The Intelligent Investor by Benjamin Graham audiobook full Greatest investment book ever written!!!

the purpose of this tape is to supply in a form suitable for layman guidance in the adoption and execution of an investment policy comparatively little will be said here about the technique of analyzing securities attention will be paid cheaply to investment principles and investors attitudes to invest intelligently in securities one should be forearmed with an adequate knowledge of how the various types of bonds and stocks have actually behaved under varying conditions some of which at least one is likely to meet again in one's own experience no statement is more true or better applicable to wall street than the famous warning of santayana those who do not remember the past are condemned to repeat it our tape is directed to investors as distinguished from speculators and our first task will be to clarify and emphasize this now all but forgotten distinction we may say at the outset that this is not a how to make a million tape there are no sure and easy paths to riches in wall street or anywhere else it may be well to point out what we have just said by a bit of financial history especially since there is more than one moral to be drawn from it in the climactic year 1929 john j raskob a most important figure nationally as well as on wall street extolled the blessings of capitalism in an article in the ladies home journal entitled everybody ought to be rich his thesis was that savings of only fifteen dollars per month invested in good common stocks with dividends reinvested would produce in a state of eighty thousand dollars in twenty years against total contributions of only thirty six hundred dollars if the general motors tycoon was right this was indeed a simple road to riches how nearly right was he our rough calculation based on assumed investment in the 30 stocks making up the dow jones industrial average or the djia indicates that if roskob's prescription had been followed during 1929 through 1948 the investors holdings at the beginning of 1949 would have been worth about 8 500 this is a far cry from the great man's promise of 80 000 and it shows how little reliance can be placed on such optimistic forecasts and assurances but as an aside we should remark that the return actually realized by the 20-year operation would have been better than 8 percent compounded annually and this despite the fact that the investor would have begun his purchases with the djia at 300 and ended with a valuation based on the 1948 closing level of 177 this record may be regarded as a persuasive argument for the principle of regular monthly purchases of strong common stocks through thick and thin a program known as dollar cost averaging since our tape is not addressed to speculators it is not meant for those who trade in the market most of these people are guided by charts or other largely mechanical means of determining the right moments to buy and sell the one principle that applies to nearly all these so-called technical approaches is that one should buy because a stock or the market has gone up and one should sell because it has declined this is the exact opposite of sound business sense everywhere else and it is most unlikely that it can lead to lasting success in wall street in our own stock market experience and observation extending over 50 years we have not known a single person who has consistently or lastingly made money by thus following the market we do not hesitate to declare that this approach is as fallacious as it is popular since its first publication in 1949 revisions of the intelligent investor have appeared at intervals of approximately five years in updating the current version we shall have to deal with quite a number of new developments since the nineteen 1965 edition was written the underlying principles of sound investment should not alter from decade to decade but the application of these principles must be adapted to significant changes in the financial mechanisms and climate we have not allowed these fluctuations to affect our general attitude towards sound investment policy which remains substantially unchanged since 1949 the extent of the market shrinkage in 1969 and 1970 should have served to dispel an illusion that had been gaining ground during the past two decades this was that leading common stocks could be bought at any time at any price with the assurance not only of ultimate profit but also that any intervening loss would soon be recouped by a renewed advance of the market to new high levels that was too good to be true at long last the stock market has returned to normal in the sense that both speculators and stock investors must again be prepared to experience significant and perhaps protracted falls as well as rises in the value of their holdings in the area of many secondary and third line common stocks especially recently floated enterprises the havoc wrought by the last market break was catastrophic this was nothing new in itself it had happened to a similar degree in 1961-1962 but there was now a novel element in the fact that some of the investment funds had large commitments and highly speculative and obviously overvalued issues of this type evidently it is not only the tyro who needs to be warned that while enthusiasm may be necessary for great accomplishments elsewhere in wall street it almost invariably leads to disaster the major question we shall have to deal with grows out of the huge rise in the rate of interest on first quality bonds since late 1967 the investor has been able to obtain more than twice as much income from such bonds as he could from dividends on representative common stocks we have consistently urged that at least 25 of the conservative investors portfolio be held in common stocks and we have favored in general a 50 50 division between the two media we must now consider whether the current great advantage of bond yields over stock yields would justify an all bond policy until a more sensible relationship returns as we expect it will naturally the question of continued inflation will be of great importance in reaching our decision here in the past we have made a basic distinction between two kinds of investors to whom this tape was addressed the defensive and the enterprising the defensive or passive investor will place his chief emphasis on the avoidance of serious mistakes or losses his second aim will be freedom from effort annoyance and the need for making frequent decisions the determining trait of the enterprising or active or aggressive investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average over many decades an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort in the form of a better average return than that realized by the passive investor we have some doubt whether a really substantial extra recompense is promised to the active investor under today's conditions but next year or the years after may well be different it has long been the prevalent view that the art of successful investment lies first in the choice of those industries that are most likely to grow in the future and then in identifying the most promising companies in these industries for example smart investors or their smart advisors would have long ago recognized the great growth