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Today we are going to Read, Common Stocks
and Uncommon Profits and Other Writings
by PHILIP A.FISHER
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Common Stocks and Uncommon Profits and Other
Writings
by PHILIP A.FISHER
Part One
COMMON STOCKS AND UNCOMMON PROFITS
Clues from the Past
You have some money in the bank.You decide
you would like to buy some common stock. You
may have reached this decision because you
desire to have more income than you would
if you used these funds in other ways. You
may have reached it because you want to grow
with America. Possibly you think of earlier
years when Henry Ford was starting the Ford
Motor Company or Andrew Mellon was building
up the Aluminum Company of America, and you
wonder if you could not discover some young
enterprise which might today lay the groundwork
for a great fortune for you, too. Just as
likely you are more afraid than hopeful and
want to have a nest egg against a rainy day.
Consequently, after hearing more and more
about inflation, you desire something which
will be safe and yet protected from further
shrinkage in the buying power of the dollar.
Probably your real motives are a mixture of
a number of these things, influenced somewhat
by knowing a neighbor who has made some money
in the market and, possibly, by receiving
a pamphlet in the mail explaining just why
Midwestern Pumpernickel is now a bargain.A
single basic motive lies behind all this,
however. For one reason or another, through
one method or another, you buy common stocks
in order to make money.
Therefore, it seems logical that before even
thinking of buying any common stock the first
step is to see how money has been most successfully
made in the past. Even a casual glance at
American stock market history will show that
two very different methods have been used
to amass spectacular fortunes. In the nineteenth
century and in the early
part of the twentieth century, a number of
big fortunes and many small ones were made
largely by betting on the business cycle.
In a period when an unstable banking system
caused recurring boom and bust, buying stocks
in bad times and selling them in good had
strong elements of value. This was particularly
true for those with good financial connections
who might have some advance information about
when the banking system was becoming a bit
strained.
But perhaps the most significant fact to be
realized is that even in the stock market
era which started to end with the coming of
the Federal Reserve System in 1913 and became
history with the passage of the securities
and exchange legislation in the early days
of the Roosevelt administration, those who
used a different method made far more money
and took far less risk. Even in those earlier
times, finding the really outstanding companies
and staying with them through all the fluctuations
of a gyrating market proved far more profitable
to far more people than did the more colorful
practice of trying to buy them cheap and sell
them dear.
If this statement appears surprising, further
amplification of it may prove even more so.
It may also provide the key to open the first
door to successful investing. Listed on the
various stock exchanges of the nation today
are not just a few, but scores of companies
in which it would have been possible to invest,
say, $10,000 somewhere between twenty-five
and fifty years ago and today have this purchase
represent anywhere from $250,000 to several
times this amount. In other words, within
the lifetime of most investors and within
the period in which their parents could have
acted for nearly all of them, there were available
scores of opportunities to lay the groundwork
for substantial fortunes for oneself or one's
children.These opportunities did not require
purchasing on a particular day at the bottom
of a great panic.The shares of these companies
were available year after year at prices that
were to make this kind of profit possible.
What was required was the ability to distinguish
these relatively few companies with outstanding
investment possibilities from the much greater
number whose future would vary all the way
from the moderately successful to the complete
failure.
Are there opportunities existing today to
make investments that in the years ahead will
yield corresponding percentage gains? The
answer to this question deserves rather detailed
attention. If it be in the affirmative, the
path for making real profits through common
stock investment starts to become clear. Fortunately,
there is strong evidence indicating
that the opportunities of today are not only
as good as those of the first quarter of this
century but are actually much better.
One reason for this is the change that has
occurred during this period in the fundamental
concept of corporate management and the corresponding
changes in handling corporate affairs that
this has brought about.A generation ago, heads
of a large corporation were usually members
of the owning family.They regarded the corporation
as a personal possession.The interests of
outside stockholders were largely ignored.
If any consideration at all was given to the
problem of management continuity--that is,
of training younger men to step into the shoes
of those whose age might make them no longer
available--the motive was largely that of
taking care of a son or a nephew who would
inherit the job. Providing the best available
talent to protect the average stockholder's
investment was seldom a matter in the forefront
of the minds of management. In that age of
autocratic personal domination, the tendency
of aging management was to resist innovation
or improvement and frequently to refuse even
to listen to suggestions or criticism.This
is a far cry from today's constant competitive
search to find ways of doing things better.
Today's top corporate management is usually
engaged in continuous self-analysis and, in
a never-ending search for improvement, frequently
even goes outside its own organization by
consulting all sorts of experts in its effort
to get good advice.
In former days there was always great danger
that the most attractive corporation of the
moment would not continue to stay ahead in
its field or, if it did, that the insiders
would grab all the benefits for themselves.Today,
investment dangers like these, while not entirely
a thing of the past, are much less likely
to prove a hazard for the careful investor.
One facet of the change that has come over
corporate management is worthy of attention.This
is the growth of the corporate research and
engineering laboratory--an occurrence that
would hardly have benefited the stockholder
if it had not been accompanied by corporate
management's learning a parallel technique
whereby this research could be made a tool
to open up a golden harvest of ever-growing
profits to the stockholder. Even today, many
investors seem but slightly aware of how fast
this development has come, how much further
it is almost certainly going, and its impact
on basic investment policy.
Actually, even by the late 1920's, only a
half dozen or so industrial corporations had
significant research organizations. By today's
standards, their size was small. It was not
until the fear of Adolf Hitler accelerated
this type of activity for military purposes
that industrial research really started to
grow.
It has been growing ever since.A survey made
in the spring of 1956, published in Business
Week and a number of other McGraw-Hill trade
publications, indicated that in 1953 private
corporate expenditures for research and development
were about $3.7 billion. By 1956 they had
grown to $5.5 billion and present corporate
planning called for this to be running at
the rate of better than $6.3 billion by 1959.
Equally startling, this survey indicated that
by 1959, or in just three years, a number
of our leading industries expect to get from
15 per cent to more than 20 per cent of their
total sales from products which were not in
commercial existence in 1956.
In the spring of 1957 the same source made
a similar survey. If the totals revealed in
1956 were startling in their significance,
those revealed just one year later might be
termed explosive. Research expenditures were
up 20 per cent from the previous year's total
to $7.3 billion! This represents almost a
100 per cent growth in four years. It means
the actual growth in twelve months was $1
billion more than only a year before had been
expected as the total growth that would occur
in the ensuing thirty-six months. Meanwhile,
anticipated research expenditures in 1960
were estimated at $9 billion! Furthermore,
all manufacturing industries, rather than
just a few selected industries as represented
in the earlier survey, expected that 10 per
cent of 1960 sales would be from products
not yet in commercial existence only three
years before.For certain selected industries,
this percentage--from which sales representing
merely new model and style changes had been
excluded--was several times higher.
The impact of this sort of thing on investment
can hardly be overstated.The cost of this
type of research is becoming so great that
the corporation which fails to handle it wisely
from a commercial standpoint may stagger under
a crushing burden of operating expense. Furthermore,
there is no quick and easy yardstick for either
management or the investor to measure the
profitability of research. Just as even the
ablest professional baseball player cannot
expect to get a hit much more often than one
out of every three times he comes to bat,
so a sizable number of research projects,
governed merely by the law of averages, are
bound to produce nothing profitable at all.
Furthermore, by pure chance, an abnormal number
of such unprofitable projects may happen to
be bunched together in one particular span
of time in even the best-run
commercial laboratory. Finally, it is apt
to take from seven to eleven years from the
time a project is first conceived until it
has a significant favorable effect on corporate
earnings.Therefore,even the most profitable
of research projects is pretty sure to be
a financial drain before it eventually adds
to the stockholder's profit.
But if the cost of poorly organized research
is both high and hard to detect, the cost
of too little research may be even higher.
During the next few years, the introduction
of many kinds of new materials and new types
of machinery will steadily narrow the market
for thousands of companies, possibly entire
industries, which fail to keep pace with the
times. So will such major changes in basic
ways of doing things as will be brought about
by the adoption of electronic computers for
the keeping of records and the use of irradiation
for industrial processing. However, other
companies will be alert to the trends and
will maneuver to make enormous sales gains
from such awareness. The managements of certain
of such companies may continue to maintain
the highest standards of efficiency in handling
their day-to-day operations while using equally
good judgment in keeping ahead of the field
on these matters affecting the long-range
future.Their fortunate stockholders, rather
than the proverbial meek, may well inherit
the earth.
In addition to these influences of the changed
outlook in corporate management and the rise
of research, there is a third factor likewise
tending to give today's investor greater opportunities
than those existing in most past periods.
Later in this book--in those sections dealing
with when stocks should be bought and sold--it
would seem more appropriate to discuss what,
if any, influence the business cycle should
have on investment policies. But discussion
of one segment of this subject seems called
for at this point.This is the greater advantage
in owning certain types of common stocks,
as a result of a basic policy change that
has occurred within the framework of our federal
government, largely since 1932.
Both prior to and since that date, regardless
of how little they had to do with bringing
it about, both major parties took and usually
received credit for any prosperity that might
occur when they were in power. Similarly,
they were usually blamed by both the opposition
and the general public if a bad slump occurred.
However, prior to 1932 there would have been
serious question from the responsible leadership
of either party as to whether there was any
moral justification or even political wisdom
in deliberately running a huge deficit in
order to buttress ailing
segments of business. Fighting unemployment
by methods far more costly than the opening
of bread lines and soup kitchens would not
have been given serious consideration, regardless
of which party might have been in office.
Since 1932 all that is reversed. The Democrats
may or may not be less concerned with a balanced
federal budget than the Republicans. However,
from President Eisenhower on down, with the
possible exception of former Secretary of
the Treasury Humphrey, the responsible Republican
leadership has said again and again that if
business should really turn down they would
not hesitate to lower taxes or make whatever
other deficit-producing moves were necessary
to restore prosperity and eliminate unemployment.This
is a far cry from the doctrines that prevailed
prior to the big depression.
Even if this change in policy had not become
generally accepted, certain other changes
have occurred that would produce much the
same results, though possibly not so quickly.The
income tax only became legal during the Wilson
administration. It was not a major influence
on the economy until the 1930's. In earlier
years, much of the federal revenue came from
customs duties and similar excise sources.
These fluctuated moderately with the level
of prosperity but as a whole were fairly stable.
Today, in contrast, about 80 per cent of the
federal revenue comes from corporate and personal
income taxes.This means that any sharp decline
in the general level of business causes a
corresponding decline in federal revenue.
Meanwhile, various devices such as farm price
supports and unemployment compensation have
become imbedded in our laws. At just the time
that a business decline would be greatly reducing
the federal government's income, expenditures
in these fields made mandatory by legislation
would cause governmental expenses to mount
sharply. Add to this the definite intention
of reversing any unfavorable business trend
by cutting taxes, building more public works,
and lending money to various hard-pressed
business groups, and it becomes increasingly
plain that if a real depression were to occur
the federal deficit could easily run at a
rate of $25 to $30 billion per annum. Deficits
of this type would produce further inflation
in much the same way that the deficits resulting
from wartime expenditures produced the major
price spirals of the postwar period.
This means that when a depression does occur
it is apt to be shorter than some of the great
depressions of the past. It is almost bound
to be
followed by enough further inflation to produce
the type of general price rise that in the
past has helped certain industries and hurt
others.With this general economic background,the
menace of the business cycle may well be as
great as it ever was for the stockholder in
the financially weak or marginal company.
But to the stockholder in the growth company
with sufficient financial strength or borrowing
ability to withstand a year or two of hard
times, a business decline under today's economic
conditions represents far more a temporary
shrinking of the market value of his holdings
than the basic threat to the very existence
of the investment itself that had to be reckoned
with prior to 1932.
Another basic financial trend has resulted
from this built-in inflationary bias having
become imbedded so deeply in both our laws
and our accepted concepts of the economic
duties of government. Bonds have become undesirable
investments for the strictly long-term holdings
of the average individual investor.The rise
in interest rates that had been going on for
several years gained major momentum in the
fall of 1956. With high-grade bonds subsequently
selling at the lowest prices in twenty-five
years, many voices in the financial community
were raised to advocate switching from stocks
which were selling at historically high levels
into such fixed-income securities.The abnormally
high yield of bonds over dividend return on
stocks--in relation to the ratio that normally
prevails--would appear to have given strong
support to the soundness of this policy. For
the short term, such a policy sooner or later
may prove profitable. As such, it might have
great appeal for those making short- or medium-term
investments--that is, for "traders" with the
acuteness and sense of timing to judge when
to make the necessary buying and selling moves.
This is because the coming of any significant
business recession is almost certain to cause
an easing of money rates and a corresponding
rise in bond prices at a time when equity
quotations are hardly likely to be buoyant.This
leads us to the conclusion that highgrade
bonds may be good for the speculator and bad
for the long-term investor. This seems to
run directly counter to all normally accepted
thinking on this subject. However, any understanding
of the influences of inflation will show why
this is likely to be the case.
In its letter of December 1956, the First
National City Bank of New York furnished a
table showing the worldwide nature of the
depreciation in the purchasing power of money
that occurred in the ten years from 1946 to
1956. Sixteen of the major nations of the
free world were included in this table. In
every one of them the value of
money significantly declined. These declines
ranged from a minimum in Switzerland, where
at the end of the ten-year period money would
buy 85 per cent of what could be purchased
ten years before, to the other extreme in
Chile, where in ten years it had lost 95 per
cent of its former value. In the United States
this decline amounted to 29 per cent and in
Canada to 35 per cent. This means that in
the United States the annual rate of monetary
depreciation during the period was 3.4 per
cent, and in Canada it was 4.2 per cent. In
contrast, the yield offered by United States
Government bonds bought at the beginning of
the period, which admittedly was one of rather
low interest rates, was only 2.19 per cent.
This means that the holder of this type of
high-grade, fixed-income security actually
received negative interest (or loss) of better
than 1 per cent per annum if the real value
of his money is considered.
Suppose, however, that instead of acquiring
bonds at the rather low rates that prevailed
at the beginning of this period, the investor
could have bought them at the rather high
interest rates that prevailed ten years later.The
First National City Bank of New York in the
same article also supplied figures on this
matter.At the end of the period covered in
the article, they estimated the return on
United States Government bonds at 3.27 per
cent, which still would leave no return whatever,
actually a slight loss, on the investment.
However, six months after this article was
written, interest rates had risen sharply,
and were above 3.5 per cent. How would the
investor actually have fared if he had had
the opportunity at the beginning of this period
to invest with the highest returns that have
prevailed in over a quarter of a century?
In the great majority of cases he would still
have gotten no real return on his investment.
In many instances he would have had an actual
loss. This is because nearly all such bond
purchasers would have had to pay at least
a 20 per cent income tax on the interest received
before the genuine rate of their return on
the investment could have been calculated.
In many cases the bondholder's tax would have
been at a considerably higher rate, since
only the first $2000 to $4000 of taxable income
qualifies at this 20 per cent level. Similarly,
if an investor had purchased taxfree municipal
bonds at this all-time high, the somewhat
lower interest rate that these tax-free securities
carry would again not have provided any real
return on his investment.
Of course, these figures are only conclusive
for this one ten-year period.They do indicate,
however, that these conditions are worldwide
and therefore not too likely to be reversed
by political trends in any one country.What
is really important concerning the attractiveness
of bonds as long-term investments is whether
a similar trend can be expected in the period
ahead. It seems to me that if this whole inflation
mechanism is studied carefully it becomes
clear that major inflationary spurts arise
out of wholesale expansions of credit, which
in turn result from large government deficits
greatly enlarging the monetary base of the
credit system. The huge deficit incurred in
winning World War II laid such a base.The
result was that prewar bondholders who have
maintained their positions in fixed-income
securities have lost over half the real value
of their investments.
As already explained, our laws, and more importantly
our accepted beliefs of what should be done
in a depression, make one of two courses seem
inevitable. Either business will remain good,
in which event outstanding stocks will continue
to out-perform bonds, or a significant recession
will occur. If this happens, bonds should
temporarily outperform the best stocks, but
a train of major deficit-producing actions
will then be triggered that will cause another
major decline in the true purchasing power
of bond-type investments. It is almost certain
that a depression will produce further major
inflation; the extreme difficulty of determining
when in such a disturbing period bonds should
be sold makes me believe that securities of
this type are,in our complex economy, primarily
suited either to banks, insurance companies
and other institutions that have dollar obligations
to offset against them, or to individuals
with short-term objectives. They do not provide
for sufficient gain to the long-term investor
to offset this probability of further depreciation
in purchasing power.
Before going further, it might be well to
summarize briefly the various investment clues
that can be gleaned from a study of the past
and from a comparison of the major differences,
from an investment standpoint, between the
past and the present. Such a study indicates
that the greatest investment reward comes
to those who by good luck or good sense find
the occasional company that over the years
can grow in sales and profits far more than
industry as a whole. It further shows that
when we believe we have found such a company
we had better stick with it for a long period
of time. It gives us a strong hint that such
companies need not necessarily be young and
small. Instead, regardless of size, what really
counts is a management having both a determination
to attain further important growth and an
ability to bring its plans to completion.
The past gives us a further clue that this
growth is often associated with knowing how
to organize research in the various fields
of the natural sciences so as to bring to
market economically worthwhile and usually
interrelated product lines. It makes clear
to us that a general characteristic of such
companies is a management that does not let
its preoccupation with long-range planning
prevent it from exerting constant vigilance
in performing the day-to-day tasks of ordinary
business outstandingly well.Finally,it furnishes
considerable assurance that in spite of the
very many spectacular investment opportunities
that existed twentyfive or fifty years ago,
there are probably even more such opportunities
available today.
What "Scuttlebutt" Can Do.
As a general description of what to look for,
all this may be helpful. But as a practical
guide for finding outstanding investments,
it obviously contributes relatively little.
Granted that this furnishes a broad outline
of the type of investment that should be sought,
how does the investor go about finding the
specific company which might open the way
to major appreciation?
One way that immediately suggests itself is
logical but rather impractical.This is to
find someone who is sufficiently skilled in
the various facets of management to examine
each subdivision of a company's organization
and by detailed investigation of its executive
personnel, its production, its sales organization,
its research, and each of its other major
functions, form a worthwhile conclusion as
to whether the particular company has outstanding
potentialities for growth and development.
Such a method may appear sensible. Unfortunately
there are several reasons why it usually will
not serve the average investor very well.
In the first place, there are only a few individuals
who have the necessary degree of top management
skill to do a job of this kind. Most of them
are busy at top-level and high-paying management
jobs.They have neither the time nor the inclination
to occupy themselves in this way. Furthermore,
if they were so inclined, it is doubtful if
many of the real growth companies of the nation
would allow someone outside their own organization
to have all the data necessary to make an
informed decision. Some of the knowledge gained
in this way would be too valuable to existing
or potential competition to permit its being
passed on to anyone having no responsibility
to the company furnishing the data.
Fortunately, there is another course which
the investor can pursue. If properly handled,
this method will provide the clues that are
needed to find really outstanding investments.
For lack of a better term, I shall call this
way of proceeding the "scuttlebutt" method.
As this method is spelled out in detail in
the pages that follow, the average investor
will have one predominant reaction.This is
that regardless of how beneficial this "scuttlebutt"
method may be to someone else, it is not going
to be helpful to him, because he just won't
have much chance to apply it. I am aware that
most investors are not in a position to do
for themselves much of what is needed to get
the most from their investment funds. Nevertheless
I think they should thoroughly understand
just what is needed and why. Only in this
way are they in a position to select the type
of professional advisor who can best help
them. Only in this way can they adequately
evaluate the work of that advisor. Furthermore,
when they understand not only what can be
accomplished, but also how it can be accomplished,
they may be surprised at how from time to
time they may be in a position to enrich and
make more profitable the worthwhile work already
being done for them by their investment advisors.
The business "grapevine" is a remarkable thing.
It is amazing what an accurate picture of
the relative points of strength and weakness
of each company in an industry can be obtained
from a representative cross-section of the
opinions of those who in one way or another
are concerned with any particular company.
Most people, particularly if they feel sure
there is no danger of their being quoted,
like to talk about the field of work in which
they are engaged and will talk rather freely
about their competitors. Go to five companies
in an industry, ask each of them intelligent
questions about the points of strength and
weakness of the other four, and nine times
out of ten a surprisingly detailed and accurate
picture of all five will emerge.
However, competitors are only one and not
necessarily the best source of informed opinion.
It is equally astonishing how much can be
learned from both vendors and customers about
the real nature of the people with whom they
deal. Research scientists in universities,
in government, and in competitive companies
are another fertile source of worthwhile data.
So are executives of trade associations.
In the case of trade association executives
especially, but to a great extent the other
groups as well, it is impossible to lay too
much stress on the importance of two matters.The
inquiring investor must be able
to make clear beyond any doubt that his source
of information will never be revealed.Then
he must scrupulously live up to this policy.
Otherwise, the danger of getting an informant
into trouble is obviously so great that unfavorable
opinions just do not get passed along.
There is still one further group which can
be of immense help to the prospective investor
in search of a bonanza company. This group,
however, can be harmful rather than helpful
if the investor does not use good judgment
and does not do plenty of cross-checking with
others to verify his own judgment as to the
reliability of what is told him.This group
consists of former employees. Such people
frequently have a real inside view in regard
to their former employer's strengths and weaknesses.
Equally important, they will usually talk
freely about them. But enough such former
employees may, rightly or wrongly, feel they
were fired without good cause or left because
of a justified grievance that it is always
important to check carefully into why employees
left the company being studied. Only then
is it possible to determine the degree of
prejudice that may exist and to allow for
it in considering what the former employee
has to say.
If enough different sources of information
are sought about a company, there is no reason
to believe that each bit of data obtained
should agree with each other bit of data.Actually,
there is not the slightest need for this to
happen. In the case of really outstanding
companies, the preponderant information is
so crystal clear that even a moderately experienced
investor who knows what he is seeking will
be able to tell which companies are likely
to be of enough interest to him to warrant
taking the next step in his investigation.This
next step is to contact the officers of the
company to try and fill out some of the gaps
still existing in the investor's picture of
the situation being studied.
What to Buy.
The Fifteen Points to Look for in a Common
Stock
What are these matters about which the investor
should learn if he is to obtain the type of
investment which in a few years might show
him a gain of several hundred per cent, or
over a longer period of time might show a
correspondingly greater increase? In other
words, what attributes should a company have
to give it the greatest likelihood of attaining
this kind of results for its shareholders?
There are fifteen points with which I believe
the investor should concern himself.A company
could well be an investment bonanza if it
failed fully to qualify on a very few of them.
I do not think it could come up to my definition
of a worthwhile investment if it failed to
qualify on many. Some of these points are
matters of company policy;others deal with
how efficiently this policy is carried out.Some
of these points concern matters which should
largely be determined from information obtained
from sources outside the company being studied,while
others are best solved by direct inquiry from
company personnel.These fifteen points are:
point 1. Does the company have products or
services with sufficient market potential
to make possible a
sizable increase in sales for at least several
years? It is by no means impossible to make
a fair one-time profit from companies with
a stationary or even a declining sales curve.
Operating
economies resulting from better control of
costs can at times create enough improvement
in net income to produce an increase in the
market price of a company's shares. This sort
of one-time profit is eagerly sought by many
speculators and bargain hunters. It does not
offer the degree of opportunity, however,
that should interest those desiring to make
the greatest possible gains from their investment
funds.
Neither does another type of situation which
sometimes offers a considerably larger degree
of profit. Such a situation occurs when a
changed condition opens up a large increase
in sales for a period of a very few years,
after which sales stop growing. A large-scale
example of this is what happened to the many
radio set manufacturers with the commercial
development of television. A huge increase
in sales occurred for several years. Now that
nearly 90 per cent of United States homes
that are wired for electricity have television
sets, the sales curve is again static. In
the case of a great many companies in the
industry, a large profit was made by those
who bought early enough. Then as the sales
curve leveled out, so did the attractiveness
of many of these stocks.
Not even the most outstanding growth companies
need necessarily be expected to show sales
for every single year larger than those of
the year before. In another chapter I will
attempt to show why the normal intricacies
of commercial research and the problems of
marketing new products tend to cause such
sales increases to come in an irregular series
of uneven spurts rather than in a smooth year-by-year
progression. The vagaries of the business
cycle will also have a major influence on
year-to-year comparisons. Therefore growth
should not be judged on an annual basis but,
say, by taking units of several years each.
Certain companies give promise of greater
than normal growth not only for the next several-year
period, but also for a considerable time beyond
that.
Those companies which decade by decade have
consistently shown spectacular growth might
be divided into two groups. For lack of better
terms I will call one group those that happen
to be both "fortunate and able" and the other
group those that are "fortunate because they
are able."A high order of management ability
is a must for both groups. No company grows
for a long period of years just because it
is lucky. It must have and continue to keep
a high order of business skill, otherwise
it will not be able to capitalize on its good
fortune and to defend its competitive position
from the inroads of others.
The Aluminum Company of America is an example
of the "fortunate and able" group. The founders
of this company were men with great vision.They
correctly foresaw important commercial uses
for their new product. However, neither they
nor anyone else at that time could foresee
anything like the full size of the market
for aluminum products that was to develop
over the next seventy years. A combination
of technical developments and economies, of
which the company was far more the beneficiary
than the instigator, was to bring this about.Alcoa
has and continues to show a high order of
skill in encouraging and taking advantage
of these trends. However, if background conditions,
such as the perfecting of airborne transportation,
had not caused influences completely beyond
Alcoa's control to open up extensive new markets,
the company would still have grown--but at
a slower rate.
The Aluminum Company was fortunate in finding
itself in an even better industry than the
attractive one envisioned by its early management.The
fortunes made by many of the early stockholders
of this company who held on to their shares
is of course known to everyone.What may not
be so generally recognized is how well even
relative newcomers to the stockholder list
have done.When I wrote the original edition,
Alcoa shares were down almost 40 per cent
from the all-time high made in 1956.Yet at
this "low" price the stock showed an increase
in value of almost 500 per cent over not the
low price, but the median average price at
which it could have been purchased in 1947,
just ten years before.
Now let us take Du Pont as an example of the
other group of growth stocks--those which
I have described as "fortunate because they
are able." This company was not originally
in the business of making nylon, cellophane,
lucite, neoprene, orlon, milar, or any of
the many other glamorous products with which
it is frequently associated in the public
mind and which have proven so spectacularly
profitable to the investor. For many years
Du Pont made blasting powder. In time of peace
its growth would largely have paralleled that
of the mining industry. In recent years, it
might have grown a little more rapidly than
this as additional sales volume accompanied
increased activity in road building. None
of this would have been more than an insignificant
fraction of the volume of business that has
developed, however, as the company's brilliant
business and financial judgment teamed up
with superb technical skill to attain a sales
volume that is now exceeding two billion dollars
each year. Applying the skills and knowledge
learned in its original
powder business, the company has successfully
launched product after product to make one
of the great success stories of American industry.
The investment novice taking his first look
at the chemical industry might think it is
a fortunate coincidence that the companies
which usually have the highest investment
rating on many other aspects of their business
are also the ones producing so many of the
industry's most attractive growth products.
Such an investor is confusing cause and effect
to about the same degree as the unsophisticated
young lady who returned from her first trip
to Europe and told her friends what a nice
coincidence it was that wide rivers often
happened to flow right through the heart of
so many of the large cities. Studies of the
history of corporations such as Du Pont or
Dow or Union Carbide show how clearly this
type of company falls into the "fortunate
because they are able" group so far as their
sales curve is concerned.
Possibly one of the most striking examples
of these "fortunate because they are able"
companies is General American Transportation.
A little over fifty years ago when the company
was formed, the railroad equipment industry
appeared a good one with ample growth prospects.
In recent years few industries would appear
to offer less rewarding prospects for continued
growth. Yet when the altered outlook for the
railroads began to make the prospects for
the freight car builders increasingly less
appealing, brilliant ingenuity and resourcefulness
kept this company's income on a steady uptrend.
Not satisfied with this, the management started
taking advantage of some of the skills and
knowledge learned in its basic business to
go into other unrelated lines affording still
further growth possibilities.
A company which appears to have sharply increasing
sales for some years ahead may prove to be
a bonanza for the investor regardless of whether
such a company more closely resembles the
"fortunate and able" or the "fortunate because
it is able" type. Nevertheless, examples such
as General American Transportation make one
thing clear. In either case the investor must
be alert as to whether the management is and
continues to be of the highest order of ability;
without this, the sales growth will not continue.
Correctly judging the long-range sales curve
of a company is of extreme importance to the
investor. Superficial judgment can lead to
wrong conclusions.For example,I have already
mentioned radio-television stocks as an instance
where instead of continued long-range growth
there was one major spurt as the homes of
the nation acquired television sets.
Nevertheless, in recent years certain of these
radio-television companies have shown a new
trend.They have used their electronic skills
to build up sizable businesses in other electronic
fields such as communication and automation
equipment.These industrial and, in some cases,
military electronic lines give promise of
steady growth for many years to come. In a
few of these companies, such as Motorola for
example, they already are of more importance
than the television operation. Meanwhile,
certain new technical developments afford
a possibility that in the early 1960's current
model television sets will appear as awkward
and obsolete as the original wall-type crank-operated
hand telephones appear today.
One potential development, color television,
has possibly been overdiscounted by the general
public. Another is a direct result of transistor
development and printed circuitry. It is a
screen-type television with sets that would
be little different in size and shape from
the larger pictures we now have on our walls.The
present bulky cabinet would be a thing of
the past. Should such developments obtain
mass commercial acceptance, a few of the technically
most skillful of existing television companies
might enjoy another major spurt in sales even
larger and longer lasting than that which
they experienced a few years ago. Such companies
would find this spurt superimposed on a steadily
growing industrial and military electronics
business.They would then be enjoying the type
of major sales growth which should be the
first point to be considered by those desiring
the most profitable type of investments.
I have mentioned this example not as something
which is sure to happen, but rather as something
which could easily happen. I do so because
I believe that in regard to a company's future
sales curve there is one point that should
always be kept in mind. If a company's management
is outstanding and the industry is one subject
to technological change and development research,
the shrewd investor should stay alert to the
possibility that management might handle company
affairs so as to produce in the future exactly
the type of sales curve that is the first
step to consider in choosing an outstanding
investment.
Since I wrote these words in the original
edition, it might be interesting to note,
not what "is sure to happen" or "may happen,"
but what has happened in regard to Motorola.
We are not yet in the early 1960's, the closest
time to which I refer as affording a possibility
of developing television models that will
obsolete those of the 1950's. This has not
happened nor is it likely to do so in the
near future. But in the meanwhile
let us see what an alert management has done
to take advantage of technological change
to develop the type of upward sales curve
that I stated was the first requisite of an
outstanding investment.
Motorola has made itself an outstanding leader
in the field of twoway electronic communications
that started out as a specialty for police
cars and taxicabs, and now appears to offer
almost unlimited growth. Trucking companies,
owners of delivery fleets of all types, public
utilities, large construction projects, and
pipe lines are but a few of the users of this
type of versatile equipment. Meanwhile, after
several years of costly developmental effort,
the company has established a semi-conductor
(transistor) division on a profitable basis
which appears headed toward obtaining its
share of the fabulous growth trend of that
industry. It has become a major factor in
the new field of stereophonic phonographs
and is obtaining an important and growing
new source of sales in this way. By a rather
unique style tie-in with a leading national
furniture manufacturer (Drexel), it has significantly
increased its volume in the higher-priced
end of its television line. Finally, through
a small acquisition it is just getting into
the hearing-aid field and may develop other
new specialties as well. In short, while some
time in the next decade important major stimulants
may cause another large spurt in its original
radio-television lines, this has not happened
yet nor is it likely to happen soon. Yet management
has taken advantage of the resources and skills
within the organization again to put this
company in line for growth. Is the stock market
responding to this? When I finished writing
the original edition, Motorola was 45½.Today
it is 122.
When the investor is alert to this type of
opportunity, how profitable may it be? Let
us take an actual example from the industry
we have just been discussing. In 1947 a friend
of mine in Wall Street was making a survey
of the infant television industry. He studied
approximately a dozen of the principal set
producers over the better part of a year.
His conclusion was that the business was going
to be competitive, that there were going to
be major shifts in position between the leading
concerns, and that certain stocks in the industry
had speculative appeal. However, in the process
of this survey it developed that one of the
great shortages was the glass bulb for the
picture tube.The most successful producer
appeared to be Corning Glass Works. After
further examination of the technical and research
aspects of Corning Glass Works it became apparent
that this company was unusually well qualified
to produce these glass bulbs for the television
industry. Estimates of
the possible market indicated that this would
be a major source of new business for the
company. Since prospects for other product
lines seemed generally favorable, this analyst
recommended the stock for both individual
and institutional investment. The stock at
that time was selling at about 20. It has
since been split 2½-for-l and ten years after
his purchase was selling at over 100, which
was the equivalent of a price of 250 on the
old stock.
point 2. Does the management have a determination
to continue to develop products or processes
that will still further increase total sales
potentials when the growth
potentials of currently attractive product
lines have largely been exploited?
Companies which have a significant growth
prospect for the next few years because of
new demand for existing lines, but which have
neither policies nor plans to provide for
further developments beyond this may provide
a vehicle for a nice one-time profit.They
are not apt to provide the means for the consistent
gains over ten or twenty-five years that are
the surest route to financial success. It
is at this point that scientific research
and development engineering begin to enter
the picture. It is largely through these means
that companies improve old products and develop
new ones. This is the usual route by which
a management not content with one isolated
spurt of growth sees that growth occurs in
a series of more or less continuous spurts.
The investor usually obtains the best results
in companies whose engineering or research
is to a considerable extent devoted to products
having some business relationship to those
already within the scope of company activities.
This does not mean that a desirable company
may not have a number of divisions, some of
which have product lines quite different from
others. It does mean that a company with research
centered around each of these divisions, like
a cluster of trees each growing additional
branches from its own trunk, will usually
do much better than a company working on a
number of unrelated new products which, if
successful, will land it in several new industries
unrelated to its existing business.
At first glance Point 2 may appear to be a
mere repetition of Point 1. This is not the
case. Point 1 is a matter of fact, appraising
the degree of potential sales growth that
now exists for a company's product. Point
2 is
a matter of management attitude. Does the
company now recognize that in time it will
almost certainly have grown up to the potential
of its present market and that to continue
to grow it may have to develop further new
markets at some future time? It is the company
that has both a good rating on the first point
and an affirmative attitude on the second
that is likely to be of the greatest investment
interest.
point 3. How effective are the company's research
and development efforts in relation to its
size?
For a large number of publicly-owned companies
it is not too difficult to get a figure showing
the number of dollars being spent each year
on research and development. Since virtually
all such companies report their annual sales
total, it is only a matter of the simplest
mathematics to divide the research figure
by total sales and so learn the per cent of
each sales dollar that a company is devoting
to this type of activity. Many professional
investment analysts like to compare this research
figure for one company with that of others
in the same general field. Sometimes they
compare it with the average of the industry,
by averaging the figures of many somewhat
similar companies. From this, conclusions
are drawn both as to the importance of a company's
research effort in relation to competition
and the amount of research per share of stock
that the investor is getting in a particular
company.
