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FOREWORD BY WARREN E. BUFFETT PRAISE FOR THE SIXTH EDITION OF SECURITY ANALYSIS “The sixth edition of the iconic Security Analysis disproves the adage ‘ ’tis best to leave well enough alone.’ An extraordinary team of commentators, led by Seth Klarman and James Grant, bridge the gap between the sim- pler financial world of the 1930s and the more complex investment arena of the new millennium. Readers benefit from the experience and wisdom of some of the financial world’s finest practitioners and best informed market observers. The new edition of Security Analysis belongs in the library of every serious student of finance.” David F. Swensen Chief Investment Officer Yale University author of Pioneering Portfolio Management and Unconventional Success “The best of the past made current by the best of the present. Tiger Woods updates Ben Hogan. It has to be good for your game.” Jack Meyer Managing Partner and CEO Convexity Capital “Security Analysis, a 1940 classic updated by some of the greatest financial minds of our generation, is more essential than ever as a learning tool and reference book for disciplined investors today.” Jamie Dimon Chairman and CEO JPMorgan Chase “While Coca-Cola found it couldn’t improve on a time-tested classic, Seth Klarman, Jim Grant, Bruce Greenwald, et al., prove that a great book can be made even better. Seth Klarman’s preface should be required reading for all investors, and collectively, the contributing editors’ updates make for a classic in their own right. The enduring lesson is that an understand- ing of human behavior is a critical part of the process of security analysis.” Brian C. Rogers Chairman T. Rowe Price Group “A classic has now been updated by some of the greatest and most thoughtful investors of our time. The book was a must read and has now been elevated to a new level.” Daniel S. Och Senior Managing Member Och-Ziff Capital Management Group “Readers will find the updated version of Graham and Dodd’s Security

ic in their own right. The enduring lesson is that an understand- ing of human behavior is a critical part of the process of security analysis.” Brian C. Rogers Chairman T. Rowe Price Group “A classic has now been updated by some of the greatest and most thoughtful investors of our time. The book was a must read and has now been elevated to a new level.” Daniel S. Och Senior Managing Member Och-Ziff Capital Management Group “Readers will find the updated version of Graham and Dodd’s Security Analysis to be much improved from earlier editions. While the timeless advice from two of the greatest value investors continues to resonate, the essays that are contributed by some of the world’s top value investors add immeasurably to the read. These investors practice what they preach in their essays and combine to make this edition the best ever! I highly rec- ommend this volume to all investors—old and young—who will benefit from the tried and true principles of the past and the updated applica- tions to today’s turbulent markets!” Morris Smith Private Investor Former Manager Fidelity Magellan Fund “No book empowers you with better tools for intelligent investing than Security Analysis. Seth Klarman and his fabulous team have produced a nonpareil edition of Ben Graham’s classic for the new millennium.” Mason Hawkins Chairman, Longleaf Partners Southeastern Asset Management “The ideas of Graham and Dodd have withstood all kinds of market con- ditions and 75 years of scrutiny—making them ever more relevant for modern-day investing. The essays by Klarman and other storied value investors lucidly illustrate that while the capital markets landscape may be vastly changed from years past, basic investor traits are not, and disci- plined application of the principles of Security Analysis continues to pro- vide an important edge in investing.” André F. Perold George Gund Professor of Finance and Banking Harvard Business School This page intentionally left bl

aking them ever more relevant for modern-day investing. The essays by Klarman and other storied value investors lucidly illustrate that while the capital markets landscape may be vastly changed from years past, basic investor traits are not, and disci- plined application of the principles of Security Analysis continues to pro- vide an important edge in investing.” André F. Perold George Gund Professor of Finance and Banking Harvard Business School This page intentionally left blank SECURITY ANALYSIS SECURITY ANALYSIS PRIOR EDITIONS Graham and Dodd: Security Analysis, First Edition (1934) Graham and Dodd: Security Analysis, Second Edition (1940) Graham and Dodd: Security Analysis, Third Edition (1951) Graham, Dodd, Cottle, and Tatham: Security Analysis, Fourth Edition (1962) Graham, Dodd, Cottle, Murray, Block, & Leibowitz: Security Analysis, Fifth Edition (1988) SECURITY ANALYSIS Principles and Technique BENJAMIN GRAHAM Investment Fund Manager; Lecturer in Finance Columbia University AND DAVID L. DODD Associate Professor of Finance Columbia University Sixth Edition New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. All rights reserved. Manufactured in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. 0-07-164293-5 The material in this eBook also appears in the print version of this title: 0-07-159253-9. All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with

may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. 0-07-164293-5 The material in this eBook also appears in the print version of this title: 0-07-159253-9. All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark. Where such designations appear in this book, they have been printed with initial caps. McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs. For more information, please contact George Hoare, Special Sales, at george_hoare@mcgraw-hill.com or (212) 904-4069. TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc. (“McGraw-Hill”) and its licen- sors reserve all rights in and to the work. Use of this work is subject to these terms. Except as per- mitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw-Hill’s prior consent. You may use the work for your own noncommercial and per- sonal use; any other use of the work is strictly prohibited. Your right to use the work may be termi- nated if you fail to comply with these terms. THE WORK IS PROVIDED “AS IS.” McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETE- NESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING

- sonal use; any other use of the work is strictly prohibited. Your right to use the work may be termi- nated if you fail to comply with these terms. THE WORK IS PROVIDED “AS IS.” McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETE- NESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any dam- ages resulting therefrom. McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise. DOI: 10.1036/0071592539 Professional Want to learn more? We hope you enjoy this McGraw-Hill eBook! If you’d like more information about this book, its author, or related books and websites, please click here. BENJAMIN GRAHAM AND DAVID DODD forever changed the theory and practice of investing with the 1934 publica- tion of Security Analysis. The nation, and indeed the rest of the world, was in the grips of the Great Depression, a period that brought unprecedented upheaval to the financial

.1036/0071592539 Professional Want to learn more? We hope you enjoy this McGraw-Hill eBook! If you’d like more information about this book, its author, or related books and websites, please click here. BENJAMIN GRAHAM AND DAVID DODD forever changed the theory and practice of investing with the 1934 publica- tion of Security Analysis. The nation, and indeed the rest of the world, was in the grips of the Great Depression, a period that brought unprecedented upheaval to the financial world. In 1940, the authors responded with a comprehensive revision. The second edition of Security Analysis is considered by many investors to be the defini- tive word from the most influential investment philoso- phers of our time. Around the world, Security Analysis is still regarded as the fundamental text for the analysis of stocks and bonds. It is also considered to be the bible of value investing. To commemorate the 75th Anniversary of Security Analysis, McGraw-Hill is proud to publish this sixth edition. Using the text of the 1940 edition, this new edition features lively and practical essays written by a stellar team that includes today’s leading value investors, a prominent academic, and leading financial writers. The result is a contemporary bible of value investing. The sixth edition, with a new design that pays homage to the original 1940 design, includes a CD of the entire original 1940 second edition. This book was printed and bound by R.R. Donnelley in Crawfordsville, Indiana. “Many shall be restored that now are fallen, and many shall fall that now are in honor.” HORACE—ARS POETICA. For more information about this title, click here CONTENTS Foreword • by Warren E. Buffett xi Preface to the Sixth Edition | The Timeless Wisdom of Graham and Dodd • by Seth A. Klarman xiii PREFACE TO THE SECOND EDITION xli PREFACE TO THE FIRST EDITION xliii Introduction to the Sixth Edition | Benjamin Graham and Security Analysis: The Historical Backdrop

ndiana. “Many shall be restored that now are fallen, and many shall fall that now are in honor.” HORACE—ARS POETICA. For more information about this title, click here CONTENTS Foreword • by Warren E. Buffett xi Preface to the Sixth Edition | The Timeless Wisdom of Graham and Dodd • by Seth A. Klarman xiii PREFACE TO THE SECOND EDITION xli PREFACE TO THE FIRST EDITION xliii Introduction to the Sixth Edition | Benjamin Graham and Security Analysis: The Historical Backdrop • by James Grant 1 INTRODUCTION TO THE SECOND EDITION 21 PART I SURVEY AND APPROACH Introduction to Part I | The Essential Lessons by Roger Lowenstein 39 Graham and Dodd chapters: 1. THE SCOPE AND LIMITS OF SECURITY ANALYSIS. THE CONCEPT OF INTRINSIC VALUE 61 2. FUNDAMENTAL ELEMENTS IN THE PROBLEM OF ANALYSIS. QUANTITATIVE AND QUALITATIVE FACTORS 75 3. SOURCES OF INFORMATION 89 4. DISTINCTIONS BETWEEN INVESTMENT AND SPECULATION 100 5. CLASSIFICATION OF SECURITIES 112 [vii] [viii] Contents PART II FIXED-VALUE INVESTMENTS Introduction to Part II | Unshackling Bonds • by Howard S. Marks 123 Graham and Dodd chapters: 6. THE SELECTION OF FIXED-VALUE INVESTMENTS 141 7. THE SELECTION OF FIXED-VALUE INVESTMENTS: SECOND AND THIRD PRINCIPLES 151 8. SPECIFIC STANDARDS FOR BOND INVESTMENT 169 9. SPECIFIC STANDARDS FOR BOND INVESTMENT (CONTINUED) see accompanying CD 10. SPECIFIC STANDARDS FOR BOND INVESTMENT (CONTINUED) 180 11. SPECIFIC STANDARDS FOR BOND INVESTMENT (CONTINUED) see accompanying CD 12. SPECIAL FACTORS IN THE ANALYSIS OF RAILROAD AND PUBLIC-UTILITY BONDS see accompanying CD 13. OTHER SPECIAL FACTORS IN BOND ANALYSIS see accompanying CD 14. THE THEORY OF PREFERRED STOCKS see accompanying CD 15. TECHNIQUE OF SELECTING PREFERRED STOCKS FOR INVESTMENT 190 16. INCOME BONDS AND GUARANTEED SECURITIES 202 17. GUARANTEED SECURITIES (CONTINUED) 215 18. PROTECTIVE COVENANTS AND REMEDIES OF SENIOR SECURITY HOLDERS 229 19. PROTECTIVE COVENANTS (CONTINUED) 242 2

ED) see accompanying CD 12. SPECIAL FACTORS IN THE ANALYSIS OF RAILROAD AND PUBLIC-UTILITY BONDS see accompanying CD 13. OTHER SPECIAL FACTORS IN BOND ANALYSIS see accompanying CD 14. THE THEORY OF PREFERRED STOCKS see accompanying CD 15. TECHNIQUE OF SELECTING PREFERRED STOCKS FOR INVESTMENT 190 16. INCOME BONDS AND GUARANTEED SECURITIES 202 17. GUARANTEED SECURITIES (CONTINUED) 215 18. PROTECTIVE COVENANTS AND REMEDIES OF SENIOR SECURITY HOLDERS 229 19. PROTECTIVE COVENANTS (CONTINUED) 242 20. PREFERRED-STOCK PROTECTIVE PROVISIONS. MAINTENANCE OF JUNIOR CAPITAL see accompanying CD 21. SUPERVISION OF INVESTMENT HOLDINGS 252 PART III SENIOR SECURITIES WITH SPECULATIVE FEATURES Introduction to Part III | “Blood and Judgement” • by J. Ezra Merkin 265 Graham and Dodd chapters: 22. PRIVILEGED ISSUES 289 23. TECHNICAL CHARACTERISTICS OF PRIVILEGED SENIOR SECURITIES 299 24. TECHNICAL ASPECTS OF CONVERTIBLE ISSUES 313 25. SENIOR SECURITIES WITH WARRANTS. PARTICIPATING ISSUES. SWITCHING AND HEDGING see accompanying CD 26. SENIOR SECURITIES OF QUESTIONABLE SAFETY 323 Contents [ix] PART IV THEORY OF COMMON-STOCK INVESTMENT. THE DIVIDEND FACTOR Introduction to Part IV | Go with the Flow • by Bruce Berkowitz 339 Graham and Dodd chapters: 27. THE THEORY OF COMMON-STOCK INVESTMENT 348 28. NEWER CANONS OF COMMON-STOCK INVESTMENT 366 29. THE DIVIDEND FACTOR IN COMMON-STOCK ANALYSIS 376 30. STOCK DIVIDENDS see accompanying CD PART V ANALYSIS OF THE INCOME ACCOUNT. THE EARNINGS FACTOR IN COMMON-STOCK VALUATION Introduction to Part V | The Quest for Rational Investing by Glenn H. Greenberg 395 Graham and Dodd chapters: 31. ANALYSIS OF THE INCOME ACCOUNT 409 32. EXTRAORDINARY LOSSES AND OTHER SPECIAL ITEMS IN THE INCOME ACCOUNT 424 33. MISLEADING ARTIFICES IN THE INCOME ACCOUNT. EARNINGS OF SUBSIDIARIES 435 34. THE RELATION OF DEPRECIATION AND SIMILAR CHARGES TO EARNING POWER 453 35. PUBLIC-UTILITY DEPRECIATION POLICIES see accompanying CD 36. AMORTIZATION CHARGES

S FACTOR IN COMMON-STOCK VALUATION Introduction to Part V | The Quest for Rational Investing by Glenn H. Greenberg 395 Graham and Dodd chapters: 31. ANALYSIS OF THE INCOME ACCOUNT 409 32. EXTRAORDINARY LOSSES AND OTHER SPECIAL ITEMS IN THE INCOME ACCOUNT 424 33. MISLEADING ARTIFICES IN THE INCOME ACCOUNT. EARNINGS OF SUBSIDIARIES 435 34. THE RELATION OF DEPRECIATION AND SIMILAR CHARGES TO EARNING POWER 453 35. PUBLIC-UTILITY DEPRECIATION POLICIES see accompanying CD 36. AMORTIZATION CHARGES FROM THE INVESTOR’S STANDPOINT see accompanying CD 37. SIGNIFICANCE OF THE EARNINGS RECORD 472 38. SPECIFIC REASONS FOR QUESTIONING OR REJECTING THE PAST RECORD 487 39. PRICE-EARNINGS RATIOS FOR COMMON STOCKS. ADJUSTMENTS FOR CHANGES IN CAPITALIZATION 496 40. CAPITALIZATION STRUCTURE 507 41. LOW-PRICED COMMON STOCKS. ANALYSIS OF THE SOURCE OF INCOME 520 PART VI BALANCE-SHEET ANALYSIS. IMPLICATIONS OF ASSET VALUES Introduction to Part VI | Deconstructing the Balance Sheet by Bruce Greenwald 535 [x] Contents Graham and Dodd chapters: 42. BALANCE-SHEET ANALYSIS. SIGNIFICANCE OF BOOK VALUE 548 43. SIGNIFICANCE OF THE CURRENT-ASSET VALUE 559 44. IMPLICATIONS OF LIQUIDATING VALUE. STOCKHOLDER-MANAGEMENT RELATIONSHIPS 575 45. BALANCE-SHEET ANALYSIS (CONCLUDED) 591 PART VII ADDITIONAL ASPECTS OF SECURITY ANALYSIS. DISCREPANCIES BETWEEN PRICE AND VALUE Introduction to Part VII | The Great Illusion of the Stock Market and the Future of Value Investing • by David Abrams 617 Graham and Dodd chapters: 46. STOCK-OPTION WARRANTS see accompanying CD 47. COST OF FINANCING AND MANAGEMENT 633 48. SOME ASPECTS OF CORPORATE PYRAMIDING 644 49. COMPARATIVE ANALYSIS OF COMPANIES IN THE SAME FIELD 654 50. DISCREPANCIES BETWEEN PRICE AND VALUE 669 51. DISCREPANCIES BETWEEN PRICE AND VALUE (CONTINUED) 688 52. MARKET ANALYSIS AND SECURITY ANALYSIS 697 PART VIII GLOBAL VALUE INVESTING Globetrotting with Graham and Dodd • by Thomas A. Russo 711 APPENDIX see accompanying CD About T

and Dodd chapters: 46. STOCK-OPTION WARRANTS see accompanying CD 47. COST OF FINANCING AND MANAGEMENT 633 48. SOME ASPECTS OF CORPORATE PYRAMIDING 644 49. COMPARATIVE ANALYSIS OF COMPANIES IN THE SAME FIELD 654 50. DISCREPANCIES BETWEEN PRICE AND VALUE 669 51. DISCREPANCIES BETWEEN PRICE AND VALUE (CONTINUED) 688 52. MARKET ANALYSIS AND SECURITY ANALYSIS 697 PART VIII GLOBAL VALUE INVESTING Globetrotting with Graham and Dodd • by Thomas A. Russo 711 APPENDIX see accompanying CD About This Edition 725 Acknowledgments 727 About the Contributors 729 About the Authors 733 Index 735 FORE WORD BY WARREN E. BUFFE T T here are four books in my overflowing library that I particularly treasure, each of them written more than 50 years ago. All, though, would still be of enormous value to me if I were to read them today for the first time; their wisdom endures though their pages fade. Two of those books are first editions of The Wealth of Nations (1776), by Adam Smith, and The Intelligent Investor (1949), by Benjamin Graham. A third is an original copy of the book you hold in your hands, Graham and Dodd’s Security Analysis. I studied from Security Analysis while I was at Columbia University in 1950 and 1951, when I had the extraordinary good luck to have Ben Graham and Dave Dodd as teachers. Together, the book and the men changed my life. On the utilitarian side, what I learned then became the bedrock upon which all of my investment and business decisions have been built. Prior to meeting Ben and Dave, I had long been fascinated by the stock market. Before I bought my first stock at age 11—it took me until then to accumu- late the $115 required for the purchase—I had read every book in the Omaha Public Library having to do with the stock market. I found many of them fascinating and all interesting. But none were really useful. My intellectual odyssey ended, however, when I met Ben and Dave, first through their writings and then in person. They laid out a roadm

t. Prior to meeting Ben and Dave, I had long been fascinated by the stock market. Before I bought my first stock at age 11—it took me until then to accumu- late the $115 required for the purchase—I had read every book in the Omaha Public Library having to do with the stock market. I found many of them fascinating and all interesting. But none were really useful. My intellectual odyssey ended, however, when I met Ben and Dave, first through their writings and then in person. They laid out a roadmap for investing that I have now been following for 57 years. There’s been no reason to look for another. [xi] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. [xii] Foreword Beyond the ideas Ben and Dave gave me, they showered me with friendship, encouragement, and trust. They cared not a whit for reciproca- tion—toward a young student, they simply wanted to extend a one-way street of helpfulness. In the end, that’s probably what I admire most about the two men. It was ordained at birth that they would be brilliant; they elected to be generous and kind. Misanthropes would have been puzzled by their behavior. Ben and Dave instructed literally thousands of potential competitors, young fel- lows like me who would buy bargain stocks or engage in arbitrage trans- actions, directly competing with the Graham-Newman Corporation, which was Ben’s investment company. Moreover, Ben and Dave would use current investing examples in the classroom and in their writings, in effect doing our work for us. The way they behaved made as deep an impression on me—and many of my classmates—as did their ideas. We were being taught not only how to invest wisely; we were also being taught how to live wisely. The copy of Security Analysis that I keep in my library and that I used at Columbia is the 1940 edition. I’ve read it, I’m sure, at least four times, and obviously it is special. But let’s get to the fourth book I mentioned, which

