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BENJAMIN GRAHAM
updated with newcommentary by JASON ZWEIG
......... •••.. ••u•r WARREN E. BUFFETT
.. By far the best book on investing
ever wrinen... - Wauen E. Bufftll
REVISED EDITION
HarperBusiness Essentials
THE
INTELLIGENT INVESTOR
A BOOK OF P R A C T IC A L COUNSEL
REVISED EDITION
B E NJAM I N G RAHAM
Updated with New Commentary by Jason Zweig
To E.M.G.
Through chances various, through all vicissitudes, we make our way. . . .
Aeneid
Contents
Epigraph iii
Preface to the Fourth Edition, by Warren E. Buffett
viii
A Note About Benjamin Graham, by Jason Zweig x Introduction: What This Book Expects to Accomplish 1
COMMENTARY ON THE INTRODUCTION 12
1. Investment versus Speculation: Results to Be
Expected by the Intelligent Investor 18
COMMENTARY ON CHAPTER 1 35
2. The Investor and Inflation 47
COMMENTARY ON CHAPTER 2 58
3. A Century of Stock-Market History:
The Level of Stock Prices in Early 1972 65
COMMENTARY ON CHAPTER 3 80
4. General Portfolio Policy: The Defensive Investor 88
COMMENTARY ON CHAPTER 4 101
5. The Defensive Investor and Common Stocks 112
COMMENTARY ON CHAPTER 5 124
6. Portfolio Policy for the Enterprising Investor:
Negative Approach 133
COMMENTARY ON CHAPTER 6 145
7. Portfolio Policy for the Enterprising Investor:
The Positive Side 155
COMMENTARY ON CHAPTER 7 179
8. The Investor and Market Fluctuations 188
iv
v Contents
COMMENTARY ON CHAPTER 8 213
9. Investing in Investment Funds 226
COMMENTARY ON CHAPTER 9 242
10. The Investor and His Advisers 257
COMMENTARY ON CHAPTER 10 272
11. Security Analysis for the Lay Investor:
General Approach 280
COMMENTARY ON CHAPTER 11 302
12. Things to Consider About Per-Share Earnings 310
COMMENTARY ON CHAPTER 12 322
13. A Comparison of Four Listed Companies 330
COMMENTARY ON CHAPTER 13 339
14. Stock Selection for the Defensive Investor 347
COMMENTARY ON CHAPTER 14 367
15. Stock Selection for the Enterprising Investor 376
COMMENTARY ON CHAPTER 15 39 |
TARY ON CHAPTER 9 242
10. The Investor and His Advisers 257
COMMENTARY ON CHAPTER 10 272
11. Security Analysis for the Lay Investor:
General Approach 280
COMMENTARY ON CHAPTER 11 302
12. Things to Consider About Per-Share Earnings 310
COMMENTARY ON CHAPTER 12 322
13. A Comparison of Four Listed Companies 330
COMMENTARY ON CHAPTER 13 339
14. Stock Selection for the Defensive Investor 347
COMMENTARY ON CHAPTER 14 367
15. Stock Selection for the Enterprising Investor 376
COMMENTARY ON CHAPTER 15 396
16. Convertible Issues and Warrants 403
COMMENTARY ON CHAPTER 16 418
17. Four Extremely Instructive Case Histories 422
COMMENTARY ON CHAPTER 17 438
18. A Comparison of Eight Pairs of Companies 446
COMMENTARY ON CHAPTER 18 473
19. Shareholders and Managements: Dividend Policy 487
COMMENTARY ON CHAPTER 19 497
20. “Margin of Safety” as the Central Concept
of Investment 512
COMMENTARY ON CHAPTER 20 525
Postscript 532
COMMENTARY ON POSTSCRIPT 535
Appendixes
1. The Superinvestors of Graham-and-Doddsville 537
Contents vi
2. Important Rules Concerning Taxability of Investment Income and Security Transactions (in 1972) 561
3. The Basics of Investment Taxation
(Updated as of 2003) 562
4. The New Speculation in Common Stocks 563
5. A Case History: Aetna Maintenance Co. 575
6. Tax Accounting for NVF’s Acquisition of
Sharon Steel Shares 576
7. Technological Companies as Investments 578
Endnotes 579
Acknowledgments from Jason Zweig 589
Index 591
About the Authors Credits
Front Cover Copyright
About the Publisher
by Warren E. Buffett
I read the first edition of this book early in 1950, when I was nine- teen. I thought then that it was by far the best book about investing ever written. I still think it is.
To invest successfully over a lifetime does not require a strato- spheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making deci- sions and the ability to keep emotions from corroding that frame- work. This b |
out the Publisher
by Warren E. Buffett
I read the first edition of this book early in 1950, when I was nine- teen. I thought then that it was by far the best book about investing ever written. I still think it is.
To invest successfully over a lifetime does not require a strato- spheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making deci- sions and the ability to keep emotions from corroding that frame- work. This book precisely and clearly prescribes the proper framework. You must supply the emotional discipline.
If you follow the behavioral and business principles that Gra- ham advocates—and if you pay special attention to the invaluable advice in Chapters 8 and 20—you will not get a poor result from your investments. (That represents more of an accomplishment than you might think.) Whether you achieve outstanding results will depend on the effort and intellect you apply to your invest- ments, as well as on the amplitudes of stock-market folly that pre- vail during your investing career. The sillier the market’s behavior, the greater the opportunity for the business-like investor. Follow Graham and you will profit from folly rather than participate in it. To me, Ben Graham was far more than an author or a teacher.
More than any other man except my father, he influenced my life. Shortly after Ben’s death in 1976, I wrote the following short remembrance about him in the Financial Analysts Journal. As you read the book, I believe you’ll perceive some of the qualities I men- tioned in this tribute.
viii
BENJAMIN GRAHAM 1894–1976
Several years ago Ben Graham, then almost eighty, expressed to a friend the thought that he hoped every day to do “something foolish, something creative and something generous.”
The inclusion of that first whimsical goal reflected his knack for pack- aging ideas in a form that avoided any overtones of sermonizing or self-importance. Although his ideas were po |
. As you read the book, I believe you’ll perceive some of the qualities I men- tioned in this tribute.
viii
BENJAMIN GRAHAM 1894–1976
Several years ago Ben Graham, then almost eighty, expressed to a friend the thought that he hoped every day to do “something foolish, something creative and something generous.”
The inclusion of that first whimsical goal reflected his knack for pack- aging ideas in a form that avoided any overtones of sermonizing or self-importance. Although his ideas were powerful, their delivery was unfailingly gentle.
Readers of this magazine need no elaboration of his achievements as measured by the standard of creativity. It is rare that the founder of a disci- pline does not find his work eclipsed in rather short order by successors. But over forty years after publication of the book that brought structure and logic to a disorderly and confused activity, it is difficult to think of pos- sible candidates for even the runner-up position in the field of security analysis. In an area where much looks foolish within weeks or months after publication, Ben’s principles have remained sound—their value often enhanced and better understood in the wake of financial storms that demolished flimsier intellectual structures. His counsel of soundness brought unfailing rewards to his followers—even to those with natural abilities inferior to more gifted practitioners who stumbled while follow- ing counsels of brilliance or fashion.
A remarkable aspect of Ben’s dominance of his professional field was that he achieved it without that narrowness of mental activity that concen- trates all effort on a single end. It was, rather, the incidental by-product of an intellect whose breadth almost exceeded definition. Certainly I have never met anyone with a mind of similar scope. Virtually total recall, unending fascination with new knowledge, and an ability to recast it in a form applicable to seemingly unrelated problems made exposure to his thinking in any field a |
nce of his professional field was that he achieved it without that narrowness of mental activity that concen- trates all effort on a single end. It was, rather, the incidental by-product of an intellect whose breadth almost exceeded definition. Certainly I have never met anyone with a mind of similar scope. Virtually total recall, unending fascination with new knowledge, and an ability to recast it in a form applicable to seemingly unrelated problems made exposure to his thinking in any field a delight.
But his third imperative—generosity—was where he succeeded beyond all others. I knew Ben as my teacher, my employer, and my friend. In each relationship—just as with all his students, employees, and friends—there was an absolutely open-ended, no-scores-kept generosity of ideas, time, and spirit. If clarity of thinking was required, there was no better place to go. And if encouragement or counsel was needed, Ben was there.
Walter Lippmann spoke of men who plant trees that other men will sit under. Ben Graham was such a man.
Reprinted from the Financial Analysts Journal, November/December 1976.
by Jason Zweig
Who was Benjamin Graham, and why should you listen to him?
Graham was not only one of the best investors who ever lived; he was
also the greatest practical investment thinker of all time. Before Graham, money managers behaved much like a medieval guild, guided largely by superstition, guesswork, and arcane rituals. Graham’s Security Analysis was the textbook that transformed this musty circle into a modern pro- fession.1
And The Intelligent Investor is the first book ever to describe, for individual investors, the emotional framework and analytical tools that are essential to financial success. It remains the single best book on investing ever written for the general public. The Intelligent Investor was the first book I read when I joined Forbes Magazine as a cub reporter in 1987, and I was struck by Graham’s certainty that, sooner or later, all bull markets mu |
rmed this musty circle into a modern pro- fession.1
And The Intelligent Investor is the first book ever to describe, for individual investors, the emotional framework and analytical tools that are essential to financial success. It remains the single best book on investing ever written for the general public. The Intelligent Investor was the first book I read when I joined Forbes Magazine as a cub reporter in 1987, and I was struck by Graham’s certainty that, sooner or later, all bull markets must end badly. That October, U.S. stocks suf- fered their worst one-day crash in history, and I was hooked. (Today, after the wild bull market of the late 1990s and the brutal bear market that began in early 2000, The Intelligent Investor reads more prophet- ically than ever.)
Graham came by his insights the hard way: by feeling firsthand the anguish of financial loss and by studying for decades the history and psychology of the markets. He was born Benjamin Grossbaum on May 9, 1894, in London; his father was a dealer in china dishes and figurines.2 The family moved to New York when Ben was a year old. At first they lived the good life—with a maid, a cook, and a French gov-
1 Coauthored with David Dodd and first published in 1934.
2 The Grossbaums changed their name to Graham during World War I, when German-sounding names were regarded with suspicion.
x
erness—on upper Fifth Avenue. But Ben’s father died in 1903, the porcelain business faltered, and the family slid haltingly into poverty. Ben’s mother turned their home into a boardinghouse; then, borrow- ing money to trade stocks “on margin,” she was wiped out in the crash of 1907. For the rest of his life, Ben would recall the humiliation of cashing a check for his mother and hearing the bank teller ask, “Is Dorothy Grossbaum good for five dollars?”
Fortunately, Graham won a scholarship at Columbia, where his brilliance burst into full flower. He graduated in 1914, second in his class. Before the end of Graham’s final sem |
verty. Ben’s mother turned their home into a boardinghouse; then, borrow- ing money to trade stocks “on margin,” she was wiped out in the crash of 1907. For the rest of his life, Ben would recall the humiliation of cashing a check for his mother and hearing the bank teller ask, “Is Dorothy Grossbaum good for five dollars?”
Fortunately, Graham won a scholarship at Columbia, where his brilliance burst into full flower. He graduated in 1914, second in his class. Before the end of Graham’s final semester, three departments— English, philosophy, and mathematics—asked him to join the faculty. He was all of 20 years old.
Instead of academia, Graham decided to give Wall Street a shot. He started as a clerk at a bond-trading firm, soon became an analyst, then a partner, and before long was running his own investment part- nership.
The Internet boom and bust would not have surprised Graham. In April 1919, he earned a 250% return on the first day of trading for Savold Tire, a new offering in the booming automotive business; by October, the company had been exposed as a fraud and the stock was worthless.
Graham became a master at researching stocks in microscopic, almost molecular, detail. In 1925, plowing through the obscure reports filed by oil pipelines with the U.S. Interstate Commerce Com- mission, he learned that Northern Pipe Line Co.—then trading at $65 per share—held at least $80 per share in high-quality bonds. (He bought the stock, pestered its managers into raising the dividend, and came away with $110 per share three years later.)
Despite a harrowing loss of nearly 70% during the Great Crash of 1929–1932, Graham survived and thrived in its aftermath, harvesting bargains from the wreckage of the bull market. There is no exact record of Graham’s earliest returns, but from 1936 until he retired in 1956, his Graham-Newman Corp. gained at least 14.7% annually, versus 12.2% for the stock market as a whole—one of the best long- term track records on Wall Street history.3 |
nd, and came away with $110 per share three years later.)
Despite a harrowing loss of nearly 70% during the Great Crash of 1929–1932, Graham survived and thrived in its aftermath, harvesting bargains from the wreckage of the bull market. There is no exact record of Graham’s earliest returns, but from 1936 until he retired in 1956, his Graham-Newman Corp. gained at least 14.7% annually, versus 12.2% for the stock market as a whole—one of the best long- term track records on Wall Street history.3
3 Graham-Newman Corp. was an open-end mutual fund (see Chapter 9) that Graham ran in partnership with Jerome Newman, a skilled investor in his own right. For much of its history, the fund was closed to new investors. I am
A Note About Benjamin Graham xii
How did Graham do it? Combining his extraordinary intellectual powers with profound common sense and vast experience, Graham developed his core principles, which are at least as valid today as they were during his lifetime:
• A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price.
• The market is a pendulum that forever swings between unsustain- able optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists.
• The future value of every investment is a function of its present price. The higher the price you pay, the lower your return will be.
• No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on what Graham called the “margin of safety”—never overpaying, no mat- ter how exciting an investment seems to be—can you minimize your odds of error.
• The secret to your financial success is inside yourself. If you become a critical thinker who takes no Wall Street “fact” on faith, and you invest with patient confidenc |
gher the price you pay, the lower your return will be.
• No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on what Graham called the “margin of safety”—never overpaying, no mat- ter how exciting an investment seems to be—can you minimize your odds of error.
• The secret to your financial success is inside yourself. If you become a critical thinker who takes no Wall Street “fact” on faith, and you invest with patient confidence, you can take steady advantage of even the worst bear markets. By developing your discipline and courage, you can refuse to let other people’s mood swings govern your financial destiny. In the end, how your invest- ments behave is much less important than how you behave.
The goal of this revised edition of The Intelligent Investor is to apply Graham’s ideas to today’s financial markets while leaving his text entirely intact (with the exception of footnotes for clarification).4 After each of Graham’s chapters you’ll find a new commentary. In these reader’s guides, I’ve added recent examples that should show you just how relevant—and how liberating—Graham’s principles remain today.
grateful to Walter Schloss for providing data essential to estimating Graham-Newman’s returns. The 20% annual average return that Graham cites in his Postscript (p. 532) appears not to take management fees into account.
4 The text reproduced here is the Fourth Revised Edition, updated by Gra- ham in 1971–1972 and initially published in 1973.
I envy you the excitement and enlightenment of reading Graham’s masterpiece for the first time—or even the third or fourth time. Like all classics, it alters how we view the world and renews itself by educat- ing us. And the more you read it, the better it gets. With Graham as your guide, you are guaranteed to become a vastly more intelligent investor.
INTRODUCTION :
What This Book Expects to Accomplish
The purpose of this book is to supply, in a form |
72 and initially published in 1973.
I envy you the excitement and enlightenment of reading Graham’s masterpiece for the first time—or even the third or fourth time. Like all classics, it alters how we view the world and renews itself by educat- ing us. And the more you read it, the better it gets. With Graham as your guide, you are guaranteed to become a vastly more intelligent investor.
INTRODUCTION :
What This Book Expects to Accomplish
The purpose of this book is to supply, in a form suitable for lay- men, guidance in the adoption and execution of an investment pol- icy. Comparatively little will be said here about the technique of analyzing securities; attention will be paid chiefly to investment
principles and investors’ attitudes. We shall, however, provide a number of condensed comparisons of specific securities—chiefly in pairs appearing side by side in the New York Stock Exchange list— in order to bring home in concrete fashion the important elements involved in specific choices of common stocks.
But much of our space will be devoted to the historical patterns of financial markets, in some cases running back over many decades. To invest intelligently in securities one should be fore- armed with an adequate knowledge of how the various types of bonds and stocks have actually behaved under varying condi- tions—some of which, at least, one is likely to meet again in one’s own experience. No statement is more true and better applicable to Wall Street than the famous warning of Santayana: “Those who do not remember the past are condemned to repeat it.”
