G ETTI NG STARTE

 G ETTI NG STARTE D How should you tackle the nitty-gritty work of stock selection? Graham suggests that the defensive investor can, “most simply,” buy every stock in the DowJones Industrial Average. Today’s defensive investor can do even better—by buying a total stock-market index fund that holds essentially every stock worth having. A low-cost index fund is the best tool ever created for low-maintenance stock investing—and any effort to improve on it takes more work (and incurs more risk and higher costs) than a truly defensive investor can justify. Researching and selecting your own stocks is not necessary; for most people, it is not even advisable. However, some defensive investors do enjoy the diversion and intellectual challenge of picking individual stocks—and, if you have survived a bear market and still enjoy stock picking, then nothing that Graham or I could say will dissuade you. In that case, instead of making a total stock market index fund your complete portfolio, make it the foundation of your portfolio. Once you have that foundation in place, you can experiment around the edges with your own stock choices. Keep 90% of your stock money in an index fund, leaving 10% with which to try picking your own stocks. Only after you build that solid core should you explore. (To learn why such broad diversification is so important, please see the sidebar on the following page.) 367 368 Commentary on Chapter 14 WHY DIVERSIFY? During the bull market of the 1990s, one of the most common criticisms of diversification was that it lowers your potential for high returns. After all, if you could identify the next Microsoft, wouldn’t it make sense for you to put all your eggs into that one basket? Well, sure. As the humorist Will Rogers once said, “Don’t gamble. Take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.” However, as Rogers knew, 20/20 foresight is not a gift granted to most investors. No matter how confident we feel, there’s no way to find out whether a stock will go up until after we buy it. Therefore, the stock you think is “the next Microsoft” may well turn out to be the next MicroStrategy instead. (That former market star went from $3,130 per share in March 2000 to $15.10 at year-end 2002, an apocalyptic loss of 99.5%).1 Keeping your money spread across many stocks and industries is the only reliable insurance against the risk of being wrong. But diversification doesn’t just minimize your odds of being wrong. It also maximizes your chances of being right. Over long periods of time, a handful of stocks turn into “superstocks” that go up 10,000% or more. Money Magazine identified the 30 best-performing stocks over the 30 years ending in 2002—and, even with 20/20 hindsight, the list is startlingly unpredictable. Rather than lots of technology or health-care stocks, it includes Southwest Airlines, Worthington Steel, Dollar General discount stores, and snuff-tobacco maker UST Inc.2 If you think you would have been willing to bet big on any of those stocks back in 1972, you are kidding yourself. Think of it this way: In the huge market haystack, only a few needles ever go on to generate truly gigantic gains. The more of the haystack you own, the higher the odds go that you will end up finding at least one of those needles. By owning the entire haystack (ideally through an index fund that tracks the total U.S. stock market) you can be sure to find every needle, thus capturing the returns of all the superstocks. Especially if you are a TESTING, TESTING Let’s briefly update Graham’s criteria for stock selection. Adequate size. Nowadays, “to exclude small companies,” most defensive investors should steer clear of stocks with a total market value of less than $2 billion. In early 2003, that still left you with 437 of the companies in the Standard & Poor’s 500-stock index to choose from. However, today’s defensive investors—unlike those in Graham’s day— can conveniently own small companies by buying a mutual fund specializing in small stocks. Again, an index fund like Vanguard Small-Cap Index is the first choice, although active funds are available at reasonable cost from such firms as Ariel, T. Rowe Price, Royce, and Third Avenue. Strong financial condition. According to market strategists Steve Galbraith and Jay Lasus of Morgan Stanley, at the beginning of 2003 about 120 of the companies in the S & P 500 index met Graham’s test of a 2-to-1 current ratio. With current assets at least twice their current liabilities, these firms had a sizeable cushion of working capital that—on average—should sustain them through hard times. Wall Street has always abounded in bitter ironies, and the bursting of the growth-stock bubble has created a doozy: In 1999 and 2000, high-tech, bio-tech, and telecommunications stocks were supposed to provide “aggressive growth” and ended up giving most of their investors aggressive shrinkage instead. But, by early 2003, the wheel had come full circle, and many of those aggressive growth stocks had become financially conservative—loaded with working capital, rich in cash, and often debt-free. This table provides a sampler: Commentary on Chapter 14 369 defensive investor, why look for the needles when you can own the whole haystack? 