SECURITIES IN AN INSECURE WORLD ~ A LECTURE dy BENVARIN GRARAN ros | StFrancitHotel November 15-1963 Ot per copySECURITY Ty AN INSECURE WORLD ‘ALLECTURE BY BENJAMIN GRABAN Doctor Reppaport has chosen a very intriguing title for ay talk, "SECURITY ‘UH AW INSECURE WORLD." T hope that not saay of you cane under the mistaken in pression thet I am going to telx about security in general. I an going to talk Only about fineneiel security, not about physical eecurity, sentel security, matrimonial security, or other types. ven as fer as financial security is con- cerned, T an going to address myself only to investaent policy in stocks and bonds. ‘The title of this telk might better have Deen SBIURIFIES IN All INSECURE WORLD, Daceuse securities are ay field. I an not going to talk ebout savings and bulget policy, life insurance, hone ommership, pension plans and other axtters of that Hind. “The reason ie that I don't consider yself an expert in those areas, end I would rather talk to you tbout things I hope T know more about than you do. ‘This reminds we of the fact that when the New York Society of Security Analysts eoteblished « Journel in 1946 ve gave it the simple title "The Anelysts Journsl.” But then we got 0 many inquiries and even subscriptions from psychoanalysts that ‘ye were forced in self-defense to change the nane to the present title "Ihe Financial Analysts, Journal, In the f1014 of financial security, es Limited to the problems of investamnt policy, I vould sey there are three Kins of thrests or daagers that investors ‘Should’ recognize ea possibly existing et the present tine, One of than would be ‘he trent. fron etoaie ver; the aecoad vould be the three’ from inflation; and t hind vould be the treat fron severe mrket fluctuations up and dova, and of course Primzity dova How, I have no prescription for financiel security or for portfolio poliey thet could desi with the possibility of etonie var. I don't think enyout Sine aaa; ve prefer to eveep that problen under the rug snd go forvard to thing ‘aot ve can deel with sore effectively. ‘The aecood dager I mentioned vas iafintion. Inflation hes been « big factor in investors finanotel experience going beck es Tar ‘86 1500, Not many people realize thet we had nore inflation in the firet thirty Years of this century then in the sucond thirty years, oa neasured by the gual inden The continustion of sone degree of inflation ts certainly probable in the future, and thet ie the chief reason wiy wost intelligent investors now recognise ‘toxt sowe common stocks must be ineluded in their portfolio. However, tat ie omy pert of the question of the effect of inflation on investamat policy. The fect ie Bhat Both the extent of inflation and the investor's reaction fo #8 have varied grectly over the years. Tt in by bo means « straight-line natter, A good exaaple Sate woet recent one. We have had « ausll inflation in recent youre eccompanied by a very large increase in stock-mrket prices, vaicn seen to be geared not to the inflation experienced but rather to the expectation of greeter tafletion in fe Futures” You probably know there hag Deen ineroue sn the Wolesale-prict fvorage since 1958, There bas indeed deen a rise of 6} per cent in the cost of \ Living'sn the last ive years, which of course is not negligible, but it could \ scarcey in itaele bee sound beste for «100 per cent rise in stock prices. Con~ \ Yersely, diring the youre 1945-1949 ve Aid have « rather explosive Kini of infle~ Hone-the consumer price index, (that ie, the "cost of Iiving") advanced over ‘totually ad © sual! decline. \35 per cente-but during that period tock priction bere ie that investors" feelings ant reactions regarding intle- a are probably more the pesult of the stook-narket action that they bave recently “‘tasertonced. than the eause GE'Tts Consequently there is great danger of Investores giving inflation too imck weight vhen the market advances end ignoring it extirely, ‘ss they did in 1945-9, ven the market declines, ais hae actually been the bistory Of inflation and stock market behavior ever eince 1900. ‘me problen of price fluctustions, or market fluctuations, is a very real one for investors as well as speculators, tlthough there has been « tency in Wall Street to deny that Zor a number of years in the past anf even currently. Actually, ‘the real probien is not whether price fluctuations are important to the investor; i te rather the opposite, that ie to find some good vorkable distinction between the dovestor and the apectlator in common stocks, Ag vill be painted out leter that distinction has alnost vanished from Wall Street, a fact which nas caused a great eal cf trouble in the past and will omige « great deel of trouble in the future. Yet only last year, although 1t seems « long tine ago--narket fluctuations, fas evidenoad by a declige in the Dov Jones Average from 135 0.535, €id loom as extrenely important to investors and speculators alike. This fall of sbout 27% in the Dow Jones Average vas accompanied by declines af betwean 50 and 90 per cent for wore in ost of the nev securieties that had been issued in the preceding tro yours and had played such « spectacular part in the stock market activity of that period. At that tine then, in May 1962, the concept of « one-way market, which could go only upvards vith very small reactions, seemed to be abandoned for good. Hovever, Wall Street has a very short mesory, and ov the majority of fiumeial authorities een to be slipping back to the concepts af 1960 and 1961. They are returning to the idea that for the suart investor the question of stock market Fluctuations doas not have to be considered to ay great extent. There in « tvoufold emphasis here, which slurs over the reality of stock market fluctuations. The first i the general conviction that the market can de counted on ‘to advance so emphatically through the years that vistever declines take place are comparatively unisportant; hence if you have the true investor's attitude you don't have to concern youreelr with them, fhe second claim 1s denial that the “atock market” axiets at all, meaning thereby that what the market averages 40 18 of no real inportance to the’ intalligert, vell-advieed investor