Figures of this sort can prove a crude yardstick
that may give a worthwhile hint that one company
is doing an abnormal amount of research or
another not nearly enough. But unless a great
deal of further knowledge is obtained, such
figures can be misleading. One reason for
this is that companies vary enormously in
what they include or exclude as research and
development expense. One company will include
a type of engineering expense that most authorities
would not consider genuine research at all,
since it is really tailoring an existing product
to a particular order--in other words, sales
engineering. Conversely, another company will
charge the expense of operating a pilot plant
on a completely new product to production
rather than research. Most experts would call
this a pure research function, since it is
directly related to obtaining the know-how
to make a new product. If all companies were
to report research on a comparable accounting
basis, the relative figures on the amount
of research done by various well-known companies
might look quite different from those frequently
used in financial circles.
In no other major subdivision of business
activity are to be found such great variations
from one company to another between what goes
in as expense and what comes out in benefits
as occurs in research. Even among the best-managed
companies this variation seems to run in a
ratio of as much as two to one. By this is
meant some well-run companies will get as
much as twice the ultimate gain for each research
dollar spent as will others. If averagely-run
companies are included, this variation between
the best and the mediocre is still greater.
This is largely because the big strides in
the way of new products and processes are
no longer the work of a single genius. They
come from teams of highly trained men, each
with a different specialty. One may be a chemist,
another a solid state physicist, a third a
metallurgist and a fourth a mathematician.
The degree of skill of each of these experts
is only part of what is needed to produce
outstanding results. It is also necessary
to have leaders who can coordinate the work
of people of such diverse backgrounds and
keep them driving toward a common goal. Consequently,
the number or prestige of research workers
in one company may be overshadowed by the
effectiveness with which they are being helped
to work as a team in another.
Nor is a management's ability to coordinate
diverse technical skills into a closely-knit
team and to stimulate each expert on that
team to his greatest productivity the only
kind of complex coordination upon which optimum
research results depend. Close and detailed
coordination between research workers on each
developmental project and those thoroughly
familiar with both production and sales problems
is almost as important. It is no simple task
for management to bring about this close relationship
between research, production, and sales.Yet
unless this is done, new products as finally
conceived frequently are either not designed
to be manufactured as cheaply as possible,
or, when designed, fail to have maximum sales
appeal.Such research usually results in products
vulnerable to more efficient competition.
Finally there is one other type of coordination
necessary if research expenditures are to
attain maximum efficiency. This is coordination
with top management. It might perhaps better
be called top management's understanding of
the fundamental nature of commercial research.
Development projects cannot be expanded in
good years and sharply curtailed in poor ones
without tremendously increasing the total
cost of reaching the desired objective. The
"crash" programs so loved by a few top managements
may occasionally be necessary but are
often just expensive. A crash program is what
occurs when important elements of the research
personnel are suddenly pulled from the projects
on which they have been working and concentrated
on some new task which may have great importance
at the moment but which, frequently, is not
worth all the disruption it causes.The essence
of successful commercial research is that
only tasks be selected which promise to give
dollar rewards of many times the cost of the
research. However, once a project is started,
to allow budget considerations and other extraneous
factors outside the project itself to curtail
or accelerate it invariably expands the total
cost in relation to the benefits obtained.
Some top managements do not seem to understand
this. I have heard executives of small but
successful electronic companies express surprisingly
little fear of the competition of one of the
giants of the industry. This lack of worry
concerning the ability of the much larger
company to produce competitive products is
not due to lack of respect for the capabilities
of the larger company's individual researchers
or unawareness of what might otherwise be
accomplished with the large sums the big company
regularly spends on research. Rather it is
the historic tendency of this larger company
to interrupt regular research projects with
crash programs to attain the immediate goals
of top management that has produced this feeling.
Similarly, some years ago I heard that while
they desired no publicity on the matter for
obvious reasons, an outstanding technical
college quietly advised its graduating class
to avoid employment with a certain oil company.
This was because top management of that company
had a tendency to hire highly skilled people
for what would normally be about five-year
projects.Then in about three years the company
would lose interest in the particular project
and abandon it, thereby not only wasting their
own money but preventing those employed from
gaining the technical reputation for accomplishment
that otherwise might have come to them.
Another factor making proper investment evaluation
of research even more complex is how to evaluate
the large amount of research related to defense
contracts. A great deal of such research is
frequently done not at the expense of the
company doing it, but for the account of the
federal government. Some of the subcontractors
in the defense field also do significant research
for the account of the contractors whom they
are supplying. Should such totals be appraised
by the investor as being as significant as
research done at a company's own expense?
If not, how should it be valued in relation
to company-sponsored research? Like so
many other phases in the investment field,
these matters cannot be answered by mathematical
formulae. Each case is different.
The profit margin on defense contracts is
smaller than that of nongovernment business,
and the nature of the work is often such that
the contract for a new weapon is subject to
competitive bidding from government blueprints.This
means that it is sometimes impossible to build
up steady repeat business for a product developed
by governmentsponsored research in a way that
can be done with privately sponsored research,
where both patents and customer goodwill can
frequently be brought into play. For reasons
like these, from the standpoint of the investor
there are enormous variations in the economic
worth of different government-sponsored research
projects, even though such projects might
be roughly equal in their importance so far
as the benefits to the defense effort are
concerned. The following theoretical example
might serve to show how three such projects
might have vastly different values to the
investor:
One project might produce a magnificent new
weapon having no non-military applications.The
rights to this weapon would all be owned by
the government and, once invented, it would
be sufficiently simple to manufacture that
the company which had done the research would
have no advantage over others in bidding for
a production contract. Such a research effort
would have almost no value to the investor.
Another project might produce the same weapon,
but the technique of manufacturing might be
sufficiently complex that a company not participating
in the original development work would have
great difficulty trying to make it. Such a
research project would have moderate value
to the investor since it would tend to assure
continuous, though probably not highly profitable,
business from the government.
Still another company might engineer such
a weapon and in so doing might learn principles
and new techniques directly applicable to
its regular commercial lines, which presumably
show a higher profit margin. Such a research
project might have great value to the investor.
Some of the most spectacularly successful
companies of the recent past have been those
that show a high order of talent for finding
complex and technical defense work, the doing
of which provides them at government expense
with know-how that can legitimately be transferred
into profitable non-defense fields related
to their existing commercial activities. Such
companies are providing the government the
research results the defense authorities vitally
need. However, at the same time
they are obtaining, at little or no cost,
related non-defense research benefits which
otherwise they would probably be paying for
themselves. This factor may well have been
one of the reasons for the spectacular investment
success of Texas Instruments, Inc., which
in four years rose nearly 500 per cent from
the price of 5¼ at which it traded when first
listed on the New York Stock Exchange in 1953;
it may also have contributed, in the same
period, to the even greater 700 per cent rise
experienced by Ampex shareholders from the
time this company's shares were first offered
to the public in the same year.
Finally, in judging the relative investment
value of company research organizations, another
type of activity must be evaluated. This is
something which ordinarily is not considered
as developmental research at all--the seemingly
unrelated field of market research. Market
research may be regarded as the bridge between
developmental research and sales.Top management
must be alert against the temptation to spend
significant sums on the research and development
of a colorful product or process which, when
perfected, has a genuine market but one too
small to be profitable. By too small to be
profitable I mean one that never will enjoy
a large enough sales volume to get back the
cost of the research, much less a worthwhile
profit for the investor.A market research
organization that can steer a major research
effort of its company from one project which
if technically successful would have barely
paid for itself, to another which might cater
to so much broader a market that it would
pay out three times as well, would have vastly
increased the value to its stockholders of
that company's scientific manpower.
If quantitative measurements--such as the
annual expenditures on research or the number
of employees holding scientific degrees--are
only a rough guide and not the final answer
to whether a company has an outstanding research
organization, how does the careful investor
obtain this information? Once again it is
surprising what the "scuttlebutt" method will
produce. Until the average investor tries
it, he probably will not believe how complete
a picture will emerge if he asks intelligent
questions about a company's research activities
of a diversified group of research people,
some from within the company and others engaged
in related lines in competitive industries,
in universities, and in government. A simpler
and often worthwhile method is to make a close
study of how much in dollar sales or net profits
has been contributed to a company by the results
of its research organization during a particular
span, such as the prior ten years. An organization
which in
relation to the size of its activities has
produced a good flow of profitable new products
during such a period will probably be equally
productive in the future as long as it continues
to operate under the same general methods.
point 4. Does the company have an above-average
sales organization?
In this competitive age, the products or services
of few companies are so outstanding that they
will sell to their maximum potentialities
if they are not expertly merchandised. It
is the making of a sale that is the most basic
single activity of any business.Without sales,
survival is impossible. It is the making of
repeat sales to satisfied customers that is
the first benchmark of success.Yet, strange
as it seems, the relative efficiency of a
company's sales, advertising, and distributive
organizations receives far less attention
from most investors, even the careful ones,
than do production, research, finance, or
other major subdivisions of corporate activity.
There is probably a reason for this. It is
relatively easy to construct simple mathematical
ratios that will provide some sort of guide
to the attractiveness of a company's production
costs, research activity, or financial structure
in comparison with its competitors. It is
a great deal harder to make ratios that have
even a semblance of meaning in regard to sales
and distribution efficiency. In regard to
research we have already seen that such simple
ratios are far too crude to provide anything
but the first clues as to what to look for.
Their value in relation to production and
the financial structure will be discussed
shortly. However, whether or not such ratios
have anything like the value frequently placed
upon them in financial circles, the fact remains
that investors like to lean upon them. Because
sales effort does not readily lend itself
to this type of formulae, many investors fail
to appraise it at all in spite of its basic
importance in determining real investment
worth.
Again, the way out of this dilemma lies in
the use of the "scuttlebutt" technique. Of
all the phases of a company's activity, none
is easier to learn about from sources outside
the company than the relative efficiency of
a sales organization. Both competitors and
customers know the answers. Equally important,
they are seldom hesitant to express their
views.The time spent by the careful investor
in inquiring into this subject is usually
richly rewarded.
I am devoting less space to this matter of
relative sales ability than I did to the matter
of relative research ability. This does not
mean that I consider it less important. In
today's competitive world, many things are
important to corporate success. However, outstanding
production, sales, and research may be considered
the three main columns upon which such success
is based. Saying that one is more important
than another is like saying that the heart,
the lungs, or the digestive tract is the most
important single organ for the proper functioning
of the body. All are needed for survival,
and all must function well for vigorous health.
Look around you at the companies that have
proven outstanding investments. Try to find
some that do not have both aggressive distribution
and a constantly improving sales organization.
I have already referred to the Dow Chemical
Company and may do so several times again,
as I believe this company, which over the
years has proven so rewarding to its stockholders,
is an outstanding example of the ideal conservative
long-range investment. Here is a company which
in the public mind is almost synonymous with
outstandingly successful research. However,
what is not as well known is that this company
selects and trains its sales personnel with
the same care as it handles its research chemists.
Before a young college graduate becomes a
Dow salesman, he may be invited to make several
trips to Midland so that both he and the company
can become as sure as possible that he has
the background and temperament that will fit
him into their sales organization. Then, before
he so much as sees his first potential customer,
he must undergo specialized training that
occasionally lasts only a few weeks but at
times continues for well over a year to prepare
him for the more complex selling jobs.This
is but the beginning of the training he will
receive; some of the company's greatest mental
effort is devoted to seeking and frequently
finding more efficient ways to solicit from,
service, and deliver to the customer.
Are Dow and the other outstanding companies
in the chemical industry unique in this great
attention paid to sales and distribution?
Definitely not. In another and quite different
industry, International Business Machines
is a company which has (speaking conservatively)
handsomely rewarded its owners. An IBM executive
recently told me that the average salesman
spends a third of his entire time training
in company-sponsored schools! To a considerable
degree this amazing ratio results from an
attempt to keep the sales force abreast of
a rapidly changing technology. Nevertheless
I believe it one more indication of the
weight that most successful companies give
to steadily improving their sales arm. A one-time
profit can be made in the company which because
of manufacturing or research skill obtains
some worthwhile business without a strong
distribution organization. However, such companies
can be quite vulnerable. For steady long-term
growth a strong sales arm is vital.
point 5. Does the company have a worthwhile
profit margin?
Here at last is a subject of importance which
properly lends itself to the type of mathematical
analysis which so many financial people feel
is the backbone of sound investment decisions.
From the standpoint of the investor, sales
are only of value when and if they lead to
increased profits. All the sales growth in
the world won't produce the right type of
investment vehicle if, over the years, profits
do not grow correspondingly. The first step
in examining profits is to study a company's
profit margin, that is, to determine the number
of cents of each dollar of sales that is brought
down to operating profit. The wide variation
between different companies, even those in
the same industry, will immediately become
apparent. Such a study should be made, not
for a single year, but for a series of years.
It then becomes evident that nearly all companies
have broader profit margins--as well as greater
total dollar profits--in years when an industry
is unusually prosperous. However, it also
becomes clear that the marginal companies--that
is, those with the smaller profit margins--nearly
always increase their profit margins by a
considerably greater percentage in the good
years than do the lowercost companies, whose
profit margins also get better but not to
so great a degree. This usually causes the
weaker companies to show a greater percentage
increase in earnings in a year of abnormally
good business than do the stronger companies
in the same field. However, it should also
be remembered that these earnings will decline
correspondingly more rapidly when the business
tide turns.
For this reason I believe that the greatest
long-range investment profits are never obtained
by investing in marginal companies.The only
reason for considering a long-range investment
in a company with an abnormally low profit
margin is that there might be strong indications
that a fundamental change is taking place
within the company. This would be such that
the improvement in profit margins would be
occurring for reasons other than a temporarily
expanded volume of business. In other words,
the company would not be marginal in the true
sense of the word, since the real reason for
buying is that efficiency or new products
developed within the company have taken it
out of the marginal category. When such internal
changes are taking place in a corporation
which in other respects pretty well qualifies
as the right type of long-range investment,
it may be an unusually attractive purchase.
So far as older and larger companies are concerned,
most of the really big investment gains have
come from companies having relatively broad
profit margins. Usually they have among the
best such margins in their industry. In regard
to young companies, and occasionally older
ones, there is one important deviation from
this rule--a deviation, however, that is generally
more apparent than real. Such companies will
at times deliberately elect to speed up growth
by spending all or a very large part of the
profits they would otherwise have earned on
even more research or on even more sales promotion
than they would otherwise be doing. What is
important in such instances is to make absolutely
certain that it is actually still further
research, still further sales promotion, or
still more of any other activity which is
being financed today so as to build for the
future, that is the real cause of the narrow
or non-existent profit margin.
The greatest care should be used to be sure
that the volume of the activities being credited
with reducing the profit margin is not merely
the volume of these activities needed for
a good rate of growth, but actually represents
even more research, sales promotion, etc.,
than this. When this happens, the research
company with an apparently poor profit margin
may be an unusually attractive investment.
However, with the exception of companies of
this type in which the low profit margin is
being deliberately engineered in order to
further accelerate the growth rate, investors
desiring maximum gains over the years had
best stay away from low-profit-margin or marginal
companies.
point 6. What is the company doing to maintain
or improve profit margins?
The success of a stock purchase does not depend
on what is generally known about a company
at the time the purchase is made. Rather it
depends upon what gets to be known about it
after the stock has been
bought. Therefore it is not the profit margins
of the past but those of the future that are
basically important to the investor.
In the age in which we live, there seems to
be a constant threat to profit margins.Wages
and salary costs go up year by year. Many
companies now have long-range labor contracts
calling for still further increases for several
years ahead.Rising labor costs result in corresponding
increases in raw materials and supplies.The
trend of tax rates,particularly real estate
and local tax rates, also seems to be steadily
increasing.Against this background,different
companies are going to have different results
in the trend of their profit margins. Some
companies are in the seemingly fortunate position
that they can maintain profit margins simply
by raising prices. This is usually because
they are in industries in which the demand
for their products is abnormally strong or
because the selling prices of competitive
products have gone up even more than their
own. In our economy, however, maintaining
or improving profit margins in this way usually
proves a relatively temporary matter. This
is because additional competitive production
capacity is created.This new capacity sufficiently
outbalances the increased gain so that, in
time, cost increases can no longer be passed
on as price increases. Profit margins then
start to shrink.
A striking example of this is the abrupt change
that occurred in the fall of 1956, when the
aluminum market went in a few weeks from a
condition of short supply to one of aggressive
competitive selling. Prior to that time aluminum
prices rose about with costs. Unless demand
for the product should grow even faster than
production facilities, future price increases
will occur less rapidly. Similarly the persistent
disinclination of some of the largest steel
producers to raise prices of certain classes
of scarce steel products to "all the market
would bear" may in part reflect long-range
thinking about the temporary nature of broad
profit margins that arise from no other cause
than an ability to pass on increased costs
by higher selling prices.
The long-range danger of this is perhaps best
illustrated by what happened to the leading
copper producers during this same second half
of 1956.These companies used considerable
self-restraint, even going so far as to sell
under world prices in an attempt to keep prices
from going too high. Nevertheless, copper
rose sufficiently to curtail demand and attract
new supply. Aggravated by curtailed Western
European consumption resulting from the closing
of the Suez Canal, the situation became quite
unbalanced. It is probable that 1957 profit
margins were noticeably poorer than would
have been the case if those of 1956 had
not been so good.When profit margins of a
whole industry rise because of repeated price
increases, the indication is not a good one
for the long-range investor.
In contrast, certain other companies, including
some within these same industries, manage
to improve profit margins by far more ingenious
means than just raising prices. Some companies
achieve great success by maintaining capital-improvement
or product-engineering departments. The sole
function of such departments is to design
new equipment that will reduce costs and thus
offset or partially offset the rising trend
of wages. Many companies are constantly reviewing
procedures and methods to see where economies
can be brought about.The accounting function
and the handling of records has been a particularly
fertile field for this sort of activity. So
has the transportation field. Shipping costs
have risen more than most expenses because
of the larger percentage of labor costs in
most forms of transportation as compared to
most types of manufacturing. Using new types
of containers, heretofore unused methods of
transportation, or even putting in branch
plants to avoid cross-hauling have all cut
costs for alert companies.
None of these things can be brought about
in a day.They all require close study and
considerable planning ahead. The prospective
investor should give attention to the amount
of ingenuity of the work being done on new
ideas for cutting costs and improving profit
margins. Here the "scuttlebutt" method may
prove of some value, but much less so than
direct inquiry from company personnel. Fortunately,
this is a field about which most top executives
will talk in some detail.The companies which
are doing the most successful work along this
line are very likely to be the ones which
have built up the organization with the know-how
to continue to do constructive things in the
future.They are extremely likely to be in
the group offering the greatest long-range
rewards to their shareholders.
point 7. Does the company have outstanding
labor and personnel relations?
Most investors may not fully appreciate the
profits from good labor relations. Few of
them fail to recognize the impact of bad labor
relations. The effect on production of frequent
and prolonged strikes is obvious to anyone
making even the most cursory review of corporate
financial statements.
However, the difference in the degree of profitability
between a company with good personnel relations
and one with mediocre personnel relations
is far greater than the direct cost of strikes.
If workers feel that they are fairly treated
by their employer, a background has been laid
wherein efficient leadership can accomplish
much in increasing productivity per worker.
Furthermore, there is always considerable
cost in training each new worker.Those companies
with an abnormal labor turnover have therefore
an element of unnecessary expense avoided
by better-managed enterprises.
But how does the investor properly judge the
quality of a company's labor and personnel
relations? There is no simple answer. There
is no set yardstick that will apply in all
cases. About the best that can be done is
to look at a number of factors and then judge
from the composite picture.
In this day of widespread unionization, those
companies that still have no union or a company
union probably also have well above average
labor and personnel relations. If they did
not, the unions would have organized them
long ago.The investor can feel rather sure,
for example, that Motorola, located in highly
unionized Chicago, and Texas Instruments,
Inc., in increasingly unionized Dallas, have
convinced at least an important part of their
work force of the company's genuine desire
and ability to treat its employees well. Lack
of affiliation with an international union
can only be explained by successful personnel
policies in instances of this sort.
On the other hand, unionization is by no means
a sign of poor labor relations. Some of the
companies with the very best labor relations
are completely unionized, but have learned
to get along with their unions with a reasonable
degree of mutual respect and trust. Similarly,
while a record of constant and prolonged strikes
is a good indication of bad labor relations,
the complete absence of strikes is not necessarily
a sign of fundamentally good relations. Sometimes
the company with no strikes is too much like
the henpecked husband.Absence of conflict
may not mean a basically happy relationship
so much as fear of the consequences of conflict.
Why do workers feel unusually loyal to one
employer and resentful of another? The reasons
are often so complex and difficult to trace
that for the most part the investor may do
better to concern himself with comparative
data showing how workers feel, rather than
with an attempt to appraise each part of the
background causing them to feel
that way. One series of figures that indicates
the underlying quality of labor and personnel
policies is the relative labor turnover in
one company as against another in the same
area. Equally significant is the relative
size of the waiting list of job applicants
wanting to work for one company as against
others in the same locality. In an area where
there is no labor surplus, companies having
an abnormally long list of personnel seeking
to enter their employ are usually companies
that are desirable for investment from the
standpoint of good labor and personnel relations.
Nevertheless, beyond these general figures
there are a few specific details the investor
might notice. Companies with good labor relations
usually are ones making every effort to settle
grievances quickly. The small individual grievances
that take long to settle and are not considered
important by management are ones that smoulder
and finally flare up seriously. In addition
to appraising the methods set up for settling
grievances, the investor might also pay close
attention to wage scales. The company that
makes above-average profits while paying aboveaverage
wages for the area in which it is located
is likely to have good labor relations. The
investor who buys into a situation in which
a significant part of earnings comes from
paying below-standard wages for the area involved
may in time have serious trouble on his hands.
Finally the investor should be sensitive to
the attitude of top management toward the
rank-and-file employees. Underneath all the
fine-sounding generalities, some managements
have little feeling of responsibility for,
or interest in, their ordinary workers.Their
chief concern is that no greater share of
their sales dollar go to lower echelon personnel
than the pressure of militant unionism makes
mandatory.Workers are readily hired or dismissed
in large masses, dependent on slight changes
in the company's sales outlook or profit picture.
No feeling of responsibility exists for the
hardships this can cause to the families affected.
Nothing is done to make ordinary employees
feel they are wanted, needed, and part of
the business picture. Nothing is done to build
up the dignity of the individual worker. Managements
with this attitude do not usually provide
the background for the most desirable type
of investment.
point 8. Does the company have outstanding
executive relations?
If having good relations with lower echelon
personnel is important, creating the right
atmosphere among executive personnel is vital.These
are
the men whose judgment, ingenuity, and teamwork
will in time make or break any venture. Because
the stakes for which they play are high, the
tension on the job is frequently great. So
is the chance that friction or resentment
might create conditions whereby top executive
talent either does not stay with a company
or does not produce to its maximum ability
if it does stay.
The company offering greatest investment opportunities
will be one in which there is a good executive
climate. Executives will have confidence in
their president and/or board chairman. This
means, among other things, that from the lowest
levels on up there is a feeling that promotions
are based on ability, not factionalism. A
ruling family is not promoted over the heads
of more able men. Salary adjustments are reviewed
regularly so that executives feel that merited
increases will come without having to be demanded.
Salaries are at least in line with the standard
of the industry and the locality. Management
will bring outsiders into anything other than
starting jobs only if there is no possibility
of finding anyone within the organization
who can be promoted to fill the position.
Top management will recognize that wherever
human beings work together, some degree of
factionalism and human friction will occur,
but will not tolerate those who do not cooperate
in team play so that such friction and factionalism
is kept to an irreducible minimum. Much of
this the investor can usually learn without
too much direct questioning by chatting about
the company with a few executives scattered
at different levels of responsibility.The
further a corporation departs from these standards,
the less likely it is to be a really outstanding
investment.
point 9. Does the company have depth to its
management?
A small corporation can do extremely well
and, if other factors are right, provide a
magnificent investment for a number of years
under really able one-man management. However,
all humans are finite, so even for smaller
companies the investor should have some idea
of what can be done to prevent corporate disaster
if the key man should no longer be available.
Nowadays this investment risk with an otherwise
outstanding small company is not as great
as it seems, in view of the recent tendency
of big companies with plenty of management
talent to buy up outstanding smaller units.
However, companies worthy of investment interest
are those that will continue to grow. Sooner
or later a company will reach a size where
it just will not be able to take advantage
of further opportunities unless it starts
developing executive talent in some depth.This
point will vary between companies, depending
on the industry in which they are engaged
and the skill of the one-man management. It
usually occurs when annual sales totals reach
a point somewhere between fifteen and forty
million dollars. Having the right executive
climate, as discussed in Point 8, becomes
of major investment significance at this time.
Those matters discussed in Point 8 are, of
course, needed for development of proper management
in depth. But such management will not develop
unless certain additional policies are in
effect as well. Most important of these is
the delegation of authority. If from the very
top on down, each level of executives is not
given real authority to carry out assigned
duties in as ingenious and efficient a manner
as each individual's ability will permit,
good executive material becomes much like
healthy young animals so caged in that they
cannot exercise. They do not develop their
faculties because they just do not have enough
opportunity to use them.
Those organizations where the top brass personally
interfere with and try to handle routine day-to-day
operating matters seldom turn out to be the
most attractive type of investments. Cutting
across the lines of authority which they themselves
have set up frequently results in well-meaning
executives significantly detracting from the
investment caliber of the companies they run.
No matter how able one or two bosses may be
in handling all this detail, once a corporation
reaches a certain size executives of this
type will get in trouble on two fronts. Too
much detail will have arisen for them to handle.
Capable people just are not being developed
to handle the still further growth that should
lie ahead.
Another matter is worthy of the investor's
attention in judging whether a company has
suitable depth in management. Does top management
welcome and evaluate suggestions from personnel
even if, at times, those suggestions carry
with them adverse criticism of current management
practices? So competitive is today's business
world and so great the need for improvement
and change that if pride or indifference prevent
top management from exploring what has frequently
been found to be a veritable gold mine of
worthwhile ideas, the investment climate that
results probably will not be the most suitable
one for the
investor. Neither is it likely to be one in
which increasing numbers of vitally needed
younger executives are going to develop.
point 10. How good are the company's cost
analysis and accounting controls?
No company is going to continue to have outstanding
success for a long period of time if it cannot
break down its over-all costs with sufficient
accuracy and detail to show the cost of each
small step in its operation. Only in this
way will a management know what most needs
its attention. Only in this way can management
judge whether it is properly solving each
problem that does need its attention. Furthermore,
most successful companies make not one but
a vast series of products. If the management
does not have a precise knowledge of the true
cost of each product in relation to the others,
it is under an extreme handicap. It becomes
almost impossible to establish pricing policies
that will insure the maximum obtainable over-all
profit consistent with discouraging undue
competition. There is no way of knowing which
products are worthy of special sales effort
and promotion. Worst of all, some apparently
successful activities may actually be operating
at a loss and, unknown to management, may
be decreasing rather than swelling the total
of over-all profits. Intelligent planning
becomes almost impossible.
In spite of the investment importance of accounting
controls, it is usually only in instances
of extreme inefficiency that the careful investor
will get a clear picture of the status of
cost accounting and related activities in
a company in which he is contemplating investment.
In this sphere, the "scuttlebutt" method will
sometimes reveal companies that are really
deficient. It will seldom tell much more than
this. Direct inquiry of company personnel
will usually elicit a completely sincere reply
that the cost data are entirely adequate.
Detailed cost sheets will often be shown in
support of the statement. However, it is not
so much the existence of detailed figures
as their relative accuracy which is important.
The best that the careful investor usually
can do in this field is to recognize both
the importance of the subject and his own
limitations in making a worthwhile appraisal
of it.Within these limits he usually can only
fall back on the general conclusion that a
company well above average in most other aspects
of business skill will probably be above average
in this field, too, as long as top management
understands the basic importance of expert
accounting controls and cost analysis.
point 11. Are there other aspects of the business,
somewhat peculiar to the industry involved,
which will give the investor important clues
as to how outstanding
the company may be in relation to its competition?
By definition, this is somewhat of a catch-all
point of inquiry. This is because matters
of this sort are bound to differ considerably
from each other--those which are of great
importance in some lines of business can,
at times, be of little or no importance in
others. For example, in most important operations
involving retailing, the degree of skill a
company has in handling real estate matters--the
quality of its leases, for instance--is of
great significance. In many other lines of
business, a high degree of skill in this field
is less important. Similarly, the relative
skill with which a company handles its credits
is of great significance to some companies,
of minor or no importance to others. For both
these matters, our old friend the "scuttlebutt"
method will usually furnish the investor with
a pretty clear picture. Frequently his conclusions
can be checked against mathematical ratios
such as comparative leasing costs per dollar
of sales, or ratio of credit loss, if the
point is of sufficient importance to warrant
careful study.
In a number of lines of business, total insurance
costs mount to an important per cent of the
sales dollar.At times this can matter enough
so that a company with, say, a 35 per cent
lower overall insurance cost than a competitor
of the same size will have a broader margin
of profit. In those industries where insurance
is a big enough factor to affect earnings,
a study of these ratios and a discussion of
them with informed insurance people can be
unusually rewarding to the investor. It gives
a supplemental but indicative check as to
how outstanding a particular management may
be. This is because these lower insurance
costs do not come solely from a greater skill
in handling insurance in the same way, for
example, as skill in handling real estate
results in lower than average leasing costs.
Rather they are largely the reflection of
over-all skill in handling people, inventory,
and fixed property so as to reduce the over-all
amount of accident, damage, and waste and
thereby make these lower costs possible. An
index of insurance costs in relation to the
coverage obtained points out clearly which
companies in a given field are well run.
Patents are another matter having varying
significance from company to company. For
large companies, a strong patent position
is usually a point of additional rather than
basic strength. It usually blocks off certain
subdivisions of the company's activities from
the intense competition that might otherwise
prevail. This normally enables these segments
of the company's product lines to enjoy wider
profit margins than would otherwise occur.
This in turn tends to broaden the average
of the entire line. Similarly, strong patent
positions may at times give a company exclusive
rights to the easiest or cheapest way of making
a particular product. Competitors must go
a longer way round to get to the same place,
thereby giving the patent owner a tangible
competitive advantage although frequently
a small one.
In our era of widespread technical know-how
it is seldom that large companies can enjoy
more than a small part of their activities
in areas sheltered by patent protection. Patents
are usually able to block off only a few rather
than all the ways of accomplishing the same
result. For this reason many large companies
make no attempt to shut out competition through
patent structure, but for relatively modest
fees license competition to use their patents
and in return expect the same treatment from
these licensees. Influences such as manufacturing
know-how, sales and service organization,
customer good will, and knowledge of customer
problems are depended on far more than patents
to maintain a competitive position. In fact,
when large companies depend chiefly on patent
protection for the maintenance of their profit
margin, it is usually more a sign of investment
weakness than strength. Patents do not run
on indefinitely. When the patent protection
is no longer there, the company's profit may
suffer badly.
The young company just starting to develop
its production, sales, and service organization,
and in the early stages of establishing customer
good will is in a very different position.
Without patents its products might be copied
by large entrenched enterprises which could
use their established channels of customer
relationship to put the small young competitor
out of business. For small companies in the
early years of marketing unique products or
services, the investor should therefore closely
scrutinize the patent position. He should
get information from qualified sources as
to how broad the protection actually may be.
It is one thing to get a patent on a device.
It may be quite another to get protection
that will prevent others from making
it in a slightly different way. Even here,
however, engineering that is constantly improving
the product can prove considerably more advantageous
than mere static patent protection.
For example, a few years ago when it was a
much smaller organization than as of today,
a young West Coast electronic manufacturer
had great success with a new product. One
of the giants of the industry made what was
described to me as a "Chinese copy" and marketed
it under its well-known trade name. In the
opinion of the young company's designer, this
large competitor managed to engineer all the
small company's engineering mistakes into
the model along with the good points.The large
company's model came out at just the time
the small manufacturer introduced its own
improved model with the weak points eliminated.With
a product that was not selling, the large
company withdrew from the field. As has been
true many times before and since, it is the
constant leadership in engineering, not patents,
that is the fundamental source of protection.
The investor must be at least as careful not
to place too much importance on patent protection
as to recognize its significance in those
occasional places where it is a major factor
in appraising the attractiveness of a desirable
investment.
point 12. Does the company have a short-range
or long-range outlook in regard to profits?
Some companies will conduct their affairs
so as to gain the greatest possible profit
right now. Others will deliberately curtail
maximum immediate profits to build up good
will and thereby gain greater overall profits
over a period of years. Treatment of customers
and vendors gives frequent examples of this.
One company will constantly make the sharpest
possible deals with suppliers. Another will
at times pay above contract price to a vendor
who has had unexpected expense in making delivery,
because it wants to be sure of having a dependable
source of needed raw materials or high-quality
components available when the market has turned
and supplies may be desperately needed. The
difference in treatment of customers is equally
noticeable. The company that will go to special
trouble and expense to take care of the needs
of a regular customer caught in an unexpected
jam may show lower profits on the particular
transaction, but far greater profits over
the years.
The "scuttlebutt" method usually reflects
these differences in policies quite clearly.
The investor wanting maximum results should
favor companies with a truly long-range outlook
concerning profits.
point 13. In the foreseeable future will the
growth of the company require sufficient equity
financing so that the larger number of shares
then outstanding will largely
cancel the existing stockholders' benefit
from this anticipated growth?
The typical book on investment devotes so
much space to a discussion on the corporation's
cash position, corporate structure, percentage
of capitalization in various classes of securities,
etc., that it may well be asked why these
purely financial aspects should not be given
more than the amount of space devoted to this
one point out of a total of fifteen. The reason
is that it is the basic contention of this
book that the intelligent investor should
not buy common stocks simply because they
are cheap but only if they give promise of
major gain to him.
Only a small percentage of all companies can
qualify with a high rating for all or nearly
all of the other fourteen points listed in
this discussion. Any company which can so
qualify could easily borrow money, at prevailing
rates for its size company, up to the accepted
top percentage of debt for that kind of business.
If such a company needed more cash once this
top debt limit has been reached--always assuming
of course that it qualifies at or near the
top in regard to further sales growth, profit
margins, management, research, and the various
other points we are now considering--it could
still raise equity money at some price, since
investors are always eager to participate
in ventures of this sort.
Therefore,if investment is limited to outstanding
situations,what really matters is whether
the company's cash plus further borrowing
ability is sufficient to take care of the
capital needed to exploit the prospects of
the next several years. If it is, and if the
company is willing to borrow to the limit
of prudence,the common stock investor need
have no concern as to the more distant future.
