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Chapter 28: Newer Canons of Common Stock Investment

The older approach appears to have been vitiated by the instability of the typical business and new era approach was certain to end in an appalling debacle. An acceptable approach towards common stock investment is proposed as needing the following elements:

  1. Investment is conceived as a group operation, in which diversification of risk is depended upon to yield a relatively favorable average result.
  2. The individual issues are selected by means of qualitative and quantitative tests corresponding to those employed in the choice of fixed value investments.
  3. A greater effort is made, then in the case of bond selection, to determine the future outlook of the issues considered.

Three general approaches are proposed that meet the above conditions.

1.    Secular expansion as basis: The approach here is to buy a carefully selected diversified group of common stocks and purchased at reasonable prices. This approach can be characterized as sound investment policy as long as the following three conditions are met:

a.    National wealth and earnings power will increase.

b.    Such increase will reflect itself in the increased resources and profits of important corporations.

c.    That such increase will in the main take place through the normal process of investment of new capital and reinvestment of undistributed earnings.

2.    Individual growth as basis of selection: This approach would be attractive to those who reject the belief of a general secular expansion. This stresses the element of selectivity and is based on the premise that certain favored companies may be relied on to grow steadily. Hence such companies, when located, can be bought with confidence as long-term investments.

a.    What are growth companies? These have been defined as those companies whose earnings move forward from cycle to cycle. But most company’s earnings do move forward from cycle to cycle. Only in the cycle of 1930-36 did many companies fail to do so and it does not seem that using one cycle is a reliable way to separate growth stocks.

b.    Can the investor identify them? If an investor chooses newer companies with short record of expansion, he runs the risk of being deceived by temporary prosperity; and if he chooses enterprises that have advanced through several business cycles, he may find this apparent strength to be the harbinger of coming weakness. Thus identification of a growth stock is not simple and considerable supplement of special investigation and of business judgment is needed.

c.    Does the price discount potential growth? This is the most difficult part. Once an investor pays a substantial amount for the growth factor, he is inevitably assuming certain kinds of risk; viz., that the growth will be less than he anticipates and that for a considerable period the market will value the stock less optimistically that he does.

3.    Selection based on Margin of Safety Principle: Here an investment is made if a stock is worth more than he pays for it and if he is reasonably optimistic as to the company’s future. The margin of safety resides in the discount at which the stock is selling below its minimum intrinsic value, as measured by the analyst. Two approaches are possible

a.    Buy at times when the general market is low, measured by quantitative standards of value. The purchases would be confined to representative and fairly active issues.

§  One approach would be to select a diversified list of leading industrial common stocks; Determine a base or “normal” value for the group by capitalizing their average earnings at some suitable figure, related to the going long term interest rate; Determining a buying point at some percentage below this normal value and a selling point above it.

§  The difficulty with this approach are: (1) Although the general pattern of the market behavior may be properly anticipated, the specific buying and selling points may turn out to have been badly chosen, and the operator may miss his opportunity at one extreme or the other. (2) There is always a chance that the character of the market’s behavior may change significantly, so that a scheme of operation that would have worked well in the past will cease to be practicable. (3) The method itself requires a considerable amount of human fortitude.

§  This method has a good deal to commend it to those temperamentally qualified to follow it.

b.    Discover undervalued individual common stocks, which presumably are available when the general market is not particularly low.

§  It is rare that a common stock will appear satisfactory from every qualitative angle and at the same time will be found to be selling at a low price by such quantitative standards as earnings, dividends and assets.

§  Of more practical importance is the question whether or not investment can be successfully carried on in common stocks that appear cheap from the quantitative angle and that – upon study – seem to have average prospects for the future. Securities of this type can be found in reasonable abundance, as a result of the stock market’s obsession with companies considered to have unusually good prospects of growth. Because of this emphasis on growth factor, quite a number of enterprises that are long established, well financed, important in the industries and presumably destined to stay in business and make profits indefinitely in the future, but that have no speculative or growth appeal, tend to be discriminated against by the stock market – especially in years of subnormal profits – and to sell for considerably less than the business would be worth to a private owner.

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