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The process then reached extraordinary propor- tions until brought to a catastrophic close in May 1962. After the usual “swearing-off” period of several years the whole tragicom- edy was repeated, step by step, in 1967–1969.* * In the two years from June 1960, through May 1962, more than 850 com- panies sold their stock to the public for the first time—an average of more than one per day. In late 1967 the IPO market heated up again; in 1969 an aston- ishing 781 new stocks were born. That oversupply helped create the bear markets of 1969 and 1973–1974. In 1974 the IPO market was so dead that only nine new stocks were created all year; 1975 saw only 14 stocks born. That undersupply, in turn, helped feed the bull market of the 1980s, when roughly 4,000 new stocks flooded the market—helping to trigger the over- New Common-Stock Offerings The following paragraphs are reproduced unchanged from the 1959 edition, with comment added: Common-stock financing takes two different forms. In the case of companies already listed, additional shares are offered pro rata to the existing stockholders. The subscription price is set below the current market, and the “rights” to subscribe have an initial money value.* The sale of the new shares is almost always under- written by one or more investment banking houses, but it is the general hope and expectation that all the new shares will be taken by the exercise of the subscription rights. Thus the sale of addi- tional common stock of listed companies does not ordinarily call for active selling effort on the part of distributing firms. The second type is the placement with the public of common stock of what were formerly privately owned enterprises. Most of this stock is sold for the account of the controlling interests to enable them to cash in on a favorable market and to diversify their enthusiasm that led to the 1987 crash. Then the cycle swung the other way again as IPOs dried up in 1988–1990. That shortage contributed to the b

ompanies does not ordinarily call for active selling effort on the part of distributing firms. The second type is the placement with the public of common stock of what were formerly privately owned enterprises. Most of this stock is sold for the account of the controlling interests to enable them to cash in on a favorable market and to diversify their enthusiasm that led to the 1987 crash. Then the cycle swung the other way again as IPOs dried up in 1988–1990. That shortage contributed to the bull market of the 1990s—and, right on cue, Wall Street got back into the busi- ness of creating new stocks, cranking out nearly 5,000 IPOs. Then, after the bubble burst in 2000, only 88 IPOs were issued in 2001—the lowest annual total since 1979. In every case, the public has gotten burned on IPOs, has stayed away for at least two years, but has always returned for another scald- ing. For as long as stock markets have existed, investors have gone through this manic-depressive cycle. In America’s first great IPO boom, back in 1825, a man was said to have been squeezed to death in the stampede of specu- lators trying to buy shares in the new Bank of Southwark; the wealthiest buy- ers hired thugs to punch their way to the front of the line. Sure enough, by 1829, stocks had lost roughly 25% of their value. * Here Graham is describing rights offerings, in which investors who already own a stock are asked to pony up even more money to maintain the same proportional interest in the company. This form of financing, still widespread in Europe, has become rare in the United States, except among closed-end funds. own finances. (When new money is raised for the business it comes often via the sale of preferred stock, as previously noted.) This activity follows a well-defined pattern, which by the nature of the security markets must bring many losses and disappointments to the public. The dangers arise both from the character of the businesses that are thus financed and from the market

his form of financing, still widespread in Europe, has become rare in the United States, except among closed-end funds. own finances. (When new money is raised for the business it comes often via the sale of preferred stock, as previously noted.) This activity follows a well-defined pattern, which by the nature of the security markets must bring many losses and disappointments to the public. The dangers arise both from the character of the businesses that are thus financed and from the market conditions that make the financing possible. In the early part of the century a large proportion of our leading companies were introduced to public trading. As time went on, the number of enterprises of first rank that remained closely held steadily diminished; hence original common-stock flotations have tended to be concentrated more and more on relatively small con- cerns. By an unfortunate correlation, during the same period the stock-buying public has been developing an ingrained preference for the major companies and a similar prejudice against the minor ones. This prejudice, like many others, tends to become weaker as bull markets are built up; the large and quick profits shown by common stocks as a whole are sufficient to dull the public’s critical faculty, just as they sharpen its acquisitive instinct. During these periods, also, quite a number of privately owned concerns can be found that are enjoying excellent results—although most of these would not present too impressive a record if the figures were car- ried back, say, ten years or more. When these factors are put together the following consequences emerge: Somewhere in the middle of the bull market the first common-stock flotations make their appearance. These are priced not unattractively, and some large profits are made by the buyers of the early issues. As the market rise continues, this brand of financing grows more frequent; the quality of the companies becomes steadily poorer; the prices asked and obtaine

record if the figures were car- ried back, say, ten years or more. When these factors are put together the following consequences emerge: Somewhere in the middle of the bull market the first common-stock flotations make their appearance. These are priced not unattractively, and some large profits are made by the buyers of the early issues. As the market rise continues, this brand of financing grows more frequent; the quality of the companies becomes steadily poorer; the prices asked and obtained verge on the exorbitant. One fairly dependable sign of the approaching end of a bull swing is the fact that new common stocks of small and nondescript companies are offered at prices somewhat higher than the current level for many medium-sized companies with a long market history. (It should be added that very little of this common-stock financing is ordinarily done by banking houses of prime size and reputation.)* * In Graham’s day, the most prestigious investment banks generally steered clear of the IPO business, which was regarded as an undignified exploita- The heedlessness of the public and the willingness of selling organizations to sell whatever may be profitably sold can have only one result—price collapse. In many cases the new issues lose 75% and more of their offering price. The situation is worsened by the aforementioned fact that, at bottom, the public has a real aver- sion to the very kind of small issue that it bought so readily in its careless moments. Many of these issues fall, proportionately, as much below their true value as they formerly sold above it. An elementary requirement for the intelligent investor is an abil- ity to resist the blandishments of salesmen offering new common- stock issues during bull markets. Even if one or two can be found that can pass severe tests of quality and value, it is probably bad pol- icy to get mixed up in this sort of business. Of course the salesman will point to many such issues which have had good-sized market

se issues fall, proportionately, as much below their true value as they formerly sold above it. An elementary requirement for the intelligent investor is an abil- ity to resist the blandishments of salesmen offering new common- stock issues during bull markets. Even if one or two can be found that can pass severe tests of quality and value, it is probably bad pol- icy to get mixed up in this sort of business. Of course the salesman will point to many such issues which have had good-sized market advances—including some that go up spectacularly the very day they are sold. But all this is part of the speculative atmosphere. It is easy money. For every dollar you make in this way you will be lucky if you end up by losing only two. Some of these issues may prove excellent buys—a few years later, when nobody wants them and they can be had at a small fraction of their true worth. In the 1965 edition we continued our discussion of this subject as follows: While the broader aspects of the stock market’s behavior since 1949 have not lent themselves well to analysis based on long expe- rience, the development of new common-stock flotations pro- ceeded exactly in accordance with ancient prescription. It is doubtful whether we ever before had so many new issues offered, of such low quality, and with such extreme price collapses, as we tion of naïve investors. By the peak of the IPO boom in late 1999 and early 2000, however, Wall Street’s biggest investment banks had jumped in with both feet. Venerable firms cast off their traditional prudence and behaved like drunken mud wrestlers, scrambling to foist ludicrously overvalued stocks on a desperately eager public. Graham’s description of how the IPO process works is a classic that should be required reading in investment- banking ethics classes, if there are any. experienced in 1960–1962.4 The ability of the stock market as a whole to disengage itself rapidly from that disaster is indeed an extraordinary phenomenon, bringing ba

eet. Venerable firms cast off their traditional prudence and behaved like drunken mud wrestlers, scrambling to foist ludicrously overvalued stocks on a desperately eager public. Graham’s description of how the IPO process works is a classic that should be required reading in investment- banking ethics classes, if there are any. experienced in 1960–1962.4 The ability of the stock market as a whole to disengage itself rapidly from that disaster is indeed an extraordinary phenomenon, bringing back long-buried memories of the similar invulnerability it showed to the great Florida real- estate collapse in 1925. Must there be a return of the new-stock-offering madness before the present bull market can come to its definitive close? Who knows? But we do know that an intelligent investor will not forget what happened in 1962 and will let others make the next batch of quick profits in this area and experience the consequent harrowing losses. We followed these paragraphs in the 1965 edition by citing “A Horrible Example,” namely, the sale of stock of Aetna Maintenance Co. at $9 in November 1961. In typical fashion the shares promptly advanced to $15; the next year they fell to 23⁄8, and in 1964 to 7⁄8. The later history of this company was on the extraordinary side, and illustrates some of the strange metamorphoses that have taken place in American business, great and small, in recent years. The curious reader will find the older and newer history of this enter- prise in Appendix 5. It is by no means difficult to provide even more harrowing examples taken from the more recent version of “the same old story,” which covered the years 1967–1970. Nothing could be more pat to our purpose than the case of AAA Enterprises, which hap- pens to be the first company then listed in Standard & Poor’s Stock Guide. The shares were sold to the public at $14 in 1968, promptly advanced to 28, but in early 1971 were quoted at a dismal 25¢. (Even this price represented a gross overvaluation o

It is by no means difficult to provide even more harrowing examples taken from the more recent version of “the same old story,” which covered the years 1967–1970. Nothing could be more pat to our purpose than the case of AAA Enterprises, which hap- pens to be the first company then listed in Standard & Poor’s Stock Guide. The shares were sold to the public at $14 in 1968, promptly advanced to 28, but in early 1971 were quoted at a dismal 25¢. (Even this price represented a gross overvaluation of the enter- prise, since it had just entered the bankruptcy court in a hopeless condition.) There is so much to be learned, and such important warnings to be gleaned, from the story of this flotation that we have reserved it for detailed treatment below, in Chapter 17. COMMENTARY ON CHAPTER 6 The punches you miss are the ones that wear you out. —Boxing trainer Angelo Dundee For the aggressive as well as the defensive investor, what you don’t do is as important to your success as what you do. In this chapter, Graham lists his “don’ts” for aggressive investors. Here is a list for today. JUNK YA RD D O GS ? High-yield bonds—which Graham calls “second-grade” or “lower- grade” and today are called “junk bonds”—get a brisk thumbs-down from Graham. In his day, it was too costly and cumbersome for an indi- vidual investor to diversify away the risks of default.1 (To learn how bad a default can be, and how carelessly even “sophisticated” profes- sional bond investors can buy into one, see the sidebar on p. 146.) Today, however, more than 130 mutual funds specialize in junk bonds. These funds buy junk by the cartload; they hold dozens of different bonds. That mitigates Graham’s complaints about the difficulty of diversifying. (However, his bias against high-yield preferred stock remains valid, since there remains no cheap and widely available way to spread their risks.) Since 1978, an annual average of 4.4% of the junk-bond market has gone into default—but, even after those defa

e the sidebar on p. 146.) Today, however, more than 130 mutual funds specialize in junk bonds. These funds buy junk by the cartload; they hold dozens of different bonds. That mitigates Graham’s complaints about the difficulty of diversifying. (However, his bias against high-yield preferred stock remains valid, since there remains no cheap and widely available way to spread their risks.) Since 1978, an annual average of 4.4% of the junk-bond market has gone into default—but, even after those defaults, junk bonds have 1 In the early 1970s, when Graham wrote, there were fewer than a dozen junk-bond funds, nearly all of which charged sales commissions of up to 8.5%; some even made investors pay a fee for the privilege of reinvesting their monthly dividends back into the fund. 145 A W OR LD OF H U RT F OR W OR LD COM B ON D S Buying a bond only for its yield is like getting married only for the sex. If the thing that attracted you in the first place dries up, you’ll find yourself asking, “What else is there?” When the answer is “Nothing,” spouses and bondholders alike end up with broken hearts. On May 9, 2001, WorldCom, Inc. sold the biggest offering of bonds in U.S. corporate history—$11.9 billion worth. Among the eager beavers attracted by the yields of up to 8.3% were the California Public Employees’ Retirement System, one of the world’s largest pension funds; Retirement Systems of Alabama, whose managers later explained that “the higher yields” were “very attractive to us at the time they were purchased”; and the Strong Corporate Bond Fund, whose comanager was so fond of WorldCom’s fat yield that he boasted, “we’re getting paid more than enough extra income for the risk.” 1 But even a 30-second glance at WorldCom’s bond prospec- tus would have shown that these bonds had nothing to offer but their yield—and everything to lose. In two of the previous five years WorldCom’s pretax income (the company’s profits before it paid its dues to the IRS) fell short of cove

us at the time they were purchased”; and the Strong Corporate Bond Fund, whose comanager was so fond of WorldCom’s fat yield that he boasted, “we’re getting paid more than enough extra income for the risk.” 1 But even a 30-second glance at WorldCom’s bond prospec- tus would have shown that these bonds had nothing to offer but their yield—and everything to lose. In two of the previous five years WorldCom’s pretax income (the company’s profits before it paid its dues to the IRS) fell short of covering its fixed charges (the costs of paying interest to its bondholders) by a stupen- dous $4.1 billion. WorldCom could cover those bond payments only by borrowing more money from banks. And now, with this mountainous new helping of bonds, WorldCom was fattening its interest costs by another $900 million per year!2 Like Mr. Creosote in Monty Python’s The Meaning of Life, WorldCom was gorging itself to the bursting point. No yield could ever be high enough to compensate an investor for risking that kind of explosion. The WorldCom bonds did pro- duce fat yields of up to 8% for a few months. Then, as Graham would have predicted, the yield suddenly offered no shelter: • WorldCom filed bankruptcy in July 2002. • WorldCom admitted in August 2002 that it had overstated its earnings by more than $7 billion.3 still produced an annualized return of 10.5%, versus 8.6% for 10-year U.S. Treasury bonds.2 Unfortunately, most junk-bond funds charge high fees and do a poor job of preserving the original principal amount of your investment. A junk fund could be appropriate if you are retired, are looking for extra monthly income to supplement your pension, and can tolerate temporary tumbles in value. If you work at a bank or other financial company, a sharp rise in interest rates could limit your raise or even threaten your job security—so a junk fund, which tends to outper- form most other bond funds when interest rates rise, might make sense as a counterweight in your 401(k). A junk-b

original principal amount of your investment. A junk fund could be appropriate if you are retired, are looking for extra monthly income to supplement your pension, and can tolerate temporary tumbles in value. If you work at a bank or other financial company, a sharp rise in interest rates could limit your raise or even threaten your job security—so a junk fund, which tends to outper- form most other bond funds when interest rates rise, might make sense as a counterweight in your 401(k). A junk-bond fund, though, is only a minor option—not an obligation—for the intelligent investor. 2 Edward I. Altman and Gaurav Bana, “Defaults and Returns on High-Yield Bonds,” research paper, Stern School of Business, New York University, 2002. TH E V OD KA-AN D-B URRI T O P ORTF OLI O Graham considered foreign bonds no better a bet than junk bonds.3 Today, however, one variety of foreign bond may have some appeal for investors who can withstand plenty of risk. Roughly a dozen mutual funds specialize in bonds issued in emerging-market nations (or what used to be called “Third World countries”) like Brazil, Mexico, Nigeria, Russia, and Venezuela. No sane investor would put more than 10% of a total bond portfolio in spicy holdings like these. But emerging- markets bond funds seldom move in synch with the U.S. stock market, so they are one of the rare investments that are unlikely to drop merely because the Dow is down. That can give you a small corner of comfort in your portfolio just when you may need it most.4 D YI N G A TRAD E R’S D EA TH As we’ve already seen in Chapter 1, day trading—holding stocks for a few hours at a time—is one of the best weapons ever invented for com- mitting financial suicide. Some of your trades might make money, most of your trades will lose money, but your broker will always make money. And your own eagerness to buy or sell a stock can lower your return. Someone who is desperate to buy a stock can easily end up having to bid 10 cents higher than

n you may need it most.4 D YI N G A TRAD E R’S D EA TH As we’ve already seen in Chapter 1, day trading—holding stocks for a few hours at a time—is one of the best weapons ever invented for com- mitting financial suicide. Some of your trades might make money, most of your trades will lose money, but your broker will always make money. And your own eagerness to buy or sell a stock can lower your return. Someone who is desperate to buy a stock can easily end up having to bid 10 cents higher than the most recent share price before any sellers will be willing to part with it. That extra cost, called “market impact,” never shows up on your brokerage statement, but it’s real. If you’re overeager to buy 1,000 shares of a stock and you drive its price 3 Graham did not criticize foreign bonds lightly, since he spent several years early in his career acting as a New York–based bond agent for borrowers in Japan. 4 Two low-cost, well-run emerging-markets bond funds are Fidelity New Markets Income Fund and T. Rowe Price Emerging Markets Bond Fund; for more information, see www.fidelity.com, www.troweprice.com, and www. morningstar.com. Do not buy any emerging-markets bond fund with annual operating expenses higher than 1.25%, and be forewarned that some of these funds charge short-term redemption fees to discourage investors from holding them for less than three months. up by just five cents, you’ve just cost yourself an invisible but very real $50. On the flip side, when panicky investors are frantic to sell a stock and they dump it for less than the most recent price, market impact hits home again. The costs of trading wear away your returns like so many swipes of sandpaper. Buying or selling a hot little stock can cost 2% to 4% (or 4% to 8% for a “round-trip” buy-and-sell transaction).5 If you put $1,000 into a stock, your trading costs could eat up roughly $40 before you even get started. Sell the stock, and you could fork over another 4% in trading expenses. Oh, yes—th

estors are frantic to sell a stock and they dump it for less than the most recent price, market impact hits home again. The costs of trading wear away your returns like so many swipes of sandpaper. Buying or selling a hot little stock can cost 2% to 4% (or 4% to 8% for a “round-trip” buy-and-sell transaction).5 If you put $1,000 into a stock, your trading costs could eat up roughly $40 before you even get started. Sell the stock, and you could fork over another 4% in trading expenses. Oh, yes—there’s one other thing. When you trade instead of invest, you turn long-term gains (taxed at a maximum capital-gains rate of 20%) into ordinary income (taxed at a maximum rate of 38.6%). Add it all up, and a stock trader needs to gain at least 10% just to break even on buying and selling a stock.6 Anyone can do that once, by luck alone. To do it often enough to justify the obsessive attention it requires—plus the nightmarish stress it generates—is impossible. Thousands of people have tried, and the evidence is clear: The more you trade, the less you keep. Finance professors Brad Barber and Terrance Odean of the Univer- sity of California examined the trading records of more than 66,000 customers of a major discount brokerage firm. From 1991 through 1996, these clients made more than 1.9 million trades. Before the costs of trading sandpapered away at their returns, the people in the study actually outperformed the market by an average of at least half a percentage point per year. But after trading costs, the most active of these traders—who shifted more than 20% of their stock holdings per 5 The definitive source on brokerage costs is the Plexus Group of Santa Monica, California, and its website, www.plexusgroup.com. Plexus argues persuasively that, just as most of the mass of an iceberg lies below the ocean surface, the bulk of brokerage costs are invisible—misleading investors into believing that their trading costs are insignificant if commis- sion costs are low. The costs