n the classroom and in their writings, in effect doing our work for us. The way they behaved made as deep an impression on me—and many of my classmates—as did their ideas. We were being taught not only how to invest wisely; we were also being taught how to live wisely. The copy of Security Analysis that I keep in my library and that I used at Columbia is the 1940 edition. I’ve read it, I’m sure, at least four times, and obviously it is special. But let’s get to the fourth book I mentioned, which is even more pre- cious. In 2000, Barbara Dodd Anderson, Dave’s only child, gave me her father’s copy of the 1934 edition of Security Analysis, inscribed with hun- dreds of marginal notes. These were inked in by Dave as he prepared for publication of the 1940 revised edition. No gift has meant more to me. P r eface to the Six th Edition THE TIMELESS WISDOM OF GRAHAM AND DODD BY SET H A. KLARM AN eventy-five years after Benjamin Graham and David Dodd wrote Security Analysis, a growing coterie of modern-day value investors remain deeply indebted to them. Graham and David were two assiduous and unusually insightful thinkers seeking to give order to the mostly uncharted financial wilderness of their era. They kindled a flame that has illuminated the way for value investors ever since. Today, Security Analysis remains an invaluable roadmap for investors as they navigate through unpredictable, often volatile, and sometimes treacherous finan- cial markets. Frequently referred to as the “bible of value investing,” Secu- rity Analysis is extremely thorough and detailed, teeming with wisdom for the ages. Although many of the examples are obviously dated, their les- sons are timeless. And while the prose may sometimes seem dry, readers can yet discover valuable ideas on nearly every page. The financial mar- kets have morphed since 1934 in almost unimaginable ways, but Graham and Dodd’s approach to investing remains remarkably applicable today. Value investing, today as in th

s the “bible of value investing,” Secu- rity Analysis is extremely thorough and detailed, teeming with wisdom for the ages. Although many of the examples are obviously dated, their les- sons are timeless. And while the prose may sometimes seem dry, readers can yet discover valuable ideas on nearly every page. The financial mar- kets have morphed since 1934 in almost unimaginable ways, but Graham and Dodd’s approach to investing remains remarkably applicable today. Value investing, today as in the era of Graham and Dodd, is the prac- tice of purchasing securities or assets for less than they are worth—the proverbial dollar for 50 cents. Investing in bargain-priced securities pro- vides a “margin of safety”—room for error, imprecision, bad luck, or the vicissitudes of the economy and stock market. While some might mistak- enly consider value investing a mechanical tool for identifying bargains, [xiii] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. it is actually a comprehensive investment philosophy that emphasizes the need to perform in-depth fundamental analysis, pursue long-term investment results, limit risk, and resist crowd psychology. Far too many people approach the stock market with a focus on mak- ing money quickly. Such an orientation involves speculation rather than investment and is based on the hope that share prices will rise irrespec- tive of valuation. Speculators generally regard stocks as pieces of paper to be quickly traded back and forth, foolishly decoupling them from business reality and valuation criteria. Speculative approaches—which pay little or no attention to downside risk—are especially popular in ris- ing markets. In heady times, few are sufficiently disciplined to maintain strict standards of valuation and risk aversion, especially when most of those abandoning such standards are quickly getting rich. After all, it is easy to confuse genius with a bull market. In recent

es of paper to be quickly traded back and forth, foolishly decoupling them from business reality and valuation criteria. Speculative approaches—which pay little or no attention to downside risk—are especially popular in ris- ing markets. In heady times, few are sufficiently disciplined to maintain strict standards of valuation and risk aversion, especially when most of those abandoning such standards are quickly getting rich. After all, it is easy to confuse genius with a bull market. In recent years, some people have attempted to expand the defini- tion of an investment to include any asset that has recently—or might soon—appreciate in price: art, rare stamps, or a wine collection. Because these items have no ascertainable fundamental value, generate no pres- ent or future cash flow, and depend for their value entirely on buyer whim, they clearly constitute speculations rather than investments. In contrast to the speculator’s preoccupation with rapid gain, value investors demonstrate their risk aversion by striving to avoid loss. A risk- averse investor is one for whom the perceived benefit of any gain is out- weighed by the perceived cost of an equivalent loss. Once any of us has accumulated a modicum of capital, the incremental benefit of gaining more is typically eclipsed by the pain of having less.1 Imagine how you 1 Losing money, as Graham noted, can also be psychologically unsettling. Anxiety from the financial damage caused by recently experienced loss or the fear of further loss can significantly impede our ability to take advantage of the next opportunity that comes along. If an undervalued stock falls by half while the fundamentals—after checking and rechecking—are confirmed to be unchanged, we should relish the opportunity to buy significantly more “on sale.” But if our net worth has tumbled along with the share price, it may be psychologically difficult to add to the position. would respond to the proposition of a coin flip that would either double y

further loss can significantly impede our ability to take advantage of the next opportunity that comes along. If an undervalued stock falls by half while the fundamentals—after checking and rechecking—are confirmed to be unchanged, we should relish the opportunity to buy significantly more “on sale.” But if our net worth has tumbled along with the share price, it may be psychologically difficult to add to the position. would respond to the proposition of a coin flip that would either double your net worth or extinguish it. Being risk averse, nearly all people would respectfully decline such a gamble. Such risk aversion is deeply ingrained in human nature. Yet many unwittingly set aside their risk aversion when the sirens of market speculation call. Value investors regard securities not as speculative instruments but as fractional ownership in, or debt claims on, the underlying businesses. This orientation is key to value investing. When a small slice of a business is offered at a bargain price, it is helpful to evaluate it as if the whole business were offered for sale there. This analytical anchor helps value investors remain focused on the pursuit of long-term results rather than the profitability of their daily trading ledger. At the root of Graham and Dodd’s philosophy is the principle that the financial markets are the ultimate creators of opportunity. Sometimes the markets price securities correctly, other times not. Indeed, in the short run, the market can be quite inefficient, with great deviations between price and underlying value. Unexpected developments, increased uncer- tainty, and capital flows can boost short-term market volatility, with prices overshooting in either direction.2 In the words of Graham and Dodd, “The price [of a security] is frequently an essential element, so that a stock . . . may have investment merit at one price level but not at another.” (p. 106) As Graham has instructed, those who view the market as a weighing machine—a preci

inefficient, with great deviations between price and underlying value. Unexpected developments, increased uncer- tainty, and capital flows can boost short-term market volatility, with prices overshooting in either direction.2 In the words of Graham and Dodd, “The price [of a security] is frequently an essential element, so that a stock . . . may have investment merit at one price level but not at another.” (p. 106) As Graham has instructed, those who view the market as a weighing machine—a precise and efficient assessor of value—are part of the emo- tionally driven herd. Those who regard the market as a voting machine— 2 Over the long run, however, as investors perform fundamental analysis, and corporate manage- ments explain their strategies and manage their capital structures, share prices often migrate toward underlying business value. In particular, shares priced significantly below underlying value will attract bargain hunters and, ultimately, corporate acquirers, reinforcing the tendency toward longer- term share price efficiency. This tendency, however, is always subject to interruption by the short- term forces of greed and fear. a sentiment-driven popularity contest—will be well positioned to take proper advantage of the extremes of market sentiment. While it might seem that anyone can be a value investor, the essential characteristics of this type of investor—patience, discipline, and risk aver- sion—may well be genetically determined. When you first learn of the value approach, it either resonates with you or it doesn’t. Either you are able to remain disciplined and patient, or you aren’t. As Warren Buffett said in his famous article, “The Superinvestors of Graham-and-Doddsville,” “It is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately with people or it doesn’t take at all. It’s like an inocula- tion. If it doesn’t grab a person right away, I find you can talk to him for years and show him records, and it doesn’

he value approach, it either resonates with you or it doesn’t. Either you are able to remain disciplined and patient, or you aren’t. As Warren Buffett said in his famous article, “The Superinvestors of Graham-and-Doddsville,” “It is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately with people or it doesn’t take at all. It’s like an inocula- tion. If it doesn’t grab a person right away, I find you can talk to him for years and show him records, and it doesn’t make any difference.” 3,4 If Security Analysis resonates with you—if you can resist speculating and sometimes sit on your hands—perhaps you have a predisposition toward value investing. If not, at least the book will help you understand where you fit into the investing landscape and give you an appreciation for what the value-investing community may be thinking. Just as Relevant Now Perhaps the most exceptional achievement of Security Analysis, first pub- lished in 1934 and revised in the acclaimed 1940 edition, is that its les- sons are timeless. Generations of value investors have adopted the teachings of Graham and Dodd and successfully implemented them across highly varied market environments, countries, and asset classes. 3 “The Superinvestors of Graham-and-Doddsville,” Hermes, the Columbia Business School magazine, 1984. 4 My own experience has been exactly the one that Buffett describes. My 1978 summer job at Mutual Shares, a no-load value-based mutual fund, set the course for my professional career. The planned liquidation of Telecor and spin-off of its Electro Rent subsidiary in 1980 forever imprinted in my mind the merit of fundamental investment analysis. A buyer of Telecor stock was effectively creating an investment in the shares of Electro Rent, a fast-growing equipment rental company, at the giveaway valuation of approximately 1 times the cash flow. You always remember your first value investment. This would delight the authors, who hoped to set forth prin

r my professional career. The planned liquidation of Telecor and spin-off of its Electro Rent subsidiary in 1980 forever imprinted in my mind the merit of fundamental investment analysis. A buyer of Telecor stock was effectively creating an investment in the shares of Electro Rent, a fast-growing equipment rental company, at the giveaway valuation of approximately 1 times the cash flow. You always remember your first value investment. This would delight the authors, who hoped to set forth principles that would “stand the test of the ever enigmatic future.” (p. xliv) In 1992, Tweedy, Browne Company LLC, a well-known value invest- ment firm, published a compilation of 44 research studies entitled, “What Has Worked in Investing.” The study found that what has worked is fairly simple: cheap stocks (measured by price-to-book values, price- to-earnings ratios, or dividend yields) reliably outperform expensive ones, and stocks that have underperformed (over three- and five-year periods) subsequently beat those that have lately performed well. In other words, value investing works! I know of no long-time practitioner who regrets adhering to a value philosophy; few investors who embrace the fundamental principles ever abandon this investment approach for another. Today, when you read Graham and Dodd’s description of how they navigated through the financial markets of the 1930s, it seems as if they were detailing a strange, foreign, and antiquated era of economic depression, extreme risk aversion, and obscure and obsolete businesses. But such an exploration is considerably more valuable than it superfi- cially appears. After all, each new day has the potential to bring with it a strange and foreign environment. Investors tend to assume that tomor- row’s markets will look very much like today’s, and, most of the time, they will. But every once in a while,5 conventional wisdom is turned on its head, circular reasoning is unraveled, prices revert to the mean, and speculative b

risk aversion, and obscure and obsolete businesses. But such an exploration is considerably more valuable than it superfi- cially appears. After all, each new day has the potential to bring with it a strange and foreign environment. Investors tend to assume that tomor- row’s markets will look very much like today’s, and, most of the time, they will. But every once in a while,5 conventional wisdom is turned on its head, circular reasoning is unraveled, prices revert to the mean, and speculative behavior is exposed as such. At those times, when today fails to resemble yesterday, most investors will be paralyzed. In the words of Graham and Dodd, “We have striven throughout to guard the student against overemphasis upon the superficial and the temporary,” which is “at once the delusion and the nemesis of the world of finance.” (p. xliv) It 5 The credit crunch triggered by subprime mortgage losses that began in July 2007 is a recent and dramatic example. is during periods of tumult that a value-investing philosophy is particu- larly beneficial. In 1934, Graham and Dodd had witnessed over a five-year span the best and the worst of times in the markets—the run-up to the 1929 peak, the October 1929 crash, and the relentless grind of the Great Depression. They laid out a plan for how investors in any environment might sort through hundreds or even thousands of common stocks, pre- ferred shares, and bonds to identify those worthy of investment. Remark- ably, their approach is essentially the same one that value investors employ today. The same principles they applied to the U.S. stock and bond markets of the 1920s and 1930s apply to the global capital markets of the early twenty-first century, to less liquid asset classes like real estate and private equity, and even to derivative instruments that hardly existed when Security Analysis was written. While formulas such as the classic “net working capital” test are nec- essary to support an investment analysis, value investin

ially the same one that value investors employ today. The same principles they applied to the U.S. stock and bond markets of the 1920s and 1930s apply to the global capital markets of the early twenty-first century, to less liquid asset classes like real estate and private equity, and even to derivative instruments that hardly existed when Security Analysis was written. While formulas such as the classic “net working capital” test are nec- essary to support an investment analysis, value investing is not a paint- by-numbers exercise.6 Skepticism and judgment are always required. For one thing, not all elements affecting value are captured in a company’s financial statements—inventories can grow obsolete and receivables uncollectible; liabilities are sometimes unrecorded and property values over- or understated. Second, valuation is an art, not a science. Because the value of a business depends on numerous variables, it can typically be assessed only within a range. Third, the outcomes of all investments depend to some extent on the future, which cannot be predicted with certainty; for this reason, even some carefully analyzed investments fail to achieve profitable outcomes. Sometimes a stock becomes cheap for good reason: a broken business model, hidden liabilities, protracted liti- 6 Graham and Dodd recommended that investors purchase stocks trading for less than two-thirds of “net working capital,” defined as working capital less all other liabilities. Many stocks fit this criterion during the Depression years, far fewer today. gation, or incompetent or corrupt management. Investors must always act with caution and humility, relentlessly searching for additional infor- mation while realizing that they will never know everything about a company. In the end, the most successful value investors combine detailed business research and valuation work with endless discipline and patience, a well-considered sensitivity analysis, intellectual honesty, and years of analyt

criterion during the Depression years, far fewer today. gation, or incompetent or corrupt management. Investors must always act with caution and humility, relentlessly searching for additional infor- mation while realizing that they will never know everything about a company. In the end, the most successful value investors combine detailed business research and valuation work with endless discipline and patience, a well-considered sensitivity analysis, intellectual honesty, and years of analytical and investment experience. Interestingly, Graham and Dodd’s value-investing principles apply beyond the financial markets—including, for example, to the market for baseball talent, as eloquently captured in Moneyball, Michael Lewis’s 2003 bestseller. The market for baseball players, like the market for stocks and bonds, is inefficient—and for many of the same reasons. In both investing and baseball, there is no single way to ascertain value, no one metric that tells the whole story. In both, there are mountains of information and no broad consensus on how to assess it. Decision makers in both arenas mis- interpret available data, misdirect their analyses, and reach inaccurate conclusions. In baseball, as in securities, many overpay because they fear standing apart from the crowd and being criticized. They often make decisions for emotional, not rational, reasons. They become exuberant; they panic. Their orientation sometimes becomes overly short term. They fail to understand what is mean reverting and what isn’t. Baseball’s value investors, like financial market value investors, have achieved significant outperformance over time. While Graham and Dodd didn’t apply value principles to baseball, the applicability of their insights to the market for athletic talent attests to the universality and timelessness of this approach. Value Investing Today Amidst the Great Depression, the stock market and the national econ- omy were exceedingly risky. Downward movements in share pr

is mean reverting and what isn’t. Baseball’s value investors, like financial market value investors, have achieved significant outperformance over time. While Graham and Dodd didn’t apply value principles to baseball, the applicability of their insights to the market for athletic talent attests to the universality and timelessness of this approach. Value Investing Today Amidst the Great Depression, the stock market and the national econ- omy were exceedingly risky. Downward movements in share prices and business activity came suddenly and could be severe and protracted. Optimists were regularly rebuffed by circumstances. Winning, in a sense, was accomplished by not losing. Investors could achieve a margin of safety by buying shares in businesses at a large discount to their under- lying value, and they needed a margin of safety because of all the things that could—and often did—go wrong. Even in the worst of markets, Graham and Dodd remained faithful to their principles, including their view that the economy and markets sometimes go through painful cycles, which must simply be endured. They expressed confidence, in those dark days, that the economy and stock market would eventually rebound: “While we were writing, we had to combat a widespread conviction that financial debacle was to be the permanent order.” (p. xliv) Of course, just as investors must deal with down cycles when busi- ness results deteriorate and cheap stocks become cheaper, they must also endure up cycles when bargains are scarce and investment capital is plentiful. In recent years, the financial markets have performed exceed- ingly well by historic standards, attracting substantial fresh capital in need of managers. Today, a meaningful portion of that capital—likely totaling in the trillions of dollars globally—invests with a value approach. This includes numerous value-based asset management firms and mutual funds, a number of today’s roughly 9,000 hedge funds, and some of the largest and most s

hen bargains are scarce and investment capital is plentiful. In recent years, the financial markets have performed exceed- ingly well by historic standards, attracting substantial fresh capital in need of managers. Today, a meaningful portion of that capital—likely totaling in the trillions of dollars globally—invests with a value approach. This includes numerous value-based asset management firms and mutual funds, a number of today’s roughly 9,000 hedge funds, and some of the largest and most successful university endowments and family investment offices. It is important to note that not all value investors are alike. In the aforementioned “Superinvestors of Graham-and-Doddsville,” Buffett describes numerous successful value investors who have little portfolio overlap. Some value investors hold obscure, “pink-sheet shares” while others focus on the large-cap universe. Some have gone global, while others focus on a single market sector such as real estate or energy. Some run computer screens to identify statistically inexpensive compa- nies, while others assess “private market value”—the value an industry buyer would pay for the entire company. Some are activists who aggres- sively fight for corporate change, while others seek out undervalued securities with a catalyst already in place—such as a spin-off, asset sale, major share repurchase plan, or new management team—for the partial or full realization of the underlying value. And, of course, as in any pro- fession, some value investors are simply more talented than others. In the aggregate, the value-investing community is no longer the very small group of adherents that it was several decades ago. Competition can have a powerful corrective effect on market inefficiencies and mis- pricings. With today’s many amply capitalized and skilled investors, what are the prospects for a value practitioner? Better than you might expect, for several reasons. First, even with a growing value community, there are far more mar