If the investor has properly appraised the
situation, any equity financing that might
be done some years ahead will be at prices
so much higher than present levels that he
need not be concerned.This is because the
near-term financing will have produced enough
increase in earnings,by the time still further
financing is needed some years hence,to have
brought the stock to a substantially higher
price level.
If this borrowing power is not now sufficient,
however, equity financing becomes necessary.
In this case, the attractiveness of the investment
depends on careful calculations as to how
much the dilution resulting from the greater
number of shares to be outstanding will cut
into the benefits to the present common stockholder
that will result from the increased earnings
this financing makes possible. This equity
dilution is just as mathematically calculable
when the dilution occurs through the issuance
of senior securities with conversion features
as when it occurs through the issuance of
straight common stock. This is because such
conversion features are usually exercisable
at some moderate level above the market price
at the time of issuance--usually from 10 to
20 per cent. Since the investor should never
be interested in small gains of 10 to 20 per
cent, but rather in gains which over a period
of years will be closer to ten or a hundred
times this amount, the conversion price can
usually be ignored and the dilution calculated
upon the basis of complete conversion of the
new senior issue. In other words, it is well
to consider that all senior convertible issues
have been converted and that all warrants,
options, etc., have been exercised when calculating
the real number of common shares outstanding.
If equity financing will be occurring within
several years of the time of common stock
purchase, and if this equity financing will
leave common stockholders with only a small
increase in subsequent per-share earnings,
only one conclusion is justifiable.This is
that the company has a management with sufficiently
poor financial judgment to make the common
stock undesirable for worthwhile investment.
Unless this situation prevails, the investor
need not be deterred by purely financial considerations
from going into any situation which, because
of its high rating on the remaining fourteen
points covered, gives promise of being outstanding.
Conversely, from the standpoint of making
maximum profits over the years, the investor
should never go into a situation with a poor
score on any of the other fourteen points,
merely because of great financial strength
or cash position.
point 14. Does the management talk freely
to investors about its affairs when things
are going well but "clam
up" when troubles and disappointments occur?
It is the nature of business that in even
the best-run companies unexpected difficulties,
profit squeezes, and unfavorable shifts in
demand for
their products will at times occur. Furthermore,
the companies into which the investor should
be buying if greatest gains are to occur are
companies which over the years will constantly,
through the efforts of technical research,
be trying to produce and sell new products
and new processes. By the law of averages,
some of these are bound to be costly failures.
Others will have unexpected delays and heartbreaking
expenses during the early period of plant
shake-down. For months on end, such extra
and unbudgeted costs will spoil the most carefully
laid profit forecasts for the business as
a whole. Such disappointments are an inevitable
part of even the most successful business.
If met forthrightly and with good judgment,
they are merely one of the costs of eventual
success.They are frequently a sign of strength
rather than weakness in a company.
How a management reacts to such matters can
be a valuable clue to the investor.The management
that does not report as freely when things
are going badly as when they are going well
usually "clams up" in this way for one of
several rather significant reasons. It may
not have a program worked out to solve the
unanticipated difficulty. It may have become
panicky. It may not have an adequate sense
of responsibility to its stockholders, seeing
no reason why it should report more than what
may seem expedient at the moment. In any event,
the investor will do well to exclude from
investment any company that withholds or tries
to hide bad news.
point 15. Does the company have a management
of unquestionable integrity?
The management of a company is always far
closer to its assets than is the stockholder.
Without breaking any laws, the number of ways
in which those in control can benefit themselves
and their families at the expense of the ordinary
stockholder is almost infinite. One way is
to put themselves--to say nothing of their
relatives or in-laws--on the payroll at salaries
far above the normal worth of the work performed.
Another is to own properties they sell or
rent to the corporation at above-market rates.
Among smaller corporations this is sometimes
hard to detect, since controlling families
or key officers at times buy and lease real
estate to such companies, not for purposes
of unfair gain but in a sincere desire to
free limited working capital for other corporate
purposes.
Another method for insiders to enrich themselves
is to get the corporation's vendors to sell
through certain brokerage firms which perform
little if any service for the brokerage commissions
involved but which are owned by these same
insiders and relatives or friends. Probably
most costly of all to the investor is the
abuse by insiders of their power of issuing
common stock options.They can pervert this
legitimate method of compensating able management
by issuing to themselves amounts of stock
far beyond what an unbiased outsider might
judge to represent a fair reward for services
performed.
There is only one real protection against
abuses like these.This is to confine investments
to companies the managements of which have
a highly developed sense of trusteeship and
moral responsibility to their stockholders.This
is a point concerning which the "scuttlebutt"
method can be very helpful. Any investment
may still be considered interesting if it
falls down in regard to almost any other one
of the fifteen points which have now been
covered, but rates an unusually high score
in regard to all the rest. Regardless of how
high the rating may be in all other matters,
however, if there is a serious question of
the lack of a strong management sense of trusteeship
for stockholders, the investor should never
seriously consider participating in such an
enterprise.
What to Buy: Applying This to Your Own Needs.
The average investor is not a specialist in
the field of investment. If a man, he usually
gives but a tiny fraction of the time or mental
effort to handling his investments that he
devotes to his own work. If a woman, the time
and effort given to investments is equally
small compared to that devoted to her normal
duties.The result is that the typical investor
has usually gathered a good deal of the half-truths,
misconceptions, and just plain bunk that the
general public has gradually accumulated about
successful investing.
One of the most widespread and least accurate
of such ideas is the popular conception of
what traits are needed to be an investment
wizard. If a public opinion poll were taken
on this subject, I suspect John Q. Public's
composite picture of such an expert would
be an introverted, bookish individual with
an accounting-type mind. This scholastic-like
investment expert would sit all day in undisturbed
isolation poring over vast quantities of balance
sheets, corporate earning statements, and
trade statistics. From these, his superior
intellect and deep understanding of figures
would glean information not available to the
ordinary mortal. This type of cloistered study
would yield invaluable knowledge about the
location of magnificent investments.
Like so many other widespread misconceptions,
this mental picture has just enough accuracy
to make it highly dangerous for anyone wanting
to get the greatest long-range benefit from
common stocks.
As already pointed out in the discussion of
the fifteen points to be considered if a major
investment winner is to be selected by any
means other than pure luck, a few of these
matters are largely determined by cloistered
mathematical calculation. Furthermore, as
mentioned near the beginning of this book,
there is more than one method by which an
investor, if sufficiently skilled, can over
the years make some money--occasionally even
really worthwhile money--through investment.
The purpose of this book is not to point out
every way such money can be made. Rather it
is to point out the best way. By the best
way is meant the greatest total profit for
the least risk. The type of accounting-statistical
activity which the general public seems to
visualize as the heart of successful investing
will, if enough effort be given it, turn up
some apparent bargains. Some of these may
be real bargains. In the case of others there
may be such acute business troubles lying
ahead, yet not discernible from a purely statistical
study, that instead of being bargains they
are actually selling at prices which in a
few years will have proven to be very high.
Meanwhile, in the case of even the genuine
bargain, the degree by which it is undervalued
is usually somewhat limited. The time it takes
to get adjusted to its true value is frequently
considerable. So far as I have been able to
observe, this means that over a time sufficient
to give a fair comparison--say five years--the
most skilled statistical bargain hunter ends
up with a profit which is but a small part
of the profit attained by those using reasonable
intelligence in appraising the business characteristics
of superbly managed growth companies. This,
of course, is after charging the growth-stock
investor with losses on ventures which did
not turn out as expected, and charging the
bargain hunter for a proportionate amount
of bargains that just didn't turn out.
The reason why the growth stocks do so much
better is that they seem to show gains in
value in the hundreds of per cent each decade.
In contrast, it is an unusual bargain that
is as much as 50 per cent undervalued.The
cumulative effect of this simple arithmetic
should be obvious.
At this point, the potential investor may
have to start revising his ideas about the
amount of time needed to locate the right
investments for his purpose, to say nothing
of the characteristics he must have if he
is to find them. Perhaps he looked forward
to spending a few hours each week in the comfort
of his home, studying scads of written material
which he felt would unlock the door to worthwhile
profits. He just does not have the time to
seek out, cultivate, and talk with all the
various people it might be wise to contact
if he wants to handle his common stock investments
to his optimum benefit. Perhaps he does have
the time. He still may not have the inclination
and personality to seek out and chat with
a group of people, most of whom he previously
had not known very well if at all. Furthermore,
it is not enough just to chat with them; it
is necessary to arouse their interest and
their confidence to a point where they will
tell what they know. The successful investor
is usually an individual who is inherently
interested in business problems.This results
in his discussing such matters in a way that
will arouse the interest of those from whom
he is seeking data. Naturally he must have
reasonably good judgment or all the data he
gets will avail him nothing.
An investor may have the time, inclination,
and judgment but still be blocked from getting
maximum results in the handling of his common
stocks. The matter of geography is also a
factor. An investor, for example, living in
or near Detroit would have opportunities for
learning about automotive accessory and parts
companies that would not be available to one
equally diligent or able in Oregon. But so
many major companies and industries are today
organized on a nation-wide basis with distribution,
if not manufacturing, centers in most key
cities, that investors living in larger industrial
centers or their suburbs usually have ample
opportunities to practice the art of finding
at least a few outstanding long-range investments.
This unfortunately is not equally true for
those living in rural areas remote from such
centers.
However, the rural investor or the overwhelming
majority of other investors who may not have
the time, inclination, or ability to uncover
outstanding investments for themselves are
by no means barred from making such investments
because of this. Actually, the investor's
work is so specialized and so intricate that
there is no more reason why an individual
should handle his own investments than that
he should be his own lawyer, doctor, architect,
or automobile mechanic. He should perform
these functions if he has special interest
in and skill at the particular field. Otherwise,
he definitely should go to an expert.
What is important is that he know enough of
the principles involved so that he can pick
a real expert rather than a hack or a charlatan.
In some
ways it is easier for a careful layman to
pick an outstanding investment advisor than,
say, a comparably superior doctor or lawyer.
In other ways it is much harder. It is harder
because the investment field has developed
much more recently than most comparable specialties.
As a result mass ideas have not yet crystallized
to the point where there is an accepted line
of demarcation between true knowledge and
mumbojumbo. There are not as yet the barriers
to weed out the ignorant and the incompetent
in the financial field that exist, for example,
in the fields of law or medicine. Even among
some of the so-called authorities on investment,
there is still enough lack of agreement on
the basic principles involved that it is as
yet impossible to have schools for training
investment experts comparable to the recognized
schools for teaching law or medicine.This
makes even more remote the practicability
of government authorities licensing those
having the necessary background of knowledge
to guide others in investments in a manner
comparable to the way our states license the
practicing of law or medicine. It is true
that many of our states do go through the
form of licensing investment advisors. However
in such instances only known dishonesty or
financial insolvency, rather than a lack of
training or skill, provides the basis for
denying a license.
All this probably results in a higher percentage
of incompetence among financial advisors than
may exist in fields such as law and medicine.
However, there are compensating factors that
can enable an individual with no personal
expertness in investments to pick a capable
financial advisor more easily than a comparably
outstanding doctor or lawyer. Finding out
which physician had lost the smallest percentage
of his practice through deaths would not be
a good way to pick a superb doctor. Neither
would a corresponding box score of cases won
and lost show the relative skill of attorneys.
Fortunately, most medical treatments are not
matters of immediate life or death, and a
good lawyer will frequently avoid going into
litigation at all.
In the investment advisor's case it is quite
different, however. There is a score board
that, after enough time has elapsed, should
pretty much reflect that advisor's investment
skill. In occasional cases it may take as
much as five years for investments to demonstrate
their real merit. Usually it does not take
that long. It would normally be foolhardy
for anyone to entrust his savings to the skill
of a so-called advisor who, working either
for himself or others, had less than five
years experience. Therefore, in the case of
investments, there is no reason
why those trying to pick a professional advisor
should not demand to see a fair cross-section
of results obtained for others. Those results,
compared to a record of security prices for
the same period of time, give a real clue
to the advisor's ability.
Two more steps are then necessary before an
investor should make final determination of
the individual or organization to which he
will delegate the important responsibility
for his funds. One is the obvious step of
being certain of that advisor's complete and
unquestioned honesty. The other step is more
complex. A financial advisor may have obtained
far above average results during a period
of falling prices not because of skill but
because he always keeps a large part of the
funds he manages in, let us say, high-grade
bonds. At another time, after a long period
of rising prices, another advisor may have
obtained above-average results because of
a tendency to go into risky, marginal companies.
As explained in the discussion of profit margins,
such companies usually do well only in such
a period and subsequently do rather poorly.
Still a third advisor might do well in both
such periods because of a tendency to try
to guess what the security markets are going
to do.This can produce magnificent results
for a while, but is almost impossible to continue
indefinitely.
Before selecting an advisor, an investor should
learn from that advisor the nature of his
basic concept of financial management. He
should then only accept an advisor with concepts
fundamentally the same as the investor's own.
Naturally, I believe that the concepts expressed
in this book are those which fundamentally
should govern. Many, reared in the old-time
financial atmosphere of "buy them when they
are cheap and sell them when they are high,"would
strongly disagree with this conclusion.
Assuming an investor desires the type of huge,
long-range gain which I believe should be
the objective of nearly all common stock purchases,
there is one matter which he must decide for
himself: whether he uses an investment advisor
or handles his own affairs. It is a decision
which must be made because the type of stocks
which qualify most satisfactorily under the
previously discussed fifteen points can vary
considerably among themselves in their investment
characteristics.
At one end of the scale are large companies
which in spite of outstanding prospects of
major further growth are so financially strong,
with roots going so deep into the economic
soil, that they qualify under the general
classification of "institutional stocks."
This means
that insurance companies, professional trustees,
and similar institutional buyers will buy
them.They will do so because they feel that,
while they may misjudge market prices and
could lose a part of their original investment
should they be forced to sell such stocks
at a time of lower quotations, they are avoiding
the greater danger of loss they could suffer
if they bought into a company that subsequently
fell from its present competitive position.
The Dow Chemical Company, Du Pont, and International
Business Machines are good examples of this
type of growth stock. In Chapter One I mentioned
the totally insignificant return available
from highgrade bonds during the ten-year period
1946 to 1956. At the close of this period,
each of these three stocks--Dow, Du Pont,
and IBM--had a value approximately five times
what it sold for at the beginning of the period.
Nor during these ten years did their holders
suffer from the standpoint of current income.
Dow, for example, is almost notorious for
the low rate of return it customarily pays
on current market price.Yet the investor who
bought Dow at the start of this period would
at the end of it be doing well from the standpoint
of current income.Although Dow at the time
of purchase would only have provided a return
of about 2½ per cent (this was a period when
yields on all stocks were high), just ten
years later it had increased dividends or
split stock so many times that the investor
would have been enjoying a dividend return
of between 8 and 9 per cent on the price of
his investment ten years earlier. More significantly,
the ten-year period covered is not an unusual
one for companies of the caliber of these
three. Decade after decade, with only occasional
interruptions from such one-time influences
as the great 1929-1932 bear market or World
War II, these stocks have given almost fabulous
performance.
At the other end of the scale, also of extreme
interest for the right sort of long-range
investment, are small and frequently young
companies which may only have total sales
of from one to six or seven million dollars
per annum, but which also have products that
might bring a sensational future. To qualify
under the fifteen points already described,
such companies will usually have a combination
of outstanding business management and equally
capable scientific personnel who are pioneering
in a new or economically promising field.The
Ampex Corporation at the time the stock was
first offered to the public in 1953 might
serve as a good example of this type of company.Within
four years the value of this stock had increased
over seven-fold.
Between these two extremes lie a host of other
promising growth companies varying all the
way from those as young and risky as wasAmpex
in 1953 to those as strong and well entrenched
as are Dow, Du Pont, and IBM today.Assuming
it is time to buy at all (see the next chapter),
which type should the investor buy?
The young growth stock offers by far the greatest
possibility of gain. Sometimes this can mount
up to several thousand per cent in a decade.
But making at least an occasional investment
mistake is inevitable even for the most skilled
investor. It should never be forgotten that
if such a mistake is made in this type of
common stock, every dollar put into the investment
can be lost. In contrast, if the stock is
bought according to the rules described in
the next chapter, any losses that might occur
in the older and more established growth stocks
should be temporary, resulting from a period
of unanticipated decline in the stock market
as a whole. The long-range gain in value of
this class of big company growth stock will,
over the years, be considerably less than
that of the small and usually younger enterprise.
Nevertheless it will mount to thoroughly worthwhile
totals. Even in the most conservative of the
growth stocks it should run to at least several
times the original investment.
Therefore, for anyone risking a stake big
enough to be of real significance to himself
or his family, the rule to follow should be
rather obvious. It is to put "most" of his
funds into the type of company which, while
perhaps not as large as a Dow, a Du Pont,
or an International Business Machines, at
least comes closer to that type of stock than
to the small young company. Whether this "most"
be 60 per cent or 100 per cent of total investments
varies with the needs or requirements of each
individual. A widow with a half million dollars
of total assets and no children might put
all her funds in the more conservative class
of growth stocks. Another widow with a million
dollars to invest and three children for whom
she would like to increase her assets--to
a degree that would not, however, jeopardize
her scale of living--might well put up to
15 per cent of her assets in carefully selected
small young companies. A businessman with
a wife, two children, a present investment
worth $400,000, and an income big enough to
save $10,000 per annum after taxes might put
all his present $400,000 into the more conservative-type
growth companies but venture the $10,000 of
new savings each year on the more risky half
of the investment scale.
In all these cases, however, the gain in value
over the years of the more conservative group
of stocks should be enough to outweigh even
complete loss of all funds put into the more
risky type. Meanwhile, if properly selected,
the more risky type could significantly increase
the total capital gain. Equally important
if this happens, these young risky companies
will by that time have reached a point in
their own development where their stocks will
no longer be carrying anything like the former
degree of risk but may even have progressed
to a status where institutions have begun
buying them.
The problems of the small investor are somewhat
more difficult.The large investor can often
completely ignore the matter of dividend returns
in his endeavor to employ all his funds in
situations affording maximum growth potential.
After his funds are so invested he may still
obtain from them sufficient dividends either
to take care of his desired standard of living
or to enable him to attain this standard if
the dividend income is added to his other
regular earning power. Most small investors
cannot live on the return on their investment
no matter how high a yield is obtained, since
the total value of their holdings is not great
enough.Therefore for the small investor the
matter of current dividend return usually
comes down to a choice between a few hundred
dollars a year starting right now, or the
chance of obtaining an income many times this
few hundred dollars a year at a later date.
Before reaching a decision on this crucial
point, there is one matter which the small
investor should face squarely.This is that
the only funds he should consider using for
common stock investment are funds that are
truly surplus. This does not mean using all
funds that remain over and above what he needs
for everyday living expense. Except in the
most unusual circumstances, he should have
a backlog of several thousand dollars, sufficient
to take care of illnesses or other unexpected
contingencies, before attempting to buy anything
with as much intrinsic risk as a common stock.
Similarly, funds already set aside for some
specific future purpose, such as sending a
child through college, should never be risked
in the stock market. It is only after taking
care of matters of this sort that he should
consider common stock investment.
The objective which the small investor then
has for this surplus becomes somewhat a matter
of personal choice and of his particular circumstances,
including the size and nature of his other
income. A young man or woman, or an older
investor with children or other heirs of whom
he or she is particularly fond, may be willing
to sacrifice a
dividend income of, say, $30 or $40 a month
in order to obtain an income ten times that
size in fifteen years. In contrast, an elderly
person with no close heirs would naturally
prefer a larger immediate income. Similarly,
a person earning a relatively small income
and with heavy financial obligations might
have no choice but to provide for immediate
needs.
However, for the great majority of small investors,
the decision on the importance of immediate
income is one of personal choice. It probably
is largely dependent on the psychology of
each individual investor. My own purely personal
view is that a small amount of additional
income (after taxes) palls in comparison to
an investment that in the years ahead could
bring me a sizable income and, in time, might
make my children really wealthy. Others may
feel quite differently about this. It is to
the large investor, and to the small investor
who feels as I do on this subject and desires
an intelligent approach to the principles
that have made these kinds of results possible,
that the procedures set forth in this book
are presented.
The success which any particular individual
will have in applying these principles to
his own investments will depend on two things.
One is the degree of skill with which he applies
them.The other is, of course, the matter of
good fortune. In an age when an unforeseeable
discovery might happen tomorrow in a research
laboratory in no way connected with the company
in which the investment has been made, and
in an age when five years from now that unrelated
research development could result in either
tripling or cutting in half the profits of
this investment, good fortune obviously can
play a tremendous part so far as any one investment
is concerned. This is why even the medium-sized
investor has an advantage over those of very
small means.This element of good or bad fortune
will largely average out if several well-selected
investments are chosen.
However, for both large and small investors
who prefer far greater income some years from
now to maximum possible return today, it is
well to remember that during the past thirty-five
years numerous studies have been made by various
financial authorities. These have compared
the results obtained from the purchase of
common stocks which afford a high dividend
yield with those obtained from the purchase
of low-yield stocks of companies that have
concentrated on growth and the reinvestment
of assets. As far as I know, every one of
these studies has shown the same trend. The
growth stocks, over a five- or ten-year
span, have proven spectacularly better so
far as their increase in capital value is
concerned.
More surprising, in the same time span such
stocks have usually so increased their dividends
that, while still paying a low return in relation
to the enhanced value at which they were by
then selling, they were by this time paying
a greater dividend return on the original
investment than were the stocks selected for
yield alone. In other words, the growth stocks
had not only shown a marked superiority in
the field of capital appreciation, but given
a reasonable time, they had grown to a point
where they showed superiority in the matter
of dividend return as well.
When to Buy:
The preceding chapters attempted to show that
the heart of successful investing is knowing
how to find the minority of stocks that in
the years ahead will have spectacular growth
in their per-share earnings.Therefore, is
there any reason to divert time or mental
effort from the main issue? Does not the matter
of when to buy become of relatively minor
importance? Once the investor is sure he has
definitely found an outstanding stock, isn't
any time at all a good time to buy it? The
answer to this depends somewhat on the investor's
objective. It also depends on his temperament.
Let us take an example.With the ease of hindsight
it can be made the most extreme example in
modern financial history. This would be the
purchase of several superbly selected enterprises
in the summer of 1929 or just before the greatest
stock market crash of American history. In
time such a purchase would have turned out
well. But twenty-five years later it would
provide a much smaller percentage gain than
would have been the case if, having done the
hardest part of the job in selecting his companies
properly, an investor had made the small extra
effort needed to understand a few simple principles
about the timing of growth stocks.
In other words, if the right stocks are bought
and held long enough they will always produce
some profit. Usually they will produce a handsome
profit. However, to produce close to the maximum
profit, the kind of spectacular profit defined
earlier, some consideration must be given
to timing.
The conventional method of timing when to
buy stocks is, I believe, just as silly as
it appears on the surface to be sensible.This
method is to
marshal a vast mass of economic data. From
these data conclusions are reached as to the
near- and medium-term course of general business.
More sophisticated investors will usually
form opinions about the future course of money
rates as well as business activity.Then, if
their forecasts for all these matters indicate
no major worsening of background conditions,
the conclusion is that the desired stock may
be bought. It sometimes appears that dark
clouds are forming on the horizon.Then those
who use this generally accepted method will
postpone or cancel purchases they otherwise
would make.
My objection to this approach is not that
it is unreasonable in theory. It is that in
the current state of human knowledge about
the economics which deal with forecasting
future business trends, it is impossible to
apply this method in practice. The chances
of being right are not good enough to warrant
such methods being used as a basis for risking
the investment of savings. This may not always
be the case. It might not even be the case
five or ten years from now. At present, able
men are attempting to harness electronic computers
to establish "input-output" series of sufficient
intricacy that perhaps at some future date
it may be possible to know with a fair degree
of precision what the coming business trends
will be.
When, if ever, such developments occur, the
art of common stock investment may have to
be radically revised. Until they occur, however,
I believe that the economics which deal with
forecasting business trends may be considered
to be about as far along as was the science
of chemistry during the days of alchemy in
the Middle Ages. In chemistry then, as in
business forecasting now, basic principles
were just beginning to emerge from a mysterious
mass of mumbo-jumbo. However, chemistry had
not reached a point where such principles
could be safely used as a basis for choosing
a course of action.
Occasionally, as in 1929, the economy gets
so out of line that speculative enthusiasm
for the future runs to unprecedented proportions.
Even in our present state of economic ignorance,
it is possible to make a pretty accurate guess
as to what will occur. However, I doubt if
the years when it is safe to do this have
averaged much more than one out of ten.They
may be even rarer in the future.
The typical investor is so used to having
economic forecasts made for him that he may
start by trusting too strongly the dependability
of such forecasts. If so, I suggest that he
look over a file of the back issues of the
Commercial & Financial Chronicle for any year
he may choose since
the end of World War II. As a matter of fact
it might pay him to look over such a file
even though he is aware of the fallibility
of these forecasts. Regardless of the year
he selects he will find, among other material,
a sizable number of articles in which leading
economic and financial authorities give their
views of the outlook for the period ahead.
Since the editors of this journal appear to
select their material so as to give the ablest
available presentations of both optimistic
and pessimistic opinions, it is not surprising
that opposing forecasts will be found in any
such series of back issues.What is surprising
is the degree by which such experts disagree
with each other. Even more surprising is how
strong and convincing some of the arguments
were bound to seem at the time they were written.This
is particularly true of some of the forecasts
that turned out to be most wrong.
The amount of mental effort the financial
community puts into this constant attempt
to guess the economic future from a random
and probably incomplete series of facts makes
one wonder what might have been accomplished
if only a fraction of such mental effort had
been applied to something with a better chance
of proving useful. I have already compared
economic forecasting with chemistry in the
days of alchemy. Perhaps this preoccupation
with trying to do something which apparently
cannot yet be done properly permits another
comparison with the Middle Ages.
That was a period when most of the Western
world lived in an environment of unnecessary
want and human suffering. This was largely
because the considerable mental ability of
the period was devoted to fruitless results.
Consider what might have been accomplished
if half as much thought had been given to
fighting hunger, disease, and greed as was
devoted to debating such points as the number
of angels that could balance on the head of
a pin. Perhaps just part of the collective
intelligence nowadays employed in the investment
community's attempt to guess the future trend
of the business cycle could produce spectacular
results if it were harnessed to more productive
purposes.
If, then, conventional studies of the near-term
economic prospect do not provide the right
method of approach to the proper timing of
buying, what does provide it? The answer lies
in the very nature of growth stocks themselves.
At the risk of being repetitious, let us review
for a moment some of the basic characteristics
of outstandingly desirable investments, as
discussed in the preceding chapter. These
companies are usually working
in one way or another on the very frontiers
of scientific technology. They are developing
various new products or processes from the
laboratory through the pilot plant to the
early stages of commercial production. All
of this costs money in varying amounts. All
of it is a drain on other profits of the business.
Even in the early stage of commercial production
the extra sales expense involved in building
sufficient volume for a new product to furnish
the desired margin of profit is such that
the out-of-pocket losses at this stage of
development may be greater than they were
during the pilot-plant period.
From the standpoint of the investor there
are two aspects of all this that have particular
significance. One of these is the impossibility
of depending on any sure time table in the
development cycle of a new product.The other
is that even for the most brilliantly-managed
enterprises, a percentage of failures is part
of the cost of doing business. In a sport,
such as baseball, even the most outstanding
league champions will have dropped some percentage
of their scheduled games.
The point in the development of a new process
that is perhaps worth the closest scrutiny
from the standpoint of timing the buying of
common stocks is that at which the first full-scale
commercial plant is about to begin production.
In a new plant for even established processes
or products, there will probably be a shake-down
period of six to eight weeks that will prove
rather expensive. It takes this long to get
the equipment adjusted to the required operating
efficiency and to weed out the inevitable
"bugs" that seem to occur in breaking in modern
intricate machinery.When the process is really
revolutionary, this expensive shake-down period
may extend far beyond the estimate of even
the most pessimistic company engineer. Furthermore,
when problems finally do get solved, the weary
stockholder still cannot look forward to immediate
profits. There are more months of still further
drain while even more of the company's profits
from older lines are being ploughed back into
special sales and advertising efforts to get
the new product accepted.
It may be that the company making all this
effort is having such growth in revenue from
other and older products that the drain on
profits is not noticed by the average stockholder.
Frequently, however, just the opposite happens.
As word first gets out about a spectacular
new product in the laboratory of a well-run
company, eager buyers bid up the price of
that company's shares. When word comes of
successful pilot-plant operation, the shares
go still higher. Few think of the old
analogy that operating a pilot plant is like
driving an automobile over a winding country
road at ten miles per hour. Running a commercial
plant is like driving on that same road at
100 miles per hour.
Then when month after month difficulties crop
up in getting the commercial plant started,
these unexpected expenses cause per-share
earnings to dip noticeably. Word spreads that
the plant is in trouble. Nobody can guarantee
when, if ever, the problems will be solved.
The former eager buyers of the stock become
discouraged sellers. Down goes the price of
the stock. The longer the shake-down lasts
the more market quotations sag. At last comes
the good news that the plant is finally running
smoothly. A two-day rally occurs in the price
of the stock. However, in the following quarter
when special sales expenses have caused a
still further sag in net income, the stock
falls to the lowest price in years.Word passes
all through the financial community that the
management has blundered.
At this point the stock might well prove a
sensational buy. Once the extra sales effort
has produced enough volume to make the first
production scale plant pay, normal sales effort
is frequently enough to continue the upward
movement of the sales curve for many years.
Since the same techniques are used, the placing
in operation of a second, third, fourth, and
fifth plant can nearly always be done without
the delays and special expenses that occurred
during the prolonged shake-down period of
the first plant. By the time plant Number
Five is running at capacity, the company has
grown so big and prosperous that the whole
cycle can be repeated on another brand new
product without the same drain on earnings
percentage-wise or the same downward effect
on the price of the company's shares. The
investor has acquired at the right time an
investment which can grow for him for many
years.
In the original edition I then used the following
words to describe an example of this type
of opportunity. I used an example that was
still fairly recent at that time. I said:
"Immediately prior to the 1954 congressional
elections, certain investment funds took advantage
of this type of situation. For several years
before this time, American Cyanamid shares
had sold in the market at a considerably lower
price-earnings ratio than most of the other
major chemical companies. I believe this was
because the general feeling in the financial
community was that, while the Lederle division
represented one of the world's most outstanding
pharmaceutical
organizations, the relatively larger industrial
and agricultural chemical activities constituted
a hodge-podge of expensive and inefficient
plants flung together in the typical `stock
market' merger period of the booming 1920's.
These properties were generally considered
anything but a desirable investment.
"Largely unnoticed was the fact that a new
management was steadily but without fanfare
cutting production costs, eliminating dead
wood, and streamlining the organization.What
was noticed was that this company was `making
a huge bet'--making a major capital expenditure,
for a company its size, in a giant new organic
chemical plant at Fortier, Louisiana. So much
complex engineering was designed into this
plant that it should have surprised no one
when the plant lagged many months behind schedule
in reaching the break-even point. As the problems
at Fortier continued, however, the situation
added to the generally unfavorable light in
which American Cyanamid shares were then being
regarded. At this stage, in the belief a buying
point was at hand, the funds to which I have
already referred acquired their holdings at
an average price of 45¾. This would be 227
8 on the present shares as a result of a 2-for-l
stock split which occurred in 1957.
"What has happened since? Sufficient time
has elapsed for the company to begin getting
the benefits of some of the management activities
that were creating abnormal costs in 1954.Fortier
is now profitable.Earnings have increased
from $1.48 per (present) common share in 1954
to $2.10 per share in 1956 and promise to
be slightly higher in 1957, a year in which
most chemical (though not pharmaceutical)
profits have run behind those of the year
before. At least as important, `Wall Street'
has come to realize that American Cyanamid's
industrial and agricultural chemical activities
are worthy of institutional investment.As
a result, the price-earnings ratio of these
shares has changed noticeably.A 37 per cent
increase in earnings that has taken place
in somewhat under three years has produced
a gain in market value of approximately 85
per cent."
Since writing these words, the financial community's
steady upgrading of the status of American
Cyanamid appears to have continued.With earnings
for 1959 promising to top the previous all-time
peak of $2.42 in 1957, the market price of
these shares has steadily advanced. It now
is about 60, representing a gain of about
70 per cent in earning power and 163 per cent
in market value in the five years since the
shares referred to in the first edition were
acquired.
I would like to end the discussion of American
Cyanamid on this happy note. However, in the
preface to this revised edition I stated I
intended to make this revision an honest record
and not the most favorable sounding record
it might appear plausible to present.You may
have noticed that in the original edition
I referred to this 1954 purchase of Cyanamid
stock by "certain funds"; these funds are
no longer retaining the shares, which were
sold in the spring of 1959 at an average price
of about 49.This was of course significantly
below the current market but still represented
a profit of about 110 per cent.
The size of the profit had nothing whatsoever
to do with the decision to sell.There were
two motives behind this decision. One was
that the long-range outlook for another company
appeared even better.You will find this discussed
in the next chapter as one of the valid reasons
for selling. While not enough time has yet
passed to give conclusive proof one way or
the other, so far comparative market quotations
for both stocks appear to have warranted this
move.
However, there was a second motive behind
this switch of investments which hindsight
may prove to be less creditable.This was concern
that in relation to the most outstanding of
competitive companies,American Cyanamid's
chemical (in contrast to its pharmaceutical)
business was not making as much progress in
broadening profit margins and establishing
profitable new lines as had been hoped. Concern
over these factors was accentuated by uncertainty
over the possible costs of the company's attempt
to establish itself in the acrylic fiber business
in the highly competitive textile industry.This
reasoning may prove to be correct and still
could turn out to have been the wrong investment
decision, because of bright prospects in the
Lederle, or pharmaceutical, division. These
prospects have become more apparent since
the shares were sold. The possibilities for
a further sharp jump in Lederle earning power
in the medium-term future center around 1)
a new and quite promising antibiotic, and
2) in time a sizable market for an oral "live"
polio vaccine, a field in which this company
has been a leader. These developments make
it problematic and a matter that only the
future will decide as to whether this decision
to dispose of Cyanamid shares may not have
been an investment mistake. Because studying
possible mistakes can be even more rewarding
than reviewing past successes, I am going
to suggest--even at the risk of appearing
presumptuous--that anyone seriously interested
in bettering his investment technique mark
these last several paragraphs and reread them
after having read the coming chapter on "When
to Sell."
Now let me turn to the next and more recent
example of this type of purchasing opportunity
which I cited in the original edition. I said:
"A somewhat similar situation may be occurring
in the second half of 1957 in the case of
the Food Machinery and Chemical Corporation.
A few large institutional buyers have liked
these shares for some time. Many more, however,
seem to feel that in spite of some elements
of interest they want evidence concerning
certain matters before acquiring shares.To
understand this attitude it is necessary to
go into some of the background.
