The Intelligent Investor -...

TheIntelligentInvestor

ABookofPracticalCounsel

RevisedEdition

BenjaminGraham

UpdatedwithNewCommentarybyJasonZweig

ToE.M.G.

Throughchancesvarious,throughall

vicissitudes,wemakeourway….

Aeneid

Contents

Epigraph

PrefacetotheFourthEdition,byWarrenE.Buffett

ANoteAboutBenjaminGraham,byJasonZweig

Introduction:WhatThisBookExpectstoAccomplish

CommentaryontheIntroduction

1.InvestmentversusSpeculation:ResultstoBeExpectedbytheIntelligentInvestor

CommentaryonChapter1

2.TheInvestorandInflationCommentaryonChapter2

3.ACenturyofStock-MarketHistory:TheLevelofStockPricesinEarly1972


4.GeneralPortfolioPolicy:TheDefensiveInvestor


5.TheDefensiveInvestorandCommonStocks


6.PortfolioPolicyfortheEnterprisingInvestor:NegativeApproach


7.PortfolioPolicyfortheEnterprisingInvestor:ThePositiveSide


8.TheInvestorandMarketFluctuations


9.InvestinginInvestmentFunds


10.TheInvestorandHis

AdvisersCommentaryonChapter10

11.SecurityAnalysisfortheLayInvestor:GeneralApproach


12.ThingstoConsiderAboutPer-ShareEarnings


13.AComparisonofFourListedCompanies


14.StockSelectionfortheDefensiveInvestor


15.StockSelectionfortheEnterprisingInvestor


16.ConvertibleIssuesandWarrants


17.FourExtremelyInstructiveCaseHistories


18.AComparisonofEightPairsofCompanies


19.ShareholdersandManagements:DividendPolicy


20.“MarginofSafety”asthe

CentralConceptofInvestment


Postscript

CommentaryonPostscript

Appendixes

1. The Superinvestors ofGraham-and-Doddsville2. Important RulesConcerning Taxability ofInvestment Income and

Security Transactions (in1972)3. The Basics ofInvestment Taxation(Updatedasof2003)4.TheNewSpeculationinCommonStocks5. A Case History: AetnaMaintenanceCo.6. Tax Accounting forNVF’s Acquisition ofSharonSteelShares7. TechnologicalCompaniesasInvestments

Endnotes

AcknowledgmentsfromJasonZweig

Index

AbouttheAuthors

Credits

Copyright

AboutthePublisher

The text reproduced hereis the Fourth RevisedEdition, updated byGrahamin1971-1972andinitiallypublishedin1973.The numbered chapternotes are original toGraham—bolded text inthese notes is by Jason

Zweig.

Jason Zweig’s new noteswithin Graham’s chaptersare designated by anasteriskoracross.

PrefacetotheFourthEdition,byWarrenE.Buffett

Ireadthefirsteditionofthis

book early in 1950, when Iwas nineteen. I thought thenthat it was by far the bestbook about investing everwritten.Istillthinkitis.

Toinvestsuccessfullyovera lifetime does not require astratospheric IQ, unusualbusiness insights, or insideinformation. What’s neededis a sound intellectualframework for makingdecisions and the ability to

keep emotions fromcorroding that framework.This book precisely andclearly prescribes the properframework.Youmust supplytheemotionaldiscipline.

If you follow thebehavioral and businessprinciples that Grahamadvocates—and if you payspecial attention to theinvaluableadviceinChapters8and20—youwillnotgeta

poor result from yourinvestments. (That representsmore of an accomplishmentthan you might think.)Whether you achieveoutstanding results willdepend on the effort andintellect you apply to yourinvestments,aswellasontheamplitudes of stock-marketfolly thatprevailduringyourinvesting career. The sillierthe market’s behavior, thegreatertheopportunityforthe

business-likeinvestor.FollowGraham and you will profitfrom folly rather thanparticipateinit.

To me, Ben Graham wasfarmore than an author or ateacher.More than any otherman except my father, heinfluenced my life. Shortlyafter Ben’s death in 1976, Iwrote the following shortremembrance about him inthe Financial Analysts

Journal. As you read thebook, I believe you’llperceivesomeofthequalitiesImentionedinthistribute.

BenjaminGraham1894–1976

Several years ago BenGraham, then almost eighty,expressed to a friend thethought that he hoped every

daytodo“somethingfoolish,something creative andsomethinggenerous.”

The inclusion of that firstwhimsical goal reflected hisknack for packaging ideas ina form that avoided anyovertones of sermonizing orself-importance.Althoughhisideas were powerful, theirdelivery was unfailinglygentle.

Readers of this magazineneed no elaboration of hisachievementsasmeasuredbythestandardofcreativity.Itisrare that the founder of adiscipline does not find hiswork eclipsed in rather shortorderbysuccessors.Butoverforty years after publicationof the book that broughtstructure and logic to adisorderly and confusedactivity,itisdifficulttothinkof possible candidates for

eventherunner-uppositioninthe field of security analysis.Inanareawheremuch looksfoolish within weeks ormonths after publication,Ben’s principles haveremained sound—their valueoften enhanced and betterunderstood in the wake offinancial storms thatdemolished flimsierintellectual structures. Hiscounselofsoundnessbroughtunfailing rewards to his

followers—eventothosewithnatural abilities inferior tomoregiftedpractitionerswhostumbled while followingcounsels of brilliance orfashion.

A remarkable aspect ofBen’s dominance of hisprofessionalfieldwasthatheachieved it without thatnarrownessofmentalactivitythatconcentratesalleffortona single end. It was, rather,

the incidental by-product ofan intellect whose breadthalmost exceeded definition.Certainly I have never metanyonewithamindofsimilarscope. Virtually total recall,unending fascination withnew knowledge, and anability to recast it in a formapplicable to seeminglyunrelated problems madeexposure to his thinking inanyfieldadelight.

But his third imperative—generosity—was where hesucceededbeyondallothers.IknewBenasmy teacher,myemployer, and my friend. Ineach relationship—just aswith all his students,employees, and friends—therewasanabsolutelyopen-ended, no-scores-keptgenerosityofideas,time,andspirit. If clarity of thinkingwas required, there was nobetter place to go. And if

encouragement or counselwasneeded,Benwasthere.

WalterLippmann spokeofmen who plant trees thatothermenwillsitunder.BenGrahamwassuchaman.

Reprinted from theFinancialAnalysts Journal,November/December1976.

ANoteAboutBenjaminGrahambyJasonZweig

WhowasBenjaminGraham,andwhyshouldyou listen to

him?

Graham was not only oneofthebestinvestorswhoeverlived;hewasalsothegreatestpractical investment thinkerof all time. Before Graham,money managers behavedmuch like a medieval guild,guided largely bysuperstition, guesswork, andarcane rituals. Graham’sSecurity Analysis was thetextbookthattransformedthis

musty circle into a modernprofession.1

And The IntelligentInvestoristhefirstbookeverto describe, for individualinvestors, the emotionalframework and analyticaltools that are essential tofinancial success. It remainsthe single best book oninvestingeverwritten for thegeneralpublic.TheIntelligentInvestor was the first book I

read when I joined ForbesMagazineasacubreporterin1987, and I was struck byGraham’s certainty that,sooner or later, all bullmarketsmustendbadly.ThatOctober,U.S.stockssufferedtheir worst one-day crash inhistory, and I was hooked.(Today, after the wild bullmarket of the late 1990s andthe brutal bear market thatbegan in early 2000, TheIntelligent Investor reads

more prophetically thanever.)

Graham came by hisinsights the hard way: byfeeling firsthand the anguishof financial loss and bystudying for decades thehistoryandpsychologyofthemarkets. He was bornBenjaminGrossbaumonMay9,1894,inLondon;hisfatherwas a dealer in china dishesand figurines.2 The family

moved to New York whenBen was a year old. At firsttheylivedthegoodlife—withamaid,acook,andaFrenchgoverness—on upper FifthAvenue. But Ben’s fatherdied in 1903, the porcelainbusiness faltered, and thefamily slid haltingly intopoverty.Ben’smother turnedtheir home into aboardinghouse; then,borrowing money to tradestocks “on margin,” she was

wiped out in the crash of1907.For the restofhis life,Ben would recall thehumiliation of cashing acheck for his mother andhearing the bank teller ask,“IsDorothyGrossbaumgoodforfivedollars?”

Fortunately,Grahamwonascholarship at Columbia,wherehisbrillianceburstintofull flower. He graduated in1914, second in his class.

Before the end of Graham’sfinal semester, threedepartments—English,philosophy, and mathematics—asked him to join thefaculty. He was all of 20yearsold.

Instead of academia,GrahamdecidedtogiveWallStreet a shot.He started as aclerk at a bond-trading firm,soonbecameananalyst, thena partner, and before long

was running his owninvestmentpartnership.

TheInternetboomandbustwould not have surprisedGraham. In April 1919, heearned a 250% return on thefirstdayoftradingforSavoldTire, a new offering in thebooming automotivebusiness; by October, thecompany had been exposedas a fraud and the stockwasworthless.

Graham became a masterat researching stocks inmicroscopic, almostmolecular, detail. In 1925,plowing through the obscurereports filed by oil pipelineswith the U.S. InterstateCommerce Commission, helearned that Northern PipeLineCo.—thentradingat$65per share—held at least $80per share in high-qualitybonds. (He bought the stock,pestered its managers into

raising the dividend, andcame away with $110 persharethreeyearslater.)

Despiteaharrowinglossofnearly 70% during the GreatCrashof1929–1932,Grahamsurvived and thrived in itsaftermath, harvestingbargains from the wreckageof the bull market. There isno exact record of Graham’searliest returns, but from1936untilheretiredin1956,

his Graham-Newman Corp.gained at least 14.7%annually, versus 12.2% forthestockmarketasawhole—one of the best long-termtrack records on Wall Streethistory.3

How did Graham do it?Combining his extraordinaryintellectual powers withprofound common sense andvast experience, Grahamdevelopedhiscoreprinciples,

which are at least as validtodayastheywereduringhislifetime:

A stock is not just aticker symbol or anelectronic blip; it is anownership interest in anactual business, with anunderlying value thatdoes not depend on itsshareprice.The market is a

pendulum that foreverswings betweenunsustainable optimism(whichmakesstockstooexpensive) andunjustified pessimism(which makes them toocheap). The intelligentinvestor is a realistwhosells to optimists andbuysfrompessimists.The future value ofevery investment is afunction of its present

price. The higher thepriceyoupay, the loweryourreturnwillbe.No matter how carefulyou are, the one risk noinvestor can evereliminate is the risk ofbeing wrong. Only byinsisting on whatGraham called the“margin of safety”—never overpaying, nomatter how exciting aninvestment seems to be

—can you minimizeyouroddsoferror.The secret to yourfinancial success isinside yourself. If youbecomeacriticalthinkerwhotakesnoWallStreet“fact” on faith, and youinvest with patientconfidence,youcantakesteadyadvantageofeventhe worst bear markets.By developing yourdiscipline and courage,

you can refuse to letother people’s moodswings govern yourfinancial destiny. In theend, how yourinvestments behave ismuchlessimportantthanhowyoubehave.

The goal of this revisededition of The IntelligentInvestoristoapplyGraham’sideas to today’s financialmarketswhileleavinghistext

entirely intact (with theexception of footnotes forclarification).4 After each ofGraham’schaptersyou’llfinda new commentary. In thesereader’s guides, I’ve addedrecent examples that shouldshowyoujusthowrelevant—and how liberating—Graham’s principles remaintoday.

I envy you the excitementandenlightenmentof reading

Graham’smasterpieceforthefirst time—or even the thirdor fourth time. Like allclassics, it alters how weview the world and renewsitself by educating us. Andthe more you read it, thebetteritgets.WithGrahamasyour guide, you areguaranteed to become avastly more intelligentinvestor.


The purpose of this book is

to supply, in a form suitablefor laymen, guidance in theadoptionandexecutionofaninvestment policy.Comparatively little will besaidhereabout the techniqueof analyzing securities;attentionwill be paid chieflyto investment principles andinvestors’attitudes.Weshall,however,provideanumberofcondensed comparisons ofspecificsecurities—chieflyinpairs appearing side by side

in the New York StockExchange list—in order tobring home in concretefashion the importantelements involved in specificchoicesofcommonstocks.

Butmuchofourspacewillbe devoted to the historicalpatterns of financialmarkets,in some cases running backovermanydecades.Toinvestintelligently in securities oneshould be forearmedwith an

adequate knowledge of howthe various types of bondsand stocks have actuallybehaved under varyingconditions—some of which,at least,one is likely tomeetagain in one’s ownexperience. No statement ismore true and betterapplicabletoWallStreetthanthe famous warning ofSantayana: “Those who donot remember the past arecondemnedtorepeatit.”

Our text is directed toinvestors as distinguishedfromspeculators,andourfirsttask will be to clarify andemphasize this now all butforgottendistinction.Wemaysay at the outset that this isnot a “how to make amillion” book. There are nosure and easy paths to richeson Wall Street or anywhereelse. It may bewell to pointupwhatwehavejustsaidbya bit of financial history—

especiallysincethereismorethan one moral to be drawnfrom it. In the climactic year1929 John J.Raskob, amostimportantfigurenationallyaswell as on Wall Street,extolled the blessings ofcapitalisminanarticle in theLadies’ Home Journal,entitled“EverybodyOughttoBeRich.”*Histhesiswasthatsavings of only $15 permonth invested in good

common stocks—withdividends reinvested—wouldproduce an estate of $80,000in twenty years against totalcontributions of only $3,600.If theGeneralMotors tycoonwas right, this was indeed asimple road to riches. Hownearly right was he? Ourrough calculation—based onassumedinvestmentinthe30stocks making up the DowJones Industrial Average(DJIA)—indicates that if

Raskob’s prescription hadbeen followed during 1929–1948, the investor’s holdingsat the beginning of 1949wouldhavebeenworthabout$8,500.Thisisafarcryfromthe great man’s promise of$80,000, and it shows howlittle reliance can be placedon such optimistic forecastsand assurances. But, as anaside,we should remark thatthereturnactuallyrealizedbythe 20-year operation would

have been better than 8%compounded annually—andthis despite the fact that theinvestor would have begunhis purchases with the DJIAat 300 and ended with avaluation based on the 1948closing level of 177. Thisrecord may be regarded as apersuasive argument for theprinciple of regular monthlypurchases of strong commonstocks through thickand thin—a program known as

“dollar-costaveraging.”

Since our book is notaddressed tospeculators, it isnotmeantforthosewhotradein the market.Most of thesepeopleareguidedbychartsorother largely mechanicalmeans of determining theright moments to buy andsell. The one principle thatapplies tonearlyall theseso-called“technicalapproaches”is that one should buy

becauseastockorthemarkethas gone up and one shouldsell because it has declined.This is the exact opposite ofsound business senseeverywhere else, and it ismostunlikely that itcan leadto lasting success on WallStreet. In our own stock-market experience andobservation, extending over50years,wehavenotknowna single person who hasconsistentlyorlastinglymade

moneybythus“followingthemarket.” We do not hesitateto declare that this approachis as fallacious as it ispopular. We shall illustratewhat we have just said—though, of course this shouldnot be taken as proof—by alater brief discussion of thefamous Dow theory fortradinginthestockmarket.*

Sinceitsfirstpublicationin1949, revisions of The

Intelligent Investor haveappeared at intervals ofapproximately five years. Inupdating the current versionwe shall have to deal withquite a number of newdevelopments since the 1965edition was written. Theseinclude:

1. An unprecedentedadvance in the interestrate on high-grade

bonds.2. A fall of about 35% in

thepricelevelofleadingcommon stocks, endingin May 1970. This wasthe highest percentagedecline in some 30years. (Countless issuesof lower quality had amuchlargershrinkage.)

3. A persistent inflation ofwholesale andconsumer’s prices,which gained

momentum even in theface of a decline ofgeneral business in1970.

4. The rapid developmentof “conglomerate”companies, franchiseoperations, and otherrelative novelties inbusiness and finance.(Theseincludeanumberoftrickydevicessuchas“letter stock,”1

proliferation of stock-option warrants,misleading names, useof foreign banks, andothers.)†

5. Bankruptcy of ourlargest railroad,excessive short- andlong-term debt of manyformerly stronglyentrenched companies,and even a disturbingproblem of solvency

among Wall Streethouses.*

6. The advent of the“performance” vogue inthe management ofinvestment funds,including some bank-operated trust funds,withdisquietingresults.

These phenomena willhave our carefulconsideration, and some willrequire changes in

conclusions and emphasisfrom our previous edition.The underlying principles ofsound investment should notalter from decade to decade,but the application of theseprinciplesmustbeadaptedtosignificant changes in thefinancial mechanisms andclimate.

The last statementwasputto the test during thewritingofthepresentedition,thefirst

draftofwhichwasfinishedinJanuary 1971. At that timethe DJIA was in a strongrecoveryfromits1970lowof632 and was advancingtoward a 1971 high of 951,with attendant generaloptimism. As the last draftwas finished, in November1971, the market was in thethroes of a new decline,carrying it down to 797witharenewedgeneraluneasinessabout itsfuture.Wehavenot

allowed these fluctuations toaffect our general attitudetoward sound investmentpolicy, which remainssubstantiallyunchangedsincethe first edition of this bookin1949.

The extent of themarket’sshrinkage in 1969–70 shouldhave served to dispel anillusionthathadbeengainingground during the past twodecades. This was that

leadingcommonstockscouldbebought at any time and atanyprice,with the assurancenotonlyofultimateprofitbutalso thatany intervening losswouldsoonberecoupedbyarenewed advance of themarket to new high levels.Thatwastoogoodtobetrue.At long last the stockmarkethas “returned to normal,” inthe sense that bothspeculators and stockinvestors must again be

prepared to experiencesignificant and perhapsprotracted falls as well asrises in the value of theirholdings.

In the area of manysecondary and third-linecommon stocks, especiallyrecently floated enterprises,thehavocwroughtbythelastmarket break wascatastrophic. This wasnothing new in itself—it had

happened to a similar degreein 1961–62—but there wasnow a novel element in thefact that some of theinvestment funds had largecommitments in highlyspeculative and obviouslyovervaluedissuesofthistype.Evidently it is not only thetyrowhoneeds tobewarnedthatwhileenthusiasmmaybenecessary for greataccomplishments elsewhere,on Wall Street it almost

invariablyleadstodisaster.

The major question weshallhavetodealwithgrowsoutofthehugeriseintherateof interest on first-qualitybonds. Since late 1967 theinvestor has been able toobtain more than twice asmuch income from suchbonds as he could fromdividends on representativecommon stocks. At thebeginning of 1972 the return

was 7.19% on highest-gradebonds versus only 2.76% onindustrial stocks. (Thiscompares with 4.40% and2.92%respectivelyattheendof1964.) It ishard to realizethatwhenwe firstwrote thisbookin1949thefigureswerealmosttheexactopposite:thebonds returned only 2.66%and the stocks yielded6.82%.2 In previous editionswe have consistently urged

that at least 25% of theconservative investor’sportfolio be held in commonstocks, and we have favoredin general a 50–50 divisionbetween the two media. Wemust now consider whetherthecurrentgreatadvantageofbondyieldsoverstockyieldswould justify an all-bondpolicy until a more sensiblerelationship returns, as weexpect it will. Naturally thequestion of continued

inflation will be of greatimportance in reaching ourdecision here.A chapterwillbe devoted to thisdiscussion.*

Inthepastwehavemadeabasicdistinctionbetweentwokinds of investors to whomthisbookwasaddressed—the“defensive” and the“enterprising.” The defensive(or passive) investor willplace his chief emphasis on

the avoidance of seriousmistakes or losses. Hissecond aim will be freedomfrom effort, annoyance, andtheneed formaking frequentdecisions. The determiningtrait of the enterprising (oractive,oraggressive)investoris his willingness to devotetimeandcaretotheselectionof securities that are bothsound and more attractivethan the average.Overmanydecades an enterprising

investor of this sort couldexpect a worthwhile rewardfor his extra skill and effort,in the form of a betteraverage return than thatrealized by the passiveinvestor. We have somedoubt whether a reallysubstantial extra recompenseis promised to the activeinvestor under today’sconditions. But next year orthe years after may well bedifferent. We shall

accordingly continue todevote attention to thepossibilities for enterprisinginvestment,astheyexistedinformer periods and mayreturn.

It has long been theprevalentview that theartofsuccessful investment liesfirst in the choice of thoseindustriesthataremostlikelytogrowinthefutureandthenin identifying the most

promisingcompaniesintheseindustries. For example,smart investors—or theirsmart advisers—would longagohaverecognizedthegreatgrowth possibilities of thecomputerindustryasawholeand of InternationalBusinessMachines in particular. Andsimilarly for a number ofother growth industries andgrowthcompanies.Butthisisnotaseasyasitalwayslooksin retrospect. To bring this

pointhomeattheoutsetletusaddhereaparagraph thatweincluded first in the 1949editionofthisbook.

Suchaninvestormayforexample be a buyer ofair-transport stocksbecausehebelievestheirfuture is even morebrilliant than the trendthe market alreadyreflects.Forthisclassofinvestorthevalueofour

bookwill liemore in itswarnings against thepitfalls lurking in thisfavorite investmentapproach than in anypositive technique thatwill help him along hispath.*

The pitfalls have provedparticularly dangerous in theindustry we mentioned. Itwas, of course, easy toforecastthatthevolumeofair

traffic would growspectacularly over the years.Because of this factor theirshares became a favoritechoice of the investmentfunds. But despite theexpansion of revenues—at apace evengreater than in thecomputer industry—acombination of technologicalproblems and overexpansionof capacity made forfluctuating and evendisastrous profit figures. In

the year 1970, despite a newhigh in traffic figures, theairlines sustained a loss ofsome $200 million for theirshareholders. (They hadshownlossesalsoin1945and1961.) The stocks of thesecompanies once againshowed a greater decline in1969–70 thandid thegeneralmarket. The record showsthateventhehighlypaidfull-time experts of the mutualfundswerecompletelywrong

about the fairly short-termfuture of a major andnonesotericindustry.

On the other hand, whilethe investment funds hadsubstantial investments andsubstantial gains in IBM, thecombinationof its apparentlyhigh price and theimpossibilityofbeingcertainabout its rate of growthprevented them from havingmore than, say, 3% of their

funds in this wonderfulperformer. Hence the effectof this excellent choice ontheiroverallresultswasbynomeansdecisive.Furthermore,many—if not most—of theirinvestments in computer-industrycompaniesotherthanIBM appear to have beenunprofitable. From these twobroadexampleswedrawtwomoralsforourreaders:

1. Obvious prospects forphysical growth in abusinessdonottranslateinto obvious profits forinvestors.

2. Theexpertsdonothavedependable ways ofselecting andconcentrating on themost promisingcompanies in the mostpromisingindustries.

The author did not follow

this approach in his financialcareer as fund manager, andhecannotoffereitherspecificcounsel or muchencouragement to those whomaywishtotryit.

What then will we aim toaccomplishinthisbook?Ourmain objective will be toguide the reader against theareas of possible substantialerror and to develop policieswith which he will be

comfortable. We shall sayquite a bit about thepsychology of investors. Forindeed, the investor’s chiefproblem—andevenhisworstenemy—is likely to behimself. (“The fault, dearinvestor, isnot inourstars—andnot inourstocks—butinourselves….”) This hasproved the more true overrecent decades as it hasbecome more necessary forconservative investors to

acquire common stocks andthus to expose themselves,willy-nilly, to the excitementand the temptations of thestock market. By arguments,examples, and exhortation,wehopetoaidourreaderstoestablish the proper mentaland emotional attitudestoward their investmentdecisions. We have seenmuchmoremoneymadeandkept by “ordinary people”who were temperamentally

wellsuitedfortheinvestmentprocess than by those wholacked this quality, eventhough theyhadanextensiveknowledge of finance,accounting, and stock-marketlore.

Additionally, we hope toimplant in the reader atendency to measure orquantify.For99issuesoutof100wecouldsaythatatsomeprice they are cheap enough

to buy and at some otherprice they would be so dearthat theyshouldbe sold.Thehabit of relatingwhat is paidtowhatisbeingofferedisaninvaluabletraitininvestment.In an article in a women’smagazinemanyyearsagoweadvised the readers to buytheir stocks as they boughttheir groceries, not as theybought their perfume. Thereally dreadful losses of thepast fewyears (andonmany

similar occasions before)were realized in thosecommon-stock issues wherethebuyerforgottoask“Howmuch?”

In June 1970 the question“How much?” could beansweredbythemagicfigure9.40%—the yield obtainableon new offerings of high-grade public-utility bonds.This has now dropped toabout 7.3%, but even that

returntemptsustoask,“Whygive any other answer?” Butthere are other possibleanswers, and these must becarefully considered. Besideswhich,werepeatthatbothweand our readers must beprepared in advance for thepossibly quite differentconditions of, say, 1973–1977.

We shall therefore presentin some detail a positive

program for common-stockinvestment, part of which iswithin the purview of bothclasses of investors and partis intended mainly for theenterprising group. Strangelyenough, we shall suggest asoneofourchiefrequirementshere that our readers limitthemselves to issues sellingnot far above their tangible-asset value.* The reason forthis seemingly outmoded

counsel is both practical andpsychological. Experiencehastaughtusthat,whilethereare many good growthcompanies worth severaltimesnetassets, thebuyerofsuch shares will be toodependent on the vagariesand fluctuations of the stockmarket. By contrast, theinvestor in shares, say, ofpublic-utility companies atabout their net-asset valuecan always consider himself

the owner of an interest insound and expandingbusinesses, acquired at arational price—regardless ofwhat the stock market mightsay to the contrary. Theultimate result of such aconservative policy is likelyto work out better thanexciting adventures into theglamorous and dangerousfieldsofanticipatedgrowth.

The art of investment has

one characteristic that is notgenerally appreciated. Acreditable, if unspectacular,resultcanbeachievedby thelay investorwith aminimumofeffortandcapability;buttoimprove this easily attainablestandard requires muchapplication and more than atrace of wisdom. If youmerelytrytobringjustalittleextra knowledge andcleverness to bear upon yourinvestment program, instead

ofrealizingalittlebetterthannormal results,youmaywellfind that you have doneworse.

Since anyone—by justbuying and holding arepresentative list—canequalthe performance of themarket averages, it wouldseem a comparatively simplematterto“beattheaverages”;but as a matter of fact theproportion of smart people

who try this and fail issurprisingly large. Even themajority of the investmentfunds, with all theirexperienced personnel, havenot performed so well overthe years as has the generalmarket. Allied to theforegoingis therecordof thepublished stock-marketpredictions of the brokeragehouses, for there is strongevidence that their calculatedforecasts have been

somewhat less reliable thanthesimpletossingofacoin.

In writing this book wehave tried to keep this basicpitfallof investment inmind.The virtues of a simpleportfolio policy have beenemphasized—thepurchaseofhigh-grade bonds plus adiversified list of leadingcommon stocks—which anyinvestor can carry outwith alittle expert assistance. The

adventure beyond this safeand sound territory has beenpresented as fraught withchallenging difficulties,especially in the area oftemperament. Beforeattemptingsuchaventuretheinvestor should feel sure ofhimselfandofhisadvisers—particularly as to whetherthey have a clear concept ofthe differences betweeninvestment and speculationandbetweenmarketpriceand

underlyingvalue.

A strong-minded approachto investment, firmly basedon the margin-of-safetyprinciple,canyieldhandsomerewards.Butadecisiontotryfor these emoluments ratherthan for the assured fruits ofdefensive investment shouldnot be made without muchself-examination.

A final retrospective

thought. When the youngauthor enteredWall Street inJune 1914 no one had anyinklingofwhatthenexthalf-century had in store. (Thestock market did not evensuspectthataWorldWarwasto break out in two months,and close down the NewYorkStockExchange.)Now,in1972,wefindourselvestherichest and most powerfulcountryonearth,butbesetbyall sorts of major problems

and more apprehensive thanconfidentofthefuture.Yetifwe confine our attention toAmerican investmentexperience, there is somecomfort to be gleaned fromthelast57years.Throughalltheir vicissitudes andcasualties,asearth-shakingasthey were unforeseen, itremained true that soundinvestment principlesproduced generally soundresults. We must act on the

assumption that they willcontinuetodoso.

Note to the Reader: Thisbook does not address itselftotheoverallfinancialpolicyof savers and investors; itdealsonlywiththatportionoftheir funds which they areprepared to place inmarketable (or redeemable)securities, that is, in bondsand stocks. Consequentlywe

donotdiscusssuchimportantmedia as savings and timedesposits, savings-and-loan-association accounts, lifeinsurance,annuities,andreal-estate mortgages or equityownership.Thereadershouldbear in mind that when hefinds theword “now,” or theequivalent, in the text, itrefers to late 1971 or early1972.

CommentaryontheIntroduction

If you have built castles in theair, yourwork need not be lost;that is where they should be.

Now put the foundations underthem.—HenryDavidThoreau,Walden

Notice that Grahamannounces from the start thatthis book will not tell youhow to beat the market. Notruthfulbookcan.

Instead, this book willteach you three powerfullessons:

how you can minimizethe odds of sufferingirreversiblelosses;how you can maximizethechancesofachievingsustainablegains;howyoucancontrol theself-defeating behaviorthatkeepsmostinvestorsfrom reaching their fullpotential.

Back in theboomyearsofthe late 1990s, when

technology stocks seemed tobe doubling in value everyday,thenotionthatyoucouldlose almost all your moneyseemed absurd. But, by theendof2002,manyofthedot-com and telecom stocks hadlost 95% of their value ormore.Once you lose 95%ofyourmoney,youhavetogain1,900% just to get back towhereyoustarted.1Takingafoolish risk can put you so

deep in the hole that it’svirtually impossible to getout. That’s why Grahamconstantly emphasizes theimportanceofavoidinglosses—not just in Chapters 6, 14,and 20, but in the threads ofwarning that he has woventhroughouthisentiretext.

But nomatter how carefulyou are, the price of yourinvestments will go downfrom time to time.While no

one can eliminate that risk,Graham will show you howtomanageit—andhowtogetyourfearsundercontrol.

AreYouanIntelligentInvestor?

Now let’s answer a vitallyimportant question. Whatexactly does Graham meanby an “intelligent” investor?Back in the first edition ofthisbook,Grahamdefinesthe

term—and he makes it clearthat this kind of intelligencehasnothing to dowith IQorSAT scores. It simplymeansbeingpatient,disciplined,andeager to learn;youmustalsobe able to harness youremotions and think foryourself. This kind ofintelligence, explainsGraham, “is a trait more ofthe character than of thebrain.”2

There’s proof that high IQand higher education are notenough to make an investorintelligent. In 1998, Long-Term Capital ManagementL.P., a hedge fund run by abattalion of mathematicians,computer scientists, and twoNobel Prize–winningeconomists,lostmorethan$2billion in a matter of weekson a huge bet that the bondmarket would return to“normal.” But the bond

market kept right onbecoming more and moreabnormal—and LTCM hadborrowed so much moneythat its collapse nearlycapsized the global financialsystem.3

And back in the spring of1720, Sir Isaac Newtonowned shares in the SouthSea Company, the hotteststock in England. Sensingthat the market was getting

out of hand, the greatphysicist muttered that he“could calculate the motionsof the heavenly bodies, butnot the madness of thepeople.”Newton dumped hisSouthSeashares,pocketinga100% profit totaling £7,000.But just months later, sweptup in thewild enthusiasm ofthe market, Newton jumpedback in at a much higherprice—and lost £20,000 (ormore than $3 million in

today’s money). For the restofhislife,heforbadeanyoneto speak the words “SouthSea”inhispresence.4

Sir Isaac Newton was oneofthemostintelligentpeoplewhoeverlived,asmostofuswould define intelligence.But, in Graham’s terms,Newton was far from anintelligentinvestor.Bylettingtheroarofthecrowdoverridehis own judgment, the

world’s greatest scientistactedlikeafool.

Inshort,ifyou’vefailedatinvesting so far, it’s notbecause you’re stupid. It’sbecause, like Sir IsaacNewton, you haven’tdeveloped the emotionaldiscipline that successfulinvestingrequires.InChapter8, Graham describes how toenhance your intelligence byharnessingyouremotionsand

refusing to stoop to themarket’slevelofirrationality.There you can master hislesson that being anintelligent investor is more amatter of “character” than“brain.”

AChronicleofCalamity

Now let’s take a moment tolook at some of the majorfinancialdevelopmentsofthe

pastfewyears:

1. The worst market crashsince the GreatDepression, with U.S.stocks losing 50.2% oftheir value—or $7.4trillion—betweenMarch2000andOctober2002.

2. Far deeper drops in theshare prices of thehottest companiesof the1990s, including AOL,

Cisco, JDS Uniphase,Lucent, and Qualcomm—plus the utterdestruction of hundredsofInternetstocks.

3. Accusations of massivefinancial fraud at someof the largest and mostrespectedcorporationsinAmerica, includingEnron,Tyco,andXerox.

4. Thebankruptciesofsuchonce-glisteningcompanies as Conseco,

Global Crossing, andWorldCom.

5. Allegations thataccountingfirmscookedthe books, and evendestroyed records, tohelptheirclientsmisleadtheinvestingpublic.

6. Charges that topexecutives at leadingcompanies siphoned offhundreds of millions ofdollars for their ownpersonalgain.

7. Proof that securityanalysts on Wall Streetpraised stocks publiclybut admitted privatelythattheyweregarbage.

8. A stock market that,even after itsbloodcurdling decline,seems overvalued byhistorical measures,suggesting to manyexperts that stocks havefurtheryettofall.

9. A relentless decline in

interestratesthathasleftinvestors with noattractive alternative tostocks.

10. An investingenvironment bristlingwith the unpredictablemenace of globalterrorismandwar in theMiddleEast.

Muchofthisdamagecouldhavebeen(andwas!)avoidedbyinvestorswholearnedand

livedbyGraham’sprinciples.As Graham puts it, “whileenthusiasmmaybenecessaryfor great accomplishmentselsewhere, on Wall Street italmost invariably leads todisaster.” By lettingthemselves get carried away—on Internet stocks, on big“growth”stocks,onstocksasawhole—many peoplemadethe same stupid mistakes asSir Isaac Newton. They letother investors’ judgments

determine their own. Theyignored Graham’s warningthat “the really dreadfullosses” always occur after“thebuyerforgottoask‘Howmuch?’” Most painfully ofall, by losing their self-controljustwhentheyneededit the most, these peopleproved Graham’s assertionthat “the investor’s chiefproblem—andevenhisworstenemy—is likely to behimself.”

TheSureThingThatWasn’T

Many of those people gotespecially carried away ontechnology and Internetstocks, believing the high-tech hype that this industrywouldkeepoutgrowingeveryotherforyearstocome,ifnotforever:

In mid-1999, afterearning a 117.3% return

in just the first fivemonths of the year,MonumentInternetFundportfolio managerAlexander Cheungpredicted that his fundwould gain 50% a yearover the next three tofiveyearsandanannualaverage of 35% “overthenext20years.”5After his AmerindoTechnology Fund rose

an incredible 248.9% in1999, portfolio managerAlberto Vilar ridiculedanyone who dared todoubt that the Internetwas a perpetualmoneymaking machine:“If you’re out of thissector, you’re going tounderperform.You’re ina horse and buggy, andI’m in a Porsche. Youdon’tliketenfoldgrowthopportunities? Then go

withsomeoneelse.”6In February 2000,hedge-fund managerJames J. CramerproclaimedthatInternet-related companies “arethe only ones worthowning right now.”These “winners of thenewworld,”ashecalledthem,“aretheonlyonesthat are going higherconsistently in good

days and bad.” Cramereven took a potshot atGraham: “You have tothrow out all of thematrices and formulasand texts that existedbeforetheWeb….Ifweused any of whatGrahamandDodd teachus, we wouldn’t have adime undermanagement.”7

All these so-called experts

ignored Graham’s soberwords of warning: “Obviousprospectsforphysicalgrowthinabusinessdonot translateinto obvious profits forinvestors.” While it seemseasy to foresee whichindustrywillgrowthefastest,that foresight has no realvalue if most other investorsare already expecting thesame thing. By the timeeveryonedecidesthatagivenindustry is “obviously” the

best one to invest in, thepricesofitsstockshavebeenbid up so high that its futurereturns have nowhere to gobutdown.

For now at least, no onehas the gall to try claimingthat technology will still bethe world’s greatest growthindustry. But make sure youremember this: The peoplewho now claim that the next“sure thing” will be health

care,orenergy,orrealestate,orgold,arenomorelikelytobe right in the end than thehypestersofhigh tech turnedouttobe.

TheSilverLining

If no price seemed too highfor stocks in the 1990s, in2003we’vereachedthepointat which no price appears tobe low enough. The

pendulum has swung, asGrahamknewitalwaysdoes,from irrational exuberance tounjustifiable pessimism. In2002, investors yanked $27billion out of stock mutualfunds, and a surveyconducted by the SecuritiesIndustry Association foundthat one out of 10 investorshad cut back on stocks by atleast 25%. The same peoplewhowereeagertobuystocksinthelate1990s—whenthey

were going up in price and,therefore, becomingexpensive—sold stocks astheywentdowninpriceand,by definition, becamecheaper.

As Graham shows sobrilliantlyinChapter8,thisisexactly backwards. Theintelligent investor realizesthat stocks become morerisky,not less,as theirpricesrise—and less risky, not

more,astheirpricesfall.Theintelligent investor dreads abull market, since it makesstocks more costly to buy.And conversely (so long asyou keep enough cash onhand to meet your spendingneeds),youshouldwelcomeabear market, since it putsstocksbackonsale.8

Sotakeheart:Thedeathofthebullmarketisnotthebadnews everyone believes it to

be. Thanks to the decline instock prices, now is aconsiderably safer—andsaner—time to be buildingwealth. Read on, and letGrahamshowyouhow.

Chapter1InvestmentversusSpeculation:ResultstoBeExpectedbytheIntelligentInvestor

This chapterwill outline theviewpoints that will be setforth in the remainder of thebook.Inparticularwewishtodevelop at the outset ourconcept of appropriateportfolio policy for theindividual, nonprofessionalinvestor.

InvestmentversusSpeculation

What do we mean by“investor”? Throughout this

bookthetermwillbeusedincontradistinction to“speculator.” As far back as1934, in our textbookSecurity Analysis,1 weattempted a preciseformulation of the differencebetween the two, as follows:“An investment operation isone which, upon thoroughanalysis promises safety ofprincipal and an adequatereturn. Operations not

meeting these requirementsarespeculative.”

While we have clungtenaciously to this definitionover the ensuing 38 years, itis worthwhile noting theradical changes that haveoccurred in the use of theterm “investor” during thisperiod.Afterthegreatmarketdecline of 1929–1932 allcommon stocks were widelyregarded as speculative by

nature. (A leading authoritystated flatly that only bondscould be bought forinvestment.2) Thus we hadthen to defend our definitionagainstthechargethatitgavetoowidescopetotheconceptofinvestment.

Nowour concern is of theopposite sort. We mustprevent our readers fromacceptingthecommonjargonwhich applies the term

“investor” to anybody andeverybody in the stockmarket.Inourlasteditionwecited the following headlineof a front-page article of ourleading financial journal inJune1962:SMALLINVESTORSBEARISH,THEYARESELLINGODD-LOTSSHORT

In October 1970 the samejournal had an editorialcritical of what it called

“recklessinvestors,”whothistime were rushing in on thebuyingside.

These quotations wellillustrate the confusion thathas been dominant for manyyears in theuseof thewordsinvestment and speculation.Think of our suggesteddefinitionofinvestmentgivenabove, and compare it withthe sale of a few shares ofstock by an inexperienced

member of the public, whodoesnotevenownwhatheisselling, andhas some largelyemotional conviction that hewillbeabletobuythembackat a much lower price. (It isnotirrelevanttopointoutthatwhen the 1962 articleappeared the market hadalreadyexperiencedadeclineof major size, and was nowgetting ready for an evengreaterupswing.Itwasaboutaspooratimeaspossiblefor

selling short.) In a moregeneral sense, the later-usedphrase “reckless investors”could be regarded as alaughable contradiction interms—something like“spendthrift misers”—werethismisuseoflanguagenotsomischievous.

The newspaper employedthe word “investor” in theseinstancesbecause,intheeasylanguage of Wall Street,

everyonewhobuysorsellsasecurity has become aninvestor, regardless of whathebuys,orforwhatpurpose,or at what price, or whetherfor cash or on margin.Compare this with theattitude of the public towardcommon stocks in 1948,when over 90% of thosequeriedexpressed themselvesasopposedtothepurchaseofcommon stocks.3 About half

gaveastheirreason“notsafe,agamble,”andabouthalf,thereason“notfamiliarwith.”*Itisindeedironical(thoughnotsurprising) that common-stock purchases of all kindswerequitegenerallyregardedashighlyspeculativeorriskyat a time when they wereselling on a most attractivebasis, and due soon to begintheir greatest advance inhistory; conversely the very

fact they had advanced towhat were undoubtedlydangerouslevelsasjudgedbypast experience latertransformed them into“investments,” and the entirestock-buying public into“investors.”

The distinction betweeninvestmentandspeculationincommon stocks has alwaysbeen a useful one and itsdisappearance is a cause for

concern.We have often saidthat Wall Street as aninstitution would be welladvised to reinstate thisdistinction and to emphasizeit in all its dealingswith thepublic. Otherwise the stockexchanges may some day beblamed forheavy speculativelosses, which those whosuffered them had not beenproperly warned against.Ironically, once more, muchof the recent financial

embarrassment of somestock-exchange firms seemsto have come from theinclusion of speculativecommon stocks in their owncapital funds. We trust thatthe reader of this book willgain a reasonably clear ideaof the risks that are inherentin common-stockcommitments—risks whichare inseparable from theopportunities of profit thattheyoffer,andbothofwhich

must be allowed for in theinvestor’scalculations.

What we have just saidindicates that there may nolonger be such a thing as asimon-pureinvestmentpolicycomprising representativecommonstocks—inthesensethat one can always wait tobuy them at a price thatinvolves no risk of a marketor “quotational” loss largeenough to be disquieting. In

most periods the investormust recognize the existenceof a speculative factor in hiscommon-stock holdings. It ishis task to keep thiscomponent within minorlimits, and to be preparedfinancially andpsychologically for adverseresultsthatmaybeofshortorlongduration.

Two paragraphs should beaddedaboutstockspeculation

per se, as distinguished fromthe speculative componentnow inherent in mostrepresentative commonstocks. Outright speculationis neither illegal, immoral,nor (for most people)fattening to the pocketbook.More than that, somespeculation is necessary andunavoidable, for in manycommon-stock situationsthere are substantialpossibilitiesofbothprofitand

loss, and the risks thereinmust be assumed bysomeone.*Thereisintelligentspeculation as there isintelligent investing. Buttherearemanywaysinwhichspeculation may beunintelligent. Of these theforemost are: (1) speculatingwhen you think you areinvesting; (2) speculatingseriously instead of as apastime, when you lack

proper knowledge and skillfor it; and (3) risking moremoney in speculation thanyoucanaffordtolose.

In our conservative viewevery nonprofessional whooperates on margin † shouldrecognizethatheisipsofactospeculating, and it is hisbroker’s duty so to advisehim.Andeveryonewhobuysa so-called “hot” common-stock issue, or makes a

purchase in any way similarthereto, is either speculatingor gambling. Speculation isalwaysfascinating,anditcanbea lotof funwhileyouareahead of the game. If youwanttotryyourluckatit,putaside a portion—the smallerthebetter—ofyourcapital ina separate fund for thispurpose. Never add moremoney to this account justbecause themarket has goneup and profits are rolling in.

(That’s the time to think oftaking money out of yourspeculative fund.) Nevermingle your speculative andinvestment operations in thesameaccount,norinanypartofyourthinking.

ResultstoBeExpectedbytheDefensiveInvestor

We have already definedthe defensive investor as oneinterested chiefly in safety

plus freedom frombother. Ingeneral what course shouldhefollowandwhatreturncanhe expect under “averagenormal conditions”—if suchconditions really exist? Toanswer these questions weshall consider first what wewrote on the subject sevenyears ago, next whatsignificant changes haveoccurred since then in theunderlying factors governingthe investor’s expectable

return, and finally what heshoulddoandwhatheshouldexpect under present-day(early1972)conditions.

1.WhatWeSaidSixYearsAgo

We recommended that theinvestor divide his holdingsbetween high-grade bondsand leading common stocks;that the proportion held inbondsbeneverlessthan25%or more than 75%, with the

converse being necessarilytrue for the common-stockcomponent; that his simplestchoicewouldbetomaintaina50–50proportionbetweenthetwo, with adjustments torestore the equality whenmarket developments haddisturbed it by as much as,say, 5%. As an alternativepolicy he might choose toreduce his common-stockcomponent to25%“ifhefeltthe market was dangerously

high,” and conversely toadvance it toward themaximum of 75% “if he feltthat a decline in stock priceswas making themincreasinglyattractive.”

In 1965 the investor couldobtain about 4½% on high-gradetaxablebondsand3¼%on good tax-free bonds. Thedividend return on leadingcommon stocks (with theDJIAat892)wasonlyabout

3.2%. This fact, and others,suggested caution. Weimpliedthat“atnormallevelsof the market” the investorshould be able to obtain aninitial dividend return ofbetween 3½% and 4½% onhisstockpurchases, towhichshould be added a steadyincrease in underlying value(and in the “normal marketprice”) of a representativestock list of about the sameamount, giving a return from

dividends and appreciationcombined of about 7½% peryear. The half and halfdivision between bonds andstockswouldyield about 6%beforeincometax.Weaddedthat the stock componentshould carry a fair degree ofprotection against a loss ofpurchasing power caused bylarge-scaleinflation.

It should be pointed outthat the above arithmetic

indicated expectation of amuch lower rate of advancein the stockmarket than hadbeen realized between 1949and 1964. That rate hadaveraged a good deal betterthan10% for listed stocks asa whole, and it was quitegenerallyregardedasasortofguarantee that similarlysatisfactory results could becountedoninthefuture.Fewpeople were willing toconsider seriously the

possibility that the high rateofadvance in thepastmeansthatstockpricesare“nowtoohigh,” and hence that “thewonderful results since 1949would imply not very goodbut bad results for thefuture.”4

2.WhatHasHappenedSince1964

The major change since1964 has been the rise ininterest rates on first-grade

bonds to record high levels,althoughtherehassincebeena considerable recovery fromthe lowest prices of 1970.The obtainable return ongood corporate issues is nowabout 7½% and even moreagainst 4½% in 1964. In themeantime thedividendreturnon DJIA-type stocks had afair advance also during themarket decline of 1969–70,but as we write (with “theDow” at 900) it is less than

3.5%against3.2%at theendof1964.Thechangeingoinginterest rates produced amaximum decline of about38% in the market price ofmedium-term (say 20-year)bondsduringthisperiod.

There is a paradoxicalaspecttothesedevelopments.In 1964 we discussed atlength thepossibility that theprice of stocks might be toohighandsubjectultimatelyto

a serious decline; butwe didnot consider specifically thepossibility that the samemight happen to the price ofhigh-grade bonds. (Neitherdidanyoneelsethatweknowof.)We did warn (on p. 90)that “a long-term bond mayvary widely in price inresponse to changes ininterest rates.” In the lightofwhat has since happened wethink that thiswarning—withattendant examples—was

insufficiently stressed. Forthe fact is that if the investorhadagivensum in theDJIAat its closing price of 874 in1964 he would have had asmall profit thereon in late1971;evenatthelowestlevel(631) in 1970 his indicatedloss would have been lessthan that shown on goodlong-termbonds.Ontheotherhand, if he had confined hisbond-type investments toU.S. savings bonds, short-

term corporate issues, orsavings accounts, he wouldhave had no loss in marketvalue of his principal duringthisperiodandhewouldhaveenjoyed a higher incomereturn than was offered bygood stocks. It turned out,therefore, that true “cashequivalents” proved to bebetter investments in 1964than common stocks—inspite of the inflationexperience that in theory

should have favored stocksover cash. The decline inquoted principal value ofgood longer-term bonds wasdue to developments in themoney market, an abstrusearea which ordinarily doesnothaveanimportantbearingon the investment policy ofindividuals.

This is just another of anendless series of experiencesover time that have

demonstrated that the futureof security prices is neverpredictable.* Almost alwaysbonds have fluctuated muchless than stock prices, andinvestorsgenerallycouldbuygood bonds of any maturitywithout having to worryaboutchangesintheirmarketvalue. There were a fewexceptions to this rule, andthe period after 1964 provedto be one of them.We shall

have more to say aboutchange in bond prices in alaterchapter.

3. Expectations and Policy in Late1971andEarly1972

Toward the end of 1971 itwas possible to obtain 8%taxable interest on goodmedium-term corporatebonds, and 5.7% tax-free ongood state or municipalsecurities. In theshorter-term

field the investor couldrealize about 6% on U.S.governmentissuesdueinfiveyears. In the latter case thebuyer need not be concernedabout a possible loss inmarketvalue,sinceheissureof full repayment, includingthe 6% interest return, at theend of a comparatively shortholding period. The DJIA atitsrecurrentpricelevelof900in1971yieldsonly3.5%.

Letusassumethatnow,asin the past, the basic policydecisiontobemadeishowtodividethefundbetweenhigh-grade bonds (or other so-called “cash equivalents”)and leading DJIA-typestocks. What course shouldthe investor follow underpresentconditions,ifwehaveno strong reason to predicteitherasignificantupwardora significant downwardmovement for some time in

the future? First let us pointout that if there isno seriousadversechange,thedefensiveinvestor should be able tocount on the current 3.5%dividend returnonhis stocksand also on an averageannual appreciation of about4%.Asweshallexplainlaterthis appreciation is basedessentially on thereinvestment by the variouscompaniesofacorrespondingamount annually out of

undistributed profits. On abefore-taxbasisthecombinedreturn of his stocks wouldthen average, say, 7.5%,somewhat less than hisinterestonhigh-gradebonds.*On an after-tax basis theaverage return on stockswould work out at some5.3%.5 This would be aboutthesameasisnowobtainableon good tax-free medium-termbonds.

These expectations aremuch less favorable forstocks against bonds thanthey were in our 1964analysis. (That conclusionfollows inevitably from thebasic fact that bond yieldshavegoneupmuchmorethanstock yields since 1964.)Wemust never lose sight of thefact that the interest andprincipal payments on goodbonds are much betterprotected and therefore more

certainthanthedividendsandprice appreciation on stocks.Consequently we are forcedto the conclusion that now,towardtheendof1971,bondinvestment appears clearlypreferable to stockinvestment. If we could besure that this conclusion isrightwewouldhavetoadvisethe defensive investor to putall his money in bonds andnone in common stocksuntilthe current yield relationship

changessignificantlyinfavorofstocks.

Butofcoursewecannotbecertain that bonds will workout better than stocks fromtoday’s levels. The readerwill immediately thinkof theinflation factor as a potentreason on the other side. Inthe next chapter we shallargue that our considerableexperience with inflation inthe United States during this

centurywouldnotsupportthechoice of stocks againstbonds at present differentialsin yield. But there is alwaysthe possibility—though weconsider it remote—of anaccelerating inflation, whichinonewayor anotherwouldhave to make stock equitiespreferable to bonds payableinafixedamountofdollars.*There is the alternativepossibility—which we also

consider highly unlikely—that American business willbecomesoprofitable,withoutstepped-up inflation, as tojustify a large increase incommon-stock values in thenext fewyears.Finally, thereis the more familiarpossibility that we shallwitness another greatspeculative rise in the stockmarket without a realjustificationintheunderlyingvalues.Anyof thesereasons,

and perhaps others wehaven’t thought of, mightcause the investor to regret a100%concentrationonbondseven at their more favorableyieldlevels.

Hence, after thisforeshortened discussion ofthe major considerations, weonce again enunciate thesame basic compromisepolicyfordefensiveinvestors—namely that at all times

theyhaveasignificantpartoftheir funds in bond-typeholdings and a significantpartalsoinequities.It isstilltrue that they may choosebetweenmaintainingasimple50–50 division between thetwo components or a ratio,dependenton their judgment,varying between a minimumof 25% and a maximum of75%of either.We shall giveour more detailed view ofthesealternativepolicies ina

laterchapter.

Sinceatpresenttheoverallreturn envisaged fromcommon stocks is nearly thesame as that frombonds, thepresently expectable return(including growth of stockvalues)fortheinvestorwouldchange little regardless ofhow he divides his fundbetweenthetwocomponents.As calculated above, theaggregate return from both

parts should be about 7.8%beforetaxesor5.5%onatax-free (or estimated tax-paid)basis.Areturnofthisorderisappreciably higher than thatrealized by the typicalconservative investor overmostofthelong-termpast.Itmay not seem attractive inrelation to the 14%, or so,return shown by commonstocksduring the20yearsofthe predominantly bullmarket after 1949. But it

should be remembered thatbetween 1949 and 1969 theprice of the DJIA hadadvanced more than fivefoldwhile its earnings anddividendshadaboutdoubled.Hence the greater part of theimpressivemarket record forthat period was based on achange in investors’ andspeculators’ attitudes ratherthan in underlying corporatevalues.Tothatextentitmightwell be called a “bootstrap

operation.”

Indiscussingthecommon-stock portfolio of thedefensive investor, we havespokenonlyofleadingissuesofthetypeincludedinthe30componentsoftheDowJonesIndustrial Average. We havedone this for convenience,andnottoimplythatthese30issues alone are suitable forpurchase by him. Actually,there are many other

companiesofqualityequaltoor excelling the average ofthe Dow Jones list; thesewould include a host ofpublicutilities (whichhaveaseparate Dow Jones averageto represent them).* But themajor point here is that thedefensive investor’s overallresults are not likely to bedecisively different from onediversified or representativelist than from another, or—

moreaccurately—thatneitherhe nor his advisers couldpredict with certaintywhatever differences wouldultimately develop. It is truethat the art of skillful orshrewd investment issupposedtolieparticularlyinthe selection of issues thatwill give better results thanthe general market. Forreasons to be developedelsewhereweareskepticalofthe ability of defensive

investors generally to getbetter than average results—which in factwouldmean tobeat their own overallperformance.* (Ourskepticism extends to themanagement of large fundsbyexperts.)

Let us illustrate our pointby an example that at firstmay seem to prove theopposite. Between December1960andDecember1970the

DJIA advanced from 616 to839,or36%.Butinthesameperiod the much largerStandard & Poor’s weightedindexof500stocksrosefrom58.11 to 92.15, or 58%.Obviously the second grouphad proved a better “buy”thanthefirst.Butwhowouldhave been so rash as topredict in 1960 that whatseemed like a miscellaneousassortment of all sorts ofcommon stocks would

definitely outper-forms thearistocratic“thirty tyrants”oftheDow?Allthisproves,weinsist,thatonlyrarelycanonemake dependable predictionsaboutpricechanges,absoluteorrelative.

We shall repeat herewithout apology—for thewarning cannot be given toooften—that the investorcannot hope for better thanaverage results by buying

newofferings,or“hot”issuesof any sort,meaning therebythose recommended for aquickprofit.†Thecontrary isalmost certain to be true inthe long run. The defensiveinvestormustconfinehimselfto the shares of importantcompanieswithalongrecordof profitable operations andin strong financial condition.(Any security analyst worthhissaltcouldmakeupsucha

list.) Aggressive investorsmay buy other types ofcommon stocks, but theyshould be on a definitelyattractivebasis as establishedbyintelligentanalysis.

To conclude this section,let us mention briefly threesupplementary concepts orpractices for the defensiveinvestor. The first is thepurchase of the shares ofwell-established investment

funds as an alternative tocreating his own common-stockportfolio.Hemightalsoutilize one of the “commontrust funds,”or “commingledfunds,” operated by trustcompaniesandbanksinmanystates; or, if his funds aresubstantial, use the servicesof a recognized investment-counsel firm. This will givehim professionaladministration of hisinvestment program along

standard lines. The third isthe device of “dollar-costaveraging,” which meanssimply that the practitionerinvestsincommonstocksthesame number of dollars eachmonthoreachquarter.Inthisway he buys more shareswhen themarket is low thanwhen it is high, and he islikely to end up with asatisfactory overall price forall his holdings. Strictlyspeaking, this method is an

application of a broaderapproach known as “formulainvesting.” The latter wasalready alluded to in oursuggestion that the investormay vary his holdings ofcommon stocks between the25% minimum and the 75%maximum, in inverserelationship to the action ofthemarket.These ideas havemerit for the defensiveinvestor, and they will bediscussedmoreamplyinlater

chapters.*

ResultstoBeExpectedbytheAggressiveInvestor

Our enterprising securitybuyer, of course, will desireand expect to attain betteroverall results than hisdefensive or passivecompanion.But firsthemustmakesurethathisresultswillnotbeworse.Itisnodifficulttrick to bring a great deal of

energy, study, and nativeabilityintoWallStreetandtoendupwith losses insteadofprofits. These virtues, ifchanneled in the wrongdirections, becomeindistinguishable fromhandicaps. Thus it is mostessential that the enterprisinginvestor start with a clearconception as to whichcourses of action offerreasonablechancesofsuccessandwhichdonot.

Firstletusconsiderseveralways in which investors andspeculators generally haveendeavored to obtain betterthan average results. Theseinclude:

1.TRADING INTHEMARKET.This usually means buyingstocks when the market hasbeen advancing and sellingthem after it has turneddownward. The stocks

selected are likely to beamongthosewhichhavebeen“behaving” better than themarket average. A smallnumber of professionalsfrequently engage in shortselling. Here they will sellissues they do not own butborrow through theestablishedmechanismof thestockexchanges.Theirobjectis to benefit from asubsequent decline in theprice of these issues, by

buying them back at a pricelowerthantheysoldthemfor.(As our quotation from theWall Street Journal on p. 19indicates, even “smallinvestors”—perish the term!—sometimes try theirunskilled hand at shortselling.)

2.SHORT-TERMSELECTIVITY.Thismeans buying stocks ofcompanies which are

reporting or expected toreport increased earnings, orfor which some otherfavorable development isanticipated.

3. LONG-TERM SELECTIVITY.Heretheusualemphasisisonan excellent record of pastgrowth, which is consideredlikely to continue in thefuture.Insomecasesalsothe“investor” may choose

companies which have notyetshownimpressiveresults,butareexpectedtoestablishahigh earning power later.(Such companies belongfrequently in sometechnological area—e.g.,computers, drugs, electronics—and they often aredeveloping new processes orproducts that are deemed tobeespeciallypromising.)

Wehavealreadyexpresseda negative view about theinvestor’s overall chances ofsuccess in these areas ofactivity. The first we haveruledout, onboth theoreticaland realistic grounds, fromthe domain of investment.Stock trading is not anoperation “which, onthorough analysis, offerssafety of principal and asatisfactory return.” Morewill be said on stock trading

inalaterchapter.*

In his endeavor to selectthe most promising stockseitherfortheneartermorthelonger future, the investorfaces obstacles of two kinds—the first stemming fromhuman fallibility and thesecondfromthenatureofhiscompetition. He may bewrong in his estimate of thefuture; or even if he is right,the currentmarket pricemay

already fully reflect what heis anticipating. In the area ofnear-term selectivity, thecurrent year’s results of thecompany are generallycommon property on WallStreet; next year’s results, tothe extent they arepredictable,arealreadybeingcarefully considered. Hencethe investor who selectsissues chieflyon thebasisofthisyear’ssuperiorresults,oron what he is told he may

expectfornextyear,islikelyto find that others have donethe same thing for the samereason.

Inchoosingstocksfortheirlong-term prospects, theinvestor’s handicaps arebasically the same. Thepossibilityofoutrighterrorinthe prediction—which weillustrated by our airlinesexampleonp.6—isnodoubtgreater than when dealing

with near-term earnings.Because the expertsfrequently go astray in suchforecasts, it is theoreticallypossible for an investor tobenefit greatly by makingcorrectpredictionswhenWallStreet as a whole is makingincorrect ones. But that isonly theoretical. How manyenterprising investors couldcount on having the acumenor prophetic gift to beat theprofessional analysts at their

favorite game of estimatinglong-termfutureearnings?

We are thus led to thefollowing logical ifdisconcerting conclusion: Toenjoyareasonablechanceforcontinuedbetter thanaverageresults, the investor mustfollow policieswhich are (1)inherently sound andpromising, and (2) notpopularonWallStreet.

Arethereanysuchpoliciesavailable for the enterprisinginvestor? In theory onceagain, the answer should beyes; and there are broadreasons to think that theanswer should be affirmativeinpractice aswell.Everyoneknows that speculative stockmovementsarecarriedtoofarin both directions, frequentlyin the general market and atall times in at least some ofthe individual issues.

Furthermore,acommonstockmay be undervalued becauseof lack of interest orunjustified popular prejudice.Wecango further andassertthat in an astonishingly largeproportion of the trading incommon stocks, thoseengaged therein don’t appearto know—in polite terms—one part of their anatomyfromanother.Inthisbookweshall point out numerousexamples of (past)

discrepancies between priceandvalue.Thusitseemsthatany intelligentperson,withagoodheadforfigures,shouldhave a veritable picnic onWall Street, battening offotherpeople’sfoolishness.Soit seems, but somehow itdoesn’tworkoutthatsimply.Buying a neglected andtherefore undervalued issuefor profit generally proves aprotractedandpatience-tryingexperience.And selling short

a too popular and thereforeovervaluedissueisapttobeatestnotonlyofone’scourageand stamina but also of thedepth of one’s pocketbook.*The principle is sound, itssuccessful application is notimpossible,butitisdistinctlynotaneasyarttomaster.

There is also a fairlywidegroup of “special situations,”whichovermanyyearscouldbecountedontobringanice

annual return of 20% orbetter, with a minimum ofoverall risk to those whoknewtheirwayaroundinthisfield. They includeintersecurity arbitrages,payouts or workouts inliquidations,protectedhedgesof certain kinds. The mosttypical case is a projectedmerger or acquisition whichoffers a substantially highervalue for certain shares thantheir price on the date of the

announcement. The numberof such deals increasedgreatlyinrecentyears,anditshould have been a highlyprofitable period for thecognoscenti. But with themultiplication of mergerannouncements came amultiplication of obstacles tomergers and of deals thatdidn’tgothrough;quiteafewindividual losses were thusrealizedintheseonce-reliableoperations. Perhaps, too, the

overall rate of profit wasdiminished by too muchcompetition.†

The lessened profitabilityof these special situationsappears one manifestation ofa kind of self-destructiveprocess—akin to the law ofdiminishing returns—whichhas developed during thelifetimeofthisbook.In1949we could present a study ofstock-market fluctuations

over the preceding 75 years,which supporteda formula—basedonearningsandcurrentinterest rates—fordeterminingaleveltobuytheDJIA below its “central” or“intrinsic” value, and to sellout above such value. It wasan application of thegoverning maxim of theRothschilds: “Buy cheap andsell dear.”* And it had theadvantageof runningdirectly

counter to the ingrained andpernicious maxim of WallStreet that stocks should bebought because they havegone up and sold becausethey have gone down. Alas,after 1949 this formula nolonger worked. A secondillustrationisprovidedbythefamous “Dow Theory” ofstock-marketmovements,inacomparison of its indicatedsplendid results for 1897–1933 and its much more

questionable performancesince1934.

A third and final exampleof the golden opportunitiesnot recently available: Agood part of our ownoperationsonWallStreethadbeen concentrated on thepurchase of bargain issueseasily identified as such bythefactthattheyweresellingat less than their share in thenet current assets (working

capital) alone, not countingthe plant account and otherassets,andafterdeductingallliabilities ahead of the stock.It is clear that these issueswere selling at a price wellbelow the value of theenterprise as a privatebusiness. No proprietor ormajority holder would thinkof selling what he owned atso ridiculously low a figure.Strangely enough, suchanomalies were not hard to

find. In 1957 a list waspublishedshowingnearly200issuesofthistypeavailableinthe market. In various wayspractically all these bargainissues turned out to beprofitable, and the averageannual result proved muchmore remunerative thanmostother investments. But theytoo virtually disappearedfrom the stockmarket in thenextdecade,andwiththemadependable area for shrewd

and successful operation bythe enterprising investor.However,atthelowpricesof1970 there again appeared aconsiderable number of such“sub-working-capital” issues,and despite the strongrecovery of the market,enough of them remained atthe end of the year to makeupafull-sizedportfolio.

The enterprising investorunder today’s conditions still

has various possibilities ofachievingbetter thanaverageresults. The huge list ofmarketable securities mustincludeafairnumberthatcanbe identified as undervaluedby logical and reasonablydependable standards. Theseshouldyieldmoresatisfactoryresults on the average thanwilltheDJIAoranysimilarlyrepresentative list. In ourview the search for thesewould not be worth the

investor’s effort unless hecould hope to add, say, 5%before taxes to the averageannual return from the stockportion of his portfolio. Weshall try to develop one ormore such approaches tostockselectionforusebytheactiveinvestor.


Allofhumanunhappinesscomesfrom one single thing: notknowinghowtoremainatrestinaroom.

—BlaisePascal

Why do you suppose thebrokers on the floor of the

New York Stock Exchangealways cheer at the sound ofthe closing bell—no matterwhatthemarketdidthatday?Becausewheneveryou trade,they make money—whetheryou did or not. Byspeculating instead ofinvesting, you lower yourown odds of building wealthandraisesomeoneelse’s.

Graham’s definition ofinvesting could not be

clearer: “An investmentoperation is onewhich, uponthorough analysis, promisessafety of principal and anadequate return.”1 Note thatinvesting, according toGraham, consists equally ofthreeelements:

you must thoroughlyanalyze a company, andthe soundness of itsunderlying businesses,

beforeyoubuyitsstock;you must deliberatelyprotect yourself againstseriouslosses;you must aspire to“adequate,” notextraordinary,performance.

Aninvestorcalculateswhatastockisworth,basedonthevalue of its businesses. Aspeculator gambles that astock will go up in price

because somebody else willpay even more for it. AsGrahamonceputit,investorsjudge “the market price byestablished standards ofvalue,” while speculators“base [their] standards ofvalue upon the marketprice.”2 For a speculator, theincessant stream of stockquotes is like oxygen; cut itoff and he dies. For aninvestor,whatGrahamcalled

“quotational” values mattermuchless.Grahamurgesyoutoinvestonlyifyouwouldbecomfortable owning a stockeven if you had no way ofknowing its daily shareprice.3

Like casino gambling orbetting on the horses,speculatinginthemarketcanbeexcitingorevenrewarding(if you happen to get lucky).But it’s theworst imaginable

way to build your wealth.That’s because Wall Street,like Las Vegas or theracetrack, has calibrated theoddssothatthehousealwaysprevails, in the end, againsteveryonewhotriestobeatthehouse at its own speculativegame.

On the other hand,investing is a unique kind ofcasino—one where youcannot lose in the end, so

long as youplayonlyby therules that put the oddssquarelyinyourfavor.Peoplewho invest make money forthemselves; people whospeculate make money fortheir brokers. And that, inturn, is why Wall Streetperennially downplays thedurable virtues of investingand hypes the gaudy appealofspeculation.

UnsafeatHighSpeed

Confusing speculation withinvestment,Grahamwarns,isalways a mistake. In the1990s, that confusion led tomass destruction. Almosteveryone,itseems,ranoutofpatienceatonce,andAmericabecame the SpeculationNation, populated withtraders who went shootingfrom stock to stock likegrasshoppers whizzing

around in an August hayfield.

Peoplebeganbelievingthatthe test of an investmenttechnique was simplywhether it “worked.” If theybeat the market over anyperiod, no matter howdangerous or dumb theirtactics, people boasted thatthey were “right.” But theintelligent investor has nointerest in being temporarily

right. To reach your long-term financial goals, youmust be sustainably andreliablyright.The techniquesthat became so trendy in the1990s—day trading, ignoringdiversification, flipping hotmutual funds, followingstock-picking “systems”—seemedtowork.Buttheyhadnochanceofprevailinginthelong run, because they failedtomeetallthreeofGraham’scriteriaforinvesting.

To see why temporarilyhigh returns don’t proveanything, imagine that twoplacesare130milesapart. IfI observe the 65-mph speedlimit,Icandrivethatdistancein two hours. But if I drive130 mph, I can get there inone hour. If I try this andsurvive,amI“right”?Shouldyoube tempted to try it, too,because you hear mebragging that it “worked”?Flashy gimmicks for beating

the market are much thesame: In short streaks, solong as your luck holds out,they work. Over time, theywillgetyoukilled.

In1973,whenGrahamlastrevised The IntelligentInvestor, the annual turnoverrate on the New York StockExchangewas20%,meaningthat the typical shareholderheld a stock for five yearsbeforesellingit.By2002,the

turnoverratehadhit105%—aholdingperiodofonly11.4months. Back in 1973, theaveragemutual fund held onto a stock for nearly threeyears; by 2002, thatownership period had shrunkto just10.9months. It’sas ifmutual-fund managers werestudyingtheirstocksjustlongenough to learn theyshouldn’t have bought themin the first place, thenpromptly dumping them and

startingallover.

Even the most respectedmoney-managementfirmsgotantsy. In early 1995, JeffreyVinik, manager of FidelityMagellan (then the world’slargest mutual fund), had42.5% of its assets intechnology stocks. Vinikproclaimed that most of hisshareholders “have investedin the fund for goals that areyears away…. I think their

objectives are the same asmine, and that they believe,as I do, that a long-termapproach is best.” But sixmonths after he wrote thosehigh-minded words, Viniksold off almost all histechnology shares, unloadingnearly $19 billion worth ineight frenzied weeks. Somuch for the “long term”!And by 1999, Fidelity’sdiscount brokerage divisionwas egging on its clients to

trade anywhere, anytime,using a Palm handheldcomputer—which wasperfectly in tune with thefirm’s new slogan, “Everysecondcounts.”

FIGURE1-1

StocksonSpeed

And on the NASDAQexchange, turnover hit warpspeed,asFigure1-1shows.4

In 1999, shares in Puma

Technology, for instance,changed hands an average ofonce every 5.7 days.DespiteNASDAQ’s grandiose motto—“TheStockMarket for theNextHundredYears”—manyof its customers could barelyhold on to a stock for ahundredhours.

TheFinancialVideoGame

Wall Street made online

trading sound like an instantwaytomintmoney:DiscoverBrokerage, the online arm ofthevenerablefirmofMorganStanley,ranaTVcommercialin which a scruffy tow-truckdriverpicksupaprosperous-lookingexecutive.Spottingaphotoofatropicalbeachfrontposted on the dashboard, theexecutive asks, “Vacation?”“Actually,”repliesthedriver,“that’s my home.” Takenaback, the suit says, “Looks

like an island.” With quiettriumph, the driver answers,“Technically,it’sacountry.”

The propaganda wentfurther.Online tradingwouldtake no work and require nothought.AtelevisionadfromAmeritrade, the onlinebroker, showed twohousewives just back fromjogging; one logs on to hercomputer, clicks themouseafewtimes,andexults,“Ithink

Ijustmadeabout$1,700!”Ina TV commercial for theWaterhouse brokerage firm,someone asked basketballcoach Phil Jackson, “Youknow anything about thetrade?” His answer: “I’mgoing tomake it right now.”(How many games wouldJackson’s NBA teams havewon if he had brought thatphilosophy to courtside?Somehow, knowing nothingabout the other team, but

saying, “I’m ready to playthem right now,” doesn’tsound like a championshipformula.)

By1999atleastsixmillionpeoplewere trading online—and roughly a tenth of themwere“daytrading,”usingtheInternettobuyandsellstocksat lightning speed. Everyonefrom showbiz diva BarbraStreisand toNicholasBirbas,a 25-year-old former waiter

in Queens, New York, wasflinging stocks around likelive coals. “Before,” scoffedBirbas, “I was investing forthelongtermandIfoundoutthat it was not smart.” Now,Birbastradedstocksupto10times a day and expected toearn $100,000 in a year. “Ican’t stand to see red in myprofit-or-loss column,”Streisand shuddered in aninterviewwithFortune. “I’mTaurus the bull, so I react to

red. If I see red, I sell mystocksquickly.”5

Bypouringcontinuousdataabout stocks into bars andbarbershops, kitchens andcafés, taxicabs and truckstops, financial websites andfinancialTVturnedthestockmarket into a nonstopnational video game. Thepublic felt moreknowledgeable about themarkets than ever before.

Unfortunately, while peoplewere drowning in data,knowledge was nowhere tobe found. Stocks becameentirely decoupled from thecompanies that had issuedthem—pure abstractions, justblipsmoving across a TV orcomputer screen. If the blipsweremovingup,nothingelsemattered.

On December 20, 1999,Juno Online Services

unveiled a trailblazingbusinessplan:toloseasmuchmoney as possible, onpurpose.Junoannouncedthatit would henceforth offer allitsretailservicesforfree—nocharge for e-mail, no chargefor Internet access—and thatit would spend millions ofdollars more on advertisingover the next year. On thisdeclarationofcorporatehara-kiri, Juno’s stock roared upfrom $16.375 to $66.75 in

twodays.6

Why bother learningwhether a business wasprofitable, or what goods orservicesacompanyproduced,or who its management was,or even what the company’snamewas?Allyouneededtoknow about stocks was thecatchy code of their tickersymbols: CBLT, INKT,PCLN, TGLO, VRSN,WBVN.7Thatwayyoucould

buythemevenfaster,withoutthe pesky two-second delayof looking them up on anInternetsearchengine.Inlate1998, the stock of a tiny,rarely traded building-maintenance company,Temco Services, nearlytripledinamatterofminutesonrecord-highvolume.Why?Inabizarre formof financialdyslexia,thousandsoftradersboughtTemcoaftermistakingits tickersymbol,TMCO,for

that of Ticketmaster Online(TMCS), an Internet darlingwhose stock began tradingpubliclyforthefirsttimethatday.8

Oscar Wilde joked that acynic “knows the price ofeverything, and the value ofnothing.” Under thatdefinition,thestockmarketisalways cynical, but by thelate 1990s it would haveshocked Oscar himself. A

single half-baked opinion onprice could double acompany’s stock even as itsvalue went entirelyunexamined. In late 1998,Henry Blodget, an analyst atCIBC Oppenheimer, warnedthat “as with all Internetstocks, a valuation is clearlymoreartthanscience.”Then,citing only the possibility offuture growth, he jacked uphis “price target” onAmazon.com from $150 to

$400 in one fell swoop.Amazon.com shot up 19%that day and—despiteBlodget’s protest that hisprice target was a one-yearforecast—soaredpast$400injustthreeweeks.Ayearlater,PaineWebber analyst WalterPiecyk predicted thatQualcomm stock would hit$1,000 a share over the next12 months. The stock—already up 1,842% that year—soared another 31% that

day,hitting$659ashare.9

FromFormulatoFiasco

But trading as if yourunderpants are on fire is nottheonly formof speculation.Throughout the past decadeorso,onespeculativeformulaafter another was promoted,popularized, and then thrownaside. All of them shared afew traits—This is quick!

This is easy! And it won’thurt a bit!—and all of themviolated at least one ofGraham’s distinctionsbetween investing andspeculating.Hereareafewofthe trendy formulas that fellflat:

Cash in on thecalendar. The “Januaryeffect”—the tendencyofsmall stocks to produce

biggainsaroundtheturnof theyear—waswidelypromoted in scholarlyarticles and popularbooks published in the1980s. These studiesshowed that ifyoupiledinto small stocks in thesecondhalfofDecemberand held them intoJanuary,youwouldbeatthemarketbyfive to10percentage points. Thatamazed many experts.

After all, if it were thiseasy, surely everyonewouldhearabout it, lotsof people would do it,and the opportunitywouldwitheraway. What caused theJanuaryjolt?Firstofall,many investorssell theircrummiest stocks late intheyeartolockinlossesthat can cut their taxbills. Second,professional money

managers grow morecautious as the yeardrawstoaclose,seekingto preserve theiroutperformance (orminimize theirunderperformance).Thatmakes them reluctant tobuy(orevenhangonto)afallingstock.Andifanunderperformingstockisalsosmallandobscure,amoney manager will beeven less eager to show

it in his year-end list ofholdings. All thesefactors turn small stocksinto momentarybargains; when the tax-driven selling ceases inJanuary, they typicallybounce back, producingarobustandrapidgain. The January effecthas not withered away,but it has weakened.According to financeprofessor William

Schwert of theUniversity of Rochester,if you had bought smallstocks in late Decemberand sold them in earlyJanuary,youwouldhavebeatenthemarketby8.5percentage points from1962 through 1979, by4.4 points from 1980through1989,andby5.8points from 1990through2001.10

As more peoplelearned about theJanuary effect, moretraders bought smallstocks in December,making them less of abargain and thusreducing their returns.Also, the January effectis biggest among thesmallest stocks—butaccording to PlexusGroup, the leadingauthority on brokerage

expenses, the total costof buying and sellingsuch tiny stockscan runup to 8% of yourinvestment.11 Sadly, bythe time you’re donepaying your broker, allyour gains on theJanuary effect will meltaway.

Just do “what works.”In 1996, an obscuremoney manager named

James O’Shaughnessypublished a book calledWhat Works on WallStreet. In it, he arguedthat “investors can domuch better than themarket.”O’Shaughnessymade a stunning claim:From 1954 through1994, you could haveturned $10,000 into$8,074,504, beating themarketbymorethan10-fold—a towering 18.2%

average annual return.How? By buying abasketof50stockswiththe highest one-yearreturns, five straightyears of rising earnings,and share prices lessthan 1.5 times theircorporaterevenues.12Asifhewere theEdisonofWall Street,O’ShaughnessyobtainedU.S. Patent No.

5,978,778 for his“automated strategies”and launchedagroupoffourmutual funds basedon his findings. By late1999 the funds hadsucked in more than$175 million from thepublic—and, in hisannual letter toshareholders,O’Shaughnessy statedgrandly: “As always, Ihope that together, we

can reach our long-termgoals by staying thecourseand stickingwithour time-testedinvestmentstrategies.” But“whatworksonWall Street” stoppedworking right afterO’Shaughnessypublicized it. As Figure1-2 shows, two of hisfundsstanksobadlythatthey shut down in early2000, and the overall

stock market (asmeasured by the S & P500 index) wallopedevery O’Shaughnessyfund almost nonstop fornearly four yearsrunning.

FIGURE1-2

WhatUsedtoWorkonWallStreet…

In June 2000,O’Shaughnessy movedcloser tohisown“long-term goals” by turningthe funds over to a newmanager, leaving hiscustomers to fend forthemselves with those“time-tested investmentstrategies.”13O’Shaughnessy’sshareholdersmight havebeenlessupsetifhehad

given his book a moreprecise title—forinstance, What Used toWork on Wall Street…UntilIWroteThisBook.

Follow “The FoolishFour.” In the mid-1990s, the Motley Foolwebsite (and severalbooks) hyped thedaylights out of atechnique called “TheFoolish Four.”

AccordingtotheMotleyFool, you would have“trashed the marketaveragesoverthelast25years” and could “crushyour mutual funds” byspending “only 15minutes a year” onplanning yourinvestments. Best of all,this technique had“minimal risk.” All youneededtodowasthis:

1. Takethefivestocksin the Dow JonesIndustrial Averagewith the loweststock prices andhighest dividendyields.

2. Discard the onewith the lowestprice.

3. Put 40% of yourmoney in the stockwith the second-lowestprice.

4. Put20% ineachofthe three remainingstocks.

5. One year later, sortthe Dow the sameway and reset theportfolio accordingto steps 1 through4.

6. Repeat untilwealthy.

Over a 25-yearperiod, the Motley Foolclaimed, this technique

would have beaten themarket by a remarkable10.1 percentage pointsannually. Over the nexttwo decades, theysuggested, $20,000invested in The FoolishFour should flower into$1,791,000. (And, theyclaimed, you could dostillbetterbypickingthefiveDowstockswiththehighest ratioofdividendyield to the square root

of stock price, droppingthe one that scored thehighest, and buying thenextfour.) Let’s considerwhether this “strategy”could meet Graham’sdefinitions of aninvestment:

What kind of “thoroughanalysis” could justifydiscardingthestockwiththesinglemostattractiveprice and dividend—butkeeping the four thatscore lower for thosedesirablequalities?How could putting 40%ofyourmoneyintoonlyonestockbea“minimalrisk”?

And how could aportfolio of only fourstocks be diversifiedenough to provide“safetyofprincipal”?

TheFoolishFour,inshort, was one of themostcockamamiestock-picking formulas everconcocted. The Foolsmade the same mistakeas O’Shaughnessy: Ifyou look at a large

quantity of data longenough, a huge numberof patterns will emerge—ifonlyby chance.Byrandom luck alone, thecompanies that produceabove-average stockreturns will have plentyof things in common.But unless those factorscause the stocks tooutper-forms, they can’tbeusedtopredictfuturereturns.

None of the factorsthat the Motley Fools“discovered” with suchfanfare—dropping thestockwiththebestscore,doubling up on the onewith the second-highestscore, dividing thedividend yield by thesquare root of stockprice—could possiblycause or explain thefuture performance of astock.Money Magazine

found that a portfoliomadeupofstockswhosenames contained norepeating letters wouldhave performed nearlyas well as The FoolishFour—and for the samereason: luck alone.14 AsGraham never stopsreminding us, stocks dowell or poorly in thefuture because thebusinesses behind them

do well or poorly—nothing more, andnothingless.Sureenough,insteadof crushing the market,The Foolish Fourcrushedthethousandsofpeoplewhowere fooledintobelievingthatitwasa form of investing. In2000 alone, the fourFoolish stocks—Caterpillar, EastmanKodak, SBC, and

General Motors—lost14% while the Dowdroppedbyjust4.7%.

As these examples show,there’s only one thing thatnever suffers a bear marketon Wall Street: dopey ideas.Each of these so-calledinvestingapproachesfellpreyto Graham’s Law. Allmechanical formulas forearning higher stockperformance are “a kind of

self-destructive process—akintothelawofdiminishingreturns.” There are tworeasonsthereturnsfadeaway.If theformulawas justbasedon random statistical flukes(like The Foolish Four), themere passage of time willexpose that itmade no senseinthefirstplace.Ontheotherhand, if the formula actuallydidwork in thepast (like theJanuary effect), then bypublicizing it,marketpundits

always erode—and usuallyeliminate—itsabilitytodosointhefuture.

All this reinforcesGraham’s warning that youmust treat speculation asveteran gamblers treat theirtripstothecasino:

You must never deludeyourself into thinkingthat you’re investing

whenyou’respeculating.Speculating becomesmortally dangerous themoment you begin totakeitseriously.You must put strictlimitsontheamountyouarewillingtowager.

Just as sensible gamblerstake, say, $100 down to thecasinofloorandleavetherestof theirmoney locked in thesafe in their hotel room, the

intelligentinvestordesignatesa tiny portion of her totalportfolio as a “mad money”account.Formostofus,10%of our overall wealth is themaximum permissibleamount to put at speculativerisk.Neverminglethemoneyin your speculative accountwith what’s in yourinvestment accounts; neverallow your speculativethinking to spill over intoyour investing activities; and

never put more than 10% ofyour assets into your madmoney account, no matterwhathappens.

For better or worse, thegambling instinct is part ofhuman nature—so it’s futilefor most people even to trysuppressing it. But youmustconfineandrestrainit.That’sthe single best way to makesure you will never foolyourself into confusing

speculationwithinvestment.

Chapter2TheInvestorandInflation

Inflation, and the fightagainst it, has been verymuch in thepublic’smind in

recentyears.Theshrinkageinthe purchasing power of thedollar in the past, andparticularly the fear (or hopeby speculators) of a seriousfurther decline in the future,has greatly influenced thethinking ofWall Street. It isclear that those with a fixeddollar income will sufferwhen the cost of livingadvances, and the sameapplies to a fixed amount ofdollar principal. Holders of

stocks, on the other hand,havethepossibilitythatalossof the dollar’s purchasingpower may be offset byadvances in their dividendsandthepricesoftheirshares.

On the basis of theseundeniable facts manyfinancial authorities haveconcluded that (1) bonds arean inherently undesirableform of investment, and (2)consequently,commonstocks

arebytheirverynaturemoredesirable investments thanbonds. We have heard ofcharitable institutions beingadvised that their portfoliosshould consist 100% ofstocks and zero percent ofbonds.* This is quite areversalfromtheearlierdayswhen trust investments wererestricted by law to high-grade bonds (and a fewchoicepreferredstocks).

Our readers must haveenough intelligence torecognize that even high-quality stocks cannot be abetter purchase than bondsunder all conditions—i.e.,regardless of how high thestockmarketmaybeandhowlow the current dividendreturn compared with therates available on bonds. Astatement of this kind wouldbe as absurd as was thecontraryone—toooftenheard

years ago—that any bond issafer than any stock. In thischapterwe shall try to applyvarious measurements to theinflation factor, in order toreach someconclusionsas tothe extent to which theinvestor may wisely beinfluenced by expectationsregarding future rises in thepricelevel.

In this matter, as in somany others in finance, we

mustbaseourviewsoffuturepolicyonaknowledgeofpastexperience. Is inflationsomething new for thiscountry,atleastintheseriousformithastakensince1965?If we have seen comparable(orworse)inflationsinlivingexperience, what lessons canbe learned from them inconfronting the inflation oftoday?LetusstartwithTable2-1, a condensed historicaltabulation thatcontainsmuch

information about changes inthe general price level andconcomitant changes in theearningsandmarketvalueofcommon stocks. Our figureswill begin with 1915, andthuscover55years,presentedatfive-yearintervals.(Weuse1946insteadof1945toavoidthelastyearofwartimepricecontrols.)

Thefirstthingwenoticeisthatwe have had inflation in

the past—lots of it. Thelargest five-year dose wasbetween 1915 and 1920,whenthecostoflivingnearlydoubled. This compareswiththe advance of 15% between1965 and 1970. In between,wehavehad threeperiodsofdeclining prices and then sixof advances at varying rates,some rather small. On thisshowing, the investor shouldclearly allow for theprobability of continuing or

recurrentinflationtocome.

Canwetellwhattherateofinflation is likely to be? Noclear answer is suggested byour table; it shows variationsof all sorts. It would seemsensible,however,totakeourcuefromtheratherconsistentrecord of the past 20 years.Theaverageannualriseintheconsumer price level for thisperiodhasbeen2.5%;thatfor1965–1970was4.5%;thatfor

1970 alone was 5.4%.Official government policyhas been strongly againstlarge-scale inflation, andthere are some reasons tobelieve that Federal policieswill bemore effective in thefuture than in recent years.*We think it would bereasonable for an investor atthispointtobasehisthinkingand decisions on a probable(far from certain) rate of

future inflation of, say, 3%per annum. (This wouldcompare with an annual rateof about 2½% for the entireperiod1915–1970.)1

What would be theimplications of such anadvance? It would eat up, inhigher living costs, aboutone-half the income nowobtainable on good medium-term tax-free bonds (or ourassumed after-tax equivalentfrom high-grade corporatebonds). This would be aserious shrinkage, but itshouldnot be exaggerated. Itwouldnotmean that the true

value, or the purchasingpower, of the investor’sfortuneneedbereducedovertheyears.Ifhespenthalfhisinterest incomeafter taxeshewould maintain this buyingpower intact, even against a3%annualinflation.

But the next question,naturally, is, “Can theinvestorbereasonablysureofdoing better by buying andholding other things than

high-gradebonds,evenattheunprecedented rate of returnoffered in 1970–1971?”Would not, for example, anall-stock program bepreferable to a part-bond,part-stock program? Do notcommon stocks have a built-inprotectionagainstinflation,and are they not almostcertain togiveabetter returnover the years than willbonds? Have not in factstockstreatedtheinvestorfar

better than have bonds overthe 55-year period of ourstudy?

The answer to thesequestions is somewhatcomplicated.Commonstockshave indeed done better thanbonds over a long period oftime in the past. The rise oftheDJIA fromanaverageof77 in 1915 to an average of753 in 1970works out at anannual compounded rate of

just about 4%, to which wemay add another 4% foraveragedividendreturn.(Thecorresponding figures for theS & P composite are aboutthe same.) These combinedfiguresof8%peryearareofcourse much better than thereturn enjoyed from bondsoverthesame55-yearperiod.But they do not exceed thatnow offered by high-gradebonds. This brings us to thenextlogicalquestion:Isthere

apersuasivereasontobelievethatcommonstocksarelikelyto do much better in futureyears than they have in thelast five and one-halfdecades?

Our answer to this crucialquestion must be a flat no.Common stocks may dobetterinthefuturethaninthepast, but they are far fromcertain to do so. We mustdeal here with two different

time elements in investmentresults.The first coverswhatis likely to occur over thelong-term future—say, thenext 25 years. The secondapplies to what is likely tohappen to the investor—bothfinancially andpsychologically—over shortor intermediate periods, sayfive years or less. His frameof mind, his hopes andapprehensions, hissatisfactionordiscontentwith

what he has done, above allhisdecisionswhattodonext,are all determined not in theretrospect of a lifetime ofinvestment but rather by hisexperiencefromyeartoyear.

On this point we can becategorical.There isnoclosetime connection betweeninflationary (or deflationary)conditionsand themovementof common-stock earningsand prices. The obvious

example is the recent period,1966–1970. The rise in thecost of living was 22%, thelargest in a five-year periodsince 1946–1950. But bothstock earnings and stockprices as a whole havedeclined since 1965. Thereare similar contradictions inboth directions in the recordofpreviousfive-yearperiods.

InflationandCorporateEarnings

Another and highlyimportant approach to thesubject is by a study of theearnings rate on capitalshownbyAmericanbusiness.Thishasfluctuated,ofcourse,with the general rate ofeconomic activity, but it hasshownnogeneraltendencytoadvance with wholesaleprices or the cost of living.Actually this rate has fallenrather markedly in the pasttwenty years in spite of the

inflation of the period. (Tosome degree the decline wasdue to the charging of moreliberaldepreciationrates.SeeTable 2-2.) Our extendedstudies have led to theconclusion that the investorcannot count onmuch abovethe recent five-year rateearned on the DJIA group—about 10% on net tangibleassets (book value) behindthe shares.2Since the market

value of these issues is wellabove theirbookvalue—say,900 market vs. 560 book inmid-1971—the earnings oncurrentmarketpriceworkoutonly at some 6¼%. (Thisrelationship is generallyexpressed in the reverse, or“times earnings,” manner—e.g., that the DJIA price of900equals18timestheactualearnings for the 12 monthsendedJune1971.)

Ourfiguresgearindirectlywith the suggestion in theprevious chapter* that theinvestor may assume anaverage dividend return ofabout 3.5% on the marketvalue of his stocks, plus anappreciation of, say, 4%annually resulting fromreinvested profits. (Note thateach dollar added to bookvalue is here assumed toincrease the market price by

about$1.60.)

The readerwill object thatin the end our calculationsmake no allowance for anincrease in common-stockearnings and values to resultfromourprojected3%annualinflation. Our justification isthe absence of any sign thatthe inflation of a comparableamount in the past has hadanydirect effect on reportedper-share earnings. The cold

figures demonstrate that allthe largegain in theearningsof the DJIA unit in the past20 years was due to aproportionately large growthof invested capital comingfrom reinvested profits. Ifinflation had operated as aseparate favorable factor, itseffect would have been toincrease the “value” ofpreviously existing capital;this in turn should increasethe rate of earnings on such

old capital and therefore onthe old and new capitalcombined.Butnothingofthekindactuallyhappenedinthepast 20 years, during whichthewholesale price level hasadvanced nearly 40%.(Business earnings should beinfluencedmorebywholesaleprices than by “consumerprices.”) The only way thatinflation can add to commonstockvalues isby raising therate of earnings on capital

investment. On the basis ofthe past record this has notbeenthecase.

In the economic cycles ofthe past, good business wasaccompaniedbyarisingpricelevel and poor business byfalling prices. It wasgenerally felt that “a littleinflation” was helpful tobusinessprofits.Thisview isnot contradicted by thehistory of 1950–1970, which

reveals a combination ofgenerally continuedprosperity and generallyrising prices. But the figuresindicate that the effect of allthis on the earning power ofcommon-stock capital(“equity capital”) has beenquitelimited;infactithasnoteven served to maintain therate of earnings on theinvestment. Clearly therehave been importantoffsetting influences which

have prevented any increasein the real profitability ofAmerican corporations as awhole. Perhaps the mostimportant of these have been(1) a rise in wage ratesexceeding the gains inproductivity,and(2)theneedfor huge amounts of newcapital,thusholdingdowntheratio of sales to capitalemployed.

Our figures in Table 2-2

indicate that so far frominflationhavingbenefitedourcorporations and theirshareholders, its effect hasbeen quite the opposite. Themost striking figures in ourtablearethoseforthegrowthof corporate debt between1950 and 1969. It issurprisinghowlittleattentionhas been paid by economistsand by Wall Street to thisdevelopment. The debt ofcorporations has expanded

nearly fivefold while theirprofits before taxes a littlemore than doubled.With thegreat rise in interest ratesduring this period, it isevident that the aggregatecorporate debt is now anadverse economic factor ofsome magnitude and a realproblem for many individualenterprises. (Note that in1950 net earnings afterinterestbutbeforeincometaxwereabout30%ofcorporate

debt,whilein1969theywereonly13.2%ofdebt.The1970ratio must have been evenless satisfactory.) In sum itappearsthatasignificantpartof the 11% being earned oncorporateequitiesasawholeisaccomplishedbytheuseofa large amount of new debtcosting 4% or less after taxcredit.Ifourcorporationshadmaintained the debt ratio of1950, their earnings rate onstock capital would have

fallen still lower, in spite oftheinflation.

TABLE 2-2 CorporateDebt,Profits, andEarningsonCapital,1950–1969

The stock market hasconsidered that the public-

utilityenterpriseshavebeenachief victim of inflation,beingcaughtbetweenagreatadvance in the cost ofborrowed money and thedifficulty of raising the ratescharged under the regulatoryprocess. But thismay be theplace to remark that theveryfact that the unit costs ofelectricity,gas,andtelephoneservices have advanced somuch less than the generalprice index puts these

companies in a strongstrategic position for thefuture.3 They are entitled bylaw to charge rates sufficientfor an adequate return ontheirinvestedcapital,andthiswill probably protect theirshareholdersinthefutureasithas in the inflations of thepast.

All of the above brings usback to our conclusion thatthe investor has no sound

basisforexpectingmorethanan average overall return of,say, 8% on a portfolio ofDJIA-type common stockspurchased at the late 1971price level.But even if theseexpectations should prove tobe understated by asubstantial amount, the casewouldnotbemadeforanall-stock investment program. Ifthere is one thing guaranteedfor the future, it is that theearnings and average annual

market value of a stockportfoliowillnotgrowat theuniform rate of 4%, or anyother figure. In thememorablewordsoftheelderJ. P. Morgan, “They willfluctuate.”*Thismeans, first,that the common-stock buyerat today’s prices—ortomorrow’s—will be runninga real risk of havingunsatisfactory resultstherefrom over a period of

years. It took 25 years forGeneral Electric (and theDJIA itself) to recover thegroundlostinthe1929–1932debacle. Besides that, if theinvestor concentrates hisportfolio on common stockshe is very likely to be ledastray either by exhilaratingadvances or by distressingdeclines. This is particularlytrueifhisreasoningisgearedclosely to expectations offurther inflation. For then, if

another bull market comesalong,hewilltakethebigrisenot as a danger signal of aninevitable fall, not as achance to cash in on hishandsome profits, but ratheras a vindication of theinflation hypothesis and as areason to keep on buyingcommon stocks no matterhowhighthemarketlevelnorhow low thedividend return.Thatwayliessorrow.

AlternativestoCommonStocksasInflationHedges

The standard policy ofpeopleallovertheworldwhomistrust their currency hasbeen to buy and hold gold.Thishasbeenagainstthelawfor American citizens since1935—luckily for them. Inthepast35years thepriceofgold in the open market hasadvancedfrom$35perounceto $48 in early 1972—a rise

of only 35%. But during allthis time the holder of goldhasreceivednoincomereturnonhiscapital,andinsteadhasincurredsomeannualexpensefor storage. Obviously, hewouldhavedonemuchbetterwithhismoneyatinterestinasavings bank, in spite of theriseinthegeneralpricelevel.

The near-complete failureof gold to protect against aloss in the purchasing power

of the dollarmust cast gravedoubt on the ability of theordinary investor to protecthimself against inflation byputting his money in“things.”* Quite a fewcategoriesofvaluableobjectshavehadstrikingadvancesinmarketvalueovertheyears—such as diamonds, paintingsby masters, first editions ofbooks,rarestampsandcoins,etc. But in many, perhaps

most, of these cases thereseemstobeanelementoftheartificial or the precarious oreven the unreal about thequotedprices.Somehow it ishard to think of paying$67,500 for a U.S. silverdollar dated 1804 (but notevenminted that year) as an“investment operation.”4 Weacknowledge we are out ofour depth in this area. Veryfew of our readers will find

the swimming safe and easythere.

The outright ownership ofreal estate has long beenconsidered as a sound long-term investment, carryingwith it a goodly amount ofprotection against inflation.Unfortunately, real-estatevalues are also subject towide fluctuations; seriouserrors can be made inlocation, price paid, etc.;

there are pitfalls insalesmen’s wiles. Finally,diversificationisnotpracticalfor the investor of moderatemeans, except by varioustypes of participations withothers and with the specialhazards that attach to newflotations—not too differentfrom common-stockownership.Thistooisnotourfield.Allweshouldsaytotheinvestor is, “Be sure it’syoursbeforeyougointoit.”

Conclusion

Naturally,we return to thepolicy recommended in ourprevious chapter. Justbecause of the uncertaintiesof the future the investorcannot afford to put all hisfunds into one basket—neither in the bond basket,despite the unprecedentedlyhigh returns that bonds haverecently offered; nor in thestock basket, despite the

prospect of continuinginflation.

The more the investordepends on his portfolio andthe income therefrom, themore necessary it is for himto guard against theunexpected and thedisconcerting in this part ofhis life. It is axiomatic thatthe conservative investorshould seek to minimize hisrisks.We think strongly that

the risks involved in buying,say, a telephone-companybondatyieldsofnearly7½%are much less than thoseinvolved in buying the DJIAat 900 (or any stock listequivalent thereto). But thepossibility of large-scaleinflation remains, and theinvestor must carry someinsurance against it. There isno certainty that a stockcomponent will insureadequately against such

inflation, but it should carrymoreprotectionthanthebondcomponent.

Thisiswhatwesaidonthesubjectinour1965edition(p.97), and we would write thesametoday:

Itmustbeevidenttothereader that we have noenthusiasm for commonstocks at these levels(892 for the DJIA). For

reasonsalreadygivenwefeel that the defensiveinvestorcannotaffordtobe without anappreciable proportionofcommonstocksinhisportfolio, even if weregardthemasthelesseroftwoevils—thegreaterbeingtherisksinanall-bondholding.


Americans are getting stronger.Twenty years ago, it took twopeopletocarrytendollars’worthof groceries.Today, a five-year-oldcandoit.

—HennyYoungman

Inflation? Who cares about

that?

Afterall,theannualriseinthecostofgoodsandservicesaveraged less than 2.2%between1997and2002—andeconomists believe that eventhat rock-bottomratemaybeoverstated.1 (Think, forinstance,ofhowthepricesofcomputers and homeelectronics have plummeted—and how the quality ofmany goods has risen,

meaning that consumers aregetting better value for theirmoney.) In recent years, thetrue rate of inflation in theUnited States has probablyrun around 1% annually—anincrease so infinitesimal thatmany pundits haveproclaimed that “inflation isdead.”2

TheMoneyIllusion

There’s another reasoninvestors overlook theimportance of inflation:whatpsychologistscallthe“moneyillusion.”Ifyoureceivea2%raiseinayearwheninflationruns at 4%, you will almostcertainly feel better than youwillifyoutakea2%paycutduring a year when inflationis zero. Yet both changes inyour salary leave you in avirtually identical position—2%worse off after inflation.

So long as the nominal (orabsolute) change is positive,weviewitasagood thing—even if the real (or after-inflation) result is negative.Andanychange inyourownsalary is more vivid andspecific than the generalizedchange of prices in theeconomy as a whole.3Likewise, investors weredelighted to earn 11% onbank certificates of deposit

(CDs)in1980andarebitterlydisappointed to be earningonly around 2% in 2003—eventhoughtheywerelosingmoney after inflation backthen but are keeping upwithinflation now. The nominalrateweearn isprinted in thebank’s ads and posted in itswindow, where a highnumber makes us feel good.Butinflationeatsawayatthathighnumberinsecret.Insteadof taking out ads, inflation

just takes away our wealth.That’s why inflation is soeasy to overlook—and whyit’s so important to measureyour investing success notjustbywhatyoumake,butbyhow much you keep afterinflation.

More basically still, theintelligent investor mustalways be on guard againstwhatever is unexpected andunderestimated. There are

threegoodreasons tobelievethatinflationisnotdead:

As recently as 1973–1982, the United Stateswent throughoneof themost painful bursts ofinflation in our history.As measured by theConsumer Price Index,prices more thandoubledoverthatperiod,rising at an annualized

rate of nearly 9%. In1979 alone, inflationraged at 13.3%,paralyzing the economyin what became knownas “stagflation”—andleading manycommentators toquestion whetherAmerica could competein the global marketplace.4 Goods andservices priced at $100

inthebeginningof1973cost $230 by the end of1982, shriveling thevalue of a dollar to lessthan 45 cents. No onewho lived through itwould scoff at suchdestructionofwealth;noone who is prudent canfailtoprotectagainsttheriskthatitmightrecur.Since 1960, 69% of theworld’s market-orientedcountries have suffered

at least one year inwhichinflationranatanannualized rate of 25%or more. On average,those inflationaryperiods destroyed 53%of an investor’spurchasing power.5 Wewould be crazy not tohope that America issomehow exempt fromsuch a disaster. But wewouldbeevencrazierto

conclude that it canneverhappenhere.6Rising prices allowUncleSamtopayoffhisdebts with dollars thathavebeencheapenedbyinflation. Completelyeradicatinginflationrunsagainst the economicself-interest of anygovernment thatregularly borrowsmoney.7

HalfaHedge

What,then,cantheintelligentinvestor do to guard againstinflation? The standardanswer is “buy stocks”—but,as common answers so oftenare,itisnotentirelytrue.

Figure2-1shows, foreachyearfrom1926through2002,the relationship betweeninflationandstockprices.

As you can see, in yearswhen the prices of consumergoodsandservicesfell,asonthe left side of the graph,stock returns were terrible—with the market losing up to43% of its value.8 Wheninflationshotabove6%,asinthe years on the right end ofthe graph, stocks also stank.The stockmarket lostmoneyin eight of the 14 years inwhichinflationexceeded6%;

the average return for those14yearswasameasly2.6%.

Whilemildinflationallowscompanies to pass theincreased costs of their ownraw materials on tocustomers, high inflationwreaks havoc—forcingcustomers to slash theirpurchases and depressingactivity throughout theeconomy.

The historical evidence isclear: Since the advent ofaccurate stock-marketdata in1926, there have been 64five-year periods (i.e., 1926–1930, 1927–1931, 1928–1932, and so on through1998–2002). In 50 of those64 five-year periods (or 78%of the time), stocks outpacedinflation.9 That’s impressive,but imperfect; it means thatstocks failed tokeepupwith

inflation about one-fifth ofthetime.

TwoAcronymstotheRescue

Fortunately, you can bolsteryour defenses againstinflation by branching outbeyondstocks.SinceGrahamlast wrote, two inflation-fighters have become widelyavailabletoinvestors:

REITs. Real EstateInvestment Trusts, or REITs

(pronounced “reets”), arecompanies that own andcollect rent from commercialand residential properties.10Bundled into real-estatemutual funds, REITs do adecent job of combatinginflation. The best choice isVanguard REIT Index Fund;other relatively low-costchoices include Cohen &Steers Realty Shares,ColumbiaReal Estate Equity

Fund, and Fidelity RealEstate Investment Fund.11While a REIT fund isunlikely to be a foolproofinflation-fighter, in the longrun it should give you somedefenseagainsttheerosionofpurchasing power withouthampering your overallreturns.

TIPS. Treasury Inflation-ProtectedSecurities,orTIPS,are U.S. government bonds,

first issued in 1997, thatautomatically go up in valuewhen inflation rises.BecausethefullfaithandcreditoftheUnited States stands behindthem, all Treasury bonds aresafe from the risk of default(or nonpayment of interest).But TIPS also guarantee thatthe value of your investmentwon’tbeerodedby inflation.In one easy package, youinsure yourself againstfinancial loss and the loss of

purchasingpower.12

There is one catch,however. When the value ofyour TIPS bond rises asinflationheatsup,theInternalRevenueService regards thatincrease in value as taxableincome—even though it ispurely a paper gain (unlessyousoldthebondatitsnewlyhigher price).Why does thismake sense to the IRS? Theintelligent investor will

remember the wise words offinancial analyst MarkSchweber:“Theonequestionnever to ask a bureaucrat is‘Why?’” Because of thisexasperating taxcomplication, TIPS are bestsuited for a tax-deferredretirement account like anIRA,Keogh,or401(k),wherethey will not jack up yourtaxableincome.

YoucanbuyTIPSdirectly

from the U.S. government atwww.publicdebt.treas.gov/of/ofinflin.htm,or in a low-costmutual fundlike Vanguard Inflation-Protected Securities orFidelity Inflation-ProtectedBond Fund.13 Either directlyor through a fund, TIPS arethe ideal substitute for theproportionofyour retirementfunds you would otherwisekeep in cash. Do not trade

them:TIPScanbevolatileinthe short run, so they workbest as a permanent, lifelongholding. For most investors,allocating at least 10% ofyour retirement assets toTIPS is an intelligentway tokeepaportionofyourmoneyabsolutely safe—and entirelybeyondthereachofthelong,invisibleclawsofinflation.

Chapter3ACenturyofStock-MarketHistory:TheLevelofStockPricesinEarly1972

The investor’s portfolio of

commonstockswillrepresenta small cross-section of thatimmense and formidableinstitutionknownasthestockmarket. Prudence suggeststhathehaveanadequateideaof stock-market history, interms particularly of themajorfluctuationsinitspricelevel and of the varyingrelationships between stockprices as a whole and theirearningsanddividends.Withthisbackgroundhemaybein

a position to form someworthwhile judgment of theattractiveness or dangers ofthe level of the market as itpresents itself at differenttimes. By a coincidence,useful statistical data onprices, earnings, anddividends go back just 100years, to 1871. (Thematerialis not nearly as full ordependable in the first half-periodasinthesecond,butitwillserve.)Inthischapterwe

shall present the figures, inhighly condensed form, withtwoobjectsinview.Thefirstistoshowthegeneralmannerin which stocks have madetheir underlying advancethrough the many cycles ofthe past century. The secondistoviewthepictureintermsof successive ten-yearaverages, not only of stockprices but of earnings anddividends as well, to bringout the varying relationship

between the three importantfactors. With this wealth ofmaterial as a backgroundweshall pass to a considerationof thelevelofstockpricesatthebeginningof1972.

The long-term history ofthe stock market issummarizedintwotablesanda chart. Table 3-1 sets forththe low and high points ofnineteen bear- and bull-marketcyclesinthepast100

years. We have used twoindexes here. The firstrepresents a combination ofanearlystudyby theCowlesCommission going back to1870,whichhasbeensplicedontoandcontinuedtodateinthe well-known Standard &Poor’s composite index of500stocks.Thesecondistheeven more celebrated DowJones IndustrialAverage (theDJIA, or “the Dow”), whichdates back to 1897; it

contains 30 companies, ofwhich one is AmericanTelephone & Telegraph andthe other 29 are largeindustrialenterprises.1

TABLE 3-1 Major Stock-Market Swings Between1871and1971

Chart I, presented bycourtesy of Standard &Poor’s, depicts the marketfluctuations of its 425-industrial-stock index from1900 through 1970. (Acorresponding chart availablefor the DJIA will look verymuch the same.) The readerwill note three quite distinctpatterns, eachcoveringabouta third of the 70 years. Thefirst runsfrom1900 to1924,

andshowsforthemostpartaseriesofrathersimilarmarketcycles lasting from three tofive years. The annualadvance in this periodaveraged just about 3%. Wemove on to the “New Era”bull market, culminating in1929, with its terribleaftermath of collapse,followed by quite irregularfluctuations until 1949.Comparing the average levelof1949withthatof1924,we

find the annual rate ofadvance to be a mere 1½%;hencethecloseofoursecondperiod found the public withno enthusiasm at all forcommon stocks. By the ruleofoppositesthetimewasripefor the beginning of thegreatest bull market in ourhistory, presented in the lastthird of our chart. Thisphenomenon may havereached its culmination inDecember 1968 at 118 for

Standard & Poor’s 425industrials (and 108 for its500-stock composite). AsTable 3-1 shows, there werefairly important setbacksbetween 1949 and 1968(especially in 1956–57 and1961–62), but the recoveriestherefrom were so rapid thatthey had to be denominated(in the long- acceptedsemantics) as recessions in asinglebullmarket,ratherthanas separate market cycles.

Betweenthelowlevelof162for “the Dow” in mid-1949and the high of 995 in early1966, the advance had beenmorethansixfoldin17years—which is at the averagecompounded rateof11%peryear, not counting dividendsof, say, 3½% per annum.(The advance for theStandard&Poor’scompositeindex was somewhat greaterthan that of the DJIA—actuallyfrom14to96.)

These 14% and betterreturns were documented in1963, and later, in a muchpublicizedstudy.*2ItcreatedanaturalsatisfactiononWallStreet with such fineachievements, and a quiteillogical and dangerousconviction that equallymarvelous results could beexpected for common stocksin the future. Few peopleseem to have been bothered

by the thought that the veryextent of the rise mightindicate that it had beenoverdone. The subsequentdeclinefromthe1968hightothe1970lowwas36%fortheStandard&Poor’scomposite(and 37% for the DJIA), thelargestsincethe44%sufferedin 1939–1942, which hadreflected the perils anduncertainties after PearlHarbor. In the dramaticmanner so characteristic of

Wall Street, the low level ofMay1970wasfollowedbyamassive and speedy recoveryof both averages, and theestablishment of a new all-timehigh for theStandard&Poor’s industrials in early1972.Theannualrateofpriceadvance between 1949 and1970 works out at about 9%for the S & P composite (orthe industrial index), usingthe average figures for bothyears.Thatrateofclimbwas,

of course, much greater thanfor any similar period before1950. (But in the last decadetherateofadvancewasmuchlower—5¼% for the S & Pcompositeindexandonlytheonce familiar 3% for theDJIA.)

The record of pricemovements should besupplemented bycorresponding figures forearnings and dividends, inorder to provide an overallviewofwhathashappenedtoour share economy over theten decades. We present aconspectusofthiskindinourTable3-2(p.71).Itisagooddealtoexpectfromthereaderthathestudyallthesefigures

with care, but for some wehope they will be interestingandinstructive.

Letuscommentonthemasfollows: The full decadefigures smooth out the year-to-yearfluctuationsandleaveageneralpictureofpersistentgrowth.Onlytwoof theninedecadesafter thefirstshowadecrease in earnings andaverageprices(in1891–1900and 1931–1940), and no

decade after 1900 shows adecrease in averagedividends. But the rates ofgrowth inall threecategoriesare quite variable. In generalthe performance sinceWorldWar II has been superior tothatofearlierdecades,buttheadvanceinthe1960swaslesspronounced than that of the1950s. Today’s investorcannot tell from this recordwhat percentage gain inearningsdividendsandprices

hemayexpectinthenexttenyears, but it does supply allthe encouragement he needsfor a consistent policy ofcommon-stockinvestment.

However,apointshouldbemade here that is notdisclosed in our table. Theyear 1970 was marked by adefinite deterioration in theoverall earnings posture ofour corporations. The rate ofprofit on invested capital fell

tothelowestpercentagesincetheWorldWaryears.Equallystriking is the fact that aconsiderable number ofcompaniesreportednetlossesfor the year; many became“financially troubled,” andfor the first time in threedecades there were quite afew important bankruptcyproceedings. These facts asmuch as any others haveprompted thestatementmade

above* that the great boomeramayhavecometoanendin1969–1970.

AstrikingfeatureofTable3-2 is the change in theprice/earnings ratios sinceWorldWarII.† In June 1949the S & P composite indexsold at only 6.3 times theapplicable earnings of thepast 12 months; in March1961theratiowas22.9times.Similarly, the dividend yield

ontheS&Pindexhadfallenfromover7%in1949toonly3.0% in 1961, a contrastheightened by the fact thatinterest rates on high-gradebonds had meanwhile risenfrom2.60%to4.50%.Thisiscertainlythemostremarkableturnabout in the public’sattitude in all stock-markethistory.

To people of longexperienceandinnatecaution

thepassagefromoneextremeto another carried a strongwarning of trouble ahead.Theycouldnothelp thinkingapprehensively of the 1926–1929 bull market and itstragic aftermath. But thesefears have not beenconfirmedbytheevent.True,theclosingpriceof theDJIAin 1970 was the same as itwas6½yearsearlier,andthemuch heralded “SoaringSixties” proved to bemainly

a march up a series of highhills and then down again.But nothing has happenedeither to business or to stockprices that can comparewiththe bear market anddepressionof1929–1932.

TheStock-MarketLevelinEarly1972

With a century-longconspectus of stock, prices,earnings, and dividendsbefore our eyes, let us try todrawsomeconclusionsaboutthelevelof900for theDJIAand 100 for the S & Pcomposite index in January1972.

In each of our formereditions we have discussedthe level of the stockmarketat the time of writing, andendeavored to answer thequestion whether it was toohigh for conservativepurchase. The reader mayfind it informing to reviewthe conclusions we reachedon these earlier occasions.This is not entirely anexercise in self-punishment.It will supply a sort of

connecting tissue that linksthevariousstagesofthestockmarket in the past twentyyears and also a taken-from-life picture of the difficultiesfacing anyone who tries toreachaninformedandcriticaljudgment of current marketlevels.Letus,first,reproducethe summary of the 1948,1953, and1959 analyses thatwegaveinthe1965edition:

In 1948 we applied

conservative standardsto the Dow Jones levelof 180, and found nodifficultyinreachingtheconclusion that “it wasnot too high in relationto underlying values.”When we approachedthisproblemin1953theaveragemarket level forthat year had reached275,againofover50%in five years.We askedourselves the same

question—namely,“whether in our opinionthe level of 275 for theDow Jones Industrialswasorwasnot toohighfor sound investment.”In the light of thesubsequent spectacularadvance, it may seemstrangetohavetoreportthat itwas by nomeanseasy for us to reach adefinitive conclusion asto the attractiveness of

the 1953 level. We didsay, positively enough,that“fromthestandpointof value indications—our chief investmentguide—the conclusionabout 1953 stock pricesmust be favorable.” Butwe were concernedabout the fact that in1953, the averages hadadvanced for a longerperiod than inmost bullmarkets of the past, and

that its absolute levelwas historically high.Setting these factorsagainst our favorablevalue judgment, weadvised a cautious orcompromise policy. Asit turned out, this wasnot a particularlybrilliantcounsel.Agoodprophet would haveforeseen that themarketlevelwasduetoadvancean additional 100% in

the next five years.Perhaps we should addin self-defense that fewif any of those whosebusiness was stock-market forecasting—asours was not—had anybetter inkling than wedidofwhatlayahead.

Atthebeginningof1959wefoundtheDJIAatanall-timehighof584.Ourlengthy analysis made

from all points of viewmay be summarized inthefollowing(frompage59 of the 1959 edition):“In sum, we feelcompelledtoexpresstheconclusion that thepresent level of stockprices is a dangerousone. It may well beperilous because pricesare already far toohigh.Butevenifthisisnotthecase the market’s

momentum is such asinevitably to carry it tounjustifiable heights.Frankly, we cannotimagine amarket of thefuture in which therewillneverbeanyseriouslosses, and in which,every tyro will beguaranteeda largeprofitonhisstockpurchases.”

The caution weexpressed in 1959 was

somewhat betterjustified by the sequelthan was ourcorrespondingattitudein1954. Yet it was farfrom fully vindicated.The DJIA advanced to685 in 1961; then fell alittlebelowour584level(to566)laterintheyear;advancedagainto735inlate 1961; and thendeclinedinnearpanicto536 in May 1962,

showing a loss of 27%withinthebriefperiodofsixmonths.At the sametime there was a farmore serious shrinkagein the most popular“growth stocks”—asevidencedbythestrikingfall of the indisputableleader, InternationalBusiness Machines,from a high of 607 inDecember1961toalowof300inJune1962.

This period saw acomplete debacle in ahost of newly launchedcommonstocksof smallenterprises—the so-calledhotissues—whichhad been offered to thepublic at ridiculouslyhighpricesandthenhadbeen further pushed upby needless speculationto levels little short ofinsane. Many of theselost90%andmoreofthe

quotations in just a fewmonths.

The collapse in the firsthalf of 1962 wasdisconcerting, if notdisastrous, tomanyself-acknowledgedspeculators and perhapstomanymoreimprudentpeople who calledthemselves “investors.”But the turnabout thatcame later thatyearwas

equally unsuspected bythefinancialcommunity.The stock-marketaverages resumed theirupward course,producing the followingsequence:

The recovery and newascent of common-stockprices was indeedremarkableandcreatedacorresponding revisionofWallStreetsentiment.

At the lowlevelofJune1962 predictions hadappeared predominantlybearish, and after thepartial recovery to theend of that year theywere mixed, leaning totheskepticalside.Butatthe outset of 1964 thenatural optimism ofbrokerage firms wasagain manifest; nearlyall theforecastswereonthebullishside,andthey

socontinuedthroughthe1964advance.

We then approached thetask of appraising theNovember1964 levelsof thestock market (892 for theDJIA). After discussing itlearnedly from numerous

angleswereachedthreemainconclusions. The first wasthat “old standards (ofvaluation) appearinapplicable; new standardshave not yet been tested bytime.” The second was thatthe investor “must base hispolicy on the existence ofmajor uncertainties. Thepossibilities compass theextremes,ontheonehand,ofa protracted and furtheradvanceinthemarket’slevel

—sayby50%,orto1350forthe DJIA; or, on the otherhand,ofa largelyunheraldedcollapse of the samemagnitude, bringing theaverage in the neighborhoodof, say, 450" (p. 63). Thethird was expressed in muchmoredefiniteterms.Wesaid:“Speakingbluntly,ifthe1964price level is not too highhow could we say that anyprice level is toohigh?”Andthechapterclosedasfollows:

WHATCOURSETOFOLLOW

Investors should notconclude that the 1964market level isdangerous merelybecause they read it inthis book. They mustweigh our reasoningagainst the contraryreasoning theywill hearfrom most competentand experienced people

on Wall Street. In theendeachonemustmakehis own decision andaccept responsibilitytherefor. We suggest,however, that if theinvestorisindoubtastowhich course to pursuehe should choose thepath of caution. Theprinciplesofinvestment,as set forth herein,would call for thefollowing policy under

1964conditions,inorderofurgency:

1. No borrowing to buy orholdsecurities.

2. No increase in theproportionof fundsheldincommonstocks.

3. Areductionincommon-stock holdings whereneeded to bring it downtoamaximumof50percent of the total

portfolio. The capital-gains tax must be paidwith as good grace aspossible, and theproceeds invested infirst-quality bonds orheld as a savingsdeposit.

Investors who for sometime have beenfollowing a bona fidedollar-cost averagingplan can in logic elect

either to continue theirperiodic purchasesunchangedortosuspendthem until they feel themarketlevelisnolongerdangerous. We shouldadvise rather stronglyagainsttheinitiationofanew dollar-averagingplan at the late 1964levels, since manyinvestorswouldnothavethe stamina to pursuesuch a scheme if the

results soon afterinitiation should appearhighlyunfavorable.

This time we can say thatour caution was vindicated.The DJIA advanced about11%further, to995,but thenfell irregularly to a low of632in1970,andfinishedthatyearat839.Thesamekindofdebacle took place in theprice of “hot issues”—i.e.,with declines running as

much as 90%—as hadhappened in the 1961–62setback. And, as pointed outintheIntroduction,thewholefinancial picture appeared tohavechangedinthedirectionoflessenthusiasmandgreaterdoubts. A single fact maysummarize the story: TheDJIA closed 1970 at a levellowerthansixyearsbefore—thefirsttimesuchathinghadhappenedsince1944.

Such were our efforts toevaluate former stock-marketlevels. Is there anything weand our readers can learnfrom them? We consideredthemarketlevelfavorableforinvestment in1948and1953(but too cautiously in thelatter year), “dangerous” in1959 (at 584 for DJIA), and“too high” (at 892) in 1964.All of these judgments couldbe defended even today byadroit arguments. But it is

doubtful if theyhavebeenasusefulasourmorepedestriancounsels—in favor of aconsistent and controlledcommon-stock policy on theone hand, and discouragingendeavors to “beat themarket” or to “pick thewinners”ontheother.

Nonetheless we think ourreaders may derive somebenefit from a renewedconsideration of the level of

the stock market—this timeasoflate1971—evenifwhatwe have to say will provemore interesting thanpractically useful, or moreindicative than conclusive.There is a fine passage nearthe beginning of Aristotle’sEthics that goes: “It is themarkof an educatedmind toexpect that amount ofexactnesswhichthenatureofthe particular subject admits.It is equally unreasonable to

accept merely probableconclusions from amathematicianandtodemandstrict demonstration from anorator.” The work of afinancial analyst fallssomewhere in the middlebetween that of amathematician and of anorator.

At various times in 1971the Dow Jones IndustrialAverage stood at the 892

level ofNovember 1964 thatweconsideredinourpreviousedition. But in the presentstatistical study we havedecidedtousethepriceleveland the related data for theStandard&Poor’scompositeindex(orS&P500),becauseitismorecomprehensiveandrepresentative of the generalmarket than the 30-stockDJIA. We shall concentrateon a comparison of thismaterialnearthefourdatesof

our former editions—namelythe year-ends of 1948, 1953,1958 and 1963—plus 1968;for thecurrentprice levelweshall take the convenientfigure of 100, which wasregistered at various times in1971 and in early 1972. Thesalient data are set forth inTable 3-3. For our earningsfigures we present both thelast year’s showing and theaverage of three calendaryears; for1971dividendswe

use the last twelve months’figures; and for 1971 bondinterest and wholesale pricesthoseofAugust1971.

The 3-year price/earningsratioforthemarketwaslowerinOctober1971thanatyear-end 1963 and 1968. It wasabout the same as in 1958,but much higher than in theearly years of the long bullmarket. This importantindicator, taken by itself,

could not be construed toindicate that the market wasespecially high in January1972. But when the interestyield on high-grade bonds isbrought into the picture, theimplications become muchless favorable. The readerwill note from our table thatthe ratio of stock returns(earnings/price) to bondreturns has grown worseduring the entire period, sothat the January 1972 figure

was less favorable to stocks,by this criterion, than in anyof the previous yearsexamined. When dividendyields are compared withbond yields we find that therelationship was completelyreversed between 1948 and1972.Intheearlyyearstocksyielded twice as much asbonds;nowbondsyieldtwiceas much, and more, thanstocks.

Our final judgment is thatthe adverse change in thebond-yield/stock-yield ratiofully offsets the betterprice/earnings ratio for late1971, based on the 3-yearearnings figures. Hence ourviewoftheearly1972marketlevel would tend to be thesame as itwas some 7 yearsago—i.e., that it is anunattractive one from thestandpoint of conservative

investment. (This wouldapply to most of the 1971price range of the DJIA:between,say,800and950.)

In terms of historicalmarket swings the 1971picture would still appear tobe one of irregular recoveryfromthebadsetbacksufferedin 1969–1970. In the pastsuch recoveries have usheredin a new stage of therecurrent and persistent bull

market that began in 1949.(This was the expectation ofWall Street generally during1971.) After the terribleexperience suffered by thepublic buyers of low-gradecommon-stock offerings inthe1968–1970cycle,itistooearly (in 1971) for anothertwirlof thenew-issuemerry-go-round. Hence thatdependable sign of imminentdanger in the market islacking now, as itwas at the

892 level of the DJIA inNovember 1964, consideredin our previous edition.Technically,then,theoutlookwouldappeartofavoranothersubstantialrisefarbeyondthe900 DJIA level before thenext serious setback orcollapse.Butwecannotquiteleave the matter there, asperhapsweshould.Tous,theearly-1971-market’sdisregard of the harrowingexperiences of less than a

year before is a disquietingsign. Can such heedlessnessgounpunished?Wethinktheinvestormustbepreparedfordifficult times ahead—perhapsintheformofafairlyquickreplayofthethe1969–1970 decline, or perhaps inthe form of another bull-market fling, to be followedby a more catastrophiccollapse.3

WhatCoursetoFollow

Turnback towhatwesaidinthelastedition,reproducedonp. 75.This is our view atthesamepricelevel—say900—for theDJIAinearly1972asitwasinlate1964.


You’ve got to be careful if youdon’t knowwhere you’re going,’causeyoumightnotgetthere.

—YogiBerra

Bull-MarketBaloney

In this chapter, Grahamshows how prophetic he canbe.Helookstwoyearsahead,foreseeing the “catastrophic”bearmarketof1973–1974,inwhichU.S.stockslost37%oftheir value.1 He also looksmore than two decades intothe future, eviscerating thelogic of market gurus andbest-selling books that werenotevenonthehorizoninhislifetime.

The heart of Graham’sargument is that theintelligent investor mustnever forecast the futureexclusively by extrapolatingthepast.Unfortunately,that’sexactly the mistake that onepundit after another made inthe1990s.Astreamofbullishbooks followed Whartonfinance professor JeremySiegel’s Stocks for the LongRun (1994)—culminating, inawildcrescendo,withJames

Glassman and KevinHassett’sDow36,000, DavidElias’ Dow 40,000, andCharles Kadlec’s Dow100,000 (all published in1999). Forecasters arguedthat stocks had returned anannual average of 7% afterinflation ever since 1802.Therefore, they concluded,that’s what investors shouldexpectinthefuture.

Some bulls went further.

Since stocks had “always”beatenbondsoveranyperiodof at least 30 years, stocksmustbelessriskythanbondsorevencashinthebank.Andif you can eliminate all theriskof owning stocks simplyby hanging on to them longenough, then why quibbleover how much you pay forthem in the first place? (Tofindoutwhy, see the sidebaronp.82.)

In 1999 and early 2000,bull-market baloney waseverywhere:

On December 7, 1999,Kevin Landis, portfoliomanageroftheFirsthandmutual funds, appearedon CNN’s Moneylinetelecast. Asked ifwirelesstelecommunicationstocks were overvalued

—with many trading atinfinitemultiplesoftheirearnings—Landis had areadyanswer.“It’snotamania,” he shot back.“Look at the outrightgrowth, the absolutevalueof thegrowth. It’sbig.”On January 18, 2000,Robert Froelich, chiefinvestment strategist atthe Kemper Funds,declared in the Wall

Street Journal: “It’s anewworldorder.Weseepeople discard all theright companieswith alltherightpeoplewiththerightvisionbecausetheirstockpriceistoohigh—that’s the worst mistakeaninvestorcanmake.”In the April 10, 2000,issue of BusinessWeek,Jeffrey M. Applegate,thenthechiefinvestmentstrategist at Lehman

Brothers, askedrhetorically: “Is thestock market riskiertodaythantwoyearsagosimply because pricesare higher? The answerisno.”

But the answer is yes. Italways has been. It alwayswillbe.

And when Graham asked,“Can such heedlessness go

unpunished?” he knew thatthe eternal answer to thatquestion is no. Like anenragedGreekgod, thestockmarketcrushedeveryonewhohad come to believe that thehighreturnsofthelate1990swere some kind of divineright. Just look at how thoseforecastsbyLandis,Froelich,andApplegateheldup:

From 2000 through

2002, themost stable ofLandis’s pet wirelessstocks, Nokia, lost“only” 67%—while theworst, WinstarCommunications, lost99.9%.Froelich’s favoritestocks—Cisco SystemsandMotorola—fellmorethan 70% by late 2002.Investors lost over $400billiononCiscoalone—more than the annual

economic output ofHong Kong, Israel,Kuwait, and Singaporecombined.In April 2000, whenApplegate asked hisrhetorical question, theDow Jones Industrialsstood at 11,187; theNASDAQ CompositeIndex was at 4446. Bythe end of 2002, theDow was hobblingaround the 8,300 level,

while NASDAQ hadwithered to roughly1300—eradicatingall itsgains over the previoussixyears.

SURVIVALOFTHEFATTEST

There was a fatal flaw inthe argument that stockshave “always” beatenbonds in the long run:Reliable figures before1871 do not exist. Theindexes used to representthe U.S. stock market’s

earliest returns contain asfew as seven (yes, 7!)stocks.1 By 1800,however, thereweresome300companiesinAmerica(many in the JeffersonianequivalentsoftheInternet:wooden turnpikes andcanals). Most wentbankrupt, and theirinvestors lost theirknickers.

But the stock indexesignore all the companiesthat went bust in thoseearly years, a problemtechnically known as“survivorship bias.” Thus

these indexes wildlyoverstate the resultsearned by real-lifeinvestors—wholackedthe20/20 hindsight necessaryto know exactly whichseven stocks to buy. Alonely handful ofcompanies, includingBankofNewYorkandJ.P. Morgan Chase, haveprospered continuouslysince the 1790s. But forevery such miraculoussurvivor, there werethousands of financialdisasters like the DismalSwamp Canal Co., thePennsylvania Cultivation

of Vines Co., and theSnickers’s Gap Turn-pikeCo.—all omitted from the“historical”stockindexes.

JeremySiegel’sdatashowthat, after inflation, from1802 through 1870 stocksgained 7.0% per year,bonds 4.8%, and cash5.1%. But Elroy Dimsonand his colleagues atLondon Business Schoolestimate that thepre-1871stock returns areoverstated by at least twopercentage points peryear.2 In the real world,then, stocks did no better

thancashandbonds—andperhaps a bit worse.Anyone who claims thatthe long-term record“proves” that stocks areguaranteed to outper-formsbondsor cash is anignoramus.

TheHighertheyGo,theHardertheyFall

As the enduring antidote tothis kind of bull-marketbaloney, Graham urges theintelligent investor to ask

some simple, skepticalquestions. Why should thefuture returns of stocksalways be the same as theirpast returns? When everyinvestorcomestobelievethatstocksareguaranteedtomakemoneyinthelongrun,won’tthe market end up beingwildly overpriced?And oncethat happens, how can futurereturnspossiblybehigh?

Graham’s answers, as

always, are rooted in logicandcommonsense.Thevalueof any investment is, andalwaysmustbe,afunctionofthe price you pay for it. Bythe late 1990s, inflation waswithering away, corporateprofits appeared to bebooming, and most of theworldwas at peace. But thatdid not mean—nor could itever mean—that stocks wereworth buying at any price.Since the profits that

companiescanearnarefinite,thepricethatinvestorsshouldbe willing to pay for stocksmustalsobefinite.

Think of it this way:Michael Jordan may wellhave been the greatestbasketball player of all time,and he pulled fans intoChicagoStadium likeagiantelectromagnet. The ChicagoBullsgotabargainbypayingJordan up to $34 million a

year to bounce a big leatherball around a wooden floor.But that does not mean theBulls would have beenjustified paying him $340million, or $3.4 billion, or$34billion,perseason.

TheLimitsofOptimism

Focusing on the market’srecentreturnswhentheyhavebeen rosy, warns Graham,

will lead to “a quite illogicaland dangerous conclusionthatequallymarvelousresultscould be expected forcommonstocksinthefuture.”From 1995 through 1999, asthe market rose by at least20% each year—a surgeunprecedented in Americanhistory—stock buyersbecameevermoreoptimistic:

In mid-1998, investors

surveyed by the GallupOrganization for thePaineWebber brokeragefirm expected theirportfolios to earn anaverage of roughly 13%over the year to come.By early 2000, theiraverage expected returnhadjumpedtomorethan18%.“Sophisticatedprofessionals” were justas bullish, jacking up

theirownassumptionsoffuture returns. In 2001,for instance, SBCCommunications raisedthe projected return onits pension plan from8.5% to9.5%.By2002,theaverageassumedrateof returnon thepensionplans of companies inthe Standard & Poor’s500-stock index hadswollen to a record-high9.2%.

Aquickfollow-upshowstheawfulaftermathofexcessenthusiasm:

Gallup found in 2001and 2002 that theaverage expectation ofone-year returns onstocks had slumped to7%—even thoughinvestorscouldnowbuyat prices nearly 50%

lowerthanin2000.2Those gung-hoassumptions about thereturns on their pensionplans will cost thecompanies in theS&P500 a bare minimum of$32 billion between2002 and 2004,accordingtorecentWallStreetestimates.

Even though investors allknowthey’resupposedtobuy

lowandsellhigh, inpracticethey often end up getting itbackwards. Graham’swarning in this chapter issimple: “By the rule ofopposites,” the moreenthusiasticinvestorsbecomeabout thestockmarket in thelong run, the more certainthey are to be proved wrongin the short run. On March24, 2000, the total value oftheU.S.stockmarketpeakedat$14.75trillion.ByOctober

9,2002,just30monthslater,the total U.S. stock marketwas worth $7.34 trillion, or50.2% less—a loss of $7.41trillion. Meanwhile, manymarket pundits turned sourlybearish, predicting flat oreven negativemarket returnsfor years—even decades—tocome.

At this point, Grahamwould ask one simplequestion: Considering how

calamitously wrong the“experts” were the last timethey agreed on something,why on earth should theintelligent investor believethemnow?

What’sNext?

Instead, let’s tune out thenoise and think about futurereturnsasGrahammight.Thestock market’s performance

dependsonthreefactors:

real growth (the rise ofcompanies’earningsanddividends)inflationary growth (thegeneral rise of pricesthroughout theeconomy)speculative growth—ordecline (any increase ordecreaseintheinvestingpublic’s appetite for

stocks)

In the long run, the yearlygrowth in corporate earningsper share has averaged 1.5%to 2% (not countinginflation).3As of early 2003,inflation was running around2.4% annually; the dividendyieldonstockswas1.9%.So,

Inthelongrun,thatmeansyou can reasonably expectstocks to average roughly a6% return (or 4% afterinflation). If the investingpublic gets greedy again andsends stocks back into orbit,then that speculative feverwill temporarilydrivereturnshigher. If, instead, investorsare full of fear, as theywerein the 1930s and 1970s, thereturns on stocks will gotemporarily lower. (That’s

wherewearein2003.)

Robert Shiller, a financeprofessor at Yale University,says Graham inspired hisvaluation approach: Shillercomparesthecurrentpriceofthe Standard & Poor’s 500-stock index against averagecorporateprofitsoverthepast10 years (after inflation). Byscanningthehistoricalrecord,Shiller has shown that whenhis ratio goeswell above 20,

the market usually deliverspoor returns afterward;whenitdropswellbelow10,stockstypically produce handsomegainsdowntheroad.Inearly2003, by Shiller’s math,stocks were priced at about22.8 times the averageinflation-adjusted earnings ofthe past decade—still in thedanger zone, but way downfrom their demented level of44.2 times earnings inDecember1999.

