fail to have its impact on the investor's thinking he may well need some education in this area for it abounds in misleading possibilities as this chapter is being written the earnings report of aluminum company of america alcoa phi 1970 appears in the wall street journal the first figures shown are 1970-1969 share earnings are cents 5.20 dollars and 58 cents the little a at the outset is explained in a footnote to refer to primary earnings before special charges there is much more footnote material in fact it occupies twice as much space as do the basic figures themselves for the december quarter alone the earnings per share are given as 1.58 in 1970 against 1.56 in 1969. the investor or speculator interested in alcoa shares reading those figures might say to himself not so bad i knew that 1970 was a recession year in aluminium but the fourth quarter shows again over 1969 with earnings at the rate of 6.32 cents per year let me see the stock is selling at 62. why that's less than 10 times earnings that makes it look pretty cheap compared with 16 times for international nickel etc etc but if our investor a friend had bothered to read all the material in the footnote he would have found that instead of one figure of earnings per share for the year 1970 there were actually four viz 1970-1969 primary earnings five dollars and twenty cents five dollars and fifty eight cents net income after special charges four point three two five point five eight fully diluted before special charges 5.01 5.35 fully diluted after special charge is 4.19 5.35 for the fourth quarter alone only two figures are given primary earnings 1.58 1.56 net income after special charge is 0.701.56 what do all these additional earnings mean which earnings are true earnings for the year and the december quarter if the latter should be taken at 70 cents the net income after special charges the annual rate would be and eighty cents instead of six dollars and 32 cents and the price 62 would be 22 times earnings instead of the 10 times we started with part of the question as to the true earnings of alcoa can be answered quite easily the reduction from five dollars and twenty cents to five dollars and one cent to allow for the effects of dilution is clearly called for alcoa has large bond issue convertible into common stock to calculate the earning power of the common based on the 1970 results it must be assumed that the conversion privilege will be exercised if it should prove profitable to the bondholders to do so the amount involved in the alcoa picture is relatively small and hardly deserves detailed comment but in other cases making allowance for conversion rights and the existence of stock purchase warrants can reduce the apparent earnings by half or more we shall present examples of a really significant dilution factor below page 411. the financial services are not always consistent in their allowance for the dilution factor in their reporting and analyzes let us turn now to the matter of special charges this figure of 18 800 000 or 88 cents per share deducted in the fourth quarter is not unimportant is it to be ignored entirely or fully recognized as an earnings reduction or partly recognized and partly ignored the alert investor might ask himself also how does it happen that there was a virtual epidemic of such special charge-offs appearing after the close of 1970 but not in previous years could depose sibley have been some fine italian hands at work with the accounting but always of course within the limits of the permissible when we look closely we may find that such losses charged off before they actually occur can be charmed away as it were with no unhappy effect on either past or future primary earnings in some extreme cases they might be availed if to make subsequent earnings appear nearly twice as large as in reality by a more or less prestigious treatment of the tax credit involved in dealing with alcoa's special charges the first thing to establish is how they arose the footnotes are specific enough the deductions came from four sources viz 1. management's estimate of the anticipated costs of closing down the manufactured products division 2. ditto for closing down alcoa castings co.s plants three ditto for losses in phasing out alcoa credit company four also estimated costs of 5.3 million dollars associated with compulsion of the contract for a curtain wall all of these items are related to future costs and losses it is easy to say that they are not part of the regular operating results of 1970 but if so where do they belong are they so extraordinary and non-recurring is to belong nowhere a widespread enterprise such as alcoa doing a 1.5 billion dollar business annually must have a lot of divisions departments affiliates and the like would it not be normal rather than extraordinary for one or more to prove unprofitable and to require closing down similarly for such things as a contract to build a wall suppose that any time a company had a loss on any part of its business it had the bright idea of charging it off as a special item and thus reporting its primary earnings per share so as to include only its profitable contracts and operations like king edward the seventh's sundial that marked only the sunny hours the king probably took his inspiration from a once famous essay by the english writer william hazlitt who mused about a sundial near venice that bore the words horror's non-numero nisi serenas or i count only the hours that are serene companies that chronically exclude bad news from their financial results on the pretext that negative events are extraordinary or non-recurring are taking a page from hazlitt who urged his readers to take no note of time but by its benefits to watch only for the smiles and neglect the frowns of fate to compose our lives of bright and gentle moments turning away to the sunny side of things and letting the rest slip from our imaginations unheeded or forgotten william hazlitt on a sundial ca 1827 unfortunately investors must always count the sunny and dark hours alike the reader should note two ingenious aspects of the alcoa procedure we have been discussing the first is that by anticipating future losses the company escapes the necessity of allocating the losses themselves to an identifiable year they don't belong in 1970 because they were not actually taken in that year and they won't be shown in the year when they are actually taken because they have already been provided for neat work but might it not be just a little misleading the alcoa footnote says nothing about the future tax saving from these losses most other statements of this sort state specifically that only the after tax effect has been charged off if the alcoa figure represents future losses before the related tax credit then not only will future earnings be freed from the weight of these charges as they are actually incurred but they will be increased by a tax credit of some 50 thereof it is difficult to believe that the accounts will be handled that way but it is a fact that certain companies which have had large losses in the past have been able to report future earnings without charging the normal taxes against them in that way making a very fine profits appearance indeed based paradoxically enough on their past disgraces tax credits resulting from past years losses are now being shown separately as special items but they will enter into future statistics as part of the final net income figure however a reserve now set up for future losses if net of expected tax credit should not create an addition of this sort to the net income of later years the other ingenious feature is the use by alcoa and many other companies of the 1970 year end for making these special charge-offs the stock market took what appeared to be a blood bath in the first half of 1970. everyone expected relatively poor results for the year for most companies wall street was now anticipating better results in 1971 1972 etc what a nice arrangement then to charge as much as possible to the bad year which had already been written off mentally and had virtually reseeded into the past leaving the way clear for nicely fattened figures in the next few years perhaps this is good accounting good business policy and good for management shareholder relationships but we have lingering doubts the combination of widely or should it be wildly diversified operations with the impulse to clean house at the end of 1970 has produced some strange-looking footnotes to the annual reports the reader may be amused by the following explanation given by a new york stock exchange company which shall remain unnamed of its special items aggregating 2 357 000 or about a third of the income before charge-offs consists of provision for closing spalding united kingdom operations provision for reorganizational expenses of a division costs of selling a small baby pants and bib manufacturing company disposing of part interest in a spanish car leasing facility and liquidation of a ski boot operation years ago the strong companies used to set up contingency reserves out of the profits of good years to absorb some of the bad effects of depression years to come the underlying idea was to equalize the reported earnings more or less and to improve the stability factor in the company's record a worthy motive it would seem but the accountants quite rightly objected to the practice as misstating the true earnings they insisted that each year's results be presented as they were good or bad and the shareholders and analysts be allowed to do the averaging or equalizing for themselves we seem now to be witnessing the opposite phenomenon with everyone charging off as much as possible against forgotten 1970 so as to start 1971 with a slate not only clean but specially prepared to show pleasing per share figures in the coming years it is time to return to our first question what then were the true earnings of alcoa in 1970. the accurate answer would be the 5.01 per share after dilution less than part of the 82 cents of special charges that may properly be attributed to occurrences in 1970 but we do not know what that portion is and hence we cannot properly state the true earnings for the year the management and the auditors should have given us their best judgment on this point but they did not do so and furthermore the management and the auditors should have provided for deduction of the balance of these charges from the ordinary earnings of a suitable number of future years say not more than five this evidently they will not do either since they have already conveniently disposed of the entire summers and 1970 special charge the more seriously investors take the pusher earnings figures as published the more necessary it is for them to be on their guard against accounting factors of one kind and another that may impair the true comparability of the numbers we have mentioned three sorts of these factors the use of special charges which may never be reflected in the per share earnings the reduction in the normal income tax deduction by reason of past losses and the dilution fact or implicit in the existence of substantial amounts of convertible securities or warrants.1 a fourth item that has had a significant effect on reported earnings in the past is the method of treating depreciation chiefly as between the straight line and the accelerated schedules we refrain from details here but as an example current as we write let us mention the 1970 report of tran company this firm showed an increase of nearly 20 in per share earnings over 1969 3.29 versus 2.76 but half of this came from returning to the older straight line depreciation rates less burden some on earnings than the accelerated method used the year before the company will continue to use the accelerated rate on its income tax return thus deferring income tax payments on the difference still another factor important at times is the choice between charging off research and development costs in the year they are incurred or amortizing them over a period of years finally let us mention the choice between the fifo first in first out and lifo last in first out methods of valuing inventories an obvious remark here would be that investors should not pay any attention to these accounting variables if the amounts involved are relatively small but wall street being as it is even items quite minor in themselves can be taken seriously two days before the alcoa report appeared in the wall street journal the paper had quite a discussion of the corresponding statement of dow chemie california it closed with the observation that many analysts had been troubled by the fact that dao had included a 21 item in regular profits for 1969 instead of treating it as an item of extraordinary income why the fuss because evidently evaluations of dow chemical involving many millions of dollars in the aggregate seemed to depend on exactly what was the percentage gain for 1969 over 1968. in this case either 9 or 41 halves of a percent this strikes us as rather absurd it is very unlikely that small differences involved in one year's results could have any bearing on future average profits or growth and on a conservative realistic valuation of the enterprise by contrast consider another statement also appearing in january 1971 this concern northwest industries incorporated's report for 1970. the company was planning to write off as a special charge not less than 264 million dollars in one fell swoop of this 200 million dollars represents the loss to be taken on the proposed sale of the railroad subsidiary to its employees and the balance a write-down of a recent stock purchase these sums would work out to a loss of about 35 dollars per share of common before dilution offsets or twice its then current market price here we have something really signify can't if the transaction goes through and if the tax laws are not changed this loss provided fed in 1970 will permit northwest industries to realize about 400 million dollars of future profits within five years from its other diversified interests without paying income tax thereon what will then be the real earnings of that enterprise should they be calculated with or without provision for the nearly 50 in income taxes which it will not actually have to pay in our opinion the proper mode of calculation would be first to consider the indicated earning power on the basis of full income tax liability and to derive some broad idea of the stock's value based on that estimate to this should be added some bonus figure representing the value per share of the important but temporary tax exemption the company will enjoy allowance must be made also for a possible large-scale dilution in this case actually the convertible preferred issues and warrants would more than double the outstanding common shares if the privileges are exercised all this may be confusing and weary some to our readers but it belongs in our story corporate accounting is often tricky security analysis can be complicated stock valuations are really dependable only in exceptional cases for most investors it would be probably best to assure themselves that they are getting good value for the prices they pay and let it go at that use of average earnings informer times analysts and investors paid considerable attention to the average earnings over a fairly long period in the past usually from 7 to 10 years this mean figure was useful for ironing out the frequent ups and downs of the business cycle and it was thought to give a better idea of the company's earning power than the results of the latest year alone one important advantage of such an averaging process is that it will solve the problem of what to do about nearly all the special charges and credits they should be included in the average earnings for certainly most of these losses and gains represent a part of the company's operating history if we do this for alcoa the average earnings for 1961-1970 years would appear as 3.62 cents and for the seven years 1964 to 1970 as 4.62 cents per share if such figures are used in conjunction with ratings for growth and stability of earnings during the same period they could give a really informing picture of the company's past performance calculation of the past growth rate it is of prime importance that the growth factor in a company's record be taken adequately into account where the growth has been large the recent earnings will be well above the 7 or 10 year average and analysts may deem these long-term figures irrelevant this need not be the case the earnings can be given in terms both of the average and the latest figure we suggest that the growth rate itself be calculated by comparing the average of the last three years with corresponding figures 10 years earlier where there is a problem of special charges or credits it may be dealt with on some compromise basis note the following calculation for the growth of alcoa as against that of sears roebuck and the dow jones industrial average group as a whole comment these few figures could be made the subject of a long discussion they probably show as well as any others derived by elaborate mathematical treatment the actual growth of earnings for the long period 1958 to 1970 but how relevant is this figure generally considered central in common stock valuations to the case of alcoa its past growth rate was excellent actually a bit better than that of acclaimed sears roebuck and much higher than that of the dow jones industrial average composite but the market price at the beginning of 1971 seemed to pay no attention to this fine performance alcoa sold at only 111 halves times the recent three-year average while sears sold it 27 times and the dow jones industrial average itself at 15 plus times how did this come about evidently wall street has fairly pessimistic views about the future course of alcoa's earnings in contrast with its past record surprisingly enough the high price for alcoa was made as far back as 1959 in that year it sold at 116 or 45 times its earnings this compares with a 1959 adjusted high price of 251 halves for sears roebuck or 20 times its then earnings even though alcoa's profits did show excellent growth thereafter it is evident that in this case the future possibilities were greatly overestimated in the market price it closed 1970 at exactly half of the 1959 high while sears tripled in price and the dow jones industrial average moved up nearly 30 percent it should be pointed out that alcoa's earnings on capital funds had been only average or less and this may be the decisive factor here high multipliers have been maintained in the stock market only if the company has maintained better than average professor retardability let us apply at this point to alcoa the suggestion we made in the previous chapter for a two-part appraisal process such an approach might have produced a past performance value for alcoa of 10 of the dow jones industrial average or 84. per share relative to the closing price of 840 for the dow jones industrial average in 1970. on this basis the shares would have appeared quite attractive at their price of 571 fourths to what extent should the senior analyst have marked down the past performance value to allow for adverse developments that he saw in the future frankly we have no idea assume he had reassured to believe that the 1971 earnings would be as low as 2.50 per share a large drop from the 1970 figure as against an advance expected for the dow jones industrial average very likely the stock market would take this poor performance quite seriously but would it really establish the once mighty aluminium company of america as a relatively unprofitable enterprise to be valued at less than its tangible assets behind the shares in 1971 the price declined from a high of 70 in may to a low of 36 in december against a book value of 55. alcoa is surely a representative industrial company of huge size but we think that its price and earnings history is more unusual even contradictory than that of most other large enterprises yet this instance supports to some degree the doubts we expressed in the last chapter as to the dependability of the appraisal procedure when applied to the typical industrial company chapter 13 a comparison of four listed companies in this chapter we should like to present a sample of security analysis in operation we have selected more or less at random four companies which are found successively on the new york stock exchange list these are ultra corporation a merger of electric autolight and mergentellino type enterprises emerson electric company a manufacturer of electric and electronic products emery air freight a domestic forwarder of air freight and m art corporation originally a maker of bottling machinery only but now also in builders hardware there are some broad resemblances between the three manufacturing firms but the differences will seem more significant there should be sufficient variety in the financial and operating data to make the examination of interest in table 13 1 we present a summary of what the four companies were selling for in the market at the end of 1970 and a few figures on their 1970 operations we then detail certain key ratios which relate on the one hand to performance and on the other to price comment is called for on how various aspects of the performance pattern agree with the relative price pattern finally we shall pass the four companies in review suggesting some comparisons and relationships and evaluating each in terms of the requirements of a conservative common stock investor the most striking fact about the four companies is that the current price earnings ratios vary much more widely than their operating performance or financial condition two of the enterprises ultra and mrt were modestly priced at only 9.7 times and 12 times the average earnings for 1968 1970 as against a similar figure of 15.5 times for the dow jones industrial average the other two amazon and emery showed very high multiples of 33 and 45 times such earnings there is bound to be some explanation of a difference such as this and it is found in the superior growth of the favored company's profits in recent years especially by the freight forwarder but the growth figures of the other two firms were not unsatisfactory for more comprehensive treatment let us review briefly the chief elements of performance as they appear from our figures 1. profitability a all the companies show satisfactory earnings on their book value but the figures for emerson and emery are much higher than for the other two a high rate of return on invested capital often goes along with a high annual growth rate in earnings per share all the companies except emery showed better earnings on book value in 1969 than in 1961 but the emory figure was exceptionally large in both years b for manufacturing companies the profit figure per dollar of sales is usually an indication of comparative strength or weakness we use here the ratio of operating income to sales common as given in standard and poorest listed stock reports here again the results are satisfactory for all four companies with an especially impressive showing by emerson the changes between 1961 and 1969 vary considerably among the companies 2. stability this we measure by the maximum decline in per share earnings in any one of the past 10 years as against the average of the three preceding years no decline translates into 100 stability and this was registered by the two popular concerns but the shrinkages of eltera and m art were quite moderate in the poor year 1970 amounting to only eight percent each by our measurement against seven percent for the dow jones industrial average three growth the two low multiplier companies show quite satisfactory growth rates in both cases doing better than the dow jones group the altar of figures are especially impressive when set against its low price earnings ratio the growth is of course more impressive for the high multiplier pair 4. financial position the three manufacturing companies are in sound financial condition having better than the standard ratio of two dollars of current assets for one dollar of current liabilities emery air freight has a lower ratio but it falls in a different category and with its fine record it would have no problem raising needed cash all the companies have relatively low long-term debt dilution note emerson electric had 163 million dollars of market value of low dividend convertible preferred shares outstanding at the end of 1970. in our analysis we have made allowance for the dilution factor in the usual way by treating the preferred as if converted into com monday this decreased recent earnings by about 10 cents per share or some 4 percent 5. dividends what really counts is the history of continuance without interruption the best record here is mr tess which has not suspended a payment since 1902. ultra s record is very good emerson s quite satisfactory emery freight is a newcomer the variations in payout percentage do not seem especially significant the current dividend yield is twice as high on