"Prior to World War II this company had confined
its activities to a diversified line of machinery
manufacture. As a result of brilliant management
and equally brilliant developmental engineering,
Food Machinery had become one of the spectacularly
successful investments of the prewar period.Then
during the war, in addition to going into
the related line of ordnance manufacture at
which the company has been comparably successful,
the company built up a diversified chemical
business. Reason for this was a desire to
stabilize the cyclical tendency of the machinery
business through the manufacture of consumable
products, sales of which over the years could
be continuously expanded through research
in much the same manner as had been so successfully
exploited in the machinery and ordnance divisions.
"By 1952, four separate companies had been
acquired and were converted into four (now
five) divisions. Combined they represent slightly
less than half the total sales volume if ordnance
activities are included, slightly more than
half if only the normal non-defense activities
are considered. Before and in the early acquisition
years, these chemical units varied enormously.
One was a leader in a rapidly growing field
with broad profit margins and excellent technical
prestige in the industry. Another suffered
from obsolete plant, low margins, and poor
morale.The average of all left much to be
desired in comparison with the real leaders
among chemical companies. In some cases there
were intermediate products without basic raw
materials. In others, there were plenty of
low-profit raw materials, but few products
with higher profit margins that could be built
from these raw materials.
"The financial community reached some pretty
definite conclusions on all this.The machinery
divisions--with an internal growth rate of
9 to 10 per cent per annum (comparable to
the chemical industry as a whole), with a
demonstrated ability to design and sell ingenious
and commercially worthwhile new products year
after year, and with some of the lowest cost
plants in their respective fields--represented
the highest grade investment. However, until
the chemical divisions could demonstrate broader
over-all profit margins and other evidence
of intrinsic quality, there was little desire
to invest in this combined enterprise.
"Meanwhile, the management went aggressively
to work to solve this problem. What did they
do? Their first move was through internal
promotions and external recruitments to build
up a top management team.This new team spent
money on modernizing old plant, developing
new plant, and on research. Entirely aside
from plant expenditures that are normally
capitalized, it is impossible to undergo major
modernization and plant expansion without
running up current expenses as well. It is
rather surprising that all the abnormal expenses
that occurred in 1955, 1956, and 1957 did
not cause reported chemical earnings to decline
during that period. The fact that earnings
held steady gives strong indication of the
worth of what had already been done.
"In any event, if projects have been properly
planned, the cumulative effect of those already
completed must in time outweigh the abnormal
expense of those still to come. Something
of this sort might have happened as far back
as 1956 if research expenditures in that year
had not been increased about 50 per cent above
the 1955 levels. This was done even though
in 1955 these expenditures for chemical research
were not far below the average of the industry,
and those for machinery research were well
above that of most segments of the machinery
business. In spite of continuing this higher
level of research, such an earning spurt was
expected in the second half of 1957.At midyear
the company's modernized chlorine cells at
South Charleston, West Virginia, were scheduled
to go on stream. Unexpected troubles, characteristic
of the chemical industry but from which this
company had been surprisingly free in most
of its other modernization and expansion programs,
indicate that it will be the first quarter
of 1958 before this earning spurt will now
occur.
"I suspect that until this earning betterment
comes and chemical profit margins grow and
continue to broaden for a period of time,
the institutional buyer will generally fail
to look beneath the surface and will largely
stay away from this stock. If, as I suspect
will happen, such a development manifests
itself in 1958 and 1959, financial sentiment
some time in that period will come around
to recognizing the basic improvement
in fundamentals that started several years
before. At that time the stock, which may
then continue to grow for years, will be selling
at a price that has advanced partly because
of the improvement in per-share earnings that
had already occurred but even more because
of the changed price-earnings ratio that results
from a general reappraisal of the company's
intrinsic quality."
I believe the record of the past two years
emphatically validates these comments. Possibly
the first general recognition of what had
been happening beneath the surface came when
in the depression-like year of 1958, a year
when nearly all chemical and machinery companies
showed a decided drop in earning power, Food
Machinery reported profits at an all-time
peak of $2.39 per share.This was moderately
above the levels of the several preceding
years when the general economy was at higher
levels. It was a tip-off that the chemical
divisions were at last being brought to a
point where they could take their place along
with the machinery end of the business as
a highly desirable and not a marginal investment.While
1959 profits are not yet available as these
words are written, the sharp gains in earning
power reported for the first nine months over
the corresponding period of 1958 give further
assurance that the long period of reorganizing
the chemical divisions is bearing rich fruit.The
1959 gains are perhaps particularly significant
in that this is the year in which the ordnance
division is in transition from its former
principal product of an armored personnel
and light equipment amphibious tank-like carrier
made of steel, to an aluminum one that can
be dropped from the air by parachute.This
means that 1959 was the one year in the recent
past or foreseeable future in which ordnance
activities made no significant contribution
to total earning power. Yet an important new
earning peak was attainted.
How is the market responding to all this?
At the end of September 1957, when writing
of the first edition was concluded, these
shares were selling at 25¼.Today they are
at 51, a gain of 102 per cent. It is beginning
to look as though the financial sentiment
I mentioned in the original edition is beginning
"to recognize the basic improvement in fundamentals
that started some years before."
Other events are confirming this trend and
may give further impetus to it. In 1959 the
McGraw-Hill Publications inaugurated a new
custom. They decided each year to give an
award for outstanding management achievement
in the chemical industries. To determine the
first winner
of this honor they selected an unusually distinguished
and informed panel of ten members. Four represented
leading university graduate schools of business
administration, three came from major investment
institutions with heavy holdings in the chemical
industry, and three were leading members of
prominent chemical consulting firms.Twentytwo
companies were nominated and fourteen submitted
presentations. This award for management accomplishment
did not go to one or another of the giants
of the industry, the managements of several
of which, with very good reason, are highly
respected in Wall Street. Instead it went
to the Chemical Divisions of the Food Machinery
Corporation which, two years before, had been
regarded by most and is still regarded by
many institutional stock buyers as a rather
undesirable investment!
Why is a matter of this sort of major importance
to long-range investors? First, it gives strong
assurance that, plus or minus the trend of
general business activity, the earnings of
such a company will grow for years to come.
Informed chemical businessmen would not give
this kind of award in the industry to a company
that did not have the research departments
to keep developing worthwhile new products
and the chemical engineers to produce them
profitably.Secondly,this type of award will
leave its impression on the investment community.
Nothing is more desirable for stockholders
than the influence on share prices of an upward
trend of earnings multiplied by a comparable
upward trend in the way each dollar of such
earnings is valued in the market place, as
I mentioned in my concluding remarks about
this company in the original edition.
Other matters besides the introduction of
new products and the problems of starting
complex plants can also open up buying opportunities
in the unusual company. For example, a Middle
Western electronic company was, among other
things, well known for its unusual and excellent
labor relations. It grew to a point where
size alone forced some change in its method
of handling employees. An unfortunate interplay
of personalities caused friction, slow-down
strikes, and low productivity in an enterprise
heretofore known for its good labor relations
and high labor productivity. At just this
time the company made one of the very few
mistakes it has made in judging the potential
market for a new product. Earnings dropped
precipitously and so did the price of the
shares.
The unusually able and ingenious management
made plans at once to correct this situation.While
plans can be made in a matter of weeks,
putting them into effect takes much longer.
As results from these plans began coming through
to earnings, the stock reached what might
be called buying point A. However, it took
about a year and a half before all the benefits
could flow through to the profit statement.Toward
the end of this period a second strike occurred,
settlement of which was the last step needed
to enable the company to restore competitive
efficiency. This strike was not a long one.
Nevertheless, while this short and relatively
inexpensive strike was occurring, word went
through the financial community that labor
matters were going from bad to worse. In spite
of heavy buying from officers of the company,
the stock went lower. It did not stay lower
for long. This proved to be another of the
right sort of buying opportunities from the
standpoint of timing, and might be called
buying point B.Those who looked beneath the
surface and saw what was really happening
were able to buy, at bargain prices, a stock
that may well grow for them for many years.
Let us see just how profitable it might have
been if an investor had bought at either buying
point A or buying point B. I do not intend
to use the lowest price which a table of monthly
price ranges would show that this stock reached
in either period.This is because only a few
hundred shares changed hands at the extreme
low point. If an investor had bought at the
absolute lows, it would have been more a matter
of luck than anything else. Instead, I will
use a figure moderately above the low in one
case and several points above in the other.
In each instance a good many thousand shares
were available and changed hands at these
levels. I will use only prices at which the
shares could easily have been bought by anyone
making a realistic study of the situation.
At buying point A the stock had slipped in
just a few months by about 24 per cent from
its former peak.Within about a year those
who bought here would have had a gain in market
value of between 55 per cent and 60 per cent.Then
came the strike that produced buying point
B. The stock dropped back almost 20 per cent.
Strangely enough, it remained there for some
weeks after the strike ended. At this time,
a brilliant employee of a large investment
trust explained to me that he knew how good
the situation was and what was almost sure
to happen. Nevertheless he would not recommend
the purchase to his financial committee. He
said certain of the members were sure to check
with Wall Street friends and not only turn
down his recommendation, but rebuke him for
bringing to their attention a company with
a sloppy management and hopeless labor relations!
As I write this not so many months later,
the stock has already risen 50 per cent from
buying point B. This means that it is now
up over 90 per cent from buying point A. More
important, the company's future looks brilliant,
with every prospect that it will enjoy abnormal
growth for years to come just as it did for
some years before the combination of unusual
and temporary unfortunate occurrences produced
buying points A and B. Those who bought at
either time got into the right sort of company
at the right sort of time.
In short, the company into which the investor
should be buying is the company which is doing
things under the guidance of exceptionally
able management.A few of these things are
bound to fail. Others will from time to time
produce unexpected troubles before they succeed.
The investor should be thoroughly sure in
his own mind that these troubles are temporary
rather than permanent. Then if these troubles
have produced a significant decline in the
price of the affected stock and give promise
of being solved in a matter of months rather
than years, he will probably be on pretty
safe ground in considering that this is a
time when the stock may be bought.
All buying points do not arise out of corporate
troubles. In industries such as chemical production,
where large amounts of capital are required
for each dollar of sales, another type of
opportunity sometimes occurs.The mathematics
of such situations are usually about like
this: A new plant or plants will be erected
for, say, $10 million. A year or two after
these plants are in full-scale operation,
the company's engineers will go over them
in detail.They will come up with proposals
for spending an additional, say, $1½ million.
For this 15 per cent greater total capital
investment the engineers will show how the
output of the plants can be increased by perhaps
40 per cent of previous capacity.
Obviously, since the plants are already profitable
and 40 per cent more output can be made and
sold for only 15 per cent more capital cost,
and since almost no additional general overhead
is involved, the profit margin on this extra
40 per cent of output will be unusually good.
If the project is large enough to affect the
company's earnings as a whole, buying the
company's shares just before this improvement
in earning power has been reflected in the
market price for these shares can similarly
mean a chance to get into the right sort of
company at the right time.
What is the common denominator of each of
the examples just given? It is that a worthwhile
improvement in earnings is coming in the
right sort of company, but that this particular
increase in earnings has not yet produced
an upward move in the price of that company's
shares. I believe that whenever this situation
occurs the right sort of investment may be
considered to be in a buying range. Conversely,
when it does not occur, an investor will still
in the long run make money if he buys into
outstanding companies. However, he had then
better have a somewhat greater degree of patience
for it will take him longer to make this money
and percentage-wise it will be a considerably
smaller profit on his original investment.
Does this mean that if a person has some money
to invest he should completely ignore what
the future trend of the business cycle may
be and invest 100 per cent of this fund the
moment he has found the right stocks, as defined
in Chapter Three, and located a good buying
point, as indicated in this chapter? A depression
might strike right after he has made his investment.
Since a decline of 40 to 50 per cent from
its peak is not at all uncommon for even the
best stock in a normal business depression,
is not completely ignoring the business cycle
rather a risky policy?
I think this risk may be taken in stride by
the investor who, for a considerable period
of time, has already had the bulk of his stocks
placed in well-chosen situations. If properly
chosen, these should by now have already shown
him some fairly substantial capital gains.
But now, either because he believes one of
his securities should be sold or because some
new funds have come his way, such an investor
has funds to purchase something new. Unless
it is one of those rare years when speculative
buying is running riot in the stock market
and major economic storm signals are virtually
screaming their warnings (as happened in 1928
and 1929), I believe this class of investor
should ignore any guesses on the coming trend
of general business or the stock market. Instead
he should invest the appropriate funds as
soon as the suitable buying opportunity arises.
In contrast to guessing which way general
business or the stock market may go, he should
be able to judge with only a small probability
of error what the company into which he wants
to buy is going to do in relation to business
in general. Therefore he starts off with two
advantages. He is making his bet upon something
which he knows to be the case, rather than
upon something about which he is largely guessing.
Furthermore, since by definition he is only
buying into a situation which for one reason
or another is about to have a worthwhile increase
in its earning power in the near- or medium-term
future, he has a
second element of support. Just as his stock
would have risen more than the average stock
when this new source of earning power became
recognized in the market place if business
had remained good, so if by bad fortune he
has made his new purchase just prior to a
general market break this same new source
of earnings should prevent these shares from
declining quite as much as other stocks of
the same general type.
However, many investors are not in the happy
position of having a backlog of well-chosen
investments bought comfortably below present
prices. Perhaps this may be the first time
they have funds to invest. Perhaps they may
have a portfolio of bonds or relatively static
non-growth stocks which at long last they
desire to convert into shares that in the
future will show them more worthwhile gains.
If such investors get possession of new funds
or develop a desire to convert to growth stocks
after a prolonged period of prosperity and
many years of rising stock prices, should
they, too, ignore the hazards of a possible
business depression? Such an investor would
not be in a very happy position if, later
on, he realized he had committed all or most
of his assets near the top of a long rise
or just prior to a major decline.
This does create a problem. However, the solution
to this problem is not especially difficult--as
in so many other things connected with the
stock market it just requires an extra bit
of patience. I believe investors in this group
should start buying the appropriate type of
common stocks just as soon as they feel sure
they have located one or more of them. However,
having made a start in this type of purchasing,
they should stagger the timing of further
buying. They should plan to allow several
years before the final part of their available
funds will have become invested. By so doing,
if the market has a severe decline somewhere
in this period, they will still have purchasing
power available to take advantage of such
a decline. If no decline occurs and they have
properly selected their earlier purchases,
they should have at least a few substantial
gains on such holdings. This would provide
a cushion so that if a severe decline happened
to occur at the worst possible time for them--which
would be just after the final part of their
funds had become fully invested--the gains
on the earlier purchases should largely, if
not entirely, offset the declines on the more
recent ones. No severe loss of original capital
would therefore be involved.
There is an equally important reason why investors
who have not already obtained a record of
satisfactory investments, and who have
enough funds to be able to stagger their purchases
should do so. This is that such investors
will have had a practical demonstration, prior
to using up all their funds, that they or
their advisors are sufficient masters of investment
technique to operate with reasonable efficiency.
In the event that such a record had not been
attained, at least all of an investor's assets
would not be committed before he had had a
warning signal to revise his investment technique
or to get someone else to handle such matters
for him.
All types of common stock investors might
well keep one basic thought in mind; otherwise
the financial community's constant worry about
and preoccupation with the danger of downswings
in the business cycle will paralyze much worthwhile
investment action. This thought is that here
in the mid-twentieth century the current phase
of the business cycle is but one of at least
five powerful forces. All of these forces,
either by influencing mass psychology or by
direct economic operation, can have an extremely
powerful influence on the general level of
stock prices.
The other four influences are the trend of
interest rates, the over-all governmental
attitude toward investment and private enterprise,
the long-range trend to more and more inflation,
and--possibly most powerful of all--new inventions
and techniques as they affect old industries.
These forces are seldom all pulling stock
prices in the same direction at the same time.
Nor is any one of them necessarily going to
be of vastly greater importance than any other
for long periods of time. So complex and diverse
are these influences that the safest course
to follow will be the one that at first glance
appears to be the most risky.This is to take
investment action when matters you know about
a specific company appear to warrant such
action. Be undeterred by fears or hopes based
on conjectures, or conclusions based on surmises.
When to Sell, And When Not To.
There are many good reasons why an investor
might decide to sell common stocks. He may
want to build a new home or finance his son
in a business. Any one of a number of similar
reasons can, from the standpoint of happy
living, make selling common stocks sensible.
This type of selling, however, is personal
rather than financial in its motive. As such
it is well beyond the scope of this book.
These comments are only designed to cover
that type of selling that is motivated by
a single objective--obtaining the greatest
total dollar benefit from the investment dollars
available.
I believe there are three reasons, and three
reasons only, for the sale of any common stock
which has been originally selected according
to the investment principles already discussed.
The first of these reasons should be obvious
to anyone. This is when a mistake has been
made in the original purchase and it becomes
increasingly clear that the factual background
of the particular company is, by a significant
margin, less favorable than originally believed.
The proper handling of this type of situation
is largely a matter of emotional self-control.
To some degree it also depends upon the investor's
ability to be honest with himself.
Two of the important characteristics of common
stock investment are the large profits that
can come with proper handling, and the high
degree of skill, knowledge, and judgment required
for such proper handling. Since the process
of obtaining these almost fantastic profits
is so complex, it is not surprising that a
certain percentage of errors in purchasing
are sure to occur. Fortunately the long-range
profits from really good common stocks should
more than balance the losses from a normal
percentage of such mistakes. They should leave
a tremendous margin of gain as well.This is
particularly true if the mistake is recognized
quickly. When this happens, losses, if any,
should be far smaller than if the stock bought
in error had been held for a long period of
time. Even more important, the funds tied
up in the undesirable situation are freed
to be used for something else which, if properly
selected, should produce substantial gains.
However, there is a complicating factor that
makes the handling of investment mistakes
more difficult. This is the ego in each of
us. None of us likes to admit to himself that
he has been wrong. If we have made a mistake
in buying a stock but can sell the stock at
a small profit, we have somehow lost any sense
of having been foolish. On the other hand,
if we sell at a small loss we are quite unhappy
about the whole matter. This reaction, while
completely natural and normal, is probably
one of the most dangerous in which we can
indulge ourselves in the entire investment
process. More money has probably been lost
by investors holding a stock they really did
not want until they could "at least come out
even" than from any other single reason. If
to these actual losses are added the profits
that might have been made through the proper
reinvestment of these funds if such reinvestment
had been made when the mistake was first realized,
the cost of self-indulgence becomes truly
tremendous.
Furthermore this dislike of taking a loss,
even a small loss, is just as illogical as
it is natural. If the real object of common
stock investment is the making of a gain of
a great many hundreds per cent over a period
of years, the difference between, say, a 20
per cent loss or a 5 per cent profit becomes
a comparatively insignificant matter.What
matters is not whether a loss occasionally
occurs.What does matter is whether worthwhile
profits so often fail to materialize that
the skill of the investor or his advisor in
handling investments must be questioned.
While losses should never cause strong self-disgust
or emotional upset, neither should they be
passed over lightly. They should always
be reviewed with care so that a lesson is
learned from each of them. If the particular
elements which caused a misjudgment on a common
stock purchase are thoroughly understood,
it is unlikely that another poor purchase
will be made through misjudging the same investment
factors.
We come now to the second reason why sale
should be made of a common stock purchased
under the investment principles already outlined
in Chapters Two and Three. Sales should always
be made of the stock of a company which, because
of changes resulting from the passage of time,
no longer qualifies in regard to the fifteen
points outlined in Chapter Three to about
the same degree it qualified at the time of
purchase. This is why investors should be
constantly on their guard. It explains why
it is of such importance to keep at all times
in close contact with the affairs of companies
whose shares are held.
When companies deteriorate in this way they
usually do so for one of two reasons. Either
there has been a deterioration of management,
or the company no longer has the prospect
of increasing the markets for its product
in the way it formerly did. Sometimes management
deteriorates because success has affected
one or more key executives. Smugness, complacency,
or inertia replace the former drive and ingenuity.
More often it occurs because a new set of
top executives do not measure up to the standard
of performance set by their predecessors.
Either they no longer hold to the policies
that have made the company outstandingly successful,
or they do not have the ability to continue
to carry out such policies. When any of these
things happen the affected stock should be
sold at once, regardless of how good the general
market may look or how big the capital gains
tax may be.
Similarly it sometimes happens that after
growing spectacularly for many years, a company
will reach a stage where the growth prospects
of its markets are exhausted. From this time
on it will only do about as well as industry
as a whole. It will only progress at about
the same rate as the national economy does.This
change may not be due to any deterioration
of the management. Many managements show great
skill in developing related or allied products
to take advantage of growth in their immediate
field. They recognize, however, that they
do not have any particular advantage if they
go into unrelated spheres of activity. Hence,
if after years of being experts in a young
and growing industry, times change and the
company has pretty well exhausted the growth
prospects of its market, its shares have deteriorated
in an important way from the
standards outlined under our frequently mentioned
fifteen points. Such a stock should then be
sold.
In this instance, selling might take place
at a more leisurely pace than if management
deterioration had set in.Possibly part of
the holding might be kept until a more suitable
investment could be found. However, in any
event,the company should be recognized as
no longer suitable for worthwhile investment.The
amount of capital gains tax, no matter how
large, should seldom prevent the switching
of such funds into some other situation which,
in the years ahead, may grow in a manner similar
to the way in which this investment formerly
grew.
There is a good test as to whether companies
no longer adequately qualify in regard to
this matter of expected further growth. This
is for the investor to ask himself whether
at the next peak of a business cycle, regardless
of what may happen in the meantime, the comparative
pershare earnings (after allowances for stock
dividends and stock splits but not for new
shares issued for additional capital) will
probably show at least as great an increase
from present levels as the present levels
show from the last known peak of general business
activity. If the answer is in the affirmative,
the stock probably should be held. If in the
negative, it should probably be sold.
For those who follow the right principles
in making their original purchases, the third
reason why a stock might be sold seldom arises,
and should be acted upon only if an investor
is very sure of his ground. It arises from
the fact that opportunities for attractive
investment are extremely hard to find. From
a timing standpoint, they are seldom found
just when investment funds happen to be available.
If an investor has had funds for investment
for quite a period of time and found few attractive
situations into which to place these funds,
he may well place some or all of them in a
well-run company which he believes has definite
growth prospects. However, these growth prospects
may be at a slower average annual rate than
may appear to be the case for some other seemingly
more attractive situation that is found later.
The already-owned company may in some other
important aspects appear to be less attractive
as well.
If the evidence is clear-cut and the investor
feels quite sure of his ground, it will, even
after paying capital gains taxes, probably
pay him handsomely to switch into the situation
with seemingly better prospects.The company
that can show an average annual increase of
12 per cent for a long period of years should
be a source of considerable
financial satisfaction to its owners. However,
the difference between these results and those
that could occur from a company showing a
20 per cent average annual gain would be well
worth the additional trouble and capital gains
taxes that might be involved.
A word of caution may not be amiss, however,
in regard to too readily selling a common
stock in the hope of switching these funds
into a still better one.There is always the
risk that some major element in the picture
has been misjudged. If this happens, the investment
probably will not turn out nearly as well
as anticipated. In contrast, an alert investor
who has held a good stock for some time usually
gets to know its less desirable as well as
its more desirable characteristics. Therefore,
before selling a rather satisfactory holding
in order to get a still better one, there
is need of the greatest care in trying to
appraise accurately all elements of the situation.
At this point the critical reader has probably
discerned a basic investment principle which
by and large seems only to be understood by
a small minority of successful investors.This
is that once a stock has been properly selected
and has borne the test of time, it is only
occasionally that there is any reason for
selling it at all. However, recommendations
and comments continue to pour out of the financial
community giving other types of reasons for
selling outstanding common stocks.What about
the validity of such reasons?
Most frequently given of such reasons is the
conviction that a general stock market decline
of some proportion is somewhere in the offing.
In the preceding chapter I tried to show that
postponing an attractive purchase because
of fear of what the general market might do
will, over the years, prove very costly.This
is because the investor is ignoring a powerful
influence about which he has positive knowledge
through fear of a less powerful force about
which, in the present state of human knowledge,
he and everyone else is largely guessing.
If the argument is valid that the purchase
of attractive common stocks should not be
unduly influenced by fear of ordinary bear
markets, the argument against selling outstanding
stocks because of these fears is even more
impressive. All the arguments mentioned in
the previous chapter equally apply here. Furthermore,
the chance of the investor being right in
making such sales is still further diminished
by the factor of the capital gains tax. Because
of the very large profits such outstanding
stocks should be showing if they have been
held for a period of years, this capital gains
tax can still further accentuate the cost
of making such sales.
There is another and even more costly reason
why an investor should never sell out of an
outstanding situation because of the possibility
that an ordinary bear market may be about
to occur. If the company is really a right
one, the next bull market should see the stock
making a new peak well above those so far
attained. How is the investor to know when
to buy back? Theoretically it should be after
the coming decline. However, this presupposes
that the investor will know when the decline
will end. I have seen many investors dispose
of a holding that was to show stupendous gain
in the years ahead because of this fear of
a coming bear market. Frequently the bear
market never came and the stock went right
on up.When a bear market has come, I have
not seen one time in ten when the investor
actually got back into the same shares before
they had gone up above his selling price.
Usually he either waited for them to go far
lower than they actually dropped, or, when
they were way down, fear of something else
happening still prevented their reinstatement.
This brings us to another line of reasoning
so often used to cause well-intentioned but
unsophisticated investors to miss huge future
profits. This is the argument that an outstanding
stock has become overpriced and therefore
should be sold.What is more logical than this?
If a stock is overpriced, why not sell it
rather than keep it?
Before reaching hasty conclusions, let us
look a little bit below the surface. Just
what is overpriced? What are we trying to
accomplish? Any really good stock will sell
and should sell at a higher ratio to current
earnings than a stock with a stable rather
than an expanding earning power. After all,
this probability of participating in continued
growth is obviously worth something. When
we say that the stock is overpriced, we may
mean that it is selling at an even higher
ratio in relation to this expected earning
power than we believe it should be. Possibly
we may mean that it is selling at an even
higher ratio than are other comparable stocks
with similar prospects of materially increasing
their future earnings.
All of this is trying to measure something
with a greater degree of preciseness than
is possible.The investor cannot pinpoint just
how much per share a particular company will
earn two years from now. He can at best judge
this within such general and non-mathematical
limits as "about the same," "up moderately,"
"up a lot," or "up tremendously." As a matter
of fact, the company's top management cannot
come a great deal closer than this. Either
they or the investor should come pretty
close in judging whether a sizable increase
in average earnings is likely to occur a few
years from now. But just how much increase,
or the exact year in which it will occur,
usually involves guessing on enough variables
to make precise predictions impossible.
Under these circumstances, how can anyone
say with even moderate precision just what
is overpriced for an outstanding company with
an unusually rapid growth rate? Suppose that
instead of selling at twentyfive times earnings,
as usually happens, the stock is now at thirty-five
times earnings. Perhaps there are new products
in the immediate future, the real economic
importance of which the financial community
has not yet grasped. Perhaps there are not
any such products. If the growth rate is so
good that in another ten years the company
might well have quadrupled, is it really of
such great concern whether at the moment the
stock might or might not be 35 per cent overpriced?
That which really matters is not to disturb
a position that is going to be worth a great
deal more later.
Again our old friend the capital gains tax
adds its bit to these conclusions. Growth
stocks which are recommended for sale because
they are supposedly overpriced nearly always
will cost their owners a sizable capital gains
tax if they are sold.Therefore, in addition
to the risk of losing a permanent position
in a company which over the years should continue
to show unusual further gains, we also incur
a sizable tax liability. Isn't it safer and
cheaper simply to make up our minds that momentarily
the stock may be somewhat ahead of itself?
We already have a sizable profit in it. If
for a while the stock loses, say, 35 per cent
of its current market quotation, is this really
such a serious matter? Again, isn't the maintaining
of our position rather than the possibility
of temporarily losing a small part of our
capital gain the matter which is really important?
There is still one other argument investors
sometimes use to separate themselves from
the profits they would otherwise make.This
one is the most ridiculous of all. It is that
the stock they own has had a huge advance.
Therefore, just because it has gone up, it
has probably used up most of its potential.
Consequently they should sell it and buy something
that hasn't gone up yet. Outstanding companies,
the only type which I believe the investor
should buy, just don't function this way.
How they do function might best be understood
by considering the following somewhat fanciful
analogy:
Suppose it is the day you graduated from college.
If you did not go to college, consider it
to be the day of your high school graduation;
from the standpoint of our example it will
make no difference whatsoever. Now suppose
that on this day each of your male classmates
had an urgent need of immediate cash. Each
offered you the same deal. If you would give
them a sum of money equivalent to ten times
whatever they might earn during the first
twelve months after they had gone to work,
that classmate would for the balance of his
life turn over to you one quarter of each
year's earnings! Finally let us suppose that,
while you thought this was an excellent proposition,
you only had spare cash on hand sufficient
to make such a deal with three of your classmates.
At this point, your reasoning would closely
resemble that of the investor using sound
investment principles in selecting common
stocks. You would immediately start analyzing
your classmates, not from the standpoint of
how pleasant they might be or even how talented
they might be in other ways, but solely to
determine how much money they might make.
If you were part of a large class, you would
probably eliminate quite a number solely on
the ground of not knowing them sufficiently
well to be able to pass worthwhile judgment
on just how financially proficient they actually
would get to be. Here again, the analogy with
intelligent common stock buying runs very
close.
Eventually you would pick the three classmates
you felt would have the greatest future earning
power. You would make your deal with them.
Ten years have passed. One of your three has
done sensationally. Going to work for a large
corporation, he has won promotion after promotion.
Already insiders in the company are saying
that the president has his eye on him and
that in another ten years he will probably
take the top job. He will be in line for the
large compensation, stock options, and pension
benefits that go with that job.
Under these circumstances,what would even
the writers of stock market reports who urge
taking profits on superb stocks that"have
gotten ahead of the market"think of your selling
out your contract with this former classmate,
just because someone has offered you 600 per
cent on your original investment? You would
think that anyone would need to have his head
examined if he were to advise you to sell
this contract and replace it with one with
another former classmate whose annual earnings
still were about the same as when he left
school ten years before.The argument that
your successful classmate had had his advance
while the advance of your (financially) unsuccessful
classmate still lay ahead of him would probably
sound rather silly. If you know your common
stocks equally well, many of the arguments
commonly heard for selling the good one sound
equally silly.
You may be thinking all this sounds fine,
but actually classmates are not common stocks.
To be sure, there is one major difference.
That difference increases rather than decreases
the reason for never selling the outstanding
common stock just because it has had a huge
rise and may be temporarily overpriced.This
difference is that the classmate is finite,
may die soon and is sure to die eventually.
There is no similar life span for the common
stock. The company behind the common stock
can have a practice of selecting management
talent in depth and training such talent in
company policies, methods, and techniques
in a way which will retain and pass on the
corporate vigor for generations. Look at Du
Pont in its second century of corporate existence.
Look at Dow years after the death of its brilliant
founder. In this era of unlimited human wants
and incredible markets, there is no limitation
to corporate growth such as the life span
places upon the individual.
Perhaps the thoughts behind this chapter might
be put into a single sentence: If the job
has been correctly done when a common stock
is purchased, the time to sell it is--almost
never.
The Hullabaloo about Dividends.
There is a considerable degree of twisted
thinking and general acceptance of half truths
about a number of aspects of common stock
investments. However, whenever the significance
and importance of dividends are considered,
the confusion of the typical investor becomes
little short of monumental.
This confusion and acceptance of half truths
spreads over even to the choice of words customarily
used in describing various types of dividend
action. A corporation has been paying no dividend
or a small one. Its president requests the
board of directors to start paying a substantial
dividend.This is done. In speaking of this
action he or the board will often describe
it by saying that the time had come to "do
something" for stockholders.The inference
is that by not paying or raising the dividend
the company had been doing nothing for its
stockholders. This could possibly be true.
However, it certainly was not true just because
no dividend action had been taken. It is possible
that by spending earnings not as dividends
but to build a new plant, to launch a new
product line, or to install some major cost-saving
equipment in an old plant, the management
might have been doing much more to benefit
the stockholder than it would have been doing
just by passing these earnings out as dividends.
No matter what might be done with any earnings
not passed on as dividends, increases in the
dividend rate are invariably referred to as
"favorable" dividend action. Possibly with
greater reason, reduction or elimination of
dividends is nearly always called "unfavorable."
One of the main reasons for the confusion
about dividends in the public mind is the
great variation between the amount of benefit,
if any,
that accrues to the stockholder each time
earnings are not passed on to him but retained
in the business. At times he is not benefited
at all by such retained earnings. At others
he is benefited only in a negative sense.
If the earnings were not retained, his holdings
would decrease in value. However, the retained
earnings in no sense increase the value of
his holdings, therefore, they seem of no benefit
to him. Finally, in the many cases where the
stockholder benefits enormously from retained
earnings the benefits accrue in quite different
proportions to different types of stockholders
within the same company, thereby confusing
investor thinking even more. In other words,
each time earnings are not passed out as dividends,
such action must be examined on its own merit
to see exactly what is actually happening.
It might pay to look a little below the surface
here and discuss some of these differences
in detail.
When do stockholders get no benefit from retained
earnings? One way is when managements pile
up cash and liquid assets far beyond any present
or prospective needs of the business. The
management might have no nefarious motive
in doing this. Some executives get a sense
of confidence and security from steadily piling
up unneeded liquid reserves.They don't seem
to realize they are buttressing their own
feelings of security by not turning over to
the stockholder wealth which he should be
entitled to use in his own way and as he sees
fit. Today there are tax laws which tend to
curb this evil so that while it still occurs,
it is no longer the factor which it once was.
There is another and more serious way in which
earnings are frequently retained in the business
without any significant benefit to stockholders.This
occurs when substandard managements can get
only a subnormal return on the capital already
in the business, yet use the retained earnings
merely to enlarge the inefficient operation
rather than to make it better.What normally
happens is that the management having in time
built up a larger inefficient domain over
which to rule usually succeeds in justifying
bigger salaries for itself on the grounds
that it is doing a bigger job.The stockholders
end up with little or no profit.
Neither of these situations is likely to affect
the investor who follows the concept discussed
in this book. He is buying stocks because
they are outstanding and not just because
they are cheap. Managements with inefficient
and substandard operations would fail to qualify
under our fifteen points. Meanwhile, managements
of the type that do qualify would almost certainly
be finding uses for surplus cash and not just
piling it up!
How can it happen that earnings retained in
the business can be vitally needed yet have
no possibility of increasing the value of
the stockholder shares? This can occur in
one of two ways. One way is when a change
in custom or public demand forces each competitive
company to spend money on so-called assets
which in no sense increase the volume of business,
but which would cause a loss of business if
the expenditure had not been made. A retail
store installing an expensive air conditioning
system is a classic example of this sort of
thing. After each competitive store has installed
such equipment, no net increase in business
will occur, yet any store which had not met
the competitive move might find very few customers
on a hot summer day. Since for some strange
reason our accepted accounting system and
the tax laws which are based on it make no
differentiation between "assets" of this type
and those which have actually increased the
value of the business, the stockholder frequently
thinks that he has been badly treated when
earnings have not been passed out to him and
yet he can see no increase in value coming
to him from what was retained in the business.
