survival8

Reading from "A Note About Benjamin Graham by Jason Zweig"

Here are Graham's core investment priciples that he developed combining his extraordinary intellectual powers with profound common sense and vast experience which are at least as valid today as they were during his lifetime:

• A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price.

• The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists.

• The future value of every investment is a function of its present price. The higher the price you pay, the lower your return will be.

• No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on what Graham called the “margin of safety”—never overpaying, no matter how exciting an investment seems to be—can you minimize your odds of error.

• The secret to your financial success is inside yourself. If you become a critical thinker who takes no Wall Street “fact” on faith, and you invest with patient confidence, you can take steady advantage of even the worst bear markets. By developing your discipline and courage, you can refuse to let other people’s mood swings govern your financial destiny. In the end, how your investments behave is much less important than how you behave.

Introduction: What This Book Expects to Accomplish

In the past we have made a basic distinction between two kinds of investors to whom this book was addressed—the “defensive” and the “enterprising.” The defensive (or passive) investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions. The determining trait of the enterprising (or active, or aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort, in the form of a better average return than that realized by the passive investor. We have some doubt whether a really substantial extra recompense is promised to the active investor under today’s conditions. But next year or the years after may well be different. We shall accordingly continue to devote attention to the possibilities for enterprising investment, as they existed in former periods and may return.

It has long been the prevalent view that the art of successful investment lies first in the choice of those industries that are most likely to grow in the future and then in identifying the most promising companies in these industries. For example, smart investors—or their smart advisers—would long ago have recognized the great growth possibilities of the computer industry as a whole and of International Business Machines in particular. And similarly for a number of other growth industries and growth companies. But this is not as easy as it always looks in retrospect. To bring this point home at the outset let us add here a paragraph that we included first in the 1949 edition of this book.
Such an investor may for example be a buyer of air-transport stocks because he believes their future is even more brilliant than the trend the market already reflects. For this class of investor the value of our book will lie more in its warnings against the pitfalls lurking in this favorite investment approach than in any positive technique that will help him along his path.

[Note: “Air-transport stocks,” of course, generated as much excitement in the late 1940s and early 1950s as Internet stocks did a half century later. Among the hottest mutual funds of that era were Aeronautical Securities and theThe pitfalls have proved particularly dangerous in the industry we mentioned. It was, of course, easy to forecast that the volume of air traffic would grow spectacularly over the years. Because of this factor their shares became a favorite choice of the investment funds. But despite the expansion of revenues—at a pace even greater than in the computer industry—a combination of technological problems and overexpansion of capacity made for fluctuating and even disastrous profit figures. In the year 1970, despite a new high in traffic figures, the airlines sustained a loss of some $200 million for their shareholders. (They had shown losses also in 1945 and 1961.) The stocks of these companies once again showed a greater decline in 1969–70 than did the general market. The record shows that even the highly paid full-time experts of the mutual funds were completely wrong about the fairly short-term future of a major and nonesoteric industry.

Missiles-Rockets-Jets & Automation Fund. They, like the stocks they owned, turned out to be an investing disaster. It is commonly accepted today that the cumulative earnings of the airline industry over its entire history have been negative. The lesson Graham is driving at is not that you should avoid buying airline stocks, but that you should never succumb to the “certainty” that any industry will outperform all others in the future.]

On the other hand, while the investment funds had substantial investments and substantial gains in IBM, the combination of its apparently high price and the impossibility of being certain about its rate of growth prevented them from having more than, say, 3% of their funds in this wonderful performer. Hence the effect of this excellent choice on their overall results was by no means decisive. Furthermore, many—if not most—of their investments in computer-industry companies other than IBM appear to have been unprofitable. From these two broad examples we draw two morals for our readers:

1. Obvious prospects for physical growth in a business do not translate into obvious profits for investors.

2. The experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries.

~ ~ ~

Additionally, we hope to implant in the reader a tendency to measure or quantify. For 99 issues out of 100 we could say that at some price they are cheap enough to buy and at some other price they would be so dear that they should be sold. The habit of relating what is paid to what is being offered is an invaluable trait in investment. In an article in a women’s magazine many years ago we advised the readers to buy their stocks as they bought their groceries, not as they bought their perfume. The really dreadful losses of the past few years (and on many similar occasions before) were realized in those common-stock issues where the buyer forgot to ask “How much?”

CALCULATION OF TANGIBLE ASSET VALUE:

Tangible assets include a company’s physical property (like real estate, factories, equipment, and inventories) as well as its financial balances (such as cash, short-term investments, and accounts receivable). Among the elements not included in tangible assets are brands, copyrights, patents, franchises, goodwill, and trademarks.

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 balance sheets in a company’s annual and quarterly reports; from total shareholders’ 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.

COMMENTARY ON THE INTRODUCTION

This book will teach you three powerful lessons:
• how you can minimize the odds of suffering irreversible losses;
• how you can maximize the chances of achieving sustainable gains;
• how you can control the self-defeating behavior that keeps most investors from reaching their full potential.

THE BEAR MARKET SILVER LINING

Graham shows in Chapter 8 that "The intelligent investor" realizes that stocks become more risky, not less, as their prices rise—and less risky, not more, as their prices fall. The intelligent investor dreads a bull market, since it makes stocks more costly to buy. And conversely (so long as you keep enough cash on hand to meet your spending needs), you should welcome a bear market, since it puts stocks back on sale.
So take heart: The death of the bull market is not the bad news everyone believes it to be. Thanks to the decline in stock prices, now is a considerably safer—and saner—time to be building wealth. Read on, and let Graham show you how.

The only exception to this rule is an investor in the advanced stage of retirement, who may not be able to outlast a long bear market. Yet even an elderly investor should not sell her stocks merely because they have gone down in price; that approach not only turns her paper losses into real ones but deprives her heirs of the potential to inherit those stocks at lower costs for tax purposes.

CHAPTER 1. INVESTMENT VERSUS SPECULATION: RESULTS TO BE EXPECTED BY THE INTELLIGENT INVESTOR

Investment versus Speculation

An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

~ ~ ~

Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common-stock situations there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone. There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are:

(1) speculating when you think you are investing;
(2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and
(3) risking more money in speculation than you can afford to lose.

Speculation is beneficial on two levels: First, without speculation, untested new companies (like Amazon.com or, in earlier times, the Edison Electric Light Co.) would never be able to raise the necessary capital for expansion.
The alluring, long-shot chance of a huge gain is the grease that lubricates the machinery of innovation. Secondly, risk is exchanged (but never eliminated) every time a stock is bought or sold. The buyer purchases the primary risk that this stock may go down. Meanwhile, the seller still retains a residual risk—the chance that the stock he just sold may go up!

~ ~ ~

DECIDING BETWEEN STOCKS AND BONDS

Let us assume that now, as in the past, the basic policy decision to be made is how to divide the fund between high-grade bonds (or other so-called “cash equivalents”) and leading DJIA-type stocks. What course should the investor follow under present conditions, if we have no strong reason to predict either a significant upward or a significant downward movement for some time in the future? First let us point out that if there is no serious adverse change, the defensive investor should be able to count on the current 3.5% dividend return on his stocks and also on an average annual appreciation of about 4%. As we shall explain later this appreciation is based essentially on the reinvestment by the various companies of a corresponding amount annually out of undistributed profits. On a before-tax basis the combined return of his stocks would then average, say, 7.5%, somewhat less than his interest on high-grade bonds. On an after-tax basis the average return on stocks would work out at some 5.3%. This would be about the same as is now obtainable on good tax-free medium-term bonds.

How well did Graham’s forecast pan out? At first blush, it seems, very well: From the beginning of 1972 through the end of 1981, stocks earned an annual average return of 6.5%. (Graham did not specify the time period for his forecast, but it’s plausible to assume that he was thinking of a 10- year time horizon.) However, inflation raged at 8.6% annually over this period, eating up the entire gain that stocks produced. In this section of his chapter, Graham is summarizing what is known as the “Gordon equation,” which essentially holds that the stock market’s future return is the sum of the current dividend yield plus expected earnings growth. With a dividend yield of just under 2% in early 2003, and long-term earnings growth of around 2%, plus inflation at a bit over 2%, a future average annual return of roughly 6% is plausible. (See the commentary on Chapter 3 in the book.)

~ ~ ~

We have already defined the defensive investor as one interested chiefly in safety plus freedom from bother.

Let us mention briefly three supplementary concepts or practices for the defensive investor.

(1) The first is the purchase of the shares of well-established investment funds as an alternative to creating his own common-stock portfolio.

(2) He might also utilize one of the “common trust funds,” or “commingled funds,” operated by trust companies and banks in many states; or, if his funds are substantial, use the services of a recognized investment-counsel firm. This will give him professional administration of his investment program along standard lines.

(3) The third is the device of “dollar-cost averaging,” which means simply that the practitioner invests in common stocks the same number of dollars each month or each quarter. In this way he buys more shares when the market is low than when it is high, and he is likely to end up with a satisfactory overall price for all his holdings. Strictly speaking, this method is an application of a broader approach known as “formula investing.” The latter was already alluded to in our suggestion that the investor may vary his holdings of common stocks between the 25% minimum and the 75% maximum, in inverse relationship to the action of the market. These ideas have merit for the defensive investor, and they will be discussed more amply in later chapters.

Results to Be Expected by the Aggressive Investor

First let us consider several ways in which aggressive investors and speculators generally have endeavored to obtain better than average results. These include:

1. Trading in the market. This usually means buying stocks when the market has been advancing and selling them after it has turned downward. The stocks selected are likely to be among those which have been “behaving” better than the market average. A small number of professionals frequently engage in short selling.
Here they will sell issues they do not own but borrow through the established mechanism of the stock exchanges. Their object is to benefit from a subsequent decline in the price of these issues, by buying them back at a price lower than they sold them for.

2. Short-term selectivity. This means buying stocks of companies which are reporting or expected to report increased earnings, or for which some other favorable development is anticipated.

3. Long-term selectivity. Here the usual emphasis is on an excellent record of past growth, which is considered likely to continue in the future. In some cases also the “investor” may choose companies which have not yet shown impressive results, but are expected to establish a high earning power later. (Such companies belong frequently in some technological area—e.g., computers, drugs, electronics—and they often are developing new processes or products that are deemed to be especially promising.)

We have already expressed a negative view about the investor’s overall chances of success in these areas of activity. The first we have ruled out, on both theoretical and realistic grounds, from the domain of investment. Stock trading is not an operation “which, on thorough analysis, offers safety of principal and a satisfactory return.”

In his endeavor to select the most promising stocks either for the near term or the longer future, the investor faces obstacles of two kinds—the first stemming from human fallibility and the second from the nature of his competition. He may be wrong in his estimate of the future; or even if he is right, the current market price may already fully reflect what he is anticipating. In the area of near-term selectivity, the current year’s results of the company are generally common property on Wall Street; next year’s results, to the extent they are predictable, are already being carefully considered. Hence the investor who selects issues chiefly on the basis of this year’s superior results, or on what he is told he may expect for next year, is likely to find that others have done the same thing for the same reason.
In choosing stocks for their long-term prospects, the investor’s handicaps are basically the same. The possibility of outright error in the prediction—which we illustrated by our airlines example earlier (and on page 6 in the book)—is no doubt greater than when dealing with near-term earnings. Because the experts frequently go astray in such forecasts, it is theoretically possible for an investor to benefit greatly by making correct predictions when Wall Street as a whole is making incorrect ones. But that is only theoretical. How many enterprising investors could count on having the acumen or prophetic gift to beat the professional analysts at their favorite game of estimating long-term future earnings? We are thus led to the following logical if disconcerting conclusion: To enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising, and (2) not popular on Wall Street.

In “selling short” (or “shorting”) a stock, you make a bet that its share price will go down, not up. Shorting is a three-step process:

(1) First, you borrow shares from someone who owns them;
(2) then you immediately sell the borrowed shares;
(3) finally, you replace them with shares you buy later.

If the stock drops, you will be able to buy your replacement shares at a lower price. The difference between the price at which you sold your borrowed shares and the price you paid for the replacement shares is your gross profit (reduced by dividend or interest charges, along with brokerage costs). However, if the stock goes up in price instead of down, your potential loss is unlimited—making short sales unacceptably speculative for most individual investors.

COMMENTARY ON CHAPTER 1

Graham’s definition of investing could not be clearer: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.”
Graham goes even further, fleshing out each of the key terms in his definition: “thorough analysis” means “the study of the facts in the light of established standards of safety and value” while “safety of principal” signifies “protection against loss under all normal or reasonably likely conditions or variations” and “adequate” (or “satisfactory”) return refers to “any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.”

Note that investing, according to Graham, consists equally of three elements:

• you must thoroughly analyze a company, and the soundness of its underlying businesses, before you buy its stock;
• you must deliberately protect yourself against serious losses;
• you must aspire to “adequate,” not extraordinary, performance.

An investor calculates what a stock is worth, based on the value of its businesses. A speculator gambles that a stock will go up in price because somebody else will pay even more for it. As Graham once put it, investors judge “the market price by established standards of value,” while speculators “base [their] standards of value upon the market price.” 2 For a speculator, the incessant stream of stock quotes is like oxygen; cut it off and he dies. For an investor, what Graham called “quotational” values matter much less. Graham urges you to invest only if you would be comfortable owning a stock even if you had no way of knowing its daily share price.

As Graham advised in an interview, “Ask yourself: If there was no market for these shares, would I be willing to have an investment in this company on these terms?” (Forbes, January 1, 1972, p. 90.)

The intelligent investor never dumps a stock purely because its share price has fallen; she always asks first whether the value of the company’s underlying businesses has changed.

Like casino gambling or betting on the horses, speculating in the market can be exciting or even rewarding (if you happen to get lucky).
But it’s the worst imaginable way to build your wealth. That’s because Wall Street, like Las Vegas or the racetrack, has calibrated the odds so that the house always prevails, in the end, against everyone who tries to beat the house at its own speculative game.
On the other hand, investing is a unique kind of casino—one where you cannot lose in the end, so long as you play only by the rules that put the odds squarely in your favor. People who invest make money for themselves; people who speculate make money for their brokers. And that, in turn, is why Wall Street perennially downplays the durable virtues of investing and hypes the gaudy appeal of speculation.

To see why temporarily high returns don’t prove anything, imagine that two places are 130 miles apart. If I observe the 65-mph speed limit, I can drive that distance in two hours. But if I drive 130 mph, I can get there in one hour. If I try this and survive, am I “right”? Should you be tempted to try it, too, because you hear me bragging that it “worked”? Flashy gimmicks for beating the market are much the same: In short streaks, so long as your luck holds out, they work. Over time, they will get you killed.

FROM FORMULA TO FIASCO

But trading as if your underpants are on fire is not the only form of speculation. Throughout the past decade or so, one speculative formula after another was promoted, popularized, and then thrown aside.
All of them shared a few traits—This is quick! This is easy! And it won’t hurt a bit!—and all of them violated at least one of Graham’s distinctions between investing and speculating. Here are a few of the trendy formulas that fell flat:

• Cash in on the calendar.

The “January effect”—the tendency of small stocks to produce big gains around the turn of the year— was widely promoted in scholarly articles and popular books published in the 1980s. These studies showed that if you piled into small stocks in the second half of December and held them into January, you would beat the market by five to 10 percentage points. That amazed many experts. After all, if it were this easy, surely everyone would hear about it, lots of people would do it, and the opportunity would wither away.
What caused the January jolt? First of all, many investors sell their crummiest stocks late in the year to lock in losses that can cut their tax bills. Second, professional money managers grow more cautious as the year draws to a close, seeking to preserve their outperformance (or minimize their underperformance). That makes them reluctant to buy (or even hang on to) a falling stock.
And if an underperforming stock is also small and obscure, a money manager will be even less eager to show it in his year-end list of holdings. All these factors turn small stocks into momentary bargains; when the tax-driven selling ceases in January, they typically bounce back, producing a robust and rapid gain.
The January effect has not withered away, but it has weakened.
According to finance professor William Schwert of the University of Rochester, if you had bought small stocks in late December and sold them in early January, you would have beaten the market by 8.5 percentage points from 1962 through 1979, by 4.4 points from 1980 through 1989, and by 5.8 points from 1990 through 2001.10
As more people learned about the January effect, more traders bought small stocks in December, making them less of a bargain and thus reducing their returns. Also, the January effect is biggest among the smallest stocks—but according to Plexus Group, the leading authority on brokerage expenses, the total cost of buying and selling such tiny stocks can run up to 8% of your investment. Sadly, by the time you’re done paying your broker, all your gains on the January effect will melt away.

• Just do “what works.”

In 1996, an obscure money manager named James O’Shaughnessy published a book called What Works on Wall Street. In it, he argued that “investors can do much better than the market.” O’Shaughnessy made a stunning claim: From 1954 through 1994, you could have turned $10,000 into $8,074,504, beating the market by more than 10-fold—a towering 18.2% average annual return. How? By buying a basket of 50 stocks with the highest one-year returns, five straight years of rising earnings, and share prices less than 1.5 times their corporate revenues.12 As if he were the Edison of Wall Street,
O’Shaughnessy obtained U.S. Patent No. 5,978,778 for his “automated strategies” and launched a group of four mutual funds based on his findings. By late 1999 the funds had sucked in more than $175 million from the public—and, in his annual letter to shareholders, O’Shaughnessy stated grandly: “As always, I hope that together, we can reach our long-term goals by staying the course and sticking with our time-tested investment strategies.”
But “what works on Wall Street” stopped working right after O’Shaughnessy publicized it. Two of his funds stank so badly that they shut down in early 2000, and the overall stock market (as measured by the S&P 500 index) walloped every O’Shaughnessy fund almost nonstop for nearly four years running.

In June 2000, O’Shaughnessy moved closer to his own “longterm goals” by turning the funds over to a new manager, leaving his customers to fend for themselves with those “time-tested investment strategies.”

• Follow “The Foolish Four.”

In the mid-1990s, the Motley Fool website (and several books) hyped the daylights out of a technique called “The Foolish Four.” According to the Motley Fool, you would have “trashed the market averages over the last 25 years” and could “crush your mutual funds” by spending “only 15 minutes a year” on planning your investments. Best of all, this technique had “minimal risk.” All you needed to do was this:

1. Take the five stocks in the Dow Jones Industrial Average with the lowest stock prices and highest dividend yields.
2. Discard the one with the lowest price.
3. Put 40% of your money in the stock with the second-lowest price.
4. Put 20% in each of the three remaining stocks.
5. One year later, sort the Dow the same way and reset the portfolio according to steps 1 through 4.
6. Repeat until wealthy.

Over a 25-year period, the Motley Fool claimed, this technique would have beaten the market by a remarkable 10.1 percentage points annually. Over the next two decades, they suggested,
$20,000 invested in The Foolish Four should flower into $1,791,000. (And, they claimed, you could do still better by picking the five Dow stocks with the highest ratio of dividend yield to the square root of stock price, dropping the one that scored the highest, and buying the next four.)

Let’s consider whether this “strategy” could meet Graham’s definitions of an investment:
• What kind of “thorough analysis” could justify discarding the stock with the single most attractive price and dividend—but keeping the four that score lower for those desirable qualities?
• How could putting 40% of your money into only one stock be a “minimal risk”?
• And how could a portfolio of only four stocks be diversified enough to provide “safety of principal”?

The Foolish Four, in short, was one of the most cockamamie stock-picking formulas ever concocted. The Fools made the same mistake as O’Shaughnessy: If you look at a large quantity of data long enough, a huge number of patterns will emerge—if only by chance. By random luck alone, the companies that produce above-average stock returns will have plenty of things in common.

But unless those factors cause the stocks to outperform, they can’t be used to predict future returns.
None of the factors that the Motley Fools “discovered” with such fanfare—dropping the stock with the best score, doubling up on the one with the second-highest score, dividing the dividend yield by the square root of stock price—could possibly cause or explain the future performance of a stock. Money Magazine found that a portfolio made up of stocks whose names contained no repeating letters would have performed nearly as well as The Foolish Four—and for the same reason: luck alone.14 As Graham never stops reminding us, stocks do well or poorly in the future because the businesses behind them do well or poorly—nothing more, and nothing less.

All this reinforces Graham’s warning that you must treat speculation as veteran gamblers treat their trips to the casino:

• You must never delude yourself into thinking that you’re investing when you’re speculating.
• Speculating becomes mortally dangerous the moment you begin to take it seriously.
• You must put strict limits on the amount you are willing to wager.

CHAPTER 2. THE INVESTOR AND INFLATION

On the basis of these undeniable facts many financial authorities have concluded that
(1) bonds are an inherently undesirable form of investment, and
(2) consequently, common stocks are by their very nature more desirable investments than bonds.

We have heard of charitable institutions being advised that their portfolios should consist 100% of stocks and zero percent of bonds.

By the late 1990s, this advice—which can be appropriate for a foundation or endowment with an infinitely long investment horizon—had spread to individual investors, whose life spans are finite. In the 1994 edition of his influential book, Stocks for the Long Run, finance professor Jeremy Siegel of the Wharton School recommended that “risk-taking” investors should buy on margin, borrowing more than a third of their net worth to sink 135% of their assets into stocks. Even government officials got in on the act: In February 1999, the Honorable Richard Dixon, state treasurer of Maryland, told the audience at an investment conference: "It doesn’t make any sense for anyone to have any money in a bond fund."

This is quite a reversal from the earlier days when trust investments were restricted by law to high-grade bonds (and a few choice preferred stocks).

The first thing about inflation is that it is real and that we have had inflation in the past—lots of it. The largest five-year dose was between 1915 and 1920, when the cost of living nearly doubled. This compares with the advance of 15% between 1965 and 1970. In between, we have had three periods of declining prices and then six of advances at varying rates, some rather small. On this showing, the investor should clearly allow for the probability of continuing or recurrent inflation to come.
Can we tell what the rate of inflation is likely to be? No clear answer is suggested by our table; it shows variations of all sorts. It would seem sensible, however, to take our cue from the rather consistent record of the past 20 years. The average annual rise in the consumer price level for this period has been 2.5%; that for 1965–1970 was 4.5%; that for 1970 alone was 5.4%. Official government policy has been strongly against large-scale inflation, and there are some reasons to believe that Federal policies will be more effective in the future than in recent years. [ This is one of Graham’s rare misjudgments. In 1973, just two years after President Richard Nixon imposed wage and price controls, inflation hit 8.7%, its highest level since the end of World War II. The decade from 1973 through 1982 was the most inflationary in modern American history, as the cost of living more than doubled. ]

We think it would be reasonable for an investor at this point to base his thinking and decisions on a probable (far from certain) rate of future inflation of, say, 3% per annum. (This would compare with an annual rate of about 2.5% for the entire period 1915–1970.)

What would be the implications of such an advance? It would eat up, in higher living costs, about one-half the income now obtainable on good medium-term tax-free bonds (or our assumed after-tax equivalent from high-grade corporate bonds). This would be a serious shrinkage, but it should not be exaggerated. It would not mean that the true value, or the purchasing power, of the investor’s fortune need be reduced over the years. If he spent half his interest income after taxes he would maintain this buying power intact, even against a 3% annual inflation.

This brings us to the next logical question: Is there a persuasive reason to believe that common stocks are likely to do much better in future years than they have in the last five and one-half decades? Our answer to this crucial question must be a flat no. Common stocks may do better in the future than in the past, but they are far from certain to do so. We must deal here with two different time elements in investment results. The first covers what is likely to occur over the long-term future—say, the next 25 years. The second applies to what is likely to happen to the investor—both financially and psychologically—over short or intermediate periods, say five years or less. His frame of mind, his hopes and apprehensions, his satisfaction or discontent with what he has done, above all his decisions what to do next, are all determined not in the retrospect of a lifetime of investment but rather by his experience from year to year.

On this point we can be categorical. There is no close time connection between inflationary (or deflationary) conditions and the movement of common-stock earnings and prices. The obvious example is the recent period, 1966–1970. The rise in the cost of living was 22%, the largest in a five-year period since 1946–1950. But both stock earnings and stock prices as a whole have declined since 1965. There are similar contradictions in both directions in the record of previous five-year periods.

Inflation and Corporate Earnings

In the economic cycles of the past, good business was accompanied by a rising price level and poor business by falling prices. It was generally felt that “a little inflation” was helpful to business profits. This view is not contradicted by the history of 1950–1970, which reveals a combination of generally continued prosperity and generally rising prices. But the figures indicate that the effect of all this on the earning power of common-stock capital (“equity capital”) has been quite limited; in fact it has not even served to maintain the rate of earnings on the investment. Clearly there have been important offsetting influences which have prevented any increase in the real profitability of American corporations as a whole. Perhaps the most important of these have been

(1) a rise in wage rates exceeding the gains in productivity, and
(2) the need for huge amounts of new capital, thus holding down the ratio of sales to capital employed.

All of the above brings us back to our conclusion that the investor has no sound basis for expecting more than an average overall return of, say, 8% on a portfolio of DJIA-type common stocks purchased at the late 1971 price level. But even if these expectations should prove to be understated by a substantial amount, the case would not be made for an all-stock investment program. If there is one thing guaranteed for the future, it is that the earnings and average annual market value of a stock portfolio will not grow at the uniform rate of 4%, or any other figure. In the memorable words of the elder J. P. Morgan, “They will fluctuate.” [ John Pierpont Morgan was the most powerful financier of the late nineteenth and early twentieth centuries. Because of his vast influence, he was constantly asked what the stock market would do next. Morgan developed a mercifully short and unfailingly accurate answer: “It will fluctuate.” ]

This means, first, that the common-stock buyer at today’s prices— or tomorrow’s —will be running a real risk of having unsatisfactory results therefrom over a period of years. It took 25 years for General Electric (and the DJIA itself) to recover the ground lost in the 1929–1932 debacle. Besides that, if the investor concentrates his portfolio on common stocks he is very likely to be led astray either by exhilarating advances or by distressing declines. This is particularly true if his reasoning is geared closely to expectations of further inflation. For then, if another bull market comes along, he will take the big rise not as a danger signal of an inevitable fall, not as a chance to cash in on his handsome profits, but rather as a vindication of the inflation hypothesis and as a reason to keep on buying common stocks no matter how high the market level nor how low the dividend return. That way lies sorrow.

Alternatives to Common Stocks as Inflation Hedges

The standard policy of people all over the world who mistrust their currency has been to buy and hold gold. This has been against the law for American citizens since 1935—luckily for them. In the past 35 years the price of gold in the open market has advanced from $35 per ounce to $48 in early 1972—a rise of only 35%. But during all this time the holder of gold has received no income return on his capital, and instead has incurred some annual expense for storage. Obviously, he would have done much better with his money at interest in a savings bank, in spite of the rise in the general price level.
The near-complete failure of gold to protect against a loss in the purchasing power of the dollar must cast grave doubt on the ability of the ordinary investor to protect himself against inflation by putting his money in “things.” [ The investment philosopher Peter L. Bernstein feels that Graham was “dead wrong” about precious metals, particularly gold, which (at least in the years after Graham wrote this chapter) has shown a robust ability to outpace inflation. Financial adviser William Bernstein agrees, pointing out that a tiny allocation to a precious-metals fund (say, 2% of your total assets) is too small to hurt your overall returns when gold does poorly. But, when gold does well, its returns are often so spectacular—sometimes exceeding 100% in a year—that it can, all by itself, set an otherwise lackluster portfolio glittering. However, the intelligent investor avoids investing in gold directly, with its high storage and insurance costs; instead, seek out a well-diversified mutual fund specializing in the stocks of precious-metal companies and charging below 1% in annual expenses. Limit your stake to 2% of your total financial assets (or perhaps 5% if you are over the age of 65). ]

COMMENTARY ON CHAPTER 2

Inflation? Who cares about that?

After all, the annual rise in the cost of goods and services averaged less than 2.2% between 1997 and 2002—and economists believe that even that rock-bottom rate may be overstated. (Think, for instance, of how the prices of computers and home electronics have plummeted—and how the quality of many goods has risen, meaning that consumers are getting better value for their money.) In recent years, the true rate of inflation in the United States has probably run around 1% annually—an increase so infinitesimal that many pundits have proclaimed that “inflation is dead.”

In 1996, the Boskin Commission, a group of economists asked by the government to investigate whether the official rate of inflation is accurate, estimated that it has been overstated, often by nearly two percentage points per year. Many investment experts now feel that deflation, or falling prices, is an even greater threat than inflation; the best way to hedge against that risk is by including bonds as a permanent component of your portfolio. (See the commentary on Chapter 4 in the book.)

THE MONEY ILLUSION

There’s another reason investors overlook the importance of inflation: what psychologists call the “money illusion.” If you receive a 2% raise in a year when inflation runs at 4%, you will almost certainly feel better than you will if you take a 2% pay cut during a year when inflation is zero. Yet both changes in your salary leave you in a virtually identical position—2% worse off after inflation. So long as the nominal (or absolute) change is positive, we view it as a good thing—even if the real (or after-inflation) result is negative. And any change in your own salary is more vivid and specific than the generalized change of prices in the economy as a whole. Likewise, investors were delighted to earn 11% on bank certificates of deposit (CDs) in 1980 and are bitterly disappointed to be earning only around 2% in 2003—even though they were losing money after inflation back then but are keeping up with inflation now. The nominal rate we earn is printed in the bank’s ads and posted in its window, where a high number makes us feel good. But inflation eats away at that high number in secret. Instead of taking out ads, inflation just takes away our wealth. That’s why inflation is so easy to overlook—and why it’s so important to measure your investing success not just by what you make, but by how much you keep after inflation.
More basically still, the intelligent investor must always be on guard against whatever is unexpected and underestimated. There are three good reasons to believe that inflation is not dead:

• As recently as 1973–1982, the United States went through one of the most painful bursts of inflation in our history. As measured by the Consumer Price Index, prices more than doubled over that period, rising at an annualized rate of nearly 9%. In 1979 alone, inflation raged at 13.3%, paralyzing the economy in what became known as “stagflation”—and leading many commentators to question whether America could compete in the global market place. Goods and services priced at $100 in the beginning of 1973 cost $230 by the end of 1982, shriveling the value of a dollar to less than 45 cents. No one who lived through it would scoff at such destruction of wealth; no one who is prudent can fail to protect against the risk that it might recur.

• Since 1960, 69% of the world’s market-oriented countries have suffered at least one year in which inflation ran at an annualized rate of 25% or more. On average, those inflationary periods destroyed 53% of an investor’s purchasing power. We would be crazy not to hope that America is somehow exempt from such a disaster. But we would be even crazier to conclude that it can never happen here. [ In fact, the United States has had two periods of hyperinflation. During the American Revolution, prices roughly tripled every year from 1777 through 1779, with a pound of butter costing $12 and a barrel of flour fetching nearly $1,600 in Revolutionary Massachusetts. During the Civil War, inflation raged at annual rates of 29% (in the North) and nearly 200% (in the Confederacy). As recently as 1946, inflation hit 18.1% in the United States. ]

• Rising prices allow Uncle Sam to pay off his debts with dollars that have been cheapened by inflation. Completely eradicating inflation runs against the economic self-interest of any government that regularly borrows money. [ I am indebted to Laurence Siegel of the Ford Foundation for this cynical, but accurate, insight. Conversely, in a time of deflation (or steadily falling prices) it’s more advantageous to be a lender than a borrower—which is why most investors should keep at least a small portion of their assets in bonds, as a form of insurance against deflating prices. ]

HALF A HEDGE

While mild inflation allows companies to pass the increased costs of their own raw materials on to customers, high inflation wreaks havoc—forcing customers to slash their purchases and depressing activity throughout the economy.
The historical evidence is clear: Since the advent of accurate stock-market data in 1926, there have been 64 five-year periods (i.e., 1926–1930, 1927–1931, 1928–1932, and so on through 1998–2002). In 50 of those 64 five-year periods (or 78% of the time), stocks outpaced inflation. That’s impressive, but imperfect; it means that stocks failed to keep up with inflation about one-fifth of the time.

Note: When inflation is negative, it is technically termed “deflation.” Regularly falling prices may at first sound appealing, until you think of the Japanese example. Prices have been deflating in Japan since 1989, with real estate and the stock market dropping in value year after year—a relentless water torture for the world’s second-largest economy.

TWO ACRONYMS TO THE RESCUE

Fortunately, you can bolster your defenses against inflation by branching out beyond stocks. Since Graham last wrote, two inflation-fighters have become widely available to investors:

1. REITs

Real Estate Investment Trusts, or REITs (pronounced “reets”), are companies that own and collect rent from commercial and residential properties.

2. TIPS

Treasury Inflation-Protected Securities, or TIPS, are U.S.
government bonds, first issued in 1997, that automatically go up in value when inflation rises. Because the full faith and credit of the United States stands behind them, all Treasury bonds are safe from the risk of default (or nonpayment of interest). But TIPS also guarantee that the value of your investment won’t be eroded by inflation. In one easy package, you insure yourself against financial loss and the loss of purchasing power.
There is one catch, however. When the value of your TIPS bond rises as inflation heats up, the Internal Revenue Service regards that increase in value as taxable income—even though it is purely a paper gain (unless you sold the bond at its newly higher price). Why does this make sense to the IRS? The intelligent investor will remember the wise words of financial analyst Mark Schweber: “The one question never to ask a bureaucrat is ‘Why?’ ” Because of this exasperating tax complication, TIPS are best suited for a tax-deferred retirement account like an IRA, Keogh, or 401(k), where they will not jack up your taxable income.

CHAPTER 3. A CENTURY OF STOCK-MARKET HISTORY: THE LEVEL OF STOCK PRICES IN EARLY 1972

The investor’s portfolio of common stocks will represent a small cross-section of that immense and formidable institution known as the stock market. Prudence suggests that he have an adequate idea of stock-market history, in terms particularly of the major fluctuations in its price level and of the varying relationships between stock prices as a whole and their earnings and dividends. With this background he may be in a position to form some worthwhile judgment of the attractiveness or dangers of the level of the market as it presents itself at different times. By a coincidence, useful statistical data on prices, earnings, and dividends go back just 100 years, to 1871. (The material is not nearly as full or dependable in the first half-period as in the second, but it will serve.) In this chapter we shall present the figures, in highly condensed form, with two objects in view. The first is to show the general manner in which stocks have made their underlying advance through the many cycles of the past century. The second is to view the picture in terms of successive ten-year averages, not only of stock prices but of earnings and dividends as well, to bring out the varying relationship between the three important factors. With this wealth of material as a background we shall pass to a consideration of the level of stock prices at the beginning of 1972.

Two massive declines in US stock market:

1939–1942: The 44% decline that had reflected the perils and uncertainties after Pearl Harbor.
1968-1970: The decline from the 1968 high to the 1970 low was 36% for the Standard & Poor’s composite (and 37% for the DJIA), the largest since the World War II.

Let us look at a smoothed out data:

The full decade figures smooth out the year-to-year fluctuations and leave a general picture of persistent growth. Only two of the nine decades after the first show a decrease in earnings and average prices (in 1891–1900 and 1931–1940), and no decade after 1900 shows a decrease in average dividends. But the rates of growth in all three categories are quite variable. In general the performance since World War II has been superior to that of earlier decades, but the advance in the 1960s was less pronounced than that of the 1950s. Today’s investor cannot tell from this record what percentage gain in earnings dividends and prices he may expect in the next ten years, but it does supply all the encouragement he needs for a consistent policy of common-stock investment.

The year 1970 was marked by a definite deterioration in the overall earnings posture of our corporations. The rate of profit on invested capital fell to the lowest percentage since the World War years. Equally striking is the fact that a considerable number of companies reported net losses for the year; many became “financially troubled,” and for the first time in three decades there were quite a few important bankruptcy proceedings. These facts as much as any others have prompted the statement made above that the great boom era may have come to an end in 1969–1970.

A striking feature of Table 3-2 is the change in the price/earnings ratios since World War II. [The “price/earnings ratio” of a stock, or of a market average like the S&P 500-stock index, is a simple tool for taking the market’s temperature. If, for instance, a company earned $1 per share of net income over the past year, and its stock is selling at $8.93 per share, its price/earnings ratio would be 8.93; if, however, the stock is selling at $69.70, then the price/earnings ratio would be 69.7. In general, a price/earnings ratio (or “P/E” ratio) below 10 is considered low, between 10 and 20 is considered moderate, and greater than 20 is considered expensive.]