er trading costs, the most active of these traders—who shifted more than 20% of their stock holdings per 5 The definitive source on brokerage costs is the Plexus Group of Santa Monica, California, and its website, www.plexusgroup.com. Plexus argues persuasively that, just as most of the mass of an iceberg lies below the ocean surface, the bulk of brokerage costs are invisible—misleading investors into believing that their trading costs are insignificant if commis- sion costs are low. The costs of trading NASDAQ stocks are considerably higher for individuals than the costs of trading NYSE-listed stocks (see p. 128, footnote 5). 6 Real-world conditions are still more harsh, since we are ignoring state income taxes in this example. month—went from beating the market to underperforming it by an abysmal 6.4 percentage points per year. The most patient investors, however—who traded a minuscule 0.2% of their total holdings in an average month—managed to outperform the market by a whisker, even after their trading costs. Instead of giving a huge hunk of their gains away to their brokers and the IRS, they got to keep almost everything.7 For a look at these results, see Figure 6-1. The lesson is clear: Don’t just do something, stand there. It’s time for everyone to acknowledge that the term “long-term investor” is redundant. A long-term investor is the only kind of investor there is. Someone who can’t hold on to stocks for more than a few months at a time is doomed to end up not as a victor but as a victim. TH E EAR LY B I R D G ETS W O RMED Among the get-rich-quick toxins that poisoned the mind of the invest- ing public in the 1990s, one of the most lethal was the idea that you can build wealth by buying IPOs. An IPO is an “initial public offering,” or the first sale of a company’s stock to the public. At first blush, investing in IPOs sounds like a great idea—after all, if you’d bought 100 shares of Microsoft when it went public on March 13, 1986, your $2,100 investme

a victor but as a victim. TH E EAR LY B I R D G ETS W O RMED Among the get-rich-quick toxins that poisoned the mind of the invest- ing public in the 1990s, one of the most lethal was the idea that you can build wealth by buying IPOs. An IPO is an “initial public offering,” or the first sale of a company’s stock to the public. At first blush, investing in IPOs sounds like a great idea—after all, if you’d bought 100 shares of Microsoft when it went public on March 13, 1986, your $2,100 investment would have grown to $720,000 by early 2003.8 And finance professors Jay Ritter and William Schwert have shown that if you had spread a total of only $1,000 across every IPO in Janu- ary 1960, at its offering price, sold out at the end of that month, then invested anew in each successive month’s crop of IPOs, your portfolio would have been worth more than $533 decillion by year- end 2001. (On the printed page, that looks like this: $533,000,000,000,000,000,000,000,000,000,000,000.) 7 Barber and Odean’s findings are available at http://faculty.haas.berkeley. edu/odean/Current%20Research.htm and http://faculty.gsm.ucdavis.edu/ ~bmbarber/research/default.html. Numerous studies, incidentally, have found virtually identical results among professional money managers—so this is not a problem limited to “naïve” individuals. 8 See www.microsoft.com/msft/stock.htm, “IPO investment results.” FIGURE 6-1 The Faster You Run, the Behinder You Get 20 19 18 17 16 15 14 13 12 11 10 Extremely patient Very patient Patient Impatient Hyperactive Market index fund Researchers Brad Barber and Terrance Odean divided thousands of traders into five tiers based on how often they turned over their holdings. Those who traded the least (at the left) kept most of their gains. But the impatient and hyperactive traders made their brokers rich, not themselves. (The bars at the far right show a market index fund for comparison.) Source: Profs. Brad Barber, University of California at

xtremely patient Very patient Patient Impatient Hyperactive Market index fund Researchers Brad Barber and Terrance Odean divided thousands of traders into five tiers based on how often they turned over their holdings. Those who traded the least (at the left) kept most of their gains. But the impatient and hyperactive traders made their brokers rich, not themselves. (The bars at the far right show a market index fund for comparison.) Source: Profs. Brad Barber, University of California at Davis, and Terrance Odean, Univer- sity of California at Berkeley Unfortunately, for every IPO like Microsoft that turns out to be a big winner, there are thousands of losers. The psychologists Daniel Kahn- erman and Amos Tversky have shown when humans estimate the like- lihood or frequency of an event, we make that judgment based not on how often the event has actually occurred, but on how vivid the past examples are. We all want to buy “the next Microsoft”—precisely because we know we missed buying the first Microsoft. But we con- veniently overlook the fact that most other IPOs were terrible invest- ments. You could have earned that $533 decillion gain only if you never missed a single one of the IPO market’s rare winners—a practi- cal impossibility. Finally, most of the high returns on IPOs are captured by members of an exclusive private club—the big investment banks and fund houses that get shares at the initial (or “underwriting”) price, before the stock begins public trading. The biggest “run-ups” often occur in stocks so small that even many big investors can’t get any shares; there just aren’t enough to go around. If, like nearly every investor, you can get access to IPOs only after their shares have rocketed above the exclusive initial price, your results will be terrible. From 1980 through 2001, if you had bought the average IPO at its first public closing price and held on for three years, you would have underperformed the market by more than 23 percentage po

g. The biggest “run-ups” often occur in stocks so small that even many big investors can’t get any shares; there just aren’t enough to go around. If, like nearly every investor, you can get access to IPOs only after their shares have rocketed above the exclusive initial price, your results will be terrible. From 1980 through 2001, if you had bought the average IPO at its first public closing price and held on for three years, you would have underperformed the market by more than 23 percentage points annually.9 Perhaps no stock personifies the pipe dream of getting rich from IPOs better than VA Linux. “LNUX THE NEXT MSFT,” exulted an early owner; “BUY NOW, AND RETIRE IN FIVE YEARS FROM NOW.” 10 On December 9, 1999, the stock was placed at an initial public offer- ing price of $30. But demand for the shares was so ferocious that when NASDAQ opened that morning, none of the initial owners of VA Linux would let go of any shares until the price hit $299. The stock peaked at $320 and closed at $239.25, a gain of 697.5% in a single day. But that gain was earned by only a handful of institutional traders; individual investors were almost entirely frozen out. More important, buying IPOs is a bad idea because it flagrantly vio- lates one of Graham’s most fundamental rules: No matter how many other people want to buy a stock, you should buy only if the stock is a cheap way to own a desirable business. At the peak price on day one, investors were valuing VA Linux’s shares at a total of $12.7 billion. What was the company’s business worth? Less than five years old, VA Linux had sold a cumulative total of $44 million worth of its soft- ware and services—but had lost $25 million in the process. In its most recent fiscal quarter, VA Linux had generated $15 million in sales but 9 Jay R. Ritter and Ivo Welch, “A Review of IPO Activity, Pricing, and Alloca- tions,” Journal of Finance, August, 2002, p. 1797. Ritter’s website, at http:// bear.cba.ufl.edu/ritter/, and Welch’s home page,

12.7 billion. What was the company’s business worth? Less than five years old, VA Linux had sold a cumulative total of $44 million worth of its soft- ware and services—but had lost $25 million in the process. In its most recent fiscal quarter, VA Linux had generated $15 million in sales but 9 Jay R. Ritter and Ivo Welch, “A Review of IPO Activity, Pricing, and Alloca- tions,” Journal of Finance, August, 2002, p. 1797. Ritter’s website, at http:// bear.cba.ufl.edu/ritter/, and Welch’s home page, at http://welch.som.yale. edu/, are gold mines of data for anyone interested in IPOs. 10 Message no. 9, posted by “GoldFingers69,” on the VA Linux (LNUX) mes- sage board at messages.yahoo.com, dated December 16, 1999. MSFT is the ticker symbol for Microsoft Corp. had lost $10 million on them. This business, then, was losing almost 70 cents on every dollar it took in. VA Linux’s accumulated deficit (the amount by which its total expenses had exceeded its income) was $30 million. If VA Linux were a private company owned by the guy who lives next door, and he leaned over the picket fence and asked you how much you would pay to take his struggling little business off his hands, would you answer, “Oh, $12.7 billion sounds about right to me”? Or would you, instead, smile politely, turn back to your barbecue grill, and wonder what on earth your neighbor had been smoking? Relying exclusively on our own judgment, none of us would be caught dead agreeing to pay nearly $13 billion for a money-loser that was already $30 million in the hole. But when we’re in public instead of in private, when valuation sud- denly becomes a popularity contest, the price of a stock seems more important than the value of the business it represents. As long as someone else will pay even more than you did for a stock, why does it matter what the business is worth? This chart shows why it matters. FIGURE 6-2 The Legend of VA Linux $250 $200 $150 $100 $50 $0 Sources: VA Linux Systems Inc.

-loser that was already $30 million in the hole. But when we’re in public instead of in private, when valuation sud- denly becomes a popularity contest, the price of a stock seems more important than the value of the business it represents. As long as someone else will pay even more than you did for a stock, why does it matter what the business is worth? This chart shows why it matters. FIGURE 6-2 The Legend of VA Linux $250 $200 $150 $100 $50 $0 Sources: VA Linux Systems Inc.; www.morningstar.com After going up like a bottle rocket on that first day of trading, VA Linux came down like a buttered brick. By December 9, 2002, three years to the day after the stock was at $239.50, VA Linux closed at $1.19 per share. Weighing the evidence objectively, the intelligent investor should conclude that IPO does not stand only for “initial public offering.” More accurately, it is also shorthand for: It’s Probably Overpriced, Imaginary Profits Only, Insiders’ Private Opportunity, or Idiotic, Preposterous, and Outrageous. CHAPTER 7 Portfolio Policy for the Enterprising Investor: The Positive Side The enterprising investor, by definition, will devote a fair amount of his attention and efforts toward obtaining a better than run-of- the-mill investment result. In our discussion of general investment policy we have made some suggestions regarding bond investments that are addressed chiefly to the enterprising investor. He might be interested in special opportunities of the following kinds: (1) Tax-free New Housing Authority bonds effectively guaranteed by the United States government. (2) Taxable but high-yielding New Community bonds, also guar- anteed by the United States government. (3) Tax-free industrial bonds issued by municipalities, but ser- viced by lease payments made by strong corporations. References have been made to these unusual types of bond issues in Chapter 4.* At the other end of the spectrum there may be lower-quality bonds obtainable a

s of the following kinds: (1) Tax-free New Housing Authority bonds effectively guaranteed by the United States government. (2) Taxable but high-yielding New Community bonds, also guar- anteed by the United States government. (3) Tax-free industrial bonds issued by municipalities, but ser- viced by lease payments made by strong corporations. References have been made to these unusual types of bond issues in Chapter 4.* At the other end of the spectrum there may be lower-quality bonds obtainable at such low prices as to constitute true bargain opportunities. But these would belong in the “special situation” area, where no true distinction exists between bonds and common stocks.† * As already noted (see p. 96, footnote †), the New Housing Authority and New Community bonds are no longer issued. † Today these “lower-quality bonds” in the “special situation” area are known as distressed or defaulted bonds. When a company is in (or 155 Operations in Common Stocks The activities specially characteristic of the enterprising investor in the common-stock field may be classified under four heads: 1. Buying in low markets and selling in high markets 2. Buying carefully chosen “growth stocks” 3. Buying bargain issues of various types 4. Buying into “special situations” General Market Policy—Formula Timing We reserve for the next chapter our discussion of the possibili- ties and limitations of a policy of entering the market when it is depressed and selling out in the advanced stages of a boom. For many years in the past this bright idea appeared both simple and feasible, at least from first inspection of a market chart covering its periodic fluctuations. We have already admitted ruefully that the market’s action in the past 20 years has not lent itself to operations of this sort on any mathematical basis. The fluctuations that have taken place, while not inconsiderable in extent, would have required a special talent or “feel” for trading to take advantage of them. This is so

f a boom. For many years in the past this bright idea appeared both simple and feasible, at least from first inspection of a market chart covering its periodic fluctuations. We have already admitted ruefully that the market’s action in the past 20 years has not lent itself to operations of this sort on any mathematical basis. The fluctuations that have taken place, while not inconsiderable in extent, would have required a special talent or “feel” for trading to take advantage of them. This is something quite different from the intelligence which we are assuming in our readers, and we must exclude operations based on such skill from our terms of reference. The 50–50 plan, which we proposed to the defensive investor and described on p. 90, is about the best specific or automatic for- mula we can recommend to all investors under the conditions of 1972. But we have retained a broad leeway between the 25% mini- approaching) bankruptcy, its common stock becomes essentially worthless, since U.S. bankruptcy law entitles bondholders to a much stronger legal claim than shareholders. But if the company reorganizes successfully and comes out of bankruptcy, the bondholders often receive stock in the new firm, and the value of the bonds usually recovers once the company is able to pay interest again. Thus the bonds of a troubled company can perform almost as well as the common stock of a healthy company. In these special situations, as Graham puts it, “no true distinction exists between bonds and common stocks.” mum and the 75% maximum in common stocks, which we allow to those investors who have strong convictions about either the dan- ger or the attractiveness of the general market level. Some 20 years ago it was possible to discuss in great detail a number of clear-cut formulas for varying the percentage held in common stocks, with confidence that these plans had practical utility.1 The times seem to have passed such approaches by, and there would be little point in trying

onds and common stocks.” mum and the 75% maximum in common stocks, which we allow to those investors who have strong convictions about either the dan- ger or the attractiveness of the general market level. Some 20 years ago it was possible to discuss in great detail a number of clear-cut formulas for varying the percentage held in common stocks, with confidence that these plans had practical utility.1 The times seem to have passed such approaches by, and there would be little point in trying to determine new levels for buying and selling out of the market patterns since 1949. That is too short a period to furnish any reliable guide to the future.* Growth-Stock Approach Every investor would like to select the stocks of companies that will do better than the average over a period of years. A growth stock may be defined as one that has done this in the past and is expected to do so in the future.2 Thus it seems only logical that the intelligent investor should concentrate upon the selection of growth stocks. Actually the matter is more complicated, as we shall try to show. It is a mere statistical chore to identify companies that have “out- performed the averages” in the past. The investor can obtain a list of 50 or 100 such enterprises from his broker.† Why, then, should he not merely pick out the 15 or 20 most likely looking issues of this group and lo! he has a guaranteed-successful stock portfolio? * Note very carefully what Graham is saying here. Writing in 1972, he con- tends that the period since 1949—a stretch of more than 22 years—is too short a period from which to draw reliable conclusions! With his mastery of mathematics, Graham never forgets that objective conclusions require very long samples of large amounts of data. The charlatans who peddle “time- tested” stock-picking gimmicks almost always base their findings on smaller samples than Graham would ever accept. (Graham often used 50-year peri- ods to analyze past data.) † Today, the enterprising in

n- tends that the period since 1949—a stretch of more than 22 years—is too short a period from which to draw reliable conclusions! With his mastery of mathematics, Graham never forgets that objective conclusions require very long samples of large amounts of data. The charlatans who peddle “time- tested” stock-picking gimmicks almost always base their findings on smaller samples than Graham would ever accept. (Graham often used 50-year peri- ods to analyze past data.) † Today, the enterprising investor can assemble such a list over the Internet by visiting such websites as www.morningstar.com (try the Stock Quickrank tool), www.quicken.com/investments/stocks/search/full, and http://yahoo. marketguide.com. There are two catches to this simple idea. The first is that com- mon stocks with good records and apparently good prospects sell at correspondingly high prices. The investor may be right in his judgment of their prospects and still not fare particularly well, merely because he has paid in full (and perhaps overpaid) for the expected prosperity. The second is that his judgment as to the future may prove wrong. Unusually rapid growth cannot keep up forever; when a company has already registered a brilliant expan- sion, its very increase in size makes a repetition of its achievement more difficult. At some point the growth curve flattens out, and in many cases it turns downward. It is obvious that if one confines himself to a few chosen instances, based on hindsight, he could demonstrate that fortunes can readily be either made or lost in the growth-stock field. How can one judge fairly of the overall results obtainable here? We think that reasonably sound conclusions can be drawn from a study of the results achieved by the investment funds specializing in the growth-stock approach. The authoritative manual entitled Invest- ment Companies, published annually by Arthur Wiesenberger & Company, members of the New York Stock Exchange, computes the annual performance of

d demonstrate that fortunes can readily be either made or lost in the growth-stock field. How can one judge fairly of the overall results obtainable here? We think that reasonably sound conclusions can be drawn from a study of the results achieved by the investment funds specializing in the growth-stock approach. The authoritative manual entitled Invest- ment Companies, published annually by Arthur Wiesenberger & Company, members of the New York Stock Exchange, computes the annual performance of some 120 such “growth funds” over a period of years. Of these, 45 have records covering ten years or more. The average overall gain for these companies—unweighted for size of fund—works out at 108% for the decade 1961–1970, compared with 105% for the S & P composite and 83% for the DJIA.3 In the two years 1969 and 1970 the majority of the 126 “growth funds” did worse than either index. Similar results were found in our earlier studies. The implication here is that no out- standing rewards came from diversified investment in growth companies as compared with that in common stocks generally.* * Over the 10 years ending December 31, 2002, funds investing in large growth companies—today’s equivalent of what Graham calls “growth funds”—earned an annual average of 5.6%, underperforming the overall stock market by an average of 3.7 percentage points per year. However, “large value” funds investing in more reasonably priced big companies also underperformed the market over the same period (by a full percentage point per year). Is the problem merely that growth funds cannot reliably select There is no reason at all for thinking that the average intelligent investor, even with much devoted effort, can derive better results over the years from the purchase of growth stocks than the invest- ment companies specializing in this area. Surely these organiza- tions have more brains and better research facilities at their disposal than you do. Consequently we should advise against the usu

y a full percentage point per year). Is the problem merely that growth funds cannot reliably select There is no reason at all for thinking that the average intelligent investor, even with much devoted effort, can derive better results over the years from the purchase of growth stocks than the invest- ment companies specializing in this area. Surely these organiza- tions have more brains and better research facilities at their disposal than you do. Consequently we should advise against the usual type of growth-stock commitment for the enterprising investor.* This is one in which the excellent prospects are fully rec- ognized in the market and already reflected in a current price- earnings ratio of, say, higher than 20. (For the defensive investor we suggested an upper limit of purchase price at 25 times average earnings of the past seven years. The two criteria would be about equivalent in most cases.)† stocks that will outperform the market in the future? Or is it that the high costs of running the average fund (whether it buys growth or “value” compa- nies) exceed any extra return the managers can earn with their stock picks? To update fund performance by type, see www.morningstar.com, “Category Returns.” For an enlightening reminder of how perishable the performance of different investment styles can be, see www.callan.com/resource/periodic_ table/pertable.pdf. * Graham makes this point to remind you that an “enterprising” investor is not one who takes more risk than average or who buys “aggressive growth” stocks; an enterprising investor is simply one who is willing to put in extra time and effort in researching his or her portfolio. † Notice that Graham insists on calculating the price/earnings ratio based on a multiyear average of past earnings. That way, you lower the odds that you will overestimate a company’s value based on a temporarily high burst of profitability. Imagine that a company earned $3 per share over the past 12 months, but an average of onl

erage or who buys “aggressive growth” stocks; an enterprising investor is simply one who is willing to put in extra time and effort in researching his or her portfolio. † Notice that Graham insists on calculating the price/earnings ratio based on a multiyear average of past earnings. That way, you lower the odds that you will overestimate a company’s value based on a temporarily high burst of profitability. Imagine that a company earned $3 per share over the past 12 months, but an average of only 50 cents per share over the previous six years. Which number—the sudden $3 or the steady 50 cents—is more likely to represent a sustainable trend? At 25 times the $3 it earned in the most recent year, the stock would be priced at $75. But at 25 times the average earnings of the past seven years ($6 in total earnings, divided by seven, equals 85.7 cents per share in average annual earnings), the stock would be priced at only $21.43. Which number you pick makes a big difference. Finally, it’s worth noting that the prevailing method on Wall Street today— basing price/earnings ratios primarily on “next year’s earnings”—would be The striking thing about growth stocks as a class is their ten- dency toward wide swings in market price. This is true of the largest and longest-established companies—such as General Elec- tric and International Business Machines—and even more so of newer and smaller successful companies. They illustrate our thesis that the main characteristic of the stock market since 1949 has been the injection of a highly speculative element into the shares of com- panies which have scored the most brilliant successes, and which themselves would be entitled to a high investment rating. (Their credit standing is of the best, and they pay the lowest interest rates on their borrowings.) The investment caliber of such a company may not change over a long span of years, but the risk characteris- tics of its stock will depend on what happens to it in the stock mar- ket.