or eyeculator. It yas to be a ruling tenet of Wall Street that if you practice the proper Kind of selectivity in investaeate you don't have to worry about viet the stock market does fas a wncle, as shown by the averages,tor at all tines the good stocks vill be going ‘up and the bad ones vill be going dow and all you need to do is pick the good stocks forget about the stock-warket averages, Tow valid are these tyo axgusente? Tue firet one-- the ergunent thet comon favocks are and always vill be attractive, including the present tine, because of / tas excellent recom since 1949-- involves in those terns a very funtusental and / smportant fallacy. ‘This ie the idea that the better the past record of the stock market as such the more certain it is that comon stocks are sound Snvestuente for ‘the future. Now we all know that if a corporation hae had a very good record over the past years that is a fair iniiostion (but no guarantes) that ste recor’ 4s Likely to be goo! in the future, because it hes certain business alvantazes Which in most cases ought to coutiaue, But you cannot aay that the fact that the stock marist bas risen continously (or slightly irregularly) over « long period in the pas is a guarantee that it vill continue to act in the sane way in the | future. As I ens it, the real truth ts exactly the opposite, Zor the higher the \ stock markSt advances the more reason there is to alstrist Ste future action i? \you are going to consider only the market's internal belavior. We all knov thatBaas 5 Gor macy decades the typical history of the stock market has been a succession of large rises, 42 gool part apeculative olloved inevitably by substantial falls. Coasaquentiy, the substantial upeveeye of the past have alvays carried vith then ‘warning sigels of usbapzy consequences to cose. Tt does not necessarily folloy Ghat a large rise in the price of « individual stock or in the market everages mast be colloved by © daoling; but the only reason to view with confidence the Zutire reice cf a security that hag alzpady advanced substantially in the presence ‘of srternal seasons, other than the actual price movenent iteelf, which vould justity wish coat idence. dence a lange advance in the stock market is basically « sign for ousttion and not a reason for confident Tat us diesuns the market's possibilities from present levels in teras first cof theoretical xessoning and then in terns of some practical considerations. I would like to presant thee possibilities} undoubtably there are a great nazy nore. One possibility, which 1s a very popular one in present thought, ia that the rise Ghat bas taken Place #ince 19s0-- from about 163 n the Dov Jones Average, to 750 at the present tine-s reflects a aev and a marvelously improved character of common Stocks, and therefore can be expected to continue more oF less at the sane rate in the future, Only such « point of View can make sense out of the prevalent practice of ‘caloulating the gains thet investors could have made in mtual-fund shares or in similar purchases over the last lt youre ay « basis for trying to parauade thea to Duy guch securities af thety present advanced prices. As you knoy, this kind of cal- culation Sa dont all the tine by mtual-tund aglegmed'to impress investors. The Suc requires it to be accompanied by a perfunotéiy statenent that the caleulstion ‘carries no varrantly for the future, but I doa't think very much emphasis is placed ‘upon that qualification. =" The second ponaibilsty is that a good yart of the rise I spoke of vas an ad- ‘Justannt from an undervalued level in 1949 to a proper level on some nev basis of yaluation, If that ia #0, © good part of the 1989-1963 rise could not be expected Yo be repeated from @ level whic is nov a corrected one, Hovever, vo could have = satisfactoy advance on the average, say 4% per annum, from vhetever level turns out to be about right for totay. If 750 te about the right present level then the in- yestor might possibiy expect a more or less standard M4 advance frou this level, year by year, subject to moderate dovmvard fluctuations. ‘But the thisd possibility i that the nature of the mnket hes not changed ‘from ite earliest tims, as shom in our recoris that go back at least to the South ‘Seas Bubble in 1720, pratically 200 yaara. WE have also very detailed data on in the United States since 1872, which vere incorporated in the Covlé Pe ost recext axample of sxcessive prssinion is the very period which vas a starting fone fer this narket. During 19h9-50 the market had the lovest peace-tine price- earnings vatio in its history. Stocks sold at only sbout 7 tines their earnings, Sn the market averages Tam talking aboxt, as compared with about 20 tines at the presect tine. The implication here is that just as stocks vere evidently under- Valued at seven tines their earnings they aight very well be overvalued at twenty ‘ines earnings or at some higher multiplier that vill be established later in this market and vill represent « level of excessive optimien. My ova opinion about these three choices ta thet the first possibility 1s really out of the quasticn. It ig agt in the nature of economic reality to perait et gains at the shovn rates from iysy to O3-~ something like 14 per annum in cluding the divident zeturne-- to comtime iniePinitely-a the future. We just don't hava a financial and econoste aysten that can operate on that basis. If ‘that vere true nobody would have to vork for a living. I renesber very well thePAGE ‘nusber cf people tn the late 1920's vho got a corresponding view of the stock market, gave up their joba and plunged into Wall Street to take advantage of its vonderful fubura. The second possibility-which ie thet the market will advance pretty stead- Ady from approxivately the present level, but vill not have the advantage of starting frou a vary low level-~ is admissible in'theory. But the grext problem, one thet I Vil talk about inter, 48 hov cen you deteraine the proper nev basis for common stocks valustions ant therefore hov can you determine the mare.or less stoper-Zevel for nest’. I discussed this question in « paper read to the Anericen Pinence Ave’, in December 1961, and caid then that the market ves really