1 Adjusted for stock splits. To many people, MicroStrategy really did look like the next Microsoft in early 2000; its stock had gained 566.7% in 1999, and its chairman, Michael Saylor, declared that “our future today is better than it was 18 months ago.” The U.S. Securities and Exchange Commission later accused MicroStrategy of accounting fraud, and Saylor paid an $8.3 million fine to settle the charges. 2 Jon Birger, “The 30 Best Stocks,” Money, Fall 2002, pp. 88–95. 370 Commentary on Chapter 14 FIGURE 14-1 Everything New Is Old Again Ratio of Ratio of Current Long-Term Assets to Debt to Current Current Current Long-Term Working Company Assets Liabilities Liabilities Debt Capital Applied Micro Circuits 1091.2 61.9 17.6 0 none Linear Technology 1736.4 148.1 11.7 0 none QLogic Corp. 713.1 69.6 10.2 0 none Analog Devices 3711.1 467.3 7.9 1274.5 0.39 Qualcomm Inc. 4368.5 654.9 6.7 156.9 0.04 Maxim Integrated Products 1390.5 212.3 6.5 0 none Applied Materials 7878.7 1298.4 6.1 573.9 0.09 Tellabs Inc. 1533.6 257.3 6.0 0.5 0.0004 Scientific-Atlanta 1259.8 252.4 5.0 8.8 0.01 Altera Corp. 1176.2 240.5 4.9 0 none Xilinx Inc. 1108.8 228.1 4.9 0 none American Power Conversion 1276.3 277.4 4.6 0 none Chiron Corp. 1393.8 306.7 4.5 414.9 0.38 Biogen Inc. 1194.7 265.4 4.5 39 0.04 Novellus Systems 1633.9 381.6 4.3 0 none Amgen Inc. 6403.5 1529.2 4.2 3039.7 0.62 LSI Logic Corp. 1626.1 397.8 4.1 1287.1 1.05 Rowan Cos. 469.9 116.0 4.1 494.8 1.40 Biomet Inc. 1000.0 248.6 4.0 0 none Siebel Systems 2588.4 646.5 4.0 315.6 0.16 All figures in millions of dollars from latest available financial statements as of 12/31/02. Working capital is current assets minus current liabilities. Long-term debt includes preferred stock, excludes deferred tax liabilities. Sources: Morgan Stanley; Baseline; EDGAR database at www.sec.gov. In 1999, most of these companies were among the hottest of the market’s darlings, offering the promise of high potential growth. By early 2003, they offered hard evidence of true value. The lesson here is not that these stocks were “a sure thing,” or that you should rush out and buy everything (or anything) in this table.1 Instead, you should realize that a defensive investor can always prosper by looking patiently and calmly through the wreckage of a bear market. Graham’s criterion of financial strength still works: If you build a diversified basket of stocks whose current assets are at least double their current liabilities, and whose long-term debt does not exceed working capital, you should end up with a group of conservatively financed companies with plenty of staying power. The best values today are often found in the stocks that were once hot and have since gone cold. Throughout history, such stocks have often provided the margin of safety that a defensive investor demands. Earnings stability. According to Morgan Stanley, 86% of all the companies in the S & P 500 index have had positive earnings in every year from 1993 through 2002. So Graham’s insistence on “some earnings for the common stock in each of the past ten years” remains a valid test—tough enough to eliminate chronic losers, but not so restrictive as to limit your choices to an unrealistically small sample. Dividend record. As of early 2003, according to Standard & Poor’s, 354 companies in the S & P 500 (or 71% of the total) paid a dividend. No fewer than 255 companies have paid a dividend for at least 20 years in a row. And, according to S & P, 57 companies in the index have raised their dividends for at least 25 consecutive years. That’s no guarantee that they will do so forever, but it’s a comforting sign. Earnings growth. How many companies in the S & P 500 increased their earnings per share by “at least one third,” as Graham requires, over the 10 years ending in 2002? (We’ll average each company’s earnings from 1991 through 1993, and then determine whether the average earnings from 2000 through 2002 were at least 33% higher.) According to Morgan Stanley, 264 companies in the S & P 500 met that test. But here, it seems, Graham set a very low hurdle; 33% cumulative growth over a decade is less than a 3% average annual increase. Cumulative growth in earnings per share of at least 50%—or a 4% average annual rise—is a bit less conservative. No Commentary on Chapter 14 371 1 By the time you read this, much will already have changed since year-end 2002. 