FIGURE 12-1 Micron booked

 

FIGURE 12-1 Micron booked further inventory write-downs in every one of the next six fiscal quarters. Was the devaluation of Micron’s inventory a nonrecurring event, or had it become a chronic condition? Reasonable minds can differ on this particular case, but one thing is clear: The intelligent investor must always be on guard for “nonrecurring” costs that, like the Energizer bunny, just keep on going.5 THE PENSION DIMENSION In 2001, SBC Communications, Inc., which owns interests in Cingular Wireless, PacTel, and Southern New England Telephone, earned $7.2 billion in net income—a stellar performance in a bad year for the overextended telecom industry. But that gain didn’t come only from SBC’s business. Fully $1.4 billion of it—13% of the company’s net income—came from SBC’s pension plan. Because SBC had more money in the pension plan than it estimated was necessary to pay its employees’ future benefits, the company got to treat the difference as current income. One simple reason for that surplus: In 2001, SBC raised the rate of return it expected to earn on the pension plan’s investments from 8.5% to 9.5%—lowering the amount of money it needed to set aside today. SBC explained its rosy new expectations by noting that “for each of the three years ended 2001, our actual 10-year return on investments exceeded 10%.” In other words, our past returns have been high, so let’s assume that our future returns will be too. But that not only flunked the most rudimentary tests of logic, it flew in the face of the fact that interest rates were falling to near-record lows, depressing the future returns on the bond portion of a pension portfolio. The same year, in fact, Warren Buffett’s Berkshire Hathaway lowered the expected rate of return on its pension assets from 8.3% to 6.5%. Was SBC being realistic in assuming that its pension-fund managers could significantly outperform the world’s greatest investor? Probably not: In 2001, Berkshire Hathaway’s pension fund gained 9.8%, but SBC’s pension fund lost 6.9%.6 Commentary on Chapter 12 327 5 I am grateful to Howard Schilit and Mark Hamel of the Center for Financial Research and Analysis for providing this example. 6 Returns are approximated by dividing the total net value of plan assets at the beginning of the year by “actual return on plan assets.” Here are some quick considerations for the intelligent investor: Is the “net pension benefit” more than 5% of the company’s net income? (If so, would you still be comfortable with the company’s other earnings if those pension gains went away in future years?) Is the assumed “long-term rate of return on plan assets” reasonable? (As of 2003, anything above 6.5% is implausible, while a rising rate is downright delusional.) CAVEAT INVESTOR A few pointers will help you avoid buying a stock that turns out to be an accounting time bomb: Read backwards. When you research a company’s financial reports, start reading on the last page and slowly work your way toward the front. Anything that the company doesn’t want you to find is buried in the back—which is precisely why you should look there first. Read the notes. Never buy a stock without reading the footnotes to the financial statements in the annual report. Usually labeled “summary of significant accounting policies,” one key note describes how the company recognizes revenue, records inventories, treats installment or contract sales, expenses its marketing costs, and accounts for the other major aspects of its business.7 In the other footnotes, 328 Commentary on Chapter 12 7 Do not be put off by the stupefyingly boring verbiage of accounting footnotes. They are designed expressly to deter normal people from actually reading them—which is why you must persevere. A footnote to the 1996 annual report of Informix Corp., for instance, disclosed that “The Company generally recognizes license revenue from sales of software licenses upon delivery of the software product to a customer. However, for certain computer hardware manufacturers and end-user licensees with amounts payable within twelve months, the Company will recognize revenue at the time the customer makes a contractual commitment for a minimum nonrefundable license fee, if such computer hardware manufacturers and enduser licensees meet certain criteria established by the Company.” In plain English, Informix was saying that it would credit itself for revenues on products even if they had not yet been resold to “end-users” (the actual customers for Informix’s software). Amid allegations by the U.S. Securities and watch for disclosures about debt, stock options, loans to customers, reserves against losses, and other “risk factors” that can take a big chomp out of earnings. Among the things that should make your antennae twitch are technical terms like “capitalized,” “deferred,” and “restructuring”—and plain-English words signaling that the company has altered its accounting practices, like “began,” “change,” and “however.” None of those words mean you should not buy the stock, but all mean that you need to investigate further. Be sure to compare the footnotes with those in the financial statements of at least one firm that’s a close competitor, to see how aggressive your company’s accountants are. Read more. If you are an enterprising investor willing to put plenty of time and energy into your portfolio, then you owe it to yourself to learn more about financial reporting. That’s the only way to minimize your odds of being misled by a shifty earnings statement. Three solid books full of timely and specific examples are Martin Fridson and Fernando Alvarez’s Financial Statement Analysis, Charles Mulford and Eugene Comiskey’s The Financial Numbers Game, and Howard Schilit’s Financial Shenanigans.8 Commentary on Chapter 12 329 Exchange Commission that Informix had committed accounting fraud, the company later restated its revenues, wiping away $244 million in such “sales.” This case is a keen reminder of the importance of reading the fine print with a skeptical eye. I am indebted to Martin Fridson for suggesting this example. 8 Martin Fridson and Fernando Alvarez, Financial Statement Analysis: A Practitioner’s Guide (John Wiley & Sons, New York, 2002); Charles W. Mulford and Eugene E. Comiskey, The Financial Numbers Game: Detecting Creative Accounting Practices (John Wiley & Sons, New York, 2002); Howard Schilit, Financial Shenanigans (McGraw-Hill, New York, 2002). Benjamin Graham’s own book, The Interpretation of Financial Statements (HarperBusiness, New York, 1998 reprint of 1937 edition), remains an excellent brief introduction to the basic principles of earnings and expenses, assets and liabilities. CHAPTER 13 A Comparison of Four Listed Companies In this chapter we should like to present a sample of security analysis in operation. We have selected, more or less at random, four companies which are found successively on the New York Stock Exchange list. These are eltra Corp. (a merger of Electric Autolite and Mergenthaler Linotype enterprises), Emerson Electric Co. (a manufacturer of electric and electronic products), Emery Air Freight (a domestic forwarder of air freight), and Emhart Corp. (originally a maker of bottling machinery only, but now also in builders’ hardware).* There are some broad resemblances between the three manufacturing firms, but the differences will seem more significant. There should be sufficient variety in the financial and operating data to make the examination of interest. In Table 13-1 we present a summary of what the four companies were selling for in the market at the end of 1970, and a few figures on their 1970 operations. We then detail certain key ratios, which relate on the one hand to performance and on the other to price. Comment is called for on how various aspects of the performance pattern agree with the relative price pattern. Finally, we shall pass the four companies in review, suggesting some comparisons and relationships and evaluating each in terms of the requirements of a conservative common-stock investor. 