adrift on a sea of tn. settled stasiaris. The old standards of value, which had been well established for Gecedes and perkays generations, no longer seen to be tensble, as mich too con- srvative; but the proper nev standards of valle could certainly not be worked out either by somebody's inner-conscioumness ox by mathematical caletlations. We ‘shall have to walt, probably for « considerable length of tine before we can, detarsine depeniabie nev standards. In the mean tine it seened to me that the stock market vill have to carry on ita celoulations by a process of trial snd error, Waich ootld lead to large flustuxtions around what in the end vill tur out to be te new central value. I think vhat happened since Deceuber 1961 bears out his inter- pretation to sone degree. Cartainly the big decline in 1962 represented « sbarp fluctuation of cne Kind, and the impressive recovery since June 1962 aay represext a fluctuation of the other Kind. Ho doubt you would be interested to know whet I nean by the terms “old and new standards of value" as applied to the stock market level. The old standards of value--viieh vere pretty well accepted up to aay 1955 ware reached by © nuaber of afferent approaches based on reasoning or experience. The one T like dest of course vas uy ovn, viich has been knova as the "Grahan.” Tt vas derived fron the Gantra Vaitis avefage earnings of the 30 stocks in the Doy Jones Industrial Average for ten years past, capitalized at tice the interest rate on high grade ‘onds. For exenple at the present time the average earnings for the last ten years sare about $33 on the Dov Jones unit and the present sate on bigh grede bonis iv ha} per cent. if you capitalize $33 at8.Gf-- vhicn 1s « multiplier of about 12 you ‘would get a central Value on the old basie af about 360, as compared with the present price of about 750. Zp early 1955 vhen I testiciea before the Pull Committee the stock market yas then spout 400, my central value vas also around $00 and the valuations of otner “experts” using other wethoda all seemed 20 cone to about thet level, The action of ‘the stock market ilbe then vould appear to denonstrate that these metio’s of val- uations are ultra-consarvative and mch too lov, although they did vork out extrene- ly well through the stock market fluctustions from 1871 to sbout 1954, whlch ts an ‘exceptionally long period of tine for a test, Unfortuately in this Kind of vork, where you are trying to determine relationships based won past behevior, the lnost invariable experience 1s that by the tine you here bad a long enough period Yo give you sufficient confidence in your form of easurenent Just then nev cone itions suparssde and the neamzenent ie no longer dependable Zor the future. We had to deal with this problen in the fourth edition of "Security Ansiyeis” published last year, and to recognize tha probability thet stocks should be valued ‘nore Liberally nov than in the past, our chief reason for thet, incidentally {» 2ot Decause the governnent's commitnent to prevent large scale depressions has changed ‘the climate of corporate earnings from woat it was prior to the Zaployment Act of 1946, We think this nev 2 against a very severe Zalling off in the arnings of corporations generally would Justify a higher valuation of these ‘earnings than in forser years. Henge ve have added an arbitrary 50 per cent to ‘the valuation based upon our Old method. That vould give us nov a value of about19 for the Dov Jones Average, and a corresponding value of sbout 56 for the Standard Poors 500-stock average. Let me point out that the two avevages stand 40 close to- wether on ten-tomone asia in their price level, dividenis and earnings,thet you can use the tro figures almost interchangeably for purposes of description or an~ alysie, You must recognize that this level of 570, vhich ts derived from an arbitrary ‘mark up of 50K from the old level, has no special authority behind it. Tt waa nerely the best Judgnent that we could give on a situation which does not sdait of aay veally dependable calculations. ‘Asa matter of fact if one te wufficiestly optimistic and adroit it is quite possible to develop & method of valuation waich sounds plausible enough and would justify the presext level of 750 for the Dov Jones Average. Let me shov you hov that could be done. You say first that tne Tastors vould Like to get an over-all return of 7H on their noney in future years, ‘Taat ‘a what common stocks have returned on the average- in dividends and price spprectation-ever since 1671, as shown by the Covles and Molodoraky studies, ow if ve can expect rate of grovth of aaraings and dividends of Hak a year then all ve eed ts a dividend return of 36 to make up the desired 72% total, Since the Dow Jones sai Staniard Poor's dividend return is Just a Little more than 36 right now on the arket price, ve could buy these at the present level with confidence, es we vould then get «3% return in dividends and a Hf anneal return in grovel Maay people might think that even less than an overall 7if should suffices All that sounds fine but if you reflect that by some chance the future grovth rete vould be 328 instead of |f— and 344 vas about the actual anmal grovth in dividends in the last ten years-- then you get quite a difterence. For if nov you are expecting & 338 grovth rate, you will needs if dividend retum to make up the required TH. On that basis the Dov Jones Average is vorth just about the 570 which we exbierarily rave to ite There is & lot of juggling with figures thet om be done now as alvays; but none of these nethods in itself gives « dependable remult. To a grest exvent the figures selected are detersined by the general attitate cé the man vho is selecting ‘them, and that general attitude is very often determined in turn by vist the stock barket has been doing. When the stock market ia at 750 you take an optinistic attitude and use sone favorable figures; but if it should have a severe decline Rost pecple vould jump dack to the older and more conservative evaluation methods. st me nov point out a striking area in vhich the uncertainty of the proper Yaluation of comon stocks 1a brought to the fore, That is thie Yery question cf ‘the relationship detween