How has the market doneinthepastwhenitwaspricedaroundtoday’slevels?Figure3-1 shows the previousperiods when stocks were atsimilar highs, and how theyfared over the 10-yearstretchesthatfollowed:

FIGURE3-1

Sources:http://aida.econ.yale.edu/˜shiller/data/ie_data.htm;JackWilsonandCharlesJones,“AnAnalysisoftheS&P500IndexandCowles’Extensions:PriceIndexandStockReturns,1870–1999,”TheJournalofBusiness,vol.75,no.3,July,2002,pp.527–529;IbbotsonAssociates.

Notes:Price/earningsratioisShillercalculation(10-yearaveragerealearningsofS&P500-stockindexdividedbyDecember31indexvalue).Totalreturnisnominalannualaverage.

So, from valuation levelssimilartothoseofearly2003,the stock market hassometimes done verywell in

the ensuing 10 years,sometimes poorly, andmuddledalongtherestofthetime.IthinkGraham,evertheconservative, would split thedifferencebetweenthelowestand highest past returns andproject that over the nextdecade stocks will earnroughly 6% annually, or 4%after inflation. (Interestingly,that projection matches theestimatewe got earlierwhenwe added together real

growth, inflationary growth,and speculative growth.)Comparedtothe1990s,6%ischicken feed. But it’s awhisker better than the gainsthat bonds are likely toproduce—and reason enoughformostinvestorstohangonto stocks as part of adiversifiedportfolio.

Butthereisasecondlessonin Graham’s approach. Theonly thing you can be

confidentofwhileforecastingfuture stock returns is thatyouwillprobably turnout tobe wrong. The onlyindisputable truth that thepast teaches us is that thefuturewillalwayssurpriseus—always! And the corollarytothatlawoffinancialhistoryis that themarkets will mostbrutally surprise the verypeople who are most certainthat their views about thefuture are right. Staying

humble about yourforecasting powers, asGraham did, will keep youfrom risking too much on aview of the future that maywellturnouttobewrong.

So, by all means, youshould lower yourexpectations—but take carenottodepressyourspirit.Forthe intelligent investor, hopealways springs eternal,because it should. In the

financial markets, the worsethe future looks, the better itusually turns out to be. Acynic once told G. K.Chesterton, the Britishnovelist and essayist,“Blessedishewhoexpectethnothing, for he shall not bedisappointed.” Chesterton’srejoinder?“Blessedishewhoexpecteth nothing, for heshallenjoyeverything.”

Chapter4GeneralPortfolioPolicy:TheDefensiveInvestor

The basic characteristics ofan investment portfolio are

usually determined by thepositionandcharacteristicsofthe owner or owners.At oneextremewehavehadsavingsbanks, life-insurancecompanies, and so-calledlegal trust funds. Ageneration ago theirinvestments were limited bylaw in many states to high-grade bonds and, in somecases, high-grade preferredstocks. At the other extremewe have the well-to-do and

experienced businessman,whowill includeanykindofbond or stock in his securitylist provided he considers itanattractivepurchase.

It has been an old andsound principle that thosewho cannot afford to takerisksshouldbecontentwitharelatively low return on theirinvested funds. From thisthere has developed thegeneralnotionthattherateof

return which the investorshouldaimforismoreorlessproportionatetothedegreeofrisk he is ready to run. Ourview is different.The rate ofreturn sought should bedependent, rather, on theamount of intelligent effortthe investor is willing andable to bring to bear on histask. The minimum returngoes to our passive investor,who wants both safety andfreedom from concern. The

maximum return would berealized by the alert andenterprising investor whoexercises maximumintelligenceandskill.In1965we added: “In many casesthere may be less real riskassociated with buying a‘bargain issue’ offering thechance of a large profit thanwith a conventional bondpurchase yielding about 4½%.”This statementhadmoretruth in it than we ourselves

suspected, since insubsequent years even thebest long-term bonds lost asubstantial part of theirmarket value because of theriseininterestrates.

TheBasicProblemofBond-StockAllocation

We have already outlinedin briefest form the portfoliopolicy of the defensiveinvestor.* He should divide

his fundsbetweenhigh-gradebonds and high-gradecommonstocks.

We have suggested as afundamentalguidingrulethatthe investor should neverhave less than 25% or morethan 75% of his funds incommon stocks, with aconsequent inverse range ofbetween 75% and 25% inbonds. There is animplication here that the

standard division should bean equal one, or 50–50,between the two majorinvestment mediums.According to tradition thesound reason for increasingthe percentage in commonstocks would be theappearance of the “bargainprice” levels created in aprotracted bear market.Conversely, sound procedurewould call for reducing thecommon-stock component

below 50% when in thejudgment of the investor themarket level has becomedangerouslyhigh.

These copybook maximshave always been easy toenunciateandalwaysdifficultto follow—because they goagainst that very humannature which produces thatexcesses of bull and bearmarkets. It is almost acontradiction in terms to

suggest as a feasible policyfor the average stockownerthat he lighten his holdingswhen the market advancesbeyond a certain point andadd to them after acorresponding decline. It isbecause the average manoperates,andapparentlymustoperate, in opposite fashionthat we have had the greatadvancesandcollapsesofthepast; and—this writerbelieves—we are likely to

havetheminthefuture.

If the division betweeninvestment and speculativeoperationswereasclearnowas once it was, we might beabletoenvisageinvestorsasashrewd, experienced groupwho sell out to the heedless,hapless speculators at highprices and buy back fromthematdepressedlevels.Thispicture may have had someverisimilitude in bygone

days,butitishardtoidentifyit with financialdevelopments since 1949.There is no indication thatsuch professional operationsas those of the mutual fundshave been conducted in thisfashion. The percentage ofthe portfolio held in equitiesby the two major types offunds—“balanced” and“common-stock”—haschangedvery little fromyearto year. Their selling

activities have been largelyrelatedtoendeavorstoswitchfrom less to more promisingholdings.

If, as we have longbelieved,thestockmarkethaslost contact with its oldbounds,andifnewoneshavenotyetbeenestablished,thenwe can give the investor noreliable rules by which toreduce his common-stockholdings toward the 25%

minimum and rebuild themlater to the 75% maximum.We can urge that in generalthe investor should not havemorethanone-halfinequitiesunless he has strongconfidence in the soundnessof his stock position and issure that he could view amarket decline of the 1969–70typewithequanimity.Itishard for us to see how suchstrong confidence can bejustifiedat thelevelsexisting

inearly1972.Thuswewouldcounselagainstagreaterthan50% apportionment tocommon stocks at this time.But, for complementaryreasons, it is almost equallydifficulttoadviseareductionofthefigurewellbelow50%,unless the investor isdisquieted in his own mindabout the current marketlevel, and will be satisfiedalso to limit his participationin any further rise to, say,

25%ofhistotalfunds.

We are thus led to putforward for most of ourreaders what may appear tobe an oversimplified 50–50formula. Under this plan theguidingruleis tomaintainasnearlyaspracticableanequaldivision between bond andstock holdings. Whenchanges in the market levelhave raised the common-stock component to, say,

55%, the balance would berestored by a sale of one-eleventhofthestockportfolioand the transfer of theproceeds to bonds.Conversely, a fall in thecommon-stock proportion to45%wouldcallfortheuseofone-eleventhofthebondfundtobuyadditionalequities.

YaleUniversityfollowedasomewhat similar plan for anumber of years after 1937,

but it was geared around a35% “normal holding” incommon stocks. In the early1950s, however, Yale seemsto have given up its oncefamous formula, and in 1969held 61% of its portfolio inequities (including someconvertibles). (At that timethe endowment funds of 71suchinstitutions,totaling$7.6billion, held 60.3% incommon stocks.) The Yaleexampleillustratesthealmost

lethal effect of the greatmarket advance upon theonce popular formulaapproach to investment.Nonetheless we areconvinced that our 50–50version of this approachmakes good sense for thedefensive investor. It isextremely simple; it aimsunquestionably in the rightdirection; it gives thefollowerthefeelingthatheisat least making some moves

in response to marketdevelopments; mostimportant of all, it willrestrain him from beingdrawnmoreandmoreheavilyinto common stocks as themarket rises to more andmoredangerousheights.

Furthermore, a trulyconservative investor will besatisfiedwiththegainsshownon half his portfolio in arising market, while in a

severedeclinehemayderivemuch solace from reflectinghow much better off he isthan many of his moreventuresomefriends.

While our proposed 50–50division is undoubtedly thesimplest “all-purposeprogram” devisable, it maynot turnout tobe thebest intermsofresultsachieved.(Ofcourse, no approach,mechanical or otherwise, can

be advanced with anyassurancethatitwillworkoutbetter than another.) Themuch larger income returnnow offered by good bondsthan by representative stocksis a potent argument forfavoringthebondcomponent.The investor’s choicebetween 50% or a lowerfigureinstocksmaywellrestmainly on his owntemperament and attitude. Ifhe can act as a cold-blooded

weigher of the odds, hewould be likely to favor thelow25%stockcomponentatthis time, with the idea ofwaiting until the DJIAdividendyieldwas,say, two-thirds of the bond yieldbeforehewouldestablishhismedian 50–50 divisionbetween bonds and stocks.Starting from 900 for theDJIAanddividendsof$36onthe unit, this would requireeither a fall in taxable bond

yields from 7½% to about5.5% without any change inthe present return on leadingstocks,orafallintheDJIAtoas low as 660 if there is noreduction in bond yields andno increase in dividends. Acombination of intermediatechanges could produce thesame “buying point.” Aprogram of that kind is notespecially complicated; thehardpartistoadoptitandtostick to it not tomention the

possibilitythatitmayturnoutto have been much tooconservative.

TheBondComponent

Thechoiceof issuesinthebond component of theinvestor’s portfolio will turnabout two main questions:Shouldhebuytaxableortax-freebonds,andshouldhebuyshorter- or longer-termmaturities? The tax

decision should be mainly amatter of arithmetic, turningon thedifference inyieldsascomparedwith the investor’stax bracket. In January 1972the choice in 20-yearmaturities was betweenobtaining, say, 7½% on“grade Aa” corporate bondsand 5.3% on prime tax-freeissues. (The term“municipals” is generallyapplied to all species of tax-exemptbonds,includingstate

obligations.) There was thusfor this maturity a loss inincome of some 30% inpassingfromthecorporatetothemunicipal field.Hence ifthe investor was in amaximum tax bracket higherthan30%hewouldhaveanetsaving after taxes bychoosing the municipalbonds; the opposite, if hismaximum tax was less than30%. A single person startspaying a 30% rate when his

income after deductionspasses$10,000;foramarriedcouple the rate applies whencombined taxable incomepasses $20,000. It is evidentthat a large proportion ofindividual investors wouldobtain a higher return aftertaxes from good municipalsthan from good corporatebonds.

The choice of longerversus shorter maturities

involves quite a differentquestion, viz.: Does theinvestor want to assurehimself against a decline inthepriceofhisbonds,but atthecostof(1)alowerannualyield and (2) loss of thepossibility of an appreciablegain in principal value? Wethink it best to discuss thisquestion in Chapter 8, TheInvestor and MarketFluctuations.

Foraperiodofmanyyearsin the past the only sensiblebond purchases forindividuals were the U.S.savings issues. Their safetywas—and is—unquestioned;theygaveahigherreturnthanother bond investments offirst quality; they had amoney-backoptionandotherprivileges which addedgreatlytotheirattractiveness.Inourearliereditionswehadan entire chapter entitled

“U.S. Savings Bonds: ABoontoInvestors.”

Asweshallpointout,U.S.savings bonds still possesscertain unique merits thatmake them a suitablepurchase by any individualinvestor. For the man ofmodest capital—with, say,notmorethan$10,000toputinto bonds—we think theyare still the easiest and thebest choice. But those with

larger funds may find othermediumsmoredesirable.

Let us list a few majortypes of bonds that deserveinvestor consideration, anddiscuss them briefly withrespecttogeneraldescription,safety, yield, market price,risk, income-tax status, andotherfeatures.

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

shall first summarize theirimportant provisions, andthen discuss briefly thenumerousadvantagesoftheseunique, attractive, andexceedingly convenientinvestments. The Series Hbonds pay interest semi-annually, as do other bonds.Therateis4.29%forthefirstyear, and then a flat 5.10%for the next nine years tomaturity. Interest on theSeries E bonds is not paid

out,butaccruestotheholderthrough increase inredemption value.The bondsare sold at 75%of their facevalue,andmatureat100%in5 years 10 months afterpurchase. If held to maturitythe yield works out at 5%,compounded semi-annually.If redeemed earlier, the yieldmovesupfromaminimumof4.01% in the first year to anaverageof5.20% in thenext45/6years.

Interest on the bonds issubjecttoFederalincometax,but is exempt from stateincometax.However,Federalincome tax on the Series Ebonds may be paid at theholder’s option eitherannually as the interestaccrues (through higherredemption value), or notuntil the bond is actuallydisposedof.

Owners of Series E bonds

maycashtheminatanytime(shortly after purchase) attheir current redemptionvalue. Holders of Series Hbonds have similar rights tocash them in at par value(cost). Series E bonds areexchangeable for Series Hbonds, with certain taxadvantages. Bonds lost,destroyed, or stolen may bereplaced without cost. Thereare limitations on annualpurchases, but liberal

provisions for co-ownershipby family members make itpossibleformostinvestorstobuy as many as they canafford.Comment:Thereisnoother investment thatcombines (1) absoluteassurance of principal andinterest payments, (2) theright to demand full “moneyback” at any time, and (3)guarantee of at least a 5%interest rate for at least tenyears. Holders of the earlier

issuesofSeriesEbondshavehad the right to extend theirbondsatmaturity,andthustocontinue to accumulateannual values at successivelyhigher rates. The deferral ofincome-tax payments overtheselongperiodshasbeenofgreat dollar advantage; wecalculate it has increased theeffective net-after-tax ratereceived by as much as athird in typical cases.Conversely, the right to cash

in the bonds at cost price orbetter has given thepurchasersinformeryearsoflow interest rates completeprotection against theshrinkage in principal valuethat befell many bondinvestors; otherwise stated, itgave them the possibility ofbenefiting from the rise ininterest rates by switchingtheir low-interest holdingsinto very-high-coupon issuesonaneven-moneybasis.

In our view the specialadvantages enjoyed byownersofsavingsbondsnowwill more than compensatefor their lower current returnascomparedwithotherdirectgovernmentobligations.

2. OTHER UNITED STATESBONDS. Aprofusion of theseissuesexists,coveringawidevariety of coupon rates andmaturity dates. All of them

are completely safe withrespecttopaymentofinterestand principal. They aresubject to Federal incometaxes but free from stateincome tax. In late 1971 thelong-term issues—over tenyears—showed an averageyield of 6.09%, intermediateissues (three to five years)returned 6.35%, and shortissuesreturned6.03%.

In 1970 it was possible to

buyanumberofoldissuesatlarge discounts. Some ofthese are accepted at par insettlement of estate taxes.Example: The U.S. Treasury3½s due 1990 are in thiscategory; they sold at 60 in1970, but closed 1970 above77.

Itisinterestingtonotealsothat in many cases theindirect obligations of theU.S. government yield

appreciably more than itsdirectobligationsofthesamematurity. As we write, anoffering appears of 7.05%of“Certificates FullyGuaranteed by the Secretaryof Transportation of theDepartmentofTransportationof the United States.” Theyieldwasfully1%morethanthat on direct obligations ofthe U.S., maturing the sameyear (1986). The certificateswere actually issued in the

name of the Trustees of thePenn Central TransportationCo.,buttheyweresoldonthebasis of a statement by theU.S. Attorney General thatthe guarantee “brings intobeing a general obligation ofthe United States, backed byitsfullfaithandcredit.”Quitea number of indirectobligations of this sort havebeen assumed by the U.S.government in the past, andall of them have been

scrupulouslyhonored.

The reader may wonderwhy all this hocus-pocus,involving an apparently“personal guarantee” by ourSecretary of Transportation,and a higher cost to thetaxpayerintheend.Thechiefreasonfor the indirectionhasbeen the debt limit imposedon government borrowing bythe Congress. Apparentlyguaranteesbythegovernment

are not regarded as debts—asemantic windfall forshrewder investors. Perhapsthe chief impact of thissituation has been thecreation of tax-free HousingAuthoritybonds,enjoyingtheequivalent of a U.S.guarantee, and virtually theonly tax-exempt issues thatare equivalent to governmentbonds. Another type ofgovernment-backed issues isthe recently created New

Community Debentures,offered to yield 7.60% inSeptember1971.

3. STATE AND MUNICIPALBONDS. These enjoyexemption from Federalincome tax. They are alsoordinarily free of income taxin the state of issue but notelsewhere. They are eitherdirectobligationsofastateorsubdivision, or “revenue

bonds”dependent for interestpayments on receipts from atoll road, bridge, buildinglease, etc. Not all tax-freebonds are strongly enoughprotected to justify theirpurchase by a defensiveinvestor.Hemaybeguidedinhis selection by the ratinggiven to each issue byMoody’s or Standard &Poor’s. One of three highestratingsbybothservices—Aaa(AAA), Aa (AA), or A—

should constitute a sufficientindicationofadequatesafety.Theyieldonthesebondswillvarybothwiththequalityandthematurity,with the shortermaturities giving the lowerreturn.Inlate1971theissuesrepresented in Standard &Poor’s municipal bond indexaveraged AA in qualityrating, 20 years in maturity,and5.78%inyield.Atypicaloffering of Vineland, N.J.,bonds, rated AA for A and

gave a yield of only 3% onthe one-year maturity, risingto5.8%tothe1995and1996maturities.1

4. CORPORATION BONDS.These bonds are subject tobothFederalandstate tax.Inearly 1972 those of highestquality yielded 7.19% for a25-yearmaturity,as reflectedin the published yield ofMoody’sAaacorporatebond

index. The so-called lower-medium-grade issues—ratedBaa—returned 8.23% forlongmaturities. Ineachclassshorter-term issues wouldyield somewhat less thanlonger-termobligations.

Comment. The abovesummaries indicate that theaverage investor has severalchoices among high-gradebonds.Thoseinhighincome-tax brackets can undoubtedly

obtainabetternetyieldfromgood tax-free issues thanfromtaxableones.Forothersthe early 1972 range oftaxable yield would seem tobe from 5.00% on U.S.savings bonds, with theirspecialoptions,toabout7½%on high-grade corporateissues.

Higher-Yielding BondInvestments

By sacrificing quality aninvestor can obtain a higherincomereturnfromhisbonds.Long experience hasdemonstrated that theordinary investor is wiser tokeep away from such high-yieldbonds.While,takenasawhole, they may work outsomewhat better in terms ofoverall return than the first-quality issues, they exposethe owner to too manyindividual risks of untoward

developments, ranging fromdisquieting price declines toactual default. (It is true thatbargain opportunities occurfairly often in lower-gradebonds, but these requirespecial study and skill toexploitsuccessfully.)*

Perhaps we should addhere that the limits imposedby Congress on direct bondissues of the United Stateshave produced at least two

sorts of “bargainopportunities”forinvestorsinthe purchase of government-backed obligations. One isprovided by the tax-exempt“New Housing” issues, andthe other by the recentlycreated (taxable) “NewCommunity debentures.” Anoffering of New HousingissuesinJuly1971yieldedashighas5.8%, free frombothFederalandstatetaxes,whilean issue of (taxable) New

Community debentures soldin September 1971 yielded7.60%.Bothobligationshavethe “full faith and credit” oftheUnitedStatesgovernmentbehind them and hence aresafewithoutquestion.And—on a net basis—they yieldconsiderably more thanordinary United Statesbonds.†

SavingsDepositsinLieuofBonds

An investor may nowobtainashighaninterestratefrom a savings deposit in acommercial or savings bank(or fromabankcertificateofdeposit) as he can from afirst-grade bond of shortmaturity.The interest rateonbank savings accounts maybe lowered in the future, butunderpresentconditions theyare a suitable substitute forshort-term bond investmentbytheindividual.

ConvertibleIssues

These are discussed inChapter 16. The pricevariabilityofbondsingeneralis treated in Chapter 8, TheInvestor and MarketFluctuations.

CallProvisions

Inpreviouseditionswehadafairlylongdiscussionofthisaspect of bond financing,

because it involved a seriousbut little noticed injustice tothe investor. In the typicalcase bonds were callablefairlysoonafterissuance,andatmodestpremiums—say5%—above the issueprice.Thismeant thatduringaperiodofwide fluctuations in theunderlying interest rates theinvestor had to bear the fullbrunt of unfavorable changesandwasdeprivedofallbutameager participation in

favorableones.

EXAMPLE: Our standardexamplehasbeentheissueofAmerican Gas & Electric100-year5%debentures,soldto the public at 101 in 1928.Four years later, under near-panicconditions, thepriceofthesegoodbondsfellto62½,yielding 8%. By 1946, in agreat reversal, bonds of thistype could be sold to yieldonly 3%, and the 5% issue

should have been quoted atcloseto160.Butatthatpointthe company took advantageof the call provision andredeemed the issueatamere106.

The call feature in thesebond contracts was a thinlydisguisedinstanceof“headsIwin, tails you lose.” At longlast, the bond-buyinginstitutions refused to acceptthis unfair arrangement; in

recent years most long-termhigh-couponissueshavebeenprotected against redemptionfor ten years or more afterissuance.Thisstilllimitstheirpossible price rise, but notinequitably.

In practical terms, weadvise the investor in long-term issues to sacrifice asmall amount of yield toobtain the assurance ofnoncallability—say for 20 or

25 years. Similarly, there isanadvantageinbuyingalow-coupon bond* at a discountrather than a high-couponbondsellingataboutparandcallable in a few years. Forthediscount—e.g.,ofa3½%bond at 63½%, yielding7.85%—carries fullprotection against adversecallaction.

Straight—i.e.,Nonconvertible—PreferredStocks

Certain generalobservations should bemadehere on the subject ofpreferredstocks.Reallygoodpreferred stocks can and doexist, but they are good inspite of their investmentform, which is an inherentlybadone.Thetypicalpreferredshareholder is dependent forhis safety on the ability anddesireof thecompany topaydividends on its commonstock. Once the common

dividends are omitted, oreven in danger, his ownposition becomes precarious,for thedirectorsareundernoobligation to continuepayinghim unless they also pay onthe common. On the otherhand, the typical preferredstock carries no share in thecompany’sprofitsbeyondthefixed dividend rate. Thus thepreferred holder lacks boththe legal claim of thebondholder (or creditor) and

the profit possibilities of acommon shareholder (orpartner).

These weaknesses in thelegal position of preferredstocks tend to come to thefore recurrently in periods ofdepression. Only a smallpercentage of all preferredissues are so stronglyentrenched as tomaintain anunquestioned investmentstatusthroughallvicissitudes.

Experience teaches that thetime to buy preferred stocksiswhen their price is undulydepressed by temporaryadversity.(Atsuchtimestheymay be well suited to theaggressive investor but toounconventional for thedefensiveinvestor.)

Inotherwords,theyshouldbe bought on a bargain basisor not at all. We shall referlater to convertible and

similarly privileged issues,which carry some specialpossibilities of profits. Thesearenotordinarilyselectedforaconservativeportfolio.

Another peculiarity in thegeneral position of preferredstocks deserves mention.They have amuch better taxstatus for corporation buyersthan for individual investors.Corporations pay income taxon only 15% of the income

theyreceiveindividends,buton the full amount of theirordinary interest income.Sincethe1972corporaterateis48%, thismeans that $100received as preferred-stockdividendsistaxedonly$7.20,whereas $100 received asbondinterestistaxed$48.Onthe other hand, individualinvestors pay exactly thesame tax on preferred-stockinvestments as on bondinterest, except for a recent

minor exemption. Thus, instrict logic, all investment-gradepreferredstocksshouldbe bought by corporations,just as all tax-exempt bondsshouldbeboughtbyinvestorswhopayincometax.*

SecurityForms

The bond form and thepreferred-stock form, ashitherto discussed, are well-understood and relatively

simplematters.Abondholderis entitled to receive fixedinterest and payment ofprincipal on a definite date.The owner of a preferredstock is entitled to a fixeddividend,andnomore,whichmust be paid before anycommon dividend. Hisprincipalvaluedoesnotcomedue on any specified date.(The dividend may becumulativeornoncumulative.He may or may not have a

vote.)

The above describes thestandard provisions and, nodoubt, the majority of bondandpreferredissues,butthereare innumerable departuresfrom these forms. The best-known types are convertibleand similar issues, andincome bonds. In the lattertype,interestdoesnothavetobepaidunless it isearnedbythe company. (Unpaid

interestmay accumulate as acharge against futureearnings, but the period isoftenlimitedtothreeyears.)

Income bonds should beused by corporations muchmore extensively than theyare. Their avoidanceapparentlyarisesfromamereaccident of economic history—namely,thattheywerefirstemployed in quantity inconnection with railroad

reorganizations, and hencethey have been associatedfrom the start with financialweakness and poorinvestment status. But theform itself has severalpractical advantages,especiallyincomparisonwithand in substitution for thenumerous (convertible)preferred-stock issues ofrecentyears.Chiefoftheseisthe deductibility of theinterest paid from the

company’s taxable income,which in effect cuts the costofthatformofcapitalinhalf.From the investor’sstandpoint it is probably bestforhiminmostcases thatheshould have (1) anunconditional right to receiveinterest payments when theyare earned by the company,and(2)arighttootherformsofprotectionthanbankruptcyproceedings if interest is notearnedandpaid.Thetermsof

incomebondscanbetailoredto the advantage of both theborrowerandthelenderinthemanner best suited to both.(Conversion privileges can,of course, be included.) Theacceptance by everybody ofthe inherently weakpreferred-stock form and therejection of the strongerincome-bond form is afascinating illustration of theway in which traditionalinstitutions and habits often

tendtopersistonWallStreetdespite new conditionscalling for a fresh point ofview. With every new waveofoptimismorpessimism,weare ready to abandon historyand time-tested principles,but we cling tenaciously andunquestioningly to ourprejudices.


When you leave it to chance,then all of a sudden you don’thaveanymoreluck.

—BasketballcoachPatRiley

Howaggressive shouldyourportfoliobe?

That, says Graham,dependslessonwhatkindsofinvestmentsyouownthanonwhatkindofinvestoryouare.There are twoways to be anintelligentinvestor:

by continuallyresearching, selecting,and monitoring adynamic mix of stocks,bonds,ormutualfunds;or by creating a

permanent portfolio thatruns on autopilot andrequiresnofurthereffort(butgeneratesvery littleexcitement).

Graham calls the firstapproach “active” or“enterprising”;ittakeslotsoftimeandloadsofenergy.The“passive” or “defensive”strategy takes little time oreffort but requires an almostascetic detachment from the

alluring hullabaloo of themarket. As the investmentthinker Charles Ellis hasexplained, the enterprisingapproach is physically andintellectually taxing, whilethe defensive approach isemotionallydemanding.1

If you have time to spare,are highly competitive, thinklikeasports fan,andrelishacomplicated intellectualchallenge, then the active

approach is up your alley. Ifyoualwaysfeelrushed,cravesimplicity, and don’t relishthinking about money, thenthe passive approach is foryou. (Some people will feelmost comfortable combiningboth methods—creating aportfoliothatismainlyactiveand partly passive, or viceversa.)

Both approaches areequally intelligent, and you

can be successfulwith either—but only if you knowyourself well enough to pickthe right one, stick with itover the course of yourinvesting lifetime, and keepyour costs and emotionsunder control. Graham’sdistinction between activeand passive investors isanother of his reminders thatfinancial risk lies not onlywheremost of us look for it—in the economy or in our

investments—but also withinourselves.

CanYoubeBrave,orwillYouCave?

How, then, should adefensive investor getstarted? The first and mostbasicdecisionishowmuchtoput in stocks and how muchto put in bonds and cash.(Note that Grahamdeliberately places this

discussion after his chapteron inflation, forearming youwith the knowledge thatinflationisoneofyourworstenemies.)

The most striking thingaboutGraham’sdiscussionofhow to allocate your assetsbetween stocks and bonds isthat he never mentions theword “age.” That sets hisadvice firmly against thewinds of conventional

wisdom—which holds thathowmuch investing riskyououghttotakedependsmainlyon how old you are.2 Atraditional ruleof thumbwastosubtractyouragefrom100and invest that percentage ofyourassetsinstocks,withtherest inbondsor cash. (A28-year-old would put 72% ofher money in stocks; an 81-year-oldwouldputonly19%there.) Like everything else,

these assumptions gotoverheated in the late 1990s.By 1999, a popular bookargued that if you wereyounger than 30 you shouldput 95% of your money instocks—evenifyouhadonlya “moderate” tolerance forrisk!3

Unless you’ve allowed theproponents of this advice tosubtract 100 from your IQ,youshouldbeabletotellthat

something is wrong here.Why should your agedeterminehowmuchriskyoucan take? An 89-year-oldwith $3 million, an amplepension, and a gaggle ofgrandchildren would befoolish to move most of hermoney into bonds. Shealreadyhasplentyofincome,and her grandchildren (whowill eventually inherit herstocks) have decades ofinvesting ahead of them. On

the other hand, a 25-year-oldwhoissavingforhisweddingand a house down paymentwould be out of his mind toputallhismoneyinstocks.Ifthe stock market takes anAcapulco high dive, he willhavenobondincometocoverhis downside—or hisbackside.

What’s more, no matterhow young you are, youmight suddenlyneed to yank

yourmoneyoutofstocksnot40 years from now, but 40minutesfromnow.Withoutawhiff of warning, you couldlose your job, get divorced,become disabled, or sufferwho knows what other kindof surprise. The unexpectedcanstrikeanyone,atanyage.Everyone must keep someassetsintherisklesshavenofcash.

Finally, many people stop

investing precisely becausethe stockmarket goes down.Psychologists have shownthatmostofusdoaverypoorjob of predicting today howwe will feel about anemotionally charged event inthe future.4 When stocks aregoingup15%or20%ayear,as they did in the 1980s and1990s, it’s easy to imaginethat you and your stocks aremarried for life. But when

you watch every dollar youinvestedgettingbasheddownto a dime, it’s hard to resistbailing out into the “safety”ofbondsandcash.Insteadofbuying and holding theirstocks, many people end upbuyinghigh,selling low,andholdingnothingbuttheirownhead in their hands. Becausesofewinvestorshavethegutstocling to stocks in a fallingmarket, Graham insists thateveryone should keep a

minimum of 25% in bonds.That cushion, he argues,willgiveyou thecourage tokeepthe rest of your money instocks even when stocksstink.

Togetabetterfeelforhowmuchriskyoucantake,thinkabout the fundamentalcircumstances of your life,whentheywillkickin,whenthey might change, and howthey are likely to affect your

needforcash:

Are you single ormarried? What doesyour spouse or partnerdoforaliving?Doyouorwillyouhavechildren?Whenwill thetuitionbillshithome?Will you inheritmoney,or will you end upfinancially responsibleforaging,ailingparents?

What factors might hurtyour career? (If youwork for a bank or ahomebuilder, a jump ininterest rates could putyou out of a job. If youwork for a chemicalmanufacturer,soaringoilprices could be badnews.)If you are self-employed, how long dobusinesses similar toyourstendtosurvive?

Do you need yourinvestments tosupplement your cashincome? (In general,bonds will; stockswon’t.)Given your salary andyour spending needs,how much money canyou afford to lose onyourinvestments?

If, after considering thesefactors,youfeelyoucantake

the higher risks inherent ingreater ownership of stocks,you belong aroundGraham’sminimumof25%inbondsorcash.Ifnot,thensteermostlyclearofstocks,edgingtowardGraham’s maximum of 75%inbondsorcash.(Tofindoutwhether you can go up to100%, see the sidebar on p.105.)

Once you set these targetpercentages, change them

only as your lifecircumstanceschange.Donotbuymore stocks because thestockmarkethasgoneup;donot sell them because it hasgonedown.TheveryheartofGraham’s approach is toreplace guesswork withdiscipline. Fortunately,throughyour401(k),it’seasyto put your portfolio onpermanent autopilot. Let’ssayyouarecomfortablewitha fairly high level of risk—

say, 70% of your assets instocks and 30% in bonds. Ifthe stock market rises 25%(but bonds stay steady), youwillnowhavejustunder75%in stocks and only 25% inbonds.5 Visit your 401(k)’swebsite (or call its toll-freenumber) and sell enough ofyour stock funds to“rebalance”backtoyour70–30 target. The key is torebalance on a predictable,

patient schedule—not sooften that you will driveyourself crazy, and not soseldom that your targets willget out of whack. I suggestthat you rebalance every sixmonths,nomoreandnoless,on easy-to-remember dateslike New Year’s and theFourthofJuly.

WHYNOT100%STOCKS?

Grahamadvisesyounevertohavemorethan75%of

yourtotalassetsinstocks.But is putting all yourmoney into the stockmarket inadvisable foreveryone? For a tinyminority of investors, a100%-stock portfoliomaymake sense. You are oneofthemifyou:

have set aside enough cash tosupport your family for at leastoneyearwill be investing steadily for atleast20yearstocomesurvived the bear market that

beganin2000did not sell stocks during thebearmarketthatbeganin2000bought more stocks during thebearmarketthatbeganin2000havereadChapter8inthisbookand implemented a formal planto control your own investingbehavior.

Unless you can honestlypass all these tests, youhave no business puttingall your money in stocks.Anyone who panicked in

the last bear market isgoing topanic in thenextone—and will regrethavingnocushionofcashandbonds.

Thebeautyofthisperiodicrebalancing is that it forcesyou to base your investingdecisions on a simple,objectivestandard—DoInowown more of this asset thanmy plan calls for?—insteadof the sheer guesswork ofwhere interest rates are

headingorwhetheryouthinkthe Dow is about to dropdead. Some mutual-fundcompanies, including T.Rowe Price, may soonintroduce services that willautomatically rebalance your401(k) portfolio to yourpreset targets, so you willneverneedtomakeanactivedecision.

TheInsandOutsofIncomeInvesting

In Graham’s day, bondinvestors faced two basicchoices: Taxable or tax-free?Short-term or long-term?Todaythereisa third:Bondsorbondfunds?

Taxable or tax-free?Unless you’re in the lowesttax bracket,6 you should buyonly tax-free (municipal)bondsoutsideyourretirementaccounts. Otherwise toomuch of your bond income

will end up in the hands ofthe IRS. The only place toown taxable bonds is insideyour 401(k) or anothersheltered account,where youwill owe no current tax ontheir income—and wheremunicipal bonds have noplace, since their taxadvantagegoestowaste.7

Short-termorlong-term?Bondsandinterestratesteeteronoppositeendsofaseesaw:

If interest rates rise, bondprices fall—althougha short-termbondfallsfarlessthanalong-termbond.On theotherhand, if interest rates fall,bondpricesrise—andalong-term bond will outper-formsshorter ones.8 You can splitthe difference simply bybuying intermediate-termbondsmaturing in five to 10years—which do not soarwhentheirsideoftheseesaw

rises,butdonotslamintotheground either. For mostinvestors, intermediate bondsare thesimplestchoice,sincetheyenableyou togetoutofthe game of guessing whatinterestrateswilldo.

Bonds or bond funds?Since bonds are generallysold in $10,000 lots and youneed a bare minimum of 10bonds to diversify away therisk that any one of them

might go bust, buyingindividual bonds makes nosenseunlessyouhaveatleast$100,000toinvest.(Theonlyexception is bonds issued bythe U.S. Treasury, sincethey’re protected againstdefaultbythefullforceoftheAmericangovernment.)

Bond funds offer cheapand easy diversification,alongwiththeconvenienceofmonthly income, which you

can reinvest right back intothe fund at current rateswithoutpayingacommission.For most investors, bondfunds beat individual bondshands down (the mainexceptions are Treasurysecuritiesandsomemunicipalbonds). Major firms likeVanguard, Fidelity, Schwab,and T. Rowe Price offer abroadmenuofbond fundsatlowcost.9

The choices for bondinvestors have proliferatedlike rabbits, so let’s updateGraham’s list of what’savailable.Asof2003,interestrates have fallen so low thatinvestors are starved foryield, but there are ways ofamplifying your interestincome without taking onexcessive risk.10 Figure 4-1summarizes the pros andcons.

Now let’s look at a fewtypes of bond investmentsthatcanfillspecialneeds.

CashisnotTrash

How can you wring moreincomeoutofyourcash?Theintelligent investor shouldconsidermoving out of bankcertificates of deposit ormoney-market accounts—which have offered meager

returns lately—into some ofthesecashalternatives:

Treasury securities, asobligations of the U.S.government, carry virtuallyno credit risk—since, insteadof defaulting on his debts,Uncle Sam can just jack uptaxesorprintmoremoneyatwill.Treasurybillsmature infour, 13, or 26 weeks.Because of their very shortmaturities, T-bills barely get

dented when rising interestrates knock down the pricesof other income investments;longer-term Treasury debt,however, suffers severelywhen interest rates rise. Theinterest income on Treasurysecurities is generally freefrom state (but not Federal)income tax. And, with $3.7trillion in public hands, themarket for Treasury debt isimmense, so you can readilyfindabuyerifyouneedyour

money back before maturity.You can buy Treasury bills,short-term notes, and long-term bonds directly from thegovernment, with nobrokerage fees, atwww.publicdebt.treas.gov.(For more on inflation-protected TIPS, see thecommentaryonChapter2.)

FIGURE 4-1 The WideWorldofBonds

Sources:Bankrate.com,Bloomberg,LehmanBrothers,MerrillLynch,Morningstar,www.savingsbonds.gov

Notes:(D):purchaseddirectly.(F):purchasedthroughamutualfund.“Easeofsalebeforematurity”indicateshowreadilyyoucansellatafairpricebeforematuritydate;mutualfundstypicallyofferbettereaseofsalethanindividualbonds.Money-marketfundsareFederallyinsuredupto$100,000ifpurchasedatanFDIC-memberbank,butotherwisecarryonlyanimplicitpledgenottolosevalue.Federalincometaxonsavingsbondsisdeferreduntilredemptionormaturity.Municipalbondsaregenerallyexemptfromstateincometaxonlyinthestatewheretheywereissued.

Savings bonds, unlikeTreasuries, are notmarketable; you cannot sellthemtoanother investor,andyou’ll forfeit threemonthsofinterestifyouredeemtheminless than five years. Thusthey are suitable mainly as“set-aside money” to meet afuture spending need—a giftfor a religious ceremonythat’s years away, or a jumpstartonputtingyournewbornthroughHarvard. They come

in denominations as low as$25, making them ideal asgifts to grandchildren. Forinvestorswhocanconfidentlyleave some cash untouchedfor years to come, inflation-protected “I-bonds” recentlyoffered an attractive yield ofaround 4%. To learn more,seewww.savingsbonds.gov.

MovingBeyondUncleSam

Mortgage securities. Pooledtogether from thousands ofmortgages around theUnitedStates,thesebondsareissuedby agencies like the FederalNational MortgageAssociation (“Fannie Mae”)or the Government NationalMortgage Association(“Ginnie Mae”). However,they are not backed by theU.S.Treasury, so theysell athigher yields to reflect theirgreater risk. Mortgage bonds

generallyunderperformwheninterest rates fall and bombwhen rates rise. (Over thelongrun,thoseswingstendtoeven out and the higheraverageyieldspayoff.)Goodmortgage-bond funds areavailable from Vanguard,Fidelity, and Pimco.But if abroker ever tries to sell youan individual mortgage bondor “CMO,” tell him you arelate for an appointment withyourproctologist.

Annuities. Theseinsurance-like investmentsenable you to defer currenttaxesandcaptureastreamofincomeafteryouretire.Fixedannuities offer a set rate ofreturn; variable ones provideafluctuatingreturn.Butwhatthe defensive investor reallyneeds to defend against hereare thehard-selling insuranceagents, stockbrokers, andfinancialplannerswhopeddleannuities at rapaciously high

costs.Inmostcases, thehighexpenses of owning anannuity—including“surrender charges” thatgnaw away at your earlywithdrawals—willoverwhelm its advantages.The few good annuities arebought,notsold;ifanannuityproducesfatcommissionsforthe seller, chances are itwillproduce meager results forthe buyer. Consider onlythose you can buy directly

from providers with rock-bottom costs like Ameritas,TIAA-CREF, andVanguard.11

Preferredstock. Preferredshares are a worst-of-both-worlds investment. They areless secure than bonds, sincethey have only a secondaryclaim on a company’s assetsif it goesbankrupt.And theyofferlessprofitpotentialthancommon stocks do, since

companiestypically“call”(orforcibly buy back) theirpreferredshareswheninterestrates drop or their creditrating improves. Unlike theinterest payments onmost ofitsbonds,anissuingcompanycannot deduct preferreddividend payments from itscorporate tax bill. Askyourself: If this company ishealthyenoughtodeservemyinvestment,whyisitpayingafat dividend on its preferred

stockinsteadofissuingbondsand getting a tax break?Thelikely answer is that thecompany is not healthy, themarket for its bonds isglutted, and you shouldapproach its preferred sharesas you would approach anunrefrigerateddeadfish.

Commonstock.Avisit tothe stock screener athttp://screen.yahoo.com/stocks.html in

early 2003 showed that 115of the stocks in the Standard& Poor’s 500 index haddividend yields of 3.0% orgreater. No intelligentinvestor, no matter howstarved for yield,would everbuy a stock for its dividendincome alone; the companyand its businesses must besolid,anditsstockpricemustbe reasonable.But, thanks tothebearmarket thatbeganin2000,someleadingstocksare

now outyielding Treasurybonds. So even the mostdefensive investor shouldrealizethatselectivelyaddingstocks to an all-bond ormostly-bond portfolio canincrease its income yield—and raise its potentialreturn.12

Chapter5TheDefensiveInvestorandCommonStocks

InvestmentMeritsofCommonStocks

In our first edition (1949)we found it necessary at thispoint to insert a longexposition of the case forincluding a substantialcommon-stock component inall investment portfolios.*Common stocks weregenerally viewed as highlyspeculative and thereforeunsafe; they had declinedfairly substantially from thehigh levels of 1946, but

insteadofattracting investorsto them because of theirreasonable prices, this fallhadhadtheoppositeeffectofundermining confidence inequity securities. We havecommented on the conversesituation that has developedin the ensuing 20 years,whereby the big advance instock prices made themappear safe and profitableinvestments at record highlevels which might actually

carry with them aconsiderabledegreeofrisk.†

Theargumentwemadeforcommon stocks in 1949turned on two main points.The first was that they hadofferedaconsiderabledegreeof protection against theerosion of the investor’sdollar caused by inflation,whereas bonds offered noprotection at all. The secondadvantage of common stocks

lay in their higher averagereturn to investors over theyears. This was producedboth by an average dividendincome exceeding the yieldon good bonds and by anunderlying tendency formarketvaluetoincreaseoverthe years in consequence ofthe reinvestment ofundistributedprofits.

While these twoadvantages have been of

major importance—and havegiven common stocks a farbetterrecordthanbondsoverthe long-term past—we haveconsistentlywarnedthatthesebenefits could be lost by thestock buyer if he pays toohigh a price for his shares.This was clearly the case in1929,andittook25yearsforthe market level to climbbacktotheledgefromwhichit had abysmally fallen in

1929–1932.* Since 1957common stocks have onceagain, through their highprices, lost their traditionaladvantage in dividend yieldover bond interest rates.† Itremains to be seen whetherthe inflation factor and theeconomic-growth factor willmakeupinthefutureforthissignificantly adversedevelopment.

It should be evident to the

reader that we have noenthusiasm for commonstocks in general at the 900DJIA level of late 1971. Forreasons already given* wefeel that the defensiveinvestor cannot afford to bewithout an appreciableproportionofcommonstocksin his portfolio, even if hemustregardthemasthelesserof two evils—the greaterbeingtherisksattachedtoan

all-bondholding.

RulesfortheCommon-StockComponent

The selection of commonstocksfortheportfolioofthedefensive investor should bea relatively simple matter.Here we would suggest fourrulestobefollowed:

1. There should be

adequate though notexcessive diversification.Thismightmeanaminimumof ten different issues and amaximumofaboutthirty.†

2. Each company selectedshould be large, prominent,and conservatively financed.Indefinite as these adjectivesmustbe,theirgeneralsenseisclear. Observations on thispoint are addedat theendof

thechapter.

3. Each company shouldhave a long record ofcontinuous dividendpayments. (All the issues inthe Dow Jones IndustrialAver age met this dividendrequirement in 1971.) To bespecific on this point wewould suggest therequirement of continuousdividendpayments beginning

atleastin1950.*

4. The investor shouldimpose some limit on thepricehewillpayforanissuein relation to its averageearnings over, say, the pastseven years.We suggest thatthis limit be set at 25 timessuch average earnings, andnotmore than20 times thoseof the last twelve-monthperiod.But such a restriction

wouldeliminatenearlyallthestrongest and most popularcompaniesfromtheportfolio.In particular, it would banvirtually the entire categoryof “growth stocks,” whichhaveforsomeyearspastbeenthe favorites of bothspeculators and institutionalinvestors. We must give ourreasons for proposing sodrasticanexclusion.

GrowthStocksandtheDefensive

Investor

Theterm“growthstock”isapplied to one which hasincreased its per-shareearnings in the past at wellabove the rate for commonstocks generally and isexpectedtocontinuetodosoin the future. (Someauthorities would say that atrue growth stock should beexpectedatleasttodoubleitsper-share earnings in ten

years—i.e., to increase themat a compounded annual rateof over 7.1%.)† Obviouslystocks of this kind areattractive to buy and to own,providedthepricepaidisnotexcessive. The problem liesthere,ofcourse,sincegrowthstockshave longsoldathighprices in relation to currentearnings and at much highermultiples of their averageprofits over a past period.

This has introduced aspeculative element ofconsiderable weight in thegrowth-stock picture and hasmadesuccessfuloperationsinthis field a far from simplematter.

The leading growth issuehas long been InternationalBusinessMachines,andithasbrought phenomenal rewardsto thosewho bought it yearsago and held on to it

tenaciously. But we havealreadypointedout* that this“best of common stocks”actually lost 50% of itsmarketpriceinasix-months’decline during 1961–62 andnearlythesamepercentagein1969–70. Other growthstocks have been even morevulnerable to adversedevelopments; in some casesnot only has the price fallenbackbuttheearningsaswell,

thus causing a doublediscomfiture to those whoowned them. A good secondexample for our purpose isTexas Instruments, which insixyears rose from5 to256,without paying a dividend,while its earnings increasedfrom 40 cents to $3.91 pershare. (Note that the priceadvancedfivetimesasfastasthe profits; this ischaracteristic of popularcommon stocks.) But two

years later the earnings haddropped off by nearly 50%andthepricebyfour-fifths,to49.†

The readerwill understandfrom these instanceswhyweregard growth stocks as awhole as too uncertain andrisky a vehicle for thedefensiveinvestor.Ofcourse,wonderscanbeaccomplishedwith the right individualselections,boughtattheright

levels, and later sold after ahuge rise and before theprobable decline. But theaverageinvestorcannomoreexpect to accomplish thisthan to find money growingontrees.Incontrastwethinkthat the group of largecompanies that are relativelyunpopular, and thereforeobtainable at reasonableearningsmultipliers,*offersasoundifunspectacularareaof

choice by the general public.Weshallillustratethisideainour chapter on portfolioselection.

PortfolioChanges

It is now standard practicetosubmitallsecuritylistsforperiodicinspectioninordertoseewhether their quality canbeimproved.This,ofcourse,is amajorpartof the serviceprovided for clients by

investment counselors.Nearly all brokerage housesare ready to makecorresponding suggestions,without special fee, in returnfor the commission businessinvolved. Some brokeragehouses maintain investmentservicesonafeebasis.

Presumably our defensiveinvestor should obtain—atleast once a year—the samekind of advice regarding

changesinhisportfolioashesought when his funds werefirstcommitted.Sincehewillhave little expertness of hisown on which to rely, it isessential that he entrusthimself only to firms of thehighest reputation; otherwisehe may easily fall intoincompetent or unscrupuloushands. It is important, in anycase, that at every suchconsultationhemakecleartohis adviser that he wishes to

adhere closely to the fourrules of common-stockselection given earlier in thischapter. Incidentally, if hislist has been competentlyselected in the first instance,there should be no need forfrequent or numerouschanges.†

Dollar-CostAveraging

The New York StockExchange has put

considerable effort intopopularizing its “monthlypurchase plan,” under whichan investor devotes the samedollar amount eachmonth tobuyingoneormorecommonstocks.This is an applicationof a special typeof “formulainvestment”knownasdollar-cost averaging. During thepredominantly rising-marketexperience since 1949 theresultsfromsuchaprocedurewere certain to be highly

satisfactory, especially sincethey prevented thepractitioner fromconcentrating his buying atthewrongtimes.

In Lucile Tomlinson’scomprehensive study offormula investment plans,1the author presented acalculation of the results ofdollar-cost averaging in thegroup of stocks making upthe Dow Jones industrial

index. Tests were madecovering23ten-yearpurchaseperiods, the first ending in1929, the last in1952.Everytest showed a profit either atthe close of the purchaseperiod or within five yearsthereafter. The averageindicated profit at the end ofthe 23 buying periods was21.5%,exclusiveofdividendsreceived. Needless to say, insome instances there was asubstantial temporary

depreciation atmarket value.Miss Tomlinson ends herdiscussion of this ultrasimpleinvestment formula with thestriking sentence: “No onehas yet discovered any otherformula for investing whichcan be used with so muchconfidence of ultimatesuccess, regardless of whatmay happen to securityprices, as Dollar CostAveraging.”

It may be objected thatdollar-cost averaging, whilesound in principle, is ratherunrealistic in practice,because few people are sosituated that they can haveavailable for common-stockinvestment the same amountofmoney each year for, say,20years. It seems tome thatthis apparent objection haslost much of its force inrecentyears.Commonstocksare becoming generally

accepted as a necessarycomponent of a soundsavings-investment program.Thus,systematicanduniformpurchases of common stocksmay present no morepsychological and financialdifficulties than similarcontinuous payments forUnited States savings bondsand for life insurance—towhich they should becomplementary.Themonthlyamountmaybesmall,butthe

resultsafter20ormoreyearscan be impressive andimportanttothesaver.

TheInvestor’sPersonalSituation

At the beginning of thischapterwereferredbrieflytothe position of the individualportfolioowner.Letusreturnto thismatter, in the light ofour subsequent discussion ofgeneral policy. To whatextent should the type of

securities selected by theinvestor vary with hiscircumstances? As concreteexamplesrepresentingwidelydifferent conditions,we shalltake: (1) a widow left$200,000 with which tosupport herself and herchildren; (2) a successfuldoctor in mid-career, withsavings of $100,000 andyearly accretions of $10,000;and (3)ayoungmanearning$200 per week and saving

$1,000ayear.*

For the widow, theproblem of living on herincomeisaverydifficultone.On the other hand the needfor conservatism in herinvestments is paramount. Adivision of her fund aboutequally between UnitedStates bonds and first-gradecommon stocks is acompromise between theseobjectivesandcorrespondsto

our general prescription forthe defensive investor. (Thestock component may beplaced as high as 75% if theinvestor is psychologicallyprepared for this decision,and if she can be almostcertain she is not buying attoo high a level. Assuredlythis is not the case in early1972.)

We do not preclude thepossibility that the widow

may qualify as anenterprising investor, inwhichcaseherobjectivesandmethods will be quitedifferent. The one thing thewidowmustnotdois totakespeculative chances in orderto “make some extraincome.” By this we meantrying for profits or highincomewithoutthenecessaryequipment to warrant fullconfidenceinoverallsuccess.Itwouldbe farbetter forher

to draw $2,000 per year outof her principal, in order tomakebothendsmeet,thantorisk half of it in poorlygrounded, and thereforespeculative,ventures.

The prosperous doctor hasnone of the widow’spressures and compulsions,yet we believe that hischoices are pretty much thesame. Is hewilling to take aserious interest in the

businessof investment? Ifhelackstheimpulseortheflair,hewill do best to accept theeasy role of the defensiveinvestor. The division of hisportfolio should then be nodifferent from that of the“typical” widow, and therewould be the same area ofpersonal choice in fixing thesize of the stock component.Theannualsavingsshouldbeinvested in about the sameproportionsasthetotalfund.

Theaveragedoctormaybemore likely than the averagewidow to elect tobecomeanenterprising investor, and heis perhaps more likely tosucceed in the undertaking.He has one importanthandicap, however—the factthathehaslesstimeavailableto give to his investmenteducation and to theadministrationofhisfunds.Infact, medical men have beennotoriously unsuccessful in

their security dealings. Thereason for this is that theyusually have an ampleconfidence in their ownintelligence and a strongdesire tomake a good returnon their money, without therealization that to do sosuccessfully requires bothconsiderable attention to thematter and something of aprofessional approach tosecurityvalues.

Finally, the young manwho saves $1,000 a year—and expects to do bettergradually—findshimselfwiththe same choices, though forstill different reasons. Someof his savings should goautomatically into Series Ebonds. The balance is somodest that it seems hardlyworthwhile for him toundergo a tough educationaland temperamental disciplinein order to qualify as an

aggressive investor. Thus asimple resort to our standardprogram for the defensiveinvestorwouldbeatoncetheeasiest and the most logicalpolicy.

Let us not ignore humannature at this point. Financehas a fascination for manybright young people withlimited means. They wouldliketobebothintelligentandenterprising in the placement

of their savings, even thoughinvestment income is muchless important to them thantheir salaries. This attitude isall to the good. There is agreatadvantagefortheyoungcapitalist to begin hisfinancial education andexperience early. If he isgoing to operate as anaggressive investor he iscertain to make somemistakes and to take somelosses.Youthcanstand these

disappointmentsandprofitbythem. We urge the beginnerin security buying not towaste his efforts and hismoney in trying to beat themarket. Let him studysecurity values and initiallytestouthisjudgmentonpriceversusvaluewiththesmallestpossiblesums.

Thus we return to thestatement,madeattheoutset,that the kind of securities to

be purchased and the rate ofreturn to be sought dependnotontheinvestor’sfinancialresourcesbutonhisfinancialequipment in terms ofknowledge, experience, andtemperament.

NoteontheConceptof“Risk”

It is conventional to speakof good bonds as less riskythan good preferred stocksandof the latter as less risky

than good common stocks.From this was derived thepopular prejudice againstcommon stocks because theyare not “safe,” which wasdemonstrated in the FederalReserve Board’s survey of1948.Weshouldliketopointout that thewords“risk”and“safety” are applied tosecurities in two differentsenses, with a resultantconfusioninthought.

A bond is clearly provedunsafe when it defaults itsinterest or principalpayments. Similarly, if apreferred stock or even acommonstockisboughtwiththe expectation that a givenrate of dividend will becontinued,thenareductionorpassing of the dividendmeans that it has provedunsafe. It is also true that aninvestment contains a risk ifthere is a fair possibility that

theholdermayhavetosellata timewhen theprice iswellbelowcost.

Nevertheless, the idea ofriskisoftenextendedtoapplyto a possible decline in theprice of a security, eventhoughthedeclinemaybeofa cyclical and temporarynature and even though theholderisunlikelytobeforcedto sell at such times. Thesechances are present in all

securities, other than UnitedStatessavingsbonds,andtoagreater extent in the generalrunofcommonstocksthaninsenior issues as a class. Butwe believe that what is hereinvolved is not a true risk inthe useful sense of the term.The man who holds amortgageonabuildingmighthavetotakeasubstantiallossif hewere forced to sell it atan unfavorable time. Thatelement is not taken into

account in judging the safetyor riskofordinaryreal-estatemortgages, the only criterionbeing the certainty ofpunctual payments. In thesamewaytheriskattachedtoan ordinary commercialbusiness is measured by thechance of its losing money,notbywhatwouldhappen iftheownerwereforcedtosell.

In Chapter 8 we shall setforth our conviction that the

bona fide investor does notlose money merely becausethe market price of hisholdings declines; hence thefact thatadeclinemayoccurdoes not mean that he isrunninga true riskof loss. Ifa group of well-selectedcommon-stock investmentsshows a satisfactory overallreturn,asmeasuredthroughafairnumberofyears,thenthisgroup investment has provedto be “safe.” During that

period its market value isbound to fluctuate, and aslikely asnot itwill sell for awhile under thebuyer’s cost.If that fact makes theinvestment “risky,” it wouldthen have to be called bothrisky and safe at the sametime. This confusionmay beavoided if we apply theconcept of risk solely to aloss of value which either isrealized through actual sale,or is caused by a significant

deterioration in thecompany’s position—or,more frequently perhaps, isthe result of the payment ofanexcessiveprice in relationto the intrinsic worth of thesecurity.2

Many common stocks doinvolve risks of suchdeterioration. But it is ourthesis that a properlyexecutedgroup investment incommon stocks does not

carry any substantial risk ofthis sort and that therefore itshould not be termed “risky”merely because of theelement of price fluctuation.But such risk is present ifthere is danger that the pricemay prove to have beenclearly too high by intrinsic-value standards—even if anysubsequent severe marketdecline may be recoupedmanyyearslater.

NoteontheCategoryof“Large,Prominent,andConservativelyFinancedCorporations”

The quoted phrase in ourcaption was used earlier inthe chapter to describe thekind of common stocks towhich defensive investorsshouldlimittheirpurchases—provided also that they hadpaidcontinuousdividendsfora considerable number ofyears. A criterion based on

adjectives is alwaysambiguous. Where is thedividing line for size, forprominence, and forconservatism of financialstructure? On the last pointwe can suggest a specificstandard that, thougharbitrary, is in line withaccepted thinking. Anindustrialcompany’sfinancesare not conservative unlessthe common stock (at bookvalue) representsat leasthalf

of the total capitalization,including all bank debt.3 Forarailroadorpublicutilitythefigureshouldbeatleast30%.

The words “large” and“prominent” carry the notionof substantial size combinedwithaleadingpositionintheindustry.Suchcompaniesareoften referred to as“primary”; all other commonstocks are then called“secondary,” except that

growth stocks are ordinarilyplaced in a separate class bythosewhobuy themas such.To supply an element ofconcreteness here, let ussuggest that to be “large” inpresent-day termsa companyshould have $50 million ofassets or do $50 million ofbusiness.* Again to be“prominent” a companyshould rank among the firstquarter or first third in size

withinitsindustrygroup.

It would be foolish,however, to insist upon sucharbitrary criteria. They areoffered merely as guides tothose who may ask forguidance.Butanyrulewhichthe investor may set forhimself and which does noviolence to the common-sense meanings of “large”and “prominent” should beacceptable. By the very

natureof the case theremustbealargegroupofcompaniesthatsomewillandotherswillnot include among thosesuitable for defensiveinvestment.There isnoharmin such diversity of opinionand action. In fact, it has asalutary effect upon stock-market conditions, because itpermits a gradualdifferentiation or transitionbetween the categories ofprimary and secondary stock

issues.


Humanfelicityisproduc’dnotsomuch by great Pieces of goodFortune that seldom happen, asby little Advantages that occureveryday.

—BenjaminFranklin

TheBestDefenseisaGoodOffense

After the stock-marketbloodbath of the past fewyears, why would anydefensiveinvestorputadimeintostocks?

First, remember Graham’sinsistence thathowdefensiveyou should be depends lesson your tolerance for riskthan on your willingness toputtimeandenergyintoyour

portfolio.Andifyougoaboutit the right way, investing instocks is just as easy asparkingyourmoneyinbondsand cash. (As we’ll see inChapter 9, you can buy astock-market indexfundwithnomoreeffortthanittakestogetdressedinthemorning.)

Amidst the bear marketthat began in 2000, it’sunderstandable if you feelburned—and if, in turn, that

feelingmakesyoudeterminednever to buy another stockagain. As an old Turkishproverbsays,“Afteryouburnyourmouthonhotmilk, youblow on your yogurt.”Because the crash of 2000–2002 was so terrible, manyinvestorsnowviewstocksasscaldingly risky; but,paradoxically, theveryactofcrashing has taken much ofthe risk out of the stockmarket. It was hot milk

before, but it is room-temperatureyogurtnow.

Viewed logically, thedecision of whether to ownstocks today has nothing todo with how much moneyyou might have lost byowningthemafewyearsago.When stocks are pricedreasonably enough to giveyou future growth, then youshould own them, regardlessof the losses they may have

cost you in the recent past.That’sallthemoretruewhenbondyieldsarelow,reducingthefuture returnson income-producinginvestments.

As we have seen inChapter 3, stocks are (as ofearly 2003) only mildlyoverpriced by historicalstandards. Meanwhile, atrecent prices, bonds offersuch low yields that aninvestor who buys them for

theirsupposedsafetyislikeasmoker who thinks he canprotect himself against lungcancer by smoking low-tarcigarettes. No matter howdefensiveaninvestoryouare—in Graham’s sense of lowmaintenance, or in thecontemporary sense of lowrisk—today’s values meanthat you must keep at leastsome of your money instocks.

Fortunately,it’sneverbeeneasierforadefensiveinvestorto buy stocks. And apermanentautopilotportfolio,whicheffortlesslyputsalittlebit of your money to workeverymonthinpredeterminedinvestments, can defend youagainsttheneedtodedicatealargepartofyourlifetostockpicking.

ShouldYou“BuyWhatYouKnow”?

But first, let’s look atsomething the defensiveinvestor must always defendagainst: the belief that youcanpickstockswithoutdoingany homework. In the 1980sand early 1990s, one of themost popular investingslogans was “buy what youknow.” Peter Lynch—whofrom 1977 through 1990piloted Fidelity Magellan tothe best track record evercompiledbyamutualfund—

was the most charismaticpreacher of this gospel.Lynch argued that amateurinvestors have an advantagethat professional investorshave forgotten how to use:“the power of commonknowledge.”Ifyoudiscoveragreat new restaurant, car,toothpaste, or jeans—or ifyounoticethattheparkinglotatanearbybusinessisalwaysfull or that people are stillworking at a company’s

headquarters long after JayLeno goes off the air—thenyou have a personal insightinto a stock that aprofessional analyst orportfolio manager mightnever pick up on. As Lynchput it, “During a lifetime ofbuying cars or cameras, youdevelop a sense of what’sgood and what’s bad, whatsells and what doesn’t…andthe most important part is,you know it before Wall

Streetknowsit.”1

Lynch’s rule—“You canoutper-forms the experts ifyou use your edge byinvesting in companies orindustries you alreadyunderstand”—isn’t totallyimplausible,andthousandsofinvestors have profited fromitovertheyears.ButLynch’srule can work only if youfollow its corollary as well:“Finding the promising

companyisonlythefirststep.The next step is doing theresearch.” To his credit,Lynch insists that no oneshould ever invest in acompany, no matter howgreat its products or howcrowded its parking lot,without studying its financialstatements and estimating itsbusinessvalue.

Unfortunately, most stockbuyershaveignoredthatpart.

Barbra Streisand, the day-trading diva, personified theway people abuse Lynch’steachings. In 1999 sheburbled,“WegotoStarbuckseveryday,soIbuyStarbucksstock.” But the Funny Girlforgot that no matter howmuch you love those tallskinnylattes,youstillhavetoanalyze Starbucks’s financialstatementsandmakesurethestock isn’t even moreoverpriced than the coffee.

Countless stock buyersmadethe same mistake by loadinguponsharesofAmazon.combecause they loved thewebsite or buying e*Tradestock because it was theirownonlinebroker.

“Experts” gave the ideacredence too. Inan interviewtelevised on CNN in late1999, portfolio managerKevinLandisoftheFirsthandFunds was asked plaintively,

“How do you do it? Whycan’t I do it, Kevin?” (From1995 through the end of1999, the FirsthandTechnology Value fundproduced an astounding58.2% average annualizedgain.) “Well, you can do it,”Landis chirped. “All youreally need to do is focus onthethingsthatyouknow,andstayclosetoanindustry,andtalktopeoplewhoworkin it

everyday.”2

The most painfulperversion of Lynch’s ruleoccurred in corporateretirement plans. If you’resupposed to “buy what youknow,” then what couldpossibly be a betterinvestment for your 401(k)than your own company’sstock? After all, you workthere; don’t you know moreabout the company than an

outsider ever could? Sadly,the employees of Enron,Global Crossing, andWorldCom—many of whomputnearlyall theirretirementassetsintheirowncompany’sstock,onlytobewipedout—learned that insiders oftenpossess only the illusion ofknowledge,nottherealthing.

Psychologists led byBaruchFischhoffofCarnegieMellon University have

documentedadisturbingfact:becomingmore familiarwitha subject does notsignificantly reduce people’stendency to exaggerate howmuch they actually knowabout it.3 That’s why“investinginwhatyouknow”can be so dangerous; themoreyouknowgoing in, theless likelyyouare toprobeastock for weaknesses. Thispernicious form of

overconfidence is called“home bias,” or the habit ofsticking to what is alreadyfamiliar:

Individualinvestorsownthree times more sharesin their local phonecompany than in allother phone companiescombined.The typicalmutual fundowns stocks whose

headquarters are 115miles closer to thefund’s main office thanthe average U.S.companyis.401(k) investors keepbetween 25% and 30%oftheirretirementassetsinthestockoftheirowncompany.4

In short, familiarity breedscomplacency. On the TVnews, isn’t it always the

neighbororthebestfriendortheparentofthecriminalwhosays in a shockedvoice, “Hewassuchaniceguy”?That’sbecausewheneverwearetooclose to someone orsomething, we take ourbeliefsforgranted, insteadofquestioning them as we dowhenwe confront somethingmore remote. The morefamiliar a stock is, the morelikelyitistoturnadefensiveinvestor into a lazy onewho

thinks there’s no need to doanyhomework.Don’tletthathappentoyou.

CanyouRollYourOwn?

Fortunately, for a defensiveinvestorwho iswilling todothe required homework forassembling a stock portfolio,thisistheGoldenAge:Neverbeforeinfinancialhistoryhasowningstocksbeen socheap

andconvenient.5

Do it yourself. Throughspecializedonlinebrokerageslike www. sharebuilder.com,www.foliofn.com, andwww.buyandhold.com, youcan buy stocks automaticallyeven if you have very littlecashtospare.Thesewebsiteschargeaslittleas$4foreachperiodic purchase of any ofthe thousands of U.S. stockstheymakeavailable.Youcan

invest every week or everymonth,reinvestthedividends,and even trickle yourmoneyintostocksthroughelectronicwithdrawals from your bankaccountordirectdepositfromyour paycheck. Sharebuildercharges more to sell than tobuy—reminding you, like alittle whack across the nosewith a rolled-up newspaper,that rapid selling is aninvesting no-no—whileFolioFN offers an excellent

tax-trackingtool.

Unlike traditional brokersormutualfundsthatwon’tletyou in the door for less than$2,000 or $3,000, theseonline firms have nominimum account balancesand are tailor-made forbeginninginvestorswhowantto put fledgling portfolios onautopilot. To be sure, atransaction fee of $4 takes amonstrous 8% bite out of a

$50monthlyinvestment—butif that’s all the money youcan spare, then thesemicroinvesting sites are theonly game in town forbuilding a diversifiedportfolio.

You can also buyindividual stocks straightfrom the issuing companies.In 1994, the U.S. Securitiesand Exchange Commissionloosenedthehandcuffsithad

long ago clamped onto thedirect sale of stocks to thepublic. Hundreds ofcompanies responded bycreating Internet-basedprograms allowing investorsto buy shares without goingthrough a broker. Somehelpful online sources ofinformationonbuying stocksdirectly includewww.dripcentral.com,www.netstock direct.com (anaffiliateofSharebuilder),and

www.stockpower.com. Youmay often incur a variety ofnuisancefeesthatcanexceed$25peryear.Evenso,direct-stock purchase programs areusually cheaper thanstockbrokers.

Be warned, however, thatbuying stocks in tinyincrements for years on endcansetoffbigtaxheadaches.If you are not prepared tokeep a permanent and

exhaustively detailed recordofyourpurchases,donotbuyin the first place. Finally,don’tinvestinonlyonestock—or even just a handful ofdifferent stocks. Unless youarenotwillingtospreadyourbets,youshouldn’tbetatall.Graham’s guideline ofowning between 10 and 30stocks remains a goodstarting point for investorswho want to pick their ownstocks, but you must make

sure that you are notoverexposedtooneindustry.6(Formoreonhowtopicktheindividual stocks that willmake up your portfolio, seepp.114–115andChapters11,14,and15.)

If,afteryousetupsuchanonlineautopilotportfolio,youfind yourself trading morethan twice a year—orspending more than an houror two per month, total, on

your investments—thensomething has gone badlywrong. Do not let the easeand up-to-the-minute feel ofthe Internet seduce you intobecoming a speculator. Adefensive investor runs—andwins—theracebysittingstill.

Get some help. Adefensive investor can alsoown stocks through adiscount broker, a financialplanner, or a full-service

stockbroker. At a discountbrokerage, you’ll need to domost of the stock-pickingwork yourself; Graham’sguidelines will help youcreate a core portfoliorequiring minimalmaintenance and offeringmaximal odds of a steadyreturn. On the other hand, ifyou cannot spare the time orsummon the interest to do ityourself, there’sno reason tofeel any shame in hiring

someone to pick stocks ormutual funds for you. Butthere’soneresponsibilitythatyou must never delegate.You, and no one but you,must investigate (before youhand over your money)whether an adviser istrustworthy and chargesreasonable fees. (For morepointers,seeChapter10.)

Farmitout.Mutual fundsare the ultimate way for a

defensive investor to capturetheupsideofstockownershipwithout the downside ofhaving to police your ownportfolio. At relatively lowcost, you can buy a highdegree of diversification andconvenience—letting aprofessional pick and watchthe stocks for you. In theirfinest form—index portfolios—mutual funds can requirevirtually no monitoring ormaintenance whatsoever.

IndexfundsareakindofRipVan Winkle investment thatis highly unlikely to causeany suffering or surpriseseven if, like WashingtonIrving’s lazy farmer, you fallasleep for20years.Theyarea defensive investor’s dreamcome true. For more detail,seeChapter9.

FillinginthePotholes

As the financial marketsheaveandcrashtheirwayupand down day after day, thedefensive investor can takecontrol of the chaos. Yourveryrefusaltobeactive,yourrenunciationofanypretendedability to predict the future,can become your mostpowerful weapons. Byputting every investmentdecision on autopilot, youdrop any self-delusion thatyou know where stocks are

headed, and you take awaythe market’s power to upsetyou no matter how bizarrelyitbounces.

As Graham notes, “dollar-cost averaging” enables youto put a fixed amount ofmoney into an investment atregularintervals.Everyweek,month, or calendar quarter,you buy more—whether themarkets have gone (or areabout to go) up, down, or

sideways. Any major mutualfund company or brokeragefirm can automatically andsafely transfer the moneyelectronicallyforyou,soyouneverhavetowriteacheckorfeel the conscious pang ofpayment. It’salloutofsight,outofmind.

The ideal way to dollar-cost average is into aportfolio of index funds,which own every stock or

bondworthhaving.Thatway,you renounce not only theguessing game of where themarket is going but whichsectors of the market—andwhich particular stocks orbonds within them—will dothebest.

Let’s say you can spare$500 a month. By owninganddollar-costaveragingintojust three index funds—$300into one that holds the total

U.S. stockmarket, $100 intoonethatholdsforeignstocks,and $100 into one that holdsU.S. bonds—you can ensurethat you own almost everyinvestment on the planetthat’s worth owning.7 Everymonth, like clockwork, youbuy more. If the market hasdropped, your preset amountgoes further, buying youmore shares than the monthbefore.Ifthemarkethasgone

up, then your money buysyou fewer shares.By puttingyour portfolio on permanentautopilot this way, youprevent yourself from eitherflingingmoneyat themarketjust when it is seems mostalluring(and isactuallymostdangerous)orrefusingtobuymoreafteramarketcrashhasmade investments trulycheaper (but seeminglymore“risky”).

According to IbbotsonAssociates, the leadingfinancialresearchfirm,ifyouhad invested $12,000 in theStandard& Poor’s 500-stockindex at the beginning ofSeptember 1929, 10 yearslater you would have hadonly $7,223 left. But if youhadstartedwithapaltry$100and simply invested another$100 every single month,then by August 1939, yourmoneywould have grown to

$15,571!That’s thepowerofdisciplined buying—even inthe face of the GreatDepression and the worstbearmarketofalltime.8

Figure 5-1 shows themagic of dollar-costaveraging in a more recentbearmarket.

Bestofall,onceyoubuilda permanent autopilotportfoliowith index funds as

its heart and core, you’ll beable to answer every marketquestion with the mostpowerful response adefensive investor couldeverhave: “I don’t know and Idon’t care.” If someone askswhether bonds will outper-forms stocks, just answer, “Idon’t know and I don’tcare”—after all, you’reautomatically buying both.Will health-care stocksmakehigh-techstockslooksick?“I

don’t know and I don’tcare”—you’re a permanentowner of both. What’s thenext Microsoft? “I don’tknow and I don’t care”—assoon as it’s big enough toown, your index fund willhave it, and you’ll go alongfor the ride. Will foreignstocks beat U.S. stocks nextyear? “I don’t know and Idon’t care”—if they do,you’ll capture that gain; ifthey don’t, you’ll get to buy

moreatlowerprices.

By enabling you to say “Idon’tknowandIdon’tcare,”a permanent autopilotportfolio liberates you fromthe feeling that you need toforecast what the financialmarketsareabouttodo—andthe illusion that anyone elsecan. The knowledge of howlittleyoucanknowabout thefuture, coupled with theacceptanceofyourignorance,

isadefensiveinvestor’smostpowerfulweapon.

FIGURE5-1

EveryLittleBitHelps

Fromtheendof1999throughtheendof2002,theS&P500-stockaveragefellrelentlessly.Butifyouhadopenedanindex-fundaccountwitha$3,000minimuminvestmentandadded$100everymonth,your

totaloutlayof$6,600wouldhavelost30.2%—considerablylessthanthe41.3%plungeinthemarket.Betteryet,yoursteadybuyingatlowerpriceswouldbuildthebaseforanexplosiverecoverywhenthemarketrebounds.

Source:TheVanguardGroup

Chapter6PortfolioPolicyfortheEnterprisingInvestor:NegativeApproach

The “aggressive” investor

should start from the samebase as the defensiveinvestor, namely, a divisionof his funds between high-grade bonds and high-gradecommon stocks bought atreasonableprices.*Hewillbeprepared to branch out intoother kinds of securitycommitments, but in eachcase he will want a well-reasoned justification for thedeparture. There is a

difficulty in discussing thistopic in orderly fashion,because there is no single orideal pattern for aggressiveoperations. The field ofchoice is wide; the selectionshoulddependnotonlyontheindividual’s competence andequipment but perhapsequally well upon hisinterestsandpreferences.

The most usefulgeneralizations for the

enterprising investor are of anegative sort. Let him leavehigh-gradepreferredstockstocorporate buyers. Let himalso avoid inferior types ofbonds and preferred stocksunless they can be bought atbargain levels—whichmeansordinarily at prices at least30% under par for high-couponissues,andmuchlessfor the lower coupons.* Hewill let someone else buy

foreign-government bondissues, even though the yieldmay be attractive. He willalso be wary of all kinds ofnew issues, includingconvertible bonds andpreferreds that seem quitetemptingandcommonstockswith excellent earningsconfinedtotherecentpast.

For standard bondinvestments the aggressiveinvestor would do well to

follow the pattern suggestedtohisdefensiveconfrere,andmake his choice betweenhigh-grade taxable issues,whichcannowbeselectedtoyield about 7¼%, and good-quality tax-freebonds,whichyield up to 5.30% on longermaturities.†

Second-GradeBondsandPreferredStocks

Since in late-1971 it is

possible to find first-ratecorporate bonds to yield 7¼%, and even more, it wouldnotmakemuch sense to buysecond-grade issues merelyfor the higher return theyoffer. In fact corporationswith relatively poor creditstanding have found itvirtually impossible to sell“straight bonds”—i.e.,nonconvertibles—to thepublic in the past two years.Hence their debt financing

has been done by the sale ofconvertible bonds (or bondswith warrants attached),which place them in aseparate category. It followsthat virtually all thenonconvertible bonds ofinferior ratingrepresentolderissues which are selling at alarge discount. Thus theyoffer the possibility of asubstantial gain in principalvalue under favorable futureconditions—which would

mean here a combination ofan improved credit rating forthe company and lowergeneralinterestrates.

But even in the matter ofprice discounts and resultantchance of principal gain, thesecond-grade bonds are incompetition with betterissues. Some of the well-entrenched obligations with“old-style” coupon rates (2½% to 4%) sold at about 50

cents on the dollar in 1970.Examples: AmericanTelephone & Telegraph 25/8s, due 1986 sold at 51;AtchisonTopeka&SantaFeRR4s, due1995, sold at 51;McGraw-Hill 3 7/8s, due1992,soldat50½.

Hence under conditions oflate-1971 the enterprisinginvestors can probably getfrom good-grade bondsselling at a largediscount all

that he should reasonablydesire in the form of bothincome and chance ofappreciation.

Throughout this book werefer to the possibility thatany well-defined andprotractedmarketsituationofthe past may return in thefuture. Hence we shouldconsider what policy theaggressive investor mighthave to choose in the bond

field if prices and yields ofhigh-grade issues shouldreturntoformernormals.Forthis reason we shall reprinthereourobservationson thatpoint made in the 1965edition, when high-gradebondsyieldedonly4½%.

Something should be saidnow about investing insecond-grade issues, whichcan readilybe found toyieldanyspecifiedreturnupto8%

ormore.Themaindifferencebetween first- and second-grade bonds is usually foundin the number of times theinterest charges have beencovered by earnings.Example: In early 1964Chicago,Milwaukee,St.Pauland Pacific 5% incomedebenture bonds, at 68,yielded 7.35%. But the totalinterest charges of the road,before income taxes, wereearned only 1.5 times in

1963,againstourrequirementof 5 times for a well-protectedrailroadissue.1

Many investors buysecuritiesofthiskindbecausethey “need income” andcannot get along with themeagerreturnofferedbytop-grade issues. Experienceclearlyshowsthatitisunwiseto buy a bond or a preferredwhich lacks adequate safetymerely because the yield is

attractive.* (Here the word“merely” implies that theissue is not selling at a largediscount and thus does notoffer an opportunity for asubstantial gain in principalvalue.)Wheresuchsecuritiesareboughtatfullprices—thatis,notmanypointsunder100*—thechancesareverygreatthat at some future time theholder will see much lowerquotations. For when bad

businesscomes,or justabadmarket, issues of this kindprove highly susceptible tosevere sinking spells; ofteninterest or dividends aresuspended or at leastendangered, and frequentlythere is a pronounced priceweakness even though theoperatingresultsarenotatallbad.

Asaspecificillustrationofthis characteristic of second-

quality senior issues, let ussummarizethepricebehaviorof a group of ten railroadincome bonds in 1946–47.These comprise all of thosewhich sold at 96 or more in1946, their high pricesaveraging 102½. By thefollowingyear thegrouphadregistered low pricesaveraging only 68, a loss ofone-thirdof themarketvaluein a very short time.Peculiarly enough, the

railroads of the countrywereshowingmuchbetterearningsin 1947 than in 1946; hencethe drastic price decline rancounter to the businesspicture and was a reflectionof the selloff in the generalmarket. But it should bepointedoutthattheshrinkagein these income bonds wasproportionately larger thanthat in the common stocks inthe Dow Jones industrial list(about 23%). Obviously the

purchaserof thesebondsatacost above 100 could nothave expected to participatetoanyextent inafurtherrisein the securities market. Theonlyattractivefeaturewastheincome yield, averagingabout 4.25% (against 2.50%for first-grade bonds, anadvantageof1.75%inannualincome). Yet the sequelshowed all too soon and tooplainly that for the minoradvantage in annual income

the buyer of these second-grade bonds was risking theloss of a substantial part ofhisprincipal.

Theaboveexamplepermitsus to pay our respects to thepopular fallacy that goesunder the sobriquet of a“businessman’s investment.”Thatinvolvesthepurchaseofa security showing a largeryield than is obtainable on ahigh-gradeissueandcarrying

a correspondingly greaterrisk. It is bad business toaccept an acknowledgedpossibility of a loss ofprincipal in exchange for amere 1 or 2% of additionalyearly income. If you arewilling to assume some riskyoushouldbecertainthatyoucanrealizeareallysubstantialgain in principal value ifthings go well. Hence asecond-grade5.5or6%bondselling at par is almost

always a bad purchase. Thesame issueat70mightmakemore sense—and if you arepatient you will probably beabletobuyitatthatlevel.

Second-grade bonds andpreferred stocks possess twocontradictoryattributeswhichthe intelligent investor mustbear clearly in mind. Nearlyall suffer severe sinkingspells inbadmarkets.Ontheotherhand,alargeproportion

recover their position whenfavorable conditions return,and these ultimately “workout all right.” This is trueeven of (cumulative)preferred stocks that fail topaydividendsformanyyears.Therewereanumberofsuchissuesintheearly1940s,asaconsequence of the longdepression of the 1930s.During the postwar boomperiodof1945–1947manyofthese large accumulations

werepaidoffeitherincashorin new securities, and theprincipal was oftendischarged as well. As aresult, large profits weremade by people who, a fewyears previously, had boughtthese issues when they werefriendless and sold at lowprices.2

Itmaywellbetruethat, inan overall accounting, thehigher yields obtainable on

second-grade senior issueswill prove to have offsetthose principal losses thatwere irrecoverable. In otherwords, an investor whoboughtallsuchissuesattheiroffering prices mightconceivably fare as well, inthe long run, as one wholimitedhimselftofirst-qualitysecurities; or even somewhatbetter.3

But for practical purposes

the question is largelyirrelevant. Regardless of theoutcome, the buyer ofsecond-grade issues at fullprices will be worried anddiscommoded when theirprice declines precipitately.Furthermore, he cannot buyenough issues to assure an“average” result, nor is he ina position to set aside aportion of his larger incometo offset or “amortize” thoseprincipal losses which prove

tobepermanent.Finally,itismere common sense toabstainfrombuyingsecuritiesat around 100 if longexperienceindicatesthattheycanprobablybeboughtat70or less in the next weakmarket.

ForeignGovernmentBonds

All investors with evensmall experience know thatforeign bonds, as a whole,

have had a bad investmenthistory since 1914. This wasinevitable in the light of twoworld wars and anintervening world depressionof unexampled depth. Yetevery few years marketconditions are sufficientlyfavorabletopermitthesaleofsomenew foreign issues at aprice of about par. Thisphenomenon tells us a gooddealabouttheworkingoftheaverageinvestor’smind—and

notonlyinthefieldofbonds.

We have no concretereasontobeconcernedaboutthe future history of well-regarded foreign bonds suchas those of Australia orNorway. But we do knowthat, if and when troubleshould come, the owner offoreign obligations has nolegal or other means ofenforcing his claim. ThosewhoboughtRepublicofCuba

4½s as high as 117 in 1953saw them default theirinterest and then sell as lowas 20 cents on the dollar in1963. The New York StockExchange bond list in thatyear also included BelgianCongo5¼sat36,Greek7sat30, and various issues ofPoland as low as 7. Howmany readers have any ideaoftherepeatedvicissitudesofthe 8% bonds ofCzechoslovakia, since they

were first offered in thiscountryin1922at96½?Theyadvanced to 112 in 1928,declined to 67 3/4 in 1932,recovered to 106 in 1936,collapsed to 6 in 1939,recovered (unbelievably) to117 in1946, fellpromptly to35in1948,andsoldaslowas8in1970!

Years ago an argument ofsorts was made for thepurchase of foreign bonds

here on the grounds that arich creditor nation such asours was under moralobligation to lend abroad.Time, which brings somanyrevenges, now finds usdealing with an intractablebalance-of-paymentsproblemof our own, part of which isascribable to the large-scalepurchaseof foreignbondsbyAmerican investorsseekingasmall advantage inyield.Formany years past we have

questioned the inherentattractiveness of suchinvestments from thestandpoint of the buyer;perhaps we should add nowthat the latter would benefitboth his country and himselfif he declined theseopportunities.

NewIssuesGenerally

Itmightseemill-advisedtoattempt any broad statements

about new issues as a class,since they cover the widestpossible range of quality andattractiveness.Certainlytherewill be exceptions to anysuggested rule. Our onerecommendation is that allinvestors should be wary ofnew issues—which means,simply, that these should besubjected to carefulexamination and unusuallysevere tests before they arepurchased.

There are two reasons forthisdoublecaveat.Thefirstisthat new issues have specialsalesmanship behind them,which calls therefore for aspecial degree of salesresistance.*Thesecondisthatmost new issues are soldunder “favorable marketconditions”—which meansfavorable for the seller andconsequently less favorableforthebuyer.†

The effect of theseconsiderations becomessteadilymoreimportantaswego down the scale from thehighest-qualitybondsthroughsecond-grade senior issues tocommon-stock flotations atthe bottom. A tremendousamount of financing,consisting of the repaymentofexistingbondsatcallpriceandtheirreplacementbynewissues with lower coupons,wasdoneinthepast.Mostof

this was in the category ofhigh-grade bonds andpreferred stocks. The buyerswere largely financialinstitutions, amply qualifiedto protect their interests.Hence these offerings werecarefully priced to meet thegoing rate for comparableissues, and high-poweredsalesmanship had little effecton the outcome. As interestratesfelllowerandlowerthebuyers finally came to pay

too high a price for theseissues, and many of themlater declined appreciably inthemarket.Thisisoneaspectofthegeneraltendencytosellnew securities of all typeswhen conditions are mostfavorabletotheissuer;butinthecaseoffirst-qualityissuestheilleffectstothepurchaserare likely to be unpleasantratherthanserious.

The situation proves

somewhat different when westudy the lower-grade bondsand preferred stocks soldduring the 1945–46 and1960–61 periods. Here theeffect of the selling effort ismore apparent, becausemostoftheseissueswereprobablyplaced with individual andinexpert investors. It wascharacteristic of theseofferings that they did notmake an adequate showingwhen judged by the

performance of thecompanies over a sufficientnumber of years. They didlook safe enough, for themost part, if it could beassumed that the recentearnings would continuewithout a serious setback.The investment bankers whobrought out these issuespresumably accepted thisassumption, and theirsalesmen had little difficultyinpersuading themselvesand

their customers to a likeeffect.Neverthelessitwasanunsound approach toinvestment, andone likely toprovecostly.

Bull-market periods areusually characterized by thetransformation of a largenumber of privately ownedbusinesses into companieswithquoted shares.Thiswasthecasein1945–46andagainbeginning in 1960. The

process then reachedextraordinary proportionsuntilbroughttoacatastrophicclose inMay1962.After theusual “swearing-off” periodof several years the wholetragicomedy was repeated,stepbystep,in1967–1969.*

NewCommon-StockOfferings

The following paragraphsare reproduced unchangedfrom the 1959 edition, with

commentadded:

Common-stockfinancing takes twodifferent forms. In thecase of companiesalready listed,additionalshares are offered prorata to the existingstockholders. Thesubscription price is setbelow the currentmarket, and the “rights”to subscribe have an

initial money value.*The sale of the newshares is almost alwaysunder-written by one ormore investmentbankinghouses,but it isthe general hope andexpectation that all thenewshareswillbetakenby the exercise of thesubscriptionrights.Thusthe sale of additionalcommon stock of listed

companies does notordinarily call for activesellingefforton thepartofdistributingfirms.

The second type is theplacement with thepublic of common stockof what were formerlyprivately ownedenterprises.Most of thisstock is sold for theaccount of thecontrolling interests to

enable them to cash inon a favorable marketand to diversify theirown finances. (Whennewmoney is raised forthe business it comesoften via the sale ofpreferred stock, aspreviously noted.) Thisactivity follows a well-defined pattern, whichby the nature of thesecurity markets mustbring many losses and

disappointments to thepublic.Thedangersariseboth from the characterofthebusinessesthatarethus financed and fromthe market conditionsthat make the financingpossible.

In the early part of thecentury a largeproportionofourleadingcompanies wereintroduced to public

trading. As time wenton, the number ofenterprises of first rankthat remained closelyheldsteadilydiminished;hence original common-stock flotations havetended to beconcentrated more andmoreon relatively smallconcerns. By anunfortunate correlation,during the same periodthe stock-buying public

has been developing aningrained preference forthemajorcompaniesanda similar prejudiceagainst the minor ones.This prejudice, likemany others, tends tobecome weaker as bullmarketsarebuiltup; thelarge and quick profitsshown by commonstocks as a whole aresufficient to dull thepublic’s critical faculty,

just as they sharpen itsacquisitive instinct.During these periods,also, quite a number ofprivately ownedconcerns can be foundthat are enjoyingexcellent results—although most of thesewould not present tooimpressive a record ifthe figures were carriedback, say, ten years ormore.

When these factors areput together thefollowing consequencesemerge: Somewhere inthe middle of the bullmarket the firstcommon-stockflotationsmake their appearance.These are priced notunattractively, and somelargeprofitsaremadebythe buyers of the earlyissues. As the marketrisecontinues,thisbrand

offinancinggrowsmorefrequent; the quality ofthe companies becomessteadily poorer; theprices asked andobtained verge on theexorbitant. One fairlydependable sign of theapproaching end of abullswingisthefactthatnew common stocks ofsmall and nondescriptcompaniesareofferedatprices somewhat higher

thanthecurrentlevelformany medium-sizedcompanies with a longmarket history. (Itshould be added thatvery little of thiscommon-stockfinancingis ordinarily done bybankinghousesofprimesizeandreputation.)*

The heedlessness of thepublic and thewillingness of selling

organizations to sellwhatever may beprofitably sold can haveonly one result—pricecollapse. In many casesthenewissueslose75%and more of theiroffering price. Thesituation isworsened bythe aforementioned factthat, at bottom, thepublic has a realaversiontotheverykindof small issue that it

bought so readily in itscarelessmoments.Manyof these issues fall,proportionately,asmuchbelowtheirtruevalueastheyformerlysoldaboveit.

An elementaryrequirement for theintelligent investor is anability to resist theblandishments ofsalesmen offering new

common-stock issuesduring bull markets.Even if one or two canbe found that can passsevere tests of qualityandvalue, it isprobablybad policy to get mixedup in this sort ofbusiness. Of course thesalesman will point tomany such issueswhichhave had good-sizedmarket advances—including some that go

upspectacularlytheverydaytheyaresold.Butallthis is part of thespeculative atmosphere.It is easy money. Foreverydollaryoumakeinthis way you will belucky if you end up bylosingonlytwo.

Some of these issuesmay prove excellentbuys—a fewyears later,when nobody wants

them and they can behadatasmallfractionoftheirtrueworth.

In the 1965 edition wecontinued our discussion ofthissubjectasfollows:

While the broaderaspects of the stockmarket’s behavior since1949 have not lentthemselves well toanalysis based on long

experience, thedevelopment of newcommon-stockflotationsproceeded exactly inaccordance with ancientprescription. It isdoubtful whether weeverbeforehadsomanynew issues offered, ofsuch low quality, andwith such extreme pricecollapses, as weexperienced in 1960–

1962.4Theabilityofthestockmarketasawholeto disengage itselfrapidlyfromthatdisasteris indeed anextraordinaryphenomenon, bringingback long-buriedmemories of the similarinvulnerabilityitshowedtothegreatFloridareal-estatecollapsein1925.

Musttherebeareturnof

the new-stock-offeringmadness before thepresent bull market cancome to its definitiveclose?Whoknows?Butwe do know that anintelligent investor willnot forget whathappened in 1962 andwill let others make thenext batch of quickprofits in this area andexperience theconsequent harrowing

losses.

We followed theseparagraphs in the 1965editionbyciting“AHorribleExample,”namely,thesaleofstock of Aetna MaintenanceCo.at$9inNovember1961.In typical fashion the sharespromptly advanced to $15;the next year they fell to 23/8, and in 1964 to 7/8. Thelater history of this companywasontheextraordinaryside,

and illustrates some of thestrange metamorphoses thathavetakenplaceinAmericanbusiness, great and small, inrecent years. The curiousreaderwillfindtheolderandnewer history of thisenterpriseinAppendix5.

It is by nomeans difficultto provide even moreharrowing examples takenfrom themore recentversionof “the same old story,”

which covered the years1967–1970.Nothingcouldbemorepat toourpurpose thanthecaseofAAAEnterprises,whichhappens tobe the firstcompany then listed inStandard & Poor’s StockGuide. The shares were soldto the public at $14 in 1968,promptlyadvancedto28,butin early 1971were quoted atadismal25¢.(Eventhispricerepresented a grossovervaluation of the

enterprise, since it had justentered the bankruptcy courtin a hopeless condition.)There is so much to belearned, and such importantwarnings tobegleaned, fromthestoryof thisflotationthatwe have reserved it fordetailed treatment below, inChapter17.


The punches you miss are theonesthatwearyouout.—BoxingtrainerAngeloDundee

Fortheaggressiveaswellasthe defensive investor, whatyou don’t do is as important

to your success as what youdo. In this chapter, Grahamlists his “don’ts” foraggressive investors. Here isalistfortoday.

JunkyardDogs?

High-yield bonds—whichGraham calls “second-grade”or “lower-grade” and todayare called “junk bonds”—geta brisk thumbs-down from

Graham.Inhisday,itwastoocostlyandcumbersomeforanindividual investor todiversify away the risks ofdefault.;1(Tolearnhowbadadefault can be, and howcarelessly even“sophisticated” professionalbond investors can buy intoone, see the sidebar on p.146.) Today, however, morethan 130 mutual fundsspecialize in junk bonds.

These funds buy junk by thecartload; theyholddozensofdifferent bonds. Thatmitigates Graham’scomplaints about thedifficulty of diversifying.(However, his bias againsthigh-yield preferred stockremains valid, since thereremainsnocheapandwidelyavailableway to spread theirrisks.)

Since 1978, an annual

average of 4.4%of the junk-bond market has gone intodefault—but,evenafterthosedefaults,junkbondshavestillproduced an annualizedreturnof10.5%,versus8.6%for 10-year U.S. Treasurybonds.2 Unfortunately, mostjunk-bond funds charge highfees and do a poor job ofpreserving the originalprincipal amount of yourinvestment. A junk fund

could be appropriate if youare retired, are looking forextra monthly income tosupplementyourpension,andcan tolerate temporarytumblesinvalue.Ifyouworkat a bank or other financialcompany, a sharp rise ininterestratescouldlimityourraise or even threaten yourjob security—soa junk fund,which tends to outper-formsmost other bond funds wheninterestratesrise,mightmake

sense as a counterweight inyour 401(k). A junk-bondfund, though, isonlyaminoroption—not an obligation—fortheintelligentinvestor.

AWORLDOFHURTFORWORLDCOMBONDS

Buyingabondonlyforitsyield is like gettingmarriedonlyforthesex.Ifthethingthatattractedyouin the first placedriesup,you’ll find yourselfasking, “What else isthere?” When the answer

is “Nothing,” spouses andbondholders alike end upwithbrokenhearts.

On May 9, 2001,WorldCom, Inc. sold thebiggest offering of bondsin U.S. corporate history—$11.9 billion worth.Among the eager beaversattracted by the yields ofup to 8.3% were theCalifornia PublicEmployees’ RetirementSystem,oneoftheworld’slargest pension funds;Retirement Systems ofAlabama,whosemanagerslater explained that “the

higher yields”were “veryattractivetousatthetimetheywerepurchased”;andtheStrongCorporateBondFund, whose comanagerwas so fond ofWorldCom’sfatyieldthatheboasted,“we’regettingpaid more than enoughextraincomefortherisk.”1

But even a 30-secondglance at WorldCom’sbond prospectus wouldhave shown that thesebondshadnothingtoofferbut their yield—andeverything to lose. In two

of the previous five yearsWorldCom’s pretaxincome (the company’sprofits before it paid itsdues to theIRS)fellshortof covering its fixedcharges (the costs ofpaying interest to itsbondholders) by astupendous $4.1 billion.WorldCom could coverthosebondpaymentsonlybyborrowingmoremoneyfrom banks. And now,withthismountainousnewhelping of bonds,WorldCom was fatteningits interest costs byanother $900 million per

year!2 Like Mr. Creosotein Monty Python’s TheMeaning of Life,WorldCom was gorgingitselftotheburstingpoint.

No yield could ever behigh enough tocompensateaninvestorforrisking that kind ofexplosion.TheWorldCombonds did produce fatyields of up to 8% for afew months. Then, asGraham would havepredicted, the yieldsuddenly offered noshelter:

WorldCom filed bankruptcy inJuly2002.WorldCom admitted in August2002 that it had overstated itsearnings by more than $7billion.3

WorldCom’s bonds defaultedwhen the company could nolonger cover their interestcharges;thebondslostmorethan80%oftheiroriginalvalue.

TheVodka-and-BurritoPortfolio

Graham considered foreignbonds no better a bet thanjunk bonds.3Today, however,one variety of foreign bondmay have some appeal forinvestors who can withstandplenty of risk. Roughly adozenmutualfundsspecializeinbonds issued in emerging-marketnations (orwhatusedto be called “Third Worldcountries”) like Brazil,

Mexico,Nigeria,Russia, andVenezuela. No sane investorwouldputmore than10%ofatotalbondportfolioinspicyholdings like these. Butemerging-marketsbondfundsseldom move in synch withtheU.S.stockmarket,sotheyare one of the rareinvestments that are unlikelyto drop merely because theDow is down. That can giveyouasmallcornerofcomfortin your portfolio just when

youmayneeditmost.4

DyingaTrader’sDeath

As we’ve already seen inChapter 1, day trading—holding stocks for a fewhoursatatime—isoneofthebest weapons ever inventedfor committing financialsuicide. Some of your tradesmight make money, most ofyour trades will lose money,

but your broker will alwaysmakemoney.

Andyourowneagernesstobuyor sell a stockcan loweryour return.Someonewho isdesperate to buy a stock caneasilyenduphavingtobid10cents higher than the mostrecent share price before anysellerswill bewilling topartwithit.Thatextracost,called“market impact,” nevershows up on your brokerage

statement, but it’s real. Ifyou’reovereagertobuy1,000shares of a stock and youdrive itspriceupby just fivecents, you’ve just costyourselfaninvisiblebutveryreal $50. On the flip side,when panicky investors arefrantictosellastockandtheydumpitforlessthanthemostrecent price, market impacthitshomeagain.

The costs of trading wear

away your returns like somany swipes of sandpaper.Buying or selling a hot littlestock can cost 2% to 4% (or4% to 8% for a “round-trip”buy-and-sell transaction).5 Ifyou put $1,000 into a stock,your trading costs could eatup roughly $40 before youeven get started. Sell thestock, and you could forkover another 4% in tradingexpenses.

Oh,yes—there’soneotherthing.Whenyoutradeinsteadof invest, you turn long-termgains (taxed at a maximumcapital-gains rate of 20%)into ordinary income (taxedatamaximumrateof38.6%).

Add it all up, and a stocktrader needs to gain at least10% just to break even onbuying and selling a stock.6Anyone can do that once, byluck alone. To do it often

enough to justify theobsessiveattentionitrequires—plus the nightmarish stressitgenerates—isimpossible.

Thousands of people havetried, and the evidence isclear:Themoreyoutrade,thelessyoukeep.

Finance professors BradBarber and Terrance Odeanof the University ofCalifornia examined the

trading records of more than66,000 customers of amajordiscount brokerage firm.From 1991 through 1996,theseclientsmademore than1.9milliontrades.Beforethecosts of trading sandpaperedaway at their returns, thepeople in the study actuallyoutperformed the market byan average of at least half apercentagepointperyear.Butafter trading costs, the mostactive of these traders—who

shifted more than 20% oftheir stock holdings permonth—went from beatingthe market tounderperforming it by anabysmal 6.4 percentagepoints per year. The mostpatient investors, however—whotradedaminuscule0.2%of their total holdings in anaverage month—managed tooutper-forms themarketbyawhisker, even after theirtrading costs. Instead of

giving a huge hunk of theirgains away to their brokersandtheIRS,theygottokeepalmost everything.7 For alook at these results, seeFigure6-1.

The lesson is clear: Don’tjust do something, standthere. It’s time for everyonetoacknowledge that the term“long-term investor” isredundant. A long-terminvestor is the only kind of

investor there is. Someonewho can’t hold on to stocksformorethanafewmonthsata time is doomed to end upnotasavictorbutasavictim.

TheEarlyBirdGetsWormed

Among the get-rich-quicktoxinsthatpoisonedthemindof the investingpublic in the1990s,oneof themost lethalwas the idea that you can

buildwealthbybuyingIPOs.An IPO is an “initial publicoffering,”orthefirstsaleofacompany’s stock to thepublic. At first blush,investinginIPOssoundslikea great idea—after all, ifyou’d bought 100 shares ofMicrosoft when it wentpublic on March 13, 1986,your $2,100 investmentwould have grown to$720,000byearly2003.8And

finance professors Jay Ritterand William Schwert haveshown that ifyouhadspreada total of only $1,000 acrosseveryIPOinJanuary1960,atits offering price, sold out atthe end of that month, theninvested anew in eachsuccessive month’s crop ofIPOs, your portfolio wouldhave been worth more than$533 decillion by year-end2001.

(Ontheprintedpage,thatlookslikethis:

$533,000,000,000,000,000,000,000,000,000,000,000.)

FIGURE6-1

TheFasterYouRun,theBehinderYouGet

ResearchersBradBarberandTerrance Odean divided

thousandsof tradersintofivetiersbasedonhowoftentheyturned over their holdings.Those who traded the least(attheleft)keptmostoftheirgains. But the impatient andhyperactive traders madetheir brokers rich, notthemselves. (The bars at thefarrightshowamarketindexfundforcomparison.)

Source: Profs. Brad Barber,

University of California atDavis, and Terrance Odean,University of California atBerkeley

Unfortunately, for everyIPO likeMicrosoft that turnsout to be a bigwinner, thereare thousands of losers. Thepsychologists DanielKahnerman and AmosTversky have shown whenhumans estimate the

likelihoodor frequencyofanevent,wemakethatjudgmentbased not on how often theevent has actually occurred,but on how vivid the pastexamplesare.Weallwant tobuy “the next Microsoft”—precisely because we knowwe missed buying the firstMicrosoft. But weconveniently overlook thefact that most other IPOswere terrible investments.You could have earned that

$533 decillion gain only ifyounevermissedasingleoneof the IPO market’s rarewinners—a practicalimpossibility.Finally,mostofthe high returns on IPOs arecaptured by members of anexclusive private club—thebig investment banks andfundhousesthatgetsharesattheinitial(or“underwriting”)price,beforethestockbeginspublic trading. The biggest“run-ups” often occur in

stocks so small that evenmany big investors can’t getany shares; there just aren’tenoughtogoaround.

If, like nearly everyinvestor, you can get accesstoIPOsonlyaftertheirshareshave rocketed above theexclusive initial price, yourresults will be terrible. From1980 through 2001, if youhad bought the average IPOatitsfirstpublicclosingprice

and held on for three years,you would haveunderperformed the marketby more than 23 percentagepointsannually.9

Perhaps no stockpersonifies thepipedreamofgetting rich from IPOs betterthanVALinux.“LNUXTHENEXT MSFT,” exulted anearly owner; “BUY NOW,AND RETIRE IN FIVEYEARSFROMNOW.”10On

December 9, 1999, the stockwasplacedataninitialpublicoffering price of $30. Butdemandfortheshareswassoferocious that whenNASDAQ opened thatmorning, none of the initialowners of VA Linux wouldlet goof any shares until theprice hit $299. The stockpeakedat$320andclosedat$239.25,againof697.5% ina single day. But that gainwasearnedbyonlyahandful

of institutional traders;individual investors werealmostentirelyfrozenout.

More important, buyingIPOs isabad ideabecause itflagrantly violates one ofGraham’s most fundamentalrules: No matter how manyother people want to buy astock,youshouldbuyonlyifthe stock is a cheap way toown a desirable business. Atthe peak price on day one,

investors were valuing VALinux’s shares at a total of$12.7 billion. What was thecompany’s business worth?Less than five years old,VALinux had sold a cumulativetotal of $44millionworth ofitssoftwareandservices—buthad lost $25 million in theprocess. In its most recentfiscal quarter,VALinux hadgenerated$15millioninsalesbut had lost $10 million onthem. This business, then,

waslosingalmost70centsonevery dollar it took in. VALinux’s accumulated deficit(theamountbywhichitstotalexpenses had exceeded itsincome)was$30million.

IfVALinuxwereaprivatecompany owned by the guywho lives next door, and heleaned over the picket fenceandaskedyouhowmuchyouwould pay to take hisstruggling little business off

hishands,wouldyouanswer,“Oh, $12.7 billion soundsaboutrighttome”?Orwouldyou, instead, smile politely,turn back to your barbecuegrill, and wonder what onearthyourneighborhadbeensmoking? Relyingexclusively on our ownjudgment, none of us wouldbe caught dead agreeing topay nearly $13 billion for amoney-loser thatwasalready$30millioninthehole.

But when we’re in publicinstead of in private, whenvaluationsuddenlybecomesapopularity contest, the priceof a stock seems moreimportant than the value ofthebusiness it represents.Aslongassomeoneelsewillpayevenmorethanyoudidforastock, why does it matterwhatthebusinessisworth?

This chart shows why itmatters.

FIGURE6-2

TheLegendofVALinux

Aftergoinguplikeabottlerocket on that first day oftrading, VA Linux camedown like a buttered brick.By December 9, 2002, threeyears to the day after thestock was at $239.50, VALinux closed at $1.19 pershare.

Weighing the evidenceobjectively, the intelligentinvestor shouldconclude thatIPO does not stand only for

“initial public offering.”More accurately, it is alsoshorthandfor:

It’s ProbablyOverpriced,

ImaginaryProfitsOnly,

Insiders’ PrivateOpportunity,or

Idiotic, Preposterous,andOutrageous.

Chapter7PortfolioPolicyfortheEnterprisingInvestor:ThePositiveSide

Theenterprising investor,by

definition, will devote a fairamount of his attention andefforts toward obtaining abetter than run-of-the-millinvestment result. In ourdiscussion of generalinvestment policy we havemade some suggestionsregarding bond investmentsthat are addressed chiefly tothe enterprising investor. Hemightbeinterestedinspecialopportunitiesofthefollowingkinds:

1. Tax-free New HousingAuthority bondseffectively guaranteedby the United Statesgovernment.

2. Taxable but high-yielding NewCommunity bonds, alsoguaranteedbytheUnitedStatesgovernment.

3. Tax-free industrialbonds issued by

municipalities, butserviced by leasepayments made bystrongcorporations.

References have beenmade to these unusual typesofbondissuesinChapter4.*

At the other end of thespectrumtheremaybelower-quality bonds obtainable atsuch low prices as toconstitute true bargain

opportunities. But thesewould belong in the “specialsituation”area,wherenotruedistinction exists betweenbondsandcommonstocks.†

OperationsinCommonStocks

The activities speciallycharacteristic of theenterprising investor in thecommon-stock field may beclassifiedunderfourheads:

1. Buying in low marketsand selling in highmarkets

2. Buying carefully chosen“growthstocks”

3. Buyingbargainissuesofvarioustypes

4. Buying into “specialsituations”

GeneralMarketPolicy—FormulaTiming

We reserve for the next

chapter our discussion of thepossibilitiesandlimitationsofa policy of entering themarket when it is depressedand selling out in theadvanced stages of a boom.For many years in the pastthisbrightideaappearedbothsimple and feasible, at leastfrom first inspection of amarket chart covering itsperiodic fluctuations. Wehave already admittedruefully that the market’s

actioninthepast20yearshasnotlentitselftooperationsofthissortonanymathematicalbasis. The fluctuations thathave taken place, while notinconsiderable in extent,wouldhaverequiredaspecialtalentor “feel” for trading totake advantageof them.Thisis something quite differentfrom the intelligence whichwe are assuming in ourreaders,andwemustexcludeoperationsbasedonsuchskill

fromourtermsofreference.

The50–50plan,whichweproposed to the defensiveinvestor and described on p.90, is about the best specificor automatic formulawe canrecommend to all investorsundertheconditionsof1972.Butwehaveretainedabroadleeway between the 25%minimum and the 75%maximumincommonstocks,which we allow to those

investors who have strongconvictions about either thedangerortheattractivenessofthe general market level.Some 20 years ago it waspossible to discuss in greatdetail a number of clear-cutformulas for varying thepercentage held in commonstocks, with confidence thatthese plans had practicalutility.1 The times seem tohave passed such approaches

by, and there would be littlepoint in trying to determinenew levels for buying andselling out of the marketpatterns since 1949. That istoo short a period to furnishany reliable guide to thefuture.*

Growth-StockApproach

Every investor would liketo select the stocks ofcompanies thatwilldobetter

thantheaverageoveraperiodofyears.Agrowthstockmaybe defined as one that hasdone this in the past and isexpected to do so in thefuture.2 Thus it seems onlylogical that the intelligentinvestor should concentrateupon the selection of growthstocks.Actually thematter ismorecomplicated,asweshalltrytoshow.

Itisamerestatisticalchore

to identify companies thathave “out-performed theaverages” in the past. Theinvestor can obtain a list of50 or 100 such enterprisesfromhis broker.†Why, then,shouldhenotmerelypickoutthe 15 or 20 most likelylooking issues of this groupand lo! he has a guaranteed-successfulstockportfolio?

There are two catches tothis simple idea. The first is

that common stocks withgood records and apparentlygood prospects sell atcorrespondingly high prices.The investormay be right inhis judgment of theirprospects and still not fareparticularly well, merelybecause he has paid in full(and perhaps overpaid) forthe expected prosperity. Thesecondisthathisjudgmentasto the future may provewrong. Unusually rapid

growth cannot keep upforever;whenacompanyhasalready registered a brilliantexpansion,itsveryincreaseinsizemakes a repetition of itsachievement more difficult.At some point the growthcurve flattens out, and inmany cases it turnsdownward.

It is obvious that if oneconfines himself to a fewchosen instances, based on

hindsight, he coulddemonstrate that fortunescanreadilybeeithermadeorlostin the growth-stock field.How can one judge fairly ofthe overall results obtainablehere? We think thatreasonablysoundconclusionscanbedrawnfromastudyofthe results achieved by theinvestment fundsspecializinginthegrowth-stockapproach.The authoritative manualentitled Investment

Companies, publishedannually by ArthurWiesenberger & Company,members of the New YorkStock Exchange, computesthe annual performance ofsome 120 such “growthfunds”overaperiodofyears.Of these, 45 have recordscovering ten years or more.The average overall gain forthese companies—unweightedforsizeoffund—works out at 108% for the

decade1961–1970,comparedwith 105% for the S & Pcomposite and 83% for theDJIA.3Inthetwoyears1969and 1970 themajority of the126 “growth funds” didworse than either index.Similar resultswere found inour earlier studies. Theimplication here is that nooutstanding rewards camefrom diversified investmentin growth companies as

compared with that incommonstocksgenerally.*

Thereisnoreasonatallforthinking that the averageintelligentinvestor,evenwithmuch devoted effort, canderive better results over theyears from the purchase ofgrowth stocks than theinvestment companiesspecializing in this area.Surely these organizationshave more brains and better

research facilities at theirdisposal than you do.Consequently we shouldadvise against the usual typeof growth-stock commitmentfor theenterprising investor.*This is one in which theexcellent prospects are fullyrecognized in themarketandalready reflected in a currentprice-earnings ratio of, say,higher than 20. (For thedefensive investor we

suggested an upper limit ofpurchase price at 25 timesaverage earnings of the pastseven years. The two criteriawouldbeaboutequivalent inmostcases.)†

The striking thing aboutgrowth stocks as a class istheir tendency toward wideswings in market price. Thisis true of the largest andlongest-establishedcompanies—such as General

Electric and InternationalBusiness Machines—andeven more so of newer andsmallersuccessfulcompanies.They illustrateour thesis thatthemain characteristic of thestock market since 1949 hasbeentheinjectionofahighlyspeculative element into theshares of companies whichhavescoredthemostbrilliantsuccesses, and whichthemselveswould be entitledto a high investment rating.

(Their credit standing is ofthe best, and they pay thelowest interest rates on theirborrowings.) The investmentcaliber of such a companymay not change over a longspan of years, but the riskcharacteristicsofitsstockwilldependonwhathappenstoitinthestockmarket.Themoreenthusiastic the public growsabout it, and the faster itsadvanceascomparedwiththeactual growth in its earnings,

the riskier a proposition itbecomes.*

Butisitnottrue,thereadermay ask, that the really bigfortunesfromcommonstockshave been garnered by thosewho made a substantialcommitment in the earlyyearsofacompanyinwhosefuture they had greatconfidence, and who heldtheir original sharesunwaveringly while they

increased100-foldormoreinvalue? The answer is “Yes.”But the big fortunes fromsingle-company investmentsarealmostalwaysrealizedbypersons who have a closerelationship with theparticular company—throughemployment, familyconnection, etc.—whichjustifies them in placing alargepartoftheirresourcesinone medium and holding onto this commitment through

all vicissitudes, despitenumerous temptations to sellout at apparently high pricesalong the way. An investorwithout such close personalcontact will constantly befaced with the question ofwhethertoolargeaportionofhis funds are in this onemedium.* Each decline—however temporary it provesinthesequel—willaccentuatehisproblem;andinternaland

external pressures are likelyto force him to take whatseems to be a goodly profit,but one far less than theultimatebonanza.4

ThreeRecommendedFieldsfor“EnterprisingInvestment”

To obtain better thanaverage investment resultsover a long pull requires apolicy of selection oroperation possessing atwofold merit: (1) It mustmeet objective or rationaltestsofunderlyingsoundness;and (2) it must be differentfrom the policy followed by

mostinvestorsorspeculators.Our experience and studyleads us to recommend threeinvestment approaches thatmeet these criteria. Theydiffer ratherwidelyfromoneanother,andeachmayrequireadifferenttypeofknowledgeand temperament on the partofthosewhoassayit.

The Relatively Unpopular LargeCompany

Ifwe assume that it is thehabit of the market toovervalue common stockswhich have been showingexcellent growth or areglamorous for some otherreason, it is logical to expectthat it will undervalue—relatively, at least—companies that are out offavor because ofunsatisfactory developmentsof a temporary nature. Thismay be set down as a

fundamental lawof the stockmarket, and it suggests aninvestment approach thatshould prove bothconservativeandpromising.

The key requirement hereis that the enterprisinginvestor concentrate on thelarger companies that aregoing through a period ofunpopularity. While smallcompanies may also beundervalued for similar

reasons, and in many casesmay later increase theirearningsandshareprice,theyentail the risk of a definitiveloss of profitability and alsoof protracted neglect by themarket in spite of betterearnings. The largecompaniesthushaveadoubleadvantage over the others.First, theyhave theresourcesin capital andbrainpower tocarry them through adversityand back to a satisfactory

earnings base. Second, themarket is likely to respondwith reasonable speed to anyimprovementshown.

A remarkabledemonstration of thesoundness of this thesis isfound in studies of the pricebehavior of the unpopularissues in the Dow JonesIndustrialAverage.Intheseitwas assumed that aninvestment was made each

year in either the six or theten issues in theDJIAwhichwere selling at the lowestmultipliersof theircurrentorprevious year’s earnings.These could be called the“cheapest” stocks in the list,and their cheapness wasevidently the reflection ofrelative unpopularity withinvestors or traders. It wasassumed further that thesepurchasesweresoldoutattheend of holding periods

ranging from one to fiveyears. The results of theseinvestments were thencompared with the resultsshownineithertheDJIAasawhole or in the highestmultiplier (i.e., the mostpopular)group.

The detailed material wehave available covers theresults of annual purchasesassumed in each of the past53years.5Intheearlyperiod,

1917–1933, this approachproved unprofitable. Butsince 1933 the method hasshown highly successfulresults. In 34 tests made byDrexel & Company (nowDrexel Firestone)* of one-year holding—from 1937through 1969—the cheapstocks did definitely worsethan the DJIA in only threeinstances; the results wereabout the same in six cases;

and the cheap stocks clearlyoutperformed the average in25 years. The consistentlybetter performance of thelow-multiplier stocks isshown (Table 7-2) by theaverageresultsforsuccessivefive-year periods, whencompared with those of theDJIA and of the ten high-multipliers.

TABLE7-2AverageAnnual

PercentageGainorLossonTestIssues,1937–1969

The Drexel computationshowsfurtherthatanoriginal

investment of $10,000 madeinthelow-multiplierissuesin1936,andswitchedeachyearin accordance with theprinciple, would have grownto $66,900 by 1962. Thesame operations in high-multiplier stocks would haveended with a value of only$25,300; while an operationinallthirtystockswouldhaveincreasedtheoriginalfundto$44,000.†

The concept of buying“unpopular large companies”and its execution on a groupbasis,asdescribedabove,areboth quite simple. But inconsidering individualcompaniesaspecial factorofopposite import mustsometimes to be taken intoaccount. Companies that areinherently speculativebecause of widely varyingearningstendtosellbothatarelatively high price and at a

relatively low multiplier intheir good years, andconversely at low prices andhigh multipliers in their badyears.Theserelationshipsareillustrated in Table 7-3,covering fluctuations ofChrysler Corp. common. Inthese cases the market hassufficientskepticismastothecontinuation of the unusuallyhigh profits to value themconservatively, andconverselywhenearningsare

low or nonexistent. (Notethat, by the arithmetic, if acompany earns “next tonothing” its shares must sellat a high multiplier of theseminusculeprofits.)

AsithappensChryslerhasbeen quite exceptional in theDJIA list of leadingcompanies, and hence it didnotgreatlyaffectthethelow-multiplier calculations. Itwouldbequite easy to avoid

inclusion of such anomalousissues ina low-multiplier listby requiring also that theprice be low in relation topast average earnings or bysomesimilartest.

Whilewriting this revisionwe tested the results of theDJIA-low-multiplier methodappliedtoagroupassumedtobeboughtat theendof1968and revalued on June 30,

1971. This time the figuresproved quite disappointing,showing a sharp loss for thelow-multiplier six or ten anda good profit for the high-multiplier selections. Thisone bad instance should notvitiate conclusions based on30-odd experiments, but itsrecent happening gives it aspecial adverse weight.Perhaps the aggressiveinvestor should startwith the“low-multiplier”idea,butadd

other quantitative andqualitative requirementsthereto in making up hisportfolio.

TABLE 7-3 ChryslerCommon Prices andEarnings,1952–1970

PurchaseofBargainIssues

We define a bargain issueasonewhich,onthebasisof

facts established by analysis,appears to be worthconsiderably more than it isselling for. The genusincludes bonds and preferredstockssellingwellunderpar,aswellascommonstocks.Tobeasconcreteaspossible,letussuggestthatanissueisnota true “bargain” unless theindicated value is at least50% more than the price.What kind of facts wouldwarranttheconclusionthatso

great a discrepancy exists?How do bargains come intoexistence, and how does theinvestorprofitfromthem?

There are two tests bywhich a bargain commonstock is detected.The first isby the method of appraisal.This relies largely onestimating future earningsandthenmultiplyingthesebya factor appropriate to theparticular issue. If the

resultant value is sufficientlyabove themarket price—andiftheinvestorhasconfidencein the technique employed—he can tag the stock as abargain. The second test isthevalueof thebusiness toaprivateowner.Thisvaluealsoisoftendeterminedchieflybyexpected future earnings—inwhichcase the resultmaybeidenticalwiththefirst.Butinthesecondtestmoreattentionis likely to be paid to the

realizablevalueoftheassets,with particular emphasis onthe net current assets orworkingcapital.

At low points in thegeneral market a largeproportionofcommonstocksare bargain issues, asmeasured by these standards.(A typical example wasGeneralMotors when it soldat less than 30 in 1941,equivalent to only 5 for the

1971 shares. It had beenearning in excess of $4 andpaying $3.50, or more, individends.) It is true thatcurrent earnings and theimmediate prospects mayboth be poor, but alevelheaded appraisal ofaverage future conditionswould indicate values farabove rulingprices.Thus thewisdomofhavingcourage indepressed markets isvindicated not only by the

voice of experience but alsoby application of plausibletechniquesofvalueanalysis.

The same vagaries of themarket place that recurrentlyestablish a bargain conditioninthegenerallistaccountforthe existence of manyindividual bargains at almostallmarket levels.Themarketis fond ofmakingmountainsout of molehills andexaggerating ordinary

vicissitudes into majorsetbacks.* Even a mere lackofinterestorenthusiasmmayimpel a price decline toabsurdly lowlevels.Thuswehave what appear to be twomajor sources ofundervaluation: (1) currentlydisappointing results and (2)protracted neglect orunpopularity.

However, neither of thesecauses,ifconsideredbyitself

alone, can be relied on as aguide to successful common-stock investment. How canwe be sure that the currentlydisappointing results areindeed going to be onlytemporary? True, we cansupply excellent examples ofthat happening. The steelstocks used to be famous fortheir cyclicalquality, and theshrewd buyer could acquirethem at low prices whenearnings were low and sell

them out in boom years at afine profit. A spectacularexample is supplied byChrysler Corporation, asshownbythedatainTable7-3.

If this were the standardbehavior of stocks withfluctuating earnings, thenmaking profits in the stockmarket would be an easymatter. Unfortunately, wecould citemany examples of

declinesinearningsandpricewhich were not followedautomatically by a handsomerecovery of both. One suchwas Anaconda Wire andCable, which had largeearnings up to 1956, with ahighpriceof85 in thatyear.The earnings then declinedirregularly for six years; thepricefellto23½in1962,andthe following year it wastaken over by its parententerprise (Anaconda

Corporation)attheequivalentofonly33.

The many experiences ofthis type suggest that theinvestor would need morethanamerefallingoffinbothearnings and price to givehim a sound basis forpurchase. He should requirean indication of at leastreasonable stability ofearningsoverthepastdecadeor more—i.e., no year of

earnings deficit—plussufficient size and financialstrength to meet possiblesetbacks in the future. Theidealcombinationhereisthusthatofa largeandprominentcompany selling both wellbelow its past average priceand its past averageprice/earnings multiplier.This would no doubt haveruled out most of theprofitable opportunities incompanies such as Chrysler,

sincetheirlow-priceyearsaregenerally accompanied byhigh price/earnings ratios.But let us assure the readernow—and no doubtwe shalldo it again—that there is aworld of difference between“hindsight profits” and “real-money profits.” We doubtseriously whether theChryslertypeofrollercoasteris a suitable medium foroperationsbyourenterprisinginvestor.

We have mentionedprotracted neglect orunpopularity as a secondcause of price declines tounduly low levels. A currentcase of this kind wouldappear to be National PrestoIndustries. In thebullmarketof1968itsoldatahighof45,which was only 8 times the$5.61 earnings for that year.The per-share profitsincreased in both 1969 and1970, but the price declined

toonly21 in1970.Thiswasless than4 times the(record)earnings in thatyearand lessthan its net-current-assetvalue. InMarch 1972 it wasselling at 34, still only 5½times the last reportedearnings, and at about itsenlarged net-current-assetvalue.

Another example of thistype is provided currently byStandard Oil of California, a

concernofmajorimportance.Inearly1972itwassellingatabout the same price as 13years before, say 56. Itsearningshadbeenremarkablysteady, with relatively smallgrowth but with only onesmall decline over the entireperiod. Its book value wasabout equal to the marketprice. With thisconservatively favorable1958–71 record the companyhas never shown an average

annual price as high as 15times its current earnings. Inearly 1972 the price/earningsratiowasonlyabout10.

Athirdcauseforanundulylowpriceforacommonstockmaybethemarket’sfailuretorecognize its true earningspicture. Our classic examplehere is Northern PacificRailway which in 1946–47declinedfrom36to13½.Thetrue earnings of the road in

1947 were close to $10 pershare. The price of the stockwas held down in great partby its $1 dividend. It wasneglected also becausemuchof its earnings power wasconcealed by accountingmethodspeculiartorailroads.

The type of bargain issuethat can be most readilyidentified is a common stockthat sells for less than thecompany’s net working

capital alone, after deductingall prior obligations.* Thiswould mean that the buyerwould pay nothing at all forthe fixed assets—buildings,machinery,etc.,oranygood-will items that might exist.Veryfewcompanies turnouttohaveanultimatevaluelessthan the working capitalalone, although scatteredinstancesmay be found. Thesurprisingthing,rather,isthat

there have been so manyenterprises obtainable whichhave been valued in themarket on this bargain basis.Acompilationmade in1957,when the market’s level wasby no means low, disclosedabout 150 of such commonstocks. In Table 7-4 wesummarize the result ofbuying, on December 31,1957,oneshareofeachofthe85 companies in that list forwhich data appeared in

Standard & Poor’s MonthlyStock Guide, and holdingthemfortwoyears.

By something of acoincidence, each of thegroups advanced in the twoyears to somewhere in theneighborhood of theaggregate net-current-assetvalue.Thegainfor theentire“portfolio”inthatperiodwas75%, against 50% forStandard & Poor’s 425

industrials. What is moreremarkableisthatnoneoftheissues showed significantlosses,sevenheldabouteven,and 78 showed appreciablegains.

Our experience with thistype of investment selection—onadiversifiedbasis—wasuniformly good for manyyears prior to 1957. It canprobablybeaffirmedwithouthesitation that itconstitutesa

safeandprofitablemethodofdetermining and takingadvantage of undervaluedsituations. However, duringthe general market advanceafter1957thenumberofsuchopportunities becameextremely limited, and manyof those available wereshowing small operatingprofits or even losses. Themarket decline of 1969–70producedanewcropofthese“sub-working-capital” stocks.

We discuss this group inChapter15,onstockselectionfortheenterprisinginvestor.

TABLE 7-4 ProfitExperience of UndervaluedStocks,1957–1959

BARGAIN-ISSUEPATTERN INSECONDARY COMPANIES. Wehave defined a secondarycompany as one that is not aleader in a fairly important

industry. Thus it is usuallyoneofthesmallerconcernsinits field, but it may equallywell be the chief unit in anunimportant line. By way ofexception, any company thathas established itself as agrowthstockisnotordinarilyconsidered“secondary.”

In thegreatbullmarketofthe 1920s relatively littledistinction was drawnbetween industry leaders and

other listed issues, providedthe latterwere of respectablesize. The public felt that amiddle-sized company wasstrong enough to weatherstormsandthatithadabetterchance for really spectacularexpansion than one that wasalready ofmajor dimensions.The depression years 1931–32, however, had aparticularly devastatingimpact on the companiesbelow the first rank either in

size or in inherent stability.Asaresultofthatexperienceinvestors have sincedeveloped a pronouncedpreference for industryleaders and a correspondinglack of interest most of thetimeintheordinarycompanyof secondary importance.Thishasmeant that the lattergroup have usually sold atmuchlowerpricesinrelationto earnings and assets thanhavetheformer.Ithasmeant

furtherthatinmanyinstancesthepricehasfallensolowasto establish the issue in thebargainclass.

When investors rejectedthe stocks of secondarycompanies,eventhoughthesesold at relatively low prices,theywereexpressingabeliefor fear that such companiesfacedadismalfuture.Infact,at least subconsciously, theycalculated thatany pricewas

too high for them becausethey were heading forextinction—just as in 1929thecompanion theory for the“bluechips”wasthatnopricewas too high for thembecause their futurepossibilities were limitless.Both of these views wereexaggerations and wereproductive of seriousinvestment errors. Actually,thetypicalmiddle-sizedlistedcompanyisa largeonewhen

compared with the averageprivately owned business.Thereisnosoundreasonwhysuch companies should notcontinue indefinitely inoperation, undergoing thevicissitudes characteristic ofour economy but earning onthe whole a fair return ontheirinvestedcapital.

This brief review indicatesthat the stock market’sattitude toward secondary

companies tends to beunrealistic and consequentlyto create in normal timesinnumerable instances ofmajor undervaluation. As ithappens, the World War IIperiodand thepostwarboomwere more beneficial to thesmaller concerns than to thelarger ones, because then thenormal competition for saleswas suspended and theformer could expand salesand profit margins more

spectacularly. Thus by 1946the market’s pattern hadcompletely reversed itselffrom that before the war.Whereastheleadingstocksinthe Dow Jones IndustrialAverage had advanced only40%fromtheendof1938tothe 1946 high, Standard &Poor’s index of low-pricedstocks had shot up no lessthan 280% in the sameperiod.Speculatorsandmanyself-styled investors—with

theproverbialshortmemoriesofpeopleinthestockmarket—wereeagertobuybotholdand new issues ofunimportant companies atinflated levels. Thus thependulumhadswungcleartothe opposite extreme. Theveryclassofsecondaryissuesthathadformerlysuppliedbyfar the largest proportion ofbargain opportunities wasnow presenting the greatestnumber of examples of

overenthusiasm andovervaluation. In a differentway this phenomenon wasrepeated in1961and1968—the emphasis now beingplaced on new offerings ofthesharesofsmallcompaniesof less than secondarycharacter, and on nearly allcompanies in certain favoredfields such as “electronics,”“computers,” “franchise”concerns,andothers.*

Aswas to be expected theensuing market declines fellmost heavily on theseovervaluations.Insomecasesthe pendulum swing mayhave gone as far as definiteundervaluation.

If most secondary issuestend normally to beundervalued,whatreasonhastheinvestortobelievethathecan profit from such asituation? For if it persists

indefinitely, will he notalwaysbeinthesamemarketposition as when he boughttheissue?Theanswerhereissomewhat complicated.Substantial profits from thepurchase of secondarycompanies at bargain pricesarise in a variety of ways.First, the dividend return isrelatively high. Second, thereinvested earnings aresubstantial in relation to thepricepaidandwillultimately

affect the price. In a five-toseven-year period theseadvantages can bulk quitelarge in a well-selected list.Third, a bull market isordinarily most generous tolow-priced issues; thus ittends to raise the typicalbargain issue to at least areasonablelevel.Fourth,evenduring relatively featurelessmarket periods a continuousprocess of price adjustmentgoes on, under which

secondary issues that wereundervaluedmayriseat leastto the normal level for theirtype of security. Fifth, thespecific factors that in manycases made for adisappointing record ofearningsmaybecorrectedbytheadventofnewconditions,or the adoption of newpolicies, or by a change inmanagement.

Animportantnewfactorin

recent years has been theacquisition of smallercompanies by larger ones,usually as part of adiversification program. Inthese cases the considerationpaid has almost always beenrelativelygenerous,andmuchinexcessofthebargainlevelsexistingnotlongbefore.

When interest rates weremuchlowerthanin1970,thefield of bargain issues

extended to bonds andpreferred stocks that sold atlarge discounts from theamount of their claim.Currentlywehaveadifferentsituation inwhichevenwell-secured issues sell at largediscounts if carrying couponrates of, say, 4½% or less.Example: AmericanTelephone & Telegraph 25/8s,due1986,soldaslowas51in1970;Deere&Co.4½s,due 1983, sold as low as 62.

These may well turn out tohave been bargainopportunities before verylong—if ruling interest ratesshould decline substantially.For a bargain bond issue inthe more traditional senseperhapsweshallhavetoturnonce more to the first-mortgage bonds of railroadsnow in financial difficulties,which sell in the 20s or 30s.Suchsituationsarenotfortheinexpert investor; lacking a

real sense of values in thisarea,hemayburnhisfingers.But there is an underlyingtendency for market declinein this field to be overdone;consequently the group as awhole offers an especiallyrewarding invitation tocareful and courageousanalysis.Inthedecadeendingin 1948 the billion-dollargroup of defaulted railroadbonds presented numerousand spectacular opportunities

in this area. Suchopportunitieshavebeenquitescarce since then; but theyseem likely to return in the1970s.*

SpecialSituations,or“Workouts”

Notsolongagothiswasafield which could almostguaranteeanattractiverateofreturn to those who knewtheir way around in it; andthis was true under almost

any sort of general marketsituation. It was not actuallyforbidden territory tomembers of the generalpublic.Somewhohada flairfor this sort of thing couldlearn the ropes and becomepretty capable practitionerswithout the necessity of longacademic study orapprenticeship. Others havebeen keen enough torecognize the underlyingsoundness of this approach

and to attach themselves tobright young men whohandledfundsdevotedchieflyto these “special situations.”But in recent years, forreasons we shall developlater, the field of “arbitragesandworkouts”becameriskierandlessprofitable.Itmaybethat in years to comeconditions in this field willbecome more propitious. Inany case it is worthwhileoutlining the general nature

and origin of theseoperations, with one or twoillustrativeexamples.

The typical “specialsituation” has grown out ofthe increasing number ofacquisitions of smaller firmsbylargeones,asthegospelofdiversification of productshas been adopted by moreand more managements. Itoften appears good businessfor such an enterprise to

acquire an existing companyin the field itwishes to enterrather than to start a newventurefromscratch.Inorderto make such acquisitionpossible, and to obtainacceptanceof thedealby therequired large majority ofshareholders of the smallercompany, it is almost alwaysnecessary to offer a priceconsiderably above thecurrent level. Such corporatemoves have been producing

interesting profit-makingopportunities for those whohave made a study of thisfield, and have goodjudgment fortified by ampleexperience.

Agreatdealofmoneywasmadebyshrewdinvestorsnotso many years ago throughthe purchase of bonds ofrailroads in bankruptcy—bonds which they knewwould be worth much more

than their cost when therailroads were finallyreorganized. Afterpromulgation of the plans ofreorganization a “whenissued” market for the newsecurities appeared. Thesecould almost always be soldfor considerably more thanthe cost of the old issueswhich were to be exchangedtherefor. There were risks ofnonconsummation of theplans or of unexpected

delays,butonthewholesuch“arbitrageoperations”provedhighlyprofitable.

There were similaropportunities growing out ofthe breakup of public-utilityholding companies pursuantto1935legislation.Nearlyalltheseenterprisesprovedtobeworth considerably morewhen changed from holdingcompanies to a group ofseparateoperatingcompanies.

The underlying factor hereisthetendencyofthesecuritymarkets to undervalue issuesthat are involved in any sortof complicated legalproceedings. An old WallStreetmottohasbeen:“Neverbuyintoalawsuit.”Thismaybe sound advice to thespeculator seeking quickaction on his holdings. Butthe adoption of this attitudebythegeneralpublicisboundto create bargain

opportunities in thesecuritiesaffected by it, since theprejudice against them holdstheir prices down to undulylowlevels.*

The exploitation of specialsituations is a technicalbranch of investment whichrequires a somewhat unusualmentality and equipment.Probably only a smallpercentageofourenterprisinginvestorsarelikelytoengage

in it,and thisbook isnot theappropriate medium forexpounding itscomplications.6

BroaderImplicationsofOurRulesforInvestment

Investmentpolicy,asithasbeendevelopedhere,dependsin the first place on a choiceby the investor of either thedefensive (passive) oraggressive(enterprising)role.