Our text is directed to investors as distinguished from specula- tors, 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” book. There are no sure and easy paths to riches on Wall Street or anywhere else. It may be well to point up what we have just said by a bit of financial history—especially sinc |
mous warning of Santayana: “Those who do not remember the past are condemned to repeat it.”
Our text is directed to investors as distinguished from specula- tors, 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” book. There are no sure and easy paths to riches on Wall Street or anywhere else. It may be well to point up 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 cli- mactic 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
1
Rich.”* His thesis was that savings of only $15 per month invested in good common stocks—with dividends reinvested—would pro- duce an estate of $80,000 in twenty years against total contributions of only $3,600. 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 (DJIA)—indicates that if Raskob’s prescription had been followed during 1929–1948, the investor’s 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% 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 “do |
ecasts 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% 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 book 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
* Raskob (1879–1950) was a director of Du Pont, the giant chemical com- pany, and chairman of the finance committee at General Motors. He also served as national chairman of the Democratic Party and was the driving force behind the construction of the Empire State Building. Calculations by finance professor Jeremy Siegel confirm that Raskob’s plan would have grown to just under $9,000 after 20 years, although inflation would have eaten away much of that gain. For the best recent look at Raskob’s views on long-term stock investing, see the essay by financial adviser William Bern- stein at www.efficientfrontier.com/ef/197/raskob.htm.
lasting success on 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. |
uch of that gain. For the best recent look at Raskob’s views on long-term stock investing, see the essay by financial adviser William Bern- stein at www.efficientfrontier.com/ef/197/raskob.htm.
lasting success on 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. We shall illustrate what we have just said—though, of course this should not be taken as proof—by a later brief discussion of the famous Dow theory for trading in the stock market.*
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 1965 edition was written. These include:
1. An unprecedented advance in the interest rate on high-grade bonds.
2. A fall of about 35% in the price level of leading common stocks, ending in May 1970. This was the highest percentage decline in some 30 years. (Countless issues of lower quality had a much larger shrinkage.)
3. A persistent inflation of wholesale and consumer’s prices, which gained momentum even in the face of a decline of gen- eral business in 1970.
4. The rapid development of “conglomerate” companies, fran- chise operations, and other relative novelties in business and finance. (These include a number of tricky devices such as “let- ter stock,” 1 proliferation of stock-option warrants, misleading names, use of foreign banks, and others.)†
* Graham’s “brief discussion” is in two parts, on p. 33 and pp. 191–192. For more detail on the Dow Theory, see http://viking.som.yale.edu/will/ dow/dowpage.html.
† Mutual funds bought “letter stock” in private transactions, then immedi- ately revalued these shares at a higher public price (see Graham’s definition on |
ess and finance. (These include a number of tricky devices such as “let- ter stock,” 1 proliferation of stock-option warrants, misleading names, use of foreign banks, and others.)†
* Graham’s “brief discussion” is in two parts, on p. 33 and pp. 191–192. For more detail on the Dow Theory, see http://viking.som.yale.edu/will/ dow/dowpage.html.
† Mutual funds bought “letter stock” in private transactions, then immedi- ately revalued these shares at a higher public price (see Graham’s definition on p. 579). That enabled these “go-go” funds to report unsustainably high returns in the mid-1960s. The U.S. Securities and Exchange Commission cracked down on this abuse in 1969, and it is no longer a concern for fund investors. Stock-option warrants are explained in Chapter 16.
5. Bankruptcy of our largest railroad, excessive short- and long- term debt of many formerly strongly entrenched companies, and even a disturbing problem of solvency among Wall Street houses.*
6. The advent of the “performance” vogue in the management of investment funds, including some bank-operated trust funds, with disquieting results.
These phenomena will have our careful consideration, and some will require changes in conclusions and emphasis from our previ- ous edition. The underlying principles of sound investment should not alter from decade to decade, but the application of these princi- ples must be adapted to significant changes in the financial mecha- nisms and climate.
The last statement was put to the test during the writing of the present edition, the first draft of which was finished in January 1971. At that time the DJIA was in a strong recovery from its 1970 low of 632 and was advancing toward a 1971 high of 951, with attendant general optimism. As the last draft was finished, in November 1971, the market was in the throes of a new decline, car- rying it down to 797 with a renewed general uneasiness about its future. We have not allowed these fluctuations to affect our general atti |
to the test during the writing of the present edition, the first draft of which was finished in January 1971. At that time the DJIA was in a strong recovery from its 1970 low of 632 and was advancing toward a 1971 high of 951, with attendant general optimism. As the last draft was finished, in November 1971, the market was in the throes of a new decline, car- rying it down to 797 with a renewed general uneasiness about its future. We have not allowed these fluctuations to affect our general attitude toward sound investment policy, which remains substan- tially unchanged since the first edition of this book in 1949.
The extent of the market’s shrinkage in 1969–70 should have served to dispel an illusion that had been gaining ground dur- ing the past two decades. This was that leading common stocks could be bought at any time and 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 lev-
* The Penn Central Transportation Co., then the biggest railroad in the United States, sought bankruptcy protection on June 21, 1970—shocking investors, who had never expected such a giant company to go under (see p. 423). Among the companies with “excessive” debt Graham had in mind were Ling-Temco-Vought and National General Corp. (see pp. 425 and 463). The “problem of solvency” on Wall Street emerged between 1968 and 1971, when several prestigious brokerages suddenly went bust.
els. 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 per- haps 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 deg |
els. 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 per- haps 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 1961–62—but there was now a novel element in the fact that some of the investment funds had large commitments in 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, on Wall Street it almost invari- ably 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 representa- tive common stocks. At the beginning of 1972 the return was 7.19% on highest-grade bonds versus only 2.76% on industrial stocks. (This compares with 4.40% and 2.92% respectively at the end of 1964.) It is hard to realize that when we first wrote this book in 1949 the figures were almost the exact opposite: the bonds returned only 2.66% and the stocks yielded 6.82%.2 In previous editions we have consistently urged that at least 25% of the conservative investor’s 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 rela- tionship returns, as we expect it will. Naturally the question of con- tinued inflation will be of great importance in reaching our decisi |
.82%.2 In previous editions we have consistently urged that at least 25% of the conservative investor’s 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 rela- tionship returns, as we expect it will. Naturally the question of con- tinued inflation will be of great importance in reaching our decision here. A chapter will be devoted to this discussion.*
* See Chapter 2. As of the beginning of 2003, U.S. Treasury bonds matur- ing in 10 years yielded 3.8%, while stocks (as measured by the Dow Jones Industrial Average) yielded 1.9%. (Note that this relationship is not all that different from the 1964 figures that Graham cites.) The income generated by top-quality bonds has been falling steadily since 1981.
In the past we have made a basic distinction between two kinds of investors to whom this book 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. We shall accordingly continue to devote attention to the possibilities for enterprising investment, as they existed in former |
cades 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. We shall accordingly continue to devote attention to the possibilities for enterprising investment, as they existed in former periods and may return.
It has long been the prevalent view that the art of success-
ful 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 advisers—would long ago have recog- nized 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 com- panies. But this is not as easy as it always looks in retrospect. To bring this point home at the outset let us add here a paragraph that we included first in the 1949 edition of this book.
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 book 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.*
* “Air-transport stocks,” of course, generated as much excitement in the late 1940s and early 1950s as Internet stocks did a half century later. Among the hottest mutual funds of that era were Aeronautical Securities and the
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 specta |
king in this favorite investment approach than in any positive technique that will help him along his path.*
* “Air-transport stocks,” of course, generated as much excitement in the late 1940s and early 1950s as Internet stocks did a half century later. Among the hottest mutual funds of that era were Aeronautical Securities and the
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 in the computer industry—a combination of techno- logical problems and overexpansion of capacity made for fluctuat- ing and even disastrous profit figures. In the year 1970, despite a new high in traffic figures, the airlines sustained a loss of some
$200 million for their shareholders. (They had shown losses also in 1945 and 1961.) The stocks of these companies once again showed a greater decline in 1969–70 than did the general market. The record shows that even the highly paid full-time experts of the mutual funds were completely wrong about the fairly short-term future of a major and nonesoteric 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, 3% 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 readers:
1. Obvious prospects for physical growth in a business do not translate into obvious profits for investors.
2. The |
owth prevented them from having more than, say, 3% 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 readers:
1. Obvious prospects for physical growth in a business do not translate into obvious profits for investors.
2. The experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries.
Missiles-Rockets-Jets & Automation Fund. They, like the stocks they owned, turned out to be an investing disaster. It is commonly accepted today that the cumulative earnings of the airline industry over its entire history have been negative. The lesson Graham is driving at is not that you should avoid buying airline stocks, but that you should never succumb to the “certainty” that any industry will outperform all others in the future.
The author did not follow this approach in his financial career as 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 book? Our main objective will be to guide the reader 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 as it has become more necessary for conservative investors to acquire common stocks and thus to expose themselves, willy-nilly, to the excitement and the temptations of the stock market. By arguments, examples, and exhortation, we hope to aid our |
hology 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 as it has become more necessary for conservative investors to acquire common stocks and thus to expose themselves, willy-nilly, to the excitement and the temptations of the stock market. By arguments, examples, and exhortation, we hope to aid our readers to establish the proper mental and emotional attitudes toward their investment decisions. We have seen much more money made and kept by “ordinary peo- ple” who were temperamentally well suited for the investment process than by those who lacked this quality, even though they had an extensive knowledge of finance, accounting, and stock- market lore.
Additionally, we hope to implant in the reader a tendency to measure or quantify. For 99 issues out of 100 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 relat- ing what is paid to what is being offered is an invaluable trait in investment. In an article in a women’s magazine many years ago we advised the readers to buy their stocks as they bought their gro- ceries, not as they bought their perfume. The really dreadful losses of the past few years (and on many similar occasions before) were realized in those common-stock issues where the buyer forgot to ask “How much?”
In June 1970 the question “How much?” could be answered by the magic figure 9.40%—the yield obtainable on new offerings of high-grade public-utility bonds. This has now dropped to about 7.3%, but even that return tempts us to ask, “Why give any other answer?” But there are other possible answers, and these must be carefully considered. Besides which, we repeat that both we and our readers must be prepared in advance for the possibly quite dif- ferent conditions |
he buyer forgot to ask “How much?”
In June 1970 the question “How much?” could be answered by the magic figure 9.40%—the yield obtainable on new offerings of high-grade public-utility bonds. This has now dropped to about 7.3%, but even that return tempts us to ask, “Why give any other answer?” But there are other possible answers, and these must be carefully considered. Besides which, we repeat that both we and our readers must be prepared in advance for the possibly quite dif- ferent conditions of, say, 1973–1977.
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 enter- prising group. Strangely enough, we shall suggest as one of our chief requirements here that our readers limit themselves to issues selling not far above their tangible-asset value.* The reason for this seemingly outmoded counsel is both practical and psychologi- cal. 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 knowle |
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
* Tangible assets include a company’s physical property (like real estate, factories, equipment, and inventories) as well as its financial balances (such as cash, short-term investments, and accounts receivable). Among the ele- ments not included in tangible assets are brands, copyrights, patents, fran- chises, goodwill, and trademarks. To see how to calculate tangible-asset value, see footnote † on p. 198.
over the years as has the general market. Allied 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 writing this book 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 diver- sified list of leading common stocks—which any investor can carry ou |
et. Allied 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 writing this book 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 diver- sified 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 challeng- ing difficulties, especially in the area of temperament. Before attempting such a venture the investor should feel sure of himself and of his advisers—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 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 produced generally sound results. We must act on the assumption that t |
72, 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 produced generally sound results. We must act on the assumption that they will continue to do so.
Note to the Reader: This book does not address itself to the overall financial policy of savers and investors; it deals only with that portion of their funds which they are prepared to place in mar- ketable (or redeemable) securities, that is, in bonds and stocks.
Consequently we do not discuss such important media as savings and time desposits, savings-and-loan-association accounts, life insurance, annuities, and real-estate mortgages or equity owner- ship. The reader should bear in mind that when he finds the word “now,” or the equivalent, in the text, it refers to late 1971 or early 1972.
COMMENTARY ON THE INTRODUCTION
If you have built castles in the air, your work need not be lost; that is where they should be. Now put the foundations under them.
—Henry David Thoreau, Walden
Notice that Graham announces from the start that this book will not tell you how to beat the market. No truthful book can.
Instead, this book will teach you three powerful lessons:
• how you can minimize the odds of suffering irreversible losses;
• how you can maximize the chances of achieving sustainable gains;
• how you can control the self-defeating behavior that keeps most investors from reaching their full potential.
Back in the boom years of the late 1990s, when technology stocks seemed to be doubling in value every day, the notion that you could lose almost all your money seemed absurd. But, by the end of 2002, many of the dot-com and telecom stocks had los |
ssons:
• how you can minimize the odds of suffering irreversible losses;
• how you can maximize the chances of achieving sustainable gains;
• how you can control the self-defeating behavior that keeps most investors from reaching their full potential.
Back in the boom years of the late 1990s, when technology stocks seemed to be doubling in value every day, the notion that you could lose almost all your money seemed absurd. But, by the end of 2002, many of the dot-com and telecom stocks had lost 95% of their value or more. Once you lose 95% of your money, you have to gain 1,900% just to get back to where you started.1 Taking a foolish risk can put you so deep in the hole that it’s virtually impossible to get out. That’s why Graham constantly emphasizes the importance of avoiding losses—not just in Chapters 6, 14, and 20, but in the threads of warn- ing that he has woven throughout his entire text.
But no matter how careful you are, the price of your investments
will go down from time to time. While no one can eliminate that risk,
1 To put this statement in perspective, consider how often you are likely to buy a stock at $30 and be able to sell it at $600.
12
Graham will show you how to manage it—and how to get your fears under control.
AR E Y OU AN I NTE LLI G E NT I NVE ST OR?
Now let’s answer a vitally important question. What exactly does Gra- ham mean by an “intelligent” investor? Back in the first edition of this book, Graham defines the term—and he makes it clear that this kind of intelligence has nothing to do with IQ or SAT scores. It simply means being patient, disciplined, and eager to learn; you must also be able to harness your emotions and think for yourself. This kind of intelligence, explains Graham, “is a trait more of the character than of the brain.” 2
There’s proof that high IQ and higher education are not enough to make an investor intelligent. In 1998, Long-Term Capital Management L.P., a hedge fund run by a battalion of mathematicians, |
r that this kind of intelligence has nothing to do with IQ or SAT scores. It simply means being patient, disciplined, and eager to learn; you must also be able to harness your emotions and think for yourself. This kind of intelligence, explains Graham, “is a trait more of the character than of the brain.” 2
There’s proof that high IQ and higher education are not enough to make an investor intelligent. In 1998, Long-Term Capital Management L.P., a hedge fund run by a battalion of mathematicians, computer scientists, and two Nobel Prize–winning economists, lost more than
$2 billion in a matter of weeks on a huge bet that the bond market would return to “normal.” But the bond market kept right on becoming more and more abnormal—and LTCM had borrowed so much money that its collapse nearly capsized the global financial system.3
And back in the spring of 1720, Sir Isaac Newton owned shares in the South Sea Company, the hottest stock in England. Sensing that the market was getting out of hand, the great physicist muttered that he “could calculate the motions of the heavenly bodies, but not the madness of the people.” Newton dumped his South Sea shares, pock- eting a 100% profit totaling £7,000. But just months later, swept up in the wild enthusiasm of the market, Newton jumped back in at a much higher price—and lost £20,000 (or more than $3 million in today’s money). For the rest of his life, he forbade anyone to speak the words “South Sea” in his presence.4
2 Benjamin Graham, The Intelligent Investor (Harper & Row, 1949), p. 4.
3 A “hedge fund” is a pool of money, largely unregulated by the government, invested aggressively for wealthy clients. For a superb telling of the LTCM story, see Roger Lowenstein, When Genius Failed (Random House, 2000).
4 John Carswell, The South Sea Bubble (Cresset Press, London, 1960),
pp. 131, 199. Also see www.harvard-magazine.com/issues/mj99/damnd. html.