the cheap pair as on the dear pair comma corresponding to the price earnings ratios 6. price history the reader should be impressed by the percentage advance shown in the price of all four of these issues as mere should from the lowest to the highest points during the past 34 years in all cases the low price has been adjusted for subsequent stock splits note that for the dow jones industrial average the range from low to high was on the order of 11 to 1 for our companies the spread has varied from only 17 to 1 for emart to no less than 528 to 1 for emory air freight these manifold price advances are characteristic of most of our older common stock issues and they proclaim the great opportunities of profit that have existed in the stock markets of the past but they may indicate also how overdone were the declines in the bear markets before 1950 when the low prices were registered both ultra and m art sustained price shrinkages of more than 50 in the 1900 1969-70 price break emerson and emery had serious but less distressing declines the former rebounded to a new all-time high before the end of 1970. the latter in early 1971 general observations on the four companies emerson electric has an enormous total market value dwarfing the other three companies combined it is one of our goodwill giants comma to be commented on later a financial analyst blessed or handicapped with a good memory will think of an analogy between emerson electric and zenith radio and that would not be reassuring for zenith had a brilliant growth record for many years it too sold in the market for 1.7 billion dollars in 1966 but its professor its fell from 43 million in 1968 to only half as much in 1970 and in that year s big sell-off its price declined to 221 question mark 2 against the previous top of 89. high valuations entail high risks emory air freight must be the most promising of the four companies in terms of future growth if the price earnings ratio of nearly 40 times its highest reported earnings is to be even partially justified the past growth of course has been most impressive but these figures may not be so significant for the future if we consider that they started quite small but only 570 000 of net earnings in 1958 it often proves much more difficult to continue to grow at a high rate after volume and profits have already expanded to big totals the most surprising aspect of emery s story is that its earnings and market price continued to grow a pace in 1970 which was the worst year in the domestic air passenger industry this is a remarkable achievement indeed but it raises the question whether future profits may not be vulnerable to adverse developments through increased competition pressure for new arrangements between forwarders and airlines etc and elaborate study might be needed before a sound judgment could be passed on these points but the conservative investor cannot leave them out of his general reckoning emmart and ultra mart has done better in its business than in the stock market over the past 14 years in 1958 it sold as high as 22 times the current earnings about the same ratio as for the dow jones industrial average since then its profits tripled as against a rise of less than 100 for the dow but its closing price in 1970 was only a third above there 1958 high versus 43 for the dow the record of ultra is somewhat similar it appears that neither of these companies possesses glamour or sex appeal comma in the present market but in all the statistical data they show up surprisingly well their future prospects we have no sage remarks to make here but this is what standard in poorest had to say about the four companies in 1971. elta long-term prospects certain operations are cyclical but an established competitive position and diversification are offsetting factors dot emerson electric while adequately priced at 71 on the current outlook the shares have appeal for the long term a continued acquisition policy together with a strong position in industrial fields and an accelerated international program suggests further sales and earnings progress dot emery air freight the shares appear amply priced at 57 on current prospects but are well worth holding for the long pull dot mr tallow restricted this year by lower capital spending in the glass container industry earnings should be aided by an improved business environment in 1972. the shares are worth holding at 34. conclusions many financial analysts will find emerson and emery more interesting and appealing stocks than the other two primarily perhaps because of their better market action comma and secondarily because of their faster recent growth in earnings under our principles of conservative investment the first is not a valid reason for selection that is something for the speculators to play around with the second has validity but within limits can the past growth and the presumably good prospects of emery air freight justify a price more than 60 times its recent earnings question mark 1 our answer would be maybe for someone who has made an in-depth study of the possibilities of this company and come up with exceptionally firm and optimistic conclusions but not for the careful investor who wants to be reasonably sure in advance that he is not committing the typical wall street error of over enthusiasm for good performance in earnings and in the stock market the same cautionary statements seem called for in the case of emerson electric with a special reference to the market s current valuation of over a billion dollars for the intangible or earning power factor here we should add that the electronics industry comma once a fair-haired child of the stock market has in general fallen on disastrous days emerson is an outstanding exception but it will have to continue to be such an exception for a great many years in the future before the 1970 closing price will have been fully justified by its subsequent performance by contrast both ultra at 27 and mr 33 have the earmarks of companies with sufficient value behind their price to constitute reasonably protected investments here the investor can if he wishes consider himself basically a part owner of these businesses at a cost corresponding to what the balance sheet shows to be the money invested therein the rate of earnings on invested capital has long been satisfactory the stability of profits also the past growth rate surprisingly so the two companies will meet our seven statistical requirements for inclusion in a defensive investor s portfolio these will be developed in the next chapter but we summarize them as follows 1. adequate size 2. a sufficiently strong financial condition 3. continued dividends for at least the past 20 years 4. no earnings deficit in the past 10 years 5. 10-year growth of at least one-third in per share earnings 6. price of stock no more than 11 question mark 2 times net asset value 7. price no more than 15 times average earnings of the past three years we make no predictions about the future earnings performance of ultra or mrt in the investor s diversified list of common stocks there are bound to be some that prove disappointing and this may be the case for one or both of this pair but the diversified list itself based on the above principles of selection plus whatever other sensible criteria the investor may wish to apply should perform well enough across the years at least long experience tells us so a final observation an experienced security analyst even if he accepted our general reasoning on these four companies would have hesitated to recommend that a holder of emerson or emery exchange his shares for ultra or mrt at the end of 1970 unless the holder understood clearly the philosophy behind the recommendation there was no reason to expect that in any short period of time the low multiplier duo would outperform the high multipliers the latter were well thought of in the market and thus had a considerable degree of momentum behind them which might continue for an indefinite period the sound basis for preferring ultra and m art to emerson and emery would be the client s considered conclusion that he preferred value type investments to glamour type investments thus to a substantial extent common stock investment policy must depend on the attitude of the individual investor this approach is treated at greater length in our next chapter chapter 14 stock selection for the defensive investor it is time to turn to some broader applications of the techniques of security analysis since we have already described in general terms the investment policies recommended for our two categories of investors it would be logical for us now to indicate how security analysis comes into play in order to implement these policies the defensive investor who follows our suggestions will purchase only high-grade bonds plus a diversified list of leading common stocks he is to make sure that the price at which he bought the latter is not unduly high as judged by applicable standards in setting up this diversified list he has a choice of two approaches the dow jones industrial average type of portfolio and the quantitatively tested portfolio in the first he acquires a true cross-section sample of the leading issues which will include both some favored growth companies whose shares sell at especially high multipliers and also less popular and less expensive enterprises this could be done most simply perhaps by buying the same amounts of all 30 of the issues in the dow jones industrial average dow jones industrial average 10 shares of each at the 900 level for the average would cost an aggregate of about 16 000 and 10 cents on the basis of the past record he might expect approximately the same future results by buying shares of several representative investment funds dot his second choice would be to apply a set of standards to each purchase to make sure that he obtains one a minimum of quality in the past performance and current financial position of the company and also to a minimum of quantity in terms of earnings and assets per dollar of price at the close of the previous chapter we listed seven such quality and quantity criteria suggested for the selection of specific common stocks let us describe them in order 1. adequate size of the enterprise all our minimum figures must be arbitrary and especially in the matter of size required our idea is to exclude small companies which may be subject to more than average vicissitudes especially in the industrial field there are often good possibilities in such enterprises but we do not consider them suited to the needs of the defensive investor let us use round amounts not less than 100 million dollars of annual sales for an industrial company and not less than 50 million dollars of total assets for a public utility 2. a sufficiently strong financial condition for industrial companies current assets should be at least twice current liabilities a so-called two-to-one current ratio also long-term debt should not exceed the net current assets or working capital for public utilities the debt should not exceed twice the stock equity at book value 3. earnings stability some earnings for the common stock in each of the past 10 years 4. dividend record uninterrupted payments for at least the past 20 years 5. earnings growth a minimum increase of at least one-third in per-share earnings in the past 10 years using three-year averages at the beginning and end six moderate price earnings ratio current price should not be more than 15 times average earnings of the past three years seven moderate ratio of price to assets current price should not be more than 11 question mark two times the book value last reported however a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets as a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5 this figure corresponds to 15 times earnings and 11 question mark 2 times book value it would admit an issue selling at only 9 times earnings and 2.5 times asset value etc general comments these requirements are set up especially for the needs and the temperament of defensive investors they will eliminate the great majority of common stocks as candidates for the portfolio and in two opposite ways on the one hand they will exclude companies that are one too small two in relatively weak financial condition 3 with a deficit stigma in their 10-year record and 4 not having a long history of continuous dividends of these tests the most severe and recent financial conditions are those of financial strength a considerable number of our large and formerly strongly entrenched enterprises have weakened their current ratio or over expanded their debt or both in recent years our last two criteria are exclusive in the opposite direction by demanding more earnings and more assets per dollar of price than the popular issues will supply this is by no means the standard viewpoint of financial analysts in fact most will insist that even conservative investors should be prepared to pay generous prices for stocks of the choice companies we have expounded our contrary view above it rests largely on the absence of an adequate factor of safety when too large a portion of the price must depend on ever increasing earnings in the future the reader will have to decide this important question for himself after weighing the arguments on both sides we have nonetheless opted for the inclusion of a modest requirement of growth over the past decade without it the typical company would show retrogression at least in terms of profit per dollar of invested capital there is no reason for the defensive investor to include such companies though if the price is low enough they could qualify as bargain opportunities the suggested maximum figure of 15 times earnings might well result in a typical portfolio with an average multiplier of say 12 to 13 times note that in february 1972 american telephone and telephone sold at 11 times its three year and current earnings and standard oil of california at less than 10 times latest earnings our basic recommendation is that the stock portfolio when acquired should have an overall earnings price ratio the reverse of the p e ratio at least as high as the current high grade bond rate this would mean a p e ratio no higher than 13.3 against an a bond yield of 7.5 percent application of our criteria to the dow jones industrial average at the end of 1970. all of our suggested criteria were satisfied by the dow jones industrial average issues at the end of 1970 but two of them just barely here is a survey based on the closing price of 1970 and the relevant figures the basic data for each company are shown in tables 14 1 and 14 2. 1. size is more than ample for each company 2. financial condition is adequate in the aggregate but not for every company.2 3. some dividend has been paid by every company since at least 1940. five of the dividend records go back to the last century four the aggregate earnings have been quite stable in the past decade none of the companies reported a deficit during the prosperous period 1961 69 but chrysler showed a small deficit in 1970. 5. the total growth comparing three-year averages a decade apart was 77 or about 6 per year but five of the firms did not grow by one-third six the ratio of year-end price to three-year average earnings was 839-55 or 15 to 1 right at our suggested upper limit 7. the ratio of price to net asset value was 839 to 562 also just within our suggested limit of 11 question mark 2 to 1. if however we wish to apply the same 7 criteria to each individual company we would find that only 5 of them would meet our requirements these would be american can american telephone and tell anaconda swift and woolworth the totals for these five appear in table 14 3. naturally they make a much better statistical showing than the dow jones industrial average as a whole except in the past growth rate dot three our application of specific criteria to this select group of industrial stocks indicates that the number meeting every one of our tests will be a relatively small percentage of all listed industrial issues we hazard the guess that about 100 issues of this sort could have been found in the standard and poorest stock guide at the end of 1970 just about enough to provide the investor with a satisfactory range of personal choice the public utility solution if we turn now to the field of public utility stocks we find a much more comfortable and inviting situation for the investor dot here the vast majority of issues appear to be cut out by their performance record and their price ratios in accordance with the defensive investor s needs as we judge them we exclude one criterion from our tests of public utility stocks namely the ratio of current assets to current liabilities the working capital factor takes care of itself in this industry as part of the continuous financing of its growth by sales of bonds and shares we do require an adequate proportion of stock capital to debt dot 4. in table 14 4 we present a resume of the 15 issues in the dow jones public utility average for comparison table 14 5 gives a similar picture of a random selection of 15 other utilities taken from the new york stock exchange list as 1972 began the defensive investor could have had quite a wide choice of utility commons stocks each of which would have met our requirements for both performance and price these companies offered him everything he had a right to demand from simply chosen common stock investments in comparison with prominent industrial companies as represented by the dow jones industrial average they offered almost as good a record of past growth plus smaller fluctuations in the annual figures both at a lower price in relation to earnings and assets the dividend return was significantly higher the position of the utilities as regulated monopolies is assuredly more of an advantage than a disadvantage for the conservative investor under law they are entitled to charge rates sufficiently remunerative to attract the capital they need for their continuous expansion and this implies adequate offsets to inflated costs while the process of regulation has often been cumbersome and perhaps tilitary it has not prevented the utilities from earning a fair return on their rising invested capital over many decades sold and decommissioned nuclear energy plants nor did he foresee the consequences of bungled regulation in california utility stocks are vastly more volatile than they were in graemes day and most investors should own them only through a well-diversified low-cost fund like the dow jones u.s utilities sector index fund ticker symbol i do or utilities select sector spdr xlu for more information see www.tishares.com and www.sprindx.com web link be sure your broker will not charge commissions to reinvest your dividends for the defensive investor the central appeal of the public utility stocks at this time should be their availability at a moderate price in relation to book value this means that he can ignore stock market considerations if he wishes and consider himself primarily as a part owner of well-established and well-earning businesses the market quotations are always the for him to take advantage of when times are propitious either for purchases at unusually attractive low levels or for sales when their prices seem definitely too high the market record of the public utility index is condensed in table 14 6 along with those of other groups indicates that there have been ample possibilities of profit in these investments in the past while the rise has not been as great as in the industrial index the individual utilities have shown more price stability in most periods than have other groups it is striking to observe in this table that the relative price earnings ratios of the industrials and the utilities have changed places during the past two decades in a remarkable confirmation of graham s point the dull sounding standard and poorest utility index outperformed the vaunted nasdaq composite index for the 30 years ending december 31 2002. these reversals will have more meaning for the active than for the passive investor but they suggest that even defensive portfolios should be changed from time to time especially if the securities purchased have an apparently excessive advance and can be replaced by issues much more reasonably priced alas there will be capital gains taxes to pay which for the typical investor seems to be about the same as the devil to pay our old ally experience tells us here that it is better to sell and pay the tax than not sell and repent investing in stocks of financial enterprises a considerable variety of concerns may be ranged under the rubric of financial companies.these would include banks insurance companies savings and loan associations credit and small loan companies mortgage companies and investment companies for example mutual funds it is characteristic of all these enterprises that they have a relatively small part of their assets in the form of material things such as fixed assets and merchandise inventories but on the other hand most categories have short-term obligations well in excess of their stock capital the question of financial soundness is therefore more relevant here than in the case of the typical manufacturing or commercial enterprise this in turn has given rise to various forms of regulation and supervision with the design and general result of assuring against unsound financial practices broadly speaking the shares of financial concerns have produced investment results similar to those of other types of common shares table 14 7 shows price changes between 1948 and 1970 in six groups represented in the standard and poorest stock price indexes the average for 1941 1943 is taken as 10 the base level today the financial services industry is made up of even more components including commercial banks savings and loan and mortgage financing companies consumer finance firms like credit card issuers money managers and trust companies investment banks and brokerages insurance companies and firms engaged in developing or owning real estate including real estate investment trusts although the sector is much more diversified today graham s caveats about financial soundness apply more than ever the year-end 1970 figures ranged between 44.3 for the nine new york banks and 218 for the 11 life insurance stocks during the sub-intervals there was considerable variation in the respective price movements for example the new york city bank stocks did quite well between 1958 and 1968. conversely the spectacular life insurance group actually lost ground between 1963 and 1968. these cross movements are found in many perhaps most of the numerous industry groups in the standard and poorest indexes we have no very helpful remarks to offer in this broad area of investment other than to counsel that the same arithmetical standards for price in relation to earnings and book value be applied to the choice of companies in these groups as we have suggested for industrial and public utility investments railroad issues the railroad story is a far different one from that of the utilities the carriers have suffered severely from a combination of severe competition and strict regulation their labor cost problem has of course been difficult as well but that has not been confined to railroads automobiles buses and airlines have drawn off most of their passenger business and left the rest highly unprofitable the trucks have taken a good deal of their freight traffic more than half of the railroad mileage of the country has been in bankruptcy or trusteeship at various times during the past 50 years but this half century has not been all downhill for the carriers there have been prosperous periods for the industry especially the war years some of the lines have managed to maintain their earning power and their dividends despite the general difficulties the standard and poorest index advanced seven-fold from the low of 1942 to the high of 1968 not much below the percentage gain in the public utility index the bankruptcy of the penn central transportation co our most important railroad in 1970 shocked the financial world only a year and two years previously the stock sold at close to the highest price level in its long history and it had paid continuous dividends for more than 120 years on p 423 below we present a brief analysis of this railroad to illustrate how a competent student could have detected the developing weaknesses in the company s picture and counselled against ownership of its securities the market level of railroad shares as a whole was seriously affected by this financial disaster it is usually unsound to make blanket recommendations of whole classes of securities and there are equal objections to broad condemnations the record of railroad share prices in table 14 6 shows that the group as a whole has often offered chances for a large profit but in our view the great advances were in themselves largely unwarranted let us confine our suggestion to this there is no compelling reason for the investor to own railroad shares before he buys