The aggressive investormusthave a considerableknowledge of security values—enough, in fact, towarrantviewing his securityoperations as equivalent to abusiness enterprise. There isno room in this philosophyfor a middle ground, or aseries of gradations, betweenthe passive and aggressivestatus. Many, perhaps most,investors seek to placethemselves in such an

intermediate category; in ouropinion that is acompromisethatismorelikelytoproducedisappointment thanachievement.

As an investor you cannotsoundly become “half abusinessman,” expectingthereby to achieve half thenormal rate of businessprofitsonyourfunds.

It follows from this

reasoningthatthemajorityofsecurity owners should electthe defensive classification.Theydonothavethetime,orthe determination, or themental equipment to embarkupon investing as a quasi-business. They shouldthereforebesatisfiedwiththeexcellent return nowobtainable from a defensiveportfolio(andwithevenless),and theyshouldstoutly resistthe recurrent temptation to

increase this return bydeviatingintootherpaths.

The enterprising investormay properly embark uponany security operation forwhich his training andjudgment are adequate andwhich appears sufficientlypromisingwhenmeasuredbyestablished businessstandards.

In our recommendations

and caveats for this group ofinvestors we have attemptedto apply such businessstandards. In those for thedefensive investor we havebeen guided largely by thethree requirements ofunderlying safety, simplicityof choice, and promise ofsatisfactory results, in termsof psychology as well asarithmetic. The use of thesecriteria has led us to excludefrom the field of

recommended investment anumber of security classesthatarenormallyregardedassuitable for various kinds ofinvestors. These prohibitionswerelistedinourfirstchapteronp.30.

Let us consider a littlemorefullythanbeforewhatisimplied in these exclusions.We have advised against thepurchase at “full prices” ofthree important categories of

securities: (1) foreign bonds,(2)ordinarypreferred stocks,and (3) secondary commonstocks, including, of course,original offerings of suchissues. By “full prices” wemean prices close to par forbondsorpreferredstocks,andpricesthatrepresentaboutthefair business value of theenterprise in the case ofcommon stocks. The greaternumberofdefensiveinvestorsare to avoid these categories

regardless of price; theenterprisinginvestoristobuythemonlywhenobtainableatbargain prices—which wedefineaspricesnotmorethantwo-thirds of the appraisalvalueofthesecurities.

What would happen if allinvestorswereguidedbyouradvice in thesematters?Thatquestion was considered inregardtoforeignbonds,onp.138, andwe have nothing to

addat thispoint. Investment-grade preferred stockswouldbe bought solely bycorporations, such asinsurance companies, whichwould benefit from thespecial income-tax status ofstockissuesownedbythem.

The most troublesomeconsequenceofourpolicyofexclusion is in the field ofsecondarycommonstocks. Ifthe majority of investors,

being in the defensive class,arenottobuythematall,thefield of possible buyersbecomes seriously restricted.Furthermore, if aggressiveinvestors are to buy themonly at bargain levels, thenthese issues would bedoomed to sell for less thantheir fair value, except to theextent that they werepurchasedunintelligently.

Thismaysoundsevereand

even vaguely unethical. Yetin truth we are merelyrecognizingwhathasactuallyhappened in this area for thegreater part of the past 40years. Secondary issues, forthe most part, do fluctuateaboutacentrallevelwhichiswell below their fair value.They reach and even surpassthat value at times; but thisoccursintheupperreachesofbull markets, when thelessons of practical

experience would argueagainst the soundness ofpaying the prevailing pricesforcommonstocks.

Thus we are suggestingonly that the aggressiveinvestorrecognizethefactsoflifeasitislivedbysecondaryissuesandthattheyacceptthecentralmarket levels that arenormal for that class as theirguide in fixing their ownlevelsforpurchase.

There is a paradox here,nevertheless. The averagewell-selected secondarycompany may be fully aspromising as the averageindustrial leader. What thesmaller concern lacks ininherent stability it mayreadily make up in superiorpossibilities of growth.Consequently it may appearillogical to many readers toterm “unintelligent” thepurchase of such secondary

issuesat theirfull“enterprisevalue.” We think that thestrongest logic is that ofexperience. Financial historysays clearly that the investormay expect satisfactoryresults, on the average, fromsecondary common stocksonly ifhebuys them for lessthan their value to a privateowner, that is, on a bargainbasis.

The last sentence indicates

that this principle relates totheordinaryoutside investor.Anyone who can control asecondary company, or whois part of a cohesive groupwith such control, is fullyjustified in buying the shareson the same basis as if hewere investing in a “closecorporation” or other privatebusiness. The distinctionbetween the position, andconsequent investmentpolicy, of insiders and of

outsiders becomes moreimportant as the enterpriseitselfbecomesless important.Itisabasiccharacteristicofaprimary or leading companythatasingledetachedshareisordinarilyworthasmuchasashare in a controlling block.In secondary companies theaverage market value of adetached share issubstantially less than itsworth toacontrollingowner.Because of this fact, the

matter of shareholder-management relations and ofthose between inside andoutside shareholders tends tobemuchmore important andcontroversial in the case ofsecondary than in that ofprimarycompanies.

AttheendofChapter5wecommented on the difficultyof making any hard and fastdistinction between primaryand secondary companies.

Themany common stocks inthe boundary area mayproperly exhibit anintermediatepricebehavior.Itwould not be illogical for aninvestor tobuysuchan issueat a small discount from itsindicated or appraisal value,onthetheorythatit isonlyasmall distance away from aprimary classification andthat it may acquire such aratingunqualifiedlyinthenottoodistantfuture.

Thus the distinctionbetween primary andsecondary issues need not bemade too precise; for, if itwere, then a small differencein quality must produce alarge differential in justifiedpurchaseprice. Insaying thiswe are admitting a middlegroundintheclassificationofcommon stocks, althoughwecounseled against such amiddle ground in theclassification of investors.

Our reason for this apparentinconsistency is as follows:No great harm comes fromsome uncertainty ofviewpoint regarding a singlesecurity, because such casesare exceptional and not agreat deal is at stake in thematter. But the investor’schoice as between thedefensive or the aggressivestatus is of majorconsequence to him, and heshould not allow himself to

be confused or compromisedinthisbasicdecision.


It requires a great deal ofboldness and a great deal ofcaution tomake a great fortune;and when you have got it, itrequirestentimesasmuchwittokeepit.

—NathanMayerRothschild

TimingisNothing

In an ideal world, theintelligent investor wouldhold stocks only when theyarecheapandsellthemwhentheybecomeoverpriced,thenduckintothebunkerofbondsand cash until stocks againbecomecheapenoughtobuy.From1966throughlate2001,one study claimed, $1 heldcontinuously in stockswouldhavegrown to$11.71.But if

you had gotten out of stocksright before the five worstdays of each year, youroriginal$1wouldhavegrownto$987.12.1

Like most magical marketideas, this one is based onsleightofhand.How,exactly,wouldyou(oranyone)figureout which days will be theworst days—before theyarrive? On January 7, 1973,theNew York Times featured

an interview with one of thenation’s top financialforecasters, who urgedinvestors to buy stockswithout hesitation: “It’s veryrare that you can be asunqualifiedly bullish as youcan now.” That forecasterwas named Alan Greenspan,andit’sveryrarethatanyonehas ever been sounqualifiedly wrong as thefuture Federal Reservechairmanwas that day: 1973

and1974turnedouttobetheworst years for economicgrowth and the stock marketsincetheGreatDepression.2

Can professionals time themarket any better than AlanGreen-span?“Iseenoreasonnot to think the majority ofthe decline is behind us,”declared Kate Leary Lee,president of the market-timingfirmofR.M.Leary&Co., on December 3, 2001.

“Thisiswhenyouwanttobein the market,” she added,predicting that stocks “lookgood” for the first quarter of2002.3 Over the next threemonths, stocks earned ameasly 0.28% return,underperforming cash by 1.5percentagepoints.

Learyisnotalone.Astudyby two finance professors atDukeUniversityfoundthatifyou had followed the

recommendations of the best10% of all market-timingnewsletters, you would haveearned a 12.6% annualizedreturn from 1991 through1995.But ifyouhad ignoredthemandkeptyourmoneyina stock index fund, youwouldhaveearned16.4%.4

As theDanish philosopherSørenKierkegaardnoted,lifecan only be understoodbackwards—but it must be

livedforwards.Lookingback,you can always see exactlywhenyoushouldhaveboughtand sold your stocks. Butdon’t let that fool you intothinking you can see, in realtime, justwhen toget in andout. In the financialmarkets,hindsightisforever20/20,butforesightislegallyblind.Andthus, for most investors,market timing is a practicalandemotionalimpossibility.5

WhatGoesUp…

Like spacecraft that pick upspeed as they rise into theEarth’s stratosphere, growthstocks often seem to defygravity. Let’s look at thetrajectories of three of thehottest growth stocks of the1990s: General Electric,Home Depot, and SunMicrosystems.(SeeFigure7-1.)

In every year from 1995through 1999, each grewbigger and more profitable.RevenuesdoubledatSunandmore than doubled at HomeDepot. According to ValueLine, GE’s revenues grew29%; its earnings rose 65%.At Home Depot and Sun,earnings per share roughlytripled.

But something else washappening—and it wouldn’t

have surprised Graham onebit. The faster thesecompanies grew, the moreexpensive their stocksbecame. And when stocksgrow faster than companies,investors always end upsorry.AsFigure7-2shows:

A great company is not agreat investment if you paytoomuchforthestock.

Themoreastockhasgone

up,themoreitseemslikelytokeep going up. But thatinstinctive belief is flatlycontradicted by afundamental law of financialphysics:Thebigger theyget,the slower they grow. A $1-billion company can doubleits sales fairly easily; butwhere can a $50-billioncompany turn to findanother$50billioninbusiness?

Growth stocks are worth

buying when their prices arereasonable, but when theirprice/earningsratiosgomuchabove 25 or 30 the odds getugly:

Journalist Carol Loomisfound that, from 1960through1999,onlyeightof the largest 150companies on theFortune 500 listmanaged to raise their

earnings by an annualaverage of at least 15%fortwodecades.6Looking at five decadesofdata,theresearchfirmof Sanford C. Bernstein&Co. showed that only10% of large U.S.companieshadincreasedtheir earnings by 20%for at least fiveconsecutive years; only3% had grown by 20%

for at least 10 yearsstraight;andnotasingleone had done it for 15yearsinarow.7An academic study ofthousandsofU.S.stocksfrom1951through1998found that over all 10-year periods, netearnings grew by anaverage of 9.7%annually. But for thebiggest 20% of

companies, earningsgrew by an annualaverageofjust9.3%.8

FIGURE 7-2 Look OutBelow

n/a:Notapplicable;Sunhadnetlossin2002.

Sources:www.morningstar.com,yahoo.marketguide.com

Even many corporateleaders fail to understandthese odds (see sidebar on p.184).Theintelligentinvestor,however, gets interested inbig growth stocks not whentheyareattheirmostpopular—but when something goeswrong.InJuly2002,Johnson& Johnson announced thatFederal regulators wereinvestigating accusations offalserecordkeepingatoneofits drug factories, and the

stock lost 16% in a singleday. That took J& J’s sharepricedownfrom24timestheprevious12months’earningstojust20times.Atthatlowerlevel, Johnson & Johnsonmight once again havebecome a growth stock withroom to grow—making it anexample of what Grahamcalls“therelativelyunpopularlargecompany.”9

This kind of temporary

unpopularity can createlasting wealth by enablingyou to buy a great companyatagoodprice.

HIGHPOTENTIALFORHYPEPOTENTIAL

Investors aren’t the onlypeoplewhofallpreytothedelusion that hyper-growthcangoonforever.In February 2000, chiefexecutive John Roth ofNortel Networks wasasked how much biggerhis giant fiber-optics

company could get. “Theindustry is growing 14%to 15% a year,” Rothreplied, “and we’re goingto grow six points fasterthan that. For a companyour size, that’s prettyheady stuff.” Nortel’sstock, up nearly 51%annuallyovertheprevioussixyears,wasthentradingat 87 times what WallStreet was guessing itmight earn in 2000. Wasthestockoverpriced?“It’sgetting up there,”shrugged Roth, “butthere’sstillplentyofroomto grow our valuation as

weexecuteonthewirelessstrategy.” (After all, headded,CiscoSystemswastrading at 121 times itsprojectedearnings!)1

AsforCisco,inNovember2000, its chief executive,John Chambers, insistedthat his company couldkeepgrowingatleast50%annually. “Logic,” hedeclared, “would indicatethis is a breakaway.”Cisco’s stock had comeway down—it was thentradingatamere98timesits earnings over theprevious year—and

Chambers urged investorstobuy.“Sowhoyougoingto bet on?” he asked.“Now may be theopportunity.”2

Instead, these growthcompanies shrank—andtheir overpriced stocksshriveled. Nortel’srevenues fell by 37% in2001, and the companylostmore than$26billionthatyear.Cisco’srevenuesdid rise by 18% in 2001,butthecompanyendedupwith a net loss of morethan $1 billion. Nortel’sstock, at $113.50 when

Rothspoke,finished2002at$1.65.Cisco’sshares,at$52 when Chamberscalled his company a“break-away,” crumbledto$13.

Both companies havesince become morecircumspect aboutforecastingthefuture.

ShouldYouPutAllYourEggsinOneBasket?

“Put all your eggs into onebasket and then watch thatbasket,” proclaimed AndrewCarnegie a century ago. “Donot scatter your shot…. Thegreat successes of life aremade by concentration.” AsGraham points out, “thereally big fortunes fromcommon stocks” have beenmade by people who packedall their money into oneinvestment they knewsupremelywell.

Nearly all the richestpeople inAmerica trace theirwealth to a concentratedinvestment in a singleindustry or even a singlecompany (think Bill Gatesand Microsoft, Sam Waltonand Wal-Mart, or theRockefellers and StandardOil). The Forbes 400 list ofthe richest Americans, forexample,hasbeendominatedbyundiversifiedfortuneseversince itwas first compiled in

1982.

However, almost no smallfortuneshavebeenmade thisway—and not many bigfortunes have been kept thisway. What Carnegieneglected to mention is thatconcentration also makesmost of the great failures oflife.LookagainattheForbes“Rich List.” Back in 1982,the average net worth of aForbes 400 member was

$230million.Tomakeitontothe 2002 Forbes 400, theaverage1982memberneededto earn only a 4.5% averageannualreturnonhiswealth—during a period when evenbank accounts yielded farmore than that and the stockmarket gained an annualaverageof13.2%.

So how many of theForbes 400 fortunes from1982 remained on the list 20

years later? Only 64 of theoriginal members—a measly16%—werestillonthelistin2002. By keeping all theireggs in the one basket thathad gotten themonto the listin the first place—once-booming industries like oiland gas, or computerhardware, or basicmanufacturing—all the otheroriginal members fell away.Whenhardtimeshit,noneofthese people—despite all the

huge advantages that greatwealth can bring—wereproperly prepared. Theycould only stand by andwinceatthesickeningcrunchas the constantly changingeconomy crushed their onlybasketandalltheireggs.10

TheBargainBin

You might think that in ourendlesslynetworkedworld,it

wouldbeacinchtobuildandbuya listof stocks thatmeetGraham’scriteriaforbargains(p. 169). Although theInternet is a help, you’ll stillhave todomuchof theworkbyhand.

Grab a copy of today’sWall Street Journal, turn tothe “Money & Investing”section,andtakealookattheNYSE and NASDAQScorecards to find the day’s

lists of stocks that have hitnewlowsforthepastyear—aquickandeasywaytosearchforcompaniesthatmightpassGraham’snet-working-capitaltests.(Online,tryhttp://quote.morningstar.com/highlow.html?msection=HighLow.)

To see whether a stock issellingforlessthanthevalueof net working capital (whatGraham’s followers call “netnets”), download or request

the most recent quarterly orannual report from thecompany’s website or fromthe EDGAR database atwww.sec.gov. From thecompany’s current assets,subtract its total liabilities,includinganypreferred stockand long-term debt. (Orconsult your local publiclibrary’s copy of the ValueLine Investment Survey,saving yourself a costlyannual subscription. Each

issuecarriesalistof“BargainBasement Stocks” that comeclosetoGraham’sdefinition.)Most of these stocks latelyhave been in bombed-outareas like high-tech andtelecommunications.

AsofOctober31,2002,forinstance, ComverseTechnology had $2.4 billionin current assets and $1.0billion in total liabilities,giving it $1.4 billion in net

working capital. With fewerthan 190 million shares ofstock,andastockpriceunder$8pershare,Comversehadatotal market capitalization ofjust under $1.4 billion. Withthe stock priced at no morethanthevalueofComverse’scash and inventories, thecompany’s ongoing businesswas essentially selling fornothing. As Graham knew,youcanstilllosemoneyonastock like Comverse—which

iswhy you should buy themonly ifyoucanfindacoupledozenatatimeandholdthempatiently.Butontheveryrareoccasions when Mr. Marketgenerates that many truebargains, you’re all butcertaintomakemoney.

What’sYourForeignPolicy?

Investing in foreign stocksmaynotbemandatoryforthe

intelligent investor, but it isdefinitely advisable. Why?Let’s try a little thoughtexperiment. It’s the end of1989, and you’re Japanese.Herearethefacts:

Over the past 10 years,your stock market hasgained an annualaverage of 21.2%, wellahead of the 17.5%annual gains in the

UnitedStates.Japanese companies arebuying up everything inthe United States fromthe Pebble Beach golfcourse to RockefellerCenter; meanwhile,American firms likeDrexel BurnhamLambert, FinancialCorp. of America, andTexaco are goingbankrupt.The U.S. high-tech

industry is dying.Japan’sisbooming.

In1989, in the landof therising sun, you can onlyconclude that investingoutside of Japan is thedumbest idea since sushivendingmachines.Naturally,you put all your money inJapanesestocks.

The result? Over the nextdecade,youloseroughlytwo-

thirdsofyourmoney.

The lesson? It’s not thatyou should never invest inforeign markets like Japan;it’s that the Japanese shouldnever have kept all theirmoney at home. And neithershouldyou.IfyouliveintheUnited States, work in theUnitedStates,andgetpaidinU.S. dollars, you are alreadymakingamultilayeredbetonthe U.S. economy. To be

prudent,youshouldputsomeof your investment portfolioelsewhere—simply becauseno one, anywhere, can everknow what the future willbring at home or abroad.Putting up to a third of yourstockmoney inmutual fundsthat hold foreign stocks(including those in emergingmarkets) helps insure againstthe risk that our ownbackyard may not always bethebestplacein theworldto

invest.

Chapter8TheInvestorandMarketFluctuations

To the extent that theinvestor’sfundsareplacedin

high-gradebondsofrelativelyshortmaturity—say,ofsevenyears or less—hewill not beaffected significantly bychanges inmarketpricesandneed not take them intoaccount. (Thisappliesalso tohis holdings of U.S. savingsbonds, which he can alwaysturn in at his cost price ormore.)Hislonger-termbondsmay have relatively wideprice swings during theirlifetimes, and his common-

stock portfolio is almostcertain to fluctuate in valueover any period of severalyears.

The investor should knowabout these possibilities andshould be prepared for themboth financially andpsychologically.Hewillwantto benefit from changes inmarket levels—certainlythrough an advance in thevalueofhisstockholdingsas

time goes on, and perhapsalsobymakingpurchasesandsales at advantageous prices.This interest on his part isinevitable, and legitimateenough. But it involves thevery real danger that it willlead him into speculativeattitudes and activities. It iseasy for us to tell younot tospeculate; thehard thingwillbe for you to follow thisadvice.Letusrepeatwhatwesaidattheoutset:Ifyouwant

to speculate do so with youreyes open, knowing that youwill probably lose money inthe end; be sure to limit theamountatriskandtoseparateit completely from yourinvestmentprogram.

Weshalldealfirstwiththemore important subject ofprice changes in commonstocks, and pass later to thearea of bonds. In Chapter 3we supplied a historical

survey of the stock market’saction over the past hundredyears.Inthissectionweshallreturn to that material fromtime to time, in order to seewhatthepastrecordpromisesthe investor—in either theform of long-termappreciation of a portfolioheld relatively unchangedthrough successive rises anddeclines, or in thepossibilities of buying nearbear-market lows and selling

nottoofarbelowbull-markethighs.

MarketFluctuationsasaGuidetoInvestmentDecisions

Since common stocks,evenofinvestmentgrade,aresubject to recurrentandwidefluctuations in their prices,theintelligentinvestorshouldbe interested in thepossibilitiesofprofitingfromthese pendulum swings.

There are two possible waysby which he may try to dothis: the way of timing andthewayofpricing.Bytimingwe mean the endeavor toanticipate the action of thestockmarket—tobuyorholdwhen the future course isdeemed tobeupward, to sellor refrain from buying whenthe course is downward. Bypricingwemeantheendeavorto buy stocks when they arequoted below their fair value

and to sell them when theyriseabovesuchvalue.A lessambitious form of pricing isthesimpleefforttomakesurethatwhenyoubuyyoudonotpaytoomuchforyourstocks.This may suffice for thedefensive investor, whoseemphasis is on long-pullholding; but as such itrepresents an essentialminimum of attention tomarketlevels.1

We are convinced that theintelligentinvestorcanderivesatisfactory results frompricingofeithertype.Weareequally sure that if he placeshisemphasisontiming,inthesense of forecasting, he willend up as a speculator andwith a speculator’s financialresults. This distinction mayseem rather tenuous to thelayman, and it is notcommonly accepted on WallStreet. As a matter of

business practice, or perhapsof thoroughgoing conviction,the stock brokers and theinvestment services seemwedded to the principle thatbothinvestorsandspeculatorsin common stocks shoulddevote careful attention tomarketforecasts.

The farther one gets fromWall Street, the moreskepticism one will find, webelieve, as to the pretensions

ofstock-marketforecastingortiming. The investor canscarcely take seriously theinnumerable predictionswhich appear almost dailyandarehisfortheasking.Yetin many cases he paysattention to them and evenacts upon them. Why?Because he has beenpersuaded that it is importantforhimtoformsomeopinionof the future course of thestockmarket,andbecausehe

feels that the brokerage orservice forecast is at leastmore dependable than hisown.11

We lack space here todiscuss indetail theprosandconsofmarketforecasting.Agreat deal of brain powergoes into this field, andundoubtedlysomepeoplecanmake money by being goodstock-market analysts. But itis absurd to think that the

generalpubliccanevermakemoney out of marketforecasts. For who will buywhen thegeneralpublic, at agiven signal, rushes to sellout at a profit? If you, thereader,expecttogetrichoverthe years by following somesystem or leadership inmarket forecasting, youmustbeexpectingtotrytodowhatcountless others are aimingat, and to be able to do itbetter than your numerous

competitors in the market.There is no basis either inlogic or in experience forassuming that any typical oraverage investor cananticipatemarketmovementsmore successfully than thegeneralpublic,ofwhichheishimselfapart.

There is one aspect of the“timing” philosophy whichseems to have escapedeveryone’s notice. Timing is

of great psychologicalimportance to the speculatorbecausehewantstomakehisprofit inahurry.The ideaofwaiting a year before hisstock moves up is repugnanttohim.Butawaitingperiod,assuch,isofnoconsequenceto the investor. Whatadvantage is there to him inhaving hismoney uninvesteduntil he receives some(presumably) trustworthysignal that thetimehascome

to buy? He enjoys anadvantage only if by waitinghesucceedsinbuyinglaterata sufficiently lower price tooffset his loss of dividendincome. What this means isthattimingisofnorealvalueto the investor unless itcoincides with pricing—thatis, unless it enables him torepurchase his shares atsubstantially under hisprevioussellingprice.

In this respect the famousDow theory for timingpurchases and sales has hadan unusual history.* Briefly,thistechniquetakesitssignaltobuyfromaspecialkindof“breakthrough” of the stockaverages on the up side, andits selling signal from asimilar breakthrough on thedown side. The calculated—not necessarily actual—results of using this method

showed an almost unbrokenseriesofprofits inoperationsfrom1897totheearly1960s.On the basis of thispresentation the practicalvalue of the Dow theorywould have appeared firmlyestablished;thedoubt,ifany,would apply to thedependability of thispublished “record” as apicture of what a Dowtheorist would actually havedoneinthemarket.

A closer study of thefigures indicates that thequality of the results shownby the Dow theory changedradically after 1938—a fewyears after the theory hadbegun to be taken seriouslyonWallStreet.Itsspectacularachievement had been ingiving a sell signal, at 306,about a month before the1929crashandinkeepingitsfollowersoutofthelongbearmarketuntilthingshadpretty

well righted themselves, at84, in 1933. But from 1938on the Dow theory operatedmainly by taking itspractitioners out at a prettygood price but then puttingthembackinagainatahigherprice. For nearly 30 yearsthereafter, one would havedone appreciably better byjust buying and holding theDJIA.2

In our view, based on

much study of this problem,thechangeintheDow-theoryresults is not accidental. Itdemonstrates an inherentcharacteristic of forecastingand trading formulas in thefieldsofbusinessandfinance.Those formulas that gainadherents and importance dosobecause theyhaveworkedwell over a period, orsometimes merely becausethey have been plausiblyadapted to the statistical

recordofthepast.Butastheiracceptance increases, theirreliability tends to diminish.Thishappensfortworeasons:First, the passage of timebrings new conditions whichtheoldformulanolongerfits.Second, in stock-marketaffairs the popularity of atrading theory has itself aninfluence on the market’sbehaviorwhichdetractsinthelong run from its profit-making possibilities. (The

popularity of something liketheDow theorymayseem tocreate its own vindication,since it would make themarketadvanceordeclinebythe very action of itsfollowers when a buying orselling signal is given. A“stampede”ofthiskindis,ofcourse, much more of adanger than an advantage tothepublictrader.)

Buy-Low–Sell-HighApproach

We are convinced that theaverage investor cannot dealsuccessfully with pricemovementsbyendeavoringtoforecast them.Canhebenefitfrom them after they havetaken place—i.e., by buyingafter each major decline andselling out after each majoradvance? The fluctuations ofthe market over a period ofmanyyearspriorto1950lentconsiderable encouragementto that idea. In fact, a classic

definition of a “shrewdinvestor” was “one whoboughtinabearmarketwheneveryone else was selling,andsoldout inabullmarketwhen everyone else wasbuying.” If we examine ourChart I, covering thefluctuations of the Standard& Poor’s composite indexbetween 1900 and 1970, andthe supporting figures inTable 3-1 (p.66), we canreadily see why this

viewpoint appeared validuntilfairlyrecentyears.

Between 1897 and 1949there were ten completemarket cycles, running frombear-market low to bull-markethighandbacktobear-marketlow.Sixofthesetookno longer than four years,four ran for six or sevenyears, and one—the famous“new-era” cycle of 1921–1932—lasted eleven years.

The percentage of advancefromthelowstohighsrangedfrom 44% to 500%, withmostbetweenabout50%and100%. The percentage ofsubsequent declines rangedfrom24%to89%,withmostfoundbetween40%and50%.(Itshouldberememberedthatadeclineof50%fullyoffsetsa preceding advance of100%.)

Nearlyall thebullmarkets

hadanumberofwell-definedcharacteristics in common,suchas(1)ahistoricallyhighprice level, (2) highprice/earnings ratios, (3) lowdividend yields as againstbond yields, (4) muchspeculation on margin, and(5) many offerings of newcommon-stock issuesofpoorquality.Thustothestudentofstock-market history itappeared that the intelligentinvestor should have been

able to identify the recurrentbearandbullmarkets,tobuyin the former and sell in thelatter, and to do so for themost part at reasonably shortintervals of time. Variousmethods were developed fordetermining buying andselling levels of the generalmarket,basedoneithervaluefactors or percentagemovementsofpricesorboth.

Butwemustpointout that

even prior to theunprecedented bull marketthat began in 1949, therewere sufficient variations inthe successive market cyclesto complicate and sometimesfrustratethedesirableprocessof buying low and sellinghigh. The most notable ofthese departures, of course,was the great bull market ofthe late 1920s, which threwall calculations badly out of

gear.* Even in 1949,therefore,itwasbynomeansa certainty that the investorcould base his financialpolicies and proceduresmainly on the endeavor tobuy at low levels in bearmarketsandtoselloutathighlevelsinbullmarkets.

Itturnedout,inthesequel,that the opposite was true.Themarket’s behavior in thepast 20 years has not

followed the former pattern,nor obeyed what once werewell-established dangersignals, nor permitted itssuccessful exploitation byapplyingoldrules forbuyinglowandsellinghigh.Whetherthe old, fairly regular bull-and-bear-market pattern willeventually return we do notknow.Butitseemsunrealisticto us for the investor toendeavor to base his presentpolicy on the classic formula

—i.e., to wait fordemonstrable bear-marketlevels before buying anycommon stocks. Ourrecommended policy has,however, made provision forchanges in the proportion ofcommon stocks to bonds inthe portfolio, if the investorchooses to do so, accordingas the level of stock pricesappears less or moreattractivebyvaluestandards.*

FormulaPlans

In the early years of thestock-market rise that beganin 1949–50 considerableinterest was attracted tovarious methods of takingadvantage of the stockmarket’s cycles. These havebeen known as “formulainvestment plans.” Theessence of all such plans—except the simple case ofdollar averaging—is that the

investor automatically doessome selling of commonstocks when the marketadvances substantially. Inmany of them a very largeriseinthemarketlevelwouldresult in the sale of allcommon-stock holdings;others provided for retentionof a minor proportion ofequities under allcircumstances.

This approach had the

double appeal of soundinglogical(andconservative)andof showing excellent resultswhen applied retrospectivelyto the stock market overmany years in the past.Unfortunately,itsvoguegrewgreatestattheverytimewhenitwas destined towork leastwell. Many of the “formulaplanners” found themselvesentirely or nearly out of thestockmarketatsomelevelinthemiddle 1950s. True, they

hadrealizedexcellentprofits,but in a broad sense themarket“ranaway”fromthemthereafter, and their formulasgave them little opportunityto buy back a common-stockposition.*

There is a similaritybetween the experience ofthose adopting the formula-investing approach in theearly 1950s and those whoembraced the purely

mechanical version of theDow theory some 20 yearsearlier. In both cases theadvent of popularity markedalmost the exact momentwhen the system ceased towork well. We have had alike discomfiting experiencewith our own “central valuemethod” of determiningindicated buying and sellinglevels of the Dow JonesIndustrial Average. Themoral seems to be that any

approach tomoneymaking inthe stock market which canbe easily described andfollowedbyalotofpeopleisby its terms too simple andtoo easy to last.† Spinoza’sconcluding remark applies toWall Street as well as tophilosophy: “All thingsexcellent are as difficult astheyarerare.”

MarketFluctuationsoftheInvestor’sPortfolio

Every investor who ownscommon stocks must expecttoseethemfluctuateinvalueover the years. The behaviorof the DJIA since our lastedition was written in 1964probably reflects pretty wellwhat has happened to thestock portfolio of aconservative investor wholimited his stock holdings tothoseoflarge,prominent,andconservatively financedcorporations. The overall

value advanced from anaveragelevelofabout890toa high of 995 in 1966 (and985 again in 1968), fell to631 in 1970, and made analmostfullrecoveryto940inearly 1971. (Since theindividual issues set theirhigh and low marks atdifferent times, thefluctuationsintheDowJonesgroup as a whole are lesssevere than those in theseparate components.) We

have traced through thepricefluctuations of other types ofdiversified and conservativecommon-stock portfolios andwe find that the overallresults are not likely to bemarkedly different from theabove. In general, the sharesof second-line companies*fluctuate more widely thanthemajor ones, but this doesnot necessarily mean that agroup ofwell-established but

smaller companieswillmakeapoorershowingoverafairlylong period. In any case theinvestor may as well resignhimself in advance to theprobability rather than themere possibility that most ofhis holdings will advance,say, 50% ormore from theirlow point and decline theequivalent one-third or morefrom their high point atvarious periods in the next

fiveyears.†

A serious investor is notlikelytobelievethattheday-to-day or even month-to-month fluctuations of thestockmarketmakehimricherorpoorer.Butwhataboutthelonger-term and widerchanges? Here practicalquestionspresent themselves,and the psychologicalproblems are likely to growcomplicated. A substantial

riseinthemarketisatoncealegitimate reason forsatisfaction and a cause forprudent concern, but it mayalsobringastrongtemptationtoward imprudent action.Your shares have advanced,good!Youarericherthanyouwere,good!Buthasthepricerisen too high, and shouldyou think of selling? Orshould you kick yourself fornot having bought moreshares when the level was

lower?Or—worst thought ofall—should you now giveway to the bull-marketatmosphere, become infectedwith the enthusiasm, theoverconfidenceand thegreedofthegreatpublic(ofwhich,after all, you are a part), andmake larger and dangerouscommitments?Presentedthusinprint,theanswertothelastquestion is a self-evidentno,but even the intelligentinvestor is likely to need

considerable will power tokeep from following thecrowd.

It is for these reasons ofhuman nature, even morethan by calculation offinancialgainorloss,thatwefavor some kind ofmechanical method forvarying the proportion ofbonds to stocks in theinvestor’sportfolio.Thechiefadvantage, perhaps, is that

sucha formulawillgivehimsomething to do. As themarketadvanceshewillfromtimetotimemakesalesoutofhisstockholdings,putting theproceeds into bonds; as itdeclines he will reverse theprocedure. These activitieswill provide some outlet forhis otherwise too-pent-upenergies. If he is the rightkind of investor he will takeadded satisfaction from thethought that his operations

are exactly opposite fromthoseofthecrowd.*

BusinessValuationsversusStock-MarketValuations

The impact of marketfluctuations upon theinvestor’s true situation maybe considered also from thestandpoint of the shareholderas the part owner of variousbusinesses. The holder ofmarketable shares actually

has adouble status, andwithit the privilege of takingadvantage of either at hischoice. On the one hand hisposition is analogous to thatof a minority shareholder orsilent partner in a privatebusiness.Herehis results areentirely dependent on theprofitsoftheenterpriseorona change in the underlyingvalue of its assets.Hewouldusually determine the valueof such a private-business

interest by calculating hisshare of the net worth asshown in the most recentbalance sheet. On the otherhand, the common-stockinvestor holds a piece ofpaper, an engraved stockcertificate,whichcanbesoldin a matter of minutes at aprice which varies frommoment to moment—whenthemarket is open, that is—andoftenisfarremovedfrom

thebalance-sheetvalue.*

The development of thestock market in recentdecadeshasmade the typicalinvestor more dependent onthecourseofpricequotationsandlessfreethanformerlytoconsider himself merely abusinessowner.Thereasonisthatthesuccessfulenterprisesin which he is likely toconcentrate his holdings sellalmost constantly at prices

well above their net assetvalue (or book value, or“balance-sheet value”). Inpaying these marketpremiums the investor givesprecious hostages to fortune,for he must depend on thestockmarketitselftovalidatehiscommitments.†

This is a factor of primeimportance in present-dayinvesting, and ithas receivedlessattentionthanitdeserves.

Thewholestructureofstock-market quotations contains abuilt-in contradiction. Thebetter a company’s recordand prospects, the lessrelationship the price of itsshareswillhavetotheirbookvalue. But the greater thepremium above book value,the less certain the basis ofdeterminingitsintrinsicvalue—i.e., the more this “value”will depend on the changingmoods and measurements of

the stock market. Thus wereach the final paradox, thatthe more successful thecompany, the greater arelikelytobethefluctuationsinthe price of its shares. Thisreally means that, in a veryreal sense, the better thequality of a common stock,the more speculative it islikely to be—at least ascompared with theunspectacular middle-grade

issues.* (What we have saidappliestoacomparisonoftheleading growth companieswith the bulk of well-established concerns; weexclude from our purviewhere those issues which arehighly speculative becausethebusinessesthemselvesarespeculative.)

The argumentmade aboveshould explain the oftenerratic price behavior of our

most successful andimpressive enterprises. Ourfavorite example is themonarch of them all—International BusinessMachines. The price of itssharesfellfrom607to300inseven months in 1962–63;after two splits its price fellfrom 387 to 219 in 1970.Similarly, Xerox—an evenmore impressive earningsgainerinrecentdecades—fellfrom 171 to 87 in 1962–63,

and from 116 to 65 in 1970.These striking losses did notindicate any doubt about thefuture long-term growth ofIBMorXerox;theyreflectedinstead a lack of confidenceinthepremiumvaluationthatthe stock market itself hadplaced on these excellentprospects.

The previous discussionleads us to a conclusion ofpractical importance to the

conservative investor incommon stocks. If he is topaysomespecial attention tothe selection of his portfolio,it might be best for him toconcentrate on issues sellingat a reasonably closeapproximation to theirtangible-asset value—say, atnot more than one-thirdabove that figure. Purchasesmadeatsuchlevels,orlower,maywithlogicberegardedasrelated to the company’s

balancesheet,andashavingajustification or supportindependentofthefluctuatingmarket prices. The premiumover book value thatmay beinvolvedcanbeconsideredasa kind of extra fee paid forthe advantage of stock-exchange listing and themarketability that goes withit.

A caution is needed here.A stock does not become a

sound investment merelybecause it can be bought atclose to its asset value. Theinvestor should demand, inaddition, a satisfactory ratioof earnings to price, asufficiently strong financialposition,andtheprospectthatits earnings will at least bemaintained over the years.This may appear likedemanding a lot from amodestlypricedstock,buttheprescriptionisnothardtofill

under all but dangerouslyhighmarketconditions.Oncethe investor is willing toforgobrilliantprospects—i.e.,better than average expectedgrowth—he will have nodifficulty in finding a wideselection of issues meetingthesecriteria.

In our chapters on theselection of common stocks(Chapters14and15)weshallgive data showing that more

than half of the DJIA issuesmet our asset-value criterionat theendof1970.Themostwidelyheld investmentofall—American Tel. & Tel.—actually sells below itstangible-asset value as wewrite.Most of the light-and-power shares, in addition totheir other advantages, arenow(early1972)availableatprices reasonably close totheirassetvalues.

The investor with a stockportfolio having such bookvalues behind it can take amuch more independent anddetached view of stock-marketfluctuationsthanthosewho have paid highmultipliers of both earningsand tangible assets. As longas the earning power of hisholdingsremainssatisfactory,he cangive as little attentionas he pleases to the vagariesof the stock market. More

thanthat,at timeshecanusethese vagaries to play themaster game of buying lowandsellinghigh.

TheA.&P.Example

At this point we shallintroduce one of our originalexamples, which dates backmany years but which has acertain fascination for usbecause itcombinessomanyaspects of corporate and

investment experience. ItinvolvestheGreatAtlantic&Pacific Tea Co. Here is thestory:

A. & P. shares wereintroduced to trading on the“Curb” market, now theAmericanStockExchange,in1929andsoldashighas494.By1932theyhaddeclinedto104, although the company’searningswerenearlyas largein that generally catastrophic

year as previously. In 1936the range was between 111and131.Theninthebusinessrecession and bearmarket of1938 theshares fell toanewlowof36.

That price wasextraordinary. It meant thatthe preferred and commonweretogethersellingfor$126million, although thecompany had just reportedthat it held $85 million in

cash alone and a workingcapital (or net current assets)of$134million.A.&P.wasthe largest retailenterprise inAmerica, if not in theworld,with a continuous andimpressive record of largeearnings formanyyears.Yetin 1938 this outstandingbusiness was considered onWall Street to be worth lessthanitscurrentassetsalone—whichmeans less as a goingconcern than if it were

liquidated. Why? First,because therewere threatsofspecial taxesonchain stores;second, because net profitshadfallenoff in thepreviousyear; and, third, because thegeneral market wasdepressed. The first of thesereasons was an exaggeratedand eventually groundlessfear; the other two weretypical of temporaryinfluences.

Let us assume that theinvestor had bought A. & P.common in 1937 at, say, 12times its five-year averageearnings,orabout80.Wearefar from asserting that theensuing decline to 36was ofno importance to him. Hewouldhavebeenwelladvisedto scrutinize the picture withsomecare, to seewhetherhehad made anymiscalculations. But if theresults of his study were

reassuring—as they shouldhave been—he was entitledthen to disregard the marketdeclineasatemporaryvagaryof finance, unless he had thefundsandthecouragetotakeadvantage of it by buyingmore on the bargain basisoffered.

SequelandReflections

The following year, 1939,A. & P. shares advanced to

117½,or three times the lowpriceof1938andwellabovethe average of 1937. Such aturnabout in the behavior ofcommon stocks is by nomeansuncommon, but in thecase ofA.& P. it wasmorestriking than most. In theyears after 1949 the grocerychain’s shares rose with thegeneral market until in 1961the split-up stock (10 for 1)reachedahighof70½whichwasequivalent to705for the

1938shares.

This price of 70½ wasremarkableforthefactitwas30 times the earnings of1961. Such a price/earningsratio—which compares with23 timesfor theDJIAin thatyear—must have impliedexpectations of a brilliantgrowth in earnings. Thisoptimismhadno justificationin the company’s earningsrecordintheprecedingyears,

and it proved completelywrong. Instead of advancingrapidly, the course ofearningsintheensuingperiodwasgenerallydownward.Theyear after the 70½ high thepricefellbymorethanhalfto34. But this time the sharesdid not have the bargainquality that they showed atthe low quotation in 1938.After varying sorts offluctuations the price fell toanother low of 21½ in 1970

and 18 in 1972—havingreported the first quarterlydeficitinitshistory.

Weseeinthishistoryhowwide can be the vicissitudesof a major Americanenterpriseinlittlemorethanasingle generation, and alsowith what miscalculationsandexcessesofoptimismandpessimism the public hasvalueditsshares.In1938thebusiness was really being

givenaway,withnotakers;in1961 the public wasclamoring for the shares at aridiculously high price.Afterthatcameaquicklossofhalfthe market value, and someyears later a substantialfurther decline. In themeantime the company wastoturnfromanoutstandingtoa mediocre earningsperformer; its profit in theboom-year 1968 was to beless than in1958; ithadpaid

a series of confusing smallstockdividendsnotwarrantedby the current additions tosurplus;andsoforth.A.&P.wasalargercompanyin1961and 1972 than in 1938, butnot as well-run, not asprofitable, and not asattractive.*

Therearetwochiefmoralsto this story.The first is thatthe stock market often goesfarwrong, and sometimes an

alert andcourageous investorcan take advantage of itspatenterrors.Theotheristhatmost businesses change incharacterandqualityovertheyears, sometimes for thebetter,perhapsmoreoftenfortheworse. The investor neednot watch his companies’performancelikeahawk;butheshouldgiveitagood,hardlookfromtimetotime.

Let us return to our

comparison between theholder of marketable sharesand themanwith an interestin a private business. Wehavesaid that the formerhasthe option of consideringhimself merely as the partowner of the variousbusinesseshehasinvestedin,or as the holder of shareswhicharesalableatanytimehe wishes at their quotedmarketprice.

But note this importantfact: The true investorscarcelyeveris forced tosellhis shares, and at all othertimes he is free to disregardthe current price quotation.He need pay attention to itand act upon it only to theextent that it suits his book,and no more.* Thus theinvestorwho permits himselfto be stampeded or undulyworriedbyunjustifiedmarket

declines in his holdings isperversely transforming hisbasic advantage into a basicdisadvantage. That manwould be better off if hisstocks had no marketquotationatall, forhewouldthen be spared the mentalanguish caused him byotherpersons’ mistakes ofjudgment.†

Incidentally, a widespreadsituationof thiskindactually

existed during the darkdepression days of 1931–1933. There was then apsychological advantage inowningbusinessintereststhathad no quoted market. Forexample, people who ownedfirstmortgages on real estatethat continued topay interestwere able to tell themselvesthat their investments hadkept their full value, therebeingnomarketquotationstoindicate otherwise. On the

other hand, many listedcorporation bonds of evenbetter quality and greaterunderlying strength sufferedsevere shrinkages in theirmarket quotations, thusmaking their owners believethey were growing distinctlypoorer. In reality the ownerswerebetteroffwiththelistedsecurities, despite the lowprices of these. For if theyhad wanted to, or werecompelled to, they could at

least have sold the issues—possiblytoexchangethemforevenbetter bargains.Or theycould just as logically haveignoredthemarket’sactionastemporary and basicallymeaningless. But it is self-deceptiontotellyourself thatyou have suffered noshrinkage in value merelybecause your securities havenoquotedmarketatall.

Returning to our A. & P.

shareholder in 1938, weassert that as longasheheldon to his shares he sufferedno loss in theirpricedecline,beyond what his ownjudgmentmay have told himwas occasioned by ashrinkage in their underlyingor intrinsic value. If no suchshrinkage had occurred, hehad a right to expect that indue course the marketquotationwouldreturn to the1937 level or better—as in

factitdidthefollowingyear.In this respect his positionwas at least as good as if hehad owned an interest in aprivate business with noquoted market for its shares.Forinthatcase,too,hemightor might not have beenjustified in mentally loppingoff part of the cost of hisholdings because of theimpact of the 1938 recession—depending on what hadhappenedtohiscompany.

Critics of the valueapproach to stock investmentargue that listed commonstocks cannot properly beregarded or appraised in thesameway as an interest in asimilar private enterprise,because the presence of anorganized security market“injectsintoequityownershipthe new and extremelyimportant attribute ofliquidity.” But what thisliquidityreallymeansis,first,

that the investor has thebenefit of the stockmarket’sdaily and changing appraisalof his holdings, for whateverthat appraisalmaybeworth,and,second, that the investorisabletoincreaseordecreasehisinvestmentatthemarket’sdaily figure—if he chooses.Thus the existence of aquoted market gives theinvestor certain options thathe does not have if hissecurity is unquoted. But it

does not impose the currentquotationonan investorwhoprefers to take his idea ofvalue from some othersource.

Let us close this sectionwith something in the natureof a parable. Imagine that insome private business youown a small share that costyou $1,000. One of yourpartners, named Mr. Market,isveryobligingindeed.Every

day he tells you what hethinks your interest is worthand furthermore offers eithertobuyyououtor to sellyouan additional interest on thatbasis. Sometimes his idea ofvalue appears plausible andjustified by businessdevelopments and prospectsasyouknowthem.Often,onthe other hand, Mr. Marketlets his enthusiasm or hisfearsrunawaywithhim,andthe value he proposes seems

toyoualittleshortofsilly.

If you are a prudentinvestor or a sensiblebusinessman,willyouletMr.Market’s dailycommunication determineyour view of the value of a$1,000 interest in theenterprise? Only in case youagreewithhim,orincaseyouwant to tradewith him. Youmay be happy to sell out tohim when he quotes you a

ridiculously high price, andequally happy to buy fromhim when his price is low.But the rest of the time youwill be wiser to form yourown ideas of the value ofyour holdings, based on fullreports from the companyabout its operations andfinancialposition.

The true investor is in thatverypositionwhenheownsalisted common stock.He can

take advantage of the dailymarketpriceorleaveitalone,as dictated by his ownjudgment and inclination.Hemust take cognizance ofimportant price movements,for otherwise his judgmentwillhavenothingtoworkon.Conceivably they may givehim a warning signal whichhewilldowell toheed—thisinplainEnglishmeansthatheis to sell his shares becausethe price has gone down,

foreboding worse things tocome. In our view suchsignalsaremisleadingatleastas often as they are helpful.Basically, price fluctuationshave only one significantmeaningforthetrueinvestor.They provide him with anopportunity to buy wiselywhen prices fall sharply andto sell wisely when theyadvanceagreatdeal.Atothertimes he will do better if heforgets about the stock

market and pays attention tohis dividend returns and tothe operating results of hiscompanies.

Summary

The most realisticdistinction between theinvestorand thespeculator isfoundintheirattitudetowardstock-market movements.The speculator’s primaryinterest lies in anticipating

and profiting from marketfluctuations. The investor’sprimary interest lies inacquiring and holdingsuitable securities at suitableprices. Market movementsare important to him in apractical sense, because theyalternately create low pricelevels at which he would bewise to buy and high pricelevels at which he certainlyshould refrain from buyingand probably would be wise

tosell.

It is far from certain thatthe typical investor shouldregularly hold off buyinguntil low market levelsappear, because this mayinvolve a long wait, verylikelythelossofincome,andthe possible missing ofinvestment opportunities. Onthewholeitmaybebetterforthe investor to do his stockbuying whenever he has

money to put in stocks,except when the generalmarket level is much higherthancanbejustifiedbywell-established standards ofvalue. If he wants to beshrewd he can look for theever-present bargainopportunities in individualsecurities.

Aside from forecasting themovements of the generalmarket, much effort and

ability are directed on WallStreettowardselectingstocksor industrial groups that inmatter of price will “dobetter” than the rest over afairly short period in thefuture. Logical as thisendeavor may seem, we donot believe it is suited to theneeds or temperament of thetrue investor—particularlysincehewouldbecompetingwithalargenumberofstock-market traders and first-class

financial analysts who aretrying to do the same thing.As in all other activities thatemphasize price movementsfirst and underlying valuessecond, the work of manyintelligent minds constantlyengaged in this field tends tobe self-neutralizing and self-defeatingovertheyears.

The investor with aportfolio of sound stocksshould expect their prices to

fluctuate and should neitherbe concerned by sizabledeclines nor become excitedby sizable advances. Heshouldalways remember thatmarket quotations are thereforhisconvenience, either tobetakenadvantageofortobeignored.Heshouldneverbuya stock because it has goneup or sell onebecause it hasgonedown.Hewouldnotbefar wrong if this motto readmore simply: “Never buy a

stock immediately after asubstantial rise or sell oneimmediately after asubstantialdrop.”

AnAddedConsideration

Something should be saidabout the significance ofaverage market prices as ameasure of managerialcompetence. The shareholderjudges whether his owninvestment has been

successful in terms both ofdividendsreceivedandofthelong-range trend of theaverage market value. Thesamecriteriashould logicallybe applied in testing theeffectiveness of a company’smanagement and thesoundness of its attitudetoward the owners of thebusiness.

This statement may soundlike a truism, but it needs to

be emphasized. For as yetthereisnoacceptedtechniqueor approach by whichmanagementisbroughttothebarofmarketopinion.Onthecontrary, managements havealwaysinsistedthattheyhaveno responsibility of any kindfor what happens to themarket value of their shares.It is true,ofcourse, that theyare not accountable for thosefluctuationsinpricewhich,aswe have been insisting, bear

no relationship to underlyingconditions and values. But itis only the lack of alertnessand intelligence among therank and file of shareholdersthatpermits this immunity toextend to the entire realm ofmarket quotations, includingthe permanent establishmentof a depreciated andunsatisfactory price level.Good managements produceagood averagemarket price,and bad managements

producebadmarketprices.*

FluctuationsinBondPrices

The investor should beawarethateventhoughsafetyof its principal and interestmaybeunquestioned,along-term bond could varywidelyinmarketpriceinresponsetochanges in interest rates. InTable 8-1 we give data forvarious years back to 1902covering yields for high-

grade corporate and tax-freeissues. As individualillustrationswe add the pricefluctuations of tworepresentative railroad issuesfor a similar period. (Theseare the Atchison, Topeka &SantaFegeneralmortgage4s,due1995,forgenerationsoneof our premier noncallablebondissues,andtheNorthernPacific Ry. 3s, due 2047—originally a 150-yearmaturity!—long a typical

Baaratedbond.)

Because of their inverserelationship the low yieldscorrespond to thehighpricesandviceversa.Thedeclineinthe Northern Pacific 3s in1940 represented mainlydoubtsas to thesafetyof theissue. It is extraordinary thattheprice recovered to an all-time high in the next fewyears,andthenlosttwo-thirdsofitspricechieflybecauseof

the rise in general interestrates. There have beenstartlingvariations,aswell,inthepriceofeventhehighest-grade bonds in the past fortyyears.

Note that bond prices donot fluctuate in the same(inverse) proportion as thecalculated yields, becausetheir fixed maturity value of100% exerts a moderatinginfluence. However, for very

long maturities, as in ourNorthern Pacific example,prices and yields change atclosetothesamerate.

Since 1964 recordmovementsinbothdirectionshave takenplace in thehigh-grade bond market. Taking“primemunicipals” (tax-free)as an example, their yieldmore than doubled, from3.2% in January 1965 to 7%in June 1970. Their price

index declined,correspondingly, from 110.8to 67.5. In mid-1970 theyields on high-grade long-term bonds were higher thanatany time in thenearly200years of this country’seconomic history. * Twenty-five years earlier, just beforeour protracted bull marketbegan, bond yields were attheir lowest point in history;long-term municipals

returned as little as 1%, andindustrials gave 2.40%comparedwith the4½ to5%formerly considered“normal.”Thoseofuswithalong experience on WallStreethadseenNewton’slawof“actionandreaction,equalandopposite”work itselfoutrepeatedlyinthestockmarket—the most noteworthyexamplebeing the rise in theDJIAfrom64in1921to381in1929,followedbyarecord

collapse to 41 in 1932. Butthistimethewidestpendulumswings took place in theusually staid and slow-moving array of high-gradebond prices and yields.Moral:Nothing important onWallStreetcanbecountedonto occur exactly in the sameway as it happened before.This represents the first halfof our favorite dictum: “Themoreitchanges,themoreit’sthesamething.”

If it isvirtually impossibleto make worthwhilepredictions about the pricemovements of stocks, it iscompletely impossible to dosoforbonds.*Intheolddays,atleast,onecouldoftenfindausefulcluetothecomingendof a bull or bear market bystudying the prior action ofbonds, but no similar clueswere given to a comingchange in interest rates and

bond prices. Hence theinvestormustchoosebetweenlong-term and short-termbondinvestmentsonthebasischiefly of his personalpreferences.Ifhewantstobecertainthatthemarketvalueswill not decrease, his bestchoices are probably U.S.savingsbonds,SeriesEorH,whichwere described above,p. 93. Either issue will givehima5%yield(afterthefirstyear),theSeriesEforupto5

5/6years,theSeriesHforupto ten years, with aguaranteed resale value ofcostorbetter.

If the investor wants the7.5% now available on goodlong-termcorporatebonds,orthe 5.3% on tax-freemunicipals, he must bepreparedtoseethemfluctuateinprice.Banksandinsurancecompanies have the privilegeof valuing high-rated bonds

of this type on themathematical basis of“amortized cost,” whichdisregards market prices; itwould not be a bad idea forthe individual investor to dosomethingsimilar.

The price fluctuations ofconvertible bonds andpreferred stocks are theresultant of three differentfactors: (1) variations in theprice of the related common

stock, (2) variations in thecredit standing of thecompany, and (3) variationsin general interest rates. Agoodmanyoftheconvertibleissues have been sold bycompanies that have creditratings well below the best.3Some of these were badlyaffected by the financialsqueeze in1970.As a result,convertible issuesasawholehave been subjected to triply

unsettlinginfluencesinrecentyears, and price variationshavebeenunusuallywide. Inthetypicalcase,therefore,theinvestor would deludehimselfifheexpectedtofindin convertible issues thatideal combination of thesafety of a high-grade bondand price protection plus achance to benefit from anadvance in the price of thecommon.

This may be a good placeto make a suggestion aboutthe “long-term bond of thefuture.” Why should not theeffects of changing interestrates be divided on somepractical and equitable basisbetweentheborrowerandthelender?Onepossibilitywouldbe to sell long-term bondswith interest payments thatvary with an appropriateindex of the going rate. Themain results of such an

arrangement would be: (1)the investor’s bond wouldalwayshaveaprincipalvalueofabout100, if thecompanymaintainsitscreditrating,butthe interest received willvary, say, with the rateoffered on conventional newissues; (2) the corporationwouldhavetheadvantagesoflong-termdebt—beingsparedproblems and costs offrequent renewals ofrefinancing—but its interest

costswouldchangefromyeartoyear.4

Over the past decade thebond investor has beenconfrontedbyanincreasinglyserious dilemma: Shall hechoose complete stability ofprincipal value, but withvarying and usually low(short-term)interestrates?Orshall he choose a fixed-interest income, withconsiderable variations

(usuallydownward, it seems)in his principal value? Itwould be good for mostinvestors if they couldcompromise between theseextremes,andbeassuredthatneither their interest returnnor their principal value willfall below a statedminimumover, say, a 20-year period.This could be arranged,withoutgreatdifficulty, inanappropriatebondcontractofanew form. Importantnote: In

effect the U.S. governmenthasdoneasimilarthinginitscombination of the originalsavings-bonds contracts withtheir extensions at higherinterest rates.The suggestionwemakeherewould cover alonger fixed investmentperiod than the savingsbonds, and would introducemore flexibility in theinterest-rateprovisions.*

It is hardly worthwhile to

talk about nonconvertiblepreferred stocks, since theirspecial tax status makes thesafe ones much moredesirable holdings bycorporations—e.g., insurancecompanies— than byindividuals. The poorer-quality ones almost alwaysfluctuate over a wide range,percentagewise, not toodifferently from commonstocks.Wecanoffernootheruseful remark about them.

Table 16-2 below, p. 406,gives some information onthe price changes of lower-grade nonconvertiblepreferredsbetweenDecember1968 and December 1970.The average decline was17%,against11.3%fortheS& P composite index ofcommonstocks.


Thehappinessofthosewhowanttobepopulardependsonothers;thehappinessof thosewho seekpleasure fluctuates with moodsoutside their control; but thehappiness of thewise grows outoftheirownfreeacts.

—MarcusAurelius

Dr.JekyllandMr.Market

Most of the time, themarketis mostly accurate in pricingmost stocks. Millions ofbuyers and sellers hagglingover price do a remarkablygood job of valuingcompanies—on average. Butsometimes, the price is notright; occasionally, it is verywrong indeed. And at suchtimes,youneedtounderstandGraham’s image of Mr.

Market, probably the mostbrilliant metaphor evercreated for explaining howstocks can becomemispriced.1 The manic-depressive Mr. Market doesnot always price stocks thewayanappraiseroraprivatebuyerwouldvalueabusiness.Instead, when stocks aregoing up, he happily paysmore than their objectivevalue; and, when they are

going down, he is desperateto dump them for less thantheirtrueworth.

IsMr.Marketstillaround?Ishestillbipolar?Youbetheis.

On March 17, 2000, thestock of Inktomi Corp. hit anew high of $231.625. Sincetheyfirstcameonthemarketin June 1998, shares in theInternet-searching software

company had gained roughly1,900%. Just in the fewweeks sinceDecember 1999,thestockhadnearlytripled.

What was going on atInktomi the business thatcouldmakeInktomithestockso valuable? The answerseemsobvious:phenomenallyfast growth. In the threemonths ending in December1999, Inktomi sold $36million in products and

services,more than it had inthe entire year ending inDecember 1998. If Inktomicould sustain its growth rateoftheprevious12monthsforjust five more years, itsrevenueswouldexplodefrom$36 million a quarter to $5billion a month. With suchgrowthinsight,thefasterthestockwent up, the farther upitseemedcertaintogo.

But in his wild love affair

with Inktomi’s stock, Mr.Market was overlookingsomethingabout itsbusiness.The company was losingmoney—lotsof it. Ithad lost$6million in themost recentquarter,$24millioninthe12months before that, and $24million in the year beforethat. In its entire corporatelifetime, Inktomi had nevermade a dime in profits. Yet,on March 17, 2000, Mr.Market valued this tiny

business at a total of $25billion. (Yes, that’s billion,withaB.)

AndthenMr.Marketwentinto a sudden, nightmarishdepression.OnSeptember30,2002, just two and a halfyears after hitting $231.625per share, Inktomi’s stockclosed at 25 cents—collapsingfromatotalmarketvalue of $25 billion to lessthan $40 million. Had

Inktomi’s business dried up?Not at all; over the previous12months, the company hadgenerated $113 million inrevenues. So what hadchanged?OnlyMr.Market’smood: In early 2000,investors were so wild aboutthe Internet that they pricedInktomi’ssharesat250timesthe company’s revenues.Now, however, they wouldpay only 0.35 times itsrevenues. Mr. Market had

morphed from Dr. Jekyll toMr. Hyde and wasferociously trashing everystockthathadmadeafooloutofhim.

But Mr. Market was nomorejustifiedinhismidnightrage than he had been in hismanic euphoria. OnDecember 23, 2002, Yahoo!Inc. announced that it wouldbuy Inktomi for $1.65 pershare. Thatwas nearly seven

times Inktomi’s stock priceonSeptember30.Historywillprobably show that Yahoo!got a bargain. When Mr.Market makes stocks socheap, it’s no wonder thatentire companies get boughtrightoutfromunderhim.2

ThinkforYourself

Would youwillingly allow acertifiablelunatictocomeby

at least five times a week totell you that you should feelexactly the way he feels?Would you ever agree to beeuphoricjustbecauseheis—or miserable just because hethinks you should be? Ofcourse not. You’d insist onyour right to take control ofyour own emotional life,based on your experiencesandyourbeliefs.But,whenitcomestotheirfinanciallives,millions of people let Mr.

Market tell themhow to feeland what to do—despite theobvious fact that, from timeto time, he can get nuttierthanafruitcake.

In1999,whenMr.Marketwas squealing with delight,Americanemployeesdirectedan average of 8.6% of theirpaychecks into their 401(k)retirement plans. By 2002,after Mr. Market had spentthree years stuffing stocks

into black garbage bags, theaverage contribution rate haddropped by nearly one-quarter, to just 7%.3 Thecheaper stocks got, the lesseager people became to buythem—because they wereimitatingMr.Market, insteadofthinkingforthemselves.

The intelligent investorshouldn’t ignore Mr. Marketentirely. Instead, you shoulddo business with him—but

only to the extent that itserves your interests. Mr.Market’s job is to provideyouwithprices;yourjobistodecide whether it is to youradvantagetoactonthem.Youdonothavetotradewithhimjust because he constantlybegsyouto.

By refusing to let Mr.Market be your master, youtransform him into yourservant.After all, evenwhen

he seems to be destroyingvalues, he is creating themelsewhere. In 1999, theWilshire 5000 index—thebroadest measure of U.S.stock performance—gained23.8%, powered bytechnology andtelecommunications stocks.But3,743ofthe7,234stocksin the Wilshire index wentdown in value even as theaverage was rising. Whilethose high-tech and telecom

stocks were hotter than thehood of a race car on anAugust afternoon, thousandsof “Old Economy” shareswere frozen in the mud—gettingcheaperandcheaper.

The stock of CMGI, an“incubator” or holdingcompany for Internet start-upfirms,wentupanastonishing939.9% in 1999.Meanwhile,Berkshire Hathaway—theholding company through

which Graham’s greatestdisciple, Warren Buffett,owns such Old Economystalwarts as Coca-Cola,Gillette, and the WashingtonPost Co.—dropped by24.9%.4

But then, as it so oftendoes,themarkethadasuddenmood swing. Figure 8-1offers a samplingofhow thestinkers of 1999 became thestarsof2000through2002.

As for those two holdingcompanies,CMGIwentontolose 96% in 2000, another70.9% in 2001, and still39.8% more in 2002—acumulative loss of 99.3%.

BerkshireHathawaywent up26.6% in 2000 and 6.5% in2001, then had a slight 3.8%loss in 2002—a cumulativegainof30%.

CanYouBeattheProsatTheirOwnGame?

One of Graham’s mostpowerful insights is this:“The investor who permitshimself to be stampeded or

undulyworriedbyunjustifiedmarket declines in hisholdings is perverselytransforming his basicadvantage into a basicdisadvantage.”

What does Graham meanby those words “basicadvantage”? He means thatthe intelligent individualinvestor has the full freedomto choose whether or not tofollowMr.Market.Youhave

the luxury of being able tothinkforyourself.5

The typical moneymanager, however, has nochoice but to mimic Mr.Market’s every move—buying high, selling low,marching almost mindlesslyin his erratic footsteps. Hereare some of the handicapsmutual-fund managers andother professional investorsaresaddledwith:

With billions of dollarsundermanagement, theymust gravitate towardthe biggest stocks—theonly ones they can buyin the multimillion-dollar quantities theyneed to fill theirportfolios. Thus manyfundsendupowningthesame few overpricedgiants.

Investors tend to pourmore money into fundsas themarket rises. Themanagers use that newcash to buymore of thestockstheyalreadyown,driving prices to evenmoredangerousheights.If fund investorsask fortheir money back whenthe market drops, themanagers may need tosell stocks to cash themout.Justasthefundsare

forced to buy stocks atinflatedpricesinarisingmarket, they becomeforced sellers as stocksgetcheapagain.Many portfoliomanagers get bonusesfor beating the market,so they obsessivelymeasure their returnsagainst benchmarks liketheS&P500index.Ifacompany gets added toan index, hundreds of

funds compulsively buyit.(Iftheydon’t,andthatstockthendoeswell,themanagers look foolish;ontheotherhand,iftheybuyitanditdoespoorly,noonewillblamethem.)Increasingly, fundmanagers are expectedto specialize. Just as inmedicine the generalpractitioner has givenway to the pediatricallergistandthegeriatric

otolaryngologist, fundmanagersmustbuyonly“small growth” stocks,or only “mid-sizedvalue”stocks,ornothingbut “large blend”stocks.6 If a companygets too big, or toosmall, or too cheap, oranittybittooexpensive,the fund has to sell it—even if the managerlovesthestock.

So there’s no reason youcan’t do as well as the pros.What you cannot do (despiteall the pundits who say youcan) is to “beat the pros attheir own game.” The proscan’t even win their owngame!Why shouldyouwanttoplayitatall?Ifyoufollowtheir rules, you will lose—since you will end up asmuch a slave to Mr. Marketastheprofessionalsare.

Instead, recognize thatinvesting intelligently isabout controlling thecontrollable. You can’tcontrolwhether the stocksorfunds you buy will outper-forms themarket today, nextweek, this month, or thisyear; in the short run, yourreturns will always behostagetoMr.Marketandhiswhims.Butyoucancontrol:

your brokerage costs,by trading rarely,patiently,andcheaplyyour ownership costs,by refusing to buymutual funds withexcessive annualexpensesyour expectations, byusing realism, notfantasy, to forecast yourreturns7your risk, by deciding

howmuch of your totalassetstoputathazardinthe stock market, bydiversifying, and byrebalancingyour tax bills, byholding stocks for atleast one year and,wheneverpossible,foratleastfiveyears,toloweryour capital-gainsliabilityand, most of all, yourownbehavior.

If you listen to financialTV, or read most marketcolumnists, you’d think thatinvesting is some kind ofsport, or awar, or a strugglefor survival in a hostilewilderness.Butinvestingisn’tabout beating others at theirgame. It’s about controllingyourself at your own game.The challenge for theintelligent investor is not tofindthestocksthatwillgoupthemost and down the least,

but rather topreventyourselffrom being your own worstenemy—from buying highjustbecauseMr.Marketsays“Buy!” and from selling lowjustbecauseMr.Marketsays“Sell!”

If you investment horizonis long—at least 25 or 30years—there is only onesensibleapproach:Buyeverymonth, automatically, andwhenever else you can spare

somemoney.The singlebestchoice for this lifelongholding is a total stock-market index fund. Sell onlywhenyouneedthecash(forapsychological boost, clip outand sign your “InvestmentOwner’s Contract”—whichyoucanfindonp.225).

To be an intelligentinvestor,youmustalsorefuseto judge your financialsuccess by how a bunch of

total strangers are doing.You’renotonepennypoorerif someone in Dubuque orDallas orDenver beats theS& P 500 and you don’t. Noone’s gravestone reads “HEBEATTHEMARKET.”

IonceinterviewedagroupofretireesinBocaRaton,oneof Florida’s wealthiestretirement communities. Iasked these people—mostlyintheirseventies—iftheyhad

beaten the market over theirinvestinglifetimes.Somesaidyes, some said no; mostweren’t sure. Then one mansaid,“Whocares?AllIknowis, my investments earnedenough for me to end up inBoca.”

Could there be a moreperfect answer?Afterall, thewhole point of investing isnot toearnmoremoney thanaverage, but to earn enough

money to meet your ownneeds. The best way tomeasure your investingsuccess is not by whetheryou’rebeatingthemarketbutby whether you’ve put inplace a financial plan and abehavioral discipline that arelikely to get you where youwant to go. In the end,whatmatters isn’t crossing thefinish line before anybodyelsebutjustmakingsurethat

youdocrossit.8

YourMoneyandYourBrain

Why, then, do investors findMr. Market so seductive? Itturns out that our brains arehardwired to get us intoinvestingtrouble;humansarepattern-seeking animals.Psychologists have shownthat if you present peoplewith a random sequence—

and tell them that it’sunpredictable—they willnevertheless insist on tryingtoguesswhat’scomingnext.Likewise,we“know”thatthenextrollofthedicewillbeaseven, that a baseball playerisdue for abasehit, that thenext winning number in thePowerball lottery willdefinitelybe4-27-9-16-42-10—andthatthishotlittlestockisthenextMicrosoft.

Groundbreaking newresearch in neuroscienceshows that our brains aredesigned to perceive trendseven where they might notexist. After an event occursjust two or three times in arow, regions of the humanbrain called the anteriorcingulate and nucleusaccumbens automaticallyanticipate that it will happenagain. If it does repeat, anatural chemical called

dopamine is released,flooding your brain with asofteuphoria.Thus,ifastockgoesupafewtimesinarow,you reflexively expect it tokeep going—and your brainchemistry changes as thestock rises, giving you a“natural high.” Youeffectively become addictedtoyourownpredictions.

Butwhenstocksdrop, thatfinancial loss fires up your

amygdala—the part of thebrain that processes fear andanxiety and generates thefamous “fight or flight”response that is common toall cornered animals. Just asyoucan’tkeepyourheartratefrom rising if a fire alarmgoes off, just as you can’tavoid flinching if arattlesnake slithers onto yourhiking path, you can’t helpfeeling fearful when stock

pricesareplunging.9

In fact, the brilliantpsychologists DanielKahneman and AmosTversky have shown that thepainof financial loss ismorethan twice as intense as thepleasure of an equivalentgain. Making $1,000 on astock feels great—but a$1,000 loss wields anemotional wallop more thantwice as powerful. Losing

moneyissopainfulthatmanypeople, terrified at theprospect of any further loss,sell out near the bottom orrefusetobuymore.

Thathelpsexplainwhywefixate on the raw magnitudeofamarketdeclineandforgetto put the loss in proportion.So, if a TV reporter hollers,“Themarketisplunging—theDow is down 100 points!”most people instinctively

shudder. But, at the Dow’srecent levelof8,000, that’sadropofjust1.2%.Nowthinkhow ridiculous it wouldsound if, on a day when it’s81 degrees outside, the TVweatherman shrieked, “Thetemperature isplunging—it’sdropped from 81 degrees to80 degrees!” That, too, is a1.2% drop.When you forgetto view changing marketprices in percentage terms,it’sall tooeasytopanicover

minorvibrations.(Ifyouhavedecadesofinvestingaheadofyou, there’s a better way tovisualize the financial newsbroadcasts;seethesidebaronp.222.)

In the late 1990s, manypeoplecame to feel that theywere in the dark unless theychecked the prices of theirstocks several times a day.But, as Graham puts it, thetypical investor “would be

betteroffifhisstockshadnomarketquotationatall,forhewould then be spared themental anguish caused himbyotherpersons’mistakesofjudgment.” If, after checkingthe value of your stockportfolioat1:24P.M.,youfeelcompelledtocheckitalloveragain at 1:37 P.M., askyourselfthesequestions:

NEWSYOUCOULDUSE

Stocks are crashing, so

you turn on the televisionto catch the latest marketnews. But instead ofCNBC or CNN, imaginethatyoucantuneintotheBenjamin GrahamFinancial Network. OnBGFN, the audio doesn’tcapture that famous sourclang of the market’sclosing bell; the videodoesn’t home in onbrokers scurrying acrossthe floor of the stockexchange like angryrodents. Nor does BGFNrun any footage ofinvestors gasping onfrozen sidewalks as red

arrows whiz overhead onelectronicstocktickers.

Instead, the image thatfillsyourTVscreenisthefacade of the New YorkStock Exchange,festooned with a hugebanner reading: “SALE!50% OFF!” As intromusic, Bachman-TurnerOverdrive can be heardblaringafewbarsoftheirold barn-burner, “YouAin’t Seen Nothin’ Yet.”Then the anchormanannounces brightly,“Stocks became moreattractiveyet again today,

as the Dow droppedanother 2.5% on heavyvolume—thefourthdayina row that stocks havegotten cheaper. Techinvestors fared evenbetter, as leadingcompanies like Microsoftlostnearly5%ontheday,making them even moreaffordable.Thatcomesontop of the good news ofthe past year, in whichstocks have already lost50%, putting them atbargain levelsnot seen inyears. And someprominent analysts areoptimistic that pricesmay

drop still further in theweeks and months tocome.”

Thenewscast cutsover tomarket strategist IgnatzAnderson of the WallStreet firmofKetchum&Skinner, who says, “Myforecast is for stocks toloseanother15%byJune.I’m cautiously optimisticthat if everything goeswell, stocks could lose25%,maybemore.”

“Let’s hope IgnatzAnderson is right,” theanchor says cheerily.

“Falling stock priceswould be fabulous newsfor any investor with avery long horizon. Andnow over toWally Woodfor our exclusiveAccuWeatherforecast.”

Did I call a real-estateagent to check themarket price of myhouseat1:24P.M.?DidIcallbackat1:37P.M.?IfIhad,wouldthepricehave changed? If it did,

would I have rushed tosellmyhouse?Bynotchecking,orevenknowing, the marketprice of my house fromminute to minute, do Iprevent its value fromrisingovertime?10

The only possible answertothesequestionsisofcoursenot! And you should viewyour portfolio the sameway.Overa10-or20-or30-year

investment horizon, Mr.Market’s daily dipsy-doodlessimply do notmatter. In anycase, for anyonewhowill beinvesting for years to come,falling stock prices are goodnews, not bad, since theyenable you to buy more forless money. The longer andfurther stocks fall, and themore steadily you keepbuyingastheydrop,themoremoney you will make in theend—if you remain steadfast

until the end. Instead offearing a bear market, youshould embrace it. Theintelligent investor should beperfectlycomfortableowningastockormutualfundevenifthe stock market stoppedsupplyingdailypricesforthenext10years.11

Paradoxically,“youwillbemuch more in control,”explains neuroscientistAntonio Damasio, “if you

realizehowmuchyouarenotin control.” Byacknowledging yourbiological tendency to buyhigh and sell low, you canadmit the need to dollar-costaverage, rebalance, and signan investment contract. Byputting much of yourportfolio on permanentautopilot, you can fight thepredictionaddiction,focusonyour long-term financialgoals, and tune out Mr.

Market’smoodswings.

WhenMr.MarketGivesYouLemons,MakeLemonade

Although Graham teachesthatyoushouldbuywhenMr.Market is yelling “sell,”there’s one exception theintelligent investor needs tounderstand. Selling into abearmarketcanmakesenseifit creates a taxwindfall. The

U.S. Internal Revenue Codeallows you to use yourrealized losses (any declinesin value that you lock in byselling your shares) to offsetup to $3,000 in ordinaryincome.12 Let’s say youbought 200 shares of Coca-Cola stock in January 2000for $60 a share—a totalinvestment of $12,000. Byyear-end2002, the stockwasdown to $44 a share, or

$8,800foryourlot—alossof$3,200.

Youcouldhavedonewhatmostpeopledo—eitherwhineabout your loss, or sweep itunder the rug and pretend itneverhappened.Oryoucouldhave taken control. Before2002 ended, you could havesold all your Coke shares,locking in the $3,200 loss.Then,afterwaiting31daystocomply with IRS rules, you

would buy 200 shares ofCoke all over again. Theresult:Youwould be able toreduce your taxable incomeby $3,000 in 2002, and youcouldusetheremaining$200loss to offset your income in2003. And better yet, youwould still own a companywhose future you believe in—butnowyouwouldown itforalmostone-thirdlessthanyoupaidthefirsttime.13

With Uncle Samsubsidizingyourlosses,itcanmakesensetosellandlockinaloss.IfUncleSamwantstomakeMr.Marketlooklogicalbycomparison,whoarewetocomplain?

InvestmentOwner’sContract

I, ________________________________,hereby state that I am aninvestor who is seeking toaccumulate wealth for many

yearsintothefuture.

I know that there will bemany times when I will betemptedtoinvestinstocksorbonds because they havegone (or “are going”) up inprice,andothertimeswhenIwill be tempted to sell myinvestments because theyhave gone (or “are going”)down.

Iherebydeclaremyrefusal

to let a herd of strangersmake my financial decisionsfor me. I further make asolemn commitment never toinvest because the stockmarket has gone up, andnever to sell because it hasgone down. Instead, I willinvest$______.00permonth,every month, through anautomatic investment plan or“dollar-cost averagingprogram,” into the followingmutual fund(s) or diversified

portfolio(s):

_________________________________,

_________________________________,

_________________________________.

Iwillalsoinvestadditionalamounts whenever I canafford to spare the cash (andcan afford to lose it in theshortrun).

Iherebydeclare that Iwillhold each of theseinvestments continuallythroughatleastthefollowingdate (which must be aminimum of 10 years afterthe date of this contact):_________________ _____,20__. The only exceptionsallowed under the terms ofthis contract are a sudden,pressingneedforcash, likeahealth-care emergency or theloss ofmy job, or a planned

expenditure like a housingdown payment or a tuitionbill.

I am, by signing below,statingmy intention not onlyto abide by the terms of thiscontract, but to re-read thisdocument whenever I amtempted to sell any of myinvestments.

This contract is valid onlywhen signed by at least one

witness,andmustbekeptinasafe place that is easilyaccessible for futurereference.

Chapter9InvestinginInvestmentFunds

One course open to thedefensive investor is to put

his money into investment-company shares. Those thatareredeemableondemandbytheholder,atnetassetvalue,are commonly known as“mutualfunds”(or“open-endfunds”). Most of these areactively selling additionalshares through a corps ofsalesmen. Those withnonredeemable shares arecalled “closed-end”companies or funds; thenumber of their shares

remains relatively constant.All of the funds of anyimportance are registeredwith the Securities &Exchange Commission(SEC), and are subject to itsregulationsandcontrols.*

Theindustryisaverylargeone.Attheendof1970therewere 383 funds registeredwith the SEC, having assetstotaling $54.6 billions. Ofthese 356 companies, with

$50.6 billions, were mutualfunds,and27companieswith$4.0 billions, were closed-end.†

Therearedifferentwaysofclassifying the funds. One isbythebroaddivisionof theirportfolio; they are “balancedfunds” if they have asignificant (generally aboutone-third) component ofbonds, or “stock-funds” iftheir holdings are nearly all

common stocks. (There aresome other varieties here,suchas“bondfunds,”“hedgefunds,” “letter-stock funds,”etc.)* Another is by theirobjectives, as their primaryaim is for income, pricestability, or capitalappreciation (“growth”).Anotherdistinctionisbytheirmethodofsale.“Loadfunds”add a selling charge(generally about 9% of asset

valueonminimumpurchases)to the value before charge.1Others, known as “no-load”funds, make no such charge;themanagements are contentwith the usual investment-counsel fees for handling thecapital.Sincetheycannotpaysalesmen’s commissions, thesize of the no-load fundstends to be on the low side.†Thebuyingandsellingpricesof the closed-end funds are

not fixed by the companies,but fluctuate in the openmarket as does the ordinarycorporatestock.

Most of the companiesoperate under specialprovisions of the income-taxlaw, designed to relieve theshareholders from doubletaxation on their earnings. Ineffect,thefundsmustpayoutvirtually all their ordinaryincome—i.e., dividends and

interest received, lessexpenses.Inadditiontheycanpay out their realized long-term profits on sales ofinvestments—in the form of“capital-gains dividends”—which are treated by theshareholder as if they werehis own security profits.(Thereisanotheroptionhere,which we omit to avoidclutter.)†Nearlyall the fundshavebutoneclassofsecurity

outstanding. A new wrinkle,introduced in 1967, dividesthe capitalization into apreferred issue, which willreceive all the ordinaryincome,andacapitalissue,orcommon stock, which willreceive all the profits onsecurity sales. (These arecalled “dual-purposefunds.”)*

Many of the companiesthatstatetheirprimaryaimis

for capital gains concentrateon the purchase of the so-called “growth stocks,” andthey often have the word“growth”intheirname.Somespecializeinadesignatedareasuch as chemicals, aviation,overseas investments; this isusually indicated in theirtitles.

The investorwhowants tomake an intelligentcommitment in fund shares

has thus a large andsomewhat bewilderingvarietyofchoicesbeforehim—nottoodifferentfromthoseoffered in direct investment.In this chapter we shall dealwith some major questions,viz:

1. Is there any way bywhichtheinvestorcanassurehimselfofbetterthanaverageresults by choosing the right

funds? (Subquestion: Whatabout the “performancefunds”?)†

2.Ifnot,howcanheavoidchoosing funds thatwillgivehim worse than averageresults?

3.Can hemake intelligentchoices between differenttypes of funds—e.g.,

balanced versus all-stock,open-end versus closed-end,loadversusno-load?

Investment-FundPerformanceasaWhole

Before trying to answerthesequestionsweshouldsaysomething about theperformance of the fundindustry as a whole. Has itdone a good job for itsshareholders? In the most

general way, how have fundinvestors fared as againstthose who made theirinvestments directly?We arequitecertainthatthefundsinthe aggregate have served auseful purpose. They havepromoted good habits ofsavings and investment; theyhave protected countlessindividuals against costlymistakes in thestockmarket;they have brought theirparticipants income and

profits commensurate withthe overall returns fromcommon stocks. On acomparative basis we wouldhazard the guess that theaverage individual who puthis money exclusively ininvestment-fundshares in thepasttenyearshasfaredbetterthan the average person whomade his common-stockpurchasesdirectly.

The last point is probably

true even though the actualperformance of the fundsseems tohavebeennobetterthan that of common stocksas awhole, and even thoughthe cost of investing inmutual fundsmay have beengreater than that of directpurchases.Therealchoiceoftheaverageindividualhasnotbeen between constructingandacquiringawell-balancedcommon-stock portfolio ordoing the same thing, a bit

more expensively, by buyinginto the funds. More likelyhis choice has been betweensuccumbing to the wiles ofthe doorbell-ringing mutual-fund salesman on the onehand, as against succumbingto the even wilier and muchmore dangerous peddlers ofsecond- and third-rate newofferings. We cannot helpthinking,too,thattheaverageindividual who opens abrokerage account with the

idea of making conservativecommon-stock investments islikelytofindhimselfbesetbyuntoward influences in thedirection of speculation andspeculative losses; thesetemptations should be muchless for the mutual-fundbuyer.

But how have theinvestment funds performedasagainstthegeneralmarket?This is a somewhat

controversial subject, but weshall try to deal with it insimple but adequate fashion.Table 9-1 gives somecalculated results for 1961–1970of our ten largest stockfundsat theendof1970,butchoosingonlythelargestonefrom each managementgroup. It summarizes theoverallreturnofeachofthesefunds for 1961–1965, 1966–1970,andforthesingleyears1969and1970.Wealsogive

average results based on thesum of one share of each ofthe ten funds. Thesecompanies had combinedassets of over $15 billion attheendof1969,oraboutone-thirdofallthecommon-stockfunds. Thus they should befairly representative of theindustry as a whole. (Intheory,thereshouldbeabiasin this list on the side ofbetter than industryperformance, since these

bettercompaniesshouldhavebeen entitled to more rapidexpansionthantheothers;butthis may not be the case inpractice.)

Some interesting facts canbe gathered from this table.First,wefindthat theoverallresults of these ten funds for1961–1970 were notappreciably different fromthose of the Standard &Poor’s 500-stock compositeaverage (or the S & P 425-industrialstockaverage).Butthey were definitely betterthanthoseoftheDJIA.(Thisraises the intriguing question

astowhythe30giantsintheDJIA did worse than themuch more numerous andapparently rathermiscellaneous list used byStandard & Poor’s.)* Asecondpointisthatthefunds’aggregate performance asagainst the S & P index hasimproved somewhat in thelastfiveyears,comparedwiththeprecedingfive.Thefunds’gain ran a little lower thanS

& P’s in 1961–1965 and alittle higher than S & P’s in1966–1970.Thethirdpointisthat a wide difference existsbetween the results of theindividualfunds.

We do not think themutual-fund industry can becriticized for doing no betterthan the market as a whole.Their managers and theirprofessional competitorsadminister so large a portion

of all marketable commonstocks that what happens tothe market as a whole mustnecessarily happen(approximately)tothesumoftheir funds. (Note that thetrust assets of insuredcommercial banks included$181 billion of commonstocks at the end of 1969; ifwe add to this the commonstocksinaccountshandledbyinvestment advisers, plus the$56 billion of mutual and

similar funds, we mustconclude that the combineddecisions of theseprofessionals pretty welldetermine the movements ofthe stock averages, and thatthe movement of the stockaverages pretty welldetermines the funds’aggregateresults.)

Are there better thanaverage funds and can theinvestor select these so as to

obtain superior results forhimself? Obviously allinvestors could not do this,since in that case we wouldsoon be back where westarted, with no one doingbetter than anyone else. Letus consider the question firstin a simplified fashion.Whyshouldn’t the investor findout what fund has made thebestshowingofthelotoveraperiod of sufficient years inthe past, assume from this

that its management is themost capable and willtherefore do better thanaverageinthefuture,andputhismoney in that fund?Thisidea appears the morepracticable because, in thecase of the mutual funds, hecould obtain this “mostcapable management”without paying any specialpremium for it as against theother funds. (By contrast,among noninvestment

corporations the best-managed companies sell atcorrespondingly high pricesin relation to their currentearningsandassets.)

Theevidenceon thispointhas been conflicting over theyears. But our Table 9-1coveringthetenlargestfundsindicates that the resultsshown by the top fiveperformers of 1961–1965carried over on the whole

through 1966–1970, eventhoughtwoofthissetdidnotdoaswellastwooftheotherfive.Ourstudiesindicatethatthe investor in mutual-fundsharesmayproperlyconsidercomparative performanceover a period of years in thepast, say at least five,provided the data do notrepresent a large net upwardmovementof themarketasawhole. In the latter casespectacularly favorable

results may be achieved inunorthodoxways—aswill bedemonstrated in ourfollowing section on“performance” funds. Suchresults in themselves mayindicate only that the fundmanagers are taking unduespeculative risks, and gettingawaywith same for the timebeing.

“Performance”Funds

Oneofthenewphenomenaof recent years was theappearance of the cult of“performance” in themanagement of investmentfunds(andevenofmanytrustfunds). We must start thissection with the importantdisclaimer that it does notapplytothelargemajorityofwell-established funds, butonly to a relatively smallsectionof the industrywhichhas attracted a

disproportionate amount ofattention.The story is simpleenough. Some of those incharge set out to get muchbetterthanaverage(orDJIA)results. They succeeded indoing this for a while,garnering considerablepublicityandadditionalfundsto manage. The aim waslegitimate enough;unfortunately, it appears that,in the context of investingreally sizable funds, the aim

cannot be accomplishedwithout incurring sizablerisks.Andinacomparativelyshort time the risks camehometoroost.

Several of thecircumstances surroundingthe “performance”phenomenon causedominousheadshaking by those of uswhose experience went farback—even to the 1920s—and whose views, for that

very reason,were consideredold-fashioned and irrelevantto this (second) “New Era.”In the firstplace,andon thisvery point, nearly all thesebrilliant performers wereyoung men—in their thirtiesand forties—whose directfinancial experience waslimited to the all butcontinuous bull market of1948–1968. Secondly, theyoftenactedasifthedefinitionof a “sound investment”was

astockthatwaslikelytohavea good rise in the market inthenextfewmonths.Thisledto large commitments innewer ventures at pricescompletely disproportionateto their assets or recordedearnings. They could be“justified” only by acombinationofnaïvehopeinthe future accomplishmentsof these enterprises with anapparent shrewdness inexploiting the speculative

enthusiasms of theuninformed and greedypublic.

This section will notmention people’s names.Butwehaveeveryreasontogiveconcrete examples ofcompanies.The“performancefund”mostinthepublic’seyewas undoubtedly ManhattanFund, Inc., organized at theendof1965.Itsfirstofferingwas of 27 million shares at

$9.25 to $10 per share. Thecompany started out with$247 million of capital. Itsemphasis was, of course, oncapital gains. Most of itsfundswere invested in issuesselling at high multipliers ofcurrent earnings, paying nodividends (or very smallones), with a largespeculative following andspectacularpricemovements.The fund showed an overallgain of 38.6% in 1967,

against 11% for the S & Pcomposite index. Butthereafteritsperformanceleftmuch to be desired, as isshowninTable9-2.

TheportfolioofManhattanFund at the endof 1969wasunorthodoxtosaytheleast.Itis an extraordinary fact thattwoofits largest investmentswere in companies that filedfor bankruptcy within sixmonthsthereafter,andathirdfaced creditors’ actions in1971. It is anotherextraordinary fact that sharesof at least one of thesedoomed companies were

bought not only byinvestment funds but byuniversity endowment funds,thetrustdepartmentsoflargebanking institutions, and thelike.* A third extraordinaryfact was that the founder-manager of Manhattan Fundsoldhis stock in a separatelyorganized managementcompany to another largeconcern for over $20millionin its stock; at that time the

management company soldhad less than $1 million inassets. This is undoubtedlyoneofthegreatestdisparitiesof all times between theresultsforthe“manager”andthe“managees.”

A book published at theend of 19692 providedprofiles of nineteen men“who are tops at thedemanding game ofmanaging billions of dollars

of other people’s money.”The summary told us furtherthat “they are young…someearn more than a milliondollars a year…they are anewfinancialbreed…theyallhave a total fascination withthe market…and aspectacularknackforcomingup with winners.” A fairlygood idea of theaccomplishments of this topgroup can be obtained byexamining the published

results of the funds theymanage. Such results areavailable for funds directedby twelve of the nineteenpersons described in TheMoney Managers. Typicallyenough, theyshowedupwellin 1966, and brilliantly in1967. In 1968 theirperformancewasstillgoodintheaggregate,butmixedastoindividualfunds.In1969theyall showed losses, with onlyone managing to do a bit

better than the S & Pcomposite index. In 1970their comparativeperformancewas evenworsethanin1969.

We have presented thispicture in order to point amoral, which perhaps canbest be expressed by the oldFrench proverb: Plus çachange, plus c’est la mêmechose. Bright, energeticpeople—usually quite young

—have promised to performmiracleswith“otherpeople’smoney” since timeimmemorial. They haveusuallybeenable todo it forawhile—oratleasttoappearto have done it—and theyhave inevitably broughtlosses to their public in theend.* About a half centuryagothe“miracles”wereoftenaccompanied by flagrantmanipulation, misleading

corporate reporting,outrageous capitalizationstructures, and othersemifraudulent financialpractices.All thisbroughtonan elaborate system offinancialcontrolsbytheSEC,aswell as a cautious attitudetowardcommonstocksonthepart of the general public.The operations of the new“money managers” in 1965–1969 came a littlemore thanone full generation after the

shenanigans of 1926–1929.†The specific malpracticesbanned after the 1929 crashwere no longer resorted to—they involved the risk of jailsentences. But in manycorners of Wall Street theywere replaced by newergadgets and gimmicks thatproduced very similar resultsin the end. Outrightmanipulation of pricesdisappeared, but there were

many other methods ofdrawing the gullible public’sattention to the profitpossibilities in “hot” issues.Blocks of “letter stock”3could be bought well belowthe quoted market price,subject to undisclosedrestrictionsontheirsale;theycould immediately be carriedin the reports at their fullmarket value, showing alovely and illusory profit.

Andsoon.Itisamazinghow,in a completely differentatmosphere of regulation andprohibitions,Wall Streetwasable to duplicate somuch oftheexcessesanderrorsofthe1920s.

Nodoubttherewillbenewregulations and newprohibitions. The specificabuses of the late 1960swillbe fairly adequately bannedfrom Wall Street. But it is

probably toomuch to expectthattheurgetospeculatewillever disappear, or that theexploitation of that urge caneverbeabolished.Itispartofthe armament of theintelligent investor to knowabout these “ExtraordinaryPopular Delusions,”4 and tokeep as far away from themaspossible.

The picture ofmost of theperformance funds is a poor

one if we start after theirspectacular record in 1967.With the 1967 figuresincluded, their overallshowing is not at alldisastrous. On that basis oneof “The Money Managers”operatorsdidquiteabitbetterthan the S & P compositeindex, three did distinctlyworse, and six did about thesame.Let us take as a checkanothergroupofperformancefunds—the ten thatmade the

best showing in 1967, withgainsrangingfrom84%upto301% in that single year. Ofthese, four gave a betteroverallfour-yearperformancethan the S & P index, if the1967 gains are included; andtwo excelled the index in1968–1970. None of thesefunds was large, and theaverage size was about $60million. Thus, there is astrong indication that smallersize is a necessary factor for

obtaining continuedoutstandingresults.

The foregoing accountcontains the implicitconclusion that theremay bespecial risks involved inlooking for superiorperformance by investment-fund managers. All financialexperience up to nowindicates that large funds,soundly managed, canproduce at best only slightly

better than average resultsover the years. If they areunsoundlymanaged they canproduce spectacular, butlargely illusory, profits for awhile, followed inevitablybycalamitouslosses.Therehavebeen instances of funds thathave consistentlyoutperformed the marketaveragesfor,say,tenyearsormore. But these have beenscarce exceptions, havingmost of their operations in

specialized fields, with self-imposed limits on the capitalemployed—and not activelysoldtothepublic.*

Closed-EndversusOpen-EndFunds

Almost all the mutualfunds or open-end funds,which offer their holders therighttocashintheirsharesateach day’s valuation of theportfolio, have acorresponding machinery for

selling new shares. By thismeans most of them havegrown in sizeover theyears.The closed-end companies,nearly all of which wereorganized a long time ago,haveafixedcapitalstructure,and thus have diminished inrelative dollar importance.Open-end companies arebeing sold by manythousands of energetic andpersuasive salesmen, theclosed-end shares have no

one especially interested indistributing them.Consequently it has beenpossible to sellmost“mutualfunds”tothepublicatafixedpremium of about 9% abovenet asset value (to coversalesmen’s commissions,etc.), while the majority ofclose-end shares have beenconsistentlyobtainableatlessthan their asset value. Thisprice discount has variedamong individual companies,

and the average discount forthegroupasawholehasalsovaried from one date toanother.Figuresonthispointfor 1961–1970 are given inTable9-3.

It does not take muchshrewdnesstosuspectthatthelower relative price forclosed-end as against open-end shares has very little todowith the difference in theoverall investment results

betweenthetwogroups.Thatthisistrueisindicatedbythecomparison of the annualresults for 1961–1970 of thetwogroupsincludedinTable9-3.

Thus we arrive at one ofthe few clearly evident rulesfor investors’ choices. If youwant to put money ininvestment funds, buy agroupofclosed-endsharesata discount of, say, 10% to

15%fromassetvalue,insteadofpayingapremiumofabout9% above asset value forshares of an open-endcompany. Assuming that thefuture dividends and changesinassetvaluescontinuetobeabout the same for the twogroups, you will thus obtainaboutone-fifthmoreforyourmoney from the closed-endshares.

The mutual-fund salesman

willbequick tocounterwiththeargument:“Ah,butifyouown closed-end shares youcan never be surewhat priceyou can sell them for. Thediscountcanbegreaterthanitis today, and you will sufferfrom the wider spread. Withoursharesyouareguaranteedthe right to turn in yoursharesat100%ofassetvalue,never less.” Let us examinethisargumentabit; itwillbea good exercise in logic and

plain common sense.Question: Assuming that thediscountonclosed-endsharesdoes widen, how likely is itthat you will be worse offwiththosesharesthanwithanotherwise equivalentpurchaseofopen-endshares?

TABLE 9-3 Certain Dataon Closed-End Funds,Mutual Funds, and S & PCompositeIndex

This calls for a littlearithmetic. Assume thatInvestor A buys some open-end shares at 109% of assetvalue, and Investor B buysclosed-end shares at 85%thereof, plus 1½%commission. Both sets ofshares earn and pay 30% ofthis asset value in, say, fouryears, and end up with thesame value as at thebeginning. Investor A

redeems his shares at 100%of value, losing the 9%premiumhepaid.Hisoverallreturn for the period is 30%less 9%, or 21% on assetvalue.This,inturn,is19%onhis investment. How muchmustInvestorBrealizeonhisclosed-end shares to obtainthe same return on hisinvestment as Investor A?The answer is 73%, or adiscount of 27% from assetvalue. In other words, the

closed-endmancouldsufferawidening of 12 points in themarket discount (aboutdouble) before his returnwouldgetdowntothatoftheopen-end investor. Anadverse change of thismagnitude has happenedrarely, if ever, in the historyofclosed-endshares.Henceitisveryunlikely thatyouwillobtain a lower overall returnfrom a (representative)closed-end company, bought

atadiscount,ifitsinvestmentperformanceisaboutequaltothat of a representativemutual fund. If a small-load(or no-load) fund issubstituted for one with theusual “8½%” load, theadvantage of the closed-endinvestment is of coursereduced, but it remains anadvantage.

Thefact thatafewclosed-end funds are selling atpremiums greater than thetrue 9% charge on most

mutual funds introduces aseparate question for theinvestor. Do these premiumcompanies enjoy superiormanagement of sufficientprovenworthtowarranttheirelevatedprices?Iftheansweris sought in the comparativeresultsforthepastfiveortenyears, the answer wouldappear tobeno.Threeof thesix premium companies havemainly foreign investments.A striking feature of these is

thelargevariationinpricesina fewyears’ time; at the endof1970onesoldatonlyone-quarterof itshigh,anotherata third, another at less thanhalf. Ifweconsider the threedomestic companies sellingabove asset value, we findthat the average of their ten-year overall returns wassomewhat better than that often discount funds, but theopposite was true in the lastfive years. A comparison of

the 1961–1970 record ofLehmanCorp.andofGeneralAmerican Investors, two ofouroldestandlargestclosed-end companies, is given inTable 9-5.One of these sold14% above and the other7.6% below its net-assetvalueattheendof1970.Thedifferenceinpricetonet-assetrelationships did not appearwarrantedbythesefigures.

InvestmentinBalancedFunds

The 23 balanced fundscovered in the WiesenbergerReporthadbetween25%and

59% of their assets inpreferred stocks and bonds,the average being just 40%.The balance was held incommon stocks. It wouldappear more logical for thetypical investor to make hisbond-type investmentsdirectly, rather than to havethem form part of a mutual-fund commitment. Theaverage incomereturnshownby these balanced funds in1970 was only 3.9% per

annumonassetvalue, or say3.6% on the offering price.Thebetterchoiceforthebondcomponent would be thepurchase of United Statessavings bonds, or corporatebonds rated A or better, ortax-free bonds, for theinvestor’sbondportfolio.


The schoolteacher asksBilly Bob: “If you have twelvesheep and one jumps over thefence, how many sheep do youhaveleft?”

Billy Bob answers,“None.”

“Well,” says the teacher,“you sure don’t know yoursubtraction.”

“Maybe not,” Billy Bobreplies,“butIdarnsureknowmysheep.”

—anoldTexasjoke

AlmostPerfect

A purely American creation,the mutual fund wasintroduced in 1924 by aformersalesmanofaluminum

potsandpansnamedEdwardG. Leffler. Mutual funds arequite cheap,veryconvenient,generally diversified,professionally managed, andtightly regulated under someof the toughest provisions ofFederal securities law. Bymaking investing easy andaffordableforalmostanyone,the fundshavebrought some54millionAmericanfamilies(and millions more aroundthe world) into the investing

mainstream—probably thegreatest advance in financialdemocracyeverachieved.

But mutual funds aren’tperfect; they are almostperfect, and thatwordmakesall thedifference.Becauseoftheir imperfections, mostfunds underperform themarket, overcharge theirinvestors, create taxheadaches, and suffer erraticswings in performance. The

intelligent investor mustchoose funds with great carein order to avoid ending upowningabigfatmess.

TopoftheCharts

Most investors simply buy afund that has been going upfast,ontheassumptionthatitwillkeepongoing.Andwhynot? Psychologists haveshown that humans have an

inborn tendency to believethat the long run can bepredicted from even a shortseries of outcomes. What’smore,weknowfromourownexperience that someplumbers are far better thanothers, that some baseballplayersaremuchmore likelyto hit home runs, that ourfavorite restaurant servesconsistently superior food,and that smart kids getconsistently good grades.

Skill and brains and hardwork are recognized,rewarded—and consistentlyrepeated—all around us. So,ifafundbeatsthemarket,ourintuition tells us to expect itto keep right onoutperforming.

Unfortunately, in thefinancial markets, luck ismoreimportantthanskill.Ifamanagerhappenstobeintheright corner of the market at

just the right time, he willlook brilliant—but all toooften,whatwashotsuddenlygoes cold and the manager’sIQ seems to shrivel by 50points.Figure9-1showswhathappenedtothehottestfundsof1999.

This is yet anotherreminder that the market’shottest market sector—in1999, that was technology—often turns as cold as liquid

nitrogen,withblinding speedandutterlynowarning.1Andit’s a reminder that buyingfunds based purely on theirpastperformanceisoneofthestupidest things an investorcan do. Financial scholarshave been studying mutual-fundperformance forat leasta half century, and they arevirtually unanimous onseveralpoints:

the average fund doesnot pick stocks wellenough to overcome itscosts of researching andtradingthem;the higher a fund’sexpenses, the lower itsreturns;the more frequently afund trades its stocks,thelessittendstoearn;highly volatile funds,which bounce up anddown more than

average, are likely tostayvolatile;funds with high pastreturns are unlikely toremain winners forlong.2

Your chances of selectingthe top-performing funds ofthefutureonthebasisoftheirreturns in the past are aboutas high as the odds thatBigfoot and the AbominableSnowmanwill both show upinpinkballetslippersatyournext cocktail party. In otherwords, your chances are notzero—but they’re prettyclose.(Seesidebar,p.255.)

Butthere’sgoodnews,too.First of all, understandingwhy it’s so hard to find agood fund will help youbecome a more intelligentinvestor. Second, while pastperformance is a poorpredictor of future returns,there are other factors thatyou can use to increase yourodds of finding a good fund.Finally, a fund can offerexcellent value even if itdoesn’t beat the market—by

providinganeconomicalwaytodiversifyyourholdingsandby freeing up your time foralltheotherthingsyouwouldrather be doing than pickingyourownstocks.

TheFirstshallbeLast

Why don’t more winningfundsstaywinners?

Thebetterafundperforms,

the more obstacles itsinvestorsface:

Migrating managers.Whenastockpickerseemstohave the Midas touch,everyone wants him—including rival fundcompanies. If you boughtTransamerica Premier EquityFund to cash in on the skillsof Glen Bickerstaff, whogained 47.5% in 1997, youwere quickly out of luck;

TCW snatched him away inmid-1998 to run its TCWGalileoSelectEquitiesFund,and the Transamerica fundlagged themarket in threeofthe next four years. If youbought Fidelity AggressiveGrowthFundinearly2000tocapitalizeon thehigh returnsof Erin Sullivan, who hadnearly tripled hershareholders’ money since1997, oh well: She quit tostart her own hedge fund in

2000, and her former fundlost more than three-quartersof its value over the nextthreeyears.3

Assetelephantiasis.Whena fund earns high returns,investors notice—oftenpouring in hundreds ofmillionsofdollarsinamatterof weeks. That leaves thefund manager with fewchoices—allof thembad.Hecankeep thatmoneysafe for

a rainyday,but then the lowreturnsoncashwillcrimpthefund’s results if stocks keepgoingup.Hecanputthenewmoney into the stocks healready owns—which haveprobably gone up since hefirst bought them and willbecome dangerouslyovervalued if he pumps inmillions of dollars more. Orhe can buy new stocks hedidn’t like well enough toown already—but he will

have to research them fromscratch and keep an eye onfarmorecompaniesthanheisusedtofollowing.

Finally, when the $100-millionNimbleFundputs2%ofitsassets(or$2million)inMinnowCorp.,astockwithatotal market value of $500million, it’s buying up lessthan one-half of 1% ofMinnow. But if hotperformance swells the

Nimble Fund to $10 billion,then an investment of 2% ofits assets would total $200million—nearly half theentire value of Minnow, alevel of ownership that isn’teven permissible underFederal law. If Nimble’sportfolio manager still wantsto own small stocks, he willhave to spread his moneyover vastly more companies—and probably end upspreading his attention too

thin.

Nomore fancy footwork.Somecompaniesspecializein“incubating” their funds—test-driving them privatelybefore selling them publicly.(Typically, the onlyshareholders are employeesand affiliates of the fundcompany itself.) By keepingthem tiny, the sponsor canuse these incubated funds asguinea pigs for risky

strategiesthatworkbestwithsmall sums of money, likebuying truly tiny stocks orrapid-fire trading of initialpublic offerings. If itsstrategy succeeds, the fundcan lure public investors enmasse by publicizing itsprivatereturns.Inothercases,the fund manager “waives”(or skips charging)management fees, raising thenet return—then slaps thefees on later after the high

returns attract plenty ofcustomers. Almost withoutexception, the returns ofincubated and fee-waivedfunds have faded intomediocrity after outsideinvestors poured millions ofdollarsintothem.

Rising expenses. It oftencostsmore to trade stocks invery large blocks than insmallones;withfewerbuyersand sellers, it’s harder to

make a match. A fund with$100 million in assets mightpay 1% a year in tradingcosts. But, if high returnssend the fund mushroomingup to $10 billion, its tradescould easily eat up at least2% of those assets. Thetypical fund holds on to itsstocksforonly11monthsatatime, so trading costs eataway at returns like acorrosive acid. Meanwhile,the other costs of running a

fund rarely fall—andsometimes even rise—asassets grow. With operatingexpensesaveraging1.5%,andtrading costs at around 2%,the typical fund has to beatthemarket by3.5percentagepoints per year before costsjusttomatchitaftercosts!

Sheepish behavior.Finally,onceafundbecomessuccessful, itsmanagers tendto become timid and

imitative.Asafundgrows,itsfeesbecomemorelucrative—makingitsmanagersreluctantto rock the boat. The veryrisks that the managers tookto generate their initial highreturns could now driveinvestors away—andjeopardize all that fat feeincome.So thebiggest fundsresemble a herd of identicalandoverfedsheep,allmovingin sluggish lockstep, allsaying “baaaa” at the same

time. Nearly every growthfundownsCiscoandGEandMicrosoft and Pfizer andWal-Mart—and in almostidentical proportions. Thisbehavior is so prevalent thatfinancescholarssimplycallitherding.4 But by protectingtheir own fee income, fundmanagers compromise theirability to produce superiorreturns for their outsideinvestors.

FIGURE9-2TheFunnelofFundPerformance

LookingbackfromDecember31,2002,howmanyU.S.stockfundsoutperformedVanguard500

IndexFund?Oneyear:

1,186of2,423funds(or48.9%)Threeyears:

1,157of1,944funds(or59.5%)Fiveyears:

768of1,494funds(or51.4%)Tenyears:

227of728funds(or31.2%)Fifteenyears:

125of445funds(or28.1%)Twentyyears:

37of248funds(or14.9%)

Source:LipperInc.

Because of their fat costsandbadbehavior,mostfundsfail to earn their keep. Nowonder high returns arenearly as perishable asunrefrigerated fish. What’smore,astimepasses,thedragof their excessive expenses

leavesmostfundsfartherandfarther behind, as Figure 9.2shows.5

What, then, should theintelligentinvestordo?

First of all, recognize thatan index fund—which ownsall the stocks in the market,all the time, without anypretense of being able toselect the “best” and avoidthe “worst”—will beat most

funds over the long run. (Ifyourcompanydoesn’tofferalow-cost index fund in your401(k), organize yourcoworkers and petition tohave one added.) Its rock-bottom overhead—operatingexpenses of 0.2% annually,and yearly trading costs ofjust 0.1%—give the indexfund an insurmountableadvantage.Ifstocksgenerate,say, a 7% annualized returnoverthenext20years,alow-

cost index fund likeVanguardTotalStockMarketwill return just under 6.7%.(That would turn a $10,000investment into more than$36,000.) But the averagestock fund, with its 1.5% inoperating expenses androughly 2% in trading costs,will be lucky to gain 3.5%annually. (That would turn$10,000 into just under$20,000—ornearly 50% lessthantheresultfromtheindex

fund.)

Index fundshaveonlyonesignificant flaw: They areboring. You’ll never be abletogo to a barbecue andbragabout how you own the top-performing fund in thecountry.You’llneverbeableto boast that you beat themarket,becausethejobofanindex fund is to match themarket’sreturn,nottoexceedit. Your index-fund manager

isnotlikelyto“rollthedice”andgamblethatthenextgreatindustrywillbeteleportation,or scratch-’n’-sniff websites,or telepathic weight-lossclinics; the fund will alwaysowneverystock,notjustonemanager’s best guess at thenext new thing. But, as theyearspass,thecostadvantageof indexing will keepaccruingrelentlessly.Holdanindex fund for 20 years ormore, adding new money

everymonth, and you are allbut certain to outper-formsthe vast majority ofprofessional and individualinvestors alike. Late in hislife, Graham praised indexfunds as the best choice forindividual investors, as doesWarrenBuffett.6

TiltingtheTables

When you add up all their

handicaps, the wonder is notthat so few funds beat theindex, but that any do. Andyet, some do.What qualitiesdotheyhaveincommon?

Their managers are thebiggest shareholders. Theconflict of interest betweenwhat’s best for the fund’smanagersandwhat’sbestforits investors is mitigatedwhen the managers areamong the biggest owners of

the fund’s shares. Somefirms, likeLongleafPartners,even forbid their employeesfrom owning anything buttheirown funds.AtLongleafand other firms like Davisand FPA, the managers ownso much of the funds thatthey are likely to manageyourmoneyasifitweretheirown—lowering the odds thattheywill jackupfees, let thefunds swell to gargantuansize, or whack you with a

nastytaxbill.Afund’sproxystatement and Statement ofAdditional Information, bothavailable from the Securitiesand Exchange CommissionthroughtheEDGARdatabaseat www.sec.gov, disclosewhetherthemanagersownatleast1%ofthefund’sshares.

They are cheap. One ofthe most common myths inthefundbusinessisthat“youget what you pay for”—that

high returns are the bestjustification for higher fees.There are two problemswiththis argument. First, it isn’ttrue;decadesofresearchhaveproventhatfundswithhigherfees earn lower returns overtime. Secondly, high returnsare temporary, while highfees are nearly as permanentas granite. If you buy a fundfor its hot returns, you maywellendupwithahandfulofcoldashes—butyourcostsof

owning the fund are almostcertainnottodeclinewhenitsreturnsdo.

Theydaretobedifferent.When Peter Lynch ranFidelityMagellan, he boughtwhatever seemed cheap tohim—regardless of whatother fund managers owned.In 1982, his biggestinvestment was Treasurybonds; right after that, hemade Chrysler his top

holding, even though mostexperts expected theautomaker to go bankrupt;then, in 1986, Lynch putalmost 20% of FidelityMagellan in foreign stockslike Honda, Norsk Hydro,and Volvo. So, before youbuy a U.S. stock fund,comparetheholdingslistedinits latest report against therosteroftheS&P500index;if they look like Tweedledeeand Tweedledum, shop for

anotherfund.7

They shut the door. Thebestfundsoftenclosetonewinvestors—permitting onlytheir existing shareholders tobuy more. That stops thefeedingfrenzyofnewbuyerswhowanttopileinatthetopandprotectsthefundfromthepains of asset elephantiasis.It’salsoasignalthatthefundmanagersarenotputtingtheirown wallets ahead of yours.

But the closing should occurbefore—not after—the fundexplodes in size. Somecompanieswithanexemplaryrecord of shutting their owngates are Longleaf,Numeric,Oakmark, T. Rowe Price,Vanguard,andWasatch.

Theydon’tadvertise. JustasPlatosaysinTheRepublicthat the ideal rulersare thosewho do not want to govern,the best fundmanagers often

behave as if they don’t wantyour money. They don’tappearconstantlyonfinancialtelevisionorrunadsboastingof their No. 1 returns. Thesteady little Mairs & PowerGrowth Fund didn’t evenhaveawebsiteuntil2001andstillsellsitssharesinonly24states. The Torray Fund hasnever run a retailadvertisementsinceitslaunchin1990.

What else should youwatch for?Most fund buyerslookatpastperformancefirst,then at the manager’sreputation, then at theriskiness of the fund, andfinally (if ever) at the fund’sexpenses.8

The intelligent investorlooks at those same things—butintheoppositeorder.

Sinceafund’sexpensesare

far more predictable than itsfuture risk or return, youshould make them your firstfilter.There’snogoodreasonever to pay more than theselevels of annual operatingexpenses,byfundcategory:

Taxable and municipalbonds:0.75%U.S. equities (large andmid-sized stocks):1.0%

High-yield(junk)bonds:1.0%U.S. equities (smallstocks):1.25%Foreignstocks:1.50%9

Next, evaluate risk. In itsprospectus(orbuyer’sguide),every fund must show a bargraph displaying its worstloss over a calendar quarter.If you can’t stand losing atleast that much money inthree months, go elsewhere.

It’s also worth checking afund’s Morningstar rating. Aleading investment researchfirm, Morningstar awards“star ratings” to funds, basedon howmuch risk they tooktoearn their returns (onestaris theworst, five is thebest).But, just like pastperformance itself, theseratings look back in time;they tell you which fundswere the best, not which aregoing to be. Five-star funds,

in fact, have a disconcertinghabit of going on tounderperform one-star funds.So first find a low-cost fundwhose managers are majorshareholders, dare to bedifferent, don’t hype theirreturns, and have shown awillingness to shut downbefore they get too big fortheirbritches.Then,andonlythen, consult theirMorningstarrating.10

Finally, look at pastperformance, rememberingthatitisonlyapalepredictorof future returns. As we’vealready seen, yesterday’swinners often becometomorrow’s losers. Butresearchers have shown thatone thing is almost certain:Yesterday’s losers almostnever become tomorrow’swinners.Soavoidfundswithconsistentlypoorpast returns—especially if they have

above-average annualexpenses.

TheClosedWorldofClosed-EndFunds

Closed-end stock funds,although popular during the1980s,haveslowlyatrophied.Today, there are only 30diversified domestic equityfunds, many of them tiny,trading only a few hundred

shares a day, with highexpensesandweirdstrategies(like Morgan Fun-Shares,which specializes in thestocks of “habit-forming”industrieslikebooze,casinos,and cigarettes). Research byclosed-end fund expertDonald Cassidy of LipperInc. reinforces Graham’searlier observations:Diversified closed-end stockfunds trading at a discountnotonlytendtooutper-forms

those trading at a premiumbutarelikelytohaveabetterreturnthantheaverageopen-end mutual fund. Sadly,however, diversified closed-end stock funds are notalwaysavailableatadiscountin what has become a dusty,dwindlingmarket.11

But there are hundreds ofclosed-end bond funds, withespecially strong choicesavailable in the municipal-

bond area.When these fundstradeatadiscount,theiryieldis amplified and they can beattractive, so long as theirannual expenses are belowthethresholdslistedabove.12

The new breed ofexchange-traded index fundscan be worth exploring aswell. These low-cost “ETFs”sometimes offer the onlymeans by which an investorcan gain entrée to a narrow

market like, say, companiesbasedinBelgiumorstocksinthe semiconductor industry.OtherindexETFsoffermuchbroader market exposure.However, they are generallynotsuitableforinvestorswhowish toaddmoneyregularly,since most brokers willchargeaseparatecommissiononeverynewinvestmentyoumake.13

KnowWhentoFold’Em

Once you own a fund, howcanyoutellwhenit’stimetosell?Thestandardadviceistoditch a fund if itunderperforms themarket (orsimilar portfolios) for one—orisittwo?—orisitthree?—years in a row. But thisadvicemakesnosense.Fromits birth in 1970 through1999, the Sequoia Fundunderperformed the S & P

500 index in12outof its29years—or more than 41% ofthe time.YetSequoia gainedmore than12,500%over thatperiod,versus4,900%fortheindex.14

The performance of mostfunds falters simply becausethetypeofstockstheyprefertemporarilygoesoutoffavor.If you hired a manager toinvest in a particular way,why fire him for doingwhat

he promised? By sellingwhen a style of investing isout of fashion, you not onlylock in a loss but lockyourself out of the all-but-inevitable recovery. Onestudy showed that mutual-fund investorsunderperformed their ownfunds by 4.7 percentagepoints annually from 1998through 2001—simply bybuying high and selling

low.15

So when should you sell?Hereafewdefiniteredflags:

a sharp andunexpected change instrategy, such as a“value” fund loading upon technology stocks in1999ora“growth”fundbuyingtonsofinsurancestocksin2002;

an increase inexpenses, suggestingthat the managers areliningtheirownpockets;large and frequent taxbills generated byexcessivetrading;suddenly erraticreturns, as when aformerly conservativefundgeneratesabigloss(or even produces agiantgain).

WHYWELOVEOUROUIJABOARDS

Believing—or even justhoping—thatwe can pickthebestfundsofthefuturemakes us feel better. Itgives us the pleasingsensation that we are incharge of our owninvestment destiny. This“I’m-in-control-here”feeling is part of thehumancondition;it’swhatpsychologists calloverconfidence. Here arejust a few examples ofhowitworks:

In1999,MoneyMagazineaskedmore than 500 people whethertheir portfolios had beaten themarket. One in four said yes.When asked to specify theirreturns, however, 80% of thoseinvestors reported gains lowerthan themarket’s. (Four percenthad no idea how much theirportfolios rose—but were surethey had beaten the marketanyway!)

A Swedish study asked driverswho had been in severe carcrashes to rate their own skillsbehind the wheel. These people—including some thepolicehadfound responsible for theaccidents and others who hadbeen so badly injured that theyanswered the survey from theirhospitalbeds—insistedtheywerebetter-than-averagedrivers.Inapolltakeninlate2000,TimeandCNNaskedmorethan1,000likely voters whether they

thought theywere in the top1%of the population by income.Nineteen percent placedthemselvesamongtherichest1%ofAmericans.In late 1997, a survey of 750investors found that 74%believed their mutual-fundholdings would “consistentlybeat the Standard & Poor’s 500each year”—even though mostfundsfail tobeat theS&P500in the long runandmany fail tobeatitinanyyear.1

While this kind ofoptimismisanormalsignof a healthy psyche, thatdoesn’t make it goodinvestment policy. Itmakes sense to believeyoucanpredictsomethingonly if it actually ispredictable. Unless youarerealistic,yourquestforself-esteemwill endup inself-defeat.

As the investmentconsultant Charles Ellis putsit, “If you’re not prepared tostay married, you shouldn’t

get married.”16 Fundinvesting is no different. Ifyou’re not prepared to stickwith a fund through at leastthree lean years, youshouldn’t buy it in the firstplace. Patience is the fundinvestor’s single mostpowerfulally.

Chapter10TheInvestorandHisAdvisers

The investment ofmoney insecurities is unique among

business operations in that itis almost always based insome degree on advicereceived from others. Thegreat bulk of investors areamateurs.Naturally they feelthat in choosing theirsecurities they can profit byprofessional guidance. Yetthere are peculiaritiesinherent in the very conceptofinvestmentadvice.

If the reason people invest

is to make money, then inseeking advice they areaskingotherstotellthemhowtomakemoney.Thatideahassome element of naïveté.Businessmen seekprofessional advice onvarious elements of theirbusiness, but they do notexpecttobetoldhowtomakea profit. That is their ownbailiwick. When they, ornonbusiness people, rely onothers to make investment

profits for them, they areexpectingakindof result forwhich there is no truecounterpart in ordinarybusinessaffairs.

Ifweassumethattherearenormal or standard incomeresults to be obtained frominvestingmoneyinsecurities,then the role of the advisercan be more readilyestablished. He will use hissuperior training and

experience to protect hisclients against mistakes andtomakesure that theyobtainthe results to which theirmoney is entitled. It iswhenthe investor demands morethananaveragereturnonhismoney, or when his adviserundertakes to do better forhim, that the question ariseswhethermore is being askedor promised than is likely tobedelivered.

Advice on investmentsmay be obtained from avariety of sources. Theseinclude: (1) a relative orfriend, presumablyknowledgeable in securities;(2) a local (commercial)banker; (3) a brokerage firmor investmentbankinghouse;(4) a financial service orperiodical; and (5) aninvestment counselor.* Themiscellaneous character of

this list suggests that nological or systematicapproach in this matter hascrystallized, as yet, in themindsofinvestors.

Certain common-senseconsiderations relate to thecriterion of normal orstandard results mentionedabove. Our basic thesis isthis: If the investor is to relychiefly on the advice ofothers in handling his funds,

then either he must limithimself and his advisersstrictly to standard,conservative, and evenunimaginative forms ofinvestment, or he must havean unusually intimate andfavorable knowledge of thepersonwhoisgoingtodirecthisfundsintootherchannels.But if the ordinary businessor professional relationshipexists between the investorand his advisers, he can be

receptivetolessconventionalsuggestionsonlytotheextentthat he himself has grown inknowledge and experienceand has therefore becomecompetent to passindependent judgment on therecommendations of others.He has then passed from thecategory of defensive orunenterprising investor intothat of aggressive orenterprisinginvestor.

InvestmentCounselandTrustServicesofBanks

The truly professionalinvestment advisers—that is,the well-establishedinvestment counsel firms,whochargesubstantialannualfees—are quite modest intheir promises andpretentions.Forthemostparttheyplacetheirclients’fundsin standard interest- anddividend-paying securities,

and they rely mainly onnormalinvestmentexperiencefortheiroverallresults.Inthetypical case it is doubtfulwhether more than 10% ofthetotalfundiseverinvestedin securities other than thoseof leading companies, plusgovernment bonds (includingstate and municipal issues);nor do they make a seriouseffort to take advantage ofswingsinthegeneralmarket.

The leading investment-counsel firmsmake no claimto being brilliant; they dopride themselves on beingcareful, conservative, andcompetent.Theirprimaryaimis to conserve the principalvalue over the years andproduce a conservativelyacceptable rate of income.Any accomplishment beyondthat—and they do strive tobetter the goal—they regardin the nature of extra service

rendered. Perhaps their chiefvalue to their clients lies inshielding them from costlymistakes.Theyofferasmuchas the defensive investor hasthe right to expect from anycounselor serving thegeneralpublic.

What we have said aboutthe well-establishedinvestment-counsel firmsapplies generally to the trustand advisory services of the

largerbanks.*

FinancialServices

The so-called financialservicesareorganizationsthatsend out uniform bulletins(sometimes in the form oftelegrams) to theirsubscribers. The subjectscoveredmayincludethestateandprospectsofbusiness,thebehavior and prospect of thesecurities markets, and

information and adviceregarding individual issues.There is often an “inquirydepartment” which willanswer questons affecting anindividual subscriber. Thecost of the service averagesmuch less than the fee thatinvestment counselors chargetheir individualclients.Someorganizations—notablyBabson’s and Standard &Poor’s—operate on separatelevels as a financial service

and as investment counsel.(Incidentally, otherorganizations—such asScudder, Stevens & Clark—operate separately asinvestment counsel and asone or more investmentfunds.)

The financial servicesdirect themselves, on thewhole, to a quite differentsegmentofthepublicthandothe investment-counsel firms.

The latters’ clients generallywish tobe relievedofbotherand the need for makingdecisions. The financialservicesofferinformationandguidance to those who aredirecting their own financialaffairs or are themselvesadvising others. Many ofthese services confinethemselves exclusively, ornearly so, to forecastingmarketmovementsbyvarious“technical” methods. We

shall dismiss these with theobservation that their workdoes not concern “investors”as the term is used in thisbook.

Ontheotherhand,someofthe best known—such asMoody’s Investment Serviceand Standard & Poor’s—areidentified with statisticalorganizationsthatcompilethevoluminous statistical datathat form the basis for all

serious security analysis.These services have a variedclientele, ranging from themost conservative-mindedinvestor to the rankestspeculator. As a result theymustfinditdifficulttoadhereto any clear-cut orfundamental philosophy inarrivingat theiropinionsandrecommendations.

An old-established serviceof the type of Moody’s and

the others must obviouslyprovide somethingworthwhiletoabroadclassofinvestors. What is it?Basically they addressthemselves to the matters inwhich the average activeinvestor-speculator isinterested,andtheirviewsonthese either command somemeasure of authority or atleast appear more reliablethan those of the unaidedclient.

For years the financialservices have been makingstock-market forecastswithout anyone taking thisactivity very seriously. Likeeveryoneelseinthefieldtheyare sometimes right andsometimes wrong. Whereverpossible they hedge theiropinions so as to avoid therisk of being provedcompletelywrong.(Thereisawell-developedartofDelphicphrasing that adjusts itself

successfully to whatever thefuture brings.) In our view—perhaps a prejudiced one—thissegmentoftheirworkhasno real significance exceptfor the light it throws onhumannatureinthesecuritiesmarkets. Nearly everyoneinterested in common stockswants to be told by someoneelse what he thinks themarket is going to do. Thedemand being there, it mustbesupplied.

Their interpretations andforecasts of businessconditions, of course, aremuch more authoritative andinforming. These are animportant part of the greatbody of economicintelligence which is spreadcontinuously among buyersand sellers of securities andtends to create fairly rationalprices for stocks and bondsunder most circumstances.Undoubtedly the material

published by the financialservices adds to the store ofinformation available andfortifies the investmentjudgmentoftheirclients.

It is difficult to evaluatetheir recommendations ofindividual securities. Eachservice is entitled to bejudged separately, and theverdict could properly bebased only on an elaborateand inclusive study covering

many years. In our ownexperience we have notedamong them a pervasiveattitudewhichwethinktendsto impair what couldotherwise be more usefuladvisory work. This is theirgeneral view that a stockshouldbebought if thenear-termprospectsofthebusinessare favorable and should besold if these are unfavorable—regardless of the currentprice. Such a superficial

principle often prevents theservicesfromdoingthesoundanalytical job of which theirstaffs are capable—namely,to ascertain whether a givenstock appears over- orundervalued at the currentprice in the light of itsindicated long-term futureearningpower.

The intelligent investorwill not do his buying andselling solely on the basis of

recommendations receivedfromafinancialservice.Oncethis point is established, therole of the financial servicethen becomes the useful oneof supplying information andofferingsuggestions.

AdvicefromBrokerageHouses

Probably the largestvolume of information andadvicetothesecurity-owningpublic comes from

stockbrokers. These aremembers of the New YorkStockExchange,andofotherexchanges, who executebuying and selling orders fora standard commission.Practicallyall thehousesthatdealwith thepublicmaintaina “statistical” or analyticaldepartment, which answersinquiries and makesrecommendations. A greatdeal of analytical literature,some of it elaborate and

expensive, is distributedgratis tothefirms’customers—more impressively referredtoasclients.

A great deal is at stake inthe innocent-appearingquestionwhether“customers”or “clients” is the moreappropriatename.Abusinesshascustomers; aprofessionalperson or organization hasclients. The Wall Streetbrokerage fraternity has

probably the highest ethicalstandardsofanybusiness,butit is still feeling its waytoward the standards andstandingofatrueprofession.*

In thepastWallStreethasthrived mainly onspeculation,andstock-marketspeculators as a class werealmostcertaintolosemoney.Hence it has been logicallyimpossible for brokeragehouses to operate on a

thoroughlyprofessionalbasis.To do that would haverequired them to direct theireffortstowardreducingratherthanincreasingtheirbusiness.

The farthest that certainbrokerage houses have gonein that direction—and couldhavebeenexpectedtogo—isto refrain from inducing orencouraging anyone tospeculate. Such houses haveconfined themselves to

executing orders given them,to supplying financialinformationandanalyses,andto rendering opinions on theinvestment merits ofsecurities. Thus, in theory atleast, they are devoid of allresponsibility for either theprofits or the losses of theirspeculativecustomers.†

Most stock-exchangehouses, however, still adhereto the old-time slogans that

they are in business tomakecommissionsandthatthewayto succeed in business is togive thecustomerswhat theywant. Since the mostprofitable customers wantspeculative advice andsuggestions, the thinking andactivities of the typical firmare pretty closely geared today-to-day trading in themarket. Thus it tries hard tohelp its customers makemoney in a field where they

are condemned almost bymathematical law to lose inthe end.† By this we meanthat the speculative part oftheir operations cannot beprofitable over the long runfor most brokeragehousecustomers. But to the extentthattheiroperationsresembletrue investing they mayproduceinvestmentgainsthatmore than offset thespeculativelosses.

Theinvestorobtainsadviceand information from stock-exchangehousesthroughtwotypes of employees, nowknown officially as“customers’ brokers” (or“account executives”) andfinancialanalysts.

The customer’s broker,also called a “registeredrepresentative,”formerlyborethe less dignified title of“customer’s man.” Today he

is for the most part anindividual of good characterand considerable knowledgeof securities, who operatesunder a rigid code of rightconduct. Nevertheless, sincehis business is to earncommissions, he can hardlyavoid being speculation-minded. Thus the securitybuyer who wants to avoidbeing influenced byspeculative considerationswill ordinarily have to be

careful and explicit in hisdealing with his customer’sbroker; hewill have to showclearly, by word and deed,that he is not interested inanything faintly resemblingastock-market “tip.” Once thecustomer’s brokerunderstands clearly that hehas a real investor on hishands, he will respect thispoint of view and cooperatewithit.

The financial analyst,formerly known chiefly assecurity analyst, is a personof particular concern to theauthor, who has been onehimself for more than fivedecades and has helpededucate countless others. Atthisstagewereferonlytothefinancial analysts employedby brokerage houses. Thefunction of the securityanalyst is clear enough fromhis title. It is he who works

up the detailed studies ofindividual securities,developscarefulcomparisonsofvarious issues in the samefield, and forms an expertopinion of the safety orattractiveness or intrinsicvalueofallthedifferentkindsofstocksandbonds.

Bywhatmustseemaquirkto the outsider there are noformalrequirementsforbeinga security analyst. Contrast

with this the facts that acustomer’s broker must passan examination, meet therequired character tests, andbe duly accepted andregistered by the New YorkStock Exchange. As apracticalmatter,nearlyalltheyounger analysts have hadextensive business-schooltraining,andtheoldstershaveacquired at least theequivalent in the school oflong experience. In the great

majority of cases, theemploying brokerage housecan be counted on to assureitselfofthequalificationsandcompetenceofitsanalysts.*

The customer of thebrokeragefirmmaydealwiththe security analysts directly,or his contact may be anindirect one via thecustomer’s broker. In eithercasetheanalystisavailabletothe client for a considerable

amount of information andadvice. Let us make anemphaticstatementhere.Thevalue of the security analystto the investor dependslargelyon the investor’sownattitude. If the investor asksthe analyst the rightquestions, he is likely to gettheright—oratleastvaluable—answers.Theanalystshiredby brokerage houses, we areconvinced, are greatlyhandicapped by the general

feelingthattheyaresupposedtobemarketanalystsaswell.Whentheyareaskedwhethera given common stock is“sound,” the question oftenmeans,“Isthisstocklikelytoadvance during the next fewmonths?”Asaresultmanyofthem are compelled toanalyze with one eye on thestock ticker—a pose notconducive to sound thinkingorworthwhileconclusions.*

In the next section of thisbookweshalldealwithsomeof the concepts and possibleachievements of securityanalysis. A great manyanalysts working for stockexchange firms could be ofprime assistance to the bonafideinvestorwhowantstobesurethathegetsfullvalueforhis money, and possibly alittlemore.As in the case ofthe customers’ brokers, whatisneededatthebeginningisa

clear understanding by theanalyst of the investor’sattitude and objectives.Oncethe analyst is convinced thatheisdealingwithamanwhois value-minded rather thanquotation-minded, there is anexcellent chance that hisrecommendations will proveofrealoverallbenefit.

TheCFACertificateforFinancialAnalysts

An important step wastaken in 1963 toward givingprofessional standing andresponsibility to financialanalysts. The official title ofchartered financial analyst(CFA) is now awarded tothoseseniorpractitionerswhopass required examinationsand meet other tests offitness.1Thesubjectscoveredinclude security analysis andport-folio management. The

analogy with the long-established professional titleof certifiedpublic accountant(CPA) is evident andintentional. This relativelynew apparatus of recognitionand control should serve toelevate the standards offinancial analysts andeventuallytoplacetheirworkonatrulyprofessionalbasis.†

DealingswithBrokerageHouses

One of the mostdisquieting developments oftheperiod inwhichwewritethis revision has been thefinancial embarrassment—inplain words, bankruptcy ornear-bankruptcy—of quite afew New York StockExchange firms, including atleast two of considerablesize.*This is thefirst timeinhalf a century or more thatsuch a thing has happened,

and it is startling for morethan one reason. For manydecades theNewYorkStockExchangehasbeenmovinginthe direction of closer andstricter controls over theoperations and financialcondition of its members—including minimum capitalrequirements, surprise audits,andthelike.Besidesthis,wehave had 37 years of controlover the exchanges and theirmembers by the Securities

and Exchange Commission.Finally, the stock-brokerageindustry itself has operatedunder favorable conditions—namely, a huge increase involume, fixed minimumcommission rates (largelyeliminatingcompetitivefees),and a limited number ofmemberfirms.

The first financial troublesof the brokerage houses (in1969) were attributed to the

increase in volume itself.This, it was claimed,overtaxed their facilities,increased theiroverhead, andproduced many troubles inmaking financial settlements.It should be pointed out thiswasprobablythefirsttimeinhistory that importantenterprises have gone brokebecause they had morebusiness than they couldhandle.In1970,asbrokeragefailures increased, they were

blamedchieflyon“thefallingoff in volume.” A strangecomplaint when one reflectsthattheturnoveroftheNYSEin1970 totaled2,937millionshares, the largest volume initshistoryandwellovertwiceaslargeasinanyyearbefore1965.During the15yearsofthe bull market ending in1964 the annual volume hadaveraged “only” 712 millionshares—one quarter of the1970 figure—but the

brokerage business hadenjoyed the greatestprosperityinitshistory.If,asit appears, themember firmsas awhole had allowed theiroverhead and other expensestoincreaseataratethatcouldnot sustain even a mildreduction in volume duringpart of a year, this does notspeak well for either theirbusiness acumen or theirfinancialconservatism.

A third explanation of thefinancial trouble finallyemerged out of a mist ofconcealment, andwe suspectthat it is the most plausibleandsignificantofthethree.Itseems thatagoodpartof thecapital of certain brokeragehouses was held in the formof common stocks owned bythe individualpartners.Someof these seem to have beenhighlyspeculativeandcarriedat inflated values. When the

market declined in 1969 thequotations of such securitiesfell drastically and asubstantial part of the capitalof the firms vanished withthem.2 In effect the partnerswere speculating with thecapital that was supposed toprotect the customers againsttheordinaryfinancialhazardsof the brokerage business, inordertomakeadoubleprofitthereon. This was

inexcusable; we refrain fromsayingmore.