Sir Isaac Newton was one of the most intelligent people who ever lived, as most of u |
Intelligent Investor (Harper & Row, 1949), p. 4.
3 A “hedge fund” is a pool of money, largely unregulated by the government, invested aggressively for wealthy clients. For a superb telling of the LTCM story, see Roger Lowenstein, When Genius Failed (Random House, 2000).
4 John Carswell, The South Sea Bubble (Cresset Press, London, 1960),
pp. 131, 199. Also see www.harvard-magazine.com/issues/mj99/damnd. html.
Sir Isaac Newton was one of the most intelligent people who ever lived, as most of us would define intelligence. But, in Graham’s terms, Newton was far from an intelligent investor. By letting the roar of the crowd override his own judgment, the world’s greatest scientist acted like a fool.
In short, if you’ve failed at investing so far, it’s not because you’re stupid. It’s because, like Sir Isaac Newton, you haven’t developed the emotional discipline that successful investing requires. In Chapter 8, Graham describes how to enhance your intelligence by harnessing your emotions and refusing to stoop to the market’s level of irrational- ity. There you can master his lesson that being an intelligent investor is more a matter of “character” than “brain.”
A CH R ON I CLE OF C ALAM ITY
Now let’s take a moment to look at some of the major financial devel- opments of the past few years:
1. The worst market crash since the Great Depression, with U.S. stocks losing 50.2% of their value—or $7.4 trillion—between March 2000 and October 2002.
2. Far deeper drops in the share prices of the hottest companies of the 1990s, including AOL, Cisco, JDS Uniphase, Lucent, and Qualcomm—plus the utter destruction of hundreds of Internet stocks.
3. Accusations of massive financial fraud at some of the largest and most respected corporations in America, including Enron, Tyco, and Xerox.
4. The bankruptcies of such once-glistening companies as Con- seco, Global Crossing, and WorldCom.
5. Allegations that accounting firms cooked the books, and even destroyed records, to help their cl |
ces of the hottest companies of the 1990s, including AOL, Cisco, JDS Uniphase, Lucent, and Qualcomm—plus the utter destruction of hundreds of Internet stocks.
3. Accusations of massive financial fraud at some of the largest and most respected corporations in America, including Enron, Tyco, and Xerox.
4. The bankruptcies of such once-glistening companies as Con- seco, Global Crossing, and WorldCom.
5. Allegations that accounting firms cooked the books, and even destroyed records, to help their clients mislead the investing public.
6. Charges that top executives at leading companies siphoned off hundreds of millions of dollars for their own personal gain.
7. Proof that security analysts on Wall Street praised stocks publicly but admitted privately that they were garbage.
8. A stock market that, even after its bloodcurdling decline, seems overvalued by historical measures, suggesting to many experts that stocks have further yet to fall.
9. A relentless decline in interest rates that has left investors with no attractive alternative to stocks.
10. An investing environment bristling with the unpredictable menace of global terrorism and war in the Middle East.
Much of this damage could have been (and was!) avoided by investors who learned and lived by Graham’s principles. As Graham puts it, “while enthusiasm may be necessary for great accomplish- ments elsewhere, on Wall Street it almost invariably leads to disaster.” By letting themselves get carried away—on Internet stocks, on big “growth” stocks, on stocks as a whole—many people made the same stupid mistakes as Sir Isaac Newton. They let other investors’ judg- ments determine their own. They ignored Graham’s warning that “the really dreadful losses” always occur after “the buyer forgot to ask ‘How much?’ ” Most painfully of all, by losing their self-control just when they needed it the most, these people proved Graham’s asser- tion that “the investor’s chief problem—and even his worst enemy—is likely to be himself. |
n big “growth” stocks, on stocks as a whole—many people made the same stupid mistakes as Sir Isaac Newton. They let other investors’ judg- ments determine their own. They ignored Graham’s warning that “the really dreadful losses” always occur after “the buyer forgot to ask ‘How much?’ ” Most painfully of all, by losing their self-control just when they needed it the most, these people proved Graham’s asser- tion that “the investor’s chief problem—and even his worst enemy—is likely to be himself.”
TH E S U R E TH I N G THA T W AS N’T
Many of those people got especially carried away on technology and Internet stocks, believing the high-tech hype that this industry would keep outgrowing every other for years to come, if not forever:
• In mid-1999, after earning a 117.3% return in just the first five months of the year, Monument Internet Fund portfolio manager Alexander Cheung predicted that his fund would gain 50% a year over the next three to five years and an annual average of 35% “over the next 20 years.” 5
5 Constance Loizos, “Q&A: Alex Cheung,” InvestmentNews, May 17, 1999,
p. 38. The highest 20-year return in mutual fund history was 25.8% per year, achieved by the legendary Peter Lynch of Fidelity Magellan over the two decades ending December 31, 1994. Lynch’s performance turned $10,000 into more than $982,000 in 20 years. Cheung was predicting that his fund would turn $10,000 into more than $4 million over the same length of time. Instead of regarding Cheung as ridiculously overoptimistic, investors threw
• After his Amerindo Technology Fund rose an incredible 248.9% in 1999, portfolio manager Alberto Vilar ridiculed anyone who dared to doubt that the Internet was a perpetual moneymaking machine: “If you’re out of this sector, you’re going to underper- form. You’re in a horse and buggy, and I’m in a Porsche. You don’t like tenfold growth opportunities? Then go with someone else.” 6
• In February 2000, hedge-fund manager James J. Cramer pro- claimed that I |
lously overoptimistic, investors threw
• After his Amerindo Technology Fund rose an incredible 248.9% in 1999, portfolio manager Alberto Vilar ridiculed anyone who dared to doubt that the Internet was a perpetual moneymaking machine: “If you’re out of this sector, you’re going to underper- form. You’re in a horse and buggy, and I’m in a Porsche. You don’t like tenfold growth opportunities? Then go with someone else.” 6
• In February 2000, hedge-fund manager James J. Cramer pro- claimed that Internet-related companies “are the only ones worth owning right now.” These “winners of the new world,” as he called them, “are the only ones that are going higher consistently in good days and bad.” Cramer even took a potshot at Graham: “You have to throw out all of the matrices and formulas and texts that existed before the Web. If we used any of what Graham and
Dodd teach us, we wouldn’t have a dime under management.” 7
All these so-called experts ignored Graham’s sober words of warn- ing: “Obvious prospects for physical growth in a business do not translate into obvious profits for investors.” While it seems easy to foresee which industry will grow the fastest, that foresight has no real value if most other investors are already expecting the same thing. By the time everyone decides that a given industry is “obviously” the best
money at him, flinging more than $100 million into his fund over the next year. A $10,000 investment in the Monument Internet Fund in May 1999 would have shrunk to roughly $2,000 by year-end 2002. (The Monument fund no longer exists in its original form and is now known as Orbitex Emerging Technology Fund.)
6 Lisa Reilly Cullen, “The Triple Digit Club,” Money, December, 1999, p. 170. If you had invested $10,000 in Vilar’s fund at the end of 1999, you would have finished 2002 with just $1,195 left—one of the worst destructions of wealth in the history of the mutual-fund industry.
7 See www.thestreet.com/funds/smarter/891820.html. Cramer’s favorit |
shrunk to roughly $2,000 by year-end 2002. (The Monument fund no longer exists in its original form and is now known as Orbitex Emerging Technology Fund.)
6 Lisa Reilly Cullen, “The Triple Digit Club,” Money, December, 1999, p. 170. If you had invested $10,000 in Vilar’s fund at the end of 1999, you would have finished 2002 with just $1,195 left—one of the worst destructions of wealth in the history of the mutual-fund industry.
7 See www.thestreet.com/funds/smarter/891820.html. Cramer’s favorite stocks did not go “higher consistently in good days and bad.” By year-end 2002, one of the 10 had already gone bankrupt, and a $10,000 investment spread equally across Cramer’s picks would have lost 94%, leaving you with a grand total of $597.44. Perhaps Cramer meant that his stocks would be “winners” not in “the new world,” but in the world to come.
one to invest in, the prices of its stocks have been bid up so high that its future returns have nowhere to go but down.
For now at least, no one has the gall to try claiming that technology will still be the world’s greatest growth industry. But make sure you remember this: The people who now claim that the next “sure thing” will be health care, or energy, or real estate, or gold, are no more likely to be right in the end than the hypesters of high tech turned out to be.
TH E S I LVE R LI N I N G
If no price seemed too high for stocks in the 1990s, in 2003 we’ve reached the point at which no price appears to be low enough. The pendulum has swung, as Graham knew it always does, from irrational exuberance to unjustifiable pessimism. In 2002, investors yanked $27 billion out of stock mutual funds, and a survey conducted by the Secu- rities Industry Association found that one out of 10 investors had cut back on stocks by at least 25%. The same people who were eager to buy stocks in the late 1990s—when they were going up in price and, therefore, becoming expensive—sold stocks as they went down in price and, by definition, becam |
lum has swung, as Graham knew it always does, from irrational exuberance to unjustifiable pessimism. In 2002, investors yanked $27 billion out of stock mutual funds, and a survey conducted by the Secu- rities Industry Association found that one out of 10 investors had cut back on stocks by at least 25%. The same people who were eager to buy stocks in the late 1990s—when they were going up in price and, therefore, becoming expensive—sold stocks as they went down in price and, by definition, became cheaper.
As Graham shows so brilliantly in Chapter 8, this is exactly back- wards. The intelligent investor realizes that stocks become more risky, not less, as their prices rise—and less risky, not more, as their prices fall. The intelligent investor dreads a bull market, since it makes stocks more costly to buy. And conversely (so long as you keep enough cash on hand to meet your spending needs), you should welcome a bear market, since it puts stocks back on sale.8
So take heart: The death of the bull market is not the bad news everyone believes it to be. Thanks to the decline in stock prices, now is a considerably safer—and saner—time to be building wealth. Read on, and let Graham show you how.
8 The only exception to this rule is an investor in the advanced stage of retirement, who may not be able to outlast a long bear market. Yet even an elderly investor should not sell her stocks merely because they have gone down in price; that approach not only turns her paper losses into real ones but deprives her heirs of the potential to inherit those stocks at lower costs for tax purposes.
CHAPTER 1
Investment versus Speculation: Results to Be Expected by the Intelligent Investor
This chapter will outline the viewpoints that will be set forth in the remainder of the book. In particular we wish to develop at the outset our concept of appropriate portfolio policy for the individ- ual, nonprofessional investor.
Investment versus Speculation
What do we mean by “investor”? Th |
eal ones but deprives her heirs of the potential to inherit those stocks at lower costs for tax purposes.
CHAPTER 1
Investment versus Speculation: Results to Be Expected by the Intelligent Investor
This chapter will outline the viewpoints that will be set forth in the remainder of the book. In particular we wish to develop at the outset our concept of appropriate portfolio policy for the individ- ual, nonprofessional investor.
Investment versus Speculation
What do we mean by “investor”? Throughout this book the term will be used in contradistinction to “speculator.” As far back as 1934, in our textbook Security Analysis,1 we attempted a precise formulation of the difference between the two, as follows: “An investment operation is one which, upon thorough analysis prom- ises safety of principal 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 1929–1932 all common stocks were widely regarded as speculative by nature. (A leading author- ity stated flatly that only bonds could be bought for investment.2) Thus we had then to defend our definition against the charge that it gave too wide scope to the concept of investment.
Now our concern is of the opposite sort. We must prevent our readers from accepting the common jargon which applies the term “investor” to anybody and everybody in the stock market. In our last edition we cited the following headline of a front-page article of our leading financial journal in June 1962:
18
SMALL INVESTORS BEARISH, THEY ARE SELLING ODD-LOTS SHORT
In October 1970 the same journal had an editorial critical of what it called “reckless investors,” who this time were rushing in on the buying side.
These quotations well illustrate the confusion that has been dominant for ma |
jargon which applies the term “investor” to anybody and everybody in the stock market. In our last edition we cited the following headline of a front-page article of our leading financial journal in June 1962:
18
SMALL INVESTORS BEARISH, THEY ARE SELLING ODD-LOTS SHORT
In October 1970 the same journal had an editorial critical of what it called “reckless investors,” who this time were rushing in on the buying side.
These quotations well illustrate the confusion that has been dominant for many years in the use of the words investment and speculation. Think of our suggested definition of investment given above, and compare it with the sale of a few shares of stock by an inexperienced member of the public, who does not even own what he is selling, and has some largely emotional conviction that he will be able to buy them back at a much lower price. (It is not irrel- evant to point out that when the 1962 article appeared the market had already experienced a decline of major size, and was now get- ting ready for an even greater upswing. It was about as poor a time as possible for selling short.) In a more general sense, the later-used phrase “reckless investors” could be regarded as a laughable con- tradiction in terms—something like “spendthrift misers”—were this misuse of language not so mischievous.
The newspaper employed the word “investor” in these
instances because, in the easy language of Wall Street, everyone who buys or sells a security has become an investor, regardless of what he buys, or for what purpose, or at what price, or whether for cash or on margin. Compare this with the attitude of the public toward common stocks in 1948, when over 90% of those queried expressed themselves as opposed to the purchase of common stocks.3 About half gave as their reason “not safe, a gamble,” and about half, the reason “not familiar with.”* It is indeed ironical
* The survey Graham cites was conducted for the Fed by the University of Michigan and was published |
regardless of what he buys, or for what purpose, or at what price, or whether for cash or on margin. Compare this with the attitude of the public toward common stocks in 1948, when over 90% of those queried expressed themselves as opposed to the purchase of common stocks.3 About half gave as their reason “not safe, a gamble,” and about half, the reason “not familiar with.”* It is indeed ironical
* The survey Graham cites was conducted for the Fed by the University of Michigan and was published in the Federal Reserve Bulletin, July, 1948. People were asked, “Suppose a man decides not to spend his money. He can either put it in a bank or in bonds or he can invest it. What do you think would be the wisest thing for him to do with the money nowadays—put it in the bank, buy savings bonds with it, invest it in real estate, or buy common stock with it?” Only 4% thought common stock would offer a “satisfactory” return; 26% considered it “not safe” or a “gamble.” From 1949 through 1958, the stock market earned one of its highest 10-year returns in history,
(though not surprising) that common-stock purchases of all kinds were quite generally regarded as highly speculative or risky at a time when they were selling on a most attractive basis, and due soon to begin their greatest advance in history; conversely the very fact they had advanced to what were undoubtedly dangerous lev- els as judged by past experience later transformed them into “invest- ments,” 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 institu- tion would be well advised to reinstate this distinction and to emphasize it in all its dealings with the public. Otherwise the stock exchanges may some day be blamed for heavy speculative losses, which those who suffered them had not been properly warned against. Ironically, on |
g 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 institu- tion would be well advised to reinstate this distinction and to emphasize it in all its dealings with the public. Otherwise the stock exchanges may some day 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 embar- rassment of some stock-exchange firms seems to have come from the inclusion of speculative common stocks in their own capital funds. We trust that the reader of this book will gain a reasonably clear idea of the risks that are inherent in common-stock commit- ments—risks which are inseparable from the opportunities of profit that they offer, and both of which must be allowed for in the investor’s calculations.
What we have just said indicates that there may no longer be
such a thing as a simon-pure investment policy comprising repre- sentative common stocks—in the sense that one can always wait to buy them at a price that involves no risk of a market or “quota- tional” 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 psycholog- ically for adverse results that may be of short or long duration.
Two paragraphs should be added about stock speculation per se, as distinguished from the speculative component now inherent
averaging 18.7% annually. In a fascinating echo of that early Fed survey, a poll conducted by BusinessWeek at year-end 2002 found that only 24% of investors were willing to invest more in their mutual funds or stock portfolios, down from 47% just three years earlier.
in most representative common stocks. Outright speculation is |
lts that may be of short or long duration.
Two paragraphs should be added about stock speculation per se, as distinguished from the speculative component now inherent
averaging 18.7% annually. In a fascinating echo of that early Fed survey, a poll conducted by BusinessWeek at year-end 2002 found that only 24% of investors were willing to invest more in their mutual funds or stock portfolios, down from 47% just three years earlier.
in most representative common stocks. 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 sub- stantial possibilities of both profit and loss, and the risks therein must be assumed by someone.* There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seri- ously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.