any he should make sure that he is getting so much value for his money that it would be unreasonable to look for something else instead selectivity for the defensive investor every investor would like his list to be no better or more promising than the average hence the reader will ask whether if he gets himself a competent advisor or security analyst he should not be able to count on being supplied with an investment package of really superior merits after all comma he may say the rules you have outlined are pretty simple and easy going a highly trained analyst ought to be able to use all his skill and techniques to improve substantially on something as obvious as the dow jones list if not what good are all his statistics calculations and pontifical judgments question mark suppose as a practical test we had asked a hundred security analysts to choose the best five stocks in the dow jones average to be bought at the end of 1970. few would have come up with identical choices and many of the lists would have differed completely from each other this is not so surprising as it may at first appear the underlying reason is that the current price of each prominent stock pretty well reflects the salient factors in its financial record plus the general opinion as to its future prospects hence the view of any analyst that one stock is a better buy than the rest must arise to a great extent from his personal partialities and expectations or from the placing of his emphasis on one set of factors rather than on another in his work of evaluation if all analysts were agreed that one particular stock was better than all the rest that issue would quickly advance to a price which would offset all of its previous advantages our statement that the current price reflects both known facts and future expectations was intended to emphasize the double basis for market valuations corresponding with these two kinds of value elements are two basically different approaches to security analysis to be sure every competent analyst looks forward to the future rather than backward to the past and he realizes that his work will prove good or bad depending on what will happen and not on what has happened nevertheless the future itself can be approached in two different ways which may be called the way of prediction or projection and the way of protection those who emphasize prediction will endeavour to anticipate fairly accurately just what the company will accomplish in future years in particular whether earnings will show pronounced and persistent growth these conclusions may be based on a very careful study of such factors as supply and demand in the industry or volume price and costs or else they may be derived from rather naive projection of the line of past growth into the future if these authorities are convinced that the fairly long-term prospects are unusually favorable they will almost always recommend the stock for purchase without paying too much regard to the level at which it is selling such for example was the general attitude with respect to the air transport stocks and attitude that persisted for many years despite the distressingly bad results often shown after 1946. in the introduction we have commented on the disparity between the strong price action and the relatively disappointing earnings record of this industry by contrast those who emphasize protection are always especially concerned with the price of the issue at the time of study their main effort is to assure themselves of a substantial margin of indicated present value above the market price which margin could absorb unfavorable developments in the future generally speaking therefore it is not so necessary for them to be enthusiastic over the company s long run prospects as it is to be reasonably confident that the enterprise will get along the first or predictive approach could also be called the qualitative approach since it emphasizes prospects management and other unmeasurable albeit highly important factors that go under the heading of quality the second or protective approach may be called the quantitative or statistical approach since it emphasizes the measurable relationships between selling price and earnings assets dividends and so forth incidentally the quantitative method is really an extension into the field of common stocks of the viewpoint that security analysis has found to be sound in the selection of bonds and preferred stocks for investment in our own attitude and professional work we were always committed to the quantitative approach from the first we wanted to make sure that we were getting ample value for our money in concrete demonstrable terms we were not willing to accept the prospects and promises of the future as compensation for a lack of sufficient value in hand this has by no means been the standard viewpoint among investment authorities in fact the majority would probably subscribe to the view that prospects quality of management other intangibles and the human factor far outweigh the indications supplied by any study of the past record the balance sheet and all the other cold figures thus this matter of choosing the best stocks is at bottom a highly controversial one our advice to the defensive investor is that he let it alone let him emphasize diversification more than individual selection incidentally the universally accepted idea of diversification is in part at least the negation of the ambitious pretensions of selectivity if one could select the best stocks unerringly one would only lose by diversifying yet within the limits of the foremost general rules of common stock selection suggested for the defensive investor on pp 114 115 there is room for a rather considerable freedom of preference at the worst the indulgence of such preferences should do no harm beyond that it may add something worthwhile to the results with the increasing impacts of technological developments on long-term corporate results the investor cannot leave them out of his calculations here as elsewhere he must seek a mean between neglect and over emphasis chapter 15 stock selection for the enterprising investor in the previous chapter we have dealt with common stock selection in terms of broad groups of eligible securities from which the defensive investor is free to make up any list that he or his advisor prefers provided adequate diversification is achieved our emphasis in selection has been chiefly on exclusions advising on the one hand against all issues of recognizably poor quality and on the other against the highest quality issues if their price is so high as to involve a considerable speculative risk in this chapter addressed to the enterprising investor we must consider the possibilities and the means of making individual selections which are likely to prove more profitable than an across the board average what are the prospects of doing this successfully we would be less than frank as the euphemism goes if we did not at the outset express some grave reservations on this score at first blush the case for successful selection appears self-evident to get average results e dot g equivalent to the performance of the jia should require no special ability of any kind all that is needed is a portfolio identical with or similar to those 30 prominent issues surely then by the exercise of even a moderate degree of skill derived from study experience and native ability it should be possible to obtain substantially better results than the dow jones industrial average yet there is considerable and impressive evidence to the effect that this is very hard to do even though the qualifications of those trying it are of the highest the evidence lies in the record of the numerous investment companies or funds comma which have been in operation for many years most of these funds are large enough to command the services of the best financial or security analysts in the field together with all the other constituents of inadequate research department their expenses of operation when spread over their and pool capital average about one half of one percent a year they're wrong or less these costs are not negligible in themselves but when they are compared with the approximately 15 percent annual overall return on common stocks generally in the decade 1951 1960 and even the six percent return in 1961 1970 they do not bulk large a small amount of superior selective ability should easily have overcome that expense handicap and brought in a superior net result for the fund shareholders taken as a whole however the all common stock funds failed over a long span of years to earn quite as good a return as was shown on standard and poor s 500 stock averages or the market as a whole this conclusion has been substantiated by several comprehensive studies to quote the latest one before us covering the period 1961 968 it appears from these results that random portfolios of new york stock exchange stocks with equal investment in each stock performed on the average better over the period than did mutual funds in the same risk class the differences were fairly substantial for the low and medium risk portfolios 3.7 and 2.5 respectively per annum but quite small for the high-risk portfolios 0.2 per annum 1. as we pointed out in chapter 9 these comparative figures in no way invalidate the usefulness of the investment funds as a financial institution for they do make available to all members of the investing public the possibility of obtaining approximately average results on their common stock commitments for a variety of reassurance most members of the public who put their money in common stocks of their own choice fail to do nearly as well but to the objective observer the failure of the funds to better the performance of a broad average is a pretty conclusive indication that such an achievement instead of being easy is in fact extremely difficult why should this be so we can think of two different explanations each of which may be partially applicable the first is the possibility that the stock market does in fact reflect in the current prices not only all the important facts about the company's past and current performance but also whatever expectations can be reasonably formed as to their future if this is so then the diverse market movements which subsequently take place and these are often extreme must be the result of new developments and probabilities that could not be reliably foreseen this would make the price movements essentially fortuitous and random to the extent that the foregoing is true the work of the security analyst however intelligent and thorough must be largely ineffective because in essence he is trying to predict the unpredictable the very multiplication of the number of security analysts may have played an important part in bringing about this result with hundreds even thousands of experts studying the value factors behind an important common stock it would be natural to expect that its current price would reflect pretty well the consensus of informed opinion on its value those who would prefer it to other issues would do so for reasons of personal partiality or optimism that could just as well be wrong as right we have often thought of the analogy between the work of the host of security analysts on wall street and the performance of master bridge players at a duplicate bridge tournament the former tried to pick the stocks most likely to succeed the latter to get top score for each hand blade only a limited few can accomplish either aim to the extent that all the bridge players have about the same level of expertness the winners are likely to be determined by breaks of various sorts rather than superior skill on wall street the leveling process is helped along by the freemasonry that exists in the profession under which ideas and discoveries are quite freely shared at the numerous get-togethers of various sorts it is almost as if at the analogous bridge tournament the various experts were looking over each other's shoulders and arguing out each hand as it was played the second possibility is of a quite different sort perhaps many of the security analysts are handicapped by a flaw in their basic approach to the problem of stock selection they seek the industries with the best prospects of growth and the companies in these industries with the best management and other advantages the implication is that they will buy into such industries and such companies at any price however high and they will avoid less promising industries and companies no matter how low the price of their shares this would be the only correct procedure if the earnings of the good companies were sure to grow at a rapid rate indefinitely in the future for then in theory their value would be infinite and if the less promising companies were headed for extinction with no salvage the analysts would be right to consider them unattractive at any price the truth about our corporate ventures is quite otherwise extremely few companies have been able to show a high rate of uninterrupted growth for long periods of time remarkably few also of the larger companies suffer ultimate extinction for most their history is one of vicissitudes of ups and downs of change in their relative standing in some the variations from rags to riches and back have been repeated on almost a cyclical basis the phrase used to be a standard one applied to the steel industry for others spectacular changes have been identified with deterioration or improvement of management how does the foregoing inquiry apply to the enterprising investor who would like to make individual selections that will yield superior results it suggests first of all that he is taking on a difficult and perhaps impracticable assignment readers of this book however intelligent and knowing could scarcely expect to do a better job of portfolio selection than the top analysts of the country but if it is true that a fairly large segment of the stock market is often discriminated against or entirely neglected in the standard analytical selections then the intelligent investor may be in a position to profit from the resultant undervaluations but to do so he must follow specific methods that are not general ally accepted on wall street since those that are so accepted do not seem to produce the results everyone would like to achieve it would be rather strange if with all the brains that work profession ally in the stock market there could be approaches which are both sound and relatively unpopular yet our own career and reputation have been based on this unlikely fact a summary of the graham newman methods to give concreteness to the last statement it should be worthwhile to give a brief account of the types of operations we engaged in during the 30-year life of graham newman corporation between 1926 and 1956.these were classified in our records as follows arbitrage is the purchase of a security and the simultaneous sale in this section as he did also on pp 363 364 graham is summarizing the efficient market hypothesis recent appearances to the contrary the problem with the stock market today is not that so many financial analysts are idiots but rather that so many of them are so smart as more and more smart people search the market for bargains that very act of searching makes those bargains rarer and in a cruel paradox makes the analysts look as if they lack the intelligence to justify the search the market s valuation of a given stock is the result of a vast continuous real-time operation of collective intelligence most of the time for most stocks that collective intelligence gets the valuation approximately right only rarely does graham s mr market see chapter 8 send prices wildly out of whack graham launched graham newman corporation in january 1936 and dissolved it when he retired from active money management in 1956. it was the successor to a partnership called the benjamin graham joint account which he ran from january 1926 through december 1935 stock selection for the enterprising investor 381 of one or more other securities into which it was to be exchanged under a plan of reorganization merger or the like liquidations purchase of shares which were to receive one or more cash payments in liquidation of the company s assets operations of these two classes were selected on the twin basis of a a calculated annual return of 20 or more and b our jug meant that the chance of a successful outcome was at least four out of five related hedges the purchase of convertible bonds or convertible preferred shares and the simultaneous sale of the common stock into which they were exchangeable the position was established at close to a parity basis i.t at a small maximum loss if the senior issue had actually to be converted and the operation closed out in that way but a profit would be made if the common stock fell considerably more than the senior issue and the position closed out in the market net current asset or bargain issues the idea here was to acquire as many issues as possible at a cost for each of less than their book value in terms of net current assets alone i.t giving no value to the plant account and other assets our purchases were made typically at two-thirds or less of such stripped-down asset value in most years we carried a wide diversification here at least 100 different issues we should add that from time to time we had some large scale acquisitions of the control type but these are not relevant to the present discussion we kept close track of the results shown by each class of operation in consequence of these follow-ups we discontinued two broader fields which were found not to have shown satisfactory overall results the first was the purchase of apparently attractive issues based on our general analysis which were not obtainable at less than their working capital value alone the second were unrelated hedging operations in which the purchased security was not exchangeable for the common shares sold such operations correspond roughly to those recently embarked on by the new group of hedge funds in the investment company field in an unrelated hedge involves buying a stock or bond issued by one company in short selling or betting on a decline in a security issued by a diff 382 both cases a study of the results realized by us over a period of 10 years or more led us to conclude that the profits were not sufficiently dependable and the operations not sufficiently headache proof to justify our continuing them hence from 1939 on our operations were limited to self-liquidating situations related hedges working capital bargains and a few control operations each of these classes gave us quite consistently satisfactory results from then on with the special fear to that the related hedges turned in good profits in the bear markets when our undervalued issues were not doing so well we hesitate to prescribe our own diet for any large number of intelligent investors obviously the professional techniques we have followed are not suitable for the defensive investor who by definition is an amateur as for the aggressive investor perhaps only a small minority of them would have the type of temperament needed to limit themselves so severely to only a relatively small part of the world of securities most active-minded practitioners would prefer to venture into wider channels their natural hunting grounds would be the entire field of securities that they felt a were certainly not overvalued by conservative measures and b appeared decidedly more attractive because of their prospects or past record or both than the average common stock in such choices they would do well to apply various tests of quality and price reasonableness along the lines we have proposed for the defensive investor but they should be less inflexible permitting a considerable plus in one factor to offset a small black mark in another for example he might not rule out a company which had shown a deficit in a year such as 1970 if large average earnings and other important attributes made the stock look cheap the enterprising investor may confine his choice to industries and companies about which he holds an optimistic view but we counsel strongly against paying a high price for a stock in relation to earn kings and assets because of such enthusiasm if he followed our philosophy in this field he would more likely be the buyer of important cyclical enterprises such as steel shares perhaps when the current situation is unfavorable the near-term prospects are poor and the low price fully reflects the current pessimism secondary next in order for examination and possible selection would come secondary companies that are making a good showing have a satisfactory past record but appear to hold no charm for the public these would be enterprises on the order of ultra and mrt at their 1970 closing prices see chapter 13 above there are various ways of going about locating such companies we should like to try a novel approach here and give a reasonably detailed exposition of one such exercise in stock selection ours is a double purpose many of our readers may find a substantial practical value in the method we shall follow or it may suggest comparable methods to try out beyond that what we shall do may help them to come to grips with the real world of common stocks and introduce them to one of the most fascinating and valuable little volumes in existence it is standard and poorest stock guide published monthly and made available to the general public under annual subscription in addition many brokerage firms distribute the guide to their clients on request the great bulk of the guide is given over to about 230 pages of condensed statistical information on the stocks of more than 4500 companies these include all the issues listed on the various exchanges say 3000 plus some 1500 unlisted issues most of the items needed for a first and even a second look at a given company appear in this compendium from our viewpoint the important missing datum is the net asset value or book value per share which can be found in the larger standard and poorest volumes and elsewhere the investor who likes to play around with corporate figures will find himself in clover with the stock guide he can open to any page and see before his eyes are condensed panorama of the splendors and miseries of the stock market with all-time high and low prices going as far back as 1936 when available he will find companies that have multiplied their price 2000 times from the minuscule low to the majestic high for prestigious ibm the growth was only 330 times in that period he will find not so exceptionally a company whose shares advanced from three question mark 8 to 68 and then fell back to 3.2 in the dividend record column he will find one that goes back to 1791 paid by industrial national bank of rhode island which recently saw fit to change its ancient corporate name if he looks at the guide for the year end 1969 he will read that penn central company as successor to pennsylvania railroad has been paying dividends steadily since 1848 alas it was doomed to bankruptcy a few months later he will find a company selling at only two times its last reported earnings and another selling at 99 times such earnings.3 in most cases he will find it difficult to tell the line of business from the corporate name for one u.s steel there will be three called such things as iti corporation bakery stuff or santa fe industries mainly the large railroad he can feast on an extraordinary variety of price histories dividend earnings histories financial positions capitalization setups and what not backward leaning conservatism run-of-the-mine featureless companies the most peculiar combinations of principal business comma all kinds of wall street gadgets and widgets they are all there waiting to be browsed over or studied with a serious objective the guides give in separate columns the current dividend yields and price earnings ratios based on latest 12-month figures wherever applicable it is this last item that puts us on the track of our exercise in common stock selection a winnowing of the stock guide suppose we look for a simple prima facie indication that a stock is cheap the first such clue that comes to mind is a low price in relation to recent earnings let s make a preliminary list of stocks that sold at a multiple of 9 or less at the end of 1970. that datum is conveniently provided in the last column of the even numbered pages for an illustrative sample we shall take the first 20 such low multiplier stocks they begin with the sixth issue listed aberdeen manufacturing go which closed the year at 101 question mark 4 or 9 times its reported earnings of 1.20 per share for the 12 months ended september 1970. the 20th such issue is american maze products which closed at 91 question mark 2 also with a multiplier of nine the group may have seemed mediocre with ten issues selling below ten dollars per share this fact is not truly important it would probably not necessarily warn defensive investors against such a list but the inference for enterprising investors might be favorable on balance before making a further scrutiny let us calculate some numbers our list represents about 1 in 10 of the first 200 issues looked at on that basis the guide should yield say 450 issues selling at multipliers under 10. this would make a goodly number of candidates for further selectivity so let us apply to our list some additional criteria rather similar to those we suggested for the defensive investor but not so severe we suggest the following 1. financial condition a current assets at least 11 question mark two times current liabilities and b debt not more than 110 of net current assets for industrial companies 2. earnings stability no deficit in the last five years covered in the stock guide 3. dividend record some current dividend 4. earnings growth last year s earnings more than those of 1966 5. price less than 120 net tangible assets the earnings figures in the guy were generally for those ending september 30 1970 and thus do not include what may be a bad quarter at the end of that year but an intelligent investor can t ask for the moon at least not to start with note also that we set no lower limit on the size of the enterprise small companies may afford enough safety if bought carefully and on a group basis when we have applied the five additional criteria our list of 20 candidates is reduced to only five let us continue our search until the first 450 issues in the guide have yielded us a little portfolio of 15 stocks meeting our six requirements they are set forth in table 15 1 together with some relevant data the group of course is presented for illustration only and would not necessarily have been chosen by our inquiring investor the fact is that the user of our method would have had a much wider choice if our winnowing approach had been applied to all 4500 companies in the stock guide and if the ratio for the first tenth had held good throughout we would end up with about 150 companies meeting all six of our criteria of selection the enterprising investor would then be able to follow his judgment or his partialities and prejudices in making a third selection of say one out of 5 in this ample list the stock guide material includes earnings and dividend rankings comma which are based on stability and growth of these factors for the past eight years thus price attractiveness does not enter here we include the s and p rankings in our table 15 1. 