372 Commentary on Chapter 14 FIGURE 14-2 Steady Eddies These companies have paid higher dividends with each passing year with no exception. Company Sector Cash dividends paid each year since . . . Number of annual dividend increases in the past 40 years 3M Co Industrials 1916 40 Abbott Laboratories Health Care 1926 35 ALLTEL Corp Telecomm. Services 1961 37 Altria Group (formerly Philip Morris) Consumer Staples 1928 36 AmSouth Bancorp Financials 1943 34 Anheuser-Busch Cos Consumer Staples 1932 39 Archer-Daniels-Midland Consumer Staples 1927 32 Automatic Data Proc Industrials 1974 29 Avery Dennison Corp Industrials 1964 36 Bank of America Financials 1903 36 Bard (C. R.) Health Care 1960 36 Becton, Dickinson Health Care 1926 38 CenturyTel Inc Telecomm. Services 1974 29 Chubb Corp Financials 1902 28 Clorox Co Consumer Staples 1968 30 Coca-Cola Co Consumer Staples 1893 40 Comerica Inc Financials 1936 39 ConAgra Foods Consumer Staples 1976 32 Consolidated Edison Utilities 1885 31 Donnelley(R. R.) & Sons Industrials 1911 36 Dover Corp Industrials 1947 37 Emerson Electric Industrials 1947 40 Family Dollar Stores Consumer Discretionary 1976 27 First Tenn Natl Financials 1895 31 Gannett Co Consumer Discretionary 1929 35 General Electric Industrials 1899 35 Grainger (W. W.) Industrials 1965 33 Heinz (H. J.) Consumer Staples 1911 38 Commentary on Chapter 14 373 Household Intl. Financials 1926 40 Jefferson-Pilot Financials 1913 36 Johnson & Johnson Health Care 1944 40 Johnson Controls Consumer Discretionary 1887 29 KeyCorp Financials 1963 36 Kimberly-Clark Consumer Staples 1935 34 Leggett & Platt Consumer Discretionary 1939 33 Lilly (Eli) Health Care 1885 38 Lowe’s Cos. Consumer Discretionary 1961 40 May Dept Stores Consumer Discretionary 1911 31 McDonald’s Corp. Consumer Discretionary 1976 27 McGraw-Hill Cos. Consumer Discretionary 1937 35 Merck & Co Health Care 1935 38 Nucor Corp. Materials 1973 30 PepsiCo Inc. Consumer Staples 1952 35 Pfizer, Inc. Health Care 1901 39 PPG Indus. Materials 1899 37 Procter & Gamble Consumer Staples 1891 40 Regions Financial Financials 1968 32 Rohm & Haas Materials 1927 38 Sigma-Aldrich Materials 1970 28 Stanley Works Consumer Discretionary 1877 37 Supervalu Inc. Consumer Staples 1936 36 Target Corp. Consumer Discretionary 1965 34 TECO Energy Utilities 1900 40 U.S. Bancorp Financials 1999 35 VF Corp. Consumer Discretionary 1941 35 Wal-Mart Stores Consumer Discretionary 1973 29 Walgreen Co. Consumer Staples 1933 31 Source: Standard & Poor’s Corp. Data as of 12/31/2002. fewer than 245 companies in the S & P 500 index met that criterion as of early 2003, leaving the defensive investor an ample list to choose from. (If you double the cumulative growth hurdle to 100%, or 7% average annual growth, then 198 companies make the cutoff.) Moderate P/E ratio. Graham recommends limiting yourself to stocks whose current price is no more than 15 times average earnings over the past three years. Incredibly, the prevailing practice on Wall Street today is to value stocks by dividing their current price by something called “next year’s earnings.” That gives what is sometimes called “the forward P/E ratio.” But it’s nonsensical to derive a price/earnings ratio by dividing the known current price by unknown future earnings. Over the long run, money manager David Dreman has shown, 59% of Wall Street’s “consensus” earnings forecasts miss the mark by a mortifyingly wide margin—either underestimating or overestimating the actual reported earnings by at least 15%.2 Investing your money on the basis of what these myopic soothsayers predict for the coming year is as risky as volunteering to hold up the bulls-eye at an archery tournament for the legally blind. Instead, calculate a stock’s price/earnings ratio yourself, using Graham’s formula of current price divided by average earnings over the past three years.3 As of early 2003, how many stocks in the Standard & Poor’s 500 index were valued at no more than 15 times their average earnings of 2000 through 2002? According to Morgan Stanley, a generous total of 185 companies passed Graham’s test. Moderate price-to-book ratio. Graham recommends a “ratio of price to assets” (or price-to-book-value ratio) of no more than 1.5. In recent years, an increasing proportion of the value of companies has come from intangible assets like franchises, brand names, and patents and trademarks. Since these factors (along with goodwill from acquisitions) are excluded from the standard definition of book value, most companies today are priced at higher price-to-book multiples than in Graham’s day. According to Morgan Stanley, 123 of the companies in the S & P 500 (or one in four) are priced below 1.5 times book value. 