330 * Of Graham’s four examples, only Emerson Electric still exists in the same form. ELTRA Corp. is no longer an independent company; it merged with Bunker Ramo Corp. in the 1970s, putting it in the business of supplying stock quotes to brokerage firms across an early network of computers. What remains of ELTRA’s operations is now part of Honeywell Corp. The firm formerly known as Emery Air Freight is now a division of CNF Inc. Emhart Corp. was acquired by Black & Decker Corp. in 1989. TABLE 13-1 A Comparison of Four Listed Companies ELTRA Emerson Electric Emery Air Freight Emhart Corp. A. Capitalization Price of common, Dec. 31, 1970 27 66 573 ⁄4 323 ⁄4 Number of shares of common 7,714,000 24,884,000a 3,807,000 4,932,000 Market value of common $208,300,000 $1,640,000,000 $220,000,000 $160,000,000 Bonds and preferred stock 8,000,000 42,000,000 9,200,000 Total capitalization 216,300,000 1,682,000,000 220,000,000 169,200,000 B. Income Items Sales, 1970 $454,000,000 $657,000,000 $108,000,000 $227,000,000 Net income, 1970 20,773,000 54,600,000 5,679,000 13,551,000 Earned per share, 1970 $2.70 $2.30 $1.49 $2.75b Earned per share, ave., 1968–1970 2.78 2.10 1.28 2.81 Earned per share, ave., 1963–1965 1.54 1.06 .54 2.46 Earned per share, ave., 1958–1960 .54 .57 .17 1.21 Current dividend 1.20 1.16 1.00 1.20 C. Balance-sheet Items, 1970 Current assets $205,000,000 $307,000,000 $20,400,000 $121,000,000 Current liabilities 71,000,000 72,000,000 11,800,000 34,800,000 Net assets for common stock 207,000,000 257,000,000 15,200,000 133,000,000 Book value per share $27.05 $10.34 $3.96 $27.02 a Assuming conversion of preferred stock. b After special charge of 13 cents per share. c Year ended Sept. 1970. The most striking fact about the four companies is that the current price/earnings ratios vary much more widely than their operating performance or financial condition. Two of the enterprises—eltra and Emhart—were modestly priced at only 9.7 times and 12 times the average earnings for 1968–1970, as against a similar figure of 15.5 times for the DJIA. The other two—Emerson and Emery—showed very high multiples of 33 and 45 times such earnings. There is bound to be some explanation of a difference such as this, and it is found in the superior growth of the favored companies’ profits in recent years, especially by the freight forwarder. (But the growth figures of the other two firms were not unsatisfactory.) For more comprehensive treatment let us review briefly the chief elements of performance as they appear from our figures. 332 The Intelligent Investor TABLE 13-2 A Comparison of Four Listed Companies (continued) Emerson Emery Emhart ELTRA Electric Air Freight Corp. B. Ratios Price/earnings, 1970 10.0
30.0
38.5
11.9
Price/earnings, 1968–1970 9.7
33.0
45.0
11.7
Price/book value 1.00
6.37
14.3
1.22
Net/sales, 1970 4.6 % 8.5 % 5.4 % 5.7 % Net per share/book value 10.0 % 22.2 % 34.5 % 10.2 % Dividend yield 4.45 % 1.78 % 1.76 % 3.65 % Current assets to current liabilities 2.9
4.3
1.7
3.4
Working capital/debt Very large 5.6
no debt 3.4
Earnings growth per share: 1968–1970 vs. 1963–1965 + 81% + 87% + 135% +14 % 1968–1970 vs. 1958–1970 +400% +250% Very large +132% C. Price Record 1936–1968 Low 3 ⁄4 1 1 ⁄8 35 ⁄8 High 503 ⁄4 611 ⁄2 66 581 ⁄4 1970 Low 185 ⁄8 421 ⁄8 41 231 ⁄2 1971 High 293 ⁄8 783 ⁄4 72 443 ⁄8 1. Profitability. (a) All the companies show satisfactory earnings on their book value, but the figures for Emerson and Emery are much higher than for the other two. A high rate of return on invested capital often goes along with a high annual growth rate in earnings per share.* All the companies except Emery showed better earnings on book value in 1969 than in 1961; but the Emery figure was exceptionally large in both years. (b) For manufacturing companies, the profit figure per dollar of sales is usually an indication of comparative strength or weakness. We use here the “ratio of operating income to sales,” as given in Standard & Poor’s Listed Stock Reports. Here again the results are satisfactory for all four companies, with an especially impressive showing by Emerson. The changes between 1961 and 1969 vary considerably among the companies. 2. Stability. This we measure by the maximum decline in pershare earnings in any one of the past ten years, as against the average of the three preceding years. No decline translates into 100% stability, and this was registered by the two popular concerns. But the shrinkages of eltra and Emhart were quite moderate in the “poor year” 1970, amounting to only 8% each by our measurement, against 7% for the DJIA. 3. Growth. The two low-multiplier companies show quite satisfactory growth rates, in both cases doing better than the Dow Jones group. The eltra figures are especially impressive when set against its low price/earnings ratio. The growth is of course more impressive for the high-multiplier pair. 4. Financial Position. The three manufacturing companies are in sound financial condition, having better than the standard ratio of $2 of current assets for $1 of current liabilities. Emery Air Freight has a lower ratio; but it falls in a different category, and with its fine record it would have no problem raising needed cash. All the companies have relatively low long-term debt. “Dilution” note: Emerson Electric had $163 million of market value of low-dividend A Comparison of Four Listed Companies 333 * This measure is captured in the line “Net per share/book value” in Table 13-2, which measures the companies’ net income as a percentage of their tangible book value. convertible preferred shares outstanding at the end of 1970. In our analysis we have made allowance for the dilution factor in the usual way by treating the preferred as if converted into common. This decreased recent earnings by about 10 cents per share, or some 4%. 5. Dividends. What really counts is the history of continuance without interruption. The best record here is Emhart’s, which has not suspended a payment since 1902. eltra’s record is very good, Emerson’s quite satisfactory, Emery Freight is a newcomer. The variations in payout percentage do not seem especially significant. The current dividend yield is twice as high on the “cheap pair” as on the “dear pair,” corresponding to the price/earnings ratios. 6. Price History. The reader should be impressed by the percentage advance shown in the price of all four of these issues, as measured from the lowest to the highest points during the past 34 years. (In all cases the low price has been adjusted for subsequent stock splits.) Note that for the DJIA the range from low to high was on the order of 11 to 1; for our companies the spread has varied from “only” 17 to 1 for Emhart to no less than 528 to 1 for Emery Air Freight.* These manifold price advances are characteristic of most of our older common-stock issues, and they proclaim the great opportunities of profit that have existed in the stock markets of the past. (But they may indicate also how overdone were the declines in the bear markets before 1950 when the low prices were registered.) Both eltra and Emhart sustained price shrinkages of more than 50% in the 1969–70 price break. Emerson and Emery had serious, but less distressing, declines; the former rebounded to a new all-time high before the end of 1970, the latter in early 1971. 334 The Intelligent Investor * In each case, Graham is referring to Section C of Table 13-2 and dividing the high price during the 1936–1968 period by the low price. For example, Emery’s high price of 66 divided by its low price of 1/8 equals 528, or a ratio of 528 to 1 between the high and low. General Observations on the Four Companies Emerson Electric has an enormous total market value, dwarfing the other three companies combined.* It is one of our “good-will giants,” to be commented on later. A financial analyst blessed (or handicapped) with a good memory will think of an analogy between Emerson Electric and Zenith Radio, and that would not be reassuring. For Zenith had a brilliant growth record for many years; it too sold in the market for $1.7 billion (in 1966); but its profits fell from $43 million in 1968 to only half as much in 1970, and in that year’s big selloff its price declined to 221 ⁄2 against the previous top of 89. High valuations entail high risks. Emery Air Freight must be the most promising of the four companies in terms of future growth, if the price/earnings ratio of nearly 40 times its highest reported earnings is to be even partially justified. The past growth, of course, has been most impressive. But these figures may not be so significant for the future if we consider that they started quite small, at only $570,000 of net earnings in 1958. It often proves much more difficult to continue to grow at a high rate after volume and profits have already expanded to big totals. The most surprising aspect of Emery’s story is that its earnings and market price continued to grow apace in 1970, which was the worst year in the domestic air-passenger industry. This is a remarkable achievement indeed, but it raises the question whether future profits may not be vulnerable to adverse developments, through increased competition, pressure for new arrangements between forwarders and airlines, etc. An elaborate study might be needed before a sound judgment could be passed on these points, but the conservative investor cannot leave them out of his general reckoning. Emhart and eltra. Emhart has done better in its business than in the stock market over the past 14 years. In 1958 it sold as high as 22 times the current earnings—about the same ratio as for the DJIA. Since then its profits tripled, as against a rise of less than 100% for the Dow, but its closing price in 1970 was only a third above the A Comparison of Four Listed Companies 335 * At the end of 1970, Emerson’s $1.6 billion in market value truly was “enormous,” given average stock sizes at the time. At year-end 2002, Emerson’s common stock had a total market value of approximately $21 billion. 