alue investors are simply more talented than others. In the aggregate, the value-investing community is no longer the very small group of adherents that it was several decades ago. Competition can have a powerful corrective effect on market inefficiencies and mis- pricings. With today’s many amply capitalized and skilled investors, what are the prospects for a value practitioner? Better than you might expect, for several reasons. First, even with a growing value community, there are far more market participants with little or no value orientation. Most man- agers, including growth and momentum investors and market indexers, pay little or no attention to value criteria. Instead, they concentrate almost single-mindedly on the growth rate of a company’s earnings, the momentum of its share price, or simply its inclusion in a market index. Second, nearly all money managers today, including some hapless value managers, are forced by the (real or imagined) performance pres- sures of the investment business to have an absurdly short investment horizon, sometimes as brief as a calendar quarter, month, or less. A value strategy is of little use to the impatient investor since it usually takes time to pay off. Finally, human nature never changes. Capital market manias regularly occur on a grand scale: Japanese stocks in the late 1980s, Internet and technology stocks in 1999 and 2000, subprime mortgage lending in 2006 and 2007, and alternative investments currently. It is always difficult to take a contrarian approach. Even highly capable investors can wither under the relentless message from the market that they are wrong. The pressures to succumb are enormous; many investment managers fear they’ll lose business if they stand too far apart from the crowd. Some also fail to pursue value because they’ve handcuffed themselves (or been saddled by clients) with constraints preventing them from buying stocks selling at low dollar prices, small-cap stocks, stocks of companies that

t to take a contrarian approach. Even highly capable investors can wither under the relentless message from the market that they are wrong. The pressures to succumb are enormous; many investment managers fear they’ll lose business if they stand too far apart from the crowd. Some also fail to pursue value because they’ve handcuffed themselves (or been saddled by clients) with constraints preventing them from buying stocks selling at low dollar prices, small-cap stocks, stocks of companies that don’t pay dividends or are losing money, or debt instruments with below investment-grade ratings.7 Many also engage in career manage- ment techniques like “window dressing” their portfolios at the end of cal- endar quarters or selling off losers (even if they are undervalued) while buying more of the winners (even if overvalued). Of course, for those value investors who are truly long term oriented, it is a wonderful thing that many potential competitors are thrown off course by constraints that render them unable or unwilling to effectively compete. Another reason that greater competition may not hinder today’s value investors is the broader and more diverse investment landscape in which they operate. Graham faced a limited lineup of publicly traded U.S. equity and debt securities. Today, there are many thousands of publicly traded stocks in the United States alone, and many tens of thousands worldwide, plus thousands of corporate bonds and asset-backed debt securities. Previously illiquid assets, such as bank loans, now trade regu- larly. Investors may also choose from an almost limitless number of derivative instruments, including customized contracts designed to meet any need or hunch. Nevertheless, 25 years of historically strong stock market perform- ance have left the market far from bargain-priced. High valuations and 7 Another sort of constraint involves the “prudent man rule,” which is a legal concept that divides per- missible from impermissible investments. In th

iquid assets, such as bank loans, now trade regu- larly. Investors may also choose from an almost limitless number of derivative instruments, including customized contracts designed to meet any need or hunch. Nevertheless, 25 years of historically strong stock market perform- ance have left the market far from bargain-priced. High valuations and 7 Another sort of constraint involves the “prudent man rule,” which is a legal concept that divides per- missible from impermissible investments. In the mid- to late 1970s, many interpreted this rule to pre- clude meaningful exposure to equities. Since then, prudence has become a moving target as investors, gaining comfort over time from the actions of their peers, have come to invest in more exotic and increasingly illiquid asset classes. intensified competition raise the specter of lower returns for value investors generally. Also, some value investment firms have become extremely large, and size can be the enemy of investment performance because decision making is slowed by bureaucracy and smaller opportu- nities cease to move the needle. In addition, because growing numbers of competent buy-side and sell-side analysts are plying their trade with the assistance of sophisti- cated information technology, far fewer securities seem likely to fall through the cracks to become extremely undervalued.8 Today’s value investors are unlikely to find opportunity armed only with a Value Line guide or by thumbing through stock tables. While bargains still occasion- ally hide in plain sight, securities today are most likely to become mis- priced when they are either accidentally overlooked or deliberately avoided. Consequently, value investors have had to become thoughtful about where to focus their analysis. In the early 2000s, for example, investors became so disillusioned with the capital allocation procedures of many South Korean companies that few considered them candidates for worthwhile investment. As a result, the shares of

bargains still occasion- ally hide in plain sight, securities today are most likely to become mis- priced when they are either accidentally overlooked or deliberately avoided. Consequently, value investors have had to become thoughtful about where to focus their analysis. In the early 2000s, for example, investors became so disillusioned with the capital allocation procedures of many South Korean companies that few considered them candidates for worthwhile investment. As a result, the shares of numerous South Korean companies traded at great discounts from prevailing international valuations: at two or three times the cash flow, less than half the underly- ing business value, and, in several cases, less than the cash (net of debt) held on their balance sheets. Bargain issues, such as Posco and SK Tele- com, ultimately attracted many value seekers; Warren Buffett reportedly profited handsomely from a number of South Korean holdings. Today’s value investors also find opportunity in the stocks and bonds of companies stigmatized on Wall Street because of involvement in pro- 8 Great innovations in technology have made vastly more information and analytical capability avail- able to all investors. This democratization has not, however, made value investors any better off. With information more widely and inexpensively available, some of the greatest market inefficiencies have been corrected. Developing innovative sources of ideas and information, such as those available from business consultants and industry experts, has become increasingly important. tracted litigation, scandal, accounting fraud, or financial distress. The securities of such companies sometimes trade down to bargain levels, where they become good investments for those who are able to remain stalwart in the face of bad news. For example, the debt of Enron, per- haps the world’s most stigmatized company after an accounting scandal forced it into bankruptcy in 2001, traded as low as 10 cents on the dolla

ess consultants and industry experts, has become increasingly important. tracted litigation, scandal, accounting fraud, or financial distress. The securities of such companies sometimes trade down to bargain levels, where they become good investments for those who are able to remain stalwart in the face of bad news. For example, the debt of Enron, per- haps the world’s most stigmatized company after an accounting scandal forced it into bankruptcy in 2001, traded as low as 10 cents on the dollar of claim; ultimate recoveries are expected to be six times that amount. Similarly, companies with tobacco or asbestos exposure have in recent years periodically come under severe selling pressure due to the uncer- tainties surrounding litigation and the resultant risk of corporate finan- cial distress. More generally, companies that disappoint or surprise investors with lower-than-expected results, sudden management changes, accounting problems, or ratings downgrades are more likely than consistently strong performers to be sources of opportunity. When bargains are scarce, value investors must be patient; compro- mising standards is a slippery slope to disaster. New opportunities will emerge, even if we don’t know when or where. In the absence of com- pelling opportunity, holding at least a portion of one’s portfolio in cash equivalents (for example, U.S. Treasury bills) awaiting future deployment will sometimes be the most sensible option. Recently, Warren Buffett stated that he has more cash to invest than he has good investments. As all value investors must do from time to time, Buffett is waiting patiently. Still, value investors are bottom-up analysts, good at assessing securi- ties one at a time based on the fundamentals. They don’t need the entire market to be bargain priced, just 20 or 25 unrelated securities—a num- ber sufficient for diversification of risk. Even in an expensive market, value investors must keep analyzing securities and assessing businesses, gainin

more cash to invest than he has good investments. As all value investors must do from time to time, Buffett is waiting patiently. Still, value investors are bottom-up analysts, good at assessing securi- ties one at a time based on the fundamentals. They don’t need the entire market to be bargain priced, just 20 or 25 unrelated securities—a num- ber sufficient for diversification of risk. Even in an expensive market, value investors must keep analyzing securities and assessing businesses, gaining knowledge and experience that will be useful in the future. Value investors, therefore, should not try to time the market or guess whether it will rise or fall in the near term. Rather, they should rely on a bottom-up approach, sifting the financial markets for bargains and then buying them, regardless of the level or recent direction of the market or economy. Only when they cannot find bargains should they default to holding cash. A Flexible Approach Because our nation’s founders could not foresee—and knew they could not foresee—technological, social, cultural, and economic changes that the future would bring, they wrote a flexible constitution that still guides us over two centuries later. Similarly, Benjamin Graham and David Dodd acknowledged that they could not anticipate the business, economic, technological, and competitive changes that would sweep through the investment world over the ensuing years. But they, too, wrote a flexible treatise that provides us with the tools to function in an investment landscape that was destined—and remains destined—to undergo pro- found and unpredictable change. For example, companies today sell products that Graham and Dodd could not have imagined. Indeed, there are companies and entire indus- tries that they could not have envisioned. Security Analysis offers no examples of how to value cellular phone carriers, software companies, satellite television providers, or Internet search engines. But the book provides the analytical tool

function in an investment landscape that was destined—and remains destined—to undergo pro- found and unpredictable change. For example, companies today sell products that Graham and Dodd could not have imagined. Indeed, there are companies and entire indus- tries that they could not have envisioned. Security Analysis offers no examples of how to value cellular phone carriers, software companies, satellite television providers, or Internet search engines. But the book provides the analytical tools to evaluate almost any company, to assess the value of its marketable securities, and to determine the existence of a margin of safety. Questions of solvency, liquidity, predictability, busi- ness strategy, and risk cut across businesses, nations, and time. Graham and Dodd did not specifically address how to value private businesses or how to determine the value of an entire company rather than the value of a fractional interest through ownership of its shares.9 9 They did consider the relative merits of corporate control enjoyed by a private business owner ver- sus the value of marketability for a listed stock (p. 372). But their analytical principles apply equally well to these different issues. Investors still need to ask, how stable is the enterprise, and what are its future prospects? What are its earnings and cash flow? What is the downside risk of owning it? What is its liquidation value? How capable and honest is its management? What would you pay for the stock of this company if it were public? What factors might cause the owner of this business to sell control at a bargain price? Similarly, the pair never addressed how to analyze the purchase of an office building or apartment complex. Real estate bargains come about for the same reasons as securities bargains—an urgent need for cash, inability to perform proper analysis, a bearish macro view, or investor disfavor or neglect. In a bad real estate climate, tighter lending standards can cause even healthy propert

pany if it were public? What factors might cause the owner of this business to sell control at a bargain price? Similarly, the pair never addressed how to analyze the purchase of an office building or apartment complex. Real estate bargains come about for the same reasons as securities bargains—an urgent need for cash, inability to perform proper analysis, a bearish macro view, or investor disfavor or neglect. In a bad real estate climate, tighter lending standards can cause even healthy properties to sell at distressed prices. Graham and Dodd’s principles—such as the stability of cash flow, sufficiency of return, and analysis of downside risk—allow us to identify real estate investments with a margin of safety in any market environment. Even complex derivatives not imagined in an earlier era can be scruti- nized with the value investor’s eye. While traders today typically price put and call options via the Black-Scholes model, one can instead use value-investing precepts—upside potential, downside risk, and the likeli- hood that each of various possible scenarios will occur—to analyze these instruments. An inexpensive option may, in effect, have the favorable risk-return characteristics of a value investment—regardless of what the Black-Scholes model dictates. Institutional Investing Perhaps the most important change in the investment landscape over the past 75 years is the ascendancy of institutional investing. In the 1930s, individual investors dominated the stock market. Today, by con- trast, most market activity is driven by institutional investors—large pools of pension, endowment, and aggregated individual capital. While the advent of these large, quasi-permanent capital pools might have resulted in the wide-scale adoption of a long-term value-oriented approach, in fact this has not occurred. Instead, institutional investing has evolved into a short-term performance derby, which makes it diffi- cult for institutional managers to take contrarian or long-term

Today, by con- trast, most market activity is driven by institutional investors—large pools of pension, endowment, and aggregated individual capital. While the advent of these large, quasi-permanent capital pools might have resulted in the wide-scale adoption of a long-term value-oriented approach, in fact this has not occurred. Instead, institutional investing has evolved into a short-term performance derby, which makes it diffi- cult for institutional managers to take contrarian or long-term positions. Indeed, rather than standing apart from the crowd and possibly suffering disappointing short-term results that could cause clients to withdraw capital, institutional investors often prefer the safe haven of assured mediocre performance that can be achieved only by closely following the herd. Alternative investments—a catch-all category that includes venture capital, leveraged buyouts, private equity, and hedge funds—are the cur- rent institutional rage. No investment treatise written today could fail to comment on this development. Fueled by performance pressures and a growing expectation of low (and inadequate) returns from traditional equity and debt investments, institutional investors have sought high returns and diversification by allocating a growing portion of their endowments and pension funds to alternatives. Pioneering Portfolio Management, written in 2000 by David Swensen, the groundbreaking head of Yale’s Investment Office, makes a strong case for alternative investments. In it, Swensen points to the historically inefficient pricing of many asset classes,10 the historically high risk-adjusted returns of many alternative managers, and the limited 10 Many investors make the mistake of thinking about returns to asset classes as if they were perma- nent. Returns are not inherent to an asset class; they result from the fundamentals of the underlying businesses and the price paid by investors for the related securities. Capital flowing into an asset class c

vestments. In it, Swensen points to the historically inefficient pricing of many asset classes,10 the historically high risk-adjusted returns of many alternative managers, and the limited 10 Many investors make the mistake of thinking about returns to asset classes as if they were perma- nent. Returns are not inherent to an asset class; they result from the fundamentals of the underlying businesses and the price paid by investors for the related securities. Capital flowing into an asset class can, reflexively, impair the ability of those investing in that asset class to continue to generate the anticipated, historically attractive returns. performance correlation between alternatives and other asset classes. He highlights the importance of alternative manager selection by noting the large dispersion of returns achieved between top-quartile and third- quartile performers. A great many endowment managers have emulated Swensen, following him into a large commitment to alternative investments, almost certainly on worse terms and amidst a more competitive environment than when he entered the area. Graham and Dodd would be greatly concerned by the commitment of virtually all major university endowments to one type of alternative investment: venture capital. The authors of the margin-of-safety approach to investing would not find one in the entire venture capital universe.11 While there is often the prospect of substantial upside in ven- ture capital, there is also very high risk of failure. Even with the diversifi- cation provided by a venture fund, it is not clear how to analyze the underlying investments to determine whether the potential return justi- fies the risk. Venture capital investment would, therefore, have to be characterized as pure speculation, with no margin of safety whatsoever. Hedge funds—a burgeoning area of institutional interest with nearly $2 trillion of assets under management—are pools of capital that vary widely in their tactics but have a comm

of failure. Even with the diversifi- cation provided by a venture fund, it is not clear how to analyze the underlying investments to determine whether the potential return justi- fies the risk. Venture capital investment would, therefore, have to be characterized as pure speculation, with no margin of safety whatsoever. Hedge funds—a burgeoning area of institutional interest with nearly $2 trillion of assets under management—are pools of capital that vary widely in their tactics but have a common fee structure that typically pays the manager 1% to 2% annually of assets under management and 20% (and sometimes more) of any profits generated. They had their start in the 1920s, when Ben Graham himself ran one of the first hedge funds. What would Graham and Dodd say about the hedge funds operating in today’s markets? They would likely disapprove of hedge funds that make investments based on macroeconomic assessments or that pursue 11 Nor would they find one in leveraged buyouts, through which businesses are purchased at lofty prices using mostly debt financing and a thin layer of equity capital. The only value-investing ration- ale for venture capital or leveraged buyouts might be if they were regarded as mispriced call options. Even so, it is not clear that these areas constitute good value. speculative, short-term strategies. Such funds, by avoiding or even sell- ing undervalued securities to participate in one or another folly, inadver- tently create opportunities for value investors. The illiquidity, lack of transparency, gargantuan size, embedded leverage, and hefty fees of some hedge funds would no doubt raise red flags. But Graham and Dodd would probably approve of hedge funds that practice value-ori- ented investment selection. Importantly, while Graham and Dodd emphasized limiting risk on an investment-by-investment basis, they also believed that diversification and hedging could protect the downside for an entire portfolio. (p. 106) This is what most hedge

investors. The illiquidity, lack of transparency, gargantuan size, embedded leverage, and hefty fees of some hedge funds would no doubt raise red flags. But Graham and Dodd would probably approve of hedge funds that practice value-ori- ented investment selection. Importantly, while Graham and Dodd emphasized limiting risk on an investment-by-investment basis, they also believed that diversification and hedging could protect the downside for an entire portfolio. (p. 106) This is what most hedge funds attempt to do. While they hold individual securities that, considered alone, may involve an uncomfortable degree of risk, they attempt to offset the risks for the entire portfolio through the short sale of similar but more highly valued securities, through the purchase of put options on individual securities or market indexes, and through adequate diversification (although many are guilty of overdiver- sification, holding too little of their truly good ideas and too much of their mediocre ones). In this way, a hedge fund portfolio could (in theory, anyway) have characteristics of good potential return with limited risk that its individual components may not have. Modern-day Developments As mentioned, the analysis of businesses and securities has become increasingly sophisticated over the years. Spreadsheet technology, for example, allows for vastly more sophisticated modeling than was possible even one generation ago. Benjamin Graham’s pencil, clearly one of the sharpest of his era, might not be sharp enough today. On the other hand, technology can easily be misused; computer modeling requires making a series of assumptions about the future that can lead to a spurious preci- sion of which Graham would have been quite dubious. While Graham was interested in companies that produced consistent earnings, analysis in his day was less sophisticated regarding why some company’s earnings might be more consistent than others. Analysts today examine businesses but also business

ra, might not be sharp enough today. On the other hand, technology can easily be misused; computer modeling requires making a series of assumptions about the future that can lead to a spurious preci- sion of which Graham would have been quite dubious. While Graham was interested in companies that produced consistent earnings, analysis in his day was less sophisticated regarding why some company’s earnings might be more consistent than others. Analysts today examine businesses but also business models; the bottom-line impact of changes in revenues, profit margins, product mix, and other variables is carefully studied by managements and financial analysts alike. Investors know that businesses do not exist in a vacuum; the actions of competitors, suppliers, and cus- tomers can greatly impact corporate profitability and must be considered.12 Another important change in focus over time is that while Graham looked at corporate earnings and dividend payments as barometers of a company’s health, most value investors today analyze free cash flow. This is the cash generated annually from the operations of a business after all capital expenditures are made and changes in working capital are con- sidered. Investors have increasingly turned to this metric because reported earnings can be an accounting fiction, masking the cash gener- ated by a business or implying positive cash generation when there is none. Today’s investors have rightly concluded that following the cash— as the manager of a business must do—is the most reliable and reveal- ing means of assessing a company. In addition, many value investors today consider balance sheet analy- sis less important than was generally thought a few generations ago. With returns on capital much higher at present than in the past, most stocks trade far above book value; balance sheet analysis is less helpful in understanding upside potential or downside risk of stocks priced at 12 Professor Michael Porter of Harvard Business School