The other and even more important way that
retained earnings fail to produce increased
profits results from an even more serious
failure of our accepted accounting methods.
In our world of rapid and major changes in
the purchasing value of our money units, standard
accounting proceeds as though the dollar were
a fixed unit of value. Accountants say this
is all accounting is supposed to do.This may
very well be true; but if a balance sheet
is supposed to have any relationship to the
real values of the assets described thereon,
the confusion that results seems about parallel
to what would happen if engineers and scientists
made their calculations in our three dimensional
world by using only two dimensional plane
geometry.
The depreciation allowance in theory should
be enough to replace an existing asset when
that asset is no longer economically usable.
If the depreciation rate were properly calculated
and the replacement cost of the asset remained
unchanged over its useful life, this would
happen. But with ever rising costs, the total
accumulated depreciation is seldom enough
to replace the outmoded asset. Therefore,
additional sums must be retained from the
earnings merely to make up the difference
if the corporation is to continue to have
what it had before.
This type of thing, while affecting all investors,
usually affects holders of growth companies
less than any other class. This is because
the rate of acquiring new capital assets (as
against merely replacing existing
and about-to-be-retired assets) is usually
so fast that more of the depreciation is on
recently acquired assets installed at somewhere
near today's values. A smaller percentage
of it is for assets installed years ago at
a fraction of today's costs.
It would be repetitious to go into detail
concerning the cases where retaining earnings
for building new plants and launching new
products has proven of spectacular advantage
to investors. However, consideration of how
much one type of investor benefits in relation
to another is worthy of careful consideration
for two reasons. It is a matter about which
there is always misunderstanding throughout
the financial community. It is also a matter
the proper understanding of which provides
an easy key to evaluating the real significance
of dividends.
Let us examine these misconceptions about
who benefits most from dividends by taking
a fictitious example. The well-managed XYZ
Corporation has had a steady growth in its
earnings over the last several years.The dividend
rate has remained the same. Consequently,
whereas four years ago it took 50 per cent
of earnings to pay the dividend, so much additional
earning power has developed in these four
years that paying the same dividend now requires
only 25 per cent of this year's earnings.
Some directors want to raise the dividend.
Others point out that never before has the
corporation had so many attractive places
to invest their retained earnings.They further
point out that only by maintaining rather
than raising the rate will it be possible
to exploit all the attractive opportunities
available. Only in this way can the maximum
growth be attained.At this point a lively
discussion breaks out as to what course to
follow.
Someone on this fictitious board of directors
is then sure to state one of the financial
community's most common half-truths about
dividends.This is that if the XYZ Corporation
does not raise its dividend, it will be favoring
its large stockholders at the expense of its
small ones. The theory behind this is that
the big stockholder is presumably in the higher
bracket. After paying taxes, the big stockholder
can retain a much smaller percentage of his
dividends than the small stockholder. Therefore
he does not want the increased dividend, whereas
the small stockholder does want it.
Actually, whether it is more to the interest
of any individual XYZ Corporation stockholder
to have the dividend raised or to have more
funds ploughed back into the growth depends
upon something quite different from the size
of his income. It depends upon whether or
not
each stockholder is at the point where he
is putting any part of his income aside for
additional investment. Millions of stockholders
in the lower income brackets are handling
their affairs so that each year they put something,
no matter how little, aside for additional
investment. If they are doing this and if,
as is likely to be the case, they are paying
income tax, it is a matter of elementary arithmetic
that the board of directors would be acting
against their interests by raising the dividend
at a time when all these worthwhile opportunities
are available for using retained company earnings.
In contrast, the raised dividend might be
to the interest of a big stockholder who had
urgent need of additional funds, a contingency
not entirely unknown to those in high tax
brackets.
Let us see just why all this is so. Almost
anyone having enough surplus funds to own
common stocks will probably also have enough
income to be in at least the lowest tax bracket.
Therefore, once he has used up his individual
dividend exemption of $50, even the smallest
stockholder will presumably have to pay as
tax at least 20 per cent of any additional
income he receives as dividends. In addition,
he must pay a brokerage commission on any
stock he buys. Because of odd lot charges,
minimum commissions, etc., these costs run
to a much larger percentage of the sums involved
in small purchases than in large ones. This
will bring the actual capital available for
reinvestment well below 80 per cent of the
amount received. If the shareholder is in
a higher tax bracket, the percentage of a
dividend increase which he can actually use
for reinvestment becomes proportionately less.
There are, of course, certain special types
of stockholders such as universities and pension
funds that pay no income tax.There are also
some individuals with dividend income less
than the $50 individual exemption, although
the total number of shares owned by this group
appears to be small. For these special groups
the equation is somewhat different. However,
for the great majority of all stockholders,
regardless of size, there is no avoiding this
one basic fact about dividends. If they are
saving any part of their income rather than
spending it and if they have their funds invested
in the right sort of common stocks, they are
better off when the managements of such companies
reinvest increased earnings than they would
be if these increased earnings were passed
on to them as larger dividends which they
would have to reinvest themselves.
Nor is this advantage--having 100 per cent
of such funds put to work for them in place
of the smaller amount that would be available
after income taxes and brokerage charges--the
only one the stockholders get. Selecting the
right common stock is not an easy or simple
matter. If the company considering the dividends
is a good one, the investor has already wisely
done his task of selection.Therefore, he is
usually running less risk in having this good
management make the additional investment
of these retained extra earnings than he would
be running if he had to again risk serious
error in finding some new and equally attractive
investment for himself. The more outstanding
the company considering whether to retain
or pass on increased earnings, the more important
this factor can become.This is why even the
stockholder who does not pay income tax and
who is not spending every bit of his income
finds it almost as much to his interest as
to the interest of his tax-paying counterpart
to have such companies retain funds to take
advantage of worthwhile new opportunities.
Measured against this background dividends
begin to fall into true perspective. For those
desiring the greatest benefit from the use
of their funds, dividends begin rapidly to
lose the importance that many in the financial
community give them. This is as true for the
conservative investor going into the institutional
type growth stock as for those willing and
able to take greater risks for greater gain.The
opinion is sometimes expressed that a high
dividend return is a factor of safety. The
theory behind this is that since the high-yield
stock is already offering an aboveaverage
return, it cannot be overpriced and is not
likely to go down very much. Nothing could
be farther from the truth. Every study I have
seen on this subject indicates that far more
of those stocks giving a bad performance price-wise
have come from the high dividend-paying rather
than the low dividend-paying group. An otherwise
good management which increases dividends,
and thereby sacrifices worthwhile opportunities
for reinvesting increased earnings in the
business, is like the manager of a farm who
rushes his magnificent livestock to market
the minute he can sell them rather than raising
them to the point where he can get the maximum
price above his costs. He has produced a little
more cash right now but at a frightful cost.
I have commented about a corporation raising
its dividend rather than about it paying any
dividend at all. I am aware that while the
occasional investor might not need any income,
nearly all do. It is only in rare cases, even
among outstanding corporations, that the opportunity
for growth is so great that the management
cannot afford to pay some part of earnings
and still--through retaining the rest and
through senior
financing--obtain adequate cash to take advantage
of worthwhile growth opportunities. Each investor
must decide in relation to his own needs how
much, if any, money to put into corporations
with such abnormal growth factors that no
dividends whatsoever are justified. What is
most important, however, is that stocks are
not bought in companies where the dividend
pay-out is so emphasized that it restricts
realizable growth.
This brings us to what is probably the most
important but least discussed aspect of dividends.This
is regularity or dependability.The wise investor
will plan his affairs. He will look ahead
to what he can or cannot do with his income.
He may not care about immediately increasing
income but he will want assurance against
the decreased income and unexpected disruption
of his plans that this can cause. Furthermore,
he will want to make his own decisions between
companies which should plough back a great
part or all of their earnings and those that
may grow at a good but slower rate and need
to plough back a smaller proportion.
For these reasons, those who set wise policies
on stockholder relations and those who enjoy
the high price-earnings ratios for their shares,
which such policies help bring about, usually
avoid the muddled thinking that typifies so
many corporate treasurers and financial vice
presidents. They set a dividend policy and
will not change it. They will let stockholders
know what this policy is.They may substantially
change the dividend but seldom the policy.
This policy will be based on the percentage
of earnings that should be retained in the
business for maximum growth. For younger and
rapidly growing companies, it may be that
no dividends at all will be paid for so many
years. Then when assets have been brought
to the point where the depreciation flow-back
is greater, from 25 to 40 per cent of profits
will be paid out to stockholders. For older
companies this payout ratio will vary from
company to company. However, in no case will
the rough percentages govern the exact amount
paid out; this would make each year's dividend
different from that of the year before. This
is just what stockholders do not want, since
it makes impossible independent long-range
planning on their part.What they desire is
a set amount approximating these percentages
and paid out regularly--quarterly, semiannually,
or annually, as the case may be. As earnings
grow, the amount will occasionally be increased
to bring the pay-out up to the former percentage.This,
however, will only be done when a) funds are
otherwise available for taking advantage of
all the good opportunities for growth that
the management is uncovering and b) there
is every reason to believe that this new regular
rate can be maintained from this time on,
after allowing for all reasonable probabilities
of a subsequent downturn in the business or
the appearance of additional opportunities
for growth.
The managements whose dividend policies win
the widest approval among discerning investors
are those who hold that a dividend should
be raised with the greatest caution and only
when there is great probability that it can
be maintained. Similarly, only in the gravest
of emergencies should such dividends be lowered.
It is surprising how many corporate financial
officers will approve the paying of one-shot
extra dividends.They do this even though such
unanticipated extra dividends almost always
fail to leave a permanent impact on the market
price of their shares--which should indicate
how contrary such policies are to the desires
of most long-range investors.
No matter how wise or foolish a dividend policy
may be, a corporation can usually in time
get an investor following which likes the
particular policy, provided that the corporation
follows the policy consistently. Many stockholders,
whether it is to their best interests or not,
still like a high rate of return. Others like
a low rate. Others like none at all. Some
like a very low rate combined with a small
regular annual stock dividend. Others do not
want this stock dividend, preferring the low
rate by itself. If a management selects one
of these policies in line with its natural
needs, it usually builds up a stockholder
group which likes and comes to expect the
continuation of such a policy. A wise management
wishing to obtain investment prestige for
its stock will respect that desire for continuity.
There is perhaps a close parallel between
setting policy in regard to dividends and
setting policy on opening a restaurant. A
good restaurant man might build up a splendid
business with a high-priced venture. He might
also build up a splendid business with an
attractive place selling the best possible
meals at the lowest possible prices. Or he
could make a success of Hungarian, Chinese,
or Italian cuisine. Each would attract a following.
People would come there expecting a certain
kind of meal. However, with all his skill,
he could not possibly build up a clientele
if one day he served the costliest meals,
the next day low-priced ones, and then without
warning served nothing but exotic dishes.
The corporation that keeps shifting its dividend
policies becomes as unsuccessful in
attracting a permanent shareholder following.
Its shares do not make the best long-range
investments.
As long as dividend policy is consistent,
so that investors can plan ahead with some
assurance, this whole matter of dividends
is a far less important part of the investment
picture than might be judged from the endless
arguments frequently heard about the relative
desirability of this dividend policy or that.
The large groups in the financial community
that would dispute this view fail to explain
the number of stocks that have offered no
prospect of anything but below-average yield
for years ahead, yet which have done so well
for their owners. Several examples of such
stocks have already been mentioned. Another
typical investment of this type is Rohm & Haas.This
stock first became publicly available in 1949,
when a group of investment bankers purchased
a large block held by the Alien Property Custodian
and reoffered it publicly. The public offering
price was $41.25.At that time the stock was
paying only $1.00 in dividends, supplemented
by stock dividends. Many investors felt that
in view of the low yield the stock was unattractive
for conservative investment. Since this date,
however, the company has continued to pay
stock dividends, has raised the cash dividend
at frequent intervals although the yield has
remained very low, and the stock has sold
at well over 400.The original owner of Rohm
& Haas has received stock dividends of 4 per
cent each year from 1949 through 1955, and
3 per cent in 1956, so his capital gain has
been well over ten-fold.
Actually dividend considerations should be
given the least, not the most, weight by those
desiring to select outstanding stocks. Perhaps
the most peculiar aspect of this much-discussed
subject of dividends is that those giving
them the least consideration usually end up
getting the best dividend return.Worthy of
repetition here is that over a span of five
to ten years, the best dividend results will
come not from the high-yield stocks but from
those with the relatively low yield. So profitable
are the results of the ventures opened up
by exceptional managements that while they
still continue the policy of paying out a
low proportion of current earnings, the actual
number of dollars paid out progressively exceed
what could have been obtained from high-yield
shares. Why shouldn't this logical and natural
trend continue in the future?
Five Don'ts for Investors.
1. Don't buy into promotional companies.
Close to the very heart of successful investing
is finding companies which are developing
new products and processes or exploiting new
markets. Companies that have just started
or are about to be started are frequently
attempting to do just this. Many of them are
formed to develop a colorful new invention.
Many are started to participate in industries,
such as electronics, in which there is great
growth potential. Another large group is formed
to discover mineral or other natural wealth--a
field where the rewards for success can be
outstanding. For these reasons, young companies
not yet earning a profit on their operations
may at first glance appear to be of investment
value.
There is another argument which frequently
increases interest.This is that by buying
now when the first shares are offered to the
public, there is a chance to "get in on the
ground floor." The successful company is now
selling at several times the price at which
it was originally offered. Therefore why wait
and have somebody else make all this money?
Instead why not use the same methods of inquiry
and judgment in finding the outstanding new
enterprise now being promoted as can be used
in finding the outstanding established corporation?
From the investment standpoint, I believe
there is a basic matter which puts any company
without at least two or three years of commercial
operation and one year of operating profit
in a completely different category from an
established company--even one so small that
it may not have more than a million dollars
of annual sales. In the
established company, all the major functions
of the business are currently operating. The
investor can observe the company's production,
sales, cost accounting, management teamwork,
and all the other aspects of its operations.
Perhaps even more important, he can obtain
the opinion of other qualified observers who
are in a position to observe regularly some
or all of these points of relative strength
or weakness in the company under consideration.
In contrast, when a company is still in the
promotional stage, all an investor or anyone
else can do is look at a blueprint and guess
what the problems and the strong points may
be. This is a much more difficult thing to
do. It allows a much greater probability of
error in the conclusions reached.
Actually, it is so difficult to do that no
matter how skillful the investor, it makes
it impossible to obtain even a fraction of
the "batting average" for selecting outstanding
companies that can be attained if judgment
is confined to established operations. All
too often, young promotional companies are
dominated by one or two individuals who have
great talent for certain phases of business
procedure but are lacking in other equally
essential talents. They may be superb salesmen
but lack other types of business ability.
More often they are inventors or production
men, totally unaware that even the best products
need skillful marketing as well as manufacture.
The investor is seldom in a position to convince
such individuals of the skills missing in
themselves or their young organizations. Usually
he is even less in a position to point out
to such individuals where such talents may
be found.
For these reasons, no matter how appealing
promotional companies may seem at first glance,
I believe their financing should always be
left to specialized groups. Such groups have
management talent available to bolster up
weak spots as unfolding operations uncover
them.Those who are not in a position to supply
such talent and to convince new managements
of the need of taking advantage of such help
will find investing in promotional companies
largely a disillusioning experience.There
are enough spectacular opportunities among
established companies that ordinary individual
investors should make it a rule never to buy
into a promotional enterprise, no matter how
attractive it may appear to be.
2. Don't ignore a good stock just because
it is traded "over the counter."
The attractiveness of unlisted stocks versus
those listed on a stock exchange is closely
related to the marketability of one group
as against
the other. Everyone should recognize the importance
of marketability. Normally, most if not all
buying should be confined to stocks which
can be sold should a reason--either financial
or personal--arise for such selling. However,
some confusion seems to exist in the minds
of investors as to what gives adequate protection
in this regard and what does not.This in turn
gives rise to even more confusion concerning
the desirability of those stocks not listed
on any exchange. Such stocks are commonly
called "over-the-counter" stocks.
The reason for this confusion lies in basic
changes that have come over common stock buying
in the last quarter century--changes that
make the markets of the 1950's very different
even from those as recent as the never-to-be-forgotten
1920's. During most of the 1920's and in all
of the period before that, the stock broker
had as customers a relatively small number
of rather rich men. Most buying was done in
large blocks, frequently in multiples of thousands
of shares. The motive was usually to sell
out to someone else at a higher price. Gambling
rather than investment was the order of the
day. Buying on margin--that is, with borrowed
funds--was then the accepted method of operation.
Today a very large percentage of all buying
is on a cash basis.
Many things have happened to change these
colorful markets of the past. High income
and inheritance tax rates are one. A more
important influence is the tendency toward
a levelling of incomes that continues year
after year in every section of the United
States.The very rich and the very poor each
year grow smaller in number. Each year the
middle groups grow larger. This has produced
a steady shrinkage of big stock buyers, and
an even greater growth of small stock buyers.
Along with them has come a tremendous growth
in another class of stock buyer, the institutional
buyer.The investment trust, the pension and
profit-sharing trusts, even to some degree
the trust departments of the great banks do
not represent a few big buyers. Rather they
are a few professional managers entrusted
with handling the collective savings of innumerable
small buyers.
Partly as a result of all this, and partly
as a cause helping to bring it about, basic
changes have come in our laws and institutions
as they affect the stock market. The Securities
and Exchange Commission has been created to
prevent the type of manipulation and pool
operation that spurred on the rampant stock
market gambling of the past. Rules are in
force limiting margin buying to a fraction
of what was formerly considered customary.
But most important of all, as already discussed
in an earlier chapter, the corporation of
today is a very different
thing from what it used to be. For the reasons
already explained, today's corporation is
designed to be far more suitable as an investment
medium for those desiring long-range growth
than as a vehicle for in-and-out trading.
All this has profoundly changed the market
place. It undoubtedly represents tremendous
improvement--improvement, however, at the
expense of marketability. The liquidity of
the average stock has decreased rather than
increased. In spite of breathtaking economic
growth and a seemingly endless procession
of stock splits, the volume of trading on
the New York Stock Exchange has declined.
For the smaller exchanges it has almost vanished.
The gambler, the in-and-out buyer, and even
the "sucker" trying to outguess the pool manipulator
were not conducive to a healthy economy. They
did, however, help provide a ready market.
I do not want to get involved in semantics.
Nevertheless, it must be realized that this
has resulted in the gradual decline of the
"stock broker" and the rise of what might
be called the "stock salesman." So far as
stocks are concerned, the broker works in
an auction market. He takes an order from
someone who has already decided on his investment
course. He matches this order with an order
he or some other broker has received to sell.
This process is not overly time-consuming.
If the orders received are for a large rather
than small number of shares, the broker can
operate on a very small commission for each
share handled and still end the year with
a handsome profit.
Contrast him with the salesman, who must go
through the far more time-consuming routine
of persuading the customer on the course of
action to be taken.There are only a given
number of hours in the day. Therefore, to
make a profit commensurate with that of a
broker, he must charge a higher commission
for his services. This is particularly true
if the salesman is serving a large number
of small customers rather than a few big ones.
Under todays economic conditions, small customers
are the ones most salesmen must serve.
The stock exchanges are still primarily operating
as a vehicle for stock brokers rather than
stock salesmen. Their commission rates have
gone up.They have only gone up, however, about
in proportion to that of most other types
of services. In contrast, the over-the-counter
markets work on a quite different principle.
Each day, designated members of the National
Association of Securities Dealers furnish
the newspapers of that region with quotations
on a long list of the more active unlisted
securities of interest to stockholders in
that locality.These are compiled by close
contact with the over-the-counter houses most
active in trading each of these securities.
Unlike those furnished by the stock exchanges,
these quotations are not the price ranges
within which transactions took place.They
cannot be, for there is no central clearing
house to which transactions are reported.
Instead these are bid-and-ask quotations.
Such quotations supposedly give the highest
price at which any of the interested financial
houses will bid for each of these shares and
the lowest offering price at which they will
sell them.
Close checking will nearly always show that
the reported quotations on the bid or buy
side are closely in line with what could be
obtained for shares at the moment the quotation
was furnished.The sales or ask side is usually
higher than the bid by an amount several times
greater than the equivalent stock exchange
commission for shares selling at the same
price.This difference is calculated to enable
the over-the-counter house to buy at the bid
price, pay its salesmen an appropriate commission
for the time spent in selling the security,
and still leave a reasonable profit after
allowing for general overhead. On the other
hand, if a customer, particularly a large
customer, approaches the same financial house
with a bid to buy this stock so that no salesman's
commission is involved, he can usually buy
it at the bid price plus just about the equivalent
of the stock exchange commission. As one over-the-counter
dealer expressed it,"We have one market on
the buy side. On the selling side we have
two.We have a retail and a wholesale market,
depending partly on the size of the purchase
and partly on the amount of selling and servicing
that is involved."
This system in the hands of an unscrupulous
dealer is subject to obvious abuse. So is
any other system. But if the investor picks
the overthe-counter dealer with the same care
he should employ in choosing any other specialist
to serve him, it works surprisingly well.The
average investor has neither the time nor
the ability to select his own securities.
Through the close supervision dealers give
the securities they permit their salesmen
to offer, he is receiving in effect something
closely resembling investment counsel. As
such it should be worth the cost involved.
From the standpoint of the more sophisticated
investor, however, the real benefits of this
system are not in regard to buying. They are
in regard to the increased liquidity or marketability
which it produces for those unlisted stocks
he may desire to own. Because the profit margin
available for dealers in such stocks is large
enough to make it worthwhile,
a great many over-the-counter dealers keep
a regular inventory of the stocks they normally
handle.They usually are not at all reluctant
to take on additional 500- or 1000-share lots
when they become available. When larger blocks
appear in their favorite issues, they will
frequently hold a sales meeting and put on
a special drive to move the shares that may
be available. Normally they will ask a special
selling commission of a point or so for doing
this. However, all this means that if an over-thecounter
stock is regularly dealt in by two or more
high-grade over-thecounter dealers, it usually
has a sufficient degree of marketability to
take care of the needs of most investors.
Depending on the amount offered, a special
selling commission may or may not be required
to move a large block. However, for what is
at most a relatively small percentage of the
sales price, the stock which the investor
desires to sell can actually be converted
into cash without breaking the market.
How does this compare with the marketability
of a stock listed on a stock exchange? The
answer depends largely on what stock and on
what stock exchange. For the larger and more
active issues listed on the New York Stock
Exchange, even under today's conditions a
big enough auction market still exists so
that in normal times all but the largest blocks
can be moved at the low prevailing commission
rates without depressing prices. For the less
active stocks listed on the NewYork Stock
Exchange, this marketability factor is still
fair, but at times can sag rather badly if
regular commissions are depended on when large
selling orders appear. For common stocks listed
on the small exchanges, it is my opinion that
this marketability factor frequently becomes
considerably worse.
The stock exchanges have recognized this situation
and have taken steps to meet it. Nowadays,
whenever a block of a listed stock appears
which the exchange thinks is too big to market
in the normal fashion, permission may be given
for the use of devices such as "special offerings."
This simply means that the offering is made
known to all members, who are given a predetermined
larger commission for selling these shares.
In other words, when the block is too large
for the brokers to handle it as brokers, they
are given commissions large enough to reward
them for selling as salesmen.
All this narrows the apparent gap between
listed and unlisted markets in a period such
as the present, when more and more purchases
are being handled by salesmen rather than
by brokers who just take orders. It does not
mean that from the standpoint of marketability
a well-known, actively-traded stock on the
New York Stock Exchange
has no advantage over the better over-the-counter
stocks. It does mean that the better of these
over-the-counter stocks are frequently more
liquid than the shares of many of the companies
listed on the American Stock Exchange and
the various regional stock exchanges. I imagine
those connected with the smaller stock exchanges
would sincerely disagree with this statement.
Nevertheless, I believe an unprejudiced study
of the facts would show it to be true. It
is why a number of the more progressive of
smaller and medium-size companies have in
recent years refused to list their stocks
on the smaller exchanges. Instead they have
chosen the over-the-counter markets until
their companies reach a size that would warrant
"big board"-- that is, New York Stock Exchange--listing.
In short, so far as over-the-counter securities
are concerned, the rules for the investor
are not too different from those for listed
securities. First, be very sure that you have
picked the right security.Then be sure you
have selected an able and conscientious broker.
If an investor is on sound ground in both
these respects, he need have no fear of purchasing
stock just because it is traded "over-the-counter"
rather than on an exchange.
3. Don't buy a stock just because you like
the "tone" of its annual report.
Investors are not always careful to analyze
just what has caused them to buy one stock
rather than another. If they did, they might
be surprised how often they were influenced
by the wording and format of the general comments
in a company's annual report to stockholders.
This tone of the annual report may reflect
the management's philosophies, policies, or
goals with as much accuracy as the audited
financial statement should reflect the dollars
and cents results for the period involved.
The annual report may also, however, reflect
little more than the skill of the company's
public relations department in creating an
impression about the company in the public
mind.There is no way of telling whether the
president has actually written the remarks
in an annual report, or whether a public relations
officer has written them for his signature.Attractive
photographs and nicely colored charts do not
necessarily reflect a close-knit and able
management team working in harmony and with
enthusiasm.
Allowing the general wording and tone of an
annual report to influence a decision to purchase
a common stock is much like buying a
product because of an appealing advertisement
on a billboard.The product may be just as
attractive as the advertisement. It also may
not be. For a low-priced product it may be
quite sensible to buy in this way, to find
out how attractive the purchase really is.With
a common stock, however, few of us are rich
enough to afford impulse buying. It is well
to remember that annual reports nowadays are
generally designed to build up stockholder
good will. It is important to go beyond them
to the underlying facts. Like any other sales
tool they are prone to put a corporation's
"best foot forward." They seldom present balanced
and complete discussions of the real problems
and difficulties of the business. Often they
are too optimistic.
If, then, an investor should not let a favorable
reaction to the tone of an annual report overly
influence his subsequent action, how about
the opposite? Should he let an unfavorable
reaction influence him? Usually not, for again
it is like trying to appraise the contents
of a box by the wrapping paper on the outside.
There is one important exception to this,
however. This is when such reports fail to
give proper information on matters of real
significance to the investor. Companies which
follow such policies are usually not the ones
most likely to provide the background for
successful investment.
4. Don't assume that the high price at which
a stock may be selling in relation to earnings
is necessarily an
indication that further growth in those earnings
has largely been already discounted in the
price.
There is a costly error in investment reasoning
that is common enough to make it worthy of
special mention. To explain it, let us take
a fictitious company.We might call it the
XYZ Corporation. XYZ has qualified magnificently
for years in regard to our fifteen points.
For three decades there has been constant
growth in both sales and profits, and also
there have been enough new products under
development to furnish strong indication of
comparable growth in the period ahead. The
excellence of the company is generally appreciated
throughout the financial community. Consequently
for years XYZ stock has sold for from twenty
to thirty times current earnings. This is
nearly twice as much for each dollar earned
as the sales price of the average stock that
has made up, say, the Dow Jones Industrial
Averages.
Today this stock is selling at just twice
the price-earnings ratio of the Dow Jones
averages.This means that its market price
is twice as high in relation to each dollar
it is earning as is the average of the stocks
comprising these Dow Jones averages in relation
to each dollar they are earning. The XYZ management
has just issued a forecast indicating it expects
to double earnings in the next five years.
On the basis of the evidence at hand, the
forecast looks valid.
Whereupon a surprising number of investors
jump to false conclusions.They say that since
XYZ is selling twice as high as stocks in
general, and since it will take five years
for XYZ's earnings to double, the present
price of XYZ stock is discounting future earnings
ahead.They are sure the stock is overpriced.
No one can argue that a stock discounting
its earnings five years ahead is likely to
be overpriced.The fallacy in their reasoning
lies in the assumption that five years from
now XYZ will be selling on the same price-earnings
ratio as will the average Dow Jones stock
with which they compare it. For thirty years
this stock, because of all those factors which
make it an outstanding company, has been selling
at twice the price-earnings ratio of these
other stocks. Its record has been rewarding
to those who have placed their faith in it.
If the same policies are continued, five years
from now its management will bring out still
another group of new products that in the
ensuing decade will swell earnings in the
same way that new products are increasing
earnings now and others did five, ten, fifteen,
and twenty years ago. If this happens, why
shouldn't this stock sell five years from
now for twice the price-earnings ratio of
these more ordinary stocks just as it is doing
now and has done for many years past? If it
does, and if the price-earnings ratio of all
stocks remain about the same, XYZ's doubling
of earnings five years from now will also
cause its price to have doubled in the market
over this five-year period. On this basis,
this stock, selling at its normal price-earnings
ratio, cannot be said to be discounting future
earnings at all!
Obvious, isn't it? Well, look around you and
see how many supposedly sophisticated investors
get themselves crossed up on this matter of
what price-earnings ratio to use in considering
how far ahead a stock is actually discounting
future growth. This is particularly true if
a change has been taking place in the background
of the company being studied. Let us now consider
the ABC Company instead of the XYZ Corporation.
The two companies are almost exactly alike
except that the ABC
Company is much younger. Only in the last
two years has its fundamental excellence been
appreciated by the financial community to
the point that its shares, too, are now selling
at twice the price-earnings ratio of the average
Dow Jones stock. It seems almost impossible
for many investors to realize, in the case
of a stock that in the past has not sold at
a comparably high price-earnings ratio, that
the price-earnings ratio at which it is now
selling may be a reflection of its intrinsic
quality and not an unreasonable discounting
of further growth.
What is important here is thoroughly understanding
the nature of the company, with particular
reference to what it may be expected to do
some years from now. If the earning spurt
that lies ahead is a onetime matter, and the
nature of the company is not such that comparable
new sources of earning growth will be developed
when the present one is fully exploited, that
is quite a different situation. Then the high
price-earnings ratio does discount future
earnings.This is because, when the present
spurt is over, the stock will settle back
to the same selling price in relation to its
earnings as run-of-the-mill shares. However,
if the company is deliberately and consistently
developing new sources of earning power, and
if the industry is one promising to afford
equal growth spurts in the future, the price-earnings
ratio five or ten years in the future is rather
sure to be as much above that of the average
stock as it is today. Stocks of this type
will frequently be found to be discounting
the future much less than many investors believe.
This is why some of the stocks that at first
glance appear highest priced may, upon analysis,
be the biggest bargains.
5. Don't quibble over eighths and quarters.
I have used fictitious examples in attempting
to make clear various other matters.This time
I will use an actual example. A little over
twenty years ago, a gentleman who in most
respects has demonstrated a high order of
investment ability wanted to buy one hundred
shares of a stock listed on the New York Stock
Exchange. On the day he decided to buy, the
stock closed at 35½. On the following day
it sold repeatedly at that price. But this
gentleman would not pay 35½. He decided he
might as well save fifty dollars. He put his
order in at 35. He refused to raise it.The
stock never again sold at 35.Today, almost
twenty-five years later, the stock appears
to have a particularly bright future.As a
result of the stock dividends and splits that
have occurred in the intervening years, it
is now selling at over 500.
In other words, in an attempt to save fifty
dollars, this investor failed to make at least
$46,500. Furthermore, there is no question
that this investor would have made the $46,500,
because he still has other shares of this
same company which he bought at even lower
figures. Since $46,500 is about 930 times
50, this means that our investor would have
had to save his fifty dollars 930 times just
to break even. Obviously, following a course
of action with this kind of odds against it
borders on financial lunacy.
This particular example is by no means an
extreme one. I purposely selected a stock
which for a number of years was more of a
market laggard than a market leader. If our
investor had picked any one of perhaps fifty
other growth stocks listed on the New York
Stock Exchange, missing $3500 worth of such
stock in order to save $50 would have cost
a great deal more than the $46,500.
For the small investor wanting to buy only
a few hundred shares of a stock, the rule
is very simple. If the stock seems the right
one and the price seems reasonably attractive
at current levels, buy "at the market." The
extra eighth, or quarter, or half point that
may be paid is insignificant compared to the
profit that will be missed if the stock is
not obtained. Should the stock not have this
sort of long-range potential, I believe the
investor should not have decided to buy it
in the first place.
For the larger investor, wanting perhaps many
thousands of shares, the problem is not quite
as simple. For all but a very small minority
of stocks, the available supply is usually
sufficiently limited that an attempt to buy
at the market even half of this desired amount
could well cause a sizable advance in quotations.
This sudden price rise might, in turn, produce
two further effects, both tending to make
accumulating a block of this stock even more
difficult. The price spurt by itself might
be enough to arouse the interest and competition
of other buyers. It might also cause some
of those who have been planning to sell to
hold their shares off the market with the
hope that the rise might continue.What then
should a large buyer do to meet this situation?
He should go to his broker or securities dealer.
He should disclose to him exactly how much
stock he desires to buy. He should tell the
broker to pick up as much stock as possible
but authorize him to pass up small offerings
if buying them would arouse many competitive
bids. Most important, he should give his broker
a completely free hand on price up to a point
somewhat above the most recent sale. How much
above should be decided in consultation with
the broker or dealer after
taking into account such factors as the size
of the block desired, the normal activity
of the shares, how eager the investor may
be for the holding, and any other special
factors that might be involved.
The investor may feel he does not have a broker
or dealer upon whom he may rely as having
sufficient judgment or discretion to handle
something of this sort. If so, he should proceed
forthwith to find a broker or dealer in whom
such confidence can be placed. After all,
doing exactly this sort of thing is the primary
function of a broker or the trading department
of a securities dealer.
Five More Don'ts for Investors.
1. Don't overstress diversification.
No investment principle is more widely acclaimed
than diversification. (Some cynics have hinted
that this is because the concept is so simple
that even stock brokers can understand it!)
Be that as it may, there is very little chance
of the average investor being influenced to
practice insufficient diversification. The
horrors of what can happen to those who "put
all their eggs in one basket" are too constantly
being expounded.
Too few people, however, give sufficient thought
to the evils of the other extreme. This is
the disadvantage of having eggs in so many
baskets that a lot of the eggs do not end
up in really attractive baskets, and it is
impossible to keep watching all the baskets
after the eggs get put into them. For example,
among investors with common stock holdings
having a market value of a quarter to a half
million dollars, the percentage who own twenty-five
or more different stocks is appalling. It
is not this number of twenty-five or more
which itself is appalling. Rather it is that
in the great majority of instances only a
small percentage of such holdings is in attractive
stocks about which the investor or his advisor
has a high degree of knowledge. Investors
have been so oversold on diversification that
fear of having too many eggs in one basket
has caused them to put far too little into
companies they thoroughly know and far too
much in others about which they know nothing
at all. It never seems to occur to them, much
less to their advisors, that buying a company
without having sufficient knowledge of it
may be even more dangerous than having inadequate
diversification.