possibilities of the computer industry as a whole and of international business machines in particular and similarly for a number of other growth industries and growth companies but this is not as easy as it always looks in retrospect such an investor may for example be a buyer of air transport stocks because he believes their future is even more brilliant than the trend the market already reflects for this class of investor the value of our tape will lie more in its warnings against the pitfalls lurking in this favorite investment approach than in any positive technique that will help him along his path the pitfalls have proved particularly dangerous in the industry we mentioned it was of course easy to forecast that the volume of air traffic would grow spectacularly over the years because of this factor their shares became a favorite choice of the investment funds but despite the expansion of revenues at a pace even greater than that in the computer industry a combination of technological problems and over expansion of capacity made for fluctuating and even disastrous profit figures in the year 1970 despite a new high in traffic figures the airline sustained a loss of some 200 million dollars for their stockholders they had shown losses also in 1945 and 1961. the stocks of these companies once again showed a greater decline in 1969 and 1970 then did the general market the record shows that even the highly paid full-time experts of the mutual funds were completely wrong about the short-term future of a major and non-esoteric industry on the other hand while the investment funds had substantial investments and substantial gains in ibm the combination of its apparently high price and the impossibility of being certain about its rate of growth prevented them from having more than say three percent of their funds in this wonderful performer hence the effect of this excellent choice on their overall results was by no means decisive furthermore many if not most of their investments in computer industry companies other than ibm appear to have been unprofitable from these two broad examples we draw two morals for our listeners one obvious prospects for physical growth in a business do not translate into obvious profits for investors two the experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries the author did not follow this approach in his financial career as a fund manager and he cannot offer either specific counsel or much encouragement to those who may wish to try it what then will we aim to accomplish in this tape our main objective will be to guide the listener against the areas of possible substantial error and to develop policies with which he will be comfortable we shall say quite a bit about the psychology of investors for indeed the investor's chief problem and even his worst enemy is likely to be himself the fault dear investor is not in our stars and not in our stocks but in ourselves this has proved the more true over recent decades and it has become more necessary for conservative investors to acquire common stocks and thus expose themselves willy-nilly to the excitement and the temptations of the stock market by arguments examples and exhortation we hope to aid our listeners to establish the proper mental and emotional attitudes toward their investment decisions we have seen much more money made and kept by ordinary people who were temperamentally well suited for the investment process than by those who lacked this quality even though they had extensive knowledge of finance and stock market lore additionally we hope to implant in the listener a tendency to measure or quantify for 99 issues out of a hundred we could say that at some price they are cheap enough to buy and at some other price they would be so dear that they should be sold the habit of relating what is paid to what is being offered is an invaluable trait in investment in an article in a woman's magazine many years ago we advised our readers to buy their stocks as they bought their groceries not as they bought their perfume the really dreadful losses of the past few years and on many occasions before were realized in those common stock issues where the buyer forgot to ask how much we shall therefore present in some detail a positive program for common stock investment part of which is within the purview of both classes of investors and part is intended mainly for the enterprising group strangely enough we shall suggest as one of our chief requirements here that our listeners limit themselves to issues selling not far above their tangible asset value the reason for this seemingly outmoded council is both practical and psychological experience has taught us that while there are many good growth companies worth several times net assets the buyer of such shares will be too dependent on the vagaries and fluctuations of the stock market by contrast the investor in shares say of public utility companies at about their net asset value can always consider himself the owner of an interest in sound and expanding businesses acquired at a rational price regardless of what the stock market might say to the contrary the ultimate result of such a conservative policy is likely to work out better than exciting adventures into the glamorous and dangerous fields of anticipated growth the art of investment has one characteristic that is not generally appreciated a creditable if unspectacular result can be achieved by the lay investor with a minimum of effort and capability but to improve this easily attainable standard requires much application and more than a trace of wisdom if you merely try to bring just a little extra knowledge and cleverness to bear upon your investment program instead of realizing a little better than normal results you may well find that you have done worse since anyone by just buying and holding a representative list can equal the performance of the market averages it would seem a comparatively simple matter to beat the averages but as a matter of fact the proportion of smart people who try this and fail is surprisingly large even the majority of the investment funds with all their experienced personnel have not performed so well over the years as has the general market a lie to the foregoing is the record of the published stock market predictions of the brokerage houses for there is strong evidence that their calculated forecasts have been somewhat less reliable than the simple tossing of a coin in making this tape we have tried to keep this basic pitfall of investment in mind the virtues of a simple portfolio policy have been emphasized the purchase of high-grade bonds plus a diversified list of leading common stocks which any investor can carry out with a little expert assistance the adventure beyond this safe and sound territory has been presented as fraught with challenging difficulties especially in the area of temperament before attempting such a venture the investor should feel sure of himself and of his advisors particularly as to whether they have a clear concept of the differences between investment and speculation and between market price and underlying value a strong-minded approach to investment firmly based on the margin of safety principle can yield handsome rewards but a decision to try for these emoluments rather than for