r of a business must do—is the most reliable and reveal- ing means of assessing a company. In addition, many value investors today consider balance sheet analy- sis less important than was generally thought a few generations ago. With returns on capital much higher at present than in the past, most stocks trade far above book value; balance sheet analysis is less helpful in understanding upside potential or downside risk of stocks priced at 12 Professor Michael Porter of Harvard Business School, in his seminal book Competitive Strategy (Free Press, 1980), lays out the groundwork for a more intensive, thorough, and dynamic analysis of busi- nesses and industries in the modern economy. A broad industry analysis has become particularly necessary as a result of the passage in 2000 of Regulation FD (Fair Disclosure), which regulates and restricts the communications between a company and its actual or potential shareholders. Wall Street analysts, facing a dearth of information from the companies they cover, have been forced to expand their areas of inquiry. such levels. The effects of sustained inflation over time have also wreaked havoc with the accuracy of assets accounted for using historic cost; this means that two companies owning identical assets could report very different book values. Of course, balance sheets must still be carefully scrutinized. Astute observers of corporate balance sheets are often the first to see business deterioration or vulnerability as inventories and receivables build, debt grows, and cash evaporates. And for investors in the equity and debt of underperforming companies, balance sheet analysis remains one generally reliable way of assessing downside protection. Globalization has increasingly affected the investment landscape, with most investors looking beyond their home countries for opportunity and diversification. Graham and Dodd’s principles fully apply to international markets, which are, if anything, even more subject to the vicis

and receivables build, debt grows, and cash evaporates. And for investors in the equity and debt of underperforming companies, balance sheet analysis remains one generally reliable way of assessing downside protection. Globalization has increasingly affected the investment landscape, with most investors looking beyond their home countries for opportunity and diversification. Graham and Dodd’s principles fully apply to international markets, which are, if anything, even more subject to the vicissitudes of investor sentiment—and thus more inefficiently priced—than the U.S. market is today. Investors must be cognizant of the risks of international investing, including exposure to foreign currencies and the need to consider hedging them. Among the other risks are political instability, different (or absent) securities laws and investor protections, varying accounting standards, and limited availability of information. Oddly enough, despite 75 years of success achieved by value investors, one group of observers largely ignores or dismisses this disci- pline: academics. Academics tend to create elegant theories that purport to explain the real world but in fact oversimplify it. One such theory, the Efficient Market Hypothesis (EMH), holds that security prices always and immediately reflect all available information, an idea deeply at odds with Graham and Dodd’s notion that there is great value to fundamental security analysis. The Capital Asset Pricing Model (CAPM) relates risk to return but always mistakes volatility, or beta, for risk. Modern Portfolio Theory (MPT) applauds the benefits of diversification in constructing an optimal portfolio. But by insisting that higher expected return comes only with greater risk, MPT effectively repudiates the entire value-invest- ing philosophy and its long-term record of risk-adjusted investment out- performance. Value investors have no time for these theories and generally ignore them. The assumptions made by these theories—inc

return but always mistakes volatility, or beta, for risk. Modern Portfolio Theory (MPT) applauds the benefits of diversification in constructing an optimal portfolio. But by insisting that higher expected return comes only with greater risk, MPT effectively repudiates the entire value-invest- ing philosophy and its long-term record of risk-adjusted investment out- performance. Value investors have no time for these theories and generally ignore them. The assumptions made by these theories—including continuous markets, perfect information, and low or no transaction costs—are unre- alistic. Academics, broadly speaking, are so entrenched in their theories that they cannot accept that value investing works. Instead of launching a series of studies to understand the remarkable 50-year investment record of Warren Buffett, academics instead explain him away as an aber- ration. Greater attention has been paid recently to behavioral economics, a field recognizing that individuals do not always act rationally and have systematic cognitive biases that contribute to market inefficiencies and security mispricings. These teachings—which would not seem alien to Graham—have not yet entered the academic mainstream, but they are building some momentum. Academics have espoused nuanced permutations of their flawed the- ories for several decades. Countless thousands of their students have been taught that security analysis is worthless, that risk is the same as volatility, and that investors must avoid overconcentration in good ideas (because in efficient markets there can be no good ideas) and thus diver- sify into mediocre or bad ones. Of course, for value investors, the propa- gation of these academic theories has been deeply gratifying: the brainwashing of generations of young investors produces the very ineffi- ciencies that savvy stock pickers can exploit. Another important factor for value investors to take into account is the growing propensity of the Federal Reserve to inter

ust avoid overconcentration in good ideas (because in efficient markets there can be no good ideas) and thus diver- sify into mediocre or bad ones. Of course, for value investors, the propa- gation of these academic theories has been deeply gratifying: the brainwashing of generations of young investors produces the very ineffi- ciencies that savvy stock pickers can exploit. Another important factor for value investors to take into account is the growing propensity of the Federal Reserve to intervene in financial markets at the first sign of trouble. Amidst severe turbulence, the Fed frequently lowers interest rates to prop up securities prices and restore investor confidence. While the intention of Fed officials is to maintain orderly capital markets, some money managers view Fed intervention as a virtual license to speculate. Aggressive Fed tactics, sometimes referred to as the “Greenspan put” (now the “Bernanke put”), create a moral haz- ard that encourages speculation while prolonging overvaluation. So long as value investors aren’t lured into a false sense of security, so long as they can maintain a long-term horizon and ensure their staying power, market dislocations caused by Fed action (or investor anticipation of it) may ultimately be a source of opportunity. Another modern development of relevance is the ubiquitous cable television coverage of the stock market. This frenetic lunacy exacerbates the already short-term orientation of most investors. It foments the view that it is possible—or even necessary—to have an opinion on everything pertinent to the financial markets, as opposed to the patient and highly selective approach endorsed by Graham and Dodd. This sound-bite cul- ture reinforces the popular impression that investing is easy, not rigorous and painstaking. The daily cheerleading pundits exult at rallies and record highs and commiserate over market reversals; viewers get the impression that up is the only rational market direction and that sellin

w that it is possible—or even necessary—to have an opinion on everything pertinent to the financial markets, as opposed to the patient and highly selective approach endorsed by Graham and Dodd. This sound-bite cul- ture reinforces the popular impression that investing is easy, not rigorous and painstaking. The daily cheerleading pundits exult at rallies and record highs and commiserate over market reversals; viewers get the impression that up is the only rational market direction and that selling or sitting on the sidelines is almost unpatriotic. The hysterical tenor is exacerbated at every turn. For example, CNBC frequently uses a format- ted screen that constantly updates the level of the major market indexes against a digital clock. Not only is the time displayed in hours, minutes, and seconds but in completely useless hundredths of seconds, the num- bers flashing by so rapidly (like tenths of a cent on the gas pump) as to be completely unreadable. The only conceivable purpose is to grab the viewers’ attention and ratchet their adrenaline to full throttle. Cable business channels bring the herdlike mentality of the crowd into everyone’s living room, thus making it much harder for viewers to stand apart from the masses. Only on financial cable TV would a commentator with a crazed persona become a celebrity whose pronouncements regularly move markets. In a world in which the differences between investing and speculating are frequently blurred, the nonsense on financial cable channels only compounds the problem. Graham would have been appalled. The only saving grace is that value investors prosper at the expense of those who fall under the spell of the cable pundits. Meanwhile, human nature virtually ensures that there will never be a Graham and Dodd channel. Unanswered Questions Today’s investors still wrestle, as Graham and Dodd did in their day, with a number of important investment questions. One is whether to focus on relative or absolute value. Relative valu

le channels only compounds the problem. Graham would have been appalled. The only saving grace is that value investors prosper at the expense of those who fall under the spell of the cable pundits. Meanwhile, human nature virtually ensures that there will never be a Graham and Dodd channel. Unanswered Questions Today’s investors still wrestle, as Graham and Dodd did in their day, with a number of important investment questions. One is whether to focus on relative or absolute value. Relative value involves the assessment that one security is cheaper than another, that Microsoft is a better bargain than IBM. Relative value is easier to determine than absolute value, the two-dimensional assessment of whether a security is cheaper than other securities and cheap enough to be worth purchasing. The most intrepid investors in relative value manage hedge funds where they purchase the relatively less expensive securities and sell short the relatively more expensive ones. This enables them potentially to profit on both sides of the ledger, long and short. Of course, it also exposes them to double- barreled losses if they are wrong.13 It is harder to think about absolute value than relative value. When is a stock cheap enough to buy and hold without a short sale as a hedge? One standard is to buy when a security trades at an appreciable—say, 30%, 40%, or greater—discount from its underlying value, calculated either as its liquidation value, going-concern value, or private-market 13 Many hedge funds also use significant leverage to goose their returns further, which backfires when analysis is faulty or judgment is flawed. value (the value a knowledgeable third party would reasonably pay for the business). Another standard is to invest when a security offers an acceptably attractive return to a long-term holder, such as a low-risk bond priced to yield 10% or more, or a stock with an 8% to 10% or higher free cash flow yield at a time when “risk-free” U.S. government bonds deli

y hedge funds also use significant leverage to goose their returns further, which backfires when analysis is faulty or judgment is flawed. value (the value a knowledgeable third party would reasonably pay for the business). Another standard is to invest when a security offers an acceptably attractive return to a long-term holder, such as a low-risk bond priced to yield 10% or more, or a stock with an 8% to 10% or higher free cash flow yield at a time when “risk-free” U.S. government bonds deliver 4% to 5% nominal and 2% to 3% real returns. Such demanding standards virtually ensure that absolute value will be quite scarce. Another area where investors struggle is trying to define what consti- tutes a good business. Someone once defined the best possible business as a post office box to which people send money. That idea has certainly been eclipsed by the creation of subscription Web sites that accept credit cards. Today’s most profitable businesses are those in which you sell a fixed amount of work product—say, a piece of software or a hit recording—millions and millions of times at very low marginal cost. Good businesses are generally considered those with strong barriers to entry, limited capital requirements, reliable customers, low risk of tech- nological obsolescence, abundant growth possibilities, and thus signifi- cant and growing free cash flow. Businesses are also subject to changes in the technological and com- petitive landscape. Because of the Internet, the competitive moat sur- rounding the newspaper business—which was considered a very good business only a decade ago—has eroded faster than almost anyone anticipated. In an era of rapid technological change, investors must be ever vigilant, even with regard to companies that are not involved in technology but are simply affected by it. In short, today’s good busi- nesses may not be tomorrow’s. Investors also expend considerable effort attempting to assess the quality of a company’s management. Some mana

titive moat sur- rounding the newspaper business—which was considered a very good business only a decade ago—has eroded faster than almost anyone anticipated. In an era of rapid technological change, investors must be ever vigilant, even with regard to companies that are not involved in technology but are simply affected by it. In short, today’s good busi- nesses may not be tomorrow’s. Investors also expend considerable effort attempting to assess the quality of a company’s management. Some managers are more capable or scrupulous than others, and some may be able to manage certain businesses and environments better than others. Yet, as Graham and Dodd noted, “Objective tests of managerial ability are few and far from scientific.” (p. 84) Make no mistake about it: a management’s acumen, foresight, integrity, and motivation all make a huge difference in share- holder returns. In the present era of aggressive corporate financial engi- neering, managers have many levers at their disposal to positively impact returns, including share repurchases, prudent use of leverage, and a valuation-based approach to acquisitions. Managers who are unwilling to make shareholder-friendly decisions risk their companies becoming perceived as “value traps”: inexpensively valued, but ulti- mately poor investments, because the assets are underutilized. Such companies often attract activist investors seeking to unlock this trapped value. Even more difficult, investors must decide whether to take the risk of investing—at any price—with management teams that have not always done right by shareholders. Shares of such companies may sell at steeply discounted levels, but perhaps the discount is warranted; value that today belongs to the equity holders may tomorrow have been spir- ited away or squandered. An age-old difficulty for investors is ascertaining the value of future growth. In the preface to the first edition of Security Analysis, the authors said as much: “Some matters of vital signif

risk of investing—at any price—with management teams that have not always done right by shareholders. Shares of such companies may sell at steeply discounted levels, but perhaps the discount is warranted; value that today belongs to the equity holders may tomorrow have been spir- ited away or squandered. An age-old difficulty for investors is ascertaining the value of future growth. In the preface to the first edition of Security Analysis, the authors said as much: “Some matters of vital significance, e.g., the determination of the future prospects of an enterprise, have received little space, because little of definite value can be said on the subject.” (p. xliii) Clearly, a company that will earn (or have free cash flow of ) $1 per share today and $2 per share in five years is worth considerably more than a company with identical current per share earnings and no growth. This is especially true if the growth of the first company is likely to continue and is not subject to great variability. Another complication is that companies can grow in many different ways—for example, selling the same number of units at higher prices; selling more units at the same (or even lower) prices; changing the product mix (selling propor- tionately more of the higher-profit-margin products); or developing an entirely new product line. Obviously, some forms of growth are worth more than others. There is a significant downside to paying up for growth or, worse, to obsessing over it. Graham and Dodd astutely observed that “analysis is concerned primarily with values which are supported by the facts and not with those which depend largely upon expectations.” (p. 86) Strongly preferring the actual to the possible, they regarded the “future as a haz- ard which his [the analyst’s] conclusions must encounter rather than as the source of his vindication.” (p. 86) Investors should be especially vigi- lant against focusing on growth to the exclusion of all else, including the risk of overpayi

Dodd astutely observed that “analysis is concerned primarily with values which are supported by the facts and not with those which depend largely upon expectations.” (p. 86) Strongly preferring the actual to the possible, they regarded the “future as a haz- ard which his [the analyst’s] conclusions must encounter rather than as the source of his vindication.” (p. 86) Investors should be especially vigi- lant against focusing on growth to the exclusion of all else, including the risk of overpaying. Again, Graham and Dodd were spot on, warning that “carried to its logical extreme, . . . [there is no price] too high for a good stock, and that such an issue was equally ‘safe’ after it had advanced to 200 as it had been at 25.” (p. 105) Precisely this mistake was made when stock prices surged skyward during the Nifty Fifty era of the early 1970s and the dot-com bubble of 1999 to 2000. The flaw in such a growth-at-any-price approach becomes obvious when the anticipated growth fails to materialize. When the future disap- points, what should investors do? Hope growth resumes? Or give up and sell? Indeed, failed growth stocks are often so aggressively dumped by disappointed holders that their price falls to levels at which value investors, who stubbornly pay little or nothing for growth characteristics, become major holders. This was the case with many technology stocks that suffered huge declines after the dot-com bubble burst in the spring of 2000. By 2002, hundreds of fallen tech stocks traded for less than the cash on their balance sheets, a value investor’s dream. One such com- pany was Radvision, an Israeli provider of voice, video, and data products whose stock subsequently rose from under $5 to the mid-$20s after the urgent selling abated and investors refocused on fundamentals. Another conundrum for value investors is knowing when to sell. Buy- ing bargains is the sweet spot of value investors, although how small a discount one might accept can be subject to deba

stocks traded for less than the cash on their balance sheets, a value investor’s dream. One such com- pany was Radvision, an Israeli provider of voice, video, and data products whose stock subsequently rose from under $5 to the mid-$20s after the urgent selling abated and investors refocused on fundamentals. Another conundrum for value investors is knowing when to sell. Buy- ing bargains is the sweet spot of value investors, although how small a discount one might accept can be subject to debate. Selling is more dif- ficult because it involves securities that are closer to fully priced. As with buying, investors need a discipline for selling. First, sell targets, once set, should be regularly adjusted to reflect all currently available information. Second, individual investors must consider tax consequences. Third, whether or not an investor is fully invested may influence the urgency of raising cash from a stockholding as it approaches full valuation. The availability of better bargains might also make one a more eager seller. Finally, value investors should completely exit a security by the time it reaches full value; owning overvalued securities is the realm of specula- tors. Value investors typically begin selling at a 10% to 20% discount to their assessment of underlying value—based on the liquidity of the security, the possible presence of a catalyst for value realization, the quality of management, the riskiness and leverage of the underlying business, and the investors’ confidence level regarding the assumptions underlying the investment. Finally, investors need to deal with the complex subject of risk. As mentioned earlier, academics and many professional investors have come to define risk in terms of the Greek letter beta, which they use as a measure of past share price volatility: a historically more volatile stock is seen as riskier. But value investors, who are inclined to think about risk as the probability and amount of potential loss, find such rea

ors’ confidence level regarding the assumptions underlying the investment. Finally, investors need to deal with the complex subject of risk. As mentioned earlier, academics and many professional investors have come to define risk in terms of the Greek letter beta, which they use as a measure of past share price volatility: a historically more volatile stock is seen as riskier. But value investors, who are inclined to think about risk as the probability and amount of potential loss, find such reasoning absurd. In fact, a volatile stock may become deeply undervalued, rendering it a very low risk investment. One of the most difficult questions for value investors is how much risk to incur. One facet of this question involves position size and its impact on portfolio diversification. How much can you comfortably own of even the most attractive opportunities? Naturally, investors desire to profit fully from their good ideas. Yet this tendency is tempered by the fear of being unlucky or wrong. Nonetheless, value investors should concentrate their holdings in their best ideas; if you can tell a good investment from a bad one, you can also distinguish a great one from a good one. Investors must also ponder the risks of investing in politically unsta- ble countries, as well as the uncertainties involving currency, interest rate, and economic fluctuations. How much of your capital do you want tied up in Argentina or Thailand, or even France or Australia, no matter how undervalued the stocks may be in those markets? Another risk consideration for value investors, as with all investors, is whether or not to use leverage. While some value-oriented hedge funds and even endowments use leverage to enhance their returns, I side with those who are unwilling to incur the added risks that come with margin debt. Just as leverage enhances the return of successful investments, it magnifies the losses from unsuccessful ones. More importantly, nonre- course (margin) debt raises risk to un

stocks may be in those markets? Another risk consideration for value investors, as with all investors, is whether or not to use leverage. While some value-oriented hedge funds and even endowments use leverage to enhance their returns, I side with those who are unwilling to incur the added risks that come with margin debt. Just as leverage enhances the return of successful investments, it magnifies the losses from unsuccessful ones. More importantly, nonre- course (margin) debt raises risk to unacceptable levels because it places one’s staying power in jeopardy. One risk-related consideration should be paramount above all others: the ability to sleep well at night, confi- dent that your financial position is secure whatever the future may bring. Final Thoughts In a rising market, everyone makes money and a value philosophy is unnecessary. But because there is no certain way to predict what the market will do, one must follow a value philosophy at all times. By con- trolling risk and limiting loss through extensive fundamental analysis, strict discipline, and endless patience, value investors can expect good results with limited downside. You may not get rich quick, but you will keep what you have, and if the future of value investing resembles its past, you are likely to get rich slowly. As investment strategies go, this is the most that any reasonable investor can hope for. The real secret to investing is that there is no secret to investing. Every important aspect of value investing has been made available to the public many times over, beginning in 1934 with the first edition of Security Analysis. That so many people fail to follow this timeless and almost foolproof approach enables those who adopt it to remain suc- cessful. The foibles of human nature that result in the mass pursuit of instant wealth and effortless gain seem certain to be with us forever. So long as people succumb to this aspect of their natures, value investing will remain, as it has been for