10 of the 15 issues are ranked b plus equals average and one american maze is given the high rating of a if our enterprising investor wanted to add a seventh mechanical criterion to his choice by considering only issues ranked by standard and poorest as average or better in quality he might still have about 100 such issues to choose from one might say that a group of issues of at least average quality meeting criteria of financial condition as well purchasable at a low multiplier of current earnings and below asset value should offer good promise of satisfactory investment results single criteria for choosing common stocks an inquiring reader might well ask whether the choice of a better than average portfolio could be made a simpler affair than we have just outlined could a single plausible criterion be used to good advantage such as a low price earnings ratio or a high dividend return or a large asset value the two methods of this sort that we have found to give quite consistently good results in the longer past have been a the purchase of low multiplier stocks of important companies such as the dow jones industrial average list and b the choice of a diversified group of stocks selling under their net current asset value or working capital value we have already pointed out that the low multiplier criterion applied to the dow jones industrial average at the end of 1968 worked out badly when the results are measured to mid 1971. the record of common stock purchases made at a price below their working capital value has no such bad mark against it the drawback here has been the drying up of such opportunities during most of the past decade what about other bases of choice in writing this book we have made a series of experiments comma each based on a single fairly obvious criterion the data used would be readily found in the standard and poorest stock guide in all cases a 30-stop portfolio was assumed to have been acquired at the 1968 closing prices and then revalued at june 30 1971. the separate criteria applied were the following as applied to otherwise random choices 1. a low multiplier of recent earnings not confined to dow jones industrial average issues 2. a high dividend return 3 a very long dividend record for a very large enterprise as measured by number of outstanding shares 5 a strong financial position 6. a low price in dollars per share 7 a low price in relation to the previous high price 8. a high quality ranking by standard and poorest it will be noted that the stock guide has at least one column relating to each of the above criteria this indicates the publisher s belief that each is of importance in analyzing and choosing common stocks as we pointed out above we should like to see another figure added the net asset value per share the most important fact that emerges from our various tests relates to the performance of stock sport at random we have tested this performance for three 30-stop portfolios each made up of issues found on the first line of the december 31 1968 stock guide and also found in the issue for august 31 1971. between these two dates the s p composite was practically unchanged and the dow jones industrial average lost about 5 but our 90 randomly chosen issues declined an average of 22 not counting 19 issues that were dropped from the guide and probably showed larger losses these comparative results undoubtedly reflect the tendency of smaller issues of inferior quality to be relatively overvalued in bull markets and not only to suffer more serious declines than the stronger issues in the ensuing price collapse but also to delay their full recovery in many cases indefinitely the moral for the intelligent investor is of course to avoid second quality issues in making up a portfolio unless for the enterprising investor they are demonstrable bargains other results gleaned from our portfolio studies may be summarized as follows only three of the groups studied showed up better than the s and p composite and hence better than the dow jones industrial average viz one industry als with the highest quality ranking a plus these advanced 91 2 in the period against a decline of 2.4 percent for the s p industrials and 5.6 percent for the dow jones industrial average however the 10 public utility issues rated a plus declined 18 against a decline of 14 for the 55 stock s and p public utility index it is worth remarking that the s and p rankings showed up very well in this single test in every case a portfolio based on a higher ranking did better than a lower ranking portfolio 2 companies with more than 50 million shares outstanding showed no change on the whole as against a small decline for the indexes 3 strangely enough stocks selling at a high price per share over 100 showed a slight 1 composite advance among our various tests we made one based on book value a figure not given in the stock guide here we found contrary to our investment philosophy that companies that combine major size with a large goodwill component in their market price did very well as a whole in the 21 question mark two-year holding period by goodwill component we mean the part of the price that exceeds the book value our list of goodwill giants was made up of 30 issues each of which had a goodwill component of over a billion dollars representing more than half of its market price the total market value of these goodwill items at the end of 1968 was more than 120 dollars billions despite these optimistic market valuations the group as a whole showed a price advance per share of 15 between december 1968 and august 1971 and acquitted itself best among the 20 odd lists studied a fact like this must not be ignored in a work on investment policies it is clear that at the least a considerable momentum is attached to those companies that combine the virtues of great size an excellent past record of earnings the public s expectation of continued earnings growth in the future and strong market action over many past years even if the price may appear excessive by our quantitative standards the underlying market momentum may well carry such issues along more or less indefinitely naturally this assumption does not apply to every individual issue in the category for example the indisputable goodwill leader ibm moved down from 315 to 304 in the 30-month period it is difficult to judge to what extent the superior market action shown is due to true or objective investment merits and to what extent along established popularity no doubt both factors are important here clearly both the long term and the recent market action of the goodwill giants would recommend them for a diversified portfolio of common stocks our own preference however remains for other types that show a combination of favorable investment factors including asset values of at least two-thirds the market price the tests using other criteria indicate in general that random lists based on a single favorable factor did better than random lists chosen for the opposite factor e dot g low multiplier issues had a smaller decline in this period than high multiplier issues and long-term dividend payers lost less than those that were not paying dividends at the end of 1968. to that extent the results support our recommendation that the sus selected meet a combination of quantitative or tangible criteria finally we should comment on the much poorer showing made by our lists as a whole as compared with the price record of the s p composite the latter is weighted by the size of each enterprise whereas our tests are based on taking one share of each company evidently the larger emphasis given to giant enterprises by the s p method made a significant difference in the results and points up once again their greater price stability is compared with run-of-the-mine companies bargain issues or net current asset stocks in the tests discussed above we did not include the results of buying 30 issues at a price less than their net current asset value the reason was that only a handful at most of such issues would have been found in the stock guide at the end of 1968 but the picture changed in the 1970 decline and at the low prices of that year a goodly number of common stocks could have been bought at below their working capital value it always seemed and still seems ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone after deducting all prior claims and counting as zero the fixed and other assets the results should be quite satisfactory they were so in our experience for more than 30 years say between 1923 and 1957 excluding a time of real trial in 1931 932 has this approach any relevance at the beginning of 1971 our answer would be a qualified yes dot a quick run over of the stock guide would have uncovered some 50 or more issues that appeared to be obtainable at or below net current asset value as might be expected a good many of these had been doing badly in the difficult year 1970. if we eliminated those which had reported net losses in the last 12-month period we would be still left with enough issues to make up a diversified list we have included in table 15 2 some data on 5 issues that sold at less than their working capital value at their low prices of technically the working capital value of a stock is the current assets per share minus the current liabilities per share divided by the number of shares outstanding here however graham means networking capital value comma or the per share value of current assets minus total liabilities 1970. these give some food for reflection on the nature of stock price fluctuations how does it come about that well-established companies whose brands are household names all over the country could be valued at such low figures at the same time when other concerns with better earnings growth of course were selling for billions of dollars in excess of what their balance sheets showed to quote the old days once more the idea of goodwill as an element of intangible value was usually associated with a trade name dot names such as lady pepperell in sheetz janssen in swimsuits and parker in pens would be considered assets of great value indeed but now if the market doesn't like a company common not only renowned trade names but land buildings machinery and what you will can all count for nothing in its scales pascal said that the heart has its reasons that the reason doesn't he understand.for heart read wall street dot there is another contrast that comes to mind when the going is good and new issues are readily saleable stock offerings of no quality at all make their appearance they quickly find buyers their prices are often bid up enthusiastically right after issuance to levels in relation to assets and earnings that would put ibm xerox and polaroid to shame wall street takes this madness in its stride with no overt efforts by anyone to call a halt before the inevitable collapse in prices the sec can t do much more than insist on disclosure of information about which the speculative public couldn't take care less or announce investigations and usually mild punitive actions of various sorts after the letter of the law has been clearly broken when many of these miniscule but grossly inflated enterprises disappear from view or nearly so it is all taken philosophically enough as part of the game.everybody swears off such inexcusable extravagances until next time thanks for the lecture says the gentle reader but what about your bargain issues can one really make money in them without taking a serious risk yes indeed if you can find enough of them to make a diversified group and if you don t lose patience if they fail to advance soon after you buy them sometimes the patients needed may appear quite considerable in our previous edition we hazarded a single example p 188 which was current as we wrote it was burton dixie corporation with stock selling at 20 against net current asset value of 30 and book value of about 50. a profit on that purchase would not have been immediate but in august 1967 all the shareholders were offered 533 question mark 4 for their shares probably at just about book value a patient holder who had bought the shares in march 1964 at 20 would have had a profit of 165 in 31 question mark 2 years a non-compounded annual return of 47 most of the bargain issues in our experience have not taken that long to show good profits nor have they shown so higher rate for a somewhat similar situation current as we write see our discussion of national presto industries above p 168 special situations or workouts let us touch briefly on this area since it is theoretically incredible in the program of operations of an enterprising investor it was commented upon above here we shall supply some examples of the genre and some further remarks on what it appears to offer an open-minded and alert investor three such situations among others were current early in 1971 and they may be summarized as follows situation 1. acquisition of kaiser roth by borden s in january 1971 borden incorporated announced a plan to acquire control of kaiser roth diversified apparel by giving 11 question mark 3 shares of its own stock in exchange for one share of kaiser roth on the following day in active trading borden closed at 26 and kaiser roth at 28. if an operator had bought 300 shares of kaiser roth and sold 400 board n at these prices and if the deal were later consummated on the announced terms he would have had a profit of some 24 on the cost of his shares less commissions and some other items assuming the deal had gone through in six months his final profit might have been at about a forty percent per annum rate situation two in november 1970 national biscuit company offered to buy control of aurora plastics company at 11 in cash the stock was selling at about 81 question mark 2. it closed the month at 9 and continued to sell there at year end here the gross profit indicated was originally about 25 subject to the risks of non-consummation and to the time element situation 3 universal marion co which had ceased its business operations asked its shareholders to ratify dissolution of the concern the treasurer indicated that the common stock had a book value of about 281 question mark 2 per share a substantial part of which was in liquid form the stock closed 1970 at 211 question mark 2 indicating a possible gross profit here if book value was realized in liquidation of more than 30 if operations of this kind conducted on a diversified basis for spreading the risk could be counted to yield annual profits of say 20 or better they would undoubtedly be more than merely worthwhile since this is not a book on special situations comma we are not going into the details of the business for it really is a business let us point out two contradictory developments there in recent years on the one hand the number of deals to choose from has increased enormously as compared with say 10 years ago this is a consequence of what might be called a mania of corporations to diversify their activities through various types of acquisitions etc in 1970 the number of merger announcements aggregated some 5000 down from over 6000 in 1969 the total money values involved in these deals amounted to many many billions perhaps only a small fraction of the 5 000 announcements could have presented a clear-cut opportunity for purchase of shares by a special situations man but this fraction was still large enough to keep him busy studying picking and choosing the other side of the picture is that an increasing proportion of the mergers announced fails to be consummated in such cases of course the aim for profit is not realized and is likely to be replaced by a more or less serious loss reasons for non-success are numerous including antitrust intervention shareholder opposition change in market conditions comma unfavorable indications from further study inability to agree on details and others the trick here of course is to have the judgment buttressed by experience to pick the deals most likely to succeed and also those which are likely to occasion the smallest loss if they fail as discussed in the commentary on chapter 7 merger arbitrage is wholly inappropriate for most individual investors further comment on the examples above kaiser roth the directors of this company had already rejected in january 1971 the borden proposal when this chapter was written if the operation had been undone immediately the overall loss including commissions would have been about 12 percent of the cost of the kaiser shares aurora plastics because of the bad showing of this company in 1970 the takeover terms were renegotiated and the price reduced to 101 question mark 2. the shares were paid for at the end of may the annual rate of return realized here was about 25 universal marion this company promptly made an initial distribution in cash and stock worth about seven dollars per share reducing the investment to say 141 question mark ii however the market price fell as low as 13 subsequently casting doubt on the ultimate outcome of the liquidation assuming that the three examples given are fairly representative of workout or arbitrage opportunities as a whole in 1971 it is clear that they are not attractive if entered into upon a random basis this has become more than ever a field for professionals with the requisite experience and judgment there is an interesting sidelight on our kaiser roth example late in 1971 the price fell below 20 while borden was selling at 25 equivalent to 33 for kaiser roth under the terms of the exchange offer it would appear that either the directors had made a great mistake in turning down that opportunity or the shares of kaiser roth were now badly undervalued in the market something for a security analyst to look into chapter 16 convertible issues and warrants convertible bonds and preferred stocks have been taking on a predominant importance in recent years in the field of senior financing as a parallel development stock option warrants which are long-term rights to buy common shares at stipulated prices have become more and more numerous more than half the preferred issues now quoted in the standard and poorest stock guide have conversion privileges and this has been true also of a major part of the corporate bond financing in 1968 1970. there are at least 60 different series of stock option warrants dealt in on the american stock exchange in 1970 for the first time in its history the new york stock exchange listed an issue of long-term war ants giving rights to buy 31 million 400 000 american telephone and telephone shares at each with mother bell now leading that procession it is bound to be augmented by many new fabricators of warrants as we shall point out later they are a fabrication in more than one sense in the overall picture the convertible issues rank as much more important than the warrants and we shall discuss them first there are two main aspects to be considered from the standpoint of the investor first how do they rank as investment opportunities and risks second how does their existence affect the value of the related common stock issues convertible su's are claimed to be especially advantageous to both the investor and the issuing corporation the investor receives the superior protection of a bond or preferred stock plus the opportunity to participate in any substantial rise in the value of the common stock the issuer is able to raise capital at a moderate interest or preferred dividend cost and if the expected prosperity materializes the issuer will get rid of the senior obligation by having it exchanged into common stock thus both sides to the bargain will fare unusually well obviously the foregoing paragraph must overstate the case somewhere for you cannot buy a mere ingenious device make a bargain much better for both sides in exchange for the conversion privilege the investor usually gives up something important in quality or yield or both dot one conversely if the company gets its money at lower cost because of the conversion feature it is surrendering in return part of the common shareholders claim to future enhancement on this subject there are a number of tricky arguments to be advanced both pro and con the safest conclusion that can be reached is that convertible issues are like any other form of security in that their form itself guarantees neither attractiveness nor unattractiveness that question will depend on all the facts surrounding the individual issue we do know however that the group of convertible issues floated during the latter part of a bull market are bound to yield unsatisfactory results as a whole it is at such optimistic periods unfortunately that most of the convertible financing has been done in the past the poor consequences must be inevitable from the timing itself since a wide decline in the stock market must invariably make the conversion privilege much less attractive and often also call in to question the underlying safety of the issue itself.as a group illustration we shall retain the example used in our first edition of the relative price behavior of convertible and straight non-convertible prefronds offered in 1946 the closing year of the bull market preceding the extraordinary one that began in 1949 a comparable presentation is difficult to make for the years 1967 1970 because there were virtually no new offerings of non-convertibles in those years but it is easy to demonstrate that the average price decline of convertible preferred stocks from december 1967 to december 1970 was greater than that for common stocks as a whole which lost only 5 also the convertibles seem to have done quite a bit worse than the older straight preferred shares during the period december 1968 to december 1970 as is shown by the sample of 20 issues of each kind in table 16 2. these comparisons would demonstrate that convertible securities as a whole have relatively poor quality as senior issues and also are tied to common stocks that do worse than the general market except during a speculative upsurge these observations do not apply to all convertible issues of course in the 1968 and 1969 particularly a fair number of strong companies used convertible issues to combat the inordinately high interest rates for even first quality bonds but it is noteworthy that in our 20 stock sample of convertible preferreds only one showed in advance and 14 suffered bad declines the conclusion to be drawn from these figures is not that convertible issues are in themselves less desirable than non-convertible or straight securities other things being equal the opposite is true but we clearly see that other things are not equal in practice and that the addition of the conversion privilege often perhaps generally betrays an absence of genuine investment