1958 high, versus 43% for the Dow. The record of eltra is somewhat similar. It appears that neither of these companies possesses glamour, or “sex appeal,” in the present market; but in all the statistical data they show up surprisingly well. Their future prospects? We have no sage remarks to make here, but this is what Standard & Poor’s had to say about the four companies in 1971: eltra—“Long-term Prospects: Certain operations are cyclical, but an established competitive position and diversification are offsetting factors.” Emerson Electric—“While adequately priced (at 71) on the current outlook, the shares have appeal for the long term....A continued acquisition policy together with a strong position in industrial fields and an accelerated international program suggests further sales and earnings progress.” Emery Air Freight—“The shares appear amply priced (at 57) on current prospects, but are well worth holding for the long pull.” Emhart—“Although restricted this year by lower capital spending in the glass-container industry, earnings should be aided by an improved business environment in 1972. The shares are worth holding (at 34).” Conclusions: Many financial analysts will find Emerson and Emery more interesting and appealing stocks than the other two— primarily, perhaps, because of their better “market action,” and secondarily because of their faster recent growth in earnings. Under our principles of conservative investment the first is not a valid reason for selection—that is something for the speculators to play around with. The second has validity, but within limits. Can the past growth and the presumably good prospects of Emery Air Freight justify a price more than 60 times its recent earnings?1 Our answer would be: Maybe for someone who has made an in-depth study of the possibilities of this company and come up with exceptionally firm and optimistic conclusions. But not for the careful investor who wants to be reasonably sure in advance that he is not committing the typical Wall Street error of overenthusiasm for good performance in earnings and in the stock market.* The same 336 The Intelligent Investor * Graham was right. Of the “Nifty Fifty” stocks that were most fashionable and highly valued in 1972, Emery fared among the worst. The March 1, cautionary statements seem called for in the case of Emerson Electric, with a special reference to the market’s current valuation of over a billion dollars for the intangible, or earning-power, factor here. We should add that the “electronics industry,” once a fairhaired child of the stock market, has in general fallen on disastrous days. Emerson is an outstanding exception, but it will have to continue to be such an exception for a great many years in the future before the 1970 closing price will have been fully justified by its subsequent performance. By contrast, both eltra at 27 and Emhart at 33 have the earmarks of companies with sufficient value behind their price to constitute reasonably protected investments. Here the investor can, if he wishes, consider himself basically a part owner of these businesses, at a cost corresponding to what the balance sheet shows to be the money invested therein.* The rate of earnings on invested capital has long been satisfactory; the stability of profits also; the past growth rate surprisingly so. The two companies will meet our seven statistical requirements for inclusion in a defensive investor’s portfolio. These will be developed in the next chapter, but we summarize them as follows: 1. Adequate size. 2. A sufficiently strong financial condition. 3. Continued dividends for at least the past 20 years. 4. No earnings deficit in the past ten years. A Comparison of Four Listed Companies 337 1982, issue of Forbes reported that since 1972 Emery had lost 72.8% of its value after inflation. By late 1974, according to the investment researchers at the Leuthold Group in Minneapolis, Emery’s stock had already fallen 58% and its price/earnings ratio had plummeted from 64 times to just 15. The “overenthusiasm” Graham had warned against was eviscerated in short order. Can the passage of time make up for this kind of excess? Not always: Leuthold calculated that $1000 invested in Emery in 1972 would be worth only $839 as of 1999. It’s likely that the people who overpaid for Internet stocks in the late 1990s will not break even for decades—if ever (see the commentary on Chapter 20). * Graham’s point is that, based on their prices at the time, an investor could buy shares in these two companies for little more than their book value, as shown in the third line of Section B in Table 13-2. 5. Ten-year growth of at least one-third in per-share earnings. 6. Price of stock no more than 11 ⁄2 times net asset value. 7. Price no more than 15 times average earnings of the past three years. We make no predictions about the future earnings performance of eltra or Emhart. In the investor’s diversified list of common stocks there are bound to be some that prove disappointing, and this may be the case for one or both of this pair. But the diversified list itself, based on the above principles of selection, plus whatever other sensible criteria the investor may wish to apply, should perform well enough across the years. At least, long experience tells us so. A final observation: An experienced security analyst, even if he accepted our general reasoning on these four companies, would have hesitated to recommend that a holder of Emerson or Emery exchange his shares for eltra or Emhart at the end of 1970—unless the holder understood clearly the philosophy behind the recommendation. There was no reason to expect that in any short period of time the low-multiplier duo would outperform the highmultipliers. The latter were well thought of in the market and thus had a considerable degree of momentum behind them, which might continue for an indefinite period. The sound basis for preferring eltra and Emhart to Emerson and Emery would be the client’s considered conclusion that he preferred value-type investments to glamour-type investments. Thus, to a substantial extent, common-stock investment policy must depend on the attitude of the individual investor. This approach is treated at greater length in our next chapter. 338 The Intelligent Investor COMMENTARY ON CHAPTER 13 In the Air Force we have a rule: check six. A guy is flying along, looking in all directions, and feeling very safe. Another guy flies up behind him (at “6 o’clock”—“12 o’clock” is directly in front) and shoots. Most airplanes are shot down that way. Thinking that you’re safe is very dangerous! Somewhere, there’s a weakness you’ve got to find. You must always check six o’clock. —U.S. Air Force Gen. Donald Kutyna E-BUSINESS As Graham did, let’s compare and contrast four stocks, using their reported numbers as of December 31, 1999—a time that will enable us to view some of the most drastic extremes of valuation ever recorded in the stock market. Emerson Electric Co. (ticker symbol: EMR) was founded in 1890 and is the only surviving member of Graham’s original quartet; it makes a wide array of products, including power tools, airconditioning equipment, and electrical motors. EMC Corp. (ticker symbol: EMC) dates back to 1979 and enables companies to automate the storage of electronic information over computer networks. Expeditors International of Washington, Inc. (ticker symbol: EXPD), founded in Seattle in 1979, helps shippers organize and track the movement of goods around the world. Exodus Communications, Inc. (ticker symbol: EXDS) hosts and manages websites for corporate customers, along with other Internet services; it first sold shares to the public in March 1998. This table summarizes the price, performance, and valuation of these companies as of year-end 1999: 339 FIGURE 13-1 E-valuations Exodus Expeditors Emerson Communications, International Electric EMC Corp. Inc. of Washington Capitalization Closing price, 12/31/99, $ per share 57.37 54.62 44.41 21.68 Total return, 1999 (%) –3.1 157.1 1005.8 109.1 Total market cap, 12/31/99, $ millions 24845.9 111054.3 14358.4 2218.8 Total debt (including preferred stock), $ millions 4600.1 27.1 2555.7 0 Earnings Total revenues, 1999, $ millions 14385.8 6715.6 242.1 1444.6 Net income, 1999, $ millions 1313.6 1010.6 –130.3 59.2 Earnings growth, 1995 through 1999 (average annual %) 7.7 28.8 NM 19.8 Earnings per share (EPS), 1999 ($ fully diluted) 3.00 0.53 –0.38 0.55 EPS growth rate, 1995–1999 (average annual %) 8.3 28.8 NM 25.8 Annual dividend ($ per share), 1999 1.30 0 0 0.08 Balance sheet Current assets, $ millions 5124.4 4320.4 1093.2 402.7 Current liabilities, $ millions 4590.4 1397.9 150.6 253.1 Book value per share ($ 12/31/99) 14.27 2.38 0.05 2.79 Valuation Price/earnings ratio (
) 17.7 103.1 NM 39.4 Price/book value (
) 3.7 22.9 888.1 7.8 Net income/revenues (% net profit margin) 9.2 17.4 NM 4.1 Net income/book value (%) 21.0 22.2 NM 19.7 Working capital/debt (
) 0.1 107.8 0.4 no debt Market cap/revenues (