In our conservative view every nonprofessional who operates on margin † should recognize that he is ipso facto speculating, and it is his broker’s duty so to advise him. And everyone who buys a so-called “hot” common-stock issue, or makes a purchase in any way similar thereto, is either speculating or gambling. Speculation is always fascinating, and it can be a lot of fun while you are ahead of the game. If you want to try your luck at it, put aside a portion— the smaller the better—of your capital in a separate fund for this purpose. Never add more money to this account just because the
* Speculation is beneficial on two levels: First, without speculation, untested new companies (like Amazon.com or, in earlier times, the Edison Electric Light Co.) would never be able to raise the necessary capital for expansion |
is always fascinating, and it can be a lot of fun while you are ahead of the game. If you want to try your luck at it, put aside a portion— the smaller the better—of your capital in a separate fund for this purpose. Never add more money to this account just because the
* Speculation is beneficial on two levels: First, without speculation, untested new companies (like Amazon.com or, in earlier times, the Edison Electric Light Co.) would never be able to raise the necessary capital for expansion. The alluring, long-shot chance of a huge gain is the grease that lubricates the machinery of innovation. Secondly, risk is exchanged (but never elimi- nated) every time a stock is bought or sold. The buyer purchases the primary risk that this stock may go down. Meanwhile, the seller still retains a residual risk—the chance that the stock he just sold may go up!
† A margin account enables you to buy stocks using money you borrow from the brokerage firm. By investing with borrowed money, you make more when your stocks go up—but you can be wiped out when they go down. The collateral for the loan is the value of the investments in your account—so you must put up more money if that value falls below the amount you borrowed. For more information about margin accounts, see www.sec.gov/investor/ pubs/margin.htm, www.sia.com/publications/pdf/MarginsA.pdf, and www. nyse.com/pdfs/2001_factbook_09.pdf.
market has gone up and profits are rolling in. (That’s the time to think of taking money out of your speculative fund.) Never mingle your speculative and investment operations in the same account, nor in any part of your thinking.
Results to Be Expected by the Defensive Investor
We have already defined the defensive investor as one inter- ested chiefly in safety plus freedom from bother. In general what course should he follow and what return can he expect under “average normal conditions”—if such conditions really exist? To answer these questions we shall consider first what we wrot |
t of your speculative fund.) Never mingle your speculative and investment operations in the same account, nor in any part of your thinking.
Results to Be Expected by the Defensive Investor
We have already defined the defensive investor as one inter- ested chiefly in safety plus freedom from bother. In general what course should he follow and what return can he expect under “average normal conditions”—if such conditions really exist? To answer these questions we shall consider first what we wrote on the subject seven years ago, next what significant changes have occurred since then in the underlying factors governing the investor’s expectable return, and finally what he should do and what he should expect under present-day (early 1972) conditions.
1. What We Said Six Years Ago
We recommended that the investor divide his holdings between high-grade bonds and leading common stocks; that the proportion held in bonds be never less than 25% or more than 75%, with the converse being necessarily true for the common-stock component; that his simplest choice would be to maintain a 50–50 proportion between the two, with adjustments to restore the equality when market developments had disturbed it by as much as, say, 5%. As an alternative policy he might choose to reduce his common-stock component to 25% “if he felt the market was dangerously high,” and conversely to advance it toward the maximum of 75% “if he felt that a decline in stock prices was making them increasingly attractive.”
In 1965 the investor could obtain about 41⁄2% on high-grade tax- able bonds and 31⁄4% on good tax-free bonds. The dividend return on leading common stocks (with the DJIA at 892) was only about 3.2%. 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 31⁄2% and 41⁄2% on his stock purchases, to which should be added a steady increase in underly- ing value (and in the “normal market |
”
In 1965 the investor could obtain about 41⁄2% on high-grade tax- able bonds and 31⁄4% on good tax-free bonds. The dividend return on leading common stocks (with the DJIA at 892) was only about 3.2%. 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 31⁄2% and 41⁄2% on his stock purchases, to which should be added a steady increase in underly- ing value (and in the “normal market price”) of a representative
stock list of about the same amount, giving a return from divi- dends and appreciation combined of about 71⁄2% per year. The half and half division between bonds and stocks would yield about 6% before income tax. We added that the stock component should carry a fair degree of protection against a loss of purchasing power caused by large-scale inflation.
It should be pointed out that the above arithmetic indicated expectation of a much lower rate of advance in the stock market than had been realized between 1949 and 1964. That rate had aver- aged a good deal better than 10% for listed stocks as a whole, and it was quite generally regarded as a sort of guarantee that similarly satisfactory results could be counted on in the future. Few people were willing to consider seriously the possibility that the high rate of advance in the past means that stock prices are “now too high,” and hence that “the wonderful results since 1949 would imply not very good but bad results for the future.” 4
2. What Has Happened Since 1964
The major change since 1964 has been the rise in interest rates on first-grade bonds to record high levels, although there has since been a considerable recovery from the lowest prices of 1970. The obtainable return on good corporate issues is now about 71⁄2% and even more against 41⁄2% in 1964. In the meantime the dividend return on DJIA-type stocks had a fair advance also during the mar- ket decline of 1969–70, but as we write (with |
results for the future.” 4
2. What Has Happened Since 1964
The major change since 1964 has been the rise in interest rates on first-grade bonds to record high levels, although there has since been a considerable recovery from the lowest prices of 1970. The obtainable return on good corporate issues is now about 71⁄2% and even more against 41⁄2% in 1964. In the meantime the dividend return on DJIA-type stocks had a fair advance also during the mar- ket decline of 1969–70, but as we write (with “the Dow” at 900) it is less than 3.5% against 3.2% at the end of 1964. The change in going interest rates produced a maximum decline of about 38% in the market price of medium-term (say 20-year) bonds during this period.
There is a paradoxical aspect to these developments. In 1964 we discussed at length the possibility that the price of stocks might be too high and subject ultimately to a serious decline; but we did not consider specifically the possibility that the same might happen to the price of high-grade bonds. (Neither did anyone else that we know of.) We did warn (on p. 90) that “a long-term bond may vary widely in price in response to changes in interest rates.” In the light of what has since happened we think that this warning—with attendant examples—was insufficiently stressed. For the fact is that
if the investor had a given sum in the DJIA at its closing price of 874 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 o |
s 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. We shall have more to say about change in bond prices in a later chapter.
3. Expectations and Policy in Late 1971 and Early 1972
Toward the end of 1971 it was possible to obtain 8% taxable interest on good medium-term corporate bonds, and 5.7% tax-free on good state or municipal securities. In the shorter-term field the investor could realize about 6% on U.S. government issues due in five years. In the latter case the buyer need not be concerned about
* Read Graham’s sentence again, and note what this greatest of investing experts is saying: The future of security prices is never predictable. And as you read ahead in the book, notice how everything else Graham tells you is designed to help you grapple with that truth. Since you cannot predict the behavior of t |
unicipal securities. In the shorter-term field the investor could realize about 6% on U.S. government issues due in five years. In the latter case the buyer need not be concerned about
* Read Graham’s sentence again, and note what this greatest of investing experts is saying: The future of security prices is never predictable. And as you read ahead in the book, notice how everything else Graham tells you is designed to help you grapple with that truth. Since you cannot predict the behavior of the markets, you must learn how to predict and control your own behavior.
a possible loss in market value, since he is sure of full repayment, including the 6% interest return, at the end of a comparatively short holding period. The DJIA at its recurrent price level of 900 in 1971 yields only 3.5%.
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 con- ditions, 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 cur- rent 3.5% dividend return on his stocks and also on an average annual appreciation of about 4%. As we shall explain later this appreciation is based essentially on the reinvestment by the vari- ous companies of a corresponding amount annually out of undis- tributed profits. On a before-tax basis the combined return of his stocks would then average, say, 7.5%, somewhat less than his inter- est on high-grade bonds.* On an after-tax basis the average return on stocks would work out at some 5.3%.5 This would be about the same as is now obtainable on good tax-free medium-term bonds.
These expectations are much less favorable for stocks against
bonds than they were in our 1 |
ment by the vari- ous companies of a corresponding amount annually out of undis- tributed profits. On a before-tax basis the combined return of his stocks would then average, say, 7.5%, somewhat less than his inter- est on high-grade bonds.* On an after-tax basis the average return on stocks would work out at some 5.3%.5 This would be about the same as is now obtainable on good tax-free medium-term bonds.
These expectations are much less favorable for stocks against
bonds than they were in our 1964 analysis. (That conclusion fol- lows inevitably from the basic fact that bond yields have gone up much more than stock yields since 1964.) We must never lose sight
* How well did Graham’s forecast pan out? At first blush, it seems, very well: From the beginning of 1972 through the end of 1981, stocks earned an annual average return of 6.5%. (Graham did not specify the time period for his forecast, but it’s plausible to assume that he was thinking of a 10- year time horizon.) However, inflation raged at 8.6% annually over this period, eating up the entire gain that stocks produced. In this section of his chapter, Graham is summarizing what is known as the “Gordon equation,” which essentially holds that the stock market’s future return is the sum of the current dividend yield plus expected earnings growth. With a dividend yield of just under 2% in early 2003, and long-term earnings growth of around 2%, plus inflation at a bit over 2%, a future average annual return of roughly 6% is plausible. (See the commentary on Chapter 3.)
of the fact that the interest and principal payments on good bonds are much better protected and therefore more certain than the divi- dends and price appreciation on stocks. Consequently we are forced to the conclusion that now, toward the end of 1971, bond investment appears clearly preferable to stock investment. If we could be sure that this conclusion is right we would have to advise the defensive investor to put all his money in bonds and no |
plausible. (See the commentary on Chapter 3.)
of the fact that the interest and principal payments on good bonds are much better protected and therefore more certain than the divi- dends and price appreciation on stocks. Consequently we are forced to the conclusion that now, toward the end of 1971, bond investment appears clearly preferable to stock investment. If we could be sure that this conclusion is right we would have to advise the defensive investor to put all his money in bonds and none in common stocks until the current yield relationship changes signifi- cantly in favor of stocks.
But of course we cannot be certain that bonds will work out bet- ter than stocks from today’s levels. The reader will immediately think of the inflation factor as a potent reason on the other side. In the next chapter we shall argue that our considerable experience with inflation in the United States during this century would not support the choice of stocks against bonds at present differentials in yield. But there is always the possibility—though we consider it remote—of an accelerating inflation, which in one way or another would have to make stock equities preferable to bonds payable in a fixed amount of dollars.* There is the alternative possibility— which we also consider highly unlikely—that American business will become so profitable, without stepped-up inflation, as to jus- tify a large increase in common-stock values in the next few years. Finally, there is the more familiar possibility that we shall witness another great speculative rise in the stock market without a real justification in the underlying values. Any of these reasons, and perhaps others we haven’t thought of, might cause the investor to regret a 100% concentration on bonds even at their more favorable yield levels.
Hence, after this foreshortened discussion of the major consider-
ations, we once again enunciate the same basic compromise policy
* Since 1997, when Treasury Inflation-Protected Securitie |
ossibility that we shall witness another great speculative rise in the stock market without a real justification in the underlying values. Any of these reasons, and perhaps others we haven’t thought of, might cause the investor to regret a 100% concentration on bonds even at their more favorable yield levels.
Hence, after this foreshortened discussion of the major consider-
ations, we once again enunciate the same basic compromise policy
* Since 1997, when Treasury Inflation-Protected Securities (or TIPS) were introduced, stocks have no longer been the automatically superior choice for investors who expect inflation to increase. TIPS, unlike other bonds, rise in value if the Consumer Price Index goes up, effectively immunizing the investor against losing money after inflation. Stocks carry no such guarantee and, in fact, are a relatively poor hedge against high rates of inflation. (For more details, see the commentary to Chapter 2.)
for defensive investors—namely that at all times they have a signif- icant part of their funds in bond-type holdings and a significant part also in equities. It is still true that they may choose between maintaining a simple 50–50 division between the two components or a ratio, dependent on their judgment, varying between a mini- mum of 25% and a maximum of 75% of either. We shall give our more detailed view of these alternative policies in a later chapter.
Since at present the overall return envisaged from common stocks is nearly the same as that from bonds, the presently expectable return (including growth of stock values) for the investor would change little regardless of how he divides his fund between the two components. As calculated above, the aggregate return from both parts should be about 7.8% before taxes or 5.5% on a tax-free (or estimated tax-paid) basis. A return of this order is appreciably higher than that realized by the typical conservative investor over most of the long-term past. It may not seem attractive in rela |
that from bonds, the presently expectable return (including growth of stock values) for the investor would change little regardless of how he divides his fund between the two components. As calculated above, the aggregate return from both parts should be about 7.8% before taxes or 5.5% on a tax-free (or estimated tax-paid) basis. A return of this order is appreciably higher than that realized by the typical conservative investor over most of the long-term past. It may not seem attractive in relation to the 14%, or so, return shown by common stocks during the 20 years of the predominantly bull market after 1949. But it should be remembered that between 1949 and 1969 the price of the DJIA had advanced more than fivefold while its earnings and dividends had about doubled. Hence the greater part of the impressive market record for that period was based on a change in investors’ and speculators’ attitudes rather than in underlying corporate values. To that extent it might well be called a “bootstrap operation.”
In discussing the common-stock portfolio of the defensive
investor, we have spoken only of leading issues of the type included in the 30 components of the Dow Jones Industrial Aver- age. 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
* Today, the most widely available alternatives to the Dow Jones Industrial Average are the Standard & Poor’s 500-stock index (the “S & P”) and the Wilshire 5000 index. The S & P focuses on 500 large, well-known compa- nies that make up roughly 70% of the total value of the U.S. equity market. The Wilshire 5000 follows the returns of nearly every significant, publicly
the major point here is that the defensive investor’s overall results are not lik |
Dow Jones average to represent them).* But
* Today, the most widely available alternatives to the Dow Jones Industrial Average are the Standard & Poor’s 500-stock index (the “S & P”) and the Wilshire 5000 index. The S & P focuses on 500 large, well-known compa- nies that make up roughly 70% of the total value of the U.S. equity market. The Wilshire 5000 follows the returns of nearly every significant, publicly
the major point here is that the defensive investor’s overall results are not likely to be decisively different from one diversified or rep- resentative list than from another, or—more accurately—that nei- ther he nor his advisers could predict with certainty whatever differences would ultimately develop. It is true that the art of skill- ful or shrewd investment is supposed to lie particularly in the selection of issues that will give better results than the general mar- ket. For reasons to be developed elsewhere we are skeptical of the ability of defensive investors generally to get better than average results—which in fact would mean to beat their own overall per- formance.* (Our skepticism extends to the management of large funds by experts.)
Let us illustrate our point by an example that at first may seem to prove the opposite. Between December 1960 and December 1970 the DJIA advanced from 616 to 839, or 36%. But in the same period the much larger Standard & Poor’s weighted index of 500 stocks rose from 58.11 to 92.15, or 58%. Obviously the second group had proved a better “buy” than the first. But who would have been so rash as to predict in 1960 that what seemed like a miscellaneous assortment of all sorts of common stocks would definitely outper- form the aristocratic “thirty tyrants” of the Dow? All this proves, we insist, that only rarely can one make dependable predictions about price changes, absolute or relative.
We shall repeat here without apology—for the warning cannot be given too often—that the investor cannot hope for better than averag |
oved a better “buy” than the first. But who would have been so rash as to predict in 1960 that what seemed like a miscellaneous assortment of all sorts of common stocks would definitely outper- form the aristocratic “thirty tyrants” of the Dow? All this proves, we insist, that only rarely can one make dependable predictions about price changes, absolute or relative.
We shall repeat here without apology—for the warning cannot be given too often—that the investor cannot hope for better than average results by buying new offerings, or “hot” issues of any sort, meaning thereby those recommended for a quick profit.† The contrary is almost certain to be true in the long run. The defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition. (Any security analyst worth his salt could make up such
traded stock in America, roughly 6,700 in all; but, since the largest compa- nies account for most of the total value of the index, the return of the Wilshire 5000 is usually quite similar to that of the S & P 500. Several low- cost mutual funds enable investors to hold the stocks in these indexes as a single, convenient portfolio. (See Chapter 9.)