374 Commentary on Chapter 14 2 David Dreman, “Bubbles and the Role of Analysts’ Forecasts,” The Journal of Psychology and Financial Markets, vol. 3, no. 1 (2002), pp. 4–14. 3 You can calculate this ratio by hand from a company’s annual reports or obtain the data at websites like www.morningstar.com or http://finance. yahoo.com. All told, 273 companies (or 55% of the index) have price-to-book ratios of less than 2.5. What about Graham’s suggestion that you multiply the P/E ratio by the price-to-book ratio and see whether the resulting number is below 22.5? Based on data from Morgan Stanley, at least 142 stocks in the S & P 500 could pass that test as of early 2003, including Dana Corp., Electronic Data Systems, Sun Microsystems, and Washington Mutual. So Graham’s “blended multiplier” still works as an initial screen to identify reasonably-priced stocks. DUE DILIGENCE No matter how defensive an investor you are—in Graham’s sense of wishing to minimize the work you put into picking stocks—there are a couple of steps you cannot afford to skip: Do your homework. Through the EDGAR database at www.sec. gov, you get instant access to a company’s annual and quarterly reports, along with the proxy statement that discloses the managers’ compensation, ownership, and potential conflicts of interest. Read at least five years’ worth.4 Check out the neighborhood. Websites like http://quicktake. morningstar.com, http://finance.yahoo.com and www.quicken.com can readily tell you what percentage of a company’s shares are owned by institutions. Anything over 60% suggests that a stock is scarcely undiscovered and probably “overowned.” (When big institutions sell, they tend to move in lockstep, with disastrous results for the stock. Imagine all the Radio City Rockettes toppling off the front edge of the stage at once and you get the idea.) Those websites will also tell you who the largest owners of the stock are. If they are moneymanagement firms that invest in a style similar to your own, that’s a good sign. Commentary on Chapter 14 375 4 For more on what to look for, see the commentary on Chapters 11, 12, and 19. If you are not willing to go to the minimal effort of reading the proxy and making basic comparisons of financial health across five years’ worth of annual reports, then you are too defensive to be buying individual stocks at all. Get yourself out of the stock-picking business and into an index fund, where you belong. CHAPTER 15 Stock Selection for the Enterprising Investor In the previous chapter we have dealt with common-stock selection in terms of broad groups of eligible securities, from which the defensive investor is free to make up any list that he or his adviser prefers, provided adequate diversification is achieved. Our emphasis in selection has been chiefly on exclusions—advising on the one hand against all issues of recognizably poor quality, and on the other against the highest-quality issues if their price is so high as to involve a considerable speculative risk. In this chapter, addressed to the enterprising investor, we must consider the possibilities and the means of making individual selections which are likely to prove more profitable than an across-the-board average. What are the prospects of doing this successfully? We would be less than frank, as the euphemism goes, if we did not at the outset express some grave reservations on this score. At first blush the case for successful selection appears self-evident. To get average results—e.g., equivalent to the performance of the DJIA—should require no special ability of any kind. All that is needed is a portfolio identical with, or similar to, those thirty prominent issues. Surely, then, by the exercise of even a moderate degree of skill— derived from study, experience, and native ability—it should be possible to obtain substantially better results than the DJIA. Yet there is considerable and impressive evidence to the effect that this is very hard to do, even though the qualifications of those trying it are of the highest. The evidence lies in the record of the numerous investment companies, or “funds,” which have been in operation for many years. Most of these funds are large enough to command the services of the best financial or security analysts