) 1.7 16.5 59.3 1.5 Sources: Value Line, Thomson/Baseline, Bloomberg, finance.yahoo.com, the companies’ SEC filings Notes: All figures adjusted for later stock splits. Debt, revenue, and earnings are for fiscal years. Market cap: total value of common stock. NM: not meaningful. ELECTRIC, NOT ELECTRIFYING The most expensive of Graham’s four stocks, Emerson Electric, ended up as the cheapest in our updated group. With its base in Old Economy industries, Emerson looked boring in the late 1990s. (In the Internet Age, who cared about Emerson’s heavy-duty wet-dry vacuums?) The company’s shares went into suspended animation. In 1998 and 1999, Emerson’s stock lagged the S & P 500 index by a cumulative 49.7 percentage points, a miserable underperformance. But that was Emerson the stock. What about Emerson the company? In 1999, Emerson sold $14.4 billion worth of goods and services, up nearly $1 billion from the year before. On those revenues Emerson earned $1.3 billion in net income, or 6.9% more than in 1998. Over the previous five years, earnings per share had risen at a robust average rate of 8.3%. Emerson’s dividend had more than doubled to $1.30 per share; book value had gone from $6.69 to $14.27 per share. According to Value Line, throughout the 1990s, Emerson’s net profit margin and return on capital—key measures of its efficiency as a business—had stayed robustly high, around 9% and 18% respectively. What’s more, Emerson had increased its earnings for 42 years in a row and had raised its dividend for 43 straight years—one of the longest runs of steady growth in American business. At year-end, Emerson’s stock was priced at 17.7 times the company’s net income per share. Like its power tools, Emerson was never flashy, but it was reliable—and showed no sign of overheating. COULD EMC GROW PDQ? EMC Corp. was one of the best-performing stocks of the 1990s, rising—or should we say levitating?—more than 81,000%. If you had invested $10,000 in EMC’s stock at the beginning of 1990, you would have ended 1999 with just over $8.1 million. EMC’s shares returned 157.1% in 1999 alone—more than Emerson’s stock had gained in the eight years from 1992 through 1999 combined. EMC had never paid a dividend, instead retaining all its earnings “to provide funds for the continued growth of the company.” 1 At their December Commentary on Chapter 13 341 1 As we will see in Chapter 19, this rationale often means, in practice, “to provide funds for the continued growth of the company’s top managers’ wealth.” 31 price of $54.625, EMC’s shares were trading at 103 times the earnings the company would report for the full year—nearly six times the valuation level of Emerson’s stock. What about EMC the business? Revenues grew 24% in 1999, rising to $6.7 billion. Its earnings per share soared to 92 cents from 61 cents the year before, a 51% increase. Over the five years ending in 1999, EMC’s earnings had risen at a sizzling annual rate of 28.8%. And, with everyone expecting the tidal wave of Internet commerce to keep rolling, the future looked even brighter. Throughout 1999, EMC’s chief executive repeatedly predicted that revenues would hit $10 billion by 2001—up from $5.4 billion in 1998.2 That would require average annual growth of 23%, a monstrous rate of expansion for so big a company. But Wall Street’s analysts, and most investors, were sure EMC could do it. After all, over the previous five years, EMC had more than doubled its revenues and better than tripled its net income. But from 1995 through 1999, according to Value Line, EMC’s net profit margin slid from 19.0% to 17.4%, while its return on capital dropped from 26.8% to 21%. Although still highly profitable, EMC was already slipping. And in October 1999, EMC acquired Data General Corp., which added roughly $1.1 billion to EMC’s revenues that year. Simply by subtracting the extra revenues brought in from Data General, we can see that the volume of EMC’s existing businesses grew from $5.4 billion in 1998 to just $5.6 billion in 1999, a rise of only 3.6%. In other words, EMC’s true growth rate was almost nil— even in a year when the scare over the “Y2K” computer bug had led many companies to spend record amounts on new technology.3 342 Commentary on Chapter 13 2 Appearing on CNBC on December 30, 1999, EMC’s chief executive, Michael Ruettgers, was asked by host Ron Insana whether “2000 and beyond” would be as good as the 1990s had been. “It actually looks like it’s accelerating,” boasted Ruettgers. When Insana asked if EMC’s stock was overvalued, Ruettgers answered: “I think when you look at the opportunity we have in front of us, it’s almost unlimited. . . . So while it’s hard to predict whether these things are overpriced, there’s such a major change taking place that if you could find the winners today—and I certainly think EMC is one of those people—you’ll be well rewarded in the future.” 3 The “Y2K bug” or the “Year 2000 Problem” was the belief that millions of computers worldwide would stop functioning at one second past midnight A SIMPLE TWIST OF FREIGHT Unlike EMC, Expeditors International hadn’t yet learned to levitate. Although the firm’s shares had risen 30% annually in the 1990s, much of that big gain had come at the very end, as the stock raced to a 109.1% return in 1999. The year before, Expeditors’ shares had gone up just 9.5%, trailing the S & P 500 index by more than 19 percentage points. What about the business? Expeditors was growing expeditiously indeed: Since 1995, its revenues had risen at an average annual rate of 19.8%, nearly tripling over the period to finish 1999 at $1.4 billion. And earnings per share had grown by 25.8% annually, while dividends had risen at a 27% annual clip. Expeditors had no long-term debt, and its working capital had nearly doubled since 1995. According to Value Line, Expeditors’ book value per share had increased 129% and its return on capital had risen by more than one-third to 21%. By any standard, Expeditors was a superb business. But the little freight-forwarding company, with its base in Seattle and much of its operations in Asia, was all-but-unknown on Wall Street. Only 32% of the shares were owned by institutional investors; in fact, Expeditors had only 8,500 shareholders. After doubling in 1999, the stock was priced at 39 times the net income Expeditors would earn for the year— no longer anywhere near cheap, but well below the vertiginous valuation of EMC. THE PROMISED LAND? By the end of 1999, Exodus Communications seemed to have taken its shareholders straight to the land of milk and honey. The stock soared 1,005.8% in 1999—enough to turn a $10,000 investment on January 1 into more than $110,000 by December 31. Wall Street’s leading Internet-stock analysts, including the hugely influential Henry Commentary on Chapter 13 343 on the morning of January 1, 2000, because programmers in the 1960s and 1970s had not thought to allow for the possibility of any date past 12/31/1999 in their operating code. U.S. companies spent billions of dollars in 1999 to ensure that their computers would be “Y2K-compliant.” In the end, at 12:00:01 A.M. on January 1, 2000, everything worked just fine. Blodget of Merrill Lynch, were predicting that the stock would rise another 25% to 125% over the coming year. And best of all, in the eyes of the online traders who gorged on Exodus’s gains, was the fact that the stock had split 2-for-1 three times during 1999. In a 2-for-1 stock split, a company doubles the number of its shares and halves their price—so a shareholder ends up owning twice as many shares, each priced at half the former level. What’s so great about that? Imagine that you handed me a dime, and I then gave you back two nickels and asked, “Don’t you feel richer now?” You would probably conclude either that I was an idiot, or that I had mistaken you for one. And yet, in 1999’s frenzy over dot-com stocks, online traders acted exactly as if two nickels were more valuable than one dime. In fact, just the news that a stock would be splitting 2-for-1 could instantly drive its shares up 20% or more. Why? Because getting more shares makes people feel richer. Someone who bought 100 shares of Exodus in January watched them turn into 200 when the stock split in April; then those 200 turned into 400 in August; then the 400 became 800 in December. It was thrilling for these people to realize that they had gotten 700 more shares just for owning 100 in the first place. To them, that felt like “found money”— never mind that the price per share had been cut in half with each split.4 In December, 1999, one elated Exodus shareholder, who went by the handle “givemeadollar,” exulted on an online message board: “I’m going to hold these shares until I’m 80, [because] after it splits hundreds of times over the next years, I’ll be close to becoming CEO.” 5 What about Exodus the business? Graham wouldn’t have touched it with a 10-foot pole and a haz-mat suit. Exodus’s revenues were exploding—growing from $52.7 million in 1998 to $242.1 million in 1999—but it lost $130.3 million on those revenues in 1999, nearly double its loss the year before. Exodus had $2.6 billion in total debt— and was so starved for cash that it borrowed $971 million in the 344 Commentary on Chapter 13 4 For more on the folly of stock splits, see Jason Zweig, “Splitsville,” Money, March, 2001, pp. 55–56. 5 Posting no. 3622, December 7, 1999, at the Exodus Communications message board on the Raging Bull website (http://ragingbull.lycos.com/ mboard/boards.cgi?board=EXDS&read=3622). month of December alone. According to Exodus’s annual report, that new borrowing would add more than $50 million to its interest payments in the coming year. The company started 1999 with $156 million in cash and, even after raising $1.3 billion in new financing, finished the year with a cash balance of $1 billion—meaning that its businesses had devoured more than $400 million in cash during 1999. How could such a company ever pay its debts? But, of course, online traders were fixated on how far and fast the stock had risen, not on whether the company was healthy. “This stock,” bragged a trader using the screen name of “Launch_Pad1999,” “will just continue climbing to infinity and beyond.” 