In June 1949 the S&P composite index sold at only 6.3 times the applicable earnings of the past 12 months; in March 1961 the ratio was 22.9 times. Similarly, the dividend yield on the S&P index had fallen from over 7% in 1949 to only 3.0% in 1961, a contrast heightened by the fact that interest rates on high-grade bonds had meanwhile risen from 2.60% to 4.50%. This is certainly the most remarkable turnabout in the public’s attitude in all stock-market history.

After giving some insights on the 100-year history of US stock market the author reprints a passage from the book's 1964 edition:

WHAT COURSE TO FOLLOW

Investors should not conclude that the 1964 market level is dangerous merely because they read it in this book. They must weigh our reasoning against the contrary reasoning they will hear from most competent and experienced people on Wall Street. In the end each one must make his own decision and accept responsibility therefor. We suggest, however, that if the investor is in doubt as to which course to pursue he should choose the path of caution. The principles of investment, as set forth herein, would call for the following policy under 1964 conditions, in order of urgency:

1. No borrowing to buy or hold securities.
2. No increase in the proportion of funds held in common stocks.
3. A reduction in common-stock holdings where needed to bring it down to a maximum of 50 per cent of the total portfolio. The capital-gains tax must be paid with as good grace as possible, and the proceeds invested in first-quality bonds or held as a savings deposit.

Investors who for some time have been following a bona fide dollar-cost averaging plan can in logic elect either to continue their periodic purchases unchanged or to suspend them until they feel the market level is no longer dangerous. We should advise rather strongly against the initiation of a new dollar-averaging plan at the late 1964 levels, since many investors would not have the stamina to pursue such a scheme if the results soon after initiation should appear highly unfavorable.

We think our readers may derive some benefit from a renewed consideration of the level of the stock market—this time as of late 1971—even if what we have to say will prove more interesting than practically useful, or more indicative than conclusive.
There is a fine passage near the beginning of Aristotle’s Ethics that goes: “It is the mark of an educated mind to expect that amount of exactness which the nature of the particular subject admits. It is equally unreasonable to accept merely probable conclusions from a mathematician and to demand strict demonstration from an orator.” The work of a financial analyst falls somewhere in the middle between that of a mathematician and of an orator.

COMMENTARY ON CHAPTER 3

In 1999 and early 2000, bull-market baloney was everywhere: • On December 7, 1999, Kevin Landis, portfolio manager of the Firsthand mutual funds, appeared on CNN’s Moneyline telecast.
Asked if wireless telecommunication stocks were overvalued— with many trading at infinite multiples of their earnings—Landis had a ready answer. “It’s not a mania,” he shot back. “Look at the outright growth, the absolute value of the growth. It’s big.”

• On January 18, 2000, Robert Froelich, chief investment strategist at the Kemper Funds, declared in the Wall Street Journal: “It’s a new world order. We see people discard all the right companies with all the right people with the right vision because their stock price is too high—that’s the worst mistake an investor can make.”

• In the April 10, 2000, issue of BusinessWeek, Jeffrey M. Applegate, then the chief investment strategist at Lehman Brothers, asked rhetorically: “Is the stock market riskier today than two years ago simply because prices are higher? The answer is no.”

But the answer is yes. It always has been. It always will be.

And when Graham asked, “Can such heedlessness go unpunished?” he knew that the eternal answer to that question is no. Like an enraged Greek god, the stock market crushed everyone who had come to believe that the high returns of the late 1990s were some kind of divine right. Just look at how those forecasts by Landis, Froelich, and Applegate held up:

• From 2000 through 2002, the most stable of Landis’s pet wireless stocks, Nokia, lost “only” 67%—while the worst, Winstar Communications, lost 99.9%.

• Froelich’s favorite stocks—Cisco Systems and Motorola—fell more than 70% by late 2002. Investors lost over $400 billion on Cisco alone—more than the annual economic output of Hong Kong, Israel, Kuwait, and Singapore combined.

• In April 2000, when Applegate asked his rhetorical question, the Dow Jones Industrials stood at 11,187; the NASDAQ Composite Index was at 4446. By the end of 2002, the Dow was hobbling around the 8,300 level, while NASDAQ had withered to roughly 1300—eradicating all its gains over the previous six years.

SURVIVAL OF THE FATTEST

There was a fatal flaw in the argument that stocks have “always” beaten bonds in the long run: Reliable figures before 1871 do not exist. The indexes used to represent the U.S. stock market’s earliest returns contain as few as seven (yes, 7!) stocks. By 1800, however, there were some 300 companies in America (many in the Jeffersonian equivalents of the Internet: wooden turnpikes and canals). Most went bankrupt, and their investors lost their knickers.
But the stock indexes ignore all the companies that went bust in those early years, a problem technically known as “survivorship bias.” Thus these indexes wildly overstate the results earned by real-life investors—who lacked the 20/20 hindsight necessary to know exactly which seven stocks to buy. A lonely handful of companies, including Bank of New York and J. P. Morgan Chase, have prospered continuously since the 1790s. But for every such miraculous survivor, there were thousands of financial disasters like the Dismal Swamp Canal Co., the Pennsylvania Cultivation of Vines Co., and the Snickers’s Gap Turnpike Co.—all omitted from the “historical” stock indexes.
Jeremy Siegel’s data show that, after inflation, from 1802 through 1870 stocks gained 7.0% per year, bonds 4.8%, and cash 5.1%. But Elroy Dimson and his colleagues at London Business School estimate that the pre-1871 stock returns are overstated by at least two percentage points per year. In the real world, then, stocks did no better than cash and bonds—and perhaps a bit worse. Anyone who claims that the long-term record “proves” that stocks are guaranteed to outperform bonds or cash is an ignoramus.

THE HIGHER THEY GO, THE HARDER THEY FALL

As the enduring antidote to this kind of bull-market baloney, Graham urges the intelligent investor to ask some simple, skeptical questions.
Why should the future returns of stocks always be the same as their past returns? When every investor comes to believe that stocks are guaranteed to make money in the long run, won’t the market end up being wildly overpriced? And once that happens, how can future returns possibly be high? Graham’s answers, as always, are rooted in logic and common sense. The value of any investment is, and always must be, a function of the price you pay for it. By the late 1990s, inflation was withering away, corporate profits appeared to be booming, and most of the world was at peace. But that did not mean—nor could it ever mean— that stocks were worth buying at any price. Since the profits that companies can earn are finite, the price that investors should be willing to pay for stocks must also be finite.
Think of it this way: Michael Jordan may well have been the greatest basketball player of all time, and he pulled fans into Chicago Stadium like a giant electromagnet. The Chicago Bulls got a bargain by paying Jordan up to $34 million a year to bounce a big leather ball around a wooden floor. But that does not mean the Bulls would have been justified paying him $340 million, or $3.4 billion, or $34 billion, per season.

THE LIMITS OF OPTIMISM

Focusing on the market’s recent returns when they have been rosy, warns Graham, will lead to “a quite illogical and dangerous conclusion that equally marvelous results could be expected for common stocks in the future.” From 1995 through 1999, as the market rose by at least 20% each year—a surge unprecedented in American history—stock buyers became ever more optimistic:

• In mid-1998, investors surveyed by the Gallup Organization for the PaineWebber brokerage firm expected their portfolios to earn an average of roughly 13% over the year to come. By early 2000, their average expected return had jumped to more than 18%.

• “Sophisticated professionals” were just as bullish, jacking up their own assumptions of future returns. In 2001, for instance, SBC
Communications raised the projected return on its pension plan from 8.5% to 9.5%. By 2002, the average assumed rate of return on the pension plans of companies in the Standard & Poor’s 500- stock index had swollen to a record-high 9.2%.

A quick follow-up shows the awful aftermath of excess enthusiasm:

• Gallup found in 2001 and 2002 that the average expectation of one-year returns on stocks had slumped to 7%—even though investors could now buy at prices nearly 50% lower than in 2000.
• Those gung-ho assumptions about the returns on their pension plans will cost the companies in the S & P 500 a bare minimum of $32 billion between 2002 and 2004, according to recent Wall Street estimates.
Even though investors all know they’re supposed to buy low and sell high, in practice they often end up getting it backwards. Graham’s warning in this chapter is simple: “By the rule of opposites,” the more enthusiastic investors become about the stock market in the long run, the more certain they are to be proved wrong in the short run. On March 24, 2000, the total value of the U.S. stock market peaked at $14.75 trillion. By October 9, 2002, just 30 months later, the total U.S. stock market was worth $7.34 trillion, or 50.2% less—a loss of $7.41 trillion. Meanwhile, many market pundits turned sourly bearish, predicting flat or even negative market returns for years—even decades—to come.
At this point, Graham would ask one simple question: Considering how calamitously wrong the “experts” were the last time they agreed on something, why on earth should the intelligent investor believe them now?

WHAT’S NEXT?

Instead, let’s tune out the noise and think about future returns as Graham might. The stock market’s performance depends on three factors:
• real growth (the rise of companies’ earnings and dividends)
• inflationary growth (the general rise of prices throughout the economy)
• speculative growth—or decline (any increase or decrease in the investing public’s appetite for stocks)

There is also a second lesson in Graham’s approach. The only thing you can be confident of while forecasting future stock returns is that you will probably turn out to be wrong. The only indisputable truth that the past teaches us is that the future will always surprise us—always! And the corollary to that law of financial history is that the markets will most brutally surprise the very people who are most certain that their views about the future are right. Staying humble about your forecasting powers, as Graham did, will keep you from risking too much on a view of the future that may well turn out to be wrong.
So, by all means, you should lower your expectations—but take care not to depress your spirit. For the intelligent investor, hope always springs eternal, because it should. In the financial markets, the worse the future looks, the better it usually turns out to be. A cynic once told G. K. Chesterton, the British novelist and essayist, “Blessed is he who expecteth nothing, for he shall not be disappointed.” Chesterton’s rejoinder? “Blessed is he who expecteth nothing, for he shall enjoy everything.”

CHAPTER 4. GENERAL PORTFOLIO POLICY: THE DEFENSIVE INVESTOR

The Basic Problem of Bond-Stock Allocation

We have already outlined in briefest form the portfolio policy of the defensive investor in chapter 2. He should divide his funds between highgrade bonds and high-grade common stocks.
We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds. There is an implication here that the standard division should be an equal one, or 50–50, between the two major investment mediums. According to tradition the sound reason for increasing the percentage in common stocks would be the appearance of the “bargain price” levels created in a protracted bear market. Conversely, sound procedure would call for reducing the common-stock component below 50% when in the judgment of the investor the market level has become dangerously high.
These copybook maxims have always been easy to enunciate and always difficult to follow—because they go against that very human nature which produces that excesses of bull and bear markets. It is almost a contradiction in terms to suggest as a feasible policy for the average stockowner that he lighten his holdings when the market advances beyond a certain point and add to them after a corresponding decline. It is because the average man operates, and apparently must operate, in opposite fashion that we have had the great advances and collapses of the past; and—this writer believes—we are likely to have them in the future.
If the division between investment and speculative operations were as clear now as once it was, we might be able to envisage investors as a shrewd, experienced group who sell out to the heedless, hapless speculators at high prices and buy back from them at depressed levels. This picture may have had some verisimilitude in bygone days, but it is hard to identify it with financial developments since 1949. There is no indication that such professional operations as those of the mutual funds have been conducted in this fashion. The percentage of the portfolio held in equities by the two major types of funds—“balanced” and “common-stock”—has changed very little from year to year. Their selling activities have been largely related to endeavors to switch from less to more promising holdings.
If, as we have long believed, the stock market has lost contact with its old bounds, and if new ones have not yet been established, then we can give the investor no reliable rules by which to reduce his common-stock holdings toward the 25% minimum and rebuild them later to the 75% maximum. We can urge that in general the investor should not have more than one-half in equities unless he has strong confidence in the soundness of his stock position and is sure that he could view a market decline of the 1969–70 type with equanimity. It is hard for us to see how such strong confidence can be justified at the levels existing in early 1972. Thus we would counsel against a greater than 50% apportionment to common stocks at this time. But, for complementary reasons, it is almost equally difficult to advise a reduction of the figure well below 50%, unless the investor is disquieted in his own mind about the current market level, and will be satisfied also to limit his participation in any further rise to, say, 25% of his total funds.
We are thus led to put forward for most of our readers what may appear to be an oversimplified 50–50 formula. Under this plan the guiding rule is to maintain as nearly as practicable an equal division between bond and stock holdings. When changes in the market level have raised the common-stock component to, say, 55%, the balance would be restored by a sale of one-eleventh of the stock portfolio and the transfer of the proceeds to bonds. Conversely, a fall in the common-stock proportion to 45% would call for the use of one-eleventh of the bond fund to buy additional equities.
Yale University followed a somewhat similar plan for a number of years after 1937, but it was geared around a 35% “normal holding” in common stocks. In the early 1950s, however, Yale seems to have given up its once famous formula, and in 1969 held 61% of its portfolio in equities (including some convertibles). (At that time the endowment funds of 71 such institutions, totaling $7.6 billion, held 60.3% in common stocks.) The Yale example illustrates the almost lethal effect of the great market advance upon the once popular formula approach to investment. Nonetheless we are convinced that our 50–50 version of this approach makes good sense for the defensive investor. It is extremely simple; it aims unquestionably in the right direction; it gives the follower the feeling that he is at least making some moves in response to market developments; most important of all, it will restrain him from being drawn more and more heavily into common stocks as the market rises to more and more dangerous heights.
Furthermore, a truly conservative investor will be satisfied with the gains shown on half his portfolio in a rising market, while in a severe decline he may derive much solace from reflecting how much better off he is than many of his more venturesome friends.
While our proposed 50–50 division is undoubtedly the simplest “all-purpose program” devisable, it may not turn out to be the best in terms of results achieved. (Of course, no approach, mechanical or otherwise, can be advanced with any assurance that it will work out better than another.) The much larger income return now offered by good bonds than by representative stocks is a potent argument for favoring the bond component. The investor’s choice between 50% or a lower figure in stocks may well rest mainly on his own temperament and attitude.

The Bond Component

The choice of issues in the bond component of the investor’s portfolio will turn about two main questions: Should he buy taxable or tax-free bonds, and should he buy shorter- or longer-term maturities? The tax decision should be mainly a matter of arithmetic, turning on the difference in yields as compared with the investor’s tax bracket.

Next the book lists a few major types of bonds (available in the US) that deserve investor consideration, and discuss them briefly with respect to general description, safety, yield, market price, risk, income-tax status, and other features.

1. U.S. SAVINGS BONDS, SERIES E AND SERIES H.

2. OTHER UNITED STATES BONDS. (Example: U.S. Treasury, “Certificates Fully Guaranteed by the Secretary of Transportation of the Department of Transportation of the United States”, New Community Debentures)

3. STATE AND MUNICIPAL BONDS

4. CORPORATION BONDS

5. Savings Deposits in Lieu of Bonds

6. Convertible Issues [These are discussed in Chapter 16. The price variability of bonds in general is treated in Chapter 8, The Investor and Market Fluctuations.]

Straight—i.e., Nonconvertible—Preferred Stocks

Certain general observations should be made here on the subject of preferred stocks. Really good preferred stocks can and do exist, but they are good in spite of their investment form, which is an inherently bad one. The typical preferred shareholder is dependent for his safety on the ability and desire of the company to pay dividends on its common stock. Once the common dividends are omitted, or even in danger, his own position becomes precarious, for the directors are under no obligation to continue paying him unless they also pay on the common. On the other hand, the typical preferred stock carries no share in the company’s profits beyond the fixed dividend rate. Thus the preferred holder lacks both the legal claim of the bondholder (or creditor) and the profit possibilities of a common shareholder (or partner).

Security Forms

The bond form and the preferred-stock form, as hitherto discussed, are well-understood and relatively simple matters. A bondholder is entitled to receive fixed interest and payment of principal on a definite date. The owner of a preferred stock is entitled to a fixed dividend, and no more, which must be paid before any common dividend. His principal value does not come due on any specified date. (The dividend may be cumulative or noncumulative. He may or may not have a vote.)

COMMENTARY ON CHAPTER 4

How aggressive should your portfolio be? That, says Graham, depends less on what kinds of investments you own than on what kind of investor you are. There are two ways to be an intelligent investor:

• by continually researching, selecting, and monitoring a dynamic mix of stocks, bonds, or mutual funds;

• or by creating a permanent portfolio that runs on autopilot and requires no further effort (but generates very little excitement).

Graham calls the first approach “active” or “enterprising”; it takes lots of time and loads of energy. The “passive” or “defensive” strategy takes little time or effort but requires an almost ascetic detachment from the alluring hullabaloo of the market.

CAN YOU BE BRAVE, OR WILL YOU CAVE?

How, then, should a defensive investor get started? The first and most basic decision is how much to put in stocks and how much to put in bonds and cash. (Note that Graham deliberately places this discussion after his chapter on inflation, forearming you with the knowledge that inflation is one of your worst enemies.) The most striking thing about Graham’s discussion of how to allocate your assets between stocks and bonds is that he never mentions the word “age.” That sets his advice firmly against the winds of conventional wisdom—which holds that how much investing risk you ought to take depends mainly on how old you are. A traditional rule of thumb was to subtract your age from 100 and invest that percentage of your assets in stocks, with the rest in bonds or cash. (A 28-year-old would put 72% of her money in stocks; an 81-year-old would put only 19% there.) Like everything else, these assumptions got overheated in the late 1990s. By 1999, a popular book argued that if you were younger than 30 you should put 95% of your money in stocks—even if you had only a “moderate” tolerance for risk!

To get a better feel for how much risk you can take, think about the fundamental circumstances of your life, when they will kick in, when they might change, and how they are likely to affect your need for cash:

• Are you single or married? What does your spouse or partner do for a living?
• Do you or will you have children? When will the tuition bills hit home?
• Will you inherit money, or will you end up financially responsible for aging, ailing parents?
• What factors might hurt your career? (If you work for a bank or a homebuilder, a jump in interest rates could put you out of a job. If you work for a chemical manufacturer, soaring oil prices could be bad news.)
• If you are self-employed, how long do businesses similar to yours tend to survive?
• Do you need your investments to supplement your cash income? (In general, bonds will; stocks won’t.)
• Given your salary and your spending needs, how much money can you afford to lose on your investments?

If, after considering these factors, you feel you can take the higher risks inherent in greater ownership of stocks, you belong around Graham’s minimum of 25% in bonds or cash. If not, then steer mostly clear of stocks, edging toward Graham’s maximum of 75% in bonds or cash.

WHY NOT 100% STOCKS?

Graham advises you never to have more than 75% of your total assets in stocks. But is putting all your money into the stock market inadvisable for everyone? For a tiny minority of investors, a 100%-stock portfolio may make sense. You are one of them if you:

• have set aside enough cash to support your family for at least one year
• will be investing steadily for at least 20 years to come
• survived the bear market that began in 2000
• did not sell stocks during the bear market that began in 2000
• bought more stocks during the bear market that began in 2000
• have read Chapter 8 in this book and implemented a formal plan to control your own investing behavior.

Unless you can honestly pass all these tests, you have no business putting all your money in stocks. Anyone who panicked in the last bear market is going to panic in the next one—and will regret having no cushion of cash and bonds.

THE INS AND OUTS OF INCOME INVESTING

In Graham’s day, bond investors faced two basic choices: Taxable or tax-free. Short-term or long-term. Today there is a third: Bonds or bond funds.

Note: Major U.S. firms like Vanguard, Fidelity, Schwab, and T. Rowe Price offer a broad menu of bond funds at low cost.

CASH IS NOT TRASH

How can you wring more income out of your cash? The intelligent investor should consider moving out of bank certificates of deposit or money-market accounts—which have offered meager returns lately— into some of these cash alternatives:

1. Treasury securities
2. Savings bonds

MOVING BEYOND UNCLE SAM

1. Mortgage securities.
2. Annuities.

3. Preferred stock.

Preferred shares are a worst-of-both-worlds investment. They are less secure than bonds, since they have only a secondary claim on a company’s assets if it goes bankrupt. And they offer less profit potential than common stocks do, since companies typically “call” (or forcibly buy back) their preferred shares when interest rates drop or their credit rating improves. Unlike the interest payments on most of its bonds, an issuing company cannot deduct preferred dividend payments from its corporate tax bill. Ask yourself: If this company is healthy enough to deserve my investment, why is it paying a fat dividend on its preferred stock instead of issuing bonds and getting a tax break? The likely answer is that the company is not healthy, the market for its bonds is glutted, and you should approach its preferred shares as you would approach an unrefrigerated dead fish.

4. Common stock.

No intelligent investor, no matter how starved for yield, would ever buy a stock for its dividend income alone; the company and its businesses must be solid, and its stock price must be reasonable.
But, thanks to the bear market that began in 2000, some leading stocks are now outyielding Treasury bonds. So even the most defensive investor should realize that selectively adding stocks to an allbond or mostly-bond portfolio can increase its income yield—and raise its potential return.

CHAPTER 5. THE DEFENSIVE INVESTOR AND COMMON STOCKS

# The Dow Jones Industrial Average closed at a then-record high of 381.17 on September 3, 1929. It did not close above that level until November 23, 1954—more than a quarter of a century later—when it hit 382.74. (When you say you intend to own stocks “for the long run,” do you realize just how long the long run can be—or that many investors who bought in 1929 were no longer even alive by 1954?) However, for patient investors who reinvested their income, stock returns were positive over this otherwise dismal period, simply because dividend yields averaged more than 5.6% per year. According to professors Elroy Dimson, Paul Marsh, and Mike Staunton of London Business School, if you had invested $1 in U.S. stocks in 1900 and spent all your dividends, your stock portfolio would have grown to $198 by 2000. But if you had reinvested all your dividends, your stock portfolio would have been worth $16,797! Far from being an afterthought, dividends are the greatest force in stock investing.

# Why do the “high prices” of stocks affect their dividend yields? A stock’s yield is the ratio of its cash dividend to the price of one share of common stock. If a company pays a $2 annual dividend when its stock price is $100 per share, its yield is 2%. But if the stock price doubles while the dividend stays constant, the dividend yield will drop to 1%. In 1959, when the trend Graham spotted in 1957 became noticeable to everyone, most Wall Street pundits declared that it could not possibly last. Never before had stocks yielded less than bonds; after all, since stocks are riskier than bonds, why would anyone buy them at all unless they pay extra dividend income to compensate for their greater risk? The experts argued that bonds would outyield stocks for a few months at most, and then things would revert to “normal.” More than four decades later, the relationship has never been normal again; the yield on stocks has (so far) continuously stayed below the yield on bonds.

Rules for the Common-Stock Component
The selection of common stocks for the portfolio of the defensive investor should be a relatively simple matter. Here we would suggest four rules to be followed:

1. There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.

2. Each company selected should be large, prominent, and conservatively financed. Indefinite as these adjectives must be, their general sense is clear.

3. Each company should have a long record of continuous dividend payments. (All the issues in the Dow Jones Industrial Average met this dividend requirement in 1971.) To be specific on this point we would suggest the requirement of continuous dividend payments beginning at least in 1950. [* Today’s defensive investor should probably insist on at least 10 years of continuous dividend payments (which would eliminate from consideration only one member of the Dow Jones Industrial Average —Microsoft— and would still leave at least 317 stocks to choose from among the S & P 500 index). Even insisting on 20 years of uninterrupted dividend payments would not be overly restrictive; according to Morgan Stanley, 255 companies in the S & P 500 met that standard as of year-end 2002.]

4. The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past seven years. We suggest that this limit be set at 25 times such average earnings, and not more than 20 times those of the last twelve-month period. But such a restriction would eliminate nearly all the strongest and most popular companies from the portfolio. In particular, it would ban virtually the entire category of “growth stocks,” which have for some years past been the favorites of both speculators and institutional investors. We must give our reasons for proposing so drastic an exclusion.

Growth Stocks and the Defensive Investor

The term “growth stock” is applied to one which has increased its per-share earnings in the past at well above the rate for common stocks generally and is expected to continue to do so in the future. (Some authorities would say that a true growth stock should be expected at least to double its per-share earnings in ten years—i.e., to increase them at a compounded annual rate of over 7.1%.) [The “Rule of 72” is a handy mental tool. To estimate the length of time an amount of money takes to double, simply divide its assumed growth rate into 72. At 6%, for instance, money will double in 12 years (72 divided by 6 = 12). At the 7.1% rate cited by Graham, a growth stock will double its earnings in just over 10 years (72/7.1 = 10.1 years).]
Obviously stocks of this kind are attractive to buy and to own, provided the price paid is not excessive. The problem lies there, of course, since growth stocks have long sold at high prices in relation to current earnings and at much higher multiples of their average profits over a past period. This has introduced a speculative element of considerable weight in the growth-stock picture and has made successful operations in this field a far from simple matter. The leading growth issue has long been International Business Machines, and it has brought phenomenal rewards to those who bought it years ago and held on to it tenaciously. But we have already pointed out* that this “best of common stocks” actually lost 50% of its market price in a six-months’ decline during 1961–62 and nearly the same percentage in 1969–70. Other growth stocks have been even more vulnerable to adverse developments; in some cases not only has the price fallen back but the earnings as well, thus causing a double discomfiture to those who owned them. A good second example for our purpose is Texas Instruments, which in six years rose from 5 to 256, without paying a dividend, while its earnings increased from 40 cents to $3.91 per share. (Note that the price advanced five times as fast as the profits; this is characteristic of popular common stocks.) But two years later the earnings had dropped off by nearly 50% and the price by four-fifths, to 49. [To show that Graham’s observations are perennially true, we can substitute Microsoft for IBM and Cisco for Texas Instruments. Thirty years apart, the results are uncannily similar: Microsoft’s stock dropped 55.7% from 2000 through 2002, while Cisco’s stock—which had risen roughly 50-fold over the previous six years—lost 76% of its value from 2000 through 2002.
As with Texas Instruments, the drop in Cisco’s stock price was sharper than the fall in its earnings, which dropped just 39.2% (comparing the three-year average for 1997–1999 against 2000–2002). As always, the hotter they are, the harder they fall.]

The reader will understand from these instances why we regard growth stocks as a whole as too uncertain and risky a vehicle for the defensive investor. Of course, wonders can be accomplished with the right individual selections, bought at the right levels, and later sold after a huge rise and before the probable decline. But the average investor can no more expect to accomplish this than to find money growing on trees. In contrast we think that the group of large companies that are relatively unpopular, and therefore obtainable at reasonable earnings multipliers, [“Earnings multiplier” is a synonym for P/E or price/earnings ratios, which measure how much investors are willing to pay for a stock compared to the profitability of the underlying business.] offers a sound if unspectacular area of choice by the general public.

Dollar-Cost Averaging

The New York Stock Exchange has put considerable effort into popularizing its “monthly purchase plan,” under which an investor devotes the same dollar amount each month to buying one or more common stocks. This is an application of a special type of “formula investment” known as dollar-cost averaging. Dollar cost averaging prevents the practitioner from concentrating his buying at the wrong times.

“No one has yet discovered any other formula for investing which can be used with so much confidence of ultimate success, regardless of what may happen to security prices, as Dollar Cost Averaging.” - Miss Tomlinson

The Investor’s Personal Situation
The investment behavior cannot be same for two people as one of these two could be a widow and the other a famous doctor.

Let us not ignore human nature at this point. Finance has a fascination for many bright young people with limited means. They would like to be both intelligent and enterprising in the placement of their savings, even though investment income is much less important to them than their salaries. This attitude is all to the good. There is a great advantage for the young capitalist to begin his financial education and experience early. If he is going to operate as an aggressive investor he is certain to make some mistakes and to take some losses. Youth can stand these disappointments and profit by them. We urge the beginner in security buying not to waste his efforts and his money in trying to beat the market. Let him study security values and initially test out his judgment on price versus value with the smallest possible sums.
Thus we return to the statement, made at the outset, that the kind of securities to be purchased and the rate of return to be sought depend not on the investor’s financial resources but on his financial equipment in terms of knowledge, experience, and temperament.

Next in the book are:
• Note on the Concept of “Risk”
• Note on the Category of “Large, Prominent, and Conservatively Financed Corporations”

# An industrial company’s finances are not conservative unless the common stock (at book value) represents at least half of the total capitalization, including all bank debt. For a railroad or public utility the figure should be at least 30%.

# The words “large” and “prominent” carry the notion of substantial size combined with a leading position in the industry. Such companies are often referred to as “primary”; all other common stocks are then called “secondary,” except that growth stocks are ordinarily placed in a separate class by those who buy them as such. To supply an element of concreteness here, let us suggest that to be “large” in present-day terms a company should have $50 million of assets or do $50 million of business (This was in 1970s). Again to be “prominent” a company should rank among the first quarter or first third in size within its industry group.

# In today’s markets, to be considered large, a company should have a total stock value (or “market capitalization”) of at least $10 billion. That gave you roughly 300 stocks to choose from as of early 2003.

COMMENTARY ON CHAPTER 5

THE BEST DEFENSE IS A GOOD OFFENSE

After the stock-market bloodbath of the past few years, why would any defensive investor put a dime into stocks?

First, remember Graham’s insistence that how defensive you should be depends less on your tolerance for risk than on your willingness to put time and energy into your portfolio. And if you go about it the right way, investing in stocks is just as easy as parking your money in bonds and cash. (As we’ll see in Chapter 9, you can buy a stock-market index fund with no more effort than it takes to get dressed in the morning.)
Amidst the bear market that began in 2000, it’s understandable if you feel burned—and if, in turn, that feeling makes you determined never to buy another stock again. As an old Turkish proverb says, “After you burn your mouth on hot milk, you blow on your yogurt.” Because the crash of 2000–2002 was so terrible, many investors now view stocks as scaldingly risky; but, paradoxically, the very act of crashing has taken much of the risk out of the stock market. It was hot milk before, but it is room-temperature yogurt now. Viewed logically, the decision of whether to own stocks today has nothing to do with how much money you might have lost by owning them a few years ago. When stocks are priced reasonably enough to give you future growth, then you should own them, regardless of the losses they may have cost you in the recent past. That’s all the more true when bond yields are low, reducing the future returns on income producing investments.

Meanwhile, at recent prices (early 2003), bonds offer such low yields that an investor who buys them for their supposed safety is like a smoker who thinks he can protect himself against lung cancer by smoking low-tar cigarettes. No matter how defensive an investor you are—in Graham’s sense of low maintenance, or in the contemporary sense of low risk—today’s values mean that you must keep at least some of your money in stocks.

SHOULD YOU “BUY WHAT YOU KNOW”?

But first, let’s look at something the defensive investor must always defend against: the belief that you can pick stocks without doing any homework. In the 1980s and early 1990s, one of the most popular investing slogans was “buy what you know.” Peter Lynch—who from 1977 through 1990 piloted Fidelity Magellan to the best track record ever compiled by a mutual fund—was the most charismatic preacher of this gospel. Lynch argued that amateur investors have an advantage that professional investors have forgotten how to use: “the power of common knowledge.” If you discover a great new restaurant, car, toothpaste, or jeans—or if you notice that the parking lot at a nearby business is always full or that people are still working at a company’s headquarters long after Jay Leno goes off the air—then you have a personal insight into a stock that a professional analyst or portfolio manager might never pick up on. As Lynch put it, “During a lifetime of buying cars or cameras, you develop a sense of what’s good and what’s bad, what sells and what doesn’t... and the most important part is, you know it before Wall Street knows it.”

Lynch’s rule—“You can outperform the experts if you use your edge by investing in companies or industries you already understand”—isn’t totally implausible, and thousands of investors have profited from it over the years. But Lynch’s rule can work only if you follow its corollary as well: “Finding the promising company is only the first step. The next step is doing the research.” To his credit, Lynch insists that no one should ever invest in a company, no matter how great its products or how crowded its parking lot, without studying its financial statements and estimating its business value.
Unfortunately, most stock buyers have ignored that part.
Barbra Streisand, the day-trading diva, personified the way people abuse Lynch’s teachings. In 1999 she burbled, “We go to Starbucks every day, so I buy Starbucks stock.” But the Funny Girl forgot that no matter how much you love those tall skinny lattes, you still have to analyze Starbucks’s financial statements and make sure the stock isn’t even more overpriced than the coffee. Countless stock buyers made the same mistake by loading up on shares of Amazon.com because they loved the website or buying e*Trade stock because it was their own online broker.
“Experts” gave the idea credence too. In an interview televised on CNN in late 1999, portfolio manager Kevin Landis of the Firsthand Funds was asked plaintively, “How do you do it? Why can’t I do it, Kevin?” (From 1995 through the end of 1999, the Firsthand Technology Value fund produced an astounding 58.2% average annualized gain.) “Well, you can do it,” Landis chirped. “All you really need to do is focus on the things that you know, and stay close to an industry, and talk to people who work in it every day.” [Kevin Landis interview on CNN In the Money, November 5, 1999, 11 A.M. eastern standard time. If Landis’s own record is any indication, focusing on “the things that you know” is not “all you really need to do” to pick stocks successfully. From the end of 1999 through the end of 2002, Landis’s fund (full of technology companies that he claimed to know “firsthand” from his base in Silicon Valley) lost 73.2% of its value, an even worse pounding than the average technology fund suffered over that period.]

The most painful perversion of Lynch’s rule occurred in corporate retirement plans. If you’re supposed to “buy what you know,” then what could possibly be a better investment for your 401(k) than your own company’s stock? After all, you work there; don’t you know more about the company than an outsider ever could? Sadly, the employees of Enron, Global Crossing, and WorldCom—many of whom put nearly all their retirement assets in their own company’s stock, only to be wiped out—learned that insiders often possess only the illusion of knowledge, not the real thing.
Psychologists led by Baruch Fischhoff of Carnegie Mellon University have documented a disturbing fact: becoming more familiar with a subject does not significantly reduce people’s tendency to exaggerate how much they actually know about it. That’s why “investing in what you know” can be so dangerous; the more you know going in, the less likely you are to probe a stock for weaknesses. This pernicious form of overconfidence is called “home bias,” or the habit of sticking to what is already familiar:

• Individual investors own three times more shares in their local phone company than in all other phone companies combined.

• The typical mutual fund owns stocks whose headquarters are 115 miles closer to the fund’s main office than the average U.S. company is.

• 401(k) investors keep between 25% and 30% of their retirement assets in the stock of their own company.

In short, familiarity breeds complacency. On the TV news, isn’t it always the neighbor or the best friend or the parent of the criminal who says in a shocked voice, “He was such a nice guy”? That’s because whenever we are too close to someone or something, we take our beliefs for granted, instead of questioning them as we do when we confront something more remote. The more familiar a stock is, the more likely it is to turn a defensive investor into a lazy one who thinks there’s no need to do any homework. Don’t let that happen to you.

CAN YOU ROLL YOUR OWN?

Fortunately, for a defensive investor who is willing to do the required homework for assembling a stock portfolio, this is the Golden Age: Never before in financial history has owning stocks been so cheap and convenient.

Do it yourself. Through specialized online brokerages like www.sharebuilder.com, www.foliofn.com, and www.buyandhold.com, you can buy stocks automatically even if you have very little cash to spare...

Get some help. A defensive investor can also own stocks through a discount broker, a financial planner, or a full-service stockbroker...

Farm it out. Mutual funds are the ultimate way for a defensive
investor to capture the upside of stock ownership without the down side of having to police your own portfolio...

FILLING IN THE POTHOLES

As Graham notes, “dollar-cost averaging” enables you to put a fixed amount of money into an investment at regular intervals. Every week, month, or calendar quarter, you buy more—whether the markets have gone (or are about to go) up, down, or sideways. Any major mutual fund company or brokerage firm can automatically and safely transfer the money electronically for you, so you never have to write a check or feel the conscious pang of payment. It’s all out of sight, out of mind.