Theinvestorshouldusehisintelligence not only informulating his financialpolicies but also in theassociated details. Theseinclude the choice of areputable broker to executehis orders.Up to now itwassufficient to counsel ourreaders to deal only with amember of the New York

Stock Exchange, unless hehadcompellingreasonstousea nonmember firm.Reluctantly, we must addsome further advice in thisarea. We think that peoplewho do not carry marginaccounts—and in ourvocabulary this means allnonprofessional investors—should have the delivery andreceipt of their securitieshandledby their bank.Whengivingabuyingordertoyour

brokersyoucaninstructthemto deliver the securitiesbought to your bank againstpaymentthereforbythebank;conversely,when selling youcan instruct your bank todeliver the securities to thebrokeragainstpaymentoftheproceeds.These serviceswillcost a little extra but theyshould be well worth theexpense in terms of safetyand peace of mind. Thisadvicemaybedisregarded,as

nolongercalledfor,aftertheinvestor is sure that all theproblems of stock-exchangefirms have been disposed of,butnotbefore.*

InvestmentBankers

The term “investmentbanker” is applied to a firmthat engages to an importantextent in originating,underwriting,andsellingnewissues of stocks and bonds.

(To underwrite means toguarantee to the issuingcorporation, or other issuer,that the securitywillbe fullysold.) A number of thebrokerage houses carry on acertain amount ofunderwriting activity.Generally this is confined toparticipating in underwritinggroups formed by leadinginvestment bankers. There isan additional tendency forbrokerage firms to originate

and sponsor a minor amountof new-issue financing,particularly in the form ofsmaller issues of commonstockswhen a bullmarket isinfullswing.

Investment banking isperhaps the most respectabledepartmentoftheWallStreetcommunity,becauseitisherethat finance plays itsconstructiveroleofsupplyingnewcapitalfortheexpansion

of industry. In fact, much ofthe theoretical justificationfor maintaining active stockmarkets, notwithstandingtheir frequent speculativeexcesses, lies in the fact thatorganized security exchangesfacilitate the sale of newissuesofbondsandstocks.Ifinvestorsorspeculatorscouldnot expect to see a readymarket for a new securityofferedthem,theymightwellrefusetobuyit.

The relationship betweentheinvestmentbankerandtheinvestor is basically that ofthe salesman to theprospective buyer. For manyyears past the great bulk ofthe new offerings in dollarvalue has consisted of bondissues thatwerepurchased inthe main by financialinstitutionssuchasbanksandinsurance companies. In thisbusiness the securitysalesmen have been dealing

with shrewd and experiencedbuyers. Hence anyrecommendations made bythe investment bankers tothese customers have had topass careful and skepticalscrutiny. Thus thesetransactions are almostalways effected on abusinesslikefooting.

But a different situationobtains in a relationshipbetween the individual

security buyer and theinvestment banking firms,including the stockbrokersacting as underwriters. Herethe purchaser is frequentlyinexperienced and seldomshrewd. He is easilyinfluenced by what thesalesmantellshim,especiallyin the case of common-stockissues, since often hisunconfessed desire in buyingis chiefly to make a quickprofit.Theeffectofallthisis

that the public investor’sprotectionlieslessinhisowncritical faculty than in thescruples and ethics of theofferinghouses.3

Itisatributetothehonestyand competence of theunderwriting firms that theyare able to combine fairlywell the discordant roles ofadviser and salesman. But itis imprudent for thebuyer totrust himself to the judgment

of the seller. In 1959 westatedat thispoint: “Thebadresults of this unsoundattitude show themselvesrecurrently in theunderwriting field and withnotable effects in the sale ofnew common stock issuesduring periods of activespeculation.” Shortlythereafterthiswarningprovedurgently needed. As alreadypointed out, the years 1960–61 and, again, 1968–69were

marked by an unprecedentedoutpouringofissuesoflowestquality, sold to the public atabsurdly high offering pricesand in many cases pushedmuch higher by heedlessspeculation and some semi-manipulation. A number ofthe more important WallStreet houses haveparticipatedtosomedegreeinthese less than creditableactivities,whichdemonstratesthat the familiar combination

of greed, folly, andirresponsibility has not beenexorcized from the financialscene.

The intelligent investorwill pay attention to theadvice and recommendationsreceived from investmentbanking houses, especiallythose known by him to havean excellent reputation; buthewillbesuretobringsoundand independent judgment to

bear upon these suggestions—either his own, if he iscompetent, or that of someothertypeofadviser.*

OtherAdvisers

It is a good old custom,especially in the smallertowns, to consult one’s localbanker about investments. Acommercial banker may notbeathoroughgoingexpertonsecurity values, but he is

experiencedandconservative.He isespeciallyuseful to theunskilled investor, who isoften tempted to stray fromthe straight and unexcitingpathofadefensivepolicyandneeds thesteadying influenceof aprudentmind.Themorealert and aggressive investor,seeking counsel in theselectionofsecuritybargains,will not ordinarily find thecommercial banker’sviewpoint to be especially

suitedtohisownobjectives.†

We take a more criticalattitude toward thewidespread custom of askinginvestment advice fromrelatives or friends. Theinquireralways thinkshehasgoodreasonforassumingthatthe person consulted hassuperior knowledge orexperience. Our ownobservationindicatesthatitisalmost as difficult to select

satisfactory lay advisers as itis to select the propersecuritiesunaided.Muchbadadviceisgivenfree.

Summary

Investorswhoarepreparedto pay a fee for themanagement of their fundsmaywiselyselectsomewell-established and well-recommended investment-counsel firm. Alternatively,

they may use the investmentdepartment of a large trustcompany or the supervisoryservice supplied on a feebasisbya fewof the leadingNew York Stock Exchangehouses. The results to beexpected are in no wiseexceptional, but they arecommensurate with those ofthe average well-informedandcautiousinvestor.

Most security buyers

obtain advicewithout payingforitspecifically.Itstandstoreason, therefore, that in themajorityofcasestheyarenotentitled to and should notexpect better than averageresults. They should bewaryof all persons, whethercustomers’ brokers orsecurity salesmen, whopromise spectacular incomeor profits. This applies bothto the selection of securitiesandtoguidanceintheelusive

(and perhaps illusive) art oftradinginthemarket.

Defensive investors, aswehave defined them, will notordinarilybeequippedtopassindependent judgment on thesecurity recommendationsmade by their advisers. Butthey can be explicit—andeven repetitiously so—instating the kind of securitiesthey want to buy. If theyfollow our prescription they

will confine themselves tohigh-grade bonds and thecommon stocks of leadingcorporations,preferablythosethat can be purchased atindividual price levels thatare not high in the light ofexperience and analysis. Thesecurity analyst of anyreputable stock-exchangehousecanmakeupasuitablelist of such common stocksandcancertifytotheinvestorwhether or not the existing

price level therefor is areasonably conservative oneasjudgedbypastexperience.

The aggressive investorwillordinarilyworkinactivecooperationwithhisadvisers.He will want theirrecommendations explainedindetail,andhewillinsistonpassing his own judgmentupon them. This means thatthe investor will gear hisexpectationsandthecharacter

of his security operations tothe development of his ownknowledge and experience inthe field. Only in theexceptional case, where theintegrity and competence ofthe advisers have beenthoroughly demonstrated,should the investor act uponthe advice of others withoutunderstanding and approvingthedecisionmade.

There have always been

unprincipled stock salesmenand fly by-night stockbrokers, and—as a matter ofcourse—wehaveadvisedourreaders to confine theirdealings, if possible, tomembers of the New YorkStock Exchange. But we arereluctantly compelled to addthe extra-cautious counselthat security deliveries andpayments be made throughthe intermediary of theinvestor’s bank. The

distressing Wall Streetbrokerage-house picture mayhaveclearedupcompletelyina fewyears, but in late 1971we still suggest, “Better safethansorry.”


I feel grateful to the Milesianwench who, seeing thephilosopher Thales continuallyspending his time incontemplation of the heavenlyvault and always keeping hiseyes raised upward, putsomething in his way to makehimstumble, towarnhimthat it

would be time to amuse histhoughts with things in thecloudswhenhehadseentothoseat his feet. Indeed she gave himor her good counsel, to lookrathertohimselfthantothesky.

—MicheldeMontaigne

DoYouNeedHelp?

In the glory days of the late1990s, many investors chosetogoitalone.Bydoingtheirown research, picking stocksthemselves, and placing their

trades through an onlinebroker, these investorsbypassedWallStreet’scostlyinfrastructure of research,advice, and trading.Unfortunately, many do-it-yourselfers asserted theirindependencerightbeforetheworst bear market since theGreat Depression—makingthem feel, in the end, thatthey were fools for going italone. That’s not necessarilytrue, of course; people who

delegatedeverydecision toatraditional stockbroker lostmoney,too.

Butmanyinvestorsdotakecomfort from the experience,judgment,andsecondopinionthat a good financial advisercan provide. Some investorsmayneedanoutsidertoshowthemwhatrateofreturntheyneed to earn on theirinvestments, or how muchextra money they need to

save, in order to meet theirfinancial goals. Others maysimply benefit from havingsomeone else to blamewhentheir investments go down;that way, instead of beatingyourself up in an agony ofself-doubt,yougettocriticizesomeone who typically candefend him or herself andencourage you at the sametime. That may provide justthe psychological boost youneed to keep investing

steadilyata timewhenotherinvestors’ hearts may failthem.Allinall,justasthere’sno reason you can’t manageyourownportfolio,sothere’sno shame in seekingprofessionalhelpinmanagingit.1

How can you tell if youneed a hand? Here are somesignals:

Biglosses.Ifyourportfolio

lost more than 40% of itsvalue from the beginning of2000 through the end of2002, then you did evenworse than the dismalperformance of the stockmarket itself. It hardlymatters whether you blew itby being lazy, reckless, orjust unlucky; after such agiant loss, your portfolio iscryingoutforhelp.

Busted budgets. If you

perennially struggle to makeends meet, have no ideawhereyourmoneygoes, findit impossible to save on aregular schedule, andchronically fail to pay yourbills on time, then yourfinances are out of control.Anadvisercanhelpyougetagrip on your money bydesigning a comprehensivefinancialplanthatwilloutlinehow—and how much—youshould spend, borrow, save,

andinvest.

Chaoticportfolios.Alltoomany investors thought theywere diversified in the late1990sbecausetheyowned39“different” Internetstocks,orseven “different” U.S.growth-stock funds. Butthat’slikethinkingthatanall-soprano chorus can handlesinging “Old Man River”better than a soprano soloistcan. No matter how many

sopranosyouadd,thatchoruswill never be able to nail allthose low notes until somebaritones join the group.Likewise,ifallyourholdingsgoupanddowntogether,youlack the investing harmonythat true diversificationbrings.Aprofessional“asset-allocation”plancanhelp.

Major changes. If you’vebecome self-employed andneed to set up a retirement

plan,youragingparentsdon’thave their finances in order,orcollegeforyourkidslooksunaffordable, an adviser cannot only provide peace ofmind but help you makegenuine improvements in thequality of your life. What’smore,aqualifiedprofessionalcan ensure that you benefitfrom and comply with thestaggering complexity of thetaxlawsandretirementrules.

Trust,thenVerify

Remember that financial conartists thrive by talking youinto trusting them and bytalking you out ofinvestigating them. Beforeyou place your financialfuture in the hands of anadviser, it’s imperative thatyou find someone who notonly makes you comfortablebutwhosehonesty is beyondreproach. As Ronald Reagan

used to say, “Trust, thenverify.” Start off by thinkingof the handful of people youknowbestandtrustthemost.Thenaskiftheycanreferyoutoanadviserwhomthey trustand who, they feel, deliversgood value for his fees. Avote of confidence fromsomeone you admire is agoodstart.2

Onceyouhavethenameofthe adviser and his firm, as

wellashisspecialty—isheastockbroker? financialplanner? accountant?insurance agent?—you canbegin your due diligence.Enterthenameoftheadviserand his or her firm into anInternet search engine likeGoogle to see if anythingcomes up (watch for termslike “fine,” “complaint,”“lawsuit,” “disciplinaryaction,” or “suspension”). Iftheadviserisastockbrokeror

insurance agent, contact theoffice of your state’ssecurities commissioner (aconvenientdirectoryofonlinelinks isatwww.nasaa.org) toask whether any disciplinaryactions or customercomplaints have been filedagainsttheadviser.3Ifyou’reconsidering an accountantwho also functions as afinancialadviser,yourstate’saccounting regulators (whom

you can find through theNationalAssociationofStateBoards of Accountancy atwww.nasba.org)will tell youwhether his or her record isclean.

Financialplanners(ortheirfirms) must register witheither theU.S.SecuritiesandExchange Commission orsecurities regulators in thestate where their practice isbased. As part of that

registration, the advisermustfile a two-part documentcalled Form ADV. Youshould be able to view anddownload it atwww.advisorinfo.sec.gov,www.iard. com, or thewebsite of your statesecurities regulator. Payspecial attention to theDisclosure Reporting Pages,where the adviser mustdisclose any disciplinaryactions by regulators.

(Because unscrupulousadvisers have been known toremove those pages beforehanding an ADV to aprospectiveclient,youshouldindependently obtain yourown complete copy.) It’s agood idea to cross-check afinancial planner’s record atwww.cfp-board.org, sincesomeplannerswhohavebeendisciplinedoutsidetheirhomestate can fall through theregulatory cracks. For more

tipsonduediligence, see thesidebarbelow.

WORDSOFWARNING

Theneedforduediligencedoesn’tstoponceyouhireanadviser.MelanieSenterLubin, securitiescommissionerfortheStateof Maryland, suggestsbeing on guard for wordsand phrases that can spelltrouble. If your adviserkeeps saying them—ortwisting your arm to doanything that makes youuncomfortable—“then get

in touch with theauthorities very quickly,”warns Lubin. Here’s thekind of lingo that shouldsetoffwarningbells:

“offshore”

“the opportunity of alifetime”

“primebank”

“This baby’s gonnamove.”

“guaranteed”

“Youneedtohurry.”

“It’sasurething.”

“our proprietary computermodel”

“The smart money isbuyingit.”

“optionsstrategy”

“It’sano-brainer.”

“You can’t afford not toownit.”

“Wecanbeatthemarket.”

“You’ll be sorry if youdon’t…”

“exclusive”

“You should focus on

performance,notfees.”

“Don’t you want to berich?”

“can’tlose”

“Theupsideishuge.”

“There’snodownside.”

“I’mputtingmymotherinit.”

“Trustme.”

“commoditiestrading”

“monthlyreturns”

“active asset-allocation

strategy”

“We can cap yourdownside.”

“No one else knows howtodothis.”

GettingtoKnowYou

A leading financial-planningnewsletter recentlycanvasseddozensofadviserstogettheirthoughts on how you shouldgo about interviewing them.4

In screening an adviser, yourgoalsshouldbeto:

determinewhetherheorshe cares about helpingclients, or just goesthroughthemotionsestablish whether he orshe understands thefundamental principlesof investing as they areoutlinedinthisbookassesswhetherheorshe

is sufficiently educated,trained, and experiencedtohelpyou.

Here are some of thequestions that prominentfinancial plannersrecommended anyprospectiveclientshouldask:

Why are you in thisbusiness?Whatisthemissionstatement of your firm?Besides your alarm clock,

whatmakesyougetupinthemorning?

What is your investingphilosophy? Do you usestocks or mutual funds? Doyou use technical analysis?Do you use market timing?(A “yes” to either of the lasttwoquestionsisa“no”signaltoyou.)

Do you focus solely onassetmanagement,ordoyou

also advise on taxes, estateand retirement planning,budgeting and debtmanagement, and insurance?How do your education,experience, and credentialsqualify you to give thosekindsoffinancialadvice?5

Whatneedsdoyourclientstypically have in common?Howcanyouhelpmeachievemygoals?Howwillyoutrackand report my progress? Do

youprovideachecklist thatIcan use to monitor theimplementation of anyfinancialplanwedevelop?

How do you chooseinvestments? What investingapproach do you believe ismost successful, and whatevidence can you show methat you have achieved thatkind of success for yourclients? What do you dowhenaninvestmentperforms

poorly for an entire year?(Any adviser who answers“sell”isnotworthhiring.)

Do you, whenrecommending investments,accept any form ofcompensation from any thirdparty? Why or why not?Under which circumstances?Howmuch, in actual dollars,do you estimate Iwould payfor your services the firstyear?Whatwouldmake that

number go up or down overtime? (If fees will consumemore than 1%of your assetsannually, you shouldprobably shop for anotheradviser.6)

How many clients do youhave, and how often do youcommunicate with them?Whathasbeenyourproudestachievement for a client?What characteristics do yourfavoriteclientsshare?What’s

the worst experience you’vehadwithaclient,andhowdidyou resolve it? Whatdetermines whether a clientspeaks to you or to yoursupport staff? How long doclients typically stay withyou?

CanIseeasampleaccountstatement? (If you can’tunderstand it, ask theadviserto explain it. If you can’tunderstand his explanation,

he’snotrightforyou.)

Do you consider yourselffinancially successful?Why?How do you define financialsuccess?

How high an averageannual returndoyou think isfeasible on my investments?(Anythingover8%to10%isunrealistic.)

Will you provide me with

your résumé, your FormADV, and at least threereferences? (If the adviser orhis firm is required to fileanADV,andhewillnotprovideyouacopy,getupand leave—andkeeponehandonyourwalletasyougo.)

Have you ever had aformalcomplaintfiledagainstyou?Why did the last clientwhofiredyoudoso?

DefeatingYourOwnWorstEnemy

Finally, bear in mind thatgreatfinancialadvisersdonotgrowontrees.Often,thebestalready have asmany clientsastheycanhandle—andmaybewillingtotakeyouononlyif you seem like a goodmatch. So they will ask yousometoughquestionsaswell,whichmightinclude:

Whydoyoufeelyouneed

afinancialadviser?

What are your long-termgoals?

What has been yourgreatest frustration indealingwithotheradvisers(includingyourself)?

Doyouhaveabudget?Doyou live within your means?What percentage of yourassets do you spend each

year?

Whenwelookbackayearfromnow,whatwillIneedtohave accomplished in orderforyoutobehappywithyourprogress?

How do you handleconflictsordisagreements?

How did you respondemotionally to the bearmarketthatbeganin2000?

What are your worstfinancial fears?Yourgreatestfinancialhopes?

Whatrateofreturnonyourinvestments do you considerreasonable? (Base youransweronChapter3.)

An adviser who doesn’taskquestionslikethese—andwho does not show enoughinterest in you to sense

intuitively what otherquestions you consider to betherightones—isnotagoodfit.

Aboveall else,youshouldtrust your adviser enough topermit him or her to protectyou from your worst enemy—yourself. “You hire anadviser,” explainscommentator Nick Murray,“not tomanagemoneybut tomanageyou.”

“If the adviser is a line ofdefense between you andyour worst impulsivetendencies,” says financial-planning analyst RobertVeres,“thenheorsheshouldhave systems in place thatwill help the two of youcontrol them.” Among thosesystems:

a comprehensivefinancial plan that

outlines how you willearn, save, spend,borrow, and invest yourmoney;an investment policystatementthatspellsoutyour fundamentalapproachtoinvesting;anasset-allocationplanthat details how muchmoney youwill keep indifferent investmentcategories.

These are the buildingblocks on which goodfinancial decisions must befounded, and they should becreated mutually—by youand the adviser—rather thanimposed unilaterally. Youshould not invest a dollar ormakeadecisionuntilyouaresatisfied that thesefoundations are in place andin accordance with yourwishes.

Chapter11SecurityAnalysisfortheLayInvestor:GeneralApproach

Financial analysis is now awell-established and

flourishing profession, orsemiprofession. The varioussocieties of analysts thatmake up the NationalFederation of FinancialAnalysts have over 13,000members, most of whommake their living out of thisbranch of mental activity.Financial analysts havetextbooks, a code of ethics,andaquarterlyjournal.*Theyalso have their share of

unresolved problems. Inrecentyears therehasbeenatendency to replace thegeneral concept of “securityanalysis”bythatof“financialanalysis.” The latter phrasehasabroaderimplicationandisbettersuitedtodescribethework ofmost senior analystson Wall Street. It would beuseful to think of securityanalysis as limiting itselfpretty much to theexamination and evaluation

ofstocksandbonds,whereasfinancial analysis wouldcomprise that work, plus thedetermination of investmentpolicy (portfolio selection),plus a substantial amount ofgeneral economic analysis.1In this chapter we shall usewhatever designation ismostapplicable, with chiefemphasis on the work of thesecurityanalystproper.

The security analyst deals

withthepast,thepresent,andthe future of any givensecurity issue. He describesthe business; he summarizesits operating results andfinancial position; he setsforth its strong and weakpoints, its possibilities andrisks; he estimates its futureearning power under variousassumptions, or as a “bestguess.” He makes elaboratecomparisons of variouscompanies, or of the same

company at various times.Finally, he expresses anopinionastothesafetyoftheissue, if it is a bond orinvestment-grade preferredstock, or as to itsattractiveness as a purchase,ifitisacommonstock.

Indoingallthesethingsthesecurityanalystavailshimselfof a number of techniques,ranging from the elementarytothemostabstruse.Hemay

modify substantially thefigures in the company’sannual statements, eventhough they bear the sacredimprimatur of the certifiedpublic accountant. He is onthe lookout particularly foritems in these reports thatmaymean a good dealmoreorlessthantheysay.

The security analystdevelops and appliesstandards of safety by which

we can conclude whether agivenbondorpreferredstockmaybetermedsoundenoughto justify purchase forinvestment. These standardsrelate primarily to pastaverageearnings,buttheyareconcerned also with capitalstructure, working capital,asset values, and othermatters.

In dealing with commonstocks the security analyst

until recently has only rarelyapplied standards of value aswell defined as were hisstandards of safety for bondsandpreferredstocks.Mostofthetimehecontendedhimselfwith a summary of pastperformances, amore or lessgeneral forecast of the future—withparticularemphasisonthe next 12 months—and arather arbitrary conclusion.The latter was, and still is,often drawnwith one eye on

thestocktickerorthemarketcharts. In the past fewyears,however, much attention hasbeen given by practicinganalysts to the problem ofvaluing growth stocks.Manyof these have sold at suchhighpricesinrelationtopastand current earnings thatthose recommending themhave felt a special obligationto justify their purchase byfairly definite projections ofexpected earnings running

fairly far into the future.Certain mathematicaltechniques of a rathersophisticated sort haveperforce been invoked tosupportthevaluationsarrivedat.

We shall deal with thesetechniques, in foreshortenedform, a little later. However,we must point out atroublesome paradox here,which is that the

mathematicalvaluationshavebecome most prevalentpreciselyinthoseareaswhereonemightconsiderthemleastreliable. For the moredependent the valuationbecomes on anticipations ofthe future—and the less it istied to a figure demonstratedby past performance—themore vulnerable it becomestopossiblemiscalculationandserious error.A large part ofthe value found for a high-

multiplier growth stock isderived from futureprojections which differmarkedly from pastperformance—exceptperhapsinthegrowthrateitself.Thusit may be said that securityanalysts today findthemselves compelled tobecome most mathematicaland “scientific” in the verysituations which lendthemselves least auspiciously

toexacttreatment.*

Let us proceed,nonetheless, with ourdiscussion of the moreimportant elements andtechniques of securityanalysis. The present highlycondensed treatment isdirected to the needs of thenonprofessional investor. Atthe minimum he shouldunderstand what the securityanalyst is talking about and

driving at; beyond that, heshould be equipped, ifpossible, to distinguishbetween superficial andsoundanalysis.

Security analysis for thelay investor is thought of asbeginning with theinterpretationofacompany’sannual financial report. Thisis a subject which we havecovered for laymen in aseparate book, entitled The

Interpretation of FinancialStatements. 2 We do notconsider it necessary orappropriate to traverse thesame ground in this chapter,especially since theemphasisin the present book is onprinciplesandattitudesratherthan on information anddescription.Letuspassontotwo basic questionsunderlying the selection ofinvestments. What are the

primary tests of safety of acorporate bond or preferredstock? What are the chieffactors entering into thevaluationofacommonstock?

BondAnalysis

The most dependable andhence the most respectablebranch of security analysisconcerns itself with thesafety, or quality, of bondissues and investment-grade

preferred stocks. The chiefcriterion used for corporatebonds is thenumberof timesthat total interest chargeshave been covered byavailable earnings for someyears in the past. In the caseof preferred stocks, it is thenumber of times that bondinterest and preferreddividends combined havebeencovered.

The exact standards

applied will vary withdifferent authorities. Sincethe tests are at bottomarbitrary, there is no way todetermine precisely the mostsuitable criteria. In the 1961revision of our textbook,Security Analysis, werecommend certain“coverage” standards, whichappearinTable11-1.*

Our basic test is appliedonlytotheaverageresultsfor

a period of years. Otherauthorities requirealso that aminimum coverage be shownforeveryyearconsidered.Weapprove a “poorest-year” testasanalternativetotheseven-year-averagetest;itwouldbesufficient if the bond orpreferred stock met either ofthesecriteria.

TABLE11-1RecommendedMinimum “Coverage” forBondsandPreferredStocks

B. For Investment-grade PreferredStocks

The same minimum figuresas above are required to beshown by the ratio ofearningsbefore income taxesto the sum of fixed chargesplus twice preferreddividends.

NOTE:Theinclusionoftwicethepreferreddividendsallowsforthefactthatpreferreddividendsarenotincome-taxdeductible,whereasinterestchargesare

sodeductible.

C. Other Categories of Bonds andPreferreds

The standards given aboveare not applicable to (1)public-utility holdingcompanies, (2) financialcompanies, (3) real-estatecompanies.

Itmaybeobjectedthat the

largeincreaseinbondinterestratessince1961wouldjustifysome offsetting reduction inthe coverage of chargesrequired. Obviously it wouldbe much harder for anindustrialcompanytoshowaseven-times coverage ofinterestchargesat8%thanat4½%. To meet this changedsituation we now suggest analternative requirementrelated to the percent earnedon the principal amount of

thedebt.Thesefiguresmightbe 33% before taxes for anindustrial company, 20% forapublicutility,and25%forarailroad.Itshouldbeborneinmind here that the rateactually paid by mostcompanieson their totaldebtis considerably less than thecurrent8%figures,sincetheyhave the benefit of olderissuesbearinglowercoupons.The “poorest year”requirement could be set at

abouttwo-thirdsoftheseven-yearrequirement.

Inadditiontotheearnings-coverage test, a number ofothers are generally applied.Theseincludethefollowing:

1.SizeofEnterprise.Thereis a minimum standard interms of volume of businessforacorporation—varyingasbetween industrials, utilities,

and railroads—and ofpopulationforamunicipality.

2.Stock/EquityRatio. Thisistheratioofthemarketpriceof the junior stock issues* tothe total face amount of thedebt, or the debt pluspreferred stock. It is a roughmeasure of the protection, or“cushion,” afforded by thepresence of a juniorinvestment that must first

bear thebruntofunfavorabledevelopments. This factorincludes the market’sappraisal of the futureprospectsoftheenterprise.

3. Property Value. Theassetvalues,asshownonthebalancesheetorasappraised,were formerlyconsidered thechief security and protectionfor a bond issue. Experiencehas shown that inmostcases

safety resides in the earningpower,andifthisisdeficientthe assets lose most of theirreputed value. Asset values,however,retainimportanceasa separate test of amplesecurity for bonds andpreferred stocks in threeenterprise groups: publicutilities (because rates maydepend largely on theproperty investment), real-estate concerns, andinvestmentcompanies.

At this point the alertinvestor should ask, “Howdependablearetestsofsafetythataremeasuredbypastandpresent performance, in viewof the fact that payment ofinterestandprincipaldependsupon what the future willbringforth?”Theanswercanbe founded only onexperience. Investmenthistory shows thatbondsand

preferredstocksthathavemetstringenttestsofsafety,basedon thepast,have in thegreatmajorityofcasesbeenabletoface the vicissitudes of thefuture successfully. This hasbeen strikingly demonstratedin themajor field of railroadbonds—a field that has beenmarked by a calamitousfrequency of bankruptciesand serious losses. In nearlyevery case the roads that gotinto trouble had long been

overbonded, had shown aninadequate coverage of fixedchargesinperiodsofaverageprosperity, and would thushave been ruled out byinvestors who applied stricttests of safety. Conversely,practicallyeveryroadthathasmet such tests has escapedfinancialembarrassment.Ourpremise was strikinglyvindicated by the financialhistory of the numerousrailroads reorganized in the

1940s and in 1950. All ofthese, with one exception,started their careers withfixed charges reduced to apoint where the currentcoverage of fixed-interestrequirementswasample,oratleast respectable. Theexception was the NewHavenRailroad,which in itsreorganization year, 1947,earned its new charges onlyabout 1.1 times. Inconsequence, while all the

otherroadswereabletocomethrough rather difficult timeswith solvency unimpaired,theNewHaven relapsed intotrusteeship(forthethirdtime)in1961.

In Chapter 17 below weshall consider some aspectsofthebankruptcyofthePennCentral Railroad, whichshook the financialcommunity in 1970. Anelementary fact in this case

wasthatthecoverageoffixedcharges did not meetconservative standards asearly as 1965; hence aprudent bond investor wouldhave avoided or disposed ofthebondissuesofthesystemlong before its financialcollapse.

Our observations on theadequacyofthepastrecordtojudgefuturesafetyapply,andto an even greater degree, to

the public utilities, whichconstitute a major area forbond investment.Receivership of a soundlycapitalized (electric) utilitycompanyor system isalmostimpossible. Since Securitiesand Exchange Commissioncontrolwas instituted,*alongwith the breakup of most ofthe holding-companysystems, public-utilityfinancinghasbeensoundand

bankruptcies unknown. Thefinancial troubles of electricand gas utilities in the 1930swere traceable almost 100%to financial excesses andmismanagement, which lefttheir imprint clearly on thecompanies’ capitalizationstructures. Simple butstringent tests of safety,therefore,wouldhavewarnedthe investor away from theissues that were later todefault.

Among industrial bondissues the long-term recordhas been different. Althoughthe industrial group as awhole has shown a bettergrowthofearningpowerthaneither the railroads or theutilities, it has revealed alesser degree of inherentstability for individualcompanies and lines ofbusiness.Thus in thepast, atleast, there have beenpersuasive reasons for

confining the purchase ofindustrialbondsandpreferredstocks to companies that notonly are of major size butalsohaveshownanability inthepasttowithstandaseriousdepression.

Few defaults of industrialbonds have occurred since1950, but this fact isattributable in part to theabsenceofamajordepressionduringthislongperiod.Since

1966therehavebeenadversedevelopments in thefinancialposition of many industrialcompanies. Considerabledifficultieshavedevelopedasthe result of unwiseexpansion. On the one handthis has involved largeadditions to both bank loansand long-term debt; on theother it has frequentlyproduced operating lossesinstead of the expectedprofits. At the beginning of

1971itwascalculatedthatinthe past seven years theinterest payments of allnonfinancialfirmshadgrownfrom $9.8 billion in 1963 to$26.1billionin1970,andthatinterest payments had taken29% of the aggregate profitsbefore interest and taxes in1971, against only 16% in1963.3Obviously, theburdenonmanyindividualfirmshadincreased much more than

this. Overbonded companieshavebecomeall toofamiliar.There is every reason torepeat the caution expressedinour1965edition:

We are not quite readyto suggest that theinvestor may count onan indefinitecontinuance of thisfavorable situation, andhencerelaxhisstandardsof bond selection in the

industrial or any othergroup.

Common-StockAnalysis

The ideal form ofcommon-stock analysis leadsto a valuation of the issuewhich can be comparedwiththecurrentpricetodeterminewhetherornot thesecurityisan attractive purchase. Thisvaluation, in turn, wouldordinarily be found by

estimating the averageearnings over a period ofyears in the future and thenmultiplying that estimate byan appropriate “capitalizationfactor.”

The now-standardprocedure for estimatingfuture earning power startswith average past data forphysical volume, pricesreceived, and operatingmargin. Future sales in

dollars are then projected onthebasisofassumptionsastothe amount of change involume and price level overthe previous base. Theseestimates, in turn, aregrounded first on generaleconomic forecasts of grossnationalproduct,and thenonspecial calculationsapplicabletotheindustryandcompanyinquestion.

An illustration of this

method of valuation may betaken from our 1965 editionand brought up to date byadding thesequel.TheValueLine, a leading investmentservice, makes forecasts offutureearningsanddividendsby the procedure outlinedabove, and then derives afigure of “price potentiality”(or projected market value)by applying a valuationformula to each issue basedlargely on certain past

relationships. In Table 11-2we reproduce the projectionsfor 1967–1969made in June1964,andcomparethemwiththe earnings, and averagemarketpriceactuallyrealizedin 1968 (which approximatesthe1967–1969period).

The combined forecastsprovedtobesomewhatonthelowside,butnotseriouslyso.The correspondingpredictions made six years

before had turned out to beoveroptimistic on earningsand dividends; but this hadbeen offset by use of a lowmultiplier,withtheresultthatthe“pricepotentiality”figureproved to be about the sameastheactualaveragepricefor1963.

The reader will note thatquite a number of theindividual forecasts werewide of themark. This is an

instance in support of ourgeneral view that compositeor group estimates are likelyto be a good deal moredependable than those forindividual companies.Ideally, perhaps, the securityanalyst should pick out thethree or four companieswhose future he thinks heknows the best, andconcentrate his own and hisclients’ interest on what heforecasts for them.

Unfortunately, it appears tobe almost impossible todistinguish in advancebetween those individualforecastswhichcanbe reliedupon and those which aresubject to a large chance oferror. At bottom, this is thereason for the widediversification practiced bytheinvestmentfunds.Foritisundoubtedly better toconcentrateononestock thatyou know is going to prove

highly profitable, rather thandilute your results to amediocre figure, merely fordiversification’s sake. Butthis is not done, because itcannotbedonedependably.4The prevalence of widediversification is in itself apragmatic repudiation of thefetish of “selectivity,” towhichWall Street constantlypayslipservice.*

TABLE 11-2 The Dow

JonesIndustrialAverage

(The Value Line’s Forecastfor1967–1969(MadeinMid-1964)ComparedWithActualResultsin1968)

FactorsAffectingtheCapitalizationRate

Though average futureearnings are supposed to bethe chief determinant ofvalue, the security analysttakes into account a numberof other factors of amore orless definite nature. Most ofthese will enter into hiscapitalization rate,whichcanvary over a wide range,

dependingupon the“quality”of the stock issue. Thus,although twocompaniesmayhave the same figure ofexpected earnings per sharein 1973–1975—say $4—theanalystmayvalueoneaslowas40andtheotherashighas100. Let us deal brieflywithsome of the considerationsthatenterintothesedivergentmultipliers.

1. General Long-TermProspects. No one reallyknows anything about whatwill happen in the distantfuture, but analysts andinvestors have strong viewson the subject just the same.These views are reflected inthe substantial differentialsbetween the price/earningsratios of individualcompanies and of industrygroups. At this point weaddedinour1965edition:

For example, at the endof 1963 the chemicalcompanies in the DJIAwere selling atconsiderably highermultipliers than the oilcompanies, indicatingstronger confidence inthe prospects of theformerthanofthelatter.Such distinctions madeby the market are oftensoundlybased,butwhendictated mainly by past

performance they are aslikely to be wrong asright.

We shall supply here, inTable11-3,the1963year-endmaterial on the chemical andoil company issues in theDJIA, and carry theirearningstotheendof1970.Itwillbeseenthatthechemicalcompanies,despite theirhighmultipliers, made practicallyno gain in earnings in the

period after 1963. The oilcompanies did much betterthan thechemicalsandaboutin line with the growthimplied in their 1963multipliers.5 Thus ourchemical-stock exampleprovedtobeoneofthecasesin which the marketmultipliers were provenwrong.*

2. Management. On WallStreet a great deal isconstantly said on thissubject,butlittlethatisreallyhelpful. Until objective,quantitative, and reasonablyreliable tests of managerialcompetence are devised andapplied, this factor willcontinue to be looked atthrough a fog. It is fair toassume that an outstandingly

successful company hasunusually good management.This will have shown itselfalready in the past record; itwill show up again in theestimates for the next fiveyears, and once more in thepreviouslydiscussedfactoroflong-term prospects. Thetendency to count it stillanother time as a separatebullish consideration caneasily lead to expensiveovervaluations. The

management factor is mostuseful, we think, in thosecases in which a recentchange has taken place thathas not yet had the time toshow its significance in theactualfigures.

Two spectacularoccurrencesofthiskindwereassociated with the ChryslerMotor Corporation. The firsttook place as far back as1921, when Walter Chrysler

took command of the almostmoribund Maxwell Motors,and in a fewyearsmade it alarge and highly profitableenterprise, while numerousother automobile companieswere forced out of business.The second happened asrecently as 1962, whenChrysler had fallen far fromits once high estate and thestockwassellingatitslowestprice in many years. Thennewinterests,associatedwith

ConsolidationCoal,tookoverthe reins. The earningsadvanced from the 1961figure of $1.24 per share totheequivalentof$17in1963,andthepricerosefromalowof 38½ in 1962 to theequivalent of nearly 200 theverynextyear.6

3. Financial Strength andCapitalStructure. Stock of acompanywithalotofsurplus

cashandnothingaheadofthecommon is clearly a betterpurchase (at the same price)than another one with thesame per share earnings butlarge bank loans and seniorsecurities. Such factors areproperly and carefully takeninto account by securityanalysts.Amodestamountofbonds or preferred stock,however, is not necessarily adisadvantage to the common,nor is the moderate use of

seasonal bank credit.(Incidentally, a top-heavystructure—too little commonstockinrelationtobondsandpreferred—may underfavorableconditionsmakefora huge speculative profit inthe common. This is thefactorknownas“leverage.”)

4.DividendRecord.Oneofthe most persuasive tests ofhigh quality is an

uninterrupted record ofdividend payments goingback over many years. Wethink that a record ofcontinuous dividendpaymentsforthelast20yearsormore is an important plusfactor in the company’squality rating. Indeed thedefensive investor might bejustified in limiting hispurchases to those meetingthistest.

5.Current Dividend Rate.This, our last additionalfactor, is the most difficultone to deal with insatisfactory fashion.Fortunately, the majority ofcompanies have come tofollowwhatmay be called astandard dividend policy.This has meant thedistribution of about two-thirds of their averageearnings, except that in therecent period of high profits

and inflationary demands formore capital the figure hastended to be lower. (In 1969itwas59.5%forthestocksinthe Dow Jones average, and55% for all Americancorporations.)* Where thedividend bears a normalrelationship to the earnings,thevaluationmaybemadeoneither basis withoutsubstantially affecting theresult.Forexample,a typical

secondary company withexpected average earnings of$3 and an expected dividendof$2maybevaluedateither12 times its earnings or 18times its dividend, to yield avalueof36inbothcases.

However, an increasingnumberofgrowthcompaniesare departing from the oncestandardpolicyofpayingout60% or more of earnings individends,onthegroundsthat

the shareholders’ interestswill be better served byretainingnearlyalltheprofitsto finance expansion. Theissue presents problems andrequires careful distinctions.Wehavedecidedtodeferourdiscussion of the vitalquestion of proper dividendpolicy to a later section—Chapter 19—where we shalldeal with it as a part of thegeneral problem ofmanagement-shareholder

relations.

CapitalizationRatesforGrowthStocks

Most of the writing ofsecurity analysts on formalappraisals relates to thevaluation of growth stocks.Our study of the variousmethodshasledustosuggesta foreshortened and quitesimple formula for thevaluation of growth stocks,

which is intended to producefigures fairly close to thoseresulting from the morerefined mathematicalcalculations.Ourformulais:

Value=Current(Normal)Earnings×(8.5plustwicetheexpectedannual

growthrate)

The growth figure should bethat expected over the nextseventotenyears.7

In Table 11-4 we showhow our formula works outfor various rates of assumedgrowth.Itiseasytomaketheconverse calculation and todetermine what rate ofgrowth is anticipated by thecurrent market price,assuming our formula isvalid. In our last edition wemade that calculation for theDJIA and for six importantstock issues. These figures

arereproducedinTable11-5.Wecommentedatthetime:

The difference betweenthe implicit 32.4%annual growth rate forXeroxandtheextremelymodest2.8%forGeneralMotors is indeedstriking.Itisexplainablein part by the stockmarket’s feeling thatGeneral Motors’ 1963earnings—thelargestfor

any corporation inhistory—can bemaintained withdifficulty and exceededonly modestly at best.The price earnings ratioof Xerox, on the otherhand, is quiterepresentative ofspeculative enthusiasmfastened upon acompany of greatachievement andperhaps still greater

promise.

The implicitorexpectedgrowth rate of 5.1% fortheDJIAcompareswithanactualannualincreaseof 3.4% (compounded)between 1951–1953 and1961–1963.

We should have added acautionsomewhatasfollows:The valuations of expectedhigh-growth stocks arenecessarilyonthelowside,ifwe were to assume thesegrowth rates will actually berealized.Infact,accordingtothe arithmetic, if a companycould be assumed to grow ata rate of 8% or moreindefinitely in the future itsvalue would be infinite, and

nopricewouldbetoohightopay for the shares.What thevaluer actually does in thesecasesistointroduceamarginofsafety intohis calculations—somewhat as an engineerdoes in his specifications fora structure.On this basis thepurchases would realize hisassignedobjective(in1963,afuture overall return of 7½%per annum) even if thegrowth rate actually realizedprovedsubstantially less than

thatprojected in the formula.Of course, then, if that ratewere actually realized theinvestor would be sure toenjoy a handsome additionalreturn.Thereisreallynowayof valuing a high-growthcompany (with an expectedrateabove,say,8%annually),inwhichtheanalystcanmakerealistic assumptions of boththe proper multiplier for thecurrent earnings and theexpectable multiplier for the

futureearnings.

As it happened the actualgrowth for Xerox and IBMprovedveryclosetothehighrates implied from ourformula. As just explained,this fine showing inevitablyproduced a large advance inthe price of both issues. ThegrowthoftheDJIAitselfwasalsoaboutasprojectedbythe1963 closing market price.But themoderate rate of 5%

did not involve themathematical dilemma ofXeroxandIBM.Itturnedoutthat the23%pricerise to theendof1970,plus the28%inaggregate dividend returnreceived, gave not far fromthe 7½% annual overall gainpositedinourformula.Inthecase of the other fourcompanies it may suffice tosay that their growth did notequal the expectationsimpliedinthe1963priceand

that their quotations failed torise as much as the DJIA.Warning: This material issupplied for illustrativepurposesonly,andbecauseofthe inescapable necessity insecurity analysis to projectthe future growth rate formost companies studied. Letthe reader not bemisled intothinkingthatsuchprojectionshave any high degree ofreliabilityor,conversely, thatfuture prices can be counted

on to behave accordingly asthe prophecies are realized,surpassed,ordisappointed.

We should point out thatany “scientific,” or at leastreasonably dependable, stockevaluation based onanticipatedfutureresultsmusttake future interest rates intoaccount.Agiven scheduleofexpected earnings, ordividends, would have asmaller present value if we

assume a higher than if weassume a lower intereststructure.* Such assumptionshave always been difficult tomake with any degree ofconfidence, and the recentviolent swings in long-terminterest rates render forecastsof this sort almostpresumptuous. Hence wehaveretainedouroldformulaabove, simply because nonew one would appear more

plausible.

IndustryAnalysis

Because the generalprospects of the enterprisecarry major weight in theestablishment of marketprices, it is natural for thesecurity analyst to devote agreat deal of attention to theeconomic position of theindustryandoftheindividualcompany in its industry.

Studies of this kind can gointo unlimited detail. Theyare sometimes productive ofvaluable insights intoimportant factors thatwillbeoperativeinthefutureandareinsufficiently appreciated bythe current market. Where aconclusionofthatkindcanbedrawn with a fair degree ofconfidence,itaffordsasoundbasis for investmentdecisions.

Our own observation,however, leads us tominimize somewhat thepracticalvalueofmostoftheindustrystudiesthataremadeavailable to investors. Thematerial developed isordinarily of a kind withwhich the public is alreadyfairly familiar and that hasalready exerted considerableinfluence on marketquotations. Rarely does onefind a brokerage-house study

that points out, with aconvincingarrayoffacts,thatapopular industry isheadingforafallorthatanunpopularone is due to prosper. WallStreet’s view of the longerfuture is notoriously fallible,andthisnecessarilyappliestothat important part of itsinvestigations which isdirected toward theforecasting of the course ofprofitsinvariousindustries.

We must recognize,however, that the rapid andpervasive growth oftechnology in recent years isnot without major effect onthe attitude and the labors ofthe security analyst.More sothan in the past, the progressorretrogressionofthetypicalcompany in the comingdecade may depend on itsrelation to new products andnew processes, which theanalystmayhaveachanceto

study and evaluate inadvance. Thus there isdoubtless a promising areafor effective work by theanalyst, based on field trips,interviewswithresearchmen,and on intensivetechnologicalinvestigationonhis own. There are hazardsconnected with investmentconclusions derived chieflyfrom such glimpses into thefuture, and not supported bypresentlydemonstrablevalue.

Yet there are perhaps equalhazards in stickingclosely tothe limits of value set bysober calculations resting onactual results. The investorcannothaveitbothways.Hecan be imaginative and playforthebigprofitsthatarethereward for vision provedsound by the event; but thenhemustrunasubstantialriskof major or minormiscalculation. Or he can beconservative, and refuse to

pay more than a minorpremium for possibilities asyetunproved;butinthatcasehe must be prepared for thelatercontemplationofgoldenopportunitiesforegone.

ATwo-PartAppraisalProcess

Letusreturnforamomentto the idea of valuation orappraisalofacommonstock,which we began to discussaboveonp.288.Agreatdeal

of reflection on the subjecthas led us to conclude thatthis better be done quitedifferently than is now theestablished practice. Wesuggestthatanalystsworkoutfirst what we call the “past-performancevalue,”which isbased solely on the pastrecord. This would indicatewhat the stock would beworth—absolutely, or as apercentageof theDJIAoroftheS&Pcomposite—if it is

assumed that its relative pastperformance will continueunchangedinthefuture.(Thisincludes the assumption thatits relative growth rate, asshowninthelastsevenyears,will also continue unchangedover the next seven years.)Thisprocesscouldbecarriedoutmechanicallybyapplyinga formula that givesindividual weights to pastfigures for profitability,stability,andgrowth,andalso

for current financialcondition.Thesecondpartofthe analysis should considertowhatextentthevaluebasedsolely on past performanceshould be modified becauseofnewconditionsexpectedinthefuture.

Such a procedure woulddivide the work betweensenior and junior analysts asfollows: (1) The senioranalyst would set up the

formula to apply to allcompanies generally fordeterminingpast-performancevalue.(2)Thejunioranalystswould work up such factorsfor the designated companies—prettymuch inmechanicalfashion. (3) The senioranalystwould thendetermineto what extent a company’sperformance—absolute orrelative—is likely to differfromitspastrecord,andwhatchangeshouldbemadeinthe

value to reflect suchanticipatedchanges. Itwouldbebest if thesenioranalyst’sreport showed both theoriginal valuation and themodified one, with hisreasonsforthechange.

Is a jobof this kindworthdoing? Our answer is in theaffirmative, but our reasonsmayappearsomewhatcynicalto the reader. We doubtwhether the valuations so

reached will provesufficientlydependableinthecase of the typical industrialcompany, great or small.Weshall illustrate the difficultiesof this job in our discussionof Aluminum Company ofAmerica (ALCOA) in thenext chapter. Nonetheless itshould be done for suchcommon stocks. Why? First,many security analysts arebound to make current orprojected valuations, as part

of their daily work. Themethodweproposeshouldbean improvement on thosegenerally followed today.Secondly, because it shouldgive useful experience andinsight to the analysts whopracticethismethod.Thirdly,because work of this kindcould produce an invaluablebody of recorded experience—ashaslongbeenthecaseinmedicine—that may lead tobetter methods of procedure

andausefulknowledgeofitspossibilities and limitations.The public-utility stocksmight well prove animportant area in which thisapproach will show realpragmatic value. Eventuallythe intelligent analyst willconfine himself to thosegroups in which the futureappears reasonablypredictable,* or where themargin of safety of past-

performance value overcurrent price is so large thathe can take his chances onfuture variations—as he doesin selecting well-securedseniorsecurities.

In subsequent chapters weshall supply concreteexamples of the applicationof analytical techniques. Buttheywillonlybeillustrations.Ifthereaderfindsthesubjectinterestingheshouldpursueit

systematicallyandthoroughlybefore he considers himselfqualified to pass a final buy-or-sell judgment of his ownonasecurityissue.


“Would you tell me, please,which way I ought to go fromhere?”

“That depends a good deal onwhere you want to get to,” saidtheCat.

—LewisCarroll,Alice’sAdventuresinWonderland

PuttingaPriceontheFuture

Whichfactorsdeterminehowmuch you should be willingto pay for a stock? Whatmakesonecompanyworth10times earnings and anotherworth20times?Howcanyoube reasonably sure that youare not overpaying for anapparently rosy future thatturns out to be a murkynightmare?

Graham feels that fiveelements are decisive.1 Hesummarizesthemas:

the company’s “generallong-termprospects”the quality of itsmanagementitsfinancialstrengthandcapitalstructureitsdividendrecordand its current dividendrate.

Let’s look at these factorsinthelightoftoday’smarket.

The long-term prospects.Nowadays, the intelligentinvestor should begin bydownloading at least fiveyears’worthofannualreports(Form 10-K) from thecompany’s website or fromthe EDGAR database atwww.sec.gov.2 Then combthrough the financialstatements, gathering

evidence to help you answertwo overriding questions.What makes this companygrow?Where do (and wherewill) its profits come from?Among the problems towatchfor:

Thecompanyisa“serialacquirer.”Anaverageofmore than two or threeacquisitions a year is asignofpotentialtrouble.

Afterall,ifthecompanyitself would rather buythe stock of otherbusinessesthaninvestinits own, shouldn’t youtake the hint and lookelsewhere too? Andcheck the company’strack record as anacquirer. Watch out forcorporate bulimics—firmsthatwolfdownbigacquisitions,only toendup vomiting them back

out. Lucent, Mattel,Quaker Oats, and TycoInternational are amongthe companies that havehad to disgorgeacquisitions at sickeninglosses. Other firms takechronic write-offs, oraccounting chargesproving that theyoverpaid for their pastacquisitions. That’s abadomenforfuturedeal

making.3ThecompanyisanOPMaddict, borrowing debtor selling stock to raiseboatloads of OtherPeople’s Money. ThesefatinfusionsofOPMarelabeled “cash fromfinancing activities” onthe statement of cashflows in the annualreport.Theycanmakeasick company appear to

be growing even if itsunderlying businessesare not generatingenough cash—asGlobalCrossingandWorldComshowednotlongago.4The company is aJohnny-One-Note,relying on one customer(or a handful) for mostof its revenues. InOctober 1999, fiber-optics maker Sycamore

Networks, Inc. soldstock to the public forthe first time. Theprospectus revealed thatone customer, WilliamsCommunications,accounted for 100% ofSycamore’s $11 millionin total revenues.Traders blithely valuedSycamore’s shares at$15 billion.Unfortunately, Williamswent bankrupt just over

two years later.Although Sycamorepicked up othercustomers, its stock lost97% between 2000 and2002.

Asyoustudythesourcesofgrowthandprofit,stayonthelookout for positives as wellasnegatives.Amongthegoodsigns:

Thecompanyhasawide“moat,” or competitiveadvantage. Like castles,some companies caneasily be stormed bymarauding competitors,while others are almostimpregnable. Severalforces can widen acompany’s moat: astrong brand identity(think of HarleyDavidson,whosebuyerstattoo the company’s

logoontotheirbodies);amonopoly or near-monopolyonthemarket;economies of scale, orthe ability to supplyhuge amounts of goodsor services cheaply(considerGillette,whichchurns out razor bladesby thebillion); auniqueintangibleasset(thinkofCoca-Cola,whosesecretformula for flavoredsyrup has no real

physical value butmaintains a pricelesshold on consumers); aresistancetosubstitution(most businesses haveno alternative toelectricity, so utilitycompanies are unlikelyto be supplanted anytimesoon).5The company is amarathoner, not asprinter. By looking

back at the incomestatements, you can seewhether revenues andnetearningshavegrownsmoothly and steadilyover the previous 10years.Arecentarticleinthe Financial AnalystsJournal confirmed whatother studies (and thesad experience of manyinvestors) have shown:that the fastest-growingcompanies tend to

overheatandflameout.6If earnings are growingat a long-term rate of10% pretax (or 6% to7% after-tax), that maybe sustainable. But the15% growth hurdle thatmany companies set forthemselvesisdelusional.Andanevenhigher rate—or a sudden burst ofgrowth in one or twoyears—is all but certain

to fade, just like aninexperiencedmarathoner who tries torun thewhole race as ifit were a 100-meterdash.The company sows andreaps. No matter howgooditsproductsorhowpowerful its brands, acompany must spendsome money to developnew business. Whileresearch and

developmentspendingisnot a source of growthtoday, it may well betomorrow—particularlyif a firm has a provenrecordofrejuvenatingitsbusinesses with newideas and equipment.The average budget forresearch anddevelopment variesacross industries andcompanies. In 2002,Procter&Gamble spent

about4%ofitsnetsaleson R & D, while 3Mspent 6.5% and Johnson&Johnson10.9%.Inthelongrun,acompanythatspends nothing on R &D is at least asvulnerable as one thatspendstoomuch.

The quality and conductof management. Acompany’s executives shouldsaywhattheywilldo,thendo

whattheysaid.Readthepastannual reports to see whatforecasts the managers madeand if they fulfilled them orfell short. Managers shouldforthrightly admit theirfailures and takeresponsibilityforthem,ratherthan blaming all-purposescapegoats like “theeconomy,” “uncertainty,” or“weak demand.” Checkwhether the tone andsubstance of the chairman’s

letter stay constant, orfluctuate with the latest fadson Wall Street. (Pay specialattention to boom years like1999:Didtheexecutivesofacement or underwearcompany suddenly declarethattheywere“ontheleadingedge of the transformativesoftwarerevolution”?)

These questions can alsohelp you determine whetherthe people who run the

company will act in theinterests of the people whoownthecompany:

AretheylookingoutforNo.1? A firm that pays itsCEO $100 million in ayear had better have avery good reason.(Perhaps he discovered—and patented—theFountain of Youth? Or

found El Dorado andboughtitfor$1anacre?Or contacted life onanother planet andnegotiated a contractobligating the aliens tobuy all their suppliesfrom only one companyon Earth?) Otherwise,this kind of obscenelyobese payday suggeststhat the firm is run bythe managers, for themanagers.

Ifacompanyreprices(or “reissues” or“exchanges”) its stockoptionsforinsiders,stayaway.Inthisswitcheroo,a company cancelsexisting (and typicallyworthless) stock optionsfor employees andexecutives,thenreplacesthem with new ones atadvantageous prices. Iftheir value is neverallowed to go to zero,

while their potentialprofit is always infinite,how can optionsencourage goodstewardshipofcorporateassets? Any establishedcompany that repricesoptions—as dozens ofhigh-techfirmshave—isa disgrace. And anyinvestorwho buys stockin such a company is asheep begging to besheared.

By looking in theannual report for themandatory footnoteaboutstockoptions,youcan see how large the“option overhang” is.AOL Time Warner, forexample, reported in thefrontofitsannualreportthat it had 4.5 billionshares of common stockoutstanding as ofDecember 31, 2002—but a footnote in the

bowels of the reportrevealsthatthecompanyhad issued options on657millionmoreshares.So AOL’s futureearningswill have to bedivided among 15%moreshares.Youshouldfactor in the potentialfloodofnewsharesfromstock options wheneveryou estimate acompany’sfuturevalue.7

“Form4,” availablethrough the EDGARdatabase atwww.sec.gov, showswhether a firm’s seniorexecutives and directorshave been buying orsellingshares.Therecanbelegitimatereasonsforan insider to sell—diversification, a biggerhouse, a divorcesettlement—butrepeatedbigsalesareabrightred

flag. A manager can’tlegitimately be yourpartner if he keepsselling while you’rebuying.Are they managers orpromoters? Executives shouldspendmostoftheir timemanagingtheircompanyinprivate,notpromotingittotheinvestingpublic.All too often, CEOscomplainthattheirstock

isundervaluednomatterhow high it goes—forgetting Graham’sinsistence thatmanagersshould try to keep thestock price from goingeither too low or toohigh.8 Meanwhile, alltoomanychief financialofficers give “earningsguidance,” orguesstimates of thecompany’s quarterly

profits. And some firmsare hype-o-chondriacs,constantlyspewingforthpress releases boastingof temporary, trivial, orhypothetical“opportunities.” A handful ofcompanies—includingCoca-Cola, Gillette, andUSA Interactive—havebegunto“justsayno”toWall Street’s short-termthinking. These few

brave outfits areproviding more detailabout their currentbudgets and long-termplans, while refusing tospeculateaboutwhatthenext90daysmighthold.(For a model of how acompany cancommunicate candidlyand fairly with itsshareholders, go to theEDGAR database atwww.sec.gov and view

the 8-K filingsmade byExpeditors Internationalof Washington, whichperiodically posts itssuperb question-and-answer dialogues withshareholdersthere.) Finally,askwhetherthe company’saccounting practices aredesigned to make itsfinancial resultstransparent—or opaque.If “nonrecurring”

charges keep recurring,“extraordinary” itemscrop up so often thatthey seem ordinary,acronyms like EBITDAtake priority over netincome, or “pro forma”earnings are used tocloak actual losses, youmaybelookingatafirmthat has not yet learnedhow to put itsshareholders’ long-term

interestsfirst.9

Financial strength andcapital structure. The mostbasic possible definition of agood business is this: Itgenerates more cash than itconsumes. Good managerskeep findingways of puttingthatcashtoproductiveuse.Inthe long run, companies thatmeet this definition arevirtually certain to grow invalue, no matter what the

stockmarketdoes.

Start by reading thestatementofcashflowsinthecompany’sannualreport.Seewhethercashfromoperationshas grown steadilythroughout thepast 10years.Then you can go further.Warren Buffett haspopularized the concept ofowner earnings, or netincomeplusamortizationanddepreciation, minus normal

capital expenditures. Asportfolio managerChristopher Davis of DavisSelectedAdvisors puts it, “Ifyou owned 100% of thisbusiness, how much cashwould you have in yourpocket at the end of theyear?” Because it adjusts foraccounting entries likeamortizationanddepreciationthat do not affect thecompany’s cash balances,owner earnings can be a

better measure than reportednet income. To fine-tune thedefinition of owner earnings,youshouldalsosubtractfromreportednetincome:

any costs of grantingstock options, whichdivert earnings awayfrom existingshareholders into thehands of new insideowners

any “unusual,”“nonrecurring,” or“extraordinary”chargesany “income” from thecompany’spensionfund.

Ifownerearningspersharehave grown at a steadyaverageofat least6%or7%over the past 10 years, thecompanyisastablegeneratorof cash, and its prospects forgrowtharegood.

Next, look at thecompany’s capital structure.Turn to the balance sheet toseehowmuchdebt(includingpreferred stock) the companyhas; in general, long-termdebt shouldbeunder50%oftotal capital. In the footnotesto the financial statements,determine whether the long-term debt is fixed-rate (withconstantinterestpayments)orvariable (with payments thatfluctuate, which could

becomecostlyifinterestratesrise).

Look in the annual reportfor the exhibit or statementshowing the “ratio ofearnings to fixed charges.”That exhibit toAmazon.com’s 2002 annualreport shows that Amazon’searnings fell $145 millionshort of covering its interestcosts. In the future, Amazonwilleitherhavetoearnmuch

more from its operations orfind away to borrowmoneyatlowerrates.Otherwise, thecompany could endupbeingownednotbyitsshareholdersbut by its bondholders, whocan lay claim to Amazon’sassets if they have no otherway of securing the interestpayments theyareowed. (Tobe fair, Amazon’s ratio ofearningstofixedchargeswasfarhealthierin2002thantwoyears earlier, when earnings

fell $1.1 billion short ofcoveringdebtpayments.)

A fewwordsondividendsand stock policy (for more,pleaseseeChapter19):

The burden of proof isonthecompanytoshowthatyouarebetteroff ifit does not pay adividend. If thefirmhasconsistently

outperformed thecompetition in goodmarkets and bad, themanagers are clearlyputting the cash tooptimaluse.If,however,business is faltering orthe stock isunderperforming itsrivals,thenthemanagersand directors aremisusing the cash byrefusing to pay adividend.

Companies thatrepeatedly split theirshares—and hype thosesplits in breathless pressreleases—treat theirinvestorslikedolts.LikeYogiBerra,whowantedhis pizza cut into fourslices because “I don’tthink I can eat eight,”the shareholders wholovestocksplitsmissthepoint. Two shares of astock at $50 are not

worth more than oneshareat$100.Managerswho use splits topromote their stock areaiding and abetting theworst instincts of theinvestingpublic,andtheintelligent investor willthink twice beforeturning anymoney overto such condescendingmanipulators.10Companies should buy

back their shares whenthey are cheap—notwhentheyareatornearrecord highs.Unfortunately, itrecently has become alltoo common forcompanies to repurchasetheir stock when it isoverpriced. There is nomore cynicalwaste of acompany’s cash—sincethe real purpose of thatmaneuver is to enable

top executives to reapmultimillion-dollarpaydays by selling theirownstockoptionsinthename of “enhancingshareholdervalue.”

A substantial amount ofanecdotal evidence, in fact,suggests that managers whotalk about “enhancingshareholder value” seldomdo. In investing, as with lifein general, ultimate victory

usuallygoestothedoers,nottothetalkers.

Chapter12ThingstoConsiderAboutPer-ShareEarnings

This chapterwill beginwithtwo pieces of advice to the

investor that cannot avoidbeing contradictory in theirimplications. The first is:Don’t take a single year’searnings seriously. Thesecond is: If you do payattention to short-termearnings, look out for boobytraps in theper-share figures.If our first warning werefollowed strictly the secondwouldbeunnecessary.But itis too much to expect thatmost shareholders can relate

all their common-stockdecisions to the long-termrecord and the long-termprospects. The quarterlyfigures, and especially theannual figures, receivemajorattention in financial circles,and this emphasis can hardlyfail tohave its impacton theinvestor’s thinking. He maywell need some education inthis area, for it abounds inmisleadingpossibilities.

As this chapter is beingwritten theearningsreportofAluminum Company ofAmerica (ALCOA) for 1970appears in the Wall StreetJournal. The first figuresshownare

1970 1969Share

earningsa $5.20 $5.58

The little a at the outset is

explained in a footnote torefer to “primary earnings,”before special charges.Thereis much more footnotematerial; in fact it occupiestwiceasmuchspaceasdothebasicfiguresthemselves.

For the December quarteralone, the “earnings pershare” are given as $1.58 in1970against$1.56in1969.

The investor or speculator

interested inALCOA shares,reading those figures, mightsaytohimself:“Notsobad.Iknew that 1970 was arecession year in aluminum.But the fourth quarter showsa gain over 1969, withearnings at the rate of $6.32per year. Let me see. Thestock is selling at 62. Why,that’s less than ten timesearnings. That makes it lookpretty cheap, compared with16 times for International

Nickel,etc.,etc.”

But if our investor-speculator friend hadbothered to read all thematerial in the footnote, hewouldhavefoundthatinsteadof one figure of earnings pershare for theyear1970 therewereactuallyfour,viz.:

1970 1969

Primaryearnings $5.20 $5.58

Netincome(afterspecialcharges)

4.32 5.58

Fullydiluted,beforespecialcharges

5.01 5.35

Fullydiluted,afterspecialcharges

4.19 5.35

Forthefourthquarteralone

onlytwofiguresaregiven:

Primaryearnings $1.58 $1.56Netincome(afterspecialcharges)

.70 1.56

What do all theseadditional earnings mean?Which earnings are trueearnings for the year and the

December quarter? If thelatter should be taken at 70cents—the net income afterspecial charges—the annualrate would be $2.80 insteadof $6.32, and the price 62would be “22 timesearnings,” instead of the 10timeswestartedwith.

Part of the question as tothe “true earnings” ofALCOA can be answeredquite easily. The reduction

from$5.20to$5.01,toallowfortheeffectsof“dilution,”isclearly called for. ALCOAhas a large bond issueconvertible into commonstock; to calculate the“earning power” of thecommon, based on the 1970results, it must be assumedthat the conversion privilegewill be exercised if it shouldprove profitable to thebondholders to do so. Theamount involved in the

ALCOA picture is relativelysmall, and hardly deservesdetailed comment. But inother cases, makingallowance for conversionrights—and the existence ofstock-purchasewarrants—canreduce the apparent earningsby half, or more. We shallpresent examples of a reallysignificant dilution factorbelow (page 411). (Thefinancial services are notalways consistent in their

allowance for the dilutionfactor in their reporting andanalyses.)*

Let us turn now to thematter of “special charges.”Thisfigureof$18,800,000,or88 cents per share, deductedin the fourth quarter, is notunimportant. Is it to beignored entirely, or fullyrecognized as an earningsreduction, or partlyrecognized and partly

ignored? The alert investormight ask himself also howdoes ithappen that therewasa virtual epidemic of suchspecial charge-offs appearingafter the close of 1970, butnot in previous years? Couldthere possibly have beensome fine Italian hands† atwork with the accounting—but always, of course,withinthe limitsof thepermissible?When we look closely we

may find that such losses,charged off before theyactually occur, can becharmed away, as it were,with no unhappy effect oneitherpastorfuture“primaryearnings.” In some extremecasestheymightbeavailedofto make subsequent earningsappear nearly twice as largeas in reality—by a more orless prestidigitous treatmentofthetaxcreditinvolved.

In dealing with ALCOA’sspecialcharges,thefirstthingtoestablishishowtheyarose.The footnotes are specificenough.Thedeductionscamefromfoursources,viz.:

1. Management’s estimateof the anticipated costsof closing down themanufactured productsdivision.

2. Ditto for closing down

ALCOA Castings Co.’splants.

3. Ditto for losses inphasing out ALCOACreditCo.

4. Also, estimated costs of$5.3 million associatedwith completion of thecontract for a “curtainwall.”

All of these items arerelated to future costs andlosses. It is easy to say that

they are not part of the“regular operating results” of1970—but if so, where dothey belong? Are they so“extraordinary andnonrecurring” as to belongnowhere? A widespreadenterprise such as ALCOA,doing a $1.5 billion businessannually, must have a lot ofdivisions, departments,affiliates,andthelike.Wouldit not be normal rather thanextraordinaryforoneormore

to prove unprofitable, and torequire closing down?Similarlyforsuchthingsasacontract to build a wall.Suppose that any time acompany had a loss on anypartof itsbusiness ithad thebright idea of charging it offas a “special item,” and thusreporting its “primaryearnings” per share so as toinclude only its profitablecontracts and operations?Like King Edward VII’s

sundial, thatmarkedonly the“sunnyhours.”*

Thereadershouldnotetwoingenious aspects of theALCOA procedure we havebeen discussing. The first isthat by anticipating futurelosses the company escapesthenecessityofallocatingthelosses themselves to anidentifiable year. They don’tbelong in1970,because theywerenotactuallytakeninthat

year. And they won’t beshown in the yearwhen theyare actually taken, becausethey have already beenprovided for. Neat work, butmight it not be just a littlemisleading?

TheALCOAfootnotesaysnothing about the future taxsaving from these losses.(Mostotherstatementsofthissort state specifically thatonlythe“after-taxeffect”has

been charged off.) If theALCOA figure representsfuture losses before therelated tax credit, then notonly will future earnings befreedfromtheweightofthesecharges (as they are actuallyincurred), but they will beincreased by a tax credit ofsome 50% thereof. It isdifficult to believe that theaccountswillbehandled thatway. But it is a fact thatcertaincompanieswhichhave

had large losses in the pasthave been able to reportfuture earnings withoutcharging the normal taxesagainst them, in that waymaking a very fine profitsappearance indeed—basedparadoxicallyenoughontheirpast disgraces. (Tax creditsresulting from past years’losses are now being shownseparatelyas “special items,”buttheywillenterintofuturestatistics as part of the final

“net-income” figure.However, a reserve now setupfor future losses, ifnetofexpected tax credit, shouldnot create an addition of thissorttothenetincomeoflateryears.)

Theotheringeniousfeatureis the use by ALCOA andmanyothercompaniesof the1970 year-end for makingthesespecialcharge-offs.Thestock market took what

appearedtobeabloodbathinthe first half of 1970.Everyone expected relativelypoor results for the year formost companies. Wall Streetwas now anticipating betterresults in 1971, 1972, etc.What a nice arrangement,then, to charge as much aspossible to the bad year,which had already beenwritten off mentally and hadvirtually receded into thepast,leavingthewayclearfor

nicely fattened figures in thenext few years! Perhaps thisis good accounting, goodbusinesspolicy,andgoodformanagement-shareholderrelationships. But we havelingeringdoubts.

Thecombinationofwidely(or should it be wildly?)diversified operations withthe impulse tocleanhouseattheendof1970hasproducedsome strange-looking

footnotes to the annualreports. The reader may beamused by the followingexplanation given by a NewYork Stock Exchangecompany(whichshallremainunnamed) of its “specialitems” aggregating$2,357,000, or about a thirdof the income before charge-offs: “Consists of provisionfor closing Spalding UnitedKingdom operations;provisionforreorganizational

expenses of a division; costsof selling a small babypantsand bib manufacturingcompany, disposing of partinterest in a Spanish car-leasing facility, andliquidation of a ski-bootoperation.”*

Years ago the strongcompanies used to set up“contingencyreserves”outofthe profits of good years toabsorb some of the bad

effectsofdepressionyears tocome. The underlying ideawas to equalize the reportedearnings,moreorless,andtoimprovethestabilityfactorinthe company’s record. Aworthy motive, it wouldseem; but the accountantsquite rightly objected to thepracticeasmisstatingthetrueearnings. They insisted thateach year’s results bepresented as theywere, goodor bad, and the shareholders

andanalystsbeallowedtodothe averaging or equalizingforthemselves.Weseemnowtobewitnessing theoppositephenomenon, with everyonecharging off as much aspossible against forgotten1970,soastostart1971witha slate not only clean butspecially prepared to showpleasing per-share figures inthecomingyears.

It is time to return to our

firstquestion.Whatthenwerethe true earnings of ALCOAin1970?Theaccurateanswerwould be: The $5.01 pershare, after “dilution,” lessthat part of the 82 cents of“special charges” that mayproperly be attributed tooccurrences in 1970. But wedonotknowwhatthatportionis, and hence we cannotproperly state the trueearnings for the year. Themanagement and theauditors

should have given us theirbest judgment on this point,but they did not do so. Andfurthermore, themanagementand the auditors should haveprovidedfordeductionofthebalanceofthesechargesfromthe ordinary earnings of asuitable number of futureyears—say, not more thanfive.This evidently theywillnotdoeither,sincetheyhavealready convenientlydisposedof theentiresumas

a1970specialcharge.

The more seriouslyinvestors take the per-shareearningsfiguresaspublished,the more necessary it is forthem to be on their guardagainst accounting factors ofone kind and another thatmay impair the truecomparabilityofthenumbers.We have mentioned threesortsof thesefactors: theuseof special charges, which

mayneverbereflectedintheper-share earnings, thereduction in the normalincome-tax deduction byreasonofpast losses,andthedilution factor implicit in theexistence of substantialamounts of convertiblesecurities or warrants.1 Afourth item that has had asignificant effect on reportedearnings in the past is themethod of treating

depreciation—chiefly asbetween the “straight-line”and the “accelerated”schedules. We refrain fromdetails here. But as anexample current aswewrite,letusmentionthe1970reportof Trane Co. This firmshowedan increaseofnearly20% in per-share earningsover 1969—$3.29 versus$2.76—but half of this camefrom returning to the olderstraight-line depreciation

rates, less burdensome onearnings than the acceleratedmethodused theyear before.(The company will continuetouse theacceleratedrateonits income-tax return, thusdeferring income-taxpayments on the difference.)Stillanotherfactor,importantat times, is the choicebetweenchargingoffresearchanddevelopmentcosts in theyear they are incurred oramortizing them over a

periodofyears.Finally,letusmention the choice betweenthe FIFO (first-in-first-out)and LIFO (last-in-first-out)methods of valuinginventories.*

An obvious remark herewould be that investorsshould not pay any attentionto these accounting variablesif the amounts involved arerelatively small. But WallStreet being as it is, even

items quite minor inthemselves can be takenseriously. Two days beforethe ALCOA report appearedintheWallStreetJournal,thepaper had quite a discussionof the correspondingstatement of Dow Chemical.Itclosedwiththeobservationthat “many analysts” hadbeentroubledbythefactthatDow had included a 21-centitem in regular profits for1969, insteadof treatingitas

an item of “extraordinaryincome.” Why the fuss?Because, evidently,evaluationsofDowChemicalinvolving many millions ofdollars in the aggregateseemed to depend on exactlywhatwasthepercentagegainfor 1969 over 1968—in thiscaseeither9%or4½%.Thisstrikes us as rather absurd; itis very unlikely that smalldifferences involved in oneyear’s results couldhaveany

bearing on future averageprofits or growth, and on aconservative, realisticvaluationoftheenterprise.

By contrast, consideranother statement alsoappearing in January 1971.This concerned NorthwestIndustries Inc.’s report for1970.* The company wasplanning to write off, as aspecial charge, not less than$264 million in one fell

swoop.Of this, $200millionrepresentsthelosstobetakenon the proposed sale of therailroad subsidiary to itsemployees and the balance awrite-down of a recent stockpurchase. These sums wouldwork out to a loss of about$35 per share of commonbefore dilution offsets, ortwice its then currentmarketprice. Here we havesomething really significant.If the transaction goes

through, and if the tax lawsare not changed, this lossprovided for in 1970 willpermit Northwest Industriesto realize about $400millionof future profits (within fiveyears) from its otherdiversified interests withoutpaying income tax thereon.*What will then be the realearnings of that enterprise;should they be calculatedwithorwithoutprovision for

the nearly 50% in incometaxes which it will notactually have to pay? In ouropinion, the proper mode ofcalculation would be first toconsidertheindicatedearningpower on the basis of fullincome-tax liability, and toderivesomebroadideaofthestock’s value based on thatestimate. To this should beadded some bonus figure,representing the value pershare of the important but

temporary tax exemption thecompany will enjoy.(Allowance must be made,also,forapossiblelarge-scaledilutioninthiscase.Actually,the convertible preferredissues and warrants wouldmore than double theoutstandingcommonsharesiftheprivilegesareexercised.)

All this may be confusingandwearisometoourreaders,but it belongs in our story.

Corporateaccountingisoftentricky; security analysis canbe complicated; stockvaluations are reallydependable only inexceptional cases.† For mostinvestors it would beprobably best to assurethemselves that they aregetting good value for theprices they pay, and let it goatthat.

UseofAverageEarnings

In former times analystsand investors paidconsiderable attention to theaverageearningsoverafairlylong period in the past—usually from seven to tenyears. This “mean figure”*wasusefulforironingoutthefrequentupsanddownsofthebusiness cycle, and it wasthought to give a better ideaof the company’s earningpower than the results of the

latest year alone. Oneimportant advantage of suchanaveragingprocessisthatitwill solve the problem ofwhat to do about nearly allthe special charges andcredits. They should beincluded in the averageearnings. For certainly mostof these losses and gainsrepresent a part of thecompany’s operating history.IfwedothisforALCOA,theaverage earnings for 1961–

1970 (ten years) wouldappear as $3.62 and for theseven years 1964–1970 as$4.62 per share. If suchfigures are used inconjunction with ratings forgrowth and stability ofearnings during the sameperiod, they could give areally informing picture ofthe company’s pastperformance.

CalculationofthePastGrowthRate

It is of prime importancethat the growth factor in acompany’s record be takenadequately into account.Where the growth has beenlarge the recentearningswillbe well above the seven-orten-yearaverage,andanalystsmay deem these long-termfigures irrelevant. This neednotbethecase.Theearningscanbegivenintermsbothofthe average and the latestfigure. We suggest that the

growth rate itself becalculated by comparing theaverageofthelastthreeyearswith corresponding figuresten years earlier. (Wherethereisaproblemof“specialchargesor credits” itmaybedealt with on somecompromise basis.) Note thefollowing calculation for thegrowthofALCOAasagainstthatofSearsRoebuckandtheDJIAgroupasawhole.

Comment: These fewfigures could be made thesubject of a long discussion.They probably show as wellas any others, derived byelaborate mathematicaltreatment, the actual growthof earnings for the longperiod 1958–1970. But howrelevant is this figure,generally considered centralin common-stock valuations,to the case of ALCOA? Itspast growth rate was

excellent,actuallyabitbetterthan that of acclaimed SearsRoebuck and much higherthan that of the DJIAcomposite. But the marketpriceatthebeginningof1971seemedtopaynoattentiontothis fine performance.ALCOA sold at only 11½times the recent three-yearaverage, while Sears sold at27 times and the DJIA itselfat 15+ times. How did thiscome about? Evidently Wall

Street has fairly pessimisticviewsaboutthefuturecourseof ALCOA’s earnings, incontrast with its past record.Surprisinglyenough,thehighprice for ALCOA was madeas far back as 1959. In thatyear it sold at 116, or 45times its earnings. (Thiscompares with a 1959adjusted high price of 25½for Sears Roebuck, or 20timesitsthenearnings.)Eventhough ALCOA’s profits did

show excellent growththereafter,itisevidentthatinthis case the futurepossibilities were greatlyoverestimated in the marketprice. It closed 1970 atexactlyhalfofthe1959high,while Sears tripled in priceand the DJIA moved upnearly30%.

TABLE12-1

It should be pointed outthat ALCOA’s earnings oncapital funds* had been onlyaverageor less, and thismaybe the decisive factor here.High multipliers have been

maintained in the stockmarket only if the companyhas maintained better thanaverageprofitability.

LetusapplyatthispointtoALCOA the suggestion wemade in the previous chapterfor a “two-part appraisalprocess.”* Such an approachmighthaveproduceda“past-performance value” forALCOAof10%oftheDJIA,or $84 per share relative to

the closing price of 840 forthe DJIA in 1970. On thisbasis the shares would haveappeared quite attractive attheirpriceof57¼.

To what extent should thesenior analyst have markeddown the “past-performancevalue” to allow for adversedevelopments that he saw inthe future? Frankly,we haveno idea. Assume he hadreason to believe that the

1971 earnings would be aslow as $2.50 per share—alarge drop from the 1970figure, as against an advanceexpected for the DJIA. Verylikelythestockmarketwouldtake this poor performancequite seriously, but would itreally establish the oncemighty Aluminum Companyof America as a relativelyunprofitable enterprise, to bevaluedatlessthanitstangible

assetsbehindtheshares?†(In1971 the price declined fromahighof70inMaytoalowof36 inDecember, against abookvalueof55.)

ALCOA is surely arepresentative industrialcompanyofhugesize,butwethink that its price-and-earnings history is moreunusual, even contradictory,than that ofmost other largeenterprises. Yet this instance

supports to some degree, thedoubts we expressed in thelast chapter as to thedependabilityoftheappraisalprocedure when applied tothe typical industrialcompany.


Youcangetrippedoffeasierbya dudewith a pen than you canbyadudewithagun.

—BoDiddley

TheNumbersGame

Even Graham would havebeenstartledby theextent towhich companies and theiraccountantspushed the limitsof propriety in the past fewyears. Compensated heavilythrough stock options, topexecutives realized that theycouldbecomefabulouslyrichmerely by increasing theircompany’searningsforjustafewyearsrunning.1Hundredsof companies violated the

spirit, if not the letter, ofaccounting principles—turning their financial reportsintogibberish,tartingupuglyresults with cosmetic fixes,cloaking expenses, ormanufacturingearningsoutofthinair.Let’slookatsomeoftheseunsavorypractices.

AsIf!

Perhaps themostwidespread

bitofaccountinghocus-pocuswasthe“proforma”earningsfad.There’sanoldsayingonWall Street that every badideastartsoutasagoodidea,and pro forma earningspresentation is no different.The original point was toprovide a truerpictureof thelong-termgrowthof earningsby adjusting for short-termdeviations from the trend orfor supposedly“nonrecurring” events.A pro

formapressreleasemight,forinstance, show what acompany would have earnedover the past year if anotherfirmitjustacquiredhadbeenpart of the family for theentire12months.

But, as theNaughty1990sadvanced, companies justcouldn’t leave well enoughalone. Just look at theseexamples of pro forma flim-flam:

For the quarter endedSeptember 30, 1999,InfoSpace, Inc.presented its pro formaearnings as if it had notpaid $159.9 million inpreferred-stockdividends.For the quarter endedOctober 31, 2001, BEASystems, Inc. presenteditsproformaearningsas

if it had not paid $193million in payroll taxeson stock optionsexercised by itsemployees.For the quarter endedMarch 31, 2001, JDSUniphase Corp.presented its pro formaearnings as if it had notpaid $4 million inpayroll taxes, had notlost$7million investingin lousy stocks, andhad

not incurred$2.5billionin charges related tomergersandgoodwill.

In short, pro formaearningsenablecompanies toshow how well they mighthavedoneiftheyhadn’tdoneas badly as they did.2 As anintelligent investor, the onlythingyoushoulddowithproforma earnings is ignorethem.

HungryforRecognition

In 2000, QwestCommunicationsInternational Inc., thetelecommunications giant,looked strong. Its sharesdroppedlessthan5%evenasthe stock market lost morethan9%thatyear.

But Qwest’s financialreports held an odd littlerevelation. In late 1999,

Qwest decided to recognizethe revenues from itstelephone directories as soonas the phone books werepublished—even though, asanyone who has ever takenout a Yellow Pagesadvertisement knows, manybusinesses pay for those adsin monthly installments.Abracadabra! That piddly-sounding “change inaccounting principle”pumped up 1999 net income

by$240millionaftertaxes—afifthofallthemoneyQwestearnedthatyear.

Like a little chunk of icecrowning a submergediceberg, aggressive revenuerecognition is often a signofdangers that run deep andloom large—and so itwas atQwest. By early 2003, afterreviewing its previousfinancial statements, thecompany announced that it

had prematurely recognizedprofits on equipment sales,improperlyrecordedthecostsof services provided byoutsiders, inappropriatelybooked costs as if theywerecapital assets rather thanexpenses, and unjustifiablytreatedtheexchangeofassetsasiftheywereoutrightsales.Alltold,Qwest’srevenuesfor2000 and 2001 had beenoverstated by $2.2 billion—including $80 million from

the earlier “change inaccounting principle,” whichwasnowreversed.3

CapitalOffenses

In the late 1990s, GlobalCrossing Ltd. had unlimitedambitions. The Bermuda-based company was buildingwhat it called the “firstintegrated global fiber opticnetwork” over more than

100,000 miles of cables,largelylaidacrossthefloorofthe world’s oceans. Afterwiring the world, GlobalCrossing would sell othercommunications companiesthe right to carry their trafficoveritsnetworkofcables.In1998 alone, Global Crossingspentmorethan$600millionto construct its optical web.That year, nearly a third ofthe construction budget wascharged against revenues as

an expense called “cost ofcapacity sold.” Ifnot for that$178millionexpense,GlobalCrossing—which reported anet loss of $96 million—could have reported a netprofitofroughly$82million.

Thenextyear,saysablandfootnote in the 1999 annualreport, Global Crossing“initiated service contractaccounting.” The companywouldno longerchargemost

construction costs asexpenses against theimmediate revenues itreceivedfromsellingcapacityon its network. Instead, amajor chunk of thoseconstructioncostswouldnowbetreatednotasanoperatingexpense but as a capitalexpenditure—therebyincreasing the company’stotal assets, instead ofdecreasingitsnetincome.4

Poof! In one wave of thewand, Global Crossing’s“property and equipment”assets rose by $575 million,while its cost of salesincreased by a mere $350million—even though thecompany was spendingmoneylikeadrunkensailor.

Capitalexpendituresareanessentialtoolformanagerstomake a good business growbigger and better. But

malleable accounting rulespermit managers to inflatereported profits bytransforming normaloperating expenses intocapital assets. As the GlobalCrossing case shows, theintelligent investor should besure to understandwhat, andwhy,acompanycapitalizes.

AnInventoryStory

Like many makers ofsemiconductor chips, MicronTechnology, Inc. suffered adrop in sales after 2000. Infact,Micron was hit so hardbytheplungeindemandthatit had to start writing downthevalueof its inventories—since customers clearly didnot want them at the pricesMicron had been asking. Inthe quarter endedMay 2001,Micron slashed the recordedvalue of its inventories by

$261million.Most investorsinterpreted the write-downnot as a normal or recurringcost of operations, but as anunusualevent.

But look what happenedafterthat:

FIGURE12-1

ABlockoftheOldChips

Source:MicronTechnology’sfinancialreports.

Micron booked further

inventory write-downs inevery one of the next sixfiscal quarters. Was thedevaluation of Micron’sinventory a nonrecurringevent, or had it become achronic condition?Reasonable minds can differon this particular case, butone thing is clear: Theintelligent investor mustalways be on guard for“nonrecurring”coststhat,likethe Energizer bunny, just

keepongoing.5

ThePensionDimension

In 2001, SBCCommunications, Inc., whichowns interests in CingularWireless, PacTel, andSouthern New EnglandTelephone, earned $7.2billion in net income—astellar performance in a badyear for the overextended

telecom industry. But thatgain didn’t come only fromSBC’s business. Fully $1.4billion of it—13% of thecompany’s net income—came from SBC’s pensionplan.

Because SBC had moremoney in the pension planthan it estimated wasnecessary to pay itsemployees’ future benefits,the company got to treat the

difference as current income.One simple reason for thatsurplus: In 2001, SBC raisedthe rate of return it expectedtoearnon thepensionplan’sinvestments from 8.5% to9.5%—lowering the amountof money it needed to setasidetoday.

SBC explained its rosynew expectations by notingthat “for each of the threeyears ended 2001, our actual

10-yearreturnoninvestmentsexceeded 10%.” In otherwords, our past returns havebeen high, so let’s assumethatourfuturereturnswillbetoo.Butthatnotonlyflunkedthemost rudimentary testsoflogic,itflewinthefaceofthefact that interest rates werefalling to near-record lows,depressing the future returnson the bond portion of apensionportfolio.

The same year, in fact,Warren Buffett’s BerkshireHathaway lowered theexpected rateof returnon itspension assets from 8.3% to6.5%. Was SBC beingrealistic in assuming that itspension-fundmanagers couldsignificantly outperform theworld’s greatest investor?Probably not: In 2001,Berkshire Hathaway’spension fund gained 9.8%,but SBC’s pension fund lost

6.9%.6

Here are some quickconsiderations for theintelligent investor: Is the“net pension benefit” morethan5%ofthecompany’snetincome? (If so, would youstill be comfortable with thecompany’s other earnings ifthose pension gains wentaway in future years?) Is theassumed “long-term rate ofreturn on plan assets”

reasonable? (As of 2003,anything above 6.5% isimplausible, while a risingrateisdownrightdelusional.)

CaveatInvestor

Afewpointerswill helpyouavoid buying a stock thatturnsout tobeanaccountingtimebomb:

Read backwards. When

you research a company’sfinancialreports,startreadingon the last page and slowlywork your way toward thefront. Anything that thecompanydoesn’twantyoutofind is buried in the back—which is precisely why youshouldlooktherefirst.

Read thenotes.Never buya stock without reading thefootnotes to the financialstatements in the annual

report. Usually labeled“summary of significantaccountingpolicies,”onekeynote describes how thecompanyrecognizes revenue,records inventories, treatsinstallment or contract sales,expenses itsmarketing costs,and accounts for the othermajoraspectsofitsbusiness.7In the other footnotes,watchfor disclosures about debt,stock options, loans to

customers, reserves againstlosses, and other “riskfactors” that can take a bigchomp out of earnings.Amongthethingsthatshouldmake your antennae twitchare technical terms like“capitalized,”“deferred,”and“restructuring”—and plain-English words signaling thatthe company has altered itsaccounting practices, like“began,” “change,” and“however.” None of those

words mean you should notbuy the stock, but all meanthat you need to investigatefurther. Be sure to comparethefootnoteswiththoseinthefinancialstatementsofatleastone firm that’s a closecompetitor, to see howaggressive your company’saccountantsare.

Readmore. If you are anenterprising investor willingto put plenty of time and

energy into your portfolio,thenyouoweittoyourselftolearn more about financialreporting. That’s the onlywaytominimizeyouroddsofbeing misled by a shiftyearnings statement. Threesolidbooksfulloftimelyandspecific examples areMartinFridson and FernandoAlvarez’s FinancialStatement Analysis, CharlesMulford and EugeneComiskey’s The Financial

NumbersGame, andHowardSchilit’s FinancialShenanigans.8

Chapter13AComparisonofFourListedCompanies

Inthischapterweshouldliketo present a sample of

securityanalysisinoperation.We have selected, more orless at random, fourcompanies which are foundsuccessively on the NewYork Stock Exchange list.These are ELTRA Corp. (amerger of Electric Autoliteand Mergenthaler Linotypeenterprises),EmersonElectricCo. (a manufacturer ofelectric and electronicproducts),EmeryAir Freight(a domestic forwarder of air

freight), and Emhart Corp.(originally a maker ofbottling machinery only, butnow also in builders’hardware).* There are somebroad resemblances betweenthe three manufacturingfirms,butthedifferenceswillseemmore significant. Thereshouldbesufficientvarietyinthe financial and operatingdatatomaketheexaminationofinterest.

InTable13-1wepresentasummary of what the fourcompaniesweresellingforinthemarketattheendof1970,and a few figures on their1970 operations. We thendetail certain key ratios,which relateon theonehandto performance and on theother to price. Comment iscalled for on how variousaspects of the performancepatternagreewiththerelativeprice pattern. Finally, we

shallpassthefourcompaniesin review, suggesting somecomparisons andrelationships and evaluatingeach in terms of therequirements of aconservative common-stockinvestor.

TABLE 13-2 A ComparisonofFourListedCompanies

The most striking factabout the four companies isthatthecurrentprice/earningsratiosvarymuchmorewidelythan their operatingperformance or financialcondition. Two of theenterprises—ELTRA andEmhart—were modestlypriced at only 9.7 times and12timestheaverageearningsfor 1968–1970, as against asimilar figure of 15.5 timesfor the DJIA. The other two

—Emerson and Emery—showed very high multiplesof 33 and 45 times suchearnings. There is bound tobe some explanation of adifferencesuchasthis,anditis found in the superiorgrowth of the favoredcompanies’ profits in recentyears, especially by thefreight forwarder. (But thegrowth figures of the othertwo firms were notunsatisfactory.)

For more comprehensivetreatmentletusreviewbrieflythe chief elements ofperformance as they appearfromourfigures.

1.Profitability. (a)All thecompanies show satisfactoryearningson theirbookvalue,but the figures for Emersonand Emery are much higherthanfortheothertwo.Ahighrate of return on investedcapital often goes alongwith

a high annual growth rate inearnings per share.* All thecompanies except Emeryshowed better earnings onbook value in 1969 than in1961; but the Emery figurewas exceptionally large inboth years. (b) Formanufacturingcompanies,theprofit figure per dollar ofsales is usually an indicationof comparative strength orweakness. We use here the

“ratioofoperating income tosales,”asgiveninStandard&Poor’s Listed Stock Reports.Here again the results aresatisfactory for all fourcompanies,withanespeciallyimpressive showing byEmerson. The changesbetween1961 and1969varyconsiderably among thecompanies.

2. Stability. This wemeasure by the maximum

decline in per-share earningsin any one of the past tenyears, as against the averageof the three preceding years.No decline translates into100% stability, and this wasregisteredbythetwopopularconcerns. But the shrinkagesof ELTRA and Emhart werequite moderate in the “pooryear” 1970, amounting toonly 8% each by ourmeasurement, against 7% fortheDJIA.

3. Growth. The two low-multiplier companies showquite satisfactory growthrates, in both cases doingbetter than the Dow Jonesgroup.TheELTRA figures areespecially impressive whenset against its lowprice/earnings ratio. Thegrowth is of course moreimpressive for the high-multiplierpair.

4.Financial Position. The

three manufacturingcompanies are in soundfinancial condition, havingbetter than the standard ratioof$2ofcurrentassets for$1of current liabilities. EmeryAirFreighthasa lowerratio;but it falls in a differentcategory, and with its finerecord it would have noproblem raising needed cash.All the companies haverelativelylowlong-termdebt.“Dilution” note: Emerson

Electric had $163 million ofmarketvalueoflow-dividendconvertible preferred sharesoutstanding at the end of1970.Inouranalysiswehavemade allowance for thedilution factor in the usualwayby treating thepreferredas ifconverted intocommon.This decreased recentearnings by about 10 centspershare,orsome4%.

5. Dividends. What really

counts is the history ofcontinuance withoutinterruption. The best recordhere is Emhart’s, which hasnot suspended a paymentsince1902.ELTRA’S record isvery good, Emerson’s quitesatisfactory,EmeryFreightisa newcomer. The variationsin payout percentage do notseem especially significant.The current dividend yield istwice as high on the “cheappair” as on the “dear pair,”

corresponding to theprice/earningsratios.

6. Price History. Thereader should be impressedby the percentage advanceshowninthepriceofallfourof these issues, as measuredfromthelowesttothehighestpoints during the past 34years. (In all cases the lowprice has been adjusted forsubsequentstocksplits.)Notethat for the DJIA the range

from low to highwas on theorder of 11 to 1; for ourcompanies the spread hasvariedfrom“only”17to1forEmharttonolessthan528to1 for Emery Air Freight.*These manifold priceadvancesarecharacteristicofmost of our older common-stock issues, and theyproclaim the greatopportunities of profit thathave existed in the stock

marketsofthepast.(Buttheymay indicate also howoverdonewerethedeclinesinthebearmarketsbefore1950when the low prices wereregistered.) Both ELTRA andEmhart sustained priceshrinkagesofmorethan50%in the 1969–70 price break.Emerson and Emery hadserious, but less distressing,declines; the formerrebounded to a new all-timehigh before the end of 1970,

thelatterinearly1971.

GeneralObservationsontheFourCompanies

Emerson Electric has anenormous totalmarket value,dwarfing the other threecompanies combined.* It isoneofour“good-willgiants,”to be commented on later.Afinancial analyst blessed (orhandicapped) with a goodmemory will think of an

analogy between EmersonElectric and Zenith Radio,and that would not bereassuring. For Zenith had abrilliant growth record formanyyears;ittoosoldinthemarket for $1.7 billion (in1966);butitsprofitsfellfrom$43 million in 1968 to onlyhalf asmuch in1970, and inthatyear’sbigselloffitspricedeclined to 22½ against theprevious top of 89. Highvaluationsentailhighrisks.

EmeryAirFreightmustbethe most promising of thefour companies in terms offuture growth, if theprice/earnings ratio of nearly40 times its highest reportedearnings is to be evenpartially justified. The pastgrowth, of course, has beenmost impressive. But thesefigures may not be sosignificantforthefutureifweconsider that they startedquitesmall,atonly$570,000

of net earnings in 1958. Itoften proves much moredifficult to continue to growat a high rate after volumeand profits have alreadyexpanded to big totals. Themost surprising aspect ofEmery’s story is that itsearnings and market pricecontinued to grow apace in1970, which was the worstyear in the domestic air-passenger industry. This is aremarkable achievement

indeed, but it raises thequestion whether futureprofitsmaynotbevulnerableto adverse developments,through increasedcompetition,pressurefornewarrangements betweenforwarders and airlines, etc.An elaborate study might beneeded before a soundjudgmentcouldbepassedonthese points, but theconservative investor cannotleave themoutofhisgeneral

reckoning.

EmhartandELTRA.Emharthasdonebetterinitsbusinessthaninthestockmarketoverthe past 14 years. In 1958 itsold as high as 22 times thecurrent earnings—about thesame ratio as for the DJIA.Since then its profits tripled,as against a rise of less than100% for the Dow, but itsclosing price in 1970 wasonly a third above the 1958

high, versus 43% for theDow.The recordofELTRA issomewhat similar. It appearsthat neither of thesecompanies possessesglamour, or “sex appeal,” inthepresentmarket; but in allthe statistical data they showup surprisingly well. Theirfutureprospects?Wehavenosage remarks to make here,but this is what Standard &Poor’s had to say about thefourcompaniesin1971:

ELTRA—“Long-termProspects: Certain operationsare cyclical, but anestablished competitiveposition and diversificationareoffsettingfactors.”

Emerson Electric—“Whileadequately priced (at 71) onthecurrentoutlook,theshareshave appeal for the longterm…. A continued

acquisition policy togetherwith a strong position inindustrial fields and anaccelerated internationalprogram suggests furthersalesandearningsprogress.”

Emery Air Freight—“Theshares appear amply priced(at 57) on current prospects,butarewellworthholdingforthelongpull.”

Emhart—“Although

restricted this year by lowercapital spending in theglass-container industry, earningsshould be aided by animproved businessenvironment in 1972. Theshares are worth holding (at34).”

Conclusions: Manyfinancial analysts will findEmerson and Emery moreinteresting and appealing

stocks than the other two—primarily,perhaps,becauseoftheir better “market action,”and secondarily because oftheir faster recent growth inearnings. Under ourprinciples of conservativeinvestment the first is not avalid reason for selection—that is something for thespeculators to play aroundwith.Thesecondhasvalidity,butwithinlimits.Canthepastgrowth and the presumably

goodprospectsofEmeryAirFreight justify a price morethan 60 times its recentearnings?1Ouranswerwouldbe:Maybe for someonewhohasmadeanin-depthstudyofthe possibilities of thiscompany and come up withexceptionally firm andoptimistic conclusions. Butnot for the careful investorwho wants to be reasonablysureinadvancethatheisnot

committing the typical WallStreet error ofoverenthusiasm for goodperformance in earnings andin the stock market.* Thesame cautionary statementsseemcalledforinthecaseofEmerson Electric, with aspecial reference to themarket’s current valuation ofover a billion dollars for theintangible, or earning-power,factor here. We should add

that the “electronicsindustry,” once a fair-hairedchildofthestockmarket,hasingeneralfallenondisastrousdays. Emerson is anoutstanding exception, but itwill have to continue to besuchanexception foragreatmany years in the futurebefore the1970closingpricewill have been fully justifiedby its subsequentperformance.

By contrast, both ELTRA at27andEmhartat33havetheearmarks of companies withsufficient value behind theirprice to constitute reasonablyprotected investments. Heretheinvestorcan,ifhewishes,consider himself basically apart owner of thesebusinesses, at a costcorresponding to what thebalancesheetshowstobethemoney invested therein.*The

rate of earnings on investedcapital has long beensatisfactory; the stability ofprofits also; the past growthrate surprisingly so. The twocompanies will meet oursevenstatistical requirementsfor inclusion in a defensiveinvestor’s portfolio. Thesewillbedeveloped in thenextchapter, but we summarizethemasfollows:

1. Adequatesize.2. A sufficiently strong

financialcondition.3. Continued dividends for

atleastthepast20years.4. No earnings deficit in

thepasttenyears.5. Ten-year growth of at

least one-third in per-shareearnings.

6. Price of stock no morethan 1½ times net assetvalue.

7. Price no more than 15

times average earningsofthepastthreeyears.

We make no predictionsabout the future earningsperformance of ELTRA orEmhart. In the investor’sdiversified list of commonstocks there are bound to besome that provedisappointing, and this maybethecaseforoneorbothofthis pair. But the diversifiedlist itself,basedontheabove

principles of selection, pluswhatever other sensiblecriteriatheinvestormaywishtoapply,shouldperformwellenough across the years. Atleast, longexperiencetellsusso.

A final observation: Anexperienced security analyst,even if he accepted ourgeneral reasoning on thesefour companies, would havehesitatedtorecommendthata

holder of Emerson or EmeryexchangehissharesforELTRAorEmhartat theendof1970—unless the holderunderstood clearly thephilosophy behind therecommendation. There wasno reason to expect that inany short period of time thelow-multiplier duo wouldoutperform the high-multipliers. The latter werewell thoughtof inthemarketand thus had a considerable

degree of momentum behindthem, which might continuefor an indefinite period. Thesound basis for preferringELTRA and Emhart toEmerson and Emery wouldbe the client’s consideredconclusion that he preferredvalue-type investments toglamour-type investments.Thus, to a substantial extent,common-stock investmentpolicy must depend on theattitude of the individual

investor. This approach istreatedatgreaterlengthinournextchapter.


In theAirForcewehavearule:checksix.Aguyisflyingalong,looking in all directions, andfeeling very safe. Another guyflies up behind him (at “6o’clock”—“12 o’clock” isdirectly in front) and shoots.Most airplanes are shot downthat way. Thinking that you’re

safe is very dangerous!Somewhere, there’s a weaknessyou’ve got to find. You mustalwayschecksixo’clock.

—U.S.AirForceGen.DonaldKutyna

E-Business

AsGrahamdid,let’scompareand contrast four stocks,using their reported numbersas ofDecember 31, 1999—atime that will enable us toviewsomeofthemostdrasticextremes of valuation ever

recordedinthestockmarket.

Emerson Electric Co.(ticker symbol: EMR) wasfounded in 1890 and is theonly surviving member ofGraham’s original quartet; itmakes a wide array ofproducts, including powertools, air-conditioningequipment, and electricalmotors.

EMC Corp. (ticker

symbol: EMC) dates back to1979 and enables companiesto automate the storage ofelectronic information overcomputernetworks.

Expeditors Internationalof Washington, Inc. (tickersymbol: EXPD), founded inSeattle in 1979, helpsshippers organize and trackthe movement of goodsaroundtheworld.

ExodusCommunications,Inc. (ticker symbol: EXDS)hosts and manages websitesfor corporate customers,along with other Internetservices;itfirstsoldsharestothepublicinMarch1998.

This table summarizes theprice, performance, andvaluation of these companiesasofyear-end1999:

Electric,NotElectrifying

The most expensive ofGraham’s four stocks,Emerson Electric, ended upasthecheapestinourupdatedgroup. With its base in OldEconomyindustries,Emersonlooked boring in the late1990s. (In the Internet Age,who cared about Emerson’sheavy-duty wet-dry

vacuums?) The company’sshares went into suspendedanimation.In1998and1999,Emerson’sstocklaggedtheS& P 500 index by acumulative 49.7 percentagepoints, a miserableunderperformance.

But that was Emerson thestock. What about Emersonthe company? In 1999,Emerson sold $14.4 billionworth of goods and services,

upnearly$1billion from theyear before. On thoserevenues Emerson earned$1.3billioninnet income,or6.9% more than in 1998.Over theprevious fiveyears,earnings per share had risenat a robust average rate of8.3%. Emerson’s dividendhad more than doubled to$1.30 per share; book valuehad gone from $6.69 to$14.27 per share. AccordingtoValueLine,throughoutthe

1990s, Emerson’s net profitmargin and return on capital—key measures of itsefficiencyasabusiness—hadstayed robustly high, around9% and 18% respectively.What’s more, Emerson hadincreased its earnings for 42yearsinarowandhadraisedits dividend for 43 straightyears—one of the longestruns of steady growth inAmerican business. At year-end, Emerson’s stock was

priced at 17.7 times thecompany’s net income pershare. Like its power tools,Emerson was never flashy,but it was reliable—andshowed no sign ofoverheating.

CouldEMCGrowPDQ?

EMC Corp. was one of thebest-performing stocksof the1990s, rising—or should we

say levitating?—more than81,000%.Ifyouhadinvested$10,000 in EMC’s stock atthe beginning of 1990, youwouldhave ended1999withjustover$8.1million.EMC’sshares returned 157.1% in1999 alone—more thanEmerson’s stock had gainedin the eight years from 1992through 1999 combined.EMC had never paid adividend,insteadretainingallitsearnings“toprovidefunds

for the continued growth ofthe company.”1 At theirDecember 31 price of$54.625, EMC’s shares weretrading at 103 times theearnings the company wouldreport for the full year—nearlysixtimesthevaluationlevelofEmerson’sstock.

What about EMC thebusiness? Revenues grew24% in 1999, rising to $6.7billion. Its earningsper share

soared to 92 cents from 61cents the year before, a 51%increase. Over the five yearsending in 1999, EMC’searnings had risen at asizzlingannualrateof28.8%.And,witheveryoneexpectingthe tidal wave of Internetcommercetokeeprolling,thefuture looked even brighter.Throughout 1999, EMC’schief executive repeatedlypredictedthatrevenueswouldhit $10 billion by 2001—up

from $5.4 billion in 1998.2That would require averageannual growth of 23%, amonstrous rate of expansionfor so big a company. ButWall Street’s analysts, andmost investors, were sureEMC could do it. After all,over the previous five years,EMChadmore thandoubledits revenues and better thantripleditsnetincome.

But from 1995 through

1999, according to ValueLine, EMC’s net profitmargin slid from 19.0% to17.4%, while its return oncapital dropped from 26.8%to21%.Althoughstillhighlyprofitable, EMC was alreadyslipping. And in October1999, EMC acquired DataGeneral Corp., which addedroughly $1.1 billion toEMC’s revenues that year.Simply by subtracting theextra revenues brought in

from Data General, we canseethatthevolumeofEMC’sexistingbusinessesgrewfrom$5.4 billion in 1998 to just$5.6billionin1999,ariseofonly 3.6%. In other words,EMC’s true growth rate wasalmost nil—even in a yearwhen the scare over the“Y2K”computerbughadledmany companies to spendrecord amounts on newtechnology.3

ASimpleTwistofFreight

Unlike EMC, ExpeditorsInternational hadn’t yetlearned to levitate. Althoughthe firm’s shares had risen30% annually in the 1990s,much of that big gain hadcome at the very end, as thestock raced to a 109.1%return in 1999. The yearbefore, Expeditors’ shareshad gone up just 9.5%,trailing the S&P 500 index

by more than 19 percentagepoints.

What about the business?Expeditors was growingexpeditiously indeed: Since1995, its revenues had risenat an average annual rate of19.8%, nearly tripling overthe period to finish 1999 at$1.4billion.Andearningspershare had grown by 25.8%annually,whiledividendshadrisen at a 27% annual clip.

Expeditors had no long-termdebt, and its working capitalhad nearly doubled since1995. According to ValueLine,Expeditors’ book valuepersharehadincreased129%and its return on capital hadrisen by more than one-thirdto21%.

By any standard,Expeditors was a superbbusiness. But the littlefreight-forwarding company,

with its base in Seattle andmuch of its operations inAsia,wasall-but-unknownonWallStreet.Only32%oftheshares were owned byinstitutionalinvestors;infact,Expeditors had only 8,500shareholders. After doublingin1999,thestockwaspricedat 39 times the net incomeExpeditorswouldearnfortheyear—no longer anywherenear cheap, but well belowthe vertiginous valuation of

EMC.

ThePromisedLand?

By the end of 1999, ExodusCommunications seemed tohave taken its shareholdersstraight to the land of milkand honey. The stock soared1,005.8%in1999—enoughtoturna$10,000 investmentonJanuary 1 into more than$110,000 by December 31.

Wall Street’s leadingInternet-stock analysts,including the hugelyinfluential Henry Blodget ofMerrill Lynch, werepredicting that the stockwould rise another 25% to125%overthecomingyear.

Andbestofall,intheeyesof the online traders whogorged on Exodus’s gains,wasthefactthatthestockhadsplit 2-for-1 three times

during 1999. In a 2-for-1stock split, a companydoubles the number of itsshares and halves their price—so a shareholder ends upowningtwiceasmanyshares,eachpricedathalftheformerlevel. What’s so great aboutthat? Imagine that youhandedmeadime,andIthengave you back two nickelsand asked, “Don’t you feelricher now?” You wouldprobably conclude either that

I was an idiot, or that I hadmistaken you for one. Andyet, in 1999’s frenzy overdot-comstocks,onlinetradersactedexactlyasiftwonickelsweremore valuable than onedime. In fact, just the newsthatastockwouldbesplitting2-for-1 could instantly driveitssharesup20%ormore.

Why? Because gettingmore shares makes peoplefeel richer. Someone who

bought100sharesofExodusinJanuarywatchedthemturninto200when the stocksplitin April; then those 200turned into 400 in August;then the 400 became 800 inDecember.Itwasthrillingforthese people to realize thatthey had gotten 700 moresharesjustforowning100inthe first place. To them, thatfelt like “found money”—nevermind that thepricepershare had been cut in half

with each split.4 InDecember, 1999, one elatedExodus shareholder, whowent by the handle“givemeadollar,” exulted onan online message board:“I’m going to hold thesesharesuntilI’m80,[because]after it splits hundreds oftimesoverthenextyears,I’llbeclosetobecomingCEO.”5

What about Exodus thebusiness? Graham wouldn’t

havetoucheditwitha10-footpole and a haz-mat suit.Exodus’s revenues wereexploding—growing from$52.7 million in 1998 to$242.1 million in 1999—butitlost$130.3milliononthoserevenues in 1999, nearlydouble its loss the yearbefore. Exodus had $2.6billionintotaldebt—andwasso starved for cash that itborrowed$971millioninthemonth of December alone.

According to Exodus’sannual report, that newborrowing would add morethan$50milliontoitsinterestpaymentsinthecomingyear.The company started 1999with $156 million in cashand, even after raising $1.3billion in new financing,finished the yearwith a cashbalance of $1 billion—meaning that its businesseshaddevouredmorethan$400million in cash during 1999.

How could such a companyeverpayitsdebts?

But, of course, onlinetraders were fixated on howfar and fast the stock hadrisen, not on whether thecompany was healthy. “Thisstock,”braggedatraderusingthe screen name of“Launch_Pad 1999,” “willjust continue climbing toinfinityandbeyond.”6

The absurdity ofLaunch_Pad’s prediction—what is “beyond” infinity?—istheperfectreminderofoneof Graham’s classicwarnings.“Today’sinvestor,”Grahamtellsus,

is so concerned withanticipating the futurethatheisalreadypayinghandsomely for it inadvance. Thus what hehas projected with so

much study and caremayactuallyhappenandstill not bring him anyprofit.Ifitshouldfailtomaterializetothedegreeexpected hemay in factbe faced with a serioustemporary and perhapsevenpermanentloss.”7

WheretheEsEndedUp

How did these four stocks

performafter1999?

Emerson Electric went onto gain 40.7% in 2000.Although the shares lostmoney in both 2001 and2002,theyneverthelessended2002lessthan4%belowtheirfinalpriceof1999.

EMC also rose in 2000,gaining 21.7%. But then theshareslost79.4%in2001andanother 54.3% in 2002. That

left them 88% below theirlevel at year-end1999.Whatabout the forecast of $10billion in revenues by 2001?EMC finished that year withrevenues of just $7.1 billion(and a net loss of $508million).

Meanwhile, as if the bearmarket did not even exist,Expeditors International’sshareswentontogain22.9%in 2000, 6.5% in 2001, and

another 15.1% in 2002—finishing that year nearly51%higherthantheirpriceattheendof1999.

Exodus’sstocklost55%in2000and99.8% in2001.OnSeptember 26, 2001, Exodusfiled for Chapter 11bankruptcy protection. Mostofthecompany’sassetswereboughtbyCable&Wireless,the Britishtelecommunications giant.

Instead of delivering itsshareholders to the promisedland,Exodusleft themexiledinthewilderness.Asofearly2003, the last trade inExodus’s stock was at onepennyashare.

Chapter14StockSelectionfortheDefensiveInvestor

It is time to turn to somebroader applications of the

techniques of securityanalysis. Since we havealready described in generalterms the investment policiesrecommended for our twocategories of investors,* itwould be logical for us nowto indicate how securityanalysis comes into play inorder to implement thesepolicies. The defensiveinvestor who follows oursuggestions will purchase

onlyhigh-gradebondsplusadiversified list of leadingcommon stocks. He is tomake sure that the price atwhich he bought the latter isnotundulyhighasjudgedbyapplicablestandards.

In setting up thisdiversifiedlisthehasachoiceoftwoapproaches,theDJIA-type of portfolio and thequantitatively-testedportfolio. In the first he

acquires a true cross-sectionsample of the leading issues,whichwillincludebothsomefavored growth companies,whose shares sell atespecially high multipliers,andalsolesspopularandlessexpensive enterprises. Thiscould be done, most simplyperhaps, by buying the sameamounts of all thirty of theissues in the DowJonesIndustrial Average (DJIA).Tensharesofeach,atthe900

level for the average, wouldcost an aggregate of about$16,000.1Onthebasisof thepast record he might expectapproximately the samefuture results by buyingshares of severalrepresentative investmentfunds.†

His second choice wouldbetoapplyasetofstandardsto each purchase, to makesure that he obtains (1) a

minimum of quality in thepast performance and currentfinancial position of thecompany, and also (2) aminimumofquantityintermsof earnings and assets perdollarofprice.Atthecloseofthepreviouschapterwelistedseven such quality andquantitycriteriasuggestedforthe selection of specificcommon stocks. Let usdescribetheminorder.

1.AdequateSizeoftheEnterprise

All our minimum figuresmust be arbitrary andespecially in the matter ofsize required. Our idea is toexclude small companieswhichmaybesubjecttomorethan average vicissitudesespecially in the industrialfield. (There are often goodpossibilities in suchenterprises but we do notconsider them suited to the

needs of the defensiveinvestor.) Let us use roundamounts: not less than $100millionofannualsalesforanindustrial company and, notless than$50millionof totalassetsforapublicutility.

2. A Sufficiently Strong FinancialCondition

For industrial companiescurrent assets should be atleast twice current liabilities

—a so-called two-to-onecurrent ratio.Also, long-termdebt should not exceed thenet current assets (or“working capital”). Forpublic utilities the debtshould not exceed twice thestockequity(atbookvalue).

3.EarningsStability

Some earnings for thecommonstock ineachof thepasttenyears.

4.DividendRecord

Uninterrupted paymentsforatleastthepast20years.

5.EarningsGrowth

Aminimum increase of atleast one-third in per-shareearnings in thepast tenyearsusing three-year averages atthebeginningandend.

6.ModeratePrice/EarningsRatio

Currentpriceshouldnotbemore than 15 times averageearnings of the past threeyears.

7.ModerateRatioofPricetoAssets

Currentpriceshouldnotbemorethan1½timesthebookvalue last reported.However,amultiplierofearningsbelow15 could justify acorrespondingly highermultiplierofassets.Asarule

of thumbwesuggest that theproduct of the multipliertimes the ratio of price tobookvalueshouldnotexceed22.5.(Thisfigurecorrespondsto 15 times earnings and 1½times book value. It wouldadmitanissuesellingatonly9 times earnings and 2.5timesassetvalue,etc.)

GENERAL COMMENTS:Theserequirementsaresetupespecially for the needs and

thetemperamentofdefensiveinvestors.Theywilleliminatethegreatmajorityofcommonstocks as candidates for theportfolio,andintwooppositeways. On the one hand theywill exclude companies thatare (1) too small, (2) inrelatively weak financialcondition, (3) with a deficitstigma in their ten-yearrecord, and (4) not having along history of continuousdividends. Of these tests the

most severe under recentfinancial conditionsare thoseof financial strength. Aconsiderable number of ourlarge and formerly stronglyentrenched enterprises haveweakened their current ratiooroverexpandedtheirdebt,orboth,inrecentyears.

Our last two criteria areexclusive in the oppositedirection,bydemandingmoreearnings andmore assets per

dollar of price than thepopular issues will supply.This is by no means thestandard viewpoint offinancial analysts; in factmost will insist that evenconservative investors shouldbe prepared to pay generouspricesforstocksofthechoicecompanies. We haveexpoundedour contraryviewabove; it rests largely on theabsenceofanadequatefactorof safety when too large a

portion of the price mustdepend on ever-increasingearnings in the future. Thereaderwillhavetodecidethisimportant question forhimself—after weighing theargumentsonbothsides.

Wehavenonethelessoptedfor the inclusionof amodestrequirement of growth overthe past decade. Without itthe typical company wouldshowretrogression,atleastin

terms of profit per dollar ofinvested capital. There is noreason for the defensiveinvestor to include suchcompanies—though if theprice is low enough theycould qualify as bargainopportunities.

The suggested maximumfigure of 15 times earningsmightwell result in a typicalportfolio with an averagemultiplier of, say, 12 to 13

times. Note that in February1972 American Tel. & Tel.soldat11timesitsthree-year(and current) earnings, andStandard Oil of California atless than 10 times latestearnings. Our basicrecommendation is that thestock portfolio, whenacquired, should have anoverall earnings/price ratio—thereverseoftheP/Eratio—atleastashighas thecurrenthigh-grade bond rate. This

would mean a P/E ratio nohigher than 13.3 against anAAbondyieldof7.5%.*

ApplicationofOurCriteriatotheDJIAattheEndof1970

All of our suggestedcriteria were satisfied by theDJIA issues at the end of1970, but two of them justbarely.Hereisasurveybasedon the closing price of 1970andtherelevantfigures.(The

basic data for each companyareshowninTables14-1and14-2.)

1. Size ismore thanampleforeachcompany.

2. Financial condition isadequate in theaggregate, but not foreverycompany.2

3. Somedividendhasbeenpaid by every companysinceat least1940.Five

of the dividend recordsgo back to the lastcentury.

4. The aggregate earningshavebeenquitestableinthepastdecade.Noneofthecompaniesreportedadeficit during theprosperousperiod1961–69,butChryslershowedasmalldeficitin1970.

5. The total growth—comparing three-yearaverages a decade apart

—was77%,orabout6%peryear.But fiveof thefirms did not grow byone-third.

6. The ratio of year-endprice to three-yearaverage earnings was839 to $55.5 or 15 to 1—right at our suggestedupperlimit.

7. The ratioofprice tonetasset value was 839 to562—also just withinour suggested limit of

1½to1.

TABLE 14-1 Basic Data on30 Stocks in the Dow JonesIndustrial Average atSeptember30,1971

If, however, we wish toapply the samesevencriteriato each individual company,

wewould find that only fiveof them would meet all ourrequirements. These wouldbe:AmericanCan,AmericanTel.&Tel.,Anaconda,Swift,and Woolworth. The totalsforthesefiveappearinTable14-3. Naturally they make amuch better statisticalshowing than the DJIA as awhole, except in the pastgrowthrate.3

Our application of specific

criteriatothisselectgroupofindustrialstocksindicatesthatthe number meeting everyone of our tests will be arelativelysmallpercentageofalllistedindustrialissues.Wehazard the guess that about100 issues of this sort couldhave been found in theStandard & Poor’s StockGuideattheendof1970,justabout enough to provide theinvestor with a satisfactory

rangeofpersonalchoice.*

ThePublic-Utility“Solution”

Ifwe turnnowto thefieldof public-utility stocks wefind a much morecomfortable and invitingsituation for the investor.†Here the vast majority ofissuesappeartobecutout,bytheir performance record andtheir price ratios, inaccordancewiththedefensive

investor’s needs as we judgethem. We exclude onecriterion from our tests ofpublic-utility stocks—namely, the ratio of currentassets to current liabilities.The working-capital factortakes care of itself in thisindustry as part of thecontinuous financing of itsgrowthbysalesofbondsandshares. We do require anadequate proportion of stock

capitaltodebt.4

InTable14-4wepresentarésuméofthe15issuesintheDow Jones public-utilityaverage. For comparison,Table 14-5 gives a similarpictureofa randomselectionof fifteenotherutilities takenfrom the New York StockExchangelist.

As 1972 began thedefensiveinvestorcouldhavehad quite a wide choice of

utility common stocks, eachofwhichwouldhavemetourrequirements for bothperformanceandprice.Thesecompanies offered himeverything he had a right todemand from simply chosencommon-stock investments.In comparison withprominent industrialcompanies as represented bytheDJIA,theyofferedalmostas good a record of pastgrowth, plus smaller

fluctuations in the annualfigures—bothatalowerpricein relation to earnings andassets. The dividend returnwas significantly higher.Theposition of the utilities asregulated monopolies isassuredly more of anadvantage than adisadvantage for theconservative investor. Underlawtheyareentitledtochargerates sufficientlyremunerative to attract the

capital they need for theircontinuous expansion, andthis implies adequate offsetsto inflated costs. While theprocess of regulation hasoften been cumbersome andperhaps dilatory, it has notprevented the utilities fromearning a fair return on theirrising invested capital overmanydecades.

For the defensive investorthe central appeal of thepublic-utility stocks at thistime should be theiravailability at a moderateprice in relation to bookvalue.Thismeansthathecanignore stockmarketconsiderations, if he wishes,and consider himselfprimarily as a part owner ofwell-established and well-earning businesses. The

market quotations are alwaysthere for him to takeadvantage of when times arepropitious—either forpurchases at unusuallyattractive low levels, or forsales when their prices seemdefinitelytoohigh.

The market record of thepublic-utility indexes—condensed in Table 14-6,along with those of othergroups—indicates that there

havebeenamplepossibilitiesofprofit in these investmentsinthepast.Whiletherisehasnot been as great as in theindustrial index, theindividual utilities haveshownmorepricestability inmost periods than have othergroups.* It is striking toobserve in this table that therelative price/earnings ratiosof the industrials and theutilities have changed places

during the past two decades.These reversals will havemore meaning for the activethan for the passive investor.But they suggest that evendefensiveportfoliosshouldbechanged from time to time,especially if the securitiespurchasedhaveanapparentlyexcessiveadvanceandcanbereplacedbyissuesmuchmorereasonablypriced.Alas!therewill be capital-gains taxes topay—which for the typical

investorseemstobeaboutthesameastheDeviltopay.Ourold ally, experience, tells usherethatitisbettertosellandpay the tax than not sell andrepent.

TABLE 14-6 Developmentof Prices andPrice/Earnings Ratios forVariousStandard&Poor’sAverages,

InvestinginStocksofFinancialEnterprises

A considerable variety ofconcerns may be ranged

under therubricof“financialcompanies.” These wouldinclude banks, insurancecompanies, savings and loanassociations,creditandsmall-loan companies, mortgagecompanies, and “investmentcompanies” (e.g., mutualfunds).* It is characteristicofall theseenterprises that theyhavearelativelysmallpartoftheir assets in the form ofmaterial things—such as

fixed assets andmerchandiseinventories—buton theotherhand most categories haveshort-termobligationswellinexcess of their stock capital.The question of financialsoundness is, therefore,morerelevantherethaninthecaseof the typical manufacturingor commercial enterprise.This,inturn,hasgivenrisetovarious forms of regulationand supervision, with thedesign and general result of

assuring against unsoundfinancialpractices.

Broadly speaking, theshares of financial concernshave produced investmentresults similar to those ofother types of commonshares. Table 14-7 showsprice changes between 1948and 1970 in six groupsrepresentedintheStandard&Poor’s stock-price indexes.Theaveragefor1941–1943is

taken as 10, the base level.The year-end 1970 figuresrangedbetween44.3forthe9NewYorkbanksand218forthe 11 life-insurance stocks.During the subintervals therewas considerable variation inthe respective pricemovements.Forexample,theNew York City bank stocksdid quite well between 1958and 1968; conversely thespectacular life-insurancegroup actually lost ground

between 1963 and 1968.These cross-movements arefoundinmany,perhapsmost,of the numerous industrygroups in the Standard &Poor’sindexes.

TABLE14-7RelativePriceMovements of Stocks ofVarious

We have no very helpful

remarkstoofferinthisbroadarea of investment—otherthan tocounsel that thesamearithmetical standards forprice in relation to earningsandbookvaluebeapplied tothe choice of companies inthese groups as we havesuggested for industrial andpublic-utilityinvestments.

RailroadIssues

The railroad story is a far

differentonefromthatof theutilities. The carriers havesuffered severely from acombination of severecompetition and strictregulation. (Their labor-costproblem has of course beendifficult aswell, but that hasnot been confined torailroads.) Automobiles,buses, and airlines havedrawn off most of theirpassenger business and leftthe rest highly unprofitable;

the trucks have taken a gooddeal of their freight traffic.Morethanhalfoftherailroadmileage of the country hasbeen in bankruptcy (or“trusteeship”) at varioustimes during the past 50years.

But this half-century hasnot been all downhill for thecarriers. There have beenprosperous periods for theindustry, especially the war

years.Someofthelineshavemanaged to maintain theirearning power and theirdividends despite the generaldifficulties.

The Standard & Poor’sindex advanced sevenfoldfrom the low of 1942 to thehighof1968,notmuchbelowthe percentage gain in thepublic-utility index. Thebankruptcy of the PennCentral Transportation Co.,

our most important railroad,in1970shockedthefinancialworld. Only a year and twoyears previously the stocksold at close to the highestpricelevelinitslonghistory,and it had paid continuousdividends for more than 120years! (On p. 423 below wepresentabriefanalysisofthisrailroad to illustrate how acompetentstudentcouldhavedetected the developingweaknesses in thecompany’s

pictureandcounseledagainstownership of its securities.)The market level of railroadshares as a whole wasseriously affected by thisfinancialdisaster.

It is usually unsound tomake blanketrecommendations of wholeclassesofsecurities,andthereare equal objections to broadcondemnations.Therecordofrailroadshareprices inTable

14-6 shows that thegroupasa whole has often offeredchances for a large profit.(But in our view the greatadvances were in themselveslargely unwarranted.) Let usconfine our suggestion tothis: There is no compellingreasonfortheinvestortoownrailroad shares; before hebuysanyheshouldmakesurethat he is getting so muchvalue for his money that itwould be unreasonable to

look for something elseinstead.*

SelectivityfortheDefensiveInvestor

Every investor would likehis list to be better or morepromising than the average.Hence the reader will askwhether, if he gets himself acompetentadviserorsecurityanalyst,heshouldnotbeableto count on being suppliedwith an investment package

of really superior merits.“After all,” hemay say, “therules you have outlined arepretty simple and easygoing.A highly trained analystoughttobeabletouseallhisskill and techniques toimprove substantially onsomething as obvious as theDow Jones list. If not, whatgood are all his statistics,calculations, and pontificaljudgments?”

Suppose,asapracticaltest,we had asked a hundredsecurity analysts to choosethe “best” five stocks in theDow Jones Average, to bebought at the end of 1970.Few would have come upwith identical choices andmanyof the listswouldhavediffered completely fromeachother.

Thisisnotsosurprisingasit may at first appear. The

underlying reason is that thecurrent price of eachprominent stock pretty wellreflects the salient factors inits financial record plus thegeneral opinion as to itsfuture prospects. Hence theview of any analyst that onestock isabetterbuy than therest must arise to a greatextent from his personalpartialities and expectations,or from the placing of hisemphasisononesetoffactors

rather than on another in hiswork of evaluation. If allanalystswereagreedthatoneparticular stock was betterthan all the rest, that issuewould quickly advance to aprice which would offset allofitspreviousadvantages.*

Our statement that thecurrent price reflects bothknown facts and futureexpectations was intended toemphasize the double basis

for market valuations.Correspondingwiththesetwokinds of value elements aretwo basically differentapproaches to securityanalysis. To be sure, everycompetent analyst looksforward to the future ratherthan backward to the past,and he realizes that hisworkwill prove good or baddepending on what willhappen and not on what hashappened. Nevertheless, the

future itself can beapproached in two differentways, which may be calledthe way of prediction (orprojection) and the way ofprotection.*

Those who emphasizeprediction will endeavor toanticipate fairly accuratelyjust what the company willaccomplish in future years—inparticularwhetherearningswill show pronounced and

persistent growth. Theseconclusionsmaybebasedona very careful study of suchfactorsassupplyanddemandin the industry—or volume,price,andcosts—orelsetheymaybederivedfromarathernaïveprojectionofthelineofpastgrowthintothefuture.Ifthese authorities areconvinced that the fairlylong-term prospects areunusuallyfavorable,theywillalmost always recommend

the stock for purchasewithout paying too muchregardtothelevelatwhichitis selling.Such, forexample,was the general attitudewithrespect to the air-transportstocks—an attitude thatpersisted for many yearsdespite the distressingly badresults often shown after1946. In the Introduction wehave commented on thedisparity between the strongpriceactionandtherelatively

disappointingearningsrecordofthisindustry.

By contrast, those whoemphasize protection arealways especially concernedwith the price of the issue atthetimeofstudy.Theirmaineffort is toassure themselvesof a substantial margin ofindicatedpresentvalueabovethe market price—whichmargin could absorbunfavorable developments in

the future. Generallyspeaking, therefore, it is notso necessary for them to beenthusiastic over thecompany’s long-runprospects as it is to bereasonably confident that theenterprisewillgetalong.

The first, or predictive,approachcouldalsobecalledthe qualitative approach,sinceitemphasizesprospects,management, and other

nonmeasurable, albeit highlyimportant, factors that gounder the heading of quality.The second, or protective,approach may be called thequantitative or statisticalapproach,sinceitemphasizesthe measurable relationshipsbetween selling price andearnings, assets, dividends,andsoforth.Incidentally,thequantitative method is reallyan extension—into the fieldof common stocks—of the

viewpoint that securityanalysis has found to besound in the selection ofbonds and preferred stocksforinvestment.

In our own attitude andprofessional work we werealways committed to thequantitative approach. Fromthe first we wanted to makesure that we were gettingamplevalueforourmoneyinconcrete,demonstrableterms.

Wewerenotwillingtoaccepttheprospectsandpromisesofthe future as compensationfor a lack of sufficient valuein hand. This has by nomeans been the standardviewpoint among investmentauthorities; in fact, themajority would probablysubscribe to the view thatprospects, quality ofmanagement, otherintangibles, and “the humanfactor” far outweigh the

indications supplied by anystudy of the past record, thebalance sheet, and all theothercoldfigures.

Thus this matter ofchoosing the “best” stocks isat bottom a highlycontroversialone.Ouradviceto the defensive investor isthat he let it alone. Let himemphasize diversificationmore than individualselection. Incidentally, the

universally accepted idea ofdiversification is, in part atleast, the negation of theambitious pretensions ofselectivity.Ifonecouldselectthe best stocks unerringly,one would only lose bydiversifying. Yet within thelimits of the four mostgeneral rules of common-stock selection suggested forthedefensiveinvestor(onpp.114–115) there is room for arather considerable freedom

of preference. At the worstthe indulgence of suchpreferences should do noharm;beyondthat,itmayaddsomething worthwhile to theresults. With the increasingimpact of technologicaldevelopments on long-termcorporateresults, theinvestorcannot leave them out of hiscalculations. Here, aselsewhere, he must seek amean between neglect andoveremphasis.


He that resteth upon gainscertain, shall hardly grow togreat riches; andhe that puts alluponadventures,dothoftentimesbreak and come to poverty: it isgood therefore to guardadventures with certainties thatmayupholdlosses.

—SirFrancisBacon

GettingStarted

How should you tackle thenitty-gritty work of stockselection? Graham suggeststhat the defensive investorcan, “most simply,” buyevery stock in theDowJonesIndustrial Average. Today’sdefensive investor can doeven better—by buying atotalstock-market indexfundthat holds essentially everystock worth having. A low-

cost index fund is the besttool ever created for low-maintenance stock investing—and any effort to improveon it takes more work (andincurs more risk and highercosts) than a truly defensiveinvestorcanjustify.

Researching and selectingyour own stocks is notnecessary;formostpeople, itis not even advisable.However, some defensive

investors do enjoy thediversion and intellectualchallenge of pickingindividual stocks—and, ifyou have survived a bearmarket and still enjoy stockpicking, then nothing thatGraham or I could say willdissuade you. In that case,instead of making a totalstockmarketindexfundyourcomplete portfolio, make itthe foundation of yourportfolio.Onceyouhavethat

foundation in place, you canexperiment around the edgeswithyourownstockchoices.Keep 90% of your stockmoney in an index fund,leaving 10% with which totry picking your own stocks.Onlyafteryoubuildthatsolidcore shouldyou explore. (Tolearn why such broaddiversification is soimportant, please see thesidebar on the followingpage.)

WHYDIVERSIFY?

During the bullmarket ofthe1990s,oneofthemostcommon criticisms ofdiversification was that itlowers your potential forhigh returns. After all, ifyoucouldidentifythenextMicrosoft, wouldn’t itmakesenseforyoutoputallyoureggsintothatonebasket?

Well, sure. As thehumoristWillRogersoncesaid,“Don’tgamble.Takeall your savings and buysomegoodstockandhold

it till it goes up, then sellit. If it don’t go up, don’tbuyit.”

However,asRogersknew,20/20 foresight is not agift granted to mostinvestors. No matter howconfident we feel, there’snowaytofindoutwhethera stock will go up untilafterwebuyit.Therefore,thestockyouthinkis“thenextMicrosoft”maywellturn out to be the nextMicroStrategy instead.(That former market starwent from $3,130 pershare in March 2000 to

$15.10 at year-end 2002,an apocalyptic loss of99.5%).1 Keeping yourmoneyspreadacrossmanystocksandindustriesistheonly reliable insuranceagainst the risk of beingwrong.

Butdiversificationdoesn’tjustminimizeyouroddsofbeing wrong. It alsomaximizes your chancesof being right. Over longperiodsof time, ahandfulof stocks turn into“superstocks” that go up10,000% or more.MoneyMagazineidentifiedthe30

best-performing stocksover the 30 years endingin 2002—and, even with20/20hindsight, the list isstartlingly unpredictable.Rather than lots oftechnology or health-carestocks, it includesSouthwest Airlines,Worthington Steel, DollarGeneral discount stores,and snuff-tobacco makerUSTInc.2Ifyouthinkyouwould have been willingtobetbigonanyof thosestocks back in 1972, youarekiddingyourself.

Thinkofitthisway:Inthe

huge market haystack,onlyafewneedlesevergoon to generate trulygigantic gains. The moreof the haystack you own,thehighertheoddsgothatyouwillendupfindingatleastoneofthoseneedles.By owning the entirehaystack (ideally throughan index fund that tracksthe total U.S. stockmarket)youcanbesuretofind every needle, thuscapturingthereturnsofallthesuperstocks.Especiallyif you are a defensiveinvestor,why lookfor theneedleswhenyoucanown

thewholehaystack?

Testing,Testing

Let’sbrieflyupdateGraham’scriteriaforstockselection.

Adequatesize.Nowadays,“to exclude smallcompanies,” most defensiveinvestorsshouldsteerclearofstocks with a total marketvalue of less than $2 billion.In early 2003, that still left

you with 437 of thecompanies in theStandard&Poor’s 500-stock index tochoosefrom.

However, today’sdefensive investors—unlikethose in Graham’s day—canconveniently own smallcompanies by buying amutual fund specializing insmallstocks.Again,anindexfund like Vanguard Small-Cap Index is the first choice,

although active funds areavailable at reasonable costfrom such firms as Ariel, T.Rowe Price, Royce, andThirdAvenue.

Strong financialcondition. According tomarket strategists SteveGalbraith and Jay Lasus ofMorgan Stanley, at thebeginningof 2003 about 120ofthecompaniesintheS&P500 indexmetGraham’s test

ofa2-to-1currentratio.Withcurrent assets at least twicetheir current liabilities, thesefirms had a sizeable cushionof working capital that—onaverage—shouldsustainthemthroughhardtimes.