6 The absurdity of Launch_Pad’s prediction—what is “beyond” infinity?—is the perfect reminder of one of Graham’s classic warnings. “Today’s investor,” Graham tells us, is so concerned with anticipating the future that he is already paying handsomely for it in advance. Thus what he has projected with so much study and care may actually happen and still not bring him any profit. If it should fail to materialize to the degree expected he may in fact be faced with a serious temporary and perhaps even permanent loss.” 7 WHERE THE E S ENDED UP How did these four stocks perform after 1999? Emerson Electric went on to gain 40.7% in 2000. Although the shares lost money in both 2001 and 2002, they nevertheless ended 2002 less than 4% below their final price of 1999. EMC also rose in 2000, gaining 21.7%. But then the shares lost 79.4% in 2001 and another 54.3% in 2002. That left them 88% below their level at year-end 1999. What about the forecast of $10 billion in revenues by 2001? EMC finished that year with revenues of just $7.1 billion (and a net loss of $508 million). Commentary on Chapter 13 345 6 Posting no. 3910, December 15, 1999, at the Exodus Communications message board on the Raging Bull website (http://ragingbull.lycos.com/ mboard/boards.cgi?board=EXDS&read=3910). 7 See Graham’s speech, “The New Speculation in Common Stocks,” in the Appendix, p. 563. Meanwhile, as if the bear market did not even exist, Expeditors International’s shares went on to gain 22.9% in 2000, 6.5% in 2001, and another 15.1% in 2002—finishing that year nearly 51% higher than their price at the end of 1999. Exodus’s stock lost 55% in 2000 and 99.8% in 2001. On September 26, 2001, Exodus filed for Chapter 11 bankruptcy protection. Most of the company’s assets were bought by Cable & Wireless, the British telecommunications giant. Instead of delivering its shareholders to the promised land, Exodus left them exiled in the wilderness. As of early 2003, the last trade in Exodus’s stock was at one penny a share. 346 Commentary on Chapter 13 CHAPTER 14 Stock Selection for the Defensive Investor It is time to turn to some broader applications of the techniques of security analysis. Since we have already described in general terms the investment policies recommended for our two categories of investors,* it would be logical for us now to indicate how security analysis comes into play in order to implement these policies. The defensive investor who follows our suggestions will purchase only high-grade bonds plus a diversified list of leading common stocks. He is to make sure that the price at which he bought the latter is not unduly high as judged by applicable standards. In setting up this diversified list he has a choice of two approaches, the DJIA-type of portfolio and the quantitativelytested portfolio. In the first he acquires a true cross-section sample of the leading issues, which will include both some favored growth companies, whose shares sell at especially high multipliers, and also less popular and less expensive enterprises. This could be done, most simply perhaps, by buying the same amounts of all thirty of the issues in the Dow-Jones Industrial Average (DJIA). Ten shares of each, at the 900 level for the average, would cost an aggregate of about $16,000.1 On the basis of the past record he might expect approximately the same future results by buying shares of several representative investment funds.† His second choice would be to apply a set of standards to each 347 * Graham describes his recommended investment policies in Chapters 4 through 7. † As we have discussed in the commentaries on Chapters 5 and 9, today’s defensive investor can achieve this goal simply by buying a low-cost index fund, ideally one that tracks the return of the total U.S. stock market. purchase, to make sure that he obtains (1) a minimum of quality in the past performance and current financial position of the company, and also (2) a minimum of quantity in terms of earnings and assets per dollar of price. At the close of the previous chapter we listed seven such quality and quantity criteria suggested for the selection of specific common stocks. Let us describe them in order. 1. Adequate Size of the Enterprise All our minimum figures must be arbitrary and especially in the matter of size required. Our idea is to exclude small companies which may be subject to more than average vicissitudes especially in the industrial field. (There are often good possibilities in such enterprises but we do not consider them suited to the needs of the defensive investor.) Let us use round amounts: not less than $100 million of annual sales for an industrial company and, not less than $50 million of total assets for a public utility. 2. A Sufficiently Strong Financial Condition For industrial companies current assets should be at least twice current liabilities—a so-called two-to-one current ratio. Also, longterm debt should not exceed the net current assets (or “working capital”). For public utilities the debt should not exceed twice the stock equity (at book value). 3. Earnings Stability Some earnings for the common stock in each of the past ten years. 4. Dividend Record Uninterrupted payments for at least the past 20 years. 5. Earnings Growth A minimum increase of at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end. 348 The Intelligent Investor 6. Moderate Price/Earnings Ratio Current price should not be more than 15 times average earnings of the past three years. 7. Moderate Ratio of Price to Assets Current price should not be more than 11 ⁄2 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5. (This figure corresponds to 15 times earnings and 11 ⁄2 times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.) General Comments: These requirements are set up especially for the needs and the temperament of defensive investors. They will eliminate the great majority of common stocks as candidates for the portfolio, and in two opposite ways. On the one hand they will exclude companies that are (1) too small, (2) in relatively weak financial condition, (3) with a deficit stigma in their ten-year record, and (4) not having a long history of continuous dividends. Of these tests the most severe under recent financial conditions are those of financial strength. A considerable number of our large and formerly strongly entrenched enterprises have weakened their current ratio or overexpanded their debt, or both, in recent years. Our last two criteria are exclusive in the opposite direction, by demanding more earnings and more assets per dollar of price than the popular issues will supply. This is by no means the standard viewpoint of financial analysts; in fact most will insist that even conservative investors should be prepared to pay generous prices for stocks of the choice companies. We have expounded our contrary view above; it rests largely on the absence of an adequate factor of safety when too large a portion of the price must depend on ever-increasing earnings in the future. The reader will have to decide this important question for himself—after weighing the arguments on both sides. We have nonetheless opted for the inclusion of a modest requirement of growth over the past decade. Without it the typical company would show retrogression, at least in terms of profit per Stock Selection for the Defensive Investor 349 dollar of invested capital. There is no reason for the defensive investor to include such companies—though if the price is low enough they could qualify as bargain opportunities. The suggested maximum figure of 15 times earnings might well result in a typical portfolio with an average multiplier of, say, 12 to 13 times. Note that in February 1972 American Tel. & Tel. sold at 11 times its three-year (and current) earnings, and Standard Oil of California at less than 10 times latest earnings. Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings/price ratio—the reverse of the P/E ratio—at least as high as the current high-grade bond rate. This would mean a P/E ratio no higher than 13.3 against an AA bond yield of 7.5%.* Application of Our Criteria to the DJIA at the End of 1970 All of our suggested criteria were satisfied by the DJIA issues at the end of 1970, but two of them just barely. Here is a survey based on the closing price of 1970 and the relevant figures. (The basic data for each company are shown in Tables 14-1 and 14-2.) 1. Size is more than ample for each company. 2. Financial condition is adequate in the aggregate, but not for every company.2 3. Some dividend has been paid by every company since at least 1940. Five of the dividend records go back to the last century. 