dividend return on stocks and the interest rave on bonds. For fifty years or more st van a tenet in wall Street that stocks should yield, considerebly sore than bonds. In speculative marketa stocks aigt rise util their yield decane less than that af bonis, But this very developaert vas a sure eign ‘hat you vere in a dangerous market-- one heading for a bad fall. A frien ef mine, hhead of a2 important brokerage house, vas so enasored of that idea he used i=. constantly in his market letters. More than that he actually had the relation” ship between stock yields and bond yields printed in «nice chart-design on neck ‘thes imported fron Paris, which he distributed to bis friends incluting we. Por svhile I vore this tie at sone of ay lectures, and auld that this vas ¢he fizet ‘ine that anybody had analyized the technical position of the stock market tres Bis necktine. Well, since 1958 stocks have been yielding considerably less. than douds vith no sign Gf a return to old relationships, Hence my broker frienis found thet thie concept increasing hard to tick te, About two years ago, actual- Ay not very long before the big sarket break, in a huge newspaper edvertisensnt ‘be abandoned thin concept completely, said 4¢ was all dosh to talk about stock yields a the baste of evaluation, clained the main thing vas the peychology and attitude of the public; and asserted this factor vas strongly bullish and justified,AGE 6 contident bwing of stocks. My chief retson for mentioning this incident 1a that T liad Jast epeat « lot of tine stulying the weekly analyses of the stock market by one of our oldest Pismctal services walsh started so 1909 and 1 ound the identical experience took place just 30 years before in this service (whose name I also won't tention.) For many years they talked thost the standard relationsniy between otock Yields and bond yieids, and they ued St to deteraice the probable top levels for tne stock market advances, In the greet bull merce’ of the late 960%» tna pelts Honship proved to be very unreliable ts a short-tera santet forecester. 30 they too, inva spectactlar stevenene uring Alsoet the sear Language, vurned dhefe back completely on the comparison of stock yielis and bond yields aid said that the sarket's paychology waa the best basis for forecasting. Tet lagpened toasting in'1928, tnd they atick to this viewpoint vo the great Green of 1359. ‘Toe present relasionshty gives conascerably Lover yields on stocks than on bonds.” High grade bonis Yield about Ago per cent valle the stocks averages Yield a little Dit ore than Jf. Becase that relationship hee esievad for te inst five youre does it represent a permanent relstlonhip for the fueuey or it Teonly an indication that the stock sarket has Seen clearly Crervalued for five yours, in the sane vay that {6 vas clenrly unervaiuel duriie the period 1949-19541 Tate de the aanj-billion-daliar question, Youwon't te able to get the anmver to that by aathenstice) you von'e De abis to get it from an expert such en ae GF mayboty else; s0 you'll have to answer that question for yourself. [But the thought at the stock sarket may save deen cvercrained” in the last Fave years, just au {© vas undervalue! fisteen youre ago, trings us to the third Jostbility viton I enuerated, nanely that ve tre stil going to have vide fluctua / tions in the future, This I consider the wort gesbetle ose, hough It le far free J certain, Ny reason for thinking that ve shell have these wide fluctuxtionss of watch J seinaa"s caave'in 1962, in bay gartioulariys da tost't don't see aay cnange is huaas Batures viswecvis the atock market whlch is sufficient to estebiion nore festrelute 4p the public vetavior than St shoved over so eaty decaies in the pasts) The ectioes cf the public with respect to loe-arede rv ‘antes distng the 1960-01 axtravagenen in ‘hat £1014 are an indication of tor inberent issk of revireist, You ought te Feneaber #150, that oany of ‘tie highest grads como stock iemies were foroed up fovexcessive ievels by « market anthortagn wich Teodiced large subeeyuene declioe et ne. give you some exaupiest The most foprensive to ay aint van cate of Teter ational Business Hackiaes vhich ia ceaoubeabiy the Leading common stock in the ative uarest, Speculative enthupiann pushed. it ay to 607" ts Deceaber 1961, frou \, Sitch st"aeckinea to 300 tn dune S9ear~'a rain ce tore thin SOf isthe aporé period of 6 sonthe, Genera Slectric, which ie the oliert nigh grade snvestamnt omen |\ stock, declined from «high of 100 in 1960 to 5h in 1962." Dow Chemical, one of our \ beet cuesical cospentes, Zeit from a high of 101 to a low of 0, ant 0.3, Seeel which \ pan ola ieaaery’ shrank from 309 in 1959 to a iow af 38 in 1902." These very fide svings underline the fact that the stock market {s basically the sase nov as it ‘Rivas vas, in the sense it ia still gubject to very substantial over-evalustion at \sonetines and undoubtebly substantial under evaluations at others. Wy basic conclusion ie that investors as well as speculators mist be prepared in their thinking and in their policy for vide price novenenta in either direction. They showla not be taken in by soothing atatenente thet « real investor doess't nave ) to worry about the fluctuations of the stock market. Z Tt is tine nov to say what Little I can say aboct the probable course of the stock market from the present level. No doust that ia the point which vould interest ‘the audience most and on which I can be the least enlightening, In ay view there is an important difference betveen the presert stock market and the mrket at sore or less the sane level in December 1961, At that time I had no hesitation about predicting that then there would have 29 be a fairly near-term collapse of the nev- Asue market, vhich had passed all bounde in apectlative excesses, And if thet-PAOE 7 collapsed it vould surely effect in soue serious way the general level of stock prices, it alent possibly usher in the bear market vhich Invardly T have been ex- pecting for soma time past. The nev iague collapse case per schedule and it aid have a najor averse effect on the rest of the market. Sut « recovery begen in ‘= comparatively short time, and it has carried the sarket averages to nev