ket since 1949 has been the injection of a highly speculative element into the shares of com- panies which have scored the most brilliant successes, and which themselves would be entitled to a high investment rating. (Their credit standing is of the best, and they pay the lowest interest rates on their borrowings.) The investment caliber of such a company may not change over a long span of years, but the risk characteris- tics of its stock will depend on what happens to it in the stock mar- ket. The more enthusiastic the public grows about it, and the faster its advance as compared with the actual growth in its earnings, the riskier a proposition it becomes.* But is it not true, the reader may ask, that the really big fortunes from common stocks have been garnered by those who made a substantial commitment in the early years of a company in whose future they had great confidence, and who held their original shares unwaveringly while they increased 100-fold or more in value? The answer is “Yes.” But the big fortunes from single- company investments are almost always realized by persons who anathema to Graham. How can you value a company based on earnings it hasn’t even generated yet? That’s like setting house prices based on a rumor that Cinderella will be building her new castle right around the corner. * Recent examples hammer Graham’s point home. On September 21, 2000, Intel Corp., the maker of computer chips, announced that it expected its revenues to grow by up to 5% in the next quarter. At first blush, that sounds great; most big companies would be delighted to increase their sales by 5% in just three months. But in response, Intel’s stock dropped 22%, a one-day loss of nearly $91 billion in total value. Why? Wall Street’s analysts had expected Intel’s revenue to rise by up to 10%. Similarly, on February 21, 2001, EMC Corp., a data-storage firm, announced that it expected its revenues to grow by at least 25% in 2001—but that a new cau- tion among customers “ma

the next quarter. At first blush, that sounds great; most big companies would be delighted to increase their sales by 5% in just three months. But in response, Intel’s stock dropped 22%, a one-day loss of nearly $91 billion in total value. Why? Wall Street’s analysts had expected Intel’s revenue to rise by up to 10%. Similarly, on February 21, 2001, EMC Corp., a data-storage firm, announced that it expected its revenues to grow by at least 25% in 2001—but that a new cau- tion among customers “may lead to longer selling cycles.” On that whiff of hesitation, EMC’s shares lost 12.8% of their value in a single day. TABLE 7-1 Average Results of “Growth Funds,” 1961–1970a 1 year 5 years 10 years 1970 Dividend 1970 1966–1970 1961–1970 Return 17 large growth funds – 7.5% +23.2% +121.1% 2.3% 106 smaller growth funds—group A –17.7 +20.3 +102.1 1.6 38 smaller growth funds—group B – 4.7 +23.2 +106.7 1.4 15 funds with “growth” in their name –14.2 +13.8 + 97.4 1.7 Standard & Poor’s composite + 3.5% +16.1 +104.7 3.4 Dow Jones Industrial Average + 8.7 + 2.9 + 83.0 3.7 a These figures are supplied by Wiesenberger Financial Services. have a close relationship with the particular company—through employment, family connection, etc.—which justifies them in plac- ing a large part of their resources in one medium and holding on to this commitment through all vicissitudes, despite numerous temptations to sell out at apparently high prices along the way. An investor without such close personal contact will constantly be faced with the question of whether too large a portion of his funds are in this one medium.* Each decline—however tempo- rary it proves in the sequel—will accentuate his problem; and internal and external pressures are likely to force him to take what seems to be a goodly profit, but one far less than the ultimate bonanza.4 Three Recommended Fields for “Enterprising Investment” To obtain better than average investment results over a long pull requires a poli

personal contact will constantly be faced with the question of whether too large a portion of his funds are in this one medium.* Each decline—however tempo- rary it proves in the sequel—will accentuate his problem; and internal and external pressures are likely to force him to take what seems to be a goodly profit, but one far less than the ultimate bonanza.4 Three Recommended Fields for “Enterprising Investment” To obtain better than average investment results over a long pull requires a policy of selection or operation possessing a twofold merit: (1) It must meet objective or rational tests of underlying soundness; and (2) it must be different from the policy followed by most investors or speculators. Our experience and study leads us to recommend three investment approaches that meet these crite- ria. They differ rather widely from one another, and each may require a different type of knowledge and temperament on the part of those who assay it. * Today’s equivalent of investors “who have a close relationship with the par- ticular company” are so-called control persons—senior managers or direc- tors who help run the company and own huge blocks of stock. Executives like Bill Gates of Microsoft or Warren Buffett of Berkshire Hathaway have direct control over a company’s destiny—and outside investors want to see these chief executives maintain their large shareholdings as a vote of confi- dence. But less-senior managers and rank-and-file workers cannot influence the company’s share price with their individual decisions; thus they should not put more than a small percentage of their assets in their own employer’s stock. As for outside investors, no matter how well they think they know the company, the same objection applies. The Relatively Unpopular Large Company If we assume that it is the habit of the market to overvalue com- mon stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will underv

ny’s share price with their individual decisions; thus they should not put more than a small percentage of their assets in their own employer’s stock. As for outside investors, no matter how well they think they know the company, the same objection applies. The Relatively Unpopular Large Company If we assume that it is the habit of the market to overvalue com- mon stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue—relatively, at least—companies that are out of favor because of unsatisfactory developments of a temporary nature. This may be set down as a fundamental law of the stock market, and it suggests an investment approach that should prove both conservative and promising. The key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity. While small companies may also be undervalued for similar reasons, and in many cases may later increase their earnings and share price, they entail the risk of a definitive loss of profitability and also of protracted neglect by the market in spite of better earnings. The large companies thus have a double advantage over the others. First, they have the resources in capital and brain power to carry them through adver- sity and back to a satisfactory earnings base. Second, the market is likely to respond with reasonable speed to any improvement shown. A remarkable demonstration of the soundness of this thesis is found in studies of the price behavior of the unpopular issues in the Dow Jones Industrial Average. In these it was assumed that an investment was made each year in either the six or the ten issues in the DJIA which were selling at the lowest multipliers of their current or previous year’s earnings. These could be called the “cheapest” stocks in the list, and their cheapness was evidently the reflection of relative unpopularity with investors or traders. It wa

of the soundness of this thesis is found in studies of the price behavior of the unpopular issues in the Dow Jones Industrial Average. In these it was assumed that an investment was made each year in either the six or the ten issues in the DJIA which were selling at the lowest multipliers of their current or previous year’s earnings. These could be called the “cheapest” stocks in the list, and their cheapness was evidently the reflection of relative unpopularity with investors or traders. It was assumed further that these purchases were sold out at the end of holding periods ranging from one to five years. The results of these investments were then compared with the results shown in either the DJIA as a whole or in the highest multiplier (i.e., the most pop- ular) group. The detailed material we have available covers the results of annual purchases assumed in each of the past 53 years.5 In the early period, 1917–1933, this approach proved unprofitable. But since 1933 the method has shown highly successful results. In 34 tests TABLE 7-2 Average Annual Percentage Gain or Loss on Test Issues, 1937–1969 Period 10 Low- Multiplier Issues 10 High- Multiplier Issues 30 DJIA Stocks 1937–1942 – 2.2 –10.0 – 6.3 1943–1947 17.3 8.3 14.9 1948–1952 16.4 4.6 9.9 1953–1957 20.9 10.0 13.7 1958–1962 10.2 – 3.3 3.6 1963–1969 (8 years) 8.0 4.6 4.0 made by Drexel & Company (now Drexel Firestone)* of one-year holding—from 1937 through 1969—the cheap stocks did definitely worse than the DJIA in only three instances; the results were about the same in six cases; and the cheap stocks clearly outperformed the average in 25 years. The consistently better performance of the low-multiplier stocks is shown (Table 7-2) by the average results for successive five-year periods, when compared with those of the DJIA and of the ten high-multipliers. The Drexel computation shows further that an original invest- ment of $10,000 made in the low-multiplier issues in 1936, and switched each year in ac

in only three instances; the results were about the same in six cases; and the cheap stocks clearly outperformed the average in 25 years. The consistently better performance of the low-multiplier stocks is shown (Table 7-2) by the average results for successive five-year periods, when compared with those of the DJIA and of the ten high-multipliers. The Drexel computation shows further that an original invest- ment of $10,000 made in the low-multiplier issues in 1936, and switched each year in accordance with the principle, would have grown to $66,900 by 1962. The same operations in high-multiplier stocks would have ended with a value of only $25,300; while an operation in all thirty stocks would have increased the original fund to $44,000.† The concept of buying “unpopular large companies” and its * Drexel Firestone, a Philadelphia investment bank, merged in 1973 with Burnham & Co. and later became Drexel Burnham Lambert, famous for its junk-bond financing of the 1980s takeover boom. † This strategy of buying the cheapest stocks in the Dow Jones Industrial Average is now nicknamed the “Dogs of the Dow” approach. Information on the “Dow 10” is available at www.djindexes.com/jsp/dow510Faq.jsp. execution on a group basis, as described above, are both quite sim- ple. But in considering individual companies a special factor of opposite import must sometimes to be taken into account. Compa- nies that are inherently speculative because of widely varying earnings tend to sell both at a relatively high price and at a rela- tively low multiplier in their good years, and conversely at low prices and high multipliers in their bad years. These relationships are illustrated in Table 7-3, covering fluctuations of Chrysler Corp. common. In these cases the market has sufficient skepticism as to the continuation of the unusually high profits to value them con- servatively, and conversely when earnings are low or nonexistent. (Note that, by the arithmetic, if a company earns “next

at a relatively high price and at a rela- tively low multiplier in their good years, and conversely at low prices and high multipliers in their bad years. These relationships are illustrated in Table 7-3, covering fluctuations of Chrysler Corp. common. In these cases the market has sufficient skepticism as to the continuation of the unusually high profits to value them con- servatively, and conversely when earnings are low or nonexistent. (Note that, by the arithmetic, if a company earns “next to nothing” its shares must sell at a high multiplier of these minuscule profits.) As it happens Chrysler has been quite exceptional in the DJIA list of leading companies, and hence it did not greatly affect the the low-multiplier calculations. It would be quite easy to avoid inclu- sion of such anomalous issues in a low-multiplier list by requiring also that the price be low in relation to past average earnings or by some similar test. While writing this revision we tested the results of the DJIA- low-multiplier method applied to a group assumed to be bought at TABLE 7-3 Chrysler Common Prices and Earnings, 1952–1970 Year Earnings Per Share High or Low Price P/E Ratio 1952 $ 9.04 H 98 10.8 1954 2.13 L 56 26.2 1955 11.49 H 1011⁄2 8.8 1956 2.29 L 52 (in 1957) 22.9 1957 13.75 H 82 6.7 1958 (def.) 3.88 L 44 a — 1968 24.92b H 294b 11.8 1970 def. L 65b — a 1962 low was 371⁄2. b Adjusted for stock splits. def.: Net loss. the end of 1968 and revalued on June 30, 1971. This time the figures proved quite disappointing, showing a sharp loss for the low- multiplier six or ten and a good profit for the high-multiplier selec- tions. This one bad instance should not vitiate conclusions based on 30-odd experiments, but its recent happening gives it a special adverse weight. Perhaps the aggressive investor should start with the “low-multiplier” idea, but add other quantitative and qualita- tive requirements thereto in making up his portfolio. Purchase of Bargain Issues We define a barg

es proved quite disappointing, showing a sharp loss for the low- multiplier six or ten and a good profit for the high-multiplier selec- tions. This one bad instance should not vitiate conclusions based on 30-odd experiments, but its recent happening gives it a special adverse weight. Perhaps the aggressive investor should start with the “low-multiplier” idea, but add other quantitative and qualita- tive requirements thereto in making up his portfolio. Purchase of Bargain Issues We define a bargain issue as one which, on the basis of facts established by analysis, appears to be worth considerably more than it is selling for. The genus includes bonds and preferred stocks selling well under par, as well as common stocks. To be as concrete as possible, let us suggest that an issue is not a true “bargain” unless the indicated value is at least 50% more than the price. What kind of facts would warrant the conclusion that so great a discrep- ancy exists? How do bargains come into existence, and how does the investor profit from them? There are two tests by which a bargain common stock is detected. The first is by the method of appraisal. This relies largely on estimating future earnings and then multiplying these by a fac- tor appropriate to the particular issue. If the resultant value is suffi- ciently above the market price—and if the investor has confidence in the technique employed—he can tag the stock as a bargain. The second test is the value of the business to a private owner. This value also is often determined chiefly by expected future earn- ings—in which case the result may be identical with the first. But in the second test more attention is likely to be paid to the realizable value of the assets, with particular emphasis on the net current assets or working capital. At low points in the general market a large proportion of com- mon stocks are bargain issues, as measured by these standards. (A typical example was General Motors when it sold at less than 30 in

r. This value also is often determined chiefly by expected future earn- ings—in which case the result may be identical with the first. But in the second test more attention is likely to be paid to the realizable value of the assets, with particular emphasis on the net current assets or working capital. At low points in the general market a large proportion of com- mon stocks are bargain issues, as measured by these standards. (A typical example was General Motors when it sold at less than 30 in 1941, equivalent to only 5 for the 1971 shares. It had been earning in excess of $4 and paying $3.50, or more, in dividends.) It is true that current earnings and the immediate prospects may both be poor, but a levelheaded appraisal of average future conditions would indicate values far above ruling prices. Thus the wisdom of having courage in depressed markets is vindicated not only by the voice of experience but also by application of plausible techniques of value analysis. The same vagaries of the market place that recurrently establish a bargain condition in the general list account for the existence of many individual bargains at almost all market levels. The market is fond of making mountains out of molehills and exaggerating ordi- nary vicissitudes into major setbacks.* Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels. Thus we have what appear to be two major sources of undervalua- tion: (1) currently disappointing results and (2) protracted neglect or unpopularity. However, neither of these causes, if considered by itself alone, can be relied on as a guide to successful common-stock investment. How can we be sure that the currently disappointing results are indeed going to be only temporary? True, we can supply excellent examples of that happening. The steel stocks used to be famous for their cyclical quality, and the shrewd buyer could acquire them at low prices when earnings were low and sell them out in boom years at a f

tracted neglect or unpopularity. However, neither of these causes, if considered by itself alone, can be relied on as a guide to successful common-stock investment. How can we be sure that the currently disappointing results are indeed going to be only temporary? True, we can supply excellent examples of that happening. The steel stocks used to be famous for their cyclical quality, and the shrewd buyer could acquire them at low prices when earnings were low and sell them out in boom years at a fine profit. A spectacular example is supplied by Chrysler Corporation, as shown by the data in Table 7-3. If this were the standard behavior of stocks with fluctuating earnings, then making profits in the stock market would be an easy matter. Unfortunately, we could cite many examples of declines in * Among the steepest of the mountains recently made out of molehills: In May 1998, Pfizer Inc. and the U.S. Food and Drug Administration announced that six men taking Pfizer’s anti-impotence drug Viagra had died of heart attacks while having sex. Pfizer’s stock immediately went flaccid, losing 3.4% in a single day on heavy trading. But Pfizer’s shares surged ahead when research later showed that there was no cause for alarm; the stock gained roughly a third over the next two years. In late 1997, shares of Warner-Lambert Co. fell by 19% in a day when sales of its new diabetes drug were temporarily halted in England; within six months, the stock had nearly doubled. In late 2002, Carnival Corp., which operates cruise ships, lost roughly 10% of its value after tourists came down with severe diarrhea and vomiting—on ships run by other companies. earnings and price which were not followed automatically by a handsome recovery of both. One such was Anaconda Wire and Cable, which had large earnings up to 1956, with a high price of 85 in that year. The earnings then declined irregularly for six years; the price fell to 231⁄2 in 1962, and the following year it was taken over by its parent

p., which operates cruise ships, lost roughly 10% of its value after tourists came down with severe diarrhea and vomiting—on ships run by other companies. earnings and price which were not followed automatically by a handsome recovery of both. One such was Anaconda Wire and Cable, which had large earnings up to 1956, with a high price of 85 in that year. The earnings then declined irregularly for six years; the price fell to 231⁄2 in 1962, and the following year it was taken over by its parent enterprise (Anaconda Corporation) at the equiv- alent of only 33. The many experiences of this type suggest that the investor would need more than a mere falling off in both earnings and price to give him a sound basis for purchase. He should require an indi- cation of at least reasonable stability of earnings over the past decade or more—i.e., no year of earnings deficit—plus sufficient size and financial strength to meet possible setbacks in the future. The ideal combination here is thus that of a large and prominent company selling both well below its past average price and its past average price/earnings multiplier. This would no doubt have ruled out most of the profitable opportunities in companies such as Chrysler, since their low-price years are generally accompanied by high price/earnings ratios. But let us assure the reader now—and no doubt we shall do it again—that there is a world of difference between “hindsight profits” and “real-money profits.” We doubt seriously whether the Chrysler type of roller coaster is a suitable medium for operations by our enterprising investor. We have mentioned protracted neglect or unpopularity as a sec- ond cause of price declines to unduly low levels. A current case of this kind would appear to be National Presto Industries. In the bull market of 1968 it sold at a high of 45, which was only 8 times the $5.61 earnings for that year. The per-share profits increased in both 1969 and 1970, but the price declined to only 21 in 1970. Th