in the field, together with all the other constituents of an adequate research department. Their expenses of operation, when spread 376 over their ample capital, average about one-half of 1% a year thereon, or less. These costs are not negligible in themselves; but when they are compared with the approximately 15% annual overall return on common stocks generally in the decade 1951–1960, and even the 6% return in 1961–1970, they do not bulk large. A small amount of superior selective ability should easily have overcome that expense handicap and brought in a superior net result for the fund shareholders. Taken as a whole, however, the all-common-stock funds failed over a long span of years to earn quite as good a return as was shown on Standard & Poor’s 500-stock averages or the market as a whole. This conclusion has been substantiated by several comprehensive studies. To quote the latest one before us, covering the period 1960–1968:* It appears from these results that random portfolios of New York Stock Exchange stocks with equal investment in each stock performed on the average better over the period than did mutual funds in the same risk class. The differences were fairly substantial for the low- and medium-risk portfolios (3.7% and 2.5% respectively per annum), but quite small for the high-risk portfolios (0.2% per annum).1 As we pointed out in Chapter 9, these comparative figures in no way invalidate the usefulness of the investment funds as a financial institution. For they do make available to all members of the Stock Selection for the Enterprising Investor 377 * The Friend-Blume-Crockett research covered January 1960, through June 1968, and compared the performance of more than 100 major mutual funds against the returns on portfolios constructed randomly from more than 500 of the largest stocks listed on the NYSE. The funds in the Friend-BlumeCrockett study did better from 1965 to 1968 than they had in the first half of the measurement period, much as Graham found in his own research (see above, pp. 158 and 229–232). But that improvement did not last. And the thrust of these studies—that mutual funds, on average, underperform the market by a margin roughly equal to their operating expenses and trading costs—has been reconfirmed so many times that anyone who doubts them should found a financial chapter of The Flat Earth Society. investing public the possibility of obtaining approximately average results on their common-stock commitments. For a variety of reasons, most members of the public who put their money in common stocks of their own choice fail to do nearly as well. But to the objective observer the failure of the funds to better the performance of a broad average is a pretty conclusive indication that such an achievement, instead of being easy, is in fact extremely difficult. Why should this be so? We can think of two different explanations, each of which may be partially applicable. The first is the possibility that the stock market does in fact reflect in the current prices not only all the important facts about the companies’ past and current performance, but also whatever expectations can be reasonably formed as to their future. If this is so, then the diverse market movements which subsequently take place—and these are often extreme—must be the result of new developments and probabilities that could not be reliably foreseen. This would make the price movements essentially fortuitous and random. To the extent that the foregoing is true, the work of the security analyst—however intelligent and thorough—must be largely ineffective, because in essence he is trying to predict the unpredictable. The very multiplication of the number of security analysts may have played an important part in bringing about this result. With hundreds, even thousands, of experts studying the value factors behind an important common stock, it would be natural to expect that its current price would reflect pretty well the consensus of informed opinion on its value. Those who would prefer it to other issues would do so for reasons of personal partiality or optimism that could just as well be wrong as right. We have often thought of the analogy between the work of the host of security analysts on Wall Street and the performance of master bridge players at a duplicate-bridge tournament. The former try to pick the stocks “most likely to succeed”; the latter to get top score for each hand played. Only a limited few can accomplish either aim. To the extent that all the bridge players have about the same level of expertness, the winners are likely to be determined by “breaks” of various sorts rather than superior skill. On Wall Street the leveling process is helped along by the freemasonry that exists in the profession, under which ideas and discoveries are quite freely shared at the numerous get-togethers of various sorts. 