quality for the issue it is true of course that a convertible preferred is safer than the common stock of the same company that is to say it carries smaller risk of eventual loss of principle consequently those who buy new convertibles instead of the corresponding common stock are logical to that extent but in most cases the common would not have been an intelligent purchase to begin with at the ruling price and the substitution of the convertible preferred did not improve the picture sufficiently furthermore a good deal of the buying of convertibles was done by investors who had no special interest or confidence in the common stock that is they would never have thought of buying the common at the time but who were tempted by what seemed an ideal combination of a prior claim plus a conversion privilege close to the current market in a number of instances this combination has worked out well but the statistics seem to show that it is more likely to prove a pitfall in connection with the ownership of convertibles there is a special problem which most investors fail to realize even when a profit appears it brings a dilemma with it should the holder sell on a small rise should he hold for a much bigger advance if the issue is called as often happens when the common has gone up considerably should he sell out then or convert into and retain the common stock let us talk in concrete terms you buy a six percent bond at 100 convertible into stock at 25 that is at the rate of 40 shares for each 1000 bond the stock goes to 30 which makes the bond worth at least 120 and so it sells at 125. you either sell or hold if you hold hopping for a higher price you are pretty much in the position of a calm shareholder since if the stock goes down your bond will go down too a conservative person is likely to say that beyond 125 his position has become too speculative and therefore he sells and makes a gratifying 25 profit so far so good but pursue the matter a bit in many cases where the holder sells at 125 the common stock continues to advance car eyeing the convertible with it and the investor experiences that peculiar pain that comes to the man who has sold out much too soon the next time he decides to hold for 150 or 200 the issue goes up to 140 and he does not sell then the market breaks and his bond slides down to 80. again he has done the wrong thing aside from the mental anguish involved in making these bad guesses and they seem to be almost inevitable there is a real arithmetical drawback to operations in convertible issues it may be assumed that a stern and uniform policy of selling at 25 or 30 profit will work out best as applied to many holdings this would then mark the upper limit of profit and would be realized only on the issues that worked out well but if as appears to be true these issues often lack adequate underlying security and tend to be floated and purchased in the latter stages of a bull market then a goodly proportion of them will fail to rise to 125 but will not fail to collapse when the market turns downward thus the spectacular opportunities and convertibles prove to be illusory in practice and the overall experience is marked by fully as many substantial losses at least of a temporary kind as there are gains of similar magnitude because of the extraordinary length of the 1951 968 bull market convertible sus as a whole gave a good account of themselves for some 18 years but this meant only that the great majority of common stocks enjoyed large advances in which most convertible sus were able to share the soundness of investment in convertible issues can only be tested by their performance in a declining stock market and this has always proved disappointing as a whole in our first edition 1949 we gave an illustration of this special problem of what to do with a convertible when it goes up we believe it still merits inclusion here like several of our references it is based on our own investment operations we were members of a select group comma mainly of investment funds who participated in a private offering of convertible 41 2 debentures of ever sharp company at par convertible into common stock at 40. per share the stock advanced rapidly to 651 question mark 2 and then after a 3 for 2 split to the equivalent of 88 the latter price made the convertible debentures worth no less than 220. during this period the two issues were called at a small premium hence they were practically all converted into common stock which was retained by a number of the original investment fund buyers of the debentures the price promptly began a severe decline and in march 1948 the stock sold as low as 73 question mark 8. this represented a value of only 27 for the debenture issues or a loss of 75 of the original price instead of a profit of over 100 the real point of this story is that some of the original purchasers converted their bonds into the stock and held the stock through its great decline in so doing they ran counter to an old maxim of wall street which runs never convert a convertible bonds dot why this advice because once you convert you have lost your strategic combination of prior claimant to interest plus a chance for an attractive profit you have probably turned from investor into speculator and quite often at an unpropitious time because the stock has already had a large advance if never converter convertible is a good rule how came it that these experienced fund managers exchanged their ever sharp bonds for stock to their subsequent embarrassing loss the answer no doubt is that they let themselves be carried away by enthusiasm for the company s prospects as well as by the favorable market action of the shares wall street has a few prudent principles the trouble is that they are always forgotten when they are most needed hence that other famous dictum of the old timers do as i say not as i do dot our general attitude toward new convertible issues is thus a mistrustful one we mean here as in other similar observations that the investor should look more than twice before he buys them after such hostile scrutiny he may find some exceptional offerings that are too good to refuse the ideal combination of course is a strongly secured convertible exchangeable for a common stock which itself is attractive and at a price only slightly higher than the current market every now and then a new offering appears that meets these requirements by the nature of the securities markets however you are more likely to find such an opportunity in some older issue which has developed into a favorable position rather than in a new floatation if a new issue is a really strong one it is not likely to have a good conversion privilege the fine balance between what is given and what is withheld in a standard type convertible issue is well illustrated by the extensive use of this type of security in the financing of american telephone and telegraph company between 1913 and 1957 the company sold at least nine separate issues of convertible bonds most of them through subscription rights to shareholders the convertible bonds had the important advantage to the company of bringing in a much wider class of buyers than would have been available for a stock offering since the bonds were popular with many financial institutions which possess huge resources but some of which were not permitted to buy stocks the interest return on the bonds has generally been less than half the corresponding dividend yield on the stock a factor that was calculated to offset the prior claim of the bondholders since the company maintained its nine dollars dividend rate for 40 years from 1919 to the stock split in 1959 the result was the eventual conversion of virtually all the convertible issues into common stock thus the buyers of these convertibles have fared well through the years but not quite so well as if they had bought the capital stock in the first place this example establishes the soundness of american telephone and telegraph but not the intrinsic attractiveness of convertible bonds to prove them sound in practice we should need to have a number of instances in which the convertible worked out well even though the common stock proved disappointing such instances are not easy to find effective convertible issues on the status of the common stock in a large number of cases convertibles have been issued in connection with mergers or new acquisitions perhaps the most striking example of this financial operation was the issuance by the nvf corporation of nearly 100 million dollars of its 5 convertible bonds plus warrants in exchange for most of the common stock of sharon steel company this extraordinary deal is discussed below pp 429 433. typically the transaction results in a pro forma increase in the reported earnings per share of common stock the shares advance in response to their larger earnings so called but also because the management has given evidence of its energy enterprise and ability to make more money for the shareholders but there are two offsetting factors one of which is practically ignored and the other entirely so in optimistic markets the first is the actual dilution of the current and future earnings on the common stock that flows arithmetically from the new conversion rights this dilution can be quantified by taking the recent earnings or assuming some other figures and calculating the adjusted earnings per share if all the convertible shares or bonds were actually converted in the majority of companies the resulting reduction in per share figures is not significant but there are numerous exceptions to this statement and there is danger that they will grow at an uncomfortable rate the fast expanding conglomerates have been the chief practitioners of convertible legit domain in table 16 3 we list seven companies with large amounts of stock issuable on conversions or against warrant stock indicated switches from common into preferred stocks for decades before say 1956 common stocks yielded more than the preferred stocks of the same companies this was particularly 412. true if the preferred stock had a conversion privilege close to the market the reverse is generally true at present as a result there are a considerable number of convertible preferred stocks which are clearly more attractive than the related common shares owners of the common have nothing to lose and important advantages to gain by switching from their junior shares into the senior issue example a typical example was presented by studebaker worthington corporation at the close of 1970. the common sold at 57 while the five dollars convertible preferred finished at 871 question mark 2. each preferred share is exchangeable for 11 question mark 2 shares of common then worth 851 question mark 2. this would indicate a small money difference against the buyer of the preferred but dividends are being paid on the common at the annual rate of 1.20 or 1.80 for the 11 question mark 2 shares against the five dollars obtainable on one share of preferred thus the original adverse difference in price would probably be made up in less than a year after which the preferred would probably return an appreciably higher dividend yield than the common for some time to come but most important of course would be the senior position that the common shareholder would gain from the switch at the low prices of 1968 and again in 1970 the preferred sold 15 points higher than 11 question mark two shares of common its conversion privilege guarantees that it could never sell lower than the common package.2 stock option warrants let us mince no words at the outset we consider the recent development of stock option warrants as an ear fraud an existing menace and a potential disaster they have created huge aggregate dollar values out of thin air they have no excuse for existence except to the extent that they mislead speculators and investors they should be prohibited by law or at least strictly limited to a minor part of the total capitalization of a company for an analogy in general history and in literature we refer the reader to the section of faust part 2 in which gerta describes the invention of paper money as an ominous precedent on wall street history we may mention the warrants of american and for in powerco which in 1929 had a quoted market value of over a billion dollars although they appeared only in a footnote to the company s balance sheet by 1932 this billion dollars had shrunk to 8 million dollars and in 1952 the warrants were wiped out in the company s recapitalization even though it had remained solvent originally stock option warrants were attached now and then to bond issues and were usually equivalent to a partial conversion privilege they were unimportant in amount and hence did no harm their use expanded in the late 1920s along with many other financial abuses but they dropped from sight for long years thereafter they were bound to turn up again like the bad pennies they are and since 1967 they have become familiar instruments of finance dot in fact a standard procedure has developed for raising the capital for new real estate ventures affiliates of large banks by selling units of an equal number of common shares and warrants to buy additional common shares at the same price example in 1971 cleve trust realty investors sold 2 million 500 000 of these combinations of common stock or shares of beneficial interest and war ants for 20 dollars per unit let us consider for a moment what is really involved in this financial setup ordinarily a common stock issue has the first right to buy additional common shares when the company s directors find it desirable to raise capital in this manner this so-called preemptive right is one of the elements of value entering into the ownership of common stock along with the right to receive dividends to participate in the company s growth and to vote for directors when separate warrants are issued for the right to subscribe additional capital that action takes away part of the value inherent in an ordinary common share and transfers it to a separate certificate an analogous thing could be done by issuing separate certificates for the right to receive dividends for a limited or unlimited period or the right to share in the proceeds of sale or liquidation of the enterprise or the right to vote the shares why then are these subscription warrants created as part of the original capital structure simply because people are an expert in financial matters they don't realize that the common stock is worth less with warrants outstanding than otherwise hence the package of stock and warrants usually commands a better price in the market than would the stock alone note that in the usual company reports the per share earnings are or have been computed without proper allowance for the effect of outstanding warrants the result is of course to overstate the true relationship between the earnings and the market value of the company s capitalization the simplest and probably the best method of allowing for the existence of warrants is to add the equivalent of their market value to the common share capitalization thus increasing the true market price per share where large amounts of warrants have been issued in connection with the sale of senior securities it is customary to make the adjustment by assuming that the proceeds of the stock payment are used to retire the related bonds or preferred shares this method does not allow adequately for the usual premium value of a warrant above exercisable value in table 16 4 we compare the effect of the two methods of calculation in the case of national general corporation for the year 1970. does the company itself derive an advantage from the creation of these warrants in the sense that they assure it in some way of receiving additional capital when it needs some not at all ordinarily there is no way in which the company can require the war and holders to exercise their rights and thus provide new capital to the company prior to the expiration date of the warrants in the meantime if the company wants to raise additional common stock funds it must offer the shares to its shareholders in the usual way which means somewhat under the ruling market price the war ants are no help in such an operation they merely complicate the situation by frequently requiring a downward revision in their own subscription price once more we assert that largest use of stock option warrants serve no purpose except to fabricate imaginary market values the paper money that goethe was familiar with when he wrote his faust were the notorious french assignats that had been greeted as a marvelous invention and were destined ultimately to lose all of their value as did the billion dollars worth of american and foreign power warrants some of the poetess remarks apply equally well to one invention or another such as the following in bayard taylor s translation practical postscript the crime of the warrants is in having been born once born they function as other security forms and offer chances of profit as well as of loss nearly all the newer warrants run for a limited time generally between 5 and 10 years the older warrants were often perpetual and they were likely to have fascinating price histories over the years example the record books will show the tri-continental corporation warrants which date from 1929 sold at a negligible 132nd of a dollar each in the depth of the depression from that lowly estate their price rose to a magnificent 753 fourths in 1969 an astronomical advance of some 242 000 the warrants then sold considerably higher than the shares themselves this is the kind of thing that occurs on wall street through technical developments such as stock splits a recent example is supplied by lingtemkovot warrants which in the first half of 1971 advanced from 21 halves to 121 halves and then fell back to four no doubt shrewd operations can be carried on in warrants from time to time but this is too technical a matter for discussion here we might say that warrants tend to sell relatively higher than the corresponding market components related to the conversion privilege of bonds or preferred stocks to that extent there is a valid argument for selling bonds with warrants attached rather than cracking an equivalent dilution factor by a convertible issue if their warrant total is relatively small there is no point in taking its theoretical aspect too seriously if their warrant issue is large relative to the outstanding stock that would probably indicate that the company has a top-heavy senior capitalization it should be selling additional common stock instead thus the main objective of our attack on warrants as a financial mechanism is not to condemn their use in connection with moderate size bond issues but to argue against the want and creation of huge paper money monstrosities of this genre graham an enthusiastic reader of spanish literature is paraphrasing a line from the play life is a dream by pedro calderon de la barca 1600-1681 the greatest crime of man is having been born chapter 18 a comparison of eight pairs of companies in this chapter we shall attempt a novel form of exposition by selecting eight pairs of companies which appear next to each other or nearly so on the stock exchange list we hope to bring home in a concrete and vivid manner some of the many varieties of character financial structure policies performance and vicissitudes of corporate enterprises and of the investment and speculative attitudes found on the financial scene in recent years in each comparison we shall comment only on those aspects that have a special meaning and import pair i real estate investment trust stores offices factories etc and realty equities corporation of new york real estate investment general construction in this first comparison we depart from the alphabetical order used for the other pairs it has a special significance for us since it seems to encapsulate on the one hand all that has been reasonable stable and generally good in the traditional methods of handling other people's money in contrast in the other company with the reckless expansion the financial legit domain and the roller coaster changes so often found in present-day corporate operations the two enterprises have similar names and for many years they appeared side by side on the american stock exchange list their stock ticker symbols ray and rec could easily have been confused but one of them is a staid new england trust administered by three trustees with operations dating back nearly a century and with dividends paid continuously since 1889. it has kept throughout to the same type of prudent investments limiting its expansion to a moderate rate and its debt to an easily manageable figure the other is a typical new york-based sudden growth venture which in eight years blew up its assets from 6.2 million dollars to 154 million dollars and its debts in the same proportion which moved out from ordinary real estate operations to a miscellany of ventures including two race tracks 74 movie theaters three literary agencies a public relations firm hotels supermarkets and a 26 interest in a large cosmetics firm which went bankrupt in 1970. this conglomeration of business ventures was matched by a corresponding variety of corporate devices including the following 1. a preferred stock entitled to 7 annual dividends but with a par value of only one dollar and carried as a liability at one dollar per share two a stated common stock value of two million five hundred thousand dollars one dollar per share more than offset by a deduction of five million five hundred thousand dollars as the cost of two hundred and nine thousand shares of reacquired stock three three series of stock option warrants giving rights to buy a total of one million five hundred and seventy eight thousand shares four at least six different kinds of debt obligations in the form of mortgages debentures publicly held notes notes payable to banks notes loans and contracts payable and loans payable to the small business administration adding up to over 100 million dollars in march 1969 in addition it had the usual taxes and accounts payable let us present first a few figures of the two enterprises as they appeared in 1960 table 18 1r here we find the trust shares selling in the market for nine times the aggregate value of equities stock the trust enterprise had a smaller relative debt and a better ratio of net to gross but the price of the common was higher in relation to per share earnings in table 18 1b we present the situation about eight years later the trust had kept the noiseless tenor of its way increasing both its revenues and its per share earnings by about three quarters but realty equities had been metamorphosed into something monstrous and vulnerable how did wall street react to these diverse developments by paying as little attention as possible to the trust and a lot to realty equities in 1968 the latter shot up from 10 to 373 fourths and the listed warrants from six to 361 halves on combined sales of two million four hundred and twenty thousand shares while this was happening the trust shares advanced sedately from 20 to 301 fourths on modest volume the march 1969 balance sheet of equities was to show an asset value of only three dollars and 41 cents per share less than a tenth of its high price that year the book value of the trust shares was 20.85 cents the next year it became clear that all was not well in the equities picture and the price fell to 91 halves when the report for march 1970 appeared the shareholders must have felt shell-shocked as they read that the enterprise had sustained a net loss of 13 200 000 or 5.17 cents per share virtually wiping out their former slim equity this disastrous figure included a reserve of eight million eight hundred thousand dollars for future losses on investments nonetheless the directors had bravely declared an extra dividend of five cents right after the close of the fiscal year but more trouble was in sight the company's auditors refused to certify the financial statements for 1969-70 and the shares were suspended from trading on the american stock exchange in the over-the-counter market the bid price dropped below two dollars per share real estate investment trust shares had typical price fluctuations after 1969. the low in 1970 was 161 halves with a recovery to 265 sixths in early 1971. the latest reported earnings were 1.50 cents per share and the stock was selling moderately above its 1970 book value of 21.60 the issue may have been somewhat overpriced at its record high in 1968 but the shareholders have been honestly and well served by their trustees the real estate equities story is a different and the sorry one pair two air products and chemicals industrial and medical gases etc and air reduction company industrial gases and equipment chemicals even more than our first pair these two resemble each other in both name and line of business the comparison they invite is thus of the conventional type in security analysis while most of our other pairs are more heterolite in nature products is