Wall Street has alwaysabounded in bitter ironies,and the bursting of thegrowth-stock bubble hascreatedadoozy: In1999and2000,high-tech,bio-tech,and

telecommunications stockswere supposed to provide“aggressive growth” andendedupgivingmostoftheirinvestors aggressiveshrinkage instead. But, byearly 2003, the wheel hadcomefullcircle,andmanyofthose aggressive growthstockshadbecomefinanciallyconservative—loaded withworkingcapital, rich incash,andoftendebt-free.Thistableprovidesasampler:

FIGURE 14-1 EverythingNewIsOldAgain

Allfiguresinmillionsofdollarsfromlatestavailablefinancialstatementsasof12/31/02.Workingcapitaliscurrentassetsminuscurrentliabilities.Long-termdebtincludespreferredstock,excludesdeferredtaxliabilities.Sources:MorganStanley;Baseline;EDGARdatabaseatwww.sec.gov.

In1999,mostofthesecompanieswereamongthehottestofthemarket’sdarlings,offeringthepromiseofhighpotentialgrowth.Byearly2003,theyofferedhardevidenceoftruevalue.

The lessonhere is not thatthese stocks were “a surething,” or that you shouldrush out and buy everything

(or anything) in this table.1Instead, you should realizethat a defensive investor canalways prosper by lookingpatiently and calmly throughthe wreckage of a bearmarket.Graham’scriterionoffinancial strength stillworks:If you build a diversifiedbasket of stocks whosecurrent assets are at leastdouble their currentliabilities, and whose long-

term debt does not exceedworking capital, you shouldend up with a group ofconservatively financedcompanies with plenty ofstaying power. The bestvalues today are often foundin the stocks that were oncehotandhavesincegonecold.Throughout history, suchstocks have often providedthe margin of safety that adefensiveinvestordemands.

Earnings stability.According to MorganStanley, 86% of all thecompanies in the S& P 500index have had positiveearnings in every year from1993 through 2002. SoGraham’s insistence on“some earnings for thecommonstock ineachof thepast ten years” remains avalid test—tough enough toeliminate chronic losers, butnot so restrictive as to limit

your choices to anunrealisticallysmallsample.

Dividend record. As ofearly 2003, according toStandard & Poor’s, 354companies in the S& P 500(or 71% of the total) paid adividend.No fewer than 255companies have paid adividendforat least20yearsinarow.And,accordingtoS& P, 57 companies in theindex have raised their

dividends for at least 25consecutive years. That’s noguaranteethattheywilldosoforever, but it’s a comfortingsign.

Earnings growth. HowmanycompaniesintheS&P500 increased their earningsper share by “at least onethird,” as Graham requires,over the 10 years ending in2002? (We’ll average eachcompany’s earnings from

1991 through 1993, and thendetermine whether theaverage earnings from 2000through 2002 were at least33% higher.) According toMorgan Stanley, 264companies in the S& P 500met that test. But here, itseems,Grahamsetaverylowhurdle; 33% cumulativegrowth over a decade is lessthan a 3% average annualincrease. Cumulative growthin earnings per share of at

least 50%—or a 4% averageannual rise—is a bit lessconservative. No fewer than245 companies in the S& P500 index met that criterionas of early 2003, leaving thedefensive investor an amplelist to choose from. (If youdoublethecumulativegrowthhurdle to 100%, or 7%average annual growth, then198 companies make thecutoff.)

FIGURE 14-2 SteadyEddies

Source:Standard&Poor’sCorp.Dataasof12/31/2002.

Moderate P/E ratio.Grahamrecommendslimitingyourself to stocks whosecurrentprice isnomore than15 times average earningsover the past three years.Incredibly, the prevailingpracticeonWallStreet todayistovaluestocksbydividingtheir current price bysomethingcalled“nextyear’s

earnings.”Thatgiveswhat issometimes called “theforward P/E ratio.” But it’snonsensical to derive aprice/earnings ratio bydividing the known currentprice by unknown futureearnings. Over the long run,money manager DavidDreman has shown, 59% ofWall Street’s “consensus”earnings forecasts miss themark by amortifyinglywidemargin—either

underestimating oroverestimating the actualreported earnings by at least15%.2 Investing your moneyon the basis of what thesemyopic soothsayers predictfor the coming year is asrisky as volunteering to holdupthebulls-eyeatanarcherytournament for the legallyblind. Instead, calculate astock’s price/earnings ratioyourself, using Graham’s

formula of current pricedivided by average earningsoverthepastthreeyears.3

As of early 2003, howmany stocks in the Standard& Poor’s 500 index werevalued at no more than 15times their average earningsof 2000 through 2002?According to MorganStanley, a generous total of185 companies passedGraham’stest.

Moderate price-to-bookratio.Grahamrecommendsa“ratio of price to assets” (orprice-to-book-value ratio) ofno more than 1.5. In recentyears, an increasingproportion of the value ofcompanies has come fromintangible assets likefranchises, brand names, andpatentsandtrademarks.Sincethese factors (along withgoodwill from acquisitions)are excluded from the

standard definition of bookvalue,most companies todayare priced at higher price-to-book multiples than inGraham’s day. According toMorgan Stanley, 123 of thecompanies in the S& P 500(or one in four) are pricedbelow 1.5 times book value.All told, 273 companies (or55%oftheindex)haveprice-to-book ratios of less than2.5.

What about Graham’ssuggestion that you multiplytheP/E ratio by the price-to-book ratio and see whethertheresultingnumberisbelow22.5? Based on data fromMorgan Stanley, at least 142stocksintheS&P500couldpassthattestasofearly2003,including Dana Corp.,ElectronicDataSystems,SunMicrosystems, andWashington Mutual. SoGraham’s “blended

multiplier” still works as aninitial screen to identifyreasonably-pricedstocks.

DueDiligence

No matter how defensive aninvestor you are—inGraham’ssenseofwishingtominimize the work you putintopickingstocks—therearea couple of steps you cannotaffordtoskip:

Do your homework.Through the EDGARdatabase at www.sec. gov,you get instant access to acompany’s annual andquarterly reports, along withthe proxy statement thatdiscloses the managers’compensation, ownership,and potential conflicts ofinterest. Read at least fiveyears’worth.4

Check out the

neighborhood.Websites likehttp://quicktake.morningstar.com,http://finance.yahoo.com andwww.quicken.com canreadily tell you whatpercentage of a company’sshares are owned byinstitutions. Anything over60% suggests that a stock isscarcely undiscovered andprobably “overowned.”(When big institutions sell,theytendtomoveinlockstep,

withdisastrousresultsforthestock. Imagine all the RadioCity Rockettes toppling offthe front edgeof the stageatonce and you get the idea.)Those websites will also tellyouwhothelargestownersofthe stock are. If they aremoney-management firmsthatinvestinastylesimilartoyourown,that’sagoodsign.

Chapter15StockSelectionfortheEnterprisingInvestor

In the previous chapter wehave dealt with common-

stock selection in terms ofbroad groups of eligiblesecurities, from which thedefensive investor is free tomakeupanylistthatheorhisadviser prefers, providedadequate diversification isachieved. Our emphasis inselection has been chiefly onexclusions—advising on theonehandagainstallissuesofrecognizably poor quality,and on the other against thehighest-quality issues if their

price is sohighas to involvea considerable speculativerisk. In this chapter,addressed to the enterprisinginvestor, we must considerthe possibilities and themeans of making individualselectionswhichare likely toprovemoreprofitablethananacross-the-boardaverage.

What are the prospects ofdoing this successfully? Wewould be less than frank, as

the euphemism goes, if wedid not at the outset expresssome grave reservations onthis score. At first blush thecase for successful selectionappears self-evident. To getaverage results—e.g.,equivalenttotheperformanceof the DJIA—should requirenospecialabilityofanykind.All that is needed is aportfolio identical with, orsimilar to, those thirtyprominent issues. Surely,

then, by the exercise of evena moderate degree of skill—derived from study,experience,andnativeability—it should be possible toobtain substantially betterresultsthantheDJIA.

Yet there is considerableand impressive evidence tothe effect that this is veryhard to do, even though thequalifications of those tryingit are of the highest. The

evidence lies in therecordofthe numerous investmentcompanies,or“funds,”whichhave been in operation formany years. Most of thesefunds are large enough tocommand the services of thebest financial or securityanalysts in the field, togetherwithalltheotherconstituentsof an adequate researchdepartment. Their expensesof operation, when spreadover their ample capital,

averageaboutone-halfof1%ayear thereon,or less.Thesecosts are not negligible inthemselves; but when theyare compared with theapproximately 15% annualoverall return on commonstocksgenerallyinthedecade1951–1960,andeven the6%return in1961–1970, theydonot bulk large. A smallamount of superior selectiveability should easily haveovercome that expense

handicap and brought in asuperior net result for thefundshareholders.

Taken as a whole,however, the all-common-stockfundsfailedoveralongspanofyearstoearnquiteasgood a return as was shownon Standard & Poor’s 500-stock averages or themarketas a whole. This conclusionhas been substantiated byseveral comprehensive

studies. To quote the latestone before us, covering theperiod1960–1968:*

It appears from theseresults that randomportfolios of New YorkStock Exchange stockswithequalinvestmentineachstockperformedonthe average better overthe period than didmutualfundsinthesamerisk class. The

differences were fairlysubstantial for the low-and medium-riskportfolios (3.7% and2.5% respectively perannum), but quite smallfor the high-riskportfolios(0.2% perannum).1

As we pointed out inChapter 9, these comparativefigures in no way invalidatethe usefulness of the

investment funds as afinancial institution. For theydo make available to allmembers of the investingpublic the possibility ofobtaining approximatelyaverage results on theircommon-stock commitments.Foravarietyofreasons,mostmembers of the public whoput their money in commonstocksoftheirownchoicefailto do nearly as well. But tothe objective observer the

failure of the funds to betterthe performance of a broadaverageisaprettyconclusiveindication that such anachievement,insteadofbeingeasy, is in fact extremelydifficult.

Whyshouldthisbeso?Wecan think of two differentexplanations, each of whichmay be partially applicable.Thefirstisthepossibilitythatthe stockmarketdoes in fact

reflect in the current pricesnot only all the importantfacts about the companies’pastandcurrentperformance,but also whateverexpectations can bereasonablyformedas to theirfuture. If this is so, then thediverse market movementswhich subsequently takeplace—and these are oftenextreme—must be the resultof new developments andprobabilitiesthatcouldnotbe

reliably foreseen.Thiswouldmake the price movementsessentially fortuitous andrandom.Totheextentthattheforegoingistrue,theworkofthe security analyst—however intelligent andthorough—must be largelyineffective, because inessenceheistryingtopredicttheunpredictable.

The very multiplication ofthe number of security

analystsmay have played animportant part in bringingabout this result. Withhundreds, even thousands, ofexperts studying the valuefactors behind an importantcommon stock, it would benatural to expect that itscurrent price would reflectpretty well the consensus ofinformedopiniononitsvalue.Thosewhowouldprefer it toother issues would do so forreasons of personal partiality

oroptimismthatcouldjustaswellbewrongasright.

We have often thought oftheanalogybetweentheworkof the host of securityanalysts on Wall Street andthe performance of masterbridgeplayersat aduplicate-bridge tournament. Theformer try to pick the stocks“most likely to succeed”; thelattertogettopscoreforeachhand played. Only a limited

few can accomplish eitheraim.Totheextentthatallthebridgeplayershaveaboutthesame level of expertness, thewinners are likely to bedetermined by “breaks” ofvarious sorts rather thansuperiorskill.OnWallStreetthelevelingprocessishelpedalongbythefreemasonrythatexistsintheprofession,underwhich ideas and discoveriesare quite freely shared at thenumerous get-togethers of

various sorts. It is almost asif, at the analogous bridgetournament, the variousexperts were looking overeach other’s shoulders andarguing out each hand as itwasplayed.

Thesecondpossibilityisofaquitedifferentsort.Perhapsmanyof thesecurityanalystsarehandicappedbya flaw intheir basic approach to theproblem of stock selection.

Theyseektheindustrieswiththe best prospects of growth,and the companies in theseindustries with the bestmanagement and otheradvantages. The implicationisthattheywillbuyintosuchindustries and suchcompanies at any price,however high, and they willavoid less promisingindustries and companies nomatter how low the price oftheir shares. This would be

the only correct procedure ifthe earnings of the goodcompaniesweresuretogrowat a rapid rate indefinitely inthe future, for then in theorytheir valuewouldbe infinite.And if the less promisingcompanies were headed forextinction, with no salvage,theanalystswouldberighttoconsider them unattractive atanyprice.

The truth about our

corporate ventures is quiteotherwise. Extremely fewcompanies have been able toshow a high rate ofuninterruptedgrowthforlongperiods of time. Remarkablyfew, also, of the largercompanies suffer ultimateextinction. For most, theirhistory isoneofvicissitudes,of ups and downs, of changein their relative standing. Insome the variations “fromragstorichesandback”have

been repeated on almost acyclical basis—the phraseused to be a standard oneappliedtothesteelindustry—forothersspectacularchangeshave been identified withdeterioration or improvementofmanagement.*

How does the foregoinginquiry apply to theenterprising investor whowouldliketomakeindividualselections that will yield

superior results? It suggestsfirstofallthatheistakingona difficult and perhapsimpracticable assignment.Readers of this book,however intelligent andknowing, could scarcelyexpect to do a better job ofportfolio selection than thetop analysts of the country.But if it is true that a fairlylarge segment of the stockmarket is often discriminatedagainst or entirely neglected

in the standard analyticalselections,thentheintelligentinvestormaybe inapositionto profit from the resultantundervaluations.

But to do so he mustfollow specific methods thatarenotgenerallyacceptedonWall Street, since those thatare so accepted do not seemto produce the resultseveryone would like toachieve. It would be rather

strangeif—withallthebrainsat work professionally in thestockmarket—therecouldbeapproaches which are bothsound and relativelyunpopular. Yet our owncareer and reputation havebeen based on this unlikelyfact.*

ASummaryoftheGraham-NewmanMethods

Togiveconcretenesstothe

last statement, it should beworthwhile to give a briefaccount of the types ofoperations we engaged induring the thirty-year life ofGraham-NewmanCorporation, between 1926and 1956.† These wereclassified in our records asfollows:

Arbitrages: The purchaseof a security and thesimultaneous sale of one or

more other securities intowhichitwastobeexchangedunder a plan ofreorganization,merger,orthelike.

Liquidations: Purchase ofshareswhichwere to receiveoneormorecashpaymentsinliquidation of the company’sassets.

Operations of these twoclasses were selected on the

twinbasisof (a) a calculatedannual return of 20% ormore, and (b) our judgmentthat the chance of asuccessful outcome was atleastfouroutoffive.

Related Hedges: Thepurchaseofconvertiblebondsor convertible preferredshares, and the simultaneoussaleofthecommonstockintowhich they wereexchangeable. The position

was established at close to aparity basis—i.e., at a smallmaximum loss if the seniorissue had actually to beconverted and the operationclosedout in thatway.Butaprofit would be made if thecommon stock fellconsiderably more than thesenior issue, and thepositionclosedoutinthemarket.

Net-Current-Asset (or“Bargain”) Issues: The idea

here was to acquire asmanyissuesaspossibleatacostforeach of less than their bookvalueintermsofnet-current-assets alone—i.e., giving novaluetotheplantaccountandother assets. Our purchaseswere made typically at two-thirdsorlessofsuchstripped-down asset value. In mostyears we carried a widediversification here—at least100differentissues.

We should add that fromtime to time we had somelarge-scaleacquisitionsofthecontroltype,butthesearenotrelevant to the presentdiscussion.

Wekept close trackof theresultsshownbyeachclassofoperation. In consequence ofthese follow-ups wediscontinued two broaderfields,whichwere found notto have shown satisfactory

overall results. The first wasthe purchase of apparentlyattractive issues—based onour general analysis—whichwere not obtainable at lessthan their working-capitalvaluealone.Thesecondwere“unrelated” hedgingoperations, in which thepurchased security was notexchangeableforthecommonshares sold. (Such operationscorrespond roughly to thoserecently embarked on by the

new group of “hedge funds”in the investment-companyfield.* In both cases a studyof the results realized by usover a period of ten years ormore led us to conclude thatthe profits were notsufficiently dependable—andtheoperationsnotsufficiently“headache proof”—to justifyourcontinuingthem.

Hence from 1939 on ouroperations were limited to

“selfliquidating” situations,related hedges, working-capital bargains, and a fewcontrol operations. Each ofthese classes gave us quiteconsistently satisfactoryresultsfromthenon,withthespecialfeaturethattherelatedhedgesturnedingoodprofitsinthebearmarketswhenour“undervalued issues” werenotdoingsowell.

We hesitate to prescribe

our own diet for any largenumber of intelligentinvestors. Obviously, theprofessional techniques wehavefollowedarenotsuitablefor the defensive investor,who by definition is anamateur. As for theaggressive investor, perhapsonlyasmallminorityofthemwould have the type oftemperament needed to limitthemselves so severely toonlyarelativelysmallpartof

theworld of securities.Mostactive-minded practitionerswould prefer to venture intowider channels.Theirnaturalhuntinggroundswouldbetheentire field of securities thatthey felt (a) were certainlynot overvalued byconservative measures, and(b) appeared decidedly moreattractive—because of theirprospects or past record, orboth—than the averagecommon stock. In such

choicestheywoulddowelltoapply various tests of qualityand price-reasonablenessalong the lines we haveproposed for the defensiveinvestor. But they should beless inflexible, permitting aconsiderable plus in onefactor to offset a small blackmark in another. Forexample, he might not ruleout a company which hadshownadeficitinayearsuchas 1970, if large average

earnings and other importantattributesmadethestocklookcheap. The enterprisinginvestor may confine hischoice to industries andcompanies about which heholds anoptimistic view, butwe counsel strongly againstpaying a high price for astock (in relation to earningsand assets) because of suchenthusiasm. If he followedourphilosophyinthisfieldhewould more likely be the

buyer of important cyclicalenterprises—such as steelshares perhaps—when thecurrent situation isunfavorable, the near-termprospects are poor, and thelow price fully reflects thecurrentpessimism.*

SecondaryCompanies

Next in order forexamination and possibleselection would come

secondarycompanies thataremakingagoodshowing,haveasatisfactorypastrecord,butappear to hold no charm forthe public. These would beenterprises on the order ofELTRA and Emhart at their1970 closing prices. (SeeChapter13above.)Therearevarious ways of going aboutlocating suchcompanies.Weshould like to try a novelapproach here and give areasonably detailed

exposition of one suchexercise in stock selection.Ours is a double purpose.Manyofourreadersmayfinda substantial practical valuein the method we shallfollow, or it may suggestcomparable methods to tryout. Beyond that what weshall do may help them tocome to grips with the realworldofcommonstocks,andintroduce them to one of themostfascinatingandvaluable

little volumes in existence. Itis Standard & Poor’s StockGuide, published monthly,and made available to thegeneral public under annualsubscription. In additionmany brokerage firmsdistribute the Guide to theirclients(onrequest.)

ThegreatbulkoftheGuideis given over to about 230pagesofcondensedstatisticalinformation on the stocks of

more than 4,500 companies.These include all the issueslisted on the variousexchanges, say 3,000, plussome 1,500 unlisted issues.Mostof the itemsneeded forafirstandevenasecondlookatagivencompanyappearinthis compendium. (From ourviewpoint the importantmissing datum is the net-asset-value, or book value,pershare,whichcanbefoundin the larger Standard &

Poor’s volumes andelsewhere.)

The investor who likes toplay around with corporatefigures will find himself inclover with the StockGuide.Hecanopentoanypageandsee before his eyes acondensed panorama of thesplendorsandmiseriesof thestock market, with all-timehighand lowpricesgoingasfar back as 1936, when

available. He will findcompanies that havemultiplied their price 2,000timesfromtheminusculelowto the majestic high. (Forprestigious IBM the growthwas “only” 333 times in thatperiod.) He will find (not soexceptionally) a companywhose shares advanced from3/8 to 68, and then fell backto 3.2 In the dividend recordcolumn hewill find one that

goes back to 1791—paid byIndustrial National Bank ofRhodeIsland(whichrecentlysaw fit to change its ancientcorporatename).* Ifhe looksat theGuide for theyear-end1969 he will read that PennCentral Co. (as successor toPennsylvania Railroad) hasbeen paying dividendssteadily since 1848; alas!, itwas doomed to bankruptcy afewmonthslater.Hewillfind

a company selling at only 2times its last reportedearnings, and another sellingat99timessuchearnings.3Inmost cases he will find itdifficult to tell the line ofbusiness from the corporatename;foroneU.S.Steeltherewill be three called suchthings as ITI Corp. (bakerystuff) or Santa Fe Industries(mainly the large railroad).He can feast on an

extraordinaryvarietyofpricehistories, dividend andearnings histories, financialpositions, capitalizationsetups, and what not.Backward-leaningconservatism, run-of-the-mine featureless companies,the most peculiarcombinations of “principalbusiness,” all kinds of WallStreet gadgets andwidgets—they are all there, waiting tobe browsed over, or studied

withaseriousobjective.

The Guides give inseparate columns the currentdividend yields andprice/earnings ratios, basedon latest 12-month figures,whereverapplicable.Itisthislast item that puts us on thetrack of our exercise incommon-stockselection.

AWinnowingoftheStockGuide

Suppose we look for asimpleprima facie indicationthatastockischeap.Thefirstsuchcluethatcomestomindis a low price in relation torecentearnings.Let’smakeapreliminarylistofstocksthatsold at a multiple of nine orless at the end of 1970.Thatdatum is convenientlyprovidedinthelastcolumnofthe even-numbered pages.Foran illustrative sampleweshall take the first 20 such

low-multiplier stocks; theybegin with the sixth issuelisted, Aberdeen Mfg. Co.,whichclosedtheyearat10¼,or 9 times its reportedearnings of $1.25 per sharefor the 12 months endedSeptember 1970. Thetwentieth such issue isAmerican Maize Products,whichclosedat9½,alsowithamultiplierof9.

The group may have

seemed mediocre, with 10issues selling below $10 pershare. (This fact is not trulyimportant; it would probably—not necessarily—warndefensive investors againstsuch a list, but the inferencefor enterprising investorsmight be favorable onbalance.)* Before making afurther scrutiny let uscalculate some numbers.Ourlist represents about one in

ten of the first 200 issueslooked at. On that basis theGuide should yield, say, 450issues selling at multipliersunder10.Thiswouldmakeagoodly number of candidatesforfurtherselectivity.

So let us apply to our listsome additional criteria,rather similar to those wesuggested for the defensiveinvestor, but not so severe.Wesuggestthefollowing:

1. Financial condition: (a)Current assets at least1½ times currentliabilities, and (b) debtnot more than 110% ofnet current assets (forindustrialcompanies).

2. Earnings stability: Nodeficit in the last fiveyears covered in theStockGuide.

3. Dividend record: Some

currentdividend.4. Earnings growth: Last

year’s earnings morethanthoseof1966.

5. Price: Less than 120%nettangibleassets.

TheearningsfiguresintheGuide were generally forthose ending September 30,1970,andthusdonotincludewhatmaybeabadquarteratthe end of that year. But anintelligent investor can’t ask

for themoon—at leastnot tostart with. Note also that wesetnolower limitonthesizeof the enterprise. Smallcompanies may affordenough safety if boughtcarefully and on a groupbasis.

Whenwehaveapplied thefiveadditionalcriteriaourlistof20candidatesisreducedtoonlyfive.Letuscontinueoursearch until the first 450

issues in the Guide haveyielded us a little “portfolio”of 15 stocksmeeting our sixrequirements. (They are setforth inTable 15–1, togetherwithsomerelevantdata.)Thegroup,ofcourse,ispresentedfor illustration only, andwould not necessarily havebeenchosenbyour inquiringinvestor.

The fact is that theuserofourmethodwouldhavehada

much wider choice. If ourwinnowing approach hadbeen applied to all 4,500companies in the StockGuide,andiftheratioforthefirst tenth had held goodthroughout,wewouldendupwith about 150 companiesmeetingallsixofourcriteriaof selection.Theenterprisinginvestorwouldthenbeabletofollow his judgment—or hispartialitiesandprejudices—inmaking a third selection of,

say, one out of five in thisamplelist.

The Stock Guide materialincludes “Earnings andDividend Rankings,” whichare based on stability andgrowthofthesefactorsforthepast eight years. (Thus priceattractiveness does not enterhere.)We include the S&Prankings in our Table 15-1.Ten of the 15 issues areranked B+ (= average) and

one (American Maize) isgiven the “high” ratingofA.If our enterprising investorwanted to add a seventhmechanical criterion to hischoice, by considering onlyissues ranked by Standard&Poor’sasaverageorbetterinquality, he might still haveabout 100 such issues tochoose from. One might saythat a group of issues, of atleastaveragequality,meetingcriteria of financial condition

aswell, purchasable at a lowmultiplierof current earningsandbelowassetvalue,shouldoffer good promise ofsatisfactory investmentresults.

TABLE 15-1 A SamplePortfolio of Low-MultiplierIndustrial

SingleCriteriaforChoosingCommonStocks

An inquiring reader mightwell ask whether the choiceof a better than averageportfolio could be made asimpler affair than we havejust outlined. Could a singleplausible criterion be used togood advantage—such as alow price/earnings ratio, or ahigh dividend return, or a

large asset value? The twomethods of this sort that wehave found to give quiteconsistently good results inthe longerpasthavebeen (a)the purchase of low-multiplierstocksofimportantcompanies (suchas theDJIAlist), and (b) the choice of adiversified group of stocksselling under their net-current-asset value (orworking-capital value). Wehavealreadypointedout that

the low-multiplier criterionappliedtotheDJIAattheendof 1968 worked out badlywhentheresultsaremeasuredto mid-1971. The record ofcommon-stock purchasesmade at a price below theirworking-capital value has nosuchbadmarkagainst it; thedrawback here has been thedrying up of suchopportunities during most ofthepastdecade.

What about other bases ofchoice? In writing this bookwe have made a series of“experiments,”eachbasedona single, fairly obviouscriterion. The data usedwouldbereadilyfoundintheStandard & Poor’s StockGuide.Inallcasesa30-stockportfolio was assumed tohave been acquired at the1968 closing prices and thenrevalued at June 30, 1971.The separate criteria applied

werethefollowing,asappliedtootherwise randomchoices:(1)Alowmultiplierofrecentearnings (not confined toDJIA issues). (2) A highdividend return. (3) A verylong dividend record. (4) Avery large enterprise, asmeasured by number ofoutstanding shares. (5) Astrong financial position. (6)A low price in dollars pershare. (7) A low price inrelation to the previous high

price. (8) A high quality-ranking by Standard &Poor’s.

It will be noted that theStockGuide has at least onecolumnrelatingtoeachoftheabove criteria. This indicatesthe publisher’s belief thateach is of importance inanalyzing and choosingcommon stocks. (As wepointedoutabove,weshouldlike to see another figure

added:thenet-asset-valuepershare.)

The most important factthatemergesfromourvarioustests relates to theperformanceofstocksboughtat random. We have testedthisperformanceforthree30-stock portfolios, each madeupofissuesfoundonthefirstline of the December 31,1968, Stock Guide and alsofoundintheissueforAugust

31, 1971.Between these twodates the S & P compositewas practically unchanged,and theDJIA lost about 5%.But our 90 randomly chosenissuesdeclinedanaverageof22%, not counting 19 issuesthat were dropped from theGuide and probably showedlarger losses. Thesecomparative resultsundoubtedly reflect thetendencyof smaller issuesofinferior quality to be

relatively overvalued in bullmarkets, and not only tosuffer more serious declinesthanthestrongerissuesintheensuing price collapse, butalso to delay their fullrecovery—in many casesindefinitely. The moral forthe intelligent investor is, ofcourse, to avoid second-qualityissuesinmakingupaportfolio, unless—for theenterprising investor—theyaredemonstrablebargains.

Other results gleaned fromour portfolio studies may besummarizedasfollows:

Only three of the groupsstudiedshowedupbetterthanthe S & P composite (andhence better than the DJIA),viz: (1) Industrials with thehighest quality ranking (A+).These advanced 9½% in theperiod against a decline of2.4% for the S & Pindustrials, and 5.6% for the

DJIA. (However, the tenpublic-utility issues ratedA+declined 18% against adecline of 14% for the 55-stock S & P public-utilityindex.) It isworth remarkingthat the S & P rankingsshowed up very well in thissingle test. In every case aportfolio based on a higherranking did better than alower-ranking portfolio. (2)Companieswithmorethan50million shares outstanding

showed no change on thewhole, as against a smalldecline for the indexes. (3)Strangely enough, stocksselling at a high price pershare (over 100) showed aslight (1%) compositeadvance.

Among our various testswemade one based on bookvalue, a figure not given inthe Stock Guide. Here wefound—contrary to our

investment philosophy—thatcompanies that combinedmajorsizewithalargegood-will component in theirmarketpricedidverywellasa whole in the 2½-yearholding period. (By “good-willcomponent”wemeanthepartof theprice thatexceedsthe book value.)* Our list of“good-will giants”wasmadeupof30issues,eachofwhichhadagood-willcomponentof

over a billion dollars,representing more than halfof itsmarket price. The totalmarket value of these good-will itemsat theendof1968wasmore than$120billions!Despite these optimisticmarket valuations the groupas a whole showed a priceadvance per share of 15%betweenDecember 1968 andAugust 1971, and acquitteditself best among the 20-oddlistsstudied.

Afactlikethismustnotbeignored in a work oninvestmentpolicies.Itisclearthat, at the least, aconsiderable momentum isattached to those companiesthat combine the virtues ofgreat size, an excellent pastrecord of earnings, thepublic’s expectation ofcontinued earnings growth inthe future, and strongmarketaction overmany past years.Even if thepricemayappear

excessive by our quantitativestandards the underlyingmarket momentum may wellcarry such issues alongmoreorlessindefinitely.(Naturallythis assumption does notapply to every individualissue in the category. Forexample, the indisputablegood-will leader, IBM,moveddownfrom315to304in the30-monthperiod.) It isdifficult to judge to whatextent the superior market

actionshownisdueto“true”or objective investmentmerits and to what extent tolong-established popularity.No doubt both factors areimportant here. Clearly, boththe long-term and the recentmarket action of the good-willgiantswouldrecommendthem for a diversifiedportfolio of common stocks.Our own preference,however, remains for othertypes that show a

combination of favorableinvestment factors, includingasset values of at least two-thirdsthemarketprice.

The tests using othercriteria indicate in generalthat random lists based on asingle favorable factor didbetter than random listschosenfortheoppositefactor—e.g., low-multiplier issueshad a smaller decline in thisperiod than high-multiplier

issues, and long-termdividendpayerslostlessthanthose that were not payingdividendsat theendof1968.To that extent the resultssupport our recommendationthattheissuesselectedmeetacombination of quantitativeortangiblecriteria.

Finally we shouldcommentonthemuchpoorershowingmadebyour listsasawholeascomparedwiththe

price record of the S & Pcomposite. The latter isweighted by the size of eachenterprise, whereas our testsarebasedontakingoneshareof each company. Evidentlythe larger emphasis given togiantenterprisesbytheS&Pmethod made a significantdifference in the results, andpoints up once again theirgreater price stability ascompared with “run-of-the-mine”companies.

BargainIssues,orNet-Current-AssetStocks

Inthetestsdiscussedabovewedidnotincludetheresultsofbuying30issuesatapriceless than their net-current-asset value. The reason wasthat only a handful, at most,of such issues would havebeenfoundintheStockGuideat the end of 1968. But thepicture changed in the 1970decline,andatthelowprices

of thatyearagoodlynumberofcommonstockscouldhavebeen bought at below theirworking-capital value. Italways seemed, and stillseems, ridiculously simple tosay that if one can acquire adiversified group of commonstocksatapricelessthantheapplicable net current assetsalone—after deducting allprior claims, and counting aszerothefixedandotherassets—the results should be quite

satisfactory.Theywereso,inourexperience,formorethan30years—say,between1923and 1957—excluding a timeofrealtrialin1930–1932.

Has this approach anyrelevanceat thebeginningof1971?Ouranswerwouldbeaqualified “yes.” A quickrunover of the Stock Guidewould have uncovered some50 or more issues thatappeared to be obtainable at

or below net-current-assetvalue.Asmightbeexpectedagoodmanyofthesehadbeendoing badly in the difficultyear 1970. If we eliminatedthosewhich had reported netlosses in the last 12-monthperiod we would be still leftwith enough issues to makeupadiversifiedlist.

WehaveincludedinTable15-2somedataonfiveissuesthat sold at less than their

working-capital value* attheir low prices of 1970.These give some food forreflection on the nature ofstock-price fluctuations.Howdoes itcomeabout thatwell-establishedcompanies,whosebrands are household namesalloverthecountry,couldbevalued at such low figures—at the same time when otherconcerns(withbetterearningsgrowth of course) were

selling for billions of dollarsin excess of what theirbalance sheets showed? Toquote the “old days” oncemore,theideaofgoodwillasan element of intangiblevalue was usually associatedwith a “trade name.” Namessuch as Lady Pepperell insheets,Jantzeninswimsuits,and Parker in penswould beconsidered assets of greatvalue indeed.Butnow, if the“market doesn’t like a

company,” not onlyrenowned trade names butland, buildings, machinery,and what you will, can allcountfornothinginitsscales.Pascalsaidthat“thehearthasits reasons that the reasondoesn’t understand.”* For“heart”read“WallStreet.”

TABLE 15-2 Stocks ofProminent CompaniesSelling at or Below Net-Current-Asset Value in

1970

There is another contrastthatcomestomind.Whenthegoingisgoodandnewissuesare readily salable, stock

offerings of no quality at allmake their appearance. Theyquickly find buyers; theirprices are often bid upenthusiastically right afterissuance to levels in relationto assets and earnings thatwould put IBM, Xerox, andPolaroid to shame. WallStreet takes this madness inits stride, with no overtefforts by anyone to call ahalt before the inevitablecollapse in prices. (The SEC

can’t do much more thaninsist on disclosure ofinformation, aboutwhich thespeculative public couldn’tcare less, or announceinvestigations and usuallymild punitive actions ofvarioussortsaftertheletterofthe law has been clearlybroken.)Whenmanyoftheseminusculebutgrosslyinflatedenterprises disappear fromview, or nearly so, it is alltaken philosophically enough

as “part of the game.”Everybody swears off suchinexcusable extravagances—untilnexttime.

Thanksforthelecture,saysthe gentle reader. But whatabout your “bargain issues”?Can one really make moneyin them without taking aserious risk? Yes indeed, ifyoucan findenoughof themto make a diversified group,andifyoudon’tlosepatience

if they fail to advance soonafter you buy them.Sometimes the patienceneeded may appear quiteconsiderable. In our previousedition we hazarded a singleexample (p. 188) which wascurrent as we wrote. It wasBurton-Dixie Corp., withstock selling at 20, againstnet-current-asset value of 30,and book value of about 50.A profit on that purchasewould not have been

immediate. But in August1967 all the shareholderswere offered 53 3/4 for theirshares,probablyat justaboutbookvalue.Apatientholder,whohadboughtthesharesinMarch1964at20wouldhavehad a profit of 165% in 3½years—a noncompoundedannual return of 47%. Mostof the bargain issues in ourexperience have not takenthat long to show goodprofits–nor have they shown

so high a rate. For asomewhat similar situation,current as we write, see ourdiscussion ofNational PrestoIndustriesabove,p.168.

SpecialSituationsor“Workouts”

Letustouchbrieflyonthisarea, since it is theoreticallyincludable in the program ofoperations of an enterprisinginvestor. It was commentedupon above. Here we shall

supply someexamplesof thegenre, and some furtherremarksonwhatitappearstooffer an open-minded andalertinvestor.

Three such situations,among others, were currentearly in 1971, and they maybesummarizedasfollows:

SITUATION1.AcquisitionofKayser-Roth byBorden’s. InJanuary 1971 Borden Inc.

announced a plan to acquirecontrol of Kayser-Roth(“diversified apparel”) bygiving11/3sharesofitsownstock in exchange for oneshareofKayser-Roth.Onthefollowing day, in activetrading. Borden closed at 26andKayser-Roth at 28. If an“operator” had bought 300shares of Kayser-Roth andsold 400 Borden at theseprices and if the deal werelater consummated on the

announced terms, he wouldhave had a profit of some24%onthecostofhisshares,less commissions and someother items. Assuming thedeal had gone through in sixmonths,hisfinalprofitmighthavebeenatabouta40%perannumrate.

SITUATION 2. In November1970 National Biscuit Co.offered to buy control ofAuroraPlasticsCo.at$11 in

cash.Thestockwassellingatabout8½;itclosedthemonthat 9 and continued to sellthere at year-end. Here thegross profit indicated wasoriginallyabout25%,subjectto the risks ofnonconsummation and to thetimeelement.

SITUATION 3. Universal-Marion Co., which hadceased its businessoperations, asked its

shareholders to ratifydissolution of the concern.The treasurer indicated thatthecommonstockhadabookvalue of about $28½ pershare, a substantial part ofwhich was in liquid form.The stock closed 1970 at21½, indicating a possiblegross profit here, if bookvalue was realized inliquidation, of more than30%.

If operations of this kind,conducted on a diversifiedbasis for spreading the risk,could be counted to yieldannualprofitsof,say,20%orbetter, they wouldundoubtedly be more thanmerelyworthwhile.Sincethisis not a book on “specialsituations,”we are not goingintothedetailsofthebusiness—for it really is a business.Let us point out twocontradictory developments

there in recent years. On theonehandthenumberofdealstochoose fromhas increasedenormously, as comparedwith,say,tenyearsago.Thisis a consequence of whatmight be called a mania ofcorporationstodiversifytheiractivities through varioustypes of acquisitions, etc. In1970 the number of “mergerannouncements” aggregatedsome5,000, down fromover6,000 in 1969. The total

money values involved inthese deals amounted tomany,manybillions.Perhapsonly a small fraction of the5,000 announcements couldhave presented a clear-cutopportunity for purchase ofshares by a special-situationsman, but this fraction wasstilllargeenoughtokeephimbusy studying, picking, andchoosing.

The other side of the

picture is that an increasingproportion of the mergersannounced failed to beconsummated. In such cases,ofcourse,theaimed-forprofitisnotrealized,andislikelytobereplacedbyamoreorlessserious loss. Reasons fornonsuccess are numerous,including antitrustintervention, shareholderopposition,changein“marketconditions,” unfavorableindications from further

study, inability to agree ondetails, and others. The trickhere,ofcourse,istohavethejudgment, buttressed byexperience, to pick the dealsmost likely to succeed andalsothosewhicharelikelytooccasion the smallest loss iftheyfail.*

Further Comment on the ExamplesAbove

KAYSER-ROTH.Thedirectors

of this company had alreadyrejected(inJanuary1971)theBorden proposal when thischapter was written. If theoperation had been “undone”immediately the overall loss,including commissions,would have been about 12%ofthecostoftheKayser-Rothshares.

AURORA PLASTICS. Becauseof the bad showing of thiscompany in 1970 the

takeover terms wererenegotiated and the pricereduced to 10½. The shareswere paid for at the end ofMay. The annual rate ofreturnrealizedherewasabout25%.

UNIVERSAL-MARION. Thiscompany promptly made aninitialdistributionincashandstock worth about $7 pershare, reducing theinvestment to say 14½.

Howeverthemarketpricefellas low as 13 subsequently,castingdoubton theultimateoutcomeoftheliquidation.

Assuming that the threeexamples given are fairlyrepresentativeof“workoutorarbitrage” opportunities as awholein1971,itisclearthatthey are not attractive ifentered into upon a randombasis. This has becomemorethan ever a field for

professionals, with therequisite experience andjudgment.

There is an interestingsidelight on ourKayser-Rothexample. Late in 1971 theprice fell below 20 whileBorden was selling at 25,equivalent to 33 for Kayser-Roth under the terms of theexchange offer. It wouldappear that either thedirectors had made a great

mistake in turning down thatopportunity or the shares ofKayser-Rothwerenowbadlyundervalued in the market.Something for a securityanalysttolookinto.


It is easy in the world to liveafter the world’s opinion; it iseasy in solitude to live after ourown;butthegreatmanishewhoin themidst of the crowd keepswith perfect sweetness theindependenceofsolitude.

—RalphWaldoEmerson

Practice,Practice,Practice

Max Heine, founder of theMutualSeriesFunds,likedtosay that “there are manyroads to Jerusalem.” Whatthis masterly stock pickermeant was that his ownvalue-centered method ofselecting stocks was not theonly way to be a successfulinvestor.Inthischapterwe’lllook at several techniquesthat some of today’s leading

money managers use forpickingstocks.

First, though, it’s worthrepeating that for mostinvestors,selectingindividualstocks is unnecessary—if notinadvisable. The fact thatmost professionals do a poorjobofstockpickingdoesnotmean thatmostamateurscando better. The vast majorityof people who try to pickstocks learn that they arenot

asgoodat itas they thought;theluckiestonesdiscoverthisearly on, while the lessfortunate take years to learnit. A small percentage ofinvestorscanexcelatpickingtheir own stocks. Everyoneelse would be better offgetting help, ideally throughanindexfund.

Graham advised investorsto practice first, just as eventhe greatest athletes and

musicians practice andrehearse before every actualperformance. He suggestedstarting off by spending ayear tracking and pickingstocks (but not with realmoney). 1 In Graham’s day,you would have practicedusingaledgerofhypotheticalbuysandsellsonalegalpad;nowadays, you can use“portfolio trackers” atwebsites like

www.morningstar.com,http://finance.yahoo.com,http://money.cnn.com/services/portfolio/ orwww.marketocracy.com (atthe last site, ignore the“market-beating” hype on itsfundsandotherservices).

By test-driving yourtechniquesbeforetryingthemwith real money, you canmake mistakes withoutincurring any actual losses,

develop the discipline toavoid frequent trading,compare your approachagainst those of leadingmoney managers, and learnwhat works for you. Best ofall, tracking the outcome ofall your stock picks willprevent you from forgettingthat some of your hunchesturn out to be stinkers. Thatwill force you to learn fromyourwinnersandyourlosers.After a year, measure your

results against how youwould have done if you hadputallyourmoneyinanS&P 500 index fund. If youdidn’t enjoy the experimentor your picks were poor, noharm done—selectingindividual stocks is not foryou. Get yourself an indexfund and stop wasting yourtimeonstockpicking.

If you enjoyed theexperiment and earned

sufficiently good returns,gradually assemble a basketof stocks—but limit it to amaximum of 10% of youroverall portfolio (keep therest in an index fund). Andremember, you can alwaysstop if it no longer interestsyouoryourreturnsturnbad.

LookingUndertheRightRocks

Sohow should yougo about

looking for a potentiallyrewardingstock?Youcanusewebsites likehttp://finance.yahoo.com andwww.morningstar.com toscreen stocks with thestatistical filters suggested inChapter14.Oryoucantakeamore patient, craftsmanlikeapproach. Unlike mostpeople, many of the bestprofessionalinvestorsfirstgetinterestedinacompanywhenitssharepricegoesdown,not

up. Christopher Browne ofTweedy Browne GlobalValueFund,WilliamNygrenoftheOakmarkFund,RobertRodriguez of FPA CapitalFund, and Robert Torray ofthe Torray Fund all suggestlooking at the daily list ofnew 52-week lows in theWall Street Journal or thesimilar table in the “MarketWeek” section of Barron’s.That will point you towardstocks and industries that are

unfashionableorunlovedandthat thus offer the potentialfor high returns onceperceptionschange.

Christopher Davis of theDavis Funds and WilliamMiller of LeggMasonValueTrustliketoseerisingreturnson invested capital, or ROIC—a way of measuring howefficiently a companygenerates what WarrenBuffett has called “owner

earnings.”2 (See the sidebaronp.398formoredetail.)

FROMEPSTOROIC

Net income or earningsper share (EPS) has beendistorted in recent yearsby factors like stock-option grants andaccounting gains andcharges.Toseehowmuchacompanyistrulyearningonthecapitalitdeploysinits businesses, lookbeyond EPS to ROIC, orreturn on invested capital.Christopher Davis of the

Davis Funds defines itwiththisformula:

ROIC=OwnerEarningsInvestedCapital,

whereOwnerEarningsisequalto:

Operatingprofit

plusdepreciation

plus amortization ofgoodwill

minus Federal income tax(paid at the company’saveragerate)

minus cost of stockoptions

minus “maintenance” (oressential) capitalexpenditures

minus any incomegenerated byunsustainable rates ofreturn on pension funds(as of 2003, anythinggreaterthan6.5%)

andwhereInvestedCapitalisequalto:

Totalassets

minus cash (as well asshort-term investmentsand non-interest-bearing

currentliabilities)

plus past accountingcharges that reducedinvestedcapital.

ROIC has the virtue ofshowing, after alllegitimate expenses, whatthe company earns fromits operating businesses—and how efficiently it hasused the shareholders’money to generate thatreturn. An ROIC of atleast 10% is attractive;even 6% or 7% can betempting if the companyhas good brand names,

focusedmanagement,orisunderatemporarycloud.

By checking“comparables,” or the pricesat which similar businesseshave been acquired over theyears, managers likeOakmark’s Nygren andLongleaf Partners’O.MasonHawkins get a better handleon what a company’s partsare worth. For an individualinvestor, it’s painstaking and

difficult work: Start bylooking at the “BusinessSegments” footnote in thecompany’s annual report,which typically lists theindustrial sector, revenues,and earnings of eachsubsidiary. (The“ManagementDiscussionandAnalysis” may also behelpful.) Then search a newsdatabase like Factiva,ProQuest, or LexisNexis forexamplesofotherfirmsinthe

same industries that haverecentlybeenacquired.Usingthe EDGAR database atwww.sec.gov to locate theirpast annual reports, youmaybeabletodeterminetheratioof purchase price to theearnings of those acquiredcompanies. You can thenapply that ratio to estimatehow much a corporateacquirer might pay for asimilar division of thecompany you are

investigating.

By separately analyzingeach of the company’sdivisions this way, you maybe able to see whether theyare worth more than thecurrent stock price.Longleaf’s Hawkins likes tofind what he calls “60-centdollars,”orcompanieswhosestockistradingat60%orlessof the value at which heappraisesthebusinesses.That

helps provide the margin ofsafetythatGrahaminsistson.

Who’stheBoss?

Finally, most leadingprofessionalinvestorswanttosee that a company is runbypeople who, in the words ofOakmark’s William Nygren,“think like owners, not justmanagers.”Twosimpletests:Are the company’s financial

statements easilyunderstandable, or are theyfull of obfuscation? Are“nonrecurring” or“extraordinary” or “unusual”charges just that, or do theyhave a nasty habit ofrecurring?

Longleaf’s MasonHawkins looks for corporatemanagers who are “goodpartners”—meaning that theycommunicate candidly about

problems,haveclearplansforallocating current and futurecash flow, and own sizablestakesinthecompany’sstock(preferably through cashpurchasesratherthanthroughgrants of options). But “ifmanagementstalkmoreaboutthestockpricethanaboutthebusiness,” warns RobertTorray of the Torray Fund,“we’re not interested.”Christopher Davis of theDavisFundsfavorsfirmsthat

limit issuance of stockoptions to roughly 3% ofsharesoutstanding.

At Vanguard PrimecapFund, Howard Schow tracks“what the company said oneyear and what happened thenext.Wewanttoseenotonlywhether managements arehonest with shareholders butalso whether they’re honestwith themselves.” (If acompany boss insists that all

is hunky-dorywhen businessis sputtering, watch out!)Nowadays, you can listen inon a company’s regularlyscheduled conference callseven if you own only a fewshares; to find out theschedule, call the investorrelations department atcorporate headquarters orvisitthecompany’swebsite.

Robert Rodriguez of FPACapitalFundturnstotheback

pageofthecompany’sannualreport,wheretheheadsof itsoperatingdivisionsare listed.If there’s a lotof turnover inthosenamesinthefirstoneortwo years of a new CEO’sregime, that’s probably agood sign; he’s cleaning outthe dead wood. But if highturnover continues, theturnaround has probablydevolvedintoturmoil.

KeepingYourEyesontheRoad

ThereareevenmoreroadstoJerusalem than these. Someleading portfolio managers,like David Dreman ofDreman Value Managementand Martin Whitman of theThird Avenue Funds, focuson companies selling at verylow multiples of assets,earnings, or cash flow.Others,likeCharlesRoyceofthe Royce Funds and Joel

Tillinghast of Fidelity Low-Priced Stock Fund, hunt forundervalued smallcompanies. And, for an all-too-brief lookathowtoday’smost revered investor,Warren Buffett, selectscompanies,seethesidebaronp.401.

One technique that can behelpful: See which leadingprofessionalmoneymanagersown the same stocksyoudo.

If one or two names keepturningup,gotothewebsitesof those fund companies anddownload their most recentreports. By seeing whichother stocks these investorsown, you can learn moreabout what qualities theyhave in common; by readingthe managers’ commentary,youmayget ideasonhowtoimproveyourownapproach.3

WARREN’SWAY

Graham’sgreateststudent,Warren Buffett, hasbecome the world’s mostsuccessful investor byputting new twists onGraham’s ideas. Buffettand his partner, CharlesMunger, have combinedGraham’s “margin ofsafety” and detachmentfromthemarketwiththeirown innovative emphasison future growth. Here isan all-too-brief summaryofBuffett’sapproach:

Helooksforwhathecalls“franchise” companieswith strong consumer

brands, easilyunderstandablebusinesses,robust financial health,and near-monopolies intheirmarkets, likeH&RBlock, Gillette, and theWashington Post Co.Buffett likes to snap up astockwhen a scandal, bigloss, or other bad newspassesoveritlikeastormcloud—aswhenheboughtCoca-Cola soon after itsdisastrousrolloutof“NewCoke” and the marketcrash of 1987. He alsowants to see managerswhosetandmeet realisticgoals; build their

businesses from withinrather than throughacquisition; allocatecapitalwisely; anddonotpay themselves hundred-million-dollar jackpots ofstock options. Buffettinsists on steady andsustainable growth inearnings, so the companywill beworthmore in thefuturethanitistoday.

In his annual reports,archived atwww.berkshirehathaway.com, Buffett has set outhis thinking like an openbook. Probably no other

investor, Grahamincluded, has publiclyrevealed more about hisapproach or written suchcompellingly readableessays. (One classicBuffett proverb: “When amanagement with areputation for brilliancetackles a business with areputation for badeconomics, it is thereputation of the businessthat remains intact.”)Every intelligent investorcan—and should—learnby reading this master’sownwords.

No matter whichtechniques they use inpicking stocks, successfulinvesting professionals havetwo things in common:First,they are disciplined andconsistent,refusingtochangetheirapproachevenwhenitisunfashionable. Second, theythinkagreatdealaboutwhattheydoandhowtodoit,butthey pay very little attentiontowhatthemarketisdoing.

Chapter16ConvertibleIssuesandWarrants

Convertible bonds andpreferred stocks have been

taking on a predominantimportance in recentyears inthe field of senior financing.As a parallel development,stock-option warrants—whichare long-termrights tobuy common shares atstipulated prices—havebecome more and morenumerous.Morethanhalfthepreferred issues now quotedin the Standard & Poor’sStockGuide have conversionprivileges, and this has been

true also of a major part ofthe corporate bond financingin 1968–1970. There are atleast 60 different series ofstock-optionwarrantsdealtinon the American StockExchange. In 1970, for thefirst time in its history, theNew York Stock Exchangelisted an issue of long-termwarrants,givingrightstobuy31,400,000 American Tel. &Tel.sharesat$52each.With“Mother Bell” now leading

thatprocession,itisboundtobe augmented by many newfabricators of warrants. (Aswe shall point out later, theyareafabricationinmorethanonesense.)*

In the overall picture theconvertible issues rank asmuch more important thanthe warrants, and we shalldiscuss them first. There aretwo main aspects to beconsidered from the

standpoint of the investor.First, how do they rank asinvestment opportunities andrisks?Second,howdoestheirexistence affect the value ofthe related common-stockissues?

Convertible issues areclaimed to be especiallyadvantageous to both theinvestor and the issuingcorporation. The investorreceives the superior

protection of a bond orpreferred stock, plus theopportunity to participate inany substantial rise in thevalue of the common stock.The issuer is able to raisecapital at amoderate interestor preferred dividend cost,andiftheexpectedprosperitymaterializes the issuer willget rid of the seniorobligation by having itexchanged into commonstock. Thus both sides to the

bargain will fare unusuallywell.

Obviously the foregoingparagraph must overstate thecase somewhere, for youcannot by a mere ingeniousdevicemake a bargainmuchbetter for both sides. Inexchange for the conversionprivilege the investor usuallygivesupsomethingimportantinqualityoryield,orboth. 1Conversely, if the company

gets its money at lower costbecause of the conversionfeature, it is surrendering inreturn part of the commonshareholders’ claim to futureenhancement.On thissubjectthere are a number of trickyarguments to be advancedboth pro and con. The safestconclusion that can bereached is that convertibleissuesarelikeanyotherformof security, in that their formitself guarantees neither

attractiveness norunattractiveness. Thatquestion will depend on allthe facts surrounding theindividualissue.*

Wedoknow,however,thatthe group of convertibleissuesfloatedduringthelatterpart of a bull market arebound to yield unsatisfactoryresults as a whole. (It is atsuch optimistic periods,unfortunately, that most of

the convertible financing hasbeen done in the past.) Thepoor consequences must beinevitable, from the timingitself,sinceawidedeclineinthe stock market mustinvariably make theconversion privilege muchless attractive—and often,also, call into question theunderlyingsafetyoftheissueitself.†Asagroupillustrationwe shall retain the example

usedinourfirsteditionoftherelative price behavior ofconvertible and straight(nonconvertible) preferredsoffered in 1946, the closingyear of the bull marketpreceding the extraordinaryonethatbeganin1949.

TABLE 16-1 Price Recordof New Preferred-StockIssuesOfferedin1946

A comparable presentationis difficult to make for theyears 1967–1970, becausethere were virtually no new

offerings of nonconvertiblesin those years. But it is easyto demonstrate that theaverage price decline ofconvertible preferred stocksfrom December 1967 toDecember 1970 was greaterthan that for common stocksas a whole (which lost only5%). Also the convertiblesseemtohavedonequiteabitworse than the older straightpreferred shares during theperiod December 1968 to

December 1970, as is shownbythesampleof20issuesofeach kind in Table 16-2.These comparisons woulddemonstrate that convertiblesecurities as a whole haverelatively poor quality asseniorissuesandalsoaretiedto common stocks that doworsethanthegeneralmarketexcept during a speculativeupsurge. These observationsdonotapplytoallconvertibleissues,ofcourse.Inthe1968

and 1969 particularly, a fairnumber of strong companiesused convertible issues tocombat the inordinately highinterest rates for even first-quality bonds. But it isnoteworthy that in our 20-stock sample of convertiblepreferreds only one showedan advance and 14 sufferedbaddeclines.*

TABLE 16-2 Price Recordof Preferred Stocks,

Common Stocks, andWarrants, December 1970versusDecember1968(Based on Random Samplesof20IssuesEach)

(Standard&Poor’scompositeindexof500commonstocksdeclined11.3%.)

The conclusion to bedrawn from these figures isnotthatconvertibleissuesarein themselves less desirablethan nonconvertible or“straight” securities. Otherthings being equal, theopposite is true. But weclearly see that other thingsarenot equal in practice andthat the addition of the

conversion privilege often—perhaps generally—betraysan absence of genuineinvestment quality for theissue.

It is true, of course, that aconvertible preferred is saferthanthecommonstockofthesame company—that is tosay, it carries smaller risk ofeventual loss of principal.Consequently those who buynew convertibles instead of

the corresponding commonstock are logical to thatextent.But inmost cases thecommonwouldnothavebeenan intelligent purchase tobeginwith,attherulingprice,and the substitution of theconvertible preferred did notimprove the picturesufficiently. Furthermore, agood deal of the buying ofconvertibles was done byinvestorswho had no specialinterest or confidence in the

common stock—that is, theywould never have thought ofbuying the common at thetime—butwhowere temptedby what seemed an idealcombination of a prior claimplus a conversion privilegeclosetothecurrentmarket.Ina number of instances thiscombination has worked outwell,butthestatisticsseemtoshow that it ismore likely toproveapitfall.

In connection with theownership of convertiblesthere is a special problemwhich most investors fail torealize. Even when a profitappears it brings a dilemmawithit.Shouldtheholdersellon a small rise; should hehold for a much biggeradvance;iftheissueiscalled—as often happenswhen thecommon has gone upconsiderably—should he sellout then or convert into and

retainthecommonstock?*

Let us talk in concreteterms.Youbuya6%bondat100,convertible into stockat25—that is, at the rate of 40shares for each $1,000 bond.The stock goes to 30, whichmakesthebondworthatleast120, and so it sells at 125.Youeithersellorhold.Ifyouhold, hoping for a higherprice,youareprettymuch inthe position of a common

shareholder,sinceifthestockgoesdownyourbondwillgodown too. A conservativeperson is likely to say thatbeyond 125 his position hasbecome too speculative, andthereforehesellsandmakesagratifying25%profit.

Sofar,sogood.Butpursuethe matter a bit. In manycaseswheretheholdersellsat125 the common stockcontinues to advance,

carrying the convertible withit, and the investorexperiencesthatpeculiarpainthat comes to the man whohas sold out much too soon.The next time, he decides toholdfor150or200.Theissuegoes up to 140 and he doesnot sell. Then the marketbreaks and his bond slidesdown to 80. Again he hasdonethewrongthing.

Aside from the mental

anguish involved in makingthese bad guesses—and theyseem to be almost inevitable—there is a real arithmeticaldrawback to operations inconvertible issues. It may beassumed that a stern anduniform policy of selling at25%or30%profitwillworkout best as applied to manyholdings. This would thenmarktheupperlimitofprofitandwouldberealizedonlyonthe issues that worked out

well. But, if—as appears tobe true—these issues oftenlack adequate underlyingsecurityandtendtobefloatedand purchased in the latterstagesofabullmarket,thenagoodly proportion of themwillfailtoriseto125butwillnot fail to collapse when themarketturnsdownward.Thusthe spectacular opportunitiesin convertibles prove to beillusory in practice, and theoverall experience is marked

by fully as many substantiallosses—at least of atemporary kind—as there aregainsofsimilarmagnitude.

Because of theextraordinary length of the1950–1968 bull market,convertible issuesasawholegave a good account ofthemselvesforsome18years.But this meant only that thegreat majority of commonstocks enjoyed large

advances, in which mostconvertible issues were ableto share. The soundness ofinvestment in convertibleissues can only be tested bytheir performance in adeclining stock market—andthis has always proveddisappointingasawhole.*

In our first edition (1949)wegaveanillustrationofthisspecial problem of “what todo” with a convertible when

itgoesup.Webelieve it stillmerits inclusion here. Likeseveralofour references it isbasedonourowninvestmentoperations. We weremembersofa“selectgroup,”mainly of investment funds,who participated in a privateoffering of convertible 4½%debentures of Eversharp Co.at par, convertible intocommon stock at $40 pershare. The stock advancedrapidly to 65½, and then

(afterathree-for-twosplit)tothe equivalent of 88. Thelatter price made theconvertible debentures worthno less than220.During thisperiod the two issues werecalled at a small premium;hence they were practicallyall converted into commonstock,whichwas retainedbya number of the originalinvestment-fundbuyersofthedebentures. The pricepromptly began a severe

decline, and in March 1948thestocksoldaslowas73/8.This represented a value ofonly 27 for the debentureissues,oralossof75%oftheoriginal price instead of aprofitofover100%.

Therealpointof thisstoryis that some of the originalpurchasers converted theirbondsintothestockandheldthe stock through its greatdecline. In so doing they ran

counter to an old maxim ofWall Street, which runs:“Never convert a convertiblebond.” Why this advice?Because once you convertyou have lost your strategiccombinationofpriorclaimantto interest plus a chance foranattractiveprofit.Youhaveprobablyturnedfrominvestorinto speculator, and quiteoften at an unpropitious time(because the stock hasalreadyhada largeadvance).

If “Never convert aconvertible” is a good rule,how came it that theseexperienced fund managersexchanged their Eversharpbonds for stock, to theirsubsequent embarrassingloss?Theanswer,nodoubt,isthat they let themselves becarried away by enthusiasmfor the company’s prospectsas well as by the “favorablemarket action” of the shares.WallStreethasafewprudent

principles; the trouble is thatthey are always forgottenwhen they aremost needed.*Hence that other famousdictumoftheold-timers:“DoasIsay,notasIdo.”

Ourgeneralattitudetowardnewconvertibleissuesisthusa mistrustful one. We meanhere, as in other similarobservations,thattheinvestorshould look more than twicebefore he buys them. After

such hostile scrutiny he mayfind some exceptionalofferingsthataretoogoodtorefuse. The idealcombination, of course, is astrongly secured convertible,exchangeable for a commonstock which itself isattractive,andatapriceonlyslightly higher than thecurrent market. Every nowand then a new offeringappears that meets theserequirements. By the nature

of the securities markets,however,youaremorelikelytofindsuchanopportunityinsome older issue which hasdeveloped into a favorableposition rather than in a newflotation. (If anew issue is areally strong one, it is notlikely to have a goodconversionprivilege.)

The fine balance betweenwhat is given and what iswithheld in a standard-type

convertible issue is wellillustrated by the extensiveuseofthistypeofsecurityinthe financing of AmericanTelephone & TelegraphCompany.Between1913and1957 the company sold atleast nine separate issues ofconvertible bonds, most ofthem through subscriptionrights to shareholders. Theconvertible bonds had theimportant advantage to thecompany of bringing in a

much wider class of buyersthan would have beenavailableforastockoffering,since thebondswerepopularwith many financialinstitutions which possesshuge resources but some ofwhich were not permitted tobuy stocks. The interestreturn on the bonds hasgenerally been less than halfthe corresponding dividendyield on the stock—a factorthat was calculated to offset

the prior claim of thebondholders. Since thecompany maintained its $9dividend rate for 40 years(from 1919 to the stock splitin 1959) the result was theeventual conversion ofvirtually all the convertibleissues into common stock.Thus the buyers of theseconvertibles have fared wellthrough the years—but notquite so well as if they hadboughtthecapitalstockinthe

first place. This exampleestablishes the soundness ofAmerican Telephone &Telegraph, but not theintrinsic attractiveness ofconvertible bonds. To provethem sound in practice weshouldneedtohaveanumberof instances in which theconvertible worked out welleven though the commonstock proved disappointing.Suchinstancesarenoteasyto

find.*

EffectofConvertibleIssuesontheStatusoftheCommonStock

Ina largenumberofcasesconvertibleshavebeenissuedinconnectionwithmergersornewacquisitions.Perhapsthemoststrikingexampleof thisfinancial operation was theissuancebytheNVFCorp.ofnearly $100,000,000 of its5% convertible bonds (plus

warrants) in exchange formostofthecommonstockofSharon Steel Co. Thisextraordinary deal isdiscussedbelowpp.429–433.Typically the transactionresultsinaproformaincreasein the reported earnings pershare of common stock; thesharesadvanceinresponsetotheir larger earnings, so-called, but also because themanagement has givenevidence of its energy,

enterprise, and ability tomake more money for theshareholders.* But there aretwooffsetting factors, oneofwhich is practically ignoredand the other entirely so inoptimistic markets. The firstis the actual dilution of thecurrentandfutureearningsonthe common stock that flowsarithmetically from the newconversion rights. Thisdilution can be quantified by

taking the recentearnings,orassuming someother figures,and calculating the adjustedearnings per share if all theconvertible shares or bondswere actually converted. Inthemajorityofcompaniestheresulting reduction in per-share figures is notsignificant. But there arenumerous exceptions to thisstatement,andthereisdangerthat they will grow at anuncomfortable rate.The fast-

expanding “conglomerates”have been the chiefpractitioners of convertiblelegerdemain. In Table 16-3welistsevencompanieswithlarge amounts of stockissuable on conversions oragainstwarrants.†

IndicatedSwitchesfromCommonintoPreferredStocks

For decades before, say,1956,commonstocksyielded

more than the preferredstocks of the samecompanies; this wasparticularly true if thepreferred stock had aconversion privilege close tothe market. The reverse isgenerallytrueatpresent.Asaresultthereareaconsiderablenumber of convertiblepreferred stocks which areclearly more attractive thanthe related common shares.Owners of the common have

nothingtoloseandimportantadvantages to gain byswitching from their juniorsharesintotheseniorissue.

TABLE 16-3 Companieswith Large Amounts ofConvertible Issues andWarrants at the End of1969(SharesinThousands)

EXAMPLE: A typicalexample was presented by

Studebaker-WorthingtonCorp. at the close of 1970.The common sold at 57,while the $5 convertiblepreferred finished at 87½.Each preferred share isexchangeable for 1½ sharesofcommon, thenworth85½.This would indicate a smallmoney difference against thebuyer of the preferred. Butdividends are being paid onthecommonattheannualrateof$1.20(or$1.80forthe1½

shares), against the $5obtainable on one share ofpreferred. Thus the originaladverse difference in pricewould probably be made upin less than a year, afterwhich the preferred wouldprobably return anappreciably higher dividendyield than the common forsometimetocome.Butmostimportant, of course, wouldbetheseniorpositionthatthecommon shareholder would

gain from the switch. At thelowpricesof1968andagainin1970 thepreferredsold15points higher than 1½ sharesof common. Its conversionprivilege guarantees that itcould never sell lower thanthecommonpackage.2

Stock-OptionWarrants

Let us mince no words atthe outset. We consider therecent development of stock-

option warrants as a nearfraud, an existing menace,andapotentialdisaster.Theyhave created huge aggregatedollar“values”outofthinair.They have no excuse forexistenceexcepttotheextentthat theymislead speculatorsandinvestors.Theyshouldbeprohibited by law, or at leaststrictlylimitedtoaminorpartofthetotalcapitalizationofacompany.*

For an analogy in generalhistory and in literature wereferthereadertothesectionof Faust (part 2), in whichGoethe describes theinventionofpapermoney.Asan ominous precedent onWall Street history, we maymention the warrants ofAmerican & Foreign PowerCo., which in 1929 had aquotedmarketvalueofoverabillion dollars, although theyappearedonlyinafootnoteto

thecompany’sbalance sheet.By 1932 this billion dollarshadshrunkto$8million,andin 1952 the warrants werewiped out in the company’srecapitalization—eventhoughithadremainedsolvent.

Originally, stock-optionwarrants were attached nowand then to bond issues, andwere usually equivalent to apartial conversion privilege.They were unimportant in

amount, and hence did noharm. Their use expanded inthe late 1920s, along withmany other financial abuses,but they dropped from sightfor long years thereafter.They were bound to turn upagain, like the bad penniestheyare,andsince1967theyhave become familiar“instruments of finance.” Infactastandardprocedurehasdeveloped for raising thecapital for new real-estate

ventures, affiliates of largebanks, by selling units of anequal number of commonshares and warrants to buyadditional common shares atthe same price. Example: In1971 CleveTrust RealtyInvestors sold 2,500,000 ofthese combinations ofcommon stock (or “shares ofbeneficial interest”) andwarrants,for$20perunit.

Let us consider for a

moment what is reallyinvolved in this financialsetup.Ordinarily,acommon-stock issue has the first rightto buy additional commonshares when the company’sdirectors find it desirable toraise capital in this manner.This so-called “preemptiveright” is one of the elementsof value entering into theownership of common stock—along with the right toreceive dividends, to

participate in the company’sgrowth, and to vote fordirectors. When separatewarrants are issued for theright to subscribe additionalcapital,thatactiontakesawaypart of the value inherent inan ordinary common shareand transfers it to a separatecertificate. An analogousthing could be done byissuing separate certificatesfor the right to receivedividends (for a limited or

unlimitedperiod),ortherightto share in the proceeds ofsale or liquidation of theenterprise,ortherighttovotethe shares. Why then arethese subscription warrantscreatedaspartoftheoriginalcapital structure? Simplybecause people are inexpertin financial matters. Theydon’trealizethatthecommonstock is worth less withwarrants outstanding thanotherwise.Hencethepackage

ofstockandwarrantsusuallycommands a better price inthe market than would thestock alone. Note that in theusual company reports theper-share earnings are (orhavebeen)computedwithoutproper allowance for theeffect of outstandingwarrants. The result is, ofcourse, to overstate the truerelationship between theearningsandthemarketvalueof the company’s

capitalization.*

The simplest and probablythe best method of allowingfor the existence of warrantsis to add the equivalent oftheir market value to thecommon-share capitalization,thus increasing the “true”marketpricepershare.Wherelarge amounts of warrantshave been issued inconnection with the sale ofsenior securities, it is

customary to make theadjustment by assuming thatthe proceeds of the stockpaymentareusedtoretiretherelated bonds or preferredshares.Thismethoddoesnotallowadequatelyfortheusual“premiumvalue”ofawarrantabove exercisable value. InTable 16-4 we compare theeffect of the twomethods ofcalculation in the case ofNational General Corp. fortheyear1970.

Does the company itselfderiveanadvantagefromthecreationof thesewarrants, inthesensethattheyassureitinsome way of receivingadditional capital when itneeds some? Not at all.Ordinarily there isnoway inwhich the company canrequirethewarrant-holderstoexercisetheirrights,andthusprovide new capital to thecompany, prior to theexpiration date of the

warrants. In themeantime, ifthe company wants to raiseadditional common-stockfundsitmustoffer thesharesto its shareholders in theusual way—which meanssomewhat under the rulingmarket price. The warrantsare no help in such anoperation; they merelycomplicate the situation byfrequently requiring adownward revision in theirownsubscriptionprice.Once

more we assert that largeissues of stock-optionwarrants serve no purpose,except to fabricate imaginarymarketvalues.

The paper money thatGoethe was familiar with,when he wrote his Faust,were the notorious Frenchassignats that had beengreeted as a marvelousinvention, and were destinedultimately to lose all of their

value—as did the billiondollarsworthofAmerican&Foreign Power warrants.*Some of the poet’s remarksapply equally well to oneinventionoranother—suchasthe following (in BayardTaylor’stranslation):

TABLE16-4Calculationof“True Market Price” andAdjusted Price/EarningsRatio of a Common Stockwith Large Amounts of

WarrantsOutstanding

Notethat,afterspecialcharges,theeffectofthecompany’scalculationistoincreasetheearningspershareandreducetheP/Eratio.Thisismanifestlyabsurd.ByoursuggestedmethodtheeffectofthedilutionistoincreasetheP/Eratiosubstantially,asitshouldbe.

FAUST:ImaginationinitshighestflightExertsitselfbutcannotgraspitquite.

MEPHISTOPHELES(theinventor):Ifoneneedscointhebrokersready

stand.

THEFOOL(finally):Themagicpaper…!

PracticalPostscript

The crime of the warrantsis in “having been born.”*Once born they function asother security forms, andofferchancesofprofitaswellas of loss. Nearly all thenewer warrants run for a

limited time—generallybetween five and ten years.Theolderwarrantswereoftenperpetual, and they werelikely to have fascinatingpricehistoriesovertheyears.

EXAMPLE:Therecordbookswill show that Tri-Continental Corp. warrants,whichdatefrom1929,soldata negligible 1/32 of a dollareach in the depth of thedepression. From that lowly

estate their price rose to amagnificent 75 3/4 in 1969,an astronomical advance ofsome 242,000%. (Thewarrants then soldconsiderably higher than theshares themselves; this is thekind of thing that occurs onWallStreet through technicaldevelopments, such as stocksplits.) A recent example issupplied by Ling-Temco-Vought warrants, which inthe first half of 1971

advanced from 2½ to 12½—andthenfellbackto4.

No doubt shrewdoperations can be carried oninwarrantsfromtimetotime,but this is too technical amatter for discussion here.We might say that warrantstend to sell relatively higherthan the correspondingmarketcomponentsrelatedtothe conversion privilege ofbondsorpreferredstocks.To

that extent there is a validargument for selling bondswithwarrants attached ratherthan creating an equivalentdilution factor by aconvertible issue. If thewarrant total is relativelysmall there is no point intaking its theoretical aspecttoo seriously; if the warrantissue is large relative to theoutstandingstock, thatwouldprobably indicate that thecompany has a top-heavy

senior capitalization. Itshould be selling additionalcommon stock instead. Thusthe main objective of ourattack on warrants as afinancialmechanismisnottocondemn their use inconnection with moderate-sizebondissues,buttoargueagainstthewantoncreationofhuge “paper-money”monstrositiesofthisgenre.

*Grahamdetestedwarrants,ashemakesclearonpp.413–416.

*Grahamispointingoutthat,despitethepromotionalrhetoricthatinvestorsusuallyhear,convertiblebondsdonotautomaticallyoffer“thebestofbothworlds.”Higheryieldandlowerriskdonotalwaysgohandinhand.WhatWallStreetgiveswithonehand,itusuallytakesawaywiththeother.Aninvestmentmayofferthebestofoneworld,ortheworstofanother;butthebestofbothworldsseldombecomesavailableinasinglepackage.

†AccordingtoGoldmanSachsandIbbotsonAssociates,from1998through2002,convertiblesgeneratedanaverageannualreturnof4.8%.Thatwasconsiderablybetterthanthe0.6%annual

lossonU.S.stocks,butsubstantiallyworsethanthereturnsofmedium-termcorporatebonds(a7.5%annualgain)andlong-termcorporatebonds(an8.3%annualgain).Inthemid-1990s,accordingtoMerrillLynch,roughly$15billioninconvertibleswereissuedannually;by1999,issuancehadmorethandoubledto$39billion.In2000,$58billioninconvertibleswereissued,andin2001,another$105billionemerged.AsGrahamwarns,convertiblesecuritiesalwayscomeoutofthewoodworkneartheendofabullmarket—largelybecauseevenpoor-qualitycompaniesthenhavestockreturnshighenoughtomaketheconversionfeatureseemattractive.

*Recentstructuralchangesintheconvertiblemarkethavenegatedsomeofthesecriticisms.Convertiblepreferredstock,whichmadeuproughlyhalfthetotal

convertiblemarketinGraham’sday,nowaccountsforonlyaneighthofthemarket.Maturitiesareshorter,makingconvertiblebondslessvolatile,andmanynowcarry“callprotection,”orassurancesagainstearlyredemption.Andmorethanhalfofallconvertiblesarenowinvestmentgrade,asignificantimprovementincreditqualityfromGraham’stime.Thus,in2002,theMerrillLynchAllU.S.ConvertibleIndexlost8.6%—versusthe22.1%lossoftheS&P500-stockindexandthe31.3%declineintheNASDAQCompositestockindex.

*Abondis“called”whentheissuingcorporationforciblypaysitoffaheadofthestatedmaturitydate,orfinalduedateforinterestpayments.Forabriefsummaryofhowconvertiblebondswork,seeNote1inthecommentaryonthischapter(p.418).

*Inrecentyears,convertibleshavetendedtooutperformtheStandard&Poor’s500-stockindexduringdecliningstockmarkets,buttheyhavetypicallyunderperformedotherbonds—whichweakens,butdoesnotfullynegate,thecriticismGrahammakeshere.

*Thissentencecouldserveastheepitaphforthebullmarketofthe1990s.Amongthe“fewprudentprinciples”thatinvestorsforgotweresuchmarketclichésas“Treesdon’tgrowtothesky”and“Bullsmakemoney,bearsmakemoney,butpigsgetslaughtered.”

*AT&TCorp.nolongerisasignificantissuerofconvertiblebonds.AmongthelargestissuersofconvertiblestodayareGeneralMotors,MerrillLynch,Tyco

International,andRoche.

*Forafurtherdiscussionof“proforma”financialresults,seethecommentaryonChapter12.

†Inrecentyears,convertiblebondshavebeenheavilyissuedbycompaniesinthefinancial,health-care,andtechnologyindustries.

*WarrantswereanextremelywidespreadtechniqueofcorporatefinanceinthenineteenthcenturyandwerefairlycommoneveninGraham’sday.Theyhavesincediminishedinimportanceandpopularity—oneofthefewrecentdevelopmentsthatwouldgiveGrahamunreservedpleasure.Asofyear-end2002,therewereonlysevenremainingwarrantissuesontheNewYorkStockExchange—

onlytheghostlyvestigeofamarket.Becausewarrantsarenolongercommonlyusedbymajorcompanies,today’sinvestorsshouldreadtherestofGraham’schapteronlytoseehowhislogicworks.

*Today,thelastremnantofactivityinwarrantsisinthecesspooloftheNASDAQ“bulletinboard,”orover-the-countermarketfortinycompanies,wherecommonstockisoftenbundledwithwarrantsintoa“unit”(thecontemporaryequivalentofwhatGrahamcallsa“package”).Ifastockbrokereverofferstosellyou“units”inanycompany,youcanbe95%certainthatwarrantsareinvolved,andatleast90%certainthatthebrokeriseitherathieforanidiot.Legitimatebrokersandfirmshavenobusinessinthisarea.

*The“notoriousFrenchassignats”were

issuedduringtheRevolutionof1789.TheywereoriginallydebtsoftheRevolutionarygovernment,purportedlysecuredbythevalueoftherealestatethattheradicalshadseizedfromtheCatholicchurchandthenobility.ButtheRevolutionarieswerebadfinancialmanagers.In1790,theinterestrateonassignatswascut;soontheystoppedpayinginterestentirelyandwerereclassifiedaspapermoney.Butthegovernmentrefusedtoredeemthemforgoldorsilverandissuedmassiveamountsofnewassignats.Theywereofficiallydeclaredworthlessin1797.

*Graham,anenthusiasticreaderofSpanishliterature,isparaphrasingalinefromtheplayLifeIsaDreambyPedroCalderondelaBarca(1600–1681):“Thegreatestcrimeofmanishavingbeenborn.”


That which thou sowest is notquickened,exceptitdie.

—I.Corinthians,XV:36.

TheZealoftheConvert

Although convertible bonds

are called “bonds,” theybehave like stocks,work likeoptions, and are cloaked inobscurity.

If you own a convertible,youalsoholdanoption:Youcaneitherkeep thebondandcontinuetoearninterestonit,or you can exchange it forcommon stock of the issuingcompany at a predeterminedratio. (An option gives itsownertherighttobuyorsell

another security at a givenpricewithinaspecificperiodof time.) Because they areexchangeable into stock,convertibles pay lower ratesof interest than mostcomparable bonds. On theother hand, if a company’sstock price soars, aconvertible bondexchangeable into that stockwillperformmuchbetterthana conventional bond.(Conversely, the typical

convertible—with its lowerinterest rate—will fareworseinafallingbondmarket.)1

From 1957 through 2002,according to IbbotsonAssociates,convertiblebondsearned an annual averagereturn of 8.3%—only twopercentage points below thetotal return on stocks, butwith steadier prices andshallower losses.2 Moreincome, less risk thanstocks:

No wonder Wall Street’ssalespeople often describeconvertiblesasa“bestofbothworlds” investment. But theintelligent investor willquickly realize thatconvertiblesofferlessincomeandmoreriskthanmostotherbonds. So they could, by thesame logic and with equaljustice, be called a “worst ofboth worlds” investment.Which side you come downon depends on how you use

them.

In truth, convertibles actmore like stocks than bonds.The return on convertibles isabout 83% correlated to theStandard& Poor’s 500-stockindex—but only about 30%correlated to theperformanceof Treasury bonds. Thus,“converts” zig when mostbonds zag. For conservativeinvestors with most or all oftheirassetsinbonds,addinga

diversifiedbundleofconvertsis a sensible way to seekstock-like returns withouthaving to take the scary stepofinvestinginstocksdirectly.You could call convertiblebonds“stocksforchickens.”

As convertibles expert F.Barry Nelson of AdventCapital Management pointsout, this roughly$200billionmarket has blossomed sinceGraham’sday.Mostconverts

arenowmedium-term, in theseven-to-10-year range;roughly half are investment-grade; and many issues nowcarrysomecallprotection(anassurance against earlyredemption).Allthesefactorsmake them less risky thantheyusedtobe.3

It’s expensive to tradesmall lots of convertiblebonds, and diversification isimpractical unless you have

well over $100,000 to investin this sector alone.Fortunately, today’sintelligent investor has theconvenient recourse ofbuyingalow-costconvertiblebond fund. Fidelity andVanguard offermutual fundswith annual expensescomfortablyunder1%,whileseveral closed-end funds arealsoavailableata reasonablecost (and, occasionally, at

discountstonetassetvalue).4

On Wall Street, cutenessand complexity go hand-in-hand—and convertibles areno exception. Among thenewer varieties are a jumbleof securities with acronymicnicknames like LYONS,ELKS, EYES, PERCS,MIPS,CHIPS,andYEELDS.These intricate securities puta“floor”underyourpotentiallosses, but also cap your

potential profits and oftencompel you to convert intocommon stock on a fixeddate. Like most investmentsthatpurport toensureagainstloss (see sidebar on p. 421),these things are generallymore trouble than they areworth. You can best shieldyourself against loss not bybuying one of these quirkycontraptions, but byintelligentlydiversifyingyourentire portfolio across cash,

bonds, and U.S. and foreignstocks.

UNCOVERINGCOVEREDCALLS

Asthebearmarketclawedits way through 2003, itdugupanoldfad:writingcovered call options. (Arecent Google search on“covered call writing”turnedupmorethan2,600hits.) What are coveredcalls, and how do theywork? Imagine that youbuy 100 shares of IxnayCorp. at $95 apiece. You

thensell(or“write”)acalloption on your shares. Inexchange, you get a cashpaymentknownas a “callpremium.” (Let’s say it’s$10per share.)Thebuyerof the option, meanwhile,hasthecontractualrighttobuyyourIxnaysharesatamutually agreed-uponprice—say,$100.Yougetto keep the stock so longasitstaysbelow$100,andyou earn a fat $1,000 inpremium income, whichwill cushion the fall ifIxnay’sstockcrashes.

Less risk, more income.

What’snottolike?

Well, now imagine thatIxnay’s stock price jumpsovernight to $110. Thenyour option buyer willexercise his rights,yankingyour sharesawayfor $100 apiece. You’vestill got your $1,000 inincome, but he’s got yourIxnay—and the more itgoes up, the harder youwillkickyourself.1

Sincethepotentialgainonastockisunlimited,whileno loss canexceed100%,the only person you will

enrichwiththisstrategyisyourbroker.You’veputafloor under your losses,but you’ve also slapped aceiling over your gains.For individual investors,coveringyourdownsideisnever worth surrenderingmostofyourupside.

Chapter17FourExtremelyInstructiveCaseHistories

Theword“extremely” in thetitleisakindofpun,because

the histories representextremesofvarioussortsthatweremanifestonWallStreetin recent years. They holdinstruction, and gravewarnings, for everyone whohasaseriousconnectionwiththeworldofstocksandbonds—not only for ordinaryinvestors and speculators butfor professionals, securityanalysts, fund managers,trust-account administrators,and even for bankers who

lend money to corporations.The four companies to bereviewed, and the differentextremes that they illustrateare:

Penn Central (Railroad)Co. An extreme example ofthe neglect of the mostelementarywarningsignalsoffinancial weakness, by allthose who had bonds orshares of this system undertheir supervision. A crazily

high market price for thestockofatotteringgiant.

Ling-Temco-Vought Inc.Anextremeexampleofquickand unsound “empirebuilding,” with ultimatecollapse practicallyguaranteed; but helped byindiscriminatebanklending.

NVF Corp. An extremeexample of one corporateacquisition, inwhich a small

company absorbed anotherseventimesitssize,incurringa huge debt and employingsome startling accountingdevices.

AAA Enterprises. Anextreme example of publicstock-financing of a smallcompany; its value based onthe magic word“franchising,” and little else,sponsored by importantstock-exchange houses.

Bankruptcy followed withintwo years of the stock saleandthedoublingoftheinitialinflated price in the heedlessstockmarket.

ThePennCentralCase

This is the country’slargest railroad in assets andgross revenues. Itsbankruptcy in 1970 shockedthe financial world. It hasdefaultedonmostofitsbond

issues,andhasbeenindangerof abandoning its operationsentirely. Its security issuesfell drastically in price, thecommon stock collapsingfrom a high level of 86½ asrecently as 1968 to a low of5½ in 1970. (There seemslittle doubt that these shareswill be wiped out inreorganization.)*

Our basic point is that theapplication of the simplest

rulesof securityanalysisandthe simplest standards ofsoundinvestmentwouldhaverevealed the fundamentalweaknessofthePennCentralsystem long before itsbankruptcy—certainly in1968, when the shares wereselling at their post-1929record, andwhenmost of itsbond issues could have beenexchanged at even prices forwell-secured public-utilityobligations with the same

coupon rates. The followingcommentsareinorder:

1.IntheS&PBondGuidethe interest charges of thesystem are shown to havebeen earned 1.91 times in1967and1.98timesin1968.The minimum coverageprescribed for railroad bondsin our textbook SecurityAnalysis is 5 times beforeincome taxes and 2.9 times

after income taxes at regularrates.As far aswe know thevalidityofthesestandardshasneverbeenquestionedbyanyinvestment authority. On thebasis of our requirements forearningsaftertaxes, thePennCentral fell short of therequirements for safety. Butour after-tax requirement isbasedonabefore-taxratiooffive times, with regularincometaxdeductedafterthebond interest. In the case of

Penn Central, it had beenpaying no income taxes tospeakofforthepast11years!Hence the coverage of itsinterest charges before taxeswas less than two times—atotally inadequate figureagainst our conservativerequirementof5times.

2. The fact that thecompany paid no incometaxes over so long a period

should have raised seriousquestionsaboutthevalidityofitsreportedearnings.

3. The bonds of the PennCentral system could havebeen exchanged in 1968 and1969, at no sacrifice of priceor income, for far bettersecured issues. For example,in 1969, Pennsylvania RR4½s, due 1994 (part of PennCentral)hada rangeof61 to

74½, while PennsylvaniaElectricCo.43/8s,due1994,had a range of 64¼ to 72¼.The public utility had earnedits interest 4.20 times beforetaxes in 1968 against only1.98 times for the PennCentral system; during 1969the latter’s comparativeshowinggrewsteadilyworse.Anexchangeof thissortwasclearly called for, and itwould have been a lifesaverfor a Penn Central

bondholder. (At the end of1970therailroad4¼swereindefault, and selling at only18½,whiletheutility’s43/8sclosedat66½.)

4. Penn Central reportedearningsof$3.80persharein1968;itshighpriceof86½inthat year was 24 times suchearnings. But any analystworth his salt would havewondered how “real” were

earnings of this sort reportedwithout the necessity ofpaying any income taxesthereon.

5. For 1966 the newlymerged company* hadreported “earnings” of $6.80a share—in reflection ofwhichthecommonstocklaterrose to itspeakof86½.Thiswas a valuation of over $2billion for the equity. How

manyofthesebuyersknewatthe time that the so lovelyearnings were before aspecial charge of $275millionor$12persharetobetaken in 1971 for “costs andlosses” incurred on themerger. O wondrousfairyland of Wall Streetwhere a company canannounce “profits” of $6.80per share in one place andspecial “costs and losses” of$12 in another, and

shareholders and speculatorsrubtheirhandswithglee!†

6.Arailroadanalystwouldhave long since known thatthe operating picture of thePennCentralwasverybadincomparison with the moreprofitableroads.Forexample,its transportation ratio was47.5%in1968against35.2%for its neighbor, Norfolk &Western.*

7. Along the way therewere some strangetransactions with peculiaraccounting results.1 Detailsaretoocomplicatedtogointohere.

CONCLUSION: Whetherbetter management couldhave saved the Penn Centralbankruptcymay be arguable.

But there is no doubtwhatever that no bonds andnosharesofthePennCentralsystemshouldhaveremainedafter1968atthelatestinanysecurities account watchedover by competent securityanalysts,fundmanagers,trustofficers, or investmentcounsel. Moral: Securityanalysts should do theirelementary jobs before theystudy stock-marketmovements, gaze into crystal

balls, make elaboratemathematical calculations, orgo on all-expense-paid fieldtrips.†

Ling-Temco-VoughtInc.

This is a story of head-over-heels expansion andhead-overheels debt, endingupinterrificlossesandahostof financial problems. Asusually happens in suchcases, a fair-haired boy, or

“young genius,” was chieflyresponsible for both thecreation of the great empireanditsignominiousdownfall;butthereisplentyofblametobeaccordedothersaswell.†

The rise and fall of Ling-Temco-Vought can besummarized by setting forthcondensed income accountsand balance-sheet items forfive years between 1958 and1970. This is done in Table

17-1.Thefirstcolumnshowsthe company’s modestbeginnings in 1958,when itssales were only $7 million.The next gives figures for1960; the enterprise hadgrowntwentyfoldinonlytwoyears, but it was stillcomparatively small. Thencame the heyday years to1967 and 1968, in whichsales again grew twentyfoldto $2.8 billion with the debtfigure expanding from $44

milliontoanawesome$1,653million. In 1969 came newacquisitions, a further hugeincrease indebt (toa totalof$1,865 million!), and thebeginning of serious trouble.A large loss, afterextraordinary items, wasreported for the year; thestock price declined from its1967 high of 169½ to a lowof 24; the young genius wassupersededastheheadofthecompany. The 1970 results

wereevenmoredreadful.Theenterprisereportedafinalnetloss of close to $70 million;the stock fell away to a lowpriceof71/8,and its largestbondissuewasquotedatonetimeatapitiable15centsonthe dollar. The company’sexpansionpolicywassharplyreversed, various of itsimportant interests wereplaced on the market, andsome headway was made inreducing its mountainous

obligations.

The figures in our tablespeak so eloquently that fewcomments are called for.Butherearesome:

1. The company’sexpansion period was notwithout an interruption. In1961 it showed a smalloperating deficit, but—adopting a practice that wasto be seen later in so manyreports for 1970—evidentlydecided to throw all possiblecharges and reserves into theone bad year.* Theseamounted to a round $13million,whichwasmorethan

the combined net profits ofthe preceding three years. Itwas now ready to show“record earnings” in 1962,etc.

2. At the end of 1966 thenet tangible assets are givenas$7.66pershareofcommon(adjusted for a 3-for-2 split).Thusthemarketpricein1967reached 22 times (!) itsreported asset value at thetime.At the end of 1968 the

balance sheet showed $286million available for3,800,000 shares of commonandClassAAstock,orabout$77 per share. But if wededuct the preferred stock atfull value and exclude thegood-will itemsand thehugebond-discount “asset,”† therewouldremain$13millionforthe common—amere $3 pershare. This tangible equitywas wiped out by the losses

ofthefollowingyears.

3.Towardtheendof1967two of our best-regardedbanking firms offered600,000 shares of Ling-Temco-Vought stock at $111pershare.Ithadbeenashighas 169½. In less than threeyearsthepricefellto71/8.†

4. At the end of 1967 thebank loanshad reached$161million, andayear later they

stoodat$414million—whichshould have been afrightening figure. Inaddition, the long-term debtamounted to $1,237 million.By 1969 combined debtreached a total of $1,869million. Thismay have beenthe largest combined debtfigure of any industrialcompany anywhere and atany time, with the singleexception of the impregnableStandardOilofN.J.

5. The losses in 1969 and1970 far exceeded the totalprofitssince theformationofthecompany.

MORAL: The primaryquestion raised in our mindby the Ling-Temco-Voughtstory is how the commercialbankers could have beenpersuaded to lend thecompany such huge amountsof money during itsexpansion period. In 1966

and earlier the company’scoverage of interest chargesdid not meet conservativestandards, and the same wastrue of the ratio of currentassets to current liabilitiesand of stock equity to totaldebt. But in the next twoyears thebanksadvanced theenterprisenearly$400millionadditional for further“diversification.” This wasnot good business for them,and it was worse in its

implications for thecompany’s shareholders. Ifthe Ling-Temco-Vought casewillservetokeepcommercialbanks from aiding andabetting unsound expansionsof this type in the future,somegoodmaycomeofitatlast.*

TheNVFTakeoverofSharonSteel(ACollector’sItem)

At the end of 1968 NVF

Company was a companywith $4.6 million of long-term debt, $17.4 million ofstock capital, $31 million ofsales, and $502,000 of netincome (before a specialcredit of $374,000). Itsbusiness was described as“vulcanized fiber andplastics.” The managementdecided to take over theSharon Steel Corp., whichhad$43millionof long-termdebt, $101 million of stock

capital,$219millionofsales,and $2,929,000 of netearnings. The company itwished to acquire was thusseven times the sizeofNVF.Inearly1969itmadeanofferfor all the shares of Sharon.Thetermspersharewere$70face amount of NVF junior5% bonds, due 1994, pluswarrants tobuy1½sharesofNVFstockat$22pershareofNVF. The management ofSharon strenuously resisted

this takeover attempt, but invain. NVF acquired 88% ofthe Sharon stock under theoffer, issuing therefore $102million of its 5% bonds andwarrants for 2,197,000 of itsshares. Had the offer been100% operative theconsolidated enterprisewould, for the year 1968,have had $163 million indebt, only $2.2 million intangible stock capital, $250million of sales. The net-

earningsquestionwouldhavebeen a bit complicated, butthe company subsequentlystatedthemasanetlossof50cents per share of NVFstocks, before anextraordinary credit, and netearnings of 3 cents per shareaftersuchcredit.*

FIRSTCOMMENT:Amongallthe takeovers effected in theyear 1969 this was no doubtthe most extreme in its

financial disproportions. Theacquiring company hadassumed responsibility for anew and top-heavy debtobligation,andithadchangedits calculated 1968 earningsfromaprofittoalossintothebargain. A measure of theimpairmentof thecompany’sfinancialpositionbythisstepis found in the fact that thenew 5% bonds did not sellhigher than 42 cents on thedollar during the year of

issuance. This would haveindicated grave doubt of thesafetyofthebondsandofthecompany’s future; however,the management actuallyexploited the bondprice in away to save the companyannualincometaxesofabout$1,000,000aswillbeshown.

The1968report,publishedafter the Sharon takeover,containedacondensedpictureof its results, carried back to

the year-end. This containedtwomostunusualitems:

1. There is listed as anasset $58,600,000 of“deferreddebtexpense.”Thissumisgreater than theentire“stockholders’ equity,”placedat$40,200,000.

2. However, not includedin the shareholders’ equity isan item of $20,700,000designated as “excess of

equity over cost ofinvestmentinSharon.”

SECOND COMMENT: If weeliminatethedebtexpenseasan asset, which it hardlyseems to be, and include theother item in theshareholders’equity(whereitwouldnormallybelong),thenwe have a more realisticstatement of tangible equityfor NVF stock, viz.,$2,200,000. Thus the first

effect of the deal was toreduce NVF’s “real equity”from $17,400,000 to$2,200,000 or from $23.71per share to about $3 pershare, on 731,000 shares. Inaddition the NVFshareholders had given toothers the right to buy 3½times as many additionalsharesatsixpointsbelowthemarket price at the close of1968.Theinitialmarketvalueof the warrants was then

about $12 each, or a total ofsome $30 million for thoseinvolved in the purchaseoffer. Actually, the marketvalue of the warrants wellexceeded the total marketvalueoftheoutstandingNVFstock—another evidence ofthe tail-wagging-dog natureofthetransaction.

TheAccountingGimmicks

When we pass from this

proformabalancesheettothenext year’s report we findseveral strange-appearingentries. In addition to thebasicinterestexpense(ahefty$7,500,000), there isdeducted $1,795,000 for“amortization of deferreddebtexpense.”Butthislastisnearlyoffset on thenext lineby a very unusual incomeitemindeed:“amortizationofequity over cost ofinvestment in subsidiary: Cr.

$1,650,000.” In one of thefootnotes we find an entry,not appearing in any otherreport that we know of: Partof the stock capital is theredesignated as “fair marketvalue of warrants issued inconnection with acquisition,etc.,$22,129,000.”

Whaton earthdo all theseentries mean? None of themis even referred to in thedescriptive text of the 1969

report. The trained securityanalysthastofigureoutthesemysteries by himself, almostindetectivefashion.Hefindsthat the underlying idea is toderive a tax advantage fromthelowinitialpriceofthe5%debentures. For readers whomay be interested in thisingeniousarrangementwesetforth our solution inAppendix6.

OtherUnusualItems

1. Right after the close of1969 the company bought innolessthan650,000warrantsatapriceof$9.38each.Thiswas extraordinary when weconsider that (a) NVF itselfhadonly$700,000 in cash atthe year-end, and had$4,400,000 of debt due in1970 (evidently the $6million paid for the warrantshad to be borrowed); (b) itwas buying in this warrant“paper money” at a time

when its 5% bonds wereselling at less than 40 centson the dollar—ordinarily awarning that financialdifficultieslayahead.

2. As a partial offset tothis, thecompanyhad retired$5,100,000ofitsbondsalongwith 253,000 warrants inexchangeforalikeamountofcommon stock. This waspossible because, by thevagaries of the securities

markets, people were sellingthe5%bondsat less than40while thecommonsoldatanaveragepriceof13½,payingnodividend.

3. The company had plansin operation not only forsellingstocktoitsemployees,but also for selling them alargernumberofwarrants tobuy the stock.Like the stockpurchases the warrants wereto be paid for 5% down and

the rest over many years inthe future. This is the onlysuch employee-purchaseplanforwarrantsthatweknowof.Will someone soon inventand sell on installments aright to buy a right to buy ashare,andsoon?

4. In the year 1969 thenewlycontrolledSharonSteelCo. changed its method ofarriving at its pension costs,and also adopted lower

depreciation rates. Theseaccounting changes addedabout $1 per share to thereported earnings of NVFbeforedilution.

5. At the end of 1970Standard & Poor’s StockGuide reported that NVFshares were selling at aprice/earning ratio of only 2,the lowest figure for all the4,500-odd issues in thebooklet. As the old Wall

Street saying went, this was“important if true.”The ratiowas based on the year’sclosingpriceof83/4andthecomputed“earnings”of$5.38per share for the 12 monthsended September 1970.(Using these figures theshares were selling at only1.6 times earnings.) But thisratio did not allow for thelargedilution factor,* nor forthe adverse results actually

realized in the last quarterof1970. When the full year’sfigures finally appeared, theyshowed only $2.03 per shareearned for the stock, beforeallowing for dilution, and$1.80 per share on a dilutedbasis. Note also that theaggregatemarketpriceofthestock and warrants on thatdate was about $14 millionagainstabondeddebtof$135million—a skimpy equitypositionindeed.

AAAEnterprises

History

About 15 years ago acollege student namedWilliams began sellingmobile homes (then called“trailers”).† In 1965 heincorporated his business. Inthat year he sold $5,800,000of mobile homes and earned$61,000beforecorporate tax.By 1968 he had joined the

“franchising” movement andwassellingotherstherighttosell mobile homes under hisbusiness name. He alsoconceived the bright idea ofgoing into the business ofpreparing income-taxreturns,using his mobile homes asoffices. He formed asubsidiary company calledMr. Tax of America, and ofcourse started to sellfranchisestootherstousetheidea and the name. He

multiplied the number ofcorporateshares to2,710,000and was ready for a stockoffering.Hefoundthatoneofour largest stock-exchangehouses, along with others,was willing to handle thedeal. In March 1969 theyoffered the public 500,000sharesofAAAEnterprisesat$13 per share. Of these,300,000 were sold for Mr.Williams’s personal accountand200,000weresoldforthe

company account, adding$2,400,000 to its resources.The price of the stockpromptly doubled to 28, or avalue of $84 million for theequity, against a book valueof, say, $4,200,000 andmaximum reported earningsof $690,000. The stock wasthus selling at a tidy 115timesitscurrent(andlargest)earnings per share.No doubtMr.WilliamshadselectedthenameAAAEnterprisesothat

itmightbeamongthefirstinthe phone books and theyellow pages. A collateralresult was that his companywasdestinedtoappearas thefirst name in Standard &Poor’s Stock Guide. LikeAbu-Ben-Adhem’s, it led alltherest.*Thisgivesaspecialreason to select it as aharrowing example of 1969new financing and “hotissues.”

COMMENT: This was not abad deal for Mr. Williams.The 300,000 shares he soldhad a book value inDecember of 1968 of$180,000 and he nettedtherefor20timesasmuch,ora cool $3,600,000. Theunderwriters and distributorssplit$500,000between them,lessexpenses.

1. This did not seem sobrilliantadeal for theclients

of the selling houses. Theywere asked to pay about tentimes the book value of thestock, after the bootstrapoperation of increasing theirequity per share from 59centsto$1.35withtheirownmoney.*Before thebestyear1968, the company’smaximum earnings had beenaridiculous7centspershare.There were ambitious plansforthefuture,ofcourse—but

thepublicwasbeingaskedtopayheavilyinadvanceforthehoped-for realizationof theseplans.

2.Nonetheless,thepriceofthe stock doubled soon afteroriginalissuance,andanyoneofthebrokerage-houseclientscould have gotten out at ahandsomeprofit.Didthisfactalter the flotation, or did theadvance possibility that itmight happen exonerate the

original distributors of theissue from responsibility forthis public offering and itslater sequel? Not an easyquestion to answer, but itdeserves carefulconsideration by Wall Streetand the governmentregulatoryagencies.†

SubsequentHistory

With its enlarged capitalAAA Enterprises went into

two additional businesses. In1969 it opened a chain ofretail carpet stores, and itacquired a plant thatmanufactured mobile homes.The results reported for thefirst nine months were notexactly brilliant, but theywere a little better than theyearbefore—22centsashareagainst 14 cents. Whathappened in the nextmonthswas literally incredible. Thecompany lost $4,365,000, or

$1.49 per share. Thisconsumed all its capitalbefore thefinancing,plus theentire$2,400,000receivedonthe sale of stock plus two-thirdsof theamount reportedas earned in the first ninemonths of 1969. There wasleftapathetic$242,000,or8centspershare,ofcapitalforthe public shareholders whohad paid $13 for the newoffering only seven monthsbefore. Nonetheless the

sharesclosedtheyear1969at81/8bid,ora“valuation”ofmorethan$25millionforthecompany.

FURTHER COMMENT: 1. It istoo much to believe that thecompany had actually earned$686,000 from January toSeptember1969andthenlost$4,365,000 in the next threemonths.Therewassomethingsadly, badly, and accusinglywrong about the September

30report.

2.Theyear’sclosingpriceof81/8bidwasevenmoreofa demonstration of thecomplete heedlessness ofstock-marketpricesthanwerethe original offering price of13 or the subsequent “hot-issue” advance to a high bidof28.These latterquotationsat least were based onenthusiasmandhope—outofall proportion to reality and

common sense, but at leastcomprehensible. The year-end valuation of $25 millionwas given to a company thathad lost all but a minusculeremnant of its capital, forwhicha completely insolventconditionwas imminent, andfor which the words“enthusiasm” or “hope”would be only bittersarcasms. (It is true theyear-end figures had not beenpublished by December 31,

but it is thebusinessofWallStreet houses associatedwitha company to have monthlyoperating statements and afairly exact idea of howthingsaregoing.)

FinalChapter

For the first half of 1970the company reported afurther loss of $1 million. Itnowhadagood-sizedcapitaldeficit. It was kept out of

bankruptcybyloansmadebyMr.Williams,uptoatotalof$2,500,000. No furtherstatementsseemtohavebeenissued, until in January 1971AAAEnterprisesfinallyfiledapetition in bankruptcy.Thequotation for the stock atmonth-endwas still 50 centsasharebid,or$1,500,000forthe entire issue, whichevidently had no more thanwallpaper value. End of ourstory.

MORALANDQUESTIONS:Thespeculative public isincorrigible. In financialterms it cannotcountbeyond3.Itwillbuyanything,atanyprice, if there seems to besome “action” in progress. Itwill fall for any companyidentified with “franchising,”computers, electronics,science, technology, or whathaveyou,whentheparticularfashion is raging. Ourreaders,sensibleinvestorsall,

are of course above suchfoolishness. But questionsremain: Should notresponsible investmenthouses be honor-bound torefrain from identifyingthemselves with suchenterprises,nineoutoftenofwhichmaybeforedoomedtoultimate failure? (This wasactually the situation whentheauthorenteredWallStreetin 1914. By comparison itwould seem that the ethical

standardsofthe“Street”havefallenratherthanadvancedinthe ensuing 57 years, despiteall the reforms and all thecontrols.) Could and shouldthe SEC be given otherpowers to protect the public,beyond the present oneswhicharelimitedtorequiringthe printing of all importantrelevant facts in the offeringprospectus? Should somekind of box score for publicofferings of various types be

compiled and published inconspicuous fashion? Shouldeveryprospectus,andperhapsevery confirmation of saleunder an original offering,carry some kind of formalwarranty that the offeringprice for the issue is notsubstantially out of line withtherulingpricesfor issuesofthesamegeneraltypealreadyestablishedinthemarket?Aswe write this edition amovement toward reform of

Wall Street abuses is underway. It will be difficult toimpose worthwhile changesin the field of newofferings,because the abuses are solargely the result of thepublic’s own heedlessnessand greed. But the matterdeserves long and carefulconsideration.*


The wisdom god, Woden, wentout to the king of the trolls, gothim in an armlock, anddemanded to know of him howordermight triumph over chaos.“Givemeyourlefteye,”saidthetroll,“andI’lltellyou.”Withouthesitation, Woden gave up hislefteye.“Nowtellme.”Thetroll

said,“Thesecretis,‘Watchwithbotheyes!’”

—JohnGardner

TheMoreThingsChange…

Graham highlights fourextremes:

an overpriced “totteringgiant”an empire-buildingconglomerate

amergerinwhichatinyfirmtookoverabigonean initialpublicofferingof shares in a basicallyworthlesscompany

The past few years haveprovided enough new casesof Graham’s extremes to fillan encyclopedia. Here is asampler:

Lucent,NotTransparent

In mid-2000, LucentTechnologiesInc.wasownedby more investors than anyother U.S. stock. With amarket capitalization of$192.9 billion, it was the12th-most-valuable companyinAmerica.

Was that giant valuationjustified? Let’s look at somebasics from Lucent’sfinancial report for the fiscalquarterendedJune30,2000:1

FIGURE 17-1 LucentTechnologiesInc.

Allnumbersinmillionsofdollars.*Otherassets,whichincludesgoodwill.Source:Lucentquarterlyfinancialreports(Form10-Q).

A closer reading ofLucent’s report sets alarmbells jangling like anunanswered telephoneswitchboard:

Lucent had just boughtan optical equipmentsupplier, Chromatis

Networks, for $4.8billion—of which $4.2billion was “goodwill”(or cost above bookvalue). Chromatis had150 employees, nocustomers, and zerorevenues, so the term“goodwill” seemsinadequate; perhaps“hope chest” is moreaccurate. If Chromatis’sembryonic products didnot work out, Lucent

would have to reversethe goodwill and chargeit off against futureearnings.AfootnotedisclosesthatLucent had lent $1.5billion to purchasers ofitsproducts.Lucentwasalso on the hook for$350 million inguaranteesformoneyitscustomers hadborrowedelsewhere. The total ofthese “customer

financings” had doubledin a year—suggestingthat purchasers wererunning out of cash tobuy Lucent’s products.What if they ran out ofcashtopaytheirdebts?Finally, Lucent treatedthe cost of developingnew software as a“capital asset.” Ratherthananasset,wasn’tthata routine businessexpense that should

comeoutofearnings?

CONCLUSION:InAugust2001, Lucent shut down theChromatis division after itsproducts reportedly attractedonlytwocustomers.2Infiscalyear 2001, Lucent lost $16.2billion; infiscalyear2002, itlost another $11.9 billion.Includedinthoselosseswere$3.5billionin“provisionsforbad debts and customerfinancings,” $4.1 billion in

“impairment charges relatedto goodwill,” and $362million incharges“related tocapitalizedsoftware.”

Lucent’s stock, at $51.062on June 30, 2000, finished2002 at $1.26—a loss ofnearly$190billion inmarketvalueintwo-and-a-halfyears.

TheAcquisitionMagician

To describe TycoInternational Ltd., we canonly paraphrase WinstonChurchill and say that neverhas somuchbeen soldby somany to so few. From 1997through 2001, this Bermuda-based conglomerate spent atotalofmorethan$37billion—mostofitinsharesofTycostock—buyingcompanies theway Imelda Marcos boughtshoes. In fiscal year 2000alone,accordingtoitsannual

report, Tyco acquired“approximately 200companies”—an average ofmore than one every otherday.

The result? Tyco grewphenomenally fast; in fiveyears, revenues went from$7.6 billion to $34 billion,and operating income shotfroma$476millionloss toa$6.2billiongain.Nowonderthe company had a total

stock-market value of $114billionattheendof2001.

But Tyco’s financialstatements were at least asmind-boggling as its growth.Nearly every year, theyfeaturedhundredsofmillionsof dollars in acquisition-related charges. Theseexpenses fell into threemaincategories:

1. “merger” or“restructuring”or “othernonrecurring”costs,

2. “charges for theimpairmentoflong-livedassets,”and

3. “write-offs of purchasedin-process research anddevelopment.”

For the sake of brevity,let’s refer to the first kindofcharge as MORON, thesecond as CHILLA, and the

third asWOOPIPRAD.Howdidtheyshowupovertime?

FIGURE 17-2 TycoInternationalLtd.

Allfiguresareasoriginallyreported,statedinhundredsofmillionsofdollars.“Mergers&acquisitions”totalsdonotincludepooling-of-interestsdeals.Source:TycoInternationalannualreports(Form10-K).

As you can see, theMORONcharges—whicharesupposed to be nonrecurring—showed up in four out offive years and totaled awhopping $2.5 billion.CHILLA cropped up just aschronically and amounted to

more than $700 million.WOOPIPRAD came toanotherhalf-billiondollars.3

The intelligent investorwouldask:

If Tyco’s strategy ofgrowth-through-acquisition was such aneat idea, how come ithad to spendanaverageof $750 million a year

cleaningupafteritself?If, as seems clear, Tycowas not in the businessof making things—butrather in the business ofbuying other companiesthat make things—thenwhy were its MORONcharges “nonrecurring”?Weren’ttheyjustpartofTyco’s normal costs ofdoingbusiness?And with accountingcharges for past

acquisitions junking upevery year’s earnings,whocouldtellwhatnextyear’swouldbe?

Infact,aninvestorcouldn’teven tell what Tyco’s pastearningswere. In 1999, afteran accounting review by theU.S.SecuritiesandExchangeCommission, Tycoretroactively added $257million in MORON chargesto its 1998 expenses—

meaning that those“nonrecurring” costs hadactuallyrecurredinthatyear,too. At the same time, thecompany rejiggered itsoriginally reported 1999charges:MORONdroppedto$929 million while CHILLAroseto$507million.

Tyco was clearly growingin size, but was it growingmore profitable? No outsidercouldsafelytell.

CONCLUSION: In fiscalyear 2002, Tyco lost $9.4billion.Thestock,whichhadclosed at $58.90 at year-end2001,finished2002at$17.08—a loss of 71% in twelvemonths.4

AMinnowSwallowsaWhale

On January 10, 2000,America Online, Inc. andTimeWarner Inc. announced

that they would merge in adeal initially valued at $156billion.

AsofDecember31, 1999,AOL had $10.3 billion inassets, and its revenues overthe previous 12 months hadamounted to $5.7 billion.Time Warner, on the otherhand, had $51.2 billion inassets and revenues of $27.3billion. Time Warner was avastlybiggercompanybyany

measure except one: thevaluation of its stock.Because America OnlinebedazzledinvestorssimplybybeingintheInternetindustry,itsstocksoldforastupendous164 times its earnings. Stockin Time Warner, a grab bagof cable television, movies,music, and magazines, soldforaround50timesearnings.

Inannouncingthedeal,thetwo companies called it a

“strategic merger of equals.”Time Warner’s chairman,Gerald M. Levin, declaredthat “the opportunities arelimitless for everyoneconnected to AOL TimeWarner”—above all, headded,foritsshareholders.

Ecstatic that their stockmightfinallygetthecachetofan Internet darling, TimeWarner shareholdersoverwhelminglyapprovedthe

deal. But they overlooked afewthings:

This “merger of equals”was designed to giveAmerica Online’sshareholders 55%of thecombined company—even though TimeWarner was five timesbigger.For the second time inthree years, the U.S.

Securities andExchangeCommission wasinvestigating whetherAmerica Online hadimproperly accountedformarketingcosts.Nearly half of AmericaOnline’s total assets—$4.9 billion worth—wasmade up of “available-for-sale equitysecurities.” If the pricesof publicly-tradedtechnology stocks fell,

that could wipe outmuch of the company’sassetbase.

CONCLUSION: OnJanuary 11, 2001, the twofirms finalized their merger.AOL Time Warner Inc. lost$4.9 billion in 2001 and—inthemostgargantuanlosseverrecorded by a corporation—another$98.7billionin2002.Mostofthelossescamefromwriting down the value of

AmericaOnline.Byyear-end2002, the shareholders forwhom Levin predicted“unlimited”opportunitieshadnothingtoshowbutaroughly80%lossinthevalueoftheirsharessincethedealwasfirstannounced.5

CanYouFlunkInvestingKindergarten?

OnMay20,1999,eToysInc.

sold 8% of its stock to thepublic. Four ofWall Street’smost prestigious investmentbanks—Goldman, Sachs &Co.; BancBoston RobertsonStephens; Donaldson, Lufkin&Jenrette;andMerrillLynch& Co.—underwrote8,320,000 shares at $20apiece, raising $166.4million.The stock roaredup,closing at $76.5625, a282.8%gaininitsfirstdayoftrading. At that price, eToys

(with its 102 million shares)had a market value of $7.8billion.1

What kind of business didbuyers get for that price?eToys’ sales had risen4,261% in the previous year,and it had added 75,000customers in the last quarteralone.But,inits20monthsinbusiness,eToyshadproducedtotal sales of $30.6 million,onwhichithadrunanetloss

of $30.8 million—meaningthat eToys was spending $2toselleverydollar’sworthoftoys.

The IPO prospectus alsodisclosed that eToys woulduse some proceeds of theoffering to acquire anotheronline operation, Baby-Center, Inc., which had lost$4.5 million on $4.8 millionin sales over the previousyear. (To land this prize,

eToyswouldpayamere$205million.) And eToys would“reserve” 40.6million sharesof common stock for futureissuance to its management.So, if eToys ever mademoney, its net incomewouldhavetobedividednotamong102 million shares, butamong 143 million—dilutingany futureearningsper sharebynearlyone-third.

A comparison of eToys

with Toys “R” Us, Inc.—itsbiggestrival—isshocking.Inthe preceding three months,Toys“R”Ushadearned$27millioninnetincomeandhadsold over 70 times moregoodsthaneToyshadsoldinan entire year. And yet asFigure 17-3 shows, the stockmarket valued eToys atnearly $2 billion more thanToys“R”Us.

CONCLUSION:OnMarch

7, 2001, eToys filed forbankruptcy protection afterrackingupnetlossesofmorethan$398million in its brieflifeasapubliccompany.Thestock, which peaked at $86per share in October 1999,lasttradedforapenny.

FIGURE17-3AToyStory

Allamountsinmillionsofdollars.Sources:Thecompanies’SECfilings.

Chapter18AComparisonofEightPairsofCompanies

In this chapter we shallattempt a novel form of

exposition.Byselectingeightpairs of companies whichappear next to each other, ornearly so, on the stock-exchange list we hope tobringhomeinaconcreteandvivid manner some of themany varieties of character,financial structure, policies,performance,andvicissitudesof corporate enterprises, andof the investment andspeculativeattitudesfoundonthe financial scene in recent

years.Ineachcomparisonweshall comment only on thoseaspects that have a specialmeaningandimport.

PairI:RealEstateInvestmentTrust(Stores,Offices,Factories,etc.)andRealtyEquitiesCorp.ofNewYork(RealEstateInvestment;GeneralConstruction)

Inthisfirstcomparisonwedepart from the alphabeticalorderusedfortheotherpairs.It has a special significance

for us, since it seems toencapsulate,ontheonehand,all that has been reasonable,stable, and generally good inthe traditional methods ofhandling other people’smoney, in contrast—in theother company—with thereckless expansion, thefinancial legerdemain, andthe roller-coaster changes sooften found in present-daycorporateoperations.Thetwoenterprises have similar

names, and for many yearstheyappearedsidebysideonthe American StockExchange list. Their stock-ticker symbols—REI andREC—couldeasilyhavebeenconfused.Butoneof them isa staid New England trust,administered by threetrustees, with operationsdatingbacknearly a century,and with dividends paidcontinuously since 1889. Ithas kept throughout to the

same type of prudentinvestments, limiting itsexpansion to amoderate rateand its debt to an easilymanageablefigure.*

Theother isa typicalNewYork-based sudden-growthventure,which in eight yearsblew up its assets from $6.2million to $154 million, andits debts in the sameproportion;whichmoved outfrom ordinary real-estate

operations to amiscellany ofventures, including tworacetracks,74movietheaters,three literary agencies, apublic-relations firm, hotels,supermarkets, and a 26%interest in a large cosmeticsfirm(whichwentbankruptin1970).† This conglomerationof business ventures wasmatched by a correspondingvariety of corporate devices,includingthefollowing:

1. A preferred stockentitled to $7 annualdividends,butwithaparvalue of only $1, andcarried as a liability at$1pershare.

2. A stated common-stockvalue of $2,500,000 ($1per share), more thanoffset by a deduction of$5,500,000asthecostof209,000 shares of

reacquiredstock.3. Three series of stock-

option warrants, givingrights to buy a total of1,578,000shares.

4. At least six differentkinds of debtobligations, in the formof mortgages,debentures,publiclyheldnotes, notes payable tobanks,“notes,loans,andcontracts payable,” andloans payable to the

Small BusinessAdministration, addingup to over $100millionin March 1969. Inaddition ithad theusualtaxes and accountspayable.

Let us present first a fewfiguresof the twoenterprisesas they appeared in 1960(Table 18-1A).Herewe findtheTrustsharessellinginthemarket for nine times the

aggregate value of Equitiesstock. The Trust enterprisehad a smaller relative debtand a better ratio of net togross, but the price of thecommon was higher inrelationtoper-shareearnings.

TABLE18-1A.Pair1.RealEstate InvestmentTrustvs.Realty Equities Corp. in1960

InTable18-1Bwepresentthesituationabouteightyears

later.TheTrusthad“keptthenoiseless tenor of its way,”increasing both its revenuesand its per-share earnings byabout three-quarters.* ButRealty Equities had beenmetamorphosed intosomething monstrous andvulnerable.

How didWall Street reactto these diversedevelopments? By paying aslittle attention as possible to

the Trust and a lot to RealtyEquities. In 1968 the lattershotupfrom10to373/4andthe listed warrants from 6 to36½, on combined sales of2,420,000 shares. While thiswas happening the Trustshares advanced sedatelyfrom 20 to 30¼ on modestvolume. The March 1969balancesheetofEquitieswastoshowanassetvalueofonly$3.41 per share, less than atenth of its high price that

year. The book value of theTrustshareswas$20.85.

TABLE18-1B.Pair1.

The next year it becameclear that allwas notwell inthe Equities picture, and theprice fell to 9½. When thereport for March 1970appeared the shareholdersmust have felt shell-shockedas they read that theenterprisehadsustainedanetlossof$13,200,000,or$5.17per share—virtually wipingout their former slim equity.(This disastrous figure

included a reserve of$8,800,000 for future losseson investments.) Nonethelessthe directors had bravely (?)declaredanextradividendof5centsrightafterthecloseofthe fiscal year. But moretrouble was in sight. Thecompany’sauditorsrefusedtocertify the financialstatements for 1969–70, andthe shares were suspendedfromtradingontheAmericanStockExchange. In theover-

the-counter market the bidprice dropped below $2 pershare.*

Real Estate InvestmentTrustshareshadtypicalpricefluctuations after 1969. Thelowin1970was16½,witharecovery to 26 5/6 in early1971. The latest reportedearnings were $1.50 pershare, and the stock wasselling moderately above its1970 book value of $21.60.

The issue may have beensomewhat overpriced at itsrecord high in 1968, but theshareholders have beenhonestly and well served bytheirtrustees.TheRealEstateEquities story is a differentandasorryone.

Pair2:AirProductsandChemicals(IndustrialandMedicalGases,etc.)andAirReductionCo.(IndustrialGasesandEquipment;Chemicals)

Even more than our first

pair,thesetworesembleeachotherinbothnameandlineofbusiness. The comparisonthey invite is thus of theconventional type in securityanalysis, while most of ourother pairs are moreheteroclite in nature.†“Products” is a newercompany than “Reduction,”andin1969hadlessthanhalfthe other’s volume.*Nonetheless its equity issues

sold for 25% more in theaggregate than AirReduction’s stock. As Table18-2shows,thereasoncanbefoundbothinAirReduction’sgreaterprofitabilityandinitsstronger growth record. Wefind here the typicalconsequences of a bettershowing of “quality.” AirProductssoldat16½timesitslatest earnings against only9.1 times for Air Reduction.Also Air Products sold well

aboveitsassetbacking,whileAir Reduction could bebought at only 75% of itsbook value.† Air Reductionpaid amore liberal dividend;but this may be deemed toreflect thegreaterdesirabilityfor Air Products to retain itsearnings.Also,AirReductionhad a more comfortableworking-capitalposition. (Onthispointwemayremarkthata profitable company can

alwaysputitscurrentpositionin shape by some form ofpermanent financing. But byour standards Air Productswassomewhatoverbonded.)

If the analyst were calledontochoosebetweenthetwocompanieshewouldhavenodifficulty in concluding thattheprospectsofAirProductslooked more promising thanthose of Air Reduction. Butdid this make Air Products

more attractive at itsconsiderably higher relativeprice?Wedoubtwhetherthisquestioncanbeansweredinadefinitive fashion. In generalWall Street sets “quality”above “quantity” in itsthinking, and probably themajority of security analystswouldoptforthe“better”butdearerAirProductsasagainstthe “poorer” but cheaper AirReduction. Whether thispreferenceistoproverightor

wrong is more likely todepend on the unpredictablefuture than on anydemonstrable investmentprinciple.Inthisinstance,AirReduction appears to belongto the group of importantcompanies in the low-multiplier class. If, as thestudies referred to above††would seem to indicate, thatgroupasawhole is likely togiveabetteraccountof itself

than the high-multiplierstocks, then Air Reductionshould logically be given thepreference—but only as partof a diversified operation.(Also,athorough-goingstudyof the individual companiescould lead the analyst to theopposite conclusion; but thatwouldhave tobe for reasonsbeyond those alreadyreflectedinthepastshowing.)

SEQUEL:AirProductsstood

up better than Air Reductionin the 1970 break, with adecline of 16% against 24%.However, Reduction made abetter comeback in early1971,risingto50%aboveits1969 close, against 30% forProducts.Inthiscasethelow-multiplier issue scored theadvantage—for the timebeing,atleast.*

TABLE18-2.Pair2.

Pair 3: American HomeProducts Co. (drugs,cosmetics, householdproducts, candy) andAmerican Hospital SupplyCo. (distributor andmanufacturer of hospitalsuppliesandequipment)

These were two “billion-dollar good-will” companiesat the end of 1969,

representing differentsegments of the rapidlygrowing and immenselyprofitable “health industry.”We shall refer to them asHome and Hospital,respectively.Selecteddataonboth are presented in Table18-3.Theyhad thefollowingfavorable points in common:excellent growth, with nosetbacks since 1958 (i.e.,100%earnings stability); andstrong financial condition.

The growth rate of Hospitalup to the end of 1969 wasconsiderably higher thanHome’s. On the other hand,Home enjoyed substantiallybetter profitability on bothsalesandcapital.†(Infact,therelatively low rate ofHospital’s earnings on itscapitalin1969—only9.7%—raises the intriguing questionwhether the business thenwasinfactahighlyprofitable

one, despite its remarkablepast growth rate in sales andearnings.)

Whencomparativeprice istaken into account, Homeoffered much more for themoneyintermsofcurrent(orpast) earnings and dividends.The very low book value ofHome illustrates a basicambiguity or contradiction incommon-stock analysis. Onthe one hand, it means that

thecompanyisearningahighreturn on its capital—whichingeneralisasignofstrengthand prosperity.On the other,it means that the investor atthe current price would beespecially vulnerable to anyimportant adverse change inthe company’s earningssituation. SinceHospitalwasselling at over four times itsbook value in 1969, thiscautionary remark must beappliedtobothcompanies.

TABLE18-3.Pair3.

CONCLUSIONS: Our clear-cut view would be that bothcompanieswere too“rich”attheir current prices to beconsidered by the investorwho decides to follow ourideas of conservativeselection.Thisdoesnotmeanthat the companies werelacking in promise. Thetrouble is, rather, that theirprice contained too much“promise” and not enough

actual performance. For thetwoenterprisescombined,the1969 price reflected almost$5 billion of good-willvaluation.Howmanyyearsofexcellent future earningswouldittaketo“realize”thatgood-will factor in the formof dividends or tangibleassets?

SHORT-TERM SEQUEL: Atthe end of 1969 the marketevidently thought more

highly of the earningsprospects ofHospital than ofHome, since it gave theformer almost twice themultiplier of the latter. As ithappened the favored issueshowedamicroscopicdeclinein earnings in 1970, whileHometurnedinarespectable8%gain.ThemarketpriceofHospital reacted significantlyto this one-yeardisappointment. It sold at 32in February 1971—a loss of

about 30% from its 1969close—while Home wasquoted slightly above itscorrespondinglevel.*

Pair4:H&RBlock,Inc.(Income-TaxService)andBlueBell,Inc.,(ManufacturersofWorkClothes,Uniforms,etc.)

These companies rubshoulders as relativenewcomers to theNewYorkStock Exchange, where theyrepresent two very different

genres of success stories.Blue Bell came up the hardway in a highly competitiveindustry, inwhich eventuallyit became the largest factor.Its earnings have fluctuatedsomewhat with industryconditions, but their growthsince 1965 has beenimpressive. The company’soperations go back to 1916and its continuous dividendrecordto1923.Attheendof1969 the stock market

showednoenthusiasmfortheissue, giving it aprice/earnings ratio of only11,againstabout17fortheS&Pcompositeindex.

Bycontrast,theriseofH&R Block has been meteoric.Itsfirstpublishedfiguresdateonlyto1961,inwhichyearitearned $83,000 on revenuesof $610,000. But eight yearslater,onourcomparisondate,its revenues had soared to

$53.6 million and its net to$6.3million.Atthat timethestock market’s attitudetoward this fine performerappeared nothing less thanecstatic.Thepriceof55atthecloseof1969wasmore than100 times the last reported12-months’ earnings—whichof course were the largest todate. The aggregate marketvalueof$300million for thestock issue was nearly 30times the tangible assets

behind the shares.* This wasalmost unheard of in theannals of serious stock-market valuations. (At thattimeIBMwassellingatabout9timesandXeroxat11timesbookvalue.)

Our Table 18-4 sets forthindollar figuresand in ratiostheextraordinarydiscrepancyin thecomparativevaluationsofBlockandBlueBell.True,Block showed twice the

profitability of Blue Bell perdollar of capital, and itspercentagegrowthinearningsoverthepastfiveyears(frompractically nothing) wasmuch higher. But as a stockenterprise Blue Bell wassellingforlessthanone-thirdthe total value of Block,althoughBlueBellwasdoingfour times asmuch business,earning2½timesasmuchforits stock, had 5½ times asmuch in tangible investment,

and gave nine times thedividendyieldontheprice.

INDICATED CONCLUSIONS:An experienced analystwould have conceded greatmomentum to Block,implying excellent prospectsfor future growth. He mighthave had some qualms aboutthe dangers of seriouscompetition in the income-tax-servicefield, luredbythehandsome return on capital

realized by Block.1 Butmindful of the continuedsuccess of such outstandingcompanies as Avon Productsin highly competitive areas,he would have hesitated topredict a speedy flatteningout of the Block growthcurve. His chief concernwouldbe simplywhether the$300millionvaluationforthecompany had not alreadyfully valued and perhaps

overvaluedall thatonecouldreasonably expect from thisexcellent business. Bycontrast the analyst shouldhave had little difficulty inrecommendingBlueBellasafine company, quiteconservativelypriced.

TABLE18-4.Pair4.

SEQUEL TO MARCH 1971.The 1970 near-panic loppedone-quarter off the price ofBlueBellandaboutone-thirdfromthatofBlock.Boththenjoined in the extraordinaryrecovery of the generalmarket. The price of Blockrose to 75 in February 1971,but Blue Bell advancedconsiderably more—to theequivalent of 109 (after athree-for-two split). Clearly

BlueBellprovedabetterbuythan Block as of the end of1969.But the fact thatBlockwas able to advance some35% from that apparentlyinflated value indicates howwary analysts and investorsmust be to sell goodcompanies short—either bywordordeed—nomatterhowhigh the quotation mayseem.*

Pair5:InternationalFlavors&

Fragrances(Flavors,etc.,forOtherBusinesses)andInternationalHarvesterCo.(TruckManufacturer,FarmMachinery,ConstructionMachinery)

This comparison shouldcarrymore thanonesurprise.Everyone knows ofInternational Harvester, oneof the 30 giants in the DowJones Industrial Average.†How many of our readershave even heard ofInternational Flavors &

Fragrances, next-doorneighbor to Harvester on theNew York Stock Exchangelist?Yet,mirabile dictu, IFFwasactuallysellingattheendof 1969 for a higheraggregate market value thanHarvester—$747 millionversus $710 million. This isthe more amazing when onereflectsthatHarvesterhad17times the stock capital ofFlavors and 27 times theannual sales. Infact, only

three years before, the netearnings of Harvester hadbeen larger than the 1969sales of Flavors! How didtheseextraordinarydisparitiesdevelop? The answer lies inthe two magic words:profitability and growth.Flavors made a remarkableshowing in both categories,while Harvester lefteverythingtobedesired.

TABLE18-5.Pair5.

The story is told in Table18-5. Here we find Flavorswith a sensational profit of14.3% of sales (beforeincome tax the figure was23%), comparedwith amere2.6% for Harvester.Similarly,Flavorshadearned19.7% on its stock capitalagainst an inadequate 5.5%earned by Harvester. In fiveyears the net earnings ofFlavors had nearly doubled,

while those of Harvesterpractically stood still.Between 1969 and 1959 thecomparison makes similarreading. These differences inperformance produced atypical stock-marketdivergence in valuation.Flavors sold in 1969 at 55times its last reportedearnings, and Harvester atonly 10.7 times.Correspondingly,Flavorswasvaluedat 10.4 times its book

value, while Harvester wasselling at a 41% discountfromitsnetworth.

COMMENT ANDCONCLUSIONS: The first thingto remark is that the marketsuccessofFlavorswasbasedentirely on the developmentof its central business, andinvolved none of thecorporate wheeling anddealing, acquisitionprograms, top-heavy

capitalization structures, andother familiar Wall Streetpracticesofrecentyears.Thecompany has stuck to itsextremely profitable knitting,andthat isvirtuallyitswholestory.TherecordofHarvesterraisesanentirelydifferentsetof questions, but these toohavenothingtodowith“highfinance.”Whyhave somanygreat companies becomerelatively unprofitable evenduringmanyyearsofgeneral

prosperity? What is theadvantageofdoingmorethan$2½billionofbusinessiftheenterprisecannotearnenoughto justify the shareholders’investment?Itisnotforustoprescribe the solution of thisproblem. But we insist thatnotonlymanagementbut therank and file of shareholdersshould be conscious that theproblem exists and that itcalls for the best brains andthe best efforts possible to

deal with it.* From thestandpoint of common-stockselection,neitherissuewouldhave met our standards ofsound, reasonably attractive,and moderately pricedinvestment. Flavors was atypical brilliantly successfulbut lavishlyvaluedcompany;Harvester’s showing was toomediocre to make it reallyattractiveevenat itsdiscountprice. (Undoubtedly there

were better values availablein the reasonably pricedclass.)

SEQUEL TO 1971: The lowprice ofHarvester at the endof 1969 protected it from alarge further decline in thebadbreakof1970.Itlostonly10% more. Flavors provedmorevulnerableanddeclinedto 45, a loss of 30%. In thesubsequent recovery bothadvanced, well above their

1969 close, but Harvestersoonfellbacktothe25level.

Pair6:McGrawEdison(PublicUtilityandEquipment;Housewares)McGraw-Hill,Inc.(Books,Films,InstructionSystems;MagazineandNewspaperPublishers;InformationServices)

This pair with so similarnames—which at times weshall call Edison and Hill—are two large and successfulenterprises in vastly different

fields. We have chosenDecember 31, 1968, as thedate of our comparison,developedinTable18-6.Theissues were selling at aboutthesameprice,butbecauseofHill’s larger capitalization itwasvaluedatabouttwicethetotal figureof theother.Thisdifference should appearsomewhat surprising, sinceEdisonhadabout50%highersales and one-quarter largernet earnings. As a result, we

find that the key ratio—themultiplier of earnings—wasmore than twice as great forHill as for Edison. Thisphenomenon seemsexplicable chiefly by thepersistence of a strongenthusiasm and partialityexhibited by the markettoward shares of book-publishingcompanies,severalofwhichhadbeenintroducedto public trading in the later

1960s.*

Actually, by the end of1968 it was evident that thisenthusiasm had beenoverdone.TheHillshareshadsoldat56in1967,morethan40 times the just-reportedrecordearningsfor1966.Buta small decline had appearedin1967anda furtherdeclinein 1968. Thus the currenthigh multiplier of 35 wasbeing applied to a company

that had already shown twoyears of receding profits.Nonetheless the stock wasstillvaluedatmorethaneighttimes its tangible assetbacking, indicating a good-will component of not farfrom a billion dollars! Thusthe price seemed to illustrate—in Dr. Johnson’s famousphrase—“The triumph ofhopeoverexperience.”

TABLE18-6.Pair6.

By contrast, McGrawEdison seemed quoted at areasonablepriceinrelationtothe (high) general marketlevel and to the company’soverall performance andfinancialposition.

SEQUEL TO EARLY 1971:The decline of McGraw-Hill’s earnings continuedthrough 1969 and 1970,droppingto$1.02andthento

$.82 per share. In the May1970 debacle its pricesuffered a devastating breakto10—lessthanafifthofthefigure two years before. Ithad a good recoverythereafter, but the high of 24in May 1971 was still only60% of the 1968 closingprice.McGrawEdisongaveabetter account of itself—declining to 22 in 1970 andrecovering fully to 41½ in

May1971.*

McGraw-Hill continues tobe a strong and prosperouscompany.Butitspricehistoryexemplifies—as do so manyother cases—the speculativehazardsinsuchstockscreatedby Wall Street through itsundisciplined waves ofoptimismandpessimism.

Pair7:NationalGeneralCorp.(ALargeConglomerate)andNationalPrestoIndustries(DiverseElectric

Appliances,Ordnance)

These two companiesinvite comparison chieflybecause theyaresodifferent.Let us call them “General”and “Presto.” We haveselected the end of 1968 forour study, because thewrite-offstakenbyGeneralin1969madethefiguresforthatyeartoo ambiguous. The fullflavor of General’s far-flungactivities could not be

savoredtheyearbefore,butitwas already conglomerateenough for anyone’s taste.Thecondenseddescription intheStockGuideread“Nation-wide theatre chain; motionpicture and TV production,savings and loan assn., bookpublishing.” To which couldbe added, then or later,“insurance, investmentbanking, records, musicpublishing, computerizedservices, real estate—and

35%ofPerformanceSystemsInc. (name recently changedfromMinnie Pearl’sChickenSystemInc.).”Prestohadalsofollowed a diversificationprogram, but in comparisonwith General it was modestindeed.Startingastheleadingmaker of pressure cookers, ithadbranchedoutintovariousother household and electricappliances. Quite differently,also, it took on a number ofordnance contracts for the

U.S.government.