378 The Intelligent Investor It is almost as if, at the analogous bridge tournament, the various experts were looking over each other’s shoulders and arguing out each hand as it was played. The second possibility is of a quite different sort. Perhaps many of the security analysts are handicapped by a flaw in their basic approach to the problem of stock selection. They seek the industries with the best prospects of growth, and the companies in these industries with the best management and other advantages. The implication is that they will buy into such industries and such companies at any price, however high, and they will avoid less promising industries and companies no matter how low the price of their shares. This would be the only correct procedure if the earnings of the good companies were sure to grow at a rapid rate indefinitely in the future, for then in theory their value would be infinite. And if the less promising companies were headed for extinction, with no salvage, the analysts would be right to consider them unattractive at any price. The truth about our corporate ventures is quite otherwise. Extremely few companies have been able to show a high rate of uninterrupted growth for long periods of time. Remarkably few, also, of the larger companies suffer ultimate extinction. For most, their history is one of vicissitudes, of ups and downs, of change in their relative standing. In some the variations “from rags to riches and back” have been repeated on almost a cyclical basis—the phrase used to be a standard one applied to the steel industry—for others spectacular changes have been identified with deterioration or improvement of management.* How does the foregoing inquiry apply to the enterprising investor who would like to make individual selections that will yield superior results? It suggests first of all that he is taking on a Stock Selection for the Enterprising Investor 379 * As we discuss in the commentary on Chapter 9, there are several other reasons mutual funds have not been able to outperform the market averages, including the low returns on the funds’ cash balances and the high costs of researching and trading stocks. Also, a fund holding 120 companies (a typical number) can trail the S & P 500-stock index if any of the other 380 companies in that benchmark turns out to be a great performer. The fewer stocks a fund owns, the more likely it is to miss “the next Microsoft.” difficult and perhaps impracticable assignment. Readers of this book, however intelligent and knowing, could scarcely expect to do a better job of portfolio selection than the top analysts of the country. But if it is true that a fairly large segment of the stock market is often discriminated against or entirely neglected in the standard analytical selections, then the intelligent investor may be in a position to profit from the resultant undervaluations. But to do so he must follow specific methods that are not generally accepted on Wall Street, since those that are so accepted do not seem to produce the results everyone would like to achieve. It would be rather strange if—with all the brains at work professionally in the stock market—there could be approaches which are both sound and relatively unpopular. Yet our own career and reputation have been based on this unlikely fact.* A Summary of the Graham-Newman Methods To give concreteness to the last statement, it should be worthwhile to give a brief account of the types of operations we engaged in during the thirty-year life of Graham-Newman Corporation, between 1926 and 1956.† These were classified in our records as follows: Arbitrages: The purchase of a security and the simultaneous sale 380 The Intelligent Investor * In this section, as he did also on pp. 363–364, Graham is summarizing the Efficient Market Hypothesis. Recent appearances to the contrary, the problem with the stock market today is not that so many financial analysts are idiots, but rather that so many of them are so smart. As more and more smart people search the market for bargains, that very act of searching makes those bargains rarer—and, in a cruel paradox, makes the analysts look as if they lack the intelligence to justify the search. The market’s valuation of a given stock is the result of a vast, continuous, real-time operation of collective intelligence. Most of the time, for most stocks, that collective intelligence gets the valuation