350 The Intelligent Investor * In early 2003, the yield on 10-year, AA-rated corporate bonds was around 4.6%, suggesting—by Graham’s formula—that a stock portfolio should have an earnings-to-price ratio at least that high. Taking the inverse of that number (by dividing 4.6 into 100), we can derive a “suggested maximum” P/E ratio of 21.7. At the beginning of this paragraph Graham recommends that the “average” stock be priced about 20% below the “maximum” ratio. That suggests that—in general—Graham would consider stocks selling at no more than 17 times their three-year average earnings to be potentially attractive given today’s interest rates and market conditions. As of December 31, 2002, more than 200—or better than 40%—of the stocks in the S & P 500- stock index had three-year average P/E ratios of 17.0 or lower. Updated AA bond yields can be found at www.bondtalk.com. Stock Selection for the Defensive Investor 351 TABLE 14-1 Basic Data on 30 Stocks in the Dow Jones Industrial Average at September 30, 1971 “Earnings Per Share”a Price Ave. Ave. Net Sept. 30, Sept. 30, 1968– 1958– Div. Asset Current 1971 1971 1970 1960 Since Value Div. Allied Chemical 321 ⁄2 1.40 1.82 2.14 1887 26.02 1.20 Aluminum Co. of Am. 451 ⁄2 4.25 5.18 2.08 1939 55.01 1.80 Amer. Brands 431 ⁄2 4.32 3.69 2.24 1905 13.46 2.10 Amer. Can 331 ⁄4 2.68 3.76 2.42 1923 40.01 2.20 Amer. Tel. & Tel. 43 4.03 3.91 2.52 1881 45.47 2.60 Anaconda 15 2.06 3.90 2.17 1936 54.28 none Bethlehem Steel 251 ⁄2 2.64 3.05 2.62 1939 44.62 1.20 Chrysler 281 ⁄2 1.05 2.72 (0.13) 1926 42.40 0.60 DuPont 154 6.31 7.32 8.09 1904 55.22 5.00 Eastman Kodak 87 2.45 2.44 0.72 1902 13.70 1.32 General Electric 611 ⁄4 2.63 1.78 1.37 1899 14.92 1.40 General Foods 34 2.34 2.23 1.13 1922 14.13 1.40 General Motors 83 3.33 4.69 2.94 1915 33.39 3.40 Goodyear 331 ⁄2 2.11 2.01 1.04 1937 18.49 0.85 Inter. Harvester 281 ⁄2 1.16 2.30 1.87 1910 42.06 1.40 Inter. Nickel 31 2.27 2.10 0.94 1934 14.53 1.00 Inter. Paper 33 1.46 2.22 1.76 1946 23.68 1.50 Johns-Manville 39 2.02 2.33 1.62 1935 24.51 1.20 Owens-Illinois 52 3.89 3.69 2.24 1907 43.75 1.35 Procter & Gamble 71 2.91 2.33 1.02 1891 15.41 1.50 Sears Roebuck 681 ⁄2 3.19 2.87 1.17 1935 23.97 1.55 Std. Oil of Calif. 56 5.78 5.35 3.17 1912 54.79 2.80 Std. Oil of N.J. 72 6.51 5.88 2.90 1882 48.95 3.90 Swift & Co. 42 2.56 1.66 1.33 1934 26.74 0.70 Texaco 32 3.24 2.96 1.34 1903 23.06 1.60 Union Carbide 431 ⁄2 2.59 2.76 2.52 1918 29.64 2.00 United Aircraft 301 ⁄2 3.13 4.35 2.79 1936 47.00 1.80 U. S. Steel 291 ⁄2 3.53 3.81 4.85 1940 65.54 1.60 Westinghouse 961 ⁄2 3.26 3.44 2.26 1935 33.67 1.80 Woolworth 49 2.47 2.38 1.35 1912 25.47 1.20 a Adjusted for stock dividends and stock splits. b Typically for the 12 months ended June 30, 1971. Allied Chemical 18.3
18.0
3.7% (–15.0%) 2.1
74% 125% Aluminum Co. of Am. 10.7 8.8 4.0 149.0% 2.7 51 84 Amer. Brands 10.1 11.8 5.1 64.7 2.1 138 282 Amer. Can 12.4 8.9 6.6 52.5 2.1 91 83 Amer. Tel. & Tel. 10.8 11.0 6.0 55.2 1.1 —c 94 Anaconda 5.7 3.9 — 80.0 2.9 80 28 Bethlehem Steel 12.4 8.1 4.7 16.4 1.7 68 58 Chrysler 27.0 10.5 2.1 —d 1.4 78 67 DuPont 24.5 21.0 3.2 (–9.0) 3.6 609 280 Eastman Kodak 35.5 35.6 1.5 238.9 2.4 1764 635 General Electric 23.4 34.4 2.3 29.9 1.3 89 410 General Foods 14.5 15.2 4.1 97.3 1.6 254 240 General Motors 24.4 17.6 4.1 59.5 1.9 1071 247 Goodyear 15.8 16.7 2.5 93.3 2.1 129 80 Inter. Harvester 24.5 12.4 4.9 23.0 2.2 191 66 Inter. Nickel 13.6 16.2 3.2 123.4 2.5 131 213 TABLE 14-2 Significant Ratios of DJIA Stocks at September 30, 1971 Price to Earnings Earnings Growth 1968–1970 vs. 1958–1960 Sept. 1971 1968–1970 Current Div. Yield Price/ Net Asset Value CA/CLa NCA/ Debtb Inter. Paper 22.5 14.0 4.6 26.1 2.2 62 139 Johns-Manville 19.3 16.8 3.0 43.8 2.6 — 158 Owens-Illinois 13.2 14.0 2.6 64.7 1.6 51 118 Procter & Gamble 24.2 31.6 2.1 128.4 2.4 400 460 Sears Roebuck 21.4 23.8 1.7 145.3 1.6 322 285 Std. Oil of Calif. 9.7 10.5 5.0 68.8 1.5 79 102 Std. Oil of N.J. 11.0 12.2 5.4 102.8 1.5 94 115 Swift & Co. 16.4 25.5 1.7 24.8 2.4 138 158 Texaco 9.9 10.8 5.0 120.9 1.7 128 138 Union Carbide 16.6 15.8 4.6 9.5 2.2 86 146 United Aircraft 9.7 7.0 5.9 55.9 1.5 155 65 U. S. Steel 8.3 6.7 5.4 (–21.5) 1.7 51 63 Westinghouse El. 29.5 28.0 1.9 52.2 1.8 145 2.86 Woolworth 19.7 20.5 2.4 76.3 1.8 185 1.90 a Figures taken for fiscal 1970 year-end co. results. b Figures taken from Moody’s Industrial Manual (1971). c Debit balance for NCA. (NCA = net current assets.) d Reported deficit for 1958–1960. 4. The aggregate earnings have been quite stable in the past decade. None of the companies reported a deficit during the prosperous period 1961–69, but Chrysler showed a small deficit in 1970. 5. The total growth—comparing three-year averages a decade apart—was 77%, or about 6% per year. But five of the firms did not grow by one-third. 6. The ratio of year-end price to three-year average earnings was 839 to $55.5 or 15 to 1—right at our suggested upper limit. 7. The ratio of price to net asset value was 839 to 562—also just within our suggested limit of 11 ⁄2 to 1. If, however, we wish to apply the same seven criteria to each individual company, we would find that only five of them would meet all our requirements. These would be: American Can, American Tel. & Tel., Anaconda, Swift, and Woolworth. The totals for these five appear in Table 14-3. Naturally they make a much better statistical showing than the DJIA as a whole, except in the past growth rate.3 Our application of specific criteria to this select group of industrial stocks indicates that the number meeting every one of our tests will be a relatively small percentage of all listed industrial issues. We hazard the guess that about 100 issues of this sort could have been found in the Standard & Poor’s Stock Guide at the end of 1970, just about enough to provide the investor with a satisfactory range of personal choice.* The Public-Utility “Solution” If we turn now to the field of public-utility stocks we find a much more comfortable and inviting situation for the investor.† 354 The Intelligent Investor * An easy-to-use online stock screener that can sort the stocks in the S & P 500 by most of Graham’s criteria is available at: www.quicken.com/ investments/stocks/search/full. † When Graham wrote, only one major mutual fund specializing in utility stocks—Franklin Utilities—was widely available. Today there are more than 30. Graham could not have anticipated the financial havoc wrought by can- TABLE 14-3 DJIA Issues Meeting Certain Investment Criteria at the End of 1970 American American Average, Can Tel. & Tel. Anaconda Swift Woolworth 5 Companies Price Dec. 31, 1970 393 ⁄4 487 ⁄8 21 301 ⁄8 361 ⁄2 Price/earnings, 1970 11.0
12.3
6.7
13.5
14.4
11.6
Price/earnings, 3 years 10.5
12.5
5.4
18.1
b 15.1
12.3
Price/book value 99% 108% 38% 113% 148% 112% Current assets/current liabilities 2.2
n.a. 2.9
2.3
1.8
c 2.3
Net current assets/debt 110% n.a. 120% 141% 190% 140% Stability indexa 85 100 72 77 99 86 Growtha 55% 53% 78% 25% 73% 57% a See definition on p. 338. b In view of Swift’s good showing in the poor year 1970, we waive the 1968–1970 deficiency here. c The small deficiency here below 2 to 1 was offset by margin for additional debt financing. n.a. = not applicable. American Tel. & Tel.’s debt was less than its stock equity. Here the vast majority of issues appear to be cut out, by their performance record and their price ratios, in accordance with the defensive investor’s needs as we judge them. We exclude one criterion from our tests of public-utility stocks—namely, the ratio of current assets to current liabilities. The working-capital factor takes care of itself in this industry as part of the continuous financing of its growth by sales of bonds and shares. We do require an adequate proportion of stock capital to debt.4 In Table 14-4 we present a résumé of the 15 issues in the Dow Jones public-utility average. For comparison, Table 14-5 gives a similar picture of a random selection of fifteen other utilities taken from the New York Stock Exchange list. As 1972 began the defensive investor could have had quite a wide choice of utility common stocks, each of which would have met our requirements for both performance and price. These companies offered him everything he had a right to demand from simply chosen common-stock investments. In comparison with prominent industrial companies as represented by the DJIA, they offered almost as good a record of past growth, plus smaller fluctuations in the annual figures—both at a lower price in relation to earnings and assets. The dividend return was significantly higher. The position of the utilities as regulated monopolies is assuredly more of an advantage than a disadvantage for the conservative investor. Under law they are entitled to charge rates sufficiently remunerative to attract the capital they need for their continuous expansion, and this implies adequate offsets to inflated costs. While the process of regulation has often been cumbersome and perhaps dilatory, it has not prevented the utilities from earning a fair return on their rising invested capital over many decades. 356 The Intelligent Investor celed and decommissioned nuclear energy plants; nor did he foresee the consequences of bungled regulation in California. Utility stocks are vastly more volatile than they were in Graham’s day, and most investors should own them only through a well-diversified, low-cost fund like the Dow Jones U.S. Utilities Sector Index Fund (ticker symbol: IDU) or Utilities Select Sector SPDR (XLU). For more information, see: www.ishares.com and www. spdrindex.com/spdr/. (Be sure your broker will not charge commissions to reinvest your dividends.) TABLE 14-4 Data on the Fifteen Stocks in the Dow Jones Utility Average at September 30, 1971 Earns. Per Share Price Price/ 1970 Sept. 30, Book Price/ Book Div. vs. 1971 Earneda Dividend Value Earnings Value Yield 1960 Am. Elec. Power 26 2.40 1.70 18.86 11