The ideal way to dollar-cost average is into a portfolio of index funds, which own every stock or bond worth having. That way, you renounce not only the guessing game of where the market is going but which sectors of the market—and which particular stocks or bonds within them—will do the best.
Let’s say you can spare $500 a month. By owning and dollar-cost averaging into just three index funds—$300 into one that holds the total U.S. stock market, $100 into one that holds foreign stocks, and $100 into one that holds U.S. bonds—you can ensure that you own almost every investment on the planet that’s worth owning. Every month, like clockwork, you buy more. If the market has dropped, your preset amount goes further, buying you more shares than the month before. If the market has gone up, then your money buys you fewer shares. By putting your portfolio on permanent autopilot this way, you prevent yourself from either flinging money at the market just when it is seems most alluring (and is actually most dangerous) or refusing to buy more after a market crash has made investments truly cheaper (but seemingly more “risky”).

Best of all, once you build a permanent autopilot portfolio with index funds as its heart and core, you’ll be able to answer every market question with the most powerful response a defensive investor could ever have: “I don’t know and I don’t care.” If someone asks whether bonds will outperform stocks, just answer, “I don’t know and I don’t care”—after all, you’re automatically buying both. Will health-care stocks make high-tech stocks look sick? “I don’t know and I don’t care”—you’re a permanent owner of both. What’s the next Microsoft? “I don’t know and I don’t care”—as soon as it’s big enough to own, your index fund will have it, and you’ll go along for the ride. Will foreign stocks beat U.S. stocks next year? “I don’t know and I don’t care”—if they do, you’ll capture that gain; if they don’t, you’ll get to buy more at lower prices.

By enabling you to say “I don’t know and I don’t care,” a permanent autopilot portfolio liberates you from the feeling that you need to forecast what the financial markets are about to do—and the illusion that anyone else can. The knowledge of how little you can know about the future, coupled with the acceptance of your ignorance, is a defensive investor’s most powerful weapon.

CHAPTER 6. PORTFOLIO POLICY FOR THE ENTERPRISING INVESTOR: NEGATIVE APPROACH

In this chapter, Graham lists his “don’ts” for aggressive investors.

Topics covered in this chapter are:
• Second-Grade Bonds and Preferred Stocks
• Foreign Government Bonds
• New Issues Generally (IPO)
• New Common-Stock Offerings

NOTES:

# “High-coupon issues” are corporate bonds paying above-average interest rates (in today’s markets, at least 8%) or preferred stocks paying large dividend yields (10% or more). If a company must pay high rates of interest in order to borrow money, that is a fundamental signal that it is risky.

# Bond prices are quoted in percentages of “par value,” or 100. A bond priced at “85” is selling at 85% of its principal value; a bond originally offered for $10,000, but now selling at 85, will cost $8,500. When bonds sell below 100, they are called “discount” bonds; above 100, they become “premium” bonds.

# New issues of common stock—initial public offerings or IPOs—normally are sold with an “underwriting discount” (a built-in commission) of 7%. By contrast, the buyer’s commission on older shares of common stock typically ranges below 4%. Whenever Wall Street makes roughly twice as much for selling something new as it does for selling something old, the new will get the harder sell.

# Recently, finance professors Owen Lamont of the University of Chicago and Paul Schultz of the University of Notre Dame have shown that corporations choose to offer new shares to the public when the stock market is near a peak. For technical discussion of these issues, see Lamont’s “Evaluating Value Weighting: Corporate Events and Market Timing” and Schultz’s “Pseudo Market Timing and the Long-Run Performance of IPOs” at http://papers.ssrn.com

# In the two years from June 1960, through May 1962, more than 850 companies 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 astonishing 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 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 business 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 scalding. 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 speculators trying to buy shares in the new Bank of Southwark; the wealthiest buyers hired thugs to punch their way to the front of the line. Sure enough, by 1829, stocks had lost roughly 25% of their value.

# In Graham’s day, the most prestigious investment banks generally steered clear of the IPO business, which was regarded as an undignified exploitation 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.

COMMENTARY ON CHAPTER 6

In this chapter, Graham lists his “don’ts” for aggressive investors in 1972, here is a list for today (early 2003):

JUNKYARD DOGS?

High-yield bonds—which Graham calls “second-grade” or “lowergrade” and today are called “junk bonds”—get a brisk thumbs-down from Graham. In his day, it was too costly and cumbersome for an individual investor to diversify away the risks of default.

[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.]

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.)

A WORLD OF HURT FOR WORLDCOM BONDS
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.”

But even a 30-second glance at WorldCom’s bond prospectus 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 stupendous $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! 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 produce 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.
• WorldCom’s bonds defaulted when the company could no longer cover their interest charges; the bonds lost more than 80% of their original value.

THE VODKA-AND-BURRITO PORTFOLIO
Graham considered foreign bonds no better a bet than junk bonds. [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.]

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 emergingmarkets 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. [Two low-cost, well-run emerging-markets bond funds are Fidelity New Markets Income Fund and T. Rowe Price Emerging Markets Bond Fund. 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.]

DYING A TRADER’S DEATH
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 committing 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 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). 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 University 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 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.

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.

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, University of California at Berkeley.

THE EARLY BIRD GETS WORMED
Among the get-rich-quick toxins that poisoned the mind of the investing 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.
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 January 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 yearend 2001.
(On the printed page, that looks like this:
$533,000,000,000,000,000,000,000,000,000,000,000.)

Unfortunately, for every IPO like Microsoft that turns out to be a big winner, there are thousands of losers. The psychologists Daniel Kahnerman and Amos Tversky have shown when humans estimate the likelihood 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 conveniently overlook the fact that most other IPOs were terrible investments. You could have earned that $533 decillion gain only if you never missed a single one of the IPO market’s rare winners—a practical 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 points annually.
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.”
On December 9, 1999, the stock was placed at an initial public offering 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 violates 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 software 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 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 suddenly 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.

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

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”

[ Notes: Today these “lower-quality bonds” in the “special situation” area are known as distressed or defaulted bonds. When a company is in (or 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.” ]

"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."

Note very carefully what Graham is saying here. Writing in 1972, he contends 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 “timetested” stock-picking gimmicks almost always base their findings on smaller samples than Graham would ever accept. (Graham often used 50-year periods to analyze past data.)

Growth-Stock Approach Every investor would like to select the stocks of companies that will do better than the average over a period of years. A growth stock may be defined as one that has done this in the past and is expected to do so in the future.2 Thus it seems only logical that the intelligent investor should concentrate upon the selection of growth stocks. Actually the matter is more complicated, as we shall try to show.
It is a mere statistical chore to identify companies that have “outperformed the averages” in the past. The investor can obtain a list of 50 or 100 such enterprises from his broker.† Why, then, should he not merely pick out the 15 or 20 most likely looking issues of this group and lo! he has a guaranteed-successful stock portfolio?

There are two catches to this simple idea. The first is that common stocks with good records and apparently good prospects sell at correspondingly high prices. The investor may be right in his judgment of their prospects and still not fare particularly well, merely because he has paid in full (and perhaps overpaid) for the expected prosperity. The second is that his judgment as to the future may prove wrong. Unusually rapid growth cannot keep up forever; when a company has already registered a brilliant expansion, 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.

[ 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 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” companies) exceed any extra return the managers can earn with their stock picks? ]

There is no reason at all for thinking that the average intelligent investor, even with much devoted effort, can derive better results over the years from the purchase of growth stocks than the investment companies specializing in this area. Surely these organizations have more brains and better research facilities at their disposal than you do. Consequently we should advise against the usual type of growth-stock commitment for the enterprising investor.

[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.]

This is one in which the excellent prospects are fully recognized in the market and already reflected in a current priceearnings 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.)

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 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.

The striking thing about growth stocks as a class is their tendency toward wide swings in market price. This is true of the largest and longest-established companies—such as General Electric and International Business Machines—and even more so of newer and smaller successful companies. They illustrate our thesis that the main characteristic of the stock market since 1949 has been the injection of a highly speculative element into the shares of companies which have scored the most brilliant successes, and which themselves would be entitled to a high investment rating. (Their credit standing is of the best, and they pay the lowest interest rates on their borrowings.) The investment caliber of such a company may not change over a long span of years, but the risk characteristics of its stock will depend on what happens to it in the stock market. The more enthusiastic the public grows about it, and the faster its advance as compared with the actual growth in its earnings, the riskier a proposition it becomes. [ 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 caution 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. ]
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 have a close relationship with the particular company—through employment, family connection, etc.—which justifies them in placing a large part of their resources in one medium and holding on to this commitment through all 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. (See note below) Each decline—however temporary it proves in the sequel—will accentuate his problem; and internal and external pressures are likely to force him to take what seems to be a goodly profit, but one far less than the ultimate bonanza.

Note: Today’s equivalent of investors “who have a close relationship with the particular company” are so-called control persons—senior managers or directors 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 confidence. 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.

Three Recommended Fields for “Enterprising Investment”

1. The Relatively Unpopular Large Company

If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue—relatively, at least—companies that are out of favor because of unsatisfactory developments of a temporary nature.
This may be set down as a fundamental law of the stock market, and it suggests an investment approach that should prove both conservative and promising.

The key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity. While small companies may also be undervalued for similar reasons, and in many cases may later increase their earnings and share price, they entail the risk of a definitive loss of profitability and also of protracted neglect by the market in spite of better earnings. The large companies thus have a double advantage over the others. First, they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base. Second, the market is likely to respond with reasonable speed to any improvement shown.

Note: The strategy of buying the cheapest stocks in the Dow Jones Industrial Average is now nicknamed the “Dogs of the Dow” approach.

2. 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 discrepancy exists? How do bargains come into existence, and how does the investor profit from them?

There are two tests by which a bargain common stock is detected. The first is by the method of appraisal. This relies largely on estimating future earnings and then multiplying these by a factor appropriate to the particular issue. If the resultant value is sufficiently above the market price—and if the investor has confidence in the technique employed—he can tag the stock as a bargain. The second test is the value of the business to a private owner. This value also is often determined chiefly by expected future earnings—in which case the result may be identical with the first. But in the second test more attention is likely to be paid to the realizable value of the assets, with particular emphasis on the net current assets or working capital.

It is 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 ordinary vicissitudes into major setbacks.* Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels.
Thus we have what appear to be two major sources of undervaluation: (1) currently disappointing results and (2) protracted neglect or unpopularity.

[ 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. ]

Note: 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).

Note: 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.

3. Special Situations, or “Workouts”

The typical “special situation” has grown out of the increasing number of acquisitions of smaller firms by large ones, as the gospel of diversification of products has been adopted by more and more managements. It often appears good business for such an enterprise to acquire an existing company in the field it wishes to enter rather than to start a new venture from scratch. In order to make such acquisition possible, and to obtain acceptance of the deal by the required large majority of shareholders of the smaller company, it is almost always necessary to offer a price considerably above the current level. Such corporate moves have been producing interesting profit-making opportunities for those who have made a study of this field, and have good judgment fortified by ample experience.

"Never buy into a lawsuit."

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 cigarettes 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 lawsuit” remains a valid rule for all but the most intrepid investors to live by.

COMMENTARY ON CHAPTER 7

TIMING IS NOTHING 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. [“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 investor. 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 appears to have ignored the reinvestment of dividends.)]

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 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.
Can professionals time the market any better than Alan Greenspan? “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. 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 University found that if you had followed the recommendations of the best 10% of all market-timing newsletters, you would have earned a 12.6% annualized 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%.
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, hindsight is forever 20/20, but foresight is legally blind. And thus, for most investors, market timing is a practical and emotional impossibility.

WHAT GOES UP...

Like spacecraft that pick up speed as they rise into the Earth’s stratosphere, growth stocks often seem to defy gravity. Let’s look at the trajectories of three of the hottest growth stocks of the 1990s: General Electric, Home Depot, and Sun Microsystems.
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 expensive their stocks became. And when stocks grow faster than companies, investors always end up sorry.

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 managed to raise their earnings by an annual average of at least 15% for two decades.

• 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.

• 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 sidebar on p. 184). The intelligent investor, however, gets interested in big growth stocks not when they are at their most popular—but when something goes wrong. In July 2002, Johnson & Johnson announced that Federal regulators were investigating accusations of false record keeping 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.” [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.]

This kind of temporary unpopularity can create lasting wealth by enabling you to buy a great company at a good price.

HIGH POTENTIAL FOR HYPE POTENTIAL

Investors aren’t the only people who fall prey to the delusion that hyper-growth can go on forever. In February 2000, chief executive John Roth of Nortel Networks was asked how much bigger his giant fiber-optics company could get. “The industry is growing 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 previous 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 strategy.” (After all, he added, Cisco Systems was trading at 121 times its projected earnings!)
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 overpriced 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 “breakaway,” crumbled to $13.
Both companies have since become more circumspect about forecasting the future.

SHOULD YOU PUT ALL YOUR EGGS IN ONE BASKET? “Put all your eggs into one basket and then watch that basket,” proclaimed Andrew Carnegie a century ago. “Do not scatter your shot.
...The great successes of life are made by concentration.” As Graham 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 concentrated 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 neglected 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—oncebooming 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 changing economy crushed their only basket and all their eggs. For this observation that it is amazingly difficult to remain on the Forbes 400, I am indebted to investment manager Kenneth Fisher (himself a Forbes columnist).

THE BARGAIN BIN

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 Scorecards 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 working 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 Basement 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 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.

WHAT’S YOUR FOREIGN POLICY?

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, Financial 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 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

Market Fluctuations as a Guide to Investment Decisions

Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which he may try to do this: the way of timing and the way of pricing.
By timing we mean the endeavor to anticipate the action of the stock market—to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value. A less ambitious form of pricing is the simple effort to make sure that when you buy you do not pay too much for your stocks. This may suffice for the defensive investor, whose emphasis is on long-pull holding; but as such it represents an essential minimum of attention to market levels.

[ Note: In the late 1990s, the forecasts of “market strategists” became more influential 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 finished at 10,021.50—30% and 23% below her forecasts, respectively. ]

There is one aspect of the “timing” philosophy which seems to have escaped everyone’s notice. Timing is of great psychological importance to the speculator because he wants to make his profit in a hurry. The idea of waiting a year before his stock moves up is repugnant to him. But a waiting period, as such, is of no consequence to the investor. What advantage is there to him in having his money uninvested until he receives some (presumably) trustworthy signal that the time has come to buy? He enjoys an advantage only if by waiting he succeeds in buying later at a sufficiently lower price to offset his loss of dividend income. What this means is that timing is of no real value to the investor unless it coincides with pricing—that is, unless it enables him to repurchase his shares at substantially under his previous selling price.

[ Note on Dow Theory: The Dow theory is a theory that says the market is in an upward trend if one of its averages (industrial or transportation) advances above a previous important high and is accompanied or followed by a similar advance in the other average. For example, if the Dow Jones Industrial Average (DJIA) climbs to an intermediate high, the Dow Jones Transportation Average (DJTA) is expected to follow suit within a reasonable period of time.

The popularity of something like the Dow theory may seem to create 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 successfully 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 market when everyone else was buying.”

Nearly all the bull markets had a number of well-defined characteristics 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 markets, 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 movements of prices or both.
But we must point out that even prior to the unprecedented bull market that began in 1949, there were sufficient variations in the successive market cycles to complicate and sometimes frustrate the desirable process of buying low and selling high. The most notable of these departures, of course, was the great bull market of the late 1920s, which threw all calculations badly out of gear. [ 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. ]

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.

Formula Plans

In the early years of the stock-market rise that began in 1949–50 considerable interest was attracted to various methods of taking advantage of the stock market’s cycles. These have been known as “formula investment plans.” The essence of all such plans—except the simple case of dollar averaging—is that the investor automatically does some selling of common stocks when the market advances substantially. In many of them a very large rise in the market level would result in the sale of all common-stock holdings; others provided for retention of a minor proportion of equities under all circumstances.

This approach had the double appeal of sounding logical (and conservative) and of showing excellent results when applied retrospectively to the stock market over many years in the past. Unfortunately, its 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 their formulas gave them little opportunity to buy back a commonstock position. [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.]

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. [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.)] 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

In general, the shares of second-line companies [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.] 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. [Note carefully what Graham is saying here. It is not just possible, but probable, that most of the stocks you own will gain at least 50% from their lowest 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.)]

A serious investor is not likely to believe that the day-to-day or even month-to-month fluctuations of the stock market make him richer or poorer. But what about the longer-term and wider changes? Here practical questions present themselves, and the psychological problems are likely to grow complicated. A substantial rise in the market is at once a legitimate reason for satisfaction and a cause for prudent concern, but it may also bring a strong temptation toward imprudent action. Your shares have advanced, good!

You are richer than you were, good! But has the price risen too high, and should you think of selling? Or should you kick yourself for not having bought more shares when the level was lower? Or— worst thought of all—should you now give way to the bull-market atmosphere, become infected with the enthusiasm, the overconfidence 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 calculation of financial gain or loss, that we favor some kind of mechanical method for varying the proportion of bonds to stocks in the investor’s portfolio. The chief advantage, perhaps, is that such a formula will give him something to do. As the market advances he will from time to time make sales out of his stockholdings, putting the proceeds into bonds; as it declines he will reverse the procedure. 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

Note: 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 balance sheets in a company’s annual and quarterly reports; from total shareholders’ 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.

Now is time for a paradox: the more successful the company, the greater are likely to be the fluctuations in the price of its shares. This really means that, in a very real sense, the better the quality of a common stock, the more speculative it is likely to be—at least as compared with the unspectacular middle-grade issues.

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 miscalculation becomes. Graham discusses this problem further in Appendix 4.

~ ~ ~

...A caution is needed here. A stock does not become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years. This may appear like demanding a lot from a modestly priced stock, but the prescription is not hard to fill under all but dangerously high market conditions. Once the investor is willing to 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.

~ ~ ~

The A. & P. Example
Great Atlantic & Pacific Tea Co.

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 stable business like groceries could fall by three-fourths in one year, triple the next year, then drop by two-thirds the year after that.

~ ~ ~

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 worried 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.[ †: 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. ]

Last subtopic covered in this chapter: Fluctuations in Bond Prices

COMMENTARY ON CHAPTER 8

DR. JEKYLL AND MR. MARKET

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 can become mispriced. The manic-depressive Mr. Market does not always price stocks the way an appraiser or a private buyer would value a business. Instead, when stocks are going up, he happily pays more than their objective value; and, when they are going down, he is desperate to dump them for less than their true worth. Is Mr. Market still around? Is he still bipolar? You bet he is. On March 17, 2000, the stock of Inktomi Corp. hit a new high of $231.625. Since they first came on the market in June 1998, shares in the Internet-searching software company had gained roughly 1,900%. Just in the few weeks since December 1999, the stock had nearly tripled.
What was going on at Inktomi the business that could make Inktomi the stock so valuable? The answer seems obvious: phenomenally fast growth. In the three months ending in December 1999, Inktomi sold $36 million in products and services, more than it had in the entire year ending in December 1998. If Inktomi could sustain its growth rate of the previous 12 months for just five more years, its revenues would explode from $36 million a quarter to $5 billion a month. With such growth in sight, the faster the stock went up, the farther up it seemed certain to go.
But in his wild love affair with Inktomi’s stock, Mr. Market was overlooking something about its business. The company was losing money—lots of it. It had lost $6 million in the most recent quarter, $24 million in the 12 months before that, and $24 million in the year before that. In its entire corporate lifetime, Inktomi had never made a dime in profits. Yet, on March 17, 2000, Mr. Market valued this tiny business at a total of $25 billion. (Yes, that’s billion, with a B.)
And then Mr. Market went into a sudden, nightmarish depression.
On September 30, 2002, just two and a half years after hitting $231.625 per share, Inktomi’s stock closed at 25 cents—collapsing from a total market value of $25 billion to less than $40 million. Had Inktomi’s business dried up? Not at all; over the previous 12 months, the company had generated $113 million in revenues. So what had changed? Only Mr. Market’s mood: In early 2000, investors were so wild about the Internet that they priced Inktomi’s shares at 250 times the company’s revenues. Now, however, they would pay only 0.35 times its revenues. Mr. Market had morphed from Dr. Jekyll to Mr. Hyde and was ferociously trashing every stock that had made a fool out of him.
But Mr. Market was no more justified in his midnight rage than he had been in his manic euphoria. On December 23, 2002, Yahoo! Inc. announced that it would buy Inktomi for $1.65 per share. That was nearly seven times Inktomi’s stock price on September 30. History will probably show that Yahoo! got a bargain. When Mr. Market makes stocks so cheap, it’s no wonder that entire companies get bought right out from under him.
As Graham noted in a classic series of articles in 1932, the Great Depression caused the shares of dozens of companies to drop below the value of their cash and other liquid assets, making them "worth more dead than alive."

THINK FOR YOURSELF

Would you willingly allow a certifiable lunatic to come by at least five times a week to tell you that you should feel exactly the way he feels? Would you ever agree to be euphoric just because he is—or miserable just because he thinks you should be? Of course not. You’d insist on your right to take control of your own emotional life, based on your experiences and your beliefs. But, when it comes to their financial lives, millions of people let Mr. Market tell them how to feel and what to do—despite the obvious fact that, from time to time, he can get nuttier than a fruitcake.
In 1999, when Mr. Market was squealing with delight, American employees directed an average of 8.6% of their paychecks into their 401(k) retirement plans. By 2002, after Mr. Market had spent three years stuffing stocks into black garbage bags, the average contribution rate had dropped by nearly one-quarter, to just 7%.3 The cheaper stocks got, the less eager people became to buy them—because they were imitating Mr. Market, instead of thinking for themselves.
The intelligent investor shouldn’t ignore Mr. Market entirely. Instead, you should do business with him—but only to the extent that it serves your interests. Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them. You do not have to trade with him just because he constantly begs you to. By refusing to let Mr. Market be your master, you transform him into your servant. After all, even when he seems to be destroying values, he is creating them elsewhere. In 1999, the Wilshire 5000 index—the broadest measure of U.S. stock performance—gained 23.8%, powered by technology and telecommunications stocks. But 3,743 of the 7,234 stocks in the Wilshire index went down in value even as the average was rising. While those high-tech and telecom stocks were hotter than the hood of a race car on an August afternoon, thousands of “Old Economy” shares were frozen in the mud—getting cheaper and cheaper.
The stock of CMGI, an “incubator” or holding company for Internet start-up firms, went up an astonishing 939.9% in 1999. Meanwhile, Berkshire Hathaway—the holding company through which Graham’s greatest disciple, Warren Buffett, owns such Old Economy stalwarts as CocaCola, Gillette, and the Washington Post Co.—dropped by 24.9%. [A few months later, on March 10, 2000—the very day that NASDAQ hit its alltime high—online trading pundit James J. Cramer wrote that he had “repeatedly” been tempted in recent days to sell Berkshire Hathaway short, a bet that Buffett’s stock had farther to fall. With a vulgar thrust of his rhetorical pelvis, Cramer even declared that Berkshire’s shares were “ripe for the banging.” That same day, market strategist Ralph Acampora of Prudential Securities asked, “Norfolk Southern or Cisco Systems: Where do you want to be in the future?” Cisco, a key to tomorrow’s Internet superhighway, seemed to have it all over Norfolk Southern, part of yesterday’s railroad system. (Over the next year, Norfolk Southern gained 35%, while Cisco lost 70%.)]

But then, as it so often does, the market had a sudden mood swing. The stinkers of 1999 became the stars of 2000 through 2002. As for those two holding companies, CMGI went on to lose 96% in 2000, another 70.9% in 2001, and still 39.8% more in 2002—a cumulative loss of 99.3%. Berkshire Hathaway went up 26.6% in 2000 and 6.5% in 2001, then had a slight 3.8% loss in 2002—a cumulative gain of 30%.

CAN YOU BEAT THE PROS AT THEIR OWN GAME?
One of Graham’s most powerful insights is this: “The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage.” What does Graham mean by those words “basic advantage”? He means that the intelligent individual investor has the full freedom to choose whether or not to follow Mr. Market. You have the luxury of being able to think for yourself.

[When asked what keeps most individual investors from succeeding, Graham had a concise answer: “The primary cause of failure is that they pay too much attention to what the stock market is doing currently.” See “Benjamin Graham: Thoughts on Security Analysis” (transcript of lecture at Northeast Missouri State University Business School, March, 1972), Financial History magazine, no. 42, March, 1991, p. 8.]

The typical money manager, however, has no choice but to mimic Mr. Market’s every move—buying high, selling low, marching almost mindlessly in his erratic footsteps. Here are some of the handicaps mutualfund managers and other professional investors are saddled with:

• With billions of dollars under management, they must gravitate toward the biggest stocks—the only ones they can buy in the multimillion-dollar quantities they need to fill their portfolios. Thus many funds end up owning the same few overpriced giants.

• Investors tend to pour more money into funds as the market rises. The managers use that new cash to buy more of the stocks they already own, driving prices to even more dangerous heights.

• If fund investors ask for their money back when the market drops, the managers may need to sell stocks to cash them out. Just as the funds are forced to buy stocks at inflated prices in a rising market, they become forced sellers as stocks get cheap again.

• Many portfolio managers get bonuses for beating the market, so they obsessively measure their returns against benchmarks like the S & P 500 index. If a company gets added to an index, hundreds of funds compulsively buy it. (If they don’t, and that stock then does well, the managers look foolish; on the other hand, if they buy it and it does poorly, no one will blame them.)

• Increasingly, fund managers are expected to specialize. Just as in medicine the general practitioner has given way to the pediatric allergist and the geriatric otolaryngologist, fund managers must buy only “small growth” stocks, or only “mid-sized value” stocks, or nothing but “large blend” stocks. [Never mind what these terms mean, or are supposed to mean. While in public these classifications are treated with the utmost respect, in private most people in the investment business regard them with the contempt normally reserved for jokes that aren’t funny.]
If a company gets too big, or too small, or too cheap, or an itty bit too expensive, the fund has to sell it—even if the manager loves the stock.
So there’s no reason you can’t do as well as the pros. What you cannot do (despite all the pundits who say you can) is to “beat the pros at their own game.” The pros can’t even win their own game!
Why should you want to play it at all? If you follow their rules, you will lose—since you will end up as much a slave to Mr. Market as the professionals are.

Instead, recognize that investing intelligently is about controlling the controllable. You can’t control whether the stocks or funds you buy will outperform the market today, next week, this month, or this year; in the short run, your returns will always be hostage to Mr. Market and his whims. But you can control:
• your brokerage costs, by trading rarely, patiently, and cheaply
• your ownership costs, by refusing to buy mutual funds with excessive annual expenses
• your expectations, by using realism, not fantasy, to forecast your returns
• your risk, by deciding how much of your total assets to put at hazard in the stock market, by diversifying, and by rebalancing
• your tax bills, by holding stocks for at least one year and, whenever possible, for at least five years, to lower your capital-gains liability
• and, most of all, your own behavior.

If you listen to financial TV, or read most market columnists, you’d think that investing is some kind of sport, or a war, or a struggle for survival in a hostile wilderness. But investing isn’t about beating others at their game. It’s about controlling yourself at your own game. The challenge for the intelligent investor is not to find the stocks that will go up the most and down the least, but rather to prevent yourself from being your own worst enemy—from buying high just because Mr. Market says “Buy!” and from selling low just because Mr. Market says “Sell!”
If you investment horizon is long—at least 25 or 30 years—there is only one sensible approach: Buy every month, automatically, and whenever else you can spare some money. The single best choice for this lifelong holding is a total stock-market index fund. Sell only when you need the cash (for a psychological boost, clip out and sign your “Investment Owner’s Contract”—which you can find on p. 225).
To be an intelligent investor, you must also refuse to judge your financial success by how a bunch of total strangers are doing. You’re not one penny poorer if someone in Dubuque or Dallas or Denver beats the S & P 500 and you don’t. No one’s gravestone reads “HE BEAT THE MARKET.” I once interviewed a group of retirees in Boca Raton, one of Florida’s wealthiest retirement communities. I asked these people— mostly in their seventies—if they had beaten the market over their investing lifetimes. Some said yes, some said no; most weren’t sure.
Then one man said, “Who cares? All I know is, my investments earned enough for me to end up in Boca.”
Could there be a more perfect answer? After all, the whole point of investing is not to earn more money than average, but to earn enough money to meet your own needs. The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go. In the end, what matters isn’t crossing the finish line before anybody else but just making sure that you do cross it.

YOUR MONEY AND YOUR BRAIN
Why, then, do investors find Mr. Market so seductive? It turns out that our brains are hardwired to get us into investing trouble; humans are pattern-seeking animals. Psychologists have shown that if you present people with a random sequence—and tell them that it’s unpredictable—they will nevertheless insist on trying to guess what’s coming next. Likewise, we “know” that the next roll of the dice will be a seven, that a baseball player is due for a base hit, that the next winning number in the Powerball lottery will definitely be 4-27-9-16-42-10—and that this hot little stock is the next Microsoft.
Groundbreaking new research in neuroscience shows that our brains are designed to perceive trends even where they might not exist. After an event occurs just two or three times in a row, regions of the human brain called the anterior cingulate and nucleus accumbens automatically anticipate that it will happen again. If it does repeat, a natural chemical called dopamine is released, flooding your brain with a soft euphoria. Thus, if a stock goes up a few times in a row, you reflexively expect it to keep going—and your brain chemistry changes as the stock rises, giving you a “natural high.” You effectively become addicted to your own predictions.
But when stocks drop, that financial loss fires up your amygdala—the part of the brain that processes fear and anxiety and generates the famous “fight or flight” response that is common to all cornered animals. Just as you can’t keep your heart rate from rising if a fire alarm goes off, just as you can’t avoid flinching if a rattlesnake slithers onto your hiking path, you can’t help feeling fearful when stock prices are plunging.
In fact, the brilliant psychologists Daniel Kahneman and Amos Tversky have shown that the pain of financial loss is more than twice as intense as the pleasure of an equivalent gain. Making $1,000 on a stock feels great—but a $1,000 loss wields an emotional wallop more than twice as powerful. Losing money is so painful that many people, terrified at the prospect of any further loss, sell out near the bottom or
refuse to buy more.
That helps explain why we fixate on the raw magnitude of a market decline and forget to put the loss in proportion. So, if a TV reporter hollers, “The market is plunging—the Dow is down 100 points!” most people instinctively shudder. But, at the Dow’s recent level of 8,000, that’s a drop of just 1.2%. Now think how ridiculous it would sound if, on a day when it’s 81 degrees outside, the TV weatherman shrieked, “The temperature is plunging—it’s dropped from 81 degrees to 80 degrees!” That, too, is a 1.2% drop. When you forget to view changing market prices in percentage terms, it’s all too easy to panic over minor vibrations. (If you have decades of investing ahead of you, there’s a better way to visualize the financial news broadcasts; see the sidebar on p. 222.)
In the late 1990s, many people came to feel that they were in the dark unless they checked the prices of their stocks several times a day. But, as Graham puts it, the typical investor “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.” If, after checking the value of your stock portfolio at 1:24 P.M., you feel compelled to check it all over again at 1:37 P.M., ask yourself these questions:

• Did I call a real-estate agent to check the market price of my house at 1:24 P.M.? Did I call back at 1:37 P.M.?
• If I had, would the price have changed? If it did, would I have rushed to sell my house?
• By not checking, or even knowing, the market price of my house from minute to minute, do I prevent its value from rising over time? [It’s also worth asking whether you could enjoy living in your house if its market price was reported to the last penny every day in the newspapers and on TV.]

The only possible answer to these questions is of course not! And you should view your portfolio the same way. Over a 10- or 20- or 30- year investment horizon, Mr. Market’s daily dipsy-doodles simply do not matter. In any case, for anyone who will be investing for years to come, falling stock prices are good news, not bad, since they enable you to buy more for less money. The longer and further stocks fall, and the more steadily you keep buying as they drop, the more money you will make in the end—if you remain steadfast until the end. Instead of fearing a bear market, you should embrace it. The intelligent investor should be perfectly comfortable owning a stock or mutual fund even if the stock market stopped supplying daily prices for the next 10 years. [In a series of remarkable experiments in the late 1980s, a psychologist at Columbia and Harvard, Paul Andreassen, showed that investors who received frequent news updates on their stocks earned half the returns of investors who got no news at all. See Jason Zweig, “Here’s How to Use the News and Tune Out the Noise,” Money, July, 1998, pp. 63–64.]

Paradoxically, “you will be much more in control,” explains neuroscientist Antonio Damasio, “if you realize how much you are not in control.” By acknowledging your biological tendency to buy high and sell low, you can admit the need to dollar-cost average, rebalance, and sign an investment contract. By putting much of your portfolio on permanent autopilot, you can fight the prediction addiction, focus on your long-term financial goals, and tune out Mr. Market’s mood swings.

NEWS YOU COULD USE
Stocks are crashing, so you turn on the television to catch the latest market news. But instead of CNBC or CNN, imagine that you can tune in to the Benjamin Graham Financial Network. On BGFN, the audio doesn’t capture that famous sour clang of the market’s closing bell; the video doesn’t home in on brokers scurrying across the floor of the stock exchange like angry rodents. Nor does BGFN run any footage of investors gasping on frozen sidewalks as red arrows whiz overhead on electronic stock tickers.

Instead, the image that fills your TV screen is the facade of the New York Stock Exchange, festooned with a huge banner reading: “SALE! 50% OFF!” As intro music, Bachman-Turner Overdrive can be heard blaring a few bars of their old barnburner, “You Ain’t Seen Nothin’ Yet.” Then the anchorman announces brightly, “Stocks became more attractive yet again today, as the Dow dropped another 2.5% on heavy volume—the fourth day in a row that stocks have gotten cheaper. Tech investors fared even better, as leading companies like Microsoft lost nearly 5% on the day, making them even more affordable.
That comes on top of the good news of the past year, in which stocks have already lost 50%, putting them at bargain levels not seen in years. And some prominent analysts are optimistic that prices may drop still further in the weeks and months to come.”
The newscast cuts over to market strategist Ignatz Anderson of the Wall Street firm of Ketchum & Skinner, who says, “My forecast is for stocks to lose another 15% by June. I’m cautiously optimistic that if everything goes well, stocks could lose 25%, maybe more.”
“Let’s hope Ignatz Anderson is right,” the anchor says cheerily. “Falling stock prices would be fabulous news for any investor with a very long horizon. And now over to Wally Wood for our exclusive AccuWeather forecast.

WHEN MR. MARKET GIVES YOU LEMONS, MAKE LEMONADE
Although Graham teaches that you should buy when Mr. Market is yelling “sell,” there’s one exception the intelligent investor needs to understand. Selling into a bear market can make sense if it creates a tax windfall. The U.S. Internal Revenue Code allows you to use your realized losses (any declines in value that you lock in by selling your shares) to offset up to $3,000 in ordinary income. Let’s say you bought 200 shares of Coca-Cola stock in January 2000 for $60 a share—a total investment of $12,000. By year-end 2002, the stock was down to $44 a share, or $8,800 for your lot—a loss of $3,200. You could have done what most people do—either whine about your loss, or sweep it under the rug and pretend it never happened. Or you could have taken control. Before 2002 ended, you could have sold all your Coke shares, locking in the $3,200 loss. Then, after waiting 31 days to comply with IRS rules, you would buy 200 shares of Coke all over again. The result: You would be able to reduce your taxable income by $3,000 in 2002, and you could use the remaining $200 loss to offset your income in 2003. And better yet, you would still own a company whose future you believe in—but now you would own it for almost one-third less than you paid the first time. With Uncle Sam subsidizing your losses, it can make sense to sell and lock in a loss. If Uncle Sam wants to make Mr. Market look logical by comparison, who are we to complain?
Note: Federal tax law is subject to constant change. The example of Coca-Cola stock given here is valid under the provisions of the U.S. tax code as it stood in early 2003.

CHAPTER 9. INVESTING IN INVESTMENT FUNDS

One course open to the defensive investor is to put his money into investment-company shares. Those that are redeemable on demand by the holder, at net asset value, are commonly known as “mutual funds” (or “open-end funds”). Most of these are actively selling additional shares through a corps of salesmen. Those with nonredeemable shares are called “closed-end” companies or funds; the number of their shares remains relatively constant. All of the funds of any importance are registered with the Securities & Exchange Commission (SEC), and are subject to its regulations and controls.