the assured fruits of defensive investment should not be made without much self-examination a final retrospective thought when the young author entered wall street in june of 1914 no one had any inkling of what the next half century had in store the stock market did not even suspect that a world war was to break out in two months and close down the new york stock exchange now in 1972 we find ourselves the richest and most powerful country on earth but beset by all sorts of major problems and more apprehensive than confident of the future yet if we confine our attention to american investment experience there is some comfort to be gleaned from the last 57 years through all their vicissitudes and casualties as earth-shaking as they were unforeseen it remained true that sound investment principles produce generally sound results we must act on the assumption that they will continue to do so what do we mean by investor throughout this tape the term will be used in contra distinction to speculator as far back as 1934 in our textbook security analysis 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 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 through 1932 all common stocks were widely regarded as speculative by nature a leading authority stated flatly that only bonds could be bought for investment 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 listeners from accepting the common jargon which applies the term investor to anybody and everybody in the stock market 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 nineteen forty nine when over ninety percent of those queried expressed themselves as opposed to the purchase of common stocks about half gave as their reason not safe a gamble and about half the reason not familiar with it 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 that they had advanced to what were undoubtedly dangerous levels as judged by past experience later transformed them into investments 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 listener 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 investors 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 quotation 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 outright speculation is neither illegal 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 one speculating when you think you're investing two speculating seriously instead of as a pastime when you lack proper knowledge and skill for it and three risking more money and 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're ahead of the game if you want to try your look 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 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 in 1965 we recommended that the investor divide his holdings between high-grade bonds and leading common stocks that the proportion held in bonds be 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 five percent as an alternative policy he might choose to reduce his common stock component to 25 percent if he felt the market was dangerously high and conversely to advance it toward the maximum of 75 percent if he felt that a decline in stock prices was making them increasingly attractive in 1965 the investor could obtain about four and a half percent on high grade taxable bonds and three and a half percent and four and a half percent on good tax-free bonds the dividend return on leading common stocks with the djia 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 three and a half and four and a half percent 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 seven and a half percent per year the half and half division between bonds and stocks would yield about six percent 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 percent 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 and hence that the wonderful results since 1949 would imply not very good but bad results for the future 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 nineteen seventy the obtainable return on good corporate issues is now about seven and a half percent and even more against four and a half percent in 1964. in the meantime the dividend return on djia type stocks had a fair advance also during the market decline of 1969-1970 but as we write with the dow now at 900 it is less than three and a half percent against 3.2 percent at the end of 1964. the change in going interest rates produced a maximum decline of about 38 percent 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 that a long-term bond may vary widely in price in response to changes in interest rates in 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 djia at its closing price of 8.74 in 1964 he would have had a small profit thereon in late 1971 even at the lowest level 631 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 in 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 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 djia 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 three and a half percent dividend return on his stocks and also on an average annual appreciation of about four percent 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 yield 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 appreciations 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 listener will immediately think of the inflation factor as a potent reason on the other side our considerable experience with inflation in the united states during this century would not support the choice of stocks against bonds at present differentials and 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 percent concentration on bonds even at their more favorable yield levels hence after this for shortened 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 division between the two components or a ratio dependent on their judgment varying between a minimum of 25 percent and a maximum of 75 percent of either 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 defense of investors 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 the defense of 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 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 let us mention 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 or co-mingle funds 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 another concept is the device of dollar cost averaging 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 low than when it's high and he's likely to end up with a satisfactory overall price for all of 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 made various holdings of common stocks between the 25 percent minimum and the 75 percent maximum in inverse relationship to the action of the market these ideas have merit for the defense of 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 endeavor to obtain better than average results these include one trading in the market this usually means buying stocks when the market has been advancing and selling them after it is 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 even small investors perished the term sometimes try their unskilled hand at short selling two 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 three 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 for example 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 investors 