Our Table 18-7summarizes the showing ofthe companies at the end of1968.ThecapitalstructureofPresto was as simple as itcould be—nothing but1,478,000 shares of commonstock, selling in the marketfor $58 million.Contrastingly, General hadmore than twice as manyshares of common, plus an

issueofconvertiblepreferred,plus three issues of stockwarrants calling for a hugeamount of common, plus atowering convertible bondissue (just given in exchangefor stock of an insurancecompany),plusagoodlysumof nonconvertible bonds. Allthis added up to a marketcapitalization of $534million, not counting animpending issue ofconvertible bonds, and $750

million, including such issue.Despite National General’senormously greatercapitalization, it had actuallydone considerably less grossbusiness than Presto in theirfiscalyears,andithadshownonly 75% of Presto’s netincome.

The determination of thetrue market value ofGeneral’s common-stockcapitalization presents an

interesting problem forsecurity analysts and hasimportant implications foranyoneinterestedinthestockon any basis more seriousthan outright gambling. Therelatively small $4½convertible preferred can bereadily taken care of byassuming its conversion intocommon,whenthelattersellsat a suitable market level.This we have done in Table18-7.Butthewarrantsrequire

different treatment. Incalculating the“fulldilution”basis the company assumesexercise of all the warrants,and the application of theproceeds to the retirement ofdebt, plus use of the balanceto buy in common at themarket. These assumptionsactuallyproducedvirtuallynoeffect on the earnings pershare in calendar 1968—whichwerereportedas$1.51both before and after

allowance for dilution. Weconsider this treatmentillogical and unrealistic. Aswe see it, the warrantsrepresent a part of the“common-stockpackage”andtheir market value is part ofthe “effective market value”of the common-stock part ofthe capital. (See ourdiscussionof thispointonp.415 above.) This simpletechnique of adding themarket price of the warrants

to that of the common has aradical effecton the showingofNationalGeneralattheendof 1968, as appears from thecalculation in Table 18-7. Infactthe“truemarketprice”ofthe common stock turns outto be more than twice thequotedfigure.Hence the truemultiplier of the 1968earningsismorethandoubled—to the inherently absurdfigure of 69 times. The totalmarket value of the

“common-stock equivalents”then becomes $413 million,which isover three times thetangible assets showntherefor.

TABLE18-7.Pair7.

These figures appear themore anomalous whencomparison is made withthoseofPresto.Oneismovedto ask how could Prestopossiblybevaluedatonly6.9times its current earningswhen the multiplier forGeneral was nearly 10 timesas great. All the ratios ofPrestoarequitesatisfactory—the growth figuresuspiciously so, in fact. By

that we mean that thecompany was undoubtedlybenefiting considerably fromits war work, and theshareholders should beprepared for some falling offin profits under peacetimeconditions. But, on balance,Presto met all therequirements of a sound andreasonablypricedinvestment,while General had all theearmarks of a typical“conglomerate” of the late

1960s vintage, full ofcorporate gadgets andgrandiose gestures, butlacking in substantial valuesbehindthemarketquotations.

SEQUEL:Generalcontinuedits diversification policy in1969, with some increase inits debt. But it took awhopping write-off ofmillions, chiefly in the valueof its investment in theMinnie Pearl Chicken deal.

The final figures showed alossof$72millionbeforetaxcreditand$46.4millionaftertax credit. The price of thesharesfellto16½in1969andas low as 9 in 1970 (only15%of its 1968highof 60).Earnings for 1970 werereported as $2.33 per sharediluted, and the pricerecovered to 28½ in 1971.National Presto increased itsper-share earnings somewhatin both 1969 and 1970,

marking 10 years ofuninterrupted growth ofprofits. Nonetheless its pricedeclined to 21½ in the 1970debacle. This was aninterestingfigure,sinceitwasless than four times the lastreported earnings, and lessthan the net current assetsavailable for the stock at thetime.Latein1971wefindthepriceofNationalPresto60%higher, at 34, but the ratiosare still startling. The

enlarged working capital isstillaboutequaltothecurrentprice, which in turn is only5½ times the last reportedearnings.Iftheinvestorcouldnow find ten such issues, fordiversification, he could beconfident of satisfactoryresults.*

Pair8:WhitingCorp.(Materials-Handlingequipment)andWillcox&Gibbs(SmallConglomerate)

This pair are close but not

touching neighbors on theAmerican Stock Exchangelist. The comparison—setforthinTable18-8A—makesonewonderifWallStreetisarational institution. Thecompany with smaller salesand earnings, and with halfthe tangible assets for thecommon, sold at about fourtimes the aggregate value ofthe other. The higher-valuedcompanywasabout to reporta large loss after special

charges; it had not paid adividend in thirteen years.The other had a long recordof satisfactory earnings, hadpaid continuous dividendssince1936,andwascurrentlyreturning one of the highestdividend yields in the entirecommon-stock list. Toindicate more vividly thedisparity in the performanceof the two companies weappend, in Table 18-8B, theearnings and price record for

1961–1970.

Table18-8A.Pair8.

TABLE 18-8B. Ten-YearPrice and Earnings Recordof Whiting and Willcox &Gibbs

The history of the twocompanies throws aninteresting light on thedevelopment of medium-sized businesses in thiscountry, in contrast withmuch larger-sized companiesthat havemainly appeared inthese pages. Whiting wasincorporated in 1896, andthus goes back at least 75years. It seems to have keptpretty faithfully to itsmaterials-handling business

andhasdonequitewellwithit over the decades. Willcox& Gibbs goes back evenfarther—to 1866—and waslongknownin its industryasa prominent maker ofindustrial sewing machines.During the past decade itadopted a policy ofdiversification inwhat seemsa rather outlandish form. Foron the one hand it has anextraordinarily large numberof subsidiary companies (at

least 24), making anastonishing variety ofproducts, but on the otherhand the entireconglomeration adds up tomighty small potatoes byusualWallStreetstandards.

Theearningsdevelopmentsin Whiting are rathercharacteristic of our businessconcerns. The figures showsteady and rather spectaculargrowthfrom41centsashare

in1960to$3.63in1968.Buttheycarriednoassurancethatsuch growth must continueindefinitely. The subsequentdecline to only $1.77 for the12 months ended January1971 may have reflectednothing more than theslowing down of the generaleconomy.But thestockpricereacted in severe fashion,falling about 60% from its1968high (43½) to the closeof 1969. Our analysis would

indicate that the sharesrepresented a sound andattractive secondary-issueinvestment—suitable for theenterprising investor as partof a group of suchcommitments.

SEQUEL: Willcox & Gibbsshowedasmalloperatinglossfor 1970. Its price declineddrastically to a low of 4½,recovering in typical fashionto 9½ in February 1971. It

would be hard to justify thatprice statistically. Whitinghadarelativelysmalldecline,to 16 3/4 in 1970. (At thatprice it was selling at justaboutthecurrentassetsaloneavailable for the shares). Itsearnings held at $1.85 pershare to July 1971. In early1971 the price advanced to24½, which seemedreasonable enough but nolonger a “bargain” by our

standards.*

GeneralObservations

The issues used in thesecomparisons were selectedwith some maliceaforethought, and thus theycannot be said to present arandom cross-section of thecommon-stock list.Also theyare limited to the industrialsection, and the importantareas of public utilities,

transportationcompanies,andfinancial enterprises do notappear. But they varysufficiently in size, lines ofbusiness, and qualitative andquantitativeaspectstoconveya fair idea of the choicesconfronting an investor incommonstocks.

The relationship betweenpriceand indicatedvaluehasalsodifferedgreatlyfromonecase toanother.For themost

part the companies withbetter growth records andhigher profitability have soldat higher multipliers ofcurrent earnings—which islogical enough in general.Whether the specificdifferentials in price/earningsratios are “justified” by thefacts—or will be vindicatedby future developments—cannot be answered withconfidence.Ontheotherhandwe do have quite a few

instances here in which aworthwhile judgment can bereached. These includevirtually all the cases wherethere has been great marketactivity in companies ofquestionable underlyingsoundness. Such stocks notonly were speculative—whichmeans inherently risky—butagooddealofthetimethey were and are obviouslyovervalued. Other issuesappeared to be worth more

than their price, beingaffected by the opposite sortofmarketattitude—whichwemight call“underspeculation”—or byundue pessimism because ofashrinkageinearnings.

TABLE 18-9. Some PriceFluctuations of SixteenCommon Stocks (Adjustedfor Stock Splits Through1970)

In Table 18-9 we providesome data on the pricefluctuations of the issuescovered in thischapter.Mostof them had large declinesbetween 1961 and 1962, aswell as from 1969 to 1970.Clearly the investor must beprepared for this type ofadversemarket movement infuturestockmarkets.InTable18-10 we show year-to-yearfluctuations of McGraw-Hill

common stock for the period1958–1970. It will be notedthat in each of the last 13years the price eitheradvanced or declined over arangeof at least three to twofromoneyeartothenext.(Inthe case of National Generalfluctuations of at least thisamplitude both upward anddownward were shown ineachtwo-yearperiod.)

TABLE18-10.LargeYear-

to-Year Fluctuations ofMcGraw-Hill,1958–1971a

In studying the stock listfor the material in thischapter, we were impressedonce again by the widedifference between the usualobjectivesofsecurityanalysisand those we deemdependable and rewarding.Most security analysts try toselecttheissuesthatwillgivethe best account ofthemselves in the future, intermschieflyofmarketaction

but considering also thedevelopmentofearnings.Weare frankly skeptical as towhetherthiscanbedonewithsatisfactory results. Ourpreference for the analyst’sworkwouldbe rather thatheshould seek the exceptionalorminoritycasesinwhichhecan form a reasonablyconfident judgment that thepriceiswellbelowvalue.Heshouldbeabletodothisworkwith sufficient expertness to

produce satisfactory averageresultsovertheyears.


Thethingthathathbeen,itisthatwhichshallbe;andthatwhichisdoneisthatwhichshallbedone:and there is no new thing underthe sun. Is there any thingwhereofitmaybesaid,See,thisis new? it hath been already ofoldtime,whichwasbeforeus.

—Ecclesiastes,I:9–10.

Let’s update Graham’sclassicwrite-upofeightpairsofcompanies,usingthesamecompare-and-contrasttechniquethathepioneeredinhis lectures at ColumbiaBusinessSchoolandtheNewYork Institute of Finance.Bear in mind that thesesummaries describe thesestocks only at the timesspecified. The cheap stocksmaylaterbecomeoverpriced;

theexpensivestocksmayturncheap. At some point in itslife, almost every stock is abargain; at another time, itwill be expensive. Althoughthere are good and badcompanies, there is no suchthing as a good stock; thereare only good stock prices,whichcomeandgo.

Pair1:CISCOandSYSCO

On March 27, 2000, CiscoSystems, Inc., became theworld’s most valuablecorporation as its stock hit$548 billion in total value.Cisco, which makesequipment that directs dataovertheInternet,firstsolditsshares to the public only 10yearsearlier.HadyouboughtCisco’s stock in the initialoffering and kept it, youwould have earned a gainresembling a typographical

error made by a madman:103,697%,ora217%averageannual return. Over itsprevious four fiscal quarters,Cisco had generated $14.9billion in revenues and $2.5billion inearnings.Thestockwas trading at 219 timesCisco’s net income, one ofthe highest price/earningsratioseveraccordedtoalargecompany.

Then there was Sysco

Corp.,whichsuppliesfoodtoinstitutionalkitchensandhadbeen publicly traded for 30years. Over its last fourquarters, Sysco served up$17.7 billion in revenues—almost 20%more thanCisco—but“only”$457million innet income. With a marketvalue of $11.7 billion,Sysco’s shares traded at 26times earnings, well belowthemarket’saverageP/Eratioof31.

A word-association gamewith a typical investormighthavegonelikethis.

Q:WhatarethefirstthingsthatpopintoyourheadwhenIsayCiscoSystems?

A: The Internet…theindustry of the future…greatstock…hot stock…Can Iplease buy some before itgoesupevenmore?

Q: And what about SyscoCorp.?

A: Delivery trucks…succotash…Sloppy Joes…shepherd’s pie…schoollunches…hospital food…nothanks, I’m not hungryanymore.

It’s well established thatpeople often assign a mentalvalue to stocks based largelyontheemotionalimagerythat

companies evoke.1 But theintelligent investor alwaysdigs deeper. Here’s what askeptical look at Cisco andSysco’s financial statementswouldhaveturnedup:

MuchofCisco’sgrowthinrevenuesandearningscame from acquisitions.Since September alone,Cisco had ponied up$10.2 billion to buy 11

other firms. How couldso many companies bemashed together soquickly?2 Also, roughlya third of Cisco’searnings over theprevious six monthscame not from itsbusinesses, but from taxbreaks on stock optionsexercised by itsexecutives andemployees. And Cisco

had gained $5.8 billionselling “investments,”then bought $6 billionmore.Was itanInternetcompany or a mutualfund? What if those“investments” stoppedgoingup?Sysco had also acquiredseveral companies overthe same period—butpaid only about $130million. Stock optionsfor Sysco’s insiders

totaled only 1.5% ofshares outstanding,versus 6.9%atCisco. Ifinsiders cashed theiroptions, Sysco’searningspersharewouldbe diluted much lessthanCisco’s.AndSyscohad raised its quarterlydividendfromninecentsashareto10;Ciscopaidnodividend.

Finally, as Wharton

finance professor JeremySiegel pointed out, nocompanyasbigasCiscohadever been able to grow fastenough to justify aprice/earnings ratio above 60—let alone a P/E ratio over200.3 Once a companybecomes a giant, its growthmust slow down—or it willend up eating the entireworld. The great Americansatirist Ambrose Bierce

coined the word“incompossible” to describetwo things that areconceivable separately butcannot exist together. Acompanycanbeagiant,oritcandeserveagiantP/Eratio,but both together areincompossible.

Thewheels soon came offtheCiscojuggernaut.First,in2001, came a $1.2 billioncharge to “restructure” some

of those acquisitions. Overthe next two years, $1.3billion in losses on those“investments” leaked out.From 2000 through 2002,Cisco’s stock lost three-quarters of its value. Sysco,meanwhile, kept dishing outprofits, and the stock gained56% over the same period(seeFigure18-1).

Pair2:Yahoo!andYum!

On November 30, 1999,Yahoo! Inc.’s stockclosedat$212.75, up 79.6% since theyear began. By December 7,the stock was at $348—a63.6% gain in five tradingdays. Yahoo! kept whoopingalong through year-end,closing at $432.687 onDecember 31. In a singlemonth, the stock had morethandoubled,gainingroughly$58 billion to reach a total

marketvalueof$114billion.4

FIGURE 18-1 Cisco vs.Sysco

Note:Totalreturnsforcalendaryear;netearningsforfiscalyear.Source:www.morningstar.com

In the previous fourquarters, Yahoo! had rackedup $433 million in revenuesand $34.9 million in netincome. So Yahoo!’s stockwas nowpriced at 263 timesrevenues and 3,264 timesearnings. (Remember that aP/E ratio much above 25madeGrahamgrimace!)5

Why was Yahoo!

screaming upward?After themarket closed on November30, Standard & Poor’sannounced that it would addYahoo!toitsS&P500indexas of December 7. Thatwould make Yahoo! acompulsoryholdingforindexfundsandotherbig investors—and that sudden rise indemandwassuretodrivethestock even higher, at leasttemporarily.With some 90%of Yahoo!’s stock locked up

in the hands of employees,venture-capital firms, andotherrestrictedholders,justafraction of its shares couldtrade.Sothousandsofpeopleboughtthestockonlybecausethey knew other peoplewould have to buy it—andpricewasnoobject.

Meanwhile, Yum! wentbegging.AformerdivisionofPepsiCo that runs thousandsof Kentucky Fried Chicken,

Pizza Hut, and Taco Belleateries, Yum! had produced$8 billion in revenues overthepreviousfourquarters,onwhich it earned $633million—making it more than 17times Yahoo!’s size. YetYum!’sstock-marketvalueatyear-end1999wasonly$5.9billion, or 1/19 of Yahoo!’scapitalization. At that price,Yum!’s stock was selling atjust over nine times itsearnings andonly73%of its

revenues.6

AsGrahamlikedtosay,inthe short run themarket is avoting machine, but in thelong run it is a weighingmachine. Yahoo! won theshort-termpopularitycontest.But in the end, it’s earningsthat matter—and Yahoo!barely had any. Once themarket stopped voting andstarted weighing, the scalestippedtowardYum!Itsstock

rose 25.4% from 2000through2002,whileYahoo!’slost92.4%cumulatively:

FIGURE 18-2 Yahoo! vs.Yum!

Notes:Totalreturnsforcalendaryear;net

earningsforfiscalyear.Yahoo!’snetearningsfor2002includeeffectofchangeinaccountingprinciple.Sources:www.morningstar.com

Pair3:CommerceOneandCapitalOne

In May 2000, CommerceOne, Inc., had been publiclytradedonlysincethepreviousJuly.Initsfirstannualreport,the company (which designsInternet “exchanges” forcorporate purchasing

departments) showed assetsof just $385 million andreported a net loss of $63millionononly$34millionintotal revenues. The stock ofthis minuscule company hadrisen nearly 900% since itsIPO, hitting a total marketcapitalization of $15 billion.Was it overpriced? “Yes,wehave a big market cap,”Commerce One’s chiefexecutive, Mark Hoffman,shrugged in an interview.

“Butwehaveabigmarkettoplay in. We’re seeingincredible demand….Analysts expect us to make$140 million in revenue thisyear.Andinthepastwehaveexceededexpectations.”

Two things jumpout fromHoffman’sanswer:

Since Commerce Onewasalreadylosing$2on

everydollarinsales,ifitquadrupled its revenues(as “analysts expect”),wouldn’t it lose moneyevenmoremassively?How could CommerceOne have exceededexpectations “in thepast”?Whatpast?

Asked whether hiscompany would ever turn aprofit, Hoffman was ready:“Thereisnoquestionwecan

turn this into a profitablebusiness. We plan onbecoming profitable in thefourthquarterof2001,ayearanalysts see us making over$250millioninrevenues.”

There come those analystsagain!“IlikeCommerceOneat these levels because it’sgrowing faster than Ariba [aclosecompetitorwhosestockwas also trading at around400 times revenues],” said

Jeanette Sing, an analyst atthe Wasserstein Perellainvestment bank. “If thesegrowth rates continue,Commerce One will betradingat60to70timessalesin 2001.” (In other words, Icannameastockthat’smoreoverpriced than CommerceOne, so Commerce One ischeap.)7

At the other extreme wasCapital One Financial Corp.,

an issuer of MasterCard andVisa credit cards. From July1999, toMay2000, its stocklost 21.5%. Yet Capital Onehad$12billionintotalassetsand earned $363 million in1999, up 32% from the yearbefore. With a market valueof about $7.3 billion, thestocksoldat20timesCapitalOne’snetearnings.Allmightnotbewell atCapitalOne—the company had barelyraised its reserves for loans

that might go bad, eventhough default rates tend tojump in a recession—but itsstock price reflected at leastsomeriskofpotentialtrouble.

What happened next? In2001, Commerce Onegenerated $409 million inrevenues. Unfortunately, itran a net loss of $2.6 billion—or $10.30 of red ink pershare—on those revenues.Capital One, on the other

hand,earnednearly$2billioninnetincomein2000through2002. Its stock lost 38% inthose three years—no worsethan the stock market as awhole. Commerce One,however, lost 99.7% of itsvalue.8

Instead of listening toHoffman and his lapdoganalysts, traders should haveheededthehonestwarninginCommerce One’s annual

report for 1999: “We havenever been profitable. Weexpect to incurnet losses fortheforeseeablefutureandwemayneverbeprofitable.”

Pair4:Palmand3COM

OnMarch 2, 2000, the data-networking company 3ComCorp. sold 5% of its Palm,Inc. subsidiary to the public.Theremaining95%ofPalm’s

stock would be spun off to3Com’s shareholders in thenext few months; for eachshare of 3Com they held,investorswouldreceive1.525sharesofPalm.

So there were two waysyou could get 100 shares ofPalm: By trying to elbowyourway into theIPO,orbybuying 66 shares of 3Comand waiting until the parentcompany distributed the rest

of the Palm stock. Gettingone-and-a-halfsharesofPalmfor each 3Com share, you’dendupwith100sharesofthenew company—and you’dstillhave66sharesof3Com.

But who wanted to wait afew months? While 3Comwas struggling against giantrivals likeCisco,Palmwasaleader in the hot “space” ofhandheld digital organizers.SoPalm’sstockshotupfrom

its offering price of $38 tocloseat$95.06,a150%first-day return.ThatvaluedPalmat more than 1,350 times itsearningsovertheprevious12months.

That same day, 3Com’sshare price dropped from$104.13 to $81.81. Whereshould3Comhaveclosedthatday,giventhepriceofPalm?Thearithmeticiseasy:

each 3Com share wasentitled to receive 1.525sharesofPalmeach share of Palmclosedat$95.061.525$95.06=$144.97

That’s what each 3Comsharewasworthbasedon itsstake inPalmalone.Thus,at$81.81, traders were sayingthat all of 3Com’s otherbusinesses combined wereworth a negative $63.16 per

share,oratotalofminus$22billion! Rarely in history hasany stock been priced morestupidly.9

Buttherewasacatch:Justas 3Comwasn’t reallyworthminus $22 billion, Palmwasn’t really worth over1,350 times earnings. By theendof2002,bothstockswerehurting in the high-techrecession, but it was Palm’sshareholders who really got

smacked—because theyabandonedall commonsensewhen theybought in the firstplace:

FIGURE18-3

Palm’sDown

Source:www.morningstar.com

Pair5:CMGIandCGI

The year 2000 started offwith a bang for CMGI, Inc.,as the stock hit $163.22 onJanuary3—againof1,126%over its price just one yearbefore. The company, an“Internetincubator,”financedandacquiredstart-upfirmsinavarietyofonlinebusinesses—among them such earlystars as theglobe.com andLycos.10

In fiscal year 1998, as its

stock rose from 98 cents to$8.52, CMGI spent $53.8million acquiring whole orpartial stakes in Internetcompanies. In fiscal year1999, as its stock shot from$8.52 to $46.09, CMGIshelled out $104.7 million.Andinthelastfivemonthsof1999,asitsshareszoomedupto$138.44,CMGIspent$4.1billion on acquisitions.Virtuallyallthe“money”wasCMGI’s own privately-

mintedcurrency: its commonstock,nowvaluedatatotalofmorethan$40billion.

It was a kind of magicalmoney merry-go-round. Thehigher CMGI’s own stockwent,themoreitcouldaffordto buy. The more CMGIcould afford to buy, thehigher its stock went. Firststocks would go up on therumor that CMGI might buythem; then, once CMGI

acquired them, its own stockwould go up because itowned them. No one caredthat CMGI had lost $127million on its operations inthelatestfiscalyear.

Down in Webster,Massachusetts, less than 70miles southwest of CMGI’sheadquarters inAndover, sitsthemainofficeofCommerceGroup, Inc. CGI waseverything CMGI was not:

Offering automobileinsurance, mainly to driversin Massachusetts, it was acoldstockinanoldindustry.Itsshareslost23%in1999—although its net income, at$89million, endedup fallingonly 7% below 1998’s level.CGI even paid a dividend ofmore than 4% (CMGI paidnone). With a total marketvalue of $870 million, CGIstockwastradingatlessthan10 times what the company

wouldearnfor1999.

And then, quite suddenly,everythingwent into reverse.CMGI’s magical moneymerry-go-round screeched toa halt: Its dot-com stocksstopped rising in price, thenwent straight down. Nolongerable tosell themforaprofit,CMGIhadtotaketheirloss in value as a hit to itsearnings. The company lost$1.4 billion in 2000, $5.5

billion in 2001, and nearly$500 million more in 2002.Its stock went from $163.22atthebeginningof2000to98cents by year-end 2002—aloss of 99.4%. Boring oldCGI, however, kept crankingout steady earnings, and itsstock rose 8.5% in 2000,43.6% in 2001, and 2.7% in2002—a 60% cumulativegain.

Pair6:BallandStryker

Between July 9 and July 23,2002, Ball Corp.’s stockdropped from $43.69 to$33.48—a loss of 24% thatleft the company with astock-market value of $1.9billion. Over the same twoweeks,StrykerCorp.’ssharesfellfrom$49.55to$45.60,an8% drop that left Strkyervaluedatatotalof$9billion.

What had made these twocompanies worth so muchless in so short a time?Stryker, which manufacturesorthopedic implants andsurgical equipment, issuedonlyonepress releaseduringthosetwoweeks.OnJuly16,Stryker announced that itssales grew 15% to $734millioninthesecondquarter,while earnings jumped 31%to$86million.Thestockrose7% the next day, then rolled

rightbackdownhill.

Ball, the originalmaker ofthe famous “Ball Jars” usedfor canning fruits andvegetables,nowmakesmetaland plastic packaging forindustrial customers. Ballissuednopressreleasesatallduring those two weeks. OnJuly 25, however, Ballreported that it had earned$50 million on sales of $1billion in the second quarter

—a 61% rise in net incomeoverthesameperiodoneyearearlier. That brought itsearningsoverthetrailingfourquarters to $152 million, sothe stock was trading at just12.5 times Ball’s earnings.And, with a book value of$1.1 billion, you could buythe stock for 1.7 times whatthecompany’stangibleassetswere worth. (Ball did,however,havejustover$900millionindebt.)

Stryker was in a differentleague. Over the last fourquarters, the company hadgenerated$301millioninnetincome.Stryker’sbookvaluewas $570 million. So thecompany was trading at fatmultiples of 30 times itsearnings over the past 12months and nearly 16 timesits book value. On the otherhand, from 1992 through theend of 2001, Stryker’searnings had risen 18.6%

annually; its dividend hadgrown by nearly 21% peryear. And in 2001, Strykerhad spent $142 million onresearch and development tolaythegroundworkforfuturegrowth.

What, then, had poundedthese two stocks down?Between July 9 and July 23,2002, as WorldCom keeledover into bankruptcy, theDow Jones Industrial

Averagefell from9096.09 to7702.34,a15.3%plunge.ThegoodnewsatBallandStrykergot lost in the bad headlinesand falling markets, whichtook these two stocks downwiththem.

Although Ball ended uppriced farmore cheaply thanStryker,thelessonhereisnotthat Ball was a steal andStryker was a wild pitch.Instead, the intelligent

investorshouldrecognizethatmarketpanicscancreategreatprices for good companies(likeBall)andgoodpricesforgreat companies (likeStryker). Ball finished 2002at $51.19 a share, up 53%from its July low; Strykerended the year at $67.12, up47%. Every once in a while,valueandgrowthstocksalikegoonsale.Whichchoiceyouprefer depends largely onyour own personality, but

bargainscanbehadoneithersideoftheplate.

Pair7:NortelandNortek

The 1999 annual report forNortel Networks, the fiber-optic equipment company,boasted that itwas“agoldenyear financially.” As ofFebruary 2000, at a marketvalue of more than $150billion, Nortel’s stock traded

at 87 times the earnings thatWall Street’s analystsestimatedthecompanywouldproducein2000.

How credible was thatestimate? Nortel’s accountsreceivable—sales tocustomers that had not yetpaidthebill—hadshotupby$1 billion in a year. Thecompany said the rise “wasdriven by increased sales inthe fourth quarter of 1999.”

However, inventories hadalsoballoonedby$1.2billion—meaning that Nortel wasproducing equipment evenfaster than those “increasedsales”couldunloadit.

Meanwhile,Nortel’s“long-term receivables”—bills notyet paid for multi-yearcontracts—jumpedfrom$519million to $1.4 billion. AndNortelwashavingahardtimecontrolling costs; its selling,

general, and administrativeexpense (or overhead) hadrisenfrom17.6%ofrevenuesin1997to18.7%in1999.Alltold, Nortel had lost $351millionin1999.

Then there was Nortek,Inc., which produces stuff atthe dim end of the glamourspectrum: vinyl siding, doorchimes, exhaust fans, rangehoods, trash compactors. In1999, Nortek earned $49

million on $2 billion in netsales,up from$21million innet incomeon$1.1billion insales in1997.Nortek’sprofitmargin (net earnings as apercentage of net sales) hadrisen by almost a third from1.9% to 2.5%. And Nortekhadcutoverheadfrom19.3%ofrevenuesto18.1%.

To be fair, much ofNortek’s expansion camefrombuyingothercompanies,

not from internal growth.What’smore, Nortek had $1billion indebt,abig loadforasmallfirm.But,inFebruary2000,Nortek’s stock price—roughly five times itsearnings in1999—includedahealthydoseofpessimism.

Ontheotherhand,Nortel’sprice—87 times theguesstimate of what it mightearn in the year to come—was a massive overdose of

optimism.When allwas saidand done, instead of earningthe $1.30 per share thatanalystshadpredicted,Nortellost $1.17 per share in 2000.By the end of 2002, Nortelhad bled more than $36billioninredink.

Nortek, on the other hand,earned$41.6millionin2000,$8 million in 2001, and $55million in the first ninemonths of 2002. Its stock

went from $28 a share to$45.75 by year-end 2002—a63% gain. In January 2003,Nortek’s managers took thecompany private, buying allthe stock from publicinvestors at $46 per share.Nortel’s stock, meanwhile,sankfrom$56.81inFebruary2000, to $1.61 at year-end2002—a97%loss.

Pair8:RedHatandBrownShoe

On August 11, 1999, RedHat, Inc., a developer ofLinuxsoftware, sold stock tothe public for the first time.RedHatwasred-hot;initiallyoffered at $7, the sharesopenedfortradingat$23andclosed at $26.031—a 272%gain.11 In a single day, RedHat’sstockhadgoneupmorethanBrownShoe’shadintheprevious 18 years. ByDecember 9, Red Hat’s

shares hit $143.13—up1,944%infourmonths.

Brown Shoe, meanwhile,had its laces tied together.Founded in 1878, thecompany wholesales BusterBrownshoesand runsnearly1,300 footwear stores in theUnited States and Canada.Brown Shoe’s stock, at$17.50ashareonAugust11,stumbled down to $14.31 byDecember9.Forallof1999,

Brown Shoe’s shares lost17.6%.12

Besidesacoolnameandahotstock,whatdidRedHat’sinvestors get? Over the ninemonthsendingNovember30,the company produced $13millioninrevenues,onwhichit ran a net loss of $9million.13RedHat’sbusinesswas barely bigger than astreet-corner delicatessen—and a lot less lucrative. But

traders, inflamed by thewords “software” and“Internet,” drove the totalvalue of RedHat’s shares to$21.3billionbyDecember9.

And Brown Shoe? Overthe previous three quarters,the company had produced$1.2 billion in net sales and$32 million in earnings.BrownShoe had nearly $5 ashare in cash and real estate;kidswere still buyingBuster

Brown shoes. Yet, thatDecember 9, Brown Shoe’sstock had a total value of$261 million—barely 1/80the size of Red Hat eventhough Brown Shoe had 100timesRedHat’srevenues.Atthat price, Brown Shoe wasvaluedat7.6timesitsannualearnings and less than one-quarter of its annual sales.Red Hat, on the other hand,hadnoprofitsatall,whileitsstockwassellingatmorethan

1,000timesitsannualsales.

RedHat thecompanykeptright on gushing red ink.Soon enough, the stock didtoo. Brown Shoe, however,trudged out more profits—andsodiditsshareholders:

FIGURE 18-4 Red Hat vs.BrownShoe

Note:Totalreturnsforcalendaryear;netearningsforfiscalyear.Source:www.morningstar.com

What have we learned?The market scoffs atGraham’s principles in the

shortrun,buttheyarealwaysrevalidated in theend. Ifyoubuyastockpurelybecauseitsprice has been going up—insteadofaskingwhethertheunderlying company’s valueis increasing—then soonerorlater you will be extremelysorry.That’snotalikelihood.Itisacertainty.

Chapter19ShareholdersandManagements:DividendPolicy

Ever since 1934 we have

argued in our writings for amoreintelligentandenergeticattitude by shareholderstoward their managements.Wehaveaskedthemtotakeagenerous attitude towardthose who are demonstrablydoing a good job. We haveasked them also to demandclear and satisfyingexplanationswhen theresultsappear tobeworse than theyshould be, and to supportmovements to improve or

remove clearly unproductivemanagements. Shareholdersare justified in raisingquestions as to thecompetence of themanagementwhentheresults(1) are unsatisfactory inthemselves, (2) are poorerthan those obtained by othercompanies that appearsimilarly situated, and (3)have resulted in anunsatisfactorymarketpriceoflongduration.

In the last 36 yearspractically nothing hasactually been accomplishedthrough intelligent action bythe great body ofshareholders. A sensiblecrusader—if there are anysuch—would take this as asignthathehasbeenwastinghis time, and that he hadbettergiveupthefight.Asithappens our cause has notbeenlost;ithasbeenrescuedby an extraneous

development—known astakeovers,or take-overbids.*We said in Chapter 8 thatpoor managements producepoor market prices. The lowmarket prices, in turn, attractthe attention of companiesinterestedindiversifyingtheiroperations—and these arenow legion. Innumerablesuch acquisitions have beenaccomplished by agreementwith the existing

managements, or else byaccumulationofsharesinthemarket and by offers madeover the head of those incontrol. The price bid hasusuallybeenwithintherangeof thevalueof the enterpriseunder reasonably competentmanagement.Hence,inmanycases, the inert publicshareholder has been bailedout by the actions of“outsiders”—who at timesmay be enterprising

individuals or groups actingontheirown.

It can be stated as a rulewithveryfewexceptionsthatpoor managements are notchanged by action of the“public stockholders,” butonly by the assertion ofcontrol by an individual orcompact group. This ishappeningoftenenoughthesedays to put themanagement,including the board of

directors,ofatypicalpubliclycontrolledcompanyonnoticethat if its operating resultsandtheresultingmarketpriceare highly unsatisfactory, itmay become the target of asuccessful take-over move.As a consequence, boards ofdirectors have probablybecome more alive thanpreviously to theirfundamental duty to see thattheir company has asatisfactory top management.

Many more changes ofpresidents have been seen inrecentyearsthanformerly.

Not all companies in theunsatisfactory class havebenefited from suchdevelopments. Also, thechange has often occurredafter a long period of badresults without remedialaction, and has depended onenough disappointedshareholders selling out at

low prices to permit theenergeticoutsiders to acquirea controlling position in theshares. But the idea thatpublic shareholders couldreally help themselves bysupporting moves forimproving management andmanagement policies hasproved too quixotic towarrant further space in thisbook. Those individualshareholders who haveenough gumption to make

their presence felt at annualmeetings—generally acompletelyfutileperformance—will not need our counselon what points to raise withthe managements. For otherstheadvicewouldprobablybewasted. Nevertheless, let usclose this section with theplea that shareholdersconsider with an open mindandwithcarefulattentionanyproxy material sent them byfellow-shareholders who

want to remedyanobviouslyunsatisfactory managementsituationinthecompany.

ShareholdersandDividendPolicy

In the past the dividendpolicy was a fairly frequentsubject of argument betweenpublic, or “minority,”shareholders andmanagements. In generalthese shareholders wantedmore liberaldividends,while

themanagementspreferredtokeep the earnings in thebusiness “to strengthen thecompany.” They asked theshareholders tosacrifice theirpresent interests for thegoodoftheenterpriseandfortheirownfuturelong-termbenefit.But in recent years theattitude of investors towarddividends has beenundergoing a gradual butsignificant change.The basicargument now for paying

small rather than liberaldividends is not that thecompany“needs” themoney,butratherthatitcanuseit tothe shareholders’ direct andimmediate advantage byretaining the funds forprofitable expansion. Yearsagoitwastypicallytheweakcompany that was more orless forced to hold on to itsprofits, instead of paying outthe usual 60% to 75% ofthemindividends.Theeffect

wasalmostalwaysadversetothemarketpriceoftheshares.Nowadaysitisquitelikelytobe a strong and growingenterprise that deliberatelykeeps down its dividendpayments, with the approvalof investors and speculatorsalike.*

Therewasalwaysa strongtheoretical case forreinvesting profits in thebusinesswheresuchretention

could be counted on toproduce a goodly increase inearnings. But there wereseveral strong counter-arguments, such as: Theprofits “belong” to theshareholders, and they areentitledtohavethempaidoutwithin the limits of prudentmanagement; many of theshareholders need theirdividend income to live on;the earnings they receive individends are “real money,”

while those retained in thecompany may or may notshow up later as tangiblevalues for the shareholders.These counter-argumentswere so compelling, in fact,that thestockmarketshoweda persistent bias in favor oftheliberaldividendpayersasagainst the companies thatpaid no dividends orrelativelysmallones.1

In the last 20 years the

“profitable reinvestment”theory has been gainingground. The better the pastrecord of growth, the readierinvestors and speculatorshave become to accept alowpay-out policy. So muchisthistruethatinmanycasesof growth favorites thedividend rate—or even theabsenceofanydividend—hasseemed to have virtually noeffectonthemarketprice.*

A striking example of thisdevelopment is found in thehistoryofTexas Instruments,Incorporated.Thepriceof itscommonstockrosefrom5in1953 to 256 in 1960, whileearnings were advancingfrom 43 cents to $3.91 pershare and while no dividendof any kind was paid. (In1962 cash dividends wereinitiated,butby that year theearnings had fallen to $2.14and the price had shown a

spectacular drop to a low of49.)

Another extremeillustration is provided bySuperior Oil. In 1948 thecompanyreportedearningsof$35.26 per share, paid $3 individends,andsoldashighas235. In 1953 the dividendwas reduced to $1, but thehighpricewas660.In1957itpaid no dividend at all, andsold at 2,000! This unusual

issue laterdeclined to795 in1962, when it earned $49.50andpaid$7.50.*

Investmentsentimentisfarfrom crystallized in thismatter of dividend policy ofgrowth companies. Theconflicting views are wellillustratedbythecasesoftwoof our very largestcorporations—AmericanTelephone & Telegraph andInternational Business

Machines. American Tel. &Tel. came to be regarded asan issue with good growthpossibilities,asshownby thefactthatin1961itsoldat25times that year’s earnings.Nevertheless, the company’scash dividend policy hasremained an investment andspeculative consideration offirstimportance,itsquotationmakinganactive response toevenrumorsofanimpendingincrease in the dividend rate.

On the other hand,comparatively little attentionappears to have been paid tothe cash dividend on IBM,which in 1960 yielded only0.5%at thehighpriceof theyearand1.5%atthecloseof1970.(Butinbothcasesstocksplits have operated as apotent stock-marketinfluence.)

The market’s appraisal ofcash-dividend policy appears

to be developing in thefollowing direction: Whereprimeemphasis isnotplacedon growth the stock is ratedasan“incomeissue,”andthedividendrateretainsits long-held importanceas theprimedeterminant of market price.At the other extreme, stocksclearlyrecognizedtobeintherapid-growth category arevalued primarily in terms ofthe expected growth rateover, say, the next decade,

and the cash-dividend rate ismore or less left out of thereckoning.

While the above statementmayproperlydescribepresenttendencies, it is bynomeansa clear-cut guide to thesituation in all commonstocks,andperhapsnotinthemajority of them. For onething, many companiesoccupy an intermediateposition between growth and

nongrowth enterprises. It ishard to say how muchimportance should beascribed to the growth factorin such cases, and themarket’s view thereof maychangeradicallyfromyeartoyear. Secondly, there seemsto be something paradoxicalabout requiring thecompanies showing slowergrowth to be more liberalwiththeircashdividends.Forthese are generally the less

prosperous concerns, and inthe past themore prosperousthe company the greater wastheexpectationofbothliberalandincreasingpayments.

It is our belief thatshareholders should demandoftheirmanagementseitheranormal payout of earnings—on the order, say, of two-thirds—or else a clear-cutdemonstration that thereinvested profits have

produced a satisfactoryincrease in per-shareearnings. Such ademonstration couldordinarilybemadeinthecaseof a recognized growthcompany. But inmany othercases a lowpayout is clearlythe cause of an averagemarketpricethatisbelowfairvalue, and here theshareholdershaveeveryrightto inquire and probably tocomplain.

A niggardly policy hasoften been imposed on acompanybecauseitsfinancialposition is relatively weak,and ithasneededallormostof its earnings (plusdepreciation charges) to paydebtsandbolsteritsworking-capitalposition.When this isso there is not much theshareholders can say about it—except perhaps to criticizethe management forpermitting the company to

fall into such anunsatisfactory financialposition.However, dividendsare sometimes held down byrelatively unprosperouscompanies for the declaredpurpose of expanding thebusiness.We feel that suchapolicy is illogicalon its face,and should require both acomplete explanation and aconvincingdefensebeforetheshareholdersshouldacceptit.In terms of the past record

there is no reason a priori tobelieve that the owners willbenefit from expansionmoves undertaken with theirmoneybyabusinessshowingmediocre results andcontinuing its oldmanagement.

StockDividendsandStockSplits

It is important thatinvestors understand theessentialdifferencebetweena

stock dividend (properly so-called) anda stock split.Thelatterrepresentsarestatementof the common-stockstructure—in a typical casebyissuingtwoorthreesharesfor one. The new shares arenot related to specificearnings reinvested in aspecific past period. Itspurposeistoestablishalowermarket price for the singleshares, presumably becausesuchlowerpricerangewould

bemoreacceptabletooldandnew shareholders. A stocksplit may be carried out bywhat technically may becalled a stock dividend,which involves a transfer ofsums from earned surplus tocapital account; or else by achange in par value, whichdoes not affect the surplusaccount.*

What we should call aproper stock dividend is one

thatispaidtoshareholderstogivethematangibleevidenceor representation of specificearnings which have beenreinvested in thebusiness fortheir account over somerelatively short period in therecent past—say, not morethanthetwoprecedingyears.Itisnowapprovedpracticetovaluesuchastockdividendatthe approximate value at thetime of declaration, and totransfer an amount equal to

such value from earnedsurplus to capital accounts.Thus the amountof a typicalstock dividend is relativelysmall—in most cases notmore than 5%. In essence astockdividendofthissorthasthesameoveralleffectas thepayment of an equivalentamount of cash out ofearnings when accompaniedby the sale of additionalshares of like total value tothe shareholders.However, a

straightstockdividendhasanimportant tax advantage overthe otherwise equivalentcombination of cashdividends with stocksubscription rights, which isthe almost standard practiceforpublic-utilitycompanies.

The New York StockExchangehassetthefigureof25% as a practical dividingline between stock splits andstock dividends. Those of

25% or more need not beaccompanied by the transferof their market value fromearnedsurplus tocapital,andso forth.† Some companies,especially banks, still followthe old practice of declaringany kind of stock dividendthey please—e.g., one of10%, not related to recentearnings—andtheseinstancesmaintain an undesirableconfusion in the financial

world.

We have long been astrong advocate of asystematic and clearlyenunciated policy withrespect to the payment ofcash and stock dividends.Under such a policy, stockdividends are paidperiodically to capitalize allor a stated portion of theearnings reinvested in thebusiness. Such a policy—

covering 100% of thereinvested earnings—hasbeen followed by Purex,Government EmployeesInsurance, andperhapsa fewothers.*

Stock dividends of alltypesseemtobedisapprovedof by most academic writerson the subject. They insistthat they are nothing butpiecesofpaper,thattheygivetheshareholdersnothing they

did not have before, and thatthey entail needless expenseand inconvenience.† On ourside we consider this acompletely doctrinaire view,which fails to take intoaccount the practical andpsychological realities ofinvestment. True, a periodicstockdividend—sayof5%—changes only the “form” ofthe owners’ investment. Hehas 105 shares in place of

100; but without the stockdividend the original 100shares would haverepresented the sameownership interest nowembodied in his 105 shares.Nonetheless, the change ofform is actually one of realimportanceandvalue tohim.If he wishes to cash in hisshareofthereinvestedprofitshe can do so by selling thenew certificate sent him,insteadofhavingtobreakup

hisoriginalcertificate.Hecancount on receiving the samecash-dividend rate on 105sharesasformerlyonhis100shares;a5%riseinthecash-dividend rate without thestock dividend would not benearlyasprobable.*

The advantages of aperiodic stock-dividendpolicyaremostevidentwhenit iscomparedwith theusualpractice of the public-utility

companies of paying liberalcash dividends and thentaking back a good part ofthis money from theshareholders by selling themadditional stock (throughsubscription rights).† As wementioned above, theshareholders would findthemselves in exactly thesamepositioniftheyreceivedstockdividends in lieuof thepopular combination of cash

dividends followed by stocksubscriptions—except thatthey would save the incometaxotherwisepaidonthecashdividends.Thosewhoneedorwish the maximum annualcash income, with noadditional stock, can get thisresult by selling their stockdividends,inthesamewayasthey sell their subscriptionrightsunderpresentpractice.

The aggregate amount of

income tax that could besaved by substituting stockdividends for the presentstock-dividends-plus-subscription-rightscombinationisenormous.Weurgethatthischangebemadebythepublicutilities,despiteitsadverseeffecton theU.S.Treasury, because we areconvinced that it iscompletely inequitable toimpose a second (personal)incometaxonearningswhich

arenotreallyreceivedbytheshareholders, since thecompanies take the samemoney back through sales ofstock.*

Efficient corporationscontinuously modernize theirfacilities, theirproducts, theirbookkeeping, theirmanagement-trainingprograms, their employeerelations. It is high time theythought about modernizing

their major financialpractices, not the leastimportant of which is theirdividendpolicy.


Themostdangerousuntruthsaretruthsslightlydistorted.

—G.C.Lichtenberg

WhyDidGrahamThrowintheTowel?

Perhaps no other part ofTheIntelligent Investorwasmoredrastically changed byGraham than this. In the firstedition, this chapter was oneof a pair that together rannearly34pages.Thatoriginalsection (“The Investor asBusiness Owner”) dealt withshareholders’ voting rights,waysofjudgingthequalityofcorporate management, andtechniques for detectingconflicts of interest between

insidersandoutsideinvestors.By his last revised edition,however, Graham had paredthewhole discussion back toless than eight terse pagesaboutdividends.

WhydidGrahamcutawaymore than three-quarters ofhis original argument? Afterdecades of exhortation, heevidently had given up hopethatinvestorswouldevertakeanyinterestinmonitoringthe

behavior of corporatemanagers.

But the latest epidemic ofscandal—allegations ofmanagerial misbehavior,shady accounting, or taxmaneuversatmajorfirmslikeAOL, Enron, GlobalCrossing, Sprint, Tyco, andWorldCom—is a starkreminder that Graham’searlier warnings about theneedforeternalvigilanceare

more vital than ever. Let’sbring them back and discussthem in light of today’sevents.

TheoryVersusPractice

Graham begins his original(1949) discussion of “TheInvestor as Business Owner”by pointing out that, intheory,“thestockholdersasaclass are king. Acting as a

majority they can hire andfire managements and bendthem completely to theirwill.” But, in practice, saysGraham,

the shareholders are acomplete washout. As aclass they show neitherintelligence noralertness. They vote insheeplike fashion forwhatever themanagement

recommends and nomatter how poor themanagement’s record ofaccomplishment maybe…. The only waytoinspire the averageAmericanshareholder totake any independentlyintelligent action wouldbe by exploding afirecrackerunderhim….We cannot resistpointing out theparadoxical fact that

Jesus seems to havebeen a more practicalbusinessman than areAmericanshareholders.1

Graham wants you torealize something basic butincredibly profound: Whenyoubuyastock,youbecomeanownerofthecompany.Itsmanagers, all the way up tothe CEO, work for you. Itsboard of directors mustanswer to you. Its cash

belongstoyou.Itsbusinessesare your property. If youdon’tlikehowyourcompanyis being managed, you havethe right to demand that themanagers be fired, thedirectors be changed, or theproperty be sold.“Stockholders,” declaresGraham,“shouldwakeup.”2

TheIntelligentOwner

Today’s investors haveforgotten Graham’s message.Theyputmost of their effortinto buying a stock, a littleinto selling it—but none intoowning it. “Certainly,”Grahamremindsus,“there isjust as much reason toexercisecareandjudgmentinbeing as in becoming astockholder.”3

So how should you, as anintelligent investor, go about

being an intelligent owner?Graham starts by telling usthat “there are just twobasicquestions to whichstockholdersshouldturntheirattention:

1. Is the managementreasonablyefficient?

2. Are the interests of theaverage outsideshareholder receivingproperrecognition?”4

You should judge theefficiency ofmanagement bycomparing each company’sprofitability, size, andcompetitiveness againstsimilar firms in its industry.Whatifyouconcludethatthemanagersarenogood?Then,urgesGraham,

A few of the moresubstantial stockholdersshould becomeconvinced that a change

is needed and shouldbewilling to work towardthat end. Second, therank and file of thestockholders should beopen-minded enough toread the proxy materialand to weigh theargumentsonbothsides.They must at least beable toknowwhen theircompany has beenunsuccessful and beready to demand more

thanartfulplatitudesasavindication of theincumbent management.Third, it would bemosthelpful,whenthefiguresclearly show that theresults are well belowaverage,ifitbecamethecustomtocallinoutsidebusiness engineers topass upon the policiesand competence of themanagement.5

THEENRONEND-RUN

Backin1999,EnronCorp.ranked seventh on theFortune 500 list ofAmerica’s top companies.The energy giant’srevenues, assets, andearnings were all risinglikerockets.

But what if an investorhad ignored the glamourand glittering numbers—and had simply putEnron’s 1999 proxystatement under themicroscope of commonsense? Under the heading

“Certain Transactions,”the proxy disclosed thatEnron’s chief financialofficer, Andrew Fastow,was the “managingmember” of twopartnerships, LJM1 andLJM2, that bought“energy andcommunications relatedinvestments.” And wherewas LJM1 and LJM2buyingfrom?Why,whereelse but from Enron! Theproxy reported that thepartnerships had alreadybought $170 million ofassets from Enron—sometimes using money

borrowedfromEnron.

The intelligent investorwould immediately haveasked:

Did Enron’s directors approvethis arrangement? (Yes, said theproxy.)Would Fastow get a piece ofLJM’s profits? (Yes, said theproxy.)As Enron’s chief financialofficer,was Fastow obligated toactexclusivelyintheinterestsof

Enron’s shareholders? (Ofcourse.)Was Fastow therefore duty-bound to maximize the priceEnron obtained for any assets itsold?(Absolutely.)But ifLJMpaidahighpriceforEnron’sassets,would that lowerLJM’s potential profits—andFastow’s personal income?(Clearly.)Ontheotherhand,ifLJMpaidalow price, would that raiseprofits for Fastow and his

partnerships, but hurt Enron’sincome?(Clearly.)Should Enron lend Fastow’spartnerships any money to buyassets from Enron that mightgenerate a personal profit forFastow?(Saywhat?!)Doesn’t all this constituteprofoundly disturbing conflictsof interest? (No other answer isevenpossible.)What does this arrangement sayabout the judgment of thedirectors who approved it? (It

says you should take yourinvestmentdollarselsewhere.)

Two clear lessons emergefrom this disaster: Neverdig so deep into thenumbers that you checkyourcommonsenseatthedoor, and always read theproxy statement before(and after) you buy astock.

What is “proxy material”and why does Graham insistthat you read it? In its proxy

statement, which it sends toeveryshareholder,acompanyannounces the agenda for itsannualmeeting and disclosesdetails about thecompensation and stockownership of managers anddirectors, along withtransactions between insidersand the company.Shareholders are asked tovote on which accountingfirm should audit the booksandwho should serve on the

boardofdirectors.Ifyouuseyour common sense whilereading the proxy, thisdocument can be like acanary in a coal mine—anearly warning systemsignaling that something iswrong. (See the Enronsidebarabove.)

Yet,onaverage,betweenathird and a half of allindividualinvestorscannotbebothered to vote their

proxies.6 Do they even readthem?

Understanding and votingyour proxy is as every bit asfundamental to being anintelligent investor asfollowing the news andvoting your conscience is tobeing a good citizen. Itdoesn’t matter whether youown 10% of a company or,with your piddling 100shares,just1/10.000of1%.If

you’ve never read the proxyof a stock you own, and thecompany goes bust, the onlyperson you should blame isyourself. If you do read theproxy and see things thatdisturbyou,then:

vote against everydirector to let themknowyoudisapproveattend the annualmeeting and speak up

foryourrightsfind an online messageboard devoted to thestock (like those athttp://finance.yahoo.com)and rally other investorstojoinyourcause.

Graham had another ideathat could benefit today’sinvestors:

…there are advantagestobegainedthroughthe

selectionofoneormoreprofessional andindependent directors.These shouldbemenofwide businessexperiencewhocan turnafreshandexperteyeonthe problems of theenterprise…. Theyshould submit aseparateannual report,addresseddirectly to thestockholders andcontaining their views

on the major questionwhich concerns theownersoftheenterprise:“Isthebusinessshowingthe results for theoutside stockholderwhichcouldbeexpectedof it under propermanagement? If not,why—and what shouldbedoneaboutit?7

One can only imagine theconsternation that Graham’s

proposalwould cause amongthe corporate cronies andgolfing buddies whoconstitutesomanyoftoday’s“independent” directors.(Let’s not suggest that itmight send a shudder of feardowntheirspines,sincemostindependent directors do notappeartohaveabackbone.)

WhoseMoneyIsIt,Anyway?

Now let’s look at Graham’ssecond criterion—whethermanagement acts in the bestinterests of outside investors.Managers have always toldshareholders that they—themanagers—know best whatto do with the company’scash. Graham saw rightthrough this managerialmalarkey:

A company’smanagement may run

thebusinesswellandyetnot give the outsidestockholders the rightresultsforthem,becauseitsefficiencyisconfinedto operations and doesnot extend to the bestuse of the capital. Theobjective of efficientoperation is to produceat low cost and to findthe most profitablearticles to sell. Efficientfinance requires that the

stockholders’ money beworking in forms mostsuitable to their interest.This is a question inwhich management, assuch, has little interest.Actually, it almostalways wants as muchcapital from the ownersasitcanpossiblyget, inorder to minimize itsown financial problems.Thus the typicalmanagement will

operate with morecapitalthannecessary,ifthe stockholders permitit—which they oftendo.8

In the late 1990s and intothe early 2000s, themanagements of leadingtechnology companies tookthis “Daddy-Knows-Best”attitudetonewextremes.Theargumentwentlikethis:Whyshould you demand a

dividendwhenwecan investthat cash for you and turn itintoarisingshareprice?Justlookatthewayourstockhasbeen going up—doesn’t thatprove that we can turn yourpennies into dollars betterthanyoucan?

Incredibly, investors fellfor it hook, line, and sinker.Daddy Knows Best becamesuch gospel that, by 1999,only 3.7% of the companies

that first sold their stock tothe public that year paid adividend—down from anaverageof72.1%ofallIPOsin the 1960s.9 Just look athow the percentage ofcompanies paying dividends(shown in the dark area) haswitheredaway:

FIGURE19-1

WhoPaysDividends?

Source:EugeneFamaandKennethFrench,“DisappearingDividends,”JournalofFinancialEconomics,April2001.

But Daddy Knows Bestwasnothingbut bunk.Whilesome companies put theircashtogooduse,manymorefellintotwoothercategories:those that simply wasted it,and those that piled it up farfaster than they couldpossiblyspendit.

In the first group,

Priceline.com wrote off $67millioninlossesin2000afterlaunchinggoofyventuresintogroceries and gasoline,whileAmazon.com destroyed atleast $233 million of itsshareholders’ wealth by“investing”indot-bombslikeWebvan and Ashford.com.10Andthetwobiggestlossessofar on record—JDSUniphase’s $56 billion in2001 and AOL Time

Warner’s$99billion in2002—occurred after companieschose not to pay dividendsbuttomergewithotherfirmsat a time when their shareswereobscenelyovervalued.11

In the second group,consider that by late 2001,OracleCorp.hadpiledup$5billionincash.CiscoSystemshad hoarded at least $7.5billion. Microsoft hadamassed a mountain of cash

$38.2 billion high—andrisingby an averageofmorethan $2 million per hour. 12JusthowrainyadaywasBillGatesexpecting,anyway?

So the anecdotal evidenceclearly shows that manycompanies don’t know howto turnexcesscash intoextrareturns. What does thestatisticalevidencetellus?

Research by moneymanagers Robert Arnottand Clifford Asnessfound that when currentdividendsarelow,futurecorporate earnings alsoturn out to be low.Andwhen current dividendsare high, so are futureearnings. Over 10-yearperiods, theaveragerateof earnings growth was3.9 points greater whendividendswerehighthan

whentheywerelow.13Columbia accountingprofessorsDoronNissimandAmirZivfoundthatcompanies that raisetheir dividend not onlyhavebetterstockreturnsbut that “dividendincreases are associatedwith [higher] futureprofitability for at leastfour years after thedividendchange.”14

Inshort,mostmanagersarewrong when they say thatthey can put your cash tobetter use than you can.Paying out a dividend doesnot guarantee great results,butitdoesimprovethereturnof the typical stock byyanking at least some cashout of the managers’ handsbefore they can eithersquander it or squirrel itaway.

SellingLow,BuyingHigh

Whatabouttheargumentthatcompaniescanputsparecashto better use by buying backtheir own shares? When acompanyrepurchasessomeofits stock, that reduces thenumber of its sharesoutstanding. Even if its netincome stays flat, thecompany’searningspersharewill rise, since its totalearningswillbespreadacross

fewer shares. That, in turn,should lift the stock price.Betteryet,unlikeadividend,a buyback is tax-free toinvestorswhodon’tsell theirshares.15Thusitincreasesthevalue of their stock withoutraising their tax bill. And ifthe shares are cheap, thenspending spare cash torepurchase them is anexcellent use of thecompany’scapital.16

All this is true in theory.Unfortunately, in the realworld, stock buybacks havecome to serve a purpose thatcan only be described assinister. Now that grants ofstock options have becomesuchalargepartofexecutivecompensation, manycompanies—especially inhigh-tech industries—mustissuehundredsofmillionsofsharestogivetothemanagerswho exercise those stock

options.17Butthatwouldjackup the number of sharesoutstanding and shrinkearnings per share. Tocounteract that dilution, thecompanies must turn rightback around and repurchasemillionsofsharesintheopenmarket. By 2000, companieswere spending an astounding41.8% of their total netincome to repurchase theirownshares—upfrom4.8%in

1980.18

Let’slookatOracleCorp.,the software giant. BetweenJune 1, 1999, and May 31,2000, Oracle issued 101million shares of commonstock to its senior executivesand another 26 million toemployees at a cost of $484million. Meanwhile, to keepthe exercise of earlier stockoptions from diluting itsearnings per share, Oracle

spent$5.3billion—or52%ofits totalrevenues thatyear—to buy back 290.7 millionsharesofstock.Oracleissuedthe stock to insiders at anaverage price of $3.53 pershareandrepurchaseditatanaverage price of $18.26. Selllow,buyhigh:Isthisanywayto “enhance” shareholdervalue?19

By 2002, Oracle’s stockhadfallentolessthanhalfits

peak in 2000. Now that itsshares were cheaper, didOracle hasten to buy backmorestock?BetweenJune1,2001, and May 31, 2002,Oracle cut its repurchases to$2.8 billion, apparentlybecause its executives andemployees exercised feweroptions that year. The samesell-low, buy-high pattern isevident at dozens of othertechnologycompanies.

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

Companies get a taxbreak when executivesand employees exercisestockoptions(whichtheIRS considers a“compensation expense”tothecompany).20Initsfiscal years from 2000through 2002, for

example, Oracle reaped$1.69 billion in taxbenefits as insiderscashed in on options.Sprint Corp. pocketed$678 million in taxbenefitsasitsexecutivesandemployeeslockedin$1.9 billion in optionsprofitsin1999and2000.A senior executiveheavily compensatedwith stockoptionshasavested interest in

favoring stock buybacksover dividends. Why?For technical reasons,optionsincreaseinvalueas the price fluctuationsof a stock grow moreextreme. But dividendsdampen the volatility ofastock’sprice.So,ifthemanagers increased thedividend, they wouldlower the value of theirownstockoptions.21

No wonder CEOs wouldmuch rather buy back stockthan pay dividends—regardlessofhowovervaluedthe shares may be or howdrasticallythatmaywastetheresources of the outsideshareholders.

KeepingTheirOptionsOpen

Finally, drowsy investorshave given their companies

free rein to over-payexecutives in ways that aresimply unconscionable. In1997, Steve Jobs, thecofounderofAppleComputerInc.,returnedtothecompanyas its “interim” chiefexecutive officer. Already awealthyman,Jobsinsistedontakingacashsalaryof$1peryear. At year-end 1999, tothank Jobs for serving asCEO “for the previous 2 1/2yearswithoutcompensation,”

theboardpresentedhimwithhis very ownGulfstream jet,atacosttothecompanyofamere $90 million. The nextmonth Jobs agreed to drop“interim” from his job title,and the board rewarded himwith options on 20 millionshares. (Until then, Jobs hadheld a grand total of twosharesofApplestock.)

The principle behind suchoption grants is to align the

interests of managers withoutside investors. If you areanoutsideAppleshareholder,you want its managers to berewarded only if Apple’sstock earns superior returns.Nothing else could possiblybe fair to you and the otherowners of the company.But,as John Bogle, formerchairman of the Vanguardfunds, points out, nearly allmanagers sell the stock theyreceive immediately after

exercisingtheiroptions.Howcould dumping millions ofshares for an instant profitpossibly align their interestswith those of the company’sloyallong-termshareholders?

In Jobs’ case, if Applestock rises by just 5%annually through thebeginningof2010,hewillbeabletocashinhisoptionsfor$548.3 million. In otherwords, even ifApple’s stock

earns no better than half thelong-term average return oftheoverallstockmarket,Jobswill land a half-a-billiondollar windfall.22 Does thatalign his interests with thoseof Apple’s shareholders—ormalign the trust that Apple’sshareholders have placed intheboardofdirectors?

Reading proxy statementsvigilantly, the intelligentowner will vote against any

executive compensation planthatusesoptiongrantstoturnmore than 3% of thecompany’ssharesoutstandingover to the managers. Andyoushouldvetoanyplanthatdoes not make option grantscontingent on a fair andenduringmeasureof superiorresults— say, outperformingtheaveragestockinthesameindustry for a period of atleastfiveyears.NoCEOeverdeservestomakehimselfrich

if he has produced poorresultsforyou.

AFinalThought

Let’s go back to Graham’ssuggestion that everycompany’sindependentboardmembers should have toreport to the shareholders inwriting on whether thebusiness isproperlymanagedon behalf of its true owners.

What if the independentdirectors also had to justifythe company’s policies ondividends and sharerepurchases? What if theyhad to describe exactly howthey determined that thecompany’s seniormanagement was notoverpaid? Andwhat if everyinvestorbecameanintelligentowner and actually read thatreport?

Chapter20“MarginofSafety”astheCentralConceptofInvestment

In the old legend the wise

men finally boiled down thehistory of mortal affairs intothe single phrase, “This toowill pass.”* Confronted witha like challenge to distill thesecret of sound investmentinto three words, we venturethe motto, MARGIN OFSAFETY. This is the threadthat runs through all thepreceding discussion ofinvestment policy—oftenexplicitly,sometimesinaless

directfashion.Letustrynow,briefly, to tracethat ideainaconnectedargument.

All experienced investorsrecognize that themargin-of-safety concept is essential tothe choice of sound bondsand preferred stocks. Forexample, a railroad shouldhave earned its total fixedchargesbetterthanfivetimes(before income tax), taking aperiodofyears, for its bonds

to qualify as investment-gradeissues.Thispastabilityto earn in excess of interestrequirements constitutes themargin of safety that iscounted on to protect theinvestor against loss ordiscomfiture in the event ofsome future decline in netincome. (The margin abovecharges may be stated inotherways—forexample, inthe percentage by whichrevenues or profits may

decline before the balanceafter interest disappears—butthe underlying idea remainsthesame.)

Thebondinvestordoesnotexpect future averageearningstoworkoutthesameasinthepast;ifheweresureofthat, themargindemandedmight be small. Nor does herely toanycontrollingextentonhisjudgmentastowhetherfuture earnings will be

materially better or poorerthaninthepast,ifhedidthat,hewouldhavetomeasurehismarginintermsofacarefullyprojected income account,instead of emphasizing themargin shown in the pastrecord. Here the function ofthe margin of safety is, inessence, that of renderingunnecessary an accurateestimate of the future. If themargin isa largeone, then itis enough to assume that

future earnings will not fallfarbelowthoseofthepastinorder for an investor to feelsufficiently protected againstthevicissitudesoftime.

The margin of safety forbonds may be calculated,alternatively, by comparingthe total value of theenterprisewiththeamountofdebt. (A similar calculationmaybemadeforapreferred-stock issue.) If the business

owes$10millionandisfairlyworth $30 million, there isroomfora shrinkageof two-thirds in value—at leasttheoretically—before thebondholders will suffer loss.The amount of this extravalue, or “cushion,” abovethe debt may beapproximated by using theaverage market price of thejunior stock issues over aperiodofyears.Sinceaveragestock prices are generally

related to average earningpower, the margin of“enterprise value” over debtand the margin of earningsover charges will in mostcasesyieldsimilarresults.

Somuchforthemargin-of-safety concept as applied to“fixed-value investments.”Canitbecarriedoverintothefieldofcommonstocks?Yes,but with some necessarymodifications.

There are instances wherea common stock may beconsidered sound because itenjoys a margin of safety aslargeas thatof agoodbond.Thiswilloccur, forexample,when a company hasoutstanding only commonstock that under depressionconditions is selling for lessthantheamountofbondsthatcouldsafelybeissuedagainstits property and earning

power.*Thatwasthepositionofahostofstronglyfinancedindustrial companies at thelow price levels of 1932–33.Insuchinstancestheinvestorcan obtain the margin ofsafetyassociatedwithabond,plus all the chancesof largerincome and principalappreciation inherent in acommon stock. (The onlything he lacks is the legalpower to insist on dividend

payments “or else”—but thisis a small drawback ascompared with hisadvantages.) Common stocksbought under suchcircumstances will supply anideal, though infrequent,combination of safety andprofitopportunity.Asaquiterecent example of thiscondition,letusmentiononcemore National PrestoIndustries stock, which soldfora totalenterprisevalueof

$43millionin1972.Withits$16 millions of recentearnings before taxes thecompany could easily havesupported this amount ofbonds.

In the ordinary commonstock, bought for investmentunder normal conditions, themargin of safety lies in anexpected earning powerconsiderablyabove thegoingrate for bonds. In former

editions we elucidated thispoint with the followingfigures:

Assumeinatypicalcasethattheearningpoweris9%onthepriceandthatthebondrateis4%;thenthestockbuyerwillhavean average annualmargin of 5% accruinginhisfavor.Someoftheexcess is paid to him inthe dividend rate; even

though spent by him, itenters into his overallinvestment result. Theundistributed balance isreinvested in thebusinessforhisaccount.In many cases suchreinvested earnings failto add commensuratelytotheearningpowerandvalueofhisstock. (Thatiswhy themarket has astubbornhabitofvaluingearnings disbursed in

dividends moregenerously than theportion retained in thebusiness.)* But, if thepicture is viewed as awhole, there is areasonably closeconnection between thegrowth of corporatesurpluses throughreinvested earnings andthe growth of corporatevalues.

Over a ten-year periodthe typical excess ofstock earning powerover bond interest mayaggregate 50% of thepricepaid.Thisfigureissufficient to provide avery real margin ofsafety—which, underfavorable conditions,willpreventorminimizea loss. If such amargin

is present in each of adiversified listof twentyor more stocks, theprobability of afavorable result under“fairly normalconditions” becomesvery large. That is whythepolicyofinvestinginrepresentative commonstocks does not requirehigh qualities of insightand foresight to workout successfully. If the

purchases are made atthe average level of themarket over a span ofyears, the prices paidshould carry with themassuranceofanadequatemargin of safety. Thedanger to investors liesin concentrating theirpurchases in the upperlevels of the market, orin buyingnonrepresentativecommon stocks that

carrymore than averagerisk of diminishedearningpower.

As we see it, the wholeproblem of common-stockinvestment under 1972conditionsliesinthefactthat“inatypicalcase”theearningpower isnowmuch less than9%onthepricepaid.*Letusassume that by concentratingsomewhat on the low-multiplier issues among the

large companies a defensiveinvestor may now acquireequities at 12 times recentearnings—i.e., with anearnings return of 8.33% oncost. He may obtain adividend yield of about 4%,andhewillhave4.33%ofhiscost reinvested in thebusiness for his account. Onthisbasis,theexcessofstockearning power over bondinterest over a ten-year basiswould still be too small to

constituteanadequatemarginof safety. For that reasonwefeel that there are real risksnoweven inadiversified listofsoundcommonstocks.Therisks may be fully offset bythe profit possibilities of thelist; and indeed the investormay have no choice but toincur them—forotherwisehemay run an even greater riskof holding only fixed claimspayable in steadilydepreciating dollars.

Nonetheless the investorwould do well to recognize,and to accept asphilosophicallyashecan,thattheoldpackageofgoodprofitpossibilities combined withsmall ultimate risk is nolongeravailabletohim.*

However, the risk ofpaying too high a price forgood-quality stocks—while areal one—is not the chiefhazard confronting the

average buyer of securities.Observationovermanyyearshas taught us that the chieflossestoinvestorscomefromthe purchase of low-qualitysecurities at times offavorablebusinessconditions.The purchasers view thecurrent good earnings asequivalentto“earningpower”andassume thatprosperity issynonymouswithsafety.It isin thoseyears thatbondsandpreferred stocks of inferior

grade can be sold to thepublic at a price around par,because they carry a littlehigher income return or adeceptively attractiveconversion privilege. It isthen, also, that commonstocks of obscure companiescan be floated at prices farabove the tangibleinvestment,onthestrengthoftwo or three years ofexcellentgrowth.

These securities do notoffer an adequate margin ofsafetyinanyadmissiblesenseof the term. Coverage ofinterestchargesandpreferreddividendsmustbetestedovera number of years, includingpreferably a period ofsubnormalbusinesssuchasin1970–71. The same isordinarily true of common-stock earnings if they are toqualify as indicators ofearning power. Thus it

follows thatmostof the fair-weather investments,acquired at fair-weatherprices, are destined to sufferdisturbing price declineswhenthehorizoncloudsover—andoften sooner than that.Nor can the investor countwith confidence on aneventual recovery—althoughthisdoescomeaboutinsomeproportion of the cases—forhehasneverhadarealsafetymargin to tide him through

adversity.

The philosophy ofinvestment in growth stocksparallels in part and in partcontravenes the margin-of-safety principle.The growth-stock buyer relies on anexpected earning power thatis greater than the averageshown in the past. Thus hemay be said to substitutethese expected earnings forthe past record in calculating

his margin of safety. Ininvestment theory there isnoreason why carefullyestimated future earningsshouldbealessreliableguidethan the bare record of thepast;infact,securityanalysisis comingmore andmore topreferacompetentlyexecutedevaluationofthefuture.Thusthe growth-stock approachmay supply as dependable amargin of safety as is foundin the ordinary investment—

provided the calculation ofthe future is conservativelymade, and provided it showsa satisfactory margin inrelationtothepricepaid.

The danger in a growth-stock program lies preciselyhere.For such favored issuesthemarket has a tendency toset prices that will not beadequately protected by aconservative projection offuture earnings. (It is a basic

rule of prudent investmentthat all estimates, when theydifferfrompastperformance,must err at least slightly onthe side of understatement.)The margin of safety isalways dependent on theprice paid. Itwill be large atone price, small at somehigher price, nonexistent atsome still higher price. If, aswe suggest, the averagemarket level of most growthstocks is too high to provide

an adequatemargin of safetyfor the buyer, then a simpletechnique of diversifiedbuying in this field may notwork out satisfactorily. Aspecial degree of foresightandjudgmentwillbeneeded,in order that wise individualselectionsmay overcome thehazards inherent in thecustomary market level ofsuchissuesasawhole.

The margin-of-safety idea

becomes much more evidentwhenweapply it to the fieldof undervalued or bargainsecurities. We have here, bydefinition, a favorabledifference between price ontheonehandandindicatedorappraised value on the other.That difference is the safetymargin. It is available forabsorbing the effect ofmiscalculationsorworsethanaverage luck. The buyer ofbargain issues places

particular emphasis on theability of the investment towithstand adversedevelopments. For in mostsuch cases he has no realenthusiasm about thecompany’sprospects.True,ifthe prospects are definitelybadtheinvestorwillprefertoavoid the security no matterhow low the price. But thefieldofundervalued issues isdrawn from the manyconcerns—perhapsamajority

of the total—for which thefuture appears neitherdistinctly promising nordistinctly unpromising. Iftheseareboughtonabargainbasis, even a moderatedecline in the earning powerneed not prevent theinvestment from showingsatisfactory results. Themargin of safety will thenhave served its properpurpose.

TheoryofDiversification

There is a close logicalconnection between theconcept of a safety marginand the principle ofdiversification. One iscorrelative with the other.Even with a margin in theinvestor’sfavor,anindividualsecuritymayworkoutbadly.For the margin guaranteesonly that he has a betterchanceforprofitthanforloss

—not that loss is impossible.But as the number of suchcommitmentsisincreasedthemore certain does it becomethat the aggregate of theprofits will exceed theaggregate of the losses. Thatis the simple basis of theinsurance-underwritingbusiness.

Diversification is anestablished tenet ofconservative investment. By

accepting it so universally,investors are reallydemonstrating theiracceptance of the margin-of-safety principle, to whichdiversification is thecompanion. This point maybe made more colorful by areference to the arithmetic ofroulette.Ifamanbets$1onasinglenumber,heispaid$35profitwhenhewins—butthechances are 37 to 1 that hewill lose.He has a “negative

marginofsafety.”Inhiscasediversification is foolish.Themorenumbershebetson,thesmaller his chance of endingwith a profit. If he regularlybets $1 on every number(including 0 and 00), he iscertaintolose$2oneachturnofthewheel.Butsupposethewinner received $39 profitinstead of $35. Then hewould have a small butimportant margin of safety.Therefore, themore numbers

he wagers on, the better hischanceofgain.Andhecouldbe certain of winning $2 onevery spin by simply betting$1 each on all the numbers.(Incidentally, the twoexamples given actuallydescribe the respectivepositions of the player andproprietor of a wheel with 0and00.)*

ACriterionofInvestmentversusSpeculation

Since there is no singledefinition of investment ingeneral acceptance,authorities have the right todefine it prettymuch as theyplease. Many of them denythat there is any useful ordependable differencebetween the concepts ofinvestment and ofspeculation. We think thisskepticismisunnecessaryandharmful. It is injuriousbecause it lends

encouragement to the innateleaning of many peopletoward the excitement andhazards of stock-marketspeculation. We suggest thatthe margin-of-safety conceptmaybe used to advantage asthe touchstone to distinguishan investmentoperationfromaspeculativeone.

Probably most speculatorsbelievetheyhavetheoddsintheir favor when they take

their chances, and thereforetheymaylayclaimtoasafetymargin in their proceedings.Eachonehas the feeling thatthe time is propitious for hispurchase, or that his skill issuperior to the crowd’s, orthat his adviser or system istrustworthy. But such claimsare unconvincing. They reston subjective judgment,unsupported by any body offavorable evidence or anyconclusive line of reasoning.

Wegreatlydoubtwhetherthemanwhostakesmoneyonhisview that the market isheadingupordowncaneverbe said to be protected by amarginofsafetyinanyusefulsenseofthephrase.

By contrast, the investor’sconcept of the margin ofsafety—as developed earlierin this chapter—rests uponsimple and definitearithmetical reasoning from

statistical data. We believe,also, that it iswell supportedby practical investmentexperience. There is noguarantee that thisfundamental quantitativeapproach will continue toshow favorable results underthe unknown conditions ofthefuture.But,equally, thereis no valid reason forpessimismonthisscore.

Thus, in sum, we say that

to have a true investmentthere must be present a truemargin of safety. And a truemargin of safety is one thatcan be demonstrated byfigures, by persuasivereasoning,andbyreferencetoabodyofactualexperience.

ExtensionoftheConceptofInvestment

Tocompleteourdiscussionof the margin-of-safety

principlewemust nowmakea further distinction betweenconventional andunconventional investments.Conventional investmentsareappropriate for the typicalportfolio.Under this headinghave always come UnitedStatesgovernment issues andhigh-grade, dividend-payingcommon stocks. We haveadded state and municipalbonds for those who willbenefit sufficiently by their

tax-exempt features. Alsoincluded are first-qualitycorporate bonds when, asnow, they can be bought toyield sufficiently more thanUnitedStatessavingsbonds.

Unconventionalinvestmentsarethosethataresuitable only for theenterprising investor. Theycover a wide range. Thebroadest category is that ofundervalued common stocks

of secondary companies,which we recommend forpurchase when they can beboughtattwo-thirdsorlessoftheir indicatedvalue.Besidesthese, there is often a widechoice of medium-gradecorporatebondsandpreferredstocks when they are sellingatsuchdepressedpricesastobe obtainable also at aconsiderable discount fromtheir apparent value. In thesecases the average investor

would be inclined to call thesecurities speculative,becauseinhismindtheirlackof a first-quality rating issynonymous with a lack ofinvestmentmerit.

It is our argument that asufficientlylowpricecanturnasecurityofmediocrequalityinto a sound investmentopportunity—provided thatthe buyer is informed andexperienced and that he

practices adequatediversification. For, if theprice is lowenough tocreateasubstantialmarginofsafety,thesecuritytherebymeetsourcriterion of investment. Ourfavorite supportingillustration is taken from thefield of real-estate bonds. Inthe1920s,billionsofdollars’worth of these issues weresold at par and widelyrecommended as soundinvestments. A large

proportion had so littlemargin of value over debt asto be in fact highlyspeculative in character. Inthe depression of the 1930sanenormousquantityofthesebondsdefaultedtheirinterest,and their price collapsed—insomecasesbelow10centsonthe dollar. At that stage thesame advisers who hadrecommended them at par assafe investments wererejectingthemaspaperofthe

most speculative andunattractive type. But as amatter of fact the pricedepreciation of about 90%mademanyofthesesecuritiesexceedingly attractive andreasonably safe—for the truevaluesbehindthemwerefouror five times the marketquotation.*

The fact that the purchaseof these bonds actuallyresulted in what is generally

called “a large speculativeprofit” did not prevent themfrom having true investmentqualities at their low prices.The “speculative” profit wasthe purchaser’s reward forhaving made an unusuallyshrewd investment. Theycould properly be calledinvestment opportunities,sinceacarefulanalysiswouldhaveshownthattheexcessofvalue over price provided alarge margin of safety. Thus

theveryclassof“fair-weatherinvestments”whichwestatedabove is a chief source ofserious loss to naïve securitybuyers is likely to affordmany sound profitopportunities to thesophisticated operator whomay buy them later at prettymuchhisownprice.†

Thewholefieldof“specialsituations”wouldcomeunderour definition of investment

operations, because thepurchaseisalwayspredicatedon a thoroughgoing analysisthat promises a largerrealization than the pricepaid. Again there are riskfactors in each individualcase, but these are allowedfor in the calculations andabsorbedintheoverallresultsofadiversifiedoperation.

To carry this discussion toa logical extreme, we might

suggest that a defensibleinvestmentoperationcouldbeset up by buying suchintangible values as arerepresented by a group of“common-stock optionwarrants” selling athistorically low prices. (Thisexample is intended assomewhatofashocker.)*Theentirevalueofthesewarrantsrests on the possibility thatthe related stocks may some

dayadvanceabovetheoptionprice. At the moment theyhave no exercisable value.Yet,sinceallinvestmentrestson reasonable futureexpectations, it is proper toview these warrants in termsof the mathematical chancesthat some future bull marketwillcreatealargeincreaseintheir indicated value and intheir price. Such a studymight well yield theconclusionthat thereismuch

more tobegained insuchanoperation than to be lost andthat the chances of anultimate profit are muchbetter than those of anultimate loss. If that is so,there is a safety marginpresent even in thisunprepossessing securityform. A sufficientlyenterprising investor couldthen include an option-warrant operation in hismiscellanyof unconventional

investments.1

ToSumUp

Investment is mostintelligent when it is mostbusinesslike. It is amazing tosee how many capablebusinessmentrytooperateinWall Street with completedisregard of all the soundprinciplesthroughwhichtheyhave gained success in theirown undertakings. Yet every

corporate security may bestbe viewed, in the firstinstance, as an ownershipinterestin,oraclaimagainst,aspecificbusinessenterprise.And if a person sets out tomake profits from securitypurchases and sales, he isembarking on a businessventure of his own, whichmust be run in accordancewith accepted businessprinciples if it is to have achanceofsuccess.

Thefirstandmostobviousof theseprinciples is, “Knowwhat you are doing—knowyour business.” For theinvestor this means: Do nottrytomake“businessprofits”out of securities—that is,returns in excess of normalinterest and dividend income—unless you know as muchabout security values as youwouldneedtoknowaboutthevalueofmerchandisethatyouproposed to manufacture or

dealin.

A second businessprinciple:“Donot letanyoneelserunyourbusiness,unless(1) you can supervise hisperformance with adequatecare and comprehension or(2)youhaveunusuallystrongreasons for placing implicitconfidence in his integrityand ability.” For the investorthisruleshoulddeterminetheconditions under which he

will permit someone else todecidewhat is donewith hismoney.

A third business principle:“Do not enter upon anoperation—that is,manufacturing or trading inan item—unless a reliablecalculationshowsthatithasafair chance to yield areasonable profit. Inparticular, keep away fromventures in which you have

little to gain and much tolose.” For the enterprisinginvestor this means that hisoperations for profit shouldbebasednotonoptimismbuton arithmetic. For everyinvestor it means that whenhelimitshisreturntoasmallfigure—as formerly, at least,in a conventional bond orpreferred stock—he mustdemand convincing evidencethat he is not risking asubstantial part of his

principal.

A fourth business rule ismore positive: “Have thecourage of your knowledgeand experience. If you haveformedaconclusionfromthefacts and if you know yourjudgmentissound,actonit—even though others mayhesitate or differ.” (You areneither right nor wrongbecause the crowd disagreeswith you. You are right

because your data andreasoning are right.)Similarly, in the world ofsecurities, courage becomesthe supreme virtue afteradequate knowledge and atestedjudgmentareathand.

Fortunately for the typicalinvestor, it is by no meansnecessaryforhissuccessthathe bring these qualities tobear upon his program—provided he limits his

ambition to his capacity andconfines his activities withinthe safe and narrow path ofstandard, defensiveinvestment. To achievesatisfactory investmentresults is easier than mostpeople realize; to achievesuperiorresultsisharderthanitlooks.


If we fail to anticipate theunforeseen or expect theunexpected in a universe ofinfinitepossibilities,wemayfindourselvesatthemercyofanyoneor anything that cannot beprogrammed, categorized, oreasilyreferenced.—AgentFoxMulder,TheX-Files

First,Don’tLose

Whatisrisk?

You’ll get differentanswersdependingonwhom,andwhen, you ask. In 1999,risk didn’t mean losingmoney; itmeantmaking lessmoney than someone else.What many people fearedwas bumping into somebodyatabarbecuewhowasgettingeven richer even quicker by

day trading dot-com stocksthan they were. Then, quitesuddenly, by 2003 risk hadcome to mean that the stockmarket might keep droppinguntil it wiped out whatevertracesofwealthyoustillhadleft.

While its meaning mayseem nearly as fickle andfluctuating as the financialmarkets themselves, risk hassome profound and

permanent attributes. Thepeople who take the biggestgamblesandmakethebiggestgains in a bull market arealmost always the ones whogethurt theworst in thebearmarket that inevitablyfollows.(Being“right”makesspeculators even more eagerto take extra risk, as theirconfidencecatchesfire.)Andonceyoulosebigmoney,youthen have to gamble evenharder just to get back to

where you were, like aracetrack or casino gamblerwho desperately doubles upafter every bad bet. Unlessyou are phenomenally lucky,that’sarecipefordisaster.Nowonder, when he was askedto sum up everything he hadlearned in his long careerabout how to get rich, thelegendary financier J. K.Klingenstein of Wertheim &Co. answered simply: “Don’t

lose.”1 This graph showswhathemeant:

FIGURE20-1

TheCostofLoss

Imaginethatyoufindastockthatyouthinkcangrowat10%ayearevenifthemarketonlygrows5%annually.Unfortunately,youaresoenthusiasticthatyoupaytoohigha

price,andthestockloses50%ofitsvaluethefirstyear.Evenifthestockthengeneratesdoublethemarket’sreturn,itwilltakeyoumorethan16yearstoovertakethemarket—simplybecauseyoupaidtoomuch,andlosttoomuch,attheoutset.

Losing some money is aninevitable part of investing,and there’s nothing you candotopreventit.But,tobeanintelligent investor,youmusttake responsibility forensuring that you never losemost or all of your money.

TheHindugoddessofwealth,Lakshmi, is often portrayedstanding on tiptoe, ready todart away in the blink of aneye.Tokeephersymbolicallyin place, some of Lakshmi’sdevotees will lash her statuedownwith strips of fabric ornail its feet to the floor. Forthe intelligent investor,Graham’s “margin of safety”performs the same function:By refusing to pay toomuchfor an investment, you

minimize the chances thatyour wealth will everdisappear or suddenly bedestroyed.

Consider this: Over thefour quarters ending inDecember 1999, JDSUniphase Corp., the fiber-optics company, generated$673million in net sales, onwhichitlost$313million.Itstangible assets totaled $1.5billion. Yet, on March 7,

2000, JDS Uniphase’s stockhit $153 a share, giving thecompanyatotalmarketvalueofroughly$143billion.2Andthen, like most “New Era”stocks, it crashed. Anyonewho bought it that day andstill clung to it at the end of2002facedtheseprospects:

FIGURE20-2

BreakingEvenIsHardtoDo

IfyouhadboughtJDSUniphaseatitspeakpriceof$153.421onMarch7,2000,andstillhelditatyear-end2002(whenitclosedat$2.47),howlongwouldittakeyoutogetbacktoyourpurchasepriceatvariousannual

averageratesofreturn?

Even at a robust 10%annual rate of return, it willtake more than 43 years tobreakevenonthisoverpricedpurchase!

TheRiskisNotinOurStocks,ButinOurselves

Risk exists in anotherdimension:insideyou.Ifyou

overestimate how well youreally understand aninvestment, or overstate yourabilitytorideoutatemporaryplunge in prices, it doesn’tmatterwhatyouownorhowthe market does. Ultimately,financial risk resides not inwhat kinds of investmentsyouhave,butinwhatkindofinvestoryouare. Ifyouwantto know what risk really is,go to the nearest bathroomand step up to the mirror.

That’s risk, gazing back atyoufromtheglass.

As you look at yourself inthe mirror, what should youwatch for? The Nobel-prize–winning psychologist DanielKahneman explains twofactors thatcharacterizegooddecisions:

“well-calibratedconfidence” (do I

understand thisinvestment as well as IthinkIdo?)“correctly-anticipatedregret”(howwillIreactif my analysis turns outtobewrong?).

To find out whether yourconfidence iswell-calibrated,look in the mirror and askyourself: “What is thelikelihoodthatmyanalysisisright?” Think carefully

throughthesequestions:

How much experiencedo I have? What is mytrackrecordwithsimilardecisionsinthepast?Whatisthetypicaltrackrecord of other peoplewho have tried this inthepast?3IfIambuying,someoneelse is selling. Howlikely is it that I know

somethingthatthisotherperson (or company)doesnotknow?If Iamselling,someoneelse is buying. Howlikely is it that I knowsomethingthatthisotherperson (or company)doesnotknow?Have I calculated howmuch this investmentneedstogoupformetobreak even after mytaxes and costs of

trading?

Next, look in themirror tofind out whether you are thekind of personwho correctlyanticipates your regret. Startby asking: “Do I fullyunderstand the consequencesifmyanalysisturnsouttobewrong?” Answer thatquestionbyconsideringthesepoints:

If I’m right, I couldmake a lot of money.But what if I’mwrong?Based on the historicalperformance of similarinvestments, how muchcouldIlose?Do I have otherinvestmentsthatwilltideme over if this decisionturns out to be wrong?DoIalreadyholdstocks,bonds, or funds with aproven record of going

up when the kind ofinvestment I’mconsidering goes down?Am I putting too muchofmycapitalatriskwiththisnewinvestment?When I tell myself,“You have a hightolerance for risk,” howdo I know?Have I everlostalotofmoneyonaninvestment? How did itfeel?DidIbuymore,ordidIbailout?

Am I relying on mywillpower alone toprevent me frompanicking at the wrongtime? Or have Icontrolled my ownbehavior in advance bydiversifying, signing aninvestment contract, anddollar-costaveraging?

You should alwaysremember,inthewordsofthepsychologistPaulSlovic,that

“riskisbrewedfromanequaldose of two ingredients—probabilities andconsequences.”4 Before youinvest, you must ensure thatyou have realisticallyassessed your probability ofbeingrightandhowyouwillreact to the consequences ofbeingwrong.

Pascal’sWager

The investment philosopherPeter Bernstein has anotherway of summing this up.HereachesbacktoBlaisePascal,the great Frenchmathematicianandtheologian(1623–1662), who created athought experiment in whichan agnostic must gamble onwhether or not God exists.Theantethispersonmustputup for the wager is hisconduct in this life; theultimatepayoffinthegamble

is the fate of his soul in theafterlife.Inthiswager,Pascalasserts, “reason cannotdecide” the probability ofGod’s existence. Either Godexists or He does not—andonly faith, not reason, cananswer that question. Butwhile the probabilities inPascal’swager are a toss-up,the consequences areperfectly clear and utterlycertain. As Bernsteinexplains:

Suppose you act asthoughGodisand[you]lead a life of virtue andabstinence,when in factthereisnogod.Youwillhave passed up somegoodiesinlife,buttherewill be rewards aswell.Nowsupposeyouactasthough God is not andspend a life of sin,selfishness, and lustwheninfactGodis.Youmay have had fun and

thrills during therelatively brief durationof your lifetime, butwhen the day ofjudgment rolls aroundyouareinbigtrouble.5

Concludes Bernstein: “Inmaking decisions underconditionsofuncertainty, theconsequences must dominatethe probabilities. We neverknow the future.” Thus, asGrahamhas remindedyou in

every chapter of this book,the intelligent investor mustfocus not just on getting theanalysis right.Youmustalsoensure against loss if youranalysisturnsouttobewrong—as even the best analyseswill be at least some of thetime. The probability ofmakingatleastonemistakeatsome point in your investinglifetime is virtually 100%,and those odds are entirelyoutofyourcontrol.However,

youdo have control over theconsequences of beingwrong.Many “investors” putessentiallyallof theirmoneyinto dot-com stocks in 1999;an online survey of 1,338Americans by MoneyMagazine in 1999 found thatnearly one-tenth of themhadatleast85%oftheirmoneyinInternet stocks. By ignoringGraham’scallforamarginofsafety, these people took thewrongsideofPascal’swager.

Certain that they knew theprobabilities of being right,they did nothing to protectthemselves against theconsequences of beingwrong.

Simply by keeping yourholdings permanentlydiversified, and refusing toflingmoney atMr.Market’slatest, craziest fashions, youcan ensure that theconsequences of your

mistakes will never becatastrophic. No matter whatMr. Market throws at you,you will always be able tosay, with a quiet confidence,“This,too,shallpassaway.”

Postscript

We know very well twopartners who spent a goodpart of their lives handlingtheir own and other people’sfunds on Wall Street. Somehard experience taught them

it was better to be safe andcareful rather than to try tomake all the money in theworld. They established arather unique approach tosecurity operations, whichcombined good profitpossibilities with soundvalues. They avoidedanything that appearedoverpriced and were rathertooquicktodisposeofissuesthat had advanced to levelsthey deemed no longer

attractive.Theirportfoliowasalways well diversified, withmorethanahundreddifferentissues represented. In thisway they did quite wellthrough many years of upsand downs in the generalmarket; they averaged about20% per annum on theseveral millions of capitalthey had accepted formanagement,andtheirclientswere well pleased with the

results.*

In the year in which thefirst edition of this bookappeared an opportunity wasoffered to the partners’ fundtopurchaseahalf-interestinagrowingenterprise.Forsomereason the industry did nothaveWallStreetappealatthetime and the deal had beenturned down by quite a fewimportanthouses.Butthepairwas impressed by the

company’spossibilities;whatwas decisive for them wasthatthepricewasmoderateinrelation to current earningsand asset value.Thepartnerswent ahead with theacquisition, amounting indollars to about one-fifth oftheir fund. They becameclosely identified with thenew business interest, whichprospered.†

In fact it did so well that

the price of its sharesadvanced to two hundredtimes or more the price paidfor the half-interest. Theadvance far outstripped theactual growth in profits, andalmost from the start thequotation appearedmuch toohighintermsof thepartners’own investment standards.But since they regarded thecompanyasasortof“familybusiness,” they continued tomaintain a substantial

ownership of the sharesdespite the spectacular pricerise. A large number ofparticipantsintheirfundsdidthe same, and they becamemillionaires through theirholdinginthisoneenterprise,plus later-organizedaffiliates.*

Ironically enough, theaggregate of profits accruingfrom this single investmentdecisionfarexceededthesum

of all the others realizedthrough 20 years of wide-ranging operations in thepartners’ specialized fields,involvingmuchinvestigation,endless pondering, andcountless individualdecisions.

Are there morals to thisstory of value to theintelligent investor? Anobvious one is that there areseveral different ways to

make and keep money inWall Street. Another, not soobvious, is that one luckybreak, or one supremelyshrewddecision—canwe tellthem apart?—may count formore than a lifetime ofjourneyman efforts.1 Butbehindtheluck,orthecrucialdecision, there must usuallyexist a background ofpreparation and disciplinedcapacity. One needs to be

sufficiently established andrecognized so that theseopportunities will knock athisparticulardoor.Onemusthave the means, thejudgment, and thecourage totakeadvantageofthem.

Of course, we cannotpromise a like spectacularexperience to all intelligentinvestors who remain bothprudentandalert through theyears. We are not going to

endwithJ.J.Raskob’ssloganthat we made fun of at thebeginning: “Everybody canbe rich.” But interestingpossibilities abound on thefinancial scene, and theintelligent and enterprisinginvestor should be able tofind both enjoyment andprofitinthisthree-ringcircus.Excitementisguaranteed.

CommentaryonPostscript

Successful investing is aboutmanaging risk, not avoidingit. At first glance, when yourealize thatGraham put 25%ofhisfundintoasinglestock,you might think he was

gambling rashly with hisinvestors’ money. But then,when you discover thatGraham had painstakinglyestablished that he couldliquidate GEICO for at leastwhat he paid for it, itbecomes clear that Grahamwas taking very littlefinancial risk. But he neededenormouscouragetotakethepsychological risk of such abig bet on so unknown a

stock.1

And today’s headlines arefull of fearful facts andunresolvedrisks:thedeathofthe 1990s bull market,sluggish economic growth,corporate fraud, the spectersof terrorism and war.“Investors don’t likeuncertainty,” a marketstrategist is intoning rightnow on financial TV or intoday’s newspaper. But

investors have never likeduncertainty—andyet it is themost fundamental andenduring condition of theinvestingworld.Italwayshasbeen, and it always will be.At heart, “uncertainty” and“investing” are synonyms. Inthe real world, no one haseverbeengiventheability toseethatanyparticulartimeisthe best time to buy stocks.Without a saving faith in thefuture, no one would ever

invest at all. To be aninvestor, you must be abelieverinabettertomorrow.

The most literate ofinvestors, Graham loved thestoryofUlysses,toldthroughthe poetry of Homer, AlfredTennyson,andDante.Lateinhis life, Graham relished thescene in Dante’s Infernowhen Ulysses describesinspiring his crew to sailwestward into the unknown

waters beyond the gates ofHercules:

“O brothers,” I said,“who after a hundredthousand

perils have reached thewest,

inthislittlewakingvigil

that still remains to oursenses,

let us not choose toavoidtheexperience

of the unpeopled worldthatliesbehindthesun.

Consider the seeds fromwhichyousprang:

You were made not tolivelikebeasts,

but to seek virtue andunderstanding.”

With this little oration Imademyshipmates

soeagerforthevoyage

thatitwouldhavehurttoholdthemback.

Andweswungoursterntowardthemorning

and turnedour oars intowings for the wildflight.2

Investing, too, is anadventure;thefinancialfutureisalwaysanunchartedworld.With Graham as your guide,your lifelong investingvoyageshouldbeassafeandconfidentasitisadventurous.

Appendixes

1.TheSuperinvestorsofGraham-and-Doddsville

byWarrenE.Buffett

EDITOR’SNOTE:This article isan edited transcript of a talkgivenatColumbiaUniversity

in 1984 commemorating thefiftieth anniversary ofSecurityAnalysis,written byBenjaminGrahamandDavidL. Dodd. This specializedvolume first introduced theideas later popularized inThe Intelligent Investor.Buffett’s essay offers afascinating study of howGraham’sdiscipleshaveusedGraham’s value investingapproach to realizephenomenal success in the

stockmarket.

Is the Graham and Dodd“look for values with asignificant margin of safetyrelativetoprices”approachtosecurityanalysisoutofdate?Many of the professors whowritetextbookstodaysayyes.They argue that the stockmarket is efficient; that is,that stock prices reflecteverything that is knownabout a company’s prospects

and about the state of theeconomy. There are noundervalued stocks, thesetheoristsargue,because thereare smart security analystswho utilize all availableinformation to ensureunfailinglyappropriateprices.Investors who seem to beatthemarketyearafteryeararejust lucky. “If prices fullyreflect available information,this sort of investmentadeptnessisruledout,”writes

one of today’s textbookauthors.

Well,maybe.ButIwanttopresent to you a group ofinvestors who have, year inand year out, beaten theStandard&Poor’s 500 stockindex. The hypothesis thattheydothisbypurechanceisat least worth examining.Crucialtothisexaminationisthe fact that these winnerswere all well known to me

andpre-identifiedas superiorinvestors, the most recentidentification occurring overfifteenyearsago.Absent thiscondition—that is, if I hadjust recently searched amongthousandsofrecordstoselecta few names for you thismorning—Iwouldadviseyouto stop reading right here. Ishould add that all theserecords have been audited.AndIshouldfurtheraddthatI have knownmany of those

whohaveinvestedwiththesemanagers, and the checksreceivedbythoseparticipantsover the years have matchedthestatedrecords.

Before we begin thisexamination,Iwouldlikeyouto imagine a national coin-flippingcontest.Let’sassumewe get 225 millionAmericans up tomorrowmorningandweask themalltowageradollar.Theygoout

inthemorningatsunrise,andtheyallcalltheflipofacoin.If they call correctly, theywin a dollar from those whocalled wrong. Each day thelosers drop out, and on thesubsequent day the stakesbuildasallpreviouswinningsare put on the line.After tenflips on ten mornings, therewill be approximately220,000people in theUnitedStates who have correctlycalledtenflipsinarow.They

each will have won a littleover$1,000.

Now this group willprobably start getting a littlepuffed up about this, humannature beingwhat it is.Theymay try to bemodest, but atcocktail parties they willoccasionally admit toattractive members of theopposite sex what theirtechnique is, and whatmarvelousinsightstheybring

tothefieldofflipping.

Assuming that thewinnersare getting the appropriaterewards from the losers, inanothertendayswewillhave215 people who havesuccessfully called their coinflips 20 times in a row andwho, by this exercise, eachhave turnedonedollar into alittle over $1 million. $225millionwouldhavebeenlost,$225 million would have

beenwon.

By then, this group willreally lose their heads. Theywill probablywrite books on“How ITurned aDollar intoa Million in Twenty DaysWorking Thirty Seconds aMorning.”Worse yet, they’llprobably start jetting aroundthe country attendingseminars on efficient coin-flipping and tacklingskeptical professors with, “If

it can’t be done, why arethere215ofus?”

But then some businessschool professor willprobably be rude enough tobring up the fact that if 225million orangutans hadengagedinasimilarexercise,theresultswouldbemuchthesame—215 egotisticalorangutans with 20 straightwinningflips.

I would argue, however,thattherearesomeimportantdifferences in the examples Iamgoing topresent.Foronething, if (a) you had taken225 million orangutansdistributed roughly as theU.S.population is; if (b)215winners were left after 20days;andif(c)youfoundthat40camefromaparticularzooin Omaha, you would bepretty sure you were on tosomething. So you would

probably go out and ask thezookeeper about what he’sfeeding them, whether theyhad special exercises, whatbooks they read, and whoknows what else. That is, ifyou found any reallyextraordinary concentrationsofsuccess,youmightwanttosee if you could identifyconcentrations of unusualcharacteristics that might becausalfactors.

Scientific inquiry naturallyfollowssuchapattern.Ifyouwere trying to analyzepossiblecausesofararetypeof cancer—with, say, 1,500cases a year in the UnitedStates—and you found that400ofthemoccurredinsomelittle mining town inMontana,youwouldgetveryinterested in the water there,or the occupation of thoseafflicted, or other variables.You know that it’s not

randomchancethat400comefromasmallarea.Youwouldnot necessarily know thecausalfactors,butyouwouldknowwheretosearch.

I submit to you that therearewaysofdefininganoriginother than geography. Inaddition to geographicalorigins, there can be what Icall an intellectual origin. Ithink you will find that adisproportionate number of

successfulcoin-flippersintheinvestment world came froma very small intellectualvillage that could be calledGraham-and-Doddsville. Aconcentration ofwinners thatsimply cannot be explainedby chance can be traced tothis particular intellectualvillage.

Conditionscouldexist thatwould make even thatconcentration unimportant.

Perhaps 100 people weresimply imitating the coin-flipping call of some terriblypersuasive personality.Whenhe called heads, 100followersautomaticallycalledthatcointhesameway.Iftheleaderwaspartofthe215leftat the end, the fact that 100came from the sameintellectual origin wouldmean nothing. You wouldsimply be identifying onecase as a hundred cases.

Similarly, let’s assume thatyou lived in a stronglypatriarchal society and everyfamily in the United Statesconveniently consisted of tenmembers.Furtherassumethatthepatriarchalculturewassostrong that, when the 225million people went out thefirst day, every member ofthefamily identifiedwith thefather’scall.Now,at theendof the 20-day period, youwouldhave215winners,and

you would find that theycamefromonly21.5families.Some naive types might saythat this indicates anenormoushereditaryfactorasan explanation of successfulcoin-flipping. But, of course,itwouldhavenosignificanceatallbecauseitwouldsimplymean that you didn’t have215 individual winners, butrather 21.5 randomlydistributedfamilieswhowerewinners.

In this groupof successfulinvestors that I want toconsider, there has been acommon intellectualpatriarch, Ben Graham. Butthe children who left thehouse of this intellectualpatriarch have called their“flips”inverydifferentways.They have gone to differentplaces and bought and solddifferent stocks andcompanies,yettheyhavehada combined record that

simply can’t be explained byrandom chance. It certainlycannot be explained by thefact that they are all callingflips identically because aleaderissignalingthecallstomake. The patriarch hasmerely set forth theintellectualtheoryformakingcoin-calling decisions, buteach student has decided onhis own manner of applyingthetheory.

The common intellectualtheme of the investors fromGraham-and-Doddsville isthis: they search fordiscrepancies between thevalue of a business and theprice of small pieces of thatbusiness in the market.Essentially,theyexploitthosediscrepancies without theefficient market theorist’sconcern as to whether thestocksareboughtonMondayorThursday, orwhether it is

January or July, etc.Incidentally, whenbusinessmen buy businesses—which is just what ourGraham&Doddinvestorsaredoingthroughthemediumofmarketable stocks—I doubtthat many are cranking intotheir purchase decision thedayoftheweekorthemonthin which the transaction isgoing to occur. If it doesn’tmake any differencewhetherall of a business is being

bought on a Monday or aFriday, I am baffled whyacademiciansinvestextensivetimeandefforttoseewhetherit makes a difference whenbuying small pieces of thosesamebusinesses.OurGraham&Doddinvestors,needlesstosay, do not discuss beta, thecapitalassetpricingmodel,orcovariance in returns amongsecurities. These are notsubjects of any interest tothem. In fact, most of them

would have difficultydefining those terms. Theinvestorssimplyfocusontwovariables:priceandvalue.

I always find itextraordinary that so manystudiesaremadeofpriceandvolumebehavior, the stuffofchartists. Can you imaginebuying an entire businesssimply because the price ofthebusinesshadbeenmarkedupsubstantiallylastweekand

the week before? Of course,thereasonalotofstudiesaremade of these price andvolumevariablesis thatnow,intheageofcomputers,thereare almost endless dataavailable about them. It isn’tnecessarily because suchstudies have any utility; it’ssimply that thedataare thereand academicians haveworked hard to learn themathematicalskillsneededtomanipulate them.Once these

skills are acquired, it seemssinfulnottousethem,evenifthe usage has no utility ornegative utility. As a friendsaid,toamanwithahammer,everythinglookslikeanail.

I think the group that wehave identifiedbyacommonintellectualhomeisworthyofstudy.Incidentally,despiteallthe academic studies of theinfluenceofsuchvariablesasprice, volume, seasonality,

capitalization size, etc., uponstock performance, nointeresthasbeenevidencedinstudying the methods of thisunusual concentration ofvalue-orientedwinners.

Ibeginthisstudyofresultsby going back to a group offour of us who worked atGraham-NewmanCorporation from 1954through 1956. There wereonly four—I have not

selected these names fromamongthousands.Iofferedtogo to work at Graham-Newman for nothing after ItookBenGraham’sclass,buthe turned me down asovervalued. He took thisvalue stuff very seriously!After much pestering hefinally hiredme. There werethree partners and four of usat the “peasant” level. Allfour left between 1955 and1957 when the firm was

woundup,andit’spossibletotracetherecordofthree.

The first example (seeTable 1, pages 549–550) isthatofWalterSchloss.Walternever went to college, buttook a course from BenGraham at night at the NewYork Institute of Finance.Walter left Graham-Newmanin 1955 and achieved therecord shown here over 28years.

Here is what “AdamSmith”—after I told himabout Walter—wrote abouthiminSupermoney(1972):

He has no connectionsor access to usefulinformation. Practicallyno one in Wall Streetknowshimandheisnotfed any ideas. He looksup the numbers in themanuals and sends forthe annual reports, and

that’saboutit.

In introducing me to[Schloss] Warren hadalso, to my mind,described himself. “Henever forgets that he ishandling other people’smoney and thisreinforces his normalstrong aversion to loss.”He has total integrityanda realisticpictureofhimself.Moneyisrealto

him and stocks are real—andfromthisflowsanattraction to the“marginofsafety”principle.

Walter has diversifiedenormously, owning wellover100stockscurrently.Heknows how to identifysecurities that sell atconsiderably less than theirvaluetoaprivateowner.Andthat’sallhedoes.Hedoesn’tworry about whether it’s

January, he doesn’t worryabout whether it’s Monday,he doesn’t worry aboutwhether it’s an electionyear.Hesimplysays, ifabusinessis worth a dollar and I canbuyitfor40cents,somethinggoodmayhappentome.Andhe does it over and over andover again. He owns manymorestocksthanIdo—andisfar less interested in theunderlying nature of thebusiness:Idon’tseemtohave

very much influence onWalter. That’s one of hisstrengths; no one has muchinfluenceonhim.

The second case is TomKnapp, who also worked atGraham-Newman with me.Tom was a chemistry majorat Princeton before the war;whenhecameback from thewar, he was a beach bum.AndthenonedayhereadthatDave Dodd was giving a

nightcourseininvestmentsatColumbia. Tom took it on anoncreditbasis,andhegotsointerested in thesubject fromtaking that course that hecame up and enrolled atColumbia Business School,where he got the MBAdegree. He took Dodd’scourse again, and took BenGraham’s course.Incidentally, 35 years later IcalledTomtoascertainsomeofthefactsinvolvedhereand

I found him on the beachagain. The only difference isthatnowheownsthebeach!

In 1968 Tom Knapp andEdAnderson, also aGrahamdisciple, along with one ortwo other fellows of similarpersuasion, formed Tweedy,Browne Partners, and theirinvestment results appear inTable 2. Tweedy, Brownebuilt that record with verywide diversification. They

occasionally bought controlof businesses, but the recordof the passive investments isequal to the record of thecontrolinvestments.

Table3describes the thirdmember of the group whoformedBuffettPartnership in1957. The best thing he didwas to quit in 1969. Sincethen, in a sense, BerkshireHathaway has been acontinuation of the

partnership in some respects.ThereisnosingleindexIcangive you that I would feelwould be a fair test ofinvestment management atBerkshire. But I think thatanyway you figure it, it hasbeensatisfactory.

Table 4 shows the recordoftheSequoiaFund,whichismanaged by a man whom Imetin1951inBenGraham’sclass, Bill Ruane. After

getting out of HarvardBusiness School, he went toWallStreet.Thenherealizedthat he needed to get a realbusiness education so hecameuptotakeBen’scourseatColumbia,wherewemetinearly1951.Bill’srecordfrom1951 to 1970, working withrelativelysmallsums,wasfarbetter than average. When IwoundupBuffettPartnershipIaskedBillifhewouldsetupa fund to handle all our

partners, so he set up theSequoiaFund.Hesetitupata terrible time, just when Iwas quitting. He went rightinto the two-tier market andall the difficulties that madefor comparative performanceforvalue-orientedinvestors.Iam happy to say that mypartners, to an amazingdegree, not only stayed withhim but added money, withthehappyresultshown.

There’s no hindsightinvolved here. Bill was theonly person I recommendedtomy partners, and I said atthetimethat ifheachievedafour-point-per-annumadvantage over the Standard&Poor’s,thatwouldbesolidperformance. Bill hasachieved well over that,working with progressivelylarger sums of money. Thatmakes things much moredifficult.Sizeistheanchorof

performance. There is noquestion about it. It doesn’tmeanyoucan’tdobetterthanaveragewhenyouget larger,butthemarginshrinks.Andifyou ever get so you’remanagingtwotrilliondollars,and that happens to be theamount of the total equityevaluation in the economy,don’t think that you’ll dobetterthanaverage!

I should add that in the

records we’ve looked at sofar, throughout this wholeperiod there was practicallyno duplication in theseportfolios. These are menwhoselectsecuritiesbasedondiscrepancies between priceand value, but they maketheir selections verydifferently. Walter’s largestholdings have been suchstalwarts as Hudson Pulp &Paper and Jeddo HighlandCoal and New York Trap

RockCompany and all thoseother names that comeinstantly to mind to even acasual reader of the businesspages. Tweedy Browne’sselections have sunk evenwellbelowthatlevelintermsof name recognition. On theother hand, Bill has workedwith big companies. Theoverlap among theseportfolioshasbeenvery,verylow. These records do notreflectoneguycallingtheflip

and fifty people yelling outthesamethingafterhim.

Table 5 is the record of afriend of mine who is aHarvard Law graduate, whosetupamajorlawfirm.Iraninto him in about 1960 andtoldhimthat lawwasfineasa hobby but he could dobetter.Hesetupapartnershipquite the opposite ofWalter’s. His portfolio wasconcentrated in very few

securities and therefore hisrecord was much morevolatile but it was based onthesamediscount-from-valueapproach. He was willing toaccept greater peaks andvalleys of performance, andhe happens to be a fellowwhose whole psyche goestoward concentration, withthe results shown.Incidentally, this recordbelongs to Charlie Munger,mypartnerfora longtimein

the operation of BerkshireHathaway. When he ran hispartnership, however, hisportfolio holdings werealmost completely differentfrom mine and the otherfellowsmentionedearlier.

Table 6 is the record of afellow who was a pal ofCharlie Munger’s—anothernon–business school type—who was a math major atUSC. He went to work for

IBMaftergraduationandwasanIBMsalesmanforawhile.AfterIgottoCharlie,Charliegot to him. This happens tobetherecordofRickGuerin.Rick, from 1965 to 1983,againstacompoundedgainof316 percent for the S&P,cameoffwith22,200percent,which, probably because helacks a business schooleducation, he regards asstatisticallysignificant.

One sidelight here: it isextraordinary to me that theideaofbuyingdollarbillsfor40 cents takes immediatelywithpeopleoritdoesn’ttakeatall.It’slikeaninoculation.If it doesn’t grab a personrightaway,Ifindthatyoucantalk to him for years andshow him records, and itdoesn’tmake any difference.They just don’t seem able tograsptheconcept,simpleasitis.AfellowlikeRickGuerin,

whohadnoformaleducationin business, understandsimmediately the valueapproach to investing andhe’s applying it fiveminuteslater. I’ve never seen anyonewho became a gradualconvertoveraten-yearperiodto this approach. It doesn’tseem tobe amatter of IQoracademictraining.It’sinstantrecognition,oritisnothing.

Table 7 is the record of

Stan Perlmeter. Stan was aliberal arts major at theUniversity of Michigan whowas a partner in theadvertising agency of Bozell&Jacobs.Wehappenedtobein the same building inOmaha. In 1965 he figuredout I had a better businessthan he did, so he leftadvertising. Again, it tookfive minutes for Stan toembracethevalueapproach.

Perlmeter does not ownwhat Walter Schloss owns.He does not own what BillRuane owns. These arerecords made independently.But every time Perlmeterbuysastockit’sbecausehe’sgetting more for his moneythan he’s paying. That’s theonly thing he’s thinkingabout. He’s not looking atquarterly earningsprojections, he’s not lookingat next year’s earnings, he’s

not thinking about what dayof the week it is, he doesn’tcarewhatinvestmentresearchfromanyplacesays,he’snotinterested in pricemomentum, volume, oranything.He’ssimplyasking:Whatisthebusinessworth?

Table8andTable9aretherecordsof twopension fundsI’ve been involved in. Theyare not selected from dozensofpensionfundswithwhichI

have had involvement; theyare the only two I haveinfluenced. In both cases Ihave steered them towardvalue-oriented managers.Very,veryfewpensionfundsare managed from a valuestandpoint. Table 8 is theWashington Post Company’sPension Fund. It was with alarge bank some years ago,and I suggested that theywould do well to selectmanagers who had a value

orientation.

As you can see, overallthey have been in the toppercentile ever since theymade the change. The Posttold the managers to keep atleast 25 percent of thesefunds in bonds,whichwouldnothavebeennecessarilythechoiceof thesemanagers.SoI’ve included the bondperformance simply toillustrate that this group has

no particular expertise aboutbonds. They wouldn’t havesaid they did. Evenwith thisdrag of 25 percent of theirfund in an area that was nottheir game, they were in thetop percentile of fundmanagement. TheWashington Post experiencedoesnotcoveraterriblylongperiod but it does representmanyinvestmentdecisionsbythreemanagerswhowerenotidentifiedretroactively.

Table9istherecordoftheFMC Corporation fund. Idon’t manage a dime of itmyself but I did, in 1974,influence their decision toselect value-orientedmanagers. Prior to that timethey had selected managersmuch the same way as mostlarger companies. They nowrank number one in theBecker survey of pensionfunds for their size over theperiod of time subsequent to

this“conversion”tothevalueapproach.Last year they hadeightequitymanagersofanyduration beyond a year.Seven of them had acumulative recordbetter thanthe S&P. All eight had abetter record last year thanthe S&P. The net differencenow between a medianperformance and the actualperformanceoftheFMCfundover this period is $243million. FMC attributes this

to themindset given to themabout the selection ofmanagers. Those managersarenot themanagersIwouldnecessarily select but theyhave the commondenominator of selectingsecuritiesbasedonvalue.

Sotheseareninerecordsof“coin-flippers”fromGraham-and-Doddsville. I haven’tselected them with hindsightfrom among thousands. It’s

not like I am reciting to youthe names of a bunch oflotterywinners—peopleIhadnever heard of before theywon the lottery. I selectedthese men years ago basedupon their framework forinvestment decision-making.I knew what they had beentaught and additionally I hadsome personal knowledge oftheir intellect, character, andtemperament. It’s veryimportant to understand that

this group has assumed farless risk than average; notetheirrecordinyearswhenthegeneral market was weak.While they differ greatly instyle, these investors are,mentally, always buying thebusiness, not buying thestock. A few of themsometimes buy wholebusinesses. Far more oftenthey simplybuysmallpiecesof businesses. Their attitude,whether buying all or a tiny

piece of a business, is thesame. Some of them holdportfolios with dozens ofstocks; others concentrate ona handful.But all exploit thedifference between themarket price of a businessanditsintrinsicvalue.

I’mconvincedthat thereismuch inefficiency in themarket. These Graham-and-Doddsville investors havesuccessfully exploited gaps

between price and value.Whenthepriceofastockcanbe influencedbya“herd”onWallStreetwithprices setatthe margin by the mostemotional person, or thegreediest person, or themostdepressedperson,itishardtoargue that themarket alwaysprices rationally. In fact,market prices are frequentlynonsensical.

I would like to say one

important thing about riskand reward. Sometimes riskandrewardarecorrelatedinapositive fashion. If someonewere to say to me, “I haveherea six-shooterand Ihaveslipped one cartridge into it.Why don’t you just spin itand pull it once? If yousurvive, I will give you $1million.” I would decline—perhaps stating that $1million is not enough. Thenhemightofferme$5million

to pull the trigger twice—now thatwouldbeapositivecorrelation between risk andreward!

The exact opposite is truewith value investing. If youbuyadollarbillfor60cents,it’s riskier than if you buy adollar bill for 40 cents, butthe expectation of reward isgreater in the lattercase.Thegreater the potential forreward in thevalueportfolio,

thelessriskthereis.

One quick example: TheWashingtonPostCompanyin1973 was selling for $80million in themarket.At thetime,thatday,youcouldhavesold the assets to any one often buyers for not less than$400 million, probablyappreciably more. Thecompany owned the Post,Newsweek, plus severaltelevision stations in major

markets. Those sameproperties are worth $2billion now, so the personwho would have paid $400million would not have beencrazy.

Now, if the stock haddeclined even further to aprice thatmade thevaluation$40 million instead of $80million, its beta would havebeen greater. And to peoplewhothinkbetameasuresrisk,

thecheaperpricewouldhavemade it look riskier. This istruly Alice inWonderland. Ihaveneverbeenabletofigureout why it’s riskier to buy$400 million worth ofproperties for $40 millionthan $80 million. And, as amatter of fact, if you buy agroup of such securities andyou know anything at allabout business valuation,there is essentially no risk inbuying $400 million for $80

million,particularlyifyoudoit by buying ten $40 millionpiles for $8 million each.Since you don’t have yourhands on the $400 million,youwanttobesureyouareinwith honest and reasonablycompetent people, but that’snotadifficultjob.

You also have to have theknowledge to enable you tomakeaverygeneralestimateabout the value of the

underlying businesses. Butyou do not cut it close. Thatis what Ben Graham meantbyhavingamarginofsafety.You don’t try and buybusinessesworth $83millionfor $80 million. You leaveyourselfanenormousmargin.Whenyoubuildabridge,youinsist it can carry 30,000pounds, but you only drive10,000-poundtrucksacrossit.And that same principleworksininvesting.

In conclusion, someof themore commercially mindedamongyoumaywonderwhyI am writing this article.Addingmanyconverts to thevalue approach will perforcenarrow the spreads betweenprice and value. I can onlytell you that the secret hasbeen out for 50 years, eversince BenGraham andDaveDodd wrote SecurityAnalysis, yet I have seen notrend toward value investing

in the 35 years that I’vepracticed it. There seems tobe some perverse humancharacteristic that likes tomake easy things difficult.The academic world, ifanything,hasactuallybackedaway from the teaching ofvalue investing over the last30 years. It’s likely tocontinue thatway.Shipswillsail around theworldbut theFlat Earth Society willflourish. There will continue

to be wide discrepanciesbetween price and value inthe marketplace, and thosewho read their Graham &Dodd will continue toprosper.

Tables1–9follow:

TABLE 2 Tweedy, BrowneInc.

TABLE 3 BuffettPartnership,Ltd

TABLE 4 Sequoia Fund,Inc.

TABLE5CharlesMunger

TABLE 6 Pacific Partners,Ltd.

2.ImportantRulesConcerningTaxabilityofInvestmentIncomeandSecurityTransactions(in1972)

Editor’s note: Due toextensivechangesintherulesgoverning such transactions,the following document ispresented here for historicalpurposes only. When firstwritten byBenjaminGrahamin 1972, all the informationthereinwascorrect.However,intervening developments

have rendered this documentinaccurate for today’spurposes. FollowingGraham’s original Appendix2 is a revised and updatedversion of “The Basics ofInvestment Taxation,” whichbrings the reader up-to-dateontherelevantrules.

Rule1—InterestandDividends

Interest and dividends aretaxable as ordinary income

except (a) income receivedfrom state, municipal, andsimilarobligations,whicharefreefromFederaltaxbutmaybe subject to state tax, (b)dividends representing areturn of capital, (c) certaindividendspaidby investmentcompanies (see below), and(d) the first $100ofordinarydomestic-corporationdividends.

Rule2—CapitalGainsandLosses

Short-term capital gainsand losses are merged toobtain net short-term capitalgain or loss. Long-termcapital gains and losses aremergedtoobtainthenetlong-term capital gain or loss. Ifthenetshort-termcapitalgainexceeds the net long-termcapital loss, 100 per cent ofsuchexcessshallbeincludedinincome.Themaximumtaxthereonis25%upto$50,000ofsuchgainsand35%onthe

balance.

A net capital loss (theamount exceeding capitalgains) is deductible fromordinary income to amaximum of $1,000 in thecurrent year and in each ofthe next five years.Alternatively, unused lossesmaybeappliedatanytimetooffset capital gains. (Carry-overs of losses taken before1970 are treated more

liberallythanlaterlosses.)

Note Concerning “RegulatedInvestmentCompanies”

Most investment funds(“investment companies”)take advantage of specialprovisions of the tax law,which enable them to betaxed substantially aspartnerships. Thus if theymake long-term securityprofits they can distribute

these as “capital-gaindividends,” which arereportedbytheirshareholdersinthesamewayaslong-termgains.Thesecarryalowertaxrate than ordinary dividends.Alternatively, such acompanymayelecttopaythe25%taxfortheaccountofitsshareholders and then retainthe balance of the capitalgains without distributingthem as capital-gaindividends.

3.TheBasicsofInvestmentTaxation(Updatedasof2003)

InterestandDividends

Interest and dividends aretaxed at your ordinary-income tax rate except (a)interest received frommunicipal bonds, which isfree fromFederal incometaxbut may be subject to statetax, (b) dividendsrepresenting a return ofcapital, and (c) long-term

capital-gaindistributionspaidbymutual funds (seebelow).Private-activity municipalbonds, even within a mutualfund,may subject you to theFederal alternative minimumtax.

CapitalGainsandLosses

Short-term capital gainsand losses are merged toobtain net short-term capitalgain or loss. Long-term

capital gains and losses aremergedtodetermineyournetlong-termcapitalgainorloss.If your net short-term capitalgain exceeds the net long-term capital loss, that excessis counted as ordinaryincome.Ifthereisanetlong-termcapitalgain,itistaxedatthe favorable capital gainsrate, generally 20%—whichwill fall to 18% forinvestments purchased afterDecember31,2000,andheld

formorethanfiveyears.

A net capital loss isdeductible from ordinaryincome to a maximum of$3,000 in the current year.Any capital losses in excessof $3,000may be applied inlatertaxyearstooffsetfuturecapitalgains.

MutualFunds

As “regulated investment

companies,”nearlyallmutualfunds take advantage ofspecial provisions of the taxlaw that exempt them fromcorporate income tax. Afterselling long-term holdings,mutual funds can distributethe profits as “capital-gaindividends,” which theirshareholders treat as long-termgains.Thesearetaxedata lower rate (generally 20%)than ordinary dividends (upto 39%). You should

generally avoidmaking largenew investments during thefourth quarter of each year,when these capital-gaindistributions are usuallydistributed; otherwise youwill incur tax for a gainearnedbythefundbeforeyouevenownedit.

4.TheNewSpeculationinCommonStocks1

What I shall have to say

will reflect the spending ofmany years in Wall Street,with their attendant varietiesof experience. This hasincluded the recurrent adventof new conditions, or a newatmosphere, which challengethevalueofexperienceitself.It is true that one of theelements that distinguisheconomics, finance, andsecurity analysis from otherpractical disciplines is theuncertain validity of past

phenomena as a guide to thepresent and future. Yet wehave no right to reject thelessons of the past until wehave at least studied andunderstoodthem.Myaddresstodayisanefforttowardsuchunderstanding in a limitedfield—in particular, anendeavor to point out somecontrasting relationshipsbetween the present and thepast in our underlyingattitudes toward investment

and speculation in commonstocks.

Let me start with asummaryofmythesis.Inthepast the speculative elementsof a common stock residedalmost exclusively in thecompanyitself;theywereduetouncertainties,orfluctuatingelements, or downrightweaknessesintheindustry,orthe corporation’s individualsetup. These elements of

speculation still exist, ofcourse;butitmaybesaidthatthey have been sensiblydiminished by a number oflong-term developments towhich I shall refer. But inrevenge a new and majorelement of speculation hasbeen introduced into thecommon-stock arena fromoutside the companies. Itcomes from the attitude andviewpointofthestock-buyingpublic and their advisers—

chiefly us security analysts.This attitude may bedescribed in a phrase:primaryemphasisuponfutureexpectations.

Nothing will appear morelogical and natural to thisaudience than the idea that acommon stock should bevalued and priced primarilyonthebasisofthecompany’sexpected future performance.Yet this simple-appearing

concept carries with it anumber of paradoxes andpitfalls. For one thing, itobliterates agoodpart of theolder, well-establisheddistinctions betweeninvestment and speculation.The dictionary says that“speculate” comes from theLatin “specula,” a lookout.Thus it was the speculatorwho looked out and sawfuture developments comingbefore other people did. But

today, if the investor isshrewd or well advised, hetoomusthavehis lookoutonthe future, or rather hemounts into a commonlookoutwhereherubselbowswiththespeculator.

Secondly,wefind that, forthemostpart,companieswiththe best investmentcharacteristics—i.e., the bestcredit rating—are the oneswhicharelikelytoattractthe

largest speculative interest intheir common stocks, sinceeveryone assumes they areguaranteed a brilliant future.Thirdly,theconceptoffutureprospects, and particularly ofcontinued growth in thefuture, invites theapplicationof formulas out of highermathematics to establish thepresent value of the favoredissues. But the combinationof precise formulas withhighly impreciseassumptions

can be used to establish, orrather to justify, practicallyany value one wishes,however high, for a reallyoutstanding issue. But,paradoxically, that very facton close examinationwill beseen to imply that no onevalue, or reasonably narrowrange of values, can becounted on to establish andmaintain itself for a givengrowth company; hence attimes the market may

conceivablyvalue thegrowthcomponentatastrikinglylowfigure.

Returningtomydistinctionbetween the older and newerspeculative elements incommon stock, we mightcharacterize them by twooutlandish but convenientwords, viz.: endogenous andexogenous. Let me illustratebriefly the old-timespeculativecommonstock,as

distinguished from aninvestment stock, by somedatarelatingtoAmericanCanandPennsylvaniaRailroad in1911–1913. (These appear inBenjaminGrahamandDavidL. Dodd, Security Analysis,McGraw-Hill,1940,pp.2–3.)

In those three years theprice range of “Pennsy”moved only between 53 and65, or between 12.2 and 15timesitsaverageearningsfor

the period. It showed steadyprofits,waspaying a reliable$3 dividend, and investorswere sure that it was backedbywellover its par of $50 intangible assets. By contrast,the price of American Canrangedbetween9 and47; itsearningsbetween7centsand$8.86;theratioofpricetothethree-year average earningsmovedbetween1.9timesand10 times; it paidnodividendat all; and sophisticated

investors were well awarethatthe$100parvalueofthecommon represented nothingbut undisclosed “water,”since the preferred issueexceeded the tangible assetsavailable for it. ThusAmericanCancommonwasarepresentative speculativeissue,becauseAmericanCanCompany was then aspeculatively capitalizedenterpriseinafluctuatinganduncertain industry. Actually,

AmericanCanhadafarmorebrilliantlong-termfuturethanPennsylvania Railroad; butnot only was this fact notsuspected by investors orspeculatorsinthosedays,buteven if it had been it wouldprobablyhavebeenputasideby the investors as basicallyirrelevant to investmentpolicies and programs in theyears1911–1913.

Now, to exposeyou to the

development through time ofthe importance of long-termprospects for investments. Ishould like to use as myexampleourmostspectaculargiant industrial enterprise—none other than InternationalBusiness Machines, whichlast year entered the smallgroup of companies with $1billion of sales. May Iintroduce one or twoautobiographical notes here,inordertoinjectalittleofthe

personal touch into whatotherwise would be anexcursion into cold figures?In1912Ihad leftcollegefora term to take charge of aresearch project for U.S.ExpressCompany.Wesetouttofindtheeffectonrevenuesof a proposed revolutionarynew system of computingexpress rates. For thispurposeweusedtheso-calledHollerith machines, leasedout by the then Computing-

Tabulating-RecordingCompany. They comprisedcard punches, card sorters,and tabulators—tools almostunknown to businessmen,then, and having their chiefapplication in the CensusBureau. IenteredWallStreetin1914,andthenextyearthebonds and common stock ofC.-T.-R. Company werelistedontheNewYorkStockExchange.Well,Ihadakindofsentimental interest in that

enterprise, and besides Iconsidered myself a sort oftechnological expert on theirproducts, being one of thefewfinancialpeoplewhohadseenandusedthem.Soearlyin1916Iwenttotheheadofmyfirm,knownasMr.A.N.,and pointed out to him thatC.-T.-R. stockwas selling inthe middle 40s (for 105,000shares); that it had earned$6.50 in 1915; that its bookvalue—including,tobesure,

some nonsegregatedintangibles—was$130;thatithadstarteda$3dividend;andthatIthoughtratherhighlyofthe company’s products andprospects. Mr. A. N. lookedat me pityingly. “Ben,” saidhe, “do not mention thatcompany to me again. Iwouldnottouchitwithaten-foot pole. [His favoriteexpression.] Its 6 per centbonds are selling in the low80sandtheyarenogood.So

how can the stock be anygood? Everybody knowsthere isnothingbehind itbutwater.” (Glossary: In thosedays thatwas theultimateofcondemnation. It meant thatthe asset account of thebalance sheet was fictitious.Many industrialcompanies—notably U.S. Steel—despitetheir $100 par, representednothing but water, concealedinawritten-upplantaccount.Since they had “nothing” to

back thembutearningpowerand futureprospects,no self-respecting investor wouldgivethemasecondthought.)

I returned to mystatistician’s cubbyhole, achastenedyoungman.Mr.A.N. was not only experiencedandsuccessful,butextremelyshrewdaswell.SomuchwasI impressed by his sweepingcondemnationofComputing-Tabulating-Recording that I

never bought a share of it inmy life, not even after itsname was changed toInternational BusinessMachinesin1926.

Now let us take a look atthe same company with itsnewname in1926, ayearofprettyhigh stockmarkets.Atthat time it first revealed thegood-will item in its balancesheet, in the rather largesumof $13.6 million. A. N. had

been right. Practically everydollar of the so-called equitybehind the common in 1915had been nothing but water.However, since that time thecompany had made animpressive record under thedirectionofT.L.Watson,Sr.Its net had risen from$691,000 to $3.7 million—over fivefold—a greaterpercentagegainthanitwastomake in any subsequenteleven-year period. It had

builtupanicetangibleequityforthecommon,andhadsplitit 3.6 for one. It hadestablisheda$3dividendratefor the new stock, whileearnings were $6.39 thereon.Youmighthaveexpectedthe1926 stock market to havebeenprettyenthusiasticabouta company with such agrowth history and so stronga trade position. Let us see.The price range for that yearwas 31 low, 59 high. At the

averageof45itwassellingatthesame7-timesmultiplierofearningsandthesame6.7percent dividend yield as it haddonein1915.Atitslowof31itwasnotfar inexcessof itstangible book value, and inthat respect was far moreconservatively priced thanelevenyearsearlier.

These data illustrate, aswell as any can, thepersistence of the old-time

investment viewpoint untilthe culminating years of thebull market of the 1920s.What has happened sincethen can be summarized byusingten-yearintervalsinthehistory of IBM. In 1936 netexpanded to twice the 1926figures, and the averagemultiplierrosefrom7to17½.From 1936 to 1946 the gainwas2½times,buttheaveragemultiplier in 1946 remainedat 17½. Then the pace

accelerated.The1956netwasnearly 4 times that of 1946,and the average multiplierroseto32½.Lastyear,withafurther gain in net, themultiplier rose again to anaverage of 42, if we do notcount the unconsolidatedequity in the foreignsubsidiary.

When we examine theserecentprice figureswithcarewe see some interesting

analogies and contrasts withthose of forty years earlier.The one-time scandalouswater, so prevalent in thebalance sheets of industrialcompanies, has all beensqueezed out—first bydisclosure and then bywriteoffs.Butadifferentkindof water has been put backintothevaluationbythestockmarket—by investors andspeculatorsthemselves.WhenIBMnow sells at 7 times its

bookvalue,insteadof7timesearnings, the effect ispractically the same as if ithad no book value at all. Orthe small book-value portioncanbeconsideredasasortofminor preferred-stockcomponent of the price, therest representing exactly thesame sort of commitment asthe old-time speculatormadewhen he bought Woolworthor U.S. Steel commonentirely for their earning

powerandfutureprospects.

It is worth remarking, inpassing, that in the thirtyyears which saw IBMtransformed from a 7-timesearnings to a 40-timesearnings enterprise, many ofwhat I have called theendogenous speculativeaspectsofourlargeindustrialcompanies have tended todisappear, or at least todiminish greatly. Their

financial positions are firm,their capital structuresconservative: they aremanaged far more expertly,andevenmorehonestly, thanbefore. Furthermore, therequirements of completedisclosure have removed oneof the important speculativeelements of years ago—thatderived from ignorance andmystery.

Another personal

digression here. In my earlyyears in theStreetoneof thefavorite mystery stocks wasConsolidated Gas of NewYork, now ConsolidatedEdison. It owned as asubsidiarytheprofitableNewYorkEdisonCompany,butitreported only dividendsreceivedfromthissource,notits full earnings. Theunreported Edison earningssupplied themystery and the“hidden value.” To my

surprise I discovered thatthese hush-hush figureswereactuallyonfileeachyearwiththe Public ServiceCommission of the state. Itwas a simple matter toconsult the records and topresent the true earnings ofConsolidated Gas in amagazine article.(Incidentally, the addition toprofits was not spectacular.)Oneofmyolder friends saidto me then: “Ben, you may

think you are a great guy tosupply thosemissing figures,but Wall Street is going tothank you for nothing.Consolidated Gas with themystery is both moreinterestingandmorevaluablethan ex-mystery. Youyoungsterswhowant tostickyour noses into everythingare going to ruin WallStreet.”