approximately right. Only rarely does Graham’s “Mr. Market” (see Chapter 8) send prices wildly out of whack. † Graham launched Graham-Newman Corp. in January 1936, and dissolved it when he retired from active money management in 1956; it was the successor to a partnership called the Benjamin Graham Joint Account, which he ran from January 1926, through December 1935. of one or more other securities into which it was to be exchanged under a plan of reorganization, merger, or the like. Liquidations: Purchase of shares which were to receive one or more cash payments in liquidation of the company’s assets. Operations of these two classes were selected on the twin basis of (a) a calculated annual return of 20% or more, and (b) our judgment that the chance of a successful outcome was at least four out of five. Related Hedges: The purchase of convertible bonds or convertible preferred shares, and the simultaneous sale of the common stock into which they were exchangeable. The position was established at close to a parity basis—i.e., at a small maximum loss if the senior issue had actually to be converted and the operation closed out in that way. But a profit would be made if the common stock fell considerably more than the senior issue, and the position closed out in the market. Net-Current-Asset (or “Bargain”) Issues: The idea here was to acquire as many issues as possible at a cost for each of less than their book value in terms of net-current-assets alone—i.e., giving no value to the plant account and other assets. Our purchases were made typically at two-thirds or less of such stripped-down asset value. In most years we carried a wide diversification here—at least 100 different issues. We should add that from time to time we had some large-scale acquisitions of the control type, but these are not relevant to the present discussion. We kept close track of the results shown by each class of operation. In consequence of these follow-ups we discontinued two broader fields, which were found not to have shown satisfactory overall results. The first was the purchase of apparently attractive issues—based on our general analysis—which were not obtainable at less than their working-capital value alone. The second were “unrelated” hedging operations, in which the purchased security was not exchangeable for the common shares sold. (Such operations correspond roughly to those recently embarked on by the new group of “hedge funds” in the investment-company field.* In Stock Selection for the Enterprising Investor 381 * An “unrelated” hedge involves buying a stock or bond issued by one company and short-selling (or betting on a decline in) a security issued by a dif- both cases a study of the results realized by us over a period of ten years or more led us to conclude that the profits were not sufficiently dependable—and the operations not sufficiently “headache proof”—to justify our continuing them. Hence from 1939 on our operations were limited to “selfliquidating” situations, related hedges, working-capital bargains, and a few control operations. Each of these classes gave us quite consistently satisfactory results from then on, with the special feature that the related hedges turned in good profits in the bear markets when our “undervalued issues” were not doing so well. We hesitate to prescribe our own diet for any large number of intelligent investors. Obviously, the professional techniques we have followed are not suitable for the defensive investor, who by definition is an amateur. As for the aggressive investor, perhaps only a small minority of them would have the type of temperament needed to limit themselves so severely to only a relatively small part of the world of securities. Most active-minded practitioners would prefer to venture into wider channels. Their natural hunting grounds would be the entire field of securities that they felt (a) were certainly not overvalued by conservative measures, and (b) appeared decidedly more attractive—because of their prospects or past record, or both—than the average common stock. In such choices they would do well to apply various tests of quality and price-reasonableness along the lines we have proposed for the defensive investor. But they should be less inflexible, permitting a considerable plus in one factor to offset a small black mark in another. For example, he might not rule out a company which had shown a deficit in a year such as 1970, if large average earnings and other important attributes made the stock look cheap. The enterprising investor may confine his choice to industries and companies about which he holds an optimistic view, but we