e investing has been made available to the public many times over, beginning in 1934 with the first edition of Security Analysis. That so many people fail to follow this timeless and almost foolproof approach enables those who adopt it to remain suc- cessful. The foibles of human nature that result in the mass pursuit of instant wealth and effortless gain seem certain to be with us forever. So long as people succumb to this aspect of their natures, value investing will remain, as it has been for 75 years, a sound and low-risk approach to successful long-term investing. SETH A. KLARMAN Boston, Massachusetts, May, 2008 THE LAPSE OF six years since first publication of this work supplies the excuse, if not the necessity, for the present comprehensive revision. Things happen too fast in the economic world to permit authors to rest comfortably for long. The impact of a major war adds special point to our problem. To the extent that we deal with investment policy we can at best merely hint at the war’s significance for the future. As for security analy- sis proper, the new uncertainties may complicate its subject matter, but they should not alter its foundations or its methods. We have revised our text with a number of objectives in view. There are weaknesses to be corrected and some new judgments to be substi- tuted. Recent developments in the financial sphere are to be taken into account, particularly the effects of regulation by the Securities and Exchange Commission. The persistence of low interest rates justifies a fresh approach to that subject; on the other hand the reaffirmance of Wall Street’s primary reliance on trend impels us to a wider, though not essen- tially different, critique of this modern philosophy of investment. Although too great insistence on up-to-date examples may prove something of a boomerang, as the years pass swiftly, we have used such new illustrations as would occur to authors writing in 1939–1940. But we have felt also that many of t

persistence of low interest rates justifies a fresh approach to that subject; on the other hand the reaffirmance of Wall Street’s primary reliance on trend impels us to a wider, though not essen- tially different, critique of this modern philosophy of investment. Although too great insistence on up-to-date examples may prove something of a boomerang, as the years pass swiftly, we have used such new illustrations as would occur to authors writing in 1939–1940. But we have felt also that many of the old examples, which challenged the future when first suggested, may now possess some utility as verifiers of the proposed techniques. Thus we have borrowed one of our own ideas and have ventured to view the sequel to all our germane 1934 examples as a “laboratory test” of practical security analysis. Reference to each such case, in the text or in notes, may enable the reader to apply certain tests of his own to the pretensions of the securities analyst. The increased size of the book results partly from a larger number of examples, partly from the addition of clarifying material at many points, and perhaps mainly from an expanded treatment of railroad analysis and [xli] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. the addition of much new statistical material bearing on the exhibits of all the industrial companies listed on the New York Stock Exchange. The general arrangement of the work has been retained, although a few who use it as a text have suggested otherwise. We trust, however, that the order of the chapters can be revised in the reading, without too much difficulty, to convenience those who prefer to start, say, with the theory and prac- tice of common-stock analysis. BENJAMIN GRAHAM AND DAVID L. DODD New York, New York, May, 1940 THIS BOOK IS intended for all those who have a serious interest in secu- rity values. It is not addressed to the complete novice, however, for it pre- supposes som

a few who use it as a text have suggested otherwise. We trust, however, that the order of the chapters can be revised in the reading, without too much difficulty, to convenience those who prefer to start, say, with the theory and prac- tice of common-stock analysis. BENJAMIN GRAHAM AND DAVID L. DODD New York, New York, May, 1940 THIS BOOK IS intended for all those who have a serious interest in secu- rity values. It is not addressed to the complete novice, however, for it pre- supposes some acquaintance with the terminology and the simpler concepts of finance. The scope of the work is wider than its title may sug- gest. It deals not only with methods of analyzing individual issues, but also with the establishment of general principles of selection and protec- tion of security holdings. Hence much emphasis has been laid upon dis- tinguishing the investment from the speculative approach, upon setting up sound and workable tests of safety, and upon an understanding of the rights and true interests of investors in senior securities and owners of common stocks. In dividing our space between various topics the primary but not the exclusive criterion has been that of relative importance. Some matters of vital significance, e.g., the determination of the future prospects of an enterprise, have received little space, because little of definite value can be said on the subject. Others are glossed over because they are so well understood. Conversely we have stressed the technique of discovering bargain issues beyond its relative importance in the entire field of invest- ment, because in this activity the talents peculiar to the securities analyst find perhaps their most fruitful expression. In similar fashion we have accorded quite detailed treatment to the characteristics of privileged senior issues (convertibles, etc.), because the attention given to these instruments in standard textbooks is now quite inadequate in view of their extensive development in recent years.

of discovering bargain issues beyond its relative importance in the entire field of invest- ment, because in this activity the talents peculiar to the securities analyst find perhaps their most fruitful expression. In similar fashion we have accorded quite detailed treatment to the characteristics of privileged senior issues (convertibles, etc.), because the attention given to these instruments in standard textbooks is now quite inadequate in view of their extensive development in recent years. Our governing aim, however, has been to make this a critical rather than a descriptive work. We are concerned chiefly with concepts, meth- ods, standards, principles, and, above all, with logical reasoning. We have stressed theory not for itself alone but for its value in practice. We have tried to avoid prescribing standards which are too stringent to follow, or technical methods which are more trouble than they are worth. [xliii] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. The chief problem of this work has been one of perspective—to blend the divergent experiences of the recent and the remoter past into a syn- thesis which will stand the test of the ever enigmatic future. While we were writing, we had to combat a widespread conviction that financial debacle was to be the permanent order; as we publish, we already see resurgent the age-old frailty of the investor—that his money burns a hole in his pocket. But it is the conservative investor who will need most of all to be reminded constantly of the lessons of 1931–1933 and of previous collapses. For what we shall call fixed-value investments can be soundly chosen only if they are approached—in the Spinozan phrase—“from the viewpoint of calamity.” In dealing with other types of security commit- ments, we have striven throughout to guard the student against overem- phasis upon the superficial and the temporary. Twenty years of varied experience in Wall Stree

the conservative investor who will need most of all to be reminded constantly of the lessons of 1931–1933 and of previous collapses. For what we shall call fixed-value investments can be soundly chosen only if they are approached—in the Spinozan phrase—“from the viewpoint of calamity.” In dealing with other types of security commit- ments, we have striven throughout to guard the student against overem- phasis upon the superficial and the temporary. Twenty years of varied experience in Wall Street have taught the senior author that this overem- phasis is at once the delusion and the nemesis of the world of finance. Our sincere thanks are due to the many friends who have encouraged and aided us in the preparation of this work. BENJAMIN GRAHAM AND DAVID L. DODD New York, New York, May, 1934 SECURITY ANALYSIS This page intentionally left blank I n tr oduc tion to the Six th Edition BENJAMIN GRAHAM AND SECURIT Y ANALYSIS : THE HISTORICAL BACKDROP BY JAMES GRANT t was a distracted world before which McGraw-Hill set, with a thud, the first edition of Security Analysis in July 1934. From Berlin dribbled reports of a shake-up at the top of the German government. “It will simplify the Führer’s whole work immensely if he need not first ask some- body if he may do this or that,” the Associated Press quoted an informant on August 1 as saying of Hitler’s ascension from chancellor to dictator. Set against such epochal proceedings, a 727-page textbook on the fine points of value investing must have seemed an unlikely candidate for bestsellerdom, then or later. In his posthumously published autobiography, The Memoirs of the Dean of Wall Street, Graham (1894–1976) thanked his lucky stars that he had entered the investment business when he did. The timing seemed not so propitious in the year of the first edition of Security Analysis, or, indeed, that of the second edition—expanded and revised—six years later. From its 1929 peak to its 1932 trough, the

e fine points of value investing must have seemed an unlikely candidate for bestsellerdom, then or later. In his posthumously published autobiography, The Memoirs of the Dean of Wall Street, Graham (1894–1976) thanked his lucky stars that he had entered the investment business when he did. The timing seemed not so propitious in the year of the first edition of Security Analysis, or, indeed, that of the second edition—expanded and revised—six years later. From its 1929 peak to its 1932 trough, the Dow Jones Industrial Average had lost 87% of its value. At cyclical low ebb, in 1933, the national unemployment rate topped 25%. That the Great Depression ended in 1933 was the considered judgment of the timekeepers of the National Bureau of Economic Research. Millions of Americans, however— not least, the relatively few who tried to squeeze a living out of a profit- less Wall Street—had reason to doubt it. [1] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. The bear market and credit liquidation of the early 1930s gave the institutions of American finance a top-to-bottom scouring. What was left of them presently came in for a rough handling by the first Roosevelt administration. Graham had learned his trade in the Wall Street of the mid–nineteen teens, an era of lightly regulated markets. He began work on Security Analysis as the administration of Herbert Hoover was giving the country its first taste of thoroughgoing federal intervention in a peacetime economy. He was correcting page proofs as the Roosevelt administration was implementing its first radical forays into macroeco- nomic management. By 1934, there were laws to institute federal regula- tion of the securities markets, federal insurance of bank deposits, and federal price controls (not to put a cap on prices, as in later, inflationary times, but rather to put a floor under them). To try to prop up prices, the administration devalued the dollar. It is a tes

l intervention in a peacetime economy. He was correcting page proofs as the Roosevelt administration was implementing its first radical forays into macroeco- nomic management. By 1934, there were laws to institute federal regula- tion of the securities markets, federal insurance of bank deposits, and federal price controls (not to put a cap on prices, as in later, inflationary times, but rather to put a floor under them). To try to prop up prices, the administration devalued the dollar. It is a testament to the enduring quality of Graham’s thought, not to mention the resiliency of America’s financial markets, that Security Analysis lost none of its relevance even as the economy was being turned upside down and inside out. Five full months elapsed following publication of the first edition before Louis Rich got around to reviewing it in the New York Times. Who knows? Maybe the conscientious critic read every page. In any case, Rich gave the book a rave, albeit a slightly rueful one. “On the assumption,” he wrote, on December 2, 1934, “that despite the debacle of recent history there are still people left whose money burns a hole in their pockets, it is hoped that they will read this book. It is a full-bodied, mature, meticu- lous and wholly meritorious outgrowth of scholarly probing and practi- cal sagacity. Although cast in the form and spirit of a textbook, the presentation is endowed with all the qualities likely to engage the liveli- est interest of the layman.”1 How few laymen seemed to care about investing was brought home to Wall Street more forcefully with every passing year of the unprosper- 1 Louis Rich, “Sagacity and Securities,” New York Times, December 2, 1934, p. BR13. ous postcrash era. Just when it seemed that trading volume could get no smaller, or New York Stock Exchange seat prices no lower, or equity valu- ations more absurdly cheap, a new, dispiriting record was set. It required every effort of the editors of the Big Board’s house organ, the Exchan

seemed to care about investing was brought home to Wall Street more forcefully with every passing year of the unprosper- 1 Louis Rich, “Sagacity and Securities,” New York Times, December 2, 1934, p. BR13. ous postcrash era. Just when it seemed that trading volume could get no smaller, or New York Stock Exchange seat prices no lower, or equity valu- ations more absurdly cheap, a new, dispiriting record was set. It required every effort of the editors of the Big Board’s house organ, the Exchange magazine, to keep up a brave face. “Must There Be an End to Progress?” was the inquiring headline over an essay by the Swedish economist Gus- tav Cassel published around the time of the release of Graham and Dodd’s second edition (the professor thought not).2 “Why Do Securities Brokers Stay in Business?” the editors posed and helpfully answered, “Despite wearying lethargy over long periods, confidence abounds that when the public recognizes fully the value of protective measures which lately have been ranged about market procedure, investment interest in securities will increase.” It did not amuse the Exchange that a New York City magistrate, sarcastically addressing in his court a collection of defen- dants hauled in by the police for shooting craps on the sidewalk, had derided the financial profession. “The first thing you know,” the judge had upbraided the suspects, “you’ll wind up as stock brokers in Wall Street with yachts and country homes on Long Island.”3 In ways now difficult to imagine, Murphy’s Law was the order of the day; what could go wrong, did. “Depression” was more than a long-lin- gering state of economic affairs. It had become a worldview. The aca- demic exponents of “secular stagnation,” notably Alvin Hansen and Joseph Schumpeter, each a Harvard economics professor, predicted a long decline in American population growth. This deceleration, Hansen contended in his 1939 essay, “together with the failure of any really important innovations of a magnitude to ab

o imagine, Murphy’s Law was the order of the day; what could go wrong, did. “Depression” was more than a long-lin- gering state of economic affairs. It had become a worldview. The aca- demic exponents of “secular stagnation,” notably Alvin Hansen and Joseph Schumpeter, each a Harvard economics professor, predicted a long decline in American population growth. This deceleration, Hansen contended in his 1939 essay, “together with the failure of any really important innovations of a magnitude to absorb large capital outlays, weighs very heavily as an explanation for the failure of the recent recov- ery to reach full employment.”4 2 Gustav Cassel, “Must There Be an End to Progress?” Exchange, January 1940. 3 Exchange, “Why Do Securities Brokers Stay in Business?” September 1940. 4 James Grant, The Trouble with Prosperity (New York: Random House, 1996), p. 84. Neither Hansen nor his readers had any way of knowing that a baby boom was around the corner. Nothing could have seemed more unlikely to a world preoccupied with a new war in Europe and the evident decline and fall of capitalism. Certainly, Hansen’s ideas must have struck a chord with the chronically underemployed brokers and traders in lower Manhat- tan. As a business, the New York Stock Exchange was running at a steady loss. From 1933, the year in which it began to report its financial results, through 1940, the Big Board recorded a profit in only one year, 1935 (and a nominal one, at that). And when, in 1937, Chelcie C. Bosland, an assis- tant professor of economics at Brown University, brought forth a book entitled The Common Stock Theory of Investment, he remarked as if he were repeating a commonplace that the American economy had peaked two decades earlier at about the time of what was not yet called World War I. The professor added, quoting unnamed authorities, that American population growth could be expected to stop in its tracks by 1975.5 Small wonder that Graham was to write that the acid test of a bond

Bosland, an assis- tant professor of economics at Brown University, brought forth a book entitled The Common Stock Theory of Investment, he remarked as if he were repeating a commonplace that the American economy had peaked two decades earlier at about the time of what was not yet called World War I. The professor added, quoting unnamed authorities, that American population growth could be expected to stop in its tracks by 1975.5 Small wonder that Graham was to write that the acid test of a bond issuer was its capacity to meet its obligations not in a time of middling prosperity (which modest test today’s residential mortgage–backed securities strug- gle to meet) but in a depression. Altogether, an investor in those days was well advised to keep up his guard. “The combination of a record high level for bonds,” writes Graham in the 1940 edition, “with a history of two catastrophic price collapses in the preceding 20 years and a major war in progress is not one to justify airy confidence in the future.” (p. 142) Wall Street, not such a big place even during the 1920s’ boom, got considerably smaller in the subsequent bust. Ben Graham, in conjunction with his partner Jerry Newman, made a very small cog of this low-horse- power machine. The two of them conducted a specialty investment busi- ness at 52 Wall Street. Their strong suits were arbitrage, reorganizations, 5 Chelcie C. Bosland, The Common Stock Theory of Investment (New York: Ronald Press, 1937), p. 74. bankruptcies, and other complex matters. A schematic drawing of the financial district published by Fortune in 1937 made no reference to the Graham-Newman offices. Then again, the partnerships and corporate headquarters that did rate a spot on the Wall Street map were them- selves—by the standards of twenty-first-century finance—remarkably compact. One floor at 40 Wall Street was enough to contain the entire office of Merrill Lynch & Co. And a single floor at 2 Wall Street was all the space required to house Morgan St

d other complex matters. A schematic drawing of the financial district published by Fortune in 1937 made no reference to the Graham-Newman offices. Then again, the partnerships and corporate headquarters that did rate a spot on the Wall Street map were them- selves—by the standards of twenty-first-century finance—remarkably compact. One floor at 40 Wall Street was enough to contain the entire office of Merrill Lynch & Co. And a single floor at 2 Wall Street was all the space required to house Morgan Stanley, the hands-down leader in 1936 corporate securities underwriting, with originations of all of $195 million. Compensation was in keeping with the slow pace of business, especially at the bottom of the corporate ladder.6 After a 20% rise in the new fed- eral minimum wage, effective October 1939, brokerage employees could earn no less than 30 cents an hour.7 In March 1940, the Exchange documented in all the detail its readers could want (and possibly then some) the collapse of public participation in the stock market. In the first three decades of the twentieth century, the annual volume of trading had almost invariably exceeded the quantity of listed shares outstanding, sometimes by a wide margin. And in only one year between 1900 and 1930 had annual volume amounted to less than 50% of listed shares—the exception being 1914, the year in which the exchange was closed for 41/2 months to allow for the shock of the out- break of World War I to sink in. Then came the 1930s, and the annual turnover as a percentage of listed shares struggled to reach as high as 50%. In 1939, despite a short-lived surge of trading on the outbreak of World War II in Europe, the turnover ratio had fallen to a shockingly low 18.4%. (For comparison, in 2007, the ratio of trading volume to listed shares amounted to 123%.) “Perhaps,” sighed the author of the study, “it is a fair statement that if the farming industry showed a similar record, gov- 6 Fortune, “Wall Street, Itself,” June 1937. 7 New York

l turnover as a percentage of listed shares struggled to reach as high as 50%. In 1939, despite a short-lived surge of trading on the outbreak of World War II in Europe, the turnover ratio had fallen to a shockingly low 18.4%. (For comparison, in 2007, the ratio of trading volume to listed shares amounted to 123%.) “Perhaps,” sighed the author of the study, “it is a fair statement that if the farming industry showed a similar record, gov- 6 Fortune, “Wall Street, Itself,” June 1937. 7 New York Times, October 3, 1939, p. 38. ernment subsidies would have been voted long ago. Unfortunately for Wall Street, it seems to have too little sponsorship in officialdom.”8 If a reader took hope from the idea that things were so bad that they could hardly get worse, he or she was in for yet another disappointment. The second edition of Security Analysis had been published only months earlier when, on August 19, 1940, the stock exchange volume totaled just 129,650 shares. It was one of the sleepiest sessions since the 49,000- share mark set on August 5, 1916. For the entire 1940 calendar year, vol- ume totaled 207,599,749 shares—a not very busy two hours’ turnover at this writing and 18.5% of the turnover of 1929, that year of seemingly irrecoverable prosperity. The cost of a membership, or seat, on the stock exchange sank along with turnover and with the major price indexes. At the nadir in 1942, a seat fetched just $17,000. It was the lowest price since 1897 and 97% below the record high price of $625,000, set—natu- rally—in 1929. “‘The Cleaners,’” quipped Fred Schwed, Jr., in his funny and wise book Where Are the Customers’ Yachts? (which, like Graham’s second edition, appeared in 1940), “was not one of those exclusive clubs; by 1932, every- body who had ever tried speculation had been admitted to membership.”9 And if an investor did, somehow, manage to avoid the cleaner’s during the formally designated Great Depression, he or she was by no means home free. In August 1937, th

h price of $625,000, set—natu- rally—in 1929. “‘The Cleaners,’” quipped Fred Schwed, Jr., in his funny and wise book Where Are the Customers’ Yachts? (which, like Graham’s second edition, appeared in 1940), “was not one of those exclusive clubs; by 1932, every- body who had ever tried speculation had been admitted to membership.”9 And if an investor did, somehow, manage to avoid the cleaner’s during the formally designated Great Depression, he or she was by no means home free. In August 1937, the market began a violent sell-off that would carry the averages down by 50% by March 1938. The nonfinancial portion of the economy fared little better than the financial side. In just nine months, industrial production fell by 34.5%, a sharper contraction even than that in the depression of 1920 to 1921, a slump that, for Graham’s generation, had seemed to set the standard for the most economic damage in the shortest elapsed time.10 The Roosevelt administration insisted that the 8 Exchange, March 1940. 9 Fred Schwed, Jr., Where Are the Customers’ Yachts? (New York: Simon and Schuster, 1940), p. 28. 10 Benjamin M. Anderson, Economics and the Public Welfare (New York: Van Nostrand, 1949), p. 431. slump of 1937 to 1938 was no depression but rather a “recession.” The national unemployment rate in 1938 was, on average, 18.8%. In April 1937, four months before the bottom fell out of the stock mar- ket for the second time in 10 years, Robert Lovett, a partner at the invest- ment firm of Brown Brothers Harriman & Co., served warning to the American public in the pages of the weekly Saturday Evening Post. Lovett, a member of the innermost circle of the Wall Street establishment, set out to demonstrate that there is no such thing as financial security—none, at least, to be had in stocks and bonds. The gist of Lovett’s argument was that, in capitalism, capital is consumed and that businesses are just as fragile, and mortal, as the people who own them. He invited his millions of readers t