ItistruethatthethreeM’s

which thensuppliedsomuchfuel to the speculative fireshavenowallbutdisappeared.These were Mystery,Manipulation, and (thin)Margins. But we securityanalysts have ourselves beencreatingvaluationapproacheswhich are so speculative inthemselves as to pretty welltake the place of those olderspeculative factors. Do wenot have our own “3M’s”now—none other than

Minnesota Mining andManufacturing Company—and does not this commonstock illustrate perfectly thenewspeculationascontrastedwith theold?Considera fewfigures. When M. M. & M.commonsoldat101lastyearthe market was valuing it at44 times 1956 earnings,which happened to show noincrease to speak of in 1957.The enterprise itself wasvalued at $1.7 billion, of

which $200 million wascovered by net assets, and acool $1½ billion representedthe market’s appraisal of“goodwill.”Wedonotknowthe process of calculation bywhich that valuation of goodwill was arrived at; we doknowthatafewmonthslaterthe market revised thisappraisal downward by some$450million,orabout30percent. Obviously it isimpossible to calculate

accurately the intangiblecomponent of a splendidcompany such as this. Itfollows as a kind ofmathematical law that themoreimportantthegoodwillor future earning-powerfactor the more uncertainbecomesthetruevalueoftheenterprise, and therefore themore speculative inherentlythecommonstock.

Itmaybewelltorecognize

a vital difference that hasdeveloped in thevaluationoftheseintangiblefactors,whenwecompareearliertimeswithtoday. A generation or moreago it was the standard rule,recognized both in averagestockprices and in formalorlegal valuations, thatintangibles were to beappraised on a moreconservative basis thantangibles. A good industrialcompanymightberequiredto

earnbetween6percentand8percentonitstangibleassets,represented typically bybonds and preferred stock;butitsexcessearnings,ortheintangible assets they gaverise to, would be valued on,say,a15percentbasis.(Youwill findapproximately theseratiosintheinitialofferingofWoolworth preferred andcommon stock in 1911, andin numerous others.) Butwhat has happened since the

1920s? Essentially the exactreverse of these relationshipsmaynowbeseen.Acompanymust now typically earnabout 10 per cent on itscommonequitytohaveitsellin the average market at fullbook value. But its excessearnings, above 10 per centoncapital,areusuallyvaluedmore liberally, or at a highermultiplier, than the baseearnings required to supportthebookvalueinthemarket.

Thus a company earning 15per cent on the equity maywell sell at 13½ timesearnings, or twice its netassets. Thiswouldmean thatthefirst10percentearnedoncapital is valued at only 10times,butthenext5percent—what used to be called the“excess”—is actually valuedat20times.

Now there is a logicalreason for this reversal in

valuationprocedure,whichisrelatedtotheneweremphasison growth expectations.Companies that earn a highreturn on capital are giventhese liberal appraisals notonly because of the goodprofitability itself, and therelative stability associatedwith it, but perhaps evenmore cogently because highearnings on capital generallygohand inhandwithagoodgrowth record and prospects.

Thus what is really paid fornowadays in the case ofhighly profitable companiesisnotthegoodwillintheoldand restricted sense of anestablished name and aprofitablebusiness,butrathertheir assumed superiorexpectations of increasedprofitsinthefuture.

This brings me to one ortwo additional mathematicalaspects of the new attitude

toward common-stockvaluations, which I shalltouch on merely in the formof brief suggestions. If, asmanytestsshow,theearningsmultiplier tends to increasewithprofitability—i.e.,astherate of return on book valueincreases—then thearithmetical consequence ofthisfeatureisthatvaluetendsto increase directly as thesquare of the earnings, butinversely the book value.

Thusinanimportantandveryreal sense tangible assetshave become a drag onaverage market value ratherthana source thereof.Takeafar from extreme illustration.If Company A earns $4 ashare on a $20 book value,and Company B also $4 ashare on $100 book value,CompanyAisalmostcertainto sell at a highermultiplier,andhenceathigherpricethanCompany B—say $60 for

Company A shares and $35for CompanyB shares. Thusit would not be inexact todeclarethatthe$80pershareofgreaterassetsforCompanyBare responsible for the$25pershare lowermarketprice,since the earnings per shareareassumedtobeequal.

But more important thanthe foregoing is the generalrelationship betweenmathematics and the new

approach to stock values.Giventhethreeingredientsof(a) optimistic assumptions astotherateofearningsgrowth,(b) a sufficiently longprojectionofthisgrowthintothe future, and (c) themiraculous workings ofcompound interest—lo! thesecurity analyst is suppliedwith a new kind ofphilosopher’s stone whichcan produce or justify anydesired valuation for a really

“good stock.” I havecommentedinarecentarticlein the Analysts’ Journal onthe vogue of highermathematics in bull markets,and quoted David Durand’sexposition of the strikinganalogy between valuecalculations of growth stocksand the famous PetersburgParadox, which haschallenged and confusedmathematiciansformorethantwohundredyears.Thepoint

I want to make here is thatthere is a special paradox inthe relationship betweenmathematics and investmentattitudes on common stocks,which is this:Mathematics isordinarily considered asproducing precise anddependableresults;butinthestock market the moreelaborate and abstruse themathematics the moreuncertain and speculative arethe conclusions we draw

therefrom.Inforty-fouryearsofWallStreetexperienceandstudy I have never seendependablecalculationsmadeabout common-stock values,orrelatedinvestmentpolicies,that went beyond simplearithmetic or the mostelementary algebra.Whenevercalculusisbroughtin, or higher algebra, youcould take it as a warningsignal that the operator wastryingtosubstitutetheoryfor

experience, and usually alsoto give to speculation thedeceptive guise ofinvestment.

The older ideas ofcommon-stock investmentmay seem quite naïve to thesophisticated security analystof today.Thegreat emphasiswas always onwhatwe nowcall the defensive aspects ofthe company or issue—mainly the assurance that it

would continue its dividendunreducedinbadtimes.Thusthe strong railroads, whichconstituted the standardinvestment commons of fiftyyears ago, were actuallyregarded in very much thesamewayasthepublic-utilitycommons in recent years. Ifthe past record indicatedstability, the chiefrequirementwasmet;nottoomuch effort was made toanticipate adversechangesof

anunderlyingcharacterinthefuture. But, conversely,especially favorable futureprospects were regarded byshrewd investors assomethingtolookforbutnottopayfor.

Ineffectthismeantthattheinvestor did not have to payanything substantial forsuperior long-term prospects.He got these, virtuallywithout extra cost, as a

reward for his own superiorintelligence and judgment inpicking the best rather thanthe merely good companies.For common stocks with thesame financial strength, pastearningsrecord,anddividendstability all sold at about thesamedividendyield.

This was indeed ashortsighted point of view,butithadthegreatadvantageof making common-stock

investmentintheolddaysnotonlysimplebutalsobasicallysound and highly profitable.Letmereturnforthelasttimeto a personal note.Somewhere around 1920 ourfirm distributed a series oflittle pamphlets entitledLessons for Investors. Ofcourseit tookabrashanalystin his middle twenties likemyselftohitonsosmugandpresumptuous a title. But inoneof thepapers Imade the

casual statement that “if acommon stock is a goodinvestment it is also a goodspeculation.”For, reasonedI,if a common stock was sosoundthatitcarriedverylittleriskof loss itmustordinarilybe so good as to possessexcellent chances for futuregains. Now this was aperfectly true and evenvaluablediscovery,butitwastrue only because nobodypaidanyattentiontoit.Some

years later, when the publicwoke up to the historicalmerits of common stocks aslong-term investments, theysoonceasedtohaveanysuchmerit, because the public’senthusiasm created pricelevels which deprived themof their builtin margin ofsafety, and thus drove themout of the investment class.Then, of course, thependulumswung to theotherextreme, and we soon saw

one of the most respectedauthorities declaring (in1931) that no common stockcouldeverbeaninvestment.

When we view this long-range experience inperspective we find anotherset of paradoxes in theinvestor’s changing attitudetoward capital gains ascontrasted with income. Itseemsatruismtosaythattheold-time common-stock

investor was not muchinterestedincapitalgains.Hebought almost entirely forsafetyandincome,andletthespeculator concern himselfwith price appreciation.Today we are likely to saythatthemoreexperiencedandshrewd the investor, the lessattention he pays to dividendreturns,and themoreheavilyhis interest centers on long-term appreciation. Yet onemight argue, perversely, that

precisely because the old-time investor did notconcentrate on future capitalappreciation he was virtuallyguaranteeing to himself thathe would have it, at least inthe field of industrial stocks.And, conversely, today’sinvestor issoconcernedwithanticipatingthefuturethatheisalreadypayinghandsomelyfor it in advance. Thus whathe has projected with somuch study and care may

actually happen and still notbring him any profit. If itshould fail to materialize tothe degree expected he mayinfactbefacedwithaserioustemporary and perhaps evenpermanentloss.

What lessons—againusingthe pretentious title of my1920 pamphlet—can theanalyst of 1958 learn fromthis linking of past withcurrent attitudes? Not much

of value, one is inclined tosay. We can look backnostalgically to the good olddays when we paid only forthepresent andcouldget thefuture for nothing—an “allthis and Heaven too”combination. Shaking ourheads sadly we mutter,“Those days are goneforever.” Have not investorsandsecurityanalystseatenofthetreeofknowledgeofgoodand evil prospects? By so

doing have they notpermanently expelledthemselves from that Edenwhere promising commonstocks at reasonable pricescould be plucked off thebushes? Are we doomedalways to run the risk eitherof paying unreasonably highprices for good quality andprospects, or of getting poorquality and prospects whenwe pay what seems areasonableprice?

Itcertainly looks thatway.Yet one cannot be sure evenof that pessimistic dilemma.Recently, I did a littleresearch in the long-termhistory of that toweringenterprise,GeneralElectric—stimulated by the arrestingchart of fifty-nine years ofearnings and dividendsappearing in their recentlypublished1957Report.Thesefigures are not without theirsurprises for the

knowledgeable analyst. Foronethingtheyshowthatpriorto 1947 the growth of G. E.was fairly modest and quiteirregular. The 1946 earnings,pershareadjusted,wereonly30 per cent higher than in1902—52 cents versus 40cents—and innoyearof thisperiod were the 1902earningsasmuchasdoubled.Yet the price-earnings ratiorosefrom9timesin1910and1916to29timesin1936and

againin1946.Onemightsay,of course, that the 1946multiplieratleastshowedthewell-known prescience ofshrewd investors. Weanalystswere able to foreseethenthereallybrilliantperiodof growth that was loomingahead in the next decade.Maybe so. But some of youremember that the next year,1947, which established animpressive new high forG.E.’s per-share earnings,

was marked also by anextraordinaryfallintheprice-earnings ratio. At its low of32 (before the 3-for-1 split)G.E. actually sold again atonly 9 times its currentearningsanditsaveragepricefor the year was only about10timesearnings.Ourcrystalballcertainlycloudedoverinthe short space of twelvemonths.

This striking reversal took

place only eleven years ago.It casts some little doubt inmy mind as to the completedependability of the popularbelief among analysts thatprominent and promisingcompanies will now alwayssell at high price-earningsratios—that this is afundamental fact of life forinvestors and they may aswellacceptandlikeit.Ihavenodesireatalltobedogmaticonthispoint.AllIcansayis

that it is not settled in mymind, and each of you mustseektosettleitforyourself.

But in my concludingremarks I can say somethingdefiniteaboutthestructureofthe market for various typesof common stocks, in termsof their investment andspeculative characteristics. Inthe old days the investmentcharacter of a common stockwasmoreorlessthesameas,

or proportionatewith, that ofthe enterprise itself, asmeasured quite well by itscredit rating. The lower theyield on its bonds orpreferred,themorelikelywasthe common to meet all thecriteria for a satisfactoryinvestment, and the smallerthe element of speculationinvolvedinitspurchase.Thisrelationship, between thespeculative ranking of thecommon and the investment

rating of the company, couldbe graphically expressedprettymuchasastraight linedescendingfromleft to right.But nowadays I woulddescribe the graph as U-shaped.Attheleft,wherethecompany itself is speculativeand its credit low, thecommon stock is of coursehighly speculative, just as ithas always been in the past.At the right extremity,however,where thecompany

has the highest credit ratingbecause both its past recordandfutureprospectsaremostimpressive, we find that thestock market tends more orlesscontinuouslytointroducea highly speculative elementinto the common sharesthroughthesimplemeansofapricesohighastocarryafairdegreeofrisk.

At this point I cannotforbear introducing a

surprisingly relevant, if quiteexaggerated,quotationonthesubject which I foundrecently in one ofShakespeare’s sonnets. Itreads:

Have I not seendwellers on formandfavor

Lose all and morebypayingtoomuchrent?

Returningtomyimaginary

graph, itwould be the centerarea where the speculativeelement in common-stockpurchases would tend toreach its minimum. In thisarea we could find manywell-established and strongcompanies, with a record ofpast growth corresponding tothat of the national economyand with future prospectsapparently of the samecharacter. Such commonstocks could be bought at

most times, except in theupperrangesofabullmarket,atmoderateprices in relationto their indicated intrinsicvalues. As a matter of fact,because of the presenttendency of investors andspeculators alike toconcentrate on moreglamorous issues, I shouldhazard the statement thatthese middle-ground stockstend to sell on the wholerather below their

independently determinablevalues. They thus have amargin-of-safety factorsupplied by the samemarketpreferences and prejudiceswhich tend to destroy themargin of safety in themorepromising issues.Furthermore, in this widearray of companies there isplenty of room forpenetrating analysis of thepast record and fordiscriminating choice in the

area of future prospects, towhich can be added thehigher assurance of safetyconferredbydiversification.

WhenPhaëthoninsistedondrivingthechariotoftheSun,his father, the experiencedoperator, gave the neophytesome advice which the latterfailed to follow—to his cost.Ovid summed up PhoebusApollo’s counsel in threewords:

Medius tutissimusibis

You will go safestinthemiddlecourse

I think this principle holdsgood for investors and theirsecurityanalystadvisers.

5.ACaseHistory:AetnaMaintenanceCo.

Thefirstpartofthishistoryis reproduced from our 1965edition, where it appeared

under the title “A HorribleExample.” The second partsummarizes the latermetamorphosis of theenterprise.

We think it might have asalutaryeffectonourreaders’future attitude toward newcommon-stockofferingsifwecited one “horrible example”hereinsomedetail.Itistakenfrom the first page ofStandard & Poor’s Stock

Guide, and illustrates inextreme fashion the glaringweaknessesofthe1960–1962flotations, the extraordinaryovervaluations given them inthe market, and thesubsequentcollapse.

In November 1961,154,000 shares of AetnaMaintenance Co. commonweresoldtopublicat$9andthe price promptly advancedto $15. Before the financing

the net assets per sharewereabout $1.20, but they wereincreased to slightly over $3per share by the moneyreceivedforthenewshares.

The sales and earningspriortothefinancingwere:

The corresponding figuresafterthefinancingwere:

June1963 $4,681,000 $42,000(def.)

$0.11(def.)

June

1962 4,234,000 149,000 0.36

In1962thepricefellto22/3,and in1964 it soldas lowas7/8. No dividends were paidduringthisperiod.

COMMENT: This wasmuchtoo small a business forpublic participation. Thestock was sold—and bought—on the basis of one goodyear; the results previously

hadbeenderisory.Therewasnothing in the nature of thishighly competitive businessto insure future stability. Atthe high price soon afterissuance the heedless publicwas paying much more perdollar of earnings and assetsthanformostofourlargeandstrong companies. Thisexample is admittedlyextreme, but it is far fromunique; the instances oflesser, but inexcusable,

overvaluations run into thehundreds.

Sequel1965–1970

In1965newinterestscameinto the company. Theunprofitable building-maintenance business wassold out, and the companyembarked in an entirelydifferent venture: makingelectronic devices.The namewas changed to Haydon

Switch and Instrument Co.Theearningsresultshavenotbeen impressive. In the fiveyears 1965–1969 theenterprise showed averageearnings of only 8 cents pershareof “old stock,”with34centsearned in thebestyear,1967. However, in truemodern style, the companysplitthestock2for1in1968.Themarketpricealsorantrueto Wall Street form. Itadvancedfrom7/8in1964to

theequivalentof16½in1968(after the split). The pricenow exceeded the record setin the enthusiastic days of1961. This time theovervaluation was muchworse thanbefore.The stockwas now selling at 52 timesthe earnings of its only goodyear, and some 200 times itsaverage earnings. Also, thecompanywas again to reportadeficit in theveryyear thatthe new high price was

established. The next year,1969,thebidpricefellto$1.

QUESTIONS: Did the idiotswhopaid$8+forthisstockin1968 know anything at allaboutthecompany’sprevioushistory, its five-year earningsrecord, its asset value (verysmall)? Did they have anyideaofhowmuch—or ratherhow little—theyweregettingfor their money? Did theycare? Has anyone on Wall

Streetanyresponsibilityatallfor the regular recurrence ofcompletely brainless,shockingly widespread, andinevitable catastrophicspeculation in this kind ofvehicle?

6.TaxAccountingforNVF’sAcquisitionofSharonSteelShares

1. NVF acquired 88% ofSharonstock in1969,payingfor each share $70 in NVF

5% bonds, due 1994, andwarrants tobuy1½sharesofNVF at $22 per share. Theinitial market value of thebonds appears to have beenonly 43% of par, while thewarrants were quoted at $10perNVFshareinvolved.ThismeantthattheSharonholdersgot only $30worth of bondsbut$15worthofwarrantsforeachshareturnedin,atotalof$45 per share. (This wasabout the average price of

Sharon in 1968, and also itsclosing price for the year.)The book value of Sharonwas $60 per share. Thedifference between this bookvalueandthemarketvalueofSharon stock amounted toabout $21 million on the1,415,000 shares of Sharonacquired.

2. The accountingtreatment was designed toaccomplish three things: (a)

To treat the issuance of thebonds as equivalent to a“sale” thereof at 43, givingthe company an annualdeduction from income foramortizationofthehugebonddiscount of $54 million.(Actually it would becharging itself about 15%annual interest on the“proceeds”ofthe$99milliondebentureissue.)(b)Tooffsetthis bond-discount charge byan approximately equal

“profit,”consistingofacredittoincomeofone-tenthof thedifference between the costprice of 45 for the Sharonstock and its book value of60. (This would correspond,in reverse fashion, to therequired practice of chargingincomeeachyearwithapartof the price paid foracquisitions in excess of thebook value of the assetsacquired.) (c) The beauty ofthis arrangement would be

that the company could saveinitially about $900,000 ayear, or $1 per share, inincome taxes from these twoannual entries, because theamortizationofbonddiscountcould be deducted fromtaxable income but theamortization of “excess ofequityovercost”didnothaveto be included in taxableincome.

3. This accounting

treatment is reflected in boththe consolidated incomeaccount and the consolidatedbalance sheet of NVF for1969,andproformafor1968.Sinceagoodpartof thecostof Sharon stock was to betreated as paid for bywarrants, it was necessary toshow the initialmarketvalueof thewarrantsaspartof thecommon-stock capital figure.Thus in this case, as in noother that we know, the

warrants were assigned asubstantial value in thebalance sheet, namely $22million+ (but only in anexplanatorynote).

7.TechnologicalCompaniesasInvestments

In the Standard & Poor’sservices in mid-1971 therewere listed about 200companies with namesbeginning with Compu-,

Data, Electro-, Scien-,Techno-.About half of thesebelonged to somepart of thecomputer industry. All ofthem were traded in themarket or had madeapplications to sell stock tothepublic.

A total of 46 suchcompanies appeared in the S& P Stock Guide forSeptember1971.Ofthese,26were reporting deficits, only

sixwere earning over $1 pershare, and only five werepayingdividends.

In the December 1968Stock Guide there hadappeared 45 companies withsimilar technological names.Tracingthesequelofthislist,as shown in the September1971 Guide, we find thefollowingdevelopments:

COMMENT: It is virtuallycertain that the manytechnological companies notincludedintheGuidein1968had a poorer subsequentrecord than those that wereincluded; also that the 12companies dropped from thelist didworse than those thatwereretained.Theharrowing

results shown by thesesamples are no doubtreasonably indicative of thequality and price history ofthe entire group of“technology” issues. Thephenomenal success of IBMand a few other companieswasboundtoproduceaspateof public offerings of newissues in their fields, forwhich large losses werevirtuallyguaranteed.

Endnotes


1.“Letterstock”isstocknotregisteredfor sale with the Securities andExchange Commission (SEC), and forwhichthebuyersuppliesaletterstatingthepurchasewasforinvestment.2. The foregoing are Moody’s figuresforAAAbondsandindustrialstocks.

Chapter1.InvestmentversusSpeculation:ResultstoBeExpectedbytheIntelligentInvestor

1. Benjamin Graham, David L. Dodd,Sidney Cottle, and Charles Tatham,McGraw-Hill, 4th. ed., 1962. Afascimile copy of the 1934 edition ofSecurityAnalysiswas reissued in 1996(McGraw-Hill).2. This is quoted from by LawrenceChamberlain,publishedin1931.3. In a survey made by the FederalReserveBoard.4.1965edition,p.8.5.Weassumehereatoptaxbracketforthe typical investor of 40% applicable

to dividends and 20% applicable tocapitalgains.

Chapter2.TheInvestorandInflation

1. This was written before PresidentNixon’s price-and-wage “freeze” inAugust1971,followedbyhis“Phase2”system of controls. These importantdevelopmentswouldappear to confirmtheviewsexpressedabove.2. The rate earned on the Standard &Poor’s index of 425 industrial stockswas about 11½% on asset value—dueinparttotheinclusionofthelargeandhighlyprofitableIBM,whichisnotoneoftheDJIA30issues.3. A chart issued by AmericanTelephone & Telegraph in 1971indicates that the rates charged forresidential telephone services were

somewhatlessin1970thanin1960.4.Reported in theWallStreetJournal,October,1970.

Chapter3.ACenturyofStock-MarketHistory:TheLevelofStockPricesinEarly1972

1. Both Standard & Poor’s and DowJoneshaveseparateaveragesforpublicutilities and transportation (chieflyrailroad) companies. Since 1965 theNew York Stock Exchange hascomputed an index representing themovement of all its listed commonshares.2.Madeby theCenter forResearch inSecurity Prices of the University ofChicago,underagrantfromtheCharlesE.MerrillFoundation.3. Thiswas first written in early 1971

with the DJIA at 940. The contraryviewheldgenerallyonWallStreetwasexemplified in a detailed study whichreachedamedianvaluationof1520forthe DJIA in 1975. This wouldcorrespond to a discounted value of,say,1200 inmid-1971. InMarch1972the DJIA was again at 940 after anintervening decline to 798. Again,Grahamwasright.The“detailedstudy”he mentions was too optimistic by anentiredecade:TheDowJonesIndustrialAveragedidnotcloseabove1520untilDecember13,1985!

Chapter4.GeneralPortfolioPolicy:TheDefensiveInvestor

1. A higher tax-free yield, withsufficient safety, can be obtained fromcertain a relative newcomer amongfinancial inventions.Theywouldbeofinterest particularly to the enterprisinginvestor.

Chapter5.TheDefensiveInvestorandCommonStocks

1.WilfredFunk,Inc.,1953.2. In current mathematical approachesto investment decisions, it has becomestandard practice to define “risk” interms of average price variations or“volatility.” See, for example, byRichard A. Brealey, TheM.I.T. Press,1969. We find this use of the word“risk” more harmful than useful forsoundinvestmentdecisions—becauseitplaces too much emphasis on marketfluctuations.3. All 30 companies in the DJIA metthisstandardin1971.

Chapter6.PortfolioPolicyfortheEnterprisingInvestor:NegativeApproach

1.In1970theMilwaukeeroadreporteda large deficit. It suspended interestpaymentson its incomebonds,and thepriceofthe5%issuefellto10.2. For example:Cities Service $6 firstpreferred,notpayingdividends,soldataslowas15in1937andat27in1943,when the accumulations had reached$60pershare.In1947itwasretiredbyexchangefor$196.50of3%debenturesfor each share, and it sold as high as186.3.Anelaborate statistical studycarriedon under the direction of the National

BureauofEconomicResearchindicatesthat such has actually been the case.Graham is referring to W. BraddockHickman,CorporateBondQualityandInvestor Experience (PrincetonUniversity Press, 1958). Hickman’sbook later inspiredMichaelMilken ofDrexel Burnham Lambert to offermassive high-yield financing tocompanieswithlessthansterlingcreditratings, helping to ignite theleveragedbuyout and hostile takeovercrazeofthelate1980s.4. A representative sample of 41 suchissues taken from Standard & Poor’sshows that five lost 90% or more oftheirhighprice,30lostmorethanhalf,and the entire group about two-thirds.Themanynotlistedintheundoubtedly

hadalargershrinkageonthewhole.

Chapter7.PortfolioPolicyfortheEnterprisingInvestor:ThePositiveSide

1.See,forexample,LucileTomlinson,andSidneyCottleandW.T.Whitman,bothpublishedin1953.2.A companywith an ordinary recordcannot,without confusing the term, becalled agrowth companyor a “growthstock” merely because its proponentexpects it todobetter thantheaveragein the future. It is just a “promisingcompany.” Graham ismaking a subtlebut importantpoint:If thedefinitionofa growth stock is a company that willthrive in the future, then that’s not adefinition at all, but wishful thinking.

It’s like calling a sports team “thechampions” before the season is over.This wishful thinking persists today;among mutual funds, “growth”portfolios describe their holdings ascompanieswith“above-averagegrowthpotential” or “favorable prospects forearnings growth.” A better definitionmightbecompanieswhosenetearningsper share have increased by an annualaverageofatleast15%foratleastfiveyears running. (Meeting this definitionin the past does not ensure that acompanywillmeetitinthefuture.)3.SeeTable7-1.4. Here are two age-old Wall Streetproverbs that counsel such sales: “NotreegrowstoHeaven”and“Abullmaymakemoney,abearmaymakemoney,

butahognevermakesmoney.”5.Two studies are available.The first,made by H. G. Schneider, one of ourstudents, covers the years 1917–1950andwaspublished in June1951 in theThe second was made by DrexelFirestone, members of the New YorkStock Exchange, and covers the years1933–1969.Thedataaregivenherebytheirkindpermission.6.Seepp.393–395,forthreeexamplesofspecialsituationsexistingin1971.

Chapter8.TheInvestorandMarketFluctuations

1. Except, perhaps, in dollar-costaveraging plans begun at a reasonablepricelevel.2. But according to Robert M. Ross,authority on the Dow theory, the lasttwo buy signals, shown in December1966 and December 1970, were wellbelowtheprecedingsellingpoints.3. The top three ratings for bonds andpreferred stocks are Aaa, Aa, and A,usedbyMoody’s,andAAA,AA,AbyStandard & Poor’s. There are others,goingdowntoD.4. This idea has already had someadoptionsinEurope—e.g.,bythestate-

owned Italian electric-energy concernon its “guaranteed floating rate loannotes,” due 1980. In June 1971 itadvertisedinNewYorkthattheannualrateofinterestpaidthereonforthenextsixmonthswouldbe81/8%.Onesuchflexiblearrangementwasincorporated inTheToronto-DominionBank’s “7%–8% debentures,” due1991,offered in June1971.Thebondspay7%toJuly1976and8%thereafter,buttheholderhastheoptiontoreceivehisprincipalinJuly1976.

Chapter9.InvestinginInvestmentFunds

1.Thesaleschargeisuniversallystatedas a percentage of the selling price,which includes the charge, making itappearlowerthanifappliedtonetassetvalue.Weconsiderthisasalesgimmickunworthyofthisrespectableindustry.2. The Money Managers, by G. E.KaplanandC.Welles,RandomHouse,1969.3.Seedefinitionof“letterstock”onp.579.4. Title of a book first published in1852.Thevolumedescribedthe“SouthSeaBubble,”thetulipmania,andotherspeculative binges of the past. It was

reprinted by Bernard M. Baruch,perhaps the only continuouslysuccessfulspeculatorofrecenttimes,in1932.Thatwas locking thestabledoorafter the horse was stolen. CharlesMackay’s Extraordinary PopularDelusions and theMadness ofCrowds(Metro Books, New York, 2002) wasfirst published in 1841.Neither a lightreadnoralwaysstrictlyaccurate,itisanextensivelookathowlargenumbersofpeopleoftenbelieveverysillythings—forinstance,thatironcanbetransmutedintogold,thatdemonsmostoftenshowup on Friday evenings, and that it ispossible to get rich quick in the stockmarket. For a more factual account,consult Edward Chancellor’s DevilTake the Hindmost (Farrar, Straus &

Giroux,NewYork,1999);foralightertake, try Robert Menschel’s Markets,Mobs,andMayhem:AModernLookattheMadnessofCrowds (JohnWiley&Sons,NewYork,2002).

Chapter10.TheInvestorandHisAdvisers

1. The examinations are given by theInstitute of Chartered FinancialAnalysts, which is an arm of theFinancial Analysts Federation. Thelatter now embraces constituentsocietieswithover50,000members.2.TheNYSEhadimposedsomedrasticrulesofvaluation(knownas“haircuts”)designed to minimize this danger, butapparently they did not helpsufficiently.3.Newofferingsmaynowbesoldonlyby means of a prospectus preparedunder the rules of the Securities andExchangeCommission.This document

must disclose all the pertinent factsabouttheissueandissuer,anditisfullyadequate to inform the as to the exactnatureof the securityofferedhim.Butthe very copiousness of the datarequired usually makes the prospectusof prohibitive length. It is generallyagreed that only a small percentage ofbuying new issues read the prospectuswith thoroughness. Thus they are stillacting mainly not on their ownjudgment but on that of the houseselling them the security or on therecommendation of the individualsalesmanoraccountexecutive.

Chapter11.SecurityAnalysisfortheLayInvestor:GeneralApproach

1.Our textbook,byBenjaminGraham,David L. Dodd, Sidney Cottle, andCharlesTatham(McGraw-Hill,4thed.,1962),retainsthetitleoriginallychosenin1934,butitcoversmuchofthescopeoffinancialanalysis.2.With CharlesMcGolrick, Harper &Row, 1964, reissued byHarperBusiness,1998.3. These figures are from SalomonBros.,alargeNewYorkbondhouse.4. At least not by the great body ofsecurity analysts and investors.Exceptional analysts, who can tell in

advance what companies are likely todeserve intensive study and have thefacilitiesandcapabilitytomakeit,mayhavecontinuedsuccesswith thiswork.For details of such an approach seePhilipFisher,Harper&Row,1960.5. On p. 295 we set forth a formularelating multipliers to the rate ofexpectedgrowth.6. Part of the fireworks in the price ofChrysler was undoubtedly inspired bytwo two-for-one stock splits takingplace in the single year 1963—anunprecedentedphenomenonforamajorcompany.Intheearly1980s,underLeeIacocca, Chrysler did a three-peat,coming back from the brink ofbankruptcy to becomeone of the best-performing stocks in America.

However, identifying managers whocan lead great corporate comebacks isnot as easy as it seems. When AlDunlap took over Sunbeam Corp. in1996afterrestructuringScottPaperCo.(anddrivingitsstockpriceup225%in18months),Wall Street hailed him aslittle short of the Second Coming.Dunlap turned out to be a sham whoused improper accounting and falsefinancial statements to misleadSunbeam’s investors—including thereveredmoneymanagersMichaelPriceandMichaelSteinhardt,whohadhiredhim.ForakeendissectionofDunlap’scareer, see John A. Byrne, Chainsaw(HarperCollins,NewYork,1999).7.Notethatwedonotsuggestthatthisformula gives the “true value” of a

growth stock, but only that itapproximates the results of the moreelaboratecalculationsinvogue.

Chapter12.ThingstoConsiderAboutPer-ShareEarnings

1.Ourrecommendedmethodofdealingwith the warrant dilution is discussedbelow.Weprefertoconsiderthemarketvalueof thewarrants as an addition tothecurrentmarketpriceofthecommonstockasawhole.

Chapter13.AComparisonofFourListedCompanies

1. In March 1972, Emery sold at 64timesits1971earnings!

Chapter14.StockSelectionfortheDefensiveInvestor

1. Because of numerous stock splits,etc., through the years, the actualaveragepriceoftheDJIAlistwasabout$53pershareinearly1972.2.In1960onlytwoofthe29industrialcompaniesfailedtoshowcurrentassetsequal to twice current liabilities, andonly two failed to have net currentassets exceeding their debt. ByDecember 1970 the number in eachcategoryhadgrownfromtwototwelve.3.Butnote that their combinedmarketaction from December 1970 to early1972waspoorerthanthatoftheDJIA.This demonstrates once again that no

system or formula will guaranteesuperior market results. Ourrequirements “guarantee” only that theportfolio-buyer is getting his money’sworth.4. As a consequence wemust excludethe majority of gas pipeline stocks,since these enterprises are heavilybonded.The justification for this setupis the underlying structure of purchasecontracts which “guarantee” bondpayments; but the considerations heremaybetoocomplicatedfortheneedsofadefensiveinvestor.

Chapter15.StockSelectionfortheEnterprisingInvestor

1.MutualFundsandOtherInstitutionalInvestors:ANewPerspective,I.Friend,M. Blume, and J. Crockett, McGraw-Hill, 1970. We should add that the1966–1970resultsofmanyofthefundswe studiedwere somewhat better thanthose of the Standard & Poor’s 500-stockcompositeandconsiderablybetterthanthoseoftheDJIA.2.Personalnote:Manyyearsbeforethestock-market pyrotechnics in thatparticular company the author was its“financial vice-president” at theprincelysalaryof$3,000perannum.Itwas then really in the fireworks

business. In early 1929, Grahambecame a financial vice president ofUnexcelled Manufacturing Co., thenation’s largest producer of fireworks.Unexcelled later became a diversifiedchemicalcompanyandnolongerexistsinindependentform.3.TheGuidedoesnotshowmultipliersabove 99. Most such would bemathematical oddities, caused byearningsjustabovethezeropoint.

Chapter16.ConvertibleIssuesandWarrants

1. This point is well illustrated by anoffering of two issues of Ford MotorFinance Co. made simultaneously inNovember 1971. One was a 20-yearnonconvertible bond, yielding 7½%.The other was a 25-year bond,subordinated to the first in order ofclaim and yielding only 4½%; but itwasmade convertible intoFordMotorstock,againstitsthenpriceof68½.Toobtain the conversion privilege thebuyer gave up 40% of income andacceptedajunior-creditorposition.2. Note that in late 1971 Studebaker-Worthingtoncommonsoldaslowas38

while the$5preferred soldator about77.The spreadhad thusgrown from2to20pointsduringtheyear,illustratingonce more the desirability of suchswitches and also the tendency of thestock market to neglect arithmetic.(Incidentally the small premium of thepreferred over the common inDecember1970hadalreadybeenmadeupbyitshigherdividend.)

Chapter17.FourExtremelyInstructiveCaseHistories

1. See, for example, the article “SixFlags at Half Mast,” by Dr. A. J.Briloff,inJanuary11,1971.

Chapter18.AComparisonofEightPairsofCompanies

1. The reader will recall from p. 434above that AAA Enterprises tried toenter this business, but quickly failed.HereGrahamismakingaprofoundandparadoxical observation: The moremoney a company makes, the morelikely it is to face new competition,since its high returns signal so clearlythateasymoney is tobehad.Thenewcompetition, in turn,will lead to lowerprices and smaller profits. This crucialpoint was overlooked byoverenthusiastic Internet stock buyers,whobelieved that earlywinnerswouldsustaintheiradvantageindefinitely.

Chapter19.ShareholdersandManagements:DividendPolicy

1.Analyticalstudieshaveshownthatinthe typical case a dollar paid out individendshadasmuchasfourtimesthepositiveeffectonmarketpriceashadadollar of undistributed earnings. Thispointwaswellillustratedbythepublic-utility group for a number of yearsbefore 1950. The low-payout issuessoldatlowmultipliersofearnings,andproved to be especially attractive buysbecause their dividends were lateradvanced.Since1950payoutrateshavebeen much more uniform for theindustry.

Chapter20.“MarginofSafety”astheCentralConceptofInvestment

1. This argument is supported by PaulHallingby, Jr., “SpeculativeOpportunities in Stock-PurchaseWarrants,”thirdquarter1947.

Postscript

1.Veracity requires the admission thatthedealalmostfellthroughbecausethepartners wanted assurance that thepurchasepricewouldbe100%coveredbyassetvalue.Afuture$300millionormore in market gain turned on, say,$50,000ofaccounting items.Bydumblucktheygotwhattheyinsistedon.

Appendixes

1.AddressofBenjaminGrahambeforethe annual Convention of the NationalFederation of Financial AnalystsSocieties,May1958.

AcknowledgmentsfromJasonZweig

My heartfelt gratitude goes to all whohelped me update Graham’s work,

including:EdwinTanofHarperCollins,whose vision and sparkling energybrought the project to light; RobertSafian,DeniseMartin,andEricGelmanofMoney Magazine, who blessed thisendeavor with their enthusiastic,patient, and unconditional support; myliterary agent, the peerless John W.Wright; and the indefatigable TaraKalwarskiofMoney. Superb ideas andcritical readings came from TheodoreAronson,KevinJohnson,MarthaOrtiz,and the staff of Aronson + Johnson +Ortiz, L.P.; Peter L. Bernstein,president, Peter L. Bernstein Inc.;William Bernstein, Efficient FrontierAdvisors; John C. Bogle, founder, theVanguard Group; Charles D. Ellis,founding partner, Greenwich

Associates; and Laurence B. Siegel,director of investment policy research,theFordFoundation.Iamalsogratefulto Warren Buffett; Nina Munk; thetireless staff of theTime Inc.BusinessInformation Research Center; MartinFridson, chief executive officer,FridsonVision LLC; Howard Schilit,president,CenterforFinancialResearch&Analysis;RobertN.Veres,editorandpublisher,InsideInformation;DanielJ.Fuss, Loomis Sayles & Co.; F. BarryNelson, Advent Capital Management;the staff of the Museum of AmericanFinancial History; Brian Mattes andGusSauter,theVanguardGroup;JamesSeidel, RIA Thomson; CamillaAltamura and Sean McLaughlin ofLipper Inc.; Alexa Auerbach of

IbbotsonAssociates;AnnetteLarsonofMorningstar;JasonBramoftheFederalReserve Bank of New York; and onefund manager who wishes to remainanonymous.Aboveall,Ithankmywifeand daughters, who bore the brunt ofmy months of round-the-clock work.Without their steadfast love andforbearance, nothing would have beenpossible.

Editor’snote:Entriesinthisindex,carriedoververbatimfromtheprinteditionofthistitle,areunlikelytocorrespondtothepaginationofagivene-book’ssoftwarereader.Noraretheseentrieshyperlinked.However,entriesinthisindex,andotherterms,maybeeasilylocatedbyusingthesearchfeatureofyoure-bookreadersoftware.

Index

A.&P.SeeGreatAtlantic&PacificTeaCo.

AAAEnterprises

AbbottLaboratories

AberdeenMfg.Co.

Acampora,Ralph

accountexecutives.See“customers’brokers”

accountingfirms

accountingpractices;“bigbath”/“kitchensink,”;casehistoriesabout;anddividends;andinvestor-managementrelations;andmarketfluctuations;andper-shareearnings;andsecurityanalysis;andstockoptions;andstocksplits.Seealsospecificcompany

acquisitions.Seemergersandacquisitions;takeovers;specificcompany

activeinvestor.Seeaggressiveinvestor

ADPInvestorCommunicationServices

ADVform

AdventCapitalManagement

advice:foraggressiveinvestors;basicthesisabout;fordefensiveinvestors;andfordefensiveinvestors;doyouneed;fees/commissionsfor;Graham’sviewsabout;andinterviewingpotentialadvisers;andinvestmentsvs.speculation;andquestionsadvisersaskinvestors;androleofadviser;sourcesof;andspeculation;andtrustandverificationofadvisers;Zweig’scommentsabout.Seealsotypeofsource

AetnaMaintenanceCo.

AffiliatedFund

age:andportfoliopolicyfordefensive

investors

aggressiveinvestors:characteristicsof;definitionof;“don’ts”for;“do’s”for;expectationsfor;andinvestmentsvs.speculation;andmixingaggressiveanddefensive;portfoliofor;andpreferredstocks;psychologyof;recommendedfieldsfor;returnfor;rulesfor;securityanalysisfor;stockselectionfor

AirProducts&Chemicals,Inc.,

AirReductionCo.

airlines

AlabamaGasCo.

Alba-Waldensian

Albert’sInc.

AlleghenyPowerCo.

AlliedChemicalCo.

AlliedMills

ALLTELCorp.

AlteraCorp.

alternativeminimumtax

AltriaGroup

AluminumCompanyofAmerica(ALCOA)

Alvarez,Fernando

Amazon.com

AmericaOnlineInc.SeeAOLTimeWarner

American&ForeignPowerCo.

AmericanBrandsCo.

AmericanCanCo.

AmericanElectricPowerCo.

AmericanFinancialGroup

AmericanGas&ElectricCo.

AmericanHomeProductsCo.,

AmericanHospitalSupplyCo.,

AmericanMachine&Foundry

AmericanMaizeProducts

AmericanPowerConversion

AmericanRubber&PlasticsCo.

AmericanSmelting&RefiningCo.,

AmericanStockExchange

AmericanTelephone&Telegraph,

AmericanTobaccoCo.

AmericanWaterWorks

AmerindoTechnologyFund

Ameritas

Ameritrade

AMFCorp.

AmgenInc.

AmSouthBancorp

Anaconda

AnalogDevices

analysts.Seefinancialanalysts

Anderson,Ed

AndersonClaytonCo.

Andreassen,Paul

Angelica

Anheuser-Busch

annualearningsmultipliers

annualmeetings

annualreports

annuities

AOLTimeWarner

AppleComputerInc.

Applegate,JeffreyM.

AppliedMaterials

AppliedMicroDevices

appreciation

arbitrages

Archer-Daniels-Midland

Ariba

Aristotle

Arnott,Robert

artwork

“asif”statements.Seeproformastatements

Asness,Clifford

assetallocation:andadviceforinvestors;andaggressiveinvestors;anddefensiveinvestors;planof;andhistoryandforecastingofstockmarket;and

inflation;andinstitutionalinvestors;andinvestmentsvs.speculation;andmarketfluctuations;tactical.Seealsodiversification

assetbacking.Seebookvalue

assets:elephantiasisof;andper-shareearnings;andsecurityanalysis;andstockselectionforaggressiveinvestors;andstockselectionfordefensiveinvestors.Seealsoassetallocation;specificcompany

AssociationforInvestmentManagementandResearch

AT&TCorp.SeealsoAmericanTelephone&Telegraph

Atchison,Topeka&SantaFe

AtlanticCityElectricCo.

AuroraPlasticsCo.

AutomaticDataProcessing

automobilestocks

AvcoCorp.

AveryDennisonCorp.

AvonProducts

Babson’sFinancialService

BabyCenter,Inc.

BagdadCopper

balance-sheetvalue.Seebookvalue

balancesheets.Seealsospecificcompany

balancedfunds

Baldwin(D.H.)

BallCorp.

BaltimoreGas&ElectricCo.

BancBostonRobertsonStephens

BankofAmerica

BankofNewYork

BankofSouthwark

BankersTrust

bankruptcy;andaggressiveinvestors;ofbrokeragehouses;casehistoriesabout;anddefensiveinvestors;andhistoryandforecastingofstockmarket;andinvestmentfunds;andmarketfluctuations;andprice;ofrailroads;andsecurityanalysis.Seealsospecificcompany

banks;andadvice;amddeliveryandreceiptofsecurities;anddividends;investingin;andinvestmentfunds;andnewofferings;andstockselectionfordefensiveinvestors;trustdepartmentsof.Seealsotypeofbankorspecificbank

Barber,Brad

Bard(C.R.)

bargains:andaggressiveinvestors;andbonds;andcommonstock;anddefensiveinvestors;definitionof;andinvestmentvs.speculation;andmarginofsafety;andmarketfluctuations;andpreferredstocks;insecondarycompanies;andvalue

Baruch,BernardM.:125DEL

Bausch&LombCo.

BaxterHealthcareCorp.

BEASystems,Inc.

bearmarkets;andaggressiveinvestors;

anddefensiveinvestors;andhistoryandforecastingofstockmarket;andmarketfluctuations;silverliningto

“beatingthemarket/average,”

“beatingthepros,”

Becton,Dickinson

BelgianCongobonds

Bender,John

BenjaminGrahamJointAccount,

BerkshireHathaway

Bernstein,PeterL.

Bernstein,William

BethlehemSteel

Bickerstaff,Glen

BigBenStores

BinksManufacturingCo.

bio-technologystocks

BiogenInc.

BiometInc.

Birbas,Nicholas

Black&DeckerCorp.

Block,Stanley

Blodget,Henry

BlueBell,Inc.

BluefieldSupplyCo.

BOCGroup

Bogle,John

bondfunds

BondGuide(Standard&Poor’s)

bonds:andadvice;andaggressiveinvestors;andassetallocation;andbargains;callson;andcharacteristicsofintelligentinvestors;commonstockscomparedwith;andconvertibleissuesandwarrants;couponsfor;“coverage”for;defaultson;anddefensiveinvestors;discount;distressed;and

diversification;earningson;andGraham’sbusinessprinciples;andhistoryandforecastingofstockmarket;inflationand;intereston;andinvestmentfunds;andinvestmentsvs.speculation;long-andshort-term;andmarginofsafety;andmarketfluctuations;andnewofferings;priceof;ratingsfor;andrisk;androleofinvestmentbankers;safetyof;second-grade;andsecurityanalysis;sellingatpar;andsizeofenterprise;taxesand;typesof;yieldon.Seealsobondfunds;convertibleissues;specificcompanyortypeofbond

bookvalue;andaggressiveinvestors;anddefensiveinvestors;definitionof;andmarketfluctuations;andper-share

earnings.Seealsospecificcompany

books

BordenInc.

BoskinCommission

brain:andmarketfluctuations,

brandnames

Brearley,RichardA.:

DELbridgeplayersanalogy

brokeragehouses:andadvice;discount;fees/commissionsof;financialtroublesof;full-service;marginaccountswith;aspartoffinancialenterpriseindustry;andportfoliopolicyfordefensive

investors;volumeoftradesin.Seealsoonlinetrading;specifichouse

brokeragetransactions:deliveryof,

Bronson,Gail

BrooklynUnionGasCo.

Brooks,John

BrownShoe

Browne,Christopher

Buffett,WarrenE.:anddiversification;andGEICO;andindexingfunds;andinvestors’relationshipwithcompany;andmarketfluctuations;and“ownerearnings,”;andper-shareearnings;prefaceby;andsecurityanalysis;

selectionmethodsof;“SuperinvestorsofGraham-and-Doddsville”talkby,.SeealsoBerkshireHathaway

BuffettPartnership,Ltd.

bullmarkets;andbargains;characteristicsof;andconvertibleissuesandwarrants;anddealingswithbrokeragehouses;death/endof;historyandforecastingof;lengthof;andmarketfluctuations;andnewofferings;andportfoliopolicyforaggressiveinvestors

BunkerRamoCorp.

BurlingtonNorthernRailroad

Burton-DixieCorp.

Bush,GeorgeW.

business:buyingthe;definitionofgood;knowingyour

businessprinciples:ofGraham,

“businessman’sinvestment,”

BusinessWeek

buy-low-sell-highapproach

“buywhatyouknow,”

buyingbackshares.Seerepurchaseplans

buzzwords,investing

C.-T.-R.Co.

Cable&Wireless

CaliforniaPublicEmployees’RetirementSystem

calls

capital.Seealsocapitalgains;capitalization;returnoninvestedcapital(ROIC);specificcompany

capitalgains;andmarketfluctuations;andportfolioforaggressiveinvestors;taxeson

CapitalOneFinancialCorp.

capitalization

CareerAcademy

Carnegie,Andrew

CarnivalCorp.

CarolinaPower&LightCo.

Carter,Jimmy

casehistories:andGraham’scomparisonofeightpairsofcompanies;Graham’sdiscussionoffour“extremelyinstructive,”;Graham’sexamplesof;Zweig’scommentsonfour“extremelyinstructive,”;andZweig’scomparisonofeightpairsofcompanies

cash/“cashequivalents”:andaggressiveinvestors;anddefensiveinvestors;andhistoryandforecastingofstockmarket;andsecurityanalysis

“cashinonthecalendar,”

Cassidy,Donald

Caterpillar

CenterforResearchinSecurityPrices(UniversityofChicago):30DEL

CentralHudsonGasandElectricCo.

CentralIllinoisLightCo.

CentralMainePowerCo.

CenturyTelephoneInc.

certificatesofdeposit

certificates,stock

CertifiedFinancialPlanner(CFP),

CGI(CommerceGroup,Inc.),

Chambers,John

charitableinstitutions

CharteredFinancialAnalyst(CFA),

ChaseManhattanBank

CheckersDrive-InRestaurants

chemicalcompanies

Chesterton,G.K.

Cheung,Alexander

ChicagoandNorthwesternRailwayCo.

Chicago,Milwaukee,St.PaulandPacificbonds

China:stockmarketin

ChironCorp.

ChromatisNetworks

ChryslerCorp.

ChubbCorp.

CIBCOppenheimer

CincinnatiGas&ElectricCo.,

CingularWireless

CiscoSystems,Inc.

ClevelandElectricCo.

CleveTrustRealtyInvestors

CloroxCo.

closed-endfunds

CMGI,Inc.

CNBC

CNFInc.

CNN

Coca-Cola

Cohen,AbbyJoseph

Cohen&SteersRealtyShares

coinflipping

coins,buyingandselling

Colgate-Palmolive

CollegeMarketingGroup

ColumbiaGasSystem

ColumbiaRealEstateEquityFund

ComericaInc.

Comiskey,Eugene

CommerceOne,Inc.

commercialbanks

commonstock:andadvice;for

aggressiveinvestors;andassetallocation;bondscomparedwith;characteristicsof;fordefensiveinvestors;dividendson;earningson;expectedgrowth(1963and1969)of;generallong-termprospectsfor;generalobservationson;asgrowthstock;andhistoryandforecastingofstockmarket;inflationand;investmentmeritsof;investmentrulesfor;andinvestmentsvs.speculation;investor’spersonalsituationand;as“juniorstockissues,”;andmarginofsafety;andmarketfluctuations;performanceof;portfoliochangesin;pricedeclinein;pricerecordof;publicattitudetoward;returnon;andrisk;securityanalysisof;selectionof;valuationof;ValueLineForecast(1967–69)about.Seealso

specifictopic

CommonwealthEdisonCo.

companies:changeincharacterof;comparisonofeightpairsof;comparisonoffourlisted;emotionalimageryof;generalobservationsabout;investors’relationshipwith;Johnny-One-Note;withlargeamountsofconvertibleissues(1969);“large,prominent,conservativelyfinanced,”;second-line;unpopularlarge.Seealsocasehistories;corporations;secondarycompanies;specificcompany

computerindustry

ComverseTechnology

ConAgraFoods

ConeMills

conflictsofinterest

conglomerates

Conseco

ConsolidatedEdison

ConsolidatedGasofNewYork,

ConsolidatedNaturalGasCo.,

ConsolidatedRailCorp.(Conrail),

ConsolidationCoal

consumer-financefirms

ConsumerPriceIndex

ConsumersPowerCo.

contract:investmentowner’s

convertibleissues:andaggressiveinvestors;anddefensiveinvestors;exampleofworkingof;Graham’sdiscussionabout;asjuniortootherlong-termdebt;andmarketfluctuations;andper-shareearnings;Zweig’scommentsabout.Seealsowarrants;specificcompany

CooperIndustries

corporatebonds;andaggressiveinvestors;anddefensiveinvestors;andinflation;andinvestmentfunds;and

marketfluctuations;returnon;andsecurityanalysis

corporations:debtof;andfluctuationsinbondprices;governanceof;investors’srelationshipwith;“large,prominent,conservativelyfinanced,”;misleadingreportingby;taxeson;unpopularlarge.Seealsocompanies;corporatebonds;specificcorporation

costs.Seeexpenses/costs;fees/commissionscoupons

CowlesCommission

Cramer,JamesJ.

Crandall,Pierce&Co.

crash,stockmarket:of1929;of1987;of2000

creditcompanies:investingin,

creditratings

CriterionInsuranceCo.

CSXCorp.

“customerfinancings,”

“customers’brokers,”

“Daddy-Knows-Best,”

Damasio,Antonio

DanaCorp.

DanteAlighieri

DataGeneralCorp.

Davis,Christopher

DavisFunds

daytrading

DaytonPower&LightCo.

debt:andaggressiveinvestors;corporate;anddefensiveinvestors;anddividends;ofemergingmarkets;limiton,ofU.S.government;andmarginofsafety;ofpublicutilities;andsecurityanalysis;andselectionofstock.Seealsobonds;specificcompanyortypeofbond

Deere&Co.

defaults;andbargains;onbonds;andportfoliopolicyforaggressiveinvestors

defensiveinvestors:characteristicsof;definitionof;exclusionsfor;expectationsfor;andinflation;andinvestmentsvs.speculation;andmarginofsafety;andmarketfluctuations;andmixingaggressiveanddefensive;portfoliofor;returnfor;rulesfor;andsecurityanalysis;selectivityfor;stockselectionfor;Zweig’scommentsabout.Seealsospecifictopic

deflation

delistedstocks

DelmarvaPower&ElectricCo.

DeltonaCo.

depreciation

Depression(1930s)

DetroitEdisonCo.

diamonds

dilution:andconvertibleissuesandwarrants;andper-shareearnings;andrepurchaseplans.Seealsospecificcompany

Dimson,Elroy

directpurchaseofstock

directors

discountbrokeragehouses

DiscoverBrokerage

diversification;andadvice;andaggressiveinvestors;anddefensiveinvestors;anddelistedstocks;andformulatrading;and;Graham’sdisciples;importanceof;andinvestmentfunds;andinvestmentsvs.speculation;andmarginofsafety;andmarketfluctuations;andsecurityanalysis

dividends:academiccriticismof;andadvice;andbargains;cumulativeornoncumulative;andearnings;andexpectationsfordefensiveinvestors;

fixed;andformulatrading;Graham’scommentsabout;andgrowth;andhistoryandforecastingofstockmarket;inflationand;andinvestor-managementrelations;andmarginofsafety;andmarketfluctuations;overviewabout;and“payoutratio,”;andper-shareearnings;andperformance(1871–1970);andportfoliopolicyforaggressiveinvestors;andportfoliopolicyfordefensiveinvestors;andprice;properstock;recordofpaying;reinvestmentof;ofsecondarycompanies;andsecurityanalysis;special;andspeculation;andstockselectionforaggressiveinvestors;andstockselectionfordefensiveinvestors;stocksplitand;taxeson;totaldollaramountof,byU.S.stocks;and

volatility;whopays;Zweig’scommentsabout.Seealsoyield;specificcompanyortypeofsecurity

Dixon,Richard

Dodd,David;SeealsoSecurityAnalysis(GrahamandDodd)

“DogsoftheDow,”

dollar-costaveraging,

DollarGeneralstores

Donaldson,Lufkin&Jenrette

Donnelley(R.R.)&Sons

dot.comstocks

DoubleClickInc.

DoverCorp.

DowChemicalCo.

DowJonesIndustrialAverage(DJIA):aggressiveinvestorsand;andbargains;“best”stocksin;andcomparisonoffourlistedcompanies;defensiveinvestorsand;anddividendreturnoncommonstocks;inearly1970s;andexpectationsforinvestors;andformulatrading;growthof;andgrowthstocks;andhistoryandforecastingofstockmarket;inflationand;andinvestmentfunds;andmarketfluctuations;andper-shareearnings;andRaskob’sprescription;riseof(1915–70);and

securityanalysis;andselectionofstocks;andunpopularlargecompanies;yieldofstocks(2003)on.Seealsospecificcompany

“DowTheory,”

Dreman,David

Drew,Daniel

DrexelBurnhamLambert

DrexelFirestoneCo.

DreyfusFund

drugindustry

DuPontCo.

DuPont,Glore,Forgan&Co.,

dual-purposefunds

duediligence

Dundee,Angelo

Durand,David

e*Trade

“earningpower,”

earnings:andadvice;average;andbargains;oncapitalfunds;“consensus”about;debtandprofitsoncapital(1950–69);anddividends;andexpectationsforinvestors;hidingtrue;andhistoryandforecastingofstock

market;inflationand;andmarginofsafety;andmarketfluctuations;owner;andper-shareearnings;andperformance(1871–1970);andportfoliopolicyforaggressiveinvestors;andportfoliopolicyfordefensiveinvestors;real;andrepurchaseplans;andsecurityanalysis;andspeculation;andstockselectionforaggressiveinvestors;andstockselectionfordefensiveinvestors.Seealso“earningpower”;per-shareearnings;price/earningsratio;specificcompanyortypeofsecurity

earnings-coveredtest

EastmanKodakCo.

EDGARdatabase

EdisonElectricLightCo.

EdwardVII(kingofGreatBritain),

“efficientmarketshypothesis”(EMH)

ElectricAutoliteCo.

ElectronicDataSystems

electronicsindustry

Elias,David

Ellis,Charles

ELTRACorp.

EMCCorp.

emerging-marketnations

Emerson,RalphWaldo

EmersonElectricCo.

EmeryAirFreight

EmhartCorp.

employee-purchaseplans

employees:stockoptionsfor.Seealsomanagers/management

endowmentfunds

“enhancingshareholdervalue,”

EnronCorp.

enterprisinginvestors.Seeaggressiveinvestors

EPS.Seeper-shareearnings

ErieRailroad

ethics

eToysInc.

EversharpCo.

exchange-tradedindexfunds(ETFs)

ExodusCommunications,Inc.,

ExpeditorsInternationalofWashington,Inc.

expenses/costs:controllingownership;

andconvertibleissuesandwarrants;ofdoingbusiness;ofinvestmentfunds;ofmutualfunds;ofoptions;andper-shareearnings;ofresearch;andstockselectionforaggressiveinvestors;andstockselectionfordefensiveinvestors;oftrading.Seealsofees/commissions

Factiva

“fair-weatherinvestments,”

Fama,Eugene

FamilyDollarStores

Farley,William

Fastow,Andrew

Faust(Goethe)

favoritestocks

FeddersCo.

FederalNationalMortgageAssociation(“FannieMae”)

FederalReserveBoard

fees/commissions:foradvice;foraggressiveinvestors;ofbrokeragehouses;controlling;andconvertibleissuesandwarrants;ofinvestmentfunds;andIPOs;andmarketfluctuations;andportfoliochanges;onreinvestments;andtiming.Seealsoexpenses/costs

FidelityFunds

50-50plan

financialanalysts;andadvice;collectiveintelligenceof;consensusopinionof;ascreatingvaluation;flawinapproachtoselectionby;andforecasting;functionsof;andinstitutionalinvestors;andinvestmentsvs.speculation;andmarginofsafety;andmarketfluctuations;requirementsfor;roleof;seniorandjunior;andspeculation;andstockselectionforaggressiveinvestors;andstockselectionfordefensiveinvestors.Seealsosecuritiesanalysis

financialcondition:andcommonstock;

anddividends;andsecurityanalysis;andstockselectionforaggressiveinvestors;andstockselectionfordefensiveinvestors.Seealsospecificcompany

FinancialCorp.ofAmerica

financialdevelopments:major,

financialinstitutions/industry.Seealsotypeofinstitutionorspecificinstitution

financialmarkets:historyandforecastingof.Seealsostockmarket

financialplan

financialplanners

financialreports.Seefinancial

statements;specificreport

financialserviceorganizations/industry

financialstatements.Seealsoper-shareearnings;securityanalysis;typeofreport

FirstTennesseeNationalBank,

Firsthandmutualfunds

Fischhoff,Baruch

Fisher,Kenneth

Fisher,Lawrence

fixed-valueinvestments.Seealsotypeofinvestment

FleetBostonFinancialCorp.

Floridarealestate,collapseof

fluctuations,market;andaggressiveinvestors;andassetallocation;inbondprices;bookvalueand;andbrain;andbuy-low-sell-highapproach;anddefensiveinvestors;exampleof;andforecasting;andformulainvestmentplans;asguidetoinvestmentdecisions;historyof(1871–1972);ofinvestor’sportfolio;managersand;andmarginofsafety;andmispricingofstock;Morgan’scommentsabout;andMr.Marketparable;andotherpeople’smistakes;silverliningto;timingandpricingof;andvaluation

FMCCorp.

FoodandDrugAdministration,U.S.

“TheFoolishFour”trading

footnotestofinancialstatements,Forbesmagazine

forcedsaleofstock

forecasting:addictionto;andadvice;andaggressiveinvestors;and“consensus”earnings;anddefensiveinvestors;andfinancialanalysts;andhistoryofstockmarket;ofinflation;andinvestmentfunds;andinvestmentsvs.speculation;andmarketfluctuations;andRaskob’sprescription;reliabilityof;andsecurityanalysis;and

selectionofstock;andspeculation;andtiming;theunpredictable

foreignstocks/bonds

formulainvesting/trading.Seealsospecificformula

formulaplans/planners

formulatiming

Fortune500list

FourSeasonsNursing

401(k)plans

FPACapitalFund

“franchise”companies

Franklin,Benjamin

FranklinUtilities

fraud

French,Kenneth

Frenchassignats

Fridson,Martin

Friend-Blume-Crockettstudy

friendsorrelatives:advicefrom

Froelich,Robert

FruitoftheLoom

fundindustry.Seeinvestmentfunds

FundamentalInvestmentsCo.

Galbraith,Steve

GalileoSelectEquitiesFund

GallupOrganization

Galvin,Thomas

“gambler’sfallacy,”

gambling

GannettCo.

Gardner,John

Gates,Bill

GEICO.SeeGovernmentEmployees

InsuranceCo.

GeneralAmericanInvestors

GeneralElectricCo.

GeneralFoodsCorp.

GeneralMotorsCorp.

GenerallyAcceptedAccountingPrinciples(GAAP)

GeorgesonShareholder

Gillette

Glassman,JamesK.

GlobalCrossingLtd.

Goethe,JohannWolfgangVon,

gold,buying

GoldmanSachs&Co.

gooddecisions:factorsthatcharacterize

Goodbody&Co.

goodwill

GoodyearTireCo.

Gordon,RobertN.

Gordonequation

GovernmentEmployeesFinancialCorp.

GovernmentEmployeesInsuranceCo.(GEICO)

GovernmentNationalMortgageAssociation(“GinnieMae”)

Graham,Benjamin:Buffett’stributeto;businessprinciplesof;definitionofinvestmentof;disciplesof;forecastsof;misjudgementsof;Zweig’scommentsabout

Graham,JohnR.

Graham-NewmanCorp.

Graham-Newmanmethods:summaryof

Graham’sLaw

Grainger(W.W.)

GreatAtlantic&PacificTeaCo.,

greed

Greenspan,Alan

GroupRexel

growth;average;calculationofpastrateof;definitionof;anddividends;andhistoryandforecastingofstockmarket;andmarginofsafety;andmarketfluctuations;mutualfundsfor;andper-shareearnings;andportfoliopolicyforaggressiveinvestors;andportfoliopolicyfordefensiveinvestors;real;andrisk;andsecurityanalysis;slowdownin;speculative;andstockselectionforaggressiveinvestors;andstockselectionfordefensiveinvestors;and

typesofinvestors.Seealsospecificcompany

Guerin,Rick

Gulf&WesternInc.

GulfOil

H&RBlock,Inc.

HarleyDavidson

Harvey,CampbellR.

Hassett,KevinA.

Hawkins,O.Mason

Hayden,Stone&Co.

HaydonSeitchandInstrumentCo.

Hazlitt,William

hedging:andaggressiveinvestors;andconvertibleissuesandwarrants;anddefensiveinvestors;anddefinitionofintelligentinvestors;andexpectationsforinvestors;andhalfahedge;andinflation;andinvestmentfunds;“related”and“unrelated,”

Heine,Max

Heinz(H.J.)

Hennessyfunds

herding

high-yieldbonds.Seejunkbonds

Hoffman,Mark

“homebias,”

HomeDepot

Honda

HoneywellCorp.

HorizonCorp.

hostiletakeovers

HouseholdInternational

HousingandUrbanDevelopment(HUD),U.S.Departmentof

HousingAuthoritybonds

HoustonLight&PowerCo.

“Howmuch?”question

HudsonPulp&Paper

“humanfactor”inselection

HuronConsultingGroup

hyperinflation

I-bonds

IbbotsonAssociates“IntheMoney”(CNN-TV),

income.Seealsospecificcompany

incomebonds

incometax.Seetaxes

“incubatedfunds,”

indexingfunds:andadvice;andaggressiveinvestors;Buffett’sadviceabout;compulsoryholdingsfor;andconvertibleissuesandwarrants;anddefensiveinvestors;flawsof;andinvestmentfunds;andmarketfluctuations;andsecurityanalysis;oftotalU.S.stockmarket.Seealsoexchange-tradedindexfunds(ETFs)

industrialbonds

IndustrialNationalBankofRhodeIsland

industrialstocks

industry:analysisof;predictinggrowthof

inflation;accuracyofrateof;asdead;anddefensiveinvestors;andhistoryandforecastingofstockmarket;andmoneyillusion;nominalandreal;andprice;protectionagainst;andRaskob’sprescription;andreturns/yield;andrisk;andtaxes;andvalue.Seealsotypeofsecurity

InformixCorp

InfoSpace,Inc.

initialpublicofferings(IPOs).Seealsospecificcompany

InktomiCorp.

Insana,Ron

insidertrading

institutionalinvestors

insurancecompanies

IntelCorp.

intelligentinvestors:asbusinesslike;characteristicsof;and“controllingthecontrollable,”;waysofbeing

interest;andaggressiveinvestors;andbargains;compound;andCramer’srecommendations;anddefensiveinvestors;andexpectationsforinvestors;fixed;andhistoryandforecastingofstockmarket;inflation

and;andmarginofsafety;andsecurityanalysis;andtaxes.Seealsospecificcompanyortypeofsecurity

InternationalBusinessMachines(IBM)

InternationalFlavors&Fragrances,

InternationalGameTechnology

InternationalHarvesterCo.

InternationalNickel

InternationalPaperCo.

InternationalTelephone&Telegraph

Internet:assourceofadvice

Internetcompanies

investmentbanks/bankers;andadvice;andaggressiveinvestors;andIPOs;andreformofWallStreet;roleof

InvestmentCompanyofAmerica,

investmentcontracts

investmentcounselingfirms

investmentfunds:andadvertising;adviceabout;andaggressiveinvestors;aim/purposeof;assetelephantiasisof;andbalancedfundinvestments;bank-operated;and“beatingthemarket,”;changesin;closedendvs.openend;closingof;andcommonstock;anddaringtobedifferent;anddefensiveinvestors;dividendson;andearnings;expenses/costsof;Graham’scomments

about;andgrowthstocks;and“hot”stocks;andinterest;managersof;methodofsaleof;numberof;overvalued,speculativeinvestmentsof;performanceof;priceof;questionsabout;ratingof;registrationof;regulationof;returnon;andrisk;selectionof;sheepishbehaviorin;taxeson;timetosell;turnoverofstockin;types/classificationof;Zweig’scommentsabout.Seealsoclosed-endfunds;mutualfunds

“InvestmentOwner’sContract,”

investmentpolicystatement,

investmenttrusts

investments:conventionaland

nonconventional;definitionof;expectationsfor;“fair-weather,”;Graham’scommentsabout;Graham’sdefinitionof;importanceoflong-term;oflargesumsofmoney;majorchangesince1964in;marginofsafetyascentralconceptof;opportunitiesfor;speculationvs.;Zweig’scommentsabout.Seealsospecifictopic

investors:activeandpassive;activismof;beginning;consistencyof;controllingbehaviorof;courageof;definitionoflong-term;disciplineof;anddividends;elderly;emotionsof;and“enhancingshareholdervalue,”;expectationsfor;functionsof;Graham’scommentsabout;inflationand;asintelligentowners;interestsof;

investmentcontractof;ironicalsituationofmanagersas;andmanagers/management;meaningofterm;measuringsuccessof;asmixedaggressiveanddefensive;andotherpeople’smistakes;personalsituationof;predictingbehaviorof;primarycauseoffailureby;andproxymaterials;psychologyof;“reckless,”;relationshipwithcompanyof;self-defeatingbehaviorof;self-knowledgeof;sheepbehaviorof;speculatorsdistinguishedfrom;theoryvs.practiceregarding;asthinkingofself;typesof;andwhosemoneyisit?;Zweig’scommentsabout.Seealsotypeofinvestor

InvestorsStockFund

IPOs.Seeinitialpublicofferings

IRAaccounts

ITICorp.

J.B.HuntTransportation

J.P.MorganChase

Jackson,Phil

Jacob(Ryan)InternetFund

JantzenInc.

“Januaryeffect,”

JanusGlobalTechologyFund,

Japan

JDSUniphaseCorp.

JeddoHighlandCoal

Jefferson-Pilot

Jesus:Graham’sreferenceto

Jobs,Steve

Johnny-One-NoteCo.

JohnsManvilleCorp.

Johnson&Johnson

JohnsonControls

Jones,Charles

Jordan,Michael

Jos.A.BankClothiers

juniorstockissues.Seecommonstock

junkbonds

JunoOnlineServices

“justdowhatworks,”

Kadlec,Charles

Kahneman,Daniel

Kaplan,G.E.

Karp,Morris

Kayos,Inc.

Kayser-RothCo.

Keckfamily

KemperFunds

Keoghaccounts

KeyCorp

Keynes,JohnMaynard

Kierkegaard,Soren

Kimberly-Clark

KingResourcesCo.

Klingenstein,J.K.

Knapp,Tom

Kozlowksi,L.Dennis

Kutyna,Donald

Lamont,Owen

Landis,Kevin

Lasus,Jay

lawsuits

Lee,KateLeary

Leffler,EdwardG.

LeggMasonValueTrust

Leggett&Platt

LehmanCorp.

LessonsforInvestors(Graham)

letterstocks

LeutholdGroup

leverage

leveragedbuyouts

Levin,GeraldM.

LexisNexis

liabilities.Seealsospecificcompany

Lichtenberg,G.C.

lifeinsurance

Lilly(Eli)

LinearTechnology

Ling-Temco-VoughtInc.

Lipper,Inc.

liquidations

liquidity

LJMCorp.

loadfunds

LockheedMartin“longrun”:howlongis

Long-TermCapitalManagementL.P.

LongleafPartners

Loomis,Carol

Lorie,JamesH.

losses;“carryingforward,”costof;andGraham’sdefinitionofinvestment;importanceofavoiding;andmarginofsafety;andper-shareearnings;“reallydreadful,”;andtaxes.Seealsospecificcompany

low-multiplierstocks

Lowe’sCompanies

LSILogicCorp.

LTVCorp.

Lubin,MelanieSenter

LucentTechnologiesInc.

luck

Lynch,Peter

“madmoney”account

Mairs&PowerGrowthFund

managers/management:compensationfor;competenceof;andconvertibleissuesandwarrants;anddaringtobedifferent;anddividends;efficiencyof;functionsof;Graham’scommentsabout;andinterestsofinvestors;ofinvestmentfunds;investors’srelationswith;andmarketfluctuations;migrating;misbehaviorof;andper-shareearnings;poor;aspromoters;andrepurchaseplans;reputationof;and

securityanalysis;asshareholders;stockoptionsfor;andstockselectionforaggressiveinvestors;wealthof;andwhosemoneyisit?

ManhattanFund,Inc.

marginaccounts

marginofsafety

Marsh,Paul

MassachusettsInvestmentTrust

mathematics

MattelInc.

MaximIntegratedProducts

MaxwellMotorsCo.

MayDepartmentStores

McCormickHarvestingMachineCo.

McDonald’sCorp.

McGrawEdison

McGraw-Hill,Inc.

Merck&Co.

MergenthalerLinotypeEnterprises,

mergersandacquisitions:andaggressiveinvestors;andcasehistories;anddefensiveinvestors;anddividends;andinvestmentsvs.speculation;andper-shareearnings;andsecurity

analysis;serial;stockvs.cashin

MerrillLynch&Co.

MicronTechnology

Microsoft

MicroStrategy

Miller,Merton

Miller,William

Minkow,Barry

MinniePearl’sChickenSystemInc.,

MobilCorp.

Modigliani,Franco

MoneyMagazine

“moneymanagers,”

money-marketfunds

“Moneyline”(CNNprogram)

monopolies

Montaigne,Michelde

MonumentInternetFund

Moody’sInvestmentService

Morey,Matthew

MorganFun-Shares

MorganGuarantyBank

MorganStanley

Morgan,J.P.

Morningstar:ratingsby;websitefor

mortgages

Motorola

Mr.Marketparable

Mr.TaxofAmerica

Mulford,Charles

Munger,Charles

municipalbonds;andaggressiveinvestors;anddefensiveinvestors;fluctuationsinpriceof;andinvestment

funds

Murray,Nick

mutualfunds:andaggressiveinvestors;asalmostperfect;and“buywhatyouknow”picking;characteristicsof;closed-endfundsvs.open-end;closingof;andconvertibleissuesandwarrants;andcorporatebonds;declineinfundsinvestedin;anddefensiveinvestors;expenses/costsof;“focused”portfoliosof;foreignstocksandbondsin;andformulatrading;andgrowthstocks;andinflation;introductionof;forjunkbonds;managersof;andmarketfluctuations;andnewofferings;performanceof;preciousmetals;andpublicattitudeaboutstocks;registration

of;as“regulatedinvestmentcompany”(RIC);returnonandsecondarycompanies;andsecurityanalysis;small-cap;andspeculation;and“surethings,”;taxeson;typesof.Seealsoinvestmentfunds;specificfund

MutualSeriesFunds

namebrands

NASDAQ

NationalBiscuitCo.

NationalCashRegister

NationalGeneralCorp.

NationalInvestorsFund

NationalPrestoIndustries

NationalStudentMarketingCorp.

Navistar

Neff,John

Nelson,F.Barry

netassetvalue.Seebookvalue

netcurrentassets.Seeworkingcapital

neuroscienceofinvesting

NewCommunitydebentures

NewHavenRailroad

NewHousingAuthority

newofferings;andadvice;andaggressiveinvestors;andcasehistories;ofcommonstock;anddefensiveinvestors;andinvestmentsvs.speculation;andmarketfluctuations;andper-shareearnings;androleofinvestmentbankers.Seealsoinitialpublicofferings

NewYorkCentralRailroad

NewYorkEdisonCo.

NewYorkInstituteofFinance

NewYorkStockExchange(NYSE):advicefrommembersof;bankruptcyoffirmsregisteredwith;andbargains;closingbellon;comparisonoffourcompanieslistedon;andcomparisonof

securities;andconvertibleissuesandwarrants;costsoftradingstockson;“customers’brokers”asregisterdwith;anddealingswithbrokeragehouses;anddividends;feesforstocklistedon;highest-pricestockon;andper-shareearnings;andportfoliopolicyforaggressiveinvestors;andstockselectionforaggressiveinvestors;andstockselectionfordefensiveinvestors;andstocksplits;turnoverofstockon;andWorldWarI

NewYorkTrapRockCo.

Newman,Jerome

Newman,Paul

news,stockmarket

Newton,Isaac

Niagara-MohawkPowerCo.

“NiftyFifty”stocks

Nissim,Doron

Nixon,RichardM.

no-loadfunds

Nokia

nonconvertiblebonds

Norfolk&Western

NorfolkSouthernRailroad

NorskHydro

Nortek,Inc.

NortelNetworks

NorthernPacificRailway

NorthwestIndustriesInc.

Norwaybonds

NovellusSystems

NucorCorp.

NVFCorp.

Nygren,William

OakmarkFund

Odean,Terrance

oilcompanies

onlinemessageboards

onlinetrading

open-endfunds.Seealsomutualfunds

OPM(OtherPeople’sMoney)

opportunities:recognizing

options,call

options,stock.Seealsowarrants;specificcompany

OracleCorp.

OrbitexEmergingTechnologyFund

orders:executionof

O’Shaughnessy,James

overvaluation;andaggressiveinvestors;“gambler’sfallacy”about;andrepurchaseplans.Seealsospecificcompany

Owens-IllinoisGlassCo.

ownerearnings

owners:intelligent

P/Eratio.Seeprice/earningsratio

PacificGas&ElectricCo.

PacificPartners,Ltd.

PacTel

PaineWebber

Palm,Inc.

PanhandleEasternPipeLineCo.

ParkerPenCo.

Pascal,Blaise

“Pascal’swager,”

patentsandtrademarks

PBHGTechnology&CommunicationsFund

PennCentralRailroad

PennsylvaniaElectricCo.

pensionfunds.Seealsospecificcompany

PeoplesGasCo.

PepsiCoInc.

per-shareearnings:andaggressiveinvestors;andcommonstock;andconvertibleissuesandwarrants;anddefensiveinvestors;anddividends;Graham’scommentsabout;andmarginofsafety;andrepurchaseplans;Zweig’scomments.Seealsospecificcompany

performance:andadvice;andaggressiveinvestors;anddefensive

investors;factorsinfluencing;andGraham’sdefinitionofinvestment;ofgrowthstocks;andmarketfluctuations;andper-shareearnings;ofsecondarycompanies;andsecurityanalysis;ofvaluestocks;vogueof.Seealso“beatingthemarket/average”;specificcompanyortypeofsecurity

performancefunds

PerformanceSystemsInc.

Perimeter(Stan)Investments

periodicals:assourceofadvice

Perot,H.Ross

PetersburgParadox

Pfizer,Inc.

PhiladelphiaElectricCo.

PhilipMorris

Pickens,T.Boone

Piecyk,Walter

Pier1Imports

Pimco

Pinault-Printemps-RedouteGroup

Plato

PlexusGroup

Polaroid

portfolio:foraggressiveinvestors;autopilot;basiccharacteristicsof;changesto;chaotic;ascombinationofactiveandpassivewaysofinvesting;andcommonstocks;fordefensiveinvestors;Graham’sconceptofappropriateindividual;inflationand;“laddered,”;marketfluctuationsand;negativeapproachtodevelopmentofstock;overviewabout;owncorporationstockin;positiveapproachtodevelopmentof;rebalancingof;vodka-and-burrito.Seealsoassetallocation;selection,stock

portfoliotrackers

Posner,Victor

PPGIndustries

“pre-emptiveright,”

preciousmetals

predictions.Seeforecasting

preferredstock:andaggressiveinvestors;andbalancedfunds;andbargains;andconvertibleissuesandwarrants;anddefensiveinvestors;dividendson;andGraham’sbusinessprinciples;andinflation;andinvestmentfunds;andmarginofsafety;andnewofferings;andper-shareearnings;pricefluctuationsin;pricerecordof;ratingsfor;recommended“coverage”for;andrisk;andsecurityanalysis;asseniorstockissues;

switchesbetweencommonand;yieldon.Seealsospecificcompany

price:andadvice;andbankruptcyBuffet’scommentsabout;calculationoftruemarket;andcomparisonoffourlistedcompanies;andconvertibleissuesandwarrants;declineincommonstock;ofdelistedstocks;anddividends;andearnings;andexpectationsforinvestors;“gambler’sfallacy”about;andhistoryandforecastingofstockmarket;andinflation;andinvestmentfunds;andinvestor-managementrelations;andmarginofsafety;andmarketfluctuations;andmispricingofstock;andnewofferings;andportfoliopolicyforaggressiveinvestors;andportfoliopolicyfordefensiveinvestors;

andrepurchaseplans;andrisk;andsecurityanalysis;andspeculation;ofstockoptions;andstockselectionforaggressiveinvestors;andstockselectionfordefensiveinvestors;andtiming;unpredictabilityof;andvalue;wholesale.Seealsoappreciation;bargains;fluctuations,market;inflation;price/earningsratio;specificcompany

price-and-wagefreeze

price/earningsratio:andadvice;andbargains;calculationof;andconvertibleissuesandwarrants;definitionof;forward;Graham’scriticismsofhigh;andgrowthstocks;andhistoryandforecastingofstockmarket;andinvestmentsvs.speculation;andmargin

ofsafety;andmarketfluctuations;andper-shareearnings;andportfoliopolicyforaggressiveinvestors;andportfoliopolicyfordefensiveinvestors;andsecurityanalysis;andstockselectionforaggressiveinvestors;andstockselectionfordefensiveinvestors.Seealsospecificcompany

price-to-assetsratio

price-to-bookvalueratio

Priceline.com

primarystockissues

proforma(“asif”)statements

Procter&Gamble

profitability.Seealsospecificmeasureofprofitability

profitablereinvestmenttheory

ProFundsUltraOTCFund

ProQuest

prospectus

ProvidenceBank

proxymaterials

PublicServiceCommission

PublicServiceElectric&GasCo.

publicutilities:andaggressiveinvestors;andbonds;debtof;as

defensiveinvestment;anddefensiveinvestors;dividendsof;andinflation;andinvestmentsvs.speculation;andmarketfluctuations;regulationof;andsecurityanalysis;andselectionofstock;andsubscriptionrights

PublicUtilityHoldingCompanyAct(1935)

PumaTechnology

PurexCo.

PutnamGrowthFund

QLogicCorp.

QuakerOats

QualcommInc.

quicken.com“quotational”value/loss

quotations,market

QwestCommunications

radiocompanies

railroads;andaggressiveinvestors;bankruptcyof;andbargains;bondsof;anddefensiveinvestors;andmarketfluctuations;andsecurityanalysis;andspeculation.Seealsospecificrailroad

Randell,Cort

RapidAmerican

Raskob,JohnJ.

rating:ofbonds;ofinvestmentfunds

ratingagencies

Reagan,Ronald

realestate

RealEstateInvestmentTrustCompany

RealEstateInvestmentTrusts(REITs)

RealtyEquitiesCorp.ofNewYork

rebalancing

RedHat,Inc.

RegionsFinancial

reinvestment;anddefensiveinvestors;anddividends;andmarginofsafety;andportfolioforaggressiveinvestors

REITs.SeeRealEstateInvestmentTrusts

repurchaseplans

research

researchanddevelopment(R&D)

restructuringcharges

retailbonds

retirementplans.Seealsopensionplans;specificplan

RetirementSystemsofAlabama

return:andadvice;aggregate;foraggressiveinvestors;averageannual;averageexpected;fordefensiveinvestors;andGraham’sbusinessprinciples;Graham’scommentsabout;andGraham’sdefinitionofinvestment;andhistoryandforecastingofstockmarket;andinflation;andinvestmentvs.speculation;measuresof;andpublicattitudeaboutstocks;onRaskob’sprescription;andrisk;andsecurityanalysis;Zweig’scommentsabout.Seealsodividends;interest;performance;returnoninvestedcapital(ROIC);yield;specificcompanyortypeofsecurity

returnoninvestedcapital(ROIC)

revenuebonds

Riley,Pat

risk:andadvice;andaggressiveinvestors;Buffett’scommentsabout;anddefensiveinvestors;andfactorsthatcharacterizegooddecisions;foolish;andformulatrading;andGraham’sbusinessprinciples;andhistoryandforecastingofstockmarket;andinflation;andinvestmentvs.speculation;managingof;andmarginofsafety;andmarketfluctuations;andprice;andreturn/reward;andsecurityanalysis;andshortselling;andspeculation;andvalue;whatis;Zweig’scommentsabout.Seealsospecificcompanyortypeofsecurity

RiskManagementAssociation

Ritter,Jay

RochePharmaceuticalCo.

Rockefellerfamily

Rodriguez,Robert

Rogers,Will

Rohm&Haas

Rosen,JanM.

Ross,RobertM.DEL

Roth,John

Rothschild,NathanMayer

Rothschildfamily

roulette

RouseCorp.

RowanCompanies

Royce,Charles

Ruane,Bill

Ruettgers,Michael

“Ruleof72,”

“ruleofopposites,”

“safetyofprinciple,”

safetytests:forbonds

SanFranciscoRealEstateInvestors

SanfordC.Bernstein&Co.

SantaFeIndustries

Santayana,George

savingsaccounts

savingsandloanassociations

savingsbanks

savingsbonds

SaxonIndustries

Saylor,Michael

SBCCommunications

Schilit,Howard

Schloss,WalterJ.

Schow,Howard

Schultz,Paul

Schwab(CharlesA.)Corp.

Schweber,Mark

Schwert,William

Scientific-Atlanta

Scudder,Stevens&Clark

SearsRoebuckCo.

SEC.SeeSecuritiesandExchange

Commission

secondarycompanies

securities:deliveryandreceiptof

Securities&ExchangeCommission(SEC):andadvice;andAOL-TimeWarnercase;anddefensiveinvestor;and;GEICO;andhedgefunds;andinvestmentfunds;andIPOs;andletter-stocks;andmutualfunds;andnewissues;andNVF-SharonSteelcase;andper-shareearnings;andRealtyEquitiescase;regulationofbrokeragehousesby;regulationofpublicutilitiesby;andrepurchaseplans;andsecurityanalysis;andstockselectionfordefensiveinvestors;andTycocase;websitefor

SecuritiesIndustryAssociation

SecuritiesInvestorProtectionCorp.(SIPC)

securityanalysis;andadvice;foraggressiveinvestors;andcapitalstructure;andcapitalization;characteristicsof;andcomparisonoffourlistedcompanies;conceptof;fordefensiveinvestors;anddividends;andfinancialstrength;andforecasting;andgenerallong-termprospects;andgrowthstocks;andmanagement;andper-shareearnings;prediction/qualitativeapproachto;andprice;protection/quantitativeapproachto;andrisk;andspeculationincommonstocks;techniquesfor;andtwo-part

appraisalprocess;andvaluation;Zweig’scommentsabout.Seealsocasehistories;financialanalysts;per-shareearnings;selection,stock;typeofsecurity

SecurityAnalysis(GrahamandDodd)

securityanalyst.Seefinancialanalysts

selection,stock:andadoptionofschemesbylargenumbersofpeople;andadvice;foraggressiveinvestors;andbargainissues;and“best”stocksinDJIA;andbridgeplayeranalogy;“buywhatyouknow,”;criteriafor;fordefensiveinvestors;doityourself;Graham-Newmanmethodsfor;Graham’scommentsabout;Graham’s

criteriafor;“humanfactor”in;forlong-andshort-term;andlow-multiplierindustrialstocks;andmarketfluctuations;“pickthewinners,”;andpracticingselectingstocks;prediction/qualitativeapproachto;protection/quantitativeapproachto;rulesforcommonstock;andsecondarycompanies;singlecriteriafor;andspecialsituations;andstock-picking“systems,”;Zweig’scommentsabout.Seealsoassetallocation;diversification;securityanalysis

SequoiaFund

shareholders.SeeInvestors

SharonSteelCo.

sheepishbehavior

Shiller,Robert

shorting

SiebelSystems

Siegel,Jeremy

Siegel,Laurence

Sigma-Aldrich

Sing,Jeanette

sizeofenterprise

Slovic,Paul

SmallBusinessAdministration,

small-capstocks

Smith,Adam

SouthSeaCo.

SouthernCaliforniaEdison

SouthernNewEnglandTelephone

SouthwestAirlines

SpaldingUnitedKingdom

specialcharges.Seealsospecificcompany

“SpecialPurposeEntities,”

specialsituations.See“workouts”

speculation:andadvice;andaggressiveinvestors;andbargains;benefitsof;andcasehistories;andconvertibleissuesandwarrants;anddefensiveinvestors;anddividends;expectationsfrom;Graham’scommentsabout;andhistoryandforecastingofstockmarket;andinflation;intelligent;investingdistinguishedfrom;andinvestmentfunds;andmarginofsafety;andmarketfluctuations;andnewofferings;andproblemsofbrokeragehouses;andRaskob’sprescription;androleofinvestmentbankers;andsecurityanalysis;Zweig’scommentsabout

Spinoza,Baruch

splits,stock

SprintCorp.

stability.Seealsovolatility

stagflation

stamps,rare

Standard&Poor’s:andadvice;andbargains;bondratingsby;andconvertibleissuesandwarrants;anddividends;andexpectationsforinvestors;andGraham’sdisciples;andhistoryandforecastingofstockmarket;andinflation;andinvestmentfunds;andinvestmentvs.speculation;listingofconstituentcompaniesin;andmarketfluctuations;andMay1970debacle;andmutualfunds;andportfolioforaggressiveinvestors;andportfoliofor

defensiveinvestors;andprice/earningsratio;pricerecordfrom;asratingagency;and“second-linecompanies,”;andsecurityanalysis;andstockselectionforaggressiveinvestors;andstockselectionfordefensiveinvestors;andtechnologycompanies;websitefor.SeealsoStockGuide;specificcompany

StandardOil

StandardOilofCalifornia

StandardOilofNewJersey

StanleyWorks

Starbucks

statebonds

Staunton,Mike

steelindustry

stock:alternativesto;“delisting”of;directpurchaseof;goodandbad;mentalvalueof;andportfoliofordefensiveinvestors;publicattitudeabout;turnoverrateof;“watered,”.Seealsocommonstock;preferredstock;specificstockorsectorofstock

stock/equityratio

StockGuide(Standard&Poor’s)

stockmarket:and“beatingthepros,”;booksabout;inChina;easywaystomakemoneyin;asgoingwrong;historyandforecastingof1972levelin;

structureof;totalvalueofU.S..Seealsofinancialmarket

stockbrokers.Seebrokeragehouses

stockholders.Seeinvestors

Streisand,Barbra

StrongCorporateBondFund

StrykerCorp.

Studebaker-WorthingtonCorp.

subscriptionrights

Sullivan,Erin

SunMicrosystems

SuperiorOil

SupervaluInc.

“surethings,”

Swift&Co.

SycamoreNetworks,Inc.

SyscoCorp.

T.RowePrice

takeovers.Seealsospecificcompany

tangible-assetvalue.Seebookvalue

TargetCorp.

taxes:andaggressiveinvestors;on

corporations;anddefensiveinvestors;ondividends;andexpectationsforinvestors;andhistoryandforecastingofstockmarket;importantrulesconcerning;andinflation;andinterest;andinvestor-managementrelations;andlosses;andmarginofsafety;andmarketfluctuations;andper-shareearnings;ofregulatedinvestmentcompanies;andrepurchaseplans;andsecurityanalysis;andstockoptions.Seealsospecificcompany

TCW

“technicalapproaches,”

technologystocks:andaggressiveinvestors;andconvertibleissuesand

warrants;anddefensiveinvestors;anddividends;ininvestmentfunds;andinvestmentsvs.speculation;andinvestor-managementrelations;andmarginofsafety;andmarketfluctuations;andrisk;andsecurityanalysis;as“surethings,”.Seealsospecificcompany

TecoEnergy

telecommunicationsstocks

TeleprompterCorp.

television,financial

TelexCorp.

TellabsInc.

TemcoServices

Tenneco

Texaco

TexasInstruments

ThirdAvenueFunds

3Com

3MCo.

ThurlowGrowthFund

TIAA-CREF

tickersymbols

TicketmasterOnline

Tillinghast,Joel

TimeWarnerInc.SeealsoAOLTimeWarner

timing

TIPS.SeeTreasuryInflation-ProtectedSecurities

Tomlinson,Lucile

Torray(Robert)Fund

Toys“R”Us,Inc.

trackingstocks

tradenames.Seebrandnames

trades:costsof;ofdelistedstocks;size

of;volumeof

trading:insider

“tradinginthemarket,”

TraneCo.

TransamericaPremierEquityFund

TreasuryInflation-ProtectedSecurities(TIPS)

Tri-ContinentalCorp.

TriconGlobalRestaurants,Inc.

trustcompanies

trustfunds

Tversky,Amos

TweedyBrownePartners

two-partappraisalprocess

TycoInternationalLtd.

Ulysses(mythologicalfigure)

uncertainty

undervaluation;andaggressiveinvestors;andbargains;Buffet’scommentsabout;andmarginofsafety

underwriting.Seealsospecificcompanyorunderwriter

UnionCarbideCo.

UnionPacificRailroad

UnionUnderwear

unitinvestmenttrusts

UnitedAccum.

UnitedAircraftCo.

“units,”

UniversalMarionCo.

UniversityofMichigan

unpopularlargecompanies

Updegrave,Walter

U.S.Bancorp

U.S.bonds(otherthansavings)

U.S.savingsbonds

U.S.SteelCorp.

U.S.Treasury

U.S.Treasurybonds

U.S.Treasurycertificates

U.S.treasurysecurities

U.S.UtilitiesSectorIndexFund

USAInteractive

USGCorp.

USTInc.

VALinux

ValueLine(investmentservice)

value/valuation:andadvice;andaggressiveinvestors;andbargains;Buffet’scommentsabout;businessvs.stock-market;anddealingswithbrokeragehouses;anddefensiveinvestors;dependabilityof;and“enhancingshareholdervalue,”;financialanalystsascreating;andhistoryandforecastingofstockmarket;importanceof;inflated;andinflation;andinvestmentfunds;andinvestor-managementrelations;andmarginofsafety;andper-shareearnings;andprice;andproblemsofbrokeragehouses;“quotational,”;andrepurchase

plans;andrisk;andsecurityanalysis;andselectionofstock;andspeculation;andstocksplits;andtwo-partappraisalprocess.Seealsoearnings;fluctuations;market;overvaluation;price/earningsratio;undervaluation;specificcompanyortypeofsecurity

VanWagonerFunds

VanguardGroup

Veres,Robert

VFCorp.

videogame,financial

Vilar,Alberto

Vinik,Jeffrey

vodka-and-burritoportfolio,

volatility.Seealsostability

volume:trading

Volvo

Wal-MartStores

WalgreenCo.

Walker,Rob

WallStreet:reformof

WallStreetJournal

Walton,Sam

Warner-LambertCo.

warrants.Seealsospecificcompany

Wasatch

WashingtonMutual

WashingtonPostCo.

WassersteinPerella

“watered”stock

Watson,T.L.,Sr.

Webvan

Welles,C.

WestPointPepperell

WestinghouseCorp.

WestinghouseElectricCo.,

Wheelabrator-Frye

WhitingCorp.

Whitman,Martin

WiesenbergerFinancialServices

Willcox&Gibbs

Williams,JackieG.

WilliamsCommunications,

Wilshireindexes

WinstarCommunications

wirelessstocks

WoolworthCompany(F.W.)

workingcapital:andaggressiveinvestors;anddefensiveinvestors;anddividends;andsecurityanalysis

“workouts,”

WorldCom

WorthingtonSteel

W.R.Grace

Wyeth

XeroxCorp.

XilinxInc

Y2Kbug

Yahoo!Inc.

yield:andaggressiveinvestors;andconvertibleissuesandwarrants;anddefensiveinvestors;fluctuationsin;andhistoryandforecastingofstockmarket;andinflation;andspeculation.Seealsodividends;interest;performance;return;typeofsecurity

Yum!Brands,Inc.

ZenithRadio

Ziv,Amir

ZZZZBest

AbouttheAuthors

BENJAMINGRAHAM (1894-1976), thefather of value investing, has been aninspiration for many of today’s mostsuccessful businesspeople. He is alsothe author of Securities Analysis andThe Interpretation of FinancialStatements.

JASON ZWEIG is a senior writer atMoney magazine, a guest columnist atTime, and a trustee of theMuseum ofAmericanFinancialHistory.Formerlyasenior editor atForbes, he haswrittenaboutinvestingsince1987.

Visit www.AuthorTracker.com forexclusive information on your favoriteHarperCollinsauthor.

Credits

Cover design by muccadesign

Copyright

Grateful acknowledgment ismade for permission toreprint:

“The Superinvestors of

Graham-and-Doddsville,” byWarren E. Buffett, from theFall 1984 issue of Hermes,Magazine of ColumbiaBusiness School. Reprintedby permission of Hermes,Magazines of ColumbiaBusinessSchool,copyright©1984 The Trustees ofColumbia University andWarrenE.Buffett.

“Benjamin Graham,” byWarren E. Buffett, from the

November/December 1976issue of Financial AnalystJournal. Reprinted bypermission of FinancialAnalystsFederation.

THE INTELLIGENT INVESTOR—RevisedEdition.Copyright©1973 by Benjamin Graham.New material: Copyright ©2003 by Jason Zweig. Allrights reserved underInternational and Pan-American Copyright

Conventions. By payment ofthe required fees, you havebeen granted the non-exclusive, non-transferableright to access and read thetextof thise-bookon-screen.No part of this text may bereproduced, transmitted,down-loaded, decompiled,reverse engineered, or storedin or introduced into anyinformation storage andretrieval system, in any formor by any means, whether

electronicormechanical,nowknown or hereinafterinvented,without the expresswritten permission ofHarperCollinse-books.

EPub © Edition JUNE 2003eISBN:9780061745171

10987654321

AboutthePublisher

AustraliaHarperCollins Publishers(Australia)Pty.Ltd.25RydeRoad(POBox321)Pymble, NSW 2073,Australiahttp://www.harpercollinsebooks.com.auCanadaHarperCollinsCanada2 Bloor Street East - 20th

FloorToronto, ON, M4W 1A8,Canadahttp://www.harpercollinsebooks.caNewZealandHarperCollins Publishers(NewZealand)LimitedP.O.Box1Auckland,NewZealandhttp://www.harpercollinsebooks.co.nz

UnitedKingdomHarperCollinsPublishersLtd.77-85FulhamPalaceRoad

London,W68JB,UKhttp://www.harpercollinsebooks.co.ukUnitedStatesHarperCollinsPublishersInc.10East53rdStreetNewYork,NY10022http://www.harpercollinsebooks.com

1CoauthoredwithDavidDoddandfirstpublishedin1934.

2TheGrossbaumschangedtheirnametoGrahamduringWorldWarI,whenGerman-soundingnameswereregardedwithsuspicion.

3Graham-NewmanCorp.wasanopen-endmutualfund(seeChapter9)thatGrahamraninpartnershipwithJeromeNewman,askilledinvestorinhisownright.Formuchofitshistory,thefundwasclosedtonewinvestors.IamgratefultoWalterSchlossforprovidingdataessentialtoestimatingGraham-Newman’sreturns.The20%annualaveragereturnthatGrahamcitesinhisPostscript(p.532)appearsnottotakemanagementfeesintoaccount.

4ThetextreproducedhereistheFourthRevisedEdition,updatedbyGrahamin1971–1972andinitiallypublishedin1973.

*ThetwopartnersGrahamcoylyreferstoareJeromeNewmanandBenjaminGrahamhimself.

†GrahamisdescribingtheGovernmentEmployeesInsuranceCo.,orGEICO,inwhichheandNewmanpurchaseda50%interestin1948,rightaroundthetimehefinishedwritingTheIntelligentInvestor.The$712,500thatGrahamandNewmanputintoGEICOwasroughly25%oftheirfund’sassetsatthetime.GrahamwasamemberofGEICO’sboardofdirectorsformanyyears.Inanicetwistoffate,Graham’sgreateststudent,WarrenBuffett,madeanimmensebetofhisown

onGEICOin1976,bywhichtimethebiginsurerhadslidtothebrinkofbankruptcy.ItturnedouttobeoneofBuffett’sbestinvestmentsaswell.

*Becauseofalegaltechnicality,GrahamandNewmanweredirectedbytheU.S.Securities&ExchangeCommissionto“spinoff,”ordistribute,Graham-NewmanCorp.’sGEICOstaketothefund’sshareholders.Aninvestorwhoowned100sharesofGraham-Newmanatthebeginningof1948(worth$11,413)andwhothenheldontotheGEICOdistributionwouldhavehad$1.66millionby1972.GEICO’s“later-organizedaffiliates”includedGovernmentEmployeesFinancialCorp.andCriterionInsuranceCo.

1Graham’sanecdoteisalsoapowerfulreminderthatthoseofuswhoarenotas

brilliantashewasmustalwaysdiversifytoprotectagainsttheriskofputtingtoomuchmoneyintoasingleinvestment.WhenGrahamhimselfadmitsthatGEICOwasa“luckybreak,”that’sasignalthatmostofuscannotcountonbeingabletofindsuchagreatopportunity.Tokeepinvestingfromdecayingintogambling,youmustdiversify.

2DanteAlighieri,TheInferno,CantoXXVI,lines112–125,translatedbyJasonZweig.

*ThesurveyGrahamciteswasconductedfortheFedbytheUniversityofMichiganandwaspublishedintheFederalReserveBulletin,July,1948.Peoplewereasked,“Supposeamandecidesnottospendhismoney.Hecaneitherputitinabankorinbondsorhecaninvestit.Whatdoyou

thinkwouldbethewisestthingforhimtodowiththemoneynowadays—putitinthebank,buysavingsbondswithit,investitinrealestate,orbuycommonstockwithit?”Only4%thoughtcommonstockwouldoffera“satisfactory”return;26%consideredit“notsafe”ora“gamble.”From1949through1958,thestockmarketearnedoneofitshighest10-yearreturnsinhistory,averaging18.7%annually.InafascinatingechoofthatearlyFedsurvey,apollconductedbyBusinessWeekatyear-end2002foundthatonly24%ofinvestorswerewillingtoinvestmoreintheirmutualfundsorstockportfolios,downfrom47%justthreeyearsearlier.

*Speculationisbeneficialontwolevels:First,withoutspeculation,untestednewcompanies(likeAmazon.comor,inearliertimes,theEdisonElectricLightCo.)would

neverbeabletoraisethenecessarycapitalforexpansion.Thealluring,long-shotchanceofahugegainisthegreasethatlubricatesthemachineryofinnovation.Secondly,riskisexchanged(butnevereliminated)everytimeastockisboughtorsold.Thebuyerpurchasestheprimaryriskthatthisstockmaygodown.Meanwhile,thesellerstillretainsaresidualrisk—thechancethatthestockhejustsoldmaygoup!

†Amarginaccountenablesyoutobuystocksusingmoneyyouborrowfromthebrokeragefirm.Byinvestingwithborrowedmoney,youmakemorewhenyourstocksgoup—butyoucanbewipedoutwhentheygodown.Thecollateralfortheloanisthevalueoftheinvestmentsinyouraccount—soyoumustputupmoremoneyifthatvaluefallsbelowtheamount

youborrowed.Formoreinformationaboutmarginaccounts,seewww.sec.gov/investor/pubs/margin.htm,www.sia.com/publications/pdf/MarginsA.pdf,andwww.nyse.com/pdfs/2001_factbook_09.pdf.

*ReadGraham’ssentenceagain,andnotewhatthisgreatestofinvestingexpertsissaying:Thefutureofsecuritypricesisneverpredictable.Andasyoureadaheadinthebook,noticehoweverythingelseGrahamtellsyouisdesignedtohelpyougrapplewiththattruth.Sinceyoucannotpredictthebehaviorofthemarkets,youmustlearnhowtopredictandcontrolyourownbehavior.

*HowwelldidGraham’sforecastpanout?Atfirstblush,itseems,verywell:Fromthebeginningof1972throughtheendof1981,

stocksearnedanannualaveragereturnof6.5%.(Grahamdidnotspecifythetimeperiodforhisforecast,butit’splausibletoassumethathewasthinkingofa10-yeartimehorizon.)However,inflationragedat8.6%annuallyoverthisperiod,eatinguptheentiregainthatstocksproduced.Inthissectionofhischapter,Grahamissummarizingwhatisknownasthe“Gordonequation,”whichessentiallyholdsthatthestockmarket’sfuturereturnisthesumofthecurrentdividendyieldplusexpectedearningsgrowth.Withadividendyieldofjustunder2%inearly2003,andlong-termearningsgrowthofaround2%,plusinflationatabitover2%,afutureaverageannualreturnofroughly6%isplausible.(SeethecommentaryonChapter3.)

*Since1997,whenTreasuryInflation-

ProtectedSecurities(orTIPS)wereintroduced,stockshavenolongerbeentheautomaticallysuperiorchoiceforinvestorswhoexpectinflationtoincrease.TIPS,unlikeotherbonds,riseinvalueiftheConsumerPriceIndexgoesup,effectivelyimmunizingtheinvestoragainstlosingmoneyafterinflation.Stockscarrynosuchguaranteeand,infact,arearelativelypoorhedgeagainsthighratesofinflation.(Formoredetails,seethecommentarytoChapter2.)

*Today,themostwidelyavailablealternativestotheDowJonesIndustrialAveragearetheStandard&Poor’s500-stockindex(the“S&P”)andtheWilshire5000index.TheS&Pfocuseson500large,well-knowncompaniesthatmakeuproughly70%ofthetotalvalueoftheU.S.equitymarket.TheWilshire5000follows

thereturnsofnearlyeverysignificant,publiclytradedstockinAmerica,roughly6,700inall;but,sincethelargestcompaniesaccountformostofthetotalvalueoftheindex,thereturnoftheWilshire5000isusuallyquitesimilartothatoftheS&P500.Severallow-costmutualfundsenableinvestorstoholdthestocksintheseindexesasasingle,convenientportfolio.(SeeChapter9.)

*Seepp.363–366andpp.376–380.

†Forgreaterdetail,seeChapter6.

*Formoreadviceon“well-establishedinvestmentfunds,”seeChapter9.“Professionaladministration”by“arecognizedinvestment-counselfirm”isdiscussedinChapter10.“Dollar-costaveraging”isexplainedinChapter5.

*SeeChapter8.

*In“sellingshort”(or“shorting”)astock,youmakeabetthatitssharepricewillgodown,notup.Shortingisathree-stepprocess:First,youborrowsharesfromsomeonewhoownsthem;thenyouimmediatelyselltheborrowedshares;finally,youreplacethemwithsharesyoubuylater.Ifthestockdrops,youwillbeabletobuyyourreplacementsharesatalowerprice.Thedifferencebetweenthepriceatwhichyousoldyourborrowedsharesandthepriceyoupaidforthereplacementsharesisyourgrossprofit(reducedbydividendorinterestcharges,alongwithbrokeragecosts).However,ifthestockgoesupinpriceinsteadofdown,yourpotentiallossisunlimited—makingshortsalesunacceptablyspeculativeformostindividualinvestors.

†Inthelate1980s,ashostilecorporatetakeoversandleveragedbuyoutsmultiplied,WallStreetsetupinstitutionalarbitragedeskstoprofitfromanyerrorsinpricingthesecomplexdeals.Theybecamesogoodatitthattheeasyprofitsdisappearedandmanyofthesedeskshavebeencloseddown.AlthoughGrahamdoesdiscussitagain(seepp.174–175),thissortoftradingisnolongerfeasibleorappropriateformostpeople,sinceonlymultimillion-dollartradesarelargeenoughtogenerateworthwhileprofits.Wealthyindividualsandinstitutionscanutilizethisstrategythroughhedgefundsthatspecializeinmergeror“event”arbitrage.

*TheRothschildfamily,ledbyNathanMayerRothschild,wasthedominantpowerinEuropeaninvestmentbankingandbrokerageinthenineteenthcentury.

Forabrillianthistory,seeNiallFerguson,TheHouseofRothschild:Money’sProphets,1798–1848(Viking,1998).

1Grahamgoesevenfurther,fleshingouteachofthekeytermsinhisdefinition:“thoroughanalysis”means“thestudyofthefactsinthelightofestablishedstandardsofsafetyandvalue”while“safetyofprincipal”signifies“protectionagainstlossunderallnormalorreasonablylikelyconditionsorvariations”and“adequate”(or“satisfactory”)returnrefersto“anyrateoramountofreturn,howeverlow,whichtheinvestoriswillingtoaccept,providedheactswithreasonableintelligence.”(SecurityAnalysis,1934ed.,pp.55–56).

2SecurityAnalysis,1934ed.,p.310.

3AsGrahamadvisedinaninterview,“Askyourself:Iftherewasnomarketfortheseshares,wouldIbewillingtohaveaninvestmentinthiscompanyontheseterms?”(Forbes,January1,1972,p.90.)

4Source:SteveGalbraith,SanfordC.Bernstein&Co.researchreport,January10,2000.Thestocksinthistablehadanaveragereturnof1196.4%in1999.Theylostanaverageof79.1%in2000,35.5%in2001,and44.5%in2002—destroyingallthegainsof1999,andthensome.

5Insteadofstargazing,StreisandshouldhavebeenchannelingGraham.Theintelligentinvestorneverdumpsastockpurelybecauseitssharepricehasfallen;shealwaysasksfirstwhetherthevalueofthecompany’sunderlyingbusinesseshas

changed.

6Just12monthslater,Juno’sshareshadshriveledto$1.093.

7Atickersymbolisanabbreviation,usuallyonetofourletterslong,ofacompany’snameusedasshorthandtoidentifyastockfortradingpurposes.

8Thiswasnotanisolatedincident;onatleastthreeotheroccasionsinthelate1990s,daytraderssentthewrongstocksoaringwhentheymistookitstickersymbolforthatofanewlymintedInternetcompany.

9In2000and2001,Amazon.comandQualcommlostacumulativetotalof85.8%and71.3%oftheirvalue,respectively.

10Schwertdiscussesthesefindingsinabrilliantresearchpaper,“AnomaliesandMarketEfficiency,”availableathttp://schwert.ssb.rochester.edu/papers.htm.

11SeePlexusGroupCommentary54,“TheOfficialIcebergsofTransactionCosts,”January,1998,atwww.plexusgroup.com/fs_research.html.

12JamesO’Shaughnessy,WhatWorksonWallStreet(McGraw-Hill,1996),pp.xvi,273–295.

13Inaremarkableirony,thesurvivingtwoO’Shaughnessyfunds(nowknownastheHennessyfunds)beganperformingquitewelljustasO’Shaughnessyannouncedthathewasturningoverthemanagementtoanothercompany.Thefunds’shareholders

werefurious.Inachatroomatwww.morningstar.com,onefumed:“Iguess‘longterm’forO’Sis3years….Ifeelyourpain.I,too,hadfaithinO’S’smethod….Ihadtoldseveralfriendsandrelativesaboutthisfund,andnowamgladtheydidn’tactonmyadvice.”

14SeeJasonZweig,“FalseProfits,”Money,August,1999,pp.55–57.AthoroughdiscussionofTheFoolishFourcanalsobefoundatwww.investorhome.com/fool.htm.

*Thelistofsourcesforinvestmentadviceremainsas“miscellaneous”asitwaswhenGrahamwrote.Asurveyofinvestorsconductedinlate2002fortheSecuritiesIndustryAssociation,aWallStreettradegroup,foundthat17%ofinvestorsdependedmostheavilyforinvestmentadviceonaspouseorfriend;2%ona

banker;16%onabroker;10%onfinancialperiodicals;and24%onafinancialplanner.TheonlydifferencefromGraham’sdayisthat8%ofinvestorsnowrelyheavilyontheInternetand3%onfinancialtelevision.(Seewww.sia.com.)

*Thecharacterofinvestmentcounselingfirmsandtrustbankshasnotchanged,buttodaytheygenerallydonotoffertheirservicestoinvestorswithlessthan$1millioninfinancialassets;insomecases,$5millionormoreisrequired.Todaythousandsofindependentfinancial-planningfirmsperformverysimilarfunctions,although(asanalystRobertVeresputsit)themutualfundhasreplacedblue-chipstocksastheinvestmentofchoiceanddiversificationhasreplaced“quality”asthestandardofsafety.

*Overall,GrahamwasastoughandcynicalanobserverasWallStreethaseverseen.Inthisrarecase,however,hewasnotnearlycynicalenough.WallStreetmayhavehigherethicalstandardsthansomebusinesses(smuggling,prostitution,Congressionallobbying,andjournalismcometomind)buttheinvestmentworldneverthelesshasenoughliars,cheaters,andthievestokeepSatan’scheck-inclerksfranticallybusyfordecadestocome.

†Thethousandsofpeoplewhoboughtstocksinthelate1990sinthebeliefthatWallStreetanalystswereprovidingunbiasedandvaluableadvicehavelearned,inapainfulway,howrightGrahamisonthispoint.

†‡Interestingly,thisstingingcriticism,

whichinhisdayGrahamwasdirectingatfull-servicebrokers,endedupapplyingtodiscountInternetbrokersinthelate1990s.Thesefirmsspentmillionsofdollarsonflashyadvertisingthatgoadedtheircustomersintotradingmoreandtradingfaster.Mostofthosecustomersendeduppickingtheirownpockets,insteadofpayingsomeoneelsetodoitforthem—andthecheapcommissionsonthatkindoftransactionareapoorconsolationfortheresult.Moretraditionalbrokeragefirms,meanwhile,beganemphasizingfinancialplanningand“integratedassetmanagement,”insteadofcompensatingtheirbrokersonlyonthebasisofhowmanycommissionstheycouldgenerate.

*Thisremainstrue,althoughmanyofWallStreet’sbestanalystsholdthetitleofcharteredfinancialanalyst.TheCFA

certificationisawardedbytheAssociationofInvestmentManagement&Research(formerlytheFinancialAnalystsFederation)onlyafterthecandidatehascompletedyearsofrigorousstudyandpassedaseriesofdifficultexams.Morethan50,000analystsworldwidehavebeencertifiedasCFAs.Sadly,arecentsurveybyProfessorStanleyBlockfoundthatmostCFAsignoreGraham’steachings:Growthpotentialrankshigherthanqualityofearnings,risks,anddividendpolicyindeterminingP/Eratios,whilefarmoreanalystsbasetheirbuyratingsonrecentpricethanonthelong-termoutlookforthecompany.SeeStanleyBlock,“AStudyofFinancialAnalysts:PracticeandTheory,”FinancialAnalystsJournal,July/August,1999,atwww.aimrpubs.org.AsGrahamwasfondofsaying,hisownbookshavebeenreadby—andignoredby—more

peoplethananyotherbooksinfinance.

*Itishighlyunusualtodayforasecurityanalysttoallowmerecommonerstocontacthimdirectly.Forthemostpart,onlythenobilityofinstitutionalinvestorsarepermittedtoapproachthethroneofthealmightyWallStreetanalyst.Anindividualinvestormight,perhaps,havesomeluckcallinganalystswhoworkat“regional”brokeragefirmsheadquarteredoutsideofNewYorkCity.Theinvestorrelationsareaatthewebsitesofmostpubliclytradedcompanieswillprovidealistofanalystswhofollowthestock.Websiteslikewww.zacks.comandwww.multex.comofferaccesstoanalysts’researchreports—buttheintelligentinvestorshouldrememberthatmostanalystsdonotanalyzebusinesses.Instead,theyengageinguessworkaboutfuturestockprices.

†BenjaminGrahamwastheprimeforcebehindtheestablishmentoftheCFAprogram,whichheadvocatedfornearlytwodecadesbeforeitbecameareality.

*ThetwofirmsGrahamhadinmindwereprobablyDuPont,Glore,Forgan&Co.andGoodbody&Co.DuPont(foundedbytheheirstothechemicalfortune)wassavedfrominsolvencyin1970onlyafterTexasentrepreneurH.RossPerotlentmorethan$50milliontothefirm;Goodbody,thefifth-largestbrokeragefirmintheUnitedStates,wouldhavefailedinlate1970hadMerrillLynchnotacquiredit.Hayden,Stone&Co.wouldalsohavegoneunderifithadnotbeenacquired.In1970,nofewerthansevenbrokeragefirmswentbust.ThefarcicalstoryofWallStreet’sfrenziedover-expansioninthelate1960sisbeautifullytoldinJohnBrooks’s

TheGo-GoYears(JohnWiley&Sons,NewYork,1999).

*Nearlyallbrokeragetransactionsarenowconductedelectronically,andsecuritiesarenolongerphysically“delivered.”ThankstotheestablishmentoftheSecuritiesInvestorProtectionCorporation,orSIPC,in1970,investorsaregenerallyassuredofrecoveringtheirfullaccountvaluesiftheirbrokeragefirmbecomesinsolvent.SIPCisagovernment-mandatedconsortiumofbrokers;allthemembersagreetopooltheirassetstocoverlossesincurredbythecustomersofanyfirmthatbecomesinsolvent.SIPC’sprotectioneliminatestheneedforinvestorstomakepaymentandtakedeliverythroughabankintermediary,asGrahamurges.

*ThosewhoheededGraham’sadvicewouldnothavebeensuckeredintobuyingInternetIPOsin1999and2000.

†Thistraditionalroleofbankershasforthemostpartbeensupplantedbyaccountants,lawyers,orfinancialplanners.

1Foraparticularlythoughtfuldiscussionoftheseissues,seeWalterUpdegrave,“AdviceonAdvice,”Money,January,2003,pp.53–55.

2Ifyou’reunabletogetareferralfromsomeoneyoutrust,youmaybeabletofindafee-onlyfinancialplannerthroughwww.napfa.org(orwww.feeonly.org),whosemembersaregenerallyheldtohighstandardsofserviceandintegrity.

3Byitself,acustomercomplaintisnotenoughtodisqualifyanadviserfromyourconsideration;butapersistentpatternofcomplaintsis.AndadisciplinaryactionbystateorFederalregulatorsusuallytellsyoutofindanotheradviser.Anothersourceforcheckingabroker’srecordishttp://pdpi.nasdr.com/PDPI.

4RobertVeres,editorandpublisheroftheInsideInformationnewsletter,generouslysharedtheseresponsesforthisbook.Otherchecklistsofquestionscanbefoundatwww.cfp-board.organdwww.napfa.org.

5CredentialsliketheCFA,CFP,orCPAtellyouthattheadviserhastakenandpassedarigorouscourseofstudy.(Mostoftheother“alphabetsoup”ofcredentialsbrandishedbyfinancialplanners,including

the“CFM”orthe“CMFC,”signifyverylittle.)Moreimportant,bycontactingtheorganizationthatawardsthecredential,youcanverifyhisrecordandcheckthathehasnotbeendisciplinedforviolationsofrulesorethics.

6Ifyouhavelessthan$100,000toinvest,youmaynotbeabletofindafinancialadviserwhowilltakeyouraccount.Inthatcase,buyadiversifiedbasketoflow-costindexfunds,followthebehavioraladvicethroughoutthisbook,andyourportfolioshouldeventuallygrowtothelevelatwhichyoucanaffordanadviser.

*TheNationalFederationofFinancialAnalystsisnowtheAssociationforInvestmentManagementandResearch;its“quarterly”researchpublication,theFinancialAnalystsJournal,nowappears

everyothermonth.

*Thehigherthegrowthrateyouproject,andthelongerthefutureperiodoverwhichyouprojectit,themoresensitiveyourforecastbecomestotheslightesterror.If,forinstance,youestimatethatacompanyearning$1persharecanraisethatprofitby15%ayearforthenext15years,itsearningswouldendupat$8.14.Ifthemarketvaluesthecompanyat35timesearnings,thestockwouldfinishtheperiodatroughly$285.Butifearningsgrowat14%insteadof15%,thecompanywouldearn$7.14attheendoftheperiod—and,intheshockofthatshortfall,investorswouldnolongerbewillingtopay35timesearnings.At,say,20timesearnings,thestockwouldenduparound$140pershare,ormorethan50%less.Becauseadvancedmathematicsgivestheappearanceof

precisiontotheinherentlyiffyprocessofforeseeingthefuture,investorsmustbehighlyskepticalofanyonewhoclaimstoholdanycomplexcomputationalkeytobasicfinancialproblems.AsGrahamputit:“In44yearsofWallStreetexperienceandstudy,Ihaveneverseendependablecalculationsmadeaboutcommon-stockvalues,orrelatedinvestmentpolicies,thatwentbeyondsimplearithmeticorthemostelementaryalgebra.Whenevercalculusisbroughtin,orhigheralgebra,youcouldtakeitasawarningsignalthattheoperatorwastryingtosubstitutetheoryforexperience,andusuallyalsotogivetospeculationthedeceptiveguiseofinvestment.”(Seep.570.)

*In1972,aninvestorincorporatebondshadlittlechoicebuttoassemblehisorherownportfolio.Today,roughly500mutual

fundsinvestincorporatebonds,creatingaconvenient,well-diversifiedbundleofsecurities.Sinceitisnotfeasibletobuildadiversifiedbondportfolioonyourownunlessyouhaveatleast$100,000,thetypicalintelligentinvestorwillbebestoffsimplybuyingalow-costbondfundandleavingthepainstakinglaborofcreditresearchtoitsmanagers.Formoreonbondfunds,seethecommentaryonChapter4.

*By“juniorstockissues”Grahammeanssharesofcommonstock.Preferredstockisconsidered“senior”tocommonstockbecausethecompanymustpayalldividendsonthepreferredbeforepayinganydividendsonthecommon.

*Afterinvestorslostbillionsofdollarsonthesharesofrecklesslyassembledutility

companiesin1929–1932,CongressauthorizedtheSECtoregulatetheissuanceofutilitystocksunderthePublicUtilityHoldingCompanyActof1935.

*Inmorerecentyears,mostmutualfundshavealmostroboticallymimickedtheStandard&Poor’s500-stockindex,lestanydifferentholdingscausetheirreturnstodeviatefromthatoftheindex.Inacountertrend,somefundcompanieshavelaunchedwhattheycall“focused”portfolios,whichown25to50stocksthatthemanagersdeclaretobetheir“bestideas.”Thatleavesinvestorswonderingwhethertheotherfundsrunbythesamemanagerscontaintheirworstideas.Consideringthatmostofthe“bestidea”fundsdonotmarkedlyoutperformtheaverages,investorsarealsoentitledtowonderwhetherthemanagers’ideasare

evenworthhavinginthefirstplace.ForindisputablyskilledinvestorslikeWarrenBuffett,widediversificationwouldbefoolish,sinceitwouldwaterdowntheconcentratedforceofafewgreatideas.Butforthetypicalfundmanagerorindividualinvestor,notdiversifyingisfoolish,sinceitissodifficulttoselectalimitednumberofstocksthatwillincludemostwinnersandexcludemostlosers.Asyouownmorestocks,thedamageanysinglelosercancausewilldecline,andtheoddsofowningallthebigwinnerswillrise.Theidealchoiceformostinvestorsisatotalstockmarketindexfund,alow-costwaytoholdeverystockworthowning.

*Graham’spointaboutchemicalandoilcompaniesinthe1960sappliestonearlyeveryindustryinnearlyeverytimeperiod.WallStreet’sconsensusviewofthefuture

foranygivensectorisusuallyeithertoooptimisticortoopessimistic.Worse,theconsensusisatitsmostcheeryjustwhenthestocksaremostoverpriced—andgloomiestjustwhentheyarecheapest.Themostrecentexample,ofcourse,istechnologyandtelecommunicationsstocks,whichhitrecordhighswhentheirfutureseemedbrightestin1999andearly2000,andthencrashedallthewaythrough2002.HistoryprovesthatWallStreet’s“expert”forecastersareequallyineptatpredictingtheperformanceof1)themarketasawhole,2)industrysectors,and3)specificstocks.AsGrahampointsout,theoddsthatindividualinvestorscandoanybetterarenotgood.Theintelligentinvestorexcelsbymakingdecisionsthatarenotdependentontheaccuracyofanybody’sforecasts,includinghisorherown.(SeeChapter8.)

*Thisfigure,nowknownasthe“dividendpayoutratio,”hasdroppedconsiderablysinceGraham’sdayasAmericantaxlawdiscouragedinvestorsfromseeking,andcorporationsfrompaying,dividends.Asofyear-end2002,thepayoutratiostoodat34.1%fortheS&P500-stockindexand,asrecentlyasApril2000,ithitanall-timelowofjust25.3%.(Seewww.barra.com/research/fundamentals.asp.)WediscussdividendpolicymorethoroughlyinthecommentaryonChapter19.

*Whyisthis?By“theruleof72,”at10%interestagivenamountofmoneydoublesinjustoversevenyears,whileat7%itdoublesinjustover10years.Wheninterestratesarehigh,theamountofmoneyyouneedtosetasidetodaytoreachagivenvalueinthefutureislower—sincethosehighinterestrateswillenableitto

growatamorerapidrate.Thusariseininterestratestodaymakesafuturestreamofearningsordividendslessvaluable—sincethealternativeofinvestinginbondshasbecomerelativelymoreattractive.

*Theseindustrygroups,ideally,wouldnotbeoverlydependentonsuchunforeseeablefactorsasfluctuatinginterestratesorthefuturedirectionofpricesforrawmaterialslikeoilormetals.Possibilitiesmightbeindustrieslikegaming,cosmetics,alcoholicbeverages,nursinghomes,orwastemanagement.

1Becausesofewoftoday’sindividualinvestorsbuy—orshouldbuy—individualbonds,wewilllimitthisdiscussiontostockanalysis.Formoreonbondfunds,seethecommentaryonChapter4.

2Youshouldalsogetatleastoneyear’sworthofquarterlyreports(onForm10-Q).Bydefinition,weareassumingthatyouarean“enterprising”investorwillingtodevoteaconsiderableamountofefforttoyourportfolio.Ifthestepsinthischaptersoundliketoomuchworktoyou,thenyouarenottemperamentallywellsuitedtopickingyourownstocks.Youcannotreliablyobtaintheresultsyouimagineunlessyouputinthekindofeffortwedescribe.

3Youcanusuallyfinddetailsonacquisitionsinthe“Management’sDiscussionandAnalysis”sectionofForm10-K;cross-checkitagainstthefootnotestothefinancialstatements.Formoreon“serialacquirers,”seethecommentaryonChapter12.

4TodeterminewhetheracompanyisanOPMaddict,readthe“StatementofCashFlows”inthefinancialstatements.Thispagebreaksdownthecompany’scashinflowsandoutflowsinto“operatingactivities,”“investingactivities,”and“financingactivities.”Ifcashfromoperatingactivitiesisconsistentlynegative,whilecashfromfinancingactivitiesisconsistentlypositive,thecompanyhasahabitofcravingmorecashthanitsownbusinessescanproduce—andyoushouldnotjointhe“enablers”ofthathabitualabuse.FormoreonGlobalCrossing,seethecommentaryonChapter12.FormoreonWorldCom,seethesidebarinthecommentaryonChapter6.

5Formoreinsightinto“moats,”seetheclassicbookCompetitiveStrategybyHarvardBusinessSchoolprofessor

MichaelE.Porter(FreePress,NewYork,1998).

6SeeCyrusA.Ramezani,LucSoenen,andAlanJung,“Growth,CorporateProfitability,andValueCreation,”FinancialAnalystsJournal,November/December,2002,pp.56–67;alsoavailableathttp://cyrus.cob.calpoly.edu/.

7JasonZweigisanemployeeofAOLTimeWarnerandholdsoptionsinthecompany.Formoreabouthowstockoptionswork,seethecommentaryonChapter19,p.507.

8Seenote19inthecommentaryonChapter19,p.508.

9Formoreontheseissues,seethecommentaryonChapter12andthesuperbessaybyJosephFullerandMichaelC.

Jensen,“JustSayNotoWallStreet,”athttp://papers.ssrn.com.

10StocksplitsarediscussedfurtherinthecommentaryonChapter13.

*“Dilution”isoneofmanywordsthatdescribestocksinthelanguageoffluiddynamics.Astockwithhightradingvolumeissaidtobe“liquid.”WhenacompanygoespublicinanIPO,it“floats”itsshares.And,inearlierdays,acompanythatdrasticallydiluteditsshares(withlargeamountsofconvertibledebtormultipleofferingsofcommonstock)wassaidtohave“watered”itsstock.ThistermisbelievedtohaveoriginatedwiththelegendarymarketmanipulatorDanielDrew(1797–1879),whobeganasalivestocktrader.HewoulddrivehiscattlesouthtowardManhattan,force-feeding

themsaltalongtheway.WhentheygottotheHarlemRiver,theywouldguzzlehugevolumesofwatertoslaketheirthirst.Drewwouldthenbringthemtomarket,wherethewatertheyhadjustdrunkwouldincreasetheirweight.Thatenabledhimtogetamuchhigherprice,sincecattleonthehoofissoldbythepound.DrewlaterwateredthestockoftheErieRailroadbymassivelyissuingnewshareswithoutwarning.

†GrahamisreferringtotheprecisecraftsmanshipoftheimmigrantItalianstonecarverswhoornamentedtheotherwiseplainfacadesofbuildingsthroughoutNewYorkintheearly1900s.Accountants,likewise,cantransformsimplefinancialfactsintointricateandevenincomprehensiblepatterns.

*Thekingprobablytookhisinspirationfromaonce-famousessaybytheEnglishwriterWilliamHazlitt,whomusedaboutasundialnearVenicethatborethewordsHorasnonnumeronisiserenas,or“Icountonlythehoursthatareserene.”Companiesthatchronicallyexcludebadnewsfromtheirfinancialresultsonthepretextthatnegativeeventsare“extraordinary”or“nonrecurring”aretakingapagefromHazlitt,whourgedhisreaders“totakenonoteoftimebutbyitsbenefits,towatchonlyforthesmilesandneglectthefrownsoffate,tocomposeourlivesofbrightandgentlemoments,turningawaytothesunnysideofthings,andlettingtherestslipfromourimaginations,unheededorforgotten!”(WilliamHazlitt,“OnaSun-Dial,”ca.1827.)Unfortunately,investorsmustalwayscountthesunnyanddarkhoursalike.

*ThecompanytowhichGrahamreferssocoylyappearstobeAmericanMachine&Foundry(orAMFCorp.),oneofthemostjumbledconglomeratesofthelate1960s.Itwasapredecessoroftoday’sAMFBowlingWorldwide,whichoperatesbowlingalleysandmanufacturesbowlingequipment.

*Nowadays,investorsneedtobeawareofseveralother“accountingfactors”thatcandistortreportedearnings.Oneis“proforma”or“asif”financialstatements,whichreportacompany’searningsasifGenerallyAcceptedAccountingPrinciples(GAAP)didnotapply.Anotheristhedilutiveeffectofissuingmillionsofstockoptionsforexecutivecompensation,thenbuyingbackmillionsofsharestokeepthoseoptionsfromreducingthevalueofthecommonstock.Athirdisunrealisticassumptionsofreturnonthecompany’s

pensionfunds,whichcanartificiallyinflateearningsingoodyearsanddepresstheminbad.Anotheris“SpecialPurposeEntities,”oraffiliatedfirmsorpartnershipsthatbuyriskyassetsorliabilitiesofthecompanyandthus“remove”thosefinancialrisksfromthecompany’sbalancesheet.Anotherelementofdistortionisthetreatmentofmarketingorother“soft”costsasassetsofthecompany,ratherthanasnormalexpensesofdoingbusiness.Wewillbrieflyexaminesuchpracticesinthecommentarythataccompaniesthischapter.

*NorthwestIndustrieswastheholdingcompanyfor,amongotherbusinesses,theChicagoandNorthwesternRailwayCo.andUnionUnderwear(themakerofbothBVDandFruitoftheLoombriefs).Itwastakenoverin1985byoverindebtedfinancierWilliamFarley,whoranthe

companyintotheground.FruitoftheLoomwasboughtinabankruptcyproceedingbyWarrenBuffett’sBerkshireHathawayInc.inearly2002.

*GrahamisreferringtotheprovisionofFederaltaxlawthatallowscorporationsto“carryforward”theirnetoperatinglosses.Asthetaxcodenowstands,theselossescanbecarriedforwardforupto20years,reducingthecompany’staxliabilityfortheentireperiod(andthusraisingitsearningsaftertax).Therefore,investorsshouldconsiderwhetherrecentseverelossescouldactuallyimprovethecompany’snetearningsinthefuture.

†Investorsshouldkeepthesewordsathandandremindthemselvesofthemfrequently:“Stockvaluationsarereallydependableonlyinexceptionalcases.”

Whilethepricesofmoststocksareapproximatelyrightmostofthetime,thepriceofastockandthevalueofitsbusinessarealmostneveridentical.Themarket’sjudgmentonpriceisoftenunreliable.Unfortunately,themarginofthemarket’spricingerrorsisoftennotwideenoughtojustifytheexpenseoftradingonthem.Theintelligentinvestormustcarefullyevaluatethecostsoftradingandtaxesbeforeattemptingtotakeadvantageofanypricediscrepancy—andshouldnevercountonbeingabletosellfortheexactpricecurrentlyquotedinthemarket.

*“Meanfigure”referstothesimple,orarithmetic,averagethatGrahamdescribesintheprecedingsentence.

aThree-fifthsofspecialchargesof82centsin1970deductedhere.

*Grahamappearstobeusing“earningsoncapitalfunds”inthetraditionalsenseofreturnonbookvalue—essentially,netincomedividedbythecompany’stangiblenetassets.

*Seepp.299–301.

†Recenthistory—andamountainoffinancialresearch—haveshownthatthemarketisunkindesttorapidlygrowingcompaniesthatsuddenlyreportafallinearnings.Moremoderateandstablegrowers,asALCOAwasinGraham’sdayorAnheuser-BuschandColgate-Palmoliveareinourtime,tendtosuffersomewhatmilderstockdeclinesiftheyreportdisappointingearnings.Greatexpectationsleadtogreatdisappointmentiftheyarenotmet;afailuretomeetmoderate

expectationsleadstoamuchmilderreaction.Thus,oneofthebiggestrisksinowninggrowthstocksisnotthattheirgrowthwillstop,butmerelythatitwillslowdown.Andinthelongrun,thatisnotmerelyarisk,butavirtualcertainty.

1Formoreonhowstockoptionscanenrichcorporatemanagers—butnotnecessarilyoutsideshareholders—seethecommentaryonChapter19.

2Alltheaboveexamplesaretakendirectlyfrompressreleasesissuedbythecompaniesthemselves.Forabrilliantsatireonwhatdailylifewouldbelikeifweallgottojustifyourbehaviorthesamewaycompaniesadjusttheirreportedearnings,see“MyProFormaLife,”byRobWalker,athttp://slate.msn.com/?id=2063953.(“…arecentpost-workoutlunchofa22-ounce,

bone-inribsteakatSmith&Wollenskyandthreeshotsofbourbonistreatedhereasanonrecurringexpense.I’llneverdothatagain!”)

3In2002,Qwestwasoneof330publicly-tradedcompaniestorestatepastfinancialstatements,anall-timerecord,accordingtoHuronConsultingGroup.AllinformationonQwestistakenfromitsfinancialfilingswiththeU.S.SecuritiesandExchangeCommission(annualreport,Form8K,andForm10-K)foundintheEDGARdatabaseatwww.sec.gov.Nohindsightwasrequiredtodetectthe“changeinaccountingprinciple,”whichQwestfullydisclosedatthetime.HowdidQwest’ssharesdooverthisperiod?Atyear-end2000,thestockhadbeenat$41pershare,atotalmarketvalueof$67.9billion.Byearly2003,Qwestwasaround$4,valuingtheentirecompany

atlessthan$7billion—a90%loss.Thedropinsharepriceisnottheonlycostassociatedwithbogusearnings;arecentstudyfoundthatasampleof27firmsaccusedofaccountingfraudbytheSEChadoverpaid$320millioninFederalincometax.AlthoughmuchofthatmoneywilleventuallyberefundedbytheIRS,mostshareholdersareunlikelytostickaroundtobenefitfromtherefunds.(SeeMerleErickson,MichelleHanlon,andEdwardMaydew,“HowMuchWillFirmsPayforEarningsthatDoNotExist?”athttp://papers.ssrn.com.)