* See pp. 363–366 and pp. 376–380.
† For greater detail, see Chapter 6.
a list.) Aggressive investors may buy other types of common stocks, but they should be on a definitely attractive basis as estab- lished by intelligent analysis.
To conclude this section, let us mention briefly three supplemen- tary 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 “commingled funds,” operated by trust companies and banks in many states; or, if his funds are substantial, use the services of a recognized invest- ment-counsel firm. This will give him professional |
section, let us mention briefly three supplemen- tary 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 “commingled funds,” operated by trust companies and banks in many states; or, if his funds are substantial, use the services of a recognized invest- ment-counsel firm. This will give him professional administration of his investment program along standard lines. The third 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 is high, and he is likely to end up with a satisfactory overall price for all his holdings. Strictly speak- ing, this method is an application of a broader approach known as “formula investing.” The latter was already alluded to in our sug- gestion that the investor may vary his holdings of common stocks between the 25% minimum and the 75% maximum, in inverse rela- tionship to the action of the market. These ideas have merit for the defensive investor, and they will be discussed more amply in later chapters.*
Results to Be Expected by the Aggressive Investor
Our enterprising security buyer, of course, will desire and expect to attain better overall results than his defensive or passive companion. But first he must make sure that his results will not be worse. It is no difficult trick to bring a great deal of energy, study, and native ability into Wall Street and to end up with losses instead of profits. These virtues, if channeled in the wrong directions, become indistinguishable from handicaps. Thus it is most essential that the enterprising investor start with a clear conception as to
* For more advice on “well-established investment funds,” see Chapter 9. “Professional ad |
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
* For more advice on “well-established investment funds,” see Chapter 9. “Professional administration” by “a recognized investment-counsel firm” is discussed in Chapter 10. “Dollar-cost averaging” is explained in Chapter 5.
which courses of action offer reasonable chances of success and which do not.
First let us consider several ways in which investors and specu- lators generally have endeavored to obtain better than average results. These include:
1. Trading in the market. This usually means buying stocks when the market has been advancing and selling them after it has turned downward. The stocks selected are likely to be among those which have been “behaving” better than the market average. A small number of professionals frequently engage in short selling. Here they will sell issues they do not own but borrow through the established mechanism of the stock exchanges. Their object is to benefit from a subsequent decline in the price of these issues, by buying them back at a price lower than they sold them for. (As our quotation from the Wall Street Journal on p. 19 indicates, even “small investors”—perish the term!—sometimes try their unskilled hand at short selling.)
2. Short-term selectivity. This means buying stocks of compa- nies which are reporting or expected to report increased earnings, or for which some other favorable development is anticipated.
3. Long-term selectivity. Here the usual emphasis is on an excellent record of past growth, which is considered likely to con- tinue in the future. In some cases also the “investor” may choose companies whi |
dicates, even “small investors”—perish the term!—sometimes try their unskilled hand at short selling.)
2. Short-term selectivity. This means buying stocks of compa- nies which are reporting or expected to report increased earnings, or for which some other favorable development is anticipated.
3. Long-term selectivity. Here the usual emphasis is on an excellent record of past growth, which is considered likely to con- tinue in the future. In some cases also the “investor” may choose companies which have not yet shown impressive results, but are expected to establish a high earning power later. (Such companies belong frequently in some technological area—e.g., computers, drugs, electronics—and they often are developing new processes or products that are deemed to be especially promising.)
We have already expressed a negative view about the investor’s overall chances of success in these areas of activity. The first we have ruled out, on both theoretical and realistic grounds, from the domain of investment. Stock trading is not an operation “which, on thorough analysis, offers safety of principal and a satisfactory return.” More will be said on stock trading in a later chapter.*
* See Chapter 8.
In his endeavor to select the most promising stocks either for the near term or the longer future, the investor faces obstacles of two kinds—the first stemming from human fallibility and the second from the nature of his competition. He may be wrong in his esti- mate of the future; or even if he is right, the current market price may already fully reflect what he is anticipating. In the area of near-term selectivity, the current year’s results of the company are generally common property on Wall Street; next year’s results, to the extent they are predictable, are already being carefully consid- ered. Hence the investor who selects issues chiefly on the basis of this year’s superior results, or on what he is told he may expect for next year, is likely to find that others have |
even if he is right, the current market price may already fully reflect what he is anticipating. In the area of near-term selectivity, the current year’s results of the company are generally common property on Wall Street; next year’s results, to the extent they are predictable, are already being carefully consid- ered. Hence the investor who selects issues chiefly on the basis of this year’s superior results, or on what he is told he may expect for next year, is likely to find that others have done the same thing for the same reason.
In choosing stocks for their long-term prospects, the investor’s
handicaps are basically the same. The possibility of outright error in the prediction—which we illustrated by our airlines example on
p. 6—is no doubt greater than when dealing with near-term earn- ings. 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 pro- fessional analysts at their favorite game of estimating long-term future earnings?
We are thus led to the following logical if disconcerting conclu- sion: To enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising, and (2) not popular on Wall Street.
Are there any such policies available for the enterprising investor? In theory once again, the answer should be yes; and there are broad reasons to think that the answer should be affirmative in practice as well. Everyone knows that speculative stock move- ments are carried too far in both directions, frequently in the gen- eral 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. W |
e 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 move- ments are carried too far in both directions, frequently in the gen- eral 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 fur- ther and assert that in an astonishingly large proportion of the trading in common stocks, those engaged therein don’t appear to know—in polite terms—one part of their anatomy from another. In this book we shall point out numerous examples of (past) dis-
crepancies between price and value. Thus it seems that any intelli- gent person, with a good head for figures, should have a veritable picnic on Wall Street, battening off other people’s foolishness. So it seems, but somehow it doesn’t work out that simply. Buying a neg- lected 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, its successful application is not impossible, but it is distinctly not an easy art to master.
There is also a fairly wide group of “special situations,” which over many years could be counted on to bring a nice annual return of 20% or better, with a minimum of overall risk to those who knew their way around in this field. They include intersecurity arbi- trages, payouts or workouts in liquidations, protected hedges of certain kinds. The most typical case is a projected merger or acqui- sition 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 r |
ch over many years could be counted on to bring a nice annual return of 20% or better, with a minimum of overall risk to those who knew their way around in this field. They include intersecurity arbi- trages, payouts or workouts in liquidations, protected hedges of certain kinds. The most typical case is a projected merger or acqui- sition which offers a substantially higher value for certain shares than their price on the date of the announcement. The number of such deals increased greatly in recent years, and it should have been a highly profitable period for the cognoscenti. But with the multiplication of merger announcements came a multiplication of obstacles to mergers and of deals that didn’t go through; quite a few individual losses were thus realized in these once-reliable operations. Perhaps, too, the overall rate of profit was diminished by too much competition.†
* In “selling short” (or “shorting”) a stock, you make a bet that its share price will go down, not up. Shorting is a three-step process: First, you bor- row shares from someone who owns them; then you immediately sell the borrowed shares; finally, you replace them with shares you buy later. If the stock drops, you will be able to buy your replacement shares at a lower price. The difference between the price at which you sold your borrowed shares and the price you paid for the replacement shares is your gross profit (reduced by dividend or interest charges, along with brokerage costs). How- ever, if the stock goes up in price instead of down, your potential loss is unlimited—making short sales unacceptably speculative for most individual investors.
† In the late 1980s, as hostile corporate takeovers and leveraged buyouts multiplied, Wall Street set up institutional arbitrage desks to profit from any
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 the lifetime |
ock goes up in price instead of down, your potential loss is unlimited—making short sales unacceptably speculative for most individual investors.
† In the late 1980s, as hostile corporate takeovers and leveraged buyouts multiplied, Wall Street set up institutional arbitrage desks to profit from any
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 the lifetime of this book. In 1949 we could present a study of stock-market fluc- tuations 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 gov- erning maxim of the Rothschilds: “Buy cheap and sell dear.”* 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 illustra- tion is provided by the famous “Dow Theory” of stock-market movements, in a comparison of its indicated splendid results for 1897–1933 and its much more questionable performance since 1934.
A third and final example of the golden opportunities not
recently available: A good part of our own operations on Wall Street had been concentrated on the purchase of bargain issues eas- ily identified as such by the fact that they were selling at less than their share in the net current assets (working capital) alone, not counting the plant account and other assets, and after deducting all liabilities ahead of the stock. It is clear that these issues were selling at a price well below the value of the enterprise as a private busi- ness. No proprietor or majority holder would think of selling what he owned at so ridiculously low a figure. Stran |
he purchase of bargain issues eas- ily identified as such by the fact that they were selling at less than their share in the net current assets (working capital) alone, not counting the plant account and other assets, and after deducting all liabilities ahead of the stock. It is clear that these issues were selling at a price well below the value of the enterprise as a private busi- ness. No proprietor or majority holder would think of selling what he owned at so ridiculously low a figure. Strangely enough, such
errors in pricing these complex deals. They became so good at it that the easy profits disappeared and many of these desks have been closed down. Although Graham does discuss it again (see pp. 174–175), this sort of trad- ing is no longer feasible or appropriate for most people, since only multi- million-dollar trades are large enough to generate worthwhile profits. Wealthy individuals and institutions can utilize this strategy through hedge funds that specialize in merger or “event” arbitrage.
* The Rothschild family, led by Nathan Mayer Rothschild, was the dominant power in European investment banking and brokerage in the nineteenth century. For a brilliant history, see Niall Ferguson, The House of Rothschild: Money’s Prophets, 1798–1848 (Viking, 1998).
anomalies were not hard to find. In 1957 a list was published show- ing 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 depend- able area for shrewd and successful operation by the enterprising investor. However, at the low prices of 1970 there again appeared a considerable number of such “sub-working-capital” issues, and despite the strong recovery of the market, enough of them remained at the end of the year to make up a full-sized po |
d 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 depend- able area for shrewd and successful operation by the enterprising investor. However, at the low prices of 1970 there again appeared a considerable number of such “sub-working-capital” issues, and despite the strong recovery of the market, enough of them remained at the end of the year to make up a full-sized portfolio.
The enterprising investor under today’s conditions still has vari- ous 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 investor’s effort unless he could hope to add, say, 5% before taxes to the aver- age 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.
COMMENTARY ON CHAPTER 1
All of human unhappiness comes from one single thing: not knowing how to remain at rest in a room.
—Blaise Pascal
Why do you suppose the brokers on the floor of the New York Stock Exchange always cheer at the sound of the closing bell—no matter
what the market did that day? Because whenever you trade, they make money—whether you did or not. By speculating instead of invest- ing, you lower your own odds of building wealth and raise someone else’s.
Graham’s definition of investing could not be clearer: “An invest- ment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.” 1 Note that investing, according to Graham, consists equally of three elements:
• you must thoroughly analyze a company, and the soundness o |
hat day? Because whenever you trade, they make money—whether you did or not. By speculating instead of invest- ing, you lower your own odds of building wealth and raise someone else’s.
Graham’s definition of investing could not be clearer: “An invest- ment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.” 1 Note that investing, according to Graham, consists equally of three elements:
• you must thoroughly analyze a company, and the soundness of its underlying businesses, before you buy its stock;
• you must deliberately protect yourself against serious losses;
• you must aspire to “adequate,” not extraordinary, performance.
1 Graham goes even further, fleshing out each of the key terms in his defini- tion: “thorough analysis” means “the study of the facts in the light of estab- lished standards of safety and value” while “safety of principal” signifies “protection against loss under all normal or reasonably likely conditions or variations” and “adequate” (or “satisfactory”) return refers to “any rate or amount of return, however low, which the investor is willing to accept, pro- vided he acts with reasonable intelligence.” (Security Analysis, 1934 ed., pp. 55–56).
35
An investor calculates what a stock is worth, based on the value of its businesses. A speculator gambles that a stock will go up in price because somebody else will pay even more for it. As Graham once put it, investors judge “the market price by established standards of value,” while speculators “base [their] standards of value upon the market price.” 2 For a speculator, the incessant stream of stock quotes is like oxygen; cut it off and he dies. For an investor, what Graham called “quotational” values matter much less. Graham urges you to invest only if you would be comfortable owning a stock even if you had no way of knowing its daily share price.3
Like casino gambling or betting on the horses, speculating in the market can be exciting or even |
ed standards of value,” while speculators “base [their] standards of value upon the market price.” 2 For a speculator, the incessant stream of stock quotes is like oxygen; cut it off and he dies. For an investor, what Graham called “quotational” values matter much less. Graham urges you to invest only if you would be comfortable owning a stock even if you had no way of knowing its daily share price.3
Like casino gambling or betting on the horses, speculating in the market can be exciting or even rewarding (if you happen to get lucky). But it’s the worst imaginable way to build your wealth. That’s because Wall Street, like Las Vegas or the racetrack, has calibrated the odds so that the house always prevails, in the end, against everyone who tries to beat the house at its own speculative game.
On the other hand, investing is a unique kind of casino—one where you cannot lose in the end, so long as you play only by the rules that put the odds squarely in your favor. People who invest make money for themselves; people who speculate make money for their brokers. And that, in turn, is why Wall Street perennially downplays the durable virtues of investing and hypes the gaudy appeal of speculation.
U N SAFE A T H I G H S PE E D
Confusing speculation with investment, Graham warns, is always a mistake. In the 1990s, that confusion led to mass destruction. Almost everyone, it seems, ran out of patience at once, and America became the Speculation Nation, populated with traders who went shooting from stock to stock like grasshoppers whizzing around in an August hay field.
People began believing that the test of an investment technique was simply whether it “worked.” If they beat the market over any
2 Security Analysis, 1934 ed., p. 310.
3 As Graham advised in an interview, “Ask yourself: If there was no market for these shares, would I be willing to have an investment in this company on these terms?” (Forbes, January 1, 1972, p. 90.)
period, no matter how dangerous or dumb t |
hooting from stock to stock like grasshoppers whizzing around in an August hay field.
People began believing that the test of an investment technique was simply whether it “worked.” If they beat the market over any
2 Security Analysis, 1934 ed., p. 310.
3 As Graham advised in an interview, “Ask yourself: If there was no market for these shares, would I be willing to have an investment in this company on these terms?” (Forbes, January 1, 1972, p. 90.)
period, no matter how dangerous or dumb their tactics, people boasted that they were “right.” But the intelligent investor has no inter- est in being temporarily right. To reach your long-term financial goals, you must be sustainably and reliably right. The techniques that became so trendy in the 1990s—day trading, ignoring diversification, flipping hot mutual funds, following stock-picking “systems”—seemed to work. But they had no chance of prevailing in the long run, because they failed to meet all three of Graham’s criteria for investing.
To see why temporarily high returns don’t prove anything, imagine that two places are 130 miles apart. If I observe the 65-mph speed limit, I can drive that distance in two hours. But if I drive 130 mph, I can get there in one hour. If I try this and survive, am I “right”? Should you be tempted to try it, too, because you hear me bragging that it “worked”? Flashy gimmicks for beating the market are much the same: In short streaks, so long as your luck holds out, they work. Over time, they will get you killed.
In 1973, when Graham last revised The Intelligent Investor, the annual turnover rate on the New York Stock Exchange was 20%, meaning that the typical shareholder held a stock for five years before selling it. By 2002, the turnover rate had hit 105%—a holding period of only 11.4 months. Back in 1973, the average mutual fund held on to a stock for nearly three years; by 2002, that ownership period had shrunk to just 10.9 months. It’s as if mutual-fund managers were studying t |
will get you killed.
In 1973, when Graham last revised The Intelligent Investor, the annual turnover rate on the New York Stock Exchange was 20%, meaning that the typical shareholder held a stock for five years before selling it. By 2002, the turnover rate had hit 105%—a holding period of only 11.4 months. Back in 1973, the average mutual fund held on to a stock for nearly three years; by 2002, that ownership period had shrunk to just 10.9 months. It’s as if mutual-fund managers were studying their stocks just long enough to learn they shouldn’t have bought them in the first place, then promptly dumping them and start- ing all over.