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 in his endeavor to select the most promising stocks either for the near term or the longer term 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 in wall street next year's results to the extent they are predictable are already being carefully considered hence the investor who selects issues cheaply 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 investors handicaps are basically the same the possibility of outright error in the prediction 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 one inherently sound and promising and two are not popular in 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 and common stocks those engaged therein don't appear to know in polite terms one part of their anatomy from another in this tape we shall point out examples of past discrepancies between price and value thus it seems that any intelligent person with a good head for figures should have a veritable picnic in wall street battening off other people's foolishness so it seems but somehow it doesn't work out that simply buying a neglected and therefore undervalued issue for profit generally proves a protracted and patience trying experience and selling short a too popular and therefore overvalued issue is apt to be a test not only of one's courage and stamina but also of the depth of one's pocketbook the principle is sound it's 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 which over many years could be counted on to bring a nice annual return of 20 percent 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 konashenti but with the multiplication of merger announcements came a multiplication of obstacles to mergers and of deals that didn't go through quite a few individual losses were thus realized in these once reliable operations perhaps two 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 has developed during our lifetime 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 djia below its central or intrinsic value and to sell out above such value it was an application of the governing maxim of the rothschilds buy cheap and sell deer 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 through 1933 and its much more questionable performance since nineteen thirty four a third and final example of the golden opportunities not recently available a good part of our own operations in wall street had been concentrated on the purchase of bargain issues easily identified as such by the fact that they were selling at less their share in the net current assets working capital alone not counting the plan 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 low a 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-size 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 djia or any similarly representative list in our view the search for these would not be worth the investors effort unless he could hope to add say five percent 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 [Music] inflation and the fight against it have 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 have 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 dollars 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 portfolio should consist one hundred percent of stocks and zero percent 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 listeners must have enough intelligence to recognize that even high quality stocks cannot be a better purchase than bonds under all conditions that is 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 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 a condensed historical tabulation that contains much information about changes in the general price level and concomitant 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 percent between 1965 and 1970. in between we have had three periods of declining prices and then six advances at varying rates some rather small on this showing the investor should clearly allow for the probability of continuing or recurrent inflation to come can we tell what the rate of inflation is likely to be no clear answer is suggested by our information it shows variations of all sorts it would seem sensible however to take our cue 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 percent that for 1965 through 1970 was 4.5 percent that for 1970 alone was 5.4 percent official government 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 three percent per annum this would compare with an annual rate of about two and a half percent for the entire period covering 1915 through 1970. 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 our 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 investors fortune need to 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 nineteen seventy through nineteen seventy one would not for example an all stock program be preferable to a part bond part stock 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 at bonds over the 55-year period of our study the answer to these questions is somewhat complicated common stocks have indeed done better than bonds over a long period of time in the past the rise in the djia 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 standard and poor's 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 and 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 hopes and apprehensions his satisfaction or discontent with what he has done above all his decisions 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 through 1970. the rise in the cost of living was 22 percent the largest in a five-year period since forty six through nineteen fifty both stock earnings and stock prices as a whole have declined since nineteen sixty five there are similar contradictions in both directions in the record of previous five-year periods 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 our extended studies have led to the conclusion that the investor cannot count on much above the recent five-year rate earned on the djia group about 10 percent on net tangible assets or book value behind the shares 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 six and one-quarter percent this relationship is generally expressed in the reverse or times earnings manner for example that the djia price of 900 equals 18 times the actual earnings for the 12 months ended june 1971. our figures gear in directly with the suggestion previously that the investor may assume an average dividend return of about 3.6 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 one dollar and sixty cents the listener 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 djia 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 percent business earnings should be influenced more by wholesale prices than by consumer prices 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 1950 through 1970 which reveals a combination of generally continued prosperity and generally rising prices but the figures indicate that the effect of all of 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 one a rise in wage rates exceeding the gains in productivity and two the need for huge amounts of new capital thus holding down the ratio of sales to capital employed 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 djia 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 tomorrows 