138% 6.5% +87% Cleveland El. Ill. 343 ⁄4 3.10 2.24 22.94 11 150 6.4 86 Columbia Gas System 33 2.95 1.76 25.58 11 129 5.3 85 Commonwealth Edison 351 ⁄2 3.05 2.20 27.28 12 130 6.2 56 Consolidated Edison 241 ⁄2 2.40 1.80 30.63 10 80 7.4 19 Consd. Nat. Gas 273 ⁄4 3.00 1.88 32.11 9 86 6.8 53 Detroit Edison 191 ⁄4 1.80 1.40 22.66 11 84 7.3 40 Houston Ltg. & Power 423 ⁄4 2.88 1.32 19.02 15 222 3.1 135 Niagara-Mohawk Pwr. 151 ⁄2 1.45 1.10 16.46 11 93 7.2 32 Pacific Gas & Electric 29 2.65 1.64 25.45 11 114 5.6 79 Panhandle E. Pipe L. 321 ⁄2 2.90 1.80 19.95 11 166 5.5 79 Peoples Gas Co. 311 ⁄2 2.70 2.08 30.28 8 104 6.6 23 Philadelphia El. 201 ⁄2 2.00 1.64 19.74 10 103 8.0 29 Public Svs. El. & Gas 251 ⁄2 2.80 1.64 21.81 9 116 6.4 80 Sou. Calif. Edison 291 ⁄4 2.80 1.50 27.28 10 107 5.1 85 Average 281 ⁄2 2.66 1.71 23.83 10.7
121% 6.2% +65% a Estimated for year 1971. TABLE 14-5 Data on a Second List of Public-Utility Stocks at September 30, 1971 Earns. Per Share Price Price/ 1970 Sept. 30, Book Price/ Book Div. vs. 1971 Earned Dividend Value Earnings Value Yield 1960 Alabama Gas 151 ⁄2 1.50 1.10 17.80 10
87% 7.1% +34% Allegheny Power 221 ⁄2 2.15 1.32 16.88 10 134 6.0 71 Am. Tel. & Tel. 43 4.05 2.60 45.47 11 95 6.0 47 Am. Water Works 14 1.46 .60 16.80 10 84 4.3 187 Atlantic City Elec. 201 ⁄2 1.85 1.36 14.81 11 138 6.6 74 Baltimore Gas & Elec. 301 ⁄4 2.85 1.82 23.03 11 132 6.0 86 Brooklyn Union Gas 231 ⁄2 2.00 1.12 20.91 12 112 7.3 29 Carolina Pwr. & Lt. 221 ⁄2 1.65 1.46 20.49 14 110 6.5 39 Cen. Hudson G. & E. 221 ⁄4 2.00 1.48 20.29 11 110 6.5 13 Cen. Ill. Lt. 251 ⁄4 2.50 1.56 22.16 10 114 6.5 55 Cen. Maine Pwr. 173 ⁄4 1.48 1.20 16.35 12 113 6.8 62 Cincinnati Gas & Elec. 231 ⁄4 2.20 1.56 16.13 11 145 6.7 102 Consumers Power 291 ⁄2 2.80 2.00 32.59 11 90 6.8 89 Dayton Pwr. & Lt. 23 2.25 1.66 16.79 10 137 7.2 94 Delmarva Pwr. & Lt. 161 ⁄2 1.55 1.12 14.04 11 117 6.7 78 Average 231 ⁄2 2.15 1.50 21.00 11
112% 6.5% +71% For the defensive investor the central appeal of the public-utility stocks at this time should be their availability at a moderate price in relation to book value. This means that he can ignore stockmarket considerations, if he wishes, and consider himself primarily as a part owner of well-established and well-earning businesses. The market quotations are always there for him to take advantage of when times are propitious—either for purchases at unusually attractive low levels, or for sales when their prices seem definitely too high. The market record of the public-utility indexes—condensed in Table 14-6, along with those of other groups—indicates that there have been ample possibilities of profit in these investments in the past. While the rise has not been as great as in the industrial index, the individual utilities have shown more price stability in most periods than have other groups.* It is striking to observe in this table that the relative price/earnings ratios of the industrials and the utilities have changed places during the past two decades. Stock Selection for the Defensive Investor 359 * In a remarkable confirmation of Graham’s point, the dull-sounding Standard & Poor’s Utility Index outperformed the vaunted NASDAQ Composite Index for the 30 years ending December 31, 2002. TABLE 14-6 Development of Prices and Price/Earnings Ratios for Various Standard & Poor’s Averages, 1948–1970. Industrials Railroads Utilities Year Pricea P/E Ratio Pricea P/E Ratio Pricea P/E Ratio 1948 15.34 6.56 15.27 4.55 16.77 10.03 1953 24.84 9.56 22.60 5.42 24.03 14.00 1958 58.65 19.88 34.23 12.45 43.13 18.59 1963 79.25 18.18 40.65 12.78 66.42 20.44 1968 113.02 17.80 54.15 14.21 69.69 15.87 1970 100.00 17.84 34.40 12.83 61.75 13.16 a Prices are at the close of the year. These reversals will have more meaning for the active than for the passive investor. But they suggest that even defensive portfolios should be changed from time to time, especially if the securities purchased have an apparently excessive advance and can be replaced by issues much more reasonably priced. Alas! there will be capital-gains taxes to pay—which for the typical investor seems to be about the same as the Devil to pay. Our old ally, experience, tells us here that it is better to sell and pay the tax than not sell and repent. Investing in Stocks of Financial Enterprises A considerable variety of concerns may be ranged under the rubric of “financial companies.” These would include banks, insurance companies, savings and loan associations, credit and small-loan companies, mortgage companies, and “investment companies” (e.g., mutual funds).* It is characteristic of all these enterprises that they have a relatively small part of their assets in the form of material things—such as fixed assets and merchandise inventories—but on the other hand most categories have shortterm obligations well in excess of their stock capital. The question of financial soundness is, therefore, more relevant here than in the case of the typical manufacturing or commercial enterprise. This, in turn, has given rise to various forms of regulation and supervision, with the design and general result of assuring against unsound financial practices. Broadly speaking, the shares of financial concerns have produced investment results similar to those of other types of common shares. Table 14-7 shows price changes between 1948 and 1970 in six groups represented in the Standard & Poor’s stock-price indexes. The average for 1941–1943 is taken as 10, the base level. 360 The Intelligent Investor * Today the financial-services industry is made up of even more components, including commercial banks; savings & loan and mortgage-financing companies; consumer-finance firms like credit-card issuers; money managers and trust companies; investment banks and brokerages; insurance companies; and firms engaged in developing or owning real estate, including real-estate investment trusts. Although the sector is much more diversified today, Graham’s caveats about financial soundness apply more than ever. The year-end 1970 figures ranged between 44.3 for the 9 New York banks and 218 for the 11 life-insurance stocks. During the subintervals there was considerable variation in the respective price movements. For example, the New York City bank stocks did quite well between 1958 and 1968; conversely the spectacular lifeinsurance group actually lost ground between 1963 and 1968. These cross-movements are found in many, perhaps most, of the numerous industry groups in the Standard & Poor’s indexes. We have no very helpful remarks to offer in this broad area of investment—other than to counsel that the same arithmetical standards for price in relation to earnings and book value be applied to the choice of companies in these groups as we have suggested for industrial and public-utility investments. Railroad Issues The railroad story is a far different one from that of the utilities. The carriers have suffered severely from a combination of severe competition and strict regulation. (Their labor-cost problem has of Stock Selection for the Defensive Investor 361 TABLE 14-7 Relative Price Movements of Stocks of Various Types of Financial Companies Between 1948 and 1970 1948 1953 1958 1963 1968 1970 Life insurance 17.1 59.5 156.6 318.1 282.2 218.0 Property and liability insurance 13.7 23.9 41.0 64.7 99.2 84.3 New York City banks 11.2 15.0 24.3 36.8 49.6 44.3 Banks outside New York City 16.9 33.3 48.7 75.9 96.9 83.3 Finance companies 15.6 27.1 55.4 64.3 92.8 78.3 Small-loan companies 18.4 36.4 68.5 118.2 142.8 126.8 Standard & Poor’s composite 13.2 24.8 55.2 75.0 103.9 92.2 a Year-end figures from Standard & Poor’s stock-price indexes. Average of 1941– 1943 = 10. course been difficult as well, but that has not been confined to railroads.) Automobiles, buses, and airlines have drawn off most of their passenger business and left the rest highly unprofitable; the trucks have taken a good deal of their freight traffic. More than half of the railroad mileage of the country has been in bankruptcy (or “trusteeship”) at various times during the past 50 years. But this half-century has not been all downhill for the carriers. There have been prosperous periods for the industry, especially the war years. Some of the lines have managed to maintain their earning power and their dividends despite the general difficulties. The Standard & Poor’s index advanced sevenfold from the low of 1942 to the high of 1968, not much below the percentage gain in the public-utility index. The bankruptcy of the Penn Central Transportation Co., our most important railroad, in 1970 shocked the financial world. Only a year and two years previously the stock sold at close to the highest price level in its long history, and it had paid continuous dividends for more than 120 years! (On p. 423 below we present a brief analysis of this railroad to illustrate how a competent student could have detected the developing weaknesses in the company’s picture and counseled against ownership of its securities.) The market level of railroad shares as a whole was seriously affected by this financial disaster. It is usually unsound to make blanket recommendations of whole classes of securities, and there are equal objections to broad condemnations. The record of railroad share prices in Table 14-6 shows that the group as a whole has often offered chances for a large profit. (But in our view the great advances were in themselves largely unwarranted.) Let us confine our suggestion to this: There is no compelling reason for the investor to own railroad shares; before he buys any he should make sure that he is getting so much value for his money that it would be unreasonable to look for something else instead.