Even the most respected money-management firms got antsy. In early 1995, Jeffrey Vinik, manager of Fidelity Magellan (then the world’s largest mutual fund), had 42.5% of its assets in technology stocks. Vinik proclaimed that most of his shareholders “have invested in the fund for goals that are years away I think their objectives are
the same as mine, and that they believe, as I do, that a long-term approach is best.” But six months after he wrote those high-minded words, Vinik sold off almost all his technology shares, unloading nearly
$19 billion worth in eight frenzied weeks. So much for the “long term”! And by 1999, Fidelity’s discount brokerage division was egging on its clients to trade anywhere, anytime, using a Palm handheld computer— which was perfectly in tune with the firm’s new slogan, “Every second counts.”
FIGURE 1-1
Stocks on Speed
25
20
15
10
5
0
And on the NASDAQ exchange, turnover hit warp speed, as Fig- ure 1-1 shows.4
In 1999, shares in Puma Technology, for instance, changed hands an average of once every 5.7 days. Despite NASDAQ’s grandiose motto—“The Stock Market for the Next Hundred Years”—many of its customers could barely hold on to a stock for a hundred hours.
TH E FI NAN CIAL VI D E O GAM E
Wall Street made online trading sound like an instant way to mint money: Discover Brokerage, t |
peed
25
20
15
10
5
0
And on the NASDAQ exchange, turnover hit warp speed, as Fig- ure 1-1 shows.4
In 1999, shares in Puma Technology, for instance, changed hands an average of once every 5.7 days. Despite NASDAQ’s grandiose motto—“The Stock Market for the Next Hundred Years”—many of its customers could barely hold on to a stock for a hundred hours.
TH E FI NAN CIAL VI D E O GAM E
Wall Street made online trading sound like an instant way to mint money: Discover Brokerage, the online arm of the venerable firm of
4 Source: Steve Galbraith, Sanford C. Bernstein & Co. research report, Jan- uary 10, 2000. The stocks in this table had an average return of 1196.4% in 1999. They lost an average of 79.1% in 2000, 35.5% in 2001, and 44.5% in 2002—destroying all the gains of 1999, and then some.
Morgan Stanley, ran a TV commercial in which a scruffy tow-truck driver picks up a prosperous-looking executive. Spotting a photo of a tropical beachfront posted on the dashboard, the executive asks, “Vacation?” “Actually,” replies the driver, “that’s my home.” Taken aback, the suit says, “Looks like an island.” With quiet triumph, the driver answers, “Technically, it’s a country.”
The propaganda went further. Online trading would take no work and require no thought. A television ad from Ameritrade, the online broker, showed two housewives just back from jogging; one logs on to her computer, clicks the mouse a few times, and exults, “I think I just made about $1,700!” In a TV commercial for the Waterhouse broker- age firm, someone asked basketball coach Phil Jackson, “You know anything about the trade?” His answer: “I’m going to make it right now.” (How many games would Jackson’s NBA teams have won if he had brought that philosophy to courtside? Somehow, knowing noth- ing about the other team, but saying, “I’m ready to play them right now,” doesn’t sound like a championship formula.)
By 1999 at least six million people were trading online—and roughly a tenth o |
n a TV commercial for the Waterhouse broker- age firm, someone asked basketball coach Phil Jackson, “You know anything about the trade?” His answer: “I’m going to make it right now.” (How many games would Jackson’s NBA teams have won if he had brought that philosophy to courtside? Somehow, knowing noth- ing about the other team, but saying, “I’m ready to play them right now,” doesn’t sound like a championship formula.)
By 1999 at least six million people were trading online—and roughly a tenth of them were “day trading,” using the Internet to buy and sell stocks at lightning speed. Everyone from showbiz diva Barbra Streisand to Nicholas Birbas, a 25-year-old former waiter in Queens, New York, was flinging stocks around like live coals. “Before,” scoffed Birbas, “I was investing for the long term and I found out that it was not smart.” Now, Birbas traded stocks up to 10 times a day and expected to earn $100,000 in a year. “I can’t stand to see red in my profit-or-loss column,” Streisand shuddered in an interview with Fortune. “I’m Taurus the bull, so I react to red. If I see red, I sell my stocks quickly.” 5
By pouring continuous data about stocks into bars and barber- shops, kitchens and cafés, taxicabs and truck stops, financial web- sites and financial TV turned the stock market into a nonstop national video game. The public felt more knowledgeable about the markets than ever before. Unfortunately, while people were drowning in data, knowledge was nowhere to be found. Stocks became entirely decou-
5 Instead of stargazing, Streisand should have been channeling Graham. The intelligent investor never dumps a stock purely because its share price has fallen; she always asks first whether the value of the company’s underly- ing businesses has changed.
pled from the companies that had issued them—pure abstractions, just blips moving across a TV or computer screen. If the blips were moving up, nothing else mattered.
On December 20, 1999, Juno Online Services unveiled |
s became entirely decou-
5 Instead of stargazing, Streisand should have been channeling Graham. The intelligent investor never dumps a stock purely because its share price has fallen; she always asks first whether the value of the company’s underly- ing businesses has changed.
pled from the companies that had issued them—pure abstractions, just blips moving across a TV or computer screen. If the blips were moving up, nothing else mattered.
On December 20, 1999, Juno Online Services unveiled a trailblaz- ing business plan: to lose as much money as possible, on purpose. Juno announced that it would henceforth offer all its retail services for free—no charge for e-mail, no charge for Internet access—and that it would spend millions of dollars more on advertising over the next year. On this declaration of corporate hara-kiri, Juno’s stock roared up from
$16.375 to $66.75 in two days.6
Why bother learning whether a business was profitable, or what goods or services a company produced, or who its management was, or even what the company’s name was? All you needed to know about stocks was the catchy code of their ticker symbols: CBLT, INKT, PCLN, TGLO, VRSN, WBVN.7 That way you could buy them even faster, without the pesky two-second delay of looking them up on an Internet search engine. In late 1998, the stock of a tiny, rarely traded building-maintenance company, Temco Services, nearly tripled in a matter of minutes on record-high volume. Why? In a bizarre form of financial dyslexia, thousands of traders bought Temco after mistaking its ticker symbol, TMCO, for that of Ticketmaster Online (TMCS), an Internet darling whose stock began trading publicly for the first time that day.8
Oscar Wilde joked that a cynic “knows the price of everything, and the value of nothing.” Under that definition, the stock market is always cynical, but by the late 1990s it would have shocked Oscar himself. A single half-baked opinion on price could double a company’s stock even as its valu |
slexia, thousands of traders bought Temco after mistaking its ticker symbol, TMCO, for that of Ticketmaster Online (TMCS), an Internet darling whose stock began trading publicly for the first time that day.8
Oscar Wilde joked that a cynic “knows the price of everything, and the value of nothing.” Under that definition, the stock market is always cynical, but by the late 1990s it would have shocked Oscar himself. A single half-baked opinion on price could double a company’s stock even as its value went entirely unexamined. In late 1998, Henry Blod- get, an analyst at CIBC Oppenheimer, warned that “as with all Inter- net stocks, a valuation is clearly more art than science.” Then, citing only the possibility of future growth, he jacked up his “price target” on
6 Just 12 months later, Juno’s shares had shriveled to $1.093.
7 A ticker symbol is an abbreviation, usually one to four letters long, of a company’s name used as shorthand to identify a stock for trading purposes.
8 This was not an isolated incident; on at least three other occasions in the late 1990s, day traders sent the wrong stock soaring when they mistook its ticker symbol for that of a newly minted Internet company.
Amazon.com from $150 to $400 in one fell swoop. Amazon.com shot up 19% that day and—despite Blodget’s protest that his price target was a one-year forecast—soared past $400 in just three weeks. A year later, PaineWebber analyst Walter Piecyk predicted that Qualcomm stock would hit $1,000 a share over the next 12 months. The stock— already up 1,842% that year—soared another 31% that day, hitting
$659 a share.9
FR OM F OR M U LA T O FIAS CO
But trading as if your underpants are on fire is not the only form of speculation. Throughout the past decade or so, one speculative for- mula after another was promoted, popularized, and then thrown aside. All of them shared a few traits—This is quick! This is easy! And it won’t hurt a bit!—and all of them violated at least one of Graham’s distinc- tio |
r the next 12 months. The stock— already up 1,842% that year—soared another 31% that day, hitting
$659 a share.9
FR OM F OR M U LA T O FIAS CO
But trading as if your underpants are on fire is not the only form of speculation. Throughout the past decade or so, one speculative for- mula after another was promoted, popularized, and then thrown aside. All of them shared a few traits—This is quick! This is easy! And it won’t hurt a bit!—and all of them violated at least one of Graham’s distinc- tions between investing and speculating. Here are a few of the trendy formulas that fell flat:
• Cash in on the calendar. The “January effect”—the tendency of small stocks to produce big gains around the turn of the year— was widely promoted in scholarly articles and popular books pub- lished in the 1980s. These studies showed that if you piled into small stocks in the second half of December and held them into January, you would beat the market by five to 10 percentage points. That amazed many experts. After all, if it were this easy, surely everyone would hear about it, lots of people would do it, and the opportunity would wither away.
What caused the January jolt? First of all, many investors sell their crummiest stocks late in the year to lock in losses that can cut their tax bills. Second, professional money managers grow more cautious as the year draws to a close, seeking to preserve their outperformance (or minimize their underperformance). That makes them reluctant to buy (or even hang on to) a falling stock. And if an underperforming stock is also small and obscure, a money manager will be even less eager to show it in his year-end
9 In 2000 and 2001, Amazon.com and Qualcomm lost a cumulative total of 85.8% and 71.3% of their value, respectively.
list of holdings. All these factors turn small stocks into momentary bargains; when the tax-driven selling ceases in January, they typi- cally bounce back, producing a robust and rapid gain.
The January effect has not with |
n hang on to) a falling stock. And if an underperforming stock is also small and obscure, a money manager will be even less eager to show it in his year-end
9 In 2000 and 2001, Amazon.com and Qualcomm lost a cumulative total of 85.8% and 71.3% of their value, respectively.
list of holdings. All these factors turn small stocks into momentary bargains; when the tax-driven selling ceases in January, they typi- cally bounce back, producing a robust and rapid gain.
The January effect has not withered away, but it has weakened. According to finance professor William Schwert of the University of Rochester, if you had bought small stocks in late December and sold them in early January, you would have beaten the market by 8.5 percentage points from 1962 through 1979, by 4.4 points from 1980 through 1989, and by 5.8 points from 1990 through 2001.10 As more people learned about the January effect, more traders bought small stocks in December, making them less of a bargain and thus reducing their returns. Also, the January effect is biggest among the smallest stocks—but according to Plexus Group, the leading authority on brokerage expenses, the total cost of buying and selling such tiny stocks can run up to 8% of your invest- ment.11 Sadly, by the time you’re done paying your broker, all your
gains on the January effect will melt away.
• Just do “what works.” In 1996, an obscure money manager named James O’Shaughnessy published a book called What Works on Wall Street. In it, he argued that “investors can do much better than the market.” O’Shaughnessy made a stunning claim: From 1954 through 1994, you could have turned $10,000 into $8,074,504, beating the market by more than 10-fold—a tow- ering 18.2% average annual return. How? By buying a basket of 50 stocks with the highest one-year returns, five straight years of rising earnings, and share prices less than 1.5 times their corpo- rate revenues.12 As if he were the Edison of Wall Street, O’Shaughnessy obtained U.S. Patent |
d that “investors can do much better than the market.” O’Shaughnessy made a stunning claim: From 1954 through 1994, you could have turned $10,000 into $8,074,504, beating the market by more than 10-fold—a tow- ering 18.2% average annual return. How? By buying a basket of 50 stocks with the highest one-year returns, five straight years of rising earnings, and share prices less than 1.5 times their corpo- rate revenues.12 As if he were the Edison of Wall Street, O’Shaughnessy obtained U.S. Patent No. 5,978,778 for his “auto- mated strategies” and launched a group of four mutual funds based on his findings. By late 1999 the funds had sucked in more than $175 million from the public—and, in his annual letter to shareholders, O’Shaughnessy stated grandly: “As always, I hope
10 Schwert discusses these findings in a brilliant research paper, “Anomalies and Market Efficiency,” available at http://schwert.ssb.rochester.edu/papers.htm.
11 See Plexus Group Commentary 54, “The Official Icebergs of Transaction Costs,” January, 1998, at www.plexusgroup.com/fs_research.html.
12 James O’Shaughnessy, What Works on Wall Street (McGraw-Hill, 1996),
pp. xvi, 273–295.
that together, we can reach our long-term goals by staying the course and sticking with our time-tested investment strategies.”
But “what works on Wall Street” stopped working right after O’Shaughnessy publicized it. As Figure 1-2 shows, two of his funds stank so badly that they shut down in early 2000, and the
FIGURE 1-2
What Used to Work on Wall Street . . .
$250
$200
$150
$100
$50
$0
Source: Morningstar, Inc.
overall stock market (as measured by the S & P 500 index) wal- loped every O’Shaughnessy fund almost nonstop for nearly four years running.
In June 2000, O’Shaughnessy moved closer to his own “long- term goals” by turning the funds over to a new manager, leaving his customers to fend for themselves with those “time-tested investment strategies.” 13 O’Shaughnessy’s shareholders might have b |
Used to Work on Wall Street . . .
$250
$200
$150
$100
$50
$0
Source: Morningstar, Inc.
overall stock market (as measured by the S & P 500 index) wal- loped every O’Shaughnessy fund almost nonstop for nearly four years running.
In June 2000, O’Shaughnessy moved closer to his own “long- term goals” by turning the funds over to a new manager, leaving his customers to fend for themselves with those “time-tested investment strategies.” 13 O’Shaughnessy’s shareholders might have been less upset if he had given his book a more precise title—for instance, What Used to Work on Wall Street . . . Until I Wrote This Book.
• Follow “The Foolish Four.” In the mid-1990s, the Motley Fool website (and several books) hyped the daylights out of a tech- nique called “The Foolish Four.” According to the Motley Fool, you would have “trashed the market averages over the last 25 years” and could “crush your mutual funds” by spending “only 15 min- utes a year” on planning your investments. Best of all, this tech- nique had “minimal risk.” All you needed to do was this:
1. Take the five stocks in the Dow Jones Industrial Average with the lowest stock prices and highest dividend yields.
2. Discard the one with the lowest price.
3. Put 40% of your money in the stock with the second-lowest price.
4. Put 20% in each of the three remaining stocks.
5. One year later, sort the Dow the same way and reset the portfolio according to steps 1 through 4.
6. Repeat until wealthy.
Over a 25-year period, the Motley Fool claimed, this technique would have beaten the market by a remarkable 10.1 percentage
13 In a remarkable irony, the surviving two O’Shaughnessy funds (now known as the Hennessy funds) began performing quite well just as O’Shaughnessy announced that he was turning over the management to another company. The funds’ shareholders were furious. In a chat room at www.morningstar.com, one fumed: “I guess ‘long term’ for O’S is 3 years.
...I feel your pain. I, too, had faith in |
period, the Motley Fool claimed, this technique would have beaten the market by a remarkable 10.1 percentage
13 In a remarkable irony, the surviving two O’Shaughnessy funds (now known as the Hennessy funds) began performing quite well just as O’Shaughnessy announced that he was turning over the management to another company. The funds’ shareholders were furious. In a chat room at www.morningstar.com, one fumed: “I guess ‘long term’ for O’S is 3 years.
...I feel your pain. I, too, had faith in O’S’s method. I had told several
friends and relatives about this fund, and now am glad they didn’t act on my advice.”
points annually. Over the next two decades, they suggested,
$20,000 invested in The Foolish Four should flower into
$1,791,000. (And, they claimed, you could do still better by pick- ing the five Dow stocks with the highest ratio of dividend yield to the square root of stock price, dropping the one that scored the highest, and buying the next four.)
Let’s consider whether this “strategy” could meet Graham’s definitions of an investment:
• What kind of “thorough analysis” could justify discarding the stock with the single most attractive price and dividend—but keeping the four that score lower for those desirable qualities?
• How could putting 40% of your money into only one stock be a “minimal risk”?
• And how could a portfolio of only four stocks be diversified enough to provide “safety of principal”?