a newer company than reduction and in 1969 had less than half the others volume nonetheless its equity issues sold for 25 more in the aggregate than air reductions stock as table 18 2 shows the reason can be found both in air reduction's greater profitability and in its stronger growth record we find here the typical consequences of a better showing of quality air products sold at 161 halves times its latest earnings against only 9.1 times for air reduction also air products sold well above its asset backing while air reduction could be bought at only 75 of its book value air reduction paid a more liberal dividend but this may be deemed to reflect the greater desirability for air products to retain its earnings also air reduction had a more comfortable working capital position on this point we may remark that a profitable company can always put its current position in shape by some form of permanent financing but by our standards air products was somewhat overbunded if the analyst were called on to choose between the two companies he would have no difficulty in concluding that the prospects of air products looked more promising than those of air reduction but did this make air products more attractive at its considerably higher relative price we doubt whether this question can be answered in a definitive fashion in general wall street sets quality above quantity in its thinking and probably the majority of security analysts would opt for the better but dearer air products is against the poorer but cheaper air reduction whether this preference is to prove right or wrong is more likely to depend on the unpredictable future than on any demonstrable investment principle in this instance air reduction appears to belong to the group of important companies in the low multiplier class if as the studies referred to above would seem to indicate that group is a whole is likely to give a better account of itself than the high multiplier stocks then air reduction should logically be given the preference but only as part of a diversified operation also a thoroughgoing study of the individual companies could lead the analyst to the opposite conclusion but that would have to be for reasons beyond those already reflected in the past showing sql air products stood up better than air reduction in their 1970 break with a decline of 16 against 24 however reduction made a better comeback in early 1971 rising to 50 above its 1969 close against 30 for products in this case the low multiplier issue scored the advantage for the time being at least pair three american home products company drugs cosmetics household products candy and american hospital supply company distributor and manufacturer of hospital supplies and equipment these were two billion dollar goodwill companies at the end of 1969 representing different segments of the rapidly growing and immensely profitable health industry we shall refer to them as home and hospital respectively selected data on both are presented in table 18 3. they had the following favorable points in common excellent growth with no setbacks since 1958 that is 100 earnings stability and strong financial condition the growth rate of hospital up to the end of 1969 was considerably higher than homes on the other hand home enjoyed substantially better profitability on both sales and capital in fact the relatively low rate of hospitals earnings on its capital in 1969 only 9.7 percent raises the intriguing question whether the business then was in fact a highly profitable one despite its remarkable past growth rate in sales and earnings when comparative price is taken into account home offered much more for the money in terms of current or past earnings and dividends the very low book value of home illustrates a basic ambiguity or contradiction in common stock analysis on the one hand it means that the company is earning a high return on its capital which in general is a sign of strength and prosperity on the other it means that the investor at the current price would be especially vulnerable to any important adverse change in the company's earnings situation since hospital was selling at over four times its book value in 1969 this cautionary remark must be applied to both companies conclusions our clear-cut view would be that both companies were too rich at their current prices to be considered by the investor who decides to follow our ideas of conservative selection this does not mean that the companies were lacking in promise the trouble is rather that their price contained too much promise and not enough actual performance for the two enterprises combined the 1969 price reflected almost 5 billion of goodwill valuation how many years of excellent future earnings would it take to realize that good will factor in the form of dividends or tangible assets short-term sequel at the end of 1969 the market evidently thought more highly of the earnings prospects of hospital than of home since it gave the former almost twice the multiplier of the latter as it happened the favored issue showed a microscopic decline in earnings in while home turned in a respectable eight percent gain the market price of hospital reacted significantly to this one-year disappointment it sold at 32 in february 1971 a loss of about 30 from its 1969 close while home was quoted slightly above its corresponding level pair 4 h r block incorporated income tax service and blue bell incorporated manufacturers of work clothes uniforms etc these companies rub shoulders as relative newcomers to the new york stock exchange where they represent two very different genres of success stories blue bell came up the hard way in a highly competitive industry in which eventually it became the largest factor its earnings have fluctuated somewhat with industry conditions but their growth since 1965 has been impressive the company's operations go back to 1916 and its continuous dividend record to 1923. at the end of 1969 the stock market showed no enthusiasm for the issue giving it a price earnings ratio of only 11 against about 17 for the s and p composite index by contrast the rise of h and r block has been meteoric its first published figures date only to 1961 in which year it earned 83 000 on revenues of 610 000 but eight years later on our comparison date its revenues had soared to 53.6 million dollars and its net to 6.3 million dollars at that time the stock market's attitude toward this fine performer appeared nothing less than ecstatic the price of 55 at the close of 1969 was more than 100 times the last reported 12 months earnings which of course were the largest to date the aggregate market value of 300 million dollars for the stock issue was nearly 30 times the tangible assets behind the shares this was almost unheard of in the annals of serious stock market valuations at that time ibm was selling at about nine times and xerox at 11 times book value our table 18 4 sets fourth in dollar figures and in ratios the extraordinary discrepancy in the comparative valuations of block and blue bell true block showed twice the profitability of blue bell per dollar of capital and its percentage growth in earnings over the past five years from practically nothing was much higher but as a stock enterprise blue bell was selling for less than one-third the total value of block although blue bell was doing four times as much business earning 21 halves times as much for its stock had 51 halves times as much intangible investment and gave nine times the dividend yield on the price indicated conclusions an experienced analyst would have conceded great momentum to block implying excellent prospects for future growth he might have had some qualms about the dangers of serious competition in the income tax service field lured by the handsome return on capital realized by block.1 but mindful of the continued success of such outstanding companies as avon products in highly competitive areas he would have hesitated to predict a speedy flattening out of the block growth curve his chief concern would be simply whether the 300 million valuation for the company had not already fully valued and perhaps overvalued all that one could reasonably expect from this excellent business by contrast the analyst should have had little difficulty in recommending blue bell as a fine company quite conservatively priced sequel to march 1971 the 1970 neopanic lopped one quarter off the price of bluebell and about one-third from that of block both then joined in the extraordinary recovery of the general ma kit the price of block rose to 75 in february 1971 but blue bell advanced considerably more to the equivalent of 109 after a 3 for 2 split clearly blue bell proved a better buy than blockers of the end of 1969 but the fact that bloch was able to advance some 35 from that apparently inflated value indicates how wary analysts and investors must be to sell good companies short either by word or deed no matter how high the quotation may seem pair five international flavors and fragrances flavors etc for other businesses and international harvester company truck manufacturer farm machinery construction machinery this comparison should carry more than one surprise everyone knows of international harvester one of the 30 giants in the dow jones industrial average how many of our readers have even heard of international flavors and fragrances next door neighbor to harvester on the new york stock exchange list yet mirabile dictu iff was actually selling at the end of 1969 for a higher aggregate market value than harvester 747 million dollars versus 710 million dollars this is the more amazing when one reflects that harvester had 17 times the stock capital of flavors and 27 times the annual sales in fact only three years before the net earnings of harvester had been larger than the 1969 sales of flavors how did these extraordinary disparities develop the answer lies in the two magic words professor itability and growth flavors made a remarkable showing in both categories while harvester left everything to be desired the story is told in table 18 5. here we find flavors with a sensational profit of 14.3 of sales before income tax the figure was 23 compared with a mere 2.6 for harvester similarly flavors had earned 19.7 percent on its stock capital against an inadequate 5.5 earned by harvester in five years the net earnings of flavors had nearly doubled while those of harvester practically stood still between 1969 and 1959 the comparison makes similar reading these differences in performance produced a typical stock market divergence in valuation flavors sold in 1969 and 55 times its last reported earnings and harvester at only 10.7 times correspondingly flavors was valued at 10.4 times its book value while harvester was selling at a 41 discount from its net worth comment and conclusions the first thing to remark is that the market success of flavors was based entirely on the development of its central business and involved none of the corporate wheeling and dealing acquisition programs top-heavy capitalization structures and other familiar wall street practices of recent years the company has stuck to its extremely profitable knitting and that is virtually its whole story the record of harvester raises an entirely different set of questions but these two have nothing to do with high finance why have so many great companies become relatively unprofitable even during many years of general prosperity what is the advantage of doing more than dollar 21 halves billion of business if the enterprise cannot earn enough to justify the shareholders investment it is not for us to prescribe the solution of this problem but we insist that not only management but the rank and file of shareholders should be conscious that the problem exists and that it calls for the best brains and the best efforts possible to deal with it from the standpoint of common stock selection neither issue would have met our standards of sound reasonably attractive and moderately priced investment flavors was a typical brilliantly successful but lavishly valued company harvesters showing was too mediocre to make it really attractive even at its discount price undoubtedly there were better values available in the reasonably priced class sequel to 1971 the low price of harvester at the end of 1969 protected it from a large further decline in the bad break of 1970. it lost only 10 percent more flavors proved more vulnerable and declined to 45 a loss of 30 in the subsequent recovery both advanced well above their 1969 close but harvester soon fell back to the 25 level pair 6 mcgraw-edison public utility and equipment housewares mcgraw-hill incorporated books films instruction systems magazine and newspaper publishers information services this pair with so similar names which at times we shall call edison and hill are two large and successful enterprises in vastly different fields we have chosen december 31 1968 as the date of our comparison developed in table 18 6. the issues were selling at about the same price but because of hill's larger capitalization it was valued at about twice the total figure of the other this difference should appear somewhat surprising since edison had about 50 percent higher sales and one-quarter large net earnings as a result we find that the key ratio the multiplier of earnings was more than twice as great for hill as for edison this phenomenon seems explicable chiefly by the persistence of a strong enthusiasm and partiality exhibited by the market toward shares of book publishing companies several of which had been introduced to public trading in the late 1960s actually by the end of 1968 it was evident that this enthusiasm had been overdone the hill shares had sold at 56 in 1967 more than 40 times the just reported record earnings for 1966 but a small decline had appeared in 1967 and a further decline in 1968. thus the current high multiplier of 35 was being applied to a company that had already shown two years of receding profits nonetheless the stock was still valued at more than eight times its tangible asset backing indicating a goodwill component of not far from a billion dollars thus the price seemed to illustrate in dr johnson's famous phrase the triumph of help over experience by contrast mcgraw-edison seemed quoted at a reasonable price in relation to the high general market level and to the company's overall performance and financial position sequel to early 1971 the decline of mcgraw-hill's earnings continued through 1969 and 1970 dropping to one dollar and two cents and then 2.82 per share in the may 1970 debacle its price suffered a devastating break to 10 less than a fifth of the figure two years before it had a good recovery thereafter but the high of 24 in may 1971 was still only 60 of the 1968 closing price mcgraw edison gave a better account of itself declining to 22 in 1970 and recovering fully to 411 halves in may 1971. mcgraw-hill continues to be a strong and prosperous company but its price history exemplifies as do so many other cases the speculative hazards in such stocks created by wall street through its undiscipline waves of optimism and pessimism pair 7 national general corporation a large conglomerate and national presto industries diverse electric appliances ordnance these two companies invite comparison chiefly because they are so different let us call them general and presto we have selected the end of 1968 for our study because the write-offs taken by general in 1969 made the figures for that year too ambiguous the full flavor of general's far-flung activities could not be savored the year before but it was already conglomerate enough for anyone's taste the condensed description in the stock guide read nationwide theater chain motion picture and tv production savings and loan association book publishing to which could be added then or later insurance investment banking records music publishing computerized services real estate and 35 of performance systems incorporated name recently changed from mini pals chicken system incorporated presto had also followed a diversification program but in comparison with general it was modest indeed starting as the leading maker of pressure cookers it had branched out into various other household and electric appliances quite differently also it took on a number of ordnance contracts for the u.s government our table 18 7 summarizes the showing of the companies at the end of 1968. the capital structure of presta was as simple as it could be nothing but 1 478 000 shares of common stock selling in the market for 58 million contrastingly general had more than twice as many shares of common plus an issue of convertible preferred plus three issues of stock warrants calling for a huge amount of common plus a towering convertible bond issue just given in exchange for stock of an insurance company plus a goodly sum of non-convertible bonds all this added up to a market capitalization of 534 million dollars not counting an impending issue of convertible bonds and 750 million dollars including such issue despite national generals enormously greater capitalization it had act to ally done considerably less gross business than presta in their fiscal years and it had shown only 75 of presta's net income the determination of the true market value of general's common stock capitalization presents an interesting problem for security analysts and has important implications for anyone interested in the stock on any basis more serious than outright gambling the relatively small dollar 41 halves convertible preferred can be readily taken care of by assuming its conversion into common when the lattice sells at a suitable market level this we have done in table 18 7 but the warrants require different treatment in calculating the full dilution basis the company assumes exercise of all their warrants and the application of the proceeds to the retirement of debt plus use of the balance to buy in common at the market these assumptions actually produced virtually no effect on the earnings per share in calendar 1968 which were reported as 1.51 both before and after allowance for dilution we consider this treatment illogical and unrealistic as we see it the warrants represent a part of the common stock package and their market value is part of the effective market value of the common stock part of the capital see our discussion of this point on p 415 above this simple technique of adding the market price of their warrants to that of the common has a radical effect on the showing of national general at the end of 1968 as appears from the calculation in table 18 7. in fact the true market price of the common stock turns out to be more than twice the quoted figure hence the true multiplier of the 1968 earnings is more than doubled to the inherently absurd figure of 69 times the total market value of the common stock equivalents then becomes 413 million dollars which is over three times the tangible assets shown therefore these figures appear the more anomalous when comparison is made with those of presto one is moved to ask how could presto possibly be valued at only 6.9 times its current earnings when the multiplier for general was nearly 10 times as great all the ratios of presto are quite satisfactory the growth figure suspiciously so in fact by that we mean that the company was undoubtedly benefiting considerably from its war work and the shareholders should be prepared for some falling off in profits under peacetime conditions but on balance presto met all the requirements of a sound and reasonably priced investment while general had all the earmarks of a typical conglomerate of the late 1960s vintage full of corporate gadgets and grandiose gestures but lacking in substantial values behind the market quotations sequel general continued its diversification policy in 1969 with some increase in its debt but it took a whopping write-off of mill lions chiefly in the value of its investment in the mini pearl chicken deal the final figures showed a loss of 72 million dollars before tax credit and 46.4 million dollars after tax credit the price of the shares fell to 161 halves in 1969 and as low as nine in 1970 only 15 of its 1968 high of 60. earnings for 1970 were reported as 2.33 cents per share diluted and the price recovered to 281 halves in 1971. national presto increased its per share earnings somewhat in both 1969 and 1970 marking 10 years of uninterrupted growth of profits nonetheless its price declined to 211 halves in the 1970 debacle this was an interesting figure since it was less than four times the last reported earnings and less than the net current assets available for the stock at the time late in 1971 we find the price of national presto 60 higher at 34 but the ratios are still startling the enlarged working capital is still about equal to the current price which in turn is only 51 halves times the last reported earnings if the investor could now find 10 such issues for diversification he could be confident of satisfactory results pair 8 whiting corporation materials handling equipment and wilcox and gibbs small conglomerate this pair are close but not touching neighbors on the american stock exchange list the comparison set forth in table 18 8 a makes one wonder if wall street is a rational institution the company with smaller sales and earnings and with half the tangible assets for the common sold at about four times the aggregate value of the other the higher valued company was about to report a large loss after special charges it had not paid a dividend in 13 years the other had a long record of satisfactory earnings had paid continuous dividends since 1936 and was currently returning one of the highest dividend yields in the entire common stock list to indicate more vividly the disparity in the performance of the two companies we append in table 18 8b the earnings and price record for 1961-1970 the history of the two companies throws an interesting light on the development of medium-sized businesses in this country in contrast with much larger sized companies that have mainly appeared in these pages whiting was incorporated in 1896 and thus goes back at least 75 years it seems to have kept pretty faithfully to its materials handling business and has done quite well with it over the decades wilcox and gibbs goes back even farther to 1866 and was long known in its industry as a prominent maker of industrial sewing machines during the past decade it adopted a policy of diversification in what seems a rather outlandish form for on the one hand it has an extraordinarily large number of subsidiary companies at least 24 making an astonishing variety of products but on the other hand the entire conglomeration adds up to mighty small potatoes by usual wall street standards the earnings developments in whiting are rather characteristic of our business concerns the figures show steady and rather spectacular growth from 41 cents a share in 1960 to 3.63 cents in 1968. but they carried no assurance that such growth must continue indefinitely the subsequent decline to only 1.77 cents for the 12 months ended january 1971 may have reflected nothing more than the slowing down of the general economy but the stock price reacted in severe fashion falling about 60 from its 1968 high 431 halves to the close of 1969. our analysis would indicate that the shares represented a sound and attractive secondary issue investment suitable for the enterprising investor as part of a group of such commitments sequel willcox and gibbs showed a small operating loss for 1970. its price declined drastically to a low of 41 halves recovering in typical fashion to 91 halves in february 1971. it would be hard to justify that price statistically whiting had a relatively small decline to 163 fourths in 1970. at that price it was selling at just about the current assets alone available for the shares its earnings held at 1.85 cents per share to july 1971. in early 1971 the price advanced to 241 halves which seemed reasonable enough but no longer a bargain by our standards general observations the issues used in these comparisons were selected with some malice a forethought and thus they cannot be said to present a random cross section of the common stock list also they are limited to the industrial section and the important areas of public utilities 470 transportation companies and financial enterprises do not appear but they vary sufficiently in size lines of business and qualitative and quantitative aspects to convey a fair idea of the choices confronting an investor in common stocks the relationship between price and indicated value has also differed greatly from one case to another for the most part the companies with better growth records and higher profitability have sold at higher multipliers of current earnings which is logical enough in general whether the specific differentials in price earnings ratios are justified by the facts on will be vindicated by future developments cannot be answered with confidence on the other hand we do have quite a few instances here in which a worthwhile jug meant can be