It is a violation of Federal law for an open-end mutual fund, a closed-end fund, or an exchange-traded fund to sell shares to the public unless it has “registered” (or made mandatory financial filings) with the SEC.

Note: The fund industry has gone from “very large” to immense. At year-end 2002, there were 8,279 mutual funds holding $6.56 trillion; 514 closed-end funds with $149.6 billion in assets; and 116 exchange-trade funds or ETFs with $109.7 billion. These figures exclude such fund-like investments as variable annuities and unit investment trusts.

There are different ways of classifying the funds. One is by the broad division of their portfolio; they are “balanced funds” if they have a significant (generally about one-third) component of bonds, or “stock-funds” if their holdings are nearly all common stocks. (There are some other varieties here, such as “bond funds,” “hedge funds,” “letter-stock funds,” etc.)

Letter-stock funds no longer exist, while hedge funds are generally banned by SEC rules from selling shares to any investor whose annual income is below $200,000 or whose net worth is below $1 million.]

Another is by their objectives, as their primary aim is for income, price stability, or capital appreciation (“growth”). Another distinction is by their method of sale.
“Load funds” add a selling charge (generally about 9% of asset value on minimum purchases) to the value before charge. Others, known as “no-load” funds, make no such charge; the managements are content with the usual investment-counsel fees for handling the capital. Since they cannot pay salesmen’s commissions, the size of the no-load funds tends to be on the low side. [Note: Today, the maximum sales load on a stock fund tends to be around 5.75%.
If you invest $10,000 in a fund with a flat 5.75% sales load, $575 will go to the person (and brokerage firm) that sold it to you, leaving you with an initial net investment of $9,425. The $575 sales charge is actually 6.1% of that amount, which is why Graham calls the standard way of calculating the charge a “sales gimmick.” Since the 1980s, no-load funds have become popular, and they no longer tend to be smaller than load funds.]

The buying and selling prices of the closed-end funds are not fixed by the companies, but fluctuate in the open market as does the ordinary corporate stock.

In this chapter we shall deal with some major questions, viz:

1. Is there any way by which the investor can assure himself of better than average results by choosing the right funds? (Subquestion: What about the “performance funds”? [“Performance funds” were all the rage in the late 1960s. They were equivalent to the aggressive growth funds of the late 1990s, and served their investors no better.])

2. If not, how can he avoid choosing funds that will give him worse than average results?

3. Can he make intelligent choices between different types of funds—e.g., balanced versus all-stock, open-end versus closedend, load versus no-load?

Next subtopic in this chapter is: Investment-Fund Performance as a Whole

Note: For periods as long as 10 years, the returns of the Dow and the S & P 500 can diverge by fairly wide margins. Over the course of the typical investing lifetime, however—say 25 to 50 years—their returns have tended to converge quite closely.

Next subtopic in this chapter is: "Performance" Funds

Performance Fund: A mutual fund that invests primarily or exclusively in high-risk, high-return securities. They may invest in IPOs and quickly re-sell; they also commonly invest in options. Very little of the income from an aggressive growth mutual fund comes from dividends; rather, most of its earnings come from capital appreciation. (Ref)

Note: As only the latest proof that “the more things change, the more they stay the same,” consider that Ryan Jacob, a 29-year-old boy wonder, launched the Jacob Internet Fund at year-end 1999, after producing a 216% return at his previous dot-com fund. Investors poured nearly $300 million into Jacob’s fund in the first few weeks of 2000. It then proceeded to lose 79.1% in 2000, 56.4% in 2001, and 13% in 2002—a cumulative collapse of 92%. That loss may have made Mr. Jacob’s investors even older and wiser than it made him.

Note: Intriguingly, the disastrous boom and bust of 1999–2002 also came roughly 35 years after the previous cycle of insanity. Perhaps it takes about 35 years for the investors who remember the last “New Economy” craze to become less influential than those who do not. If this intuition is correct, the intelligent investor should be particularly vigilant around the year 2030.

Closed-End versus Open-End Funds
Almost all the mutual funds or open-end funds, which offer their holders the right to cash in their shares at each day’s valuation of the portfolio, have a corresponding machinery for selling new shares. By this means most of them have grown in size over the years. The closed-end companies, nearly all of which were organized a long time ago, have a fixed capital structure, and thus have diminished in relative dollar importance. Open-end companies are being sold by many thousands of energetic and persuasive salesmen, the closed-end shares have no one especially interested in distributing them. Consequently it has been possible to sell most “mutual funds” to the public at a fixed premium of about 9% above net asset value (to cover salesmen’s commissions, etc.), while the majority of close-end shares have been consistently obtainable at less than their asset value.

[Today’s equivalent of Graham’s “scarce exceptions” tend to be open-end funds that are closed to new investors—meaning that the managers have stopped taking in any more cash. While that reduces the management fees they can earn, it maximizes the returns their existing shareholders can earn. Because most fund managers would rather look out for No. 1 than be No. 1, closing a fund to new investors is a rare and courageous step.]

Note: A closed-end fund has a fixed number of shares offered by an investment company through an initial public offering. Open-end funds (which most of us think of when we think mutual funds) are offered through a fund company that sells shares directly to investors. (Ref)

COMMENTARY ON CHAPTER 9

ALMOST PERFECT

A purely American creation, the mutual fund was introduced in 1924 by a former salesman of aluminum pots and pans named Edward G. Leffler. Mutual funds are quite cheap, very convenient, generally diversified, professionally managed, and tightly regulated under some of the toughest provisions of Federal securities law. By making investing easy and affordable for almost anyone, the funds have brought some 54 million American families (and millions more around the world) into the investing mainstream—probably the greatest advance in financial democracy ever achieved. But mutual funds aren’t perfect; they are almost perfect, and that word makes all the difference. Because of their imperfections, most funds underperform the market, overcharge their investors, create tax headaches, and suffer erratic swings in performance. The intelligent investor must choose funds with great care in order to avoid ending up owning a big fat mess.

TOP OF THE CHARTS

Most investors simply buy a fund that has been going up fast, on the assumption that it will keep on going. And why not? Psychologists have shown that humans have an inborn tendency to believe that the long run can be predicted from even a short series of outcomes. What’s more, we know from our own experience that some plumbers are far better than others, that some baseball players are much more likely to hit home runs, that our favorite restaurant serves consistently superior food, and that smart kids get consistently good grades. Skill and brains and hard work are recognized, rewarded—and consistently repeated—all around us. So, if a fund beats the market, our intuition tells us to expect it to keep right on outperforming. Unfortunately, in the financial markets, luck is more important than skill. If a manager happens to be in the right corner of the market at just the right time, he will look brilliant—but all too often, what was hot suddenly goes cold and the manager’s IQ seems to shrivel by 50 points. Figure 9-1 shows what happened to the hottest funds of 1999. This is yet another reminder that the market’s hottest market sector—in 1999, that was technology—often turns as cold as liquid nitrogen, with blinding speed and utterly no warning. [Sector funds specializing in almost every imaginable industry are available—and date back to the 1920s. After nearly 80 years of history, the evidence is overwhelming: The most lucrative, and thus most popular, sector of any given year often turns out to be among the worst performers of the following year. Just as idle hands are the devil’s workshop, sector funds are the investor’s nemesis.]

And it’s a reminder that buying funds based purely on their past performance is one of the stupidest things an investor can do. Financial scholars have been studying mutual-fund performance for at least a half century, and they are virtually unanimous on several points:

• the average fund does not pick stocks well enough to overcome its costs of researching and trading them;
• the higher a fund’s expenses, the lower its returns;
• the more frequently a fund trades its stocks, the less it tends to earn;
• highly volatile funds, which bounce up and down more than average, are likely to stay volatile;
• funds with high past returns are unlikely to remain winners for long.

Your chances of selecting the top-performing funds of the future on the basis of their returns in the past are about as high as the odds that Bigfoot and the Abominable Snowman will both show up in pink ballet slippers at your next cocktail party. In other words, your chances are not zero—but they’re pretty close. But there’s good news, too. First of all, understanding why it’s so hard to find a good fund will help you become a more intelligent investor. Second, while past performance is a poor predictor of future returns, there are other factors that you can use to increase your odds of finding a good fund. Finally, a fund can offer excellent value even if it doesn’t beat the market—by providing an economical way to diversify your holdings and by freeing up your time for all the other things you would rather be doing than picking your own stocks.

THE FIRST SHALL BE LAST
Why don’t more winning funds stay winners?
The better a fund performs, the more obstacles its investors face:

Migrating managers.

When a stock picker seems to have the Midas touch, everyone wants him—including rival fund companies. If you bought Transamerica Premier Equity Fund to cash in on the skills of Glen Bickerstaff, who gained 47.5% in 1997, you were quickly out of luck; TCW snatched him away in mid-1998 to run its TCW Galileo Select Equities Fund, and the Transamerica fund lagged the market in three of the next four years. If you bought Fidelity Aggressive Growth Fund in early 2000 to capitalize on the high returns of Erin Sullivan, who had nearly tripled her shareholders’ money since 1997, oh well: She quit to start her own hedge fund in 2000, and her former fund lost more than three-quarters of its value over the next three years. [Note: That’s not to say that these funds would have done better if their “superstar” managers had stayed in place; all we can be sure of is that the two funds did poorly without them.]

Asset elephantiasis.

When a fund earns high returns, investors notice—often pouring in hundreds of millions of dollars in a matter of weeks. That leaves the fund manager with few choices—all of them bad. He can keep that money safe for a rainy day, but then the low returns on cash will crimp the fund’s results if stocks keep going up. He can put the new money into the stocks he already owns—which have probably gone up since he first bought them and will become dangerously overvalued if he pumps in millions of dollars more. Or he can buy new stocks he didn’t like well enough to own already—but he will have to research them from scratch and keep an eye on far more companies than he is used to following. Finally, when the $100-million Nimble Fund puts 2% of its assets (or $2 million) in Minnow Corp., a stock with a total market value of $500 million, it’s buying up less than one-half of 1% of Minnow. But if hot performance swells the Nimble Fund to $10 billion, then an investment of 2% of its assets would total $200 million—nearly half the entire value of Minnow, a level of ownership that isn’t even permissible under Federal law. If Nimble’s portfolio manager still wants to own small stocks, he will have to spread his money over vastly more companies—and probably end up spreading his attention too thin.

No more fancy footwork.

Some companies specialize in "incubating" their funds—test-driving them privately before selling them publicly. (Typically, the only shareholders are employees and affiliates of the fund company itself.) By keeping them tiny, the sponsor can use these incubated funds as guinea pigs for risky strategies that work best with small sums of money, like buying truly tiny stocks or rapid-fire trading of initial public offerings. If its strategy succeeds, the fund can lure public investors en masse by publicizing its private returns. In other cases, the fund manager “waives” (or skips charging) management fees, raising the net return—then slaps the fees on later after the high returns attract plenty of customers. Almost without exception, the returns of incubated and fee-waived funds have faded into mediocrity after outside investors poured millions of dollars into them.

Rising expenses.

It often costs more to trade stocks in very large blocks than in small ones; with fewer buyers and sellers, it’s harder to make a match. A fund with $100 million in assets might pay 1% a year in trading costs. But, if high returns send the fund mushrooming up to $10 billion, its trades could easily eat up at least 2% of those assets. The typical fund holds on to its stocks for only 11 months at a time, so trading costs eat away at returns like a corrosive acid. Meanwhile, the other costs of running a fund rarely fall—and sometimes even rise—as assets grow. With operating expenses averaging 1.5%, and trading costs at around 2%, the typical fund has to beat the market by 3.5 percentage points per year before costs just to match it after costs!

Sheepish behavior.

Finally, once a fund becomes successful, its managers tend to become timid and imitative. As a fund grows, its fees become more lucrative—making its managers reluctant to rock the boat. The very risks that the managers took to generate their initial high returns could now drive investors away—and jeopardize all that fat fee income. So the biggest funds resemble a herd of identical and overfed sheep, all moving in sluggish lockstep, all saying “baaaa” at the same time. Nearly every growth fund owns Cisco and GE and Microsoft and Pfizer and Wal-Mart—and in almost identical proportions. This behavior is so prevalent that finance scholars simply call it herding. But by protecting their own fee income, fund managers compromise their ability to produce superior returns for their outside investors.

Because of their fat costs and bad behavior, most funds fail to earn their keep. No wonder high returns are nearly as perishable as unrefrigerated fish. What’s more, as time passes, the drag of their excessive expenses leaves most funds farther and farther behind, as Figure 9.2 shows.

Amazingly, this illustration understates the advantage of index funds, since the database from which it is taken does not include the track records of hundreds of funds that disappeared over these periods. Measured more accurately, the advantage of indexing would be overpowering.

What, then, should the intelligent investor do?
First of all, recognize that an index fund—which owns all the stocks in the market, all the time, without any pretense of being able to select the “best” and avoid the “worst”—will beat most funds over the long run. (If your company doesn’t offer a low-cost index fund in your 401(k), organize your coworkers and petition to have one added.) Its rock-bottom overhead—operating expenses of 0.2% annually, and yearly trading costs of just 0.1%—give the index fund an insurmountable advantage. If stocks generate, say, a 7% annualized return over the next 20 years, a low-cost index fund like Vanguard Total Stock Market will return just under 6.7%. (That would turn a $10,000 investment into more than $36,000.) But the average stock fund, with its 1.5% in operating expenses and roughly 2% in trading costs, will be lucky to gain 3.5% annually. (That would turn $10,000 into just under $20,000—or nearly 50% less than the result from the index fund.)

Index funds have only one significant flaw: They are boring. You’ll never be able to go to a barbecue and brag about how you own the top-performing fund in the country. You’ll never be able to boast that you beat the market, because the job of an index fund is to match the market’s return, not to exceed it. Your index-fund manager is not likely to “roll the dice” and gamble that the next great industry will be teleportation, or scratch-’n’-sniff websites, or telepathic weight-loss clinics; the fund will always own every stock, not just one manager’s best guess at the next new thing. But, as the years pass, the cost advantage of indexing will keep accruing relentlessly. Hold an index fund for 20 years or more, adding new money every month, and you are all but certain to outperform the vast majority of professional and individual investors alike. Late in his life, Graham praised index funds as the best choice for individual investors, as does Warren Buffett. [As Warren Buffett wrote in his 1996 annual report: “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”]

TILTING THE TABLES

When you add up all their handicaps, the wonder is not that so few funds beat the index, but that any do. And yet, some do. What qualities do they have in common?

Their managers are the biggest shareholders.

The conflict of interest between what’s best for the fund’s managers and what’s best for its investors is mitigated when the managers are among the biggest owners of the fund’s shares. Some firms, like Longleaf Partners, even forbid their employees from owning anything but their own funds. At Longleaf and other firms like Davis and FPA, the managers own so much of the funds that they are likely to manage your money as if it were their own—lowering the odds that they will jack up fees, let the funds swell to gargantuan size, or whack you with a nasty tax bill. A fund’s proxy statement and Statement of Additional Information, both available from the Securities and Exchange Commission through the EDGAR database at www.sec.gov, disclose whether the managers own at least 1% of the fund’s shares.

They are cheap.

One of the most common myths in the fund business is that “you get what you pay for”—that high returns are the best justification for higher fees. There are two problems with this argument. First, it isn’t true; decades of research have proven that funds with higher fees earn lower returns over time. Secondly, high returns are temporary, while high fees are nearly as permanent as granite. If you buy a fund for its hot returns, you may well end up with a handful of cold ashes—but your costs of owning the fund are almost certain not to decline when its returns do.

They dare to be different.

When Peter Lynch ran Fidelity Magellan, he bought whatever seemed cheap to him—regardless of what other fund managers owned. In 1982, his biggest investment was Treasury bonds; right after that, he made Chrysler his top holding, even though most experts expected the automaker to go bankrupt; then, in 1986, Lynch put almost 20% of Fidelity Magellan in foreign stocks like Honda, Norsk Hydro, and Volvo. So, before you buy a U.S. stock fund, compare the holdings listed in its latest report against the roster of the S & P 500 index; if they look like Tweedledee and Tweedledum, shop for another fund.

They shut the door.

The best funds often close to new investors— permitting only their existing shareholders to buy more. That stops the feeding frenzy of new buyers who want to pile in at the top and protects the fund from the pains of asset elephantiasis. It’s also a signal that the fund managers are not putting their own wallets ahead of yours. But the closing should occur before—not after—the fund explodes in size. Some companies with an exemplary record of shutting their own gates are Longleaf, Numeric, Oakmark, T. Rowe Price, Vanguard, and Wasatch.

They don’t advertise.

Just as Plato says in The Republic that the ideal rulers are those who do not want to govern, the best fund managers often behave as if they don’t want your money. They don’t appear constantly on financial television or run ads boasting of their No. 1 returns. The steady little Mairs & Power Growth Fund didn’t even have a website until 2001 and still sells its shares in only 24 states. The Torray Fund has never run a retail advertisement since its launch in 1990.

What else should you watch for? Most fund buyers look at past performance first, then at the manager’s reputation, then at the riskiness of the fund, and finally (if ever) at the fund’s expenses. The intelligent investor looks at those same things—but in the opposite order. Since a fund’s expenses are far more predictable than its future risk or return, you should make them your first filter. There’s no good reason ever to pay more than these levels of annual operating expenses, by fund category:
• Taxable and municipal bonds: 0.75%
• U.S. equities (large and mid-sized stocks): 1.0%
• High-yield (junk) bonds: 1.0%
• U.S. equities (small stocks): 1.25%
• Foreign stocks: 1.50%

Next, evaluate risk. In its prospectus (or buyer’s guide), every fund must show a bar graph displaying its worst loss over a calendar quarter. If you can’t stand losing at least that much money in three months, go elsewhere. It’s also worth checking a fund’s Morningstar rating. A leading investment research firm, Morningstar awards “star ratings” to funds, based on how much risk they took to earn their returns (one star is the worst, five is the best). But, just like past performance itself, these ratings look back in time; they tell you which funds were the best, not which are going to be. Five-star funds, in fact, have a disconcerting habit of going on to underperform one-star funds. So first find a low-cost fund whose managers are major shareholders, dare to be different, don’t hype their returns, and have shown a willingness to shut down before they get too big for their britches. Then, and only then, consult their Morningstar rating.

Finally, look at past performance, remembering that it is only a pale predictor of future returns. As we’ve already seen, yesterday’s winners often become tomorrow’s losers. But researchers have shown that one thing is almost certain: Yesterday’s losers almost never become tomorrow’s winners. So avoid funds with consistently poor past returns—especially if they have above-average annual expenses.

THE CLOSED WORLD OF CLOSED-END FUNDS

Closed-end stock funds, although popular during the 1980s, have slowly atrophied. Today, there are only 30 diversified domestic equity funds, many of them tiny, trading only a few hundred shares a day, with high expenses and weird strategies (like Morgan FunShares, which specializes in the stocks of “habit-forming” industries like booze, casinos, and cigarettes). Research by closed-end fund expert Donald Cassidy of Lipper Inc. reinforces Graham’s earlier observations: Diversified closed-end stock funds trading at a discount not only tend to outperform those trading at a premium but are likely to have a better return than the average open-end mutual fund. Sadly, however, diversified closed-end stock funds are not always available at a discount in what has become a dusty, dwindling market. [Unlike a mutual fund, a closed-end fund does not issue new shares directly to anyone who wants to buy them. Instead, an investor must buy shares not from the fund itself, but from another shareholder who is willing to part with them. Thus, the price of the shares fluctuates above and below their net asset value, depending on supply and demand.]

But there are hundreds of closed-end bond funds, with especially strong choices available in the municipal-bond area. When these funds trade at a discount, their yield is amplified and they can be attractive, so long as their annual expenses are below the thresholds listed above.

The new breed of exchange-traded index funds can be worth exploring as well. These low-cost “ETFs” sometimes offer the only means by which an investor can gain entrée to a narrow market like, say, companies based in Belgium or stocks in the semiconductor industry. Other index ETFs offer much broader market exposure. However, they are generally not suitable for investors who wish to add money regularly, since most brokers will charge a separate commission on every new investment you make. [ Unlike index mutual funds, index ETFs are subject to standard stock commissions when you buy and sell them—and these commissions are often assessed on any additional purchases or reinvested dividends. ]

KNOW WHEN TO FOLD ’EM

Once you own a fund, how can you tell when it’s time to sell? The standard advice is to ditch a fund if it underperforms the market (or similar portfolios) for one—or is it two?—or is it three?—years in a row. But this advice makes no sense. From its birth in 1970 through 1999, the Sequoia Fund underperformed the S & P 500 index in 12 out of its 29 years—or more than 41% of the time. Yet Sequoia gained more than 12,500% over that period, versus 4,900% for the index. The performance of most funds falters simply because the type of stocks they prefer temporarily goes out of favor. If you hired a manager to invest in a particular way, why fire him for doing what he promised? By selling when a style of investing is out of fashion, you not only lock in a loss but lock yourself out of the all-but-inevitable recovery. One study showed that mutual-fund investors underperformed their own funds by 4.7 percentage points annually from 1998 through 2001— simply by buying high and selling low. So when should you sell? Here a few definite red flags:

• a sharp and unexpected change in strategy, such as a “value” fund loading up on technology stocks in 1999 or a “growth” fund buying tons of insurance stocks in 2002;
• an increase in expenses, suggesting that the managers are lining their own pockets;
• large and frequent tax bills generated by excessive trading;
• suddenly erratic returns, as when a formerly conservative fund generates a big loss (or even produces a giant gain).

As the investment consultant Charles Ellis puts it, “If you’re not prepared to stay married, you shouldn’t get married.” Fund investing is
no different. If you’re not prepared to stick with a fund through at least three lean years, you shouldn’t buy it in the first place. Patience is the fund investor’s single most powerful ally.

WHY WE LOVE OUR OUIJA BOARDS

Believing—or even just hoping—that we can pick the best funds of the future makes us feel better. It gives us the pleasing sensation that we are in charge of our own investment destiny. This “I’m-in-control-here” feeling is part of the human condition; it’s what psychologists call overconfidence. Here are just a few examples of how it works:

• In 1999, Money Magazine asked more than 500 people whether their portfolios had beaten the market. One in four said yes. When asked to specify their returns, however, 80% of those investors reported gains lower than the market’s. (Four percent had no idea how much their portfolios rose— but were sure they had beaten the market anyway!)

• A Swedish study asked drivers who had been in severe car crashes to rate their own skills behind the wheel. These people—including some the police had found responsible for the accidents and others who had been so badly injured that they answered the survey from their hospital beds—insisted they were better-than-average drivers.

• In a poll taken in late 2000, Time and CNN asked more than 1,000 likely voters whether they thought they were in the top 1% of the population by income. Nineteen percent placed themselves among the richest 1% of Americans.

• In late 1997, a survey of 750 investors found that 74% believed their mutual-fund holdings would “consistently beat the Standard & Poor’s 500 each year”—even though most funds fail to beat the S & P 500 in the long run and many fail to beat it in any year.

While this kind of optimism is a normal sign of a healthy psyche, that doesn’t make it good investment policy. It makes sense to believe you can predict something only if it actually is predictable. Unless you are realistic, your quest for self-esteem will end up in self-defeat.

CHAPTER 10. THE INVESTOR AND HIS ADVISERS

Advice on investments may be obtained from a variety of sources. These include:
(1) a relative or friend, presumably knowledgeable in securities;
(2) a local (commercial) banker;
(3) a brokerage firm or investment banking house;
(4) a financial service or periodical; and
(5) an investment counselor.

The list of sources for investment advice remains as “miscellaneous” as it was when Graham wrote. A survey of investors conducted in late 2002 for the Securities Industry Association, a Wall Street trade group, found that 17% of investors depended most heavily for investment advice on a spouse or friend; 2% on a banker; 16% on a broker; 10% on financial periodicals; and 24% on a financial planner. The only difference from Graham’s day is that 8% of investors now rely heavily on the Internet and 3% on financial television.

The chapter has following subtopics:
• Investment Counsel and Trust Services of Banks
Note: The character of investment counseling firms and trust banks has not changed, but today they generally do not offer their services to investors with less than $1 million in financial assets; in some cases, $5 million or more is required. Today thousands of independent financial-planning firms perform very similar functions, although (as analyst Robert Veres puts it) the mutual fund has replaced blue-chip stocks as the investment of choice and diversification has replaced “quality” as the standard of safety.

• Financial Services
• Advice from Brokerage Houses

Note 1: A great deal is at stake in the innocent-appearing question whether “customers” or “clients” is the more appropriate name. A business has customers; a professional person or organization has clients. The Wall Street brokerage fraternity has probably the highest ethical standards of any business, but it is still feeling its way toward the standards and standing of a true profession.

Overall, Graham was as tough and cynical an observer as Wall Street has ever seen. In this rare case, however, he was not nearly cynical enough. Wall Street may have higher ethical standards than some businesses (smuggling, prostitution, Congressional lobbying, and journalism come to mind) but the investment world nevertheless has enough liars, cheaters, and thieves to keep Satan’s check-in clerks frantically busy for decades to come.

Note 2: In the past Wall Street has thrived mainly on speculation, and stock-market speculators as a class were almost certain to lose money. Hence it has been logically impossible for brokerage houses to operate on a thoroughly professional basis. To do that would have required them to direct their efforts toward reducing rather than increasing their business. The farthest that certain brokerage houses have gone in that direction—and could have been expected to go—is to refrain from inducing or encouraging anyone to speculate. Such houses have confined themselves to executing orders given them, to supplying financial information and analyses, and to rendering opinions on the investment merits of securities. Thus, in theory at least, they are devoid of all responsibility for either the profits or the losses of their speculative customers.

The thousands of people who bought stocks in the late 1990s in the belief that Wall Street analysts were providing unbiased and valuable advice have learned, in a painful way, how right Graham is on this point.

Note 3: Most stock-exchange houses, however, still adhere to the oldtime slogans that they are in business to make commissions and that the way to succeed in business is to give the customers what they want. Since the most profitable customers want speculative advice and suggestions, the thinking and activities of the typical firm are pretty closely geared to day-to-day trading in the market. Thus it tries hard to help its customers make money in a field where they are condemned almost by mathematical law to lose in the end.

Interestingly, this stinging criticism, which in his day Graham was directing at full-service brokers, ended up applying to discount Internet brokers in the late 1990s. These firms spent millions of dollars on flashy advertising that goaded their customers into trading more and trading faster. Most of those customers ended up picking their own pockets, instead of paying someone else to do it for them—and the cheap commissions on that kind of transaction are a poor consolation for the result. More traditional brokerage firms, meanwhile, began emphasizing financial planning and “integrated asset management,” instead of compensating their brokers only on the basis of how many commissions they could generate.

Note 4: By what must seem a quirk to the outsider there are no formal requirements for being a security analyst. Contrast with this the facts that a customer’s broker must pass an examination, meet the required character tests, and be duly accepted and registered by the New York Stock Exchange. As a practical matter, nearly all the younger analysts have had extensive business-school training, and the oldsters have acquired at least the equivalent in the school of long experience. In the great majority of cases, the employing brokerage house can be counted on to assure itself of the qualifications and competence of its analysts.

This remains true, although many of Wall Street’s best analysts hold the title of chartered financial analyst. The CFA certification is awarded by the Association of Investment Management & Research (formerly the Financial Analysts Federation) only after the candidate has completed years of rigorous study and passed a series of difficult exams. More than 50,000 analysts worldwide have been certified as CFAs. Sadly, a recent survey by Professor Stanley Block found that most CFAs ignore Graham’s teachings: Growth potential ranks higher than quality of earnings, risks, and dividend policy in determining P/E ratios, while far more analysts base their buy ratings on recent price than on the long-term outlook for the company. See Stanley Block, “A Study of Financial Analysts: Practice and Theory,” Financial Analysts Journal, July/August, 1999, at www.aimrpubs.org. As Graham was fond of saying, his own books have been read by—and ignored by—more people than any other books in finance.

Note 5: It is highly unusual today for a security analyst to allow mere commoners to contact him directly. For the most part, only the nobility of institutional investors are permitted to approach the throne of the almighty Wall Street analyst. An individual investor might, perhaps, have some luck calling analysts who work at “regional” brokerage firms headquartered outside of New York City. The investor relations area at the websites of most publicly traded companies will provide a list of analysts who follow the stock. Websites like www.zacks.com and www.multex.com offer access to analysts’ research reports—but the intelligent investor should remember that most analysts do not analyze businesses. Instead, they engage in guesswork about future stock prices.

• The CFA Certificate for Financial Analysts
• Dealings with Brokerage Houses

Note: The two firms Graham had in mind were probably Du Pont, Glore, Forgan & Co. and Goodbody & Co. Du Pont (founded by the heirs to the chemical fortune) was saved from insolvency in 1970 only after Texas entrepreneur H. Ross Perot lent more than $50 million to the firm; Goodbody, the fifth largest brokerage firm in the United States, would have failed in late 1970 had Merrill Lynch not acquired it. Hayden, Stone & Co. would also have gone under if it had not been acquired. In 1970, no fewer than seven brokerage firms went bust. The farcical story of Wall Street’s frenzied overexpansion in the late 1960s is beautifully told in John Brooks’s The Go-Go Years (John Wiley & Sons, New York, 1999).

• Investment Bankers
Note: The term “investment banker” is applied to a firm that engages to an important extent in originating, underwriting, and selling new issues of stocks and bonds. (To underwrite means to guarantee to the issuing corporation, or other issuer, that the security will be fully sold.)

• Other Advisers
• Summary

COMMENTARY ON CHAPTER 10

DO YOU NEED HELP?
In the glory days of the late 1990s, many investors chose to go it alone. By doing their own research, picking stocks themselves, and placing their trades through an online broker, these investors bypassed Wall Street’s costly infrastructure of research, advice, and trading. Unfortunately, many do-it-yourselfers asserted their independence right before the worst bear market since the Great Depression—making them feel, in the end, that they were fools for going it alone. That’s not necessarily true, of course; people who delegated every decision to a traditional stockbroker lost money, too.

But many investors do take comfort from the experience, judgment, and second opinion that a good financial adviser can provide. Some investors may need an outsider to show them what rate of return they need to earn on their investments, or how much extra money they need to save, in order to meet their financial goals. Others may simply benefit from having someone else to blame when their investments go down; that way, instead of beating yourself up in an agony of selfdoubt, you get to criticize someone who typically can defend him or herself and encourage you at the same time. That may provide just the psychological boost you need to keep investing steadily at a time when other investors’ hearts may fail them. All in all, just as there’s no reason you can’t manage your own portfolio, so there’s no shame in seeking professional help in managing it. How can you tell if you need a hand? Here are some signals:

Big losses.

If your portfolio lost more than 40% of its value from the beginning of 2000 through the end of 2002, then you did even worse than the dismal performance of the stock market itself. It hardly matters whether you blew it by being lazy, reckless, or just unlucky; after such a giant loss, your portfolio is crying out for help.

Busted budgets.

If you perennially struggle to make ends meet, have no idea where your money goes, find it impossible to save on a regular schedule, and chronically fail to pay your bills on time, then your finances are out of control. An adviser can help you get a grip on your money by designing a comprehensive financial plan that will outline how—and how much—you should spend, borrow, save, and invest.

Chaotic portfolios.

All too many investors thought they were diversified in the late 1990s because they owned 39 “different” Internet stocks, or seven “different” U.S. growth-stock funds. But that’s like thinking that an all-soprano chorus can handle singing “Old Man River” better than a soprano soloist can. No matter how many sopranos you add, that chorus will never be able to nail all those low notes until some baritones join the group. Likewise, if all your holdings go up and down together, you lack the investing harmony that true diversification brings. A professional “asset-allocation” plan can help.

Major changes.

If you’ve become self-employed and need to set up a retirement plan, your aging parents don’t have their finances in order, or college for your kids looks unaffordable, an adviser can not only provide peace of mind but help you make genuine improvements in the quality of your life. What’s more, a qualified professional can ensure that you benefit from and comply with the staggering complexity of the tax laws and retirement rules.

TRUST, THEN VERIFY

Remember that financial con artists thrive by talking you into trusting them and by talking you out of investigating them. Before you place your financial future in the hands of an adviser, it’s imperative that you find someone who not only makes you comfortable but whose honesty is beyond reproach. As Ronald Reagan used to say, “Trust, then verify.” Start off by thinking of the handful of people you know best and trust the most. Then ask if they can refer you to an adviser whom they trust and who, they feel, delivers good value for his fees. A vote of confidence from someone you admire is a good start. [ If you’re unable to get a referral from someone you trust, you may be able to find a fee-only financial planner through www.napfa.org (or www.feeonly.org), whose members are generally held to high standards of service and integrity.]

Once you have the name of the adviser and his firm, as well as his specialty—is he a stockbroker? financial planner? accountant? insurance agent?—you can begin your due diligence. Enter the name of the adviser and his or her firm into an Internet search engine like Google to see if anything comes up (watch for terms like “fine,” “complaint,” “lawsuit,” “disciplinary action,” or “suspension”). If the adviser is a stockbroker or insurance agent, contact the office of your state’s securities commissioner (a convenient directory of online links is at www.nasaa.org) to ask whether any disciplinary actions or customer complaints have been filed against the adviser. [By itself, a customer complaint is not enough to disqualify an adviser from your consideration; but a persistent pattern of complaints is. And a disciplinary action by state or Federal regulators usually tells you to find another adviser. Another source for checking a broker’s record is http://pdpi.nasdr.com/PDPI ]

If you’re considering an accountant who also functions as a financial adviser, your state’s accounting regulators (whom you can find through the National Association of State Boards of Accountancy at www.nasba.org) will tell you whether his or her record is clean. Financial planners (or their firms) must register with either the U.S. Securities and Exchange Commission or securities regulators in the state where their practice is based. As part of that registration, the adviser must file a two-part document called Form ADV. You should be able to view and download it at www.advisorinfo.sec.gov, www.iard.com, or the website of your state securities regulator. Pay special attention to the Disclosure Reporting Pages, where the adviser must disclose any disciplinary actions by regulators. (Because unscrupulous advisers have been known to remove those pages before handing an ADV to a prospective client, you should independently obtain your own complete copy.) It’s a good idea to cross-check a financial planner’s record at www.cfp-board.org, since some planners who have been disciplined outside their home state can fall through the regulatory cracks. For more tips on due diligence, see the sidebar below.

WORDS OF WARNING

The need for due diligence doesn’t stop once you hire an adviser. Melanie Senter Lubin, securities commissioner for the State of Maryland, suggests being on guard for words and phrases that can spell trouble. If your adviser keeps saying them—or twisting your arm to do anything that makes you uncomfortable—“then get in touch with the authorities very quickly,” warns Lubin. Here’s the kind of lingo that should set off warning bells:
“offshore”
“the opportunity of a lifetime”
“prime bank”
“This baby’s gonna move.”
“guaranteed”
“You need to hurry.”
“It’s a sure thing.”
“our proprietary computer model”
“The smart money is buying it.”
“options strategy”
“It’s a no-brainer.”
“You can’t afford not to own it.”
“We can beat the market.”
“You’ll be sorry if you don’t...”
“exclusive”
“You should focus on performance, not fees.”
“Don’t you want to be rich?”
“can’t lose”
“The upside is huge.”
“There’s no downside.”
“I’m putting my mother in it.”
“Trust me.”
“commodities trading”
“monthly returns”
“active asset-allocation strategy”
“We can cap your downside.”
"No one else knows how to do this."

GETTING TO KNOW YOU

A leading financial-planning newsletter recently canvassed dozens of advisers to get their thoughts on how you should go about interviewing them. In screening an adviser, your goals should be to:
• determine whether he or she cares about helping clients, or just goes through the motions
• establish whether he or she understands the fundamental principles of investing as they are outlined in this book
• assess whether he or she is sufficiently educated, trained, and experienced to help you.

