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n the heydey of a bull market. This wide but quite unpopular field may present the more logical challenge to the interest of the bona fide investor and to the talents of the securities analyst. This page intentionally left blank PART I SURVEY AND APPROACH Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. This page intentionally left blank I n tr oduc tion to P ar t I THE ESSENTIAL LESSONS BY ROGER LOWENSTEIN I f the modern reader were asked, what did the junk bonds of the 1980s, the dot-com stocks of the late 1990s, and, more recently, the various subprime mortgage portfolios of the 2000s all have in common, the first correct answer is that each of them took a nosedive from a highly inflated price to one rather closer to zero. You can throw in, for good measure, the net asset value and reputation of the world’s most intelligent hedge fund, Long-Term Capital Management (LTCM). The second right answer is that each was an investment disaster whose perils could have been avoided by a patient reading of Security Analysis. Graham and Dodd wrote the first edition in 1934 and first revised it in 1940—some four decades before Michael Milken became a household name and three score years in advance of the frenzy for no-documentation, adjustable- rate mortgages. The authors advocated more than a merely generalized skepticism. They prescribed (as we will see) a series of specific injunctions, each of which would have served as a prophylactic against one or more of the above-named fiascos and their associated investment fads. While the book was received by serious investors as an instant classic, I cannot say it elevated Wall Street or the public above their tendency to speculate. If I can venture a guess as to why, it is that even the experi- enced investor is too often like the teenage driver first taking over the wheel. He hears the advice about being careful,

specific injunctions, each of which would have served as a prophylactic against one or more of the above-named fiascos and their associated investment fads. While the book was received by serious investors as an instant classic, I cannot say it elevated Wall Street or the public above their tendency to speculate. If I can venture a guess as to why, it is that even the experi- enced investor is too often like the teenage driver first taking over the wheel. He hears the advice about being careful, avoiding icy patches and so forth, and consigns it to the remote part of his brain reserved for [39] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. archived parental instructions. He surely does not want to wreck the family car, but avoiding an accident is a low priority because he does not think it will happen to him. Thus with our investor: he is focused on mak- ing money, not with averting the myriad potential wrecks in the invest- ment landscape. And I suspect that Graham and Dodd have been ignored by those who suffer from the misconception that trying to make serious money requires that one take serious risks. In fact, the converse is true. Avoiding serious loss is a precondition for sustaining a high com- pound rate of growth. In 25 years as a financial journalist, virtually all of the investors of this writer’s acquaintance who have consistently earned superior profits have been Graham-and-Dodders. The most famous, of course, is Warren Buf- fett, and he is also the most illustrative. Buffett became Graham’s pupil and disciple in 1950, when as a scrawny 20-year-old, he confided to a friend that he would be studying under a pair of “hotshots” (meaning Benjamin Graham and his assistant David Dodd) at the Columbia Busi- ness School.1 And he was also, years later, the first to admit that he had moved beyond the stocks that lay within his master’s ken. Buffett was an adapter; he did not imitate his mentor s

ous, of course, is Warren Buf- fett, and he is also the most illustrative. Buffett became Graham’s pupil and disciple in 1950, when as a scrawny 20-year-old, he confided to a friend that he would be studying under a pair of “hotshots” (meaning Benjamin Graham and his assistant David Dodd) at the Columbia Busi- ness School.1 And he was also, years later, the first to admit that he had moved beyond the stocks that lay within his master’s ken. Buffett was an adapter; he did not imitate his mentor stroke for stroke. He began with Ben Graham types of stocks such as Berkshire Hathaway, which was then a struggling textile maker, and he moved on to Walt Disney and Ameri- can Express, which possessed less in the way of tangible assets but more in economic value. Yet his approach remained consistent (even if the choice of securities it yielded did not). It is this approach, successfully applied by a devoted minority of other professional and individual investors, that makes Security Analysis an enduring roadmap. It is still the bible for avoiding those icy patches— perhaps that much seems obvious—but it is also an instruction manual for identifying investments that are superior as well as safe. 1 Roger Lowenstein, Buffett: The Making of an American Capitalist (New York: Random House, 1995), p. 35. This was known without a doubt to the working investors who enrolled in Graham’s classes, some of whom would bolt from the lecture hall to call their brokers with the names of the stocks that Professor Gra- ham had used as examples. One later successful broker maintained that Graham’s tips had been so valuable that the class actually paid for his degree. Whatever the literal truth, Graham was the rare academic who was both theoretician and working practitioner. Some brief knowledge of the man will elucidate his approach.2 At a personal level, Graham was a caricature of the absent-minded professor, a devotee of the classics, a student of Latin and Greek, and a translator of Spanis

hat Professor Gra- ham had used as examples. One later successful broker maintained that Graham’s tips had been so valuable that the class actually paid for his degree. Whatever the literal truth, Graham was the rare academic who was both theoretician and working practitioner. Some brief knowledge of the man will elucidate his approach.2 At a personal level, Graham was a caricature of the absent-minded professor, a devotee of the classics, a student of Latin and Greek, and a translator of Spanish poetry who could dress for work in mismatched shoes and who evidenced little interest in money. But intellectually, his curiosity was unrivaled. When he graduated from Columbia in 1914, he was offered positions in English, mathematics, and philosophy. Taking the advice of a college dean, he went to Wall Street, which he treated rather like another branch of academia—that is, as a discipline that was subject to logical and testable principles (albeit ones that had yet to be discovered). He gravitated to money manage- ment, in which he excelled, eventually combining it with writing and teaching. It took Graham 20 years—which is to say, a complete cycle from the bull market of the Roaring Twenties through the dark, nearly ruinous days of the early 1930s—to refine his investment philosophy into a discipline that was as rigorous as the Euclidean theorems he had studied in college. An Analytical Discipline This analytical approach is evident from the first chapter; indeed, it is the cornerstone of Part I, in which Graham and Dodd set forth the funda- mentals. They promise to use “established principles and sound logic,” or what the authors term “the scientific method,” and yet they recognize 2 Lowenstein, Buffett, p. 37. that, as with law or medicine, investing is not hard science but a disci- pline in which both skill and chance play a role. Security Analysis is their prescription for maximizing the influence of the former and minimizing that of the latter. If you want to tru

stone of Part I, in which Graham and Dodd set forth the funda- mentals. They promise to use “established principles and sound logic,” or what the authors term “the scientific method,” and yet they recognize 2 Lowenstein, Buffett, p. 37. that, as with law or medicine, investing is not hard science but a disci- pline in which both skill and chance play a role. Security Analysis is their prescription for maximizing the influence of the former and minimizing that of the latter. If you want to trust your portfolio to luck, this is not the book for you. It is addressed primarily to the investor, as opposed to the speculator, and the distinction that Graham and Dodd drew between them remains the heart of the work. The investors in Graham’s day, of course, operated in a vastly different landscape than today’s. They suffered periodic and often severe eco- nomic depressions, as distinct from the occasional and generally mild recessions that have been the rule of late. They had less faith that the future would deliver prosperity, and they had less reliable information about specific securities. For such reasons, they were more inclined to invest in bonds than in stocks, most often in the bonds of well-known industrial companies. And the names of the leading companies didn’t change much from year to year or even from decade to decade. Ameri- can industry was increasingly regulated, and it was not as dynamic as it has been in recent times. Wall Street was an exclusive club, and investing was a rich person’s game, not the popular sport it has become. The range of investment possibilities was also narrower. As for “alternative investments”—suffice to say that investing in a start-up that had yet to earn any profits would have been considered positively daft. The changes in the marketplace have been so profound that it might seem astonishing that an investment manual written in the 1930s would have any relevance today. But human nature doesn’t change. People still oscillate betw

ng was a rich person’s game, not the popular sport it has become. The range of investment possibilities was also narrower. As for “alternative investments”—suffice to say that investing in a start-up that had yet to earn any profits would have been considered positively daft. The changes in the marketplace have been so profound that it might seem astonishing that an investment manual written in the 1930s would have any relevance today. But human nature doesn’t change. People still oscillate between manic highs and depressive lows, and in their hunger for instant profits, their distaste for the hard labor of seri- ous study and for independent thought, modern investors look very much like their grandfathers and even their great-grandfathers. Then as now, it takes discipline to overcome the demons (largely emotional) that impede most investors. And the essentials of security analysis have not much changed. In the 1930s, there was a common notion that bonds were safe— suitable for “investment”—while stocks were unsafe. Graham and Dodd rejected this mechanical rule, as they did, more generally, the notion of relying on the form of any security. They recognized that the various issues in the corporate food chain (senior bonds, junior debt, preferred stock, and common) were not so much dissimilar but rather part of a continuum. And though a bondholder, it is true, has an economic, and also a legal, priority over a stockholder, it is not the contractual obliga- tion that provides safety to the bondholder, the authors pointed out, but “the ability of the debtor corporation to meet its obligations.” And it follows that (leaving aside the tax shield provided from interest expense) the bondholder’s claim cannot be worth more than the company’s net worth would be to an owner who held it free and clear of debt. This might seem obvious, but it was in no way apparent to the credi- tors of Federated Department Stores (which operated Bloomingdale’s and other high-end retailers) du

safety to the bondholder, the authors pointed out, but “the ability of the debtor corporation to meet its obligations.” And it follows that (leaving aside the tax shield provided from interest expense) the bondholder’s claim cannot be worth more than the company’s net worth would be to an owner who held it free and clear of debt. This might seem obvious, but it was in no way apparent to the credi- tors of Federated Department Stores (which operated Bloomingdale’s and other high-end retailers) during the junk bond mania of the late 1980s. Investment banks had discovered, without any sense of shame, that they could sell junk bonds to a credulous public irrespective of the issuers’ ability to repay them. In 1988, Federated agreed to a leveraged acquisition by the Canadian developer and corporate raider Robert Cam- peau, which committed the company to annual interest charges there- after of $600 million. This was rather an interesting figure because Federated was earning only $400 million.3 The Federated bonds thus vio- lated the rule that creditors can never extract more from a company than it actually has. (They also violated common sense.) Not two years 3 Louis Lowenstein, University Lecture, Columbia University, Spring 1989. later, Federated filed for bankruptcy and its bonds crashed. Needless to say, the investors hadn’t read Graham and Dodd. In accordance with the customs of its era, Security Analysis spends more time on bonds than it would were it written today (another sign of its Great Depression vintage is that there is scant mention of the risk that inflation poses to bondholders). But the general argument against evaluat- ing securities on the basis of their type or formal classification is as trench- ant as ever. Investors may have overcome (to a fault) their fear of stocks, but they fall into equally simplistic traps, such as supposing that investing in a stock market index is always and ever prudent—or even, until recently, that real estate “never goes

sign of its Great Depression vintage is that there is scant mention of the risk that inflation poses to bondholders). But the general argument against evaluat- ing securities on the basis of their type or formal classification is as trench- ant as ever. Investors may have overcome (to a fault) their fear of stocks, but they fall into equally simplistic traps, such as supposing that investing in a stock market index is always and ever prudent—or even, until recently, that real estate “never goes down.” Graham and Dodd’s rejoinder was timeless: at a price, any security can be a suitable investment, but, to repeat, none is safe merely by virtue of its form. Nor does the fact that a stock is “blue chip” (that is, generally respected and widely owned) protect investors from loss. Graham and Dodd cited AT&T, which tumbled from a price of $494 a share in 1929 to a Depression low of $36. Modern readers will think of Ma Bell’s notorious offspring, Lucent Technologies, which in the late 1990s was the bluest of blue chips—the darling of institutional investors—until it tumbled from $80 to less than a dollar. Graham and Dodd went from AT&T and from the general madness of the late 1920s to argue that the standard for an investment could not be based on “psychological” factors such as popularity or renown—for it would allow the market to invent new standards as it went along. The parallel to the Internet bubble of the late 1990s is eerie, for making up standards is exactly what so-called investors did. Promoters claimed that stocks no longer needed earnings, and the cream of Wall Street—firms such as Morgan Stanley, Goldman Sachs, and Merrill Lynch—thought nothing of touting issues of companies that did not have a prayer of realizing profits. Beware of Capitalizing Hope When Graham and Dodd warned against “the capitalization of entirely conjectural future prospects,” they could have been referring to the fin- de-siècle saga of Internet Capital Group (ICG), which provided seed

investors did. Promoters claimed that stocks no longer needed earnings, and the cream of Wall Street—firms such as Morgan Stanley, Goldman Sachs, and Merrill Lynch—thought nothing of touting issues of companies that did not have a prayer of realizing profits. Beware of Capitalizing Hope When Graham and Dodd warned against “the capitalization of entirely conjectural future prospects,” they could have been referring to the fin- de-siècle saga of Internet Capital Group (ICG), which provided seed money to Web-based start-ups, most of which were trying to start online businesses. It put money in some 47 of these prospects, and its total investment was about $350 million. Then, in August 1999, ICG itself went public at a price of $6 a share. By year-end, amidst the frenzy for Internet stocks, it was trading at $170. At that price, it was valued at precisely $46 billion. Since the company had little of value besides its investments in the start-ups, the market was assuming that, on average, its 47 seedlings would provide an average return of better than 100 to 1. Talk about capi- talizing hope! Most investors do not realize a 100-for-1 return even once in their lifetimes. Alas, within a couple of years ICG’s shares had been reappraised by the market at 25 cents. Such vignettes, though useful as well as entertaining, are merely pro- scriptive; they tell us what not to do. It is only when, after considerable discussion, Graham and Dodd delineate the boundary line between investment and speculation that we get our first insight of what to do. “An investment,” we are told in a carefully chosen phrase, is an operation “that promises safety of principal and a satisfactory return.” The operative word here is “promises.” It does not assume an ironclad guarantee (some promises after all are broken, and some investments do lose money). But it assumes a high degree of certainty. No one would have said of an Internet Capital Group that it “promised” safety. But that is perhaps too e

and speculation that we get our first insight of what to do. “An investment,” we are told in a carefully chosen phrase, is an operation “that promises safety of principal and a satisfactory return.” The operative word here is “promises.” It does not assume an ironclad guarantee (some promises after all are broken, and some investments do lose money). But it assumes a high degree of certainty. No one would have said of an Internet Capital Group that it “promised” safety. But that is perhaps too easy a case. Let us look at a more established and, indeed, a more reasonably priced stock, that of Washington Mutual. Most of its shareholders at the end of 2006 presumably would have classified themselves as “investors.” The bank was large and geographically diverse; it had increased earnings nine straight years before falling off, only slightly, in 2006. Its stock over those 10 years had well more than doubled. True, “WaMu,” as it is known, had a large portfolio of mortgages, including subprime mortgages. Across the United States, such mortgages had been extended on an increasingly flimsy basis (that is, to borrowers of dubious credit), and defaults had started to tick up. But WaMu was held in high regard. It was said to have the most sophisticated tools for risk assessment, and its public statements were reassuring. The chair- man’s year-end letter applauded his company for being “positioned . . . to deliver stronger operating performance in 2007.” The casual stock picker, even the professional, would have had no trouble describing WaMu as an “investment.” Graham and Dodd, however, insisted that “safety must be based on study and on standards,” in particular, study of the published financials. For 2006, WaMu’s annual report indicated a balance of $20 billion of sub- prime loans, which (though WaMu didn’t make the connection) was equal to 80% of its total stockholder equity. What’s more, the subprime portfolio had doubled in four years. WaMu had made it a practice of get-

e professional, would have had no trouble describing WaMu as an “investment.” Graham and Dodd, however, insisted that “safety must be based on study and on standards,” in particular, study of the published financials. For 2006, WaMu’s annual report indicated a balance of $20 billion of sub- prime loans, which (though WaMu didn’t make the connection) was equal to 80% of its total stockholder equity. What’s more, the subprime portfolio had doubled in four years. WaMu had made it a practice of get- ting such loans off its balance sheet by securitizing them and selling them to investors, but, as it noted, if delinquency rates were to rise, investors might have less appetite for subprime loans and WaMu could wind up stuck with them. And delinquency rates were rising. Subprime loans classified as “nonperforming” had jumped by 50% in the past year and had tripled in four years. The risk of nonpayment was especially acute because WaMu had issued many loans above the traditional limit of 80% of home value—meaning that if the real estate market were to weaken, some customers would owe more than their homes were worth. WaMu had a much larger portfolio, about $100 billion, of traditional mortgages (those rated higher than subprime). But even many of these loans were not truly “traditional.” On 60% of the mortgages in its total portfolio, the interest rate was due to adjust within one year, meaning that its customers could face sharply higher—and potentially unafford- able—rates. WaMu disclosed that such folks had been spared the possi- bility of foreclosure by the steady rise in home prices. This was a rather powerful admission, especially as, the bank observed, “appreciation lev- els experienced during the past five years may not continue.” In fact, the real estate slump was becoming national news. WaMu had bet the ranch on a rising market and now the market was tanking. Parsing such disclosures may seem like a lot of effort (WaMu’s report is 194 pages), and indeed it does e

isclosed that such folks had been spared the possi- bility of foreclosure by the steady rise in home prices. This was a rather powerful admission, especially as, the bank observed, “appreciation lev- els experienced during the past five years may not continue.” In fact, the real estate slump was becoming national news. WaMu had bet the ranch on a rising market and now the market was tanking. Parsing such disclosures may seem like a lot of effort (WaMu’s report is 194 pages), and indeed it does entail work. But no one who took the trouble to read WaMu’s annual report would have concluded that WaMu promised safety. The Graham and Dodd investor therefore would have been spared the pain when home prices fell and subprime losses sharply escalated. Such losses would soon prove catastrophic. Late in 2007 WaMu abandoned the subprime business and laid off thousands of employees. For the fourth quarter, it reported a loss of nearly $2 billion, and over the full year its shares suffered a 70% decline. Since (as WaMu discovered) market trends can quickly reverse, Graham and Dodd counseled readers to invest on a sounder foundation, that is, on the basis of a security’s intrinsic value. They never—surprise to say— define the term, but we readily grasp its meaning. “Intrinsic value” is the worth of an enterprise to one who owns it “for keeps.” Logically, it must be based on the cash flow that would go to a continuing owner over the long run, as distinct from a speculative assessment of its resale value. The underlying premise requires a tiny leap of faith. Occasionally, stocks and bonds trade for less than intrinsic value, thus the opportunity. But sooner or later—here is where faith comes into the picture—such securities should revert to intrinsic value (else why invest in them?). To summarize the core of Part I in plain English, Graham and Dodd told investors to look for securities at a hefty discount to what they are worth. A Range of Values The rub, then and now, is how to c