The Foolish Four, in short, was one of the most cockamamie stock-picking formulas ever concocted. The Fools made the same mistake as O’Shaughnessy: If you look at a large quantity of data long enough, a huge number of patterns will emerge—if only by chance. By random luck alone, the companies that produce above-average stock returns will have plenty of things in common. But unless those factors cause the stocks to outperform, they can’t be used to predict future returns.
None of the factors that the Motley Fools “discovered” with such fanfare—dropping the |
ck-picking formulas ever concocted. The Fools made the same mistake as O’Shaughnessy: If you look at a large quantity of data long enough, a huge number of patterns will emerge—if only by chance. By random luck alone, the companies that produce above-average stock returns will have plenty of things in common. But unless those factors cause the stocks to outperform, they can’t be used to predict future returns.
None of the factors that the Motley Fools “discovered” with such fanfare—dropping the stock with the best score, doubling up on the one with the second-highest score, dividing the dividend yield by the square root of stock price—could possibly cause or explain the future performance of a stock. Money Magazine found that a portfolio made up of stocks whose names contained no repeating letters would have performed nearly as well as The Foolish Four—and for the same reason: luck alone.14 As Graham never stops reminding us, stocks do well or poorly in the future because the businesses behind them do well or poorly—nothing more, and nothing less.
14 See Jason Zweig, “False Profits,” Money, August, 1999, pp. 55–57. A thorough discussion of The Foolish Four can also be found at www.investor home.com/fool.htm.
Sure enough, instead of crushing the market, The Foolish Four crushed the thousands of people who were fooled into believing that it was a form of investing. In 2000 alone, the four Foolish stocks—Caterpillar, Eastman Kodak, SBC, and General Motors— lost 14% while the Dow dropped by just 4.7%.
As these examples show, there’s only one thing that never suffers a bear market on Wall Street: dopey ideas. Each of these so-called investing approaches fell prey to Graham’s Law. All mechanical formu- las for earning higher stock performance are “a kind of self-destructive process—akin to the law of diminishing returns.” There are two reasons the returns fade away. If the formula was just based on random statis- tical flukes (like The Foolish Four), the mere passage |
Dow dropped by just 4.7%.
As these examples show, there’s only one thing that never suffers a bear market on Wall Street: dopey ideas. Each of these so-called investing approaches fell prey to Graham’s Law. All mechanical formu- las for earning higher stock performance are “a kind of self-destructive process—akin to the law of diminishing returns.” There are two reasons the returns fade away. If the formula was just based on random statis- tical flukes (like The Foolish Four), the mere passage of time will expose that it made no sense in the first place. On the other hand, if the formula actually did work in the past (like the January effect), then by publicizing it, market pundits always erode—and usually eliminate— its ability to do so in the future.
All this reinforces Graham’s warning that you must treat specula- tion as veteran gamblers treat their trips to the casino:
• You must never delude yourself into thinking that you’re investing when you’re speculating.
• Speculating becomes mortally dangerous the moment you begin to take it seriously.
• You must put strict limits on the amount you are willing to wager.
Just as sensible gamblers take, say, $100 down to the casino floor and leave the rest of their money locked in the safe in their hotel room, the intelligent investor designates a tiny portion of her total portfolio as a “mad money” account. For most of us, 10% of our overall wealth is the maximum permissible amount to put at speculative risk. Never min- gle the money in your speculative account with what’s in your invest- ment accounts; never allow your speculative thinking to spill over into your investing activities; and never put more than 10% of your assets into your mad money account, no matter what happens.
For better or worse, the gambling instinct is part of human nature— so it’s futile for most people even to try suppressing it. But you must confine and restrain it. That’s the single best way to make sure you will never fool yourself into co |
e money in your speculative account with what’s in your invest- ment accounts; never allow your speculative thinking to spill over into your investing activities; and never put more than 10% of your assets into your mad money account, no matter what happens.
For better or worse, the gambling instinct is part of human nature— so it’s futile for most people even to try suppressing it. But you must confine and restrain it. That’s the single best way to make sure you will never fool yourself into confusing speculation with investment.
CHAPTER 2
The Investor and Inflation
Inflation, and the fight against it, has been very much in the public’s mind in recent years. The shrinkage in the purchasing power of the dollar in the past, and particularly the fear (or hope by speculators) of a serious further decline in the future, has
greatly influenced the thinking of Wall Street. It is clear that those with a fixed dollar income will suffer when the cost of living advances, and the same applies to a fixed amount of dollar princi- pal. Holders of stocks, on the other hand, have the possibility that a loss of the dollar’s purchasing power may be offset by advances in their dividends and the prices of their shares.
On the basis of these undeniable facts many financial authorities have concluded that (1) bonds are an inherently undesirable form of investment, and (2) consequently, common stocks are by their very nature more desirable investments than bonds. We have heard of charitable institutions being advised that their portfolios should consist 100% of stocks and zero percent of bonds.* This is quite a reversal from the earlier days when trust investments were
* By the late 1990s, this advice—which can be appropriate for a foundation or endowment with an infinitely long investment horizon—had spread to indi- vidual investors, whose life spans are finite. In the 1994 edition of his influ- ential book, Stocks for the Long Run, finance professor Jeremy Siegel of the Wharton Sc |
stitutions being advised that their portfolios should consist 100% of stocks and zero percent of bonds.* This is quite a reversal from the earlier days when trust investments were
* By the late 1990s, this advice—which can be appropriate for a foundation or endowment with an infinitely long investment horizon—had spread to indi- vidual investors, whose life spans are finite. In the 1994 edition of his influ- ential book, Stocks for the Long Run, finance professor Jeremy Siegel of the Wharton School recommended that “risk-taking” investors should buy on margin, borrowing more than a third of their net worth to sink 135% of their assets into stocks. Even government officials got in on the act: In February 1999, the Honorable Richard Dixon, state treasurer of Maryland, told the audience at an investment conference: “It doesn’t make any sense for any- one to have any money in a bond fund.”
47
restricted by law to high-grade bonds (and a few choice preferred stocks).
Our readers must have enough intelligence to recognize that even high-quality stocks cannot be a better purchase than bonds under all conditions—i.e., regardless of how high the stock market may be and how low the current dividend return compared with the rates available on bonds. A statement of this kind would be as absurd as was the contrary one—too often heard years ago—that any bond is safer than any stock. In this chapter we shall try to apply various measurements to the inflation factor, in order to reach some conclusions as to the extent to which the investor may wisely be influenced by expectations regarding future rises in the price level.
In this matter, as in so many others in finance, we must base our views of future policy on a knowledge of past experience. Is infla- tion something new for this country, at least in the serious form it has taken since 1965? If we have seen comparable (or worse) infla- tions in living experience, what lessons can be learned from them in confronting the inflati |
me 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 infla- tion something new for this country, at least in the serious form it has taken since 1965? If we have seen comparable (or worse) infla- tions in living experience, what lessons can be learned from them in confronting the inflation of today? Let us start with Table 2-1, a condensed historical tabulation that contains much information about changes in the general price level and 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% between 1965 and 1970. In between, we have had three periods of declining prices and then six of advances at varying rates, some rather small. On this showing, the investor should clearly allow for the probability of continuing or recurrent inflation to come.
Can we tell what the rate of inflation is likely to be? No clear answer is suggested by our table; it shows variations of all sorts. It would seem sensible, however, to take our cue from the rather con- sistent record of the past 20 years. The average annual rise in the consumer price level for this period has been 2.5%; that for 1965–1970 was 4.5%; that for 1970 alone was 5.4%. Official govern-
TABLE 2-1 The General Price Level, Stock Earnings, and Stock Prices at Five-Year Intervals, 1915–1970
Percent Change from Previous Level
Price Levela S & P 500-Stock Indexb
Wholesale
Consumer
Stock
Stock
Year Wholes |
. It would seem sensible, however, to take our cue from the rather con- sistent record of the past 20 years. The average annual rise in the consumer price level for this period has been 2.5%; that for 1965–1970 was 4.5%; that for 1970 alone was 5.4%. Official govern-
TABLE 2-1 The General Price Level, Stock Earnings, and Stock Prices at Five-Year Intervals, 1915–1970
Percent Change from Previous Level
Price Levela S & P 500-Stock Indexb
Wholesale
Consumer
Stock
Stock
Year Wholesale Consumer Earnings Price Prices Prices Earnings Prices
1915 38.0 35.4 8.31
1920 84.5 69.8 7.98 +96.0% +96.8% – 4.0%
1925 56.6 61.1 1.24 11.15 –33.4 –12.4 + 41.5
1930 47.3 58.2 .97 21.63 –16.5 – 4.7 – 21.9% + 88.0
1935 43.8 47.8 .76 15.47 – 7.4 –18.0 – 21.6 – 26.0
1940 43.0 48.8 1.05 11.02 – 0.2 + 2.1 + 33.1 – 28.8
1946c
66.1 68.0 1.06 17.08 +53.7 +40.0 + 1.0 + 55.0
1950 86.8 83.8 2.84 18.40 +31.5 +23.1 +168.0 + 21.4
1955 97.2 93.3 3.62 40.49 + 6.2 +11.4 + 27.4 +121.0
1960 100.7 103.1 3.27 55.85 + 9.2 +10.5 – 9.7 + 38.0
1965 102.5 109.9 5.19 88.17 + 1.8 + 6.6 + 58.8 + 57.0
1970 117.5 134.0 5.36 92.15 +14.6 +21.9 + 3.3 + 4.4
a Annual averages. For price level 1957 = 100 in table; but using new base, 1967 = 100, the average for 1970 is 116.3 for consumers’ prices and
110.4 for wholesale prices for the stock index.
b 1941–1943 average = 10.
c 1946 used, to avoid price controls.
ment policy has been strongly against large-scale inflation, and there are some reasons to believe that Federal policies will be more effective in the future than in recent years.* We think it would be reasonable for an investor at this point to base his thinking and decisions on a probable (far from certain) rate of future inflation of, say, 3% per annum. (This would compare with an annual rate of about 21⁄2% for the entire period 1915–1970.)1
What would be the implications of such an advance? It would eat up, in higher living costs, about one-half the income now obtainable on good mediu |
eve that Federal policies will be more effective in the future than in recent years.* We think it would be reasonable for an investor at this point to base his thinking and decisions on a probable (far from certain) rate of future inflation of, say, 3% per annum. (This would compare with an annual rate of about 21⁄2% for the entire period 1915–1970.)1
What would be the implications of such an advance? It would eat up, in higher living costs, about one-half the income now obtainable on good medium-term tax-free bonds (or 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 investor’s fortune need be reduced over the years. If he spent half his interest income after taxes he would maintain this buying power intact, even against a 3% annual inflation.
But the next question, naturally, is, “Can the investor be reason- ably sure of doing better by buying and holding other things than high-grade bonds, even at the unprecedented rate of return offered in 1970–1971?” 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 have bonds over the 55-year period of our study?
The answer to these questions is somewhat complicated. Com- mon stocks have indeed done better than bonds over a long period of time in the past. The rise of the DJIA from an average of 77 in 1915 to an average of 753 in 1970 works out at an annual com- pounded rate of just about 4%, to which we may add another 4% for average dividend return. (The corresponding figures for the S & P composite are about the same.) These combined figures of 8%
* This is one of Graham’s rare misjudgments. In 1973, just two ye |
o these questions is somewhat complicated. Com- mon stocks have indeed done better than bonds over a long period of time in the past. The rise of the DJIA from an average of 77 in 1915 to an average of 753 in 1970 works out at an annual com- pounded rate of just about 4%, to which we may add another 4% for average dividend return. (The corresponding figures for the S & P composite are about the same.) These combined figures of 8%
* This is one of Graham’s rare misjudgments. In 1973, just two years after President Richard Nixon imposed wage and price controls, inflation hit 8.7%, its highest level since the end of World War II. The decade from 1973 through 1982 was the most inflationary in modern American history, as the cost of living more than doubled.
per year are of course much better than the return enjoyed from bonds over the same 55-year period. But they do not exceed that now offered by high-grade bonds. This brings us to the next logical question: Is there a persuasive reason to believe that common stocks are likely to do much better in future years than they have in the last five and one-half decades?
Our answer to this crucial question must be a flat no. Common stocks may do better in the future than in the past, but they are far from certain to do so. We must deal here with two different time elements in investment results. The first covers what is likely to occur over the long-term future—say, the next 25 years. The second applies to what is likely to happen to the investor—both financially and psychologically—over short or intermediate periods, say five years or less. His frame of mind, his hopes and apprehensions, his satisfaction or discontent with what he has done, above all his deci- sions 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 con- nection between inflationary (or deflationary) conditions and |
o 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 deci- sions 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 con- nection between inflationary (or deflationary) conditions and the movement of common-stock earnings and prices. The obvious example is the recent period, 1966–1970. The rise in the cost of liv- ing was 22%, the largest in a five-year period since 1946–1950. But both stock earnings and stock prices as a whole have declined since 1965. There are similar contradictions in both directions in the record of previous five-year periods.
Inflation and Corporate Earnings
Another and highly important approach to the subject is by a study of the earnings rate on capital shown by American business. This has fluctuated, of course, with the general rate of economic activity, but it has shown no general tendency to advance with wholesale prices or the cost of living. Actually this rate has fallen rather markedly in the past twenty years in spite of the inflation of the period. (To some degree the decline was due to the charging of more liberal depreciation rates. See Table 2-2.) Our extended stud- ies 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% on net tangible assets (book value) behind the shares.2 Since the market value of these issues is well above their book value—say, 900 market vs. 560 book in mid-1971—the earnings on current market price work out only at some 61⁄4%. (This relation- ship is generally expressed in the reverse, or “times earnings,” manner—e.g., that the DJIA price of 900 equals 18 times the actual earnings for the 12 months ended June 1971 |
n much above the recent five-year rate earned on the DJIA group—
about 10% on net tangible assets (book value) behind the shares.2 Since the market value of these issues is well above their book value—say, 900 market vs. 560 book in mid-1971—the earnings on current market price work out only at some 61⁄4%. (This relation- ship is generally expressed in the reverse, or “times earnings,” manner—e.g., 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 in the previous chapter* that the investor may assume an average dividend return of about 3.5% on the market value of his stocks, plus an apprecia- tion of, say, 4% annually resulting from reinvested profits. (Note that each dollar added to book value is here assumed to increase the market price by about $1.60.)
The reader will object that in the end our calculations make no allowance for an increase in common-stock earnings and values to result from our projected 3% 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%. (Busi- ness 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 cap- ital investme |
“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%. (Busi- ness 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 cap- ital investment. On the basis of the past record this has not been the case.
In the economic cycles of the past, good business was accompa-
nied 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 1950–1970,
* See p. 25.
which reveals a combination of generally continued prosperity and generally rising prices. But the figures indicate that the effect of all this on the earning power of common-stock capital (“equity capital”) has been quite limited; in fact it has not even served to maintain the rate of earnings on the investment. Clearly there have been impor- tant offsetting influences which have prevented any increase in the real profitability of American corporations as a whole. Perhaps the most important of these have been (1) a rise in wage rates exceed- ing the gains in productivity, and (2) the need for huge amounts of new capital, thus holding down the ratio of sales to capital employed.
Our figures in Table 2-2 indicate that so far from inflation having benefited our corporations and their shareholders, its effect has been quite the opposite. The most striking figures in our table are those for the growth of corporate debt between 1950 and 1969. It is surprising how little attention has been paid by economists and by Wall Street to this development. The debt of corporations has expanded nearly fivefold while their profits before taxes a lit |
e ratio of sales to capital employed.