the Chrysler type of roller coaster is a suitable medium for operations by our enterprising investor. We have mentioned protracted neglect or unpopularity as a sec- ond cause of price declines to unduly low levels. A current case of this kind would appear to be National Presto Industries. In the bull market of 1968 it sold at a high of 45, which was only 8 times the $5.61 earnings for that year. The per-share profits increased in both 1969 and 1970, but the price declined to only 21 in 1970. This was less than 4 times the (record) earnings in that year and less than its net-current-asset value. In March 1972 it was selling at 34, still only 51⁄2 times the last reported earnings, and at about its enlarged net- current-asset value. Another example of this type is provided currently by Standard Oil of California, a concern of major importance. In early 1972 it was selling at about the same price as 13 years before, say 56. Its earnings had been remarkably steady, with relatively small growth but with only one small decline over the entire period. Its book value was about equal to the market price. With this conservatively favorable 1958–71 record the company has never shown an aver- age annual price as high as 15 times its current earnings. In early 1972 the price/earnings ratio was only about 10. A third cause for an unduly low price for a common stock may be the market’s failure to recognize its true earnings picture. Our classic example here is Northern Pacific Railway which in 1946–47 declined from 36 to 131⁄2. The true earnings of the road in 1947 were close to $10 per share. The price of the stock was held down in great part by its $1 dividend. It was neglected also because much of its earnings power was concealed by accounting methods peculiar to railroads. The type of bargain issue that can be most readily identified is a common stock that sells for less than the company’s net working capital alone, after deducting all prior obligations.* This would mean tha

ch in 1946–47 declined from 36 to 131⁄2. The true earnings of the road in 1947 were close to $10 per share. The price of the stock was held down in great part by its $1 dividend. It was neglected also because much of its earnings power was concealed by accounting methods peculiar to railroads. The type of bargain issue that can be most readily identified is a common stock that sells for less than the company’s net working capital alone, after deducting all prior obligations.* This would mean that the buyer would pay nothing at all for the fixed assets— buildings, machinery, etc., or any good-will items that might exist. Very few companies turn out to have an ultimate value less than the working capital alone, although scattered instances may be found. The surprising thing, rather, is that there have been so many enterprises obtainable which have been valued in the market on this bargain basis. A compilation made in 1957, when the market’s level was by no means low, disclosed about 150 of such common stocks. In Table 7-4 we summarize the result of buying, on Decem- ber 31, 1957, one share of each of the 85 companies in that list for which data appeared in Standard & Poor’s Monthly Stock Guide, and holding them for two years. By something of a coincidence, each of the groups advanced in the two years to somewhere in the neighborhood of the aggregate net-current-asset value. The gain for the entire “portfolio” in that period was 75%, against 50% for Standard & Poor’s 425 industrials. What is more remarkable is that none of the issues showed signifi- cant losses, seven held about even, and 78 showed appreciable gains. Our experience with this type of investment selection—on a * By “net working capital,” Graham means a company’s current assets (such as cash, marketable securities, and inventories) minus its total liabilities (including preferred stock and long-term debt). TABLE 7-4 Profit Experience of Undervalued Stocks, 1957–1959 Location of Number of Aggregate

ials. What is more remarkable is that none of the issues showed signifi- cant losses, seven held about even, and 78 showed appreciable gains. Our experience with this type of investment selection—on a * By “net working capital,” Graham means a company’s current assets (such as cash, marketable securities, and inventories) minus its total liabilities (including preferred stock and long-term debt). TABLE 7-4 Profit Experience of Undervalued Stocks, 1957–1959 Location of Number of Aggregate Net Current Assets Aggregate Price Aggregate Price Market Companies Per Share Dec. 1957 Dec. 1959 New York S.E. 35 $ 748 $ 419 $ 838 American S.E. 25 495 289 492 Midwest S.E. 5 163 87 141 Over the counter 20 425 288 433 Total 85 $1,831 $1,083 $1,904 diversified basis—was uniformly good for many years prior to 1957. It can probably be affirmed without hesitation that it consti- tutes a safe and profitable method of determining and taking advantage of undervalued situations. However, during the general market advance after 1957 the number of such opportunities became extremely limited, and many of those available were show- ing small operating profits or even losses. The market decline of 1969–70 produced a new crop of these “sub-working-capital” stocks. We discuss this group in Chapter 15, on stock selection for the enterprising investor. Bargain-Issue Pattern in Secondary Companies. We have defined a secondary company as one that is not a leader in a fairly important industry. Thus it is usually one of the smaller concerns in its field, but it may equally well be the chief unit in an unimpor- tant line. By way of exception, any company that has established itself as a growth stock is not ordinarily considered “secondary.” In the great bull market of the 1920s relatively little distinction was drawn between industry leaders and other listed issues, pro- vided the latter were of respectable size. The public felt that a middle-sized company was strong enough to weather st

hus it is usually one of the smaller concerns in its field, but it may equally well be the chief unit in an unimpor- tant line. By way of exception, any company that has established itself as a growth stock is not ordinarily considered “secondary.” In the great bull market of the 1920s relatively little distinction was drawn between industry leaders and other listed issues, pro- vided the latter were of respectable size. The public felt that a middle-sized company was strong enough to weather storms and that it had a better chance for really spectacular expansion than one that was already of major dimensions. The depression years 1931–32, however, had a particularly devastating impact on the companies below the first rank either in size or in inherent stability. As a result of that experience investors have since developed a pro- nounced preference for industry leaders and a corresponding lack of interest most of the time in the ordinary company of secondary importance. This has meant that the latter group have usually sold at much lower prices in relation to earnings and assets than have the former. It has meant further that in many instances the price has fallen so low as to establish the issue in the bargain class. When investors rejected the stocks of secondary companies, even though these sold at relatively low prices, they were express- ing a belief or fear that such companies faced a dismal future. In fact, at least subconsciously, they calculated that any price was too high for them because they were heading for extinction—just as in 1929 the companion theory for the “blue chips” was that no price was too high for them because their future possibilities were limit- less. Both of these views were exaggerations and were productive of serious investment errors. Actually, the typical middle-sized listed company is a large one when compared with the average pri- vately owned business. There is no sound reason why such compa- nies should not continue indefinitel

too high for them because they were heading for extinction—just as in 1929 the companion theory for the “blue chips” was that no price was too high for them because their future possibilities were limit- less. Both of these views were exaggerations and were productive of serious investment errors. Actually, the typical middle-sized listed company is a large one when compared with the average pri- vately owned business. There is no sound reason why such compa- nies should not continue indefinitely in operation, undergoing the vicissitudes characteristic of our economy but earning on the whole a fair return on their invested capital. This brief review indicates that the stock market’s attitude toward secondary companies tends to be unrealistic and conse- quently to create in normal times innumerable instances of major undervaluation. As it happens, the World War II period and the postwar boom were more beneficial to the smaller concerns than to the larger ones, because then the normal competition for sales was suspended and the former could expand sales and profit margins more spectacularly. Thus by 1946 the market’s pattern had com- pletely reversed itself from that before the war. Whereas the lead- ing stocks in the Dow Jones Industrial Average had advanced only 40% from the end of 1938 to the 1946 high, Standard & Poor’s index of low-priced stocks had shot up no less than 280% in the same period. Speculators and many self-styled investors—with the proverbial short memories of people in the stock market—were eager to buy both old and new issues of unimportant companies at inflated levels. Thus the pendulum had swung clear to the oppo- site extreme. The very class of secondary issues that had formerly supplied by far the largest proportion of bargain opportunities was now presenting the greatest number of examples of overenthusi- asm and overvaluation. In a different way this phenomenon was repeated in 1961 and 1968—the emphasis now being placed on new offerings of

f people in the stock market—were eager to buy both old and new issues of unimportant companies at inflated levels. Thus the pendulum had swung clear to the oppo- site extreme. The very class of secondary issues that had formerly supplied by far the largest proportion of bargain opportunities was now presenting the greatest number of examples of overenthusi- asm and overvaluation. In a different way this phenomenon was repeated in 1961 and 1968—the emphasis now being placed on new offerings of the shares of small companies of less than second- ary character, and on nearly all companies in certain favored fields such as “electronics,” “computers,” “franchise” concerns, and oth- ers.* As was to be expected the ensuing market declines fell most heavily on these overvaluations. In some cases the pendulum swing may have gone as far as definite undervaluation. If most secondary issues tend normally to be undervalued, what reason has the investor to believe that he can profit from such a sit- uation? For if it persists indefinitely, will he not always be in the same market position as when he bought the issue? The answer here is somewhat complicated. Substantial profits from the pur- chase of secondary companies at bargain prices arise in a variety of ways. First, the dividend return is relatively high. Second, the rein- vested earnings are substantial in relation to the price paid and will ultimately affect the price. In a five- to seven-year period these advantages can bulk quite large in a well-selected list. Third, a bull market is ordinarily most generous to low-priced issues; thus it tends to raise the typical bargain issue to at least a reasonable level. Fourth, even during relatively featureless market periods a contin- uous process of price adjustment goes on, under which secondary issues that were undervalued may rise at least to the normal level for their type of security. Fifth, the specific factors that in many * From 1975 through 1983, small (“secondary”)

e large in a well-selected list. Third, a bull market is ordinarily most generous to low-priced issues; thus it tends to raise the typical bargain issue to at least a reasonable level. Fourth, even during relatively featureless market periods a contin- uous process of price adjustment goes on, under which secondary issues that were undervalued may rise at least to the normal level for their type of security. Fifth, the specific factors that in many * From 1975 through 1983, small (“secondary”) stocks outperformed large stocks by an amazing average of 17.6 percentage points per year. The investing public eagerly embraced small stocks, mutual fund companies rolled out hundreds of new funds specializing in them, and small stocks obliged by underperforming large stocks by five percentage points per year over the next decade. The cycle recurred in 1999, when small stocks beat big stocks by nearly nine percentage points, inspiring investment bankers to sell hundreds of hot little high-tech stocks to the public for the first time. Instead of “electronics,” “computers,” or “franchise” in their names, the new buzzwords were “.com,” “optical,” “wireless,” and even prefixes like “e-” and “I-.” Investing buzzwords always turn into buzz saws, tearing apart anyone who believes in them. cases made for a disappointing record of earnings may be cor- rected by the advent of new conditions, or the adoption of new policies, or by a change in management. An important new factor in recent years has been the acquisition of smaller companies by larger ones, usually as part of a diversifi- cation program. In these cases the consideration paid has almost always been relatively generous, and much in excess of the bargain levels existing not long before. When interest rates were much lower than in 1970, the field of bargain issues extended to bonds and preferred stocks that sold at large discounts from the amount of their claim. Currently we have a different situation in which even well-sec

has been the acquisition of smaller companies by larger ones, usually as part of a diversifi- cation program. In these cases the consideration paid has almost always been relatively generous, and much in excess of the bargain levels existing not long before. When interest rates were much lower than in 1970, the field of bargain issues extended to bonds and preferred stocks that sold at large discounts from the amount of their claim. Currently we have a different situation in which even well-secured issues sell at large discounts if carrying coupon rates of, say, 41⁄2% or less. Example: American Telephone & Telegraph 25⁄8s, due 1986, sold as low as 51 in 1970; Deere & Co. 41⁄2s, due 1983, sold as low as 62. These may well turn out to have been bargain opportunities before very long—if ruling interest rates should decline substantially. For a bargain bond issue in the more traditional sense perhaps we shall have to turn once more to the first-mortgage bonds of railroads now in financial difficulties, which sell in the 20s or 30s. Such situa- tions are not for the inexpert investor; lacking a real sense of values in this area, he may burn his fingers. But there is an underlying ten- dency for market decline in this field to be overdone; consequently the group as a whole offers an especially rewarding invitation to careful and courageous analysis. In the decade ending in 1948 the billion-dollar group of defaulted railroad bonds presented numer- ous and spectacular opportunities in this area. Such opportunities have been quite scarce since then; but they seem likely to return in the 1970s.* * Defaulted railroad bonds do not offer significant opportunities today. How- ever, as already noted, distressed and defaulted junk bonds, as well as con- vertible bonds issued by high-tech companies, may offer real value in the wake of the 2000–2002 market crash. But diversification in this area is essential—and impractical without at least $100,000 to dedicate to dis- tressed sec

in this area. Such opportunities have been quite scarce since then; but they seem likely to return in the 1970s.* * Defaulted railroad bonds do not offer significant opportunities today. How- ever, as already noted, distressed and defaulted junk bonds, as well as con- vertible bonds issued by high-tech companies, may offer real value in the wake of the 2000–2002 market crash. But diversification in this area is essential—and impractical without at least $100,000 to dedicate to dis- tressed securities alone. Unless you are a millionaire several times over, this kind of diversification is not an option. Special Situations, or “Workouts” Not so long ago this was a field which could almost guarantee an attractive rate of return to those who knew their way around in it; and this was true under almost any sort of general market situa- tion. It was not actually forbidden territory to members of the gen- eral public. Some who had a flair for this sort of thing could learn the ropes and become pretty capable practitioners without the necessity of long academic study or apprenticeship. Others have been keen enough to recognize the underlying soundness of this approach and to attach themselves to bright young men who handled funds devoted chiefly to these “special situations.” But in recent years, for reasons we shall develop later, the field of “arbi- trages and workouts” became riskier and less profitable. It may be that in years to come conditions in this field will become more propitious. In any case it is worthwhile outlining the general nature and origin of these operations, with one or two illustrative examples. The typical “special situation” has grown out of the increasing number of acquisitions of smaller firms by large ones, as the gospel of diversification of products has been adopted by more and more managements. It often appears good business for such an enter- prise to acquire an existing company in the field it wishes to enter rather than to start a new ven

ropitious. In any case it is worthwhile outlining the general nature and origin of these operations, with one or two illustrative examples. The typical “special situation” has grown out of the increasing number of acquisitions of smaller firms by large ones, as the gospel of diversification of products has been adopted by more and more managements. It often appears good business for such an enter- prise to acquire an existing company in the field it wishes to enter rather than to start a new venture from scratch. In order to make such acquisition possible, and to obtain acceptance of the deal by the required large majority of shareholders of the smaller company, it is almost always necessary to offer a price considerably above the current level. Such corporate moves have been producing inter- esting profit-making opportunities for those who have made a study of this field, and have good judgment fortified by ample experience. A great deal of money was made by shrewd investors not so many years ago through the purchase of bonds of railroads in bankruptcy—bonds which they knew would be worth much more than their cost when the railroads were finally reorganized. After promulgation of the plans of reorganization a “when issued” mar- ket for the new securities appeared. These could almost always be sold for considerably more than the cost of the old issues which were to be exchanged therefor. There were risks of nonconsumma- tion of the plans or of unexpected delays, but on the whole such “arbitrage operations” proved highly profitable. There were similar opportunities growing out of the breakup of public-utility holding companies pursuant to 1935 legislation. Nearly all these enterprises proved to be worth considerably more when changed from holding companies to a group of separate operating companies. The underlying factor here is the tendency of the security mar- kets to undervalue issues that are involved in any sort of compli- cated legal proceedings. An old Wall

whole such “arbitrage operations” proved highly profitable. There were similar opportunities growing out of the breakup of public-utility holding companies pursuant to 1935 legislation. Nearly all these enterprises proved to be worth considerably more when changed from holding companies to a group of separate operating companies. The underlying factor here is the tendency of the security mar- kets to undervalue issues that are involved in any sort of compli- cated legal proceedings. An old Wall Street motto has been: “Never buy into a lawsuit.” This may be sound advice to the speculator seeking quick action on his holdings. But the adoption of this atti- tude by the general public is bound to create bargain opportunities in the securities affected by it, since the prejudice against them holds their prices down to unduly low levels.* The exploitation of special situations is a technical branch of investment which requires a somewhat unusual mentality and equipment. Probably only a small percentage of our enterprising investors are likely to engage in it, and this book is not the appro- priate medium for expounding its complications.6 Broader Implications of Our Rules for Investment Investment policy, as it has been developed here, depends in the first place on a choice by the investor of either the defensive (pas- sive) or aggressive (enterprising) role. The aggressive investor must have a considerable knowledge of security values—enough, in fact, to warrant viewing his security operations as equivalent to a business enterprise. There is no room in this philosophy for a * A classic recent example is Philip Morris, whose stock lost 23% in two days after a Florida court authorized jurors to consider punitive damages of up to $200 billion against the company—which had finally admitted that cig- arettes may cause cancer. Within a year, Philip Morris’s stock had doubled— only to fall back after a later multibillion-dollar judgment in Illinois. Several other stocks have

ity operations as equivalent to a business enterprise. There is no room in this philosophy for a * A classic recent example is Philip Morris, whose stock lost 23% in two days after a Florida court authorized jurors to consider punitive damages of up to $200 billion against the company—which had finally admitted that cig- arettes may cause cancer. Within a year, Philip Morris’s stock had doubled— only to fall back after a later multibillion-dollar judgment in Illinois. Several other stocks have been virtually destroyed by liability lawsuits, including Johns Manville, W. R. Grace, and USG Corp. Thus, “never buy into a law- suit” remains a valid rule for all but the most intrepid investors to live by. middle ground, or a series of gradations, between the passive and aggressive status. Many, perhaps most, investors seek to place themselves in such an intermediate category; in our opinion that is a compromise that is more likely to produce disappointment than achievement. As an investor you cannot soundly become “half a business- man,” expecting thereby to achieve half the normal rate of business profits on your funds. It follows from this reasoning that the majority of security own- ers should elect the defensive classification. They do not have the time, or the determination, or the mental equipment to embark upon investing as a quasi-business. They should therefore be satis- fied with the excellent return now obtainable from a defensive portfolio (and with even less), and they should stoutly resist the recurrent temptation to increase this return by deviating into other paths. The enterprising investor may properly embark upon any secu- rity operation for which his training and judgment are adequate and which appears sufficiently promising when measured by estab- lished business standards. In our recommendations and caveats for this group of investors we have attempted to apply such business standards. In those for the defensive investor we have been guided largely

ey should stoutly resist the recurrent temptation to increase this return by deviating into other paths. The enterprising investor may properly embark upon any secu- rity operation for which his training and judgment are adequate and which appears sufficiently promising when measured by estab- lished business standards. In our recommendations and caveats for this group of investors we have attempted to apply such business standards. In those for the defensive investor we have been guided largely by the three requirements of underlying safety, simplicity of choice, and prom- ise of satisfactory results, in terms of psychology as well as arith- metic. The use of these criteria has led us to exclude from the field of recommended investment a number of security classes that are normally regarded as suitable for various kinds of investors. These prohibitions were listed in our first chapter on p. 30. Let us consider a little more fully than before what is implied in these exclusions. We have advised against the purchase at “full prices” of three important categories of securities: (1) foreign bonds, (2) ordinary preferred stocks, and (3) secondary common stocks, including, of course, original offerings of such issues. By “full prices” we mean prices close to par for bonds or preferred stocks, and prices that represent about the fair business value of the enterprise in the case of common stocks. The greater number of defensive investors are to avoid these categories regardless of price; the enterprising investor is to buy them only when obtain- able at bargain prices—which we define as prices not more than two-thirds of the appraisal value of the securities. What would happen if all investors were guided by our advice in these matters? That question was considered in regard to for- eign bonds, on p. 138, and we have nothing to add at this point. Investment-grade preferred stocks would be bought solely by cor- porations, such as insurance companies, which would benefit f