Here are some of the questions that prominent financial planners recommended any prospective client should ask:
Why are you in this business? What is the mission statement of your firm? Besides your alarm clock, what makes you get up in the morning?
What is your investing philosophy? Do you use stocks or mutual funds? Do you use technical analysis? Do you use market timing? (A “yes” to either of the last two questions is a “no” signal to you.)
Do you focus solely on asset management, or do you also advise on taxes, estate and retirement planning, budgeting and debt management, and insurance? How do your education, experience, and credentials qualify you to give those kinds of financial advice? [Credentials like the CFA, CFP, or CPA tell you that the adviser has taken and passed a rigorous course of study. (Most of the other “alphabet soup” of credentials brandished by financial planners, including the “CFM” or the “CMFC,” signify very little.) More important, by contacting the organization that awards the credential, you can verify his record and check that he has not been disciplined for violations of rules or ethics.]

What needs do your clients typically have in common? How can you help me achieve my goals? How will you track and report my progress? Do you provide a checklist that I can use to monitor the implementation of any financial plan we develop?

How do you choose investments? What investing approach do you believe is most successful, and what evidence can you show me that you have achieved that kind of success for your clients? What do you do when an investment performs poorly for an entire year? (Any adviser who answers “sell” is not worth hiring.) Do you, when recommending investments, accept any form of compensation from any third party? Why or why not? Under which circumstances? How much, in actual dollars, do you estimate I would pay for your services the first year? What would make that number go up or down over time? (If fees will consume more than 1% of your assets annually, you should probably shop for another adviser. [ If you have less than $100,000 to invest, you may not be able to find a financial adviser who will take your account. In that case, buy a diversified basket of low-cost index funds, follow the behavioral advice throughout this book, and your portfolio should eventually grow to the level at which you can afford an adviser.])

How many clients do you have, and how often do you communicate with them? What has been your proudest achievement for a client? What characteristics do your favorite clients share? What’s the worst experience you’ve had with a client, and how did you resolve it? What determines whether a client speaks to you or to your support staff? How long do clients typically stay with you? Can I see a sample account statement? (If you can’t understand it, ask the adviser to explain it. If you can’t understand his explanation, he’s not right for you.)
Do you consider yourself financially successful? Why? How do you define financial success? How high an average annual return do you think is feasible on my investments? (Anything over 8% to10% is unrealistic.) Will you provide me with your résumé, your Form ADV, and at least three references? (If the adviser or his firm is required to file an ADV, and he will not provide you a copy, get up and leave—and keep one hand on your wallet as you go.) Have you ever had a formal complaint filed against you? Why did the last client who fired you do so?

DEFEATING YOUR OWN WORST ENEMY

Finally, bear in mind that great financial advisers do not grow on trees. Often, the best already have as many clients as they can handle—and may be willing to take you on only if you seem like a good match. So they will ask you some tough questions as well, which might include:
Why do you feel you need a financial adviser?
What are your long-term goals?
What has been your greatest frustration in dealing with other advisers (including yourself)?
Do you have a budget? Do you live within your means?
What percentage of your assets do you spend each year?
When we look back a year from now, what will I need to have accomplished in order for you to be happy with your progress?
How do you handle conflicts or disagreements?
How did you respond emotionally to the bear market that began in 2000?
What are your worst financial fears? Your greatest financial hopes?
What rate of return on your investments do you consider reasonable? (Base your answer on Chapter 3.)

An adviser who doesn’t ask questions like these—and who does not show enough interest in you to sense intuitively what other questions you consider to be the right ones—is not a good fit. Above all else, you should trust your adviser enough to permit him or her to protect you from your worst enemy—yourself. “You hire an adviser,” explains commentator Nick Murray, “not to manage money but to manage you.”
“If the adviser is a line of defense between you and your worst impulsive tendencies,” says financial-planning analyst Robert Veres, “then he or she should have systems in place that will help the two of you control them.” Among those systems:
• a comprehensive financial plan that outlines how you will earn, save, spend, borrow, and invest your money;
• an investment policy statement that spells out your fundamental approach to investing;
• an asset-allocation plan that details how much money you will keep in different investment categories.

These are the building blocks on which good financial decisions must be founded, and they should be created mutually—by you and the adviser—rather than imposed unilaterally. You should not invest a dollar or make a decision until you are satisfied that these foundations are in place and in accordance with your wishes.

CHAPTER 11. SECURITY ANALYSIS FOR THE LAY INVESTOR: GENERAL APPROACH

Note: The higher the growth rate you project, and the longer the future period over which you project it, the more sensitive your forecast becomes to the slightest error. If, for instance, you estimate that a company earning $1 per share can raise that profit by 15% a year for the next 15 years, its earnings would end up at $8.14. If the market values the company at 35 times earnings, the stock would finish the period at roughly $285. But if earnings grow at 14% instead of 15%, the company would earn $7.14 at the end of the period—and, in the shock of that shortfall, investors would no longer be willing to pay 35 times earnings. At, say, 20 times earnings, the stock would end up around $140 per share, or more than 50% less. Because advanced mathematics gives the appearance of precision to the inherently iffy process of foreseeing the future, investors must be highly skeptical of anyone who claims to hold any complex computational key to basic financial problems.

As Graham put it: “In 44 years of Wall Street experience and study, I have never seen dependable calculations made about common-stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.”

Bond Analysis

In 1972, an investor in corporate bonds had little choice but to assemble his or her own portfolio. Today, roughly 500 mutual funds invest in corporate bonds, creating a convenient, well-diversified bundle of securities. Since it is not feasible to build a diversified bond portfolio on your own unless you have at least $100,000, the typical intelligent investor will be best off simply buying a low-cost bond fund and leaving the painstaking labor of credit research to its managers. For more on bond funds, see the commentary on Chapter 4.

Note: "Earnings-coverage test": The interest coverage ratio is used to determine how easily a company can pay their interest expenses on outstanding debt. The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period.

In addition to the earnings-coverage test, a number of others are generally applied. These include the following:

1. Size of Enterprise. There is a minimum standard in terms of volume of business for a corporation—varying as between industrials, utilities, and railroads—and of population for a municipality.

2. Stock/Equity Ratio. This is the ratio of the market price of the junior stock issues [By “junior stock issues” Graham means shares of common stock. Preferred stock is considered “senior” to common stock because the company must pay all dividends on the preferred before paying any dividends on the common.] to the total face amount of the debt, or the debt plus preferred stock. It is a rough measure of the protection, or “cushion,” afforded by the presence of a junior investment that must first bear the brunt of unfavorable developments. This factor includes the market’s appraisal of the future prospects of the enterprise.

3. Property Value. The asset values, as shown on the balance sheet or as appraised, were formerly considered the chief security and protection for a bond issue. Experience has shown that in most cases safety resides in the earning power, and if this is deficient the assets lose most of their reputed value. Asset values, however, retain importance as a separate test of ample security for bonds and preferred stocks in three enterprise groups: public utilities (because rates may depend largely on the property investment), real-estate concerns, and investment companies.

Common-Stock Analysis

In more recent years, most mutual funds have almost robotically mimicked the Standard & Poor’s 500-stock index, lest any different holdings cause their returns to deviate from that of the index. In a countertrend, some fund companies have launched what they call “focused” portfolios, which own 25 to 50 stocks that the managers declare to be their “best ideas.” That leaves investors wondering whether the other funds run by the same managers contain their worst ideas. Considering that most of the “best idea” funds do not markedly outperform the averages, investors are also entitled to wonder whether the managers’ ideas are even worth having in the first place. For indisputably skilled investors like Warren Buffett, wide diversification would be foolish, since it would water down the concentrated force of a few great ideas. But for the typical fund manager or individual investor, not diversifying is foolish, since it is so difficult to select a limited number of stocks that will include most winners and exclude most losers. As you own more stocks, the damage any single loser can cause will decline, and the odds of owning all the big winners will rise. The ideal choice for most investors is a total stock market index fund, a low-cost way to hold every stock worth owning.

Factors Affecting the Capitalization Rate

Let us deal briefly with some of the considerations that enter into these divergent multipliers.

1. General Long-Term Prospects.

No one really knows anything about what will happen in the distant future, but analysts and investors have strong views on the subject just the same. These views are reflected in the substantial differentials between the price/earnings ratios of individual companies and of industry groups. At this point we added in our 1965 edition: For example, at the end of 1963 the chemical companies in the DJIA were selling at considerably higher multipliers than the oil companies, indicating stronger confidence in the prospects of the former than of the latter. Such distinctions made by the market are often soundly based, but when dictated mainly by past performance they are as likely to be wrong as right.

Note: Wall Street’s consensus view of the future for any given sector is usually either too optimistic or too pessimistic. Worse, the consensus is at its most cheery just when the stocks are most overpriced—and gloomiest just when they are cheapest. The most recent example, of course, is technology and telecommunications stocks, which hit record highs when their future seemed brightest in 1999 and early 2000, and then crashed all the way through 2002. History proves that Wall Street’s “expert” forecasters are equally inept at predicting the performance of 1) the market as a whole, 2) industry sectors, and 3) specific stocks. As Graham points out, the odds that individual investors can do any better are not good. The intelligent investor excels by making decisions that are not dependent on the accuracy of anybody’s forecasts, including his or her own. (See Chapter 8.)

2. Management.

On Wall Street a great deal is constantly said on this subject, but little that is really helpful. Until objective, quantitative, and reasonably reliable tests of managerial competence are devised and applied, this factor will continue to be looked at through a fog. It is fair to assume that an outstandingly successful company has unusually good management. This will have shown itself already in the past record; it will show up again in the estimates for the next five years, and once more in the previously discussed factor of long-term prospects. The tendency to count it still another time as a separate bullish consideration can easily lead to expensive overvaluations. The management factor is most useful, we think, in those cases in which a recent change has taken place that has not yet had the time to show its significance in the actual figures.

3. Financial Strength and Capital Structure.

Stock of a company with a lot of surplus cash and nothing ahead of the common is clearly a better purchase (at the same price) than another one with the same per share earnings but large bank loans and senior securities. Such factors are properly and carefully taken into account by security analysts. A modest amount of bonds or preferred stock, however, is not necessarily a disadvantage to the common, nor is the moderate use of seasonal bank credit. (Incidentally, a top-heavy structure—too little common stock in relation to bonds and preferred—may under favorable conditions make for a huge speculative profit in the common. This is the factor known as “leverage.”)

4. Dividend Record.

One of the most persuasive tests of high quality is an uninterrupted record of dividend payments going back over many years. We think that a record of continuous dividend payments for the last 20 years or more is an important plus factor in the company’s quality rating. Indeed the defensive investor might be justified in limiting his purchases to those meeting this test.

5. Current Dividend Rate.

This, our last additional factor, is the most difficult one to deal with in satisfactory fashion. Fortunately, the majority of companies have come to follow what may be called a standard dividend policy. This has meant the distribution of about two-thirds of their average earnings, except that in the recent period of high profits and inflationary demands for more capital the figure has tended to be lower. (In 1969 it was 59.5% for the stocks in the Dow Jones average, and 55% for all American corporations.) [This figure, now known as the “dividend payout ratio,” has dropped considerably since Graham’s day as American tax law discouraged investors from seeking, and corporations from paying, dividends. As of year-end 2002, the payout ratio stood at 34.1% for the S & P 500-stock index and, as recently as April 2000, it hit an all-time low of just 25.3%. ( See www.barra.com/research/fundamentals.asp ) We discuss dividend policy more thoroughly in the commentary on Chapter 19.] Where the dividend bears a normal relationship to the earnings, the valuation may be made on either basis without substantially affecting the result.

Capitalization Rates for Growth Stocks

Most of the writing of security analysts on formal appraisals relates to the valuation of growth stocks. Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the valuation of growth stocks, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations. Our formula is:

Value = Current (Normal) Earnings * (8.5 plus twice the expected annual growth rate)

Note: By “the rule of 72,” at 10% interest a given amount of money doubles in just over seven years, while at 7% it doubles in just over 10 years. When interest rates are high, the amount of money you need to set aside today to reach a given value in the future is lower—since those high interest rates will enable it to grow at a more rapid rate. Thus a rise in interest rates today makes a future stream of earnings or dividends less valuable—since the alternative of investing in bonds has become relatively more attractive.

In finance, the rule of 72, the rule of 70 and the rule of 69.3 are methods for estimating an investment's doubling time. The rule number is divided by the interest percentage per period to obtain the approximate number of periods required for doubling.

Next subtopics:
• Industry Analysis
• A Two-Part Appraisal Process

COMMENTARY ON CHAPTER 11

Putting a Price on the Future

Which factors determine how much you should be willing to pay for a stock? What makes one company worth 10 times earnings and another worth 20 times? How can you be reasonably sure that you are not overpaying for an apparently rosy future that turns out to be a murky nightmare?

Graham feels that five elements are decisive.1 He summarizes them as:
• the company’s “general long-term prospects”
• the quality of its management
• its financial strength and capital structure
• its dividend record
• and its current dividend rate.

Let’s look at these factors in the light of today’s market. The long-term prospects. Nowadays, the intelligent investor should begin by downloading at least five years’ worth of annual reports (Form 10-K) from the company’s website or from the EDGAR database at www.sec.gov. [You should also get at least one year’s worth of quarterly reports (on Form 10-Q). By definition, we are assuming that you are an “enterprising” investor willing to devote a considerable amount of effort to your portfolio. If the steps in this chapter sound like too much work to you, then you are not temperamentally well suited to picking your own stocks. You cannot reliably obtain the results you imagine unless you put in the kind of effort we describe.]

Then comb through the financial statements, gathering evidence to help you answer two overriding questions. What makes this company grow? Where do (and where will) its profits come from? Among the problems to watch for:

• The company is a “serial acquirer.” An average of more than two or three acquisitions a year is a sign of potential trouble. After all, if the company itself would rather buy the stock of other businesses than invest in its own, shouldn’t you take the hint and look elsewhere too? And check the company’s track record as an acquirer. Watch out for corporate bulimics—firms that wolf down big acquisitions, only to end up vomiting them back out. Lucent, Mattel, Quaker Oats, and Tyco International are among the companies that have had to disgorge acquisitions at sickening losses. Other firms take chronic write-offs, or accounting charges proving that they overpaid for their past acquisitions. That’s a bad omen for future deal making. [You can usually find details on acquisitions in the “Management’s Discussion and Analysis” section of Form 10-K; cross-check it against the footnotes to the financial statements. For more on “serial acquirers,” see the commentary on Chapter 12.]

• The company is an OPM addict, borrowing debt or selling stock to raise boatloads of Other People’s Money. These fat infusions of OPM are labeled “cash from financing activities” on the statement of cash flows in the annual report. They can make a sick company appear to be growing even if its underlying businesses are not generating enough cash—as Global Crossing and WorldCom showed not long ago. [To determine whether a company is an OPM addict, read the “Statement of Cash Flows” in the financial statements. This page breaks down the company’s cash inflows and outflows into “operating activities,” “investing activities,” and “financing activities.” If cash from operating activities is consistently negative, while cash from financing activities is consistently positive, the company has a habit of craving more cash than its own businesses can produce—and you should not join the “enablers” of that habitual abuse. For more on Global Crossing, see the commentary on Chapter 12. For more on WorldCom, see the sidebar in the commentary on Chapter 6.]

• The company is a Johnny-One-Note, relying on one customer (or a handful) for most of its revenues. In October 1999, fiber-optics maker Sycamore Networks, Inc. sold stock to the public for the first time. The prospectus revealed that one customer, Williams Communications, accounted for 100% of Sycamore’s $11 million in total revenues. Traders blithely valued Sycamore’s shares at $15 billion. Unfortunately, Williams went bankrupt just over two years later. Although Sycamore picked up other customers, its stock lost 97% between 2000 and 2002.

As you study the sources of growth and profit, stay on the lookout for positives as well as negatives. Among the good signs:

• The company has a wide “moat,” or competitive advantage. Like castles, some companies can easily be stormed by marauding competitors, while others are almost impregnable. Several forces can widen a company’s moat: a strong brand identity (think of Harley Davidson, whose buyers tattoo the company’s logo onto their bodies); a monopoly or near-monopoly on the market; economies of scale, or the ability to supply huge amounts of goods or services cheaply (consider Gillette, which churns out razor blades by the billion); a unique intangible asset (think of CocaCola, whose secret formula for flavored syrup has no real physical value but maintains a priceless hold on consumers); a resistance to substitution (most businesses have no alternative to electricity, so utility companies are unlikely to be supplanted any time soon).

• The company is a marathoner, not a sprinter. By looking back at the income statements, you can see whether revenues and net earnings have grown smoothly and steadily over the previous 10 years. A recent article in the Financial Analysts Journal confirmed what other studies (and the sad experience of many investors) have shown: that the fastest-growing companies tend to overheat and flame out.6 If earnings are growing at a long-term rate of 10% pretax (or 6% to 7% after-tax), that may be sustainable. But the 15% growth hurdle that many companies set for themselves is delusional. And an even higher rate—or a sudden burst of growth in one or two years—is all but certain to fade, just like an inexperienced marathoner who tries to run the whole race as if it were a 100-meter dash.

• The company sows and reaps. No matter how good its products or how powerful its brands, a company must spend some money to develop new business. While research and development spending is not a source of growth today, it may well be tomorrow—particularly if a firm has a proven record of rejuvenating its businesses with new ideas and equipment. The average budget for research and development varies across industries and companies. In 2002, Procter & Gamble spent about 4% of its net sales on R & D, while 3M spent 6.5% and Johnson & Johnson 10.9%. In the long run, a company that spends nothing on R & D is at least as vulnerable as one that spends too much.

The quality and conduct of management.

A company’s executives should say what they will do, then do what they said. Read the past annual reports to see what forecasts the managers made and if they fulfilled them or fell short. Managers should forthrightly admit their failures and take responsibility for them, rather than blaming all-purpose scapegoats like “the economy,” “uncertainty,” or “weak demand.” Check whether the tone and substance of the chairman’s letter stay constant, or fluctuate with the latest fads on Wall Street. (Pay special attention to boom years like 1999: Did the executives of a cement or underwear company suddenly declare that they were “on the leading edge of the transformative software revolution”?) These questions can also help you determine whether the people who run the company will act in the interests of the people who own the company:

• Are they looking out for No. 1?

A firm that pays its CEO $100 million in a year had better have a very good reason. (Perhaps he discovered—and patented—the Fountain of Youth? Or found El Dorado and bought it for $1 an acre? Or contacted life on another planet and negotiated a contract obligating the aliens to buy all their supplies from only one company on Earth?) Otherwise, this kind of obscenely obese payday suggests that the firm is run by the managers, for the managers. If a company reprices (or “reissues” or “exchanges”) its stock options for insiders, stay away. In this switcheroo, a company cancels existing (and typically worthless) stock options for employees and executives, then replaces them with new ones at advantageous prices. If their value is never allowed to go to zero, while their potential profit is always infinite, how can options encourage good stewardship of corporate assets? Any established company that reprices options—as dozens of high-tech firms have—is a disgrace. And any investor who buys stock in such a company is a sheep begging to be sheared. By looking in the annual report for the mandatory footnote about stock options, you can see how large the “option overhang” is. AOL Time Warner, for example, reported in the front of its annual report that it had 4.5 billion shares of common stock outstanding as of December 31, 2002—but a footnote in the bowels of the report reveals that the company had issued options on 657 million more shares. So AOL’s future earnings will have to be divided among 15% more shares. You should factor in the potential flood of new shares from stock options whenever you estimate a company’s future value. “Form 4,” available through the EDGAR database at www.sec.gov, shows whether a firm’s senior executives and directors have been buying or selling shares. There can be legitimate reasons for an insider to sell—diversification, a bigger house, a divorce settlement—but repeated big sales are a bright red flag. A manager can’t legitimately be your partner if he keeps selling while you’re buying.

• Are they managers or promoters?

Executives should spend most of their time managing their company in private, not promoting it to the investing public. All too often, CEOs complain that their stock is undervalued no matter how high it goes—forgetting Graham’s insistence that managers should try to keep the stock price from going either too low or too high. Meanwhile, all too many chief financial officers give “earnings guidance,” or guesstimates of the company’s quarterly profits. And some firms are hype-o-chondriacs, constantly spewing forth press releases boasting of temporary, trivial, or hypothetical “opportunities.” A handful of companies—including Coca-Cola, Gillette, and USA Interactive—have begun to “just say no” to Wall Street’s short-term thinking. These few brave outfits are providing more detail about their current budgets and long-term plans, while refusing to speculate about what the next 90 days might hold. (For a model of how a company can communicate candidly and fairly with its shareholders, go to the EDGAR database at www.sec.gov and view the 8-K filings made by Expeditors International of Washington, which periodically posts its superb question-and-answer dialogues with shareholders there.) Finally, ask whether the company’s accounting practices are designed to make its financial results transparent—or opaque. If “nonrecurring” charges keep recurring, “extraordinary” items crop up so often that they seem ordinary, acronyms like EBITDA take priority over net income, or “pro forma” earnings are used to cloak actual losses, you may be looking at a firm that has not yet learned how to put its shareholders’ long-term interests first.

Financial strength and capital structure.

The most basic possible definition of a good business is this: It generates more cash than it consumes. Good managers keep finding ways of putting that cash to productive use. In the long run, companies that meet this definition are virtually certain to grow in value, no matter what the stock market does.

Start by reading the statement of cash flows in the company’s annual report. See whether cash from operations has grown steadily throughout the past 10 years. Then you can go further. Warren Buffett has popularized the concept of owner earnings, or net income plus amortization and depreciation, minus normal capital expenditures. As portfolio manager Christopher Davis of Davis Selected Advisors puts it, “If you owned 100% of this business, how much cash would you have in your pocket at the end of the year?” Because it adjusts for accounting entries like amortization and depreciation that do not affect the company’s cash balances, owner earnings can be a better measure than reported net income. To fine-tune the definition of owner earnings, you should also subtract from reported net income:

• any costs of granting stock options, which divert earnings away from existing shareholders into the hands of new inside owners
• any “unusual,” “nonrecurring,” or “extraordinary” charges
• any “income” from the company’s pension fund.

If owner earnings per share have grown at a steady average of at least 6% or 7% over the past 10 years, the company is a stable generator of cash, and its prospects for growth are good. Next, look at the company’s capital structure. Turn to the balance sheet to see how much debt (including preferred stock) the company has; in general, long-term debt should be under 50% of total capital. In the footnotes to the financial statements, determine whether the long-term debt is fixed-rate (with constant interest payments) or variable (with payments that fluctuate, which could become costly if interest rates rise).

Look in the annual report for the exhibit or statement showing the “ratio of earnings to fixed charges.” That exhibit to Amazon.com’s 2002 annual report shows that Amazon’s earnings fell $145 million short of covering its interest costs. In the future, Amazon will either have to earn much more from its operations or find a way to borrow money at lower rates. Otherwise, the company could end up being owned not by its shareholders but by its bondholders, who can lay claim to Amazon’s assets if they have no other way of securing the interest payments they are owed. (To be fair, Amazon’s ratio of earnings to fixed charges was far healthier in 2002 than two years earlier, when earnings fell $1.1 billion short of covering debt payments.)

A few words on dividends and stock policy (for more, please see Chapter 19):

• The burden of proof is on the company to show that you are better off if it does not pay a dividend. If the firm has consistently outperformed the competition in good markets and bad, the managers are clearly putting the cash to optimal use. If, however, business is faltering or the stock is underperforming its rivals, then the managers and directors are misusing the cash by refusing to pay a dividend.

• Companies that repeatedly split their shares—and hype those splits in breathless press releases—treat their investors like dolts. Like Yogi Berra, who wanted his pizza cut into four slices because “I don’t think I can eat eight,” the shareholders who love stock splits miss the point. Two shares of a stock at $50 are not worth more than one share at $100. Managers who use splits to promote their stock are aiding and abetting the worst instincts of the investing public, and the intelligent investor will think twice before turning any money over to such condescending manipulators.

• Companies should buy back their shares when they are cheap— not when they are at or near record highs. Unfortunately, it recently has become all too common for companies to repurchase their stock when it is overpriced. There is no more cynical waste of a company’s cash—since the real purpose of that maneuver is to enable top executives to reap multimillion-dollar paydays by selling their own stock options in the name of “enhancing shareholder value.” A substantial amount of anecdotal evidence, in fact, suggests that managers who talk about “enhancing shareholder value” seldom do. In investing, as with life in general, ultimate victory usually goes to the doers, not to the talkers.

CHAPTER 12. THINGS TO CONSIDER ABOUT PER-SHARE EARNINGS

This chapter will begin with two pieces of advice to the investor that cannot avoid being contradictory in their implications. The first is: Don’t take a single year’s earnings seriously. The second is: If you do pay attention to short-term earnings, look out for booby traps in the per-share figures. If our first warning were followed strictly the second would be unnecessary. But it is too much to expect that most shareholders can relate all their common-stock decisions to the long-term record and the long-term prospects. The quarterly figures, and especially the annual figures, receive major attention in financial circles, and this emphasis can hardly fail to have its impact on the investor’s thinking. He may well need some education in this area, for it abounds in misleading possibilities.

Note 1: “Dilution” is one of many words that describe stocks in the language of fluid dynamics. A stock with high trading volume is said to be “liquid.” When a company goes public in an IPO, it “floats” its shares. And, in earlier days, a company that drastically diluted its shares (with large amounts of convertible debt or multiple offerings of common stock) was said to have “watered” its stock. This term is believed to have originated with the legendary market manipulator Daniel Drew (1797–1879), who began as a livestock trader. He would drive his cattle south toward Manhattan, force-feeding them salt along the way. When they got to the Harlem River, they would guzzle huge volumes of water to slake their thirst. Drew would then bring them to market, where the water they had just drunk would increase their weight. That enabled him to get a much higher price, since cattle on the hoof is sold by the pound. Drew later watered the stock of the Erie Railroad by massively issuing new shares without warning.

Note 2: King Edward VII’s sundial had marked only the “sunny hours.” The king probably took his inspiration from a once-famous essay by the English writer William Hazlitt, who mused about a sundial near Venice that bore the words Horas non numero nisi serenas, or “I count only the hours that are serene.” Companies that chronically exclude bad news from their financial results on the pretext that negative events are “extraordinary” or “nonrecurring” are taking a page from Hazlitt, who urged his readers “to take no note of time but by its benefits, to watch only for the smiles and neglect the frowns of fate, to compose our lives of bright and gentle moments, turning away to the sunny side of things, and letting the rest slip from our imaginations, unheeded or forgotten!” (William Hazlitt, “On a Sun-Dial,” ca. 1827.) Unfortunately, investors must always count the sunny and dark hours alike.

Note 3: Nowadays, investors need to be aware of several “accounting factors” that can distort reported earnings. One is “pro forma” or “as if” financial statements, which report a company’s earnings as if Generally Accepted Accounting Principles (GAAP) did not apply. Another is the dilutive effect of issuing millions of stock options for executive compensation, then buying back millions of shares to keep those options from reducing the value of the common stock. A third is unrealistic assumptions of return on the company’s pension funds, which can artificially inflate earnings in good years and depress them in bad. Another is “Special Purpose Entities,” or affiliated firms or partnerships that buy risky assets or liabilities of the company and thus “remove” those financial risks from the company’s balance sheet. Another element of distortion is the treatment of marketing or other “soft” costs as assets of the company, rather than as normal expenses of doing business. We will briefly examine such practices in the commentary that accompanies this chapter.

Note 4: Corporate accounting is often tricky; security analysis can be complicated; stock valuations are really dependable only in exceptional cases.† For most investors it would be probably best to assure themselves that they are getting good value for the prices they pay, and let it go at that.

Investors should keep these words at hand and remind themselves of them frequently: “Stock valuations are really dependable only in exceptional cases.” While the prices of most stocks are approximately right most of the time, the price of a stock and the value of its business are almost never identical. The market’s judgment on price is often unreliable. Unfortunately, the margin of the market’s pricing errors is often not wide enough to justify the expense of trading on them. The intelligent investor must carefully evaluate the costs of trading and taxes before attempting to take advantage of any price discrepancy—and should never count on being able to sell for the exact price currently quoted in the market.

Note 5: Recent history—and a mountain of financial research—have shown that the market is unkindest to rapidly growing companies that suddenly report a fall in earnings. More moderate and stable growers, as ALCOA was in Graham’s day or Anheuser-Busch and Colgate-Palmolive are in our time, tend to suffer somewhat milder stock declines if they report disappointing earnings. Great expectations lead to great disappointment if they are not met; a failure to meet moderate expectations leads to a much milder reaction. Thus, one of the biggest risks in owning growth stocks is not that their growth will stop, but merely that it will slow down. And in the long run, that is not merely a risk, but a virtual certainty.

COMMENTARY ON CHAPTER 12

THE NUMBERS GAME

Even Graham would have been startled by the extent to which companies and their accountants pushed the limits of propriety in the past few years. Compensated heavily through stock options, top executives realized that they could become fabulously rich merely by increasing their company’s earnings for just a few years running.1 Hundreds of companies violated the spirit, if not the letter, of accounting principles—turning their financial reports into gibberish, tarting up ugly results with cosmetic fixes, cloaking expenses, or manufacturing earnings out of thin air. Let’s look at some of these unsavory practices.

AS IF!

Perhaps the most widespread bit of accounting hocus-pocus was the “pro forma” earnings fad. There’s an old saying on Wall Street that every bad idea starts out as a good idea, and pro forma earnings presentation is no different. The original point was to provide a truer picture of the long-term growth of earnings by adjusting for short-term deviations from the trend or for supposedly “nonrecurring” events. A pro forma press release might, for instance, show what a company would have earned over the past year if another firm it just acquired had been part of the family for the entire 12 months.

But, as the Naughty 1990s advanced, companies just couldn’t leave well enough alone. Just look at these examples of pro forma flimflam: • For the quarter ended September 30, 1999, InfoSpace, Inc. presented its pro forma earnings as if it had not paid $159.9 million in preferred-stock dividends.
• For the quarter ended October 31, 2001, BEA Systems, Inc. presented its pro forma earnings as if it had not paid $193 million in payroll taxes on stock options exercised by its employees.
• For the quarter ended March 31, 2001, JDS Uniphase Corp. presented its pro forma earnings as if it had not paid $4 million in payroll taxes, had not lost $7 million investing in lousy stocks, and had not incurred $2.5 billion in charges related to mergers and goodwill.
In short, pro forma earnings enable companies to show how well they might have done if they hadn’t done as badly as they did.2 As an intelligent investor, the only thing you should do with pro forma earnings is ignore them.

HUNGRY FOR RECOGNITION

In 2000, Qwest Communications International Inc., the telecommunications giant, looked strong. Its shares dropped less than 5% even as the stock market lost more than 9% that year.
But Qwest’s financial reports held an odd little revelation. In late 1999, Qwest decided to recognize the revenues from its telephone directories as soon as the phone books were published—even though, as anyone who has ever taken out a Yellow Pages advertisement knows, many businesses pay for those ads in monthly installments.

Abracadabra! That piddly-sounding “change in accounting principle” pumped up 1999 net income by $240 million after taxes—a fifth of all the money Qwest earned that year.
Like a little chunk of ice crowning a submerged iceberg, aggressive revenue recognition is often a sign of dangers that run deep and loom large—and so it was at Qwest. By early 2003, after reviewing its previous financial statements, the company announced that it had prematurely recognized profits on equipment sales, improperly recorded the costs of services provided by outsiders, inappropriately booked costs as if they were capital assets rather than expenses, and unjustifiably treated the exchange of assets as if they were outright sales. All told, Qwest’s revenues for 2000 and 2001 had been overstated by $2.2 billion—including $80 million from the earlier “change in accounting principle,” which was now reversed.
[In 2002, Qwest was one of 330 publicly-traded companies to restate past financial statements, an all-time record, according to Huron Consulting Group. All information on Qwest is taken from its financial filings with the U.S. Securities and Exchange Commission (annual report, Form 8K, and Form 10-K) found in the EDGAR database at www.sec.gov. No hindsight was required to detect the “change in accounting principle,” which Qwest fully disclosed at the time. How did Qwest’s shares do over this period? At year-end 2000, the stock had been at $41 per share, a total market value of $67.9 billion. By early 2003, Qwest was around $4, valuing the entire company at less than $7 billion—a 90% loss. The drop in share price is not the only cost associated with bogus earnings; a recent study found that a sample of 27 firms accused of accounting fraud by the SEC had overpaid $320 million in Federal income tax. Although much of that money will eventually be refunded by the IRS, most shareholders are unlikely to stick around to benefit from the refunds. (See Merle Erickson, Michelle Hanlon, and Edward Maydew, “How Much Will Firms Pay for Earnings that Do Not Exist?” at http:// papers.ssrn.com.)]

CAPITAL OFFENSES

In the late 1990s, Global Crossing Ltd. had unlimited ambitions. The Bermuda-based company was building what it called the “first integrated global fiber optic network” over more than 100,000 miles of cables, largely laid across the floor of the world’s oceans. After wiring the world, Global Crossing would sell other communications companies the right to carry their traffic over its network of cables. In 1998 alone, Global Crossing spent more than $600 million to construct its optical web. That year, nearly a third of the construction budget was charged against revenues as an expense called “cost of capacity sold.” If not for that $178 million expense, Global Crossing—which reported a net loss of $96 million—could have reported a net profit of roughly $82 million.
The next year, says a bland footnote in the 1999 annual report, Global Crossing “initiated service contract accounting.” The company would no longer charge most construction costs as expenses against the immediate revenues it received from selling capacity on its network. Instead, a major chunk of those construction costs would now be treated not as an operating expense but as a capital expenditure— thereby increasing the company’s total assets, instead of decreasing its net income. [Global Crossing formerly treated much of its construction costs as an expense to be charged against the revenue generated from the sale or lease of usage rights on its network. Customers generally paid for their rights up front, although some could pay in installments over periods of up to four years. But Global Crossing did not book most of the revenues up front, instead deferring them over the lifetime of the lease. Now, however, because the networks had an estimated usable life of up to 25 years, Global Crossing began treating them as depreciable, long-lived capital assets. While this treatment conforms with Generally Accepted Accounting Principles, it is unclear why Global Crossing did not use it before October 1, 1999, or what exactly prompted the change. As of March 2001, Global Crossing had a total stock valuation of $12.6 billion; the company filed for bankruptcy on January 28, 2002, rendering its common stock essentially worthless.]

Poof! In one wave of the wand, Global Crossing’s “property and equipment” assets rose by $575 million, while its cost of sales increased by a mere $350 million—even though the company was spending money like a drunken sailor.
Capital expenditures are an essential tool for managers to make a good business grow bigger and better. But malleable accounting rules permit managers to inflate reported profits by transforming normal operating expenses into capital assets. As the Global Crossing case shows, the intelligent investor should be sure to understand what, and why, a company capitalizes.

AN INVENTORY STORY

Like many makers of semiconductor chips, Micron Technology, Inc.
suffered a drop in sales after 2000. In fact, Micron was hit so hard by the plunge in demand that it had to start writing down the value of its inventories—since customers clearly did not want them at the prices Micron had been asking. In the quarter ended May 2001, Micron slashed the recorded value of its inventories by $261 million. Most investors interpreted the write-down not as a normal or recurring cost of operations, but as an unusual event.
But look what happened after that:

Micron booked further inventory write-downs in every one of the next six fiscal quarters. Was the devaluation of Micron’s inventory a nonrecurring event, or had it become a chronic condition? Reasonable minds can differ on this particular case, but one thing is clear: The intelligent investor must always be on guard for “nonrecurring” costs that, like the Energizer bunny, just keep on going.

THE PENSION DIMENSION

In 2001, SBC Communications, Inc., which owns interests in Cingular Wireless, PacTel, and Southern New England Telephone, earned $7.2 billion in net income—a stellar performance in a bad year for the overextended telecom industry. But that gain didn’t come only from SBC’s business. Fully $1.4 billion of it—13% of the company’s net income—came from SBC’s pension plan.
Because SBC had more money in the pension plan than it estimated was necessary to pay its employees’ future benefits, the company got to treat the difference as current income. One simple reason for that surplus: In 2001, SBC raised the rate of return it expected to earn on the pension plan’s investments from 8.5% to 9.5%—lowering the amount of money it needed to set aside today. SBC explained its rosy new expectations by noting that “for each of the three years ended 2001, our actual 10-year return on investments exceeded 10%.” In other words, our past returns have been high, so let’s assume that our future returns will be too. But that not only flunked the most rudimentary tests of logic, it flew in the face of the fact that interest rates were falling to near-record lows, depressing the future returns on the bond portion of a pension portfolio.
The same year, in fact, Warren Buffett’s Berkshire Hathaway lowered the expected rate of return on its pension assets from 8.3% to 6.5%. Was SBC being realistic in assuming that its pension-fund managers could significantly outperform the world’s greatest investor? Probably not: In 2001, Berkshire Hathaway’s pension fund gained 9.8%, but SBC’s pension fund lost 6.9%.