Our figures in Table 2-2 indicate that so far from inflation having benefited our corporations and their shareholders, its effect has been quite the opposite. The most striking figures in our table are those for the growth of corporate debt between 1950 and 1969. It is surprising how little attention has been paid by economists and by Wall Street to this development. The debt of corporations has expanded nearly fivefold while their profits before taxes a little more than doubled. With the great rise in interest rates during this period, it is evident that the aggregate corporate debt is now an
TABLE 2-2 Corporate Debt, Profits, and Earnings on Capital,
1950–1969
Corporate Profits
Net Corporate
Before
After
Percent Earned on Capital
Year Debt
(billions) Income Tax
(millions) Tax
(millions) S & P
Dataa
Other
Datab
1950 $140.2 $42.6 $17 8 18.3% 15.0%
1955 212.1 48.6 27.0 18.3 12.9
1960 302.8 49.7 26.7 10.4 9.1
1965 453.3 77.8 46.5 10.8 11.8
1969 692.9 91.2 48.5 11.8 11.3
a Earnings of Standard & Poor’s industrial index divided by average book value for year.
b Figures for 1950 and 1955 from Cottle and Whitman; those for 1960–1969 from
Fortune.
adverse economic factor of some magnitude and a real problem for many individual enterprises. (Note that in 1950 net earnings after interest but before income tax were about 30% of corporate debt, while in 1969 they were only 13.2% of debt. The 1970 ratio must have been even less satisfactory.) In sum it appears that a signifi- cant part of the 11% being earned on corporate equities as a whole is accomplished by the use of a large amount of new debt costing 4% or less after tax credit. If our corporations had maintained the debt ratio of 1950, their earnings rate on stock capital would have fallen still lower, in spite of the inflation.
The stock market has considered that the public-utility enter- prises have been a chief victim of inflation, being caught between a great adva |
actory.) In sum it appears that a signifi- cant part of the 11% being earned on corporate equities as a whole is accomplished by the use of a large amount of new debt costing 4% or less after tax credit. If our corporations had maintained the debt ratio of 1950, their earnings rate on stock capital would have fallen still lower, in spite of the inflation.
The stock market has considered that the public-utility enter- prises have been a chief victim of inflation, being caught between a great advance in the cost of borrowed money and the difficulty of raising the rates charged under the regulatory process. But this may be the place to remark that the very fact that the unit costs of electricity, gas, and telephone services have advanced so much less than the general price index puts these companies in a strong strategic position for the future.3 They are entitled by law to charge rates sufficient for an adequate return on their invested capital, and this will probably protect their shareholders in the future as it has in the inflations of the past.
All of the above brings us back to our conclusion that the investor has no sound basis for expecting more than an average overall return of, say, 8% 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 4%, or any other figure. In the memorable words of the elder J. P. Morgan, “They will fluctuate.”* This means, first, that the common-stock buyer at today’s prices—
* John Pierpont Morgan was the most powerful financier of the late nine- teenth and early twentieth centuries. Because of his vast influence, he was constantly asked what the stock market would do next. Morgan developed a merc |
that the earnings and average annual market value of a stock portfolio will not grow at the uniform rate of 4%, or any other figure. In the memorable words of the elder J. P. Morgan, “They will fluctuate.”* This means, first, that the common-stock buyer at today’s prices—
* John Pierpont Morgan was the most powerful financier of the late nine- teenth and early twentieth centuries. Because of his vast influence, he was constantly asked what the stock market would do next. Morgan developed a mercifully short and unfailingly accurate answer: “It will fluctuate.” See Jean Strouse, Morgan: American Financier (Random House, 1999), p. 11.
or tomorrow’s—will be running a real risk of having unsatisfactory results therefrom over a period of years. It took 25 years for Gen- eral Electric (and the DJIA itself) to recover the ground lost in the 1929–1932 debacle. Besides that, if the investor concentrates his portfolio on common stocks he is very likely to be led astray either by exhilarating advances or by distressing declines. This is particu- larly true if his reasoning is geared closely to expectations of fur- ther 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 vindica- tion of the inflation hypothesis and as a reason to keep on buying common stocks no matter how high the market level nor how low the dividend return. That way lies sorrow.
Alternatives to Common Stocks as Inflation Hedges
The standard policy of people all over the world who mistrust their currency has been to buy and hold gold. This has been against the law for American citizens since 1935—luckily for them. In the past 35 years the price of gold in the open market has advanced from $35 per ounce to $48 in early 1972—a rise of only 35%. But during all this time the holder of gold has received no income return on his capital, and instead has incurred some an |
orrow.
Alternatives to Common Stocks as Inflation Hedges
The standard policy of people all over the world who mistrust their currency has been to buy and hold gold. This has been against the law for American citizens since 1935—luckily for them. In the past 35 years the price of gold in the open market has advanced from $35 per ounce to $48 in early 1972—a rise of only 35%. But during all this time the holder of gold has received no income return on his capital, and instead has incurred some annual expense for storage. Obviously, he would have done much better with his money at interest in a savings bank, in spite of the rise in the general price level.
The near-complete failure of gold to protect against a loss in the purchasing power of the dollar must cast grave doubt on the abil- ity of the ordinary investor to protect himself against inflation by putting his money in “things.”* Quite a few categories of valuable
* The investment philosopher Peter L. Bernstein feels that Graham was “dead wrong” about precious metals, particularly gold, which (at least in the years after Graham wrote this chapter) has shown a robust ability to out- pace inflation. Financial adviser William Bernstein agrees, pointing out that a tiny allocation to a precious-metals fund (say, 2% of your total assets) is too small to hurt your overall returns when gold does poorly. But, when gold does well, its returns are often so spectacular—sometimes exceeding 100%
objects have had striking advances in market value over the years—such as diamonds, paintings by masters, first editions of books, rare stamps and coins, etc. But in many, perhaps most, of these cases there seems to be an element of the artificial or the pre- carious or even the unreal about the quoted prices. Somehow it is hard to think of paying $67,500 for a U.S. silver dollar dated 1804 (but not even minted that year) as an “investment operation.” 4 We acknowledge we are out of our depth in this area. Very few of our readers w |
n market value over the years—such as diamonds, paintings by masters, first editions of books, rare stamps and coins, etc. But in many, perhaps most, of these cases there seems to be an element of the artificial or the pre- carious or even the unreal about the quoted prices. Somehow it is hard to think of paying $67,500 for a U.S. silver dollar dated 1804 (but not even minted that year) as an “investment operation.” 4 We acknowledge we are out of our depth in this area. Very few of our readers will find the swimming safe and easy there.
The outright ownership of real estate has long been considered as a sound long-term investment, carrying with it a goodly amount of protection against inflation. Unfortunately, real-estate values are also subject to wide fluctuations; serious errors can be made in location, price paid, etc.; there are pitfalls in salesmen’s wiles. Finally, diversification is not practical for the investor of moderate means, except by various types of participations with others and with the special hazards that attach to new flotations—not too dif- ferent from common-stock ownership. This too is not our field. All we should say to the investor is, “Be sure it’s yours before you go into it.”
Conclusion
Naturally, we return to the policy recommended in our previous chapter. Just because of the uncertainties of the future the investor cannot afford to put all his funds into one basket—neither in the bond basket, despite the unprecedentedly high returns that bonds have recently offered; nor in the stock basket, despite the prospect of continuing inflation.
The more the investor depends on his portfolio and the income therefrom, the more necessary it is for him to guard against the
in a year—that it can, all by itself, set an otherwise lackluster portfolio glitter- ing. However, the intelligent investor avoids investing in gold directly, with its high storage and insurance costs; instead, seek out a well-diversified mutual fund specializing in the stocks |
have recently offered; nor in the stock basket, despite the prospect of continuing inflation.
The more the investor depends on his portfolio and the income therefrom, the more necessary it is for him to guard against the
in a year—that it can, all by itself, set an otherwise lackluster portfolio glitter- ing. However, the intelligent investor avoids investing in gold directly, with its high storage and insurance costs; instead, seek out a well-diversified mutual fund specializing in the stocks of precious-metal companies and charging below 1% in annual expenses. Limit your stake to 2% of your total financial assets (or perhaps 5% if you are over the age of 65).
unexpected and the disconcerting in this part of his life. It is axiomatic that the conservative investor should seek to minimize his risks. We think strongly that the risks involved in buying, say, a telephone-company bond at yields of nearly 71⁄2% are much less than those involved in buying the DJIA at 900 (or any stock list equivalent thereto). 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 insure adequately against such inflation, but it should carry more protection than the bond component.
This is what we said on the subject in our 1965 edition (p. 97), and we would write the same today:
It must be evident to the reader that we have no enthusiasm for common stocks at these levels (892 for the DJIA). 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.
COMMENTARY ON CHAPTER 2
Americans are getting stronger. Twenty years ago, it took two people to carry ten dollars’ worth of groceries. Today, a five- year-old can do it.
Inflation? Who cares about that?
—Henny Youngman
After all, the |
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.
COMMENTARY ON CHAPTER 2
Americans are getting stronger. Twenty years ago, it took two people to carry ten dollars’ worth of groceries. Today, a five- year-old can do it.
Inflation? Who cares about that?
—Henny Youngman
After all, the annual rise in the cost of goods and services averaged less than 2.2% between 1997 and 2002—and economists believe that even that rock-bottom rate may be overstated.1 (Think, for instance, of how the prices of computers and home electronics have plummeted—and how the quality of many goods has risen, meaning that consumers are getting better value for their money.) In recent years, the true rate of inflation in the United States has probably run around 1% annually—an increase so infinitesimal that many pundits have proclaimed that “inflation is dead.” 2
1 The U.S. Bureau of Labor Statistics, which calculates the Consumer Price Index that measures inflation, maintains a comprehensive and helpful web- site at www.bls.gov/cpi/home.htm.
2 For a lively discussion of the “inflation is dead” scenario, see www.pbs. org/newshour/bb/economy/july-dec97/inflation_12-16.html. In 1996, the Boskin Commission, a group of economists asked by the government to investigate whether the official rate of inflation is accurate, estimated that it has been overstated, often by nearly two percentage points per year. For the commission’s report, see www.ssa.gov/history/reports/boskinrpt.html. Many investment experts now feel that deflation, or falling prices, is an even greater threat than inflation; the best way to hedge against that risk is by including bonds as a permanent component of your portfolio. (See the com- mentary on Chapter 4.)
58
TH E M ON EY I LLU S I ON
There’s another reason inves |
flation is accurate, estimated that it has been overstated, often by nearly two percentage points per year. For the commission’s report, see www.ssa.gov/history/reports/boskinrpt.html. Many investment experts now feel that deflation, or falling prices, is an even greater threat than inflation; the best way to hedge against that risk is by including bonds as a permanent component of your portfolio. (See the com- mentary on Chapter 4.)
58
TH E M ON EY I LLU S I ON
There’s another reason investors overlook the importance of inflation: what psychologists call the “money illusion.” If you receive a 2% raise in a year when inflation runs at 4%, you will almost certainly feel better than you will if you take a 2% pay cut during a year when inflation is zero. Yet both changes in your salary leave you in a virtually identical position—2% worse off after inflation. So long as the nominal (or absolute) change is positive, we view it as a good thing—even if the real (or after-inflation) result is negative. And any change in your own salary is more vivid and specific than the generalized change of prices in the economy as a whole.3 Likewise, investors were delighted to earn 11% on bank certificates of deposit (CDs) in 1980 and are bitterly disappointed to be earning only around 2% in 2003—even though they were losing money after inflation back then but are keeping up with inflation now. The nominal rate we earn is printed in the bank’s ads and posted in its window, where a high number makes us feel good. But inflation eats away at that high number in secret. Instead of taking out ads, inflation just takes away our wealth. That’s why inflation is so easy to overlook—and why it’s so important to measure your investing success not just by what you make, but by how much you keep after inflation.
More basically still, the intelligent investor must always be on guard against whatever is unexpected and underestimated. There are three good reasons to believe that inflation is not d |
r makes us feel good. But inflation eats away at that high number in secret. Instead of taking out ads, inflation just takes away our wealth. That’s why inflation is so easy to overlook—and why it’s so important to measure your investing success not just by what you make, but by how much you keep after inflation.
More basically still, the intelligent investor must always be on guard against whatever is unexpected and underestimated. There are three good reasons to believe that inflation is not dead:
• As recently as 1973–1982, the United States went through one of the most painful bursts of inflation in our history. As measured by the Consumer Price Index, prices more than doubled over that period, rising at an annualized rate of nearly 9%. In 1979 alone, inflation raged at 13.3%, paralyzing the economy in what became known as “stagflation”—and leading many commentators to question whether America could compete in the global market-
3 For more insights into this behavioral pitfall, see Eldar Shafir, Peter Dia- mond, and Amos Tversky, “Money Illusion,” in Daniel Kahneman and Amos Tversky, eds., Choices, Values, and Frames (Cambridge University Press, 2000), pp. 335–355.
60 Commentary on Chapter 2
place.4 Goods and services priced at $100 in the beginning of 1973 cost $230 by the end of 1982, shriveling the value of a dol- lar to less than 45 cents. No one who lived through it would scoff at such destruction of wealth; no one who is prudent can fail to protect against the risk that it might recur.
• Since 1960, 69% of the world’s market-oriented countries have suffered at least one year in which inflation ran at an annualized rate of 25% or more. On average, those inflationary periods destroyed 53% of an investor’s purchasing power.5 We would be crazy not to hope that America is somehow exempt from such a disaster. But we would be even crazier to conclude that it can never happen here.6
• Rising prices allow Uncle Sam to pay off his debts with dollars that have b |
risk that it might recur.
• Since 1960, 69% of the world’s market-oriented countries have suffered at least one year in which inflation ran at an annualized rate of 25% or more. On average, those inflationary periods destroyed 53% of an investor’s purchasing power.5 We would be crazy not to hope that America is somehow exempt from such a disaster. But we would be even crazier to conclude that it can never happen here.6
• Rising prices allow Uncle Sam to pay off his debts with dollars that have been cheapened by inflation. Completely eradicating inflation runs against the economic self-interest of any govern- ment that regularly borrows money.7
4 That year, President Jimmy Carter gave his famous “malaise” speech, in which he warned of “a crisis in confidence” that “strikes at the very heart and soul and spirit of our national will” and “threatens to destroy the social and the political fabric of America.”
5 See Stanley Fischer, Ratna Sahay, and Carlos A. Vegh, “Modern Hyper- and High Inflations,” National Bureau of Economic Research, Working Paper 8930, at www.nber.org/papers/w8930.
6 In fact, the United States has had two periods of hyperinflation. During the American Revolution, prices roughly tripled every year from 1777 through 1779, with a pound of butter costing $12 and a barrel of flour fetching nearly $1,600 in Revolutionary Massachusetts. During the Civil War, infla- tion raged at annual rates of 29% (in the North) and nearly 200% (in the Confederacy). As recently as 1946, inflation hit 18.1% in the United States.
7 I am indebted to Laurence Siegel of the Ford Foundation for this cynical, but accurate, insight. Conversely, in a time of deflation (or steadily falling prices) it’s more advantageous to be a lender than a borrower—which is why most investors should keep at least a small portion of their assets in bonds, as a form of insurance against deflating prices.
HALF A H E D G E
What, then, can the intelligent investor do to guard against inflation? |
as 1946, inflation hit 18.1% in the United States.
7 I am indebted to Laurence Siegel of the Ford Foundation for this cynical, but accurate, insight. Conversely, in a time of deflation (or steadily falling prices) it’s more advantageous to be a lender than a borrower—which is why most investors should keep at least a small portion of their assets in bonds, as a form of insurance against deflating prices.
HALF A H E D G E
What, then, can the intelligent investor do to guard against inflation? The standard answer is “buy stocks”—but, as common answers so often are, it is not entirely true.
Figure 2-1 shows, for each year from 1926 through 2002, the rela- tionship between inflation and stock prices.
As you can see, in years when the prices of consumer goods and services fell, as on the left side of the graph, stock returns were terri- ble—with the market losing up to 43% of its value.8 When inflation shot above 6%, as in the years on the right end of the graph, stocks also stank. The stock market lost money in eight of the 14 years in which inflation exceeded 6%; the average return for those 14 years was a measly 2.6%.
While mild inflation allows companies to pass the increased costs of their own raw materials on to customers, high inflation wreaks havoc—forcing customers to slash their purchases and depressing activity throughout the economy.
The historical evidence is clear: Since the advent of accurate stock-market data in 1926, there have been 64 five-year periods (i.e., 1926–1930, 1927–1931, 1928–1932, and so on through
1998–2002). In 50 of those 64 five-year periods (or 78% of the time), stocks outpaced inflation.9 That’s impressive, but imperfect; it means that stocks failed to keep up with inflation about one-fifth of the time.
8 When inflation is negative, it is technically termed “deflation.” Regularly falling prices may at first sound appealing, until you think of the Japanese example. Prices have been deflating in Japan since 1989, with real est |
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