Chapter 27: The Theory of Common Stock Investment

Graham addresses the utility of any analysis of stocks

·         To what extent is common stock analysis a valid and truly valuable exercise, and to what extent is it an empty but indispensable ceremony attending the wagering of money on the future of business and of the stock market?

·         As far as the typical common stock is concerned – an issue picked at random from the list – an analysis, however elaborate, is unlikely to yield a dependable conclusion as to its attractiveness or its real value. But in individual cases, the exhibit may be such as to permit reasonably confident conclusions to be drawn from the processes of analysis.

·         It would follow that analysis is of positive or scientific value only in the case of the exceptional common stock, and that for common stocks in general it must be regarded either as a somewhat questionable aid to speculative judgment or as a highly illusory method of aiming at values that defy calculation and that must somehow be calculated none the less.

Prewar conception of investment in common stocks

·         Based primarily on meeting three requirements (1) a suitable and established dividend return (2) a stable and adequate earnings record, and (3) a satisfactory backing of tangible assets.

·         The function of analysis was primarily to search for elements of weakness in the above requirements and in addition offered the best chance of future enhancement. The chief emphasis in the analysis is the relative showing for past years, in particular the average earnings in relation to price and the stability and trend of earnings. Only to a lesser extent did the analyst try to look into the future to select industries or companies that were likely to show the most rapid growth.

·         When the prime emphasis was upon what was expected of the future, instead of what has been accomplished in the past, it was considered as a speculation. The future was uncertain, therefore speculative; the past was known, therefore the source of safety.

·         The technique of investing in stocks resembled closely investing in bonds. Both wanted a stable business and having adequate margin of earnings over dividend requirements. However, the common stock investor had to content himself with lower margin of safety then he would demand of a bond, a disadvantage offset by larger dividend yield on the stock (6% standard for good common stock, 4.5% for high grade bond), by chance of an increased dividend yield if business continued to prosper and – generally of least importance in his eyes – by the possibility of stock price increase.

·         Buying stocks is viewed as taking a share in a business. The typical stock investor is a business man, and it seemed sensible to him to value any corporate enterprise in much the same manner as he would value his own business. This meant that he gave at least as much attention to the asset values behind the shares as he did to their earnings record. A man contemplating the purchase of a partnership or stock interest in a private undertaking will always start with the value of that interest as shown “on the books” i.e. the balance sheet, and will then consider whether or not the record and prospects are good enough to make such a commitment attractive. An interest in a private business may of course be sold for more or less than its proportionate asset value; but the book value is still invariably the starting point of the calculation, and the deal is finally made and viewed in terms of the premium or discount from book value involved. One of the functions of security analysis here is to discover if the fixed assets as stated on the balance sheet fairly represents reasonable worth of the properties.

New era theory

·         “The value of a common stock depends entirely upon what it will earn in the future.” This dictum resulted in three corollaries

1. Dividend rate should have slight bearing upon value
2. Since no relationship apparently existed between assets and earning power, the asset value was entirely devoid of importance
3. The past earnings were significant only to the extent that they indicated what changes in the earnings were likely to take place in the future.

·         Causes for moving to new era theory

1. One reason was that the records of the past were proving an undependable guide to investment. The tempo of economic change has been speeded up to such a degree that the fact of being long established has ceased to be, as once it was, a warranty of stability.
2. Due to this instability the three fold basis of stock investment proved inadequate. Past earnings and dividends could no longer be considered, in themselves, an index of future earnings and dividends. Furthermore, these future earnings showed no tendency whatever to be controlled by the amount of the actual investment in the business – the asset values – but instead depended upon a favorable industrial position and upon capable or fortunate managerial policies. In many cases of receivership, the current assets dwindled, and the fixed assets proved almost worthless. Because of this absence of any connection between assets and realizable values in bankruptcy, less and less attention came to be paid to book value.

·         Consequences of new era theory

1. Abolished the fundamental distinction between investment and speculation. New era investment equivalent to prewar speculation. New era investment was simply old style speculation confined to common stocks with satisfactory trend of earnings.
2. Stocks regarded as attractive irrespective of their prices. A corollary of this principle was that making money in the stock market was not the easiest thing in the world. It is only necessary to buy good stocks, regardless of price, and then to let nature take her upward course.

·         Logical validity of new era theory

1. Common stocks were shown to have a tendency to increase in value with the years, for the simple reason that they earned more than they paid out in dividends and thus the reinvested earnings added to their worth. A company would earn an average of 9%, pay 6% in dividends and add 3% in surplus. Theoretically this should increase the book value at an annual rate of 3% compounded.
2. The attractiveness of common stocks for the long pull thus lay essentially in the fact that they earned more than the bond interest rate upon their cost. This would be true, typically, of a stock earning $10 and selling at 100. But as soon as the price advanced to a much higher price in relation to earnings, this advantage disappeared, and with it disappeared the entire theoretical basis for investment purchases of common stock.
3. Average vs. Trend of earnings. Average earnings ceased to be a dependable measure of future earnings because of greater instability of the typical business. But it does not follow that the trend of earnings must therefore be more dependable guide than the average, and even if it were more dependable, it would not necessarily provide a safe basis, entirely by itself, for investment. There are several reasons why we cannot be sure that a trend of profits shown in the past will continue in the future. In the broad economic sense, there is the law of diminishing returns and of increasing competition which must finally flatten out any sharply upward curve of growth. There is also the flow and ebb of the business cycle, from which the particular danger arises that the earnings curve will look most impressive on the very eve of a serious setback.