How much diversification is really necessary
and how much is dangerous? It is somewhat
like infantrymen stacking rifles. A rifleman
cannot get as firm a stack by balancing two
rifles as he can by using five or six properly
placed. However, he can get just as secure
a stack with five as he could with fifty.
In this matter of diversification, however,
there is one big difference between stacking
rifles and common stocks. With rifles, the
number needed for a firm stack does not usually
depend on the kind of rifle used. With stocks,
the nature of the stock itself has a tremendous
amount to do with the amount of diversification
actually needed.
Some companies, such as most of the major
chemical manufacturers, have a considerable
degree of diversification within the company
itself.While all of their products may be
classified as chemicals, many of these chemicals
may have most of the attributes found in products
from completely different industries. Some
may have completely different manufacturing
problems. They may be sold against different
competition to different types of customers.
Furthermore at times when only one type of
chemical is involved, the customer group may
be such a broad section of industry that a
considerable element of internal diversification
may still be present.
The breadth and depth of a company's management
personnel-- that is, how far a company has
progressed away from one-man management--are
also important factors in deciding how much
diversification protection is intrinsically
needed. Finally, holdings in highly cyclical
industries--that is, those that fluctuate
sharply with changes in the state of the business
cycle--also inherently require being balanced
by somewhat greater diversification than do
shares in lines less subject to this type
of intermittent fluctuation.
This difference between the amount of internal
diversification found in stocks makes it impossible
to set down hard and fast rules as to the
minimum amount of diversification the average
investor requires for optimum results. The
relationship between the industries involved
will also be a factor. For example, an investor
with ten stocks in equal amounts, but eight
of them bank stocks, may have completely inadequate
diversification. In contrast, the same investor
with each of his ten stocks in a completely
different industry may have far more diversification
than he really needs.
Recognizing, therefore, that each case is
different and that no precise rules can be
laid down, the following is suggested as a
rough guide
to what might be considered as minimum diversification
needs for all but the very smallest type of
investor:
A. All investments might be confined solely
to the large entrenched type of properly selected
growth stock, of which Dow, Du Pont, and IBM
have already been mentioned as typical examples.
In this event, the investor might have a minimum
goal of five such stocks in all. This means
that he would not invest over 20 per cent
of his total original commitment in any one
of these stocks. It does not mean that should
one grow more rapidly than the rest, so that
ten years later he found 40 per cent of his
total market value in one stock, he should
in any sense disturb such a holding. This
assumes, of course, that he has gotten to
know his holding and the future continues
to look at least as bright for these stocks
as has the recent past.
An investor using this guide of 20 per cent
of his original investment for each company
should see that there is no more than a moderate
amount of overlapping, if any, between the
product lines of his five companies. Thus,
for example, if Dow were one of his five companies
there would seem to me to be no reason why
Du Pont might not be another.There are relatively
few places where the product lines of these
two companies overlap or compete. If he were
to have Dow and some other company closer
to Dow in its fields of activity, his purchase
might still be a wise one provided he had
sufficient reason for making it. Having these
two stocks in similar lines of activity might
prove very profitable over the years. However,
in such an instance the investor should keep
in mind that his diversification is essentially
inadequate, and therefore he should be alert
for troubles which might affect the industry
involved.
B. Some or all of his investments might fall
into the category of stocks about midway between
the young growth companies with their high
degree of risk and the institutional type
of investment described above.These would
be companies with a good management team rather
than one-man management.They would be companies
doing a volume of business somewhere between
fifteen and one hundred million dollars a
year and rather well entrenched in their industries.At
least two of such companies should be considered
as necessary to balance each single company
of the A type. In other words, if only companies
in this B group were involved, an investor
might start out with 10 per cent of his available
funds in each. This would make a total of
ten stocks in all. However, companies in this
general classification can vary considerably
among themselves as to their degree of risk.
It might be prudent to consider those with
the greater inherent risk as candidates for
8 per cent of original investment, rather
than 10 per cent. In any event, looking to
each stock of this class as a candidate for
8 to 10 per cent of total original investment--in
contrast to 20 per cent for the A group--should
again provide the framework for adequate minimum
diversification.
Companies of this B group are usually somewhat
harder for the investor to recognize than
those of the A or institutional type. Therefore
it might be worthwhile to furnish a brief
description of one or two such companies which
I have had the opportunity to observe rather
closely and which could be considered typical
examples.
Let us see what I said about such companies
in the original edition and how they appear
today. The first B company to which I referred
was P. R. Mallory. I said:
"P. R. Mallory & Co., Inc., enjoys a surprising
degree of internal diversification. Its principal
products are components for the electronic
and electrical industries, special metals,
and batteries. For its more important product
lines it is a major factor in the respective
industries, and in a few of them it is the
largest producer. Many of its product lines,
such as electronic components and special
metals, serve some of the most rapidly growing
segments of American industry, giving indications
that Mallory's growth should continue. In
ten years sales have increased almost four-fold
to a volume of about $80,000,000 in 1957,
with about one-third of this increase resulting
from carefully planned outside acquisitions
and about two-thirds from internal growth.
"Profit margins over this period have been
a bit lower than would normally be considered
satisfactory for a company of this B group,
but part of this is attributable to above-average
expenditures on research. More significantly,
steps have been taken which are beginning
to show indications of important improvement
in this factor. Management has demonstrated
considerable ingenuity under a dynamic president,
and in recent years has been increasing importantly
in depth. Mallory shares enjoyed about a five-fold
increase in value during the ten-year period
of 1946 to 1956, frequently selling around
fifteen times current earnings.
"Perhaps investment-wise one of the most important
factors about Mallory lies not within the
company itself but in its anticipated onethird
interest in the Mallory-Sharon Metals Corporation.This
company
is being planned as a combination of the Mallory-Sharon
Titanium Corporation--half of which is owned
by P. R. Mallory & Co., and which has already
proved to be an interesting venture for Mallory--and
National Distillers' operations in the raw-material
stages of the same industry. This new company
gives indication of being one of the lowest-cost
integrated titanium producers and as such
should play a major role in the probable growth
of this young industry. Meanwhile the corporation
in 1958 is expected to start its first commercially
significant zirconium product and has within
its organization considerable know-how in
other commercially new "wonder metals" such
as tantalum and columbium.This partially owned
company gives indications of becoming a world
leader in not one but a series of metals that
promise to play a growing part in the atomic,
chemical, and guided-missile age of tomorrow.
As such it could be an asset of tremendous
dollar significance to increase the growth
that appears inherent in Mallory itself."
If I were writing these words today, slightly
over two years later, I would write them somewhat
differently. I would tone down moderately
my enthusiasm for the possible contributions
of the one-third owned Mallory-Sharon Metals
Corporation. I think everything I said two
years ago could still occur. However, particularly
so far as titanium is concerned, I believe
it may take longer to find and develop sizable
markets for this metal than had seemed to
be the case two years ago.
On the other hand, I would be inclined to
strengthen my words for the Mallory company
itself by about the degree I would weaken
them for its affiliate. The trend I mentioned
of increasing management in depth has progressed
importantly during this period. While Mallory,
as a component supplier to the durable goods
industry, is in a line of business that is
bound to feel the ravages of any major general
slide, the management showed unusual adroitness
in adjusting to 1958 conditions and held earnings
to $1.89 per share against the all-time peak
of $2.06 the year before. Earnings came back
fast in 1959 and promise to make new records
for the full year somewhere around $2.75 per
share. Furthermore these earnings are being
established in the face of decreasing but
still heavy costs for certain of the newer
divisions. This showing gives promise that
if general economic conditions remain reasonably
prosperous, significant further growth in
profits will be seen in 1960.
Mallory stock is one of the few examples cited
in this book that to date has done worse rather
than better than the market as a whole.
Although I suspect this company has been more
successful than some of its competitors in
meeting Japanese competition in the electronic
components phases of its business, this threat
may be a reason for the relatively poor market
action. Another reason may be lack of interest
by much of the financial community in a business
that is not easily classified in one industry
or another, but cuts across several.This may
change in time, particularly as awareness
grows that its miniature battery lines are
not so far removed from some glamorous growth
fields, for they should grow with the steady
trend toward miniaturization in electronics.
At any rate, this stock which was at 35 when
the first edition was written, after allowing
for two 2 per cent stock dividends since,
is now selling at 37¼.
Now let us see what I said about the other
B group example I discussed in the original
edition:
"The Beryllium Corporation is another good
example of a group B investment.The corporate
title of this company has a young-company
implication that causes uninformed people
to assume that the stock carries with it a
greater degree of risk than may actually exist.
A lowcost producer, it is the only integrated
company making master alloys of beryllium
copper and beryllium aluminum and also operating
a fabricating plant in which the master alloy
is turned into rod, bar, strip, extrusions,
etc., and, in the case of tools, into finished
products. Sales have increased about six times
during the ten-year period ending in 1957
to a total of approximately $16,000,000. A
growing percentage of these sales is to electronic,
computing machine, and other industries promising
rapid growth in the years ahead. With important
new uses such as beryllium copper dies just
beginning to be of sales importance, it would
seem that the good growth rate of the past
ten years may be just an indication of what
is to come. This would tend to justify the
price-earnings ratio of around 20 at which
this stock has frequently sold in the past
five years.
"Indicating that this growth may continue
for many years to come, the Rand Corporation,
brilliant research arm of the Air Force owned
by the government, has been quoted in the
press as predicting an important future in
the 1960's for the as yet almost non-existent
field of beryllium metal as a structural material.
The Rand Corporation, among other things correctly
foretold, shortly after the war, the development
in titanium.
"More immediate than any eventual market that
may develop for beryllium as a structural
material, 1958 should see this company bring
into volume production another brand-new product.
This is beryllium metal for atomic purposes.
This product, being made in a completely separate
plant from the older master-alloy lines, is
under long-term contract to the Atomic Energy
Commission. It gives indications of having
a big future in the nuclear industry where
demand will probably occur from both government
and private industry sources. Management is
alert. In fact, this company qualifies rather
favorably under our fifteen points in regard
to all aspects but one, where the deficiency
is realized and steps have already been started
to correct it."
As in the case of Mallory, the past two years
have brought both pluses and minuses to the
picture I portrayed at that time. However,
the favorable developments seem to have by
far outweighed the unfavorable, as should
be the case if a company is to prove the right
sort of investment. On the unfavorable side,
the prospects for beryllium copper dies, mentioned
two years before, appear to have lost much
of their luster and the long-term growth curve
of the entire alloy end of the business may
be somewhat less brisk than indicated in that
description. Meanwhile, nuclear demand for
beryllium metal over the next few years appears
to be somewhat less now than it was then.
However, possibly far outbalancing this, there
are steadily increasing signs that there may
be a most dramatic growth in the demand for
beryllium metal for many types of airborne
purposes.The start of this demand is already
here. It is appearing in so many places and
for so many different kinds of products that
no one is safe in predicting what its limitations
may be.This may not prove quite as favorable
as might otherwise be judged, for it may make
the field so attractive as to bring threats
of a major competitive technological breakthrough
from some company not now in the field. However,
fortunately, the company may have made major
strides in strengthening itself in the only
one of our fifteen points where it had been
weak.This was in its research activities.
How has the stock responded to all this? When
the first edition was written it was at 16.16,
after allowing for the various stock dividends
that have been paid since.Today it is at 26½,
a gain of 64 per cent.
A few other companies, with which I am somewhat
less familiar but which I believe have management,
trade position, growth prospects, and other
characteristics which easily qualify them
as good examples of this B group are Foote
Minerals Company, Friden Calculating Machine
Co., Inc., and Sprague Electric Company. Each
of these companies has proven a highly desirable
investment for those who have held the shares
for a period of years. Sprague Electric roughly
quadrupled in value during the 1947-1957 period.
Friden stock was first offered to the public
in 1954, but in less than three years it had
increased about two and a half times in market
value. By 1957 it was selling at better than
four times the price at which blocks of stock
are believed to have changed hands privately
about a year prior to this public offering.These
price increases, satisfactory as they might
appear to most investors, were relatively
minor compared to what has happened to the
shares of the Foote Minerals Company. This
stock was listed on the New York Stock Exchange
early in 1957. Prior to that time the stock
was traded over the counter and was first
available to the public in 1947. At that time
the stock was selling at about $40 per share.
Due to stock dividends and split-ups the investor
who purchased 100 shares at the time of the
original financing in 1947 and held on now
has over 2400 shares.The stock recently sold
at approximately $50.
C. Finally there are the small companies with
staggering possibilities of gain for the successful,
but complete or almost complete loss of investment
for the unsuccessful. I have already pointed
out elsewhere why I believe the amount, if
any, of such securities in an investment list
should vary according to the circumstances
and goals of the particular investor. However,
there are two good rules to follow in regard
to investments of this type. One has already
been mentioned. Never put any funds into them
that you cannot afford to lose. The other
is that larger investors should never at the
time of the original investment put over 5
per cent of available funds into any one such
company. As pointed out elsewhere, one of
the risks of the small investor is that he
may be too small to obtain the spectacular
prospects of this type of investment and still
get the benefits of proper diversification.
In the original edition, I referred to Ampex
as it was in 1953 and Elox in 1956 as examples
of the huge-potential but high-risk companies
that fall into the C classification. How have
these companies done since? Elox, which was
at 10 when the first edition was completed,
is at 7 58 today. In contrast, Ampex's market
performance continues brilliant and demonstrates
why once an outstanding management has proven
itself and fundamental conditions have not
changed, shares should never be sold just
because the stock has had a huge rise and
may seem temporarily high priced. In the discussion
on research in Chapter
Three, I mentioned that in the first four
years following the offering of this stock
to the public in 1953, it had risen 700 per
cent. When I finished the original edition,
it was at 20.* Today with sales and earnings
up dramatically year after year and with 80
per cent of today's sales in products that
were not in existence only four years ago,
it is at 107½. This is a gain of 437 per
cent in just over two years. It is a gain
of over 3500 per cent in six years. In other
words, $10,000 placed in Ampex in 1953 would
have a market value of over $350,000 today
in a company with a proven ability to score
one technical and business triumph after another.
Other situations with which I am less familiar
but which might well fall in this category
were Litton Industries, Inc., when its shares
were first offered to the public, and Metal
Hydrides. However, one characteristic of this
type of company should be kept in mind from
the standpoint of diversification.They entail
so much risk and offer such promising prospects
that, in time, one of two things usually happens.
Either they fail, or else they grow in trade
position, management depth, and competitive
strength to a point where they can be classified
in the B rather than the C group.
When this has happened, the shares held in
them usually have advanced so spectacularly
in market price that, depending on what has
happened to the value of an investor's other
holdings during the period, they may then
represent a considerably greater per cent
of the total portfolio than they formerly
did. However, B stocks are so much safer than
C stocks that they may be retained in greater
volume without sacrificing proper diversification.Therefore,
if the company has changed in this way, there
is seldom reason to sell stock--at least not
on the ground that the market rise has resulted
in this company representing too great a percentage
of total holdings.
This change from a C to a B company is, for
example, exactly what happened during the
1956-1957 period in the case of Ampex. As
the company tripled in size and profits rose
even faster, and as the market for its magnetic
recorders and the components thereof broadened
into more and more growth industries, this
company grew in intrinsic strength to a point
where it could be classified in the B group.
It no longer carried with it the element of
extreme investment risk. When this point had
been reached, a considerably larger percentage
of total
*After allowing for the 2½-to-l stock split
that has since occurred.
investment might be held in Ampex without
violating principles of prudent diversification.
All the above percentages represent merely
a minimum or prudent standard of diversification.
Going below this limit is a bit like driving
an automobile above normal speeds. A driver
doing this may get where he wants to go sooner
than he otherwise would. However, he should
keep in mind that he is driving at a rate
requiring extra alertness and vigilance. Forgetting
this, he may not only fail to arrive at his
destination more quickly--he may never get
there at all.
How about the other side of the coin? Is there
any reason an investor should not have more
diversification than something resembling
the minimum amounts mentioned? There is no
reason whatsoever, as long as the additional
holdings are ones which appear equivalent
in attractiveness to this minimum number of
holdings in regard to two matters. These additional
securities should be equivalent to the other
holdings in regard to the degree of growth
which appears attainable in relation to the
risks involved. They should also be equivalent
in regard to the investor's ability to keep
in touch with and follow his investment, once
he has made it. However, practical investors
usually learn their problem is finding enough
outstanding investments, rather than choosing
among too many.The occasional investor who
does find more such unusual companies than
he really needs seldom has the time to keep
in close enough touch with all additional
corporations.
Usually a very long list of securities is
not a sign of the brilliant investor, but
of one who is unsure of himself. If the investor
owns stock in so many companies that he cannot
keep in touch with their managements directly
or indirectly, he is rather sure to end up
in worse shape than if he had owned stock
in too few companies. An investor should always
realize that some mistakes are going to be
made and that he should have sufficient diversification
so that an occasional mistake will not prove
crippling. However, beyond this point he should
take extreme care to own not the most, but
the best. In the field of common stocks, a
little bit of a great many can never be more
than a poor substitute for a few of the outstanding.
2. Don't be afraid of buying on a war scare.
Common stocks are usually of greatest interest
to people with imagination. Our imagination
is staggered by the utter horror of modern
war.
The result is that every time the international
stresses of our world produce either a war
scare or an actual war, common stocks reflect
it.This is a psychological phenomenon which
makes little sense financially.
Any decent human being becomes appalled at
the slaughter and suffering caused by the
mass killings of war. In today's atomic age,
there is added a deep personal fear for the
safety of those closest to us and for ourselves.
This worry, fear, and distaste for what lies
ahead can often distort any appraisal of purely
economic factors. The fears of mass destruction
of property, almost confiscatory higher taxes,
and government interference with business
dominate what thinking we try to do on financial
matters. People operating in such a mental
climate are inclined to overlook some even
more fundamental economic influences.
The results are always the same. Through the
entire twentieth century, with a single exception,
every time major war has broken out anywhere
in the world or whenever American forces have
become involved in any fighting whatever,
the American stock market has always plunged
sharply downward. This one exception was the
outbreak of World War II in September 1939.
At that time, after an abortive rally on thoughts
of fat war contracts to a neutral nation,
the market soon was following the typical
downward course, a course which some months
later resembled panic as news of German victories
began piling up. Nevertheless, at the conclusion
of all actual fighting--regardless of whether
it was World War I, World War II, or Korea--most
stocks were selling at levels vastly higher
than prevailed before there was any thought
of war at all. Furthermore, at least ten times
in the last twenty-two years, news has come
of other international crises which gave threat
of major war. In every instance, stocks dipped
sharply on the fear of war and rebounded sharply
as the war scare subsided.
What do investors overlook that causes them
to dump stocks both on the fear of war and
on the arrival of war itself, even though
by the end of the war stocks have always gone
much higher than lower? They forget that stock
prices are quotations expressed in money.
Modern war always causes governments to spend
far more than they can possibly collect from
their taxpayers while the war is being waged.This
causes a vast increase in the amount of money,
so that each individual unit of money, such
as a dollar, becomes worth less than it was
before. It takes lots more dollars to buy
the same number of shares of stock.This, of
course, is the classic form of inflation.
In other words, war is always bearish on money.To
sell stock at the threatened or actual outbreak
of hostilities so as to get into cash is extreme
financial lunacy.Actually just the opposite
should be done. If an investor has about decided
to buy a particular common stock and the arrival
of a full-blown war scare starts knocking
down the price, he should ignore the scare
psychology of the moment and definitely begin
buying. This is the time when having surplus
cash for investment becomes least, not most,
desirable. However, here a problem presents
itself. How fast should he buy? How far down
will the stock go? As long as the downward
influence is a war scare and not war, there
is no way of knowing. If actual hostilities
break out, the price would undoubtedly go
still lower, perhaps a lot lower.Therefore,
the thing to do is to buy but buy slowly and
at a scale-down on just a threat of war. If
war occurs, then increase the tempo of buying
significantly. Just be sure to buy into companies
either with products or services the demand
for which will continue in wartime, or which
can convert their facilities to wartime operations.The
great majority of companies can so qualify
under today's conditions of total war and
manufacturing flexibility.
Do stocks actually become more valuable in
war time, or is it just money which declines
in value? That depends on circumstances. By
the grace of God, our country has never been
defeated in any war in which it has engaged.
In war, particularly modern war, the money
of the defeated side is likely to become completely
or almost worthless, and common stocks would
lose most of their value. Certainly, if the
United States were to be defeated by Communist
Russia, both our money and our stocks would
become valueless. It would then make little
difference what investors might have done.
On the other hand, if a war is won or stalemated,
what happens to the real value of stocks will
vary with the individual war and the individual
stock. In World War I, when the enormous prewar
savings of England and France were pouring
into this country, most stocks probably increased
their real worth even more than might have
been the case if the same years had been a
period of peace.This, however, was a onetime
condition that will not be repeated. Expressed
in constant dollars-- that is, in real value--American
stocks in both World War II and the Korean
period undoubtedly did fare less well than
if the same period had been one of peace.
Aside from the crushing taxes, there was too
great a diversion of effort from the more
profitable peace-time lines to abnormally
narrow-margin defense work. If the magnificent
research
effort spent on these narrow-margin defense
projects could have been channelled to normal
peace-time lines, stockholders' profits would
have been far greater--assuming, of course,
that there would still have been a free America
in which any profits could have been enjoyed
at all.The reason for buying stocks on war
or fear of war is not that war, in itself,
is ever again likely to be profitable to American
stockholders. It is just that money becomes
even less desirable, so that stock prices,
which are expressed in units of money, always
go up.
3. Don't forget your Gilbert and Sullivan.
Gilbert and Sullivan are hardly considered
authorities on the stock market. Nevertheless,
we might keep in mind their "flowers that
bloom in the spring, tra-la" which, they tell
us, have "nothing to do with the case." There
are certain superficial financial statistics
which are frequently given an undeserved degree
of attention by many investors. Possibly it
is an exaggeration to say that they completely
parallel Gilbert and Sullivan's flowers that
bloom in the spring. Instead of saying they
have nothing to do with the case, we might
say they have very little to do with it.
Foremost among such statistics are the price
ranges at which a stock has sold in former
years. For some reason, the first thing many
investors want to see when they are considering
buying a particular stock is a table giving
the highest and lowest price at which that
stock has sold in each of the past five or
ten years. They go through a sort of mental
mumbo-jumbo, and come up with a nice round
figure which is the price they are willing
to pay for the particular stock.
Is this illogical? Is it financially dangerous?
The answer to both questions is emphatically
yes. It is dangerous because it puts the emphasis
on what does not particularly matter, and
diverts attention from what does matter. This
frequently causes investors to pass up a situation
in which they would make big profits in order
to go into one where the profits will be much
smaller. To understand this we must see why
the mental process is so illogical.
What makes the price at which a stock sells?
It is the composite estimate at that moment
of what all those interested think the corrective
value of such shares may be. It is the composite
appraisal of the outlook for this company
by all potential buyers and sellers, weighted
by the number of shares each buyer or seller
is disposed to bid for or offer, in
relation to a similar appraisal, at the same
moment, of the outlook for other companies
with their individual prospects. Occasionally,
something like forced liquidation will produce
a moderate deviation from this figure. This
happens when a large holder presses stock
on the market for reasons--such as liquidating
an estate or paying off a loan-- which may
not be directly related to the seller's view
of the real value of the shares. However,
such pressures usually cause only moderate
variation from the composite appraisal of
the prevailing price of the shares, since
bargain hunters normally step in to take advantage
of the situation, which thereby adjusts itself.
The point which is of real significance is
that the price is based on the current appraisal
of the situation.As changes in the affairs
of the company become known, these appraisals
become correspondingly more or less favorable.
In relation to other stocks, these particular
shares then move up or down. If the factors
appraised were judged correctly, the stock
becomes permanently more or less valuable
in relation to other stocks. The shares then
stay up or down. If more of these same factors
continue to develop, they in turn are recognized
by the financial community.The stock then
goes and stays either further up or down,
as the case may be.
Therefore, the price at which the stock sold
four years ago may have little or no real
relationship to the price at which it sells
today. The company may have developed a host
of able new executives, a series of new and
highly profitable products, or any number
of similar desirable attributes that make
the stock intrinsically worth four times as
much in relation to the price of other stocks
as it was worth four years ago.The company
might have fallen into the hands of an inefficient
management and slipped so badly in relation
to competition that the only way recovery
could occur would be through the raising of
much new capital.This might force such a dilution
of the shares that the stock today could not
possibly be worth more than a quarter of the
price of four years ago.
Against this background, it can be seen why
investors so frequently pass up stocks which
would have brought them huge future gains,
for ones where the gain is very much smaller.
By giving heavy emphasis to the "stock that
hasn't gone up yet" they are unconsciously
subscribing to the delusion that all stocks
go up about the same amount and that the one
that has already risen a lot will not climb
further, while the one that has not yet gone
up has something "due" it. Nothing could be
further from the truth. The fact that a stock
has or has not risen in
the last several years is of no significance
whatsoever in determining whether it should
be bought now.What does matter is whether
enough improvement has taken place or is likely
to take place in the future to justify importantly
higher prices than those now prevailing.
Similarly, many investors will give heavy
weight to the per-share earnings of the past
five years in trying to decide whether a stock
should be bought.To look at the per-share
earnings by themselves and give the earnings
of four or five years ago any significance
is like trying to get useful work from an
engine which is unconnected to any device
to which that engine's power is supposed to
be applied. Just knowing, by itself, that
four or five years ago a company's per-share
earnings were either four times or a quarter
of this year's earnings has almost no significance
in indicating whether a particular stock should
be bought or sold. Again, what counts is knowledge
of background conditions. An understanding
of what probably will happen over the next
several years is of overriding importance.
The investor is constantly being fed a diet
of reports and so-called analyses largely
centered around these price figures for the
past five years. He should keep in mind that
it is the next five years' earnings, not those
of the past five years, that now matter to
him. One reason he is fed such a diet of back
statistics is that if this type of material
is put in a report it is not hard to be sure
it is correct. If more important matters are
gone into, subsequent events may make the
report look quite silly. Therefore, there
is a strong temptation to fill up as much
space as possible with indisputable facts,
whether or not the facts are significant.
However, many people in the financial community
place emphasis on this type of prior years'
statistics for a different set of reasons.They
seem to be unable to grasp how great can be
the change in just a few years' time in the
real value of certain types of modern corporations.
Therefore they emphasize these past earnings
records in a sincere belief that detailed
accounting descriptions of what happened last
year will give a true picture of what will
happen next year.This may be true for certain
classes of regulated companies such as public
utilities. For the type of enterprise which
I believe should interest an investor desiring
the best results for his money, it can be
completely false.
A striking example of this centers around
events with which I had the good fortune to
be quite familiar. In the summer of 1956,
an opportunity arose to buy a fair-sized block
of shares in Texas Instruments, Inc., from
its principal officers who were also its largest
stockholders. Careful
study of this company revealed that it rated
not just well but magnificently in regard
to our fifteen-point test. Reason for the
officers to sell appeared entirely legitimate;
this occurs frequently in true growth companies.
Their holdings had already advanced so much
that several of them had become millionaires
so far as their holdings in their own company
were concerned. In contrast, their other assets
were relatively negligible.Therefore, particularly
since they were selling but a tiny part of
the shares they owned, some diversification
seemed entirely in order. The ever-present
possibility of estate tax liability alone
would be sufficient to make such a course
prudent from the standpoint of these key executives,
regardless of the future of their company.
At any rate, negotiations were completed to
acquire these shares at a price of 14. This
represented twenty times the anticipated 1956
pershare earnings of about 70¢. To anyone
who gave particular weight to past statistics,
this seemed well beyond the bounds of prudence.
Pershare earnings had been reported at 39¢,
40¢, 48¢, and 50¢ for the prior four years
of 1952 to 1955 respectively--hardly an exciting
growth record. Even more depressing to those
who subordinate the more important factors
of management and current business trends
to superficial statistical comparisons, the
company, through a corporate acquisition,
had obtained the benefits of some loss carry-forward,
which had made possible subnormal income tax
charges during much of this period. This made
any price calculated on the basis of past
statistics seem even higher. Finally, even
if 1956 earnings were included in an evaluation,
a superficial study of this situation might
still have produced grave forebodings.True,
the company was currently doing remarkably
well in the promising field of transistors.
But regardless of the obviously glowing future
for the semi-conductor industry as a whole,
how long could a company of this size be expected
to maintain its strong trade position against
the larger and older companies, with much
stronger balance sheets, which were sure to
make a major competitive effort to participate
in the great growth that lay ahead for transistors?
When the usual SEC channels reported this
officers selling, a rash of heavy trading
broke out in Texas Instruments shares with
relatively little change in price. Much of
this selling, I suspect, was induced by various
brokerage comments that appeared. Most of
these furnished the past statistical record
and commented on the historically high price,
the competition that lay ahead, and the inside
selling. One such bulletin went so far as
to express complete agreement with the
management of Texas Instruments. It reported
the officers were selling and stated: "We
agree with them and recommend the same course!"
The major buyer during this period, I have
been told, was a large and well-informed institution.
What happened in the next twelve months? Texas
Instruments'geophysical and military electronic
business, overlooked in the flurry of controversy,
continued to grow.The semi-conductor (transistor)
division grew even more rapidly. More important
than the growth in transistor volume were
the great strides taken by this able management
in research, in plans for mechanization, and
in building up the distribution organization
in this key semi-conductor field. As evidence
piled up that 1956 results were not a flash
in the pan but that this relatively small
company would continue as one of the largest
and lowest cost producers in what promises
to be one of the fastest growing segments
of American industry, the financial community
began revising upward the priceearnings ratio
it would pay for a chance to participate in
this well-run enterprise. As the summer of
1957 came around and the management publicly
estimated that year's per-share earnings at
around $1.10, the 54 per cent growth in earnings
had produced in just twelve months an approximate
100 per cent increase in market value.
In the original edition I went on to say:
"I suspect that if the headquarters of the
principal divisions of this company were not
located in Dallas and Houston, but were situated
along the northern half of the Atlantic seaboard
or in the Los Angeles metropolitan area--where
more financial analysts and other managers
of important funds could more easily learn
about the company--this price-earnings ratio
might have gone even higher during this period.
If, as appears probable,Texas Instruments'
sales and earnings continue their sharp upward
trend for some years to come,it will be interesting
to see whether this continued growth, of itself,
does not in time provide some further upward
change in the price-earnings ratio. If this
happens, the stock would again go up at an
even faster rate than the earnings are advancing,
the combination which always produces the
sharpest increases in share prices."
Has this optimistic forecast been confirmed?
A look at the record may jolt those who still
insist that it is possible to appraise an
investment by a superficial analysis of past
earnings and little more. Profits rose from
$1.11 per share in 1957 to $1.84 in 1958 and
give promise of topping
$3.50 in 1959. Since the first edition of
this book was completed, the company attained
honors that were bound to rivet the attention
of the financial community upon it. In 1958,
in the face of competition from some of the
generally acclaimed giants of the electronics
and electrical equipment industry, International
Business Machines Corporation, overwhelmingly
the largest electronic calculating machine
manufacturer in the world, selected Texas
Instruments to be its associate for joint
research effort in the application of semi-conductors
to this type of equipment. Again, in 1959
Texas Instruments announced a technological
breakthrough whereby it was possible to use
semi-conductor material of approximately the
same size as existing transistors, not alone
for a transistor but for a complete electronic
circuit! What this may bring about in the
way of miniaturization almost staggers the
imagination. As the company has grown, its
unusually able product research and development
groups have increased proportionately. Today
few informed people have much doubt that the
company's long series of technical and business
"firsts" will continue in the years ahead.
How has the market price of these shares responded
to all this? Has the price-earnings ratio
continued to advance as, twenty-two months
ago, I indicated appeared probable? The record
would appear to be in the affirmative. Per-share
earnings have a little more than tripled since
1957.The stock is up over five times from
the price of 26½ at which it was selling
when the first edition was completed. The
current price, incidentally, represents a
gain of better than 1000 per cent from the
price of 14, which was mentioned in the original
edition as the price at which a fair-sized
block of this stock had been bought less than
three and one-half years before. In spite
of this steep rise it will be interesting
to see whether further gains in sales and
earnings in the years ahead do not produce
still more worthwhile appreciation.
This brings up another line of reasoning which
causes some investors to pay undue attention
to these unrelated statistics on past price
ranges and per-share earnings.This is the
belief that whatever has happened for a number
of years is bound to continue indefinitely.
In other words, some investors will find a
stock the per-share earnings and market price
of which have risen in each of the past five
or ten years. They will conclude that this
trend is almost certain to continue indefinitely.
I will agree that this might happen. But in
view of the uncertainty in timing the results
of research and of the costliness of bringing
out the new products that make this type of
growth possible, it is quite common
for even the most outstanding growth companies
to have occasional one- to three-year dips
in their rate of earnings. Such dips can produce
sharp declines in their shares.Therefore,
to give emphasis to this kind of past earning
record, rather than to the background conditions
that can control the future earning curve,
may prove very costly.
Does all this mean that past earnings and
price ranges should be completely ignored
in deciding whether to buy a stock? No. It
is only when given an importance they do not
deserve that they become dangerous. They are
helpful as long as it is realized they are
only auxiliary tools to be used for specialized
purposes and not major factors in deciding
the attractiveness of a common stock. Thus,
for example, a study of per-share earnings
for various prior years will throw considerable
light on how cyclical a stock may be, that
is, on how much the company's profits will
be affected by the varying stages of the business
cycle. More important, comparing past per-share
earnings with price ranges will furnish the
price-earnings ratio at which the stock sold
in the past. This serves as a base from which
to start measuring what the price-earnings
ratio may be in the future. Here again, however,
it must be kept in mind that it is the future
and not the past which governs. Perhaps the
shares for years have steadily sold at only
eight times earnings. Now, however, changes
in management, establishment of an outstanding
research department, etc., are putting the
company into the class that is currently selling
around fifteen times earnings instead of eight.
Then anyone estimating future earnings and
figuring the anticipated value of the shares
at only eight instead of fifteen times earnings
might again be leaning too heavily on past
statistics.
I headed this subdivision of my comments "Don't
forget your Gilbert and Sullivan." Perhaps
I should have headed it "Don't be influenced
by what doesn't matter." Statistics of former
years' earnings and particularly of per-share
price ranges of these former years quite frequently
"have nothing to do with the case."
4. Don't fail to consider time as well as
price in buying a true growth stock.
Let us consider an investment situation that
occurs frequently.A company qualifies magnificently
as to the standards set up under our fifteen
points. Furthermore, very important gains
in earning power are going to appear about
a year from now, due to factors about which
the financial
community is, as yet, completely unaware.
Even more important, there are strong indications
that these new sources of earnings are going
to grow importantly for at least several years
after that.