reached these include virtually all the cases where there has been great market activity in companies of questionable underlying soundness such stocks not only were speculative which means inherently risky but a good deal of the time they were and are obviously overvalued other issues appeared to be worth more than their price being affected by the opposite sort of market attitude which we might call under speculation or by undue pessimism because of a shrinkage in earnings in table 89 we provide some data on the price fluctuations of the issues covered in this chapter most of them had large declines between 1961 and 1962 as well as from 1969 to 1970. clearly the investor must be prepared for this type of adverse market movement in future stock markets in table 18 10 we show year to year fluctuations of mcgraw-hill common stock for the period 1958-1970 it will be noted that in each of the last 13 years the price either advanced or declined over a range of at least three to two from one year to the next in the case of national general fluctuations of at least this amplitude both upward and downward were shown in each two-year period in studying the stock list for the material in this chapter we were impressed once again by the wide difference between the usual objectives of security analysis and those we deem dependable and rewarding most security analysts try to select the issues that will give the best account of themselves in the future in terms chiefly of market action but considering also the development of earnings we are frankly skeptical as to whether this can be done with satisfactory results our preference for the analyst's work would be rather that he should seek the exceptional or minority cases in which he can form a reasonably confident judgment that the price is well below value he should be able to do this work with sufficient expertness to produce satisfactory average results over the years chapter 19 shareholders and management's dividend policy ever since 1934 we have argued in our writings for a more intelligent and energetic attitude by shareholders toward their managements we have asked them to take a generous attitude toward those who are demonstrably doing a good job we have asked them also to demand clear and satisfying explanations when the results appear to be worse than they should be and to support movements to improve or remove clearly unproductive managements shareholders are justified in raising questions as to the competence of the management when the results 1 are unsatisfactory in themselves 2 are poorer than those obtained by other companies that appear similarly situated and 3 have resulted in an unsatisfactory market price of long duration in the last 36 years practically nothing has actually been accomplished through intelligent action by the great body of shareholders a sensible crusader if there are any such would take this as a sign that he has been wasting his time and that he had better give up the fight as it happens our cause has not been lost it has been rescued by an extraneous development known as takeovers or takeover bids we said in chapter 8 that poor manage mints produce poor market prices the low market prices in turn attract the attention of companies interested in diversifying their operations and these are now legion innumerable such acquisitions have been accomplished by agreement with the existing managements or else by accumulation of shares in the market and by offers made over the head of those in control the price bid has usually been within the range of the value of the enterprise under reasonably competent management hence in many cases the inert public shareholder has been bailed out by the actions of outsiders who at times may be enterprising individuals or groups acting on their own it can be stated as a rule with very few exceptions that poor managements are not changed by action of the public stockholders but only by the assertion of control by an individual or compact group this is happening often enough these days to put the management including the board of directors of a typical publicly controlled company on notice that if its operating results and the resulting market price are highly unsatisfactory it may become the target of a successful takeover move as a consequence boards of directors have probably become more alive than previously to their fundamental duty to see that their company has a satisfactory top management many more changes of precedence have been seen in recent years than formerly not all companies in the unsatisfactory class have benefited from such developments also the change has often occurred after a long period of bad results without remedial action and has depended on enough disappointed shareholders selling out at low prices to permit the energetic outsiders to acquire a controlling position in the shares but the idea that public shareholders could really help themselves by supporting moves for improving management and management policies has proved too quixotic to war rant further space in this book those individual shareholders who have enough gumption to make their presence felt at annual meetings generally a completely futile performance will not need our council on what points to raise with the managements for others the advice would probably be wasted nevertheless let us close this section with the plea that shareholders consider with an open mind and with careful attention any proxy material sent them by fellow shareholders who want to remedy an obviously unsatisfactory management situation in the company shareholders and dividend policy in the past the dividend policy was a fairly frequent subjective argument between public or minority shareholders and managements in general these shareholders wanted more liberal dividends while the managements preferred to keep the earnings in the business to strengthen the company they asked the shareholders to sacrifice their present interests for the good of the enterprise and for their own future long-term benefit but in recent years the attitude of investors toward dividends has been undergoing a gradual but significant change the basic argument now for paying small rather than liberal dividends is not that the company needs the money but rather that it can use it to the shareholders direct and immediate advantage by retaining the funds for professor edible expansion years ago it was typically the weak company that was more or less forced to hold on to its profits instead of paying out the usual 60 to 75 of them in dividends the effect was almost always adverse to the market price of the shares nowadays it is quite likely to be a strong and growing enterprise that deliberately keeps down its dividend payments with the approval of investors and speculators alike there was always a strong theoretical case for reinvesting professor it's in the business where such retention could be counted on to produce a goodly increase in earnings but there were several strong counter arguments such as the profits belong to the shareholders and they are entitled to have them paid out within the limits of prudent management many of the shareholders need their dividend income to live on the earnings they receive in dividends are real money while those retained in the company may or may not show up later as tangible values for the shareholders these counter arguments were so compelling in fact that the stock market showed a persistent bias in favor of the liberal dividend payers as against the companies that paid no dividends or relatively small ones.1 in the last 20 years the profitable reinvestment theory has been gaining ground the better the past record of growth the readier investors and speculators have become to accept a low payout policy so much is this true that in many cases of growth favorites the dividend rate or even the absence of any dividend has seemed to have virtually no effect on the market price a striking example of this development is found in the history of texas instruments incorporated the price of its common stock rose from 5 in 1953 to 256 in 1960 while earnings were advancing from 43 cents to 3.91 per share and while no dividend of any kind was paid in 1962 cash dividends were initiated but by that year the earnings had fallen to 2.14 and the price had shown a spectacular drop to a low of 49. another extreme illustration is provided by superior oil in 1948 the company reported earnings of 35.26 per share paid three dollars in dividends and sold as high as 235. in 1953 the dividend was reduced to one dollar but the high price was 660. in 1957 it paid no dividend at all and sold at 2000. this unusual issue later declined to 795 in when it earned 49.50 and paid 7.50 investment sentiment is far from crystallized in this matter of dividend policy of growth companies the conflicting views are well illustrated by the cases of two of our very largest corporations american telephone and telegraph and international business machines american telephone and telephone came to be regarded as an issue with good growth possibilities as shown by the fact that in 1961 it sold at 25 times that year's earnings nevertheless the company's cash dividend policy has remained an investment and speculative consideration of first importance its quotation making an active response to even rumors of an impending increase in the dividend rate on the other hand comparatively little attention appears to have been paid to the cash dividends on ibm which in 1960 yielded only half a percent of the high price of the year and 1.5 percent at the close of 1970 but in both cases stock splits have operated as a potent stock market influence the market's appraisal of cash dividend policy appears to be developing in the following direction where prime emphasis is not placed on growth the stock is rated as an income issue and the dividend rate retains its long-held importance as the prime determinant of market price at the other extreme stocks clearly recognized to be in the rapid growth category are valued primarily in terms of the expected growth rate over say the next decade and the cash dividend rate is more or less left out of the reckoning while the above statement may properly describe present tendencies it is by no means a clear-cut guide to the situation in all common stocks and perhaps not in the majority of them for one thing many companies occupy an intermediate position between growth and non-growth enterprises it is hard to say how much importance should be ascribed to the growth factor in such cases and the market's view thereof may change radically from year to year secondly there seems to be something paradoxical about requiring the companies showing slower growth to be more liberal with their cash dividends for these are generally the less prosperous concerns and in the past the more prosperous the company the greater was the expectation of both liberal and increasing payments it is our belief that shareholders should demand of their managements either a normal payout of earnings on the order say of two-thirds or else a clear-cut demonstration that the reinvested profits have produced a satisfactory increase in per share earnings such a demonstration could ordinarily be made in the case of a recognized growth company but in many other cases a low payout is clearly the cause of an average market price that is below fair value and here the shareholders have every right to inquire and probably to complain a niggeredly policy has often been imposed on a company because its financial position is relatively weak and it has needed all or most of its earnings plus depreciation charges to pay debts and bolster its working capital position when this is so there is not much the shareholders can say about it except perhaps to criticize the management for permitting the company to fall into such an unsatisfactory financial position however dividends are sometimes held down by relatively unprosperous companies for the declared purpose of expanding the business we feel that such a policy is illogical on its face and should require both a complete explanation and a convincing defense before the shareholders should accept it in terms of the past record there is no reason a priori to believe that the owners will benefit from expansion moves undertaken with their money by a business showing mediocre results and continuing its old management stock dividends and stock splits it is important that investors understand the essential difference between a stock dividend properly so called and a stock split the latter represents a restatement of the common stock structure in a typical case by issuing two or three shares for one the new shares are not related to specific earnings reinvested in a specific past period its purpose is to establish a lower market price for the single shares presumably because such lower price range would be more acceptable to old and new shareholders a stock split may be carried out by what technically may be called a stock dividend which involves a transfer of sums from earned surplus to capital account or else by a change in par value which does not affect the surplus account what we should call a proper stock dividend is one that is paid to shareholders to give them a tangible evidence or representation of specific earnings which have been reinvested in the business for their account over some relatively short period in the recent past say not more than the two preceding years it is now approved practice to value such a stock dividend at the approximate value at the time of declaration and to transfer an amount equal to such value from earned surplus to capital accounts thus the amount of a typical stock dividend is relatively small in most cases not more than five percent in essence a stock dividend of this sort has the same overall effect as the payment of an equivalent amount of cash out of earnings when accompanied by the sale of additional shares of like total value to the shareholders however a straight stock dividend has an important tax advantage over the otherwise equivalent combination of cash dividends with stock subscription rights which is the almost standard practice for public utility companies the new york stock exchange has set the figure of 25 as a practical dividing line between stock splits and stock dividends those of 25 or more need not be accompanied by the transfer of their market value from earned surplus to capital and so forth some companies especially banks still follow the old practice of declaring any kind of stock dividend they please for example one of 10 not related to recent earnings and these instances maintain an undesirable confusion in the financial world we have long been a strong advocate of a systematic and clearly enunciated policy with respect to the payment of cash and stock dividends under such a policy stock dividends are paid period equally to capitalize all or a stated portion of the earnings reinvested in the business such a policy covering 100 of the reinvested earnings has been followed by purex government employees insurance and perhaps a few others stock dividends of all types seem to be disapproved of by most academic writers on the subject they insist that they are nothing but pieces of paper that they give the shareholders nothing they did not have before and that they entail needless expense and inconvenience on our side we consider this a completely doctrinaire view which fails to take into account the practical and psychological realities of investment true a periodic stock dividend say of 5 is only the form of the owner's investment he has 105 shares in place of 100 but without the stock dividend the original 100 shares would have represented the same ownership interest now embodied in his 105 shares nonetheless the change of form is actually one of real importance and value to him if he wishes to cash in his share of the reinvested profits he can do so by selling the new certificate sent him instead of having to break up his original certificate he can count on receiving the same cash dividend rate on 105 shares as formerly on his 100 shares a 5 rise in the cash dividend rate without the stock dividend would not be nearly as probable the advantages of a periodic stock dividend policy are most evident when it is compared with the usual practice of the public utility companies of paying liberal cash dividends and then taking back a good part of this money from the shareholders by selling them additional stock through subscription rights as we mentioned above the shareholders would find themselves in exactly the same position if they received stock dividends in lieu of the popular combination of cash dividends followed by stock subscriptions except that they would save the income tax otherwise paid on the cash dividends those who need or wish the maximum annual cash income with no additional stock can get this result by selling their stock dividends in the same way as they sell their subscription rights under present practice the aggregate amount of income tax that could be saved by substituting stock dividends for the present stock dividends plus subscription rights combination is enormous we urge that this change be made by the public utilities despite its adverse effect on the u.s treasury because we are convinced that it is completely inequitable to impose a second personal income tax on earnings which are not really received by the shareholders since the companies take the same money back through sales of stock efficient corporations continuously modernize their facilities their products their bookkeeping their management training programs their employee relations it is high time they thought about modernizing their major financial practices not the least important of which is their dividend policy chapter 2-0 margin of safety as the central concept of investment in the old legend the wise men finally boiled down the history of mortal affairs into the single phrase this too will pass confronted with a light challenge to distill the secret of sound investment into three words we venture the motto margin of safety this is the thread that runs through all the preceding discussion of investment policy often explicitly sometimes in a less direct fashion let us try now briefly to trace that idea in a connected argument all experienced investors recognize that the margin of safety concept is essential to the choice of sound bombs and preferred stocks for example a railroad should have earned its total fixed charges better than five times before income tax taking a period of years for its bonds to qualify as investment grade issues this past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income the margin above charges may be stated in other ways it is said an eastern monarch once charged his wise men to invent him a sentence to be ever in view and which should be true and appropriate in all times and situations they presented him the words and this too shall pass away how much it expresses how chastening in the hour of pride how consoling in the depths of affliction and this too shall pass away and yet let us hope it is not quite true abraham lincoln addressed to the wisconsin state agricultural society milwaukee september 30 1859 in abraham lincoln speeches and writings 1859-1865 library of america 1985 volume 2 p 101 for example in the percentage by which revenues or profits may decline before the balance after interest disappears but the underlying idea remains the same the bond investor does not expect future average earnings to work out the same as in the past if he were sure of that the margin demanded might be small nor does he rely to any controlling extent on his judgment as to whether future earnings will be materially better or poorer than in the past if he did that he would have to measure his margin in terms of a carefully projected income account instead of emphasizing the margin shown in the past record here the function of the margin of safety is in essence that of rendering unnecessary and accurate estimate of the future if the margin is a large one then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time the margin of safety for bonds may be calculated alternatively by comparing the total value of the enterprise with the amount of debt a similar calculation may be made for a preferred stock issue if the business owes 10 million dollars and is fairly worth 30 mil lion there is room for a shrinkage of two-thirds in value at least theoretically before the bondholders will suffer loss the amount of this extra value or cushion above the debt may be approximated by using the average market price of the junior stock issues over a period of years since average stock prices are generally related to average earning power the margin of enterprise value over debt and the margin of earnings over charges will in most cases yield similar results so much for the margin of safety concept is applied to fixed value investments can it be carried over into the field of common stocks yes but with some necessary modifications there are instances where a common stock may be considered sound because it enjoys a margin of safety as large as that of a good bond this will occur for example when a company has outstanding only common stock that under depression conditions is selling for less than the amount of bonds that could safely be issued against its property and earning power that was the position of a host of strongly financed industrial companies at the low price levels of 1932-33 in such instances the investor can obtain the margin of safety associated with the bond plus all the chances of larger income and principal appreciation inherent in a common stock the only thing he lacks is the legal power to insist on dividend payments or else but this is a small drawback as compared with his advantages common stock sport under such circumstances will supply an ideal though infrequent combination of safety and profit opportunity as a quite recent example of this condition let us mention once more national press to industries stock which sold for a total enterprise value of 43 million dollars in with its 16 millions of recent earnings before taxes the company could easily have supported this amount of bonds in the ordinary common stock bought for investment under normal conditions the margin of safety lies in an expected earning power considerably above the going rate for bonds in former editions we elucidated this point with the following figures assume in a typical case that the earning power is 9 on the price and that the bond rate is four percent then the stock buyer will have an average annual margin of five percent accruing in his favor some of the excesses paid to him in the dividend rate even though spent by him it enters into his overall investment result the undistributed balance is reinvested in the business for his account in many cases such reinvested earnings fail to add commensurately to the earning power and value of his stock that is why the market has a stubborn habit of valuing earnings disbursed in dividends more generously than the portion retained in the business but if the picture is viewed as a whole there is a reasonably close connection between the growth of corporate surpluses through reinvested earnings and the growth of corporate values over a 10-year period the typical excess of stock earning power over bond interest may aggregate 50 of the price paid this figure is sufficient to provide a very real margin of safety which under favorable conditions will prevent or minimize a loss if such a margin is present in each of a diversified list of 20 or more stocks the probability of a favorable result under fairly normal conditions becomes very large that is why the policy of investing in representative common stocks does not require high qualities of insight and foresight to work out successfully if the purchases are made at the average level of the market over a span of years the prices paid should carry with the missourians of an adequate margin of safety the danger to investors lies in concentrating their purchases in the upper levels of the market or in buying non-representative common stocks that carry more than average risk of diminished earning power as we see it the whole problem of common stock investment under 1972 conditions lies in the fact that in a typical case the earning power is now much less than nine percent on the price paid let us assume that by concentrating somewhat on the low multiplier issues among the large companies a defensive investor may now acquire equities at 12 times recent earnings that is with an earnings return of 8.33 on cost he may obtain a dividend yield of about four percent and he will have 4.33 of his cost reinvested in the business for his account on this basis the excess of stock earning power over bond interest over a 10-year basis would still be too small to constitute an adequate margin of safety for that reason we feel that there are real risks now even in a diversified list of sound common stocks the risks may be fully offset by the profit possibilities of the list