4GlobalCrossingformerlytreatedmuchofitsconstructioncostsasanexpensetobechargedagainsttherevenuegeneratedfromthesaleorleaseofusagerightsonitsnetwork.Customersgenerallypaidfortheirrightsupfront,althoughsomecould

payininstallmentsoverperiodsofuptofouryears.ButGlobalCrossingdidnotbookmostoftherevenuesupfront,insteaddeferringthemoverthelifetimeofthelease.Now,however,becausethenetworkshadanestimatedusablelifeofupto25years,GlobalCrossingbegantreatingthemasdepreciable,long-livedcapitalassets.WhilethistreatmentconformswithGenerallyAcceptedAccountingPrinciples,itisunclearwhyGlobalCrossingdidnotuseitbeforeOctober1,1999,orwhatexactlypromptedthechange.AsofMarch2001,GlobalCrossinghadatotalstockvaluationof$12.6billion;thecompanyfiledforbankruptcyonJanuary28,2002,renderingitscommonstockessentiallyworthless.

5IamgratefultoHowardSchilitandMarkHameloftheCenterforFinancial

ResearchandAnalysisforprovidingthisexample.

6Returnsareapproximatedbydividingthetotalnetvalueofplanassetsatthebeginningoftheyearby“actualreturnonplanassets.”

7Donotbeputoffbythestupefyinglyboringverbiageofaccountingfootnotes.Theyaredesignedexpresslytodeternormalpeoplefromactuallyreadingthem—whichiswhyyoumustpersevere.Afootnotetothe1996annualreportofInformixCorp.,forinstance,disclosedthat“TheCompanygenerallyrecognizeslicenserevenuefromsalesofsoftwarelicensesupondeliveryofthesoftwareproducttoacustomer.However,forcertaincomputerhardwaremanufacturersandend-userlicenseeswithamountspayablewithin

twelvemonths,theCompanywillrecognizerevenueatthetimethecustomermakesacontractualcommitmentforaminimumnonrefundablelicensefee,ifsuchcomputerhardwaremanufacturersandend-userlicenseesmeetcertaincriteriaestablishedbytheCompany.”InplainEnglish,Informixwassayingthatitwouldcredititselfforrevenuesonproductseveniftheyhadnotyetbeenresoldto“end-users”(theactualcustomersforInformix’ssoftware).AmidallegationsbytheU.S.SecuritiesandExchangeCommissionthatInformixhadcommittedaccountingfraud,thecompanylaterrestateditsrevenues,wipingaway$244millioninsuch“sales.”Thiscaseisakeenreminderoftheimportanceofreadingthefineprintwithaskepticaleye.IamindebtedtoMartinFridsonforsuggestingthisexample.

8MartinFridsonandFernandoAlvarez,FinancialStatementAnalysis:APractitioner’sGuide(JohnWiley&Sons,NewYork,2002);CharlesW.MulfordandEugeneE.Comiskey,TheFinancialNumbersGame:DetectingCreativeAccountingPractices(JohnWiley&Sons,NewYork,2002);HowardSchilit,FinancialShenanigans(McGraw-Hill,NewYork,2002).BenjaminGraham’sownbook,TheInterpretationofFinancialStatements(HarperBusiness,NewYork,1998reprintof1937edition),remainsanexcellentbriefintroductiontothebasicprinciplesofearningsandexpenses,assetsandliabilities.

*OfGraham’sfourexamples,onlyEmersonElectricstillexistsinthesameform.ELTRACorp.isnolongeranindependentcompany;itmergedwith

BunkerRamoCorp.inthe1970s,puttingitinthebusinessofsupplyingstockquotestobrokeragefirmsacrossanearlynetworkofcomputers.WhatremainsofELTRA’soperationsisnowpartofHoneywellCorp.ThefirmformerlyknownasEmeryAirFreightisnowadivisionofCNFInc.EmhartCorp.wasacquiredbyBlack&DeckerCorp.in1989.

*Thismeasureiscapturedintheline“Netpershare/bookvalue”inTable13-2,whichmeasuresthecompanies’netincomeasapercentageoftheirtangiblebookvalue.

*Ineachcase,GrahamisreferringtoSectionCofTable13-2anddividingthehighpriceduringthe1936–1968periodbythelowprice.Forexample,Emery’shighpriceof66dividedbyitslowpriceof1/8equals528,oraratioof528to1between

thehighandlow.

*Attheendof1970,Emerson’s$1.6billioninmarketvaluetrulywas“enormous,”givenaveragestocksizesatthetime.Atyear-end2002,Emerson’scommonstockhadatotalmarketvalueofapproximately$21billion.

*Grahamwasright.Ofthe“NiftyFifty”stocksthatweremostfashionableandhighlyvaluedin1972,Emeryfaredamongtheworst.TheMarch1,1982,issueofForbesreportedthatsince1972Emeryhadlost72.8%ofitsvalueafterinflation.Bylate1974,accordingtotheinvestmentresearchersattheLeutholdGroupinMinneapolis,Emery’sstockhadalreadyfallen58%anditsprice/earningsratiohadplummetedfrom64timestojust15.The“overenthusiasm”Grahamhadwarned

againstwasevisceratedinshortorder.Canthepassageoftimemakeupforthiskindofexcess?Notalways:Leutholdcalculatedthat$1000investedinEmeryin1972wouldbeworthonly$839asof1999.It’slikelythatthepeoplewhooverpaidforInternetstocksinthelate1990swillnotbreakevenfordecades—ifever(seethecommentaryonChapter20).

*Graham’spointisthat,basedontheirpricesatthetime,aninvestorcouldbuysharesinthesetwocompaniesforlittlemorethantheirbookvalue,asshowninthethirdlineofSectionBinTable13-2.

1AswewillseeinChapter19,thisrationaleoftenmeans,inpractice,“toprovidefundsforthecontinuedgrowthofthecompany’stopmanagers’wealth.”

2AppearingonCNBConDecember30,1999,EMC’schiefexecutive,MichaelRuettgers,wasaskedbyhostRonInsanawhether“2000andbeyond”wouldbeasgoodasthe1990shadbeen.“Itactuallylookslikeit’saccelerating,”boastedRuettgers.WhenInsanaaskedifEMC’sstockwasovervalued,Ruettgersanswered:“Ithinkwhenyoulookattheopportunitywehaveinfrontofus,it’salmostunlimited….Sowhileit’shardtopredictwhetherthesethingsareoverpriced,there’ssuchamajorchangetakingplacethatifyoucouldfindthewinnerstoday—andIcertainlythinkEMCisoneofthosepeople—you’llbewellrewardedinthefuture.”

3The“Y2Kbug”orthe“Year2000Problem”wasthebeliefthatmillionsofcomputersworldwidewouldstop

functioningatonesecondpastmidnightonthemorningofJanuary1,2000,becauseprogrammersinthe1960sand1970shadnotthoughttoallowforthepossibilityofanydatepast12/31/1999intheiroperatingcode.U.S.companiesspentbillionsofdollarsin1999toensurethattheircomputerswouldbe“Y2K-compliant.”Intheend,at12:00:01A.M.onJanuary1,2000,everythingworkedjustfine.

4Formoreonthefollyofstocksplits,seeJasonZweig,“Splitsville,”Money,March,2001,pp.55–56.

5Postingno.3622,December7,1999,attheExodusCommunicationsmessageboardontheRagingBullwebsite(http://ragingbull.lycos.com/mboard/boards.cgi?board=EXDS&read=3622).

6Postingno.3910,December15,1999,attheExodusCommunicationsmessageboardontheRagingBullwebsite(http://ragingbull.lycos.com/mboard/boards.cgi?board=EXDS&read=3910).

7SeeGraham’sspeech,“TheNewSpeculationinCommonStocks,”intheAppendix,p.563.

*GrahamdescribeshisrecommendedinvestmentpoliciesinChapters4through7.

†AswehavediscussedinthecommentariesonChapters5and9,today’sdefensiveinvestorcanachievethisgoalsimplybybuyingalow-costindexfund,ideallyonethattracksthereturnofthe

totalU.S.stockmarket.

*Inearly2003,theyieldon10-year,AA-ratedcorporatebondswasaround4.6%,suggesting—byGraham’sformula—thatastockportfolioshouldhaveanearnings-to-priceratioatleastthathigh.Takingtheinverseofthatnumber(bydividing4.6into100),wecanderivea“suggestedmaximum”P/Eratioof21.7.AtthebeginningofthisparagraphGrahamrecommendsthatthe“average”stockbepricedabout20%belowthe“maximum”ratio.Thatsuggeststhat—ingeneral—Grahamwouldconsiderstockssellingatnomorethan17timestheirthree-yearaverageearningstobepotentiallyattractivegiventoday’sinterestratesandmarketconditions.AsofDecember31,2002,morethan200—orbetterthan40%—ofthestocksintheS&P500-stockindex

hadthree-yearaverageP/Eratiosof17.0orlower.UpdatedAAbondyieldscanbefoundatwww.bondtalk.com.

*Aneasy-to-useonlinestockscreenerthatcansortthestocksintheS&P500bymostofGraham’scriteriaisavailableat:www.quicken.com/investments/stocks/search/full.

†WhenGrahamwrote,onlyonemajormutualfundspecializinginutilitystocks—FranklinUtilities—waswidelyavailable.Todaytherearemorethan30.Grahamcouldnothaveanticipatedthefinancialhavocwroughtbycanceledanddecommissionednuclearenergyplants;nordidheforeseetheconsequencesofbungledregulationinCalifornia.UtilitystocksarevastlymorevolatilethantheywereinGraham’sday,andmostinvestorsshould

ownthemonlythroughawell-diversified,low-costfundliketheDowJonesU.S.UtilitiesSectorIndexFund(tickersymbol:IDU)orUtilitiesSelectSectorSPDR(XLU).Formoreinformation,see:www.ishares.comandwww.spdrindex.com/spdr/.(Besureyourbrokerwillnotchargecommissionstoreinvestyourdividends.)

*InaremarkableconfirmationofGraham’spoint,thedull-soundingStandard&Poor’sUtilityIndexoutperformedthevauntedNASDAQCompositeIndexforthe30yearsendingDecember31,2002.

*Todaythefinancial-servicesindustryismadeupofevenmorecomponents,includingcommercialbanks;savings&loanandmortgage-financingcompanies;

consumer-financefirmslikecredit-cardissuers;moneymanagersandtrustcompanies;investmentbanksandbrokerages;insurancecompanies;andfirmsengagedindevelopingorowningrealestate,includingreal-estateinvestmenttrusts.Althoughthesectorismuchmorediversifiedtoday,Graham’scaveatsaboutfinancialsoundnessapplymorethanever.

*Onlyafewmajorrailstocksnowremain,includingBurlingtonNorthern,CSX,NorfolkSouthern,andUnionPacific.Theadviceinthissectionisatleastasrelevanttoairlinestockstoday—withtheirmassivecurrentlossesandahalf-centuryofalmostincessantlypoorresults—asitwastorailroadsinGraham’sday.

*Grahamissummarizingthe“efficientmarketshypothesis,”orEMH,an

academictheoryclaimingthatthepriceofeachstockincorporatesallpubliclyavailableinformationaboutthecompany.Withmillionsofinvestorsscouringthemarketeveryday,itisunlikelythatseveremispricingscanpersistforlong.Anoldjokehastwofinanceprofessorswalkingalongthesidewalk;whenonespotsa$20billandbendsovertopickitup,theothergrabshisarmandsays,“Don’tbother.Ifitwasreallya$20bill,someonewouldhavetakenitalready.”Whilethemarketisnotperfectlyefficient,itisprettyclosemostofthetime—sotheintelligentinvestorwillstooptopickupthestockmarket’s$20billsonlyafterresearchingthemthoroughlyandminimizingthecostsoftradingandtaxes.

*ThisisoneofthecentralpointsofGraham’sbook.Allinvestorslaborunder

acruelirony:Weinvestinthepresent,butweinvestforthefuture.And,unfortunately,thefutureisalmostentirelyuncertain.Inflationandinterestratesareundependable;economicrecessionscomeandgoatrandom;geopoliticalupheavalslikewar,commodityshortages,andterrorismarrivewithoutwarning;andthefateofindividualcompaniesandtheirindustriesoftenturnsouttobetheoppositeofwhatmostinvestorsexpect.Therefore,investingonthebasisofprojectionisafool’serrand;eventheforecastsoftheso-calledexpertsarelessreliablethantheflipofacoin.Formostpeople,investingonthebasisofprotection—fromoverpayingforastockandfromoverconfidenceinthequalityoftheirownjudgment—isthebestsolution.GrahamexpandsonthisconceptinChapter20.

1Adjustedforstocksplits.Tomanypeople,MicroStrategyreallydidlooklikethenextMicrosoftinearly2000;itsstockhadgained566.7%in1999,anditschairman,MichaelSaylor,declaredthat“ourfuturetodayisbetterthanitwas18monthsago.”TheU.S.SecuritiesandExchangeCommissionlateraccusedMicroStrategyofaccountingfraud,andSaylorpaidan$8.3millionfinetosettlethecharges.

2JonBirger,“The30BestStocks,”Money,Fall2002,pp.88–95.

1Bythetimeyoureadthis,muchwillalreadyhavechangedsinceyear-end2002.

2DavidDreman,“BubblesandtheRoleofAnalysts’Forecasts,”TheJournalof

PsychologyandFinancialMarkets,vol.3,no.1(2002),pp.4–14.

3Youcancalculatethisratiobyhandfromacompany’sannualreportsorobtainthedataatwebsiteslikewww.morningstar.comorhttp://finance.yahoo.com.

4Formoreonwhattolookfor,seethecommentaryonChapters11,12,and19.Ifyouarenotwillingtogototheminimaleffortofreadingtheproxyandmakingbasiccomparisonsoffinancialhealthacrossfiveyears’worthofannualreports,thenyouaretoodefensivetobebuyingindividualstocksatall.Getyourselfoutofthestock-pickingbusinessandintoanindexfund,whereyoubelong.

*TheFriend-Blume-CrockettresearchcoveredJanuary1960,throughJune1968,

andcomparedtheperformanceofmorethan100majormutualfundsagainstthereturnsonportfoliosconstructedrandomlyfrommorethan500ofthelargeststockslistedontheNYSE.ThefundsintheFriend-Blume-Crockettstudydidbetterfrom1965to1968thantheyhadinthefirsthalfofthemeasurementperiod,muchasGrahamfoundinhisownresearch(seeabove,pp.158and229–232).Butthatimprovementdidnotlast.Andthethrustofthesestudies—thatmutualfunds,onaverage,underperformthemarketbyamarginroughlyequaltotheiroperatingexpensesandtradingcosts—hasbeenreconfirmedsomanytimesthatanyonewhodoubtsthemshouldfoundafinancialchapterofTheFlatEarthSociety.

*AswediscussinthecommentaryonChapter9,thereareseveralotherreasons

mutualfundshavenotbeenabletooutperformthemarketaverages,includingthelowreturnsonthefunds’cashbalancesandthehighcostsofresearchingandtradingstocks.Also,afundholding120companies(atypicalnumber)cantrailtheS&P500-stockindexifanyoftheother380companiesinthatbenchmarkturnsouttobeagreatperformer.Thefewerstocksafundowns,themorelikelyitistomiss“thenextMicrosoft.”

*Inthissection,ashedidalsoonpp.363–364,GrahamissummarizingtheEfficientMarketHypothesis.Recentappearancestothecontrary,theproblemwiththestockmarkettodayisnotthatsomanyfinancialanalystsareidiots,butratherthatsomanyofthemaresosmart.Asmoreandmoresmartpeoplesearchthemarketforbargains,thatveryactofsearchingmakes

thosebargainsrarer—and,inacruelparadox,makestheanalystslookasiftheylacktheintelligencetojustifythesearch.Themarket’svaluationofagivenstockistheresultofavast,continuous,real-timeoperationofcollectiveintelligence.Mostofthetime,formoststocks,thatcollectiveintelligencegetsthevaluationapproximatelyright.OnlyrarelydoesGraham’s“Mr.Market”(seeChapter8)sendpriceswildlyoutofwhack.

†GrahamlaunchedGraham-NewmanCorp.inJanuary1936,anddissolveditwhenheretiredfromactivemoneymanagementin1956;itwasthesuccessortoapartnershipcalledtheBenjaminGrahamJointAccount,whichheranfromJanuary1926,throughDecember1935.

*An“unrelated”hedgeinvolvesbuyinga

stockorbondissuedbyonecompanyandshort-selling(orbettingonadeclinein)asecurityissuedbyadifferentcompany.A“related”hedgeinvolvesbuyingandsellingdifferentstocksorbondsissuedbythesamecompany.The“newgroup”ofhedgefundsdescribedbyGrahamwerewidelyavailablearound1968,butlaterregulationbytheU.S.SecuritiesandExchangeCommissionrestrictedaccesstohedgefundsforthegeneralpublic.

*In2003,anintelligentinvestorfollowingGraham’strainofthoughtwouldbesearchingforopportunitiesinthetechnology,telecommunications,andelectric-utilityindustries.Historyhasshownthatyesterday’slosersareoftentomorrow’swinners.

*ThesuccessorcorporationtoIndustrial

NationalBankofRhodeIslandisFleetBostonFinancialCorp.Oneofitscorporateancestors,theProvidenceBank,wasfoundedin1791.

*Fortoday’sinvestor,thecutoffismorelikelytobearound$1pershare—thelevelbelowwhichmanystocksare“delisted,”ordeclaredineligiblefortradingonmajorexchanges.Justmonitoringthestockpricesofthesecompaniescantakeaconsiderableamountofeffort,makingthemimpracticalfordefensiveinvestors.Thecostsoftradinglow-pricedstockscanbeveryhigh.Finally,companieswithverylowstockpriceshaveadistressingtendencytogooutofbusiness.However,adiversifiedportfolioofdozensofthesedistressedcompaniesmaystillappealtosomeenterprisinginvestorstoday.

*InGraham’sterms,alargeamountofgoodwillcanresultfromtwocauses:acorporationcanacquireothercompaniesforsubstantiallymorethanthevalueoftheirassets,oritsownstockcantradeforsubstantiallymorethanitsbookvalue.

*Technically,theworking-capitalvalueofastockisthecurrentassetspershare,minusthecurrentliabilitiespershare,dividedbythenumberofsharesoutstanding.Here,however,Grahammeans“networking-capitalvalue,”ortheper-sharevalueofcurrentassetsminustotalliabilities.

*Lecoeurasesraisonsquelaraisonneconnaîtpoint.ThispoeticpassageisoneoftheconcludingargumentsinthegreatFrenchtheologian’sdiscussionofwhathas

cometobeknownas“Pascal’swager”(seecommentaryonChapter20).

*AsdiscussedinthecommentaryonChapter7,mergerarbitrageiswhollyinappropriateformostindividualinvestors.

1PatriciaDreyfus,“InvestmentAnalysisinTwoEasyLessons”(interviewwithGraham),Money,July,1976,p.36.

2SeethecommentaryonChapter11.

3Therearealsomanynewslettersdedicatedtoanalyzingprofessionalportfolios,butmostofthemareawasteoftimeandmoneyforeventhemostenterprisinginvestor.AshiningexceptionforpeoplewhocansparethecashisOutstandingInvestorDigest(www.oid.com).

1Asabriefexampleofhowconvertiblebondsworkinpractice,considerthe4.75%convertiblesubordinatednotesissuedbyDoubleClickInc.in1999.Theypay$47.50ininterestperyearandareeachconvertibleinto24.24sharesofthecompany’scommonstock,a“conversionratio”of24.24.Asofyear-end2002,DoubleClick’sstockwaspricedat$5.66ashare,givingeachbonda“conversionvalue”of$137.20($5.6624.24).Yetthebondstradedroughlysixtimeshigher,at$881.30—creatinga“conversionpremium,”orexcessovertheirconversionvalue,of542%.Ifyouboughtatthatprice,your“break-eventime,”or“paybackperiod,”wasverylong.(Youpaidroughly$750morethantheconversionvalueofthebond,soitwilltakenearly16yearsof$47.50interestpaymentsforyouto“earnback”thatconversionpremium.)Since

eachDoubleClickbondisconvertibletojustover24commonshares,thestockwillhavetorisefrom$5.66tomorethan$36ifconversionistobecomeapracticaloptionbeforethebondsmaturein2006.Suchastockreturnisnotimpossible,butitbordersonthemiraculous.Thecashyieldonthisparticularbondscarcelyseemsadequate,giventhelowprobabilityofconversion.

2LikemanyofthetrackrecordscommonlycitedonWallStreet,thisoneishypothetical.Itindicatesthereturnyouwouldhaveearnedinanimaginaryindexfundthatownedallmajorconvertibles.Itdoesnotincludeanymanagementfeesortradingcosts(whicharesubstantialforconvertiblesecurities).Intherealworld,yourreturnswouldhavebeenroughlytwopercentagepointslower.

3However,mostconvertiblebondsremainjuniortootherlong-termdebtandbankloans—so,inabankruptcy,convertibleholdersdonothavepriorclaimtothecompany’sassets.And,whiletheyarenotnearlyasdiceyashigh-yield“junk”bonds,manyconvertsarestillissuedbycompanieswithlessthansterlingcreditratings.Finally,alargeportionoftheconvertiblemarketisheldbyhedgefunds,whoserapid-firetradingcanincreasethevolatilityofprices.

4Formoredetail,seewww.fidelity.com,www.vanguard.com,andwww.morningstar.com.Theintelligentinvestorwillneverbuyaconvertiblebondfundwithannualoperatingexpensesexceeding1.0%.

*How“shocked”wasthefinancialworld

bythePennCentral’sbankruptcy,whichwasfiledovertheweekendofJune20–21,1970?TheclosingtradeinPennCentral’sstockonFriday,June19,was$11.25pershare—hardlyagoing-out-of-businessprice.Inmorerecenttimes,stockslikeEnronandWorldComhavealsosoldatrelativelyhighpricesshortlybeforefilingforbankruptcyprotection.

*PennCentralwastheproductofthemerger,announcedin1966,ofthePennsylvaniaRailroadandtheNewYorkCentralRailroad.

†Thiskindofaccountinglegerdemain,inwhichprofitsarereportedasif“unusual”or“extraordinary”or“nonrecurring”chargesdonotmatter,anticipatestherelianceon“proforma”financialstatementsthatbecamepopularinthelate

1990s(seethecommentaryonChapter12).

*Arailroad’s“transportationratio”(nowmorecommonlycalleditsoperatingratio)measurestheexpensesofrunningitstrainsdividedbytherailroad’stotalrevenues.Thehighertheratio,thelessefficienttherailroad.Todayevenaratioof70%wouldbeconsideredexcellent.

†Today,PennCentralisafadedmemory.In1976,itwasabsorbedintoConsolidatedRailCorp.(Conrail),afederally-fundedholdingcompanythatbailedoutseveralfailedrailroads.Conrailsoldsharestothepublicin1987and,in1997,wastakenoverjointlybyCSXCorp.andNorfolkSouthernCorp.

†Ling-Temco-VoughtInc.wasfoundedin1955byJamesJosephLing,anelectrical

contractorwhosoldhisfirst$1millionworthofsharestothepublicbybecominghisowninvestmentbanker,hawkingprospectusesfromaboothsetupattheTexasStateFair.Hissuccessatthatledhimtoacquiredozensofdifferentcompanies,almostalwaysusingLTV’sstocktopayforthem.ThemorecompaniesLTVacquired,thehigheritsstockwent;thehigheritsstockwent,themorecompaniesitcouldaffordtoacquire.By1969,LTVwasthe14thbiggestfirmontheFortune500listofmajorU.S.corporations.Andthen,asGrahamshows,thewholehouseofcardscamecrashingdown.(LTVCorp.,nowexclusivelyasteelmaker,endedupseekingbankruptcyprotectioninlate2000.)Companiesthatgrowprimarilythroughacquisitionsarecalled“serialacquirers”—andthesimilaritytotheterm“serialkillers”isnoaccident.Asthecaseof

LTVdemonstrates,serialacquirersnearlyalwaysleavefinancialdeathanddestructionintheirwake.InvestorswhounderstoodthislessonofGraham’swouldhaveavoidedsuchdarlingsofthe1990sasConseco,Tyco,andWorldCom.

*Thesordidtraditionofhidingacompany’strueearningspictureunderthecloakofrestructuringchargesisstillwithus.Pilingupeverypossiblechargeinoneyearissometimescalled“bigbath”or“kitchensink”accounting.Thisbookkeepinggimmickenablescompaniestomakeaneasyshowofapparentgrowthinthefollowingyear—butinvestorsshouldnotmistakethatforrealbusinesshealth.

†The“bond-discountasset”appearstomeanthatLTVhadpurchasedsomebondsbelowtheirparvalueandwastreatingthat

discountasanasset,onthegroundsthatthebondscouldeventuallybesoldatpar.Grahamscoffsatthis,sincethereisrarelyanywaytoknowwhatabond’smarketpricewillbeonagivendateinthefuture.Ifthebondscouldbesoldonlyatvaluesbelowpar,this“asset”wouldinfactbealiability.

†WecanonlyimaginewhatGrahamwouldhavethoughtoftheinvestmentbankingfirmsthatbroughtInfoSpace,Inc.publicinDecember1998.Thestock(adjustedforlatersplits)openedfortradingat$31.25,peakedat$1305.32pershareinMarch2000,andfinished2002ataprincely$8.45pershare.

*Grahamwouldhavebeendisappointed,thoughsurelynotsurprised,toseethatcommercialbankshavechronicallykept

supporting“unsoundexpansions.”EnronandWorldCom,twoofthebiggestcollapsesincorporatehistory,wereaidedandabettedbybillionsofdollarsinbankloans.

*InJune1972(justafterGrahamfinishedthischapter),aFederaljudgefoundthatNVF’schairman,VictorPosner,hadimproperlydivertedthepensionassetsofSharonSteel“toassistaffiliatedcompaniesintheirtakeoversofothercorporations.”In1977,theU.S.SecuritiesandExchangeCommissionsecuredapermanentinjunctionagainstPosner,NVF,andSharonSteeltopreventthemfromfutureviolationsofFederallawsagainstsecuritiesfraud.TheCommissionallegedthatPosnerandhisfamilyhadimproperlyobtained$1.7millioninpersonalperksfromNVFandSharon,overstatedSharon’spretax

earningsby$13.9million,misrecordedinventory,and“shiftedincomeandexpensesfromoneyeartoanother.”SharonSteel,whichGrahamhadsingledoutwithhiscoldandskepticaleye,becameknownamongWallStreetwagsas“ShareandSteal.”PosnerwaslateracentralforceinthewaveofleveragedbuyoutsandhostiletakeoversthatswepttheUnitedStatesinthe1980s,ashebecameamajorcustomerforthejunkbondsunderwrittenbyDrexelBurnhamLambert.

*The“largedilutionfactor”wouldbetriggeredwhenNVFemployeesexercisedtheirwarrantstobuycommonstock.Thecompanywouldthenhavetoissuemoreshares,anditsnetearningswouldbedividedacrossamuchgreaternumberofsharesoutstanding.

†JackieG.WilliamsfoundedAAAEnterprisesin1958.Onitsfirstdayoftrading,thestocksoared56%tocloseat$20.25.WilliamslaterannouncedthatAAAwouldcomeupwithanewfranchisingconcepteverymonth(ifpeoplewouldstepintoamobilehometogettheirincometaxesdoneby“Mr.TaxofAmerica,”justimaginewhatelsetheymightdoinsideatrailer!).ButAAAranoutoftimeandmoneybeforeWilliamsranoutofideas.ThehistoryofAAAEnterprisesisreminiscentofthesagaofalatercompanywithcharismaticmanagementandscantyassets:ZZZZBestachievedastock-marketvalueofroughly$200millioninthelate1980s,eventhoughitspurportedindustrialvacuum-cleaningbusinesswaslittlemorethanatelephoneandarentedofficerunbyateenagernamedBarryMinkow.ZZZZBestwent

bustandMinkowwenttojail.Evenasyoureadthis,anothersimilarcompanyisbeingformed,andanewgenerationof“investors”willbetakenforaride.NoonewhohasreadGraham,however,shouldclimbonboard.

*In“AbouBenAdhem,”bytheBritishRomanticpoetLeighHunt(1784–1859),arighteousMuslimseesanangelwritinginagoldenbook“thenamesofthosewholovetheLord.”WhentheangeltellsAbouthathisnameisnotamongthem,Abousays,“Ipraythee,then,writemeasonethatloveshisfellowmen.”TheangelreturnsthenextnighttoshowAbouthebook,inwhichnow“BenAdhem’snameledalltherest.”

*Bypurchasingmorecommonstockatapremiumtoitsbookvalue,theinvestingpublicincreasedthevalueofAAA’sequity

pershare.Butinvestorswereonlypullingthemselvesupbytheirownbootstraps,sincemostoftheriseinshareholders’equitycamefromthepublic’sownwillingnesstoover-payforthestock.

†Graham’spointisthatinvestmentbanksarenotentitledtotakecreditforthegainsahotstockmayproducerightafteritsinitialpublicofferingunlesstheyarealsowillingtotaketheblameforthestock’sperformanceinthelongerterm.ManyInternetIPOsrose1,000%ormorein1999andearly2000;mostofthemlostmorethan95%inthesubsequentthreeyears.Howcouldtheseearlygainsearnedbyafewinvestorsjustifythemassivedestructionofwealthsufferedbythemillionswhocamelater?ManyIPOswere,infact,deliberatelyunderpricedto“manufacture”immediategainsthatwould

attractmoreattentionforthenextoffering.

*ThefirstfoursentencesofGraham’sparagraphcouldreadastheofficialepitaphoftheInternetandtelecommunicationsbubblethatburstinearly2000.JustastheSurgeonGeneral’swarningonthesideofacigarettepackdoesnotstopeveryonefromlightingup,noregulatoryreformwilleverpreventinvestorsfromoverdosingontheirowngreed.(NotevenCommunismcanoutlawmarketbubbles;theChinesestockmarketshotup101.7%inthefirsthalfof1999,thencrashed.)Norcaninvestmentbankseverbeentirelycleansedoftheirowncompulsiontosellanystockatanypricethemarketwillbear.Thecirclecanonlybebrokenoneinvestor,andonefinancialadviser,atatime.MasteringGraham’sprinciples(seeespeciallyChapters1,8,and

20)isthebestwaytostart.

1Thisdocument,likeallthefinancialreportscitedinthischapter,isreadilyavailabletothepublicthroughtheEDGARDatabaseatwww.sec.gov.

2ThedemiseoftheChromatisacquisitionisdiscussedinTheFinancialTimes,August29,2001,p.1,andSeptember1/September2,2001,p.XXIII.

3Whenaccountingforacquisitions,loadinguponWOOPIPRADenabledTycotoreducetheportionofthepurchasepricethatitallocatedtogoodwill.SinceWOOPIPRADcanbeexpensedupfront,whilegoodwill(undertheaccountingrulestheninforce)hadtobewrittenoffovermulti-yearperiods,thismaneuverenabledTycotominimizetheimpactofgoodwill

chargesonitsfutureearnings.

4In2002,Tyco’sformerchiefexecutive,L.DennisKozlowski,waschargedbystateandFederallegalauthoritieswithincometaxfraudandimproperlydivertingTyco’scorporateassetsforhisownuse,includingtheappropriationof$15,000foranumbrellastandand$6,000forashowercurtain.Kozlowskideniedallcharges.

5Disclosure:JasonZweigisanemployeeofTimeInc.,formerlyadivisionofTimeWarnerandnowaunitofAOLTimeWarnerInc.

1eToys’prospectushadagatefoldcoverfeaturinganoriginalcartoonofArthurtheaardvark,showingincomicstylehowmucheasieritwouldbetobuytchotchkesforchildrenateToysthanatatraditional

toystore.AsanalystGailBronsonofIPOMonitortoldtheAssociatedPressonthedayofeToys’stockoffering,“eToyshasvery,verysmartlymanagedthedevelopmentofthecompanylastyearandpositionedthemselvestobethechildren’scenteroftheInternet.”AddedBronson:“ThekeytoasuccessfulIPO,especiallyadot-comIPO,isgoodmarketingandbranding.”Bronsonwaspartlyright:That’sthekeytoasuccessfulIPOfortheissuingcompanyanditsbankers.Unfortunately,forinvestorsthekeytoasuccessfulIPOisearnings,whicheToysdidn’thave.

*HereGrahamisdescribingRealEstateInvestmentTrust,whichwasacquiredbySanFranciscoRealEstateInvestorsin1983for$50ashare.ThenextparagraphdescribesRealtyEquitiesCorp.ofNew

York.

†TheactorPaulNewmanwasbrieflyamajorshareholderinRealtyEquitiesCorp.ofNewYorkafteritboughthismovie-productioncompany,Kayos,Inc.,in1969.

*Graham,anavidreaderofpoetry,isquotingThomasGray’s“ElegyWritteninaCountryChurchyard.”

*RealtyEquitieswasdelistedfromtheAmericanStockExchangeinSeptember1973.In1974,theU.S.SecuritiesandExchangeCommissionsuedRealtyEquities’accountantsforfraud.RealtyEquities’founder,MorrisKarp,laterpleadedguiltytoonecountofgrandlarceny.In1974–1975,theoverindebtednessthatGrahamcriticizesledtoafinancialcrisisamonglargebanks,

includingChaseManhattan,thathadlentheavilytothemostaggressiverealtytrusts.

†“Heteroclite”isatechnicaltermfromclassicalGreekthatGrahamusestomeanabnormalorunusual.

*By“volume,”Grahamisreferringtosalesorrevenues—thetotaldollaramountofeachcompany’sbusiness.

†“Assetbacking”andbookvaluearesynonyms.InTable18-2,therelationshipofpricetoassetorbookvaluecanbeseenbydividingthefirstline(“Price,December31,1969”)by“Bookvaluepershare.”

††Grahamiscitinghisresearchonvaluestocks,whichhediscussesinChapter15(seep.389).SinceGrahamcompletedhisstudies,avastbodyofscholarlyworkhas

confirmedthatvaluestocksoutperformgrowthstocksoverlongperiods.(MuchofthebestresearchinmodernfinancesimplyprovidesindependentconfirmationofwhatGrahamdemonstrateddecadesago.)See,forinstance,JamesL.Davis,EugeneF.Fama,andKennethR.French,“Characteristics,Covariances,andAverageReturns:1929–1997,”athttp://papers.ssrn.com.

*AirProductsandChemicals,Inc.,stillexistsasapublicly-tradedstockandisincludedintheStandard&Poor’s500-stockindex.AirReductionCo.becameawholly-ownedsubsidiaryofTheBOCGroup(thenknownasBritishOxygen)in1978.

†Youcandetermineprofitability,asmeasuredbyreturnonsalesandreturnon

capital,byreferringtothe“Ratios”sectionofTable18-3.“Net/sales”measuresreturnonsales;“Earnings/bookvalue”measuresreturnoncapital.

*AmericanHomeProductsCo.isnowknownasWyeth;thestockisincludedintheStandard&Poor’s500-stockindex.AmericanHospitalSupplyCo.wasacquiredbyBaxterHealthcareCorp.in1985.

*“Nearly30times”isreflectedintheentryof2920%under“Price/bookvalue”intheRatiossectionofTable18-4.Grahamwouldhaveshakenhisheadinastonishmentduringlate1999andearly2000,whenmanyhigh-techcompaniessoldforhundredsoftimestheirassetvalue(seethecommentaryonthischapter).Talkabout“almostunheardofintheannalsof

seriousstock-marketvaluations”!H&RBlockremainsapublicly-tradedcompany,whileBlueBellwastakenprivatein1984at$47.50pershare.

*Grahamisalertingreaderstoaformofthe“gambler’sfallacy,”inwhichinvestorsbelievethatanovervaluedstockmustdropinpricepurelybecauseitisovervalued.Justasacoindoesnotbecomemorelikelytoturnupheadsafterlandingontailsforninetimesinarow,soanovervaluedstock(orstockmarket!)canstayovervaluedforasurprisinglylongtime.Thatmakesshort-selling,orbettingthatstockswilldrop,tooriskyformeremortals.

†InternationalHarvesterwastheheirtoMcCormickHarvestingMachineCo.,themanufactureroftheMcCormickreaperthathelpedmakethemidwesternstatesthe

“breadbasketoftheworld.”ButInternationalHarvesterfellonhardtimesinthe1970sand,in1985,solditsfarm-equipmentbusinesstoTenneco.AfterchangingitsnametoNavistar,theremainingcompanywasbootedfromtheDowin1991(althoughitremainsamemberoftheS&P500index).InternationalFlavors&Fragrances,alsoaconstituentoftheS&P500,hadatotalstock-marketvalueof$3billioninearly2003,versus$1.6billionforNavistar.

*FormoreofGraham’sthoughtsonshareholderactivism,seethecommentaryonChapter19.IncriticizingHarvesterforitsrefusaltomaximizeshareholdervalue,Grahamuncannilyanticipatedthebehaviorofthecompany’sfuturemanagement.In2001,amajorityofshareholdersvotedtoremoveNavistar’s

restrictionsagainstoutsidetakeoverbids—buttheboardofdirectorssimplyrefusedtoimplementtheshareholders’wishes.It’sremarkablethatanantidemocratictendencyinthecultureofsomecompaniescanendurefordecades.

*McGraw-Hillremainsapublicly-tradedcompanythatowns,amongotheroperations,BusinessWeekmagazineandStandard&Poor’sCorp.McGraw–EdisonisnowadivisionofCooperIndustries.

*In“theMay1970debacle”thatGrahamrefersto,theU.S.stockmarketlost5.5%.FromtheendofMarchtotheendofJune1970,theS&P500indexlost19%ofitsvalue,oneoftheworstthree-monthreturnsonrecord.

*NationalPrestoremainsapublicly-

tradedcompany.NationalGeneralwasacquiredin1974byanothercontroversialconglomerate,AmericanFinancialGroup,whichatvarioustimeshashadinterestsincabletelevision,banking,realestate,mutualfunds,insurance,andbananas.AFGisalsothefinalrestingplaceofsomeoftheassetsofPennCentralCorp.(seeChapter17).

*WhitingCorp.endedupasubsidiaryofWheelabrator-Frye,butwastakenprivatein1983.Willcox&GibbsisnowownedbyGroupRexel,anelectrical-equipmentmanufacturerthatisadivisionofPinault-Printemps-RedouteGroupofFrance.Rexel’ssharestradeontheParisStockExchange.

1Askyourselfwhichcompany’sstockwouldbelikelytorisemore:onethat

discoveredacureforararecancer,oronethatdiscoveredanewwaytodisposeofacommonkindofgarbage.Thecancercuresoundsmoreexcitingtomostinvestors,butanewwaytogetridoftrashwouldprobablymakemoremoney.SeePaulSlovic,MelissaFinucane,EllenPeters,andDonaldG.MacGregor,“TheAffectHeuristic,”inThomasGilovich,DaleGriffin,andDanielKahneman,eds.,HeuristicsandBiases:ThePsychologyofIntuitiveJudgment(CambridgeUniversityPress,NewYork,2002),pp.397–420,andDonaldG.MacGregor,“ImageryandFinancialJudgment,”TheJournalofPsychologyandFinancialMarkets,vol.3,no.1,2002,pp.15–22.

2“Serialacquirers,”whichgrowlargelybybuyingothercompanies,nearlyalwaysmeetabadendonWallStreet.Seethe

commentaryonChapter17foralongerdiscussion.

3JeremySiegel,“Big-CapTechStocksareaSucker’sBet,”WallStreetJournal,March14,2000(availableatwww.jeremysiegel.com).

4Yahoo!’sstocksplittwo-for-oneinFebruary2000;thesharepricesgivenherearenotadjustedforthatsplitinordertoshowthelevelsthestockactuallytradedat.ButYahoo!’spercentagereturnandmarketvalue,ascitedhere,doreflectthesplit.

5Countingtheeffectofacquisitions,Yahoo!’srevenueswere$464million.GrahamcriticizeshighP/Eratiosin(amongotherplaces)Chapters7and11.

6Yum!wasthenknownasTriconGlobalRestaurants,Inc.,althoughitstickersymbolwasYUM.ThecompanychangeditsnameofficiallytoYum!Brands,Inc.inMay2002.

7See“CEOSpeaks”and“TheBottomLine,”Money,May2000,pp.42–44.

8Inearly2003,CapitalOne’schieffinancialofficerresignedaftersecuritiesregulatorsrevealedthattheymightchargehimwithviolationsoflawsagainstinsidertrading.

9Foramoreadvancedlookatthisbizarreevent,seeOwenA.LamontandRichardH.Thaler,“CantheMarketAddandSubtract?”NationalBureauofEconomicResearchworkingpaperno.8302,at

www.nber.org/papers/w8302.

10CMGIbegancorporatelifeasCollegeMarketingGroup,whichsoldinformationaboutcollegeprofessorsandcoursestoacademicpublishers—abusinessthatboreafaintbutdisturbingsimilaritytoNationalStudentMarketing,discussedbyGrahamonp.235.

11AllstockpricesforRedHatareadjustedforitstwo-for-onestocksplitinJanuary2000.

12Ironically,65yearsearlierGrahamhadsingledoutBrownShoeasoneofthemoststablecompaniesontheNewYorkStockExchange.Seethe1934editionofSecurityAnalysis,p.159.

13Weuseanine-monthperiodonly

becauseRedHat’s12-monthresultscouldnotbedeterminedfromitsfinancialstatementswithoutincludingtheresultsofacquisitions.

*Ironically,takeoversbegandryingupshortlyafterGraham’slastrevisededitionappeared,andthe1970sandearly1980smarkedtheabsolutelowpointofmodernAmericanindustrialefficiency.Carswere“lemons,”televisionsandradioswereconstantly“onthefritz,”andthemanagersofmanypublicly-tradedcompaniesignoredboththepresentinterestsoftheiroutsideshareholdersandthefutureprospectsoftheirownbusinesses.Allofthisbegantochangein1984,whenindependentoilmanT.BoonePickenslaunchedahostiletakeoverbidforGulfOil.Soon,fueledbyjunk-bondfinancingprovidedbyDrexelBurnhamLambert,“corporateraiders”

stalkedthelandscapeofcorporateAmerica,scaringlong-scleroticcompaniesintoanewregimenofefficiency.Whilemanyofthecompaniesinvolvedinbuy-outsandtakeoverswereravaged,therestofAmericanbusinessemergedbothleaner(whichwasgood)andmeaner(whichsometimeswasnot).

*TheironythatGrahamdescribesheregrewevenstrongerinthe1990s,whenitalmostseemedthatthestrongerthecompanywas,thelesslikelyitwastopayadividend—orforitsshareholderstowantone.The“payoutratio”(orthepercentageoftheirnetincomethatcompaniespaidoutasdividends)droppedfrom“60%to75%”inGraham’sdayto35%to40%bytheendofthe1990s.

*Inthelate1990s,technologycompanies

wereparticularlystrongadvocatesoftheviewthatalloftheirearningsshouldbe“plowedbackintothebusiness,”wheretheycouldearnhigherreturnsthananyoutsideshareholderpossiblycouldbyreinvestingthesamecashifitwerepaidouttohimorherindividends.Incredibly,investorsneverquestionedthetruthofthispatronizingDaddy-Knows-Bestprinciple—orevenrealizedthatacompany’scashbelongstotheshareholders,notitsmanagers.Seethecommentaryonthischapter.

*SuperiorOil’sstockpricepeakedat$2165persharein1959,whenitpaida$4dividend.Formanyyears,Superiorwasthehighest-pricedstocklistedontheNewYorkStockExchange.Superior,controlledbytheKeckfamilyofHouston,wasacquiredbyMobilCorp.in1984.

*Today,virtuallyallstocksplitsarecarriedoutbyachangeinvalue.Inatwo-for-onesplit,onesharebecomestwo,eachtradingathalftheformerpriceoftheoriginalsingleshare;inathree-for-onesplit,onesharebecomesthree,eachtradingatathirdoftheformerprice;andsoon.Onlyinveryrarecasesisasumtransferred“fromearnedsurplustocapitalaccount,”asinGraham’sday.

†Rule703oftheNewYorkStockExchangegovernsstocksplitsandstockdividends.TheNYSEnowdesignatesstockdividendsofgreaterthan25%andlessthan100%as“partialstocksplits.”UnlikeinGraham’sday,thesestockdividendsmaynowtriggertheNYSE’saccountingrequirementthattheamountofthedividendbecapitalizedfromretainedearnings.

*Thispolicy,alreadyunusualinGraham’sday,isextremelyraretoday.In1936andagainin1950,roughlyhalfofallstocksontheNYSEpaidaso-calledspecialdividend.By1970,however,thatpercentagehaddeclinedtolessthan10%and,bythe1990s,waswellunder5%.SeeHarryDeAngelo,LindaDeAngelo,andDouglasJ.Skinner,“SpecialDividendsandtheEvolutionofDividendSignaling,”JournalofFinancialEconomics,vol.57,no.3,September,2000,pp.309–354.Themostplausibleexplanationforthisdeclineisthatcorporatemanagersbecameuncomfortablewiththeideathatshareholdersmightinterpretspecialdividendsasasignalthatfutureprofitsmightbelow.

†TheacademiccriticismofdividendswasledbyMertonMillerandFrancoModigliani,whoseinfluentialarticle

“DividendPolicy,Growth,andtheValuationofShares”(1961)helpedwinthemNobelPrizesinEconomics.MillerandModiglianiargued,inessence,thatdividendswereirrelevant,sinceaninvestorshouldnotcarewhetherhisreturncomesthroughdividendsandarisingstockprice,orthrougharisingstockpricealone,solongasthetotalreturnisthesameineithercase.

*Graham’sargumentisnolongervalid,andtoday’sinvestorscansafelyskipoverthispassage.Shareholdersnolongerneedtoworryabout“havingtobreakup”astockcertificate,sincevirtuallyallsharesnowexistinelectronicratherthanpaperform.AndwhenGrahamsaysthata5%increaseinacashdividendon100sharesisless“probable”thanaconstantdividendon105shares,it’sunclearhowhecould

evencalculatethatprobability.

†Subscriptionrights,oftensimplyknownas“rights,”areusedlessfrequentlythaninGraham’sday.Theyconferuponanexistingshareholdertherighttobuynewshares,sometimesatadiscounttomarketprice.Ashareholderwhodoesnotparticipatewillendupowningproportionatelylessofthecompany.Thus,asisthecasewithsomanyotherthingsthatgobythenameof“rights,”somecoercionisofteninvolved.Rightsaremostcommontodayamongclosed-endfundsandinsuranceorotherholdingcompanies.

*TheadministrationofPresidentGeorgeW.Bushmadeprogressinearly2003towardreducingtheproblemofdouble-taxationofcorporatedividends,althoughitistoosoontoknowhowhelpfulanyfinal

lawsinthisareawillturnouttobe.Acleanerapproachwouldbetomakedividendpaymentstax-deductibletothecorporation,butthatisnotpartoftheproposedlegislation.

1BenjaminGraham,TheIntelligentInvestor(Harper&Row,NewYork,1949),pp.217,219,240.GrahamexplainshisreferencetoJesusthisway:“InatleastfourparablesintheGospelsthereisreferencetoahighlycriticalrelationshipbetweenamanofwealthandthoseheputsinchargeofhisproperty.Mosttothepointarethewordsthat“acertainrichman”speakstohisstewardormanager,whoisaccusedofwastinghisgoods:‘Giveanaccountofthystewardship,forthoumayestbenolongersteward.’(Luke,16:2).”AmongtheotherparablesGrahamseemstohaveinmindisMatt.,25:15–28.

2BenjaminGraham,“AQuestionnaireonStockholder-ManagementRelationship,”TheAnalystsJournal,FourthQuarter,1947,p.62.Grahampointsoutthathehadconductedasurveyofnearly600professionalsecurityanalystsandfoundthatmorethan95%ofthembelievedthatshareholdershavetherighttocallforaformalinvestigationofmanagerswhoseleadershipdoesnotenhancethevalueofthestock.Grahamaddsdrylythat“suchactionisalmostunheardofinpractice.”This,hesays,“highlightsthewidegulfbetweenwhatshouldhappenandwhatdoeshappeninshareholder-managementrelationships.”

3GrahamandDodd,SecurityAnalysis(1934ed.),p.508.

4TheIntelligentInvestor,1949edition,p.218.

51949edition,p.223.Grahamaddsthataproxyvotewouldbenecessarytoauthorizeanindependentcommitteeofoutsideshareholderstoselect“theengineeringfirm”thatwouldsubmititsreporttotheshareholders,nottotheboardofdirectors.However,thecompanywouldbearthecostsofthisproject.Amongthekindsof“engineeringfirms”Grahamhadinmindweremoneymanagers,ratingagenciesandorganizationsofsecurityanalysts.Today,investorscouldchoosefromamonghundredsofconsultingfirms,restructuringadvisers,andmembersofentitiesliketheRiskManagementAssociation.

6Tabulationsofvotingresultsfor2002by

GeorgesonShareholderandADP’sInvestorCommunicationServices,twoleadingfirmsthatmailproxysolicitationstoinvestors,suggestresponseratesthataveragearound80%to88%(includingproxiessentinbystockbrokersonbehalfoftheirclients,whichareautomaticallyvotedinfavorofmanagementunlesstheclientsspecifyotherwise).Thustheownersofbetween12%and20%ofallsharesarenotvotingtheirproxies.Sinceindividualsownonly40%ofU.S.sharesbymarketvalue,andmostinstitutionalinvestorslikepensionfundsandinsurancecompaniesarelegallyboundtovoteonproxyissues,thatmeansthatroughlyathirdofallindividualinvestorsareneglectingtovote.

71949edition,p.224.

81949edition,p.233.

9EugeneF.FamaandKennethR.French,“DisappearingDividends:ChangingFirmCharacteristicsorLowerPropensitytoPay?”JournalofFinancialEconomics,vol.60,no.1,April,2001,pp.3–43,especiallyTable1;seealsoElroyDimson,PaulMarsh,andMikeStaunton,TriumphoftheOptimists(PrincetonUniv.Press,Princeton,2002),pp.158–161.Interestingly,thetotaldollaramountofdividendspaidbyU.S.stockshasrisensincethelate1970s,evenafterinflation—butthenumberofstocksthatpayadividendhasshrunkbynearlytwo-thirds.SeeHarryDeAngelo,LindaDeAngelo,andDouglasJ.Skinner,“AreDividendsDisappearing?DividendConcentrationandtheConsolidationofEarnings,”availableat:http://papers.ssrn.com.

10PerhapsBenjaminFranklin,whoissaidtohavecarriedhiscoinsaroundinanasbestospursesothatmoneywouldn’tburnaholeinhispocket,couldhaveavoidedthisproblemifhehadbeenaCEO.

11AstudybyBusinessWeekfoundthatfrom1995through2001,61%outofmorethan300largemergersendedupdestroyingwealthfortheshareholdersoftheacquiringcompany—aconditionknownas“thewinner’scurse”or“buyer’sremorse.”Andacquirersusingstockratherthancashtopayforthedealunderperformedrivalcompaniesby8%.(DavidHenry,“Mergers:WhyMostBigDealsDon’tPayOff,”BusinessWeek,October14,2002,pp.60–70.)Asimilaracademicstudyfoundthatacquisitionsof

privatecompaniesandsubsidiariesofpubliccompaniesleadtopositivestockreturns,butthatacquisitionsofentirepubliccompaniesgeneratelossesforthewinningbidder’sshareholders.(KathleenFuller,JeffryNetter,andMikeStegemoller,“WhatDoReturnstoAcquiringFirmsTellUs?”TheJournalofFinance,vol.57,no.4,August,2002,pp.1763–1793.)

12Withinterestratesnearrecordlows,suchamountainofcashproduceslousyreturnsifitjustsitsaround.AsGrahamasserts,“Solongasthissurpluscashremainswiththecompany,theoutsidestockholdergetslittlebenefitfromit”(1949edition,p.232).Indeed,byyear-end2002,Microsoft’scashbalancehadswollento$43.4billion—clearproofthatthecompanycouldfindnogooduseforthecashits

businessesweregenerating.AsGrahamwouldsay,Microsoft’soperationswereefficient,butitsfinancenolongerwas.Inasteptowardredressingthisproblem,Microsoftdeclaredinearly2003thatitwouldbeginpayingaregularquarterlydividend.

13RobertD.ArnottandCliffordS.Asness,“Surprise!HigherDividends=HigherEarningsGrowth,”FinancialAnalystsJournal,January/February,2003,pp.70–87.

14DoronNissimandAmirZiv,“DividendChangesandFutureProfitability,”TheJournalofFinance,vol.56,no.6,December,2001,pp.2111–2133.EvenresearcherswhodisagreewiththeArnott-AsnessandNissim-Zivfindingsonfutureearningsagreethatdividendincreaseslead

tohigherfuturestockreturns;seeShlomoBenartzi,RoniMichaely,andRichardThaler,“DoChangesinDividendsSignaltheFutureorthePast?”TheJournalofFinance,vol.52,no.3,July,1997,pp.1007–1034.

15ThetaxreformsproposedbyPresidentGeorgeW.Bushinearly2003wouldchangethetaxabilityofdividends,butthefateofthislegislationwasnotyetclearbypresstime.

16Historically,companiestookacommon-senseapproachtowardsharerepurchases,reducingthemwhenstockpriceswerehighandsteppingthemupwhenpriceswerelow.AfterthestockmarketcrashofOctober19,1987,forexample,400companiesannouncednewbuybacksoverthenext12daysalone—whileonly107

firmshadannouncedbuybackprogramsintheearlierpartoftheyear,whenstockpriceshadbeenmuchhigher.SeeMuraliJagannathan,CliffordP.Stephens,andMichaelS.Weisbach,“FinancialFlexibilityandtheChoiceBetweenDividendsandStockRepurchases,”JournalofFinancialEconomics,vol.57,no.3,September,2000,p.362.

17Thestockoptionsgrantedbyacompanytoitsexecutivesandemployeesgivethemtheright(butnottheobligation)tobuysharesinthefutureatadiscountedprice.Thatconversionofoptionstosharesiscalled“exercising”theoptions.Theemployeescanthensellthesharesatthecurrentmarketpriceandpocketthedifferenceasprofit.Becausehundredsofmillionsofoptionsmaybeexercisedinagivenyear,thecompanymustincreaseits

supplyofsharesoutstanding.Then,however,thecompany’stotalnetincomewouldbespreadacrossamuchgreaternumberofshares,reducingitsearningspershare.Therefore,thecompanytypicallyfeelscompelledtobuybackothersharestocanceloutthestockissuedtotheoptionholders.In1998,63.5%ofchieffinancialofficersadmittedthatcounteractingthedilutionfromoptionswasamajorreasonforrepurchasingshares(seeCFOForum,“TheBuybackTrack,”InstitutionalInvestor,July,1998).

18OneofthemainfactorsdrivingthischangewastheU.S.SecuritiesandExchangeCommission’sdecision,in1982,torelaxitspreviousrestrictionsonsharerepurchases.SeeGustavoGrullonandRoniMichaely,“Dividends,ShareRepurchases,andtheSubstitution

Hypothesis,”TheJournalofFinance,vol.57,no.4,August,2002,pp.1649–1684.

19Throughouthiswritings,Grahaminsiststhatcorporatemanagementshaveadutynotjusttomakesuretheirstockisnotundervalued,butalsotomakesureitnevergetsovervalued.AsheputitinSecurityAnalysis(1934ed.,p.515),“theresponsibilityofmanagementstoactintheinterestoftheirshareholdersincludestheobligationtoprevent—insofarastheyareable—theestablishmentofeitherabsurdlyhighorundulylowpricesfortheirsecurities.”Thus,enhancingshareholdervaluedoesn’tjustmeanmakingsurethatthestockpricedoesnotgotoolow;italsomeansensuringthatthestockpricedoesnotgouptounjustifiablelevels.IfonlytheexecutivesofInternetcompanieshadheededGraham’swisdombackin1999!

20Incredibly,althoughoptionsareconsideredacompensationexpenseonacompany’staxreturns,theyarenotcountedasanexpenseontheincomestatementinfinancialreportstoshareholders.Investorscanonlyhopethataccountingreformswillchangethisludicrouspractice.

21SeeGeorgeW.FennandNellieLiang,“CorporatePayoutPolicyandManagerialStockIncentives,”JournalofFinancialEconomics,vol.60,no.1,April,2001,pp.45–72.Dividendsmakestockslessvolatilebyprovidingastreamofcurrentincomethatcushionsshareholdersagainstfluctuationsinmarketvalue.Severalresearchershavefoundthattheaverageprofitabilityofcompanieswithstock-buybackprograms(butnocashdividends)isatleasttwiceasvolatileasthatof

companiesthatpaydividends.Thosemorevariableearningswill,ingeneral,leadtobounciershareprices,makingthemanagers’stockoptionsmorevaluable—bycreatingmoreopportunitieswhensharepriceswillbetemporarilyhigh.Today,abouttwo-thirdsofexecutivecompensationcomesintheformofoptionsandothernoncashawards;thirtyyearsago,atleasttwo-thirdsofcompensationcameascash.

22AppleComputerInc.proxystatementforApril2001annualmeeting,p.8(availableatwww.sec.gov).Jobs’optiongrantandshareownershipareadjustedforatwo-for-onesharesplit.

*Bythelate1990s,thisadvice—whichcanbeappropriateforafoundationorendowmentwithaninfinitelylonginvestmenthorizon—hadspreadto

individualinvestors,whoselifespansarefinite.Inthe1994editionofhisinfluentialbook,StocksfortheLongRun,financeprofessorJeremySiegeloftheWhartonSchoolrecommendedthat“risk-taking”investorsshouldbuyonmargin,borrowingmorethanathirdoftheirnetworthtosink135%oftheirassetsintostocks.Evengovernmentofficialsgotinontheact:InFebruary1999,theHonorableRichardDixon,statetreasurerofMaryland,toldtheaudienceataninvestmentconference:“Itdoesn’tmakeanysenseforanyonetohaveanymoneyinabondfund.”

*ThisisoneofGraham’sraremisjudgments.In1973,justtwoyearsafterPresidentRichardNixonimposedwageandpricecontrols,inflationhit8.7%,itshighestlevelsincetheendofWorldWarII.Thedecadefrom1973through1982was

themostinflationaryinmodernAmericanhistory,asthecostoflivingmorethandoubled.

*Seep.25.

*JohnPierpontMorganwasthemostpowerfulfinancierofthelatenineteenthandearlytwentiethcenturies.Becauseofhisvastinfluence,hewasconstantlyaskedwhatthestockmarketwoulddonext.Morgandevelopedamercifullyshortandunfailinglyaccurateanswer:“Itwillfluctuate.”SeeJeanStrouse,Morgan:AmericanFinancier(RandomHouse,1999),p.11.

*TheinvestmentphilosopherPeterL.BernsteinfeelsthatGrahamwas“deadwrong”aboutpreciousmetals,particularlygold,which(atleastintheyearsafter

Grahamwrotethischapter)hasshownarobustabilitytoout-paceinflation.FinancialadviserWilliamBernsteinagrees,pointingoutthatatinyallocationtoaprecious-metalsfund(say,2%ofyourtotalassets)istoosmalltohurtyouroverallreturnswhengolddoespoorly.But,whengolddoeswell,itsreturnsareoftensospectacular—sometimesexceeding100%inayear—thatitcan,allbyitself,setanotherwiselacklusterportfolioglittering.However,theintelligentinvestoravoidsinvestingingolddirectly,withitshighstorageandinsurancecosts;instead,seekoutawell-diversifiedmutualfundspecializinginthestocksofprecious-metalcompaniesandchargingbelow1%inannualexpenses.Limityourstaketo2%ofyourtotalfinancialassets(orperhaps5%ifyouareovertheageof65).

1TheU.S.BureauofLaborStatistics,whichcalculatestheConsumerPriceIndexthatmeasuresinflation,maintainsacomprehensiveandhelpfulwebsiteatwww.bls.gov/cpi/home.htm.

2Foralivelydiscussionofthe“inflationisdead”scenario,seewww.pbs.org/newshour/bb/economy/july-dec97/inflation_12-16.html.In1996,theBoskinCommission,agroupofeconomistsaskedbythegovernmenttoinvestigatewhethertheofficialrateofinflationisaccurate,estimatedthatithasbeenoverstated,oftenbynearlytwopercentagepointsperyear.Forthecommission’sreport,seewww.ssa.gov/history/reports/boskinrpt.html.Manyinvestmentexpertsnowfeelthatdeflation,orfallingprices,isanevengreaterthreatthaninflation;thebestway

tohedgeagainstthatriskisbyincludingbondsasapermanentcomponentofyourportfolio.(SeethecommentaryonChapter4.)

3Formoreinsightsintothisbehavioralpitfall,seeEldarShafir,PeterDiamond,andAmosTversky,“MoneyIllusion,”inDanielKahnemanandAmosTversky,eds.,Choices,Values,andFrames(CambridgeUniversityPress,2000),pp.335–355.

4Thatyear,PresidentJimmyCartergavehisfamous“malaise”speech,inwhichhewarnedof“acrisisinconfidence”that“strikesattheveryheartandsoulandspiritofournationalwill”and“threatenstodestroythesocialandthepoliticalfabricofAmerica.”

5SeeStanleyFischer,RatnaSahay,and

CarlosA.Vegh,“ModernHyper-andHighInflations,”NationalBureauofEconomicResearch,WorkingPaper8930,atwww.nber.org/papers/w8930.

6Infact,theUnitedStateshashadtwoperiodsofhyperinflation.DuringtheAmericanRevolution,pricesroughlytripledeveryyearfrom1777through1779,withapoundofbuttercosting$12andabarrelofflourfetchingnearly$1,600inRevolutionaryMassachusetts.DuringtheCivilWar,inflationragedatannualratesof29%(intheNorth)andnearly200%(intheConfederacy).Asrecentlyas1946,inflationhit18.1%intheUnitedStates.

7IamindebtedtoLaurenceSiegeloftheFordFoundationforthiscynical,butaccurate,insight.Conversely,inatimeofdeflation(orsteadilyfallingprices)it’s

moreadvantageoustobealenderthanaborrower—whichiswhymostinvestorsshouldkeepatleastasmallportionoftheirassetsinbonds,asaformofinsuranceagainstdeflatingprices.

8Wheninflationisnegative,itistechnicallytermed“deflation.”Regularlyfallingpricesmayatfirstsoundappealing,untilyouthinkoftheJapaneseexample.PriceshavebeendeflatinginJapansince1989,withrealestateandthestockmarketdroppinginvalueyearafteryear—arelentlesswatertorturefortheworld’ssecond-largesteconomy.

9IbbotsonAssociates,Stocks,Bonds,Bills,andInflation,2003Handbook(IbbotsonAssociates,Chicago,2003),Table2-8.ThesamepatternisevidentoutsidetheUnitedStates:InBelgium,Italy,andGermany,

whereinflationwasespeciallyhighinthetwentiethcentury,“inflationappearstohavehadanegativeimpactonbothstockandbondmarkets,”noteElroyDimson,PaulMarsh,andMikeStauntoninTriumphoftheOptimists:101YearsofGlobalInvestmentReturns(PrincetonUniversityPress,2002),p.53.

10Thorough,ifsometimesoutdated,informationonREITscanbefoundatwww.nareit.com.

11Forfurtherinformation,seewww.vanguard.com,www.cohenandsteers.com,www.columbiafunds.com,andwww.fidelity.com.ThecaseforinvestinginaREITfundisweakerifyouownahome,sincethatgivesyouaninherentstakeinreal-estateownership.

12AgoodintroductiontoTIPScanbefoundatwww.publicdebt.treas.gov/of/ofinflin.htm.Formoreadvanceddiscussions,seewww.federalreserve.gov/Pubs/feds/2002/200232/200232pap.pdf,www.tiaa-crefinstitute.org/Publications/resdiags/73_09-2002.htm,andwww.bwater.com/research_ibonds.htm.

13Fordetailsonthesefunds,seewww.vanguard.comorwww.fidelity.com.

*“ItissaidanEasternmonarchoncechargedhiswisementoinventhimasentence,tobeeverinview,andwhichshouldbetrueandappropriateinalltimesandsituations.Theypresentedhimthewords:‘Andthis,too,shallpassaway.’Howmuchitexpresses!Howchasteninginthehourofpride!—howconsolinginthe

depthsofaffliction!‘Andthis,too,shallpassaway.’Andyetletushopeitisnotquitetrue.”—AbrahamLincoln,AddresstotheWisconsinStateAgriculturalSociety,Milwaukee,September30,1859,inAbrahamLincoln:SpeechesandWritings,1859–1865(LibraryofAmerica,1985),vol.II,p.101.

*“Earningpower”isGraham’stermforacompany’spotentialprofitsor,asheputsit,theamountthatafirm“mightbeexpectedtoearnyearafteryearifthebusinessconditionsprevailingduringtheperiodweretocontinueunchanged”(SecurityAnalysis,1934ed.,p.354).SomeofhislecturesmakeitclearthatGrahamintendedthetermtocoverperiodsoffiveyearsormore.Youcancrudelybutconvenientlyapproximateacompany’searningpowerpersharebytakingthe

inverseofitsprice/earningsratio;astockwithaP/Eratioof11canbesaidtohaveearningpowerof9%(or1dividedby11).Today“earningpower”isoftencalled“earningsyield.”

*ThisproblemisdiscussedextensivelyinthecommentaryonChapter19.

*Grahamelegantlysummarizedthediscussionthatfollowsinalecturehegavein1972:“Themarginofsafetyisthedifferencebetweenthepercentagerateoftheearningsonthestockatthepriceyoupayforitandtherateofinterestonbonds,andthatmarginofsafetyisthedifferencewhichwouldabsorbunsatisfactorydevelopments.Atthetimethe1965editionofTheIntelligentInvestorwaswrittenthetypicalstockwassellingat11timesearnings,givingabout9%returnas

against4%onbonds.Inthatcaseyouhadamarginofsafetyofover100percent.Now[in1972]thereisnodifferencebetweentheearningsrateonstocksandtheinterestrateonstocks,andIsaythereisnomarginofsafety…youhaveanegativemarginofsafetyonstocks…”See“BenjaminGraham:ThoughtsonSecurityAnalysis”[transcriptoflectureattheNortheastMissouriStateUniversitybusinessschool,March,1972],FinancialHistory,no.42,March,1991,p.9.

*Thisparagraph—whichGrahamwroteinearly1972—isanuncannilyprecisedescriptionofmarketconditionsinearly2003.(Formoredetail,seethecommentaryonChapter3.)

*In“American”roulette,mostwheelsinclude0and00alongwithnumbers1

through36,foratotalof38slots.Thecasinooffersamaximumpayoutof35to1.Whatifyoubet$1oneverynumber?Sinceonlyoneslotcanbetheoneintowhichtheballdrops,youwouldwin$35onthatslot,butlose$1oneachofyourother37slots,foranetlossof$2.That$2difference(ora5.26%spreadonyourtotal$38bet)isthecasino’s“houseadvantage,”ensuringthat,onaverage,rouletteplayerswillalwayslosemorethantheywin.Justasitisintherouletteplayer’sinteresttobetasseldomaspossible,itisinthecasino’sinteresttokeeptheroulettewheelspinning.Likewise,theintelligentinvestorshouldseektomaximizethenumberofholdingsthatoffer“abetterchanceforprofitthanforloss.”Formostinvestors,diversificationisthesimplestandcheapestwaytowidenyourmarginofsafety.

*Grahamissayingthatthereisnosuchthingasagoodorbadstock;thereareonlycheapstocksandexpensivestocks.Eventhebestcompanybecomesa“sell”whenitsstockpricegoestoohigh,whiletheworstcompanyisworthbuyingifitsstockgoeslowenough.

†Theverypeoplewhoconsideredtechnologyandtelecommunicationsstocksa“surething”inlate1999andearly2000,whentheywerehellishlyoverpriced,shunnedthemas“toorisky”in2002—eventhough,inGraham’sexactwordsfromanearlierperiod,“thepricedepreciationofabout90%mademanyofthesesecuritiesexceedinglyattractiveandreasonablysafe.”Similarly,WallStreet’sanalystshavealwaystendedtocallastocka“strongbuy”whenitspriceishigh,andtolabelita“sell”afteritspricehasfallen—theexact

oppositeofwhatGraham(andsimplecommonsense)woulddictate.Ashedoesthroughoutthebook,Grahamisdistinguishingspeculation—orbuyingonthehopethatastock’spricewillkeepgoingup—frominvesting,orbuyingonthebasisofwhattheunderlyingbusinessisworth.

*Grahamuses“common-stockoptionwarrant”asasynonymfor“warrant,”asecurityissueddirectlybyacorporationgivingtheholderarighttopurchasethecompany’sstockatapredeterminedprice.Warrantshavebeenalmostentirelysupersededbystockoptions.Grahamquipsthatheintendstheexampleasa“shocker”because,eveninhisday,warrantswereregardedasoneofthemarket’sseediestbackwaters.(SeethecommentaryonChapter16.)

1AsrecountedbyinvestmentconsultantCharlesEllisinJasonZweig,“WallStreet’sWisestMan,”Money,June,2001,pp.49–52.

2JDSUniphase’ssharepricehasbeenadjustedforlatersplits.

3Noonewhodiligentlyresearchedtheanswertothisquestion,andhonestlyacceptedtheresults,wouldeverhavedaytradedorboughtIPOs.

4PaulSlovic,“InformingandEducatingthePublicaboutRisk,”RiskAnalysis,vol.6,no.4(1986),p.412.

5“TheWager,”inBlaisePascal,Pensées(PenguinBooks,LondonandNewYork,1995),pp.122–125;PeterL.Bernstein,

AgainsttheGods(JohnWiley&Sons,NewYork,1996),pp.68–70;PeterL.Bernstein,“DecisionTheoryinIambicPentameter,”Economics&PortfolioStrategy,January1,2003,p.2.

*Thestudy,initsfinalform,wasLawrenceFisherandJamesH.Lorie,“RatesofReturnonInvestmentsinCommonStock:theYear-by-YearRecord,1926–65,”TheJournalofBusiness,vol.XLI,no.3(July,1968),pp.291–316.Forasummaryofthestudy’swideinfluence,seehttp://library.dfaus.com/reprints/work_of_art/.

*Seepp.50–52.

†The“price/earningsratio”ofastock,orofamarketaverageliketheS&P500-stockindex,isasimpletoolfortakingthe

market’stemperature.If,forinstance,acompanyearned$1pershareofnetincomeoverthepastyear,anditsstockissellingat$8.93pershare,itsprice/earningsratiowouldbe8.93;if,however,thestockissellingat$69.70,thentheprice/earningsratiowouldbe69.7.Ingeneral,aprice/earningsratio(or“P/E”ratio)below10isconsideredlow,between10and20isconsideredmoderate,andgreaterthan20isconsideredexpensive.(FormoreonP/Eratios,seep.168.)

1Ifdividendsarenotincluded,stocksfell47.8%inthosetwoyears.

1Bythe1840s,theseindexeshadwidenedtoincludeamaximumofsevenfinancialstocksand27railroadstocks—stillanabsurdlyunrepresentativesampleoftherambunctiousyoungAmericanstock

market.

2SeeJasonZweig,“NewCauseforCautiononStocks,”Time,May6,2002,p.71.AsGrahamhintsonp.65,eventhestockindexesbetween1871andthe1920ssufferfromsurvivorshipbias,thankstothehundredsofautomobile,aviation,andradiocompaniesthatwentbustwithoutatrace.Thesereturns,too,areprobablyoverstatedbyonetotwopercentagepoints.

2Thosecheaperstockpricesdonotmean,ofcourse,thatinvestors’expectationofa7%stockreturnwillberealized.

3SeeJeremySiegel,StocksfortheLongRun(McGraw-Hill,2002),p.94,andRobertArnottandWilliamBernstein,“TheTwoPercentDilution,”workingpaper,July,2002.

*SeeGraham’s“Conclusion”toChapter2,p.56–57.

*Graham’sobjectiontohigh-yieldbondsismitigatedtodaybythewidespreadavailabilityofmutualfundsthatspreadtheriskanddotheresearchofowning“junkbonds.”SeethecommentaryonChapter6formoredetail.

††The“NewHousing”bondsand“NewCommunitydebentures”arenomore.NewHousingAuthoritybondswerebackedbytheU.S.DepartmentofHousingandUrbanDevelopment(HUD)andwereexemptfromincometax,buttheyhavenotbeenissuedsince1974.NewCommunitydebentures,alsobackedbyHUD,wereauthorizedbyaFederallawpassedin1968.About$350millionofthesedebentures

wereissuedthrough1975,buttheprogramwasterminatedin1983.

*Abond’s“coupon”isitsinterestrate;a“low-coupon”bondpaysarateofinterestincomebelowthemarketaverage.

*WhileGraham’slogicremainsvalid,thenumbershavechanged.Corporationscancurrentlydeduct70%oftheincometheyreceivefromdividends,andthestandardcorporatetaxrateis35%.Thus,acorporationwouldpayroughly$24.50intaxon$100individendsfrompreferredstockversus$35intaxon$100ininterestincome.Individualspaythesamerateofincometaxondividendincomethattheydooninterestincome,sopreferredstockoffersthemnotaxadvantage.

1Formoreaboutthedistinctionbetween

physicallyandintellectuallydifficultinvestingontheonehand,andemotionallydifficultinvestingontheother,seeChapter8andalsoCharlesD.Ellis,“ThreeWaystoSucceedasanInvestor,”inCharlesD.EllisandJamesR.Vertin,eds.,TheInvestor’sAnthology(JohnWiley&Sons,1997),p.72.

2ArecentGooglesearchforthephrase“ageandassetallocation”turnedupmorethan30,000onlinereferences.

3JamesK.GlassmanandKevinA.Hassett,Dow36,000:TheNewStrategyforProfitingfromtheComingRiseintheStockMarket(TimesBusiness,1999),p.250.

4Forafascinatingessayonthispsychologicalphenomenon,seeDanielGilbertandTimothyWilson’s

“Miswanting,”atwww.wjh.harvard.edu/˜dtg/Gilbert_&_Wilson(Miswanting).pdf.

5Forthesakeofsimplicity,thisexampleassumesthatstocksroseinstantaneously.

6Forthe2003taxyear,thebottomFederaltaxbracketisforsinglepeopleearninglessthan$28,400ormarriedpeople(filingjointly)earninglessthan$47,450.

7Twogoodonlinecalculatorsthatwillhelpyoucomparetheafter-taxincomeofmunicipalandtaxablebondscanbefoundatwww.investinginbonds.com/cgi-bin/calculator.plandwww.lebenthal.com/index_infocenter.html.Todecideifa“muni”isrightforyou,findthe“taxableequivalentyield”generatedbythesecalculators,thencomparethatnumbertotheyieldcurrentlyavailableon

Treasurybonds(http://money.cnn.com/markets/bondcenter/orwww.bloomberg.com/markets/C13.html).IftheyieldonTreasurybondsishigherthanthetaxableequivalentyield,munisarenotforyou.Inanycase,bewarnedthatmunicipalbondsandfundsproducelowerincome,andmorepricefluctuation,thanmosttaxablebonds.Also,thealternativeminimumtax,whichnowhitsmanymiddle-incomeAmericans,cannegatetheadvantagesofmunicipalbonds.

8Foranexcellentintroductiontobondinvesting,seehttp://flagship.vanguard.com/web/planret/AdvicePTIBInvestmentsInvestingInBonds.html#InterestRates.Foranevensimplerexplanationofbonds,seehttp://money.cnn.com/pf/101/lessons/7/.A“laddered”portfolio,holdingbondsacrossarangeof

maturities,isanotherwayofhedginginterest-raterisk.

9Formoreinformation,seewww.vanguard.com,www.fidelity.com,www.schwab.com,andwww.troweprice.com.

10Foranaccessibleonlinesummaryofbondinvesting,seewww.aaii.com/promo/20021118/bonds.shtml.

11Ingeneral,variableannuitiesarenotattractiveforinvestorsundertheageof50whoexpecttobeinahightaxbracketduringretirementorwhohavenotalreadycontributedthemaximumtotheirexisting401(k)orIRAaccounts.Fixedannuities(withthenotableexceptionofthosefromTIAA-CREF)canchangetheir“guaranteed”ratesandsmackyouwith

nastysurrenderfees.Forthoroughandobjectiveanalysisofannuities,seetwosuperbarticlesbyWalterUpdegrave:“IncomeforLife,”Money,July,2002,pp.89–96,and“AnnuityBuyer’sGuide,”Money,November,2002,pp.104–110.

12Formoreontheroleofdividendsinaportfolio,seeChapter19.

*Atthebeginningof1949,theaverageannualreturnproducedbystocksovertheprevious20yearswas3.1%,versus3.9%forlong-termTreasurybonds—meaningthat$10,000investedinstockswouldhavegrownto$18,415overthatperiod,whilethesameamountinbondswouldhaveturnedinto$21,494.Naturallyenough,1949turnedouttobeafabuloustimetobuystocks:Overthenextdecade,theStandard&Poor’s500-stockindexgained

anaverageof20.1%peryear,oneofthebestlong-termreturnsinthehistoryoftheU.S.stockmarket.

†Graham’searliercommentsonthissubjectappearonpp.19–20.Justimaginewhathewouldhavethoughtaboutthestockmarketofthelate1990s,inwhicheachnewrecord-settinghighwasconsideredfurther“proof”thatstocksweretherisklesswaytowealth!

*TheDowJonesIndustrialAverageclosedatathen-recordhighof381.17onSeptember3,1929.ItdidnotcloseabovethatleveluntilNovember23,1954—morethanaquarterofacenturylater—whenithit382.74.(Whenyousayyouintendtoownstocks“forthelongrun,”doyourealizejusthowlongthelongruncanbe—orthatmanyinvestorswhoboughtin1929

werenolongerevenaliveby1954?)However,forpatientinvestorswhoreinvestedtheirincome,stockreturnswerepositiveoverthisotherwisedismalperiod,simplybecausedividendyieldsaveragedmorethan5.6%peryear.AccordingtoprofessorsElroyDimson,PaulMarsh,andMikeStauntonofLondonBusinessSchool,ifyouhadinvested$1inU.S.stocksin1900andspentallyourdividends,yourstockportfoliowouldhavegrownto$198by2000.Butifyouhadreinvestedallyourdividends,yourstockportfoliowouldhavebeenworth$16,797!Farfrombeinganafterthought,dividendsarethegreatestforceinstockinvesting.

†Whydothe“highprices”ofstocksaffecttheirdividendyields?Astock’syieldistheratioofitscashdividendtothepriceofoneshareofcommonstock.Ifacompanypays

a$2annualdividendwhenitsstockpriceis$100pershare,itsyieldis2%.Butifthestockpricedoubleswhilethedividendstaysconstant,thedividendyieldwilldropto1%.In1959,whenthetrendGrahamspottedin1957becamenoticeabletoeveryone,mostWallStreetpunditsdeclaredthatitcouldnotpossiblylast.Neverbeforehadstocksyieldedlessthanbonds;afterall,sincestocksareriskierthanbonds,whywouldanyonebuythematallunlesstheypayextradividendincometocompensatefortheirgreaterrisk?Theexpertsarguedthatbondswouldoutyieldstocksforafewmonthsatmost,andthenthingswouldrevertto“normal.”Morethanfourdecadeslater,therelationshiphasneverbeennormalagain;theyieldonstockshas(sofar)continuouslystayedbelowtheyieldonbonds.

*Seepp.56–57and88–89.

†Foranotherviewofdiversification,seethesidebarinthecommentaryonChapter14(p.368).

*Today’sdefensiveinvestorshouldprobablyinsistonatleast10yearsofcontinuousdividendpayments(whichwouldeliminatefromconsiderationonlyonememberoftheDowJonesIndustrialAverage—Microsoft—andwouldstillleaveatleast317stockstochoosefromamongtheS&P500index).Eveninsistingon20yearsofuninterrupteddividendpaymentswouldnotbeoverlyrestrictive;accordingtoMorganStanley,255companiesintheS&P500metthatstandardasofyear-end2002.

†The“Ruleof72”isahandymentaltool.Toestimatethelengthoftimeanamountofmoneytakestodouble,simplydivideitsassumedgrowthrateinto72.At6%,forinstance,moneywilldoublein12years(72dividedby6=12).Atthe7.1%ratecitedbyGraham,agrowthstockwilldoubleitsearningsinjustover10years(72/7.1=10.1years).

*Grahammakesthispointonp.73.

†ToshowthatGraham’sobservationsareperenniallytrue,wecansubstituteMicrosoftforIBMandCiscoforTexasInstruments.Thirtyyearsapart,theresultsareuncannilysimilar:Microsoft’sstockdropped55.7%from2000through2002,whileCisco’sstock—whichhadrisenroughly50-foldovertheprevioussixyears

—lost76%ofitsvaluefrom2000through2002.AswithTexasInstruments,thedropinCisco’sstockpricewassharperthanthefallinitsearnings,whichdroppedjust39.2%(comparingthethree-yearaveragefor1997–1999against2000–2002).Asalways,thehottertheyare,thehardertheyfall.

*“Earningsmultiplier”isasynonymforP/Eorprice/earningsratios,whichmeasurehowmuchinvestorsarewillingtopayforastockcomparedtotheprofitabilityoftheunderlyingbusiness.(Seefootnote†onp.70inChapter3.)

†Investorscannowsetuptheirownautomatedsystemtomonitorthequalityoftheirholdingsbyusinginteractive“portfoliotrackers”atsuchwebsitesaswww.quicken.com,moneycentral.msn.com,

finance.yahoo.com,andwww.morningstar.com.Grahamwould,however,warnagainstrelyingexclusivelyonsuchasystem;youmustuseyourownjudgmenttosupplementthesoftware.

*ToupdateGraham’sfigures,takeeachdollaramountinthissectionandmultiplyitbyfive.

*Intoday’smarkets,tobeconsideredlarge,acompanyshouldhaveatotalstockvalue(or“marketcapitalization”)ofatleast$10billion.Accordingtotheonlinestockscreenerathttp://screen.yahoo.com/stocks.html,thatgaveyouroughly300stockstochoosefromasofearly2003.

1PeterLynchwithJohnRothchild,OneUponWallStreet(Penguin,1989),p.23.

2KevinLandisinterviewonCNNIntheMoney,November5,1999,11A.M.easternstandardtime.IfLandis’sownrecordisanyindication,focusingon“thethingsthatyouknow”isnot“allyoureallyneedtodo”topickstockssuccessfully.Fromtheendof1999throughtheendof2002,Landis’sfund(fulloftechnologycompaniesthatheclaimedtoknow“firsthand”fromhisbaseinSiliconValley)lost73.2%ofitsvalue,anevenworsepoundingthantheaveragetechnologyfundsufferedoverthatperiod.

3SarahLichtensteinandBaruchFischhoff,“DoThoseWhoKnowMoreAlsoKnowMoreaboutHowMuchTheyKnow?”OrganizationalBehaviorandHumanPerformance,vol.20,no.2,December,1977,pp.159–183.

4SeeGurHuberman,“FamiliarityBreedsInvestment”;JoshuaD.CovalandTobiasJ.Moskowitz,“TheGeographyofInvestment”;andGurHubermanandPaulSengmuller,“CompanyStockin401(k)Plans,”allavailableathttp://papers.ssrn.com.

5AccordingtofinanceprofessorCharlesJonesofColumbiaBusinessSchool,thecostofasmall,one-waytrade(eitherabuyorasell)inaNewYorkStockExchange–listedstockdroppedfromabout1.25%inGraham’sdaytoabout0.25%in2000.Forinstitutionslikemutualfunds,thosecostsareactuallyhigher.(SeeCharlesM.Jones,“ACenturyofStockMarketLiquidityandTradingCosts,”athttp://papers.ssrn.com.)

6Tohelpdeterminewhetherthestocksyou

ownaresufficientlydiversifiedacrossdifferentindustrialsectors,youcanusethefree“InstantX-Ray”functionatwww.morningstar.comorconsultthesectorinformation(GlobalIndustryClassificationStandard)atwww.standardandpoors.com.

7Formoreontherationaleforkeepingaportionofyourportfolioinforeignstocks,seepp.186–187.

8Source:spreadsheetdataprovidedcourtesyofIbbotsonAssociates.AlthoughitwasnotpossibleforretailinvestorstobuytheentireS&P500indexuntil1976,theexampleneverthelessprovesthepowerofbuyingmorewhenstockpricesgodown.

*HereGrahamhasmadeaslipofthetongue.AfterinsistinginChapter1that

thedefinitionofan“enterprising”investordependsnotontheamountofriskyouseek,buttheamountofworkyouarewillingtoputin,Grahamfallsbackontheconventionalnotionthatenterprisinginvestorsaremore“aggressive.”Therestofthechapter,however,makesclearthatGrahamstandsbyhisoriginaldefinition.(ThegreatBritisheconomistJohnMaynardKeynesappearstohavebeenthefirsttousetheterm“enterprise”asasynonymforanalyticalinvestment.)

*“High-couponissues”arecorporatebondspayingabove-averageinterestrates(intoday’smarkets,atleast8%)orpreferredstockspayinglargedividendyields(10%ormore).Ifacompanymustpayhighratesofinterestinordertoborrowmoney,thatisafundamentalsignalthatitisrisky.Formoreonhigh-yieldor

“junk”bonds,seepp.145–147.

†Asofearly2003,theequivalentyieldsareroughly5.1%onhigh-gradecorporatebondsand4.7%on20-yeartax-freemunicipalbonds.Toupdatetheseyields,seewww.bondsonline.com/asp/news/composites/htmlorwww.bloomberg.com/markets/rates.htmlandwww.bloomberg.com/markets/psamuni.html.

*ForarecentexamplethatpainfullyreinforcesGraham’spoint,seep.146below.

*Bondpricesarequotedinpercentagesof“parvalue,”or100.Abondpricedat“85”issellingat85%ofitsprincipalvalue;abondoriginallyofferedfor$10,000,but

nowsellingat85,willcost$8,500.Whenbondssellbelow100,theyarecalled“discount”bonds;above100,theybecome“premium”bonds.

*Newissuesofcommonstock—initialpublicofferingsorIPOs—normallyaresoldwithan“underwritingdiscount”(abuilt-incommission)of7%.Bycontrast,thebuyer’scommissiononoldersharesofcommonstocktypicallyrangesbelow4%.WheneverWallStreetmakesroughlytwiceasmuchforsellingsomethingnewasitdoesforsellingsomethingold,thenewwillgetthehardersell.

†Recently,financeprofessorsOwenLamontoftheUniversityofChicagoandPaulSchultzoftheUniversityofNotreDamehaveshownthatcorporationschoosetooffernewsharestothepublicwhenthe

stockmarketisnearapeak.Fortechnicaldiscussionoftheseissues,seeLamont’s“EvaluatingValueWeighting:CorporateEventsandMarketTiming”andSchultz’s“PseudoMarketTimingandtheLong-RunPerformanceofIPOs”athttp://papers.ssrn.com.

*InthetwoyearsfromJune1960,throughMay1962,morethan850companiessoldtheirstocktothepublicforthefirsttime—anaverageofmorethanoneperday.Inlate1967theIPOmarketheatedupagain;in1969anastonishing781newstockswereborn.Thatoversupplyhelpedcreatethebearmarketsof1969and1973–1974.In1974theIPOmarketwassodeadthatonlyninenewstockswerecreatedallyear;1975sawonly14stocksborn.Thatundersupply,inturn,helpedfeedthebullmarketofthe1980s,whenroughly4,000newstocks

floodedthemarket—helpingtotriggertheover-enthusiasmthatledtothe1987crash.ThenthecycleswungtheotherwayagainasIPOsdriedupin1988–1990.Thatshortagecontributedtothebullmarketofthe1990s—and,rightoncue,WallStreetgotbackintothebusinessofcreatingnewstocks,crankingoutnearly5,000IPOs.Then,afterthebubbleburstin2000,only88IPOswereissuedin2001—thelowestannualtotalsince1979.Ineverycase,thepublichasgottenburnedonIPOs,hasstayedawayforatleasttwoyears,buthasalwaysreturnedforanotherscalding.Foraslongasstockmarketshaveexisted,investorshavegonethroughthismanic-depressivecycle.InAmerica’sfirstgreatIPOboom,backin1825,amanwassaidtohavebeensqueezedtodeathinthestampedeofspeculatorstryingtobuysharesinthenewBankofSouthwark;the

wealthiestbuyershiredthugstopunchtheirwaytothefrontoftheline.Sureenough,by1829,stockshadlostroughly25%oftheirvalue.

*HereGrahamisdescribingrightsofferings,inwhichinvestorswhoalreadyownastockareaskedtoponyupevenmoremoneytomaintainthesameproportionalinterestinthecompany.Thisformoffinancing,stillwidespreadinEurope,hasbecomerareintheUnitedStates,exceptamongclosed-endfunds.

*InGraham’sday,themostprestigiousinvestmentbanksgenerallysteeredclearoftheIPObusiness,whichwasregardedasanundignifiedexploitationofnaïveinvestors.BythepeakoftheIPOboominlate1999andearly2000,however,WallStreet’sbiggestinvestmentbankshad

jumpedinwithbothfeet.Venerablefirmscastofftheirtraditionalprudenceandbehavedlikedrunkenmudwrestlers,scramblingtofoistludicrouslyovervaluedstocksonadesperatelyeagerpublic.Graham’sdescriptionofhowtheIPOprocessworksisaclassicthatshouldberequiredreadingininvestment-bankingethicsclasses,ifthereareany.

1Seewww.calpers.ca.gov/whatshap/hottopic/worldcom_faqs.htmandwww.calpers.ca.gov/whatsnew/press/2002/0716a.htm;RetirementSystemsofAlabamaQuarterlyInvestmentReportforMay31,2001,atwww.rsa.state.al.us/Investments/quarterly_report.htm;andJohnBender,StrongCorporateBondFundcomanager,quotedinwww.businessweek.com/magazine/content/01_22/

b3734118.htm.

2ThesenumbersarealldrawnfromWorldCom’sprospectus,orsalesdocument,forthebondoffering.FiledMay11,2001,itcanbeviewedatwww.sec.gov/edgar/searchedgar/companysearch.html(in“Companyname”window,enter“WorldCom”).Evenwithouttoday’s20/20hindsightknowledgethatWorldCom’searningswerefraudulentlyoverstated,WorldCom’sbondofferingwouldhaveappalledGraham.

3FordocumentationonthecollapseofWorldCom,seewww.worldcom.com/infodesk.

1Intheearly1970s,whenGrahamwrote,therewerefewerthanadozenjunk-bondfunds,nearlyallofwhichchargedsales

commissionsofupto8.5%;someevenmadeinvestorspayafeefortheprivilegeofreinvestingtheirmonthlydividendsbackintothefund.

2EdwardI.AltmanandGauravBana,“DefaultsandReturnsonHigh-YieldBonds,”researchpaper,SternSchoolofBusiness,NewYorkUniversity,2002.

3Grahamdidnotcriticizeforeignbondslightly,sincehespentseveralyearsearlyinhiscareeractingasaNewYork–basedbondagentforborrowersinJapan.

4Twolow-cost,well-runemerging-marketsbondfundsareFidelityNewMarketsIncomeFundandT.RowePriceEmergingMarketsBondFund;formoreinformation,seewww.fidelity.com,www.troweprice.com,andwww.

morningstar.com.Donotbuyanyemerging-marketsbondfundwithannualoperatingexpenseshigherthan1.25%,andbeforewarnedthatsomeofthesefundschargeshort-termredemptionfeestodiscourageinvestorsfromholdingthemforlessthanthreemonths.

5ThedefinitivesourceonbrokeragecostsisthePlexusGroupofSantaMonica,California,anditswebsite,www.plexusgroup.com.Plexusarguespersuasivelythat,justasmostofthemassofanicebergliesbelowtheoceansurface,thebulkofbrokeragecostsareinvisible—misleadinginvestorsintobelievingthattheirtradingcostsareinsignificantifcommissioncostsarelow.ThecostsoftradingNASDAQstocksareconsiderablyhigherforindividualsthanthecostsoftradingNYSE-listedstocks(seep.128,

footnote5).

6Real-worldconditionsarestillmoreharsh,sinceweareignoringstateincometaxesinthisexample.

7BarberandOdean’sfindingsareavailableathttp://faculty.haas.berkeley.edu/odean/Current%20Research.htmandhttp://faculty.gsm.ucdavis.edu/˜bmbarber/research/default.html.Numerousstudies,incidentally,havefoundvirtuallyidenticalresultsamongprofessionalmoneymanagers—sothisisnotaproblemlimitedto“naïve”individuals.

8Seewww.microsoft.com/msft/stock.htm,“IPOinvestmentresults.”

9JayR.RitterandIvoWelch,“AReview

ofIPOActivity,Pricing,andAllocations,”JournalofFinance,August,2002,p.1797.Ritter’swebsite,athttp://bear.cba.ufl.edu/ritter/,andWelch’shomepage,athttp://welch.som.yale.edu/,aregoldminesofdataforanyoneinterestedinIPOs.

10Messageno.9,postedby“GoldFingers69,”ontheVALinux(LNUX)messageboardatmessages.yahoo.com,datedDecember16,1999.MSFTisthetickersymbolforMicrosoftCorp.

*Asalreadynoted(seep.96,footnote†),theNewHousingAuthorityandNewCommunitybondsarenolongerissued.

†Todaythese“lower-qualitybonds”inthe“specialsituation”areaareknownasdistressedordefaultedbonds.Whena

companyisinapproaching)bankruptcy,itscommonstockbecomesessentiallyworthless,sinceU.S.bankruptcylawentitlesbondholderstoamuchstrongerlegalclaimthanshareholders.Butifthecompanyreorganizessuccessfullyandcomesoutofbankruptcy,thebondholdersoftenreceivestockinthenewfirm,andthevalueofthebondsusuallyrecoversoncethecompanyisabletopayinterestagain.Thusthebondsofatroubledcompanycanperformalmostaswellasthecommonstockofahealthycompany.Inthesespecialsituations,asGrahamputsit,“notruedistinctionexistsbetweenbondsandcommonstocks.”(or

*NoteverycarefullywhatGrahamissayinghere.Writingin1972,hecontendsthattheperiodsince1949—astretchofmorethan22years—istooshortaperiod

fromwhichtodrawreliableconclusions!Withhismasteryofmathematics,Grahamneverforgetsthatobjectiveconclusionsrequireverylongsamplesoflargeamountsofdata.Thecharlatanswhopeddle“time-tested”stock-pickinggimmicksalmostalwaysbasetheirfindingsonsmallersamplesthanGrahamwouldeveraccept.(Grahamoftenused50-yearperiodstoanalyzepastdata.)

†Today,theenterprisinginvestorcanassemblesuchalistovertheInternetbyvisitingsuchwebsitesaswww.morningstar.com(trytheStockQuickranktool),www.quicken.com/investments/stocks/search/full,andhttp://yahoo.marketguide.com.

*Overthe10yearsendingDecember31,2002,fundsinvestinginlargegrowth

companies—today’sequivalentofwhatGrahamcalls“growthfunds”—earnedanannualaverageof5.6%,underperformingtheoverallstockmarketbyanaverageof3.7percentagepointsperyear.However,“largevalue”fundsinvestinginmorereasonablypricedbigcompaniesalsounderperformedthemarketoverthesameperiod(byafullpercentagepointperyear).Istheproblemmerelythatgrowthfundscannotreliablyselectstocksthatwilloutperformthemarketinthefuture?Orisitthatthehighcostsofrunningtheaveragefund(whetheritbuysgrowthor“value”companies)exceedanyextrareturnthemanagerscanearnwiththeirstockpicks?Toupdatefundperformancebytype,seewww.morningstar.com,“CategoryReturns.”Foranenlighteningreminderofhowperishabletheperformanceofdifferentinvestmentstylescanbe,see

www.callan.com/resource/periodic_table/pertable.pdf.

*Grahammakesthispointtoremindyouthatan“enterprising”investorisnotonewhotakesmoreriskthanaverageorwhobuys“aggressivegrowth”stocks;anenterprisinginvestorissimplyonewhoiswillingtoputinextratimeandeffortinresearchinghisorherportfolio.

†NoticethatGrahaminsistsoncalculatingtheprice/earningsratiobasedonamultiyearaverageofpastearnings.Thatway,youlowertheoddsthatyouwilloverestimateacompany’svaluebasedonatemporarilyhighburstofprofitability.Imaginethatacompanyearned$3pershareoverthepast12months,butanaverageofonly50centspershareovertheprevioussixyears.Whichnumber—the

sudden$3orthesteady50cents—ismorelikelytorepresentasustainabletrend?At25timesthe$3itearnedinthemostrecentyear,thestockwouldbepricedat$75.Butat25timestheaverageearningsofthepastsevenyears($6intotalearnings,dividedbyseven,equals85.7centspershareinaverageannualearnings),thestockwouldbepricedatonly$21.43.Whichnumberyoupickmakesabigdifference.Finally,it’sworthnotingthattheprevailingmethodonWallStreettoday—basingprice/earningsratiosprimarilyon“nextyear’searnings”—wouldbeanathematoGraham.Howcanyouvalueacompanybasedonearningsithasn’tevengeneratedyet?That’slikesettinghousepricesbasedonarumorthatCinderellawillbebuildinghernewcastlerightaroundthecorner.

*RecentexampleshammerGraham’s

pointhome.OnSeptember21,2000,IntelCorp.,themakerofcomputerchips,announcedthatitexpecteditsrevenuestogrowbyupto5%inthenextquarter.Atfirstblush,thatsoundsgreat;mostbigcompanieswouldbedelightedtoincreasetheirsalesby5%injustthreemonths.Butinresponse,Intel’sstockdropped22%,aone-daylossofnearly$91billionintotalvalue.Why?WallStreet’sanalystshadexpectedIntel’srevenuetorisebyupto10%.Similarly,onFebruary21,2001,EMCCorp.,adata-storagefirm,announcedthatitexpecteditsrevenuestogrowbyatleast25%in2001—butthatanewcautionamongcustomers“mayleadtolongersellingcycles.”Onthatwhiffofhesitation,EMC’sshareslost12.8%oftheirvalueinasingleday.

*Today’sequivalentofinvestors“who

haveacloserelationshipwiththeparticularcompany”areso-calledcontrolpersons—seniormanagersordirectorswhohelprunthecompanyandownhugeblocksofstock.ExecutiveslikeBillGatesofMicrosoftorWarrenBuffettofBerkshireHathawayhavedirectcontroloveracompany’sdestiny—andoutsideinvestorswanttoseethesechiefexecutivesmaintaintheirlargeshareholdingsasavoteofconfidence.Butless-seniormanagersandrank-and-fileworkerscannotinfluencethecompany’ssharepricewiththeirindividualdecisions;thustheyshouldnotputmorethanasmallpercentageoftheirassetsintheirownemployer’sstock.Asforoutsideinvestors,nomatterhowwelltheythinktheyknowthecompany,thesameobjectionapplies.

*DrexelFirestone,aPhiladelphia

investmentbank,mergedin1973withBurnham&Co.andlaterbecameDrexelBurnhamLambert,famousforitsjunk-bondfinancingofthe1980stakeoverboom.

†ThisstrategyofbuyingthecheapeststocksintheDowJonesIndustrialAverageisnownicknamedthe“DogsoftheDow”approach.Informationonthe“Dow10”isavailableatwww.djindexes.com/jsp/dow510Faq.jsp.

*Amongthesteepestofthemountainsrecentlymadeoutofmolehills:InMay1998,PfizerInc.andtheU.S.FoodandDrugAdministrationannouncedthatsixmentakingPfizer’santi-impotencedrugViagrahaddiedofheartattackswhilehavingsex.Pfizer’sstockimmediatelywentflaccid,losing3.4%inasingledayonheavytrading.ButPfizer’ssharessurged

aheadwhenresearchlatershowedthattherewasnocauseforalarm;thestockgainedroughlyathirdoverthenexttwoyears.Inlate1997,sharesofWarner-LambertCo.fellby19%inadaywhensalesofitsnewdiabetesdrugweretemporarilyhaltedinEngland;withinsixmonths,thestockhadnearlydoubled.Inlate2002,CarnivalCorp.,whichoperatescruiseships,lostroughly10%ofitsvalueaftertouristscamedownwithseverediarrheaandvomiting—onshipsrunbyothercompanies.

*By“networkingcapital,”Grahammeansacompany’scurrentassets(suchascash,marketablesecurities,andinventories)minusitstotalliabilities(includingpreferredstockandlong-termdebt).

*From1975through1983,small

(“secondary”)stocksoutperformedlargestocksbyanamazingaverageof17.6percentagepointsperyear.Theinvestingpubliceagerlyembracedsmallstocks,mutualfundcompaniesrolledouthundredsofnewfundsspecializinginthem,andsmallstocksobligedbyunderperforminglargestocksbyfivepercentagepointsperyearoverthenextdecade.Thecyclerecurredin1999,whensmallstocksbeatbigstocksbynearlyninepercentagepoints,inspiringinvestmentbankerstosellhundredsofhotlittlehigh-techstockstothepublicforthefirsttime.Insteadof“electronics,”“computers,”or“franchise”intheirnames,thenewbuzzwordswere“.com,”“optical,”“wireless,”andevenprefixeslike“e-”and“I-.”Investingbuzzwordsalwaysturnintobuzzsaws,tearingapartanyonewhobelievesinthem.

*Defaultedrailroadbondsdonotoffersignificantopportunitiestoday.However,asalreadynoted,distressedanddefaultedjunkbonds,aswellasconvertiblebondsissuedbyhigh-techcompanies,mayofferrealvalueinthewakeofthe2000–2002marketcrash.Butdiversificationinthisareaisessential—andimpracticalwithoutatleast$100,000todedicatetodistressedsecuritiesalone.Unlessyouareamillionaireseveraltimesover,thiskindofdiversificationisnotanoption.

*AclassicrecentexampleisPhilipMorris,whosestocklost23%intwodaysafteraFloridacourtauthorizedjurorstoconsiderpunitivedamagesofupto$200billionagainstthecompany—whichhadfinallyadmittedthatcigarettesmaycausecancer.Withinayear,PhilipMorris’sstockhaddoubled—onlytofallbackafteralater

multibillion-dollarjudgmentinIllinois.Severalotherstockshavebeenvirtuallydestroyedbyliabilitylawsuits,includingJohnsManville,W.R.Grace,andUSGCorp.Thus,“neverbuyintoalawsuit”remainsavalidruleforallbutthemostintrepidinvestorstoliveby.

1LisaGibbs,“OpticUptick,”Money,April,2000,pp.54–55.

2BrookeSouthall,“Cisco’sEndgameStrategy,”InvestmentNews,November30,2000,pp.1,23.

1“TheTruthAboutTiming,”Barron’s,November5,2001,p.20.Theheadlineofthisarticleisausefulreminderofanenduringprinciplefortheintelligentinvestor.Wheneveryouseetheword“truth”inanarticleaboutinvesting,brace

yourself;manyofthequotesthatfollowarelikelytobelies.(Foronething,aninvestorwhoboughtstocksin1966andheldthemthroughlate2001wouldhaveendedupwithatleast$40,not$11.71;thestudycitedinBarron’sappearstohaveignoredthereinvestmentofdividends.)

2TheNewYorkTimes,January7,1973,special“EconomicSurvey”section,pp.2,19,44.

3Pressrelease,“It’sagoodtimetobeinthemarket,saysR.M.Leary&Company,”December3,2001.

4Youwouldalsohavesavedthousandsofdollarsinannualsubscriptionfees(whichhavenotbeendeductedfromthecalculationsofthesenewsletters’returns).Andbrokeragecostsandshort-term

capitalgainstaxesareusuallymuchhigherformarkettimersthanforbuy-and-holdinvestors.FortheDukestudy,seeJohnR.GrahamandCampbellR.Harvey,“GradingthePerformanceofMarket-TimingNewsletters,”FinancialAnalystsJournal,November/December,1997,pp.54–66,alsoavailableatwww.duke.edu/˜charvey/research.htm.

5Formoreonsensiblealternativestomarkettiming—rebalancinganddollar-costaveraging—seeChapters5and8.

6CarolJ.Loomis,“The15%Delusion,”Fortune,February5,2001,pp.102–108.

7SeeJasonZweig,“AMatterofExpectations,”Money,January,2001,pp.49–50.

8LouisK.C.Chan,JasonKarceski,andJosefLakonishok,“TheLevelandPersistenceofGrowthRates,”NationalBureauofEconomicResearch,WorkingPaperNo.8282,May,2001,availableatwww.nber.org/papers/w8282.

9Almostexactly20yearsearlier,inOctober1982,Johnson&Johnson’sstocklost17.5%ofitsvalueinaweekwhenseveralpeoplediedafteringestingTylenolthathadbeenlacedwithcyanidebyanunknownoutsider.Johnson&Johnsonrespondedbypioneeringtheuseoftamper-proofpackaging,andthestockwentontobeoneofthegreatinvestmentsofthe1980s.

10FortheobservationthatitisamazinglydifficulttoremainontheForbes400,Iam

indebtedtoinvestmentmanagerKennethFisher(himselfaForbescolumnist).

11Inthelate1990s,theforecastsof“marketstrategists”becamemoreinfluentialthaneverbefore.Theydidnot,unfortunately,becomemoreaccurate.OnMarch10,2000,theverydaythattheNASDAQcompositeindexhititsall-timehighof5048.62,PrudentialSecurities’schieftechnicalanalystRalphAcamporasaidinUSATodaythatheexpectedNASDAQtohit6000within12to18months.Fiveweekslater,NASDAQhadalreadyshriveledto3321.29—butThomasGalvin,amarketstrategistatDonaldson,Lufkin&Jenrette,declaredthat“there’sonly200or300pointsofdownsidefortheNASDAQand2000ontheupside.”Itturnedoutthattherewerenopointsontheupsideandmorethan2000onthe

downside,asNASDAQkeptcrashinguntilitfinallyscrapedbottomonOctober9,2002,at1114.11.InMarch2001,AbbyJosephCohen,chiefinvestmentstrategistatGoldman,Sachs&Co.,predictedthattheStandard&Poor’s500-stockindexwouldclosetheyearat1,650andthattheDowJonesIndustrialAveragewouldfinish2001at13,000.“Wedonotexpectarecession,”saidCohen,“andbelievethatcorporateprofitsarelikelytogrowatclosetotrendgrowthrateslaterthisyear.”TheU.S.economywassinkingintorecessionevenasshespoke,andtheS&P500ended2001at1148.08,whiletheDowfinishedat10,021.50—30%and23%belowherforecasts,respectively.

*Seep.3.

*Withoutbearmarketstotakestock

pricesbackdown,anyonewaitingto“buylow”willfeelcompletelyleftbehind—and,alltoooften,willendupabandoninganyformercautionandjumpinginwithbothfeet.That’swhyGraham’smessageabouttheimportanceofemotionaldisciplineissoimportant.FromOctober1990throughJanuary2000,theDowJonesIndustrialAveragemarchedrelentlesslyupward,neverlosingmorethan20%andsufferingalossof10%ormoreonlythreetimes.Thetotalgain(notcountingdividends):395.7%.AccordingtoCrandall,Pierce&Co.,thiswasthesecond-longestuninterruptedbullmarketofthepastcentury;onlythe1949–1961boomlastedlonger.Thelongerabullmarketlasts,themoreseverelyinvestorswillbeafflictedwithamnesia;afterfiveyearsorso,manypeoplenolongerbelievethatbearmarketsareevenpossible.Allthosewhoforgetare

doomedtobereminded;and,inthestockmarket,recoveredmemoriesarealwaysunpleasant.

*Grahamdiscussesthis“recommendedpolicy”inChapter4(pp.89–91).Thispolicy,nowcalled“tacticalassetallocation,”iswidelyfollowedbyinstitutionalinvestorslikepensionfundsanduniversityendowments.

*Manyofthese“formulaplanners”wouldhavesoldalltheirstocksattheendof1954,aftertheU.S.stockmarketrose52.6%,thesecond-highestyearlyreturnthenonrecord.Overthenextfiveyears,thesemarket-timerswouldlikelyhavestoodonthesidelinesasstocksdoubled.

†Easywaystomakemoneyinthestockmarketfadefortworeasons:thenatural

tendencyoftrendstoreverseovertime,or“regresstothemean,”andtherapidadoptionofthestock-pickingschemebylargenumbersofpeople,whopileinandspoilallthefunofthosewhogottherefirst.(Notethat,inreferringtohis“discomfitingexperience,”Grahamis—asalways—honestinadmittinghisownfailures.)SeeJasonZweig,“MurphyWasanInvestor,”Money,July,2002,pp.61–62,andJasonZweig,“NewYear’sPlay,”Money,December,2000,pp.89–90.

*Today’sequivalentofwhatGrahamcalls“second-linecompanies”wouldbeanyofthethousandsofstocksnotincludedintheStandard&Poor’s500-stockindex.Aregularlyrevisedlistofthe500stocksintheS&Pindexisavailableatwww.standardandpoors.com.

†NotecarefullywhatGrahamissayinghere.Itisnotjustpossible,butprobable,thatmostofthestocksyouownwillgainatleast50%fromtheirlowestpriceandloseatleast33%fromtheirhighestprice—regardlessofwhichstocksyouownorwhetherthemarketasawholegoesupordown.Ifyoucan’tlivewiththat—oryouthinkyourportfolioissomehowmagicallyexemptfromit—thenyouarenotyetentitledtocallyourselfaninvestor.(Grahamreferstoa33%declineasthe“equivalentone-third”becausea50%gaintakesa$10stockto$15.From$15,a33%loss[or$5drop]takesitrightbackto$10,whereitstarted.)

*Fortoday’sinvestor,theidealstrategyforpursuingthis“formula”isrebalancing,whichwediscussonpp.104–105.

*Mostcompaniestodayprovide“anengravedstockcertificate”onlyuponspecialrequest.Stocksexist,forthemostpart,inpurelyelectronicform(muchasyourbankaccountcontainscomputerizedcreditsanddebits,notactualcurrency)andthushavebecomeeveneasiertotradethantheywereinGraham’sday.

†Netassetvalue,bookvalue,balance-sheetvalue,andtangible-assetvalueareallsynonymsfornetworth,orthetotalvalueofacompany’sphysicalandfinancialassetsminusallitsliabilities.Itcanbecalculatedusingthebalancesheetsinacompany’sannualandquarterlyreports;fromtotalshareholders’equity,subtractall“soft”assetssuchasgoodwill,trademarks,andotherintangibles.Dividebythefullydilutednumberofsharesoutstandingtoarriveatbookvalueper

share.

*Graham’suseoftheword“paradox”isprobablyanallusiontoaclassicarticlebyDavidDurand,“GrowthStocksandthePetersburgParadox,”TheJournalofFinance,vol.XII,no.3,September,1957,pp.348–363,whichcomparesinvestinginhigh-pricedgrowthstockstobettingonaseriesofcoinflipsinwhichthepayoffescalateswitheachflipofthecoin.Durandpointsoutthatifagrowthstockcouldcontinuetogrowatahighrateforanindefiniteperiodoftime,aninvestorshould(intheory)bewillingtopayaninfinitepriceforitsshares.Why,then,hasnostockeversoldforapriceofinfinitydollarspershare?Becausethehighertheassumedfuturegrowthrate,andthelongerthetimeperiodoverwhichitisexpected,thewiderthemarginforerrorgrows,and

thehigherthecostofevenatinymiscalculationbecomes.GrahamdiscussesthisproblemfurtherinAppendix4(p.570).

*ThemorerecenthistoryofA&Pisnodifferent.Atyear-end1999,itssharepricewas$27.875;atyear-end2000,$7.00;ayearlater,$23.78;atyear-end2002,$8.06.AlthoughsomeaccountingirregularitieslatercametolightatA&P,itdefiesalllogictobelievethatthevalueofarelativelystablebusinesslikegroceriescouldfallbythree-fourthsinoneyear,triplethenextyear,thendropbytwo-thirdstheyearafterthat.

*“Onlytotheextentthatitsuitshisbook”means“onlytotheextentthatthepriceisfavorableenoughtojustifysellingthestock.”Intraditionalbrokeragelingo,the“book”isaninvestor’sledgerofholdings

andtrades.

†ThismaywellbethesinglemostimportantparagraphinGraham’sentirebook.Inthese113wordsGrahamsumsuphislifetimeofexperience.Youcannotreadthesewordstoooften;theyarelikeKryptoniteforbearmarkets.Ifyoukeepthemcloseathandandletthemguideyouthroughoutyourinvestinglife,youwillsurvivewhateverthemarketsthrowatyou.

*Grahamhasmuchmoretosayonwhatisnowknownas“corporategovernance.”SeethecommentaryonChapter19.

*BywhatGrahamcalled“theruleofopposites,”in2002theyieldsonlong-termU.S.Treasurybondshittheirlowestlevelssince1963.Sincebondyieldsmoveinverselytoprices,thoselowyieldsmeant

thatpriceshadrisen—makinginvestorsmosteagertobuyjustasbondswereattheirmostexpensiveandastheirfuturereturnswerealmostguaranteedtobelow.ThisprovidesanotherproofofGraham’slessonthattheintelligentinvestormustrefusetomakedecisionsbasedonmarketfluctuations.

*Anupdatedanalysisfortoday’sreaders,explainingrecentyieldsandthewidervarietyofbondsandbondfundsavailabletoday,canbefoundinthecommentaryonChapter4.

*AsmentionedinthecommentaryonChapters2and4,TreasuryInflation-ProtectedSecurities,orTIPS,areanewandimprovedversionofwhatGrahamissuggestinghere.

1SeeGraham’stext,pp.204–205.

2AsGrahamnotedinaclassicseriesofarticlesin1932,theGreatDepressioncausedthesharesofdozensofcompaniestodropbelowthevalueoftheircashandotherliquidassets,makingthem“worthmoredeadthanalive.”

3Newsrelease,TheSpectremGroup,“PlanSponsorsAreLosingtheBattletoPreventDecliningParticipationandDeferralsintoDefinedContributionPlans,”October25,2002.

4Afewmonthslater,onMarch10,2000—theverydaythatNASDAQhititsall-timehigh—onlinetradingpunditJamesJ.Cramerwrotethathehad“repeatedly”beentemptedinrecentdaystosell

BerkshireHathawayshort,abetthatBuffett’sstockhadfarthertofall.Withavulgarthrustofhisrhetoricalpelvis,CramerevendeclaredthatBerkshire’sshareswere“ripeforthebanging.”Thatsameday,marketstrategistRalphAcamporaofPrudentialSecuritiesasked,“NorfolkSouthernorCiscoSystems:Wheredoyouwanttobeinthefuture?”Cisco,akeytotomorrow’sInternetsuperhighway,seemedtohaveitalloverNorfolkSouthern,partofyesterday’srailroadsystem.(Overthenextyear,NorfolkSoutherngained35%,whileCiscolost70%.)

5Whenaskedwhatkeepsmostindividualinvestorsfromsucceeding,Grahamhadaconciseanswer:“Theprimarycauseoffailureisthattheypaytoomuchattentiontowhatthestockmarketisdoing

currently.”See“BenjaminGraham:ThoughtsonSecurityAnalysis”[transcriptoflectureatNortheastMissouriStateUniversityBusinessSchool,March,1972],FinancialHistorymagazine,no.42,March,1991,p.8.

6Nevermindwhatthesetermsmean,oraresupposedtomean.Whileinpublictheseclassificationsaretreatedwiththeutmostrespect,inprivatemostpeopleintheinvestmentbusinessregardthemwiththecontemptnormallyreservedforjokesthataren’tfunny.

7SeethebrilliantcolumnbyWalterUpdegrave,“KeepItReal,”Money,February,2002,pp.53–56.

8SeeJasonZweig,“DidYouBeattheMarket?”Money,January,2000,pp.55–

58.

9TheneuroscienceofinvestingisexploredinJasonZweig,“AreYouWiredforWealth?”Money,October,2002,pp.74–83,alsoavailableathttp://money.cnn.com/2002/09/25/pf/investing/agenda_brain_short/index.htm.SeealsoJasonZweig,“TheTroublewithHumans,”Money,November,2000,pp.67–70.

10It’salsoworthaskingwhetheryoucouldenjoylivinginyourhouseifitsmarketpricewasreportedtothelastpennyeverydayinthenewspapersandonTV.

11Inaseriesofremarkableexperimentsinthelate1980s,apsychologistatColumbiaandHarvard,PaulAndreassen,showedthatinvestorswhoreceivedfrequentnewsupdatesontheirstocksearnedhalfthe

returnsofinvestorswhogotnonewsatall.SeeJasonZweig,“Here’sHowtoUsetheNewsandTuneOuttheNoise,”Money,July,1998,pp.63–64.

12Federaltaxlawissubjecttoconstantchange.TheexampleofCoca-ColastockgivenhereisvalidundertheprovisionsoftheU.S.taxcodeasitstoodinearly2003.

13Thisexampleassumesthattheinvestorhadnorealizedcapitalgainsin2002anddidnotreinvestanyCokedividends.Taxswapsarenottobeundertakenlightly,sincetheycanbemishandledeasily.Beforedoingataxswap,readIRSPublication550(www.irs.gov/pub/irspdf/p550.pdf).AgoodguidetomanagingyourinvestmenttaxesisRobertN.GordonwithJanM.Rosen,WallStreetSecretsforTax-EfficientInvesting(BloombergPress,Princeton,NewJersey,

2001).Finally,beforeyoupullthetrigger,consultaprofessionaltaxadviser.

*ItisaviolationofFederallawforanopen-endmutualfund,aclosed-endfund,oranexchange-tradedfundtosellsharestothepublicunlessithas“registered”(ormademandatoryfinancialfilings)withtheSEC.

†Thefundindustryhasgonefrom“verylarge”toimmense.Atyear-end2002,therewere8,279mutualfundsholding$6.56trillion;514closed-endfundswith$149.6billioninassets;and116exchange-tradefundsorETFswith$109.7billion.Thesefiguresexcludesuchfund-likeinvestmentsasvariableannuitiesandunitinvestmenttrusts.

*Listsofthemajortypesofmutualfunds

canbefoundatwww.ici.org/pdf/g2understanding.pdfandhttp://news.morningstar.com/fundReturns/CategoryReturns.html.Letter-stockfundsnolongerexist,whilehedgefundsaregenerallybannedbySECrulesfromsellingsharestoanyinvestorwhoseannualincomeisbelow$200,000orwhosenetworthisbelow$1million.

†Today,themaximumsalesloadonastockfundtendstobearound5.75%.Ifyouinvest$10,000inafundwithaflat5.75%salesload,$575willgototheperson(andbrokeragefirm)thatsoldittoyou,leavingyouwithaninitialnetinvestmentof$9,425.The$575saleschargeisactually6.1%ofthatamount,whichiswhyGrahamcallsthestandardwayofcalculatingthechargea“salesgimmick.”Sincethe1980s,no-loadfundshavebecome

popular,andtheynolongertendtobesmallerthanloadfunds.

†Nearlyeverymutualfundtodayistaxedasa“regulatedinvestmentcompany,”orRIC,whichisexemptfromcorporateincometaxsolongasitpaysoutessentiallyallofitsincometoitsshareholders.Inthe“option”thatGrahamomits“toavoidclutter,”afundcanasktheSECforspecialpermissiontodistributeoneofitsholdingsdirectlytothefund’sshareholders—ashisGraham-NewmanCorp.didin1948,parcelingoutsharesinGEICOtoGraham-Newman’sowninvestors.Thissortofdistributionisextraordinarilyrare.

*Dual-purposefunds,popularinthelate1980s,haveessentiallydisappearedfromthemarketplace—ashame,sincetheyofferedinvestorsamoreflexiblewayto

takeadvantageoftheskillsofgreatstockpickerslikeJohnNeff.Perhapstherecentbearmarketwillleadtoarenaissanceofthisattractiveinvestmentvehicle.

†“Performancefunds”werealltherageinthelate1960s.Theywereequivalenttotheaggressivegrowthfundsofthelate1990s,andservedtheirinvestorsnobetter.

*Forperiodsaslongas10years,thereturnsoftheDowandtheS&P500candivergebyfairlywidemargins.Overthecourseofthetypicalinvestinglifetime,however—say25to50years—theirreturnshavetendedtoconvergequiteclosely.

*Oneofthe“doomedcompanies”GrahamreferstowasNationalStudentMarketingCorp.,acongamemasqueradingasastock,whosesagawastoldbrilliantlyin

AndrewTobias’sTheFunnyMoneyGame(PlayboyPress,NewYork,1971).AmongthesupposedlysophisticatedinvestorswhoweresnookeredbyNSM’scharismaticfounder,CortRandell,weretheendowmentfundsofCornellandHarvardandthetrustdepartmentsatsuchprestigiousbanksasMorganGuarantyandBankersTrust.

*Asonlythelatestproofthat“themorethingschange,themoretheystaythesame,”considerthatRyanJacob,a29-year-oldboywonder,launchedtheJacobInternetFundatyear-end1999,afterproducinga216%returnathispreviousdot-comfund.Investorspourednearly$300millionintoJacob’sfundinthefirstfewweeksof2000.Itthenproceededtolose79.1%in2000,56.4%in2001,and13%in2002—acumulativecollapseof92%.That

lossmayhavemadeMr.Jacob’sinvestorsevenolderandwiserthanitmadehim.

†Intriguingly,thedisastrousboomandbustof1999–2002alsocameroughly35yearsafterthepreviouscycleofinsanity.Perhapsittakesabout35yearsfortheinvestorswhorememberthelast“NewEconomy”crazetobecomelessinfluentialthanthosewhodonot.Ifthisintuitioniscorrect,theintelligentinvestorshouldbeparticularlyvigilantaroundtheyear2030.

*Today’sequivalentofGraham’s“scarceexceptions”tendtobeopen-endfundsthatareclosedtonewinvestors—meaningthatthemanagershavestoppedtakinginanymorecash.Whilethatreducesthemanagementfeestheycanearn,itmaximizesthereturnstheirexistingshareholderscanearn.Becausemostfund

managerswouldratherlookoutforNo.1thanbeNo.1,closingafundtonewinvestorsisarareandcourageousstep.

1SeeJasonZweig,“DidYouBeattheMarket?”Money,January,2000,pp.55–58;Time/CNNpoll#15,October25–26,2000,question29.

1Sectorfundsspecializinginalmosteveryimaginableindustryareavailable—anddatebacktothe1920s.Afternearly80yearsofhistory,theevidenceisoverwhelming:Themostlucrative,andthusmostpopular,sectorofanygivenyearoftenturnsouttobeamongtheworstperformersofthefollowingyear.Justasidlehandsarethedevil’sworkshop,sectorfundsaretheinvestor’snemesis.

2Theresearchonmutualfund

performanceistoovoluminoustocite.Usefulsummariesandlinkscanbefoundat:www.investorhome.com/mutual.htm#do,www.ssrn.com(enter“mutualfund”inthesearchwindow),andwww.stanford.edu/˜wfsharpe/art/art.htm.

3That’snottosaythatthesefundswouldhavedonebetteriftheir“super-star”managershadstayedinplace;allwecanbesureofisthatthetwofundsdidpoorlywithoutthem.

4There’sasecondlessonhere:Tosucceed,theindividualinvestormusteitheravoidshoppingfromthesamelistoffavoritestocksthathavealreadybeenpickedoverbythegiantinstitutions,orownthemfarmorepatiently.SeeErikR.SirriandPeterTufano,“CostlySearchandMutualFundFlows,”TheJournalofFinance,vol.53,no.

8,October,1998,pp.1589–1622;KeithC.Brown,W.V.Harlow,andLauraStarks,“OfTournamentsandTemptations,”TheJournalofFinance,vol.51,no.1,March,1996,pp.85–110;JosefLakonishok,AndreiShleifer,andRobertVishny,“WhatDoMoneyManagersDo?”workingpaper,UniversityofIllinois,February,1997;StanleyEakins,StanleyStansell,andPaulWertheim,“InstitutionalPortfolioComposition,”QuarterlyReviewofEconomicsandFinance,vol.38,no.1,Spring,1998,pp.93–110;PaulGompersandAndrewMetrick,“InstitutionalInvestorsandEquityPrices,”TheQuarterlyJournalofEconomics,vol.116,no.1,February,2001,pp.229–260.

5Amazingly,thisillustrationunderstatestheadvantageofindexfunds,sincethedatabasefromwhichitistakendoesnot

includethetrackrecordsofhundredsoffundsthatdisappearedovertheseperiods.Measuredmoreaccurately,theadvantageofindexingwouldbeoverpowering.

6SeeBenjaminGraham,BenjaminGraham:MemoirsoftheDeanofWallStreet,SeymourChatman,ed.(McGraw-Hill,NewYork,1996),p.273,andJanetLowe,TheRediscoveredBenjaminGraham:SelectedWritingsoftheWallStreetLegend(JohnWiley&Sons,NewYork,1999),p.273.AsWarrenBuffettwroteinhis1996annualreport:“Mostinvestors,bothinstitutionalandindividual,willfindthatthebestwaytoowncommonstocksisthroughanindexfundthatchargesminimalfees.Thosefollowingthispatharesuretobeatthenetresults(afterfeesandexpenses)deliveredbythegreatmajorityofinvestmentprofessionals.”(See

www.berkshirehathaway.com/1996ar/1996.html.)

7AcompletelistingoftheS&P500’sconstituentcompaniesisavailableatwww.standardandpoors.com.

8SeeNoelCapon,GavanFitzsimons,andRussAlanPrince,“AnIndividualLevelAnalysisoftheMutualFundInvestmentDecision,”JournalofFinancialServicesResearch,vol.10,1996,pp.59–82;InvestmentCompanyInstitute,“UnderstandingShareholders’UseofInformationandAdvisers,”Spring,1997,atwww.ici.org/pdf/rpt_undstnd_share.pdf,p.21;GordonAlexander,JonathanJones,andPeterNigro,“MutualFundShareholders:Characteristics,InvestorKnowledge,andSourcesofInformation,”OCCworkingpaper,December,1997,at

www.occ.treas.gov/ftp/workpaper/wp97-13.pdf.

9Investorscansearcheasilyforfundsthatmeettheseexpensehurdlesbyusingthefund-screeningtoolsatwww.morningstar.comandhttp://money.cnn.com.

10SeeMatthewMorey,“RatingtheRaters:AnInvestigationofMutualFundRatingServices,”JournalofInvestmentConsulting,vol.5,no.2,November/December,2002.Whileitsstarratingsareaweakpredictoroffutureresults,Morningstaristhesinglebestsourceofinformationonfundsforindividualinvestors.

11Unlikeamutualfund,aclosed-endfunddoesnotissuenewsharesdirectlyto

anyonewhowantstobuythem.Instead,aninvestormustbuysharesnotfromthefunditself,butfromanothershareholderwhoiswillingtopartwiththem.Thus,thepriceofthesharesfluctuatesaboveandbelowtheirnetassetvalue,dependingonsupplyanddemand.

12Formoreinformation,seewww.morningstar.comandwww.etfconnect.com.

13Unlikeindexmutualfunds,indexETFsaresubjecttostandardstockcommissionswhenyoubuyandsellthem—andthesecommissionsareoftenassessedonanyadditionalpurchasesorreinvesteddividends.Detailsareavailableatwww.ishares.com,www.streettracks.com,www.amex.com,andwww.indexfunds.com.

14SeeSequoia’sJune30,1999,reporttoshareholdersatwww.sequoiafund.com/Reports/Quarterly/SemiAnn99.htm.Sequoiahasbeenclosedtonewinvestorssince1982,whichhasreinforceditssuperbperformance.

15JasonZweig,“WhatFundInvestorsReallyNeedtoKnow,”Money,June,2002,pp.110–115.

16SeeinterviewwithEllisinJasonZweig,“WallStreet’sWisestMan,”Money,June,2001,pp.49–52.

1Alternatively,youcouldbuybackthecalloption,butyouwouldhavetotakealossonit—andoptionscanhaveevenhighertradingcoststhanstocks.

1Toputthisstatementinperspective,considerhowoftenyouarelikelytobuyastockat$30andbeabletosellitat$600.

2BenjaminGraham,TheIntelligentInvestor(Harper&Row,1949),p.4.

3A“hedgefund”isapoolofmoney,largelyunregulatedbythegovernment,investedaggressivelyforwealthyclients.ForasuperbtellingoftheLTCMstory,seeRogerLowenstein,WhenGeniusFailed(RandomHouse,2000).

4JohnCarswell,TheSouthSeaBubble(CressetPress,London,1960),pp.131,199.Alsoseewww.harvard-magazine.com/issues/mj99/damnd.html.

5ConstanceLoizos,“Q&A:AlexCheung,”

InvestmentNews,May17,1999,p.38.Thehighest20-yearreturninmutualfundhistorywas25.8%peryear,achievedbythelegendaryPeterLynchofFidelityMagellanoverthetwodecadesendingDecember31,1994.Lynch’sperformanceturned$10,000intomorethan$982,000in20years.Cheungwaspredictingthathisfundwouldturn$10,000intomorethan$4millionoverthesamelengthoftime.InsteadofregardingCheungasridiculouslyoveroptimistic,investorsthrewmoneyathim,flingingmorethan$100millionintohisfundoverthenextyear.A$10,000investmentintheMonumentInternetFundinMay1999wouldhaveshrunktoroughly$2,000byyear-end2002.(TheMonumentfundnolongerexistsinitsoriginalformandisnowknownasOrbitexEmergingTechnologyFund.)

6LisaReillyCullen,“TheTripleDigitClub,”Money,December,1999,p.170.Ifyouhadinvested$10,000inVilar’sfundattheendof1999,youwouldhavefinished2002withjust$1,195left—oneoftheworstdestructionsofwealthinthehistoryofthemutual-fundindustry.

7Seewww.thestreet.com/funds/smarter/891820.html.Cramer’sfavoritestocksdidnotgo“higherconsistentlyingooddaysandbad.”Byyear-end2002,oneofthe10hadalreadygonebankrupt,anda$10,000investmentspreadequallyacrossCramer’spickswouldhavelost94%,leavingyouwithagrandtotalof$597.44.PerhapsCramermeantthathisstockswouldbe“winners”notin“thenewworld,”butintheworldtocome.

8Theonlyexceptiontothisruleisaninvestorintheadvancedstageofretirement,whomaynotbeabletooutlastalongbearmarket.Yetevenanelderlyinvestorshouldnotsellherstocksmerelybecausetheyhavegonedowninprice;thatapproachnotonlyturnsherpaperlossesintorealonesbutdeprivesherheirsofthepotentialtoinheritthosestocksatlowercostsfortaxpurposes.

*Raskob(1879–1950)wasadirectorofDuPont,thegiantchemicalcompany,andchairmanofthefinancecommitteeatGeneralMotors.HealsoservedasnationalchairmanoftheDemocraticPartyandwasthedrivingforcebehindtheconstructionoftheEmpireStateBuilding.CalculationsbyfinanceprofessorJeremySiegelconfirmthatRaskob’splanwouldhavegrowntojustunder$9,000after20years,although

inflationwouldhaveeatenawaymuchofthatgain.ForthebestrecentlookatRaskob’sviewsonlong-termstockinvesting,seetheessaybyfinancialadviserWilliamBernsteinatwww.efficientfrontier.com/ef/197/raskob.htm.

*Graham’s“briefdiscussion”isintwoparts,onp.33andpp.191–192.FormoredetailontheDowTheory,seehttp://viking.som.yale.edu/will/dow/dowpage.html.

†Mutualfundsbought“letterstock”inprivatetransactions,thenimmediatelyrevaluedthesesharesatahigherpublicprice(seeGraham’sdefinitiononp.579).Thatenabledthese“go-go”fundstoreportunsustainablyhighreturnsinthemid-1960s.TheU.S.SecuritiesandExchangeCommissioncrackeddownonthisabusein

1969,anditisnolongeraconcernforfundinvestors.Stock-optionwarrantsareexplainedinChapter16.

*ThePennCentralTransportationCo.,thenthebiggestrailroadintheUnitedStates,soughtbankruptcyprotectiononJune21,1970—shockinginvestors,whohadneverexpectedsuchagiantcompanytogounder(see.423).Amongthecompanieswith“excessive”debtGrahamhadinmindwereLing-Temco-VoughtandNationalGeneralCorp.(seepp.425and463).The“problemofsolvency”onWallStreetemergedbetween1968and1971,whenseveralprestigiousbrokeragessuddenlywentbust.

*SeeChapter2.Asofthebeginningof2003,U.S.Treasurybondsmaturingin10yearsyielded3.8%,whilestocks(as

measuredbytheDowJonesIndustrialAverage)yielded1.9%.(Notethatthisrelationshipisnotallthatdifferentfromthe1964figuresthatGrahamcites.)Theincomegeneratedbytop-qualitybondshasbeenfallingsteadilysince1981.

*“Air-transportstocks,”ofcourse,generatedasmuchexcitementinthelate1940sandearly1950sasInternetstocksdidahalfcenturylater.AmongthehottestmutualfundsofthaterawereAeronauticalSecuritiesandtheMissiles-Rockets-Jets&AutomationFund.They,likethestockstheyowned,turnedouttobeaninvestingdisaster.Itiscommonlyacceptedtodaythatthecumulativeearningsoftheairlineindustryoveritsentirehistoryhavebeennegative.ThelessonGrahamisdrivingatisnotthatyoushouldavoidbuyingairlinestocks,butthatyoushouldneversuccumb

tothe“certainty”thatanyindustrywilloutperformallothersinthefuture.

*Tangibleassetsincludeacompany’sphysicalproperty(likerealestate,factories,equipment,andinventories)aswellasitsfinancialbalances(suchascash,short-terminvestments,andaccountsreceivable).Amongtheelementsnotincludedintangibleassetsarebrands,copyrights,patents,franchises,goodwill,andtrademarks.Toseehowtocalculatetangible-assetvalue,seefootnote†onp.198.

TableofContents

CoverTitlePageDedicationEpigraphContentsPrefacetotheFourthEdition,byWarrenE.Buffett

A Note About Benjamin

Graham,byJasonZweigIntroduction:WhatThisBookExpectstoAccomplish

Commentary on theIntroduction

Chapter1Commentary onChapter1







Chapter8Commentary on

Chapter8Chapter9

Commentary onChapter9




Chapter13

Commentary onChapter13







Chapter20Commentary onChapter20PostscriptCommentary onPostscript

AppendixesAppendixes1

Appendixes2Appendixes3Appendixes4Appendixes5Appendixes6Appendixes7

EndnotesAcknowledgments fromJasonZweig

IndexAbouttheAuthorsCreditsCopyrightAboutthePublisher

The Intelligent Investor -...

Documents

Transcript of The Intelligent Investor -...