* 362 The Intelligent Investor * Only a few major rail stocks now remain, including Burlington Northern, CSX, Norfolk Southern, and Union Pacific. The advice in this section is at least as relevant to airline stocks today—with their massive current losses and a half-century of almost incessantly poor results—as it was to railroads in Graham’s day. Selectivity for the Defensive Investor Every investor would like his list to be better or more promising than the average. Hence the reader will ask whether, if he gets himself a competent adviser or security analyst, he should not be able to count on being supplied with an investment package of really superior merits. “After all,” he may say, “the rules you have outlined are pretty simple and easygoing. A highly trained analyst ought to be able to use all his skill and techniques to improve substantially on something as obvious as the Dow Jones list. If not, what good are all his statistics, calculations, and pontifical judgments?” Suppose, as a practical test, we had asked a hundred security analysts to choose the “best” five stocks in the Dow Jones Average, to be bought at the end of 1970. Few would have come up with identical choices and many of the lists would have differed completely from each other. This is not so surprising as it may at first appear. The underlying reason is that the current price of each prominent stock pretty well reflects the salient factors in its financial record plus the general opinion as to its future prospects. Hence the view of any analyst that one stock is a better buy than the rest must arise to a great extent from his personal partialities and expectations, or from the placing of his emphasis on one set of factors rather than on another in his work of evaluation. If all analysts were agreed that one particular stock was better than all the rest, that issue would quickly advance to a price which would offset all of its previous advantages.* Stock Selection for the Defensive Investor 363 * Graham is summarizing the “efficient markets hypothesis,” or EMH, an academic theory claiming that the price of each stock incorporates all publicly available information about the company. With millions of investors scouring the market every day, it is unlikely that severe mispricings can persist for long. An old joke has two finance professors walking along the sidewalk; when one spots a $20 bill and bends over to pick it up, the other grabs his arm and says, “Don’t bother. If it was really a $20 bill, someone would have taken it already.” While the market is not perfectly efficient, it is pretty close most of the time—so the intelligent investor will stoop to pick up the stock market’s $20 bills only after researching them thoroughly and minimizing the costs of trading and taxes. Our statement that the current price reflects both known facts and future expectations was intended to emphasize the double basis for market valuations. Corresponding with these two kinds of value elements are two basically different approaches to security analysis. To be sure, every competent analyst looks forward to the future rather than backward to the past, and he realizes that his work will prove good or bad depending on what will happen and not on what has happened. Nevertheless, the future itself can be approached in two different ways, which may be called the way of prediction (or projection) and the way of protection.* Those who emphasize prediction will endeavor to anticipate fairly accurately just what the company will accomplish in future years—in particular whether earnings will show pronounced and persistent growth. These conclusions may be based on a very careful study of such factors as supply and demand in the industry—or volume, price, and costs—or else they may be derived from a rather naïve projection of the line of past growth into the future. If these authorities are convinced that the fairly long-term prospects are unusually favorable, they will almost always recommend the stock for purchase without paying too much regard to the level at which it is selling. Such, for example, was the general attitude with respect to the air-transport stocks—an attitude that persisted for many years despite the distressingly bad results often shown after 1946. In the Introduction we have commented on the disparity between the strong price action and the relatively disappointing earnings record of this industry. 364 The Intelligent Investor * This is one of the central points of Graham’s book. All investors labor under a cruel irony: We invest in the present, but we invest for the future. And, unfortunately, the future is almost entirely uncertain. Inflation and interest rates are undependable; economic recessions come and go at random; geopolitical upheavals like war, commodity shortages, and terrorism arrive without warning; and the fate of individual companies and their industries often turns out to be the opposite of what most investors expect. Therefore, investing on the basis of projection is a fool’s errand; even the forecasts of the so-called experts are less reliable than the flip of a coin. For most people, investing on the basis of protection—from overpaying for a stock and from overconfidence in the quality of their own judgment—is the best solution. Graham expands on this concept in Chapter 20. By contrast, those who emphasize protection are always especially concerned with the price of the issue at the time of study. Their main effort is to assure themselves of a substantial margin of indicated present value above the market price—which margin could absorb unfavorable developments in the future. Generally speaking, therefore, it is not so necessary for them to be enthusiastic over the company’s long-run prospects as it is to be reasonably confident that the enterprise will get along. The first, or predictive, approach could also be called the qualitative approach, since it emphasizes prospects, management, and other nonmeasurable, albeit highly important, factors that go under the heading of quality. The second, or protective, approach may be called the quantitative or statistical approach, since it emphasizes the measurable relationships between selling price and earnings, assets, dividends, and so forth. Incidentally, the quantitative method is really an extension—into the field of common stocks—of the viewpoint that security analysis has found to be sound in the selection of bonds and preferred stocks for investment. In our own attitude and professional work we were always committed to the quantitative approach. From the first we wanted to make sure that we were getting ample value for our money in concrete, demonstrable terms. We were not willing to accept the prospects and promises of the future as compensation for a lack of sufficient value in hand. This has by no means been the standard viewpoint among investment authorities; in fact, the majority would probably subscribe to the view that prospects, quality of management, other intangibles, and “the human factor” far outweigh the indications supplied by any study of the past record, the balance sheet, and all the other cold figures. Thus this matter of choosing the “best” stocks is at bottom a highly controversial one. Our advice to the defensive investor is that he let it alone. Let him emphasize diversification more than individual selection. Incidentally, the universally accepted idea of diversification is, in part at least, the negation of the ambitious pretensions of selectivity. If one could select the best stocks unerringly, one would only lose by diversifying. Yet within the limits of the four most general rules of common-stock selection suggested for the defensive investor (on pp. 114–115) there is room for a rather considerable freedom of preference. At the worst the indulgence of Stock Selection for the Defensive Investor 365 such preferences should do no harm; beyond that, it may add something worthwhile to the results. With the increasing impact of technological developments on long-term corporate results, the investor cannot leave them out of his calculations. Here, as elsewhere, he must seek a mean between neglect and overemphasis. 366 The Intelligent Investor COMMENTARY ON CHAPTER 14 He that resteth upon gains certain, shall hardly grow to great riches; and he that puts all upon adventures, doth oftentimes break and come to poverty: it is good therefore to guard adventures with certainties that may uphold losses. —Sir Francis Bacon