heights, Which were contrary to ay invard expectations but not to any specific predictions Vhich I mde, I would like to point out thet the last tise T mde any stock market gredictions vas in the year 1914, vhen ay firm Judged se qualified to write thelr ‘market letter, based On the fact thet I bad one month's ax perience in Vall Street, Since then I have given up making predictions. ‘The important point nov is that the current high levels of the market are ‘not accompanied by Encas excesses in the nev-iaaue market and in sone other direc~ ‘tions which mie it appear so vulnerable in 1961. It is the general view in Wall. Street that such characteristic abuses mst develop again before the stock market can have ancther collapse,--or before « true bear sarket can begin (if it ian't against the lay to use the dixty vords "bear market"). These abuses vould include Large public participation by small people who don't imoy vhat thay are doing, high borrowings on margin, the reneval of the nev-iasues apres and #0 on. Now this con tention sounds plausitle enough based on experience, and 40 one aight guess thet ‘the market could well continue generally upvard for quite a vhile. But let we point out "for the record” that it is not impossible in theory that the market's high level ‘lone could scorer or later precipitate « collapse without the7necessity for these ‘technical weaknesses to ghov thenselves. The collapse might be triggered ty some luntovard economic or political development, But if things do happen that vay it will be the firgt tine in market history, Z believe, thet ve would have the end of 1 bull market without the excesses and abuses of the sort Ihave mentioned. But Shere 1a always = first vine for evesythiuse My opinion then regarding the present market level must be rather incon- clusive, and I shall Baby ay later prescription of policy on the assumption that investors cannot have a dependable View on the aarket's future action in the next Year or so, dut that a large and disturbing decline is Likely to take place again Sonetine-in the future, ant that ve should be prepared in thought and action for it, is a necessary sasumption for investors to uake, and for sensible apeculaters too if there aravany such. ‘The second claim vhich is that thare is no real "stock market” but only, as the atl Street people ike to aay, only "a market of stocke”-- deserves & moment oF ‘evo of aiscuasion. “What they ean by saying this is that investaent results depend only on what happens to individual securities, sose of which vill go up and others don, ant that it is illusory to talk about viet Eappens to the market as a vbole fs having © najor bearing on hoy the investor fares. I disagree with that point of view on three grounds. The Tire is that T doubt that the market is really #0 mich different in thie respect from what it alvaye vas in the past. I have sone recollection of the mar- et in 1928 and 1929, and I am sure that the disparity and diversity of stocks Detween those that acted well and those that acted poorly was alnost as great then fs ve see nov. But despite that fact it was essential for investore to be guided by a view as to the general level of the stock market, Tt is suprising to ne that Wall Street people haven't taken the time to make a study cf the spread in price Rovenents betveen individual stocks in racent years as compared vith what happen- ed in former years. (I have a student at UCLA who 1s going to mike thie study, ‘and it may prove quite iliuminatory), ~.the secon reason is that there is actually a considerable underlying con- sistency in the stock market it you measure ite aoveuents by comparing ‘vo averages Which seen to be quite different. One of them is the Dov Jones Industriel Average, which consists af only 30 stocks, and the other ie the Standard & Poor's Cot posite Average which consiste of 500 stocks. You might vel aasune that if thereina ie as underlying diversity af price sovenente then an average incluting only 30 stocks ‘oul! onrsainiy bebave difterens from one embracing 500, Dut Af you observe the Pikenuchionn 25 both averageny sow given by sost oevapapers you get virtually « tenctocone change, which wens a perity change, almoet Gay by Gay aod cervaisiy month by mont Aol yeas’ by years in the past ten yearn the Dor Joes Kverege rove Zou S iaopoine in 1935 20 750, wile she Standard Foor's index roae vom 2.7 80 75.5: da interesting Point i'that the apparently alscelleneous group of 300 iosuto Scheanay nal sitantly better advance than the gi lt-eige or Slvecchip stocks in the D5¥ Jones Average. ‘Tea sndicaeea that you canaot Sell 8 pricrsty-msntommneMADeC? Stocks 9 going to 4o over the future years in conpariaon with any athert 7 hime the shina and most Soyortant tpason why the investor showld not be ed to enghasise his selection of individual stocks, and to neglect the general 2ével ‘of the econ market. te the fact that there ie no inidostion thet the investor ca do | ester hen the market averages by saking bia om selections or by caking expert ‘sivice. She ovtavanding support for abet peasisistic ststenent ia found in the econ! of tis investenst fants, wach represent © cosbinstion of sbowt the best Homnesel vreins in the countr}, and « tremendous expenditure, ef money, time, tut Gexarly aivected effort. Tae recon? shows that the tule have nad grest Qit~ ‘Houlty as @'vhole in equaling the performance of the 30 stocks in the Dov Jones Averages cr the 500 Stassard & Poor's Index, I? an dnvestay hed been able, by some ough scross-the-board diversification to make up « portfelt epprocinatfng these ‘Sverageo he would have nad every season to expact mbost se Boot Females da were. shown by the very intelligent and careful stock selections by the investnent-fufit!