resale value. The underlying premise requires a tiny leap of faith. Occasionally, stocks and bonds trade for less than intrinsic value, thus the opportunity. But sooner or later—here is where faith comes into the picture—such securities should revert to intrinsic value (else why invest in them?). To summarize the core of Part I in plain English, Graham and Dodd told investors to look for securities at a hefty discount to what they are worth. A Range of Values The rub, then and now, is how to calculate that worth. I suspect the authors deliberately refrained from defining intrinsic value, lest they con- vey the misleading impression that the value of a security can be pre- cisely determined. Given the practical limits of people’s ability to forecast (an earnings report, a romance, the weather, or anything), the authors urge that investors think in terms of a range of values. Happily, this is quite satisfactory for the purposes of investors. To quote Graham and Dodd: “It is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his weight.” (p. 66) Precision is in any case unnecessary because the aim is to pay a good deal less than intrinsic value, so as to provide a margin of safety. Just as it would be tempting fate to cross a bridge while carrying the maximum allowable tonnage, buying a stock at full value would involve “a specula- tive component” (since one’s calculation of value could be off ). A somewhat similar cautionary note is that favorable odds will not endow the gambler with the element of safety required for investing. Graham and Dodd used the example of a mythical roulette wheel in which the odds had been reversed to 19 to 18 in favor of the customer. “If the player wagers all his money on a single number, the small odds in his favor are of slight importance,” the authors note. In fact, the investor would be ill advised to risk his all on a single spi

of value could be off ). A somewhat similar cautionary note is that favorable odds will not endow the gambler with the element of safety required for investing. Graham and Dodd used the example of a mythical roulette wheel in which the odds had been reversed to 19 to 18 in favor of the customer. “If the player wagers all his money on a single number, the small odds in his favor are of slight importance,” the authors note. In fact, the investor would be ill advised to risk his all on a single spin even if the odds were strongly in his favor. The Long-Term Capital Management hedge fund made just such a bet, or a series of bets, in 1998. Each of its trades had been mathemati- cally calculated (the fund had a pair of Nobel Prize winners in residence), and its previous experience suggested that on each of its trades the odds were in its favor. However, LTCM, which was highly leveraged, risked far more than it could afford to lose. And its various bets, though superficially unrelated, were linked thematically (each was a bet that the risk premiums on bonds would narrow). When one trade fell, they all did, and the legendary fund was wiped out. So we are back to the question of what will qualify as an investment. There is a well-traveled myth that Graham and Dodd exclusively relied on a company’s book value to determine a safe threshold. While intrinsic value measures the economic potential—what an owner might hope to get out of an asset—book value is an arithmetic computation of what has been invested into it.4 But book value alone cannot be determina- tive. If you invested an equal sum in, say, two auto companies, one run by Toyota and the other by General Motors, the book values would be equal, but their intrinsic or economic values would be very different. Gra- ham and Dodd did not fall into this error; they stated plainly that, in terms of forecasting the course of stock prices, book value was “almost worthless as a practical matter.” But Graham frequently found secu

hat has been invested into it.4 But book value alone cannot be determina- tive. If you invested an equal sum in, say, two auto companies, one run by Toyota and the other by General Motors, the book values would be equal, but their intrinsic or economic values would be very different. Gra- ham and Dodd did not fall into this error; they stated plainly that, in terms of forecasting the course of stock prices, book value was “almost worthless as a practical matter.” But Graham frequently found securities that, solely on the basis of their assets and after putting them to hard study, met the safety-of- principal test. In the 1930s, markets were so depressed that it was not uncommon for stocks to sell at less than the value of their cash on hand, even after subtracting their debt. (This was akin to buying a home for less than the amount of money in the bedroom safe and getting to keep the safe as well!) Such hypercheap investments are scarcer today due to the broader-based interest in the stock market and to the armies of investors, often armed with computer screens, perpetually looking for bargains. 4 Technically, book value equals the sum of what has been invested in a company, plus accumulated profits less the dividends it has paid. An alternate but mathematically equivalent definition is that book value is equal to the total assets minus the total liabilities. Bargain Hunting Nonetheless, they do exist. Individual stocks are often cheap when a whole industry or group of securities has been sold down indiscriminately. In the early 1980s, for instance, the savings and loan industry was depressed, and for good reason. Following the elimination of regulatory ceilings on interest rates, thrifts had been forced to pay higher rates for short-term deposits than they were receiving on long-term loans. Mutual savings banks (owned by their depositors) began to go public to attract more capital, and as they did so, their stocks fetched very low values. United Savings Bank of

urities has been sold down indiscriminately. In the early 1980s, for instance, the savings and loan industry was depressed, and for good reason. Following the elimination of regulatory ceilings on interest rates, thrifts had been forced to pay higher rates for short-term deposits than they were receiving on long-term loans. Mutual savings banks (owned by their depositors) began to go public to attract more capital, and as they did so, their stocks fetched very low values. United Savings Bank of Tacoma, for one, traded at only 35% of book value. Though many thrifts of the day were weak, Tacoma was profitable and well capitalized. “People didn’t understand them,” says one investor who did. “They had just converted [from mutual ownership], they were small, they were off people’s radar.” Within a year, the investor had quintupled his money. Another opportunity beckoned in 1997, after the contagious melt- down of Asian stock and currency markets. Once again, the selling was indiscriminate—it tarred good companies and bad alike. Graham and Dodd investors responded opportunistically, booking flights to Hong Kong, Singapore, and Kuala Lumpur. Greg Alexander, who manages money for Ruane Cunniff & Goldfarb, read the annual report of every Asian company he had heard of and determined that South Korea, which previously had discouraged foreign investment and was thus especially short on capital, offered the best bargains. He flew to Seoul and, though still in a jet-lagged stupor, realized he was in a Graham-and-Dodders’ heaven. Cheap stocks were hanging on the market like overripe fruit. Shinyoung Securities, a local brokerage firm that had stocked up on high-yielding South Korean government bonds when interest rates were at a peak, was trading at less than half of book value. Surprisingly, even as late as 2004, Daekyo Corp., an after-school tutoring company, was trading at only $20 a share, even though each share represented $22.66 in cash in addition to a slice of the ongoin

he was in a Graham-and-Dodders’ heaven. Cheap stocks were hanging on the market like overripe fruit. Shinyoung Securities, a local brokerage firm that had stocked up on high-yielding South Korean government bonds when interest rates were at a peak, was trading at less than half of book value. Surprisingly, even as late as 2004, Daekyo Corp., an after-school tutoring company, was trading at only $20 a share, even though each share represented $22.66 in cash in addition to a slice of the ongoing business. In Graham and Dodd terms, such stocks promised safety because they were selling for less than their tangible worth. Alexander bought a dozen South Korean stocks; each would rise manyfold within a relatively short time. The competition for such values is fiercer in the United States, but they can be found, especially, again, when some broader trend punishes an entire sector of the market. In 2001, for instance, energy stocks were cheap (as was the price of oil). Graham and Dodd would not have advised speculating on the price of oil—which is dependent on myriad uncertain factors from OPEC to the growth rate of China’s economy to the weather. But because the industry was depressed, drilling companies were selling for less than the value of their equipment. Ensco International was trading at less than $15 per share, while the replacement value of its rigs was esti- mated at $35. Patterson-UTI Energy owned some 350 rigs worth about $2.8 billion. Yet its stock was trading for only $1 billion. Investors were get- ting the assets at a huge discount. Though the subsequent oil price rise made these stocks home runs, the key point is that the investments weren’t dependent on the oil price. Graham and Dodd investors bought into these stocks with a substantial margin of safety. A more common sort of asset play involves peering through the cor- porate shell to the various subsidiaries: sometimes, the pieces add up to more than the whole. An interesting case was Xcel Energy in 2

y $1 billion. Investors were get- ting the assets at a huge discount. Though the subsequent oil price rise made these stocks home runs, the key point is that the investments weren’t dependent on the oil price. Graham and Dodd investors bought into these stocks with a substantial margin of safety. A more common sort of asset play involves peering through the cor- porate shell to the various subsidiaries: sometimes, the pieces add up to more than the whole. An interesting case was Xcel Energy in 2002. Xcel owned five subsidiaries, so analyzing the stock required some mathe- matical deconstruction (Graham had a natural affinity for such calcula- tions). Four of the subsidiaries were profitable utilities; the other was an alternative energy supplier that was overloaded with debt and appar- ently headed for bankruptcy. The parent was not responsible for the sub- sidiary’s debt. However, in the aftermath of the Enron collapse, utility holding companies were shunned by investors. “It was a strange time,” recalled a hedge fund manager. “People were selling first and examining second. The market was irrational.” Xcel’s bonds were trading at 56 cents on the dollar (thus, you could buy a $1,000 obligation of the parent for only $560). And the bonds paid an attractive coupon of 7%. The question was whether Xcel could pay the interest. The hedge fund investor discovered that Xcel had $1 billion of these bonds outstanding and that the book value of its healthy sub- sidiaries was $4 billion (these are the sort of endlessly useful figures that can be dug out of corporate disclosures). On paper, then, its assets were enough to redeem the bonds with plenty to spare. The hedge fund investor bought every bond he could find. When no more of the bonds were available, the investor began to look at Xcel’s stock, which was depressed for the same reason as its bonds. The stock wasn’t quite as safe (in a bankruptcy, bondholders get paid off first). Still, the investor’s calculations had con

on (these are the sort of endlessly useful figures that can be dug out of corporate disclosures). On paper, then, its assets were enough to redeem the bonds with plenty to spare. The hedge fund investor bought every bond he could find. When no more of the bonds were available, the investor began to look at Xcel’s stock, which was depressed for the same reason as its bonds. The stock wasn’t quite as safe (in a bankruptcy, bondholders get paid off first). Still, the investor’s calculations had convinced him that the parent company would not file for bankruptcy. And the profitable sub- sidiaries were earning $500 million, more than $1 a share. The stock was trading at $7, or less than seven times earnings. So the investor bought the stock too. The weak subsidiary did file for bankruptcy, but as expected this did not detract from the value of the parent. Within a year, the panic over such utilities subsided, and Wall Street reevaluated Xcel. The bonds went from $56 to $105. The stock also soared. The investor doubled his money on each of his Xcel trades. Neither had been a roll of the dice; rather, each was quantifiably demonstrable as a Graham and Dodd investment. “It was a safe, steady industry,” the investor agreed. “Not a lot of business-cycle risks. I think Ben Graham would have approved.” As intriguing as Xcel types of puzzles may be, most stocks will simply be valued on their earnings. In reality, the process isn’t “simple.” Valuing equities involves a calculation of what a company should be able to earn each year, going forward, as distinct from taking a snapshot of the assets it has at the moment. Graham and Dodd reluctantly endorsed this exer- cise—“reluctantly” because the future is never as certain as the present. Forecasting Flows To forecast earnings with any degree of confidence is extremely difficult. The best guide can only be what a company has earned in the past. But capitalism is dynamic. Graham and Dodd frowned on trying to estimate earnings for b

a company should be able to earn each year, going forward, as distinct from taking a snapshot of the assets it has at the moment. Graham and Dodd reluctantly endorsed this exer- cise—“reluctantly” because the future is never as certain as the present. Forecasting Flows To forecast earnings with any degree of confidence is extremely difficult. The best guide can only be what a company has earned in the past. But capitalism is dynamic. Graham and Dodd frowned on trying to estimate earnings for businesses of “inherently unstable character.” Due to the rapidity with which technology evolves, many high-tech companies are innately unstable or at least unpredictable. In the late 1990s, Yahoo! was vulnerable to the risk that somebody would invent a better search engine (somebody did: Google). McDonald’s doesn’t face that risk. Its business depends largely on its brand, whose strength is unlikely to change much from one year to the next. And no one is going to reinvent the hamburger. It should be noted, though, that even McDonald’s can- not stand still; it has recently introduced espresso on its menu, in part to fend off competitors such as Starbucks. Some present-day Graham-and-Dodders (perhaps because Buffett has had a well-publicized aversion to high tech) have a mistaken notion that all technology is impossible to analyze and is therefore off-limits. Such a wooden rule violates the Graham and Dodd precept that analysts make a fact-determinant, company-specific analysis. One example of a high-tech company that submits to a Graham type of analysis is Ama- zon.com. Though it does business exclusively on the Web, Amazon is essentially a retailer, and it may be evaluated in the same way as Wal- Mart, Sears, and so forth. The question, as always, is, does the business provide an adequate margin of safety at a given market price. For much of Amazon’s short life, the stock was wildly overpriced. But when the dot-com bubble burst, its securities collapsed. Buffett himself bough

ple of a high-tech company that submits to a Graham type of analysis is Ama- zon.com. Though it does business exclusively on the Web, Amazon is essentially a retailer, and it may be evaluated in the same way as Wal- Mart, Sears, and so forth. The question, as always, is, does the business provide an adequate margin of safety at a given market price. For much of Amazon’s short life, the stock was wildly overpriced. But when the dot-com bubble burst, its securities collapsed. Buffett himself bought Amazon’s deeply discounted bonds after the crash, when there was much fearful talk that Amazon was headed for bankruptcy. The bonds subsequently rose to par, and Buffett made a killing. Another example is Intel, now a relatively mature manufacturer whose chip volume varies with the performance of the economy much as General Motors’ did in earlier eras. Indeed, Intel has been around for far longer than GM had been when Graham and Dodd were writing this book. In estimating future earnings (for any sort of business), Security Analy- sis provides two vital rules. One, as noted, is that companies with stable earnings are easier to forecast and hence preferable. The world having become more changeable, this precept might be modestly updated, to wit: the more volatile a firm’s earnings, the more cautious one should be in estimating its future and the further back into its past one should look. Graham and Dodd suggested 10 years. The second point relates to the tendency of earnings to fluctuate, at least somewhat, in a cyclical pattern. Therefore, Graham and Dodd made a vital (and oft-overlooked) distinction. A firm’s average earnings can pro- vide a rough guide to the future; the earnings trend is far less reliable. Any baseball fan knows that just because a .250 hitter hits .300 for a week, it cannot be assumed that he will necessarily hit that well for the rest of the season. And even if he does, the odds are he will revert to form the next year. But investors get seduced by t

tuate, at least somewhat, in a cyclical pattern. Therefore, Graham and Dodd made a vital (and oft-overlooked) distinction. A firm’s average earnings can pro- vide a rough guide to the future; the earnings trend is far less reliable. Any baseball fan knows that just because a .250 hitter hits .300 for a week, it cannot be assumed that he will necessarily hit that well for the rest of the season. And even if he does, the odds are he will revert to form the next year. But investors get seduced by the trend; perhaps they want to be seduced, for as Graham and Dodd observed, “Trends carried far enough into the future will yield any desired result.” To understand the distinction between the average and the trend, let’s look at the earnings per share of Microsoft over the last half of the 1990s. (Each year is for the 12-month period ended in June.) 1995 $0.16 1996 $0.23 1997 $0.36 1998 $0.46 1999 $0.77 2000 $0.91 Although the average for the period is 48 cents, the more recent numbers are higher, and the upward trend is unmistakable. Projecting the trend into the future, a casual analyst at the turn of the century might have penciled in numbers like this: Give or take a few pennies, this is exactly what so-called analysts were doing. Early in 2000, the stock was trading above $50, based on the expectation that earnings would continue to soar. But 2000 was the peak of the cycle for ordering new computers. As new orders fell, Microsoft’s earnings plummeted. In 2001, it earned 72 cents. The next year, it earned only 50 cents, virtually equal to its average for the mid-1990s. The stock plunged into the low $20s. Microsoft, however, was not some Internet fly-by-night. Over 20 years, it has always been profitable, and aside from the 2001–2002 cyclical slump, its earnings have steadily increased. Investors arguably overreacted to the slump much as, in the past, they overreacted to favorable news. They became fearful that Google might invade Microsoft’s turf, though this concer

nts. The next year, it earned only 50 cents, virtually equal to its average for the mid-1990s. The stock plunged into the low $20s. Microsoft, however, was not some Internet fly-by-night. Over 20 years, it has always been profitable, and aside from the 2001–2002 cyclical slump, its earnings have steadily increased. Investors arguably overreacted to the slump much as, in the past, they overreacted to favorable news. They became fearful that Google might invade Microsoft’s turf, though this concern was highly speculative. Microsoft continued to dominate operating software (indeed, it has had a virtual monopoly in that busi- ness) and to generate a prodigious cash flow. Also, since it has little need for reinvestment, it is free to employ its cash as it chooses. (By contrast, an airline must continually reinvest in new planes.) In that sense, Microsoft is an inherently good business. By fiscal 2007, it was trading at a multiple of only 15 times earnings, well less than its intrinsic characteristics justified given the strength of the franchise. Once Wall Street reawakened to the fact, the stock quickly rose 50% from its low. This demonstrates the continuing pas de deux of price and value. At a high price, Microsoft was a sheer speculation; at a low one, a sound investment. The mention of cash flow points to an area in which Security Analysis is truly dated. In the 1930s, companies did not have to publish cash flow reports, and virtually none of them did. Today, detailed cash flow state- ments are required, and for serious investors they are indispensable. The income statement gives the company’s accounting profit; the cash flow statement reports what happened to its money. Companies that try to cook the books such as Enron or Waste Man- agement can always dress up the earnings statement, at least for a while. But they can’t manufacture cash. Thus, when the income statement and the cash flow statement start to diverge, it’s a signal that something is amiss. At Sunbeam

low state- ments are required, and for serious investors they are indispensable. The income statement gives the company’s accounting profit; the cash flow statement reports what happened to its money. Companies that try to cook the books such as Enron or Waste Man- agement can always dress up the earnings statement, at least for a while. But they can’t manufacture cash. Thus, when the income statement and the cash flow statement start to diverge, it’s a signal that something is amiss. At Sunbeam, the high-flying appliance company run by “Chain- saw” Al Dunlap, sales of blenders were reportedly (reported by the com- pany, that is) going through the roof, but the cash flow wasn’t. It turned out that Dunlap was engaged in a massive fraud. Though he sold the company, it collapsed soon after, and “Chainsaw” was sawed off by the SEC from ever again serving as an officer or director in a public company. Similarly, when Lucent’s stock was sky-high, it was not actually col- lecting cash for many of the phone systems it was delivering, in particu- lar to customers in developing countries. It was, in effect, loaning them out pending payment. Though these “sales” were booked into earnings, once again, the cash flow statement didn’t lie. This is a mischief that Graham would have discovered because an uncollected item goes on the balance sheet as a receivable, and Graham was a fiend for reading balance sheets. Graham and Dodd paid more attention to the balance sheet, which records a moment in financial time, than to earnings and cash flow statements, which depict the change over a previous quarter or year, because such information was either not avail- able or not very detailed. Even the requirement for quarterly earnings was new in 1940, and earnings statements did not come freighted, as they do today, with detailed footnotes and discussions of significant risks. Graham supplemented the published financials (though they were his primary source) with a highly eclectic mix of tr