Under normal circumstances this stock would
obviously be a buy. However, there is a factor
that gives us pause. Success of other ventures
in prior years has given this stock so much
glamour in the financial world that if it
were not for these new and generally unknown
influences, the stock might be considered
to be reasonably priced around 20 and out
of all reason at its present price of 32.
Assuming that five years from now these new
influences could easily cause it to be fully
worth 75, should we, right now, pay 32--or
60 per cent more than we believe the stock
is worth? There is always the chance that
these new developments might not turn out
to be as good as we think. There is also the
possibility that this stock might sink back
to what we consider its real value of 20.
Confronted with this situation, many conservative
investors would watch quotations closely.
If the stock got near 20 they would buy it
eagerly. Otherwise they would leave the shares
alone.This happens often enough to be worthy
of somewhat closer analysis.
Is there anything sacred about our figure
of 20? No, because it admittedly does not
take into consideration an important element
of future value--the factors we know and most
others don't know which we believe will in
a few years justify a price of 75.What is
really important here is to find a way that
we can buy the stock at a price close to the
low point at which it will sell from here
on in. Our concern is that if we buy at 32,
the stock may subsequently go somewhere around
20. This would not alone cause us a temporary
loss. More significant, it would mean that
if the stock subsequently went to 75, we would
have for our money only about 60 per cent
of the shares that we could have gotten if
we had waited and bought at 20.Assuming that
in twenty years still other new ventures would
have given these shares a value not of 75
but of 200, this factor of the total number
of shares we could have obtained for our money
would prove extremely important.
Fortunately, in a situation of this sort there
is another guide-post which may be relied
on, even if some of my friends in the insurance
and banking worlds seem to regard it as about
as safe as trying to walk over water.This
is to buy the shares not at a certain price,
but at a certain date. From a study of other
successful ventures carried through in the
past by this same company, we can learn that
these ventures were
reflected in the stock's price at a particular
point in their development. Perhaps it averaged
about one month before these ventures reached
the pilot-plant stage. Assuming that our company's
shares are still selling around 32, why not
plan to buy these shares five months from
today, which will be just one month before
the pilot plant goes on stream? Of course,
the shares can still go down after that. However,
even if we had bought these shares at 20,
there would have been no positive guarantee
against a further drop. If we have a fair
chance of buying at about as low a price as
possible, aren't we accomplishing our objective,
even if we feel that on the basis of the publicly
known factors the stock should be lower? Under
these circumstances, isn't it safer to decide
to buy at a certain date rather than a certain
price?
Fundamentally, this approach does not ignore
the concept of value at all. It only appears
to ignore it. Except for the probability that
there would be a far greater increase in value
coming in the future, it would be just as
illogical as some of my financial friends
claim it to be to decide to buy on a specific
future date rather than at a specific price.
However, when the indications are strong that
such an increase is coming, deciding the time
you will buy rather than the price at which
you will buy may bring you a stock about to
have extreme further growth at or near the
lowest price at which that stock will sell
from that time on.After all, this is exactly
what you should be trying to do when you make
any stock purchase.
5. Don't follow the crowd.
There is an important investment concept which
is frequently difficult to understand without
considerable financial experience.This is
because its explanation does not lend itself
easily to precise wording. It does not lend
itself at all to reduction to mathematical
formulae.
Time and again throughout this book I have
touched upon different influences that have
resulted in a common stock going up or down
in price.A change in net income, a change
in a company's management, appearance of a
new invention or a new discovery, a change
in interest rates or tax laws--these are but
a few random examples of conditions that will
bring about a rise or fall in the quotations
for a particular common stock. All these influences
have one thing in common. They are real occurrences
in the world about us. They are actions which
have happened or are about to happen. Now
we come to a very different
type of price influence.This is a change which
is purely psychological. Nothing has changed
in the outside or economic world at all.The
great majority of the financial community
merely look upon the same circumstances from
a different viewpoint than before. As a result
of this changed way of appraising the same
set of basic facts, they make a changed appraisal
of the price or the price-earnings ratio they
will pay for the same shares.
There are fads and styles in the stock market
just as there are in women's clothes. These
can, for as much as several years at a time,
produce distortions in the relationship of
existing prices to real values almost as great
as those faced by the merchant who can hardly
give away a rack full of the highest quality
knee-length dresses in a year when fashion
decrees that they be worn to the ankle. Let
me give a specific example: In 1948 I was
chatting with a gentleman whom I believe to
be an able investment man. He has served as
president of the New York Society of Security
Analysts, a position which is usually awarded
only to the more able in the financial community.At
any rate, I had just arrived in New York from
a visit to the headquarters of the Dow Chemical
Company at Midland, Michigan. I mentioned
that earnings for the fiscal year just closing
would be at new high levels and that I thought
the stock was a real buy. He replied that
he felt it was of historic and perhaps statistical
interest that a company such as Dow could
ever earn this much per share. He felt, however,
that these earnings did not make the stock
attractive, since it was obvious that the
company was enjoying a temporary postwar boom
that could not last. He further explained
that he felt it was impossible to judge the
real value of stocks of this sort until there
had occurred the same type of postwar depression
that within a few years followed the Civil
War and World War I. His reasoning, unfortunately,
completely ignored all the potential further
increase in value to this stock promised by
the many new and interesting products the
company was then developing.
That in no future year did Dow's earnings
fall anywhere near as low as this supposedly
abnormal peak is not what should concern us
here. Neither is the fact that from this supposedly
high plateau at which it was then selling,
the stock has since climbed many hundreds
per cent. Our interest should be in why this
normally able investment man would take this
set of facts and derive from it a quite different
conclusion as to the intrinsic value of the
stock than he would have derived from the
same facts in some other year.
The answer is that for these three years,
from 1947 to 1949, almost the whole financial
community was indulging in a mass delusion.With
all the ease of hindsight we can now sit back
and see that what appeared so frightening
then was almost as little related to reality
as the terror that gripped most of Christopher
Columbus's crew in 1492. Night after night
most of the common seamen on the Santa Maria
were unable to sleep because of a paralyzing
fear that at any moment their ship would fall
off the ends of the earth and be lost forever.
In 1948, the investment community gave little
value to the earnings of any common stock
because of the widespread conviction that
nothing could prevent the near future bringing
the same type of bitter depression and major
stock market crash that happened about the
same number of years after each of the two
preceding major wars. In 1949, a slight depression
did occur. When its modest nature was appraised
and the financial community found that the
subsequent trend was up, not down, a tremendous
psychological change occurred in the way common
stocks were regarded. Many common stocks more
than doubled in price in the following few
years, due to nothing more than this psychological
change.Those common stocks which also had
the benefit of more tangible outside occurrences
improving their fundamental worth did a great
deal better than just doubling.
These great shifts in the way the financial
community appraises the same set of facts
at different times are by no means confined
to stocks as a whole. Particular industries
and individual companies within those industries
constantly change in financial favor, due
as often to altered ways of looking at the
same facts as to actual background occurrences
themselves.
For example, in certain periods the armament
industry has been considered unattractive
by the investment community. One of its most
outstanding characteristics has been considered
to be domination by a single customer, the
government. This customer in some years goes
in for heavy military procurement, and in
others cuts buying way down. Therefore the
industry never knows from one year to the
next when it may be subject to major contract
cancellations and drying up of business.
To this must be added the abnormally low profit
margin that customarily prevails in government
work, and the tendency of the renegotiation
laws to take most of what profit is made,
but never correspondingly to allow for a mistake
in calculations that causes a
loss. Furthermore, the constant necessity
to keep bidding on new models in a field where
engineering changes come continuously means
that risk and turmoil are the order of the
day. It is impossible, no matter how good
your engineering, to standardize anything
that gives your company a long-term advantage
over the aggressive competition. Finally,
there is always the "danger" that peace might
break out with an accompanying decline in
business. When this view prevails, as it has
many times in the past twenty years, the defense
shares sell at a quite low price in relation
to their earnings.
However, the financial community has at times
in the recent past derived other conclusions
from the same set of facts. The world situation
is such that the need of heavy expenditures
for airborne defense equipment will be with
us for years.While the total value may vary
from year to year, the pace of engineering
change is causing more and more expensive
equipment to be needed, so that the long-range
trend will be upward.This means that the happy
investor in these securities will be in one
of the few industries which will in no sense
feel the next business depression, which sooner
or later will be felt by most other industries.
While the profit margin is limited by law,
so much business is available to the well-run
company that this proves no ceiling upon total
net profits.When this view prevails, a quite
different appraisal is being given to exactly
the same background facts.These stocks then
sell on a quite different basis.
Examples could be given for industry after
industry which in the past twenty years has
been looked upon first one way, then another,
by the financial community, with a resultant
change in quoted values. In 1950, pharmaceutical
stocks were generally regarded as having about
the same set of desirable characteristics
usually credited to industrial chemical companies.
Endless growth due to the wonders of research
and a steady rise in the standard of living
seemed to warrant the best of these shares
selling at the same ratio to earnings as the
best of the chemicals.Then a single manufacturer
got into trouble on a heretofore glamorous
item.The realization swept the financial community
that this was a field in which dominance today
is no assurance of being even one of the top
companies tomorrow. A reappraisal of the entire
industry took place. Completely different
price-earnings ratios prevailed, due, in all
cases but one, not to a different set of facts
but a different appraisal of the same facts.
In 1958, just the reverse took place. In the
business slump of that year, one of the few
industries that enjoyed increased rather than
decreased demand for its products was the
drug manufacturing industry. Profits of most
companies in this group rose to new highs.
At the same time earnings of the chemical
producers fell rather sharply-- largely because
of excess capacity from major expansion moves
that had just been completed. The volatile
financial community again started sharply
upgrading the price-earnings ratio of drug
shares. Meanwhile sentiment started to grow
that the chemical stocks were not as attractive
as had previously been supposed. All this
represented only changed financial appraisals.
Nothing of fundamental or intrinsic consideration
had happened.
A year later, some of this new sentiment had
already been reversed. As the better chemical
companies proved among the first to recover
lost earning power and as their growth trend
caused profits soon to go to new all-time
high levels, they rather quickly regained
their temporarily lost prestige.With the long-range
significance of an ever-growing number of
important new drugs tending further to bolster
the status of the pharmaceutical stocks as
against governmental attacks on pricing and
patent policies of this industry working in
the opposite direction, it will be interesting
to observe over the next several years whether
the recently regained standing of the pharmaceutical
stocks grows still further or starts to shrink.
In the original edition I went on to give
one (then) current example of this same sort
of changed financial appraisal, by saying:
"One more example is a change in outlook that
is taking place right now. For years the shares
of the machine tool manufacturers have sold
at a very low ratio to earnings. It was almost
unanimously felt that machine tools were the
epitome of a feast or famine industry. No
matter how good such earnings were, they did
not mean much because they were just the product
of a prevailing boom and could not last. Recently,
however, a new school, while by no means predominating
the thinking on this subject, has been gaining
converts. This school believes that since
World War II a fundamental change has taken
place affecting these companies. All industry
has been swinging from shortto long-range
planning of capital expenditures. As a result,
the cause of extreme fluctuation for the machine
tool companies has disappeared. High and rising
wage rates will prevent for many years, if
not forever, a return to the feast or famine
nature of this business. The steady pace of
engineering advance has increased and will
further increase the pace
of obsolescence of this industry's products.
Therefore, in place of the largely cyclical
prewar trends, the growth trend of the recent
past will continue further into the future.
Automation may cause this growth trend to
be spectacular.
"Under the influence of those who think this
way, the better machine tool stocks are now
appraised on a somewhat more favorable basis
in relation to the market as a whole than
they were only a few years ago. They still
sell at a rather low ratio to earnings because
the influence of the feast or famine idea
is still strong, even if it is not as strong
as it used to be. If the financial community
comes more and more to accept this non-cyclical
and growth outlook for machine tool stocks,
their price-earnings ratio will improve more
and more. They will then do much better than
the market. If the old feast or famine concept
regains its former hold, these shares will
sell at a lower ratio to earnings than prevails
today.
"This current machine tool example brings
into clear relief what the common stock investor
must do if he is to purchase shares to his
greatest advantage. He must examine factually
and analytically the prevailing financial
sentiment about both the industry and the
specific company of which he is considering
buying shares. If he can find an industry
or a company where the prevailing style or
mode of financial thinking is considerably
less favorable than the actual facts warrant,
he may reap himself an extra harvest by not
following the crowd. He should be extra careful
when buying into companies and industries
that are the current darlings of the financial
community, to be sure that these purchases
are actually warranted--as at times they well
may be--and that he is not paying a fancy
price for something which, because of too
favorable interpretation of basic facts, is
the investment fad of the moment."
Today, of course, we know the answer to the
recent ideas of some that the machine tool
industry is no longer feast or famine in its
nature. The 1957 recession completely exploded
the idea that longrange corporate planning
now cushions these stocks from their normal
extreme vulnerability to downward movements
in the business cycle. However, for every
problem of this sort which gets solved, the
ever-increasing pace of today's technology
opens up a dozen others from which the wise
investor can profit if he can think independently
of the crowd and reach the right answer when
the majority of financial opinion is leaning
the other way. Are the "exotic" fuel stocks
and certain of the smaller electronics intrinsically
worth the high appraisals being given them
today? Is there such a future for manufacturers
of ultrasonic equipment that ordinary price-earnings
may be disregarded? Is a company better or
worse for the American investor if an abnormally
large part of its earning power is derived
from foreign operations? These are all matters
about which the ideas of the multitude may
have swung too far or not far enough right
now. If he is thinking of participating in
the affected companies, the wise investor
must determine which are fundamental trends
that will go further, and which are fads of
the moment.
These investment fads and misinterpretations
of facts may run for several months or several
years. In the long run, however, realities
not only terminate them, but frequently, for
a time, cause the affected stocks to go too
far in the opposite direction.The ability
to see through some majority opinions to find
what facts are really there is a trait that
can bring rich rewards in the field of common
stocks.It is not easy to develop, however,
for the composite opinion of those with whom
we associate is a powerful influence upon
the minds of us all. There is one factor which
all of us can recognize, however, and which
can help powerfully in not just following
the crowd. This is realization that the financial
community is usually slow to recognize a fundamentally
changed condition, unless a big name or a
colorful single event is publicly associated
with that change. The ABC Company's shares
have been selling at a very low price, in
spite of the attractiveness of its industry,
because it has been badly managed. If a widely
known man is put in as the new president,
the shares will usually not only respond at
once, but will probably over-respond.This
is because the time it takes to bring about
basic improvement will probably be overlooked
in the first enthusiasm. However, if the change
to a superb management comes from the brilliance
of heretofore little-known executives, months
or years may go by during which the company
will still have poor financial repute and
sell at a low ratio to earnings. Recognizing
such situations--prior to the price spurt
that will inevitably accompany the financial
community's correction of its appraisal--is
one of the first and simplest ways in which
the fledgling investor can practice thinking
for himself rather than following the crowd.
How I Go about Finding a Growth Stock
After the publication of the original edition
of Common Stocks and Uncommon Profits, I began
receiving an amazing, to me, number of letters
from readers all over the country. One of
the most common requests made was for more
detailed data about just what an investor
(or his financial advisor) should do to find
investments that will lead to spectacular
gains in market price. Since there is so much
interest in this matter, it may be beneficial
to include some comments on this subject here.
Doing these things takes a great deal of time,
as well as skill and alertness.The small investor
may feel a disproportionate amount of work
is involved for the sums he has at his disposal.
It would be nice, not only for him but also
for the large investor, if there were some
easy, quick way of selecting bonanza stocks.
I strongly doubt that such a way exists. How
much time should be spent on these matters
is, of course, something each investor must
decide for himself in relation to the sums
he has available for investment, his interests,
and his capabilities.
I cannot say with any assurance that my method
is the only possible system for finding bonanza
investments. Nor can I even be completely
sure that it is the best method although,
obviously, if I thought some other available
approach were better I would not be using
this one. For some years, however, I have
followed the steps I am about to outline in
detail; doing this has worked and worked well
for me. Particularly in the highly important
earlier stages, someone else with greater
background knowledge, better contacts, or
more ability might make some important variations
in these methods and attain further improvement
in over-all results.
There are two stages in the following outline,
at each of which the quality of the decisions
made will have tremendous effect upon the
financial results obtained. Everyone will
recognize instantly the overwhelming importance
of the decision at the second of these two
critical points, which is,"Do I now buy this
particular stock or do I not?"What may not
be as easy to recognize is that right at the
start of an organized method for selecting
common stocks, decisions must also be made
that can have just about as great an impact
on the chance of uncovering an investment
that ten years later will have increased,
say, twelve-fold in value one rather than
that has not quite doubled.
This is the problem that confronts anyone
about to start on a quest for a major growth
security: there are literally thousands of
stocks in dozens of industries that could
conceivably qualify as worthy of the most
intensive study. You cannot be sure about
many of them until considerable work has been
done. However, no one could possibly have
the time to investigate more than a tiny per
cent of the available field. How do you select
the one or the very few stocks to the investigation
of which you will devote such time as you
have to spare?
This is a far more complex problem than it
seems.You must make decisions that can easily
screen out from investigation situations that
a few years later have produced fortunes.
You may make decisions that limit your work
to rather barren soil, in that as you gather
more data the outlook appears more and more
clear that you are approaching the answer
you are bound to find in the overwhelming
majority of all investigations. This is that
the company is run of the mill or maybe a
little better, but that it just is not the
occasional bonanza that leads to spectacular
profit. Yet this key decision determines whether,
financially speaking, you are prospecting
rich ore or poor on the basis of relatively
little knowledge of the facts. This is because
you must make decisions on what to or what
not to spend your time before you have done
enough work to have a proper basis for your
conclusion. If you have done enough work to
have adequate background for your decisions,
you will have already spent so much time on
each situation that, in effect, you will have
made this vital first decision on a snap basis
anyway. You just will not have realized that
you have done so.
Some years ago I would sincerely but mistakenly
have told you that I used what would have
sounded like a neat method for solving this
problem. As a result of companies which I
had already investigated, and particularly
as a result of familiarity with the companies
in which the
funds I manage were concentrated, I had become
friendly with a sizable number of quite able
business executives and scientists. I could
talk to these people about companies other
than their own. I believed that ideas and
leads furnished by such unusually well-informed
contacts would provide a magnificent supply
of prospects for investigation that would
contain an abnormally large per cent of companies
that might prove to have the outstanding characteristics
I am constantly seeking.
However, I attempt to use the same analytical
and self-critical methods of improving the
techniques of my own business that I expect
the companies in which I invest to use to
improve their operations. Therefore, some
years ago I made a study to determine two
things. How had I come to select the companies
which I had chosen for investigation? With
hindsight to help me, were there significant
variations in the percentage of worthwhile
results (in the way of outstanding investments
subsequently acquired) between investigations
made as a result of the original "spark plug"
idea coming from one type of source and those
coming from sources of a completely different
nature?
What I found astonished me but is entirely
logical on analysis.The business executive-scientist
classification which I had believed was my
main source of original ideas causing me to
investigate one company rather than another,
actually had furnished only about one-fifth
of the leads that had excited me enough to
engage in a further study. Of even greater
significance, these leads had not proven an
above average source of good investments.
This one-fifth of total investigations had
led to only about one-sixth of all worthwhile
purchases.
In contrast, the first original idea for almost
four-fifths of the investigations and almost
five-sixths of the ultimate pay-out (as measured
by worthwhile purchases) had come from a quite
different group. Across the nation I had gradually
come to know and respect a small number of
men whom I had seen do outstanding work of
their own in selecting common stocks for growth.A
not necessarily complete list of these able
investment men would include one or more living
in such widely scattered places as New York,
Boston, Philadelphia, Buffalo, Chicago, San
Francisco, Los Angeles, and San Diego. In
many instances I might not agree at all with
the conclusions of any of these men as to
a stock they particularly liked, even to the
point of feeling it worthy of investigation.
In one or two cases, I might even consider
the thoroughness of their work as suspect.
However, because in each case I knew their
financial minds were keen and their records
impressive, I would be disposed to
listen eagerly to details they might furnish
concerning any company within my range of
interests that they considered unusually attractive
for major appreciation.
Furthermore, since they were trained investment
men, I could usually get rather quickly their
opinion upon the key matters most important
to me in my decision as to whether it might
be a good gamble to investigate the company
in question.What are these key matters? Essentially
they cover how the company would measure up
to our already discussed fifteen points, with
special emphasis in this preliminary stage
on two specific subjects. Is the company in,
or being steered toward, lines of business
affording opportunities of unusual growth
in sales? Are these lines where, as the industry
grows, it would be relatively simple for newcomers
to start up and displace the leading units?
If the nature of the business is such that
there is little way of preventing newcomers
from entering the field, the investment value
of such growth as occurs may prove rather
slight.
How about using investment men of fewer accomplishments
or less ability as a source of original leads
on what to investigate? If I did not feel
that better men were available, I doubtless
would use them somewhat more than I do. I
always try to find the time at least to listen
once to any investment man, if only to be
on the alert for keen younger men coming up
in the business and to be sure I am not overlooking
one. However, the competition for time is
terrific. As I downgrade either a financial
man's investment judgment or his reliability
as to facts presented, I find my tendency
to spend time investigating the company he
presents decreasing even more than proportionally.
How about selecting original leads for investigation
from the ideas in printed material? Occasionally
I have been influenced by the special reports
issued by the most reliable brokerage houses
when these reports are not for widespread
distribution but solely to a few selected
people. However, on the whole, I would feel
the typical public printed brokerage bulletin
available to everyone is not a fertile source.There
is too much danger of inaccuracies in them.
More important, most only repeat what is already
common knowledge in the financial community.
Similarly, I will occasionally get a worthwhile
idea from the best of the trade and financial
periodicals (which I find quite helpful for
completely different purposes); but because
I believe they have certain inherent limitations
on what they can print about many of the matters
of greatest interest to me, I do not find
them a rich source of new ideas on the best
companies to investigate.
There is another possible source of worthwhile
original leads which others with better technical
backgrounds or greater ability might be able
to employ profitably, although I have not
successfully done so.This source is the major
consulting research laboratories such as Arthur
D. Little, Stanford Research Institute, or
Battelle. I have found that personnel of these
organizations have great understanding of
just the business and technical developments
from which worthwhile original investment
ideas should come. However, I have found the
usefulness of this group largely blocked by
their tendency (which is entirely praiseworthy)
to be unwilling to discuss most of what they
know because it might violate the confidence
of the client companies for which they have
worked. If someone smarter than I am could
find a way, without injury to these client
companies, of unlocking the mine of investment
information I suspect these organizations
possess, he might well have found a means
of importantly improving on my methods regarding
this particular step in the quest for growth
stocks.
So much for step one. On the basis of a few
hours' conversation, usually with an outstanding
investment man, occasionally with a business
executive or scientist, I have made a decision
that a particular company might be exciting.
I will start my investigation.What do I do
next?
There are three things I emphatically do not
do. I do not (for reasons that I think will
soon become clear) approach anyone in the
management at this stage. I do not spend hours
and hours going over old annual reports and
making minute studies of minor year-by-year
changes in the balance sheet. I do not ask
every stockbroker I know what he thinks of
the stock. I will, however, glance over the
balance sheet to determine the general nature
of the capitalization and financial position.
If there is an SEC prospectus I will read
with care those parts covering breakdown of
total sales by product lines, competition,
degree of officer or other major ownership
of common stock (this can also usually be
obtained from the proxy statement), and all
earning statement figures throwing light on
depreciation (and depletion, if any), profit
margins, extent of research activity, and
abnormal or non-recurring costs in prior years'
operations.
Now I am ready really to go to work. I will
use the "scuttlebutt" method I have already
described just as much as I possibly can.
Here, rather than as a source of original
ideas for investment, is where the people
I have come to know in the business executive-scientist
group can be of inestimable value. I will
try to see (or reach on the telephone)
every key customer, supplier, competitor,
ex-employee, or scientist in a related field
that I know or whom I can approach through
mutual friends. However, suppose I still do
not know enough people or do not have a friend
of a friend who knows enough of the people
who can supply me with the required background.What
do I do then?
Frankly, if I am not even close to getting
much of the information I need, I will give
up the investigation and go on to something
else.To make big money on investments it is
unnecessary to get some answer to every investment
that might be considered. What is necessary
is to get the right answer a large proportion
of the very small number of times actual purchases
are made. For this reason, if way too little
background is forthcoming and the prospects
for a great deal more are bleak, I believe
the intelligent thing to do is to put the
matter aside and go on to something else.
However, suppose quite a bit of background
has become available. You have called on everyone
you know or can readily approach, but have
spotted one or two people who you believe
could do much to complete your picture if
they would talk freely to you. I would not
just walk in on them off the street. Most
people, interested as they may be in the industry
in which they are engaged, are not inclined
to tell to total strangers what they really
think about the strong and weak points of
a customer, a competitor, or a supplier. I
would find out the commercial bank of the
people I want to meet. If in matters of this
sort you approach a commercial bank that knows
you, tell them frankly whom you want to meet
and exactly why, it is surprising how obliging
most commercial bankers will be in trying
to help you--provided you do not bother them
too often. It is possibly even more surprising
how helpful most businessmen will try to be
if you are introduced to them by their regular
bankers. Of course this help will only be
forthcoming if the bankers in question have
no doubt whatsoever that the information you
are seeking is solely for background purposes
in determining whether to make an investment,
and that under no circumstance would you ever
embarrass anyone by quoting the source of
any derogatory information. If you follow
these rules, banking help can, at times, help
complete the stage of an investigation that
otherwise might never be complete enough to
be of any value.
It is only after "scuttlebutt" has obtained
for you a large part of the data that in our
chapter on the fifteen points I indicated
can best be obtained from such sources, that
you should be ready to take the next
step and think about approaching the management.
I think it rather important that investors
thoroughly understand why this is so.
Good managements, those most suitable for
outstanding investment, are nearly all quite
frank in answering questions about the company's
weak points as fully as about its strong points.
However, no matter how punctilious a management
may be in this respect, no corporate officer
in his own self-interest can be expected,
unasked, to volunteer some of the most significant
matters for you, the investor, to know. How
can a vice president to whom you say, "Is
there anything else you think I, as a prospective
investor, should know about your company?"
give a reply to the effect that the other
top members of the management team are doing
splendidly but several years of poor work
by the vice president for marketing is beginning
to cause weakness in sales? Could he possibly
volunteer further that this may not be too
important, since young Williams, on the marketing
staff, has outstanding ability and in another
six months he will be in charge and the situation
brought back under control? Of course he could
not volunteer these things. However, I have
found that if he learns you already know of
the marketing weakness, his remark may be
diplomatically worded, but with the right
type of management and if they have confidence
in your judgment, you will be furnished with
a realistic answer as to whether anything
is or is not being done to remedy weaknesses
of this type.
In other words, only by having what "scuttlebutt"
can give you before you approach management,
can you know what you should attempt to learn
when you visit a company. Without it you may
be unable to determine that most basic of
points--the competency of top management itself.
In even a medium-sized company, there may
be a key management team of as many as five
men.You are not apt to meet all of them on
your first or second visit. If you do, you
will probably meet some for such a short time
you will have no basis for determining their
relative ability. Frequently one or two men
of the five will be far more able or far less
able than the others.Without "scuttlebutt"
to guide you, depending on whom you meet you
may form far too high or far too low an estimate
of the entire management. With "scuttlebutt"
you may have formed a fairly accurate idea
of who is particularly strong or particularly
weak, and are in a better position to ask
to meet the specific officers you may want
to know better, thereby satisfying yourself
as to whether this "scuttlebutt" impression
is correct.
It is my opinion that in almost any field
nothing is worth doing unless it is worth
doing right.When it comes to selecting growth
stocks, the rewards for proper action are
so huge and the penalty for poor judgment
is so great that it is hard to see why anyone
would want to select a growth stock on the
basis of superficial knowledge. If an investor
or financial man wants to go about finding
a growth stock properly, I believe one rule
he should always follow is this: he should
never visit the management of any company
he is considering for investment until he
has first gathered together at least 50 per
cent of all the knowledge he would need to
make the investment. If he contacts the management
without having done this first, he is in the
highly dangerous position of knowing so little
of what he should seek that his chance of
coming up with the right answer is largely
a matter of luck.
There is another reason I believe it so important
to get at least half the required knowledge
about a company before visiting it. Prominent
management and managements in companies in
colorful industries get a tremendous number
of requests for their time from people in
the investment business. Because the price
at which their stock sells can have so much
significance to them in so many ways, they
will usually devote the time of valuable people
to such visitors. However, from company after
company I have heard the same type of comment.To
no one will they be rude, but the amount of
time furnished by key men, rather than by
those who receive financial visitors but make
few executive decisions, depends far more
on the company's estimate of the competence
of the visitor than it does on the size of
the financial interest he represents. More
important, the degree of willingness to furnish
information--that is, how far the company
will go in answering specific questions and
discussing vital matters--depends overwhelmingly
on this estimate of each visitor.Those who
just drop in on a company without real advance
preparation, often have two strikes against
them almost before the visit starts.
This matter of whom you see (that it be the
men who make the real decisions, rather than
a sort of financial public relations officer)
is so important that it is wise to go to considerable
trouble to be introduced to management by
the right people. An important customer or
a major stockholding interest known to management
can be an excellent source of introduction
to pave the way for a first visit. So can
the company's investment banking connections.
In any event, those really wanting to get
optimum results from their first visit should
make sure that
those introducing them have a high regard
for the visitor and pass the reasons for this
good opinion on to the management.
Just a few weeks prior to my writing these
words an incident occurred which may illustrate
how much preparation I feel should be made
prior to a first call on management. I was
lunching with two representatives of a major
investment firm, one which is the investment
banker for two of the handful of companies
in which the funds I manage are invested.
Knowing the small number of situations I go
into and the long time I normally hold them,
one of these gentlemen asked me the ratio
between the new (to me) companies I visited
and the ones of these into which I actually
bought. I asked him to guess. He estimated
I bought into one for every two hundred and
fifty visited. The other gentleman ventured
that it might be one for every twenty-five.
Actually it runs somewhere between one to
every two and one to every two and one-half!
This is not because one out of every two and
one-half companies I look at measures up to
what I believe are my rather rigorous standards
for purchase. If he had substituted "companies
looked at" for "companies visited" perhaps
one in forty or fifty might be about right.
If he had substituted "companies considered
as possibilities for investigation" (whether
I actually investigated them or not) then
the original estimate of one stock bought
for every two hundred and fifty considered
would be rather close to the mark.What he
had overlooked was that I believe it so impossible
to get much benefit from a plant visit until
a great deal of pertinent "scuttlebutt" work
has been done first, and that I have found
that "scuttlebutt" so many times furnishes
an accurate forecast of how well a company
will measure up to my fifteen points, that
usually by the time I am ready to visit the
management there will be at least a fair chance
that I will want to buy into the company.A
great many of the less attractive situations
will have been weeded out along the way.
This about sums up how I go about finding
growth stocks. Possibly one-fifth of my first
investigations start from ideas gleaned from
friends in industry and four-fifths from culling
what I believe are the more attractive selections
of a small number of able investment men.
These decisions are frankly a fast snap judgment
on which companies I should spend my time
investigating and which I should ignore. Then
after a brief scrutiny of a few key points
in an SEC prospectus, I will seek "scuttlebutt"
aggressively, constantly working toward how
close to our fifteen-point standard the company
comes. I will discard one
prospective investment after another along
the way. Some because the evidence piles up
that they are just run of the mill. Others
because I cannot get enough evidence to be
reasonably sure one way or the other. Only
in the occasional case when I have a great
amount of favorable data do I then go to the
final step of contacting the management.Then
if after meeting with management I find my
prior hopes pretty well confirmed and some
of my previous fears eased by answers that
to me make sense, at last I am ready to feel
I may be rewarded for all my efforts.
Because I have heard them so many times, I
know the objections a few of you will make
to this approach. How can anyone be expected
to spend this amount of time finding just
one investment? Why are not the answers already
neatly worked out for me by the first person
in the investment business to whom I ask what
I should buy? I would ask those with this
reaction to look at the world around them.
In what other line of activity could you put
$10,000 in one year and ten years later (with
only occasional checking in the meantime to
be sure management continues of high caliber)
be able to have an asset worth from $40,000
to $150,000? This is the kind of reward gained
from selecting growth stocks successfully.
Is it either logical or reasonable that anyone
could do this with an effort no harder than
reading a few simply worded brokers' free
circulars in the comfort of an armchair one
evening a week? Does it make sense that anyone
should be able to pick up this type of profit
by paying the first investment man he sees
a commission of $135, which is the New York
Stock Exchange charge for buying 500 shares
of stock at $20 per share? So far as I know,
no other fields of endeavor offer these huge
rewards this easily. Similarly, they cannot
be made in the stock market unless you or
your investment advisor utilize the same traits
that will bring large rewards in any other
field of activity. These are great effort
combined with ability and enriched by both
judgment and vision. If these attributes are
employed and something fairly close to the
rules laid down in this chapter are used to
find companies measuring well on our fifteen-point
standard but not yet enjoying as much status
in the financial community as such an appraisal
would warrant, the record is crystal clear
that fortune-producing growth stocks can be
found. However, they cannot be found without
hard work and they cannot be found every day.
Summary and Conclusion.
We are starting the second decade of a half
century that may well see the standard of
living of the human race advance more than
it has in the preceding five thousand years.
Great have been the investment risks of the
recent past. Even greater have been the financial
rewards for the successful. However, in this
field of investment, the risks and rewards
of the past hundred years may be small beside
those of the next fifty.
In these circumstances it may be well to take
stock of our situation. We almost certainly
have not conquered the business cycle.We may
not even have tamed it. Nevertheless, we have
added certain new factors that significantly
affect the art of investment in common stocks.
One of these is the emergence of modern corporate
management, with all that this has done to
strengthen the investment characteristics
of common shares. Another is the economic
harnessing of scientific research and developmental
engineering.
The emergence of these factors has not changed
the basic principles of successful common
stock investment. It has made them more important
than ever.This book has attempted to show
what these basic principles are, what type
of stock to buy, when to buy it, and most
particularly, never to sell it--as long as
the company behind the common stock maintains
the characteristics of an unusually successful
enterprise.
It is hoped that those sections dealing with
the most common mistakes of many otherwise
able investors will prove of some interest.
It should be remembered, however, that knowing
the rules and understanding these common mistakes
will do nothing to help those who do
not have some degree of patience and self-discipline.
One of the ablest investment men I have ever
known told me many years ago that in the stock
market a good nervous system is even more
important than a good head. Perhaps Shakespeare
unintentionally summarized the process of
successful common stock investment: "There
is a tide in the affairs of men which, taken
at the flood, leads on to fortune."
Part Two
CONSERVATIVE INVESTORS SLEEP WELL
All of my business life, I have believed that
the success of my own business--or any business--depends
on following the principles of two I's and
an H. These principles are integrity, ingenuity,
and hard work. I would like to dedicate this
book to my three sons in the belief that Arthur
and Ken are following the principles of the
two I's and an H in businesses very similar
to mine, as is Don in one that is quite different.