™ Sanagers. But the greet fustificetion for the mavual ‘ngs ie that very few S8= estore actually do follow sash © sowd and ainjle policy. Trmge reluctantly express som atenticlen about a general efftoacy of sconoate Serecaaving, st stock markat forecsating, and of expert selection of com fon stocks, in theif reletion to the investaent 2d speculative profite viich sn be wade therefroa. Let on give you ny reasons? I say fire’ thet to the extent thet tn econonic forecast appence Zepenianle-cand it ie geiereiay wo only for the short Hermite affect is Likely to be already reflected fn the macket level, and there 4s no way to fake money fron te, or example, ve ctmot. sty becouse the forecast for IGG se Zavorehie that comscn svooks ahowla be bowgt todayy Tae price of common stocks touny, sa everyoody ahoald Kacy reflects the general expectation of © good 196k. On the other hand, longer term buniaes forecasts have proven unreldnble on the usle, Bintlarly, take the cise vere an individual stock i favored by one of Hy own genternity of security analyeis fe because he in optisistic shout {ve Future Sarninge aod general pronpastey, 70 ste eqeent that saversors genesnily sgree tat Ente company as good future grospecta tocthat extent tte prospects. Are also 2kely G0 be Fully reflected and perhaps over-reflected in the safest price, Souetlaee You Find the contrary case vere @ Wall Stree an aay sey "Noboay Likes thie Mock, sobedy han soneideroe in St, bye I nave confidence so it an 1 know ite Fesulve ace going to be better in the future.” Phat's an Snteresting ant valtahle Sonclusion #2 trae, The trovle 1s that Sn font cages you can'y rely on ive de= Pendability, The san may be Tight or he aay be wrong in saying “ht powe oe Popular stock is going to have s very good futures ‘That in the diieesa. all fae Vettors face in trying to make mosey ost oe forecasts ea t9 the future prospects Gf any individual securdy, Yor) wih respect to stock market foreceating as such, as a separate oc~ cagetion or smunnoene, I'don't think there in say good evidence thet a recognised ‘2od publicly seed nathod of stock aarket forecasting cat be relied upon to be feo+e Int ue {Liustrate vbet I mean by reference to the fenous "Dov Theory" usa is the best xnom of the aethods used for forecasting the stock market. T ‘bute sone elaborate studies of the results of applying the mechanical concepts ef she Dov Theory, in which you have vell-definea signals to by and sell stocks by the novenent of the average taroush resistance points upvard or domnverd, found that when Z studied the record fron 1858 to 1933, a period af shout 35 Yeure-othlrentlts from 26Lloving this mechanical aethod were’ Peaarkebly "good. ‘Koout 1933, the tise vhen the Dov Thecry had shown itself a very useful usthod Zor deeiing with the market action in the 1920's and early 1930's, the public's Interest in the Theory increased enoracusly. Previously it had been Kind of asoterie prescription folloved only by « few devoted adherents, and about which Gveryboiy else had bean prevty skeptical. The Dov Theory becene extrenely popular after 1933. 1 studied the consequences of using exactly the sane method in ‘he sarket etter 1933, and I found peculiarly enough that in no cage in the next 25 years aid one benefit throwh folloving the Dow signals mechanically. By this i neeo that one waa never able to buy his stocks back st = lover price than he cla then for. [As You know, the Dow Theory ie still persued by a muber of practitioners fant servioss, I think all of then vill tell you that it is act a mechanical ‘theory to, and that s large slenent of juigsant has to enter in the interpretation cof the signals. ut once you Antroduss thst elanent you don't have a true theory ‘uymore, you jist heve a certain expertise vhich may or may not be dependable and useful, ‘Tat me nov make a general cbaervation. For obvious reasons it is inpossible or Snvestors as a vhole, and therefore fcr the average investor or apeculetor, ‘oo do batter than the general market. The reason is that you are.the general narket fend you can't do vetter than yourselves. I do deileve it 1s possible for = Ininosity of investors to get eiguiticently better results than the average. Wo conditions are necesasry for that. One te that they must Zollov sose sound prine ciples of selsction vaich are related to the value of the securities ant not to ‘their market price action, The other te that their method of operation must be dasiceliy diferent than that of the majority of security buyers. They have to cout themselves cif from the general public and put themselves into © special cate~: gory. T vill toush acre briefly on that point later. x jov, et me sunnarize up this stage. The invastor needs comon stocks in his) portfolios but these introtuce hatards of vide fluctuations vhich he cannot fepact 20 avoia nore successfully than others unless perhaps he thinks intepen~ dently from she crow, that ie wiless he is constitutionally different from the average. How Let me cose to part two: whst investment policy to Zollov under the con Aitions Aiscussed? My views thereon sxe and definite and strong. In ay nearly Pitty yeara of experience in Wall Street I've fount that I know less and less shout what’ the stook market ia going to do but I know more and gore sbout what inves ore ought to do} and that's a pretty vital change in attitude, The first point Sa that the investor ia required by the very insecurity ruling tn the verla of Soday to maintain at all tines some division of his funds batreen bonds snd stocks (Cea ana" various types of interent-bearing deposits may he viewed as bond~ equivalents.) My suggestion is thet the sinimm position tf this portfolie eld in comnon stocks should be 25$ and the aaximim should be 75. Consequen~ tly the maximin holding of bonds vould ba 75 and the mintmun 25$- the figures being rerereed, Any varistions made in his portfolio mix should be held within ‘these 25% and 75% figures. Any ach veristions ahocld be cleerly based on value conalaerations, vaich vould ead him to ova more comon stocks ven the market mms low it relation to vallse and less conon stooks vhen the market seens high abegeert et5 AGE’ 10 4n Felation to value Now hile this is the classic language of investment authorities, it is amazing hov many people think in exactly opposite terms. That was brought home to ne shortly after the May 1962 break vien savings-and-loen company representative cane to me vith questions. The first question he asked ne as "Don't you think thst common stocks aov are less safe then before becsuse of ‘the decline in the market?” ‘That Lit me between Here were finene‘el people vino could seriously