in financial time, than to earnings and cash flow statements, which depict the change over a previous quarter or year, because such information was either not avail- able or not very detailed. Even the requirement for quarterly earnings was new in 1940, and earnings statements did not come freighted, as they do today, with detailed footnotes and discussions of significant risks. Graham supplemented the published financials (though they were his primary source) with a highly eclectic mix of trade and government publications. When researching a coal stock, he consulted reports of the U.S. Coal Commission; on autos, Cram’s Auto Service. For contemporary investors, in most cases, published financials are both exhaustive and reli- able. Also, today, industry data are more widely available. An investor in U.S. securities thus faces a challenge unimaginable to Graham and Dodd. Where the latter suffered a paucity of information, investors today confront a surfeit. Company financials are denser, and the information on the Internet is, of course, unlimited—a worrisome fact given its uneven quality. The challenge is to weed out what is irrele- vant, insignificant, or just plain wrong, or rather, to identify what in par- ticular is important. This would have meant identifying cash flow issues at Lucent or subprime exposure in the case of WaMu before the stocks ran into trouble. As a rule of thumb, investors should spend the bulk of their time on the disclosures of the security under study, and they should spend signif- icant time on the reports of competitors. The point is not just to memo- rize the numbers but to understand them; as we have seen, both the balance sheet and the statement of cash flow will throw significant light on the number that Wall Street pays the most attention to, the reported earnings. There cannot be an absolute recommendation regarding investors’ sources because people learn in different ways. Walter Schloss, a Graham employee and later a famed inve

tudy, and they should spend signif- icant time on the reports of competitors. The point is not just to memo- rize the numbers but to understand them; as we have seen, both the balance sheet and the statement of cash flow will throw significant light on the number that Wall Street pays the most attention to, the reported earnings. There cannot be an absolute recommendation regarding investors’ sources because people learn in different ways. Walter Schloss, a Graham employee and later a famed investor in his own right, and his son and associate Edwin shared a single telephone so that neither would spend too much time talking on it. (The Schlosses worked in an office that has been compared to a closet.) Like the Schlosses, many investors work best in teams. On the other hand, Buffett, who works in an unpretentious office in Omaha, is famously solitary. His partner, Charlie Munger, resides in Los Angeles, 1,500 miles west, and in a day-to-day sense, Buffett operates largely on his own. And while some investors rely strictly on the published financials, others do substantial legwork. Eddie Lampert, the hedge fund manager, visited dozens of outlets of auto-parts retailer AutoZone before he bought a controlling stake in it. This was Lampert’s way of getting into his comfort zone. Information at a Premium In general, the greater dispersion of public information today puts a pre- mium on information that is exclusive. The most likely source of exclu- sive information (apologies to Schloss) is the telephone. Some mutual funds employ former journalists to ferret out investing “scoops.” They call former employees for a candid appraisal of management; they talk to suppliers and competitors. One mutual fund discovered that a just- named CEO of a prominent financial company had confessed to an asso- ciate that he was nervous about taking the job because he couldn’t read financial statements. The fund, which had been looking at the stock, immediately lost interest. Though not eve

chloss) is the telephone. Some mutual funds employ former journalists to ferret out investing “scoops.” They call former employees for a candid appraisal of management; they talk to suppliers and competitors. One mutual fund discovered that a just- named CEO of a prominent financial company had confessed to an asso- ciate that he was nervous about taking the job because he couldn’t read financial statements. The fund, which had been looking at the stock, immediately lost interest. Though not everyone has the resources to hire a private sleuth, some research is eminently affordable. An enterprising stockbroker kept tabs on one of his stocks, Jones Soda, by chatting up baristas at Starbucks, one of the outlets where Jones was sold. When they told him that Starbucks was dropping the brand, he sold the stock pronto. Also, there is a certain kind of conviction that can be gleaned only from hearing management answer unscripted questions. Be fore- warned, though; some executives will lie. Graham was particularly mistrustful of executives (he did not like to visit managements for this reason). He and Dodd warned that “objective tests of managerial ability are few.” Just as it is difficult to apportion proper credit to a winning coach, it is hard to say how much of a com- pany’s success is attributable to the executives. Investors often ascribe to managerial prowess what could be the residue of favorable conditions (or simply of good luck). Coca-Cola’s earnings were rising sharply in the early and mid-1990s, and the company’s aggressively promotional CEO, Roberto Goizueta, was feted on the cover of Fortune. Goizueta was tal- ented, but his talent was fully reflected in Coca-Cola’s earnings, and the earnings were reflected in the price of the stock. Investors, however, went a further step, pushing the stock to a lofty 45 times earnings due to their faith in management to increase earnings. Graham and Dodd referred to this as “double-counting”—that is, investors buy the stoc

n the early and mid-1990s, and the company’s aggressively promotional CEO, Roberto Goizueta, was feted on the cover of Fortune. Goizueta was tal- ented, but his talent was fully reflected in Coca-Cola’s earnings, and the earnings were reflected in the price of the stock. Investors, however, went a further step, pushing the stock to a lofty 45 times earnings due to their faith in management to increase earnings. Graham and Dodd referred to this as “double-counting”—that is, investors buy the stock on the basis of their faith in management and then, seeing that the stock has risen, take it as additional proof of management’s powers and bid the stock up further. In 1997, an analyst at Oppenheimer was so smitten by Goizueta, who died later that year, that he wrote that Coca-Cola had “absolute control over near-term results.”5 Such faith was misplaced on three accounts. First, Goizueta’s talent was already factored into the stock. Second, the notion that manage- ment had “absolute control” was a myth, as was demonstrated when growth tapered off. Third, to the extent it did have control, it was by “managing” Coca-Cola’s earnings, with the aid of dubious accounting contrivances. For instance, Coca-Cola made a practice of selling stakes in bottling plants and booking the gains into operating earnings to make its numbers. The suggestion that Goizueta was a magically talented guru was a warning signal. Rather than prove that Goizueta had the power to levitate earnings in the future, it raised questions about the quality of 5 Roger Lowenstein, Origins of the Crash: The Great Bubble and Its Undoing (New York: Penguin Press, 2004), p. 70. the earnings he had achieved in the past. As reality caught up with Coca-Cola, the stock went into a decadelong funk. Such examples should demonstrate that investing is hardly less risky today than in Graham and Dodd’s era, nor is the human spirit less vul- nerable to temptation and error. The complexity of our markets has fur- ther enhanced

raised questions about the quality of 5 Roger Lowenstein, Origins of the Crash: The Great Bubble and Its Undoing (New York: Penguin Press, 2004), p. 70. the earnings he had achieved in the past. As reality caught up with Coca-Cola, the stock went into a decadelong funk. Such examples should demonstrate that investing is hardly less risky today than in Graham and Dodd’s era, nor is the human spirit less vul- nerable to temptation and error. The complexity of our markets has fur- ther enhanced the need for an investing guide that is straightforward, logical, detailed, and, most especially, prudent. This and no more was the authors’ brief. Herewith Part I—a primer on intrinsic value, an explo- ration of investment as distinct from speculation, and an introduction to Graham and Dodd’s approach, their philosophy, their stratagems and guidance, and their tools. Chapter 1 THE SCOPE AND LIMITATIONS OF SECURITY ANALYSIS. THE CONCEPT OF INTRINSIC VALUE ANALYSIS CONNOTES the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and sound logic. It is part of the scientific method. But in applying analysis to the field of securities we encounter the serious obstacle that investment is by nature not an exact science. The same is true, however, of law and medicine, for here also both individual skill (art) and chance are impor- tant factors in determining success or failure. Nevertheless, in these pro- fessions analysis is not only useful but indispensable, so that the same should probably be true in the field of investment and possibly in that of speculation. In the last three decades the prestige of security analysis in Wall Street has experienced both a brilliant rise and an ignominious fall—a history related but by no means parallel to the course of stock prices. The advance of security analysis proceeded uninterruptedly until about 1927, cover- ing a long period in which increasing attention was paid on all

not only useful but indispensable, so that the same should probably be true in the field of investment and possibly in that of speculation. In the last three decades the prestige of security analysis in Wall Street has experienced both a brilliant rise and an ignominious fall—a history related but by no means parallel to the course of stock prices. The advance of security analysis proceeded uninterruptedly until about 1927, cover- ing a long period in which increasing attention was paid on all sides to financial reports and statistical data. But the “new era” commencing in 1927 involved at bottom the abandonment of the analytical approach; and while emphasis was still seemingly placed on facts and figures, these were manipulated by a sort of pseudo-analysis to support the delusions of the period. The market collapse in October 1929 was no surprise to such ana- lysts as had kept their heads, but the extent of the business collapse which later developed, with its devastating effects on established earning power, again threw their calculations out of gear. Hence the ultimate result was that serious analysis suffered a double discrediting: the first—prior to the crash—due to the persistence of imaginary values, and the second—after the crash—due to the disappearance of real values. [61] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. The experiences of 1927–1933 were of so extraordinary a character that they scarcely provide a valid criterion for judging the usefulness of security analysis. As to the years since 1933, there is perhaps room for a difference of opinion. In the field of bonds and preferred stocks, we believe that sound principles of selection and rejection have justified themselves quite well. In the common-stock arena the partialities of the market have tended to confound the conservative viewpoint, and con- versely many issues appearing cheap under analysis have given a disap- pointing per

ly provide a valid criterion for judging the usefulness of security analysis. As to the years since 1933, there is perhaps room for a difference of opinion. In the field of bonds and preferred stocks, we believe that sound principles of selection and rejection have justified themselves quite well. In the common-stock arena the partialities of the market have tended to confound the conservative viewpoint, and con- versely many issues appearing cheap under analysis have given a disap- pointing performance. On the other hand, the analytical approach would have given strong grounds for believing representative stock prices to be too high in early 1937 and too low a year later. THREE FUNCTIONS OF ANALYSIS: 1. DESCRIPTIVE FUNCTION The functions of security analysis may be described under three head- ings: descriptive, selective, and critical. In its more obvious form, descrip- tive analysis consists of marshalling the important facts relating to an issue and presenting them in a coherent, readily intelligible manner. This function is adequately performed for the entire range of marketable cor- porate securities by the various manuals, the Standard Statistics and Fitch services, and others. A more penetrating type of description seeks to reveal the strong and weak points in the position of an issue, compare its exhibit with that of others of similar character, and appraise the factors which are likely to influence its future performance. Analysis of this kind is applicable to almost every corporate issue, and it may be regarded as an adjunct not only to investment but also to intelligent speculation in that it provides an organized factual basis for the application of judgment. 2. THE SELECTIVE FUNCTION OF SECURITY ANALYSIS In its selective function, security analysis goes further and expresses spe- cific judgments of its own. It seeks to determine whether a given issue should be bought, sold, retained, or exchanged for some other. What types of securities or situation

st every corporate issue, and it may be regarded as an adjunct not only to investment but also to intelligent speculation in that it provides an organized factual basis for the application of judgment. 2. THE SELECTIVE FUNCTION OF SECURITY ANALYSIS In its selective function, security analysis goes further and expresses spe- cific judgments of its own. It seeks to determine whether a given issue should be bought, sold, retained, or exchanged for some other. What types of securities or situations lend themselves best to this more posi- tive activity of the analyst, and to what handicaps or limitations is it sub- ject? It may be well to start with a group of examples of analytical judgments, which could later serve as a basis for a more general inquiry. Examples of Analytical Judgments. In 1928 the public was offered a large issue of 6% noncumulative preferred stock of St. Louis-San Fran- cisco Railway Company priced at 100. The record showed that in no year in the company’s history had earnings been equivalent to as much as 11/2 times the fixed charges and preferred dividends combined. The applica- tion of well-established standards of selection to the facts in this case would have led to the rejection of the issue as insufficiently protected. A contrasting example: In June 1932 it was possible to purchase 5% bonds of Owens-Illinois Glass Company, due 1939, at 70, yielding 11% to maturity. The company’s earnings were many times the interest requirements—not only on the average but even at that time of severe depression. The bond issue was amply covered by current assets alone, and it was followed by common and preferred stock with a very large aggregate market value, taking their lowest quotations. Here, analysis would have led to the recommendation of this issue as a strongly entrenched and attractively priced investment. Let us take an example from the field of common stocks. In 1922, prior to the boom in aviation securities, Wright Aeronautical Corpora- tion st

age but even at that time of severe depression. The bond issue was amply covered by current assets alone, and it was followed by common and preferred stock with a very large aggregate market value, taking their lowest quotations. Here, analysis would have led to the recommendation of this issue as a strongly entrenched and attractively priced investment. Let us take an example from the field of common stocks. In 1922, prior to the boom in aviation securities, Wright Aeronautical Corpora- tion stock was selling on the New York Stock Exchange at only $8, although it was paying a $1 dividend, had for some time been earning over $2 a share, and showed more than $8 per share in cash assets in the treasury. In this case analysis would readily have established that the intrinsic value of the issue was substantially above the market price. Again, consider the same issue in 1928 when it had advanced to $280 per share. It was then earning at the rate of $8 per share, as against $3.77 in 1927. The dividend rate was $2; the net-asset value was less than $50 per share. A study of this picture must have shown conclusively that the market price represented for the most part the capitalization of entirely conjectural future prospects—in other words, that the intrinsic value was far less than the market quotation. A third kind of analytical conclusion may be illustrated by a compar- ison of Interborough Rapid Transit Company First and Refunding 5s with the same company’s Collateral 7% Notes, when both issues were selling at the same price (say 62) in 1933. The 7% notes were clearly worth considerably more than the 5s. Each $1,000 note was secured by deposit of $1,736 face amount of 5s; the principal of the notes had matured; they were entitled either to be paid off in full or to a sale of the collateral for their benefit. The annual interest received on the collateral was equal to about $87 on each 7% note (which amount was actually being distributed to the note holders), so that

when both issues were selling at the same price (say 62) in 1933. The 7% notes were clearly worth considerably more than the 5s. Each $1,000 note was secured by deposit of $1,736 face amount of 5s; the principal of the notes had matured; they were entitled either to be paid off in full or to a sale of the collateral for their benefit. The annual interest received on the collateral was equal to about $87 on each 7% note (which amount was actually being distributed to the note holders), so that the current income on the 7s was considerably greater than that on the 5s. Whatever technicalities might be invoked to prevent the note holders from asserting their con- tractual rights promptly and completely, it was difficult to imagine conditions under which the 7s would not be intrinsically worth consid- erably more than the 5s. A more recent comparison of the same general type could have been drawn between Paramount Pictures First Convertible Preferred selling at 113 in October 1936 and the common stock concurrently selling at 15 7/8. The preferred stock was convertible at the holders’ option into seven times as many shares of common, and it carried accumulated dividends of about $11 per share. Obviously the preferred was cheaper than the common, since it would have to receive very substantial dividends before the common received anything, and it could also share fully in any rise of the common by reason of the conversion privilege. If a common stockholder had accepted this analysis and exchanged his shares for one- seventh as many preferred, he would soon have realized a large gain both in dividends received and in principal value.1 Intrinsic Value vs. Price. From the foregoing examples it will be seen that the work of the securities analyst is not without concrete results of considerable practical value, and that it is applicable to a wide variety of situations. In all of these instances he appears to be concerned with the intrinsic value of the security and more parti

is and exchanged his shares for one- seventh as many preferred, he would soon have realized a large gain both in dividends received and in principal value.1 Intrinsic Value vs. Price. From the foregoing examples it will be seen that the work of the securities analyst is not without concrete results of considerable practical value, and that it is applicable to a wide variety of situations. In all of these instances he appears to be concerned with the intrinsic value of the security and more particularly with the discovery of discrepancies between the intrinsic value and the market price. We must recognize, however, that intrinsic value is an elusive con- cept. In general terms it is understood to be that value which is justi- fied by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses. But it is a great mistake to imagine that intrinsic value is as definite and as determinable as is the market price. Some time ago intrinsic value (in the case of a common stock) was thought to be about the same thing as “book value,” i.e., it was equal to the net assets of the business, fairly priced. This 1 For the sequels to the six examples just given, see Appendix Note 2, p. 734 on accompanying CD. view of intrinsic value was quite definite, but it proved almost worth- less as a practical matter because neither the average earnings nor the average market price evinced any tendency to be governed by the book value. Intrinsic Value and “Earning Power.” Hence this idea was super- seded by a newer view, viz., that the intrinsic value of a business was determined by its earning power. But the phrase “earning power” must imply a fairly confident expectation of certain future results. It is not suf- ficient to know what the past earnings have averaged, or even that they disclose a definite line of growth or decline. There must be plausible gro

e market price evinced any tendency to be governed by the book value. Intrinsic Value and “Earning Power.” Hence this idea was super- seded by a newer view, viz., that the intrinsic value of a business was determined by its earning power. But the phrase “earning power” must imply a fairly confident expectation of certain future results. It is not suf- ficient to know what the past earnings have averaged, or even that they disclose a definite line of growth or decline. There must be plausible grounds for believing that this average or this trend is a dependable guide to the future. Experience has shown only too forcibly that in many instances this is far from true. This means that the concept of “earning power,” expressed as a definite figure, and the derived concept of intrin- sic value, as something equally definite and ascertainable, cannot be safely accepted as a general premise of security analysis. Example: To make this reasoning clearer, let us consider a concrete and typical example. What would we mean by the intrinsic value of J. I. Case Company common, as analyzed, say, early in 1933? The market price was $30; the asset value per share was $176; no dividend was being paid; the average earnings for ten years had been $9.50 per share; the results for 1932 had shown a deficit of $17 per share. If we followed a cus- tomary method of appraisal, we might take the average earnings per share of common for ten years, multiply this average by ten, and arrive at an intrinsic value of $95. But let us examine the individual figures which make up this ten-year average. They are as shown in the table on page 66. The average of $9.50 is obviously nothing more than an arithmetical resultant from ten unrelated figures. It can hardly be urged that this aver- age is in any way representative of typical conditions in the past or rep- resentative of what may be expected in the future. Hence any figure of “real” or intrinsic value derived from this average must be characterized a