Introduction
While these things are hard to measure precisely,
indications are overwhelming that only once
before in this century has the morale of the
American investor been at anything like the
low ebb that exists as these words are being
written. The well-known and much publicized
Dow Jones Industrial Average is an excellent
indicator of the day-to-day change in stock-market
levels. However, when a longer period is under
consideration, this average may mask rather
than reveal the full extent of the injuries
suffered by many who have held common stocks
in the recent past. One index that purports
to show what has happened to all publicly
traded common stocks but that does not weigh
each stock issue by the number of shares outstanding
shows the average stock in mid-1974 down 70
percent from its 1968 peak.
Faced with this kind of loss, large groups
of investors have acted in completely predictable
ways. One group has pulled out of stocks completely.Yet
many corporations are doing surprisingly well.
In an environment where more and more inflation
appears inevitable, properly selected stocks
may be far less risky than some other placements
that appear safer.There is an even larger
group that is of particular interest: people
who have decided that "from now on we will
act more conservatively." The usual rationale
here is to confine purchases only to the largest
companies, the names of which at least are
known to almost everyone. There are probably
few investors in the United States and almost
none in the Northeast who do not know the
names Penn Central and Consolidated Edison
or the nature of these companies' services.
By conventional standards, Penn Central some
years ago and Consolidated
Edison more recently were considered conservative
investments. Unfortunately, often there is
so much confusion between acting conservatively
and acting conventionally that for those truly
determined to conserve their assets, this
whole subject needs considerable untangling--which
should start with not one definition but two:
1. A conservative investment is one most likely
to conserve (i.e., maintain) purchasing power
at a minimum of risk.
2. Conservative investing is understanding
of what a conservative investment consists
and then, in regard to specific investments,
following a procedural course of action needed
properly to determine whether specific investment
vehicles are, in fact, conservative investments.
Consequently, to be a conservative investor,
not one but two things are required either
of the investor or of those whose recommendations
he is following.The qualities desired in a
conservative investment must be understood.Then
a course of inquiry must be made to see if
a particular investment so qualifies.Without
both conditions being present the buyer of
common stocks may be fortunate or unfortunate,
conventional in his approach or unconventional,
but he is not being conservative.
It seems to me of overriding importance that
confusion on matters such as these be swept
aside for all time to come. Not only stockholders
themselves but also the American economy as
a whole cannot afford ever again to have those
who make a sincere effort to understand the
rules suffer the type of bloodbath recently
experienced by this generation of investors--a
bloodletting exceeded only by that which another
generation experienced in the Great Depression
some forty years earlier. America today has
unparalleled opportunities for improving the
way of life for all its people. It certainly
has the technical knowledge and the know-how
to do so. However, to do these things in the
traditional American way will require some
genuine re-education as to the basic fundamentals
for a great many investors as well as for
many of those in the investment industry itself.
Only if many more investors come to feel financially
secure because they truly are secure will
there be a reopening of the markets for new
stock issues that will enable companies legitimately
requiring additional equity funds to be in
a position to secure them on a basis conducive
to going ahead with new projects. If this
does not happen, all that is left is to try
to go ahead with what needs to be
done in the way that, both here and abroad,
has always proven so costly, wasteful, and
inefficient--by government financing, with
management under the dead hand of bureaucratic
officialdom.
For these reasons I believe that the investors'
problems of today should be met head on and
forthrightly. In an attempt to deal with these
problems in this book, I have leaned heavily
on the counsel of my son, Ken, who contributed
the title as well as many other matters, including
part of the basic conception of what lies
herein. I cannot adequately acknowledge his
assistance in this presentation.
This book is divided into four distinct sections.The
first deals with the anatomy--if the word
may be used--of a conservative stock investment
as delineated in definition number one. The
second analyzes the part played by the financial
community--the mistakes, if you will--that
helped produce the current bear market. This
critique was not intended merely to throw
rocks but to point out that similar errors
can be avoided in the future and that certain
basic investment principles become clear when
the mistakes of the recent past are studied.The
third section deals with the course of action
that must be taken to qualify as conservative
investing as delineated in definition number
two.The final section deals with some of the
influences rampant in today's world that have
caused grave doubts in the minds of many as
to whether any common stock is a suitable
means for preserving assets--in other words,
whether for anything other than as gambling
vehicles common stocks should be considered
at all. This book will, I hope, throw light
on whether the problems that helped produce
the recent bear market have created a condition
where stock ownership is just a trap for the
unwary or whether, as in every prior major
bear market in U.S. history, they have created
a magnificent opportunity for those with the
ability and the self-discipline to think for
themselves and to act independently of the
popular emotions of the moment.
PHILIP A. FISHER
San Mateo, California
1
The First Dimension of a Conservative Investment.
Superiority in Production, Marketing, Research,
and Financial Skills.
A corporation of the size and type to provide
a conservative investment is necessarily a
complex organization. To understand what must
be present in such an investment we might
start by portraying one dimension of the characteristics
we must be sure exist. This dimension breaks
down into four major subdivisions:
LOW-COST PRODUCTION To be a truly conservative
investment a company--for a majority if not
for all of its product lines--must be the
lowest-cost producer or about as low a cost
producer as any competitor. It must also give
promise of continuing to be so in the future.
Only in this way will it give its owners a
broad enough margin between costs and selling
price to create two
vital conditions. One is sufficient leeway
below the break-even point of most competition.When
a bad year hits the industry, prices are unlikely
to stay for long under this break-even point.
As long as they do, losses for much of the
higher-cost competition will be so great that
some of these competitors will be forced to
cease production. This almost automatically
increases the profits of the surviving low-cost
companies because they benefit from the increased
production that comes to them as they take
over demand formerly supplied by the closed
plants. The low-cost company will benefit
even more when the decreased supply from competitors
enables it not only to do more business but
also to increase prices as excess supplies
stop pressing on the market.
The second condition is that the greater than
average profit margin should enable a company
to earn enough to generate internally a significant
part or perhaps all of the funds required
for financing growth. This avoids much or
even all of the need for raising additional
longterm capital that can (a) result in new
shares being issued and diluting the value
of already outstanding shares and/or (b) create
an additional burden of debt, with fixed interest
payments and fixed maturities (which must
largely be met from future earnings) which
greatly increase the risks of the common-stock
owners.
However, it should be realized that, just
as the degree to which a company is a low-cost
producer increases the safety and conservatism
of the investment, so in a boom period in
a bullish market does it decrease its speculative
appeal.The percentage that profits rise in
such times will always be far greater for
the high-cost, risky, marginal company. Simple
arithmetic will explain why. Let us take an
imaginary example of two companies of the
same size that, when times were normal, were
selling widgets at ten cents apiece. Company
A has a profit of four cents per widget and
Company B of one cent. Now let us suppose
that costs remain the same but a temporary
extra demand for widgets pushes up the price
to twelve cents, with both companies remaining
the same size. The strong company has increased
profits from four cents per widget to six
cents, a gain of 50 percent, but the high-cost
company has made a 300 percent profit gain,
or tripled its profits.This is why, short-range,
the high-cost company sometimes goes up more
in a boom and also why, a few years later,
when hard times come and widgets fall back
to eight cents, the strong company is still
making a reduced but comfortable profit. If
the high-cost company doesn't go bankrupt,
it is likely to produce another crop of badly
hurt investors (or perhaps speculators who
thought they were investors) who are sure
something is wrong with the system rather
than with themselves.
All of the above has been written with manufacturing
companies in mind; hence the term production
has been used. Many companies, of course,
are not manufacturers but are in service lines,
such as wholesaling, retailing or one of the
many subdivisions of the financial world such
as banking or insurance.The same principles
apply, but the word operations is substituted
for production and a low- or high-cost operator
for a low- or high-cost producer.
STRONG MARKETING ORGANIZATION
A strong marketer must be constantly alert
to the changing desires of its customers so
that the company is supplying what is desired
today, not what used to be desired. At the
turn of the century, for example, there was
something wrong with the marketing efforts
of a leading manufacturer of horse-drawn buggies
if it persisted in trying to compete by making
finer and finer buggies rather than turning
to automobiles or going out of business altogether.To
bring our example up to date, perhaps well
before the Arab oil embargo made every home
in America aware that large automobiles were
big gas guzzlers, there was something wrong
with the segment of the automobile industry
that failed to recognize the ever-increasing
popularity of small imported compacts as a
sign that public demand was swinging toward
a product that cost less, was cheaper to operate,
and was easier to park than the larger, flashier
models that for so many years had been favorites.
But recognizing changes in public taste and
then reacting promptly to these changes is
not enough. As has been said before, in the
business world customers simply do not beat
a path to the door of the man with the better
mousetrap. In the competitive world of commerce
it is vital to make the potential customer
aware of the advantages of a product or service.
This awareness can be created only by understanding
what the potential buyer really wants (sometimes
when the customer himself doesn't clearly
recognize why these advantages appeal to him)
and explaining it to him not in the seller's
terms but in his terms.
Whether this is best done by advertising,
by salesmen making calls, by specialized independent
marketing organizations, or by any combination
of these depends on the nature of the business.
But what is
required in every instance is close control
and constant managerial measurement of the
cost effectiveness of whatever means are used.
Lack of outstanding management in these areas
can result (a) in losing a significant volume
of business that would otherwise be available;
(b) in having much higher costs and therefore
obtaining smaller profit on what business
is obtained; and (c) because of companies'
having variations in the profitability of
various elements of their product line, in
failing to attain the maximum possible profit
mix within the line. An efficient producer
or operator with weak marketing and selling
may be compared to a powerful engine that,
because of a loose pulley belt or badly adjusted
differential, is producing only a fraction
of the results it otherwise would have attained.
OUTSTANDING RESEARCH AND TECHNICAL EFFORT.
Not so very long ago it seemed that outstanding
technical ability was vital only to a few
highly scientifically oriented industries
such as electronics, aerospace, pharmaceutical
and chemical manufacturing.As these have grown,
their ever-widening technologies have so penetrated
virtually all lines of manufacturing and nearly
all the service industries that today to have
outstanding research and technical talent
is nearly, if not quite, as important for
a shoe manufacturer, a bank, a retailer or
an insurance company as it is for what were
once considered the exotic scientific industries
that maintained large research staffs. Technological
efforts are now channeled in two directions:
to produce new and better products (in this
connection, research scientists may, of course,
do somewhat more for a chemical company than
for a grocery chain) and to perform services
in a better way or at a lower cost than in
the past.With regard to the latter objective,
outstanding technical talent can be equally
valuable for either group. Actually, in some
of the service businesses, technological groups
are opening up new product lines as well as
paving the way for performing old services
better. Banks are an example. Lowcost electronic
input devices and minicomputers are enabling
them to offer accounting and bookkeeping services
to customers, thus creating a new product
line for these institutions.
In research and technology, there is as much
variation between the efficiency of one company
and another as there is in marketing. In new
product development, the complexity of the
task almost guarantees this. Important as
it is, the degree of technical competence
or ingenuity of one company's research staff
as compared to that of another is only one
of the factors affecting the benefits that
the company derives from its research efforts.
Developing new products usually calls for
the pooling of the efforts of a number of
researchers, each skilled in a different technological
specialty. How well these individuals work
together (or can be induced by a leader to
work together and stimulate each other) is
often as important as the individual competence
of the people involved. Furthermore, to maximize
profits, it is vital not to develop just any
product but one for which there will be significant
customer demand, one that (nearly always)
can be sold by the company's existing marketing
organization, and one that can be made at
a price that will yield a worthwhile profit.
All of this requires efficient liaison between
research and both marketing and production.
The best corporate research team in the world
can become nothing but a liability if it develops
only products that cannot be readily sold.
For true investment superiority a company
must have above-average ability to control
all these complex relationships yet at the
same time not so overcontrol them as to cause
its researchers to lose the drive and the
ingenuity that made them outstanding in the
first place.
FINANCIAL SKILL
Again and again in this discussion of production,
marketing and research, the terms profit and
profit margin have been used. In a large company
with a diverse product line, it is not a simple
matter to be sure of the cost of each product
in relation to the rest, as most costs other
than materials and direct labor are spread
over a number of such products, maybe over
all of them. Companies with above-average
financial talent have several significant
advantages. Knowing accurately how much they
make on each product, they can make their
greatest efforts where these will produce
maximum gains. Intimate knowledge of the extent
of each element of costs, not just in manufacturing
but in selling and research as well, spotlights
in even minor phases of company activity the
places where it is logical to make special
efforts to reduce costs, either through technological
innovations or by improving people's specific
assignments. Most important of all, through
skillful budgeting and
accounting, the truly outstanding company
can create an early-warning system whereby
unfavorable influences that threaten the profit
plan can be quickly detected. Remedial action
can then be taken to avoid the painful surprises
that have jolted investors in many companies.
Nor do the "goodies" that accrue to investors
from superior financial skills stop at this
point. They usually lead to a better choice
of capital investments that bring the highest
return on the company's investment capital.They
also can lead to better control of receivables
and inventory, a matter of increasing importance
in periods of high interest rates.
To summarize:The company that qualifies well
in this first dimension of a conservative
investment is a very low-cost producer or
operator in its field, has outstanding marketing
and financial ability and a demonstrated above-average
skill on the complex managerial problem of
attaining worthwhile results from its research
or technological organization. In a world
where change is occurring at an ever-increasing
pace, it is (1) a company capable of developing
a flow of new and profitable products or product
lines that will more than balance older lines
that may become obsolete by the technological
innovations of others; (2) a company able
now and in the future to make these lines
at costs sufficiently low so as to generate
a profit stream that will grow at least as
fast as sales and that even in the worst years
of general business will not diminish to a
point that threatens the safety of an investment
in the business; and (3) a company able to
sell its newer products and those which it
may develop in the future at least as profitably
as those with which it is involved today.
This is a one-dimensional picture of a prudent
investment--one which, if not spoiled by the
view from other dimensions, represents an
investment with which the investor is unlikely
to become disillusioned. But before going
on to examine these other dimensions, there
is one additional point that should be fully
understood. If the objective is conserving
one's funds, if the goal is safety, why have
we been talking about growth and the development
of new and additional product lines? Why isn't
it enough to maintain a business at its existing
size and level of profits without running
all the risks that occur when new endeavors
are started? When we come to a discussion
of the influence of inflation on investments,
other reasons for the importance of growth
will present themselves. But fundamentally
it should never be forgotten that, in a world
where change is occurring at a faster and
faster pace, nothing long remains the same.
It is impossible to stand still. A company
will either
grow or shrink. A strong offense is the best
defense. Only by growing better can a company
be sure of not growing worse. Companies that
have failed to go uphill have invariably gone
downhill--and, if that has been true in the
past, it will be even more true in the future.
This is because, in addition to an ever-increasing
pace of technological innovation, changing
social customs and buying habits and new demands
of government are altering at an ever-increasing
pace the rate at which even the stodgiest
industries are changing.
2. The Second Dimension
The People Factor
Briefly summarized, the first dimension of
a conservative investment consists of outstanding
managerial competence in the basic areas of
production, marketing, research, and financial
controls. This first dimension describes a
business as it is today, being essentially
a matter of results. The second dimension
deals with what produced these results and,
more importantly, will continue to produce
them in the future.The force that causes such
things to happen, that creates one company
in an industry that is an outstanding investment
vehicle and another that is average, mediocre,
or worse, is essentially people.
Edward H. Heller, a pioneer venture capitalist
whose comments during his business life greatly
influenced some of the ideas expressed in
this book, used the term "vivid spirit" to
describe the type of individual to whom he
was ready to give significant financial backing.
He said that behind every unusually successful
corporation was this kind of determined entrepreneurial
personality with the drive, the original ideas,
and the skill to make such a company a truly
worthwhile investment.
Within the area of very small companies that
grew into considerably larger and quite prosperous
ones (the field of his greatest interest and
where he scored his most spectacular successes),
Ed Heller was undoubtedly right. But as these
smaller companies grow larger on the
way to becoming suitable for conservative
investment, Ed Heller's view might be tempered
by that of another brilliant businessman who
expressed serious doubts about the wisdom
of investing in a company whose president
was his close personal friend.This man's reason
for lack of enthusiasm: "My friend is one
of the most brilliant men I've ever known.
He always has to be right. In a small company
this may be fine. But as you grow, your men
have to be right sometimes, too."
Here is an indication of the heart of the
second dimension of a truly conservative investment:
a corporate chief executive dedicated to longrange
growth who has surrounded himself with and
delegated considerable authority to an extremely
competent team in charge of the various divisions
and functions of the company. These people
must be engaged not in an endless internal
struggle for power but instead should be working
together toward clearly outlined corporate
goals. One of these goals, which is absolutely
essential if an investment is to be a truly
successful one, is that top management take
the time to identify and train qualified and
motivated juniors to succeed senior management
whenever a replacement is necessary. In turn,
at each level down through the chain of command,
detailed attention should be paid to whether
those at this level are doing the same thing
for those one level below them.
Does this mean that a company that qualifies
for truly conservative investing should promote
only from within and should never recruit
from the outside except at the lowest levels
or for those just starting their careers?
A company growing at a very rapid rate may
have such need for additional people that
there just isn't time to train from within
for all positions. Furthermore, even the best-run
company will at times need an individual with
a highly specialized skill so far removed
from the general activities of the company
that such a specialty simply cannot be found
internally. Someone with expertise in a particular
subdivision of the law, insurance, or a scientific
discipline well removed from the company's
main line of activity would be a case in point.
In addition, occasional hiring from the outside
has one advantage: It can bring a new viewpoint
into corporate councils, an injection of fresh
ideas to challenge the accepted way as the
best way.
In general, however, the company with real
investment merit is the company that usually
promotes from within.This is because all companies
of the highest investment order (these do
not necessarily have to be the biggest and
best-known companies) have developed a set
of policies and ways of doing things peculiar
to their own needs. If these special
ways are truly worthwhile, it is always difficult
and frequently impossible to retrain those
long accustomed to them to different ways
of getting things done. The higher up in an
organization the newcomer may be, the more
costly the indoctrination can be.While I can
quote no statistics to prove the point, it
is my observation that in better-run companies
a surprising number of executives brought
in close to the top tend to disappear after
a few years.
Of one thing the investor can be certain:A
large company's need to bring in a new chief
executive from the outside is a damning sign
of something basically wrong with the existing
management--no matter how good the surface
signs may have been as indicated by the most
recent earnings statement. It may well be
that the new president will do a magnificent
job and in time will build a genuine management
team around him so that such a jolt to the
existing organization will never again become
necessary. Consequently, in time such a stock
may become one worthy of a wise investor.
But such rebuilding can be so long and risky
a process that, if an investor finds this
sort of thing happening in one of his holdings,
he will do well to review all his investment
activities to determine whether his past actions
have really been proceeding from a sound base.
A worthwhile clue is available to all investors
as to whether a management is predominantly
one man or a smoothly working team (this clue
throws no light,however,on how good that team
may be).The annual salaries of top management
of all publicly owned companies are made public
in the proxy statements. If the salary of
the number-one man is very much larger than
that of the next two or three, a warning flag
is flying. If the compensation scale goes
down rather gradually, it isn't.
For optimum results for the investor it is
not enough that management personnel work
together as a team and be capable of filling
vacancies above them.There should also be
present the greatest possible number of those
"vivid spirits" of Ed Heller's--people with
the ingenuity and determination not to leave
things just at their present, possibly quite
satisfactory, state but to build significant
further improvements upon them. Such people
are not easy to find. Motorola, Inc., has
for some time been conducting an activity
that the financial community has paid little
or no attention to that indicates it is possible
to accomplish dramatically more in this area
than is generally considered possible.
In 1967 Motorola management recognized that
the rapid rate of growth anticipated in the
years ahead would inevitably require steady
expansion in the upper layers of management.
It was decided to meet the problem head on.
In that year Motorola opened its Executive
Institute at Oracle, Arizona. It was designed
so that, in an atmosphere remote from the
daily details of the company's offices and
plants, two things would happen: Motorola
personnel of apparent unusual promise would
be trained in matters beyond the scope of
their immediate activities in order to be
able to take on more important jobs; top management
would be furnished significant further evidence
as to the degree of pro-motability of these
same people.
At the time of the Executive Institute's founding,
skeptics within the management questioned
whether the effort would be worth the cost.
This was largely because of their belief that
fewer than a hundred people would be found
in the whole Motorola organization with sufficient
talent to make it worthwhile from the company's
standpoint to provide them with this special
training. Events have proven these skeptics
spectacularly wrong.The Institute handles
five to six classes a year, with fourteen
in each class. By mid-1974 about 400 Motorola
people had gone through the school; and a
significant number, including some present
vice-presidents, were found to have capabilities
vastly greater than anything contemplated
at the time they were approved for admission.
Furthermore, those involved in this work feel
that, from the company's standpoint, results
in the more recent classes are even more favorable
than in the earlier ones. It now appears that,
as total employment at Motorola continues
to expand with the company's growth, enough
promising Motorola people can be found to
maintain this activity indefinitely. All of
this shows, from the investor's standpoint,
that if enough ingenuity is used, even the
companies with well-above-average growth rates
can also "grow" the needed unusual people
from within so as to maintain competitive
superiority without running the high risk
of friction and failure that so often occurs
when a rapidly growing company must go to
the outside for more than a very small part
of its outstanding talent.
Everyone has a personality--a combination
of character traits that sets him or her apart
from every other individual. Similarly, every
corporation has its own ways of doing things--some
formalized into well-articulated policies,
others not--that are at least slightly different
from those of other corporations. The more
successful the corporation, the more likely
it is to be unique in some of its policies.This
is particularly true of companies that have
been successful for a considerable period
of time. In contrast to individuals, whose
fundamental character traits
The Second Dimension
change but little once they reach maturity,
the ways of companies are influenced not only
by outside events but by the reactions to
those events of a whole series of different
personalities who, as time goes on, follow
one another in the top posts within the organization.
However much policies may differ among companies,
there are three elements that must always
be present if a company's shares are to be
worthy of holding for conservative, long-range
investment.
1. The company must recognize that the world
in which it is operating is changing at an
ever-increasing rate.
All corporate thinking and planning must be
attuned to challenge what is now being done--to
challenge it not occasionally but again and
again. Every accepted way of doing things
must be examined and reexamined to be as sure
as is permitted by human fallibility that
this way is really the best way. Some risks
must be accepted in substituting new methods
to meet changing conditions. No matter how
comfortable it may seem to do so, ways of
doing things cannot be maintained just because
they worked well in the past and are hallowed
by tradition.The company that is rigid in
its actions and is not constantly challenging
itself has only one way to go, and that way
is down. In contrast, certain managements
of large companies that have deliberately
endeavored to structure themselves so as to
be able to change have been those producing
some of the most striking rewards for their
shareholders. An example of this is the Dow
Chemical Company, with a record of achievements
over the last ten years that is frequently
considered to surpass that of any other major
chemical company in this country, if not in
the entire world. Possibly Dow's most significant
departure from past ways was to break its
management into five separate managements
on geographical lines (Dow USA, Dow Europe,
Dow Canada, etc.). It was believed that only
in this way could local problems be handled
quickly as best suited local conditions and
without suffering from the bureaucratic inefficiencies
that so often accompany bigness. The net effect
of this as told by the president of Dow Europe:
"The results that today challenge us are being
made by our sister [Dow] companies throughout
the world.They, not our direct competitors,
are turning in the gains that push us to be
first." From the investor's standpoint perhaps
the most important feature of this change
was not that it was made but that it was made
when Dow still had a total sales volume much
smaller than many
other multinational companies that were operating
successfully in the established way. In other
words, change and improvement arose from innovative
thinking to make a workable system better--not
from a forced reaction to a crisis.
This is but one of the many ways this pioneering
company has broken with the past to attain
its striking competitive record. Another was
the unprecedented step for an industrial company
of starting from scratch to make a success
of a wholly owned bank in Switzerland so as
to help finance the needs of its customers
in the export market. Here again the management
did not hesitate to break with the past in
ways that engendered some risk in the early
stages but that ended up by enhancing the
intrinsic strength of the company.
Many other examples could be cited from the
record of this company. However, just one
more will be mentioned merely to show the
extreme variety of areas such actions may
cover. Far earlier than most other companies,
Dow not only recognized the need to spend
sizable sums to avoid pollution but concluded
that, if major results were to be attained,
something more was needed than just exhortations
from top management. It was necessary to obtain
the consistent cooperation of middle-level
managers. It was decided that the surest way
of doing this was to appeal to the profit
motives of those most directly involved.They
were encouraged to find profitable methods
of converting the polluting materials to salable
products.The rest is now business history.With
the full power of top management, plant management,
and highly skilled chemical engineers behind
these projects, Dow has achieved a series
of firsts in eliminating pollution that has
won them the praise of many environmental
groups that are usually quite antibusiness
in their viewpoints. Possibly more important,
they have avoided hostility in most, although
not all, of the communities where their plants
are located. They have done this at very little
over-all dollar cost and in some cases at
an operating profit.
2. There must always be a conscious and continuous
effort, based on fact, not propaganda, to
have employees at every level, from the most
newly hired blue-collar or white-collar worker
to the highest levels of management,
feel that their company is a good place to
work.
This is a world that requires most of us to
put in a substantial number of hours each
week doing what is asked of us by others in
order to
receive a paycheck even though we might prefer
to spend those hours on our own amusement
or recreation. Most people recognize the necessity
for this. When a management can instill a
belief, not just among a few top people but
generally among the employees, that it is
doing everything reasonably to be expected
to create a good working environment and take
care of its employees' interests, the rewards
the company receives in greater productivity
and lower costs can vastly outweigh the costs
of such a policy.
The first step in this policy is seeing (not
just talking about it but actually assuring)
that every employee is treated with reasonable
dignity and consideration. A year or so ago
I read in the press that a union official
claimed that one of the nation's largest companies
was compelling its production-line employees
to eat lunch with grease-stained hands because
there was not sufficient time, with the number
of washroom facilities available, for most
of them to be able to wash before lunch. The
stock of this company was of no investment
interest to me for quite different reasons.
Therefore, I have no knowledge of whether
the charge was based on fact or was made in
the heat of an emotional battle over wage
negotiations. However, if true, this condition
alone would, in my opinion, make the shares
of this company unsuitable for holding by
careful investors.
Besides treating employees with dignity and
decency, the routes to obtaining genuine employee
loyalty are many and varied. Pension and profit-sharing
plans can play a significant part. So can
good communication to and from all levels
of employees. Concerning matters of general
interest, letting everyone know not only exactly
what is being done but why frequently eliminates
friction that might otherwise occur. Actually
knowing what people in various levels of the
company are thinking, particularly when that
view is adverse, can be even more important.
A feeling throughout the company that people
can express their grievances to superiors
without fear of reprisal can be beneficial,
although this open-door policy is not always
simple to maintain because of the time wasted
by cranks and nuts.When grievances occur,
decisions on what to do about them should
be made quickly. It is the long-smoldering
grievance that usually proves the most costly.
A striking example of the benefits that may
be attained through creating a unity of purpose
with employees is the "people-effectiveness"
program of Texas Instruments.The history of
this program is an excellent example of how
brilliant management perseveres with and perfects
policies of this sort even when new outside
influences force some redirection of these
policies. From the early days of this company,
top management held a deep conviction that
everyone would gain if a system could be set
up whereby all employees participated in managerial-type
decisions to improve performance but that,
to sustain interest on the part of employees,
all participants must genuinely benefit from
the results of their contributions. In the
1950s semiconductor production was largely
a matter of hand assembly, offering many opportunities
for employees to make brilliant individual
suggestions for improving performance. Meetings,
even formal classes, were held in which production
workers were shown how they could as individuals
or groups show the way to improving operations.
At the same time, through both profitsharing
plans and awards and honors, those participating
benefited both financially and by feeling
they were part of the picture. Then mechanization
of these former manual operations started
to appear. As this trend grew, there was somewhat
less opportunity for certain types of individual
contributions, as in certain ways the machines
controlled what would be done. A few foremen
within the organization began feeling that
there was no longer a place for lower-level
contributions to management-type participation.Top
management took quite the opposite viewpoint:
People-participation would play a greater
role than ever before. Now, however, it would
be a group or team effort with the workers
as a group estimating what could be done and
setting their own goals for performance.
Because workers started feeling that they
(1) were genuinely participating in decisions,
not just being told what to do, and (2) were
being rewarded both financially and in honors
and recognition, the results have been spectacular.
In instance after instance, teams of workers
have set for themselves goals quite considerably
higher than anything management would have
considered suggesting. At times when it appeared
that targeted goals might not be met or when
inter-team competition was producing rivalry,
the workers proposed and voluntarily voted
such unheard-of things (for this day and age)
as cutting down on coffee breaks or shortening
lunch periods to get the work out.The pressure
of peer groups on the tardy or lazy worker
who threatens the goals the group has set
for itself dwarfs any amount of discipline
that might be exerted from above through conventional
management methods. Nor are these results
confined to U.S. workers with their lifelong
background in political democracy. They appear
to be equally effective and
mutually beneficial to people, regardless
of the color of their skin and their origins
from countries of quite different economic
backgrounds. Though the performance-goal plan
was first initiated in the United States,
equally striking results have appeared not
just in Texas Instruments plants in the so-called
developed industrial nations such as France
and Japan but also in Singapore, with its
native Asian employees, and in Curaçao, where
those on the payroll are overwhelmingly black.
In all countries the morale effects appear
striking when worker teams not only report
directly to top management levels but also
know their reports will be heeded and their
accomplishments recognized and acknowledged.
What all this has meant to investors was spelled
out when company president Mark Shepherd,
Jr., addressed stockholders at the 1974 annual
meeting. He stated that a people-effectiveness
index had been established consisting of the
net sales billed divided by the total payroll.
Since semiconductors, the company's largest
product line, are one of the very few products
in today's inflationary world that consistently
decline in unit price and since wages have
been rising at the company's plants at rates
from 7 percent a year in the United States
to 20 percent in Italy and Japan, it would
be logical to expect, in spite of improvements
in people-effectiveness, this index to decline.
Instead it rose from about 2.25 percent in
1969 to 2.5 percent by the end of 1973. Furthermore,
with definite plans for additional improvement
and with further increases in profit-sharing
funds tied into such improvement, it was announced
that it was the company's goal to bring the
index up to 3.1 percent by 1980--a goal that,
if attained, would make the company a dramatically
profitable place to work. Over the years Texas
Instruments has frequently publicized some
rather ambitious long-range goals and to date
has rather consistently accomplished them.
From the investment standpoint, there are
some extremely important similarities in the
three examples of people-oriented programs
that were chosen to illustrate aspects of
the second dimension of a conservative investment.
It is a relatively simple matter to mention
and give a general description of Motorola's
institute for selecting and training unusual
talent to handle the growing needs of the
company. It is an equally simple affair to
mention that Dow found a means to stimulate
people to work together to master environmental
problems and to make them profitable for the
company, or to state a few facts about the
remarkable people-effectiveness program at
Texas Instruments. However, if
another company decided to start programs
like these from scratch, the problems that
could arise might be infinitely more complicated
than merely persuading a board of directors
to approve the necessary appropriation. Programs
of this kind are easy to formulate, but their
implementation is a quite different matter.
Mistakes can be very costly. It is not hard
to imagine what might happen if a training
school such as Motorola's selected the wrong
people for promotion, with the result that
the best junior talent quit the company in
disgust. Similarly, suppose a company tried
to follow, in general, a people-effectiveness
plan but either failed to create an atmosphere
where workers genuinely felt themselves involved
or failed to compensate their employees adequately,
with the result that they became disillusioned.
The misapplication of such a program could
literally wreck a company. Meanwhile, companies
that do perfect advantageous people-oriented
policies and techniques usually find more
and more ways to benefit from them. For these
companies, such policies and techniques--these
special ways of approaching problems and of
solving them--are in a sense proprietary.
For this reason they are of great importance
to long-range investors.
3. Management must be willing to submit itself
to the disciplines required for sound growth.
It has already been pointed out that in this
rapidly changing world companies cannot stand
still.They must either get better or worse,
improve or go downhill. The true investment
objective of growth is not just to make gains
but to avoid loss.There are very few companies
whose managements will not make claims to
being growth companies. However, a management
that talks about being growth-oriented is
not necessarily actually so oriented. Many
companies seem to have an irresistible urge
to show the greatest possible profits at the
end of each accounting period-- to bring every
possible cent down to the bottom line. This
a true growth-oriented company can never do.
Its focus must be on earning sufficient current
profits to finance the costs of expanding
the business. When adjustment for earning
the required additional financial strength
has been made, the company worthy of farsighted
investment will give priority to curtailing
maximum immediate profits when there are genuine
worthwhile opportunities for developing new
products or processes or for starting new
product lines or for any one of the hundred
and one more mundane actions whereby a dollar
spent today may mean
many dollars earned in the future. Such actions
can vary all the way from hiring and training
new personnel that will be needed as the business
grows to forgoing the greatest possible profit
on a customer's order to build up his permanent
loyalty by rushing something to him when he
needs it badly. For the conservative investor,
the test of all such actions is whether management
is truly building up the long-range profits
of the business rather than just seeming to.
No matter how well known, the company with
a policy that only gives lip service to these
disciplines is not likely to prove a happy
vehicle for investment funds. Neither is one
that tries to follow these disciplines but
falls down in executing them, as, for example,
a company that makes large research expenditures
but so mishandles its efforts as to gain little
from them.
3. The Third Dimension
Investment Characteristics of Some Businesses
The first dimension of a conservative stock
investment is the degree of excellence in
the company's activities that are most important
to present and future profitability. The second
dimension is the quality of the people controlling
these activities and the policies they create.
The third dimension deals with something quite
different: the degree to which there does
or does not exist within the nature of the
business itself certain inherent characteristics
that make possible an above-average profitability
for as long as can be foreseen into the future.
Before examining these characteristics it
may be well to point out why above-average
profitability is so important to the investor,
not only as a source of further gain but as
a protection for what he already has. The
vital role of growth in this connection has
already been discussed. Growth costs money
in many ways. Part of what otherwise would
be the profit stream has to be diverted to
experimenting, inventing, testmarketing, new-product
marketing, and all the other operating costs
of expansion, including the complete loss
of the inevitable percentage of such expansion
attempts that are bound to fail. Even more
costly may be the additions to factories or
stores or equipment that must be made. Meanwhile,
as the business grows, more inventory will
inevitably be
needed to fill the pipelines. Finally, except
for the very few businesses that sell only
for cash, there will be a corresponding drain
on corporate resources to take care of the
growing volume of receivables.To accomplish
all these things, profitability is vital.
In inflationary periods the matter of profitability
becomes even more important. Usually when
prices and, therefore, costs are rising on
a broad front, a business can, in time, pass
these costs along through higher prices of
its own. However, this often cannot be done
immediately. During the interim, obviously
a much smaller bite is taken out of the profits
of the broad-profit-margin company than occurs
for its higher-cost competition, since the
higher-