rice; the enterprising investor is to buy them only when obtain- able at bargain prices—which we define as prices not more than two-thirds of the appraisal value of the securities. What would happen if all investors were guided by our advice in these matters? That question was considered in regard to for- eign bonds, on p. 138, and we have nothing to add at this point. Investment-grade preferred stocks would be bought solely by cor- porations, such as insurance companies, which would benefit from the special income-tax status of stock issues owned by them. The most troublesome consequence of our policy of exclusion is in the field of secondary common stocks. If the majority of investors, being in the defensive class, are not to buy them at all, the field of possible buyers becomes seriously restricted. Further- more, if aggressive investors are to buy them only at bargain levels, then these issues would be doomed to sell for less than their fair value, except to the extent that they were purchased unintelli- gently. This may sound severe and even vaguely unethical. Yet in truth we are merely recognizing what has actually happened in this area for the greater part of the past 40 years. Secondary issues, for the most part, do fluctuate about a central level which is well below their fair value. They reach and even surpass that value at times; but this occurs in the upper reaches of bull markets, when the les- sons of practical experience would argue against the soundness of paying the prevailing prices for common stocks. Thus we are suggesting only that the aggressive investor recog- nize the facts of life as it is lived by secondary issues and that they accept the central market levels that are normal for that class as their guide in fixing their own levels for purchase. There is a paradox here, nevertheless. The average well-selected secondary company may be fully as promising as the average industrial leader. What the smaller concern lacks in inherent stabil- ity

aying the prevailing prices for common stocks. Thus we are suggesting only that the aggressive investor recog- nize the facts of life as it is lived by secondary issues and that they accept the central market levels that are normal for that class as their guide in fixing their own levels for purchase. There is a paradox here, nevertheless. The average well-selected secondary company may be fully as promising as the average industrial leader. What the smaller concern lacks in inherent stabil- ity it may readily make up in superior possibilities of growth. Con- sequently it may appear illogical to many readers to term “unintelligent” the purchase of such secondary issues at their full “enterprise value.” We think that the strongest logic is that of expe- rience. Financial history says clearly that the investor may expect satisfactory results, on the average, from secondary common stocks only if he buys them for less than their value to a private owner, that is, on a bargain basis. The last sentence indicates that this principle relates to the ordi- nary outside investor. Anyone who can control a secondary com- pany, or who is part of a cohesive group with such control, is fully justified in buying the shares on the same basis as if he were invest- ing in a “close corporation” or other private business. The distinc- tion between the position, and consequent investment policy, of insiders and of outsiders becomes more important as the enterprise itself becomes less important. It is a basic characteristic of a primary or leading company that a single detached share is ordinarily worth as much as a share in a controlling block. In secondary com- panies the average market value of a detached share is substantially less than its worth to a controlling owner. Because of this fact, the matter of shareholder-management relations and of those between inside and outside shareholders tends to be much more important and controversial in the case of secondary than in that of prim

t is a basic characteristic of a primary or leading company that a single detached share is ordinarily worth as much as a share in a controlling block. In secondary com- panies the average market value of a detached share is substantially less than its worth to a controlling owner. Because of this fact, the matter of shareholder-management relations and of those between inside and outside shareholders tends to be much more important and controversial in the case of secondary than in that of primary companies. At the end of Chapter 5 we commented on the difficulty of mak- ing any hard and fast distinction between primary and secondary companies. The many common stocks in the boundary area may properly exhibit an intermediate price behavior. It would not be illogical for an investor to buy such an issue at a small discount from its indicated or appraisal value, on the theory that it is only a small distance away from a primary classification and that it may acquire such a rating unqualifiedly in the not too distant future. Thus the distinction between primary and secondary issues need not be made too precise; for, if it were, then a small difference in quality must produce a large differential in justified purchase price. In saying this we are admitting a middle ground in the clas- sification of common stocks, although we counseled against such a middle ground in the classification of investors. Our reason for this apparent inconsistency is as follows: No great harm comes from some uncertainty of viewpoint regarding a single security, because such cases are exceptional and not a great deal is at stake in the matter. But the investor’s choice as between the defensive or the aggressive status is of major consequence to him, and he should not allow himself to be confused or compromised in this basic deci- sion. COMMENTARY ON CHAPTER 7 It requires a great deal of boldness and a great deal of caution to make a great fortune; and when you have got it, it requires ten ti

some uncertainty of viewpoint regarding a single security, because such cases are exceptional and not a great deal is at stake in the matter. But the investor’s choice as between the defensive or the aggressive status is of major consequence to him, and he should not allow himself to be confused or compromised in this basic deci- sion. COMMENTARY ON CHAPTER 7 It requires a great deal of boldness and a great deal of caution to make a great fortune; and when you have got it, it requires ten times as much wit to keep it. —Nathan Mayer Rothschild T IMIN G IS N O T HIN G In an ideal world, the intelligent investor would hold stocks only when they are cheap and sell them when they become overpriced, then duck into the bunker of bonds and cash until stocks again become cheap enough to buy. From 1966 through late 2001, one study claimed, $1 held continuously in stocks would have grown to $11.71. But if you had gotten out of stocks right before the five worst days of each year, your original $1 would have grown to $987.12.1 Like most magical market ideas, this one is based on sleight of hand. How, exactly, would you (or anyone) figure out which days will be the worst days—before they arrive? On January 7, 1973, the New York Times featured an interview with one of the nation’s top financial forecasters, who urged investors to buy stocks without hesitation: “It’s very rare that you can be as unqualifiedly bullish as you can now.” That forecaster was named Alan Greenspan, and it’s very rare that anyone 1 “The Truth About Timing,” Barron’s, November 5, 2001, p. 20. The headline of this article is a useful reminder of an enduring principle for the intelligent in- vestor. Whenever you see the word “truth” in an article about investing, brace yourself; many of the quotes that follow are likely to be lies. (For one thing, an investor who bought stocks in 1966 and held them through late 2001 would have ended up with at least $40, not $11.71; the study cited in Barron’s ap- pea

very rare that anyone 1 “The Truth About Timing,” Barron’s, November 5, 2001, p. 20. The headline of this article is a useful reminder of an enduring principle for the intelligent in- vestor. Whenever you see the word “truth” in an article about investing, brace yourself; many of the quotes that follow are likely to be lies. (For one thing, an investor who bought stocks in 1966 and held them through late 2001 would have ended up with at least $40, not $11.71; the study cited in Barron’s ap- pears to have ignored the reinvestment of dividends.) 179 has ever been so unqualifiedly wrong as the future Federal Reserve chairman was that day: 1973 and 1974 turned out to be the worst years for economic growth and the stock market since the Great Depression.2 Can professionals time the market any better than Alan Green- span? “I see no reason not to think the majority of the decline is behind us,” declared Kate Leary Lee, president of the market-timing firm of R. M. Leary & Co., on December 3, 2001. “This is when you want to be in the market,” she added, predicting that stocks “look good” for the first quarter of 2002.3 Over the next three months, stocks earned a measly 0.28% return, underperforming cash by 1.5 percentage points. Leary is not alone. A study by two finance professors at Duke Univer- sity found that if you had followed the recommendations of the best 10% of all market-timing newsletters, you would have earned a 12.6% annual- ized return from 1991 through 1995. But if you had ignored them and kept your money in a stock index fund, you would have earned 16.4%.4 As the Danish philosopher Søren Kierkegaard noted, life can only be understood backwards—but it must be lived forwards. Looking back, you can always see exactly when you should have bought and sold your stocks. But don’t let that fool you into thinking you can see, in real time, just when to get in and out. In the financial markets, hind- sight is forever 20/20, but foresight is legally blind. And thu

f you had ignored them and kept your money in a stock index fund, you would have earned 16.4%.4 As the Danish philosopher Søren Kierkegaard noted, life can only be understood backwards—but it must be lived forwards. Looking back, you can always see exactly when you should have bought and sold your stocks. But don’t let that fool you into thinking you can see, in real time, just when to get in and out. In the financial markets, hind- sight is forever 20/20, but foresight is legally blind. And thus, for most investors, market timing is a practical and emotional impossibility.5 2 The New York Times, January 7, 1973, special “Economic Survey” section, pp. 2, 19, 44. 3 Press release, “It’s a good time to be in the market, says R. M. Leary & Company,” December 3, 2001. 4 You would also have saved thousands of dollars in annual subscription fees (which have not been deducted from the calculations of these newslet- ters’ returns). And brokerage costs and short-term capital gains taxes are usually much higher for market timers than for buy-and-hold investors. For the Duke study, see John R. Graham and Campbell R. Harvey, “Grading the Performance of Market-Timing Newsletters,” Financial Analysts Journal, November/December, 1997, pp. 54–66, also available at www.duke.edu/ ~charvey/research.htm. 5 For more on sensible alternatives to market timing—rebalancing and dollar- cost averaging—see Chapters 5 and 8. W H A T G O E S U P . . . Like spacecraft that pick up speed as they rise into the Earth’s strato- sphere, growth stocks often seem to defy gravity. Let’s look at the tra- jectories of three of the hottest growth stocks of the 1990s: General Electric, Home Depot, and Sun Microsystems. (See Figure 7-1.) In every year from 1995 through 1999, each grew bigger and more profitable. Revenues doubled at Sun and more than doubled at Home Depot. According to Value Line, GE’s revenues grew 29%; its earnings rose 65%. At Home Depot and Sun, earnings per share roughly tripled. But so

the Earth’s strato- sphere, growth stocks often seem to defy gravity. Let’s look at the tra- jectories of three of the hottest growth stocks of the 1990s: General Electric, Home Depot, and Sun Microsystems. (See Figure 7-1.) In every year from 1995 through 1999, each grew bigger and more profitable. Revenues doubled at Sun and more than doubled at Home Depot. According to Value Line, GE’s revenues grew 29%; its earnings rose 65%. At Home Depot and Sun, earnings per share roughly tripled. But something else was happening—and it wouldn’t have surprised Graham one bit. The faster these companies grew, the more expen- sive their stocks became. And when stocks grow faster than compa- nies, investors always end up sorry. As Figure 7-2 shows: A great company is not a great investment if you pay too much for the stock. The more a stock has gone up, the more it seems likely to keep going up. But that instinctive belief is flatly contradicted by a fundamental law of financial physics: The bigger they get, the slower they grow. A $1- billion company can double its sales fairly easily; but where can a $50- billion company turn to find another $50 billion in business? Growth stocks are worth buying when their prices are reasonable, but when their price/earnings ratios go much above 25 or 30 the odds get ugly: • Journalist Carol Loomis found that, from 1960 through 1999, only eight of the largest 150 companies on the Fortune 500 list man- aged to raise their earnings by an annual average of at least 15% for two decades.6 • Looking at five decades of data, the research firm of Sanford C. Bernstein & Co. showed that only 10% of large U.S. companies had increased their earnings by 20% for at least five consecutive years; only 3% had grown by 20% for at least 10 years straight; and not a single one had done it for 15 years in a row.7 6 Carol J. Loomis, “The 15% Delusion,” Fortune, February 5, 2001, pp. 102–108. 7 See Jason Zweig, “A Matter of Expectations,” Money, January, 2001, p

of at least 15% for two decades.6 • Looking at five decades of data, the research firm of Sanford C. Bernstein & Co. showed that only 10% of large U.S. companies had increased their earnings by 20% for at least five consecutive years; only 3% had grown by 20% for at least 10 years straight; and not a single one had done it for 15 years in a row.7 6 Carol J. Loomis, “The 15% Delusion,” Fortune, February 5, 2001, pp. 102–108. 7 See Jason Zweig, “A Matter of Expectations,” Money, January, 2001, pp. 49–50. FIGURE 7-1 Up, Up, and Away 1995 1996 1997 1998 1999 General Electric Revenues ($ millions) 43,013 46,119 48,952 51,546 55,645 Earnings per share ($) 0.65 0.73 0.83 0.93 1.07 Yearly stock return (%) 44.5 40.0 50.6 40.7 53.2 Year-end price/earnings ratio 18.4 22.8 29.9 36.4 47.9 Home Depot Revenues ($ millions) 15,470 19,536 24,156 30,219 38,434 Earnings per share ($) 0.34 0.43 0.52 0.71 1.00 Yearly stock return (%) 4.2 5.5 76.8 108.3 68.8 Year-end price/earnings ratio 32.3 27.6 37.5 61.8 73.7 Sun Microsystems Revenues ($ millions) 5,902 7,095 8,598 9,791 11,726 Earnings per share ($) 0.11 0.17 0.24 0.29 0.36 Yearly stock return (%) 157.0 12.6 55.2 114.7 261.7 Year-end price/earnings ratio 20.3 17.7 17.9 34.5 97.7 Sources: Bloomberg, Value Line Notes: Revenues and earnings for fiscal years; stock return for calendar years; price/earnings ratio is December 31 price divided by reported earnings for previous four quarters. FIGURE 7-2 Look Out Below Stock price Stock price P/E ratio P/E ratio 12/31/99 12/31/02 12/31/99 March 2003 General Electric $51.58 $24.35 48.1 15.7 Home Depot $68.75 $23.96 97.4 14.3 Sun Microsystems $38.72 $38.72 123.3 n/a n/a: Not applicable; Sun had net loss in 2002. Sources: www.morningstar.com, yahoo.marketguide.com • An academic study of thousands of U.S. stocks from 1951 through 1998 found that over all 10-year periods, net earnings grew by an average of 9.7% annually. But for the biggest 20% of companies, earnings grew by

Stock price P/E ratio P/E ratio 12/31/99 12/31/02 12/31/99 March 2003 General Electric $51.58 $24.35 48.1 15.7 Home Depot $68.75 $23.96 97.4 14.3 Sun Microsystems $38.72 $38.72 123.3 n/a n/a: Not applicable; Sun had net loss in 2002. Sources: www.morningstar.com, yahoo.marketguide.com • An academic study of thousands of U.S. stocks from 1951 through 1998 found that over all 10-year periods, net earnings grew by an average of 9.7% annually. But for the biggest 20% of companies, earnings grew by an annual average of just 9.3%.8 Even many corporate leaders fail to understand these odds (see side- bar on p. 184). The intelligent investor, however, gets interested in big growth stocks not when they are at their most popular—but when some- thing goes wrong. In July 2002, Johnson & Johnson announced that Federal regulators were investigating accusations of false record keep- ing at one of its drug factories, and the stock lost 16% in a single day. That took J & J’s share price down from 24 times the previous 12 months’ earnings to just 20 times. At that lower level, Johnson & Johnson might once again have become a growth stock with room to grow—making it an example of what Graham calls “the relatively unpopular large company.” 9 This kind of temporary unpopularity can create lasting wealth by enabling you to buy a great company at a good price. 8 Louis K. C. Chan, Jason Karceski, and Josef Lakonishok, “The Level and Persistence of Growth Rates,” National Bureau of Economic Research, Working Paper No. 8282, May, 2001, available at www.nber.org/papers/ w8282. 9 Almost exactly 20 years earlier, in October 1982, Johnson & Johnson’s stock lost 17.5% of its value in a week when several people died after ingesting Tylenol that had been laced with cyanide by an unknown outsider. Johnson & Johnson responded by pioneering the use of tamper-proof packaging, and the stock went on to be one of the great investments of the 1980s. H I G H P O TE NTIAL F OR HYPE P O TE NTIAL Inves

ch, Working Paper No. 8282, May, 2001, available at www.nber.org/papers/ w8282. 9 Almost exactly 20 years earlier, in October 1982, Johnson & Johnson’s stock lost 17.5% of its value in a week when several people died after ingesting Tylenol that had been laced with cyanide by an unknown outsider. Johnson & Johnson responded by pioneering the use of tamper-proof packaging, and the stock went on to be one of the great investments of the 1980s. H I G H P O TE NTIAL F OR HYPE P O TE NTIAL Investors aren’t the only people who fall prey to the delusion that hyper-growth can go on forever. In February 2000, chief execu- tive John Roth of Nortel Networks was asked how much bigger his giant fiber-optics company could get. “The industry is grow- ing 14% to 15% a year,” Roth replied, “and we’re going to grow six points faster than that. For a company our size, that’s pretty heady stuff.” Nortel’s stock, up nearly 51% annually over the pre- vious six years, was then trading at 87 times what Wall Street was guessing it might earn in 2000. Was the stock overpriced? “It’s getting up there,” shrugged Roth, “but there’s still plenty of room to grow our valuation as we execute on the wireless strat- egy.” (After all, he added, Cisco Systems was trading at 121 times its projected earnings!)1 As for Cisco, in November 2000, its chief executive, John Chambers, insisted that his company could keep growing at least 50% annually. “Logic,” he declared, “would indicate this is a breakaway.” Cisco’s stock had come way down—it was then trading at a mere 98 times its earnings over the previous year— and Chambers urged investors to buy. “So who you going to bet on?” he asked. “Now may be the opportunity.” 2 Instead, these growth companies shrank—and their over- priced stocks shriveled. Nortel’s revenues fell by 37% in 2001, and the company lost more than $26 billion that year. Cisco’s revenues did rise by 18% in 2001, but the company ended up with a net loss of more than $1 billion. Nortel’