lue of $95. But let us examine the individual figures which make up this ten-year average. They are as shown in the table on page 66. The average of $9.50 is obviously nothing more than an arithmetical resultant from ten unrelated figures. It can hardly be urged that this aver- age is in any way representative of typical conditions in the past or rep- resentative of what may be expected in the future. Hence any figure of “real” or intrinsic value derived from this average must be characterized as equally accidental or artificial.2 2 Between 1933 and 1939 the earnings on Case common varied between a deficit of $14.66 and profits of $19.20 per share, averaging $3.18. The price ranged between 301/2 and 1913/4, closing in 1939 at 733/4. EARNINGS PER SHARE OF J.I. CASE COMMON 1932 $17.40(d) 1931 2.90(d) 1930 11.00 1929 20.40 1928 26.90 1927 26.00 1926 23.30 1925 15.30 1924 5.90(d) 1923 2.10(d) Average $9.50 (d) Deficit. The Role of Intrinsic Value in the Work of the Analyst. Let us try to formulate a statement of the role of intrinsic value in the work of the analyst which will reconcile the rather conflicting implications of our various examples. The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish either that the value is adequate—e.g., to pro- tect a bond or to justify a stock purchase—or else that the value is con- siderably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight. This statement of the case may be made clearer by a brief return to our examples. The rejection of St. Louis-San Francisco Preferred did not require an exact calculation of the intrinsic v

t price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight. This statement of the case may be made clearer by a brief return to our examples. The rejection of St. Louis-San Francisco Preferred did not require an exact calculation of the intrinsic value of this railroad system. It was enough to show, very simply from the earnings record, that the margin of value above the bondholders’ and preferred stockholders’ claims was too small to assure safety. Exactly the opposite was true for the Owens-Illinois Glass 5s. In this instance, also, it would undoubtedly have been difficult to arrive at a fair valuation of the business; but it was quite easy to decide that this value in any event was far in excess of the company’s debt. In the Wright Aeronautical example, the earlier situation presented a set of facts which demonstrated that the business was worth substantially more than $8 per share, or $1,800,000. In the later year, the facts were equally conclusive that the business did not have a reasonable value of $280 per share, or $70,000,000 in all. It would have been difficult for the analyst to determine whether Wright Aeronautical was actually worth $20 or $40 a share in 1922—or actually worth $50 or $80 in 1929. But fortu- nately it was not necessary to decide these points in order to conclude that the shares were attractive at $8 and unattractive, intrinsically, at $280. The J. I. Case example illustrates the far more typical common-stock situation, in which the analyst cannot reach a dependable conclusion as to the relation of intrinsic value to market price. But even here, if the price had been low or high enough, a conclusion might have been warranted. To express the uncertainty of the picture, we might say that it

it was not necessary to decide these points in order to conclude that the shares were attractive at $8 and unattractive, intrinsically, at $280. The J. I. Case example illustrates the far more typical common-stock situation, in which the analyst cannot reach a dependable conclusion as to the relation of intrinsic value to market price. But even here, if the price had been low or high enough, a conclusion might have been warranted. To express the uncertainty of the picture, we might say that it was diffi- cult to determine in early 1933 whether the intrinsic value of Case com- mon was nearer $30 or $130. Yet if the stock had been selling at as low as $10, the analyst would undoubtedly have been justified in declaring that it was worth more than the market price. Flexibility of the Concept of Intrinsic Value. This should indicate how flexible is the concept of intrinsic value as applied to security analy- sis. Our notion of the intrinsic value may be more or less distinct, depend- ing on the particular case. The degree of indistinctness may be expressed by a very hypothetical “range of approximate value,” which would grow wider as the uncertainty of the picture increased, e.g., $20 to $40 for Wright Aeronautical in 1922 as against $30 to $130 for Case in 1933. It would follow that even a very indefinite idea of the intrinsic value may still justify a conclusion if the current price falls far outside either the maximum or minimum appraisal. More Definite Concept in Special Cases. The Interborough Rapid Transit example permits a more precise line of reasoning than any of the others. Here a given market price for the 5% bonds results in a very def- inite valuation for the 7% notes. If it were certain that the collateral secur- ing the notes would be acquired for and distributed to the note holders, then the mathematical relationship—viz., $1,736 of value for the 7s against $1,000 of value for the 5s—would eventually be established at this ratio in the market. But becaus

s. The Interborough Rapid Transit example permits a more precise line of reasoning than any of the others. Here a given market price for the 5% bonds results in a very def- inite valuation for the 7% notes. If it were certain that the collateral secur- ing the notes would be acquired for and distributed to the note holders, then the mathematical relationship—viz., $1,736 of value for the 7s against $1,000 of value for the 5s—would eventually be established at this ratio in the market. But because of quasi-political complications in the picture, this normal procedure could not be expected with certainty. As a practical matter, therefore, it is not possible to say that the 7s are actu- ally worth 74% more than the 5s, but it may be said with assurance that the 7s are worth substantially more—which is a very useful conclusion to arrive at when both issues are selling at the same price. The Interborough issues are an example of a rather special group of situations in which analysis may reach more definite conclusions respect- ing intrinsic value than in the ordinary case. These situations may involve a liquidation or give rise to technical operations known as “arbitrage” or “hedging.” While, viewed in the abstract, they are probably the most sat- isfactory field for the analyst’s work, the fact that they are specialized in character and of infrequent occurrence makes them relatively unimpor- tant from the broader standpoint of investment theory and practice. Principal Obstacles to Success of the Analyst. a. Inadequate or Incorrect Data. Needless to say, the analyst cannot be right all the time. Furthermore, a conclusion may be logically right but work out badly in practice. The main obstacles to the success of the analyst’s work are three- fold, viz., (1) the inadequacy or incorrectness of the data, (2) the uncer- tainties of the future, and (3) the irrational behavior of the market. The first of these drawbacks, although serious, is the least important of the three.

to Success of the Analyst. a. Inadequate or Incorrect Data. Needless to say, the analyst cannot be right all the time. Furthermore, a conclusion may be logically right but work out badly in practice. The main obstacles to the success of the analyst’s work are three- fold, viz., (1) the inadequacy or incorrectness of the data, (2) the uncer- tainties of the future, and (3) the irrational behavior of the market. The first of these drawbacks, although serious, is the least important of the three. Deliberate falsification of the data is rare; most of the misrepresen- tation flows from the use of accounting artifices which it is the function of the capable analyst to detect. Concealment is more common than mis- statement. But the extent of such concealment has been greatly reduced as the result of regulations, first of the New York Stock Exchange and later of the S.E.C., requiring more complete disclosure and fuller explanation of accounting practices. Where information on an important point is still withheld, the analyst’s experience and skill should lead him to note this defect and make allowance therefor—if, indeed, he may not elicit the facts by proper inquiry and pressure. In some cases, no doubt, the conceal- ment will elude detection and give rise to an incorrect conclusion. b. Uncertainties of the Future. Of much greater moment is the element of future change. A conclusion warranted by the facts and by the appar- ent prospects may be vitiated by new developments. This raises the ques- tion of how far it is the function of security analysis to anticipate changed conditions. We shall defer consideration of this point until our discussion of various factors entering into the processes of analysis. It is manifest, however, that future changes are largely unpredictable, and that security analysis must ordinarily proceed on the assumption that the past record affords at least a rough guide to the future. The more questionable this assumption, the less valuable is th

ses the ques- tion of how far it is the function of security analysis to anticipate changed conditions. We shall defer consideration of this point until our discussion of various factors entering into the processes of analysis. It is manifest, however, that future changes are largely unpredictable, and that security analysis must ordinarily proceed on the assumption that the past record affords at least a rough guide to the future. The more questionable this assumption, the less valuable is the analysis. Hence this technique is more useful when applied to senior securities (which are protected against change) than to common stocks; more useful when applied to a business of inherently stable character than to one subject to wide variations; and, finally, more useful when carried on under fairly normal general condi- tions than in times of great uncertainty and radical change. c. The Irrational Behavior of the Market. The third handicap to secu- rity analysis is found in the market itself. In a sense the market and the future present the same kind of difficulties. Neither can be predicted or controlled by the analyst, yet his success is largely dependent upon them both. The major activities of the investment analyst may be thought to have little or no concern with market prices. His typical function is the selection of high-grade, fixed-income-bearing bonds, which upon inves- tigation he judges to be secure as to interest and principal. The purchaser is supposed to pay no attention to their subsequent market fluctuations, but to be interested solely in the question whether the bonds will con- tinue to be sound investments. In our opinion this traditional view of the investor’s attitude is inaccurate and somewhat hypocritical. Owners of securities, whatever their character, are interested in their market quota- tions. This fact is recognized by the emphasis always laid in investment practice upon marketability. If it is important that an issue be readily sal- able, i

ention to their subsequent market fluctuations, but to be interested solely in the question whether the bonds will con- tinue to be sound investments. In our opinion this traditional view of the investor’s attitude is inaccurate and somewhat hypocritical. Owners of securities, whatever their character, are interested in their market quota- tions. This fact is recognized by the emphasis always laid in investment practice upon marketability. If it is important that an issue be readily sal- able, it is still more important that it command a satisfactory price. While for obvious reasons the investor in high-grade bonds has a lesser concern with market fluctuations than has the speculator, they still have a strong psychological, if not financial, effect upon him. Even in this field, there- fore, the analyst must take into account whatever influences may adversely govern the market price, as well as those which bear upon the basic safety of the issue. In that portion of the analyst’s activities which relates to the discov- ery of undervalued, and possibly of overvalued securities, he is more directly concerned with market prices. For here the vindication of his judgment must be found largely in the ultimate market action of the issue. This field of analytical work may be said to rest upon a twofold assumption: first, that the market price is frequently out of line with the true value; and, second, that there is an inherent tendency for these disparities to correct themselves. As to the truth of the former statement, there can be very little doubt—even though Wall Street often speaks glibly of the “infallible judgment of the market” and asserts that “a stock is worth what you can sell it for—neither more nor less.” The Hazard of Tardy Adjustment of Price Value. The second assumption is equally true in theory, but its working out in practice is often most unsatisfactory. Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the sa

to the truth of the former statement, there can be very little doubt—even though Wall Street often speaks glibly of the “infallible judgment of the market” and asserts that “a stock is worth what you can sell it for—neither more nor less.” The Hazard of Tardy Adjustment of Price Value. The second assumption is equally true in theory, but its working out in practice is often most unsatisfactory. Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by overenthusiasm or artificial stimulants. The particular danger to the analyst is that, because of such delay, new determining fac- tors may supervene before the market price adjusts itself to the value as he found it. In other words, by the time the price finally does reflect the value, this value may have changed considerably and the facts and reason- ing on which his decision was based may no longer be applicable. The analyst must seek to guard himself against this danger as best he can: in part, by dealing with those situations preferably which are not sub- ject to sudden change; in part, by favoring securities in which the popu- lar interest is keen enough to promise a fairly swift response to value elements which he is the first to recognize; in part, by tempering his activ- ities to the general financial situation—laying more emphasis on the dis- covery of undervalued securities when business and market conditions are on a fairly even keel, and proceeding with greater caution in times of abnormal stress and uncertainty. The Relationship of Intrinsic Value to Market Price. The gen- eral question of the relation of intrinsic value to the market quotation may be made clearer by the following chart, which traces the various steps culminating in the market price. It will be evident from the chart that the influence of what we call analytical factors over the market price is both partial and indirect—partial, because it frequently compe

and proceeding with greater caution in times of abnormal stress and uncertainty. The Relationship of Intrinsic Value to Market Price. The gen- eral question of the relation of intrinsic value to the market quotation may be made clearer by the following chart, which traces the various steps culminating in the market price. It will be evident from the chart that the influence of what we call analytical factors over the market price is both partial and indirect—partial, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s senti- ments and decisions. In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion. RELATIONSHIP OF INTRINSIC VALUE FACTORS TO MARKET PRICE I. General market factors. II. Individual factors. A. Speculative B. Investment 1. Market factors 2. Future value factors 3. Intrinsic value factors a. Technical. b. Manipulative. c. Psychological. a. Management and reputation. b. Competitive conditions and prospects. c. Possible and probable changes in volume, price, and costs. a. Earnings. b. Dividends. c. Assets. d. Capital structure. e. Terms of the issue. f. Others. Attitude of public toward the issue. Bids and offers. Market price. ANALYSIS AND SPECULATION It may be thought that sound analysis should produce successful results in any type of situation, including the confessedly speculative, i.e., those subject to substantial uncertainty and risk. If the selection of speculative issues is based on expert study of the companies’ position, should not this approach give the pur

tructure. e. Terms of the issue. f. Others. Attitude of public toward the issue. Bids and offers. Market price. ANALYSIS AND SPECULATION It may be thought that sound analysis should produce successful results in any type of situation, including the confessedly speculative, i.e., those subject to substantial uncertainty and risk. If the selection of speculative issues is based on expert study of the companies’ position, should not this approach give the purchaser a considerable advantage? Admitting future events to be uncertain, could not the favorable and unfavorable developments be counted on to cancel out against each other, more or less, so that the initial advantage afforded by sound analysis will carry through into an eventual average profit? This is a plausible argument but a deceptive one; and its over-ready acceptance has done much to lead analysts astray. It is worth while, therefore, to detail several valid arguments against placing chief reliance upon analysis in speculative situations. In the first place, what may be called the mechanics of speculation involves serious handicaps to the speculator, which may outweigh the benefits conferred by analytical study. These disadvantages include the payment of commissions and interest charges, the so-called “turn of the market” (meaning the spread between the bid and asked price), and, most important of all, an inherent tendency for the average loss to exceed the average profit, unless a certain technique of trading is followed, which is opposed to the analytical approach. The second objection is that the underlying analytical factors in spec- ulative situations are subject to swift and sudden revision. The danger, already referred to, that the intrinsic value may change before the market price reflects that value, is therefore much more serious in speculative than in investment situations. A third difficulty arises from circumstances surrounding the unknown factors, whic

less a certain technique of trading is followed, which is opposed to the analytical approach. The second objection is that the underlying analytical factors in spec- ulative situations are subject to swift and sudden revision. The danger, already referred to, that the intrinsic value may change before the market price reflects that value, is therefore much more serious in speculative than in investment situations. A third difficulty arises from circumstances surrounding the unknown factors, which are necessarily left out of secu- rity analysis. Theoretically these unknown factors should have an equal chance of being favorable or unfavorable, and thus they should neutral- ize each other in the long run. For example, it is often easy to determine by comparative analysis that one company is selling much lower than another in the same field, in relation to earnings, although both appar- ently have similar prospects. But it may well be that the low price for the apparently attractive issue is due to certain important unfavorable factors which, though not disclosed, are known to those identified with the com- pany—and vice versa for the issue seemingly selling above its relative value. In speculative situations, those “on the inside” often have an advan- tage of this kind which nullifies the premise that good and bad changes in the picture should offset each other, and which loads the dice against the analyst working with some of the facts concealed from him.3 The Value of Analysis Diminishes as the Element of Chance Increases. The final objection is based on more abstract grounds, but, nevertheless, its practical importance is very great. Even if we grant that analysis can give the speculator a mathematical advantage, it does not assure him a profit. His ventures remain hazardous; in any individual case a loss may be taken; and after the operation is concluded, it is difficult to determine whether the analyst’s contribution has been a benefit or a 3 See Appendix Note 3,

Diminishes as the Element of Chance Increases. The final objection is based on more abstract grounds, but, nevertheless, its practical importance is very great. Even if we grant that analysis can give the speculator a mathematical advantage, it does not assure him a profit. His ventures remain hazardous; in any individual case a loss may be taken; and after the operation is concluded, it is difficult to determine whether the analyst’s contribution has been a benefit or a 3 See Appendix Note 3, p. 735 on accompanying CD, for the result of a study of the market behav- ior of “high price-earnings ratio stocks” as compared with “low price-earnings ratio stocks.” detriment. Hence the latter’s position in the speculative field is at best uncertain and somewhat lacking in professional dignity. It is as though the analyst and Dame Fortune were playing a duet on the speculative piano, with the fickle goddess calling all the tunes. By another and less imaginative simile, we might more convincingly show why analysis is inherently better suited to investment than to specu- lative situation. (In anticipation of a more detailed inquiry in a later chap- ter, we have assumed throughout this chapter that investment implies expected safety and speculation connotes acknowledged risk.) In Monte Carlo the odds are weighted 19 to 18 in favor of the proprietor of the roulette wheel, so that on the average he wins one dollar out of each 37 wagered by the public. This may suggest the odds against the untrained investor or spec- ulator. Let us assume that, through some equivalent of analysis, a roulette player is able to reverse the odds for a limited number of wagers, so that they are now 18 to 19 in his favor. If he distributes his wagers evenly over all the numbers, then whichever one turns up he is certain to win a moderate amount. This operation may be likened to an investment program based upon sound analysis and carried on under propitious general conditions. But if the player wag

the untrained investor or spec- ulator. Let us assume that, through some equivalent of analysis, a roulette player is able to reverse the odds for a limited number of wagers, so that they are now 18 to 19 in his favor. If he distributes his wagers evenly over all the numbers, then whichever one turns up he is certain to win a moderate amount. This operation may be likened to an investment program based upon sound analysis and carried on under propitious general conditions. But if the player wagers all his money on a single number, the small odds in his favor are of slight importance compared with the crucial ques- tion whether chance will elect the number he has chosen. His “analysis” will enable him to win a little more if he is lucky; it will be of no value when luck is against him. This, in slightly exaggerated form perhaps, describes the position of the analyst dealing with essentially speculative operations. Exactly the same mathematical advantage which practically assures good results in the investment field may prove entirely ineffective where luck is the overshadowing influence. It would seem prudent, therefore, to consider analysis as an adjunct or auxiliary rather than as a guide in speculation. It is only where chance plays a subordinate role that the analyst can properly speak in an author- itative voice and accept responsibility for the results of his judgments. 3. THE CRITICAL FUNCTION OF SECURITY ANALYSIS The principles of investment finance and the methods of corporation finance fall necessarily within the province of security analysis. Analyti- cal judgments are reached by applying standards to facts. The analyst is concerned, therefore, with the soundness and practicability of the stan- dards of selection. He is also interested to see that securities, especially bonds and preferred stocks, be issued with adequate protective provisions, and—more important still—that proper methods of enforcement of these covenants be part of accepted financial

of corporation finance fall necessarily within the province of security analysis. Analyti- cal judgments are reached by applying standards to facts. The analyst is concerned, therefore, with the soundness and practicability of the stan- dards of selection. He is also interested to see that securities, especially bonds and preferred stocks, be issued with adequate protective provisions, and—more important still—that proper methods of enforcement of these covenants be part of accepted financial practice. It is a matter of great moment to the analyst that the facts be fairly pre- sented, and this means that he must be highly critical of accounting meth- ods. Finally, he must concern himself with all corporate policies affecting the security owner, for the value of the issue which he analyzes may be largely dependent upon the acts of the management. In this category are included questions of capitalization set-up, of dividend and expansion policies, of managerial compensation, and even of continuing or liqui- dating an unprofitable business. On these matters of varied import, security analysis may be compe- tent to express critical judgments, looking to the avoidance of mistakes, to the correction of abuses, and to the better protection of those owning bonds or stocks. Chapter 2 FUNDAMENTAL ELEMENTS IN THE PROBLEM OF ANALYSIS. QUANTITATIVE AND QUALITATIVE FACTORS IN THE PREVIOUS chapter we referred to some of the concepts and materials of analysis from the standpoint of their bearing on what the analyst may hope to accomplish. Let us now imagine the analyst at work and ask what are the broad considerations which govern his approach to a particular problem, and also what should be his general attitude toward the various kinds of information with which he has to deal. FOUR FUNDAMENTAL ELEMENTS The object of security analysis is to answer, or assist in answering, certain questions of a very practical nature. Of these, perhaps the most custom- ary are the followi