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 djia itself to recover the ground lost in the 1929 through 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 handsome profits but rather as a vindication 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 naturally we returned to the policy recommended previously just because of the uncertainties of the future the investor cannot afford to put all of his funds into one basket neither in the bond basket despite the unprecedentedly high returns that bonds have recently afforded 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 the 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 seven and a half percent are much less than those involved in buying the djia at 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 bond component it must be evident to the listener 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 bond holding 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 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 there have been three quite distinct patterns each covering about a third of the seventy years between nineteen hundred and nineteen seventy 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 of 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 1940 with that of 1924 we find the annual rate of advance to be a mere one and a half 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 70-year time period this phenomenon may have reached its culmination in december 1968 at 118 for standard and poor's 425 industrials there were fairly important setbacks between 1949 and 1968 especially in 1956 1957 and in 1961 1961-1962 but the recoveries there from were so rapid that they had to be denominated as recessions in a single bull market rather than as separate market cycles the advance had been more than six-fold in 17 years which is at the average compounded rate of 11 a year not counting dividends of say three and a half percent per annum these 14 percent and better returns created a natural satisfaction in wall street and a quite illogical 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 was 36 percent for the standard and poor's composite and 37 percent for the djia and the largest since the 44 suffered in 1939 through 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 in early 1972 to people of long experience and innate caution the passage from one extreme to another carried a strong warning of trouble ahead but these fears have not been confirmed in terms of historical market swings the 1971 picture would still appear as one of irregular recovery from the bad setbacks suffered in 1969 through 1970. in the past such recoveries have ushered in a new stage of the recurrent and persistent bull market that began in 1949 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 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 there 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 sought 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 the portfolio policy of the defensive investor should divide as 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 percent of his funds in common stocks with a consequent inverse range of between 75 percent and 25 in bonds there is an implication here that the standard division should be an equal one or 50 50 between the two major investment mediums according to tradition the sound reason for increasing the percentage of 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 copy book maxims have always been easy to enunciate and always difficult to follow because they go against the very human nature which produces the 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 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 development 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 percent minimum and rebuild them later to the 75 percent maximum we can urge that in general the investor should not have more than one half in equities unless he has strong confidence in the soundness of his stock position and is sure that he could view a market decline of the 1969-1970 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 percent 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 percent 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 percent of his total funds we are thus led to put forward for most of our listeners what may appear to be an over simplified fifty-fifty formula under this plan the guiding rule is to maintain as nearly as practicable and equal division between bond and stock holdings when changes in the market level have raised the common stock component to say 55 percent 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 percent would call for the use of one 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 percent 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 in equities including some convertibles the yale example illustrates the almost lethal effect of the great market advance upon the once popular formula approach to investment nonetheless we're convinced that our fifty-fifty version of this approach makes good sense for the 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 and 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 gain 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 50 50 division is undoubtedly the simplest all-purpose program divisible 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 wayer of the odds he would be likely to favor the low 25 stock component at this time with the idea of waiting until the djia 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 djia and dividends of 36 dollars on the unit this would require either a fall and taxable bond yields from seven and a half percent to about 5.5 percent without any change in the present return on leading stocks or a fall in the djia 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 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 arithmetic turning on the difference in yields as compared with the investors tax bracket 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 depends on whether the investor wants 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 for a period of many years in the past the only sensible bond purchases for individuals with 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 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 would 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 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 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 in practical terms we advise the investor in long-term issues 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 bond at a discount rather than a high coupon bond selling it about par and callable in a few years certain general observations should be made here on the subject of preferred stocks really good preferred stocks can and do exist but they are good in spite of their investment form which is an inherently bad one the typical preferred stockholder 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 omitted 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 stockholder or partner these weaknesses in the legal position of preferred stocks tend to come to the fore recurrently 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 the bond form and the preferred stock form as previously discussed are well understood and