Brothers Harriman & Co., served warning to the American public in the pages of the weekly Saturday Evening Post. Lovett, a member of the innermost circle of the Wall Street establishment, set out to demonstrate that there is no such thing as financial security—none, at least, to be had in stocks and bonds. The gist of Lovett’s argument was that, in capitalism, capital is consumed and that businesses are just as fragile, and mortal, as the people who own them. He invited his millions of readers to examine the record, as he had done: “If an investor had pur- chased 100 shares of the 20 most popular dividend-paying stocks on December 31, 1901, and held them through 1936, adding, in the mean- time, all the melons in the form of stock dividends, and all the plums in the form of stock split-ups, and had exercised all the valuable rights to subscribe to additional stock, the aggregate market value of his total holdings on December 31, 1936, would have shown a shrinkage of 39% as compared with the cost of his original investment. In plain English, the average investor paid $294,911.90 for things worth $180,072.06 on December 31, 1936. That’s a big disappearance of dollar value in any lan- guage.” In the innocent days before the crash, people had blithely spoken of “permanent investments.” “For our part,” wrote this partner of an emi- nent Wall Street private bank, “we are convinced that the only permanent investment is one which has become a total and irretrievable loss.”11 Lovett turned out to be a prophet. At the nadir of the 1937 to 1938 bear market, one in five NYSE-listed industrial companies was valued in the market for less than its net current assets. Subtract from cash and quick assets all liabilities and the remainder was greater than the com- 11 Robert A. Lovett, “Gilt-Edged Insecurity,” Saturday Evening Post, April 3, 1937. pany’s market value. That is, business value was negative. The Great Atlantic & Pacific Tea Company (A&P), the Wal-Mart of its day, was one

rned out to be a prophet. At the nadir of the 1937 to 1938 bear market, one in five NYSE-listed industrial companies was valued in the market for less than its net current assets. Subtract from cash and quick assets all liabilities and the remainder was greater than the com- 11 Robert A. Lovett, “Gilt-Edged Insecurity,” Saturday Evening Post, April 3, 1937. pany’s market value. That is, business value was negative. The Great Atlantic & Pacific Tea Company (A&P), the Wal-Mart of its day, was one of these corporate castoffs. At the 1938 lows, the market value of the com- mon and preferred shares of A&P at $126 million was less than the value of its cash, inventories, and receivables, conservatively valued at $134 million. In the words of Graham and Dodd, the still-profitable company was selling for “scrap.” (p. 673) A Different Wall Street Few institutional traces of that Wall Street remain. Nowadays, the big broker-dealers keep as much as $1 trillion in securities in inventory; in Graham’s day, they customarily held none. Nowadays, the big broker- dealers are in a perpetual competitive lather to see which can bring the greatest number of initial public offerings (IPOs) to the public market. In Graham’s day, no frontline member firm would stoop to placing an IPO in public hands, the risks and rewards for this kind of offering being reserved for professionals. Federal securities regulation was a new thing in the 1930s. What had preceded the Securities and Exchange Commis- sion (SEC) was a regime of tribal sanction. Some things were simply beyond the pale. Both during and immediately after World War I, no self- respecting NYSE member firm facilitated a client’s switch from Liberty bonds into potentially more lucrative, if less patriotic, alternatives. There was no law against such a business development overture. Rather, according to Graham, it just wasn’t done. A great many things weren’t done in the Wall Street of the 1930s. Newly empowered regulators were resistant to

EC) was a regime of tribal sanction. Some things were simply beyond the pale. Both during and immediately after World War I, no self- respecting NYSE member firm facilitated a client’s switch from Liberty bonds into potentially more lucrative, if less patriotic, alternatives. There was no law against such a business development overture. Rather, according to Graham, it just wasn’t done. A great many things weren’t done in the Wall Street of the 1930s. Newly empowered regulators were resistant to financial innovation, trans- action costs were high, technology was (at least by today’s digital stan- dards) primitive, and investors were demoralized. After the vicious bear market of 1937 to 1938, not a few decided they’d had enough. What was the point of it all? “In June 1939,” writes Graham in a note to a discussion about corporate finance in the second edition, “the S.E.C. set a salutary precedent by refusing to authorize the issuance of ‘Capital Income Debentures’ in the reorganization of the Griess-Pfleger Tanning Company, on the ground that the devising of new types of hybrid issues had gone far enough.” (p. 115, fn. 4) In the same conservative vein, he expresses his approval of the institution of the “legal list,” a document compiled by state banking departments to stipulate which bonds the regulated sav- ings banks could safely own. The very idea of such a list flies in the face of nearly every millennial notion about good regulatory practice. But Gra- ham defends it thus: “Since the selection of high-grade bonds has been shown to be in good part a process of exclusion, it lends itself reasonably well to the application of definite rules and standards designed to dis- qualify unsuitable issues.” (p. 169) No collateralized debt obligations stocked with subprime mortgages for the father of value investing! The 1930s ushered in a revolution in financial disclosure. The new federal securities acts directed investor-owned companies to brief their stockholders once a quarter

nce the selection of high-grade bonds has been shown to be in good part a process of exclusion, it lends itself reasonably well to the application of definite rules and standards designed to dis- qualify unsuitable issues.” (p. 169) No collateralized debt obligations stocked with subprime mortgages for the father of value investing! The 1930s ushered in a revolution in financial disclosure. The new federal securities acts directed investor-owned companies to brief their stockholders once a quarter as well as at year-end. But the new stan- dards were not immediately applicable to all public companies, and more than a few continued doing business the old-fashioned way, with their cards to their chests. One of these informational holdouts was none other than Dun & Bradstreet (D&B), the financial information company. Graham seemed to relish the irony of D&B not revealing “its own earn- ings to its own stockholders.” (p. 92, fn. 4) On the whole, by twenty-first- century standards, information in Graham’s time was as slow moving as it was sparse. There were no conference calls, no automated spread- sheets, and no nonstop news from distant markets—indeed, not much truck with the world outside the 48 states. Security Analysis barely acknowledges the existence of foreign markets. Such an institutional setting was hardly conducive to the develop- ment of “efficient markets,” as the economists today call them—markets in which information is disseminated rapidly, human beings process it flawlessly, and prices incorporate it instantaneously. Graham would have scoffed at such an idea. Equally, he would have smiled at the discovery— so late in the evolution of the human species—that there was a place in economics for a subdiscipline called “behavioral finance.” Reading Security Analysis, one is led to wonder what facet of investing is not behavioral. The stock market, Graham saw, is a source of entertainment value as well as investment value: “Even when the underlying motive of purchas

lessly, and prices incorporate it instantaneously. Graham would have scoffed at such an idea. Equally, he would have smiled at the discovery— so late in the evolution of the human species—that there was a place in economics for a subdiscipline called “behavioral finance.” Reading Security Analysis, one is led to wonder what facet of investing is not behavioral. The stock market, Graham saw, is a source of entertainment value as well as investment value: “Even when the underlying motive of purchase is mere speculative greed, human nature desires to conceal this unlovely impulse behind a screen of apparent logic and good sense. To adapt the aphorism of Voltaire, it may be said that if there were no such thing as common-stock analysis, it would be necessary to counterfeit it.” (p. 348) Anomalies of undervaluation and overvaluation—of underdoing it and overdoing it—fill these pages. It bemused Graham, but did not shock him, that so many businesses could be valued in the stock market for less than their net current assets, even during the late 1920s’ boom, or that, in the dislocations to the bond market immediately following World War I, investors became disoriented enough to assign a higher price and a lower yield to the Union Pacific First Mortgage 4s than they did to the U.S. Treasury’s own Fourth Liberty 41⁄4s. Graham writes of the “inveterate tendency of the stock market to exaggerate.” (p. 679) He would not have exaggerated much if he had written, instead, “all markets.” Though he did not dwell long on the cycles in finance, Graham was certainly aware of them. He could see that ideas, no less than prices and categories of investment assets, had their seasons. The discussion in Security Analysis of the flame-out of the mortgage guarantee business in the early 1930s is a perfect miniature of the often-ruinous competition in which financial institutions periodically engage. “The rise of the newer and more aggressive real estate bond organizations had a most unfortu- nate

he did not dwell long on the cycles in finance, Graham was certainly aware of them. He could see that ideas, no less than prices and categories of investment assets, had their seasons. The discussion in Security Analysis of the flame-out of the mortgage guarantee business in the early 1930s is a perfect miniature of the often-ruinous competition in which financial institutions periodically engage. “The rise of the newer and more aggressive real estate bond organizations had a most unfortu- nate effect upon the policies of the older concerns,” Graham writes of his time and also of ours. “By force of competition they were led to relax their standards of making loans. New mortgages were granted on an increasingly liberal basis, and when old mortgages matured, they were frequently renewed in a larger sum. Furthermore, the face amount of the mortgages guaranteed rose to so high a multiple of the capital of the guarantor companies that it should have been obvious that the guaranty would afford only the flimsiest of protection in the event of a general decline in values.” (p. 217) Security analysis itself is a cyclical phenomenon; it, too, goes in and out of fashion, Graham observed. It holds a strong, intuitive appeal for the kind of businessperson who thinks about stocks the way he or she thinks about his or her own family business. What would such a fount of com- mon sense care about earnings momentum or Wall Street’s pseudo-scien- tific guesses about the economic future? Such an investor, appraising a common stock, would much rather know what the company behind it is worth. That is, he or she would want to study its balance sheet. Well, Gra- ham relates here, that kind of analysis went out of style when stocks started levitating without reference to anything except hope and prophecy. So, by about 1927, fortune-telling and chart-reading had dis- placed the value discipline by which he and his partner were earning a very good living. It is characteristic of Graham that his

nvestor, appraising a common stock, would much rather know what the company behind it is worth. That is, he or she would want to study its balance sheet. Well, Gra- ham relates here, that kind of analysis went out of style when stocks started levitating without reference to anything except hope and prophecy. So, by about 1927, fortune-telling and chart-reading had dis- placed the value discipline by which he and his partner were earning a very good living. It is characteristic of Graham that his critique of the “new era” method of investing is measured and not derisory. The old, conserva- tive approach—his own—had been rather backward looking, Graham admits. It had laid more emphasis on the past than on the future, on sta- ble earning power rather than tomorrow’s earnings prospects. But new technologies, new methods, and new forms of corporate organization had introduced new risks into the post–World War I economy. This fact— “the increasing instability of the typical business”—had blown a small hole in the older analytical approach that emphasized stable earnings power over forecast earnings growth. Beyond that mitigating considera- tion, however, Graham does not go. The new era approach, “which turned upon the earnings trend as the sole criterion of value, . . . was certain to end in an appalling debacle.” (p. 366) Which, of course, it did, and—in the CNBC-driven markets of the twenty-first century—continues to do at intervals today. A Man of Many Talents Benjamin Graham was born Benjamin Grossbaum on May 9, 1894, in London, and sailed to New York with his family before he was two. Young Benjamin was a prodigy in mathematics, classical languages, modern languages, expository writing (as readers of this volume will see for themselves), and anything else that the public schools had to offer. He had a tenacious memory and a love of reading—a certain ticket to aca- demic success, then or later. His father’s death at the age of 35 left him, his two brothers, and their

as born Benjamin Grossbaum on May 9, 1894, in London, and sailed to New York with his family before he was two. Young Benjamin was a prodigy in mathematics, classical languages, modern languages, expository writing (as readers of this volume will see for themselves), and anything else that the public schools had to offer. He had a tenacious memory and a love of reading—a certain ticket to aca- demic success, then or later. His father’s death at the age of 35 left him, his two brothers, and their mother in the social and financial lurch. Ben- jamin early learned to work and to do without. No need here for a biographical profile of the principal author of Security Analysis: Graham’s own memoir delightfully covers that ground. Suffice it to say that the high school brainiac entered Columbia College as an Alumni Scholar in September 1911 at the age of 17. So much material had he already absorbed that he began with a semester’s head start, “the highest possible advanced standing.”12 He mixed his academic studies with a grab bag of jobs, part-time and full-time alike. Upon his graduation in 1914, he started work as a runner and board-boy at the New York Stock Exchange member firm of Newberger, Henderson & Loeb. Within a year, the board-boy was playing the liquidation of the 12 Benjamin Graham, The Memoirs of the Dean of Wall Street, edited by Seymour Chatman (New York: McGraw-Hill, 1996), p. 106. Guggenheim Exploration Company by astutely going long the shares of Guggenheim and short the stocks of the companies in which Guggen- heim had made a minority investment, as his no-doubt bemused elders looked on: “The profit was realized exactly as calculated; and everyone was happy, not least myself.”13 Security Analysis did not come out of the blue. Graham had supple- mented his modest salary by contributing articles to the Magazine of Wall Street. His productions are unmistakably those of a self-assured and superbly educated Wall Street moneymaker. There was no need to quote exp

t the stocks of the companies in which Guggen- heim had made a minority investment, as his no-doubt bemused elders looked on: “The profit was realized exactly as calculated; and everyone was happy, not least myself.”13 Security Analysis did not come out of the blue. Graham had supple- mented his modest salary by contributing articles to the Magazine of Wall Street. His productions are unmistakably those of a self-assured and superbly educated Wall Street moneymaker. There was no need to quote expert opinion. He and the documents he interpreted were all the authority he needed. His favorite topics were the ones that he subse- quently developed in the book you hold in your hands. He was partial to the special situations in which Graham-Newman was to become so suc- cessful. Thus, when a high-flying, and highly complex, American Interna- tional Corp. fell from the sky in 1920, Graham was able to show that the stock was cheap in relation to the evident value of its portfolio of miscel- laneous (and not especially well disclosed) investment assets.14 The shocking insolvency of Goodyear Tire and Rubber attracted his attention in 1921. “The downfall of Goodyear is a remarkable incident even in the present plenitude of business disasters,” he wrote, in a characteristic Gra- ham sentence (how many financial journalists, then or later, had “pleni- tude” on the tips of their tongues?). He shrewdly judged that Goodyear would be a survivor.15 In the summer of 1924, he hit on a theme that would echo through Security Analysis: it was the evident non sequitor of stocks valued in the market at less than the liquidating value of the com- panies that issued them. “Eight Stock Bargains Off the Beaten Track,” said 13 Ibid., p. 145. 14 Benjamin Graham, “The ‘Collapse’ of American International,” Magazine of Wall Street, December, 11, 1920, pp. 175–176, 217. 15 Benjamin Graham, “The Goodyear Reorganization,” Magazine of Wall Street, March 19, 1921, pp. 683–685. the headline over the Benjam

d echo through Security Analysis: it was the evident non sequitor of stocks valued in the market at less than the liquidating value of the com- panies that issued them. “Eight Stock Bargains Off the Beaten Track,” said 13 Ibid., p. 145. 14 Benjamin Graham, “The ‘Collapse’ of American International,” Magazine of Wall Street, December, 11, 1920, pp. 175–176, 217. 15 Benjamin Graham, “The Goodyear Reorganization,” Magazine of Wall Street, March 19, 1921, pp. 683–685. the headline over the Benjamin Graham byline: “Stocks that Are Covered Chiefly by Cash or the Equivalent—No Bonds or Preferred Stock Ahead of These Issues—An Unusually Interesting Group of Securities.” In one case, that of Tonopah Mining, liquid assets of $4.31 per share towered over a market price of just $1.38 a share.16 For Graham, an era of sweet reasonableness in investment thinking seemed to end around 1914. Before that time, the typical investor was a businessman who analyzed a stock or a bond much as he might a claim on a private business. He—it was usually a he—would naturally try to determine what the security-issuing company owned, free and clear of any encumbrances. If the prospective investment was a bond—and it usually was—the businessman-investor would seek assurances that the borrowing company had the financial strength to weather a depression. “It’s not undue modesty,” Graham wrote in his memoir, “to say that I had become something of a smart cookie in my particular field.” His spe- cialty was the carefully analyzed out-of-the-way investment: castaway stocks or bonds, liquidations, bankruptcies, arbitrage. Since at least the early 1920s, Graham had preached the sermon of the “margin of safety.” As the future is a closed book, he urged in his writings, an investor, as a matter of self-defense against the unknown, should contrive to pay less than “intrinsic” value. Intrinsic value, as defined in Security Analysis, is “that value which is justified by the facts, e.g., the assets, earnings, divi