consider that stocks less safe because they have de- Glined in price thea they vere after they had sivanced in price. The policy 7 propose to have acre cosnon stocks vhen the market aeeus to be lov snd less vhen TEgeens to be high by value standards is obviously opposed to the paychology of investors generally and t6 that of speculators alvays. It is particularly rue nov decslise of the great confusion between investment and speculation vhich Tahal refer 29 inter, Levels than at high levels is Se could be followed by many investors to the extent of an inflexible rule that ‘they should not ineresse the percentage of common stocks in their portfolio as ‘the market advances, except of course through the rise in the aarket itself. Hov- ever, # nore sophisticated application, vatch vould take advantage of a ris Market level for sales, could be something like this. Use a fixed 50-50 division Detween bonds and stocks, When the market level of the stocks rises to © point where they constitute 55% of the total or maybe 60, you vould then sell out enough fo bring your proportion vack to 50k, putting the proceeds back into bonds or into tvings benks. And conversely when the market went down ao that your comon stock proportion had fallen sf or bof, you would use some of your bond money to buy. Common stocks and bring st back to the 50k. That was the famous Yale University Syston, weich wae OHV cf the sarliost formula methods mown. They used = 256 baste for comon stocks, a percentage hich at that {ine ves regerded ax pretty rash Zor an institution of learning, When aarket rise trout it up to bof they sola fut one efgnth of their holdings, to get back to 3563 when it vert down to 306 they ought one eixth to bring the ratio up agsin to 35%. It vas = good system until an avay on the upside, and then they decided they had too little in common stocks. low they are up. to-a 50 to 55 rubio, iike the other universities, T think, and they don't folloy the forma sayncre. ‘Andther approsch thst ie practicable, bit froa a diferent point of view, is ‘the "Dollar Averaging” method, in vaich you put the gaze asount of money in common Stocks year after year, or quarter after quarter, In that wey you buy more shares 9f stocks when the market level is lov end fever shares vien Ite high. That fkethod has worked out extreaely vell for those who have had (a) the money, (b) the ‘ine, and (2) the charecter necessary to persue a consistent policy over the years ‘of whether the market has been going up or dova, If you can do that you ‘Let ne add thst there are countless variants of this type, which are called "formula plans.” The sain need here in for the investor to select some rule which img to be suiteble for iis point of view, one vhich vill keep his out of ais chief, sod one, I insist, vhich vill always maintain some interest in comon stocks regardless of Lov high the market level goes, For if you hed followed one of these older formas which took you out af common stocks entizely et sone level of ‘the market, your disappointomnt woul have been 40 great deoause of the ensueing advance as probably to ruin you frou the standpoint cf intelligent investing for ‘the rest of your lite. Wow let ae come to the probless of security aelection. We have talked about ‘a bond cosponent (and/or a cesh~equivelent component) and a coamon stock coa~ ponent. There's a vide choice in the bond component, but the decision is not ofage ah too mich sayertance in sost cases. In the taxable List, you can put your aoney in UsS. Seviege Bonda st 343 vaich you can redeem at vill; you can buy long ‘term U.S. Government Bonds at bout 4.10% taxable; you can buy high grede, long- tera corporate bonds at 30K, or Mf if you do e Little selectings you can have savings deposits in conpercial banks which give you up to bi 4f hela for cone year; You can buy sevings-and loan sheres (beer in sind thet they are not deposies but stares) vaich nov yleld up to 5$ in California. Another chotce of Grest inportance are taxcfree stete end municipal bonds, Vaich yield up to about 334 for good quality and long maturity, For moet investors vho are in a tex Brncket of nore than 3ofy tax-free bonis have been the most attrectable for sseny years.” They actually vere in part a gift to the investor of vaiah he adn" ‘ake ivantage up to the axtent he shoud have oe ageinet taxable Donde. That sivantage hes dininiahed, Deceise tax free bonds have sdvanced relative to others, Dut St da still persuasive for people of substantial wesna. I vould Like to point out that in 1953 municipal bonds yielded 2.95 end UnS, Governnent taxable Donde 3.08%, nearly the same return despite the full tax on the governments. In Octobe 8 the municipal average waa 3.20% and that of U.S. Governaent donde 5.06%, 0 you ace the afvantage that hes wereld to the peat solder of tax-free bonds Zompared with U.S, government. One question for the savestor which I won't go nto, and I am gled I barn't got the time to do it, is whether he should take adventege of the 5% rete offered by sone of the savings end losn associations in Californie. Let me aay that I am not an expert on savings sod loan associetions, end don't want to get drew into he controversy het has now degua ea to whethey their sethods are completely sound snd their prospects ere completely dependabie. I just vant to say in general terms ‘thet nobody can assuse that be oan get exactly the gase degree of safety and dependability in standard type of investment yielding 5% as in one yielding 4. With respect to prefered stocks the inport point 1a thet they do’ aot belong tn the individual investor's portfolio. The reeson ia they have a great tax sivantage Zor carports oviers vhicn they don't heve for sndsvidoal omer Corporate ovners save 85% of the tax on these dividends, individual owners save very sanil anount, which say dizeppeer pretty soon inthe nev Lev. Tt should ‘e'obvious thet preferred atocks ahculd de bought only by corporate invertors Just 6 taxctree bonds should be dowht only by people who pay income tax. You aay have oticad inst week that one of the public utility companies offered « bond Sanwa and a preferred-atock iamue st practically the same yield, alshough hitherto preferrea Stocks