relatively simple matters a bondholder is entitled to receive a 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 this 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 several 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 investor 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 in 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 in 1949 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 twenty years whereby the big advance in stock prices made them appear safe and profitable investments at record high levels which might actually carry with them a considerable degree of risk the argument we made for common stocks in 1949 turned on two major 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 have 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 through 1932. since 1957 common stocks have once again threw their high prices lost their traditional advantage in dividend yield over bond 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 listener that we have no enthusiasm for common stocks in general at the 900 djia 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 bond holding 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 one there should be adequate though not excessive diversification this might mean a minimum of ten different issues and a maximum of about thirty two each company selected should be large prominent and conservatively financed indefinite as these adjectives must be their general sense is clear three each company should have a long record of continuous dividend payments all the issues in the dow jones industrial average 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 nineteen fifty four 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 an exclusion 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 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 pass period this has introduced a speculative element of considerable weight in the growth stock picture and has made successful operations in this field of 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 this best of common stocks actually lost 50 percent of its market price in a six months decline during 1961 and 1962 and nearly the same percentage in 1969 through 1970. 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 own them a good second example for our purpose is texas instruments which in six years rose from five to two hundred and fifty six without paying a dividend while its earnings increased from forty cents to three dollars and ninety one cents 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 49. the listener will understand from these instances why we regard growth stocks as a whole as too uncertain and risky a 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 it is now standard practice to submit all securities 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 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 it is conventional to speak of good bonds as less risky than good preferred stocks and at the latter as less risky than good common stocks from this was derived the popular prejudice against common stocks because they are not safe 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 he were 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 the 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 it is 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 investment 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 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 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 stocks bought 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 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 his 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 percent 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 pattern suggested for his defensive confrare and make his choice between high-grade taxable issues and good quality tax-free bonds throughout this tape 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 four and a half percent something should be said now about investing in second grade issues which can readily be found to yield any specified return up to eight percent 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 st paul and pacific 5 percent income debenture bonds at 68 yielded 7.35 percent 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 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 all that bad 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 coal price and the 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 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 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 1946 and again beginning in 1960 the process then reached extraordinary proportions until brought to a catastrophic close in may 1962 after the usual swearing-off period of several years the whole tragic comedy was repeated step by step in 1967 through 1969 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 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 carried 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 prices 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 percent and more of their offering price the situation is worsened by the aforementioned fact that at bottom the public has a real aversion 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 financing issues during bull markets even if one or two can be found that can pass severe tests of quality and value it's 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 size market advances including some that go up spectacularly the very day they're 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 [Music] 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 twenty for the defensive investor we suggested an upper limit of purchase price at twenty five times average earnings of the past seven years the two criteria would be about equivalent in most cases the striking things 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 listener 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 one hundred fold or more in value the answer is yes but the big fortunes from single company investments are almost always realized by persons who have a close relationship with a particular company through employment family connection etc which justifies them in placing a large part of their resources in one medium and holding on to this commitment through all facilities 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 a question 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 them to take what seems to be a goodly profit but one far less than the ultimate bonanza 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 might 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 will say it 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 a 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 6 or the 10 issues in the djia 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 djia as a whole or in the highest multiplier that is the most popular group 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 great a 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 five 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 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 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 23 and a half in 1962 and the