arefully analyzed out-of-the-way investment: castaway stocks or bonds, liquidations, bankruptcies, arbitrage. Since at least the early 1920s, Graham had preached the sermon of the “margin of safety.” As the future is a closed book, he urged in his writings, an investor, as a matter of self-defense against the unknown, should contrive to pay less than “intrinsic” value. Intrinsic value, as defined in Security Analysis, is “that value which is justified by the facts, e.g., the assets, earnings, divi- dends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses.” (p. 64) He himself had gone from the ridiculous to the sublime (and some- times back again) in the conduct of his own investment career. His quick and easy grasp of mathematics made him a natural arbitrageur. He would sell one stock and simultaneously buy another. Or he would buy 16 Benjamin Graham, “Eight Stock Bargains Off the Beaten Track,” Magazine of Wall Street, July 19,1924, pp. 450–453. or sell shares of stock against the convertible bonds of the identical issu- ing company. So doing, he would lock in a profit that, if not certain, was as close to guaranteed as the vicissitudes of finance allowed. In one instance, in the early 1920s, he exploited an inefficiency in the relation- ship between DuPont and the then red-hot General Motors (GM). DuPont held a sizable stake in GM. And it was for that interest alone which the market valued the big chemical company. By implication, the rest of the business was worth nothing. To exploit this anomaly, Graham bought shares in DuPont and sold short the hedge-appropriate number of shares in GM. And when the market came to its senses, and the price gap between DuPont and GM widened in the expected direction, Gra- ham took his profit.17 However, Graham, like many another value investors after him, some- times veered from the austere precepts of safe-and-cheap investing. A Graham onl

valued the big chemical company. By implication, the rest of the business was worth nothing. To exploit this anomaly, Graham bought shares in DuPont and sold short the hedge-appropriate number of shares in GM. And when the market came to its senses, and the price gap between DuPont and GM widened in the expected direction, Gra- ham took his profit.17 However, Graham, like many another value investors after him, some- times veered from the austere precepts of safe-and-cheap investing. A Graham only slightly younger than the master who sold GM and bought DuPont allowed himself to be hoodwinked by a crooked promoter of a company that seems not actually to have existed—at least, in anything like the state of glowing prosperity described by the manager of the pool to which Graham entrusted his money. An electric sign in Colum- bus Circle, on the upper West Side of Manhattan, did bear the name of the object of Graham’s misplaced confidence, Savold Tire. But, as the author of Security Analysis confessed in his memoir, that could have been the only tangible marker of the company’s existence. “Also, as far as I knew,” Graham added, “nobody complained to the district attorney’s office about the promoter’s bare-faced theft of the public’s money.” Cer- tainly, by his own telling, Graham didn’t.18 By 1929, when he was 35, Graham was well on his way to fame and fortune. His wife and he kept a squadron of servants, including—for the first and only time in his life—a manservant for himself. With Jerry 17 Graham, Memoirs, p. 188. 18 Ibid., pp. 181–184. Newman, Graham had compiled an investment record so enviable that the great Bernard M. Baruch sought him out. Would Graham wind up his busi- ness to manage Baruch’s money? “I replied,” Graham writes, “that I was highly flattered—flabbergasted, in fact—by his proposal, but I could not end so abruptly the close and highly satisfactory relations I had with my friends and clients.”19 Those relations soon became much less satisfactory. Graham

Jerry 17 Graham, Memoirs, p. 188. 18 Ibid., pp. 181–184. Newman, Graham had compiled an investment record so enviable that the great Bernard M. Baruch sought him out. Would Graham wind up his busi- ness to manage Baruch’s money? “I replied,” Graham writes, “that I was highly flattered—flabbergasted, in fact—by his proposal, but I could not end so abruptly the close and highly satisfactory relations I had with my friends and clients.”19 Those relations soon became much less satisfactory. Graham relates that, though he was worried at the top of the market, he failed to act on his bearish hunch. The Graham-Newman partnership went into the 1929 break with $2.5 million of capital. And they con- trolled about $2.5 million in hedged positions—stocks owned long offset by stocks sold short. They had, besides, about $4.5 million in outright long positions. It was bad enough that they were leveraged, as Graham later came to realize. Compounding that tactical error was a deeply rooted conviction that the stocks they owned were cheap enough to withstand any imaginable blow. They came through the crash creditably: down by only 20% was, for the final quarter of 1929, almost heroic. But they gave up 50% in 1930, 16% in 1931, and 3% in 1932 (another relatively excellent showing), for a cumulative loss of 70%.20 “I blamed myself not so much for my failure to protect myself against the disaster I had been predicting,” Graham writes, “as for having slipped into an extravagant way of life which I hadn’t the temperament or capacity to enjoy. I quickly convinced myself that the true key to material happiness lay in a modest standard of living which could be achieved with little difficulty under almost all economic condi- tions”—the margin-of-safety idea applied to personal finance.21 It can’t be said that the academic world immediately clasped Security Analysis to its breast as the definitive elucidation of value investing, or of anything else. The aforementioned survey of the field in which

I hadn’t the temperament or capacity to enjoy. I quickly convinced myself that the true key to material happiness lay in a modest standard of living which could be achieved with little difficulty under almost all economic condi- tions”—the margin-of-safety idea applied to personal finance.21 It can’t be said that the academic world immediately clasped Security Analysis to its breast as the definitive elucidation of value investing, or of anything else. The aforementioned survey of the field in which Graham 19 Ibid., p. 253. 20 Ibid., p. 259. 21 Ibid., p. 263. and Dodd made their signal contribution, The Common Stock Theory of Investment, by Chelcie C. Bosland, published three years after the appear- ance of the first edition of Security Analysis, cited 53 different sources and 43 different authors. Not one of them was named Graham or Dodd. Edgar Lawrence Smith, however, did receive Bosland’s full and respectful attention. Smith’s Common Stocks as Long Term Investments, published in 1924, had challenged the long-held view that bonds were innately superior to equities. For one thing, Smith argued, the dollar (even the gold-backed 1924 edition) was inflation-prone, which meant that creditors were inherently disadvantaged. Not so the owners of com- mon stock. If the companies in which they invested earned a profit, and if the managements of those companies retained a portion of that profit in the business, and if those retained earnings, in turn, produced future earnings, the principal value of an investor’s portfolio would tend “to increase in accordance with the operation of compound interest.”22 Smith’s timing was impeccable. Not a year after he published, the great Coolidge bull market erupted. Common Stocks as Long Term Investments, only 129 pages long, provided a handy rationale for chasing the market higher. That stocks do, in fact, tend to excel in the long run has entered the canon of American investment thought as a revealed truth (it looked any- thing but obvious

l value of an investor’s portfolio would tend “to increase in accordance with the operation of compound interest.”22 Smith’s timing was impeccable. Not a year after he published, the great Coolidge bull market erupted. Common Stocks as Long Term Investments, only 129 pages long, provided a handy rationale for chasing the market higher. That stocks do, in fact, tend to excel in the long run has entered the canon of American investment thought as a revealed truth (it looked any- thing but obvious in the 1930s). For his part, Graham entered a strong dis- sent to Smith’s thesis, or, more exactly, its uncritical bullish application. It was one thing to pay 10 times earnings for an equity investment, he notes, quite another to pay 20 to 40 times earnings. Besides, the Smith analysis skirted the important question of what asset values lay behind the stock certificates that people so feverishly and uncritically traded back and forth. Finally, embedded in Smith’s argument was the assumption that common stocks could be counted on to deliver in the future what they had done in the past. Graham was not a believer. (pp. 362–363) 22 Grant, The Trouble with Prosperity, p. 43. If Graham was a hard critic, however, he was also a generous one. In 1939 he was given John Burr Williams’s The Theory of Investment Value to review for the Journal of Political Economy (no small honor for a Wall Street author-practitioner). Williams’s thesis was as important as it was concise. The investment value of a common stock is the present value of all future dividends, he proposed. Williams did not underestimate the significance of these loaded words. Armed with that critical knowledge, the author ventured to hope, investors might restrain themselves from bidding stocks back up to the moon again. Graham, in whose capacious brain dwelled the talents both of the quant and behavioral financier, voiced his doubts about that forecast. The rub, as he pointed out, was that, in order to apply Williams’s meth

f a common stock is the present value of all future dividends, he proposed. Williams did not underestimate the significance of these loaded words. Armed with that critical knowledge, the author ventured to hope, investors might restrain themselves from bidding stocks back up to the moon again. Graham, in whose capacious brain dwelled the talents both of the quant and behavioral financier, voiced his doubts about that forecast. The rub, as he pointed out, was that, in order to apply Williams’s method, one needed to make some very large assumptions about the future course of interest rates, the growth of profit, and the terminal value of the shares when growth stops. “One wonders,” Graham mused, “whether there may not be too great a discrepancy between the necessarily hit-or-miss character of these assumptions and the highly refined mathematical treatment to which they are subjected.” Graham closed his essay on a characteristi- cally generous and witty note, commending Williams for the refreshing level-headedness of his approach and adding: “This conservatism is not really implicit in the author’s formulas; but if the investor can be per- suaded by higher algebra to take a sane attitude toward common-stock prices, the reviewer will cast a loud vote for higher algebra.”23 Graham’s technical accomplishments in securities analysis, by them- selves, could hardly have carried Security Analysis through its five edi- tions. It’s the book’s humanity and good humor that, to me, explain its long life and the adoring loyalty of a certain remnant of Graham readers, myself included. Was there ever a Wall Street moneymaker better 23 Benjamin Graham, “Review of John Burr Williams’s The Theory of Investment Value [Cambridge, Mass.: Harvard University Press, 1938],” Journal of Political Economy, vol. 47, no. 2 (April 1939), pp. 276–278. steeped than Graham in classical languages and literature and in the financial history of his own time? I would bet “no” with all the confidence of a val

ong life and the adoring loyalty of a certain remnant of Graham readers, myself included. Was there ever a Wall Street moneymaker better 23 Benjamin Graham, “Review of John Burr Williams’s The Theory of Investment Value [Cambridge, Mass.: Harvard University Press, 1938],” Journal of Political Economy, vol. 47, no. 2 (April 1939), pp. 276–278. steeped than Graham in classical languages and literature and in the financial history of his own time? I would bet “no” with all the confidence of a value investor laying down money to buy an especially cheap stock. Yet this great investment philosopher was, to a degree, a prisoner of his own times. He could see that the experiences through which he lived were unique, that the Great Depression was, in fact, a great anomaly. If anyone understood the folly of projecting current experience into the unpredictable future, it was Graham. Yet this investment-philosopher king, having spent 727 pages (not including the gold mine of an appendix) describing how a careful and risk-averse investor could prosper in every kind of macroeconomic conditions, arrives at a remarkable conclusion. What of the institutional investor, he asks. How should he invest? At first, Graham diffidently ducks the question—who is he to prescribe for the experienced financiers at the head of America’s philanthropic and educational institutions? But then he takes the astonishing plunge. “An institution,” he writes, “that can manage to get along on the low income provided by high-grade fixed-value issues should, in our opinion, confine its holdings to this field. We doubt if the better performance of common- stock indexes over past periods will, in itself, warrant the heavy responsi- bilities and the recurring uncertainties that are inseparable from a common-stock investment program.” (pp. 709–710) Could the greatest value investor have meant that? Did the man who stuck it out through ruinous losses in the Depression years and went on to compile a remarkable long-term

high-grade fixed-value issues should, in our opinion, confine its holdings to this field. We doubt if the better performance of common- stock indexes over past periods will, in itself, warrant the heavy responsi- bilities and the recurring uncertainties that are inseparable from a common-stock investment program.” (pp. 709–710) Could the greatest value investor have meant that? Did the man who stuck it out through ruinous losses in the Depression years and went on to compile a remarkable long-term investment record really mean that common stocks were not worth the bother? In 1940, with a new world war fanning the Roosevelt administration’s fiscal and monetary policies, high-grade corporate bonds yielded just 2.75%, while blue-chip equities yielded 5.1%. Did Graham mean to say that bonds were a safer proposi- tion than stocks? Well, he did say it. If Homer could nod, so could Gra- ham—and so can the rest of us, whoever we are. Let it be a lesson. This page intentionally left blank Introduction to the Second Edition PROBLEMS OF INVESTMENT POLICY ALTHOUGH, STRICTLY speaking, security analysis may be carried on with- out reference to any definite program or standards of investment, such a specialization of functions would be quite unrealistic. Critical examina- tion of balance sheets and income accounts, comparisons of related or similar issues, studies of the terms and protective covenants behind bonds and preferred stocks—these typical activities of the securities analyst are invariably carried on with some practical idea of purchase or sale in mind, and they must be viewed against a broader background of investment principles, or perhaps of speculative precepts. In this work we shall not strive for a precise demarcation between investment theory and analyti- cal technique but at times shall combine the two elements in the close relationship that they possess in the world of finance. It seems best, therefore, to preface our exposition with a conci

urities analyst are invariably carried on with some practical idea of purchase or sale in mind, and they must be viewed against a broader background of investment principles, or perhaps of speculative precepts. In this work we shall not strive for a precise demarcation between investment theory and analyti- cal technique but at times shall combine the two elements in the close relationship that they possess in the world of finance. It seems best, therefore, to preface our exposition with a concise review of the problems of policy that confront the security buyer. Such a discussion must be colored, in part at least, by the conditions prevailing when this chapter was written. But it is hoped that enough allowance will be made for the possibility of change to give our conclusions more than passing interest and value. Indeed, we consider this element of change as a central fact in the financial universe. For a better understanding of this point we are presenting some data, in conspectus form, designed to illus- trate the reversals and upheavals in values and standards that have devel- oped in the past quarter century. The three reference periods 1911–1913, 1923–1925, and 1936–1938 were selected to represent the nearest approximations to “normal,” or rel- ative stability, that could be found at intervals during the past quarter cen- tury. Between the first and second triennium we had the war collapse and hectic prosperity, followed by the postwar hesitation, inflation, and deep depression. Between 1925 and 1936 we had the “new-era boom,” the great [21] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. FINANCIAL AND ECONOMIC DATA FOR THREE REFERENCE PERIODS Period 1911–1913 1923–1925 1936–1938 High Low Average High Low Average High Low Average Business index* 118.8 94.6 107.9 174.9 136.0 157.9 164.9 106.0 137.0 Bond yields* 4.22% 4.02% 4.09% 4.82% 4.55% 4.68% 3.99% 3.36% 3.65% Index of industrial stock pric

pression. Between 1925 and 1936 we had the “new-era boom,” the great [21] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. FINANCIAL AND ECONOMIC DATA FOR THREE REFERENCE PERIODS Period 1911–1913 1923–1925 1936–1938 High Low Average High Low Average High Low Average Business index* 118.8 94.6 107.9 174.9 136.0 157.9 164.9 106.0 137.0 Bond yields* 4.22% 4.02% 4.09% 4.82% 4.55% 4.68% 3.99% 3.36% 3.65% Index of industrial stock prices* 121.6 92.2 107.6 198.6 128.6 153.4 293.4 124.8 211.1 Dow-Jones Industrial Average (per unit): Price range 94 72 82 159 86 112 194 97 149 Earnings $8.69 $7.81 $8.12 $13.54 $10.52 $11.81 $11.41 $6.02 $9.14 Dividends 5.69 4.50 5.13 7.09 5.51 6.13 8.15 4.84 6.66 Price-earnings ratio† 11.6x 8.9x 10.1x 13.5x 7.3x 9.5x 21.2x 10.6x 16.3x Dividend yield† 5.5% 7.1% 6.3% 3.9% 7.1% 5.5% 3.4% 6.9% 4.5% U. S. Steel:‡ Price range 82 50 65 139 86 111 178 53 96 Earnings per share $11.00 $5.70 $7.53 $16.40 $11.80 $13.70 $11.22 (d)$5.30 $3.33 Dividends per share 5.00 5.00 5.00 7.00 5.25 6.42 1.40 Nil 0.42 Price-earnings ratio† 10.9x 6.6x 8.6x 10.1x 6.3x 8.1x 53.4x 15.9x 28.8x Dividend yield† 6.1% 10.0% 7.7% 4.6% 7.5% 5.8% 0.2% 0.8% 0.4% General Electric:§ Price range 196 142 172 524 262 368 1,580 664 1,070 Earnings per share $16.72 $12.43 $14.27 $32.10 $27.75 $30.35 $53.50 $23.40 $38.00 Dividends per share 10.40 8.00 8.80 19.80 19.80 19.80 53.50 21.85 38.90 Price-earnings ratio† 13.7x 10.0x 12.1x 17.2x 8.6x 13.8x 41.5x 17.5x 28.2x Dividend yield† 4.5% 6.2% 5.1% 3.8% 7.6% 5.4% 2.5% 5.9% 3.6% American Can:¶ Price range 47 9 25 297 74 150 828 414 612 Earnings per share $8.86 $0.07 $4.71 $32.75 $19.64 $24.30 $36.48 $26.10 $32.46 Dividends per share Nil Nil Nil 7.00 5.00 6.00 30.00 24.00 26.00 Price-earnings ratio† 10.0x 1.9x 5.3x 12.2x 3.0x 6.2x 25.5x 12.7 18.8x Dividend yield† Nil Nil Nil 2.0% 8.1% 4.0% 3.1% 6.3% 4.2% Pennsylvania R.R.: Price ra

ratio† 13.7x 10.0x 12.1x 17.2x 8.6x 13.8x 41.5x 17.5x 28.2x Dividend yield† 4.5% 6.2% 5.1% 3.8% 7.6% 5.4% 2.5% 5.9% 3.6% American Can:¶ Price range 47 9 25 297 74 150 828 414 612 Earnings per share $8.86 $0.07 $4.71 $32.75 $19.64 $24.30 $36.48 $26.10 $32.46 Dividends per share Nil Nil Nil 7.00 5.00 6.00 30.00 24.00 26.00 Price-earnings ratio† 10.0x 1.9x 5.3x 12.2x 3.0x 6.2x 25.5x 12.7 18.8x Dividend yield† Nil Nil Nil 2.0% 8.1% 4.0% 3.1% 6.3% 4.2% Pennsylvania R.R.: Price range 65 53 60 55 41 46 50 14 30 Earnings per share $4.64 $4.14 $4.33 $6.23 $3.82 $5.07 $2.94 $0.84 $1.95 Dividends per share 3.00 3.00 3.00 3.00 3.00 3.00 2.00 0.50 1.25 Price-earnings ratio† 15.0x 12.2x 13.8x 10.9x 8.1x 9.2x 25.6x 7.2x 15.5x Dividend yield† 4.6% 5.7% 5.0% 5.5% 7.3% 6.5% 2.5% 8.9% 4.1% American Tel. & Tel.: Price range 153 110 137 145 119 130 190 111 155 Earnings per share $9.58 $8.64 $9.26 $11.79 $11.31 $11.48 $9.62 $8.16 $9.05 Dividends per share 8.00 8.00 8.00 9.00 9.00 9.00 9.00 9.00 9.00 Price-earnings ratio† 16.5x 11.9x 14.8x 12.6x 10.4x 11.3x 21.0x 12.3x 17.1x Dividend yield† 5.2% 7.3% 5.8% 6.2% 7.6% 6.9% 4.7% 8.1% 5.8% * Axe-Houghton indexes of business activity and of industrial stock prices, both unadjusted for trend; yields on 10 high-grade railroad bonds—all by courtesy of E. W. Axe & Co., Inc. † High, low, and average prices are compared with average earnings and dividends in each period. ‡ 1936–1938 figures adjusted to reflect 40% stock dividend. § Figures adjusted to reflect various stock dividends and split-ups between 1913 and 1930, equivalent ultimately to about 25 shares in 1936 for 1 share in 1912.  Exclusive of one share of Electric Bond and Share Securities Corporation distributed as a dividend in 1925. ¶ 1936–1938 figures adjusted to reflect six-for-one exchange of shares in 1926. [24] SECURITY ANALYSIS collapse and depression, and a somewhat irregular recovery towards nor- mal. But if we examine the three-year periods the