Here are some quick considerations for the intelligent investor: Is the “net pension benefit” more than 5% of the company’s net income? (If so, would you still be comfortable with the company’s other earnings if those pension gains went away in future years?) Is the assumed “long-term rate of return on plan assets” reasonable? (As of 2003, anything above 6.5% is implausible, while a rising rate is downright delusional.)

CAVEAT INVESTOR

A few pointers will help you avoid buying a stock that turns out to be an accounting time bomb:

Read backwards.

When you research a company’s financial reports, start reading on the last page and slowly work your way toward the front. Anything that the company doesn’t want you to find is buried in the back—which is precisely why you should look there first.

Read the notes.

Never buy a stock without reading the footnotes to the financial statements in the annual report. Usually labeled “summary of significant accounting policies,” one key note describes how the company recognizes revenue, records inventories, treats installment or contract sales, expenses its marketing costs, and accounts for the other major aspects of its business.

Do not be put off by the stupefyingly boring verbiage of accounting footnotes. They are designed expressly to deter normal people from actually reading them—which is why you must persevere. A footnote to the 1996 annual report of Informix Corp., for instance, disclosed that “The Company generally recognizes license revenue from sales of software licenses upon delivery of the software product to a customer. However, for certain computer hardware manufacturers and end-user licensees with amounts payable within twelve months, the Company will recognize revenue at the time the customer makes a contractual commitment for a minimum nonrefundable license fee, if such computer hardware manufacturers and enduser licensees meet certain criteria established by the Company.” In plain English, Informix was saying that it would credit itself for revenues on products even if they had not yet been resold to “end-users” (the actual customers for Informix’s software). Amid allegations by the U.S. Securities and Exchange Commission that Informix had committed accounting fraud, the company later restated its revenues, wiping away $244 million in such “sales.” This case is a keen reminder of the importance of reading the fine print with a skeptical eye. I am indebted to Martin Fridson for suggesting this example.

In the other footnotes, watch for disclosures about debt, stock options, loans to customers, reserves against losses, and other “risk factors” that can take a big chomp out of earnings. Among the things that should make your antennae twitch are technical terms like “capitalized,” “deferred,” and “restructuring”—and plain-English words signaling that the company has altered its accounting practices, like “began,” “change,” and “however.” None of those words mean you should not buy the stock, but all mean that you need to investigate further. Be sure to compare the footnotes with those in the financial statements of at least one firm that’s a close competitor, to see how aggressive your company’s accountants are.

If you are an enterprising investor willing to put plenty of time and energy into your portfolio, then you owe it to yourself to learn more about financial reporting. That’s the only way to minimize your odds of being misled by a shifty earnings statement. Three solid books full of timely and specific examples are Martin Fridson and Fernando Alvarez’s Financial Statement Analysis, Charles Mulford and Eugene Comiskey’s The Financial Numbers Game, and Howard Schilit’s Financial Shenanigans.
Martin Fridson and Fernando Alvarez, Financial Statement Analysis: A Practitioner’s Guide (John Wiley & Sons, New York, 2002); Charles W. Mulford and Eugene E. Comiskey, The Financial Numbers Game: Detecting Creative Accounting Practices (John Wiley & Sons, New York, 2002);
Howard Schilit, Financial Shenanigans (McGraw-Hill, New York, 2002).
Benjamin Graham’s own book, The Interpretation of Financial Statements (HarperBusiness, New York, 1998 reprint of 1937 edition), remains an excellent brief introduction to the basic principles of earnings and expenses, assets and liabilities.

CHAPTER 13. A COMPARISON OF FOUR LISTED COMPANIES

In this chapter we should like to present a sample of security analysis in operation. We have selected, more or less at random, four companies which are found successively on the New York Stock Exchange list. These are Eltra Corp. (a merger of Electric Autolite and Mergenthaler Linotype enterprises), Emerson Electric Co. (a manufacturer of electric and electronic products), Emery Air Freight (a domestic forwarder of air freight), and Emhart Corp. (originally a maker of bottling machinery only, but now also in builders’ hardware).* There are some broad resemblances between the three manufacturing firms, but the differences will seem more significant. There should be sufficient variety in the financial and operating data to make the examination of interest.

Of Graham’s four examples, only Emerson Electric still exists in the same form. ELTRA Corp. is no longer an independent company; it merged with Bunker Ramo Corp. in the 1970s, putting it in the business of supplying stock quotes to brokerage firms across an early network of computers. What remains of ELTRA’s operations is now part of Honeywell Corp. The firm formerly known as Emery Air Freight is now a division of CNF Inc. Emhart Corp. was acquired by Black & Decker Corp. in 1989.

Note 1: Chief elements of performance are:
1. Profitability
2. Stability
3. Growth
4. Financial position
5. Dividends
6. Price history

Note 2: The two companies (Eltra and Emhart) meet our seven statistical requirements for inclusion in a defensive investor’s portfolio. These will be developed in the next chapter, but we summarize them as follows:
1. Adequate size.
2. A sufficiently strong financial condition.
3. Continued dividends for at least the past 20 years.
4. No earnings deficit in the past ten years.
5. Ten-year growth of at least one-third in per-share earnings.
6. Price of stock no more than 11⁄2 times net asset value.
7. Price no more than 15 times average earnings of the past three years.

Skipping commentary.

CHAPTER 14. STOCK SELECTION FOR THE DEFENSIVE INVESTOR

At the close of the previous chapter we listed seven such quality and quantity criteria suggested for the selection of specific common stocks. Let us describe them in order.

1. Adequate Size of the Enterprise

All our minimum figures must be arbitrary and especially in the matter of size required. Our idea is to exclude small companies which may be subject to more than average vicissitudes especially in the industrial field. (There are often good possibilities in such enterprises but we do not consider them suited to the needs of the defensive investor.) Let us use round amounts: not less than $100 million of annual sales for an industrial company and, not less than $50 million of total assets for a public utility.

2. A Sufficiently Strong Financial Condition

For industrial companies current assets should be at least twice current liabilities—a so-called two-to-one current ratio. Also, longterm debt should not exceed the net current assets (or “working capital”). For public utilities the debt should not exceed twice the stock equity (at book value).

3. Earnings Stability

Some earnings for the common stock in each of the past ten years.

4. Dividend Record

Uninterrupted payments for at least the past 20 years.

5. Earnings Growth

A minimum increase of at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end.

6. Moderate Price/Earnings Ratio

Current price should not be more than 15 times average earnings of the past three years.

7. Moderate Ratio of Price to Assets

Current price should not be more than 1.5 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5. (This figure corresponds to 15 times earnings and 1.5 times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.)

Note 1: EMH or “efficient markets hypothesis” is an academic theory claiming that the price of each stock incorporates all publicly available information about the company. With millions of investors scouring the market every day, it is unlikely that severe mispricings can persist for long. An old joke has two finance professors walking along the sidewalk; when one spots a $20 bill and bends over to pick it up, the other grabs his arm and says, “Don’t bother. If it was really a $20 bill, someone would have taken it already.” While the market is not perfectly efficient, it is pretty close most of the time—so the intelligent investor will stoop to pick up the stock market’s $20 bills only after researching them thoroughly and minimizing the costs of trading and taxes.

Note 2: The future can be approached in two different ways, which may be called the way of prediction (or projection) and the way of protection. This is one of the central points of Graham’s book. All investors labor under a cruel irony: We invest in the present, but we invest for the future. And, unfortunately, the future is almost entirely uncertain. Inflation and interest rates are undependable; economic recessions come and go at random; geopolitical upheavals like war, commodity shortages, and terrorism arrive without warning; and the fate of individual companies and their industries often turns out to be the opposite of what most investors expect. Therefore, investing on the basis of projection is a fool’s errand; even the forecasts of the so-called experts are less reliable than the flip of a coin. For most people, investing on the basis of protection—from overpaying for a stock and from overconfidence in the quality of their own judgment—is the best solution. Graham expands on this concept in Chapter 20.

COMMENTARY ON CHAPTER 14

GETTING STARTED

How should you tackle the nitty-gritty work of stock selection? Graham suggests that the defensive investor can, “most simply,” buy every stock in the DowJones Industrial Average. Today’s defensive investor can do even better—by buying a total stock-market index fund that holds essentially every stock worth having. A low-cost index fund is the best tool ever created for low-maintenance stock investing—and any effort to improve on it takes more work (and incurs more risk and higher costs) than a truly defensive investor can justify. Researching and selecting your own stocks is not necessary; for most people, it is not even advisable. However, some defensive investors do enjoy the diversion and intellectual challenge of picking individual stocks—and, if you have survived a bear market and still enjoy stock picking, then nothing that Graham or I could say will dissuade you. In that case, instead of making a total stock market index fund your complete portfolio, make it the foundation of your portfolio. Once you have that foundation in place, you can experiment around the edges with your own stock choices. Keep 90% of your stock money in an index fund, leaving 10% with which to try picking your own stocks. Only after you build that solid core should you explore.

WHY DIVERSIFY?

During the bull market of the 1990s, one of the most common criticisms of diversification was that it lowers your potential for high returns. After all, if you could identify the next Microsoft, wouldn’t it make sense for you to put all your eggs into that one basket?

Well, sure. As the humorist Will Rogers once said, “Don’t gamble. Take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.” However, as Rogers knew, 20/20 foresight is not a gift granted to most investors. No matter how confident we feel, there’s no way to find out whether a stock will go up until after we buy it. Therefore, the stock you think is “the next Microsoft” may well turn out to be the next MicroStrategy instead. (That former market star went from $3,130 per share in March 2000 to $15.10 at year-end 2002, an apocalyptic loss of 99.5%). [Adjusted for stock splits. To many people, MicroStrategy really did look like the next Microsoft in early 2000; its stock had gained 566.7% in 1999, and its chairman, Michael Saylor, declared that “our future today is better than it was 18 months ago.” The U.S. Securities and Exchange Commission later accused MicroStrategy of accounting fraud, and Saylor paid an $8.3 million fine to settle the charges.]

Keeping your money spread across many stocks and industries is the only reliable insurance against the risk of being wrong.

But diversification doesn’t just minimize your odds of being wrong. It also maximizes your chances of being right. Over long periods of time, a handful of stocks turn into “superstocks” that go up 10,000% or more. Money Magazine identified the 30 best-performing stocks over the 30 years ending in 2002—and, even with 20/20 hindsight, the list is startlingly unpredictable. Rather than lots of technology or health-care stocks, it includes Southwest Airlines, Worthington Steel, Dollar General discount stores, and snuff-tobacco maker UST Inc.2 If you think you would have been willing to bet big on any of those stocks back in 1972, you are kidding yourself.

Think of it this way: In the huge market haystack, only a few needles ever go on to generate truly gigantic gains. The more of the haystack you own, the higher the odds go that you will end up finding at least one of those needles. By owning the entire haystack (ideally through an index fund that tracks the total U.S. stock market) you can be sure to find every needle, thus capturing the returns of all the superstocks. Especially if you are a defensive investor, why look for the needles when you can own the whole haystack?

TESTING, TESTING

Let’s briefly update Graham’s criteria for stock selection.

Adequate size.

Nowadays, “to exclude small companies,” most defensive investors should steer clear of stocks with a total market value of less than $2 billion. In early 2003, that still left you with 437 of the companies in the Standard & Poor’s 500-stock index to choose from. However, today’s defensive investors—unlike those in Graham’s day— can conveniently own small companies by buying a mutual fund specializing in small stocks. Again, an index fund like Vanguard Small-Cap Index is the first choice, although active funds are available at reasonable cost from such firms as Ariel, T. Rowe Price, Royce, and Third Avenue.

Strong financial condition.

According to market strategists Steve Galbraith and Jay Lasus of Morgan Stanley, at the beginning of 2003 about 120 of the companies in the S & P 500 index met Graham’s test of a 2-to-1 current ratio. With current assets at least twice their current liabilities, these firms had a sizeable cushion of working capital that—on average—should sustain them through hard times. Wall Street has always abounded in bitter ironies, and the bursting of the growth-stock bubble has created a doozy: In 1999 and 2000, high-tech, bio-tech, and telecommunications stocks were supposed to provide “aggressive growth” and ended up giving most of their investors aggressive shrinkage instead. But, by early 2003, the wheel had come full circle, and many of those aggressive growth stocks had become financially conservative—loaded with working capital, rich in cash, and often debt-free.

The lesson here is not that these stocks were “a sure thing,” or that you should rush out and buy everything (or anything) in the 1999 DJIA listing. Instead, you should realize that a defensive investor can always prosper by looking patiently and calmly through the wreckage of a bear market. Graham’s criterion of financial strength still works: If you build a diversified basket of stocks whose current assets are at least double their current liabilities, and whose long-term debt does not exceed working capital, you should end up with a group of conservatively financed companies with plenty of staying power. The best values today are often found in the stocks that were once hot and have since gone cold. Throughout history, such stocks have often provided the margin of safety that a defensive investor demands.

Earnings stability.

According to Morgan Stanley, 86% of all the companies in the S & P 500 index have had positive earnings in every year from 1993 through 2002. So Graham’s insistence on “some earnings for the common stock in each of the past ten years” remains a valid test—tough enough to eliminate chronic losers, but not so restrictive as to limit your choices to an unrealistically small sample.

Dividend record.

As of early 2003, according to Standard & Poor’s, 354 companies in the S & P 500 (or 71% of the total) paid a dividend. No fewer than 255 companies have paid a dividend for at least 20 years in a row. And, according to S & P, 57 companies in the index have raised their dividends for at least 25 consecutive years. That’s no guarantee that they will do so forever, but it’s a comforting sign.

Earnings growth.

How many companies in the S & P 500 increased their earnings per share by “at least one third,” as Graham requires, over the 10 years ending in 2002? (We’ll average each company’s earnings from 1991 through 1993, and then determine whether the average earnings from 2000 through 2002 were at least 33% higher.) According to Morgan Stanley, 264 companies in the S & P 500 met that test. But here, it seems, Graham set a very low hurdle; 33% cumulative growth over a decade is less than a 3% average annual increase. Cumulative growth in earnings per share of at least 50%—or a 4% average annual rise—is a bit less conservative. No fewer than 245 companies in the S & P 500 index met that criterion as of early 2003, leaving the defensive investor an ample list to choose from. (If you double the cumulative growth hurdle to 100%, or 7% average annual growth, then 198 companies make the cutoff.)

Moderate P/E ratio.

Graham recommends limiting yourself to stocks whose current price is no more than 15 times average earnings over the past three years. Incredibly, the prevailing practice on Wall Street today is to value stocks by dividing their current price by something called “next year’s earnings.” That gives what is sometimes called “the forward P/E ratio.” But it’s nonsensical to derive a price/earnings ratio by dividing the known current price by unknown future earnings. Over the long run, money manager David Dreman has shown, 59% of Wall Street’s “consensus” earnings forecasts miss the mark by a mortifyingly wide margin—either underestimating or overestimating the actual reported earnings by at least 15%.2 Investing your money on the basis of what these myopic soothsayers predict for the coming year is as risky as volunteering to hold up the bulls-eye at an archery tournament for the legally blind. Instead, calculate a stock’s price/earnings ratio yourself, using Graham’s formula of current price divided by average earnings over the past three years.3 As of early 2003, how many stocks in the Standard & Poor’s 500 index were valued at no more than 15 times their average earnings of 2000 through 2002? According to Morgan Stanley, a generous total of 185 companies passed Graham’s test.

Moderate price-to-book ratio.

Graham recommends a “ratio of price to assets” (or price-to-book-value ratio) of no more than 1.5. In recent years, an increasing proportion of the value of companies has come from intangible assets like franchises, brand names, and patents and trademarks. Since these factors (along with goodwill from acquisitions) are excluded from the standard definition of book value, most companies today are priced at higher price-to-book multiples than in Graham’s day. According to Morgan Stanley, 123 of the companies in the S&P 500 (or one in four) are priced below 1.5 times book value.

All told, 273 companies (or 55% of the index) have price-to-book ratios of less than 2.5. What about Graham’s suggestion that you multiply the P/E ratio by the price-to-book ratio and see whether the resulting number is below 22.5? Based on data from Morgan Stanley, at least 142 stocks in the S & P 500 could pass that test as of early 2003, including Dana Corp., Electronic Data Systems, Sun Microsystems, and Washington Mutual. So Graham’s “blended multiplier” still works as an initial screen to identify reasonably-priced stocks.

DUE DILIGENCE

No matter how defensive an investor you are—in Graham’s sense of wishing to minimize the work you put into picking stocks—there are a couple of steps you cannot afford to skip:

Do your homework.

Through the EDGAR database at www.sec.gov, you get instant access to a company’s annual and quarterly reports, along with the proxy statement that discloses the managers’ compensation, ownership, and potential conflicts of interest. Read at least five years’ worth. For more on what to look for, see the commentary on Chapters 11, 12, and 19. If you are not willing to go to the minimal effort of reading the proxy and making basic comparisons of financial health across five years’ worth of annual reports, then you are too defensive to be buying individual stocks at all. Get yourself out of the stock-picking business and into an index fund, where you belong.

Check out the neighborhood.

Websites like http://quicktake.morningstar.com, http://finance.yahoo.com and www.quicken.com can readily tell you what percentage of a company’s shares are owned by institutions. Anything over 60% suggests that a stock is scarcely undiscovered and probably “overowned.” (When big institutions sell, they tend to move in lockstep, with disastrous results for the stock. Imagine all the Radio City Rockettes toppling off the front edge of the stage at once and you get the idea.) Those websites will also tell you who the largest owners of the stock are. If they are moneymanagement firms that invest in a style similar to your own, that’s a good sign.

CHAPTER 15. STOCK SELECTION FOR THE ENTERPRISING INVESTOR

Note 1: The Friend-Blume-Crockett research covered January 1960, through June 1968, and compared the performance of more than 100 major mutual funds against the returns on portfolios constructed randomly from more than 500 of the largest stocks listed on the NYSE. The funds in the Friend-BlumeCrockett study did better from 1965 to 1968 than they had in the first half of the measurement period, much as Graham found in his own research. But that improvement did not last. And the thrust of these studies—that mutual funds, on average, underperform the market by a margin roughly equal to their operating expenses and trading costs—has been reconfirmed so many times that anyone who doubts them should found a financial chapter of The Flat Earth Society.

Note 2: Efficient Market Hypothesis: Recent appearances to the contrary, the problem with the stock market today is not that so many financial analysts are idiots, but rather that so many of them are so smart. As more and more smart people search the market for bargains, that very act of searching makes those bargains rarer—and, in a cruel paradox, makes the analysts look as if they lack the intelligence to justify the search. The market’s valuation of a given stock is the result of a vast, continuous, real-time operation of collective intelligence. Most of the time, for most stocks, that collective intelligence gets the valuation approximately right. Only rarely does Graham’s “Mr. Market” (see Chapter 8) send prices wildly out of whack.

Note 3: In 2003, an intelligent investor following Graham’s train of thought would be searching for opportunities in the technology, telecommunications, and electric-utility industries. History has shown that yesterday’s losers are often tomorrow’s winners.

Note 4: Some additional criteria for stock picking for enterprising investor, rather similar to those we suggested for the defensive investor, but not so severe.
We suggest the following:

1. Financial condition: (a) Current assets at least 1.5 times current liabilities, and (b) debt not more than 110% of net current assets (for industrial companies).

2. Earnings stability: No deficit in the last five years covered in the Stock Guide.
3. Dividend record: Some current dividend.
4. Earnings growth: Last year’s earnings more than those of 1966.
5. Price: Less than 120% net tangible assets.

Note 5: In Graham’s terms, a large amount of "Goodwill" can result from two causes: a corporation can acquire other companies for substantially more than the value of their assets, or its own stock can trade for substantially more than its book value.

A Summary of the Graham-Newman Methods

It should be worthwhile to give a brief account of the types of operations we engaged in during the thirty-year life of Graham-Newman Corporation, between 1926 and 1956. [Graham launched Graham-Newman Corp. in January 1936, and dissolved it when he retired from active money management in 1956; it was the successor to a partnership called the Benjamin Graham Joint Account, which he ran from January 1926, through December 1935.]

These were classified in our records as follows: Arbitrages: The purchase of a security and the simultaneous sale of one or more other securities into which it was to be exchanged under a plan of reorganization, merger, or the like.

Liquidations: Purchase of shares which were to receive one or more cash payments in liquidation of the company’s assets.
Operations of these two classes were selected on the twin basis of (a) a calculated annual return of 20% or more, and (b) our judgment that the chance of a successful outcome was at least four out of five.

Related Hedges: The purchase of convertible bonds or convertible preferred shares, and the simultaneous sale of the common stock into which they were exchangeable. The position was established at close to a parity basis—i.e., at a small maximum loss if the senior issue had actually to be converted and the operation closed out in that way. But a profit would be made if the common stock fell considerably more than the senior issue, and the position closed out in the market.

An “unrelated” hedge involves buying a stock or bond issued by one company and short-selling (or betting on a decline in) a security issued by a different company. A “related” hedge involves buying and selling different stocks or bonds issued by the same company. The “new group” of hedge funds described by Graham were widely available around 1968, but later regulation by the U.S. Securities and Exchange Commission restricted access to hedge funds for the general public.

Net-Current-Asset (or “Bargain”) Issues: The idea here was to acquire as many issues as possible at a cost for each of less than their book value in terms of net-current-assets alone—i.e., giving no value to the plant account and other assets. Our purchases were made typically at two-thirds or less of such stripped-down asset value. In most years we carried a wide diversification here—at least 100 different issues.

COMMENTARY ON CHAPTER 15

PRACTICE, PRACTICE, PRACTICE

Max Heine, founder of the Mutual Series Funds, liked to say that “there are many roads to Jerusalem.” What this masterly stock picker meant was that his own value-centered method of selecting stocks was not the only way to be a successful investor. In this chapter we’ll look at several techniques that some of today’s leading money managers use for picking stocks. First, though, it’s worth repeating that for most investors, selecting individual stocks is unnecessary—if not inadvisable. The fact that most professionals do a poor job of stock picking does not mean that most amateurs can do better. The vast majority of people who try to pick stocks learn that they are not as good at it as they thought; the luckiest ones discover this early on, while the less fortunate take years to learn it. A small percentage of investors can excel at picking their own stocks. Everyone else would be better off getting help, ideally through an index fund. Graham advised investors to practice first, just as even the greatest athletes and musicians practice and rehearse before every actual performance. He suggested starting off by spending a year tracking and picking stocks (but not with real money).

In Graham’s day, you would have practiced using a ledger of hypothetical buys and sells on a legal pad; nowadays, you can use “portfolio trackers” at websites like www.morningstar.com, http://finance.yahoo.com, http://money.cnn.com/services/portfolio/ or www.marketocracy.com (at the last site, ignore the “market-beating” hype on its funds and other services). By test-driving your techniques before trying them with real money, you can make mistakes without incurring any actual losses, develop the discipline to avoid frequent trading, compare your approach against those of leading money managers, and learn what works for you. Best of all, tracking the outcome of all your stock picks will prevent you from forgetting that some of your hunches turn out to be stinkers. That will force you to learn from your winners and your losers. After a year, measure your results against how you would have done if you had put all your money in an S & P 500 index fund. If you didn’t enjoy the experiment or your picks were poor, no harm done—selecting individual stocks is not for you. Get yourself an index fund and stop wasting your time on stock picking. If you enjoyed the experiment and earned sufficiently good returns, gradually assemble a basket of stocks—but limit it to a maximum of 10% of your overall portfolio (keep the rest in an index fund). And remember, you can always stop if it no longer interests you or your returns turn bad.

LOOKING UNDER THE RIGHT ROCKS

So how should you go about looking for a potentially rewarding stock? You can use websites like http://finance.yahoo.com and www.morningstar.com to screen stocks with the statistical filters suggested in Chapter 14. Or you can take a more patient, craftsmanlike approach. Unlike most people, many of the best professional investors first get interested in a company when its share price goes down, not up. Christopher Browne of Tweedy Browne Global Value Fund, William Nygren of the Oakmark Fund, Robert Rodriguez of FPA Capital Fund, and Robert Torray of the Torray Fund all suggest looking at the daily list of new 52-week lows in the Wall Street Journal or the similar table in the “Market Week” section of Barron’s. That will point you toward stocks and industries that are unfashionable or unloved and that thus offer the potential for high returns once perceptions change.

Christopher Davis of the Davis Funds and William Miller of LeggMason Value Trust like to see rising returns on invested capital, or ROIC—a way of measuring how efficiently a company generates what Warren Buffett has called “owner earnings.”

By checking “comparables,” or the prices at which similar businesses have been acquired over the years, managers like Oakmark’s Nygren and Longleaf Partners’ O. Mason Hawkins get a better handle on what a company’s parts are worth. For an individual investor, it’s painstaking and difficult work: Start by looking at the “Business Segments” footnote in the company’s annual report, which typically lists the industrial sector, revenues, and earnings of each subsidiary. (The “Management Discussion and Analysis” may also be helpful.) Then search a news database like Factiva, ProQuest, or LexisNexis for examples of other firms in the same industries that have recently been acquired. Using the EDGAR database at www.sec.gov to locate their past annual reports, you may be able to determine the ratio of purchase price to the earnings of those acquired companies. You can then apply that ratio to estimate how much a corporate acquirer might pay for a similar division of the company you are investigating. By separately analyzing each of the company’s divisions this way, you may be able to see whether they are worth more than the current stock price. Longleaf’s Hawkins likes to find what he calls “60-cent dollars,” or companies whose stock is trading at 60% or less of the value at which he appraises the businesses. That helps provide the margin of safety that Graham insists on.

FROM EPS TO ROIC

Net income or earnings per share (EPS) has been distorted in recent years by factors like stock-option grants and accounting gains and charges. To see how much a company is truly earning on the capital it deploys in its businesses, look beyond EPS to ROIC, or return on invested capital. Christopher Davis of the Davis Funds defines it with this formula:

ROIC = Owner Earnings / Invested Capital, where Owner Earnings is equal to:

Operating profit
plus depreciation
plus amortization of goodwill
minus Federal income tax (paid at the company’s average rate)
minus cost of stock options
minus “maintenance” (or essential) capital expenditures
minus any income generated by unsustainable rates of return on pension funds (as of 2003, anything greater than 6.5%)

and where Invested Capital is equal to:

Total assets
minus cash (as well as short-term investments and non-interestbearing current liabilities)
plus past accounting charges that reduced invested capital.

ROIC has the virtue of showing, after all legitimate expenses, what the company earns from its operating businesses—and how efficiently it has used the shareholders’ money to generate that return. An ROIC of at least 10% is attractive; even 6% or 7% can be tempting if the company has good brand names, focused management, or is under a temporary cloud.

WHO’S THE BOSS?

Finally, most leading professional investors want to see that a company is run by people who, in the words of Oakmark’s William Nygren, “think like owners, not just managers.” Two simple tests: Are the company’s financial statements easily understandable, or are they full of obfuscation? Are “nonrecurring” or “extraordinary” or “unusual” charges just that, or do they have a nasty habit of recurring? Longleaf’s Mason Hawkins looks for corporate managers who are “good partners”—meaning that they communicate candidly about problems, have clear plans for allocating current and future cash flow, and own sizable stakes in the company’s stock (preferably through cash purchases rather than through grants of options). But “if managements talk more about the stock price than about the business,” warns Robert Torray of the Torray Fund, “we’re not interested.” Christopher Davis of the Davis Funds favors firms that limit issuance of stock options to roughly 3% of shares outstanding. At Vanguard Primecap Fund, Howard Schow tracks “what the company said one year and what happened the next. We want to see not only whether managements are honest with shareholders but also whether they’re honest with themselves.” (If a company boss insists that all is hunky-dory when business is sputtering, watch out!) Nowadays, you can listen in on a company’s regularly scheduled conference calls even if you own only a few shares; to find out the schedule, call the investor relations department at corporate headquarters or visit the company’s website. Robert Rodriguez of FPA Capital Fund turns to the back page of the company’s annual report, where the heads of its operating divisions are listed. If there’s a lot of turnover in those names in the first one or two years of a new CEO’s regime, that’s probably a good sign; he’s cleaning out the dead wood. But if high turnover continues, the turnaround has probably devolved into turmoil.

KEEPING YOUR EYES ON THE ROAD

There are even more roads to Jerusalem than these. Some leading portfolio managers, like David Dreman of Dreman Value Management and Martin Whitman of the Third Avenue Funds, focus on companies selling at very low multiples of assets, earnings, or cash flow. Others, like Charles Royce of the Royce Funds and Joel Tillinghast of Fidelity Low-Priced Stock Fund, hunt for undervalued small companies. And, for an all-too-brief look at how today’s most revered investor, Warren Buffett, selects companies. One technique that can be helpful: See which leading professional money managers own the same stocks you do. If one or two names keep turning up, go to the websites of those fund companies and download their most recent reports. By seeing which other stocks these investors own, you can learn more about what qualities they have in common; by reading the managers’ commentary, you may get ideas on how to improve your own approach. No matter which techniques they use in picking stocks, successful investing professionals have two things in common: First, they are disciplined and consistent, refusing to change their approach even when it is unfashionable. Second, they think a great deal about what they do and how to do it, but they pay very little attention to what the market is doing.

WARREN’S WAY

Graham’s greatest student, Warren Buffett, has become the world’s most successful investor by putting new twists on Graham’s ideas. Buffett and his partner, Charles Munger, have combined Graham’s “margin of safety” and detachment from the market with their own innovative emphasis on future growth. Here is an all-too-brief summary of Buffett’s approach: He looks for what he calls “franchise” companies with strong consumer brands, easily understandable businesses, robust financial health, and near-monopolies in their markets, like H&R Block, Gillette, and the Washington Post Co. Buffett likes to snap up a stock when a scandal, big loss, or other bad news passes over it like a storm cloud—as when he bought Coca-Cola soon after its disastrous rollout of “New Coke” and the market crash of 1987. He also wants to see managers who set and meet realistic goals; build their businesses from within rather than through acquisition; allocate capital wisely; and do not pay themselves hundred-million-dollar jackpots of stock options. Buffett insists on steady and sustainable growth in earnings, so the company will be worth more in the future than it is today. In his annual reports, archived at www.berkshirehathaway. com, Buffett has set out his thinking like an open book. Probably no other investor, Graham included, has publicly revealed more about his approach or written such compellingly readable essays. (One classic Buffett proverb: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”) Every intelligent investor can—and should—learn by reading this master’s own words.

CHAPTER 16. CONVERTIBLE ISSUES AND WARRANTS

Skipping the chapter and moving on to commentary.

COMMENTARY ON CHAPTER 16

THE ZEAL OF THE CONVERT

Although convertible bonds are called “bonds,” they behave like stocks, work like options, and are cloaked in obscurity.
If you own a convertible, you also hold an option: You can either keep the bond and continue to earn interest on it, or you can exchange it for common stock of the issuing company at a predetermined ratio. (An option gives its owner the right to buy or sell another security at a given price within a specific period of time.) Because they are exchangeable into stock, convertibles pay lower rates of interest than most comparable bonds. On the other hand, if a company’s stock price soars, a convertible bond exchangeable into that stock will perform much better than a conventional bond. (Conversely, the typical convertible—with its lower interest rate—will fare worse in a falling bond market.)

As a brief example of how convertible bonds work in practice, consider the 4.75% convertible subordinated notes issued by DoubleClick Inc. in 1999.
They pay $47.50 in interest per year and are each convertible into 24.24 shares of the company’s common stock, a “conversion ratio” of 24.24. As of year-end 2002, DoubleClick’s stock was priced at $5.66 a share, giving each bond a “conversion value” of $137.20 ($5.66 * 24.24). Yet the bonds traded roughly six times higher, at $881.30—creating a “conversion premium,” or excess over their conversion value, of 542%. If you bought at that price, your “break-even time,” or “payback period,” was very long. (You paid roughly $750 more than the conversion value of the bond, so it will take nearly 16 years of $47.50 interest payments for you to “earn back” that con version premium.) Since each DoubleClick bond is convertible to just over 24 common shares, the stock will have to rise from $5.66 to more than $36 if conversion is to become a practical option before the bonds mature in 2006. Such a stock return is not impossible, but it borders on the miraculous. The cash yield on this particular bond scarcely seems adequate, given the low probability of conversion.

From 1957 through 2002, according to Ibbotson Associates, convertible bonds earned an annual average return of 8.3%—only two percentage points below the total return on stocks, but with steadier prices and shallower losses. [Like many of the track records commonly cited on Wall Street, this one is hypothetical. It indicates the return you would have earned in an imaginary index fund that owned all major convertibles. It does not include any management fees or trading costs (which are substantial for convertible securities). In the real world, your returns would have been roughly two percentage points lower.]

More income, less risk than stocks: No wonder Wall Street’s salespeople often describe convertibles as a “best of both worlds” investment. But the intelligent investor will quickly realize that convertibles offer less income and more risk than most other bonds. So they could, by the same logic and with equal justice, be called a “worst of both worlds” investment. Which side you come down on depends on how you use them.
In truth, convertibles act more like stocks than bonds. The return on convertibles is about 83% correlated to the Standard & Poor’s 500- stock index—but only about 30% correlated to the performance of Treasury bonds. Thus, “converts” zig when most bonds zag. For conservative investors with most or all of their assets in bonds, adding a diversified bundle of converts is a sensible way to seek stock-like returns without having to take the scary step of investing in stocks directly. You could call convertible bonds “stocks for chickens.”
As convertibles expert F. Barry Nelson of Advent Capital Management points out, this roughly $200 billion market has blossomed since Graham’s day. Most converts are now medium-term, in the seven-to-10-year range; roughly half are investment-grade; and many issues now carry some call protection (an assurance against early redemption). All these factors make them less risky than they used to be.

[However, most convertible bonds remain junior to other long-term debt and bank loans—so, in a bankruptcy, convertible holders do not have prior claim to the company’s assets. And, while they are not nearly as dicey as high-yield “junk” bonds, many converts are still issued by companies with less than sterling credit ratings. Finally, a large portion of the convertible market is held by hedge funds, whose rapid-fire trading can increase the volatility of prices.

For more detail, see www.fidelity.com, www.vanguard.com, and www.morningstar.com. The intelligent investor will never buy a convertible bond fund with annual operating expenses exceeding 1.0%.]

It’s expensive to trade small lots of convertible bonds, and diversification is impractical unless you have well over $100,000 to invest in this sector alone. Fortunately, today’s intelligent investor has the convenient recourse of buying a low-cost convertible bond fund. Fidelity and Vanguard offer mutual funds with annual expenses comfortably under 1%, while several closed-end funds are also available at a reasonable cost (and, occasionally, at discounts to net asset value).
On Wall Street, cuteness and complexity go hand-in-hand—and convertibles are no exception. Among the newer varieties are a jumble of securities with acronymic nicknames like LYONS, ELKS, EYES, PERCS, MIPS, CHIPS, and YEELDS. These intricate securities put a “floor” under your potential losses, but also cap your potential profits and often compel you to convert into common stock on a fixed date.
Like most investments that purport to ensure against loss, these things are generally more trouble than they are worth. You can best shield yourself against loss not by buying one of these quirky contraptions, but by intelligently diversifying your entire portfolio across cash, bonds, and U.S. and foreign stocks.