following year it was taken over by its parent enterprise anaconda corporation at the equivalent of only thirty three 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 indication 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 the listener 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 cause of price declines to unduly low levels an 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 1958-1971 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 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 and 1947 declined from 36 to 13 and a half the true earnings of the road in 1947 were close to ten dollars 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 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 our experience with this type of investment selection on a diversified basis was uniformly good for many years prior to nineteen fifty seven it can probably be affirmed without hesitation that it continues 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 in 1970 produced a new crop of these sub-working capital stocks 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 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 1931-1932 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 pronounced preference for industry leaders and a corresponding lack of interest most of the time in the ordinary company of secondary importance this is 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 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 the very class of secondary issues that had formerly 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 others 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 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 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 stockholders 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 schrute investors not so many years ago to the purchase of bonds of railroads in bankruptcy bonds which they knew would be worth much more than their cost when their 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-consummation 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 speculator 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 tape is not the appropriate medium for expanding its complications investment policy as it has been developed here depends in the first place on a choice by the investor of either the defensive or aggressive 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 steadily 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 thus we are suggesting only that the aggressive investor recognize 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 it is difficult to make 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 that 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 counseled 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 a viewpoint regarding a single security because such cases are exceptional and not a great deal is at stake in the matter but the investor's choice as 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 his basic decision 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 since common stocks even of investment grade are subject to recurring 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 a great deal of brain power goes into market forecasting 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 listener 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 inexperience for assuming that any typical or average investor can anticipate market movements more successfully than the general public of which he is himself a part 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 tea company here's the story a 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 the bear market of 1938 the shares fell to a new low of 36. that price was extraordinary it meant the preferred and common were together selling for 126 million although the company had just reported that it held 85 million in cash alone and a working capital or net current assets of 134 million a 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 in 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 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 the following year in 1939 a p shares advanced to and a half or three 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 p it was more striking than most in the years after 1949 the grocery chain shares rose with the general market until in 1961 the split up stock 10 for one reached a high of 70 and a half which was equivalent to 705 for the 1938 shares this price of 70 and a half was remarkable for the fact that it was 30 times the earnings of 1961. such a price earnings ratio which compares with 23 times for the djia 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 70 and one-half 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 20 and one half 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 courageous 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 critics of the value approach to stock investment argue that listed common stocks can not 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 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 markets 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 share 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 dollar interest in the enterprise only in case you agree with them 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 worst 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 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 sizeable advances he should always remember that market quotations are there for his convenience 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 one course open to the defensive investor is to put his money into investment company shares 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 is then passed from the category of defensive or unenterprising investor into that of aggressive or enterprising investor the investment of money and 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 are amateurs 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 counterpart in ordinary business affairs 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 interest 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 there are 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 stockholders 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 investors thinking he may well need some education in this area for it abounds in misleading possibilities in former 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 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 poor's stock guide have conversion privileges and this has been true also of a major part of the corporate bond financing in 1968 through 1970 there are at least 60 different sets of stock option warrants dealt on the american stock exchange in the overall picture the convertible issues rank as much more important than the warrants there are two main aspects to be considered first how do they rank as investment opportunities and risks second how does their existence affect the value of the common stock issues convertible issues 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 case has been overstated 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 of yield or both conversely if the company gets its money at lower cost because of the