and indeed the investor may have no choice but to incur them for otherwise he may run an even greater risk of holding only fixed claims payable in steadily depreciating dollars nonetheless the investor would do well to recognize and to accept as philosophically as he can that the old package of good profit possibilities combined with small ultimate risk is no longer available to him however the risk of paying too high a price for good quality stocks while a real one is not the chief hazard confronting the average buyer of securities observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions the purchasers view the current good earnings as equivalent to earning power and assume that prosperity is synonymous with safety it is in those years that bonds and preferred stocks of enfra grade can be sold to the public at a price around par because they carry a little higher income return or a deceptively attractive conversion privilege it is then also that common stocks of obscure companies can be floated at prices far above the tangible investment on the strength of two or three years of excellent growth these securities do not offer an adequate margin of safety in any admissible sense of the term coverage of interest charges and preferred dividends must be tested over a number of years including preferably a period of sub-normal business such as in 1970-71 the same is ordinarily true of common stock earnings if they are to qualify as indicators of earning power thus it follows that most of the fair weather investments acquired at fair weather prices are destined to suffer disturbing price declines when the horizon clouds over and often sooner than that nor can the investor count with confidence on an eventual recovery although this does come about in some proportion of the cases for he has never had a real safety margin to tide him through adversity the philosophy of investment in growth stocks parallels in part and in part contravenes the margin of safety principle the growth stock bar relies on unexpected earning power that is greater than the average shown in the past thus he may be said to substitute these expected earnings for the past record in calculating his margin of safety in investment theory there is no reason why carefully estimated future earnings should be a less reliable guide than the bear record of the past in fact security analysis is coming more and more to prefer a competently executed evaluation of the future thus the growth stock approach may supply as dependable a margin of safety as is found in the ordinary investment provided the calculation of the future is conservatively made and provided it shows a satisfactory margin in relation to the price paid the danger in a growth stock program lies precisely here for such favored issues the market has a tendency to set prices that will not be adequately protected by a conservative projection of future earnings it is a basic rule of prudent investment that all estimates when they differ from past performance must her at least slightly on the side of understatement the margin of safety is always dependent on the price paid it will be large at one price small at some higher price non-existent at some still higher price if as we suggest the average market level of most growth stocks is too high to provide an adequate margin of safety for the buyer then a simple technique of diversified buying in this field may not work out satisfactorily a special degree of foresight and judgment will be needed in order that wise individual selections may overcome the hazards inherent in the customary market level of such issues as a whole the margin of safety idea becomes much more evident when we apply it to the field of undervalued or bargained securities we have here by definition a favorable difference between price on the one hand and indicated or appraised value on the other that difference is the safety margin it is available for absorbing the effect of miscalculations or worse than average luck the buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments for in most such cases he has no real enthusiasm about the company's prospects true if the prospects are definitely bad the investor will prefer to avoid the security no matter how low the price but the field of undervalued issues is drawn from the many concerns perhaps a majority of the total for which the future appears neither distinctly promising nor distinctly unpromising if these are bought on a bargain basis even a moderate decline in the earning power need not prevent the investment from showing satisfactory results the margin of safety will then have served its proper purpose theory of diversification there is a close logical connection between the concept of a safety margin and the principle of diversification one is correlative with the other even with a margin in the investor's favor an individual security may work out badly for the margin guarantees only that he has a better chance for profit than for loss not that loss is impossible but as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses that is the simple basis of the insurance underwriting business diversification is an established tenet of conservative investment by accepting it so universally investors are really demonstrating their acceptance of the margin of safety principle to which diversification is the companion this point may be made more colorful by a reference to the arithmetic of roulette if a man bets one dollar on a single number he is paid 35 profit when he wins but the chances are 37 to 1 that he will lose he has a negative margin of safety in his case diversification is foolish the more numbers he bets on the smaller his chance of ending with a profit if he regularly bets one dollar on every number including 0.000 he is certain to lose two dollars on each turn of the wheel but suppose the winner received 39 profit instead of 35 then he would have a small but important margin of safety therefore the more numbers he wages on the better his chance of gain and he could be certain of winning two dollars on every spin by simply betting one dollar each on all the numbers incidentally the two examples given actually describe the respective positions of the player and proprietor of a wheel with zero and oh a criterion of investment versus speculation since there is no single definition of investment in general acceptance authorities have the right to define it pretty much as they please many of them deny that there is any useful or dependable difference between the concepts of investment and of speculation we think this skepticism is unnecessary and harmful it is injurious because it lends encouragement to the innate leaning of many people toward the excitement and hazards of stock market speculation we suggest that the margin of safety concept may be used to advantage as the touchstone to distinguish an investment operation from a speculative one probably most speculators believe they have the odds in their favor when they take their chances and therefore they may lay claim to a safety margin in their proceedings each one has the feeling that the time is propitious for his purchase or that his skill is superior to the crowds or that his advisor or system is trustworthi but such claims are unconvincing they rest on subjective judgment unsupported by any body of favorable evidence or any conclusive line of reasoning we greatly doubt whether the man who stakes money on his view that the market is heading up or down can ever be said to be protected by a margin of safety in any useful sense of the phrase by contrast the investors concept of the margin of safety as developed earlier in this chapter rests upon simple and definite arithmetical reasoning from statistical data we believe also that it is well supported by practical investment experience there is no guarantee that this fundamental quantitative approach will continue to show favorable results under the unknown conditions of the future but equally there is no valid reason for pessimism on this score thus in sum we say that to have a true investment there must be present a true margin of safety and a true margin of safety is one that can be demonstrated by figures by persuasive reasoning and by reference to a body of actual experience extension of the concept of investment to complete our discussion of the margin of safety principle we must now make a further distinction between conventional and unconventional investments conventional investments are appropriate for the typical portfolio under this heading have always come united states government issues and high-grade dividend paying common stocks we have added state and municipal bonds for those who will benefit sufficiently by their tax exempt features also included are first quality corporate bonds when as now they can be bought to yield sufficiently more than united states savings bonds unconventional investments are those that are suitable only for the enterprising investor they cover a wide range the broadest category is that of undervalued common stocks of secondary companies which we recommend for purchase when they can be bought at two-thirds or less of their indicated value besides these there is often a wide choice of medium-grade corporate bonds and preferred stocks when they are selling at such depressed prices as to be obtainable also at a considerable discount from their apparent value in these cases the average investor would be inclined to call the securities speculative because in his mind their lack of a first quality rating is synonymous with a lack of investment merit it is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity provided that the buyer is informed and experienced and that he practices adequate diversification for if the price is low enough to create a substantial margin of safety the security thereby meets our criterion of investment our favorite supporting illustration is taken from the field of real estate bonds in the 1920s billions of dollars worth of these issues were sold at par and widely recommended as sound investments a large proportion had so little margin of value over debt as to be in fact highly speculative in character in the depression of the 1930s an enormous quantity of these bonds defaulted their interest and their price collapsed in some cases below 10 cents on the dollar at that stage the same advisors who had recommended them at par as safe investments were rejecting them as paper of the most speculative and unattractive type but as a matter of fact the price depreciation of about 90 made many of these securities exceedingly attractive and reasonably safe for the true values behind them were four or five times the market quotation the fact that the purchase of these bonds actually resulted in what is generally called a large speculative profit did not prevent them from having true investment qualities at their low prices the speculative profit was the purchaser's reward for having made an unusually shrewd investment they could properly be called investment opportunities since a careful analysis would have shown that the excessive value over price provided a large margin of safety thus the very class of fair weather investments which we stated above is a chief source of serious loss to naive security buyers is likely to afford many sound profit opportunities to the sophisticated operator who may buy them later at pretty much his own price the whole field of special situations would come under our definition of investment operations because the purchase is always predicated on a thorough going analysis that promises a larger realization than the price paid again there are risk factors in each individual case but these are allowed for in the calculations and absorbed in the overall results of a diversified operation to carry this discussion to a logical extreme we might suggest that a defensible investment operation could be set up by buying such intangible values as are represented by a group of common stock option warrants selling at historically low prices this example is intended as somewhat of a shocker the entire value of these warrants rests on the possibility that the related stocks may someday advance above the option price at the moment they have no exercisable value yet since all investment rests on reasonable future expectations it is proper to view these warrants in terms of the mathematical chances that some future bull market will create a large increase in their indicated value and in their price such a study might well yield the conclusion that there is much more to be gained in such an operation than to be lost and that the chances of an ultimate profit are much better than those of an ultimate loss if that is so there is a safety margin present even in this unpre-possessing security form a sufficiently enterprising investor could then include an option warrant operation in his miscellany of unconventional investments.1 to sum up investment is most intelligent when it is most businesslike it is amazing to see how many capable businessmen try to operate in wall street with complete disregard of all the sound principles through which they have gained success in their own undertakings yet every corporate security may best be viewed in the first instance as an ownership interest in or a claim against a specific business enterprise and if a person sets out to make profits from security purchases and sales he is embarking on a business venter of his own which must be run in accordance with accepted business principles if it is to have a chance of success the first and most obvious of these principles is know what you are doing know your business for the investor this means do not try to make business profits out of securities that is returns in excess of normal interest and dividend income unless you know as much about security values as you would need to know about the value of merchandise that you propose to manufacture or deal in a second business principle do not let anyone else run your business unless one you can supervise his performance with adequate care and comprehension or two you have unusually strong reassurance for placing implicit confidence in his integrity and ability for the investor this rule should determine the conditions under which he will permit someone else to decide what is done with his money a third business principle do not enter upon an operation that is manufacturing or trading in an item unless a reliable calculation shows that it has a fair chance to yield a reasonable profit in particular keep away from ventures in which you have little to gain and much to lose for the enterprising investor this means that his operations for profit should be based not on optimism but on arithmetic for every investor it means that when he limits his return to a small figure as formerly at least in a conventional bond or preferred stock he must demand convincing evidence that he is not risking a substantial part of his principle a fourth business rule is more positive have the courage of your knowledge and experience if you have formed a conclusion from the facts and if you know your judgment is sound act on it even though others may hesitate or differ you are neither right nor wrong because the crowd disagrees with you you are right because your data and reasoning are right similarly in the world of securities courage becomes the supreme virtue after adequate knowledge and attested judgment are at hand fortunately for the typical investor it is by no means necessary for his success that he bring these qualities to bear upon his program provided he limits his ambition to his capacity and confines his activities within the safe and narrow path of standard defensive investment to achieve satisfactory investment results is easier than most people realize to achieve superior results is harder than it looks commentary on chapter 20 if we fail to anticipate the unforeseen or expect the unexpected in a universe of infinite possibilities we may find ourselves at the mercy of anyone or anything that cannot be programmed categorized or easily referenced agent fox mulder the x files f i r s t d o n t l o s c what is risk you'll get different answers depending on whom and when you ask in 1999 risk didn't mean losing money it meant making less money than someone else what many people feared was bumping into somebody at a barbecue who was getting even richer even quicker by daytrading.com stocks than they were then quite suddenly by 2003 risk had come to mean that the stock market might keep dropping until it wiped out whatever traces of wealth you still had left while its meaning may seem nearly as fickle and fluctuating as the financial markets themselves risk has some profound and permanent attributes the people who take the biggest gambles and make the biggest gains in a bull market are almost always the ones who get hurt the worst in the bear market that inevitably follows being right makes speculators even more eager to take extra risk as their confidence catches fire and once you lose big money you then have to gamble even harder just to get back to where you were like a race track or casino gambler who desperately doubles up after every bad bet unless you are phenomenally lucky that's a recipe for disaster no wonder when he was asked to sum up everything he had learned in his long career about how to get rich the legendary financier jay k clinchenstein of wertheim and company answered simply don't lose 1. 5 return every year 50 loss in year one 10 percent gain every year thereafter imagine that you find a stock that you think can grow at 10 percent a year even if the market only grows 5 annually unfortunately you are so enthusiastic that you pay too high a price and the stock loses 50 of its value the first year even if the stock then generates double the market's return it will take you more than 16 years to overtake the market simply because you paid too much and lost too much at the outset losing some money is an inevitable part of investing and there's nothing you can do to prevent it but to be an intelligent investor you must take responsibility for ensuring that you never lose most or all of your money the hindu goddess of wealth lakshmi is often portrayed standing on tiptoe ready to dart away in the blink of an eye to keep her sim lickly in place some of lakshmi's devotees will lash her statue down with strips of fabric or nail its feet to the floor for the intelligent investor graham's margin of safety performs the same function by refusing to pay too much for an investment you minimize the chances that your wealth will ever disappear or suddenly be destroyed consider this over the four quarters ending in december 1999 jds uniface corporation the fiber optics company generated 673 mill line in net sales on which it lost 313 million dollars its tangible assets totaled 1.5 billion dollars yet on march 7 2000 jds uni faces stock hit 153. share giving the company a total market value of roughly 143.2 and then like most new era stocks it crashed anyone who bought it that day and still clung to it at the end of 2002 faced these prospects if you had bought jds uniface at its peak price of 153.421 on march 7 2000 and still held it at year end 2002 when it closed at 2.47 how long would it take you to get back to your purchase price at various annual average rates of return even at robust 10 annual rate of return it will take more than 43 years to break even on this overpriced purchase t h e r i s k i s n o t i n o u r s d o c k s b u t i n o u r s e l v e s risk exists in another dimension inside you if you overestimate how well you really understand an investment or overstate your ability to ride out a temporary plunge in prices it doesn't matter what you own or how the market does ultimately financial risk resides not in what kinds of investments you have but in what kind of investor you are if you want to know what risk really is go to the nearest bathroom and step up to the mirror that's risk gazing back at you from the glass as you look at yourself in the mirror what should you watch for the nobel prize winning psychologist daniel kahneman explains two factors that characterize good decisions well calibrated confidence do i understand this investment as well as i think i do correctly anticipated regret how will i react if my analysis turns out to be wrong to find out whether your confidence is well calibrated look in the mirror and ask yourself what is the likelihood that my analysis is right think carefully through these questions how much experience do i have what is my track record with similar decisions in the past what is the typical track record of other people who have tried this in the past question mark iii if i am buying someone else is selling how likely is it that i know something that this other person or company does not know if i am selling someone else is buying how likely is it that i know something that this other person or company does not know have i calculated how much this investment needs to go up for me to break even after my taxes and costs of trading next look in the mirror to find out whether you are the kind of person who correctly anticipates your regret start by asking do i fully understand the consequences if my analysis turns out to be wrong answer that question by considering these points if i'm right i could make a lot of money but what if i'm wrong based on the historical performance of similar investments how much could i lose do i have other investments that will tide me over if this decision turns out to be wrong do i already hold a stocks bonds or funds with a proven record of going up when the kind of investment i'm considering goes down am i putting too much of my capital at risk with this new investment when i tell myself you have a high tolerance for risk how do i know have i ever lost a lot of money on an investment how did it feel did i buy more or did i bail out am i relying on my willpower alone to prevent me from panicking at the wrong time or have i controlled my own behavior in advance by diversifying signing an investment contract and dollar cost averaging you should always remember in the words of the psychologist paul slavic that risk is brewed from an equal dose of two ingredients probabilities and consequences for before you invest you must ensure that you have realistically assessed your probability of being right and how you will react to the consequences of being wrong p a s c a l s w a g e r the investment philosopher peter bernstein has another way of summing this up he reaches back to blaise pascal the great french mathematician and theologian 1623-1662 who created a thought experiment in which an agnostic must gamble on whether or not god exists the ante this person must put up for the wager is his conduct in this life the ultimate payoff in the gamble is the fate of his soul in the afterlife in this wager pascal asserts reason cannot decide the probability of god's existence either god exists or he does not and only faith not reason can answer that question but while the probabilities in pascal's wager are a toss-up the consequences are perfectly clear and utterly certain as bernstein explains suppose you act as though god is and you lead a life of virtue and abstinence when in fact there is no god you will have passed up some goodies in life but there will be rewards as well now suppose you act as though god is not and spend a life of sin selfishness and lust when in fact god is you may have had fun and thrills during the relatively brief duration of your lifetime but when the day of judgment rolls around you are in big trouble.5 concludes bernstein in making decisions under conditions of uncertainty the consequences must dominate the probabilities we never know the future thus as graham has reminded you in every chapter of this book the intelligent investor must focus not just on getting the analysis right you must also insure against loss if your analysis turns out to be wrong as even the best analyzes will be at least some of the time the probability of making at least one mistake at some point in your investing lifetime is virtually 100 and those odds are entirely out of your control however you do have control over the consequences of being wrong many investors put essentially all of their money into dot com stocks in 1999 an online survey of 1338 americans by money magazine in 1999 found that nearly one-tenth of them had at least 85 percent of their money in internet stocks by ignoring graham's call for a margin of safety these people took the wrong side of pascal's wager certain that they knew the probabilities of being right they did nothing to protect themselves against the consequences of being wrong simply by keeping your holdings permanently diversified and refusing to fling money at mr market's latest craziest fashions you can ensure that the consequences of your mistakes will never be catastrophic no matter what mr market throws at you you will always be able to say with a quiet confidence this too shall pass away the end thank you for listening to this audiobook