their bearing on what the analyst may hope to accomplish. Let us now imagine the analyst at work and ask what are the broad considerations which govern his approach to a particular problem, and also what should be his general attitude toward the various kinds of information with which he has to deal. FOUR FUNDAMENTAL ELEMENTS The object of security analysis is to answer, or assist in answering, certain questions of a very practical nature. Of these, perhaps the most custom- ary are the following: What securities should be bought for a given pur- pose? Should issue S be bought, or sold, or retained? In all such questions, four major factors may be said to enter, either expressly or by implication. These are: 1. The security. 2. The price. 3. The time. 4. The person. More completely stated, the second typical question would run, Should security S be bought (or sold, or retained) at price P, at this time T, by individual I? Some discussion of the relative significance of these four factors is therefore pertinent, and we shall find it convenient to consider them in inverse order. [75] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. The Personal Element. The personal element enters to a greater or lesser extent into every security purchase. The aspect of chief importance is usually the financial position of the intending buyer. What might be an attractive speculation for a business man should under no circumstances be attempted by a trustee or a widow with limited income. Again, United States Liberty 31/2s should not have been purchased by those to whom their complete tax-exemption feature was of no benefit, when a considerably higher yield could be obtained from partially taxable governmental issues.1 Other personal characteristics that on occasion might properly influ- ence the individual’s choice of securities are his financial training and competence, his temperament, and his preferences. But howeve

es be attempted by a trustee or a widow with limited income. Again, United States Liberty 31/2s should not have been purchased by those to whom their complete tax-exemption feature was of no benefit, when a considerably higher yield could be obtained from partially taxable governmental issues.1 Other personal characteristics that on occasion might properly influ- ence the individual’s choice of securities are his financial training and competence, his temperament, and his preferences. But however vital these considerations may prove at times, they are not ordinarily deter- mining factors in analysis. Most of the conclusions derived from analy- sis can be stated in impersonal terms, as applicable to investors or speculators as a class. The Time. The time at which an issue is analyzed may affect the con- clusion in various ways. The company’s showing may be better, or its out- look may seem better, at one time than another, and these changing circumstances are bound to exert a varying influence on the analyst’s view- point toward the issue. Furthermore, securities are selected by the appli- cation of standards of quality and yield, and both of these—particularly the latter—will vary with financial conditions in general. A railroad bond of highest grade yielding 5% seemed attractive in June 1931 because the average return on this type of bond was 4.32%. But the same offering made six months later would have been quite unattractive, for in the meantime bond prices had fallen severely and the yield on this group had increased to 5.86%. Finally, nearly all security commitments are influenced to some extent by the current view of the financial and business outlook. In spec- ulative operations these considerations are of controlling importance; and while conservative investment is ordinarily supposed to disregard these elements, in times of stress and uncertainty they may not be ignored. Security analysis, as a study, must necessarily concern itself as much as possible with

rely and the yield on this group had increased to 5.86%. Finally, nearly all security commitments are influenced to some extent by the current view of the financial and business outlook. In spec- ulative operations these considerations are of controlling importance; and while conservative investment is ordinarily supposed to disregard these elements, in times of stress and uncertainty they may not be ignored. Security analysis, as a study, must necessarily concern itself as much as possible with principles and methods which are valid at all times—or, at least, under all ordinary conditions. It should be kept in mind, 1 In 1927 the yield on these 31/2 s was 3.39%, while U. S. Liberty 41/4 s, due about the same time, were yielding 4.08%. however, that the practical applications of analysis are made against a background largely colored by the changing times. The Price. The price is an integral part of every complete judgment relating to securities. In the selection of prime investment bonds, the price is usually a subordinate factor, not because it is a matter of indifference but because in actual practice the price is rarely unreasonably high. Hence almost entire emphasis is placed on the question whether the issue is ade- quately secured. But in a special case, such as the purchase of high-grade convertible bonds, the price may be a factor fully as important as the degree of security. This point is illustrated by the American Telephone and Telegraph Company Convertible 41/2 s, due 1939, which sold above 200 in 1929. The fact that principal (at par) and interest were safe beyond question did not prevent the issue from being an extremely risky pur- chase at that price—one which in fact was followed by the loss of over half its market value.2 In the field of common stocks, the necessity of taking price into account is more compelling, because the danger of paying the wrong price is almost as great as that of buying the wrong issue. We shall point out later that the n

s, due 1939, which sold above 200 in 1929. The fact that principal (at par) and interest were safe beyond question did not prevent the issue from being an extremely risky pur- chase at that price—one which in fact was followed by the loss of over half its market value.2 In the field of common stocks, the necessity of taking price into account is more compelling, because the danger of paying the wrong price is almost as great as that of buying the wrong issue. We shall point out later that the new-era theory of investment left price out of the reckoning, and that this omission was productive of most disastrous consequences. The Security: Character of the Enterprise and the Terms of the Commitment. The roles played by the security and its price in an investment decision may be set forth more clearly if we restate the prob- lem in somewhat different form. Instead of asking, (1) In what security? and (2) At what price? let us ask, (1) In what enterprise? and (2) On what terms is the commitment proposed? This gives us a more comprehensive and evenly balanced contrast between two basic elements in analysis. By the terms of the investment or speculation, we mean not only the price but also the provisions of the issue and its status or showing at the time. 2 Annual price ranges for American Telephone and Telegraph Company Convertible 41/2 s, due in 1939, were as follows: Year High Low 1929 227 118 1930 1933/8 116 1931 135 95 Example of Commitment on Unattractive Terms. An investment in the soundest type of enterprise may be made on unsound and unfa- vorable terms. Prior to 1929 the value of urban real estate had tended to grow steadily over a long period of years; hence it came to be regarded by many as the “safest” medium of investment. But the purchase of a pre- ferred stock in a New York City real estate development in 1929 might have involved terms of investment so thoroughly disadvantageous as to banish all elements of soundness from the proposition. One such stock

ent in the soundest type of enterprise may be made on unsound and unfa- vorable terms. Prior to 1929 the value of urban real estate had tended to grow steadily over a long period of years; hence it came to be regarded by many as the “safest” medium of investment. But the purchase of a pre- ferred stock in a New York City real estate development in 1929 might have involved terms of investment so thoroughly disadvantageous as to banish all elements of soundness from the proposition. One such stock offering could be summarized as follows3: 1. Provisions of the Issue. A preferred stock, ranking junior to a large first mortgage and without unqualified rights to dividend or principal payments. It ranked ahead of a common stock which represented no cash investment so that the common stockholders had nothing to lose and a great deal to gain, while the preferred stockholders had everything to lose and only a small share in the pos- sible gain. 2. Status of the Issue. A commitment in a new building, constructed at an exceedingly high level of costs, with no reserves or junior capital to fall back upon in case of trouble. 3. Price of the Issue. At par the dividend return was 6%, which was much less than the yield obtainable on real-estate second mortgages having many other advantages over this preferred stock.4 Example of a Commitment on Attractive Terms. We have only to examine electric power and light financing in recent years to find countless examples of unsound securities in a fundamentally attractive industry. By way of contrast let us cite the case of Brooklyn Union 3 The financing method described is that used by the separate owning corporations organ- ized and sponsored by the Fred F. French Company and affiliated enterprises, with the exception of some of the later Tudor City units in the financing of which interest-bearing notes, convertible par for par into preferred stock at the option of the company, were substi- tuted for the preferred stock in the financial pl

amentally attractive industry. By way of contrast let us cite the case of Brooklyn Union 3 The financing method described is that used by the separate owning corporations organ- ized and sponsored by the Fred F. French Company and affiliated enterprises, with the exception of some of the later Tudor City units in the financing of which interest-bearing notes, convertible par for par into preferred stock at the option of the company, were substi- tuted for the preferred stock in the financial plan. See The French Plan (10th ed., December 1928) published and distributed by the Fred F. French Investing Company, Inc. See also Moody’s Manual; “Banks and Finance,” 1933, pp. 1703–1707. 4 The real-estate enterprise from which this example is taken gave a bonus of common stock with the preferred shares. The common stock had no immediate value, but it did have a potential value which, under favorable conditions, might have made the purchase profitable. From the investment standpoint, however, the preferred stock of this enterprise was subject to all of the objections which we have detailed. Needless to say, purchasers of these issues fared very badly in nearly every case. Elevated Railroad First 5s, due 1950, which sold in 1932 at 60 to yield 9.85% to maturity. They are an obligation of the Brooklyn-Manhattan Transit System. The traction, or electric railway, industry has long been unfavorably regarded, chiefly because of automobile competition but also on account of regulation and fare-contract difficulties. Hence this secu- rity represents a comparatively unattractive type of enterprise. Yet the terms of the investment here might well make it a satisfactory commit- ment, as shown by the following: 1. Provisions of the Issue. By contract between the operating company and the City of New York, this was a first charge on the earnings of the combined subway and elevated lines of the system, both company and city owned, repre- senting an investment enormously greater than the

fare-contract difficulties. Hence this secu- rity represents a comparatively unattractive type of enterprise. Yet the terms of the investment here might well make it a satisfactory commit- ment, as shown by the following: 1. Provisions of the Issue. By contract between the operating company and the City of New York, this was a first charge on the earnings of the combined subway and elevated lines of the system, both company and city owned, repre- senting an investment enormously greater than the size of this issue. 2. Status of the Issue. Apart from the very exceptional specific protection just described, the bonds were obligations of a company with stable and apparently fully adequate earning power. 3. Price of Issue. It could be purchased to yield somewhat more than the Brooklyn-Manhattan Transit Corporation 6s, due 1968, which occupied a sub- ordinate position. (At the low price of 68 for the latter issue in 1932, its yield was 9% against 9.85% for the Brooklyn Union Elevated 5s.5) Relative Importance of the Terms of the Commitment and the Character of the Enterprise. Our distinction between the character of the enterprise and the terms of the commitment suggests a question as to which element is the more important. Is it better to invest in an attrac- tive enterprise on unattractive terms or in an unattractive enterprise on attractive terms? The popular view unhesitatingly prefers the former alternative, and in so doing it is instinctively, rather than logically, right. Over a long period, experience will undoubtedly show that less money has been lost by the great body of investors through paying too high a price for securities of the best regarded enterprises than by trying to secure a larger income or profit from commitments in enterprises of lower grade. 5 By 1936 the price of the Brooklyn Union Elevated 5s had advanced to 1151/2. After 1937 the earnings of the B.M.T. declined, and the price of this issue fell to 59. In the purchase of the system by New York

ver a long period, experience will undoubtedly show that less money has been lost by the great body of investors through paying too high a price for securities of the best regarded enterprises than by trying to secure a larger income or profit from commitments in enterprises of lower grade. 5 By 1936 the price of the Brooklyn Union Elevated 5s had advanced to 1151/2. After 1937 the earnings of the B.M.T. declined, and the price of this issue fell to 59. In the purchase of the system by New York City in 1940, however, the strong position of this issue was recog- nized, and its price recovered again to 92. From the standpoint of analysis, however, this empirical result does not dispose of the matter. It merely exemplifies a rule that is applicable to all kinds of merchandise, viz., that the untrained buyer fares best by pur- chasing goods of the highest reputation, even though he may pay a comparatively high price. But, needless to say, this is not a rule to guide the expert merchandise buyer, for he is expected to judge quality by examination and not solely by reputation, and at times he may even sacrifice certain definite degrees of quality if that which he obtains is ade- quate for his purpose and attractive in price. This distinction applies as well to the purchase of securities as to buying paints or watches. It results in two principles of quite opposite character, the one suitable for the untrained investor, the other useful only to the analyst. 1. Principle for the untrained security buyer: Do not put money in a low-grade enterprise on any terms. 2. Principle for the securities analyst: Nearly every issue might conceivably be cheap in one price range and dear in another. We have criticized the placing of exclusive emphasis on the choice of the enterprise on the ground that it often leads to paying too high a price for a good security. A second objection is that the enterprise itself may prove to be unwisely chosen. It is natural and proper to prefer a busin

ntrained security buyer: Do not put money in a low-grade enterprise on any terms. 2. Principle for the securities analyst: Nearly every issue might conceivably be cheap in one price range and dear in another. We have criticized the placing of exclusive emphasis on the choice of the enterprise on the ground that it often leads to paying too high a price for a good security. A second objection is that the enterprise itself may prove to be unwisely chosen. It is natural and proper to prefer a business which is large and well managed, has a good record, and is expected to show increasing earnings in the future. But these expectations, though seemingly well-founded, often fail to be realized. Many of the leading enterprises of yesterday are today far back in the ranks. Tomorrow is likely to tell a similar story. The most impressive illustration is afforded by the persistent decline in the relative investment position of the railroads as a class during the past two decades. The standing of an enterprise is in part a matter of fact and in part a matter of opinion. During recent years invest- ment opinion has proved extraordinarily volatile and undependable. In 1929 Westinghouse Electric and Manufacturing Company was quite uni- versally considered as enjoying an unusually favorable industrial position. Two years later the stock sold for much less than the net current assets alone, presumably indicating widespread doubt as to its ability to earn any profit in the future. Great Atlantic and Pacific Tea Company, viewed as lit- tle short of a miraculous enterprise in 1929, declined from 494 in that year to 36 in 1938. At the latter date the common sold for less than its cash assets, the preferred being amply covered by other current assets. These considerations do not gainsay the principle that untrained investors should confine themselves to the best regarded enterprises. It should be realized, however, that this preference is enjoined upon them because of the greater risk f

c and Pacific Tea Company, viewed as lit- tle short of a miraculous enterprise in 1929, declined from 494 in that year to 36 in 1938. At the latter date the common sold for less than its cash assets, the preferred being amply covered by other current assets. These considerations do not gainsay the principle that untrained investors should confine themselves to the best regarded enterprises. It should be realized, however, that this preference is enjoined upon them because of the greater risk for them in other directions, and not because the most popular issues are necessarily the safest. The analyst must pay respectful attention to the judgment of the market place and to the enter- prises which it strongly favors, but he must retain an independent and critical viewpoint. Nor should he hesitate to condemn the popular and espouse the unpopular when reasons sufficiently weighty and convinc- ing are at hand. QUALITATIVE AND QUANTITATIVE FACTORS IN ANALYSIS Analyzing a security involves an analysis of the business. Such a study could be carried to an unlimited degree of detail; hence practical judg- ment must be exercised to determine how far the process should go. The circumstances will naturally have a bearing on this point. A buyer of a $1,000 bond would not deem it worth his while to make as thorough an analysis of an issue as would a large insurance company considering the purchase of a $500,000 block. The latter’s study would still be less detailed than that made by the originating bankers. Or, from another angle, a less intensive analysis should be needed in selecting a high-grade bond yield- ing 3% than in trying to find a well-secured issue yielding 6% or an unquestioned bargain in the field of common stocks. Technique and Extent of Analysis Should Be Limited by Character and Purposes of the Commitment. The equipment of the analyst must include a sense of proportion in the use of his technique. In choosing and dealing with the materials of analysis he must c

originating bankers. Or, from another angle, a less intensive analysis should be needed in selecting a high-grade bond yield- ing 3% than in trying to find a well-secured issue yielding 6% or an unquestioned bargain in the field of common stocks. Technique and Extent of Analysis Should Be Limited by Character and Purposes of the Commitment. The equipment of the analyst must include a sense of proportion in the use of his technique. In choosing and dealing with the materials of analysis he must consider not only inherent importance and dependability but also the question of accessibility and convenience. He must not be misled by the availability of a mass of data—e.g., in the reports of the railroads to the Interstate Commerce Commission—into making elaborate studies of nonessentials. On the other hand, he must frequently resign himself to the lack of sig- nificant information because it can be secured only by expenditure of more effort than he can spare or the problem will justify. This would be true frequently of some of the elements involved in a complete “business analysis”—as, for example, the extent to which an enterprise is depend- ent upon patent protection or geographical advantages or favorable labor conditions which may not endure. Value of Data Varies with Type of Enterprise. Most important of all, the analyst must recognize that the value of a particular kind of data varies greatly with the type of enterprise which is being studied. The five- year record of gross or net earnings of a railroad or a large chain-store enterprise may afford, if not a conclusive, at least a reasonably sound basis for measuring the safety of the senior issues and the attractiveness of the common shares. But the same statistics supplied by one of the smaller oil- producing companies may well prove more deceptive than useful, since they are chiefly the resultant of two factors, viz., price received and pro- duction, both of which are likely to be radically different in the fut

s or net earnings of a railroad or a large chain-store enterprise may afford, if not a conclusive, at least a reasonably sound basis for measuring the safety of the senior issues and the attractiveness of the common shares. But the same statistics supplied by one of the smaller oil- producing companies may well prove more deceptive than useful, since they are chiefly the resultant of two factors, viz., price received and pro- duction, both of which are likely to be radically different in the future than in the past. Quantitative vs. Qualitative Elements in Analysis. It is conven- ient at times to classify the elements entering into an analysis under two headings: the quantitative and the qualitative. The former might be called the company’s statistical exhibit. Included in it would be all the useful items in the income account and balance sheet, together with such addi- tional specific data as may be provided with respect to production and unit prices, costs, capacity, unfilled orders, etc. These various items may be subclassified under the headings: (1) capitalization, (2) earnings and dividends, (3) assets and liabilities, and (4) operating statistics. The qualitative factors, on the other hand, deal with such matters as the nature of the business; the relative position of the individual company in the industry; its physical, geographical, and operating characteristics; the character of the management; and, finally, the outlook for the unit, for the industry, and for business in general. Questions of this sort are not dealt with ordinarily in the company’s reports. The analyst must look for their answers to miscellaneous sources of information of greatly varying dependability—including a large admixture of mere opinion. Broadly speaking, the quantitative factors lend themselves far better to thoroughgoing analysis than do the qualitative factors. The former are fewer in number, more easily obtainable, and much better suited to the forming of definite and dependabl