conversion feature it is surrendering in return part of the common stockholders 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 into question the underlying safety of the issue itself 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 one hundred convertible into a stock at twenty five that is at the rate of 40 shares for each one thousand dollar bond the stock goes to 30 which makes the bond worth at least 120 so it sells at 125 you either sell or hold if you hold hoping for a higher price you're pretty much in the position of a common stockholder 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 carrying the convertible with it and the investor experiences that peculiar pain that comes to the man who was 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 twenty five percent or thirty percent 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 a similar magnitude because of the extraordinary length of the 1950-1968 bull market convertible issues 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 issues 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 let us mince no words from the outset we consider the recent development of stock option warrants as a near 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 listener to the section of faust part two in which gerta describes the invention of paper money originally stock option warrants were attached now and then to bond issues and were usually equivalent to a partial conversion privilege they were unimportant amount and hence did no harm their use expanded in the late 1920s along with many other financial abuses they were bound to turn up again like the bad pennies they are and since 1967 they have become familiar instruments of finance 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 chairs 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 warrant 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 stockholders in the usual way which means somewhat under the ruling market price the warrants 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 large issues of stock option warrants serve no purpose except to fabricate imaginary market values 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 like 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 bonds 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 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 facilities 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 million dollars 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 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 investors 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 tenant 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 dollars 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 zero and double zero he is certain to lose two dollars on each turn of the wheel but suppose the winner received thirty nine dollars profit instead of thirty one dollars then he would have a small but important margin of safety therefore the more numbers he wagers 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 double zero 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 trustworthy 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 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 some 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 investment is most intelligent when it's most business like 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 be best 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 venture 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 reasons 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 small figures 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 brings 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 we know very well two partners who spent a good part of their lives handling their own and other people's funds in wall street some hard experience taught them it was better to be safe and careful rather than to try to make all the money in the world they established a rather unique approach to security operations which combined good profit possibilities with sound values they avoided anything that appeared overpriced and were rather too quick to dispose of issues that had advanced to levels they deemed no longer attractive their portfolio was always well diversified with more than a hundred different issues represented in this way they did quite well through many years of ups and downs in the general market they averaged about 20 percent per annum on the several millions of capital they had accepted for management and their clients were well pleased with the results during the late 1940s an opportunity was offered to the partners fund to purchase a half interest in a growing enterprise for some reason the industry did not have wall street appeal at the time and the deal had been turned down by quite a few important houses but the payer was impressed by the company's possibilities what was decisive for them was that the price was moderate in relation to current earnings and asset value the partners went ahead with the acquisition amounting in dollars to about one-fifth of their fund they became closely identified with a new business interest which prospered in fact it did so well that the price of its shares advanced to 200 times or more the price paid for the half interest the advance far outstripped the actual growth in profits and almost from the start the quotation appeared much too high in terms of the partner's own investment standards but since they regarded the company as a sort of family business they continue to maintain a substantial ownership of the shares despite the spectacular price rise a large number of participants in their funds did the same and they became millionaires through their holding in this one enterprise plus better organized affiliates ironically enough the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through twenty years of wide-ranging operation in the partners specialized fields involving much investigation endless pondering and countless individual decisions are there morals to this story of value to the intelligent investor an obvious one is that there are several different ways to make and keep money in wall street another not so obvious is that one lucky break or one supremely shrewd decision can we tell them apart may count for more than a lifetime of journeyman efforts but behind the luck or the crucial decision there must usually exist a background of preparation and discipline capacity one needs to be sufficiently established and recognized so that these opportunities will knock at his particular door one must have the means the judgment and the courage to take advantage of them of course we cannot promise a like spectacular experience to all intelligent investors who remain both prudent and alert through the years we are not going to end with j.j roskopf's slogan that we made fun of at the beginning everybody can be rich but interesting possibilities abound on the financial scene and the intelligent and enterprising investor should be able to find both enjoyment and profit in this three-ring circus excitement is guaranteed

Channel: Hightower Investing and History Network

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Length: 164min 31sec (9871 seconds)

Published: Sat Sep 12 2020