’s stock had come way down—it was then trading at a mere 98 times its earnings over the previous year— and Chambers urged investors to buy. “So who you going to bet on?” he asked. “Now may be the opportunity.” 2 Instead, these growth companies shrank—and their over- priced stocks shriveled. Nortel’s revenues fell by 37% in 2001, and the company lost more than $26 billion that year. Cisco’s revenues did rise by 18% in 2001, but the company ended up with a net loss of more than $1 billion. Nortel’s stock, at $113.50 when Roth spoke, finished 2002 at $1.65. Cisco’s shares, at $52 when Chambers called his company a “break- away,” crumbled to $13. Both companies have since become more circumspect about forecasting the future. 1 Lisa Gibbs, “Optic Uptick,” Money, April, 2000, pp. 54–55. 2 Brooke Southall, “Cisco’s Endgame Strategy,” InvestmentNews, November 30, 2000, pp. 1, 23. S H OU LD Y OU PUT ALL Y OU R E G G S I N ON E B AS K ET? “Put all your eggs into one basket and then watch that basket,” pro- claimed Andrew Carnegie a century ago. “Do not scatter your shot. ... The great successes of life are made by concentration.” As Gra- ham points out, “the really big fortunes from common stocks” have been made by people who packed all their money into one investment they knew supremely well. Nearly all the richest people in America trace their wealth to a con- centrated investment in a single industry or even a single company (think Bill Gates and Microsoft, Sam Walton and Wal-Mart, or the Rockefellers and Standard Oil). The Forbes 400 list of the richest Americans, for example, has been dominated by undiversified fortunes ever since it was first compiled in 1982. However, almost no small fortunes have been made this way—and not many big fortunes have been kept this way. What Carnegie neg- lected to mention is that concentration also makes most of the great failures of life. Look again at the Forbes “Rich List.” Back in 1982, the average net worth of a Forbes 400 member

rt, or the Rockefellers and Standard Oil). The Forbes 400 list of the richest Americans, for example, has been dominated by undiversified fortunes ever since it was first compiled in 1982. However, almost no small fortunes have been made this way—and not many big fortunes have been kept this way. What Carnegie neg- lected to mention is that concentration also makes most of the great failures of life. Look again at the Forbes “Rich List.” Back in 1982, the average net worth of a Forbes 400 member was $230 million. To make it onto the 2002 Forbes 400, the average 1982 member needed to earn only a 4.5% average annual return on his wealth— during a period when even bank accounts yielded far more than that and the stock market gained an annual average of 13.2%. So how many of the Forbes 400 fortunes from 1982 remained on the list 20 years later? Only 64 of the original members—a measly 16%—were still on the list in 2002. By keeping all their eggs in the one basket that had gotten them onto the list in the first place—once- booming industries like oil and gas, or computer hardware, or basic manufacturing—all the other original members fell away. When hard times hit, none of these people—despite all the huge advantages that great wealth can bring—were properly prepared. They could only stand by and wince at the sickening crunch as the constantly chang- ing economy crushed their only basket and all their eggs.10 10 For the observation that it is amazingly difficult to remain on the Forbes 400, I am indebted to investment manager Kenneth Fisher (himself a Forbes columnist). TH E B AR GAI N B I N You might think that in our endlessly networked world, it would be a cinch to build and buy a list of stocks that meet Graham’s criteria for bargains (p. 169). Although the Internet is a help, you’ll still have to do much of the work by hand. Grab a copy of today’s Wall Street Journal, turn to the “Money & Investing” section, and take a look at the NYSE and NASDAQ Score- cards to

Forbes 400, I am indebted to investment manager Kenneth Fisher (himself a Forbes columnist). TH E B AR GAI N B I N You might think that in our endlessly networked world, it would be a cinch to build and buy a list of stocks that meet Graham’s criteria for bargains (p. 169). Although the Internet is a help, you’ll still have to do much of the work by hand. Grab a copy of today’s Wall Street Journal, turn to the “Money & Investing” section, and take a look at the NYSE and NASDAQ Score- cards to find the day’s lists of stocks that have hit new lows for the past year—a quick and easy way to search for companies that might pass Graham’s net-working-capital tests. (Online, try http://quote. morningstar.com/highlow.html?msection=HighLow.) To see whether a stock is selling for less than the value of net work- ing capital (what Graham’s followers call “net nets”), download or request the most recent quarterly or annual report from the company’s website or from the EDGAR database at www.sec.gov. From the company’s current assets, subtract its total liabilities, including any preferred stock and long-term debt. (Or consult your local public library’s copy of the Value Line Investment Survey, saving yourself a costly annual subscription. Each issue carries a list of “Bargain Base- ment Stocks” that come close to Graham’s definition.) Most of these stocks lately have been in bombed-out areas like high-tech and telecommunications. As of October 31, 2002, for instance, Comverse Technology had $2.4 billion in current assets and $1.0 billion in total liabilities, giving it $1.4 billion in net working capital. With fewer than 190 million shares of stock, and a stock price under $8 per share, Comverse had a total market capitalization of just under $1.4 billion. With the stock priced at no more than the value of Comverse’s cash and inventories, the company’s ongoing business was essentially selling for nothing. As Graham knew, you can still lose money on a stock like Comverse— which

had $2.4 billion in current assets and $1.0 billion in total liabilities, giving it $1.4 billion in net working capital. With fewer than 190 million shares of stock, and a stock price under $8 per share, Comverse had a total market capitalization of just under $1.4 billion. With the stock priced at no more than the value of Comverse’s cash and inventories, the company’s ongoing business was essentially selling for nothing. As Graham knew, you can still lose money on a stock like Comverse— which is why you should buy them only if you can find a couple dozen at a time and hold them patiently. But on the very rare occasions when Mr. Market generates that many true bargains, you’re all but certain to make money. WHA T’S Y OU R F OR E I G N P OLI C Y? Investing in foreign stocks may not be mandatory for the intelligent investor, but it is definitely advisable. Why? Let’s try a little thought experiment. It’s the end of 1989, and you’re Japanese. Here are the facts: • Over the past 10 years, your stock market has gained an annual average of 21.2%, well ahead of the 17.5% annual gains in the United States. • Japanese companies are buying up everything in the United States from the Pebble Beach golf course to Rockefeller Center; meanwhile, American firms like Drexel Burnham Lambert, Finan- cial Corp. of America, and Texaco are going bankrupt. • The U.S. high-tech industry is dying. Japan’s is booming. In 1989, in the land of the rising sun, you can only conclude that investing outside of Japan is the dumbest idea since sushi vending machines. Naturally, you put all your money in Japanese stocks. The result? Over the next decade, you lose roughly two-thirds of your money. The lesson? It’s not that you should never invest in foreign markets like Japan; it’s that the Japanese should never have kept all their money at home. And neither should you. If you live in the United States, work in the United States, and get paid in U.S. dollars, you are already making a multilaye

outside of Japan is the dumbest idea since sushi vending machines. Naturally, you put all your money in Japanese stocks. The result? Over the next decade, you lose roughly two-thirds of your money. The lesson? It’s not that you should never invest in foreign markets like Japan; it’s that the Japanese should never have kept all their money at home. And neither should you. If you live in the United States, work in the United States, and get paid in U.S. dollars, you are already making a multilayered bet on the U.S. economy. To be prudent, you should put some of your investment portfolio elsewhere—simply because no one, anywhere, can ever know what the future will bring at home or abroad. Putting up to a third of your stock money in mutual funds that hold foreign stocks (including those in emerging markets) helps insure against the risk that our own backyard may not always be the best place in the world to invest. CHAPTER 8 The Investor and Market Fluctuations To the extent that the investor’s funds are placed in high-grade bonds of relatively short maturity—say, of seven years or less—he will not be affected significantly by changes in market prices and need not take them into account. (This applies also to his holdings of U.S. savings bonds, which he can always turn in at his cost price or more.) His longer-term bonds may have relatively wide price swings during their lifetimes, and his common-stock portfolio is almost certain to fluctuate in value over any period of several years. The investor should know about these possibilities and should be prepared for them both financially and psychologically. He will want to benefit from changes in market levels—certainly through an advance in the value of his stock holdings as time goes on, and perhaps also by making purchases and sales at advantageous prices. This interest on his part is inevitable, and legitimate enough. But it involves the very real danger that it will lead him into speculative attitudes and activit

eral years. The investor should know about these possibilities and should be prepared for them both financially and psychologically. He will want to benefit from changes in market levels—certainly through an advance in the value of his stock holdings as time goes on, and perhaps also by making purchases and sales at advantageous prices. This interest on his part is inevitable, and legitimate enough. But it involves the very real danger that it will lead him into speculative attitudes and activities. It is easy for us to tell you not to speculate; the hard thing will be for you to follow this advice. Let us repeat what we said at the outset: If you want to speculate do so with your eyes open, knowing that you will proba- bly lose money in the end; be sure to limit the amount at risk and to separate it completely from your investment program. We shall deal first with the more important subject of price changes in common stocks, and pass later to the area of bonds. In Chapter 3 we supplied a historical survey of the stock market’s action over the past hundred years. In this section we shall return to that material from time to time, in order to see what the past record promises the investor—in either the form of long-term appreciation of a portfolio held relatively unchanged through 188 successive rises and declines, or in the possibilities of buying near bear-market lows and selling not too far below bull-market highs. Market Fluctuations as a Guide to Investment Decisions Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which he may try to do this: the way of timing and the way of pricing. By timing we mean the endeavor to anticipate the action of the stock market—to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the c

Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which he may try to do this: the way of timing and the way of pricing. By timing we mean the endeavor to anticipate the action of the stock market—to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value. A less ambitious form of pricing is the simple effort to make sure that when you buy you do not pay too much for your stocks. This may suffice for the defen- sive investor, whose emphasis is on long-pull holding; but as such it represents an essential minimum of attention to market levels.1 We are convinced that the intelligent investor can derive satis- factory results from pricing of either type. We are equally sure that if he places his emphasis on timing, in the sense of forecasting, he will end up as a speculator and with a speculator’s financial results. This distinction may seem rather tenuous to the layman, and it is not commonly accepted on Wall Street. As a matter of business practice, or perhaps of thoroughgoing conviction, the stock brokers and the investment services seem wedded to the principle that both investors and speculators in common stocks should devote careful attention to market forecasts. The farther one gets from Wall Street, the more skepticism one will find, we believe, as to the pretensions of stock-market forecast- ing or timing. The investor can scarcely take seriously the innumer- able predictions which appear almost daily and are his for the asking. Yet in many cases he pays attention to them and even acts upon them. Why? Because he has been persuaded that it is impor- tant for him to for

nd speculators in common stocks should devote careful attention to market forecasts. The farther one gets from Wall Street, the more skepticism one will find, we believe, as to the pretensions of stock-market forecast- ing or timing. The investor can scarcely take seriously the innumer- able predictions which appear almost daily and are his for the asking. Yet in many cases he pays attention to them and even acts upon them. Why? Because he has been persuaded that it is impor- tant for him to form some opinion of the future course of the stock market, and because he feels that the brokerage or service forecast is at least more dependable than his own.* We lack space here to discuss in detail the pros and cons of mar- ket forecasting. A great deal of brain power goes into this field, and undoubtedly some people can make money by being good stock- market analysts. But it is absurd to think that the general public can ever make money out of market forecasts. For who will buy when the general public, at a given signal, rushes to sell out at a profit? If you, the reader, expect to get rich over the years by following some system or leadership in market forecasting, you must be expecting to try to do what countless others are aiming at, and to be able to do it better than your numerous competitors in the market. There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he is himself a part. There is one aspect of the “timing” philosophy which seems to have escaped everyone’s notice. Timing is of great psychological importance to the speculator because he wants to make his profit in * In the late 1990s, the forecasts of “market strategists” became more influ- ential than ever before. They did not, unfortunately, become more accurate. On March 10, 2000, the very day that the NASDAQ composite index hit its all-time high of 5048.62, Prudential Secur

lic, of which he is himself a part. There is one aspect of the “timing” philosophy which seems to have escaped everyone’s notice. Timing is of great psychological importance to the speculator because he wants to make his profit in * In the late 1990s, the forecasts of “market strategists” became more influ- ential than ever before. They did not, unfortunately, become more accurate. On March 10, 2000, the very day that the NASDAQ composite index hit its all-time high of 5048.62, Prudential Securities’s chief technical analyst Ralph Acampora said in USA Today that he expected NASDAQ to hit 6000 within 12 to 18 months. Five weeks later, NASDAQ had already shriveled to 3321.29—but Thomas Galvin, a market strategist at Donaldson, Lufkin & Jenrette, declared that “there’s only 200 or 300 points of downside for the NASDAQ and 2000 on the upside.” It turned out that there were no points on the upside and more than 2000 on the downside, as NASDAQ kept crashing until it finally scraped bottom on October 9, 2002, at 1114.11. In March 2001, Abby Joseph Cohen, chief investment strategist at Goldman, Sachs & Co., predicted that the Standard & Poor’s 500-stock index would close the year at 1,650 and that the Dow Jones Industrial Average would finish 2001 at 13,000. “We do not expect a recession,” said Cohen, “and believe that corporate profits are likely to grow at close to trend growth rates later this year.” The U.S. economy was sinking into recession even as she spoke, and the S & P 500 ended 2001 at 1148.08, while the Dow fin- ished at 10,021.50—30% and 23% below her forecasts, respectively. a hurry. The idea of waiting a year before his stock moves up is repugnant to him. But a waiting period, as such, is of no conse- quence to the investor. What advantage is there to him in having his money uninvested until he receives some (presumably) trust- worthy signal that the time has come to buy? He enjoys an advan- tage only if by waiting he succeeds in buying later at a sufficie

ended 2001 at 1148.08, while the Dow fin- ished at 10,021.50—30% and 23% below her forecasts, respectively. a hurry. The idea of waiting a year before his stock moves up is repugnant to him. But a waiting period, as such, is of no conse- quence to the investor. What advantage is there to him in having his money uninvested until he receives some (presumably) trust- worthy signal that the time has come to buy? He enjoys an advan- tage only if by waiting he succeeds in buying later at a sufficiently lower price to offset his loss of dividend income. What this means is that timing is of no real value to the investor unless it coincides with pricing—that is, unless it enables him to repurchase his shares at substantially under his previous selling price. In this respect the famous Dow theory for timing purchases and sales has had an unusual history.* Briefly, this technique takes its signal to buy from a special kind of “breakthrough” of the stock averages on the up side, and its selling signal from a similar break- through on the down side. The calculated—not necessarily actual—results of using this method showed an almost unbroken series of profits in operations from 1897 to the early 1960s. On the basis of this presentation the practical value of the Dow theory would have appeared firmly established; the doubt, if any, would apply to the dependability of this published “record” as a picture of what a Dow theorist would actually have done in the market. A closer study of the figures indicates that the quality of the results shown by the Dow theory changed radically after 1938— a few years after the theory had begun to be taken seriously on Wall Street. Its spectacular achievement had been in giving a sell signal, at 306, about a month before the 1929 crash and in keeping its followers out of the long bear market until things had pretty well righted themselves, at 84, in 1933. But from 1938 on the Dow theory operated mainly by taking its practitioners out at a pretty

figures indicates that the quality of the results shown by the Dow theory changed radically after 1938— a few years after the theory had begun to be taken seriously on Wall Street. Its spectacular achievement had been in giving a sell signal, at 306, about a month before the 1929 crash and in keeping its followers out of the long bear market until things had pretty well righted themselves, at 84, in 1933. But from 1938 on the Dow theory operated mainly by taking its practitioners out at a pretty good price but then putting them back in again at a higher price. For nearly 30 years thereafter, one would have done appreciably better by just buying and holding the DJIA.2 In our view, based on much study of this problem, the change in the Dow-theory results is not accidental. It demonstrates an inher- ent characteristic of forecasting and trading formulas in the fields of business and finance. Those formulas that gain adherents and * See p. 3. importance do so because they have worked well over a period, or sometimes merely because they have been plausibly adapted to the statistical record of the past. But as their acceptance increases, their reliability tends to diminish. This happens for two reasons: First, the passage of time brings new conditions which the old formula no longer fits. Second, in stock-market affairs the popularity of a trading theory has itself an influence on the market’s behavior which detracts in the long run from its profit-making possibilities. (The popularity of something like the Dow theory may seem to cre- ate its own vindication, since it would make the market advance or decline by the very action of its followers when a buying or selling signal is given. A “stampede” of this kind is, of course, much more of a danger than an advantage to the public trader.) Buy-Low–Sell-High Approach We are convinced that the average investor cannot deal success- fully with price movements by endeavoring to forecast them. Can he benefit from them after th

ularity of something like the Dow theory may seem to cre- ate its own vindication, since it would make the market advance or decline by the very action of its followers when a buying or selling signal is given. A “stampede” of this kind is, of course, much more of a danger than an advantage to the public trader.) Buy-Low–Sell-High Approach We are convinced that the average investor cannot deal success- fully with price movements by endeavoring to forecast them. Can he benefit from them after they have taken place—i.e., by buying after each major decline and selling out after each major advance? The fluctuations of the market over a period of many years prior to 1950 lent considerable encouragement to that idea. In fact, a classic definition of a “shrewd investor” was “one who bought in a bear market when everyone else was selling, and sold out in a bull mar- ket when everyone else was buying.” If we examine our Chart I, covering the fluctuations of the Standard & Poor’s composite index between 1900 and 1970, and the supporting figures in Table 3-1 (p. 66), we can readily see why this viewpoint appeared valid until fairly recent years. Between 1897 and 1949 there were ten complete market cycles, running from bear-market low to bull-market high and back to bear-market low. Six of these took no longer than four years, four ran for six or seven years, and one—the famous “new-era” cycle of 1921–1932—lasted eleven years. The percentage of advance from the lows to highs ranged from 44% to 500%, with most between about 50% and 100%. The percentage of subsequent declines ranged from 24% to 89%, with most found between 40% and 50%. (It should be remembered that a decline of 50% fully offsets a pre- ceding advance of 100%.) Nearly all the bull markets had a number of well-defined char- acteristics in common, such as (1) a historically high price level, (2) high price/earnings ratios, (3) low dividend yields as against bond yields, (4) much speculation on margin, and (5) man