counsel strongly against paying a high price for a stock (in relation to earn382 The Intelligent Investor ferent company. A “related” hedge involves buying and selling different stocks or bonds issued by the same company. The “new group” of hedge funds described by Graham were widely available around 1968, but later regulation by the U.S. Securities and Exchange Commission restricted access to hedge funds for the general public. ings and assets) because of such enthusiasm. If he followed our philosophy in this field he would more likely be the buyer of important cyclical enterprises—such as steel shares perhaps— when the current situation is unfavorable, the near-term prospects are poor, and the low price fully reflects the current pessimism.* Secondary Companies Next in order for examination and possible selection would come secondary companies that are making a good showing, have a satisfactory past record, but appear to hold no charm for the public. These would be enterprises on the order of eltra and Emhart at their 1970 closing prices. (See Chapter 13 above.) There are various ways of going about locating such companies. We should like to try a novel approach here and give a reasonably detailed exposition of one such exercise in stock selection. Ours is a double purpose. Many of our readers may find a substantial practical value in the method we shall follow, or it may suggest comparable methods to try out. Beyond that what we shall do may help them to come to grips with the real world of common stocks, and introduce them to one of the most fascinating and valuable little volumes in existence. It is Standard & Poor’s Stock Guide, published monthly, and made available to the general public under annual subscription. In addition many brokerage firms distribute the Guide to their clients (on request.) The great bulk of the Guide is given over to about 230 pages of condensed statistical information on the stocks of more than 4,500 companies. These include all the issues listed on the various exchanges, say 3,000, plus some 1,500 unlisted issues. Most of the items needed for a first and even a second look at a given company appear in this compendium. (From our viewpoint the important missing datum is the net-asset-value, or book value, per share, which can be found in the larger Standard & Poor’s volumes and elsewhere.) Stock Selection for the Enterprising Investor 383 * In 2003, an intelligent investor following Graham’s train of thought would be searching for opportunities in the technology, telecommunications, and electric-utility industries. History has shown that yesterday’s losers are often tomorrow’s winners. The investor who likes to play around with corporate figures will find himself in clover with the Stock Guide. He can open to any page and see before his eyes a condensed panorama of the splendors and miseries of the stock market, with all-time high and low prices going as far back as 1936, when available. He will find companies that have multiplied their price 2,000 times from the minuscule low to the majestic high. (For prestigious IBM the growth was “only” 333 times in that period.) He will find (not so exceptionally) a company whose shares advanced from 3 ⁄8 to 68, and then fell back to 3.2 In the dividend record column he will find one that goes back to 1791—paid by Industrial National Bank of Rhode Island (which recently saw fit to change its ancient corporate name).* If he looks at the Guide for the year-end 1969 he will read that Penn Central Co. (as successor to Pennsylvania Railroad) has been paying dividends steadily since 1848; alas!, it was doomed to bankruptcy a few months later. He will find a company selling at only 2 times its last reported earnings, and another selling at 99 times such earnings.3 In most cases he will find it difficult to tell the line of business from the corporate name; for one U.S. Steel there will be three called such things as ITI Corp. (bakery stuff) or Santa Fe Industries (mainly the large railroad). He can feast on an extraordinary variety of price histories, dividend and earnings histories, financial positions, capitalization setups, and what not. Backward-leaning conservatism, run-of-the-mine featureless companies, the most peculiar combinations of “principal business,” all kinds of Wall Street gadgets and widgets—they are all there, waiting to be browsed over, or studied with a serious objective. The Guides give in separate columns the current dividend yields and price/earnings ratios, based on latest 12-month figures, wherever applicable. It is this last item that puts us on the track of our exercise in common-stock selection.