ss in general. Questions of this sort are not dealt with ordinarily in the company’s reports. The analyst must look for their answers to miscellaneous sources of information of greatly varying dependability—including a large admixture of mere opinion. Broadly speaking, the quantitative factors lend themselves far better to thoroughgoing analysis than do the qualitative factors. The former are fewer in number, more easily obtainable, and much better suited to the forming of definite and dependable conclusions. Furthermore the finan- cial results will themselves epitomize many of the qualitative elements, so that a detailed study of the latter may not add much of importance to the picture. The typical analysis of a security—as made, say, in a brokerage- house circular or in a report issued by a statistical service—will treat the qualitative factors in a superficial or summary fashion and devote most of its space to the figures. Qualitative Factors: Nature of the Business and Its Future Prospects. The qualitative factors upon which most stress is laid are the nature of the business and the character of the management. These ele- ments are exceedingly important, but they are also exceedingly difficult to deal with intelligently. Let us consider, first, the nature of the business, in which concept is included the general idea of its future prospects. Most people have fairly definite notions as to what is “a good business” and what is not. These views are based partly on the financial results, partly on knowledge of specific conditions in the industry, and partly also on surmise or bias. During most of the period of general prosperity between 1923 and 1929, quite a number of major industries were backward. These included cigars, coal, cotton goods, fertilizers, leather, lumber, meat packing, paper, shipping, street railways, sugar, woolen goods. The underlying cause was usually either the development of competitive products or services (e.g., coal, cotton goods, tractio

ncial results, partly on knowledge of specific conditions in the industry, and partly also on surmise or bias. During most of the period of general prosperity between 1923 and 1929, quite a number of major industries were backward. These included cigars, coal, cotton goods, fertilizers, leather, lumber, meat packing, paper, shipping, street railways, sugar, woolen goods. The underlying cause was usually either the development of competitive products or services (e.g., coal, cotton goods, tractions) or excessive production and demoralizing trade practices (e.g., paper, lumber, sugar). During the same period other industries were far more prosperous than the average. Among these were can manufacturers, chain stores, cigarette producers, motion pictures, public utilities. The chief cause of these superior showings might be found in unusual growth of demand (cigarettes, motion pictures) or in absence or control of competition (public utilities, can makers) or in the ability to win business from other agencies (chain stores). It is natural to assume that industries which have fared worse than the average are “unfavorably situated” and therefore to be avoided. The con- verse would be assumed, of course, for those with superior records. But this conclusion may often prove quite erroneous. Abnormally good or abnormally bad conditions do not last forever. This is true not only of general business but of particular industries as well. Corrective forces are often set in motion which tend to restore profits where they have disap- peared, or to reduce them where they are excessive in relation to capital. Industries especially favored by a developing demand may become demoralized through a still more rapid growth of supply. This has been true of radio, aviation, electric refrigeration, bus transportation, and silk hosiery. In 1922 department stores were very favorably regarded because of their excellent showing in the 1920–1921 depression; but they did not maintain this advanta

d to restore profits where they have disap- peared, or to reduce them where they are excessive in relation to capital. Industries especially favored by a developing demand may become demoralized through a still more rapid growth of supply. This has been true of radio, aviation, electric refrigeration, bus transportation, and silk hosiery. In 1922 department stores were very favorably regarded because of their excellent showing in the 1920–1921 depression; but they did not maintain this advantage in subsequent years. The public utilities were unpopular in the 1919 boom, because of high costs; they became specula- tive and investment favorites in 1927–1929; in 1933–1938 fear of inflation, rate regulation, and direct governmental competition again undermined the public’s confidence in them. In 1933, on the other hand, the cotton- goods industry—long depressed—forged ahead faster than most others. The Factor of Management. Our appreciation of the importance of selecting a “good industry” must be tempered by a realization that this is by no means so easy as it sounds. Somewhat the same difficulty is met with in endeavoring to select an unusually capable management. Objec- tive tests of managerial ability are few and far from scientific. In most cases the investor must rely upon a reputation which may or may not be deserved. The most convincing proof of capable management lies in a superior comparative record over a period of time. But this brings us back to the quantitative data. There is a strong tendency in the stock market to value the manage- ment factor twice in its calculations. Stock prices reflect the large earn- ings which the good management has produced, plus a substantial increment for “good management” considered separately. This amounts to “counting the same trick twice,” and it proves a frequent cause of over- valuation. The Trend of Future Earnings. In recent years increasing impor- tance has been laid upon the trend of earnings. Needless to say, a reco

. There is a strong tendency in the stock market to value the manage- ment factor twice in its calculations. Stock prices reflect the large earn- ings which the good management has produced, plus a substantial increment for “good management” considered separately. This amounts to “counting the same trick twice,” and it proves a frequent cause of over- valuation. The Trend of Future Earnings. In recent years increasing impor- tance has been laid upon the trend of earnings. Needless to say, a record of increasing profits is a favorable sign. Financial theory has gone further, however, and has sought to estimate future earnings by projecting the past trend into the future and then used this projection as a basis for valuing the business. Because figures are used in this process, people mistakenly believe that it is “mathematically sound.” But while a trend shown in the past is a fact, a “future trend” is only an assumption. The factors that we mentioned previously as militating against the maintenance of abnormal prosperity or depression are equally opposed to the indefinite continu- ance of an upward or downward trend. By the time the trend has become clearly noticeable, conditions may well be ripe for a change. It may be objected that as far as the future is concerned it is just as logical to expect a past trend to be maintained as to expect a past aver- age to be repeated. This is probably true, but it does not follow that the trend is more useful to analysis than the individual or average figures of the past. For security analysis does not assume that a past average will be repeated, but only that it supplies a rough index to what may be expected of the future. A trend, however, cannot be used as a rough index; it rep- resents a definite prediction of either better or poorer results, and it must be either right or wrong. This distinction, important in its bearing on the attitude of the ana- lyst, may be made clearer by the use of examples. Let us assume that in 1

idual or average figures of the past. For security analysis does not assume that a past average will be repeated, but only that it supplies a rough index to what may be expected of the future. A trend, however, cannot be used as a rough index; it rep- resents a definite prediction of either better or poorer results, and it must be either right or wrong. This distinction, important in its bearing on the attitude of the ana- lyst, may be made clearer by the use of examples. Let us assume that in 1929 a railroad showed its interest charges earned three times on the aver- age during the preceding seven years. The analyst would have ascribed great weight to this point as an indication that its bonds were sound. This is a judgment based on quantitative data and standards. But it does not imply a prediction that the earnings in the next seven years will average three times interest charges; it suggests only that earnings are not likely to fall so much under three times interest charges as to endanger the bonds. In nearly every actual case such a conclusion would have proved correct, despite the economic collapse that ensued. Now let us consider a similar judgment based primarily upon the trend. In 1929 nearly all public-utility systems showed a continued growth of earnings, but the fixed charges of many were so heavy—by reason of pyramidal capital structures—that they consumed nearly all the net income. Investors bought bonds of these systems freely on the theory that the small margin of safety was no drawback, since earnings were certain to continue to increase. They were thus making a clear-cut pre- diction as to the future, upon the correctness of which depended the jus- tification of their investment. If their prediction were wrong—as proved to be the case—they were bound to suffer serious loss. Trend Essentially a Qualitative Factor. In our discussion of the val- uation of common stocks, later in this book, we shall point out that the placing of preponderant emphasis

in of safety was no drawback, since earnings were certain to continue to increase. They were thus making a clear-cut pre- diction as to the future, upon the correctness of which depended the jus- tification of their investment. If their prediction were wrong—as proved to be the case—they were bound to suffer serious loss. Trend Essentially a Qualitative Factor. In our discussion of the val- uation of common stocks, later in this book, we shall point out that the placing of preponderant emphasis on the trend is likely to result in errors of overvaluation or undervaluation. This is true because no limit may be fixed on how far ahead the trend should be projected; and therefore the process of valuation, while seemingly mathematical, is in reality psychological and quite arbitrary. For this reason we consider the trend as a qualitative factor in its practical implications, even though it may be stated in quantitative terms. Qualitative Factors Resist Even Reasonably Accurate Appraisal. The trend is, in fact, a statement of future prospects in the form of an exact prediction. In similar fashion, conclusions as to the nature of the business and the abilities of the management have their chief significance in their bearing on the outlook. These qualitative factors are therefore all of the same general character. They all involve the same basic difficulty for the analyst, viz., that it is impossible to judge how far they may prop- erly reflect themselves in the price of a given security. In most cases, if they are recognized at all, they tend to be overemphasized. We see the same influence constantly at work in the general market. The recurrent excesses of its advances and declines are due at bottom to the fact that, when values are determined chiefly by the outlook, the resultant judg- ments are not subject to any mathematical controls and are almost inevitably carried to extremes. Analysis is concerned primarily with values which are supported by the facts and not with

urity. In most cases, if they are recognized at all, they tend to be overemphasized. We see the same influence constantly at work in the general market. The recurrent excesses of its advances and declines are due at bottom to the fact that, when values are determined chiefly by the outlook, the resultant judg- ments are not subject to any mathematical controls and are almost inevitably carried to extremes. Analysis is concerned primarily with values which are supported by the facts and not with those which depend largely upon expectations. In this respect the analyst’s approach is diametrically opposed to that of the speculator, meaning thereby one whose success turns upon his ability to forecast or to guess future developments. Needless to say, the analyst must take possible future changes into account, but his primary aim is not so much to profit from them as to guard against them. Broadly speaking, he views the business future as a hazard which his conclusions must encounter rather than as the source of his vindication. Inherent Stability a Major Qualitative Factor. It follows that the qualitative factor in which the analyst should properly be most interested is that of inherent stability. For stability means resistance to change and hence greater dependability for the results shown in the past. Stability, like the trend, may be expressed in quantitative terms—as, for example, by stating that the earnings of General Baking Company during 1923–1932 were never less than ten times 1932 interest charges or that the operating profits of Woolworth between 1924 and 1933 varied only between $2.12 and $3.66 per share of common. But in our opinion sta- bility is really a qualitative trait, because it derives in the first instance from the character of the business and not from its statistical record. A stable record suggests that the business is inherently stable, but this sug- gestion may be rebutted by other considerations. Examples: This point may be brought out by a

times 1932 interest charges or that the operating profits of Woolworth between 1924 and 1933 varied only between $2.12 and $3.66 per share of common. But in our opinion sta- bility is really a qualitative trait, because it derives in the first instance from the character of the business and not from its statistical record. A stable record suggests that the business is inherently stable, but this sug- gestion may be rebutted by other considerations. Examples: This point may be brought out by a comparison of two pre- ferred-stock issues as of early 1932, viz., those of Studebaker (motors) and of First National (grocery) Stores, both of which were selling above par. The two exhibits were similar, in that both disclosed a continuously satis- factory margin above preferred-dividend requirements. The Studebaker figures were more impressive, however, as the following table will indicate: NUMBER OF TIMES PREFERRED DIVIDEND WAS COVERED First National Stores Studebaker Period Times covered Calendar year Times covered Calendar year, 1922 4.0 1922 27.3 Calendar year, 1923 5.1 1923 30.5 Calendar year, 1924 4.9 1924 23.4 Calendar year, 1925 5.7 1925 29.7 15 mos. ended Mar. 31, 1927 4.6 1926 24.8 Year ended Mar. 31, 1928 4.4 1927 23.0 Year ended Mar. 31, 1929 8.4 1928 27.3 Year ended Mar. 31, 1930 13.4 1929 23.3 Annual average 6.3 26.2 But the analyst must penetrate beyond the mere figures and consider the inherent character of the two businesses. The chain-store grocery trade contained within itself many elements of relative stability, such as stable demand, diversified locations, and rapid inventory turnover. A typ- ical large unit in this field, provided only it abstained from reckless expan- sion policies, was not likely to suffer tremendous fluctuations in its earnings. But the situation of the typical automobile manufacturer was quite different. Despite fair stability in the industry as a whole, the indi- vidual units were subject to extraordinary variations, due chief

ed within itself many elements of relative stability, such as stable demand, diversified locations, and rapid inventory turnover. A typ- ical large unit in this field, provided only it abstained from reckless expan- sion policies, was not likely to suffer tremendous fluctuations in its earnings. But the situation of the typical automobile manufacturer was quite different. Despite fair stability in the industry as a whole, the indi- vidual units were subject to extraordinary variations, due chiefly to the vagaries of popular preference. The stability of Studebaker’s earnings could not be held by any convincing logic to demonstrate that this com- pany enjoyed a special and permanent immunity from the vicissitudes to which most of its competitors had shown themselves subject. The sound- ness of Studebaker Preferred rested, therefore, largely upon a stable sta- tistical showing which was at variance with the general character of the industry, so far as its individual units were concerned. On the other hand, the satisfactory exhibit of First National Stores Preferred was in thorough accord with what was generally thought to be the inherent character of the business. The later consideration should have carried great weight with the analyst and should have made First National Stores Preferred appear intrinsically sounder as a fixed-value investment than Studebaker Preferred, despite the more impressive statistical showing of the automo- bile company.6 Summary. To sum up this discussion of qualitative and quantitative factors, we may express the dictum that the analyst’s conclusions must always rest upon the figures and upon established tests and standards. These figures alone are not sufficient; they may be completely vitiated by qualitative considerations of an opposite import. A security may make a satisfactory statistical showing, but doubt as to the future or distrust of the management may properly impel its rejection. Again, the analyst is likely to attach prime imp

ssion of qualitative and quantitative factors, we may express the dictum that the analyst’s conclusions must always rest upon the figures and upon established tests and standards. These figures alone are not sufficient; they may be completely vitiated by qualitative considerations of an opposite import. A security may make a satisfactory statistical showing, but doubt as to the future or distrust of the management may properly impel its rejection. Again, the analyst is likely to attach prime importance to the qualitative element of stability, because its presence means that conclusions based on past results are not so likely to be upset by unexpected developments. It is also true that he will be far more confident in his selection of an issue if he can buttress an adequate quantitative exhibit with unusually favorable qualitative factors. But whenever the commitment depends to a substantial degree upon these qualitative factors—whenever, that is, the price is considerably higher than the figures alone would justify—then the analytical basis of approval is lacking. In the mathematical phrase, a satisfactory statistical exhibit is a necessary though by no means a sufficient condition for a favor- able decision by the analyst. 6 First National Stores has since maintained its earning power with little change; the pre- ferred stock was redeemed in 1934 and subsequently. Studebaker’s earnings fell off sharply after 1930; a receiver was appointed in 1933; and the preferred stock lost nearly all its value. Chapter 3 SOURCES OF INFORMATION IT IS IMPOSSIBLE to discuss or even to list all the sources of information which the analyst may find it profitable to consult at one time or another in his work. In this chapter we shall present a concise outline of the more important sources, together with some critical observations thereon; and we shall also endeavor to convey, by means of examples, an idea of the character and utility of the large variety of special avenues of

k lost nearly all its value. Chapter 3 SOURCES OF INFORMATION IT IS IMPOSSIBLE to discuss or even to list all the sources of information which the analyst may find it profitable to consult at one time or another in his work. In this chapter we shall present a concise outline of the more important sources, together with some critical observations thereon; and we shall also endeavor to convey, by means of examples, an idea of the character and utility of the large variety of special avenues of information. DATA ON THE TERMS OF THE ISSUE Let us assume that in the typical case the analyst seeks data regarding: (1) the terms of the specific issue, (2) the company, and (3) the industry. The provisions of the issue itself are summarized in the security manuals or statistical services. For more detailed information regarding a bond contract the analyst should consult the indenture (or deed of trust), a copy of which may be obtained or inspected at the office of the trustee. The terms of the respective stock issues of a company are set forth fully in the charter (or articles of incorporation), together with the by-laws. If the stock is listed, these documents are on file with the S.E.C. and also with the proper stock exchange. In the case of both bonds and stocks, the list- ing applications—which are readily obtainable—contain nearly all the significant provisions. Prospectuses of new issues also contain these provisions. DATA ON THE COMPANY Reports to Stockholders (Including Interim News Releases). Coming now to the company, the chief source of statistical data is, of course, the reports issued to the stockholders. These reports vary widely with respect to both frequency and completeness, as the following sum- mary will show: [89] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. All important railroads supply monthly figures down to net after rentals (net railway operating income). Most carry the results do

rim News Releases). Coming now to the company, the chief source of statistical data is, of course, the reports issued to the stockholders. These reports vary widely with respect to both frequency and completeness, as the following sum- mary will show: [89] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. All important railroads supply monthly figures down to net after rentals (net railway operating income). Most carry the results down to the balance for dividends (net income). Many publish carloading figures weekly, and a few have published gross earnings weekly. The pamphlet annual reports publish financial and operating figures in considerable detail.1 The ruling policy of public-utility companies varies between quarterly and monthly statements. Figures regularly include gross, net after taxes, and balance for dividends. Some companies publish only a moving twelve-month total—e.g., American Water Works and Electric Company (monthly), North American Company (quarterly). Many supply weekly or monthly figures of kilowatt-hours sold. Industrials. The practices followed by industrial companies are usually a matter of individual policy. In some industrial groups there is a tendency for most of the companies therein to follow the same course. 1. Monthly Statements. Most chain stores announce their monthly sales in dollars. Prior to 1931, copper producers regularly published their monthly output. General Motors publishes monthly sales in units. Between 1902 and 1933, United States Steel Corporation published its unfilled orders each month, but in 1933 it replaced this figure by monthly deliveries in tons. Baldwin Locomotive Works has published monthly fig- ures of shipments, new orders, and unfilled orders in dollars. The “Stan- dard Oil Group” of pipeline companies publish monthly statistics of operations in barrels. Monthly figures of net earnings are published by individual compa- nies from time to time, b

es monthly sales in units. Between 1902 and 1933, United States Steel Corporation published its unfilled orders each month, but in 1933 it replaced this figure by monthly deliveries in tons. Baldwin Locomotive Works has published monthly fig- ures of shipments, new orders, and unfilled orders in dollars. The “Stan- dard Oil Group” of pipeline companies publish monthly statistics of operations in barrels. Monthly figures of net earnings are published by individual compa- nies from time to time, but such practices have tended to be sporadic or temporary (e.g., Otis Steel, Mullins Manufacturing, Alaska Juneau).2 There is a tendency to inaugurate monthly statements during periods of improvement and to discontinue them with earnings decline. Sometimes figures by months are included in the quarterly statements—e.g., United States Steel Corporation prior to 1932. 1 Some railroads now send all stockholders a condensed annual statement but offer to send a more comprehensive report on request. 2 The Alaska Juneau figures—somewhat abbreviated—have continued from about 1925 to the end of 1939. In 1938 Caterpillar Tractor began to publish monthly a complete income account and a balance sheet. This is not really so extraordinary, for most companies supply these data to their directors. 2. Quarterly Statements. Publication of results quarterly is consid- ered as the standard procedure in nearly all lines of industry. The New York Stock Exchange has been urging quarterly reports with increasing vigor and has usually been able to make its demands effective in connec- tion with the listing of new or additional securities. Certain types of busi- nesses are considered—or consider themselves—exempt from this requirement, because of the seasonal nature of their results. These lines include sugar production, fertilizers, and agricultural implements. Seasonal fluctuations may be concealed by publishing quarterly a mov- ing twelve-months’ figure of earnings. This is done by Continental C