44% to 500%, with most between about 50% and 100%. The percentage of subsequent declines ranged from 24% to 89%, with most found between 40% and 50%. (It should be remembered that a decline of 50% fully offsets a pre- ceding advance of 100%.) Nearly all the bull markets had a number of well-defined char- acteristics in common, such as (1) a historically high price level, (2) high price/earnings ratios, (3) low dividend yields as against bond yields, (4) much speculation on margin, and (5) many offerings of new common-stock issues of poor quality. Thus to the student of stock-market history it appeared that the intelligent investor should have been able to identify the recurrent bear and bull mar- kets, to buy in the former and sell in the latter, and to do so for the most part at reasonably short intervals of time. Various methods were developed for determining buying and selling levels of the general market, based on either value factors or percentage move- ments of prices or both. But we must point out that even prior to the unprecedented bull market that began in 1949, there were sufficient variations in the successive market cycles to complicate and sometimes frustrate the desirable process of buying low and selling high. The most notable of these departures, of course, was the great bull market of the late 1920s, which threw all calculations badly out of gear.* Even in 1949, therefore, it was by no means a certainty that the investor could base his financial policies and procedures mainly on the endeavor to buy at low levels in bear markets and to sell out at high levels in bull markets. It turned out, in the sequel, that the opposite was true. The * Without bear markets to take stock prices back down, anyone waiting to “buy low” will feel completely left behind—and, all too often, will end up abandoning any former caution and jumping in with both feet. That’s why Graham’s message about the importance of emotional discipline is so important. From October 19

and procedures mainly on the endeavor to buy at low levels in bear markets and to sell out at high levels in bull markets. It turned out, in the sequel, that the opposite was true. The * Without bear markets to take stock prices back down, anyone waiting to “buy low” will feel completely left behind—and, all too often, will end up abandoning any former caution and jumping in with both feet. That’s why Graham’s message about the importance of emotional discipline is so important. From October 1990 through January 2000, the Dow Jones Industrial Average marched relentlessly upward, never losing more than 20% and suffering a loss of 10% or more only three times. The total gain (not counting dividends): 395.7%. According to Crandall, Pierce & Co., this was the second-longest uninterrupted bull market of the past century; only the 1949–1961 boom lasted longer. The longer a bull market lasts, the more severely investors will be afflicted with amnesia; after five years or so, many people no longer believe that bear markets are even possible. All those who forget are doomed to be reminded; and, in the stock market, recovered memories are always unpleasant. market’s behavior in the past 20 years has not followed the former pattern, nor obeyed what once were well-established danger sig- nals, nor permitted its successful exploitation by applying old rules for buying low and selling high. Whether the old, fairly regular bull-and-bear-market pattern will eventually return we do not know. But it seems unrealistic to us for the investor to endeavor to base his present policy on the classic formula—i.e., to wait for demonstrable bear-market levels before buying any common stocks. Our recommended policy has, however, made provision for changes in the proportion of common stocks to bonds in the portfolio, if the investor chooses to do so, according as the level of stock prices appears less or more attractive by value stan- dards.* Formula Plans In the early years of the stock-mar

w. But it seems unrealistic to us for the investor to endeavor to base his present policy on the classic formula—i.e., to wait for demonstrable bear-market levels before buying any common stocks. Our recommended policy has, however, made provision for changes in the proportion of common stocks to bonds in the portfolio, if the investor chooses to do so, according as the level of stock prices appears less or more attractive by value stan- dards.* Formula Plans In the early years of the stock-market rise that began in 1949–50 considerable interest was attracted to various methods of taking advantage of the stock market’s cycles. These have been known as “formula investment plans.” The essence of all such plans—except the simple case of dollar averaging—is that the investor automati- cally does some selling of common stocks when the market advances substantially. In many of them a very large rise in the market level would result in the sale of all common-stock holdings; others provided for retention of a minor proportion of equities under all circumstances. This approach had the double appeal of sounding logical (and conservative) and of showing excellent results when applied retro- spectively to the stock market over many years in the past. Unfor- tunately, its vogue grew greatest at the very time when it was destined to work least well. Many of the “formula planners” found themselves entirely or nearly out of the stock market at some level in the middle 1950s. True, they had realized excellent profits, but in a broad sense the market “ran away” from them thereafter, and * Graham discusses this “recommended policy” in Chapter 4 (pp. 89–91). This policy, now called “tactical asset allocation,” is widely followed by insti- tutional investors like pension funds and university endowments. their formulas gave them little opportunity to buy back a common- stock position.* There is a similarity between the experience of those adopting the formula-investing approach in th

realized excellent profits, but in a broad sense the market “ran away” from them thereafter, and * Graham discusses this “recommended policy” in Chapter 4 (pp. 89–91). This policy, now called “tactical asset allocation,” is widely followed by insti- tutional investors like pension funds and university endowments. their formulas gave them little opportunity to buy back a common- stock position.* There is a similarity between the experience of those adopting the formula-investing approach in the early 1950s and those who embraced the purely mechanical version of the Dow theory some 20 years earlier. In both cases the advent of popularity marked almost the exact moment when the system ceased to work well. We have had a like discomfiting experience with our own “central value method” of determining indicated buying and selling levels of the Dow Jones Industrial Average. The moral seems to be that any approach to moneymaking in the stock market which can be easily described and followed by a lot of people is by its terms too simple and too easy to last.† Spinoza’s concluding remark applies to Wall Street as well as to philosophy: “All things excellent are as difficult as they are rare.” Market Fluctuations of the Investor’s Portfolio Every investor who owns common stocks must expect to see them fluctuate in value over the years. The behavior of the DJIA since our last edition was written in 1964 probably reflects pretty well what has happened to the stock portfolio of a conservative investor who limited his stock holdings to those of large, promi- nent, and conservatively financed corporations. The overall value advanced from an average level of about 890 to a high of 995 in * Many of these “formula planners” would have sold all their stocks at the end of 1954, after the U.S. stock market rose 52.6%, the second-highest yearly return then on record. Over the next five years, these market-timers would likely have stood on the sidelines as stocks doubled. † Easy ways t

vative investor who limited his stock holdings to those of large, promi- nent, and conservatively financed corporations. The overall value advanced from an average level of about 890 to a high of 995 in * Many of these “formula planners” would have sold all their stocks at the end of 1954, after the U.S. stock market rose 52.6%, the second-highest yearly return then on record. Over the next five years, these market-timers would likely have stood on the sidelines as stocks doubled. † Easy ways to make money in the stock market fade for two reasons: the natural tendency of trends to reverse over time, or “regress to the mean,” and the rapid adoption of the stock-picking scheme by large numbers of people, who pile in and spoil all the fun of those who got there first. (Note that, in referring to his “discomfiting experience,” Graham is—as always— honest in admitting his own failures.) See Jason Zweig, “Murphy Was an Investor,” Money, July, 2002, pp. 61–62, and Jason Zweig, “New Year’s Play,” Money, December, 2000, pp. 89–90. 1966 (and 985 again in 1968), fell to 631 in 1970, and made an almost full recovery to 940 in early 1971. (Since the individual issues set their high and low marks at different times, the fluc- tuations in the Dow Jones group as a whole are less severe than those in the separate components.) We have traced through the price fluctuations of other types of diversified and conservative common-stock portfolios and we find that the overall results are not likely to be markedly different from the above. In general, the shares of second-line companies* fluctuate more widely than the major ones, but this does not necessarily mean that a group of well- established but smaller companies will make a poorer showing over a fairly long period. In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent

ly to be markedly different from the above. In general, the shares of second-line companies* fluctuate more widely than the major ones, but this does not necessarily mean that a group of well- established but smaller companies will make a poorer showing over a fairly long period. In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.† A serious investor is not likely to believe that the day-to-day or even month-to-month fluctuations of the stock market make him richer or poorer. But what about the longer-term and wider changes? Here practical questions present themselves, and the psy- chological problems are likely to grow complicated. A substantial rise in the market is at once a legitimate reason for satisfaction and a cause for prudent concern, but it may also bring a strong tempta- tion toward imprudent action. Your shares have advanced, good! * Today’s equivalent of what Graham calls “second-line companies” would be any of the thousands of stocks not included in the Standard & Poor’s 500-stock index. A regularly revised list of the 500 stocks in the S & P index is available at www.standardandpoors.com. † Note carefully what Graham is saying here. It is not just possible, but prob- able, that most of the stocks you own will gain at least 50% from their low- est price and lose at least 33% from their highest price—regardless of which stocks you own or whether the market as a whole goes up or down. If you can’t live with that—or you think your portfolio is somehow magically exempt from it—then you are not yet entitled to call yourself an investor. (Graham refers to a 33% decline as the “equivalent one-third” because a 50% gain takes a $10 stock to $15. From $15, a 33% loss [or $5 drop] takes it right back to $10, where

n at least 50% from their low- est price and lose at least 33% from their highest price—regardless of which stocks you own or whether the market as a whole goes up or down. If you can’t live with that—or you think your portfolio is somehow magically exempt from it—then you are not yet entitled to call yourself an investor. (Graham refers to a 33% decline as the “equivalent one-third” because a 50% gain takes a $10 stock to $15. From $15, a 33% loss [or $5 drop] takes it right back to $10, where it started.) You are richer than you were, good! But has the price risen too high, and should you think of selling? Or should you kick yourself for not having bought more shares when the level was lower? Or— worst thought of all—should you now give way to the bull-market atmosphere, become infected with the enthusiasm, the overconfi- dence and the greed of the great public (of which, after all, you are a part), and make larger and dangerous commitments? Presented thus in print, the answer to the last question is a self-evident no, but even the intelligent investor is likely to need considerable will power to keep from following the crowd. It is for these reasons of human nature, even more than by calcu- lation of financial gain or loss, that we favor some kind of mechan- ical method for varying the proportion of bonds to stocks in the investor’s portfolio. The chief advantage, perhaps, is that such a formula will give him something to do. As the market advances he will from time to time make sales out of his stockholdings, putting the proceeds into bonds; as it declines he will reverse the proce- dure. These activities will provide some outlet for his otherwise too-pent-up energies. If he is the right kind of investor he will take added satisfaction from the thought that his operations are exactly opposite from those of the crowd.* Business Valuations versus Stock-Market Valuations The impact of market fluctuations upon the investor’s true situ- ation may be considered als

ime make sales out of his stockholdings, putting the proceeds into bonds; as it declines he will reverse the proce- dure. These activities will provide some outlet for his otherwise too-pent-up energies. If he is the right kind of investor he will take added satisfaction from the thought that his operations are exactly opposite from those of the crowd.* Business Valuations versus Stock-Market Valuations The impact of market fluctuations upon the investor’s true situ- ation may be considered also from the standpoint of the share- holder as the part owner of various businesses. The holder of marketable shares actually has a double status, and with it the privilege of taking advantage of either at his choice. On the one hand his position is analogous to that of a minority shareholder or silent partner in a private business. Here his results are entirely dependent on the profits of the enterprise or on a change in the underlying value of its assets. He would usually determine the value of such a private-business interest by calculating his share of the net worth as shown in the most recent balance sheet. On the * For today’s investor, the ideal strategy for pursuing this “formula” is rebal- ancing, which we discuss on pp. 104–105. other hand, the common-stock investor holds a piece of paper, an engraved stock certificate, which can be sold in a matter of minutes at a price which varies from moment to moment—when the mar- ket is open, that is—and often is far removed from the balance- sheet value.* The development of the stock market in recent decades has made the typical investor more dependent on the course of price quotations and less free than formerly to consider himself merely a business owner. The reason is that the successful enterprises in which he is likely to concentrate his holdings sell almost constantly at prices well above their net asset value (or book value, or “balance-sheet value”). In paying these market premiums the investor gives precious hostag

balance- sheet value.* The development of the stock market in recent decades has made the typical investor more dependent on the course of price quotations and less free than formerly to consider himself merely a business owner. The reason is that the successful enterprises in which he is likely to concentrate his holdings sell almost constantly at prices well above their net asset value (or book value, or “balance-sheet value”). In paying these market premiums the investor gives precious hostages to fortune, for he must depend on the stock market itself to validate his commitments.† This is a factor of prime importance in present-day investing, and it has received less attention than it deserves. The whole struc- ture of stock-market quotations contains a built-in contradiction. The better a company’s record and prospects, the less relationship the price of its shares will have to their book value. But the greater the premium above book value, the less certain the basis of deter- mining its intrinsic value—i.e., the more this “value” will depend on the changing moods and measurements of the stock market. Thus we reach the final paradox, that the more successful the com- pany, the greater are likely to be the fluctuations in the price of its shares. This really means that, in a very real sense, the better the * Most companies today provide “an engraved stock certificate” only upon special request. Stocks exist, for the most part, in purely electronic form (much as your bank account contains computerized credits and debits, not actual currency) and thus have become even easier to trade than they were in Graham’s day. † Net asset value, book value, balance-sheet value, and tangible-asset value are all synonyms for net worth, or the total value of a company’s physical and financial assets minus all its liabilities. It can be calculated using the bal- ance sheets in a company’s annual and quarterly reports; from total share- holders’ equity, subtract all “soft” assets

account contains computerized credits and debits, not actual currency) and thus have become even easier to trade than they were in Graham’s day. † Net asset value, book value, balance-sheet value, and tangible-asset value are all synonyms for net worth, or the total value of a company’s physical and financial assets minus all its liabilities. It can be calculated using the bal- ance sheets in a company’s annual and quarterly reports; from total share- holders’ equity, subtract all “soft” assets such as goodwill, trademarks, and other intangibles. Divide by the fully diluted number of shares outstanding to arrive at book value per share. quality of a common stock, the more speculative it is likely to be—at least as compared with the unspectacular middle-grade issues.* (What we have said applies to a comparison of the leading growth companies with the bulk of well-established concerns; we exclude from our purview here those issues which are highly speculative because the businesses themselves are speculative.) The argument made above should explain the often erratic price behavior of our most successful and impressive enterprises. Our favorite example is the monarch of them all—International Busi- ness Machines. The price of its shares fell from 607 to 300 in seven months in 1962–63; after two splits its price fell from 387 to 219 in 1970. Similarly, Xerox—an even more impressive earnings gainer in recent decades—fell from 171 to 87 in 1962–63, and from 116 to 65 in 1970. These striking losses did not indicate any doubt about the future long-term growth of IBM or Xerox; they reflected instead a lack of confidence in the premium valuation that the stock mar- ket itself had placed on these excellent prospects. The previous discussion leads us to a conclusion of practical importance to the conservative investor in common stocks. If he is to pay some special attention to the selection of his portfolio, it might be best for him to concentrate on issues selling at a reaso

se striking losses did not indicate any doubt about the future long-term growth of IBM or Xerox; they reflected instead a lack of confidence in the premium valuation that the stock mar- ket itself had placed on these excellent prospects. The previous discussion leads us to a conclusion of practical importance to the conservative investor in common stocks. If he is to pay some special attention to the selection of his portfolio, it might be best for him to concentrate on issues selling at a reason- ably close approximation to their tangible-asset value—say, at not more than one-third above that figure. Purchases made at such levels, or lower, may with logic be regarded as related to the * Graham’s use of the word “paradox” is probably an allusion to a classic article by David Durand, “Growth Stocks and the Petersburg Paradox,” The Journal of Finance, vol. XII, no. 3, September, 1957, pp. 348–363, which compares investing in high-priced growth stocks to betting on a series of coin flips in which the payoff escalates with each flip of the coin. Durand points out that if a growth stock could continue to grow at a high rate for an indefinite period of time, an investor should (in theory) be willing to pay an infinite price for its shares. Why, then, has no stock ever sold for a price of infinity dollars per share? Because the higher the assumed future growth rate, and the longer the time period over which it is expected, the wider the margin for error grows, and the higher the cost of even a tiny mis- calculation becomes. Graham discusses this problem further in Appendix 4 (p. 570). company’s balance sheet, and as having a justification or support independent of the fluctuating market prices. The premium over book value that may be involved can be considered as a kind of extra fee paid for the advantage of stock-exchange listing and the marketability that goes with it. A caution is needed here. A stock does not become a sound investment merely because it can be bought

st of even a tiny mis- calculation becomes. Graham discusses this problem further in Appendix 4 (p. 570). company’s balance sheet, and as having a justification or support independent of the fluctuating market prices. The premium over book value that may be involved can be considered as a kind of extra fee paid for the advantage of stock-exchange listing and the marketability that goes with it. A caution is needed here. A stock does not become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years. This may appear like demanding a lot from a modestly priced stock, but the prescription is not hard to fill under all but danger- ously high market conditions. Once the investor is willing to forgo brilliant prospects—i.e., better than average expected growth—he will have no difficulty in finding a wide selection of issues meeting these criteria. In our chapters on the selection of common stocks (Chapters 14 and 15) we shall give data showing that more than half of the DJIA issues met our asset-value criterion at the end of 1970. The most widely held investment of all—American Tel. & Tel.—actually sells below its tangible-asset value as we write. Most of the light-and- power shares, in addition to their other advantages, are now (early 1972) available at prices reasonably close to their asset values. The investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipli- ers of both earnings and tangible assets. As long as the earning power of his holdings remains satisfactory, he can give as little attention as he pleases to the vagaries of the stock market. More than that, at times he can use these vagaries to play the master g

prices reasonably close to their asset values. The investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipli- ers of both earnings and tangible assets. As long as the earning power of his holdings remains satisfactory, he can give as little attention as he pleases to the vagaries of the stock market. More than that, at times he can use these vagaries to play the master game of buying low and selling high. The A. & P. Example At this point we shall introduce one of our original examples, which dates back many years but which has a certain fascination for us because it combines so many aspects of corporate and investment experience. It involves the Great Atlantic & Pacific Tea Co. Here is the story: A. & P. shares were introduced to trading on the “Curb” market, now the American Stock Exchange, in 1929 and sold as high as 494. By 1932 they had declined to 104, although the company’s earnings were nearly as large in that generally catastrophic year as previ- ously. In 1936 the range was between 111 and 131. Then in the busi- ness recession and bear market of 1938 the shares fell to a new low of 36. That price was extraordinary. It meant that the preferred and common were together selling for $126 million, although the com- pany had just reported that it held $85 million in cash alone and a working capital (or net current assets) of $134 million. A. & P. was the largest retail enterprise in America, if not in the world, with a continuous and impressive record of large earnings for many years. Yet in 1938 this outstanding business was considered on Wall Street to be worth less than its current assets alone—which means less as a going concern than if it were liquidated. Why? First, because there were threats of special taxes on chain stores; second, because net profits had fallen off in the previous year; and, third, because the general market