UNCOVERING COVERED CALLS

As the bear market clawed its way through 2003, it dug up an old fad: writing covered call options. (A recent Google search on “covered call writing” turned up more than 2,600 hits.) What are covered calls, and how do they work? Imagine that you buy 100 shares of Ixnay Corp. at $95 apiece. You then sell (or “write”) a call option on your shares. In exchange, you get a cash payment known as a “call premium.” (Let’s say it’s $10 per share.) The buyer of the option, meanwhile, has the contractual right to buy your Ixnay shares at a mutually agreed-upon price— say, $100. You get to keep the stock so long as it stays below $100, and you earn a fat $1,000 in premium income, which will cushion the fall if Ixnay’s stock crashes.
Less risk, more income. What’s not to like? Well, now imagine that Ixnay’s stock price jumps overnight to $110. Then your option buyer will exercise his rights, yanking your shares away for $100 apiece. You’ve still got your $1,000 in income, but he’s got your Ixnay—and the more it goes up, the harder you will kick yourself. [Alternatively, you could buy back the call option, but you would have to take a loss on it—and options can have even higher trading costs than stocks.]

Since the potential gain on a stock is unlimited, while no loss can exceed 100%, the only person you will enrich with this strategy is your broker. You’ve put a floor under your losses, but you’ve also slapped a ceiling over your gains. For individual investors, covering your downside is never worth surrendering most of your upside.

CHAPTER 17. FOUR EXTREMELY INSTRUCTIVE CASE HISTORIES

The word “extremely” in the title is a kind of pun, because the histories represent extremes of various sorts that were manifest on Wall Street in recent years. They hold instruction, and grave warnings, for everyone who has a serious connection with the world of stocks and bonds—not only for ordinary investors and speculators but for professionals, security analysts, fund managers, trustaccount administrators, and even for bankers who lend money to corporations. The four companies to be reviewed, and the different extremes that they illustrate are:

Penn Central (Railroad) Co.

An extreme example of the neglect of the most elementary warning signals of financial weakness, by all those who had bonds or shares of this system under their supervision. A crazily high market price for the stock of a tottering giant.

Moral of this case: Security analysts should do their elementary jobs before they study stock-market movements, gaze into crystal balls, make elaborate mathematical calculations, or go on all-expense-paid field trips.

Ling-Temco-Vought Inc.

An extreme example of quick and unsound “empire building,” with ultimate collapse practically guaranteed; but helped by indiscriminate bank lending.

Moral of this case: The primary question raised in our mind by the LingTemco-Vought story is how the commercial bankers could have been persuaded to lend the company such huge amounts of money during its expansion period. In 1966 and earlier the company’s coverage of interest charges did not meet conservative standards, and the same was true of the ratio of current assets to current liabilities and of stock equity to total debt. But in the next two years the banks advanced the enterprise nearly $400 million additional for further “diversification.” This was not good business for them, and it was worse in its implications for the company’s shareholders. If the Ling-Temco-Vought case will serve to keep commercial banks from aiding and abetting unsound expansions of this type in the future, some good may come of it at last.

NVF Corp.

An extreme example of one corporate acquisition, in which a small company absorbed another seven times its size, incurring a huge debt and employing some startling accounting devices.

AAA Enterprises.

An extreme example of public stock-financing of a small company; its value based on the magic word “franchising,” and little else, sponsored by important stock-exchange houses. Bankruptcy followed within two years of the stock sale and the doubling of the initial inflated price in the heedless stock market.

COMMENTARY ON CHAPTER 17

THE MORE THINGS CHANGE...

Graham highlights four extremes: • an overpriced “tottering giant”
• an empire-building conglomerate • a merger in which a tiny firm took over a big one • an initial public offering of shares in a basically worthless company The past few years have provided enough new cases of Graham’s extremes to fill an encyclopedia. Here is a sampler:

LUCENT, NOT TRANSPARENT

In mid-2000, Lucent Technologies Inc. was owned by more investors than any other U.S. stock. With a market capitalization of $192.9 billion, it was the 12th-most-valuable company in America.
Was that giant valuation justified? Let’s look at some basics from Lucent’s financial report for the fiscal quarter ended June 30, 2000:

A closer reading of Lucent’s report sets alarm bells jangling like an unanswered telephone switchboard:

• Lucent had just bought an optical equipment supplier, Chromatis Networks, for $4.8 billion—of which $4.2 billion was “goodwill” (or cost above book value). Chromatis had 150 employees, no customers, and zero revenues, so the term “goodwill” seems inadequate; perhaps “hope chest” is more accurate. If Chromatis’s embryonic products did not work out, Lucent would have to reverse the goodwill and charge it off against future earnings.

• A footnote discloses that Lucent had lent $1.5 billion to purchasers of its products. Lucent was also on the hook for $350 million in guarantees for money its customers had borrowed elsewhere. The total of these “customer financings” had doubled in a year—suggesting that purchasers were running out of cash to buy Lucent’s products. What if they ran out of cash to pay their debts?

• Finally, Lucent treated the cost of developing new software as a “capital asset.” Rather than an asset, wasn’t that a routine business expense that should come out of earnings?

CONCLUSION: In August 2001, Lucent shut down the Chromatis division after its products reportedly attracted only two customers.2 In fiscal year 2001, Lucent lost $16.2 billion; in fiscal year 2002, it lost another $11.9 billion. Included in those losses were $3.5 billion in “provisions for bad debts and customer financings,” $4.1 billion in “impairment charges related to goodwill,” and $362 million in charges “related to capitalized software.” Lucent’s stock, at $51.062 on June 30, 2000, finished 2002 at $1.26—a loss of nearly $190 billion in market value in two-and-a-half years.

THE ACQUISITION MAGICIAN

To describe Tyco International Ltd., we can only paraphrase Winston Churchill and say that never has so much been sold by so many to so few. From 1997 through 2001, this Bermuda-based conglomerate spent a total of more than $37 billion—most of it in shares of Tyco stock—buying companies the way Imelda Marcos bought shoes. In fiscal year 2000 alone, according to its annual report, Tyco acquired “approximately 200 companies”—an average of more than one every other day.
The result? Tyco grew phenomenally fast; in five years, revenues went from $7.6 billion to $34 billion, and operating income shot from a $476 million loss to a $6.2 billion gain. No wonder the company had a total stock-market value of $114 billion at the end of 2001.
But Tyco’s financial statements were at least as mind-boggling as its growth. Nearly every year, they featured hundreds of millions of dollars in acquisition-related charges. These expenses fell into three main categories:
1) “merger” or “restructuring” or “other nonrecurring” costs,
2) “charges for the impairment of long-lived assets,” and
3) “write-offs of purchased in-process research and development.”
For the sake of brevity, let’s refer to the first kind of charge as MORON, the second as CHILLA, and the third as WOOPIPRAD. How did they show up over time?

As you can see, the MORON charges—which are supposed to be nonrecurring—showed up in four out of five years and totaled a whopping $2.5 billion. CHILLA cropped up just as chronically and amounted to more than $700 million. WOOPIPRAD came to another half-billion dollars. [When accounting for acquisitions, loading up on WOOPIPRAD enabled Tyco to reduce the portion of the purchase price that it allocated to goodwill.
Since WOOPIPRAD can be expensed up front, while goodwill (under the accounting rules then in force) had to be written off over multi-year periods, this maneuver enabled Tyco to minimize the impact of goodwill charges on its future earnings.]
The intelligent investor would ask:
• If Tyco’s strategy of growth-through-acquisition was such a neat idea, how come it had to spend an average of $750 million a year cleaning up after itself?
• If, as seems clear, Tyco was not in the business of making things— but rather in the business of buying other companies that make things—then why were its MORON charges “nonrecurring”? Weren’t they just part of Tyco’s normal costs of doing business?
• And with accounting charges for past acquisitions junking up every year’s earnings, who could tell what next year’s would be?

In fact, an investor couldn’t even tell what Tyco’s past earnings were. In 1999, after an accounting review by the U.S. Securities and Exchange Commission, Tyco retroactively added $257 million in MORON charges to its 1998 expenses—meaning that those “nonrecurring” costs had actually recurred in that year, too. At the same time, the company rejiggered its originally reported 1999 charges: MORON dropped to $929 million while CHILLA rose to $507 million.
Tyco was clearly growing in size, but was it growing more profitable? No outsider could safely tell.

CONCLUSION: In fiscal year 2002, Tyco lost $9.4 billion. The stock, which had closed at $58.90 at year-end 2001, finished 2002 at $17.08—a loss of 71% in twelve months. [ In 2002, Tyco’s former chief executive, L. Dennis Kozlowski, was charged by state and Federal legal authorities with income tax fraud and improperly diverting Tyco’s corporate assets for his own use, including the appropriation of $15,000 for an umbrella stand and $6,000 for a shower curtain. Kozlowski denied all charges.]

A MINNOW SWALLOWS A WHALE

On January 10, 2000, America Online, Inc. and Time Warner Inc. announced that they would merge in a deal initially valued at $156 billion.
As of December 31, 1999, AOL had $10.3 billion in assets, and its revenues over the previous 12 months had amounted to $5.7 billion.
Time Warner, on the other hand, had $51.2 billion in assets and revenues of $27.3 billion. Time Warner was a vastly bigger company by any measure except one: the valuation of its stock. Because America Online bedazzled investors simply by being in the Internet industry, its stock sold for a stupendous 164 times its earnings. Stock in Time Warner, a grab bag of cable television, movies, music, and magazines, sold for around 50 times earnings.
In announcing the deal, the two companies called it a “strategic merger of equals.” Time Warner’s chairman, Gerald M. Levin, declared that “the opportunities are limitless for everyone connected to AOL Time Warner”—above all, he added, for its shareholders.
Ecstatic that their stock might finally get the cachet of an Internet darling, Time Warner shareholders overwhelmingly approved the deal.
But they overlooked a few things:

• This “merger of equals” was designed to give America Online’s shareholders 55% of the combined company—even though Time Warner was five times bigger.
• For the second time in three years, the U.S. Securities and Exchange Commission was investigating whether America Online had improperly accounted for marketing costs.
• Nearly half of America Online’s total assets—$4.9 billion worth— was made up of “available-for-sale equity securities.” If the prices of publicly-traded technology stocks fell, that could wipe out much of the company’s asset base.

CONCLUSION: On January 11, 2001, the two firms finalized their merger. AOL Time Warner Inc. lost $4.9 billion in 2001 and—in the most gargantuan loss ever recorded by a corporation—another $98.7 billion in 2002. Most of the losses came from writing down the value of America Online. By year-end 2002, the shareholders for whom Levin predicted “unlimited” opportunities had nothing to show but a roughly 80% loss in the value of their shares since the deal was first announced.

CAN YOU FLUNK INVESTING KINDERGARTEN?

On May 20, 1999, eToys Inc. sold 8% of its stock to the public. Four of Wall Street’s most prestigious investment banks—Goldman, Sachs & Co.; BancBoston Robertson Stephens; Donaldson, Lufkin & Jenrette; and Merrill Lynch & Co.—underwrote 8,320,000 shares at $20 apiece, raising $166.4 million. The stock roared up, closing at $76.5625, a 282.8% gain in its first day of trading. At that price, eToys (with its 102 million shares) had a market value of $7.8 billion. [ eToys’ prospectus had a gatefold cover featuring an original cartoon of Arthur the aardvark, showing in comic style how much easier it would be to buy tchotchkes for children at eToys than at a traditional toy store. As analyst Gail Bronson of IPO Monitor told the Associated Press on the day of eToys’ stock offering, “eToys has very, very smartly managed the development of the company last year and positioned themselves to be the children’s center of the Internet.” Added Bronson: “The key to a successful IPO, especially a dot-com IPO, is good marketing and branding.” Bronson was partly right: That’s the key to a successful IPO for the issuing company and its bankers.
Unfortunately, for investors the key to a successful IPO is earnings, which eToys didn’t have. ]
What kind of business did buyers get for that price? eToys’ sales had risen 4,261% in the previous year, and it had added 75,000 customers in the last quarter alone. But, in its 20 months in business, eToys had produced total sales of $30.6 million, on which it had run a net loss of $30.8 million—meaning that eToys was spending $2 to sell every dollar’s worth of toys.
The IPO prospectus also disclosed that eToys would use some proceeds of the offering to acquire another online operation, BabyCenter, Inc., which had lost $4.5 million on $4.8 million in sales over the previous year. (To land this prize, eToys would pay a mere $205 million.) And eToys would “reserve” 40.6 million shares of common stock for future issuance to its management. So, if eToys ever made money, its net income would have to be divided not among 102 million shares, but among 143 million—diluting any future earnings per share by nearly one-third.
A comparison of eToys with Toys “R” Us, Inc.—its biggest rival—is shocking. In the preceding three months, Toys “R” Us had earned $27 million in net income and had sold over 70 times more goods than eToys had sold in an entire year. And yet as Figure 17-3 shows, the stock market valued eToys at nearly $2 billion more than Toys “R” Us.

CONCLUSION: On March 7, 2001, eToys filed for bankruptcy protection after racking up net losses of more than $398 million in its brief life as a public company. The stock, which peaked at $86 per share in October 1999, last traded for a penny.

CHAPTER 18. A COMPARISON OF EIGHT PAIRS OF COMPANIES

In this chapter we shall attempt a novel form of exposition. By selecting eight pairs of companies which appear next to each other, or nearly so, on the stock-exchange list we hope to bring home in a concrete and vivid manner some of the many varieties of character, financial structure, policies, performance, and vicissitudes of corporate enterprises, and of the investment and speculative attitudes found on the financial scene in recent years. In each comparison we shall comment only on those aspects that have a special meaning and import.

Pair 1: Real Estate Investment Trust (stores, offices, factories, etc.) and Realty Equities Corp. of New York (real estate investment; general construction)

Pair 2: Air Products and Chemicals (industrial and medical gases, etc.) and Air Reduction Co. (industrial gases and equipment; chemicals)

Pair 3: American Home Products Co. (drugs, cosmetics, household products, candy) and American Hospital Supply Co. (distributor and manufacturer of hospital supplies and equipment)

Pair 4: H&R Block, Inc. (income-tax service) and Blue Bell, Inc., (manufacturers of work clothes, uniforms, etc.)

Pair 5: International Flavors & Fragrances (flavors, etc., for other businesses) and International Harvester Co. (truck manufacturer, farm machinery, construction machinery)

Note: For this case, Graham alerts readers to a form of the “gambler’s fallacy,” in which investors believe that an overvalued stock must drop in price purely because it is overvalued. Just as a coin does not become more likely to turn up heads after landing on tails for nine times in a row, so an overvalued stock (or stock market!) can stay overvalued for a surprisingly long time. That makes shortselling, or betting that stocks will drop, too risky for mere mortals.

Pair 6: McGraw Edison (public utility and equipment; housewares) McGraw-Hill, Inc. (books, films, instruction systems; magazine and newspaper publishers; information services)

Pair 7: National General Corp. (a large conglomerate) and National Presto Industries (diverse electric appliances, ordnance)

Pair 8: Whiting Corp. (materials-handling equipment) and Willcox & Gibbs (small conglomerate)

COMMENTARY ON CHAPTER 18

Let’s update Graham’s classic write-up of eight pairs of companies, using the same compare-and-contrast technique that he pioneered in his lectures at Columbia Business School and the New York Institute of Finance. Bear in mind that these summaries describe these stocks only at the times specified. The cheap stocks may later become overpriced; the expensive stocks may turn cheap. At some point in its life, almost every stock is a bargain; at another time, it will be expensive. Although there are good and bad companies, there is no such thing as a good stock; there are only good stock prices, which come and go.

PAIR 1: CISCO AND SYSCO

On March 27, 2000, Cisco Systems, Inc., became the world’s most valuable corporation as its stock hit $548 billion in total value. Cisco, which makes equipment that directs data over the Internet, first sold its shares to the public only 10 years earlier. Had you bought Cisco’s stock in the initial offering and kept it, you would have earned a gain resembling a typographical error made by a madman: 103,697%, or a 217% average annual return. Over its previous four fiscal quarters, Cisco had generated $14.9 billion in revenues and $2.5 billion in earnings. The stock was trading at 219 times Cisco’s net income, one of the highest price/earnings ratios ever accorded to a large company. Then there was Sysco Corp., which supplies food to institutional kitchens and had been publicly traded for 30 years. Over its last four quarters, Sysco served up $17.7 billion in revenues—almost 20% more than Cisco—but “only” $457 million in net income. With a market value of $11.7 billion, Sysco’s shares traded at 26 times earnings, well below the market’s average P/E ratio of 31.

A word-association game with a typical investor might have gone like this.
Q: What are the first things that pop into your head when I say Cisco Systems?
A: The Internet... the industry of the future... great stock... hot stock... Can I please buy some before it goes up even more?

Q: And what about Sysco Corp.?
A: Delivery trucks... succotash... Sloppy Joes... shepherd’s pie... school lunches... hospital food... no thanks, I’m not hungry anymore.

It’s well established that people often assign a mental value to stocks based largely on the emotional imagery that companies evoke. [Ask yourself which company’s stock would be likely to rise more: one that discovered a cure for a rare cancer, or one that discovered a new way to dispose of a common kind of garbage. The cancer cure sounds more exciting to most investors, but a new way to get rid of trash would probably make more money.]

But the intelligent investor always digs deeper. Here’s what a skeptical look at Cisco and Sysco’s financial statements would have turned up:
• Much of Cisco’s growth in revenues and earnings came from acquisitions. Since September alone, Cisco had ponied up $10.2 billion to buy 11 other firms. How could so many companies be mashed together so quickly? [“Serial acquirers,” which grow largely by buying other companies, nearly always meet a bad end on Wall Street. See the commentary on Chapter 17 for a longer discussion.] Also, roughly a third of Cisco’s earnings over the previous six months came not from its businesses, but from tax breaks on stock options exercised by its executives and employees. And Cisco had gained $5.8 billion selling “investments,” then bought $6 billion more. Was it an Internet company or a mutual fund? What if those “investments” stopped going up?

• Sysco had also acquired several companies over the same period—but paid only about $130 million. Stock options forSysco’s insiders totaled only 1.5% of shares outstanding, versus 6.9% at Cisco. If insiders cashed their options, Sysco’s earnings per share would be diluted much less than Cisco’s. And Sysco had raised its quarterly dividend from nine cents a share to 10; Cisco paid no dividend.

Finally, as Wharton finance professor Jeremy Siegel pointed out, no company as big as Cisco had ever been able to grow fast enough to justify a price/earnings ratio above 60—let alone a P/E ratio over 200.3 Once a company becomes a giant, its growth must slow down—or it will end up eating the entire world. The great American satirist Ambrose Bierce coined the word “incompossible” to describe two things that are conceivable separately but cannot exist together. A company can be a giant, or it can deserve a giant P/E ratio, but both together are incompossible.

The wheels soon came off the Cisco juggernaut. First, in 2001, came a $1.2 billion charge to “restructure” some of those acquisitions. Over the next two years, $1.3 billion in losses on those “investments” leaked out. From 2000 through 2002, Cisco’s stock lost three-quarters of its value. Sysco, meanwhile, kept dishing out profits, and the stock gained 56% over the same period (see Figure 18-1).

PAIR 2: YAHOO! AND YUM!

On November 30, 1999, Yahoo! Inc.’s stock closed at $212.75, up 79.6% since the year began. By December 7, the stock was at $348 - a 63.6% gain in five trading days. Yahoo! kept whooping along through year-end, closing at $432.687 on December 31. In a single month, the stock had more than doubled, gaining roughly $58 billion to reach a total market value of $114 billion. [Yahoo!’s stock split two-for-one in February 2000; the share prices given here are not adjusted for that split in order to show the levels the stock actually traded at. But Yahoo!’s percentage return and market value, as cited here, do reflect the split.]

In the previous four quarters, Yahoo! had racked up $433 million in revenues and $34.9 million in net income. So Yahoo!’s stock was now priced at 263 times revenues and 3,264 times earnings. (Remember that a P/E ratio much above 25 made Graham grimace!) [Counting the effect of acquisitions, Yahoo!’s revenues were $464 million. Graham criticizes high P/E ratios in (among other places) Chapters 7 and 11.]

Why was Yahoo! screaming upward? After the market closed on November 30, Standard & Poor’s announced that it would add Yahoo! to its S & P 500 index as of December 7. That would make Yahoo! a compulsory holding for index funds and other big investors—and that sudden rise in demand was sure to drive the stock even higher, at least temporarily. With some 90% of Yahoo!’s stock locked up in the hands of employees, venture-capital firms, and other restricted holders, just a fraction of its shares could trade. So thousands of people bought the stock only because they knew other people would have to buy it—and price was no object.

Meanwhile, Yum! went begging. A former division of PepsiCo that runs thousands of Kentucky Fried Chicken, Pizza Hut, and Taco Bell eateries, Yum! had produced $8 billion in revenues over the previous four quarters, on which it earned $633 million—making it more than 17 times Yahoo!’s size. Yet Yum!’s stock-market value at year-end 1999 was only $5.9 billion, or 1/19 of Yahoo!’s capitalization. At that price, Yum!’s stock was selling at just over nine times its earnings and only 73% of its revenues. [Yum! was then known as Tricon Global Restaurants, Inc., although its ticker symbol was YUM. The company changed its name officially to Yum! Brands, Inc. in May 2002.]

As Graham liked to say, in the short run the market is a voting machine, but in the long run it is a weighing machine. Yahoo! won the short-term popularity contest. But in the end, it’s earnings that matter— and Yahoo! barely had any. Once the market stopped voting and started weighing, the scales tipped toward Yum! Its stock rose 25.4% from 2000 through 2002, while Yahoo!’s lost 92.4% cumulatively:

PAIR 3: COMMERCE ONE AND CAPITAL ONE

In May 2000, Commerce One, Inc., had been publicly traded only since the previous July. In its first annual report, the company (which designs Internet “exchanges” for corporate purchasing departments) showed assets of just $385 million and reported a net loss of $63 million on only $34 million in total revenues. The stock of this minuscule company had risen nearly 900% since its IPO, hitting a total market capitalization of $15 billion. Was it overpriced? “Yes, we have a big market cap,” Commerce One’s chief executive, Mark Hoffman, shrugged in an interview. “But we have a big market to play in. We’re seeing incredible demand. . . . Analysts expect us to make $140 million in revenue this year. And in the past we have exceeded expectations.” Two things jump out from Hoffman’s answer:

• Since Commerce One was already losing $2 on every dollar in sales, if it quadrupled its revenues (as “analysts expect”), wouldn’t it lose money even more massively?

• How could Commerce One have exceeded expectations “in the past”? What past?

Asked whether his company would ever turn a profit, Hoffman was ready: “There is no question we can turn this into a profitable business. We plan on becoming profitable in the fourth quarter of 2001, a year analysts see us making over $250 million in revenues.” There come those analysts again! “I like Commerce One at these levels because it’s growing faster than Ariba [a close competitor whose stock was also trading at around 400 times revenues],” said Jeanette Sing, an analyst at the Wasserstein Perella investment bank. “If these growth rates continue, Commerce One will be trading at 60 to 70 times sales in 2001.” (In other words, I can name a stock that’s more overpriced than Commerce One, so Commerce One is cheap.)7 At the other extreme was Capital One Financial Corp., an issuer of MasterCard and Visa credit cards. From July 1999, to May 2000, its stock lost 21.5%. Yet Capital One had $12 billion in total assets and earned $363 million in 1999, up 32% from the year before. With a market value of about $7.3 billion, the stock sold at 20 times Capital One’s net earnings. All might not be well at Capital One—the company had barely raised its reserves for loans that might go bad, even though default rates tend to jump in a recession—but its stock price reflected at least some risk of potential trouble.

What happened next?

In 2001, Commerce One generated $409 million in revenues. Unfortunately, it ran a net loss of $2.6 billion—or $10.30 of red ink per share—on those revenues. Capital One, on the other hand, earned nearly $2 billion in net income in 2000 through 2002. Its stock lost 38% in those three years—no worse than the stock market as a whole. Commerce One, however, lost 99.7% of its value. [In early 2003, Capital One’s chief financial officer resigned after securities regulators revealed that they might charge him with violations of laws against insider trading.]

Instead of listening to Hoffman and his lapdog analysts, traders should have heeded the honest warning in Commerce One’s annual report for 1999: “We have never been profitable. We expect to incur net losses for the foreseeable future and we may never be profitable.”

PAIR 4: PALM AND 3COM

On March 2, 2000, the data-networking company 3Com Corp. sold 5% of its Palm, Inc. subsidiary to the public. The remaining 95% of Palm’s stock would be spun off to 3Com’s shareholders in the next few months; for each share of 3Com they held, investors would receive 1.525 shares of Palm. So there were two ways you could get 100 shares of Palm: By trying to elbow your way into the IPO, or by buying 66 shares of 3Com and waiting until the parent company distributed the rest of the Palm stock. Getting one-and-a-half shares of Palm for each 3Com share, you’d end up with 100 shares of the new company—and you’d still have 66 shares of 3Com.

But who wanted to wait a few months? While 3Com was struggling against giant rivals like Cisco, Palm was a leader in the hot “space” of handheld digital organizers. So Palm’s stock shot up from its offering price of $38 to close at $95.06, a 150% first-day return. That valued Palm at more than 1,350 times its earnings over the previous 12 months. That same day, 3Com’s share price dropped from $104.13 to $81.81. Where should 3Com have closed that day, given the price of Palm? The arithmetic is easy

• each 3Com share was entitled to receive 1.525 shares of Palm
• each share of Palm closed at $95.06
• 1.525 * $95.06 = $144.97

That’s what each 3Com share was worth based on its stake in Palm alone. Thus, at $81.81, traders were saying that all of 3Com’s other businesses combined were worth a negative $63.16 per share, or a total of minus $22 billion! Rarely in history has any stock been priced more stupidly.

But there was a catch: Just as 3Com wasn’t really worth minus $22 billion, Palm wasn’t really worth over 1,350 times earnings. By the end of 2002, both stocks were hurting in the high-tech recession, but it was Palm’s shareholders who really got smacked—because they abandoned all common sense when they bought in the first place:

PAIR 5: CMGI AND CGI

The year 2000 started off with a bang for CMGI, Inc., as the stock hit $163.22 on January 3—a gain of 1,126% over its price just one year before. The company, an “Internet incubator,” financed and acquired start-up firms in a variety of online businesses—among them such early stars as theglobe.com and Lycos.

In fiscal year 1998, as its stock rose from 98 cents to $8.52, CMGI spent $53.8 million acquiring whole or partial stakes in Internet companies. In fiscal year 1999, as its stock shot from $8.52 to $46.09, CMGI shelled out $104.7 million. And in the last five months of 1999, as its shares zoomed up to $138.44, CMGI spent $4.1 billion on acquisitions. Virtually all the “money” was CMGI’s own privately-minted currency: its common stock, now valued at a total of more than $40 billion.

It was a kind of magical money merry-go-round. The higher CMGI’s own stock went, the more it could afford to buy. The more CMGI could afford to buy, the higher its stock went. First stocks would go up on the rumor that CMGI might buy them; then, once CMGI acquired them, its own stock would go up because it owned them. No one cared that CMGI had lost $127 million on its operations in the latest fiscal year.

Down in Webster, Massachusetts, less than 70 miles southwest of CMGI’s headquarters in Andover, sits the main office of Commerce Group, Inc. CGI was everything CMGI was not: Offering automobile insurance, mainly to drivers in Massachusetts, it was a cold stock in an old industry. Its shares lost 23% in 1999—although its net income, at $89 million, ended up falling only 7% below 1998’s level. CGI even paid a dividend of more than 4% (CMGI paid none). With a total market value of $870 million, CGI stock was trading at less than 10 times what the company would earn for 1999.

And then, quite suddenly, everything went into reverse. CMGI’s magical money merry-go-round screeched to a halt: Its dot-com stocks stopped rising in price, then went straight down. No longer able to sell them for a profit, CMGI had to take their loss in value as a hit to its earnings. The company lost $1.4 billion in 2000, $5.5 billion in 2001, and nearly $500 million more in 2002. Its stock went from $163.22 at the beginning of 2000 to 98 cents by year-end 2002—a loss of 99.4%. Boring old CGI, however, kept cranking out steady earnings, and its stock rose 8.5% in 2000, 43.6% in 2001, and 2.7% in 2002—a 60% cumulative gain.

PAIR 6: BALL AND STRYKER

Between July 9 and July 23, 2002, Ball Corp.’s stock dropped from $43.69 to $33.48—a loss of 24% that left the company with a stockmarket value of $1.9 billion. Over the same two weeks, Stryker Corp.’s shares fell from $49.55 to $45.60, an 8% drop that left Strkyer valued at a total of $9 billion.

What had made these two companies worth so much less in so short a time? Stryker, which manufactures orthopedic implants and surgical equipment, issued only one press release during those two weeks. On July 16, Stryker announced that its sales grew 15% to $734 million in the second quarter, while earnings jumped 31% to $86 million. The stock rose 7% the next day, then rolled right back downhill.

Ball, the original maker of the famous “Ball Jars” used for canning fruits and vegetables, now makes metal and plastic packaging for industrial customers. Ball issued no press releases at all during those two weeks. On July 25, however, Ball reported that it had earned $50 million on sales of $1 billion in the second quarter—a 61% rise in net income over the same period one year earlier. That brought its earnings over the trailing four quarters to $152 million, so the stock was trading at just 12.5 times Ball’s earnings. And, with a book value of $1.1 billion, you could buy the stock for 1.7 times what the company’s tangible assets were worth. (Ball did, however, have just over $900 million in debt.)

Stryker was in a different league. Over the last four quarters, the company had generated $301 million in net income. Stryker’s book value was $570 million. So the company was trading at fat multiples of 30 times its earnings over the past 12 months and nearly 16 times its book value. On the other hand, from 1992 through the end of 2001, Stryker’s earnings had risen 18.6% annually; its dividend had grown by nearly 21% per year. And in 2001, Stryker had spent $142 million on research and development to lay the groundwork for future growth. What, then, had pounded these two stocks down? Between July 9 and July 23, 2002, as WorldCom keeled over into bankruptcy, the Dow Jones Industrial Average fell from 9096.09 to 7702.34, a 15.3% plunge. The good news at Ball and Stryker got lost in the bad headlines and falling markets, which took these two stocks down with them. Although Ball ended up priced far more cheaply than Stryker, the lesson here is not that Ball was a steal and Stryker was a wild pitch. Instead, the intelligent investor should recognize that market panics can create great prices for good companies (like Ball) and good prices for great companies (like Stryker). Ball finished 2002 at $51.19 a share, up 53% from its July low; Stryker ended the year at $67.12, up 47%. Every once in a while, value and growth stocks alike go on sale. Which choice you prefer depends largely on your own personality, but bargains can be had on either side of the plate.

PAIR 7: NORTEL AND NORTEK

The 1999 annual report for Nortel Networks, the fiber-optic equipment company, boasted that it was “a golden year financially.” As of February 2000, at a market value of more than $150 billion, Nortel’s stock traded at 87 times the earnings that Wall Street’s analysts estimated the company would produce in 2000.

How credible was that estimate? Nortel’s accounts receivable sales to customers that had not yet paid the bill—had shot up by $1 billion in a year. The company said the rise “was driven by increased sales in the fourth quarter of 1999.” However, inventories had also ballooned by $1.2 billion—meaning that Nortel was producing equipment even faster than those “increased sales” could unload it.

Meanwhile, Nortel’s “long-term receivables”—bills not yet paid for multi-year contracts—jumped from $519 million to $1.4 billion. And Nortel was having a hard time controlling costs; its selling, general, and administrative expense (or overhead) had risen from 17.6% of revenues in 1997 to 18.7% in 1999. All told, Nortel had lost $351 million in 1999. Then there was Nortek, Inc., which produces stuff at the dim end of the glamour spectrum: vinyl siding, door chimes, exhaust fans, range hoods, trash compactors. In 1999, Nortek earned $49 million on $2 billion in net sales, up from $21 million in net income on $1.1 billion in sales in 1997. Nortek’s profit margin (net earnings as a percentage of net sales) had risen by almost a third from 1.9% to 2.5%. And Nortek had cut overhead from 19.3% of revenues to 18.1%.

To be fair, much of Nortek’s expansion came from buying other companies, not from internal growth. What’s more, Nortek had $1 billion in debt, a big load for a small firm. But, in February 2000, Nortek’s stock price—roughly five times its earnings in 1999—included a healthy dose of pessimism.

On the other hand, Nortel’s price—87 times the guesstimate of what it might earn in the year to come—was a massive overdose of optimism. When all was said and done, instead of earning the $1.30 per share that analysts had predicted, Nortel lost $1.17 per share in 2000. By the end of 2002, Nortel had bled more than $36 billion in red ink. Nortek, on the other hand, earned $41.6 million in 2000, $8 million in 2001, and $55 million in the first nine months of 2002. Its stock went from $28 a share to $45.75 by year-end 2002—a 63% gain. In January 2003, Nortek’s managers took the company private, buying all the stock from public investors at $46 per share. Nortel’s stock, meanwhile, sank from $56.81 in February 2000, to $1.61 at year-end 2002—a 97% loss.

PAIR 8: RED HAT AND BROWN SHOE

On August 11, 1999, Red Hat, Inc., a developer of Linux software, sold stock to the public for the first time. Red Hat was red-hot; initially offered at $7, the shares opened for trading at $23 and closed at $26.031—a 272% gain. [All stock prices for Red Hat are adjusted for its two-for-one stock split in January 2000.] In a single day, Red Hat’s stock had gone up more than Brown Shoe’s had in the previous 18 years. By December 9, Red Hat’s shares hit $143.13—up 1,944% in four months. Brown Shoe, meanwhile, had its laces tied together. Founded in 1878, the company wholesales Buster Brown shoes and runs nearly 1,300 footwear stores in the United States and Canada. Brown Shoe’s stock, at $17.50 a share on August 11, stumbled down to $14.31 by December 9. For all of 1999, Brown Shoe’s shares lost 17.6%. [Ironically, 65 years earlier Graham had singled out Brown Shoe as one of the most stable companies on the New York Stock Exchange. See the 1934 edition of Security Analysis, p. 159.]

Besides a cool name and a hot stock, what did Red Hat’s investors get? Over the nine months ending November 30, the company produced $13 million in revenues, on which it ran a net loss of $9 million. [We use a nine-month period only because Red Hat’s 12-month results could not be determined from its financial statements without including the results of acquisitions.] Red Hat’s business was barely bigger than a street-corner delicatessen—and a lot less lucrative. But traders, inflamed by the words “software” and “Internet,” drove the total value of Red Hat’s shares to $21.3 billion by December 9.

And Brown Shoe? Over the previous three quarters, the company had produced $1.2 billion in net sales and $32 million in earnings. Brown Shoe had nearly $5 a share in cash and real estate; kids were still buying Buster Brown shoes. Yet, that December 9, Brown Shoe’s stock had a total value of $261 million—barely 1/80 the size of Red Hat even though Brown Shoe had 100 times Red Hat’s revenues. At that price, Brown Shoe was valued at 7.6 times its annual earnings and less than one-quarter of its annual sales. Red Hat, on the other hand, had no profits at all, while its stock was selling at more than 1,000 times its annual sales.

Red Hat the company kept right on gushing red ink. Soon enough, the stock did too. Brown Shoe, however, trudged out more profits— and so did its shareholders:

What have we learned? The market scoffs at Graham’s principles in the short run, but they are always revalidated in the end. If you buy a stock purely because its price has been going up—instead of asking whether the underlying company’s value is increasing—then sooner or later you will be extremely sorry. That’s not a likelihood. It is a certainty.

CHAPTER 19. SHAREHOLDERS AND MANAGEMENTS: DIVIDEND POLICY

Skipping this chapter and moving on to commentary.

COMMENTARY ON CHAPTER 19

WHY DID GRAHAM THROW IN THE TOWEL?

Perhaps no other part of The Intelligent Investor was more drastically changed by Graham than this. In the first edition, this chapter was one of a pair that together ran nearly 34 pages. That original section (“The Investor as Business Owner”) dealt with shareholders’ voting rights, ways of judging the quality of corporate management, and techniques for detecting conflicts of interest between insiders and outside investors. By his last revised edition, however, Graham had pared the whole discussion back to less than eight terse pages about dividends. Why did Graham cut away more than three-quarters of his original argument? After decades of exhortation, he evidently had given up hope that investors would ever take any interest in monitoring the behavior of corporate managers. But the latest epidemic of scandal—allegations of managerial misbehavior, shady accounting, or tax maneuvers at major firms like AOL, Enron, Global Crossing, Sprint, Tyco, and WorldCom—is a stark reminder that Graham’s earlier warnings about the need for eternal vigilance are more vital than ever. Let’s bring them back and discuss them in light of today’s events.