have alveys yielded quite © bit gore than the votds to vaich they were Guitor. ‘The great tax advantage of preferred stocks to corporate buyers is ov edly moving sts effect on relative yields. ‘ie cone Finally to comon-stock investaent, My recomiendstion is thet the wvestor choose either ise om list of, sty, 20 or 30 representative end Leading coupeniea, cr else put his soney in several of the well-established mutual funda. (Goere t/umslly en sdvantage for the airerd investor in buying shares of the closed-end tnvestaent companies on the Hew York Stock Exchange, when doteinable ft discounts from net cease value, rather than paying the presium added on to the rice of most opencend ahar Many’ investors vould think ay prescription too steple. If they can get rex sults equal to the averages in this easy vay wy abouldn't they try to eet @ fubstentially higher return oy carefl ani compatently-eaviaed selection? |My ‘hort anaver bas already been given: If the investaere funda aaa whole can't Dest the averages, even pretty clever investors es © whole can't do it either. The underlying problem of selection 1a tat the "good atocka--chiefly the arovth stocks vith better than average prospects-ctend to be fully priced and u\ vgs ie often overpriced," At the other extrene nev stock offertigs, vhen the craze $s one, fre likely to combine fourtharate quality vith ebsurdly high price-earaiags ration. here are better opportunsticn in Detveen these extrenee, Dut aoat investors don't ‘ook for then there. Ae race it, the fudanestal problem in comon stocks Se the market's i Jection of Large speculative eleaent into the strongest ani Dest compenten by seablioning an untensbly Bigh price for thea, (The rise of TEM or 607, soon folloved by # fall to 300, Sa the Seat illustration of ay point.) ‘Thia bes aldo figrestiy to the confuaion Detveen investeent and apeculstion, because 1% 1s «aay Yovtell oneself thet the shares of good company are alveys sound Savestuent, Fegardlvan of price, Fron this St vas en easy #tep to calling everyone an 1a etter to boubht hin saree oberg, aot'Pinaly to calling every Hell Steet Custouer an Snvestor=-period. “iy recent crusade hag been to persuade Vall Street that 1% bes made a sistake, aod naraed iteeit, in auppressing the word “speculation” frou {te voesbulary, Sprculation ie not bad in iteelf) overapeculetion in, It is taportant chat che public anould have a fatriy good idea of the extent to vhich ie ie speculating, Zot only worn {¢ Dunya "hot ‘anus" at a completely silly price, bub even when 1% bigs ito a wonlerAil concern auch ax IBM at 70 tines Ste highest recorded eara- ‘nga. To ay sind the nosy valuable contribution that security analyete could aake forthe art cf investing would be the deteraination of the invertaent aod specula silva componente in the current price of any given coagon stock, 40 that the in- fending buyer aight have som notion of the risks he in taking a vell a what profit he aight sake, I have pointed cut that ay om conservative appreted ‘put the investment component in IBM's 1961 price st not more then $200 per share Pinout $6 billion fer the entine entenpriaee-the sensioter of the quetwtion Fepresenting « apectlative valuation of the company's undoubtedly brilliant future, Conversely, 1 stated that at least Gop of the highest. pricea(55) of International Harvester in 1961 could be ascribed to its investoent value, ‘als 41d not prove that Harvester vas e Detter Diy than IDUwit vas, a 1% ‘purned outecbut st did denonstrate that the siak factor involved wes auch analler, pe tat me raise e final question: Despiig rather discouraging results frou maleavors to predict sarke® moves or 20 select the sost sttrective companies, can the intelligent investor follow any policies af comonestock selection thet pronive better than average renulte? {think 1¢ ie possible for soae stronge Einded investors to do thie, oy buying value rather then prospects oF Pop ulerity. Some examples of this approach: (1) Select stocks of important com- pasion vitch sell. on « no-glanour Jj.) International Hacverter. Seat ‘Sevraordinery results could have been obtained since 1935 by buying each Jeer ‘Gha aharen of the aix companies in the Dov donen Ind. Average witch gold at the lowest multiplier of thesr recent earnings, (2) Buy deginitely "bargain Sasues.” ‘Typically these would be shares that sold for less their value in vorking-capital Sine, vith nothing paid for fixed assets cad goosvill, Mase vere quite ‘BuserGus up to a late aa 1957, and ware consistently profitable when diver fioetion vas observed, ‘Tey such opportunities Tanain; perhaps they nave supplanted by shares of sualler companies selling on a relatively depres ‘asta an Lively to de texan over SY a larger gosoera ab 4. goot advance in price, \, (3) Pinaliy there ie the vide Field of "speoial situstiona"=-reorguntsations, Sergers, ‘ake-overs, Liguidations, eto. ‘This 10 a professional ares, Dut it in nov iapossible for intelligent tnvestors to yrofit bandaonaly frou St 12 ‘thay appronch security operations as thay vould « commercial Dustbe \CONSLUBEON. |, Mi Sivertor mut recognise thet there are uncertain sod banoe epeculativesats inherent in any policy he follovs--even an allGovernsent-bond program, ‘ist deal vith these uncertainties by a policy of continuous compromise be- vaeen bonds end common stocks, and by adequate diversification. (Exception: Fe nay put sai keep ost of his funds in shares of « promising business vith which Se da closely connected.) He must make a strong effort to have sore noney ‘crested in comon stocks at lover market levels (at least on the desis of cost) ‘han at vat be recomizes to be potentially high levels. Most inportent, he sist maintain a philosophical attitule tovards the inescapeble variations in © Financial position and the inevitable "sistakes” associated with these variations. According to an old Wall Street story, vhen a certain broker vas asked by client to recomend issues to Duy, he slvays asked in return, "what 1s your e7 Do you want to ext vell or to sleep well?” I an optinist enough ‘vo believe that by folloving sound policies almost any investor--even in this Ineshould be able to ext well enough without having to lose any