P. was the largest retail enterprise in America, if not in the world, with a continuous and impressive record of large earnings for many years. Yet in 1938 this outstanding business was considered on Wall Street to be worth less than its current assets alone—which means less as a going concern than if it were liquidated. Why? First, because there were threats of special taxes on chain stores; second, because net profits had fallen off in the previous year; and, third, because the general market was depressed. The first of these reasons was an exaggerated and eventually groundless fear; the other two were typical of temporary influences. Let us assume that the investor had bought A. & P. common in 1937 at, say, 12 times its five-year average earnings, or about 80. We are far from asserting that the ensuing decline to 36 was of no importance to him. He would have been well advised to scrutinize the picture with some care, to see whether he had made any mis- calculations. But if the results of his study were reassuring—as they should have been—he was entitled then to disregard the mar- ket decline as a temporary vagary of finance, unless he had the funds and the courage to take advantage of it by buying more on the bargain basis offered. Sequel and Reflections The following year, 1939, A. & P. shares advanced to 1171⁄2, or three times the low price of 1938 and well above the average of 1937. Such a turnabout in the behavior of common stocks is by no means uncommon, but in the case of A. & P. it was more striking than most. In the years after 1949 the grocery chain’s shares rose with the general market until in 1961 the split-up stock (10 for 1) reached a high of 701⁄2 which was equivalent to 705 for the 1938 shares. This price of 701⁄2 was remarkable for the fact it was 30 times the earnings of 1961. Such a price/earnings ratio—which compares with 23 times for the DJIA in that year—must have implied expec- tations of a brilliant growth in earnings. This optimism had

ase of A. & P. it was more striking than most. In the years after 1949 the grocery chain’s shares rose with the general market until in 1961 the split-up stock (10 for 1) reached a high of 701⁄2 which was equivalent to 705 for the 1938 shares. This price of 701⁄2 was remarkable for the fact it was 30 times the earnings of 1961. Such a price/earnings ratio—which compares with 23 times for the DJIA in that year—must have implied expec- tations of a brilliant growth in earnings. This optimism had no jus- tification in the company’s earnings record in the preceding years, and it proved completely wrong. Instead of advancing rapidly, the course of earnings in the ensuing period was generally downward. The year after the 701⁄2 high the price fell by more than half to 34. But this time the shares did not have the bargain quality that they showed at the low quotation in 1938. After varying sorts of fluctua- tions the price fell to another low of 211⁄2 in 1970 and 18 in 1972— having reported the first quarterly deficit in its history. We see in this history how wide can be the vicissitudes of a major American enterprise in little more than a single generation, and also with what miscalculations and excesses of optimism and pessimism the public has valued its shares. In 1938 the business was really being given away, with no takers; in 1961 the public was clamoring for the shares at a ridiculously high price. After that came a quick loss of half the market value, and some years later a substantial further decline. In the meantime the company was to turn from an outstanding to a mediocre earnings performer; its profit in the boom-year 1968 was to be less than in 1958; it had paid a series of confusing small stock dividends not warranted by the current additions to surplus; and so forth. A. & P. was a larger com- pany in 1961 and 1972 than in 1938, but not as well-run, not as profitable, and not as attractive.* There are two chief morals to this story. The first is that the st

a substantial further decline. In the meantime the company was to turn from an outstanding to a mediocre earnings performer; its profit in the boom-year 1968 was to be less than in 1958; it had paid a series of confusing small stock dividends not warranted by the current additions to surplus; and so forth. A. & P. was a larger com- pany in 1961 and 1972 than in 1938, but not as well-run, not as profitable, and not as attractive.* There are two chief morals to this story. The first is that the stock market often goes far wrong, and sometimes an alert and coura- * The more recent history of A & P is no different. At year-end 1999, its share price was $27.875; at year-end 2000, $7.00; a year later, $23.78; at year-end 2002, $8.06. Although some accounting irregularities later came to light at A & P, it defies all logic to believe that the value of a relatively sta- ble business like groceries could fall by three-fourths in one year, triple the next year, then drop by two-thirds the year after that. geous investor can take advantage of its patent errors. The other is that most businesses change in character and quality over the years, sometimes for the better, perhaps more often for the worse. The investor need not watch his companies’ performance like a hawk; but he should give it a good, hard look from time to time. Let us return to our comparison between the holder of mar- ketable shares and the man with an interest in a private business. We have said that the former has the option of considering himself merely as the part owner of the various businesses he has invested in, or as the holder of shares which are salable at any time he wishes at their quoted market price. But note this important fact: The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more.* Thus the investor who permits h

e option of considering himself merely as the part owner of the various businesses he has invested in, or as the holder of shares which are salable at any time he wishes at their quoted market price. But note this important fact: The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more.* Thus the investor who permits himself to be stampeded or unduly wor- ried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment.† Incidentally, a widespread situation of this kind actually existed during the dark depression days of 1931–1933. There was then a psychological advantage in owning business interests that had no quoted market. For example, people who owned first mortgages on real estate that continued to pay interest were able to tell them- selves that their investments had kept their full value, there being no market quotations to indicate otherwise. On the other hand, many listed corporation bonds of even better quality and greater * “Only to the extent that it suits his book” means “only to the extent that the price is favorable enough to justify selling the stock.” In traditional brokerage lingo, the “book” is an investor’s ledger of holdings and trades. † This may well be the single most important paragraph in Graham’s entire book. In these 113 words Graham sums up his lifetime of experience. You cannot read these words too often; they are like Kryptonite for bear markets. If you keep them close at hand and let them guide you throughout your investing life, you will survive whatever the markets throw at you. underlying strength suffered severe shrinkage

In traditional brokerage lingo, the “book” is an investor’s ledger of holdings and trades. † This may well be the single most important paragraph in Graham’s entire book. In these 113 words Graham sums up his lifetime of experience. You cannot read these words too often; they are like Kryptonite for bear markets. If you keep them close at hand and let them guide you throughout your investing life, you will survive whatever the markets throw at you. underlying strength suffered severe shrinkages in their market quotations, thus making their owners believe they were growing distinctly poorer. In reality the owners were better off with the listed securities, despite the low prices of these. For if they had wanted to, or were compelled to, they could at least have sold the issues—possibly to exchange them for even better bargains. Or they could just as logically have ignored the market’s action as temporary and basically meaningless. But it is self-deception to tell yourself that you have suffered no shrinkage in value merely because your securities have no quoted market at all. Returning to our A. & P. shareholder in 1938, we assert that as long as he held on to his shares he suffered no loss in their price decline, beyond what his own judgment may have told him was occasioned by a shrinkage in their underlying or intrinsic value. If no such shrinkage had occurred, he had a right to expect that in due course the market quotation would return to the 1937 level or better—as in fact it did the following year. In this respect his posi- tion was at least as good as if he had owned an interest in a private business with no quoted market for its shares. For in that case, too, he might or might not have been justified in mentally lopping off part of the cost of his holdings because of the impact of the 1938 recession—depending on what had happened to his company. Critics of the value approach to stock investment argue that listed common stocks cannot properly be regarded or

act it did the following year. In this respect his posi- tion was at least as good as if he had owned an interest in a private business with no quoted market for its shares. For in that case, too, he might or might not have been justified in mentally lopping off part of the cost of his holdings because of the impact of the 1938 recession—depending on what had happened to his company. Critics of the value approach to stock investment argue that listed common stocks cannot properly be regarded or appraised in the same way as an interest in a similar private enterprise, because the presence of an organized security market “injects into equity ownership the new and extremely important attribute of liquidity.” But what this liquidity really means is, first, that the investor has the benefit of the stock market’s daily and changing appraisal of his holdings, for whatever that appraisal may be worth, and, second, that the investor is able to increase or decrease his investment at the market’s daily figure—if he chooses. Thus the existence of a quoted market gives the investor certain options that he does not have if his security is unquoted. But it does not impose the current quotation on an investor who prefers to take his idea of value from some other source. Let us close this section with something in the nature of a para- ble. Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. If you are a prudent investor or a sensible businessman, will you let Mr. Ma

day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position. The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed—this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such sig- nals are misleading at least as often as they are helpful. Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies. Summary The most realistic distinction betwee

n our view such sig- nals are misleading at least as often as they are helpful. Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies. Summary The most realistic distinction between the investor and the spec- ulator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell. It is far from certain that the typical investor should regularly hold off buying until low market levels appear, because this may involve a long wait, very likely the loss of income, and the possible missing of investment opportunities. On the whole it may be better for the investor to do his stock buying whenever he has money to put in stocks, except when the general market level is much higher than can be justified by well-established standards of value. If he wants to be shrewd he can look for the ever-present bargain oppor- tunities in individual securities. Aside from forecasting the movements of the general market, much effort and ability are directed on Wall Street toward selecting stocks or industrial groups that in matter of price will “do better” than the rest over a fairly short period in the future. Logical as this endeavor may seem, we do not believe it is suited to the needs or temperament of the true investor—particularly since

ue. If he wants to be shrewd he can look for the ever-present bargain oppor- tunities in individual securities. Aside from forecasting the movements of the general market, much effort and ability are directed on Wall Street toward selecting stocks or industrial groups that in matter of price will “do better” than the rest over a fairly short period in the future. Logical as this endeavor may seem, we do not believe it is suited to the needs or temperament of the true investor—particularly since he would be competing with a large number of stock-market traders and first- class financial analysts who are trying to do the same thing. As in all other activities that emphasize price movements first and underlying values second, the work of many intelligent minds con- stantly engaged in this field tends to be self-neutralizing and self- defeating over the years. The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market quotations are there for his conve- nience, either to be taken advantage of or to be ignored. He should never buy a stock because it has gone up or sell one because it has gone down. He would not be far wrong if this motto read more simply: “Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop.” An Added Consideration Something should be said about the significance of average mar- ket prices as a measure of managerial competence. The shareholder judges whether his own investment has been successful in terms both of dividends received and of the long-range trend of the aver- age market value. The same criteria should logically be applied in testing the effectiveness of a company’s management and the soundness of its attitude toward the owners of the business. This statement may sound like a truism, but it needs to be emphasized. For as yet there is n

ance of average mar- ket prices as a measure of managerial competence. The shareholder judges whether his own investment has been successful in terms both of dividends received and of the long-range trend of the aver- age market value. The same criteria should logically be applied in testing the effectiveness of a company’s management and the soundness of its attitude toward the owners of the business. This statement may sound like a truism, but it needs to be emphasized. For as yet there is no accepted technique or approach by which management is brought to the bar of market opinion. On the contrary, managements have always insisted that they have no responsibility of any kind for what happens to the market value of their shares. It is true, of course, that they are not accountable for those fluctuations in price which, as we have been insisting, bear no relationship to underlying conditions and values. But it is only the lack of alertness and intelligence among the rank and file of share- holders that permits this immunity to extend to the entire realm of market quotations, including the permanent establishment of a depreciated and unsatisfactory price level. Good managements produce a good average market price, and bad managements pro- duce bad market prices.* Fluctuations in Bond Prices The investor should be aware that even though safety of its prin- cipal and interest may be unquestioned, a long-term bond could vary widely in market price in response to changes in interest rates. In Table 8-1 we give data for various years back to 1902 covering yields for high-grade corporate and tax-free issues. As individual illustrations we add the price fluctuations of two representative railroad issues for a similar period. (These are the Atchison, Topeka & Santa Fe general mortgage 4s, due 1995, for generations one of our premier noncallable bond issues, and the Northern Pacific Ry. 3s, due 2047—originally a 150-year maturity!—long a typical Baa- rated bond.) Because

terest rates. In Table 8-1 we give data for various years back to 1902 covering yields for high-grade corporate and tax-free issues. As individual illustrations we add the price fluctuations of two representative railroad issues for a similar period. (These are the Atchison, Topeka & Santa Fe general mortgage 4s, due 1995, for generations one of our premier noncallable bond issues, and the Northern Pacific Ry. 3s, due 2047—originally a 150-year maturity!—long a typical Baa- rated bond.) Because of their inverse relationship the low yields correspond to the high prices and vice versa. The decline in the Northern * Graham has much more to say on what is now known as “corporate gov- ernance.” See the commentary on Chapter 19. Pacific 3s in 1940 represented mainly doubts as to the safety of the issue. It is extraordinary that the price recovered to an all-time high in the next few years, and then lost two-thirds of its price chiefly because of the rise in general interest rates. There have been star- tling variations, as well, in the price of even the highest-grade bonds in the past forty years. Note that bond prices do not fluctuate in the same (inverse) pro- portion as the calculated yields, because their fixed maturity value of 100% exerts a moderating influence. However, for very long maturities, as in our Northern Pacific example, prices and yields change at close to the same rate. Since 1964 record movements in both directions have taken place in the high-grade bond market. Taking “prime municipals” (tax- free) as an example, their yield more than doubled, from 3.2% in January 1965 to 7% in June 1970. Their price index declined, corre- spondingly, from 110.8 to 67.5. In mid-1970 the yields on high- grade long-term bonds were higher than at any time in the nearly 200 years of this country’s economic history.* Twenty-five years earlier, just before our protracted bull market began, bond yields were at their lowest point in history; long-term municipals returned a

et. Taking “prime municipals” (tax- free) as an example, their yield more than doubled, from 3.2% in January 1965 to 7% in June 1970. Their price index declined, corre- spondingly, from 110.8 to 67.5. In mid-1970 the yields on high- grade long-term bonds were higher than at any time in the nearly 200 years of this country’s economic history.* Twenty-five years earlier, just before our protracted bull market began, bond yields were at their lowest point in history; long-term municipals returned as little as 1%, and industrials gave 2.40% compared with the 41⁄2 to 5% for- merly considered “normal.” Those of us with a long experience on Wall Street had seen Newton’s law of “action and reaction, equal and opposite” work itself out repeatedly in the stock market—the most noteworthy example being the rise in the DJIA from 64 in 1921 to 381 in 1929, followed by a record collapse to 41 in 1932. But this time the widest pendulum swings took place in the usually staid and slow-moving array of high-grade bond prices and yields. Moral: Nothing important on Wall Street can be counted on to occur exactly in the same way as it happened before. This repre- * By what Graham called “the rule of opposites,” in 2002 the yields on long- term U.S. Treasury bonds hit their lowest levels since 1963. Since bond yields move inversely to prices, those low yields meant that prices had risen—making investors most eager to buy just as bonds were at their most expensive and as their future returns were almost guaranteed to be low. This provides another proof of Graham’s lesson that the intelligent investor must refuse to make decisions based on market fluctuations. TABLE 8-1 Fluctuations in Bond Yields, and in Prices of Two Representative Bond Issues, 1902–1970 Bond Yields Bond Prices S & P AAA S & P A. T. & S. F. Nor. Pac. Composite Municipals 4s, 1995 3s, 2047 1902 low 4.31% 3.11% 1905 high 1051⁄2 79 1920 high 6.40 5.28 1920 low 69 491⁄2 1928 low 4.53 3.90 1930 high 105 73

most guaranteed to be low. This provides another proof of Graham’s lesson that the intelligent investor must refuse to make decisions based on market fluctuations. TABLE 8-1 Fluctuations in Bond Yields, and in Prices of Two Representative Bond Issues, 1902–1970 Bond Yields Bond Prices S & P AAA S & P A. T. & S. F. Nor. Pac. Composite Municipals 4s, 1995 3s, 2047 1902 low 4.31% 3.11% 1905 high 1051⁄2 79 1920 high 6.40 5.28 1920 low 69 491⁄2 1928 low 4.53 3.90 1930 high 105 73 1932 high 5.52 5.27 1932 low 75 463⁄4 1946 low 2.44 1.45 1936 high 1171⁄4 851⁄4 1970 high 8.44 7.06 1939–40 low 991⁄2 311⁄2 1971 close 7.14 5.35 1946 high 141 943⁄4 1970 low 51 323⁄4 1971 close 64 371⁄4 sents the first half of our favorite dictum: “The more it changes, the more it’s the same thing.” If it is virtually impossible to make worthwhile predictions about the price movements of stocks, it is completely impossible to do so for bonds.* In the old days, at least, one could often find a useful clue to the coming end of a bull or bear market by studying the prior action of bonds, but no similar clues were given to a com- ing change in interest rates and bond prices. Hence the investor must choose between long-term and short-term bond investments on the basis chiefly of his personal preferences. If he wants to be certain that the market values will not decrease, his best choices are probably U.S. savings bonds, Series E or H, which were described above, p. 93. Either issue will give him a 5% yield (after the first year), the Series E for up to 55⁄6 years, the Series H for up to ten years, with a guaranteed resale value of cost or better. If the investor wants the 7.5% now available on good long-term corporate bonds, or the 5.3% on tax-free municipals, he must be prepared to see them fluctuate in price. Banks and insurance com- panies have the privilege of valuing high-rated bonds of this type on the mathematical basis of “amortized cost,” which disregards market

will give him a 5% yield (after the first year), the Series E for up to 55⁄6 years, the Series H for up to ten years, with a guaranteed resale value of cost or better. If the investor wants the 7.5% now available on good long-term corporate bonds, or the 5.3% on tax-free municipals, he must be prepared to see them fluctuate in price. Banks and insurance com- panies have the privilege of valuing high-rated bonds of this type on the mathematical basis of “amortized cost,” which disregards market prices; it would not be a bad idea for the individual investor to do something similar. The price fluctuations of convertible bonds and preferred stocks are the resultant of three different factors: (1) variations in the price of the related common stock, (2) variations in the credit standing of the company, and (3) variations in general interest rates. A good many of the convertible issues have been sold by companies that have credit ratings well below the best.3 Some of these were badly affected by the financial squeeze in 1970. As a result, convertible issues as a whole have been subjected to triply unsettling influences in recent years, and price variations have been unusually wide. In the typical case, therefore, the investor would delude himself if he expected to find in convertible issues that ideal combination of the safety of a high-grade bond and price * An updated analysis for today’s readers, explaining recent yields and the wider variety of bonds and bond funds available today, can be found in the commentary on Chapter 4. The Investor and Market Fluctuations 211 protection plus a chance to benefit from an advance in the price of the common. This may be a good place to make a suggestion about the “long- term bond of the future.” Why should not the effects of changing interest rates be divided on some practical and equitable basis between the borrower and the lender? One possibility would be to sell long-term bonds with interest payments that vary with an approp

today, can be found in the commentary on Chapter 4. The Investor and Market Fluctuations 211 protection plus a chance to benefit from an advance in the price of the common. This may be a good place to make a suggestion about the “long- term bond of the future.” Why should not the effects of changing interest rates be divided on some practical and equitable basis between the borrower and the lender? One possibility would be to sell long-term bonds with interest payments that vary with an appropriate index of the going rate. The main results of such an arrangement would be: (1) the investor’s bond would always have a principal value of about 100, if the company maintains its credit rating, but the interest received will vary, say, with the rate offered on conventional new issues; (2) the corporation would have the advantages of long-term debt—being spared problems and costs of frequent renewals of refinancing—but its interest costs would change from year to year.4 Over the past decade the bond investor has been confronted by an increasingly serious dilemma: Shall he choose complete stability of principal value, but with varying and usually low (short-term) interest rates? Or shall he choose a fixed-interest income, with considerable variations (usually downward, it seems) in his princi- pal value? It would be good for most investors if they could compromise between these extremes, and be assured that neither their interest return nor their principal value will fall below a stated minimum over, say, a 20-year period. This could be arranged, without great difficulty, in an appropriate bond contract of a new form. Important note: In effect the U.S. government has done a similar thing in its combination of the original savings- bonds contracts with their extensions at higher interest rates. The suggestion we make here would cover a longer fixed investment period than the savings bonds, and would introduce more flexibil- ity in the interest-rate provisions.* It is hardly

ated minimum over, say, a 20-year period. This could be arranged, without great difficulty, in an appropriate bond contract of a new form. Important note: In effect the U.S. government has done a similar thing in its combination of the original savings- bonds contracts with their extensions at higher interest rates. The suggestion we make here would cover a longer fixed investment period than the savings bonds, and would introduce more flexibil- ity in the interest-rate provisions.* It is hardly worthwhile to talk about nonconvertible preferred stocks, since their special tax status makes the safe ones much more desirable holdings by corporations—e.g., insurance companies— * As mentioned in the commentary on Chapters 2 and 4, Treasury Inflation- Protected Securities, or TIPS, are a new and improved version of what Gra- ham is suggesting here. than by individuals. The poorer-quality ones almost always fluctu- ate over a wide range, percentagewise, not too differently from common stocks. We can offer no other useful remark about them. Table 16-2 below, p. 406, gives some information on the price changes of lower-grade nonconvertible preferreds between Decem- ber 1968 and December 1970. The average decline was 17%, against 11.3% for the S & P composite index of common stocks. COMMENTARY ON CHAPTER 8 The happiness of those who want to be popular depends on others; the happiness of those who seek pleasure fluctuates with moods outside their control; but the happiness of the wise grows out of their own free acts. —Marcus Aurelius D R. J E KYLL AN D M R. MAR K ET Most of the time, the market is mostly accurate in pricing most stocks. Millions of buyers and sellers haggling over price do a remarkably good job of valuing companies—on average. But sometimes, the price is not right; occasionally, it is very wrong indeed. And at such times, you need to understand Graham’s image of Mr. Market, probably the most brilliant metaphor ever created for explaining how stocks