THEORY VERSUS PRACTICE

Graham begins his original (1949) discussion of “The Investor as Business Owner” by pointing out that, in theory, “the stockholders as a class are king. Acting as a majority they can hire and fire managements and bend them completely to their will.” But, in practice, says Graham,

the shareholders are a complete washout. As a class they show neither intelligence nor alertness. They vote in sheeplike fashion for whatever the management recommends and no matter how poor the management’s record of accomplishment may be.... The only way to inspire the average American shareholder to take any independently intelligent action would be by exploding a firecracker under him.... We cannot resist pointing out the paradoxical fact that Jesus seems to have been a more practical businessman than are American shareholders.

Benjamin Graham, The Intelligent Investor (Harper & Row, New York, 1949), pp. 217, 219, 240. Graham explains his reference to Jesus this way: “In at least four parables in the Gospels there is reference to a highly critical relationship between a man of wealth and those he puts in charge of his property. Most to the point are the words that “a certain rich man” speaks to his steward or manager, who is accused of wasting his goods: ‘Give an account of thy stewardship, for thou mayest be no longer steward.’ (Luke, 16:2).” Among the other parables Graham seems to have in mind is Matt., 25:15–28.

Graham wants you to realize something basic but incredibly profound: When you buy a stock, you become an owner of the company. Its managers, all the way up to the CEO, work for you. Its board of directors must answer to you. Its cash belongs to you. Its businesses are your property. If you don’t like how your company is being managed, you have the right to demand that the managers be fired, the directors be changed, or the property be sold. “Stockholders,” declares Graham, "should wake up."

Benjamin Graham, “A Questionnaire on Stockholder-Management Relationship,” The Analysts Journal, Fourth Quarter, 1947, p. 62. Graham points out that he had conducted a survey of nearly 600 professional security analysts and found that more than 95% of them believed that shareholders have the right to call for a formal investigation of managers whose leadership does not enhance the value of the stock. Graham adds dryly that “such action is almost unheard of in practice.” This, he says, “highlights the wide gulf between what should happen and what does happen in shareholdermanagement relationships.”

THE INTELLIGENT OWNER

Today’s investors have forgotten Graham’s message. They put most of their effort into buying a stock, a little into selling it—but none into owning it. “Certainly,” Graham reminds us, “there is just as much reason to exercise care and judgment in being as in becoming a stockholder.”

So how should you, as an intelligent investor, go about being an intelligent owner? Graham starts by telling us that “there are just two basic questions to which stockholders should turn their attention:

1. Is the management reasonably efficient?
2. Are the interests of the average outside shareholder receiving proper recognition?”

You should judge the efficiency of management by comparing each company’s profitability, size, and competitiveness against similar firms in its industry. What if you conclude that the managers are no good?

Then, urges Graham, A few of the more substantial stockholders should become convinced that a change is needed and should be willing to work toward that end. Second, the rank and file of the stockholders should be openminded enough to read the proxy material and to weigh the arguments on both sides. They must at least be able to know when their company has been unsuccessful and be ready to demand more than artful platitudes as a vindication of the incumbent management. Third, it would be most helpful, when the figures clearly show that the results are well below average, if it became the custom to call in outside business engineers to pass upon the policies and competence of the management. [1949 edition, p. 223. Graham adds that a proxy vote would be necessary to authorize an independent committee of outside shareholders to select “the engineering firm” that would submit its report to the shareholders, not to the board of directors. However, the company would bear the costs of this project. Among the kinds of “engineering firms” Graham had in mind were money managers, rating agencies and organizations of security analysts. Today, investors could choose from among hundreds of consulting firms, restructuring advisers, and members of entities like the Risk Management Association. Tabulations of voting results for 2002 by Georgeson Shareholder and ADP’s Investor Communication Services, two leading firms that mail proxy solicitations to investors, suggest response rates that average around 80% to 88% (including proxies sent in by stockbrokers on behalf of their clients, which are automatically voted in favor of management unless the clients specify otherwise). Thus the owners of between 12% and 20% of all shares are not voting their proxies. Since individuals own only 40% of U.S. shares by market value, and most institutional investors like pension funds and insurance companies are legally bound to vote on proxy issues, that means that roughly a third of all individual investors are neglecting to vote.]

What is “proxy material” and why does Graham insist that you read it? In its proxy statement, which it sends to every shareholder, a company announces the agenda for its annual meeting and discloses details about the compensation and stock ownership of managers and directors, along with transactions between insiders and the company. Shareholders are asked to vote on which accounting firm should audit the books and who should serve on the board of directors. If you use your common sense while reading the proxy, this document can be like a canary in a coal mine—an early warning system signaling that something is wrong. (See the Enron sidebar above.) Yet, on average, between a third and a half of all individual investors cannot be bothered to vote their proxies. Do they even read them? Understanding and voting your proxy is as every bit as fundamental to being an intelligent investor as following the news and voting your conscience is to being a good citizen. It doesn’t matter whether you own 10% of a company or, with your piddling 100 shares, just 1/10.000 of 1%. If you’ve never read the proxy of a stock you own, and the company goes bust, the only person you should blame is yourself. If you do read the proxy and see things that disturb you, then:

• vote against every director to let them know you disapprove
• attend the annual meeting and speak up for your rights
• find an online message board devoted to the stock (like those at http://finance.yahoo.com) and rally other investors to join your cause.
Graham had another idea that could benefit today’s investors:

... there are advantages to be gained through the selection of one or more professional and independent directors. These should be men of wide business experience who can turn a fresh and expert eye on the problems of the enterprise.... They should submit a separate annual report, addressed directly to the stockholders and containing their views on the major question which concerns the owners of the enterprise: “Is the business showing the results for the outside stockholder which could be expected of it under proper management? If not, why—and what should be done about it?

One can only imagine the consternation that Graham’s proposal would cause among the corporate cronies and golfing buddies who constitute so many of today’s “independent” directors. (Let’s not suggest that it might send a shudder of fear down their spines, since most independent directors do not appear to have a backbone.)

THE ENRON END-RUN

Back in 1999, Enron Corp. ranked seventh on the Fortune 500 list of America’s top companies. The energy giant’s revenues, assets, and earnings were all rising like rockets. But what if an investor had ignored the glamour and glittering numbers—and had simply put Enron’s 1999 proxy statement under the microscope of common sense? Under the heading “Certain Transactions,” the proxy disclosed that Enron’s chief financial officer, Andrew Fastow, was the “managing member” of two partnerships, LJM1 and LJM2, that bought “energy and communications related investments.” And where was LJM1 and LJM2 buying from? Why, where else but from Enron! The proxy reported that the partnerships had already bought $170 million of assets from Enron—sometimes using money borrowed from Enron.

The intelligent investor would immediately have asked:

• Did Enron’s directors approve this arrangement? (Yes, said the proxy.)
• Would Fastow get a piece of LJM’s profits? (Yes, said the proxy.)
• As Enron’s chief financial officer, was Fastow obligated to act exclusively in the interests of Enron’s shareholders? (Of course.)
• Was Fastow therefore duty-bound to maximize the price Enron obtained for any assets it sold? (Absolutely.)
• But if LJM paid a high price for Enron’s assets, would that lower LJM’s potential profits—and Fastow’s personal income? (Clearly.)

• On the other hand, if LJM paid a low price, would that raise profits for Fastow and his partnerships, but hurt Enron’s income? (Clearly.)
• Should Enron lend Fastow’s partnerships any money to buy assets from Enron that might generate a personal profit for Fastow? (Say what?!)
• Doesn’t all this constitute profoundly disturbing conflicts of interest? (No other answer is even possible.)
• What does this arrangement say about the judgment of the directors who approved it? (It says you should take your investment dollars elsewhere.)

Two clear lessons emerge from this disaster: Never dig so deep into the numbers that you check your common sense at the door, and always read the proxy statement before (and after) you buy a stock.

WHOSE MONEY IS IT, ANYWAY?

Now let’s look at Graham’s second criterion—whether management acts in the best interests of outside investors. Managers have always told shareholders that they—the managers—know best what to do with the company’s cash. Graham saw right through this managerial malarkey:

A company’s management may run the business well and yet not give the outside stockholders the right results for them, because its efficiency is confined to operations and does not extend to the best use of the capital. The objective of efficient operation is to produce at low cost and to find the most profitable articles to sell. Efficient finance requires that the stockholders’ money be working in forms most suitable to their interest. This is a question in which management, as such, has little interest. Actually, it almost always wants as much capital from the owners as it can possibly get, in order to minimize its own financial problems. Thus the typical management will operate with more capital than necessary, if the stockholders permit it—which they often do.

In the late 1990s and into the early 2000s, the managements of leading technology companies took this “Daddy-Knows-Best” attitude to new extremes. The argument went like this: Why should you demand a dividend when we can invest that cash for you and turn it into a rising share price? Just look at the way our stock has been going up—doesn’t that prove that we can turn your pennies into dollars better than you can?

Incredibly, investors fell for it hook, line, and sinker. Daddy Knows Best became such gospel that, by 1999, only 3.7% of the companies that first sold their stock to the public that year paid a dividend—down from an average of 72.1% of all IPOs in the 1960s.9 Just look at however the percentage of companies paying dividends (shown in the dark area) has withered away:

But Daddy Knows Best was nothing but bunk. While some companies put their cash to good use, many more fell into two other categories: those that simply wasted it, and those that piled it up far faster than they could possibly spend it.

In the first group, Priceline.com wrote off $67 million in losses in 2000 after launching goofy ventures into groceries and gasoline, while Amazon.com destroyed at least $233 million of its shareholders’ wealth by “investing” in dot-bombs like Webvan and Ashford.com. [Perhaps Benjamin Franklin, who is said to have carried his coins around in an asbestos purse so that money wouldn’t burn a hole in his pocket, could have avoided this problem if he had been a CEO.]

And the two biggest losses so far on record—JDS Uniphase’s $56 billion in 2001 and AOL Time Warner’s $99 billion in 2002—occurred after companies chose not to pay dividends but to merge with other firms at a time when their shares were obscenely overvalued. [A study by BusinessWeek found that from 1995 through 2001, 61% out of more than 300 large mergers ended up destroying wealth for the shareholders of the acquiring company—a condition known as “the winner’s curse” or “buyer’s remorse.” And acquirers using stock rather than cash to pay for the deal underperformed rival companies by 8%. A similar academic study found that acquisitions of private companies and subsidiaries of public companies lead to positive stock returns, but that acquisitions of entire public companies generate losses for the winning bidder’s shareholders. (Kathleen Fuller, Jeffry Netter, and Mike Stegemoller, “What Do Returns to Acquiring Firms Tell Us?” The Journal of Finance, vol. 57, no. 4, August, 2002, pp. 1763–1793.)]

In the second group, consider that by late 2001, Oracle Corp. had piled up $5 billion in cash. Cisco Systems had hoarded at least $7.5 billion. Microsoft had amassed a mountain of cash $38.2 billion high— and rising by an average of more than $2 million per hour. [With interest rates near record lows, such a mountain of cash produces lousy returns if it just sits around. As Graham asserts, “So long as this surplus cash remains with the company, the outside stockholder gets little benefit from it” (1949 edition, p. 232). Indeed, by year-end 2002, Microsoft’s cash balance had swollen to $43.4 billion—clear proof that the company could find no good use for the cash its businesses were generating. As Graham would say, Microsoft’s operations were efficient, but its finance no longer was. In a step toward redressing this problem, Microsoft declared in early 2003 that it would begin paying a regular quarterly dividend.] Just how rainy a day was Bill Gates expecting, anyway? So the anecdotal evidence clearly shows that many companies don’t know how to turn excess cash into extra returns. What does the statistical evidence tell us?

• Research by money managers Robert Arnott and Clifford Asness found that when current dividends are low, future corporate earnings also turn out to be low. And when current dividends are high, so are future earnings. Over 10-year periods, the average rate of earnings growth was 3.9 points greater when dividends were high than when they were low.

• Columbia accounting professors Doron Nissim and Amir Ziv found that companies that raise their dividend not only have better stock returns but that “dividend increases are associated with [higher] future profitability for at least four years after the dividend change.”

In short, most managers are wrong when they say that they can put your cash to better use than you can. Paying out a dividend does not guarantee great results, but it does improve the return of the typical stock by yanking at least some cash out of the managers’ hands before they can either squander it or squirrel it away.

SELLING LOW, BUYING HIGH

What about the argument that companies can put spare cash to better use by buying back their own shares? When a company repurchases some of its stock, that reduces the number of its shares outstanding. Even if its net income stays flat, the company’s earnings per share will rise, since its total earnings will be spread across fewer shares. That, in turn, should lift the stock price. Better yet, unlike a dividend, a buyback is tax-free to investors who don’t sell their shares.

Thus it increases the value of their stock without raising their tax bill.

And if the shares are cheap, then spending spare cash to repurchase them is an excellent use of the company’s capital. [Historically, companies took a common-sense approach toward share repurchases, reducing them when stock prices were high and stepping them up when prices were low. After the stock market crash of October 19, 1987, for example, 400 companies announced new buybacks over the next 12 days alone—while only 107 firms had announced buyback programs in the earlier part of the year, when stock prices had been much higher.]

All this is true in theory. Unfortunately, in the real world, stock buybacks have come to serve a purpose that can only be described as sinister. Now that grants of stock options have become such a large part of executive compensation, many companies—especially in hightech industries—must issue hundreds of millions of shares to give to the managers who exercise those stock options. [The stock options granted by a company to its executives and employees give them the right (but not the obligation) to buy shares in the future at a discounted price. That conversion of options to shares is called “exercising” the options. The employees can then sell the shares at the current market price and pocket the difference as profit. Because hundreds of millions of options may be exercised in a given year, the company must increase its supply of shares outstanding. Then, however, the company’s total net income would be spread across a much greater number of shares, reducing its earnings per share. Therefore, the company typically feels compelled to buy back other shares to cancel out the stock issued to the option holders.

In 1998, 63.5% of chief financial officers admitted that counteracting the dilution from options was a major reason for repurchasing shares (see CFO Forum, “The Buyback Track,” Institutional Investor, July, 1998).] But that would jack up the number of shares outstanding and shrink earnings per share.

To counteract that dilution, the companies must turn right back around and repurchase millions of shares in the open market. By 2000, companies were spending an astounding 41.8% of their total net income to repurchase their own shares—up from 4.8% in 1980.

Let’s look at Oracle Corp., the software giant. Between June 1, 1999, and May 31, 2000, Oracle issued 101 million shares of common stock to its senior executives and another 26 million to employees at a cost of $484 million. Meanwhile, to keep the exercise of earlier stock options from diluting its earnings per share, Oracle spent $5.3 billion—or 52% of its total revenues that year—to buy back 290.7 million shares of stock. Oracle issued the stock to insiders at an average price of $3.53 per share and repurchased it at an average price of $18.26. Sell low, buy high: Is this any way to “enhance” shareholder value? [Throughout his writings, Graham insists that corporate managements have a duty not just to make sure their stock is not undervalued, but also to make sure it never gets overvalued. As he put it in Security Analysis (1934 ed., p. 515), “the responsibility of managements to act in the interest of their shareholders includes the obligation to prevent—in so far as they are able— the establishment of either absurdly high or unduly low prices for their securities.” Thus, enhancing shareholder value doesn’t just mean making sure that the stock price does not go too low; it also means ensuring that the stock price does not go up to unjustifiable levels. If only the executives of Internet companies had heeded Graham’s wisdom back in 1999!] By 2002, Oracle’s stock had fallen to less than half its peak in 2000. Now that its shares were cheaper, did Oracle hasten to buy back more stock? Between June 1, 2001, and May 31, 2002, Oracle cut its repurchases to $2.8 billion, apparently because its executives and employees exercised fewer options that year. The same sell-low, buy-high pattern is evident at dozens of other technology companies.

What’s going on here? Two surprising factors are at work:

• Companies get a tax break when executives and employees exercise stock options (which the IRS considers a “compensation expense” to the company). [ Incredibly, although options are considered a compensation expense on a company’s tax returns, they are not counted as an expense on the income statement in financial reports to shareholders. Investors can only hope that accounting reforms will change this ludicrous practice.] In its fiscal years from 2000 through 2002, for example, Oracle reaped $1.69 billion in tax benefits as insiders cashed in on options. Sprint Corp. pocketed $678 million in tax benefits as its executives and employees locked in $1.9 billion in options profits in 1999 and 2000.

• A senior executive heavily compensated with stock options has a vested interest in favoring stock buybacks over dividends. Why? For technical reasons, options increase in value as the price fluctuations of a stock grow more extreme. But dividends dampen the volatility of a stock’s price. So, if the managers increased the dividend, they would lower the value of their own stock options. [See George W. Fenn and Nellie Liang, “Corporate Payout Policy and Managerial Stock Incentives,” Journal of Financial Economics, vol. 60, no. 1, April, 2001, pp. 45–72. Dividends make stocks less volatile by providing a stream of current income that cushions shareholders against fluctuations in market value. Several researchers have found that the average profitability of companies with stock-buyback programs (but no cash dividends) is at least twice as volatile as that of companies that pay dividends. Those more variable earnings will, in general, lead to bouncier share prices, making the managers’ stock options more valuable—by creating more opportunities when share prices will be temporarily high. Today, about two-thirds of executive compensation comes in the form of options and other noncash awards; thirty years ago, at least two-thirds of compensation came as cash.] No wonder CEOs would much rather buy back stock than pay dividends—regardless of how overvalued the shares may be or how drastically that may waste the resources of the outside shareholders.

KEEPING THEIR OPTIONS OPEN

Finally, drowsy investors have given their companies free rein to overpay executives in ways that are simply unconscionable. In 1997, Steve Jobs, the cofounder of Apple Computer Inc., returned to the company as its “interim” chief executive officer. Already a wealthy man, Jobs insisted on taking a cash salary of $1 per year. At year-end 1999, to thank Jobs for serving as CEO “for the previous 2 1/2 years without compensation,” the board presented him with his very own Gulfstream jet, at a cost to the company of a mere $90 million. The next month Jobs agreed to drop “interim” from his job title, and the board rewarded him with options on 20 million shares. (Until then, Jobs had held a grand total of two shares of Apple stock.)

The principle behind such option grants is to align the interests of managers with outside investors. If you are an outside Apple shareholder, you want its managers to be rewarded only if Apple’s stock earns superior returns. Nothing else could possibly be fair to you and the other owners of the company. But, as John Bogle, former chairman of the Vanguard funds, points out, nearly all managers sell the stock they receive immediately after exercising their options. How could dumping millions of shares for an instant profit possibly align their interests with those of the company’s loyal long-term shareholders? In Jobs’ case, if Apple stock rises by just 5% annually through the beginning of 2010, he will be able to cash in his options for $548.3 million. In other words, even if Apple’s stock earns no better than half the long-term average return of the overall stock market, Jobs will land a half-a-billion dollar windfall. [Apple Computer Inc. proxy statement for April 2001 annual meeting, p. 8 (available at www.sec.gov). Jobs’ option grant and share ownership are adjusted for a two-for-one share split.] Does that align his interests with those of Apple’s shareholders—or malign the trust that Apple’s shareholders have placed in the board of directors?

Reading proxy statements vigilantly, the intelligent owner will vote against any executive compensation plan that uses option grants to turn more than 3% of the company’s shares outstanding over to the managers. And you should veto any plan that does not make option grants contingent on a fair and enduring measure of superior results— say, outperforming the average stock in the same industry for a period of at least five years. No CEO ever deserves to make himself rich if he has produced poor results for you.

A FINAL THOUGHT

Let’s go back to Graham’s suggestion that every company’s independent board members should have to report to the shareholders in writing on whether the business is properly managed on behalf of its true owners. What if the independent directors also had to justify the company’s policies on dividends and share repurchases? What if they had to describe exactly how they determined that the company’s senior management was not overpaid? And what if every investor became an intelligent owner and actually read that report?

CHAPTER 20. “MARGIN OF SAFETY” AS THE CENTRAL CONCEPT OF INVESTMENT

Theory of Diversification

There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss—not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business. Diversification is an established tenet of conservative investment. By accepting it so universally, investors are really demonstrating their acceptance of the margin-of-safety principle, to which diversification is the companion. This point may be made more colorful by a reference to the arithmetic of roulette. If a man bets $1 on a single number, he is paid $35 profit when he wins—but the chances are 37 to 1 that he will lose. He has a “negative margin of safety.” In his case diversification is foolish. The more numbers he bets on, the smaller his chance of ending with a profit. If he regularly bets $1 on every number (including 0 and 00), he is certain to lose $2 on each turn of the wheel. But suppose the winner received $39 profit instead of $35. Then he would have a small but important margin of safety. Therefore, the more numbers he wagers on, the better his chance of gain. And he could be certain of winning $2 on every spin by simply betting $1 each on all the numbers. (Incidentally, the two examples given actually describe the respective positions of the player and proprietor of a wheel with 0 and 00.)

In “American” roulette, most wheels include 0 and 00 along with numbers 1 through 36, for a total of 38 slots. The casino offers a maximum payout of 35 to 1. What if you bet $1 on every number? Since only one slot can be the one into which the ball drops, you would win $35 on that slot, but lose $1 on each of your other 37 slots, for a net loss of $2. That $2 difference (or a 5.26% spread on your total $38 bet) is the casino’s “house advantage,” ensuring that, on average, roulette players will always lose more than they win. Just as it is in the roulette player’s interest to bet as seldom as possible, it is in the casino’s interest to keep the roulette wheel spinning. Likewise, the intelligent investor should seek to maximize the number of holdings that offer “a better chance for profit than for loss.” For most investors, diversification is the simplest and cheapest way to widen your margin of safety.

~ ~ ~

Note 1: Graham is saying that there is no such thing as a good or bad stock; there are only cheap stocks and expensive stocks. Even the best company becomes a “sell” when its stock price goes too high, while the worst company is worth buying if its stock goes low enough.

Note 2: The very people who considered technology and telecommunications stocks a “sure thing” in late 1999 and early 2000, when they were hellishly overpriced, shunned them as “too risky” in 2002—even (cont’d on p. 522) though, in Graham’s exact words from an earlier period, “the price depreciation of about 90% made many of these securities exceedingly attractive and reasonably safe.” Similarly, Wall Street’s analysts have always tended to call a stock a “strong buy” when its price is high, and to label it a “sell” after its price has fallen—the exact opposite of what Graham (and simple common sense) would dictate. As he does throughout the book, Graham is distinguishing speculation—or buying on the hope that a stock’s price will keep going up—from investing, or buying on the basis of what the underlying business is worth.

To Sum Up

Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings. Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success.

The first and most obvious of these principles is, “Know what you are doing—know your business.” For the investor this means: Do not try to make “business profits” out of securities—that is, returns in excess of normal interest and dividend income—unless you know as much about security values as you would need to know about the value of merchandise that you proposed to manufacture or deal in.

A second business principle: “Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.” For the investor this rule should determine the conditions under which he will permit someone else to decide what is done with his money.

A third business principle: “Do not enter upon an operation— that is, manufacturing or trading in an item—unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular, keep away from ventures in which you have little to gain and much to lose.” For the enterprising investor this means that his operations for profit should be based not on optimism but on arithmetic. For every investor it means that when he limits his return to a small figure—as formerly, at least, in a conventional bond or preferred stock—he must demand convincing evidence that he is not risking a substantial part of his principal.

A fourth business rule is more positive: “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it— even though others may hesitate or differ.” (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.) Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand. Fortunately for the typical investor, it is by no means necessary for his success that he bring these qualities to bear upon his program—provided he limits his ambition to his capacity and confines his activities within the safe and narrow path of standard, defensive investment. To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.

COMMENTARY ON CHAPTER 20

FIRST, DON’T LOSE

What is risk?

You’ll get different answers depending on whom, and when, you ask. In 1999, risk didn’t mean losing money; it meant making less money than someone else. What many people feared was bumping into somebody at a barbecue who was getting even richer even quicker by day trading dot-com stocks than they were. Then, quite suddenly, by 2003 risk had come to mean that the stock market might keep dropping until it wiped out whatever traces of wealth you still had left.

While its meaning may seem nearly as fickle and fluctuating as the financial markets themselves, risk has some profound and permanent attributes. The people who take the biggest gambles and make the biggest gains in a bull market are almost always the ones who get hurt the worst in the bear market that inevitably follows. (Being “right” makes speculators even more eager to take extra risk, as their confidence catches fire.) And once you lose big money, you then have to gamble even harder just to get back to where you were, like a racetrack or casino gambler who desperately doubles up after every bad bet. Unless you are phenomenally lucky, that’s a recipe for disaster. No wonder, when he was asked to sum up everything he had learned in his long career about how to get rich, the legendary financier J. K. Klingenstein of Wertheim & Co. answered simply: “Don’t lose.” 1 This graph shows what he meant:

Losing some money is an inevitable part of investing, and there’s nothing you can do to prevent it. But, to be an intelligent investor, you must take responsibility for ensuring that you never lose most or all of your money. The Hindu goddess of wealth, Lakshmi, is often portrayed standing on tiptoe, ready to dart away in the blink of an eye. To keep her symbolically in place, some of Lakshmi’s devotees will lash her statue down with strips of fabric or nail its feet to the floor. For the intelligent investor, Graham’s “margin of safety” performs the same function: By refusing to pay too much for an investment, you minimize the chances that your wealth will ever disappear or suddenly be destroyed. Consider this: Over the four quarters ending in December 1999, JDS Uniphase Corp., the fiber-optics company, generated $673 million in net sales, on which it lost $313 million. Its tangible assets totaled $1.5 billion. Yet, on March 7, 2000, JDS Uniphase’s stock hit $153 a share, giving the company a total market value of roughly $143 billion. And then, like most “New Era” stocks, it crashed. Anyone who bought it that day and still clung to it at the end of 2002 faced these prospects:

Even at a robust 10% annual rate of return, it will take more than 43 years to break even on this overpriced purchase!

THE RISK IS NOT IN OUR STOCKS, BUT IN OURSELVES

Risk exists in another dimension: inside you. If you overestimate how well you really understand an investment, or overstate your ability to ride out a temporary plunge in prices, it doesn’t matter what you own or how the market does. Ultimately, financial risk resides not in what kinds of investments you have, but in what kind of investor you are. If you want to know what risk really is, go to the nearest bathroom and step up to the mirror. That’s risk, gazing back at you from the glass.

As you look at yourself in the mirror, what should you watch for? The Nobel-prize–winning psychologist Daniel Kahneman explains two factors that characterize good decisions:

• “well-calibrated confidence” (do I understand this investment as well as I think I do?)
• “correctly-anticipated regret” (how will I react if my analysis turns out to be wrong?).

To find out whether your confidence is well-calibrated, look in the mirror and ask yourself: “What is the likelihood that my analysis is right?” Think carefully through these questions:

• How much experience do I have? What is my track record with similar decisions in the past?

• What is the typical track record of other people who have tried this in the past? [No one who diligently researched the answer to this question, and honestly accepted the results, would ever have day traded or bought IPOs.]

• If I am buying, someone else is selling. How likely is it that I know something that this other person (or company) does not know?

• If I am selling, someone else is buying. How likely is it that I know something that this other person (or company) does not know?

• Have I calculated how much this investment needs to go up for me to break even after my taxes and costs of trading?

Next, look in the mirror to find out whether you are the kind of person who correctly anticipates your regret. Start by asking: “Do I fully understand the consequences if my analysis turns out to be wrong?”

Answer that question by considering these points:

• If I’m right, I could make a lot of money. But what if I’m wrong?
Based on the historical performance of similar investments, how much could I lose?

• Do I have other investments that will tide me over if this decision turns out to be wrong? Do I already hold stocks, bonds, or funds with a proven record of going up when the kind of investment I’m considering goes down? Am I putting too much of my capital at risk with this new investment?

• When I tell myself, “You have a high tolerance for risk,” how do I know? Have I ever lost a lot of money on an investment? How did it feel? Did I buy more, or did I bail out?

• Am I relying on my willpower alone to prevent me from panicking at the wrong time? Or have I controlled my own behavior in advance by diversifying, signing an investment contract, and dollar-cost averaging?

You should always remember, in the words of the psychologist Paul Slovic, that “risk is brewed from an equal dose of two ingredients— probabilities and consequences.” 4 Before you invest, you must ensure that you have realistically assessed your probability of being right and how you will react to the consequences of being wrong.

PASCAL’S WAGER

The investment philosopher Peter Bernstein has another way of summing this up. He reaches back to Blaise Pascal, the great French mathematician and theologian (1623–1662), who created a thought experiment in which an agnostic must gamble on whether or not God exists. The ante this person must put up for the wager is his conduct in this life; the ultimate payoff in the gamble is the fate of his soul in the afterlife. In this wager, Pascal asserts, “reason cannot decide” the probability of God’s existence. Either God exists or He does not—and only faith, not reason, can answer that question. But while the probabilities in Pascal’s wager are a toss-up, the consequences are perfectly clear and utterly certain. As Bernstein explains:

Suppose you act as though God is and [you] lead a life of virtue and abstinence, when in fact there is no god. You will have passed up some goodies in life, but there will be rewards as well. Now suppose you act as though God is not and spend a life of sin, selfishness, and lust when in fact God is. You may have had fun and thrills during the relatively brief duration of your lifetime, but when the day of judgment rolls around you are in big trouble.

Concludes Bernstein: “In making decisions under conditions of uncertainty, the consequences must dominate the probabilities. We never know the future.” Thus, as Graham has reminded you in every chapter of this book, the intelligent investor must focus not just on getting the analysis right. You must also ensure against loss if your analysis turns out to be wrong—as even the best analyses will be at least some of the time. The probability of making at least one mistake at some point in your investing lifetime is virtually 100%, and those odds are entirely out of your control. However, you do have control over the consequences of being wrong. Many “investors” put essentially all of their money into dot-com stocks in 1999; an online survey of 1,338 Americans by Money Magazine in 1999 found that nearly one-tenth of them had at least 85% of their money in Internet stocks. By ignoring Graham’s call for a margin of safety, these people took the wrong side of Pascal’s wager. Certain that they knew the probabilities of being right, they did nothing to protect themselves against the consequences of being wrong. Simply by keeping your holdings permanently diversified, and refusing to fling money at Mr. Market’s latest, craziest fashions, you can ensure that the consequences of your mistakes will never be catastrophic. No matter what Mr. Market throws at you, you will always be able to say, with a quiet confidence, "This, too, shall pass away."

POSTSCRIPT

We know very well two partners who spent a good part of their lives handling their own and other people’s funds on Wall Street. Some hard experience taught them it was better to be safe and careful rather than to try to make all the money in the world. They established a rather unique approach to security operations, which combined good profit possibilities with sound values. They avoided anything that appeared overpriced and were rather too quick to dispose of issues that had advanced to levels they deemed no longer attractive. Their portfolio was always well diversified, with more than a hundred different issues represented. In this way they did quite well through many years of ups and downs in the general market; they averaged about 20% per annum on the several millions of capital they had accepted for management, and their clients were well pleased with the results. [The two partners Graham coyly refers to are Jerome Newman and Benjamin Graham himself.]

In the year in which the first edition of this book appeared an opportunity was offered to the partners’ fund to purchase a halfinterest in a growing enterprise. For some reason the industry did not have Wall Street appeal at the time and the deal had been turned down by quite a few important houses. But the pair was impressed by the company’s possibilities; what was decisive for them was that the price was moderate in relation to current earnings and asset value. The partners went ahead with the acquisition, amounting in dollars to about one-fifth of their fund. They became closely identified with the new business interest, which prospered.

[Graham is describing the Government Employees Insurance Co., or GEICO, in which he and Newman purchased a 50% interest in 1948, right around the time he finished writing The Intelligent Investor. The $712,500 that Graham and Newman put into GEICO was roughly 25% of their fund’s assets at the time. Graham was a member of GEICO’s board of directors for many years. In a nice twist of fate, Graham’s greatest student, Warren Buffett, made an immense bet of his own on GEICO in 1976, by which time the big insurer had slid to the brink of bankruptcy. It turned out to be one of Buffett’s best investments as well.]

In fact it did so well that the price of its shares advanced to two hundred times or more the price paid for the half-interest. The advance far outstripped the actual growth in profits, and almost from the start the quotation appeared much too high in terms of the partners’ own investment standards. But since they regarded the company as a sort of “family business,” they continued to maintain a substantial ownership of the shares despite the spectacular price rise. A large number of participants in their funds did the same, and they became millionaires through their holding in this one enterprise, plus later-organized affiliates.

Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.

Are there morals to this story of value to the intelligent investor? An obvious one is that there are several different ways to make and keep money in Wall Street. Another, not so obvious, is that one lucky break, or one supremely shrewd decision—can we tell them apart?—may count for more than a lifetime of journeyman efforts.1 But behind the luck, or the crucial decision, there must usually exist a background of preparation and disciplined capacity. One needs to be sufficiently established and recognized so that these opportunities will knock at his particular door. One must have the means, the judgment, and the courage to take advantage of them. Of course, we cannot promise a like spectacular experience to all intelligent investors who remain both prudent and alert through the years. We are not going to end with J. J. Raskob’s slogan that we made fun of at the beginning: “Everybody can be rich.” But interesting possibilities abound on the financial scene, and the intelligent and enterprising investor should be able to find both enjoyment and profit in this three-ring circus. Excitement is guaranteed.

COMMENTARY ON POSTSCRIPT

Successful investing is about managing risk, not avoiding it. At first glance, when you realize that Graham put 25% of his fund into a single stock, you might think he was gambling rashly with his investors’ money. But then, when you discover that Graham had painstakingly established that he could liquidate GEICO for at least what he paid for it, it becomes clear that Graham was taking very little financial risk. But he needed enormous courage to take the psychological risk of such a big bet on so unknown a stock.

[Graham’s anecdote is also a powerful reminder that those of us who are not as brilliant as he was must always diversify to protect against the risk of putting too much money into a single investment. When Graham himself admits that GEICO was a “lucky break,” that’s a signal that most of us cannot count on being able to find such a great opportunity. To keep investing from decaying into gambling, you must diversify.]

And today’s headlines are full of fearful facts and unresolved risks: the death of the 1990s bull market, sluggish economic growth, corporate fraud, the specters of terrorism and war. “Investors don’t like uncertainty,” a market strategist is intoning right now on financial TV or in today’s newspaper. But investors have never liked uncertainty—and yet it is the most fundamental and enduring condition of the investing world. It always has been, and it always will be. At heart, “uncertainty” and “investing” are synonyms. In the real world, no one has ever been given the ability to see that any particular time is the best time to buy stocks. Without a saving faith in the future, no one would ever invest at all. To be an investor, you must be a believer in a better tomorrow. The most literate of investors, Graham loved the story of Ulysses, told through the poetry of Homer, Alfred Tennyson, and Dante. Late in his life, Graham relished the scene in Dante’s Inferno when Ulysses describes inspiring his crew to sail westward into the unknown waters beyond the gates of Hercules:

“O brothers,” I said, “who after a hundred thousand
perils have reached the west,
in this little waking vigil
that still remains to our senses,
let us not choose to avoid the experience
of the unpeopled world that lies behind the sun.
Consider the seeds from which you sprang:
You were made not to live like beasts,
but to seek virtue and understanding.”
With this little oration I made my shipmates
so eager for the voyage
that it would have hurt to hold them back.
And we swung our stern toward the morning
and turned our oars into wings for the wild flight.

Investing, too, is an adventure; the financial future is always an uncharted world. With Graham as your guide, your lifelong investing voyage should be as safe and confident as it is adventurous.

survival8

Saturday, April 18, 2020

Life Lessons By Steve Jobs

Monday, April 6, 2020

Intelligent investor (Ben Graham & Jason Zweig, 4e)