§ Figures adjusted to reflect various stock dividends and split-ups between 1913 and 1930, equivalent ultimately to about 25 shares in 1936 for 1 share in 1912.  Exclusive of one share of Electric Bond and Share Securities Corporation distributed as a dividend in 1925. ¶ 1936–1938 figures adjusted to reflect six-for-one exchange of shares in 1926. [24] SECURITY ANALYSIS collapse and depression, and a somewhat irregular recovery towards nor- mal. But if we examine the three-year periods themselves, we cannot fail to be struck by the increasing tendency toward instability even in rela- tively normal times. This is shown vividly in the progressive widening of the graphs in Chart A, page 6, which trace the fluctuations in general business and industrial stock prices during the years in question. It would be foolhardy to deduce from these developments that we must expect still greater instability in the future. But it would be equally imprudent to minimize the significance of what has happened and to return overreadily to the comfortable conviction of 1925 that we were moving steadily towards both greater stability and greater prosperity. The times would seem to call for caution in embracing any theory as to the future and for flexible and open-minded investment policies. With these caveats to guide us, let us proceed to consider briefly certain types of investment problems. A. INVESTMENT IN HIGH-GRADE BONDS AND PREFERRED STOCKS Bond investment presents many more perplexing problems today than seemed to be true in 1913. The chief question then was how to get the highest yield commensurate with safety; and if the investor was satisfied with the lower yielding standard issues (nearly all consisting of railroad mortgage bonds), he could supposedly “buy them with his eyes shut and put them away and forget them.” Now the investor must wrestle with a threefold problem: safety of interest and principal, the future of bond yields and prices, and the future value of the d

g problems today than seemed to be true in 1913. The chief question then was how to get the highest yield commensurate with safety; and if the investor was satisfied with the lower yielding standard issues (nearly all consisting of railroad mortgage bonds), he could supposedly “buy them with his eyes shut and put them away and forget them.” Now the investor must wrestle with a threefold problem: safety of interest and principal, the future of bond yields and prices, and the future value of the dollar. To describe the dilemma is easy; to resolve it satisfactorily seems next to impossible. 1. Safety of Interest and Principal. Two serious depressions in the past twenty years, and the collapse of an enormous volume of railroad issues once thought safe beyond question, suggest that the future may have further rude shocks for the complacent bond investor. The old idea of “permanent investments,” exempt from change and free from care, is no doubt permanently gone. Our studies lead us to conclude, however, that by sufficiently stringent standards of selection and reasonably frequent scrutiny thereafter the investor should be able to escape most of the seri- ous losses that have distracted him in the past, so that his collection of Introduction to the Second Edition [25] interest and principal should work out at a satisfactory percentage even in times of depression. Careful selection must include a due regard to future prospects, but we do not consider that the investor need be clair- voyant or that he must confine himself to companies that hold forth exceptional promise of expanding profits. These remarks relate to (really) high-grade preferred stocks as well as to bonds. 2. Future of Interest Rates and Bond Prices. The unprecedentedly low yields offered by both short- and long-term bond issues may well cause concern to the investor for other reasons than a natural dissatisfac- tion with the small return that his money brings him. If these low rates should prove tempora

air- voyant or that he must confine himself to companies that hold forth exceptional promise of expanding profits. These remarks relate to (really) high-grade preferred stocks as well as to bonds. 2. Future of Interest Rates and Bond Prices. The unprecedentedly low yields offered by both short- and long-term bond issues may well cause concern to the investor for other reasons than a natural dissatisfac- tion with the small return that his money brings him. If these low rates should prove temporary and are followed by a rise to previous levels, long-term bond prices could lose some 25%, or more, of their market value. Such a price decline would be equivalent to the loss of perhaps ten years’ interest. In 1934 we felt that this possibility must be taken seriously into account, because the low interest rates then current might well have been a phenomenon of subnormal business, subject to a radical advance with returning trade activity. But the persistence of these low rates for many years, and in the face of the considerable business expansion of 1936–1937, would argue strongly for the acceptance of this condition as a well-established result of a plethora of capital or of governmental fiscal policy or of both. A new uncertainty has been injected into this question by the outbreak of a European war in 1939. The first World War brought about a sharp increase in interest rates and a corresponding severe fall in high-grade bond prices. There are sufficient similarities and differences, both, between the 1914 and the 1939 situations to make prediction too risky for comfort. Obviously the danger of a substantial fall in bond prices (from the level of early 1940) is still a real one; yet a policy of noninvestment awaiting such a contingency is open to many practical objections. Perhaps a partiality to maturities no longer than, say, fifteen years from purchase date may be the most logical reaction to this uncertain situation. For the small investor, United States Savings Bon

ces, both, between the 1914 and the 1939 situations to make prediction too risky for comfort. Obviously the danger of a substantial fall in bond prices (from the level of early 1940) is still a real one; yet a policy of noninvestment awaiting such a contingency is open to many practical objections. Perhaps a partiality to maturities no longer than, say, fifteen years from purchase date may be the most logical reaction to this uncertain situation. For the small investor, United States Savings Bonds present a perfect solution of this problem (as well as the one preceding), since the right of redemption at the option of the holder guarantees them against a lower price. As we shall point out in a more detailed discussion, the advent of these baby bonds has truly revolutionized the position of most security buyers. 450 400 350 300 250 200 180 160 140 120 COURSE OF AMERICAN BUSINESS AND INDUSTRIAL STOCK PRICES 1900 -1939 1911-1913 Chart A. AXE-HOUGHTON INDEX OF INDUSTRIAL STOCK PRICES 1923-1925 1936 -1938 450 400 350 300 250 200 180 160 140 120 100 90 80 70 60 AXE-HOUGHTON INDEX OF TRADE AND INDUSTRIAL ACTIVITY 100 90 80 70 60 50 40 1900 1902 1904 1906 50 COPYRIGHT E.W.AXE & CO. NEW YORK 40 1908 1910 1912 1914 1916 1918 1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940 Chart B. 2.6 2.6 2.8 2.8 3.0 3.0 3.2 3.2 3.4 3.4 3.6 3.6 3.8 3.8 4.0 4.0 4.2 4.2 4.4 4.4 4.6 4.6 4.8 4.8 5.0 5.0 5.2 5.2 5.4 5.4 5.6 5.6 5.8 5.8 6.0 6.0 6.2 6.2 6.4 6.4 1900 1902 1904 1906 1908 1910 1912 1914 1916 1918 1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940 3. The Value of the Dollar. If the investor were certain that the pur- chasing power of the dollar is going to decline substantially, he undoubt- edly should prefer common stocks or commodities to bonds. To the extent that inflation, in the sense commonly employed, remains a possibility, the investment polic

5.0 5.0 5.2 5.2 5.4 5.4 5.6 5.6 5.8 5.8 6.0 6.0 6.2 6.2 6.4 6.4 1900 1902 1904 1906 1908 1910 1912 1914 1916 1918 1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940 3. The Value of the Dollar. If the investor were certain that the pur- chasing power of the dollar is going to decline substantially, he undoubt- edly should prefer common stocks or commodities to bonds. To the extent that inflation, in the sense commonly employed, remains a possibility, the investment policy of the typical bond buyer is made more perplexing. The arguments for and against ultimate inflation are both unusually weighty, and we must decline to choose between them. The course of the price level since 1933 would seem to belie inflation fears, but the past is not neces- sarily conclusive as to the future. Prudence may suggest some compro- mise in investment policy, to include a component of common stocks or tangible assets, designed to afford some protection against a serious fall in the dollar’s value. Such a hybrid policy would involve difficult prob- lems of its own; and in the last analysis each investor must decide for himself which of the alternative risks he would prefer to run. B. SPECULATIVE BONDS AND PREFERRED STOCKS The problems related to this large class of securities are not inherent in the class itself, but are rather derived from those of investment bonds and of common stocks, between which they lie. The broad principles under- lying the purchase of speculative senior issues remain, in our opinion, the same as they always were: (1) A risk of principal loss may not be offset by a higher yield alone but must be accompanied by a commensurate chance of principal profit; (2) it is generally sounder to approach these issues as if they were common stocks, but recognizing their limited claims, than it is to consider them as an inferior type of senior security. C. THE PROBLEM OF COMMON-STOCK INVESTMENT Common-stock speculation, as the term has always been

ve senior issues remain, in our opinion, the same as they always were: (1) A risk of principal loss may not be offset by a higher yield alone but must be accompanied by a commensurate chance of principal profit; (2) it is generally sounder to approach these issues as if they were common stocks, but recognizing their limited claims, than it is to consider them as an inferior type of senior security. C. THE PROBLEM OF COMMON-STOCK INVESTMENT Common-stock speculation, as the term has always been generally under- stood, is not so difficult to understand as it is to practice successfully. The speculator admittedly risks his money upon his guess or judgment as to the general market or the action of a particular stock or possibly on some future development in the company’s affairs. No doubt the speculator’s problems have changed somewhat with the years, but we incline to the view that the qualities and training necessary for success, as well as the mathematical odds against him, are not vitally different now from what they were before. But stock speculation, as such, does not come within the scope of this volume. Current Practice. We are concerned, however, with common-stock investment, which we shall define provisionally as purchases based upon analysis of value and controlled by definite standards of safety of principal. If we look to current practice to discern what these standards are, we find little beyond the rather indefinite concept that “a good stock is a good investment.” “Good” stocks are those of either (1) leading companies with satisfactory records, a combination relied on to produce favorable results in the future; or (2) any well-financed enterprise believed to have especially attractive prospects of increased future earnings. (As of early 1940, we may cite Coca-Cola as an example of (1), Abbott Laboratories as an example of (2), and General Electric as an example of both.) But although the stock market has very definite and apparently logi- cal ideas a

t.” “Good” stocks are those of either (1) leading companies with satisfactory records, a combination relied on to produce favorable results in the future; or (2) any well-financed enterprise believed to have especially attractive prospects of increased future earnings. (As of early 1940, we may cite Coca-Cola as an example of (1), Abbott Laboratories as an example of (2), and General Electric as an example of both.) But although the stock market has very definite and apparently logi- cal ideas as to the quality of the common stocks that it buys for invest- ment, its quantitative standards—governing the relation of price to determinable value—are so indefinite as to be almost nonexistent. Balance-sheet values are considered to be entirely out of the picture. Aver- age earnings have little significance when there is a marked trend. The so-called “price-earnings ratio” is applied variously, sometimes to the past, sometimes to the present, and sometimes to the near future. But the ratio itself can scarcely be called a standard, since it is controlled by investment practice instead of controlling it. In other words the “right” price-earnings ratio for any stock is what the market says it is. We can find no evidence that at any time from 1926 to date common-stock investors as a class have sold their holdings because the price-earnings ratios were too high. How the present practice of common-stock investors, including the investment trusts almost without exception, can properly be termed investment, in view of this virtual absence of controlling standards, is more than we can fathom. It would be far more logical and helpful to call it “speculation in stocks of strong companies.” Certainly the results in the stock market of such “investment” have been indistinguishable from those of old-time speculation, except perhaps for the margin element. A striking confirmation of this statement, as applied to the years after the 1929 crash, is found by comparing the price range of Gen

ermed investment, in view of this virtual absence of controlling standards, is more than we can fathom. It would be far more logical and helpful to call it “speculation in stocks of strong companies.” Certainly the results in the stock market of such “investment” have been indistinguishable from those of old-time speculation, except perhaps for the margin element. A striking confirmation of this statement, as applied to the years after the 1929 crash, is found by comparing the price range of General Electric since 1930 with that of common stocks generally. The following figures show that General Electric common, which is perhaps the premier and undoubtedly the longest entrenched investment issue in the industrial field today, has fluctuated more widely in market price than have the rank and file of common stocks. PRICE RANGES OF GENERAL ELECTRIC COMMON, DOW-JONES INDUSTRIALS, AND STANDARD STATISTICS’ INDUSTRIAL STOCK INDEX, 1930–1939 Year General Electric Dow-Jones Industrials Standard Statistics Industrials1 High Low High Low High Low 1930 953/8 411/2 294.1 157.5 174.1 98.2 1931 543/4 227/8 194.4 73.8 119.1 48.5 1932 261/8 81/2 88.8 41.2 63.5 30.7 1933 301/4 101/2 108.7 50.2 92.2 36.5 1934 251/4 167/8 110.7 85.5 93.3 69.3 1935 40 7/8 201/2 148.4 96.7 113.2 72.8 1936 55 341/2 184.9 143.1 148.5 109.1 1937 647/8 34 194.4 113.6 158.7 84.2 1938 48 271/4 158.4 99.0 119.3 73.5 1939 445/8 31 155.9 121.4 118.3 86.7 1 Weekly indexes of prices (1926 = 100) of 350 industrial issues in 1939 and 347 issues in earlier years. It was little short of nonsense for the stock market to say in 1937 that General Electric Company was worth $1,870,000,000 and almost pre- cisely a year later that it was worth only $784,000,000. Certainly nothing had happened within twelve months’ time to destroy more than half the value of this powerful enterprise, nor did investors even pretend to claim that the falling off in earnings from 1937 to 1938 had any permanent sig- nificance for the fut

ues in 1939 and 347 issues in earlier years. It was little short of nonsense for the stock market to say in 1937 that General Electric Company was worth $1,870,000,000 and almost pre- cisely a year later that it was worth only $784,000,000. Certainly nothing had happened within twelve months’ time to destroy more than half the value of this powerful enterprise, nor did investors even pretend to claim that the falling off in earnings from 1937 to 1938 had any permanent sig- nificance for the future of the company. General Electric sold at 647/8 because the public was in an optimistic frame of mind and at 271/4 because the same people were pessimistic. To speak of these prices as rep- resenting “investment values” or the “appraisal of investors” is to do vio- lence either to the English language or to common sense, or both. Four Problems. Assuming that a common-stock buyer were to seek definite investment standards by which to guide his operations, he might well direct his attention to four questions: (1) the general future of corpo- ration profits, (2) the differential in quality between one type of company and another, (3) the influence of interest rates on the dividends or earn- ings return that he should demand, and finally (4) the extent to which his purchases and sales should be governed by the factor of timing as distinct from price. The General Future of Corporate Profits. If we study these questions in the light of past experience, our most pronounced reaction is likely to be a wholesome scepticism as to the soundness of the stock market’s judgment on all broad matters relating to the future. The data in our first table show quite clearly that the market underestimated the attractiveness of industrial common stocks as a whole in the years prior to 1926. Their prices gener- ally represented a rather cautious appraisal of past and current earnings, with no signs of any premium being paid for the possibilities of growth inherent in the leading enterprises of

kely to be a wholesome scepticism as to the soundness of the stock market’s judgment on all broad matters relating to the future. The data in our first table show quite clearly that the market underestimated the attractiveness of industrial common stocks as a whole in the years prior to 1926. Their prices gener- ally represented a rather cautious appraisal of past and current earnings, with no signs of any premium being paid for the possibilities of growth inherent in the leading enterprises of a rapidly expanding commonwealth. In 1913 railroad and traction issues made up the bulk of investment bonds and stocks. By 1925 a large part of the investment in street railways had been endangered by the development of the automobile, but even then there was no disposition to apprehend a similar threat to the steam railroads. The widespread recognition of the factor of future growth in com- mon stocks first asserted itself as a stock-market influence at a time when in fact the most dynamic factors in our national expansion (territorial development and rapid accretions of population) were no longer oper- ative, and our economy was about to face grave problems of instability arising from these very checks to the factor of growth. The overvalua- tions of the new-era years extended to nearly every issue that had even a short period of increasing earnings to recommend it, but especial favor was accorded the public-utility and chain-store groups. Even as late as 1931 the high prices paid for these issues showed no realization of their inherent limitations, just as five years later the market still failed to appreciate the critical changes taking place in the position of railroad bonds as well as stocks. Quality Differentials. The stock market of 1940 has its well-defined characteristics, founded chiefly on the experience of the recent past and on the rather obvious prospects of the future. The tendency to favor the larger and stronger companies is perhaps more pronounced than ever

r these issues showed no realization of their inherent limitations, just as five years later the market still failed to appreciate the critical changes taking place in the position of railroad bonds as well as stocks. Quality Differentials. The stock market of 1940 has its well-defined characteristics, founded chiefly on the experience of the recent past and on the rather obvious prospects of the future. The tendency to favor the larger and stronger companies is perhaps more pronounced than ever. This is supported by the record since 1929, which indicates, we believe, both better resistance to depression and a more complete recovery of earning power in the case of the leading than of the secondary compa- nies. There is also the usual predilection for certain industrial groups, including companies of smaller size therein. Most prominent are the chemical and aviation shares—the former because of their really remark- able record of growth through research, the latter because of the great influx of armament orders. But these preferences of the current stock market, although easily understood, may raise some questions in the minds of the sceptical. First to be considered is the extraordinary disparity between the prices of prominent and less popular issues. If average earnings of 1934–1939 are taken as a criterion, the “good stocks” would appear to be selling about two to three times as high as other issues. In terms of asset values the divergence is far greater, since obviously the popular issues have earned a much larger return on their invested capital. The ignoring of asset val- ues has reached a stage where even current assets receive very little atten- tion, so that even a moderately successful enterprise is likely to be selling at considerably less than its liquidating value if it happens to be rich in working capital. The relationship between “good stocks” and other stocks must be con- sidered in the light of what is to be expected of American business gener- a