easing vigor and has usually been able to make its demands effective in connec- tion with the listing of new or additional securities. Certain types of busi- nesses are considered—or consider themselves—exempt from this requirement, because of the seasonal nature of their results. These lines include sugar production, fertilizers, and agricultural implements. Seasonal fluctuations may be concealed by publishing quarterly a mov- ing twelve-months’ figure of earnings. This is done by Continental Can Company.3 It is not easy to understand why all the large cigarette manufacturers and the majority of department stores should withhold their results for a full year. It is inconsistent also for a company such as Woolworth to pub- lish sales monthly but no interim statements of net profits. Many indi- vidual companies, belonging to practically every division of industry, still fail to publish quarterly reports. In nearly every case such interim figures are available to the management but are denied to the stockholders with- out adequate reason. The data given in the quarterly statements vary from a single figure of net earnings (sometimes without allowance for depreciation or federal taxes) to a fully detailed presentation of the income account and the bal- ance sheet, with president’s remarks appended. General Motors Corpo- ration is an outstanding example of the latter practice. 3. Semiannual Reports. These do not appear to be standard practice for any industrial group, except possibly the rubber companies. A number of individual enterprises report semiannually—e.g., American Locomotive and American Woolen. 4. Annual Reports. Every listed company publishes an annual report of some kind. The annual statement is generally more detailed than those cov- ering interim periods. It frequently contains remarks—not always illuminat- ing—by the president or the chairman of the board, relating to the past year’s results and to the future outlook. The distinguishing feature of the an

ibly the rubber companies. A number of individual enterprises report semiannually—e.g., American Locomotive and American Woolen. 4. Annual Reports. Every listed company publishes an annual report of some kind. The annual statement is generally more detailed than those cov- ering interim periods. It frequently contains remarks—not always illuminat- ing—by the president or the chairman of the board, relating to the past year’s results and to the future outlook. The distinguishing feature of the annual report, however, is that it invariably presents the balance-sheet position. 3 In March 1936 the New York Stock Exchange suggested that all listed companies follow this procedure instead of publishing the usual quarterly earnings. This suggestion aroused great opposition and was withdrawn the next month. The information given in the income account varies considerably in extent. Some reports give no more than the earnings available for dividends and the amount of dividends paid, e.g., United States Leather Company.4 The Income Account. In our opinion an annual income account is not reasonably complete unless it contains the following items: (1) sales, (2) net earnings (before the items following), (3) depreciation (and deple- tion), (4) interest charges, (5) nonoperating income (in detail), (6) income taxes, (7) dividends paid, (8) surplus adjustments (in detail). Prior to the passage of the Securities and Exchange Act it was unfor- tunately true that less than half of our industrial corporations supplied this very moderate quota of information. (By contrast, data relative to railroads and public utilities have long been uniformly adequate.) The S.E.C. regu- lations now require virtually all this information to be published in the original registration statement (Form 10) and the succeeding annual reports (Form 10-K). Quite a number of companies have requested the S.E.C. to keep their sales figures confidential, on the ground that publica- tion would be detrimental to t

rial corporations supplied this very moderate quota of information. (By contrast, data relative to railroads and public utilities have long been uniformly adequate.) The S.E.C. regu- lations now require virtually all this information to be published in the original registration statement (Form 10) and the succeeding annual reports (Form 10-K). Quite a number of companies have requested the S.E.C. to keep their sales figures confidential, on the ground that publica- tion would be detrimental to the enterprise. Most of these requests have been either withdrawn or denied.5 4 Pocohantas Fuel Company appears to have been the only enterprise that, although listed on the New York Stock Exchange, published an annual balance sheet only and provided no income statement of any kind. Its bonds were removed from listing in October 1934. The New York Curb dealings include a number of so called “unlisted issues”—dating from pre-S.E.C. days—which are not subject to requirements of the S.E.C. Among these are companies like American Book, which does not publish an income account, and New Jersey Zinc, which publishes an income account but no balance sheet. Companies whose issues are dealt in “over-the-counter,” and are thus not subject to S.E.C. regulation, generally publish annual reports only. They tend to be less detailed than the statements of listed companies, being especially prone to omit sales and depreciation figures. The great majority supply both a balance sheet and income account, but excep- tions are fairly numerous. An amusing example is Dun & Bradstreet Corporation. This purveyor of financial information does not reveal its own earnings to its stockholders. Other companies omitting income accounts are Bemis Brothers’ Bag, Joseph Dixon Crucible (since 1935), Glenwood Range, Goodman Manufacturing, Perfection Stove, Regal Shoe, etc. 5 A few companies, e.g., Celanese Corporation of America, succeeded in obtaining a confi- dential status for their sales figures in certain y

but excep- tions are fairly numerous. An amusing example is Dun & Bradstreet Corporation. This purveyor of financial information does not reveal its own earnings to its stockholders. Other companies omitting income accounts are Bemis Brothers’ Bag, Joseph Dixon Crucible (since 1935), Glenwood Range, Goodman Manufacturing, Perfection Stove, Regal Shoe, etc. 5 A few companies, e.g., Celanese Corporation of America, succeeded in obtaining a confi- dential status for their sales figures in certain years prior to 1938. In some, possibly most, of the cases later requests were denied, and sales figures were subsequently published. Our study of the 1938 reports of practically all the industrial companies listed on the New York Stock Exchange (648 enterprises) disclosed that only eight had failed to reveal their sales figures by the end of the following year. The S.E.C. advised that confidential treatment of the sales figure had been granted to one company (United Fruit) and that no The standard of reasonable completeness for annual reports, sug- gested above, by no means includes all the information which might be vouchsafed to shareholders. The reports of United States Steel Corpo- ration may be taken as a model of comprehensiveness. The data there supplied embrace, in addition to our standard requirements, the follow- ing items: 1. Production and sales in units. Rate of capacity operated. 2. Division of sales as between: Domestic and foreign. Intercompany and outsiders. 3. Details of operating expenses: Wages, wage rates, and number of employees. State and local taxes paid. Selling and general expense. Maintenance expenditures, amount and details. 4. Details of capital expenditures during the year. 5. Details of inventories. 6. Details of properties owned. 7. Number of stockholders. The Balance Sheet. The form of the balance sheet is better standard- ized than the income account, and it does not offer such frequent grounds for criticism. Formerly a widespread defect of

s of operating expenses: Wages, wage rates, and number of employees. State and local taxes paid. Selling and general expense. Maintenance expenditures, amount and details. 4. Details of capital expenditures during the year. 5. Details of inventories. 6. Details of properties owned. 7. Number of stockholders. The Balance Sheet. The form of the balance sheet is better standard- ized than the income account, and it does not offer such frequent grounds for criticism. Formerly a widespread defect of balance sheets was the fail- ure to separate intangible from tangible fixed assets, but this is now quite rare in the case of listed issues. (Among the companies that since 1935 have disclosed the amount of good-will formerly included in their prop- erty accounts are American Steel Foundries, American Can, Harbison decision had been reached with respect to the other seven (American Sumatra Tobacco, Bon Ami, Collins & Aikman, Mathieson Alkali, Mesta Machine, Sheaffer Pen, United Engineering and Foundry), as late as December 1939. Various issues, e.g., Trico Products Corporation, failed to register and were dropped from listing, presumably because of their unwillingness to supply sales figures. The withdrawal of Marlin Rockwell Corporation from listing in 1938 may be ascribed to the same reason. The stock exchanges have favored an amendment to the law requiring full disclosure in the case of over-the-counter issues, to remove what they regard as an unfair advantage. Many companies still provide their stockholders in their annual reports with much less information than they file with the S.E.C. The Standard Statistics Corporation Records Service, however, regularly publishes the S.E.C. figures as supplementary data. Walker Refractories, Loose-Wiles Biscuit, and United States Steel. In nearly all these cases the good-will was written off against surplus.) Criticism may properly be voiced against the practice of a great many companies in stating only the net figure for their pr

provide their stockholders in their annual reports with much less information than they file with the S.E.C. The Standard Statistics Corporation Records Service, however, regularly publishes the S.E.C. figures as supplementary data. Walker Refractories, Loose-Wiles Biscuit, and United States Steel. In nearly all these cases the good-will was written off against surplus.) Criticism may properly be voiced against the practice of a great many companies in stating only the net figure for their property account with- out showing the deduction for depreciation. Other shortcomings some- times met are the failure to state the market value of securities owned—e.g., Oppenheim Collins and Company in 1932; to identify “investments” as marketable or nonliquid—e.g., Pittsburgh Plate Glass Company; to value the inventory at lower of cost or market—e.g., Celanese Corporation of America in 1931; to state the nature of miscellaneous reserves—e.g., Hazel-Atlas Glass Company; and to state the amount of the company’s own securities held in the treasury—e.g., American Arch Company.6 Periodic Reports to Public Agencies. Railroads and most public util- ities are required to supply information to various federal and state com- missions. Since these data are generally more detailed than the statements to shareholders, they afford a useful supplementary source of material. A few practical illustrations of the value of these reports to commissions may be of interest. For many years prior to 1927 Consolidated Gas Company of New York (now Consolidated Edison Company of New York) was a “mystery stock” in Wall Street because it supplied very little information to its stockhold- ers. Great emphasis was laid by speculators upon the undisclosed value of its interest in its numerous subsidiary companies. However, complete operating and financial data relating to both the company and its sub- sidiaries were at all times available in the annual reports of the Public Ser- vice Commission of New York.

olidated Gas Company of New York (now Consolidated Edison Company of New York) was a “mystery stock” in Wall Street because it supplied very little information to its stockhold- ers. Great emphasis was laid by speculators upon the undisclosed value of its interest in its numerous subsidiary companies. However, complete operating and financial data relating to both the company and its sub- sidiaries were at all times available in the annual reports of the Public Ser- vice Commission of New York. The same situation pertained over a long period with respect to the Mackay Companies, controlling Postal Tele- graph and Cable Corporation, which reported no details to its stockhold- ers but considerable information to the Interstate Commerce Commission. A similar contrast exists between the unilluminating reports of Fifth Avenue Bus Securities Company to its shareholders and the complete 6 Several of these points were involved in a protracted dispute between the New York Stock Exchange and Allied Chemical and Dye Corporation, which was terminated to the satisfaction of the Stock Exchange in 1933. But the annual reports of the company to shareholders are still inadequate in that they fail to furnish figures for sales, operating expenses, or depreciation. information filed by its operating subsidiary with the New York Transit Commission. Finally, we may mention the “Standard Oil Group” of pipeline com- panies, which have been extremely chary of information to their stock- holders. But these companies come under the jurisdiction of the Interstate Commerce Commission and are required to file circumstantial annual reports at Washington. Examination of these reports several years ago would have disclosed striking facts about these companies’ holdings of cash and marketable securities. The voluminous data contained in the Survey of Current Business, published monthly by the United States Department of Commerce, have included sales figures for individual chain-store companies wh

ut these companies come under the jurisdiction of the Interstate Commerce Commission and are required to file circumstantial annual reports at Washington. Examination of these reports several years ago would have disclosed striking facts about these companies’ holdings of cash and marketable securities. The voluminous data contained in the Survey of Current Business, published monthly by the United States Department of Commerce, have included sales figures for individual chain-store companies which were not given general publicity—e.g., Waldorf System, J. R. Thompson, United Cigar Stores, Hartman Corporation, etc. Current statistical infor- mation regarding particular companies is often available in trade publi- cations or services. Examples: Cram’s Auto Service gives weekly figures of production for each motor-car company. Willett and Gray publish several estimates of sugar production by companies during the crop year. The Oil and Gas Journal often carries data regarding the production of important fields by companies. The Railway Age supplies detailed information regarding equipment orders placed. Dow, Jones and Company estimate weekly the rate of production of United States Steel. Listing Applications. In pre-S.E.C. days these were the most impor- tant nonperiodic sources of information. The reports required by the New York Stock Exchange, as a condition to admitting securities to its list, are much more detailed than those usually submitted to the stockholders. The additional data may include sales in dollars, output in units, amount of federal taxes, details of subsidiaries’ operations, basis and amount of depreciation and depletion charges. Valuable information may also be supplied regarding the properties owned, the terms of contracts, and the accounting methods followed. The analyst will find these listing applications exceedingly helpful. It is unfortunate that they appear at irregular intervals, and therefore can- not be counted upon as a steady source of

onal data may include sales in dollars, output in units, amount of federal taxes, details of subsidiaries’ operations, basis and amount of depreciation and depletion charges. Valuable information may also be supplied regarding the properties owned, the terms of contracts, and the accounting methods followed. The analyst will find these listing applications exceedingly helpful. It is unfortunate that they appear at irregular intervals, and therefore can- not be counted upon as a steady source of information. Registration Statements and Prospectuses. As a result of the S.E.C. legislation and regulations, the information available regarding all listed securities and all new securities (whether listed or not) is much more com- prehensive than heretofore. These data are contained in registration state- ments filed with the Commission in Washington and available for inspection or obtainable in copy upon payment of a fee. The more impor- tant information in the registration statement must be included in the prospectus supplied by the underwriters to intending purchasers of new issues. Similar registration statements must be filed with the S.E.C. under the terms of the Public Utility Act of 1935, which applies to holding com- panies, some of which might not come under the other legislation. Although it is true that the registration statements are undoubtedly too bulky to be read by the typical investor, and although it is doubtful if he is even careful to digest the material in the abbreviated prospectus (which still may cover more than 100 pages), there is no doubt that this material is proving of the greatest value to the analyst and through him to the investing public. Miscellaneous Official Reports. Information on individual compa- nies may be unearthed in various kinds of official documents. A few examples will give an idea of their miscellaneous character. The report of the United States Coal Commission in 1923 (finally printed as a Senate Document in 1925) gave fin

abbreviated prospectus (which still may cover more than 100 pages), there is no doubt that this material is proving of the greatest value to the analyst and through him to the investing public. Miscellaneous Official Reports. Information on individual compa- nies may be unearthed in various kinds of official documents. A few examples will give an idea of their miscellaneous character. The report of the United States Coal Commission in 1923 (finally printed as a Senate Document in 1925) gave financial and operating data on the anthracite companies which had not previously been published. Reports of the Federal Trade Commission have recently supplied a wealth of informa- tion heretofore not available concerning utility operating and holding companies, and natural-gas and pipe-line companies, unearthed in an elaborate investigation extending over a period of about nine years. In 1938 and 1939 the Commission published detailed reports on the farm implement and automobile manufacturers. In 1933 a comprehensive study of the pipe-line companies was published under the direction of the House Committee on Interstate and Foreign Commerce. Voluminous studies of the American Telephone and Telegraph System have emanated from the investigation carried on by the Federal Communications Com- mission pursuant to a Congressional resolution adopted in 1935.7 Some 7 These reports have been published respectively as Sen. Doc. 92, pts. 1–84D, 70th Congress, 1st Session (1928–1937); House Doc. 702, pts. 1 and 2, 75th Congress, 3d Session (1938); House Doc. 468, 76th Congress, 1st Session (1939); House Report No. 2192, pts. 1 and 2, 72d Congress, 2d Session (1933); House Doc. 340, 76th Congress, 1st Session (1939), together with supplementary reports mentioned on pp. 609–611 thereof; and Proposed Report, Telephone Investigation Pursuant to Public Resolution No. 8, 74th Congress (1938). of the opinions of the Interstate Commerce Commission have contained material of great value to the an

, pts. 1 and 2, 75th Congress, 3d Session (1938); House Doc. 468, 76th Congress, 1st Session (1939); House Report No. 2192, pts. 1 and 2, 72d Congress, 2d Session (1933); House Doc. 340, 76th Congress, 1st Session (1939), together with supplementary reports mentioned on pp. 609–611 thereof; and Proposed Report, Telephone Investigation Pursuant to Public Resolution No. 8, 74th Congress (1938). of the opinions of the Interstate Commerce Commission have contained material of great value to the analyst. Trustees under mortgages may have information required to be supplied by the terms of the indenture. These figures may be significant. For example, unpublished reports with the trustee of Mason City and Fort Dodge Railroad Company 4s, revealed that the interest on the bonds was not being earned, that payment thereof was being continued by Chicago Great Western Railroad Company as a matter of policy only, and hence that the bonds were in a far more vul- nerable position than was generally suspected. Statistical and Financial Publications. Most of the information required by the securities analyst in his daily work may be found conve- niently and adequately presented by the various statistical services. These include comprehensive manuals published annually with periodic supple- ments (Poor’s, Moody’s); descriptive stock and bond cards, and manuals frequently revised (Standard & Poor’s, Fitch); daily digests of news relat- ing to individual companies (Standard Corporation Records, Fitch).8 These services have made great progress during the past 20 years in the completeness and accuracy with which they present the facts. Neverthe- less they cannot be relied upon to give all the data available in the various original sources above described. Some of these sources escape them com- pletely, and in other cases they may neglect to reproduce items of impor- tance. It follows therefore that in any thoroughgoing study of an individual company, the analyst should consult the origi

Fitch).8 These services have made great progress during the past 20 years in the completeness and accuracy with which they present the facts. Neverthe- less they cannot be relied upon to give all the data available in the various original sources above described. Some of these sources escape them com- pletely, and in other cases they may neglect to reproduce items of impor- tance. It follows therefore that in any thoroughgoing study of an individual company, the analyst should consult the original reports and other docu- ments wherever possible, and not rely upon summaries or transcriptions. In the field of financial periodicals, special mention must be made of The Commercial and Financial Chronicle, a weekly publication with numerous statistical supplements. Its treatment of the financial and industrial field is unusually comprehensive; and its most noteworthy feature is perhaps its detailed reproduction of corporate reports and other documents. Requests for Direct Information from the Company. Published information may often be supplemented to an important extent by pri- vate inquiry of or by interview with the management. There is no reason why stockholders should not ask for information on specific points, and 8 During 1941 Poor’s Publishing Company and Standard Statistics Company merged into Standard & Poor’s Corp. The separate Poor’s services have been discontinued. in many cases part at least of the data asked for will be furnished. It must never be forgotten that a stockholder is an owner of the business and an employer of its officers. He is entitled not only to ask legitimate questions but also to have them answered, unless there is some persuasive reason to the contrary. Insufficient attention has been paid to this all-important point. The courts have generally held that a bona fide stockholder has the same right to full information as a partner in a private business. This right may not be exercised to the detriment of the corporation, but the burden

a stockholder is an owner of the business and an employer of its officers. He is entitled not only to ask legitimate questions but also to have them answered, unless there is some persuasive reason to the contrary. Insufficient attention has been paid to this all-important point. The courts have generally held that a bona fide stockholder has the same right to full information as a partner in a private business. This right may not be exercised to the detriment of the corporation, but the burden of proof rests upon the management to show an improper motive behind the request or that disclosure of the information would work an injury to the business. Compelling a company to supply information involves expensive legal proceedings and hence few shareholders are in a position to assert their rights to the limit. Experience shows, however, that vigorous demands for legitimate information are frequently acceded to even by the most recal- citrant managements. This is particularly true when the information asked for is no more than that which is regularly published by other com- panies in the same field. INFORMATION REGARDING THE INDUSTRY Statistical data respecting industries as a whole are available in abun- dance. The Survey of Current Business, published by the United States Department of Commerce, gives monthly figures on output, consump- tion, stocks, unfilled orders, etc., for many different lines. Annual data are contained in the Statistical Abstract, the World Almanac, and other compendiums. More detailed figures are available in the Biennial Census of Manufactures. Many important summary figures are published at frequent intervals in the various trade journals. In these publications will be found also a continuous and detailed picture of the current and prospective state of the industry. Thus it is usually possible for the analyst to acquire without undue difficulty a background of fairly complete knowledge of the history and problems of the industry with whi

and other compendiums. More detailed figures are available in the Biennial Census of Manufactures. Many important summary figures are published at frequent intervals in the various trade journals. In these publications will be found also a continuous and detailed picture of the current and prospective state of the industry. Thus it is usually possible for the analyst to acquire without undue difficulty a background of fairly complete knowledge of the history and problems of the industry with which he is dealing. In recent years the leading statistical agencies have developed addi- tional services containing basic surveys of the principal industrial groups, supplemented frequently by current data designed to keep the basic surveys up to date.9 9 For description of these services see Handbook of Commercial and Financial Services, Special Libraries Association, New York, 1939. Chapter 4 DISTINCTIONS BETWEEN INVESTMENT AND SPECULATION General Connotations of the Term “Investment.” Investment or investing, like “value” in the famous dictum of Justice Brandeis, is “a word of many meanings.” Of these, three will concern us here. The first mean- ing, or set of meanings, relates to putting or having money in a business. A man “invests” $1,000 in opening a grocery store; the “return on invest- ment” in the steel industry (including bonded debt and retained profits) averaged 2.40% during 1929–1938.1 The sense here is purely descriptive; it makes no distinctions and pronounces no judgments. Note, however, that it accepts rather than rejects the element of risk—the ordinary busi- ness investment is said to be made “at the risk of the business.” The second set of uses applies the term in a similar manner to the field of finance. In this sense all securities are “investments.” We have invest- ment dealers or brokers, investment companies2 or trusts, investment lists. Here, again, no real distinction is made between investment and other types of

istinctions and pronounces no judgments. Note, however, that it accepts rather than rejects the element of risk—the ordinary busi- ness investment is said to be made “at the risk of the business.” The second set of uses applies the term in a similar manner to the field of finance. In this sense all securities are “investments.” We have invest- ment dealers or brokers, investment companies2 or trusts, investment lists. Here, again, no real distinction is made between investment and other types of financial operations such as speculation. It is a convenient omnibus word, with perhaps an admixture of euphemism—i.e., a desire to lend a certain respectability to financial dealings of miscella- neous character. Alongside of these two indiscriminate uses of the term “investment” has always been a third and more limited connotation—that of invest- ment as opposed to speculation. That such a distinction is a useful one 1 Dollars behind Steel, pamphlet of American Iron and Steel Institute, New York, 1939. 2 Note that in October 1939 the S.E.C. listed under the title of “Investment Company” the offering of stock of “The Adventure Company, Ltd.,” a new enterprise promoted by “The Discovery Company, Ltd.” The fact that 1¢ par value stock was offered at $10 per share, although not really significant, has a certain appropriateness. [100] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. is generally taken for granted. It is commonly thought that investment, in this special sense, is good for everybody and at all times. Speculation, on the other hand, may be good or bad, depending on the conditions and the person who speculates. It should be essential, therefore, for any- one engaging in financial operations to know whether he is investing or speculating and, if the latter, to make sure that his speculation is a justi- fiable one. The difference between investment and speculation, when the two are thus opposed, is und

mmonly thought that investment, in this special sense, is good for everybody and at all times. Speculation, on the other hand, may be good or bad, depending on the conditions and the person who speculates. It should be essential, therefore, for any- one engaging in financial operations to know whether he is investing or speculating and, if the latter, to make sure that his speculation is a justi- fiable one. The difference between investment and speculation, when the two are thus opposed, is understood in a general way by nearly everyone; but when we try to formulate it precisely, we run into perplexing difficulties. In fact something can be said for the cynic’s definition that an investment is a successful speculation and a speculation is an unsuccessful invest- ment. It might be taken for granted that United States government secu- rities are an investment medium, while the common stock, say, of Radio Corporation of America—which between 1931 and 1935 had neither div- idends, earnings, nor tangible assets behind it—must certainly be a spec- ulation. Yet operations of a definitely speculative nature may be carried on in United States government bonds (e.g., by specialists who buy large blocks in anticipation of a quick rise); and on the other hand, in 1929 Radio Corporation of America common was widely regarded as an investment, to the extent in fact of being included in the portfolios of leading “Investment Trusts.” It is certainly desirable that some exact and acceptable definition of the two terms be arrived at, if only because we ought as far as possible to know what we are talking about. A more forceful reason, perhaps, might be the statement that the failure properly to distinguish between invest- ment and speculation was in large measure responsible for the market excesses of 1928–1929 and the calamities that ensued—as well as, we think, for much continuing confusion in the ideas and policies of would- be investors. On this account we shall give the question

efinition of the two terms be arrived at, if only because we ought as far as possible to know what we are talking about. A more forceful reason, perhaps, might be the statement that the failure properly to distinguish between invest- ment and speculation was in large measure responsible for the market excesses of 1928–1929 and the calamities that ensued—as well as, we think, for much continuing confusion in the ideas and policies of would- be investors. On this account we shall give the question a more thorough- going study than it usually receives. The best procedure might be first to examine critically the various meanings commonly intended in using the two expressions, and then to endeavor to crystallize therefrom a single sound and definite conception of investment. Distinctions Commonly Drawn between the Two Terms. The chief distinctions in common use may be listed in the following table: Investment Speculation 1. In bonds. In stocks. 2. Outright purchases. Purchases on margin. 3. For permanent holding. For a “quick turn.” 4. For income. For profit. 5. In safe securities. In risky issues. The first four distinctions have the advantage of being entirely defi- nite, and each of them also sets forth a characteristic which is applicable to the general run of investment or speculation. They are all open to the objection that in numerous individual cases the criterion suggested would not properly apply. 1. Bonds vs. Stocks. Taking up the first distinction, we find it corre- sponds to a common idea of investing as opposed to speculating, and that it also has the weight of at least one authority on investment who insists that only bonds belong in that category.3 The latter contention, however, runs counter to the well-nigh universal acceptance of high-grade pre- ferred stocks as media of investment. Furthermore, it is most dangerous to regard the bond form as possessing inherently the credentials of an investment, for a poorly secured bond may not only be thoroug

re- sponds to a common idea of investing as opposed to speculating, and that it also has the weight of at least one authority on investment who insists that only bonds belong in that category.3 The latter contention, however, runs counter to the well-nigh universal acceptance of high-grade pre- ferred stocks as media of investment. Furthermore, it is most dangerous to regard the bond form as possessing inherently the credentials of an investment, for a poorly secured bond may not only be thoroughly spec- ulative but the most unattractive form of speculation as well. It is logically unsound, furthermore, to deny investment rating to a strongly entrenched common stock merely because it possesses profit possibilities. Even the popular view recognizes this fact, since at all times certain especially sound common stocks have been rated as investment issues and their pur- chasers regarded as investors and not as speculators. 2 and 3. Outright vs. Marginal Purchases; Permanent vs. Temporary Holding. The second and third distinctions relate to the customary method and intention, rather than to the innate character of investment and speculative operations. It should be obvious that buying a stock outright does not ipso facto make the transaction an investment. 3 Lawrence Chamberlain at p. 8 of Investment and Speculation by Chamberlain and William W. Hay, New York, 1931. In truth the most speculative issues, e.g., “penny mining stocks,” must be purchased outright, since no one will lend money against them. Conversely, when the American public was urged during the war to buy Liberty Bonds with borrowed money, such purchases were nonetheless universally classed as investments. If strict logic were followed in finan- cial operations—a very improbable hypothesis!—the common practice would be reversed: the safer (investment) issues would be considered more suitable for marginal purchase, and the riskier (speculative) com- mitments would be paid for in full. Similarly the contra

lend money against them. Conversely, when the American public was urged during the war to buy Liberty Bonds with borrowed money, such purchases were nonetheless universally classed as investments. If strict logic were followed in finan- cial operations—a very improbable hypothesis!—the common practice would be reversed: the safer (investment) issues would be considered more suitable for marginal purchase, and the riskier (speculative) com- mitments would be paid for in full. Similarly the contrast between permanent and temporary holding is applicable only in a broad and inexact fashion. An authority on common stocks has defined an investment as any purchase made with the inten- tion of holding it for a year or longer; but this definition is admittedly suggested by its convenience rather than its penetration.4 The inexact- ness of this suggested rule is shown by the circumstance that short-term investment is a well-established practice. Long-term speculation is equally well established as a rueful fact (when the purchaser holds on hoping to make up a loss), and it is also carried on to some extent as an intentional undertaking. 4 and 5. Income vs. Profit; Safety vs. Risk. The fourth and fifth distinctions also belong together, and so joined they undoubtedly come closer than the others to both a rational and a popular understanding of the subject. Certainly, through many years prior to 1928, the typical investor had been interested above all in safety of principal and continu- ance of an adequate income. However, the doctrine that common stocks are the best long-term investments has resulted in a transfer of emphasis from current income to future income and hence inevitably to future enhancement of principal value. In its complete subordination of the income element to the desire for profit, and also in the prime reliance it places upon favorable developments expected in the future, the new-era style of investment—as exemplified in the general policy of the invest- me

ance of an adequate income. However, the doctrine that common stocks are the best long-term investments has resulted in a transfer of emphasis from current income to future income and hence inevitably to future enhancement of principal value. In its complete subordination of the income element to the desire for profit, and also in the prime reliance it places upon favorable developments expected in the future, the new-era style of investment—as exemplified in the general policy of the invest- ment trusts—is practically indistinguishable from speculation. In fact this so-called “investment” can be accurately defined as speculation in the common stocks of strongly situated companies. 4 Sloan, Laurence H., Everyman and His Common Stocks, pp. 8–9, 279 ff., New York, 1931. It would undoubtedly be a wholesome step to go back to the accepted idea of income as the central motive in investment, leaving the aim toward profit, or capital appreciation, as the typical characteristic of speculation. But it is doubtful whether the true inwardness of investment rests even in this distinction. Examining standard practices of the past, we find some instances in which current income was not the leading interest of a bona fide investment operation. This was regularly true, for example, of bank stocks, which until recent years were regarded as the exclusive province of the wealthy investor. These issues returned a smaller dividend yield than did high-grade bonds, but they were purchased on the expectation that the steady growth in earnings and surplus would result in special distri- butions and increased principal value. In other words, it was the earnings accruing to the stockholder’s credit, rather than those distributed in div- idends, which motivated his purchase. Yet it would not appear to be sound to call this attitude speculative, for we should then have to contend that only the bank stocks which paid out most of their earnings in dividends (and thus gave an adequate current r

expectation that the steady growth in earnings and surplus would result in special distri- butions and increased principal value. In other words, it was the earnings accruing to the stockholder’s credit, rather than those distributed in div- idends, which motivated his purchase. Yet it would not appear to be sound to call this attitude speculative, for we should then have to contend that only the bank stocks which paid out most of their earnings in dividends (and thus gave an adequate current return) could be regarded as invest- ments, while those following the conservative policy of building up their surplus would therefore have to be considered speculative. Such a conclu- sion is obviously paradoxical; and because of this fact it must be admitted that an investment in a common stock might conceivably be founded on its earning power, without reference to current dividend payments. Does this bring us back to the new-era theory of investment? Must we say that the purchase of low-yielding industrial shares in 1929 had the same right to be called investment as the purchase of low-yielding bank stocks in prewar days? The answer to this question should bring us to the end of our quest, but to deal with it properly we must turn our attention to the fifth and last distinction in our list—that between safety and risk. This distinction expresses the broadest concept of all those underlying the term investment, but its practical utility is handicapped by various shortcomings. If safety is to be judged by the result, we are virtually beg- ging the question, and come perilously close to the cynic’s definition of an investment as a successful speculation.5 Naturally the safety must be posited in advance, but here again there is room for much that is indefinite and 5 For a serious suggestion along these lines see Felix I. Shaffner, The Problem of Investment, pp. 18–19, New York, 1936. purely subjective. The race-track gambler, betting on a “sure thing,” is con- vinced that hi

y is to be judged by the result, we are virtually beg- ging the question, and come perilously close to the cynic’s definition of an investment as a successful speculation.5 Naturally the safety must be posited in advance, but here again there is room for much that is indefinite and 5 For a serious suggestion along these lines see Felix I. Shaffner, The Problem of Investment, pp. 18–19, New York, 1936. purely subjective. The race-track gambler, betting on a “sure thing,” is con- vinced that his commitment is safe. The 1929 “investor” in high-priced common stocks also considered himself safe in his reliance upon future growth to justify the figure he paid and more. Standards of Safety. The concept of safety can be really useful only if it is based on something more tangible than the psychology of the purchaser. The safety must be assured, or at least strongly indicated, by the applica- tion of definite and well-established standards. It was this point which dis- tinguished the bank-stock buyer of 1912 from the common-stock investor of 1929. The former purchased at price levels which he considered conser- vative in the light of experience; he was satisfied, from his knowledge of the institution’s resources and earning power, that he was getting his money’s worth in full. If a strong speculative market resulted in advancing the price to a level out of line with these standards of value, he sold his shares and waited for a reasonable price to return before reacquiring them. Had the same attitude been taken by the purchaser of common stocks in 1928–1929, the term investment would not have been the tragic mis- nomer that it was. But in proudly applying the designation “blue chips” to the high-priced issues chiefly favored, the public unconsciously revealed the gambling motive at the heart of its supposed investment selections. These differed from the old-time bank-stock purchases in the one vital respect that the buyer did not determine that they were worth the price pa

the same attitude been taken by the purchaser of common stocks in 1928–1929, the term investment would not have been the tragic mis- nomer that it was. But in proudly applying the designation “blue chips” to the high-priced issues chiefly favored, the public unconsciously revealed the gambling motive at the heart of its supposed investment selections. These differed from the old-time bank-stock purchases in the one vital respect that the buyer did not determine that they were worth the price paid by the application of firmly established standards of value. The market made up new standards as it went along, by accepting the current price—however high—as the sole measure of value. Any idea of safety based on this uncritical approach was clearly illusory and replete with danger. Carried to its logical extreme, it meant that no price could possibly be 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. A Proposed Definition of Investment. This comparison suggests that it is not enough to identify investment with expected safety; the expectation must be based on study and standards. At the same time, the investor need not necessarily be interested in current income; he may at times legitimately base his purchase on a return which is accumulating to his credit and realized by him after a longer or shorter wait. With these observations in mind, we suggest the following definition of investment as one in harmony with both the popular understanding of the term and the requirements of reasonable precision: An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative. Certain implications of this definition are worthy of further discus- sion. We speak of an investment operation rather than an issue or a pur- chase, for several reasons. It is unsound to think always of investment character as in

ith both the popular understanding of the term and the requirements of reasonable precision: An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative. Certain implications of this definition are worthy of further discus- sion. We speak of an investment operation rather than an issue or a pur- chase, for several reasons. It is unsound to think always of investment character as inhering in an issue per se. The price is frequently an essen- tial element, so that a stock (and even a bond) may have investment merit at one price level but not at another. Furthermore, an investment might be justified in a group of issues, which would not be sufficiently safe if made in any one of them singly. In other words, diversification might be necessary to reduce the risk involved in the separate issues to the mini- mum consonant with the requirements of investment. (This would be true, in general, of purchases of common stocks for investment.) In our view it is also proper to consider as investment operations cer- tain types of arbitrage and hedging commitments which involve the sale of one security against the purchase of another. In these operations the element of safety is provided by the combination of purchase and sale. This is an extension of the ordinary concept of investment, but one which appears to the writers to be entirely logical. The phrases thorough analysis, promises safety, and satisfactory return are all chargeable with indefiniteness, but the important point is that their meaning is clear enough to prevent serious misunderstanding. By thor- ough analysis we mean, of course, the study of the facts in the light of established standards of safety and value. An “analysis” that recom- mended investment in General Electric common at a price forty times its highest recorded earnings merely because of its excellent prospects would be clearly ruled out, as

romises safety, and satisfactory return are all chargeable with indefiniteness, but the important point is that their meaning is clear enough to prevent serious misunderstanding. By thor- ough analysis we mean, of course, the study of the facts in the light of established standards of safety and value. An “analysis” that recom- mended investment in General Electric common at a price forty times its highest recorded earnings merely because of its excellent prospects would be clearly ruled out, as devoid of all quality of thoroughness. The safety sought in investment is not absolute or complete; the word means, rather, protection against loss under all normal or reasonably likely conditions or variations. A safe bond, for example, is one which could suffer default only under exceptional and highly improbable cir- cumstances. Similarly, a safe stock is one which holds every prospect of being worth the price paid except under quite unlikely contingencies. Where study and experience indicate that an appreciable chance of loss must be recognized and allowed for, we have a speculative situation. A satisfactory return is a wider expression than adequate income, since it allows for capital appreciation or profit as well as current interest or dividend yield. “Satisfactory” is a subjective term; it covers any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence. It may be helpful to elaborate our definition from a somewhat differ- ent angle, which will stress the fact that investment must always consider the price as well as the quality of the security. Strictly speaking, there can be no such thing as an “investment issue” in the absolute sense, i.e., imply- ing that it remains an investment regardless of price. In the case of high- grade bonds, this point may not be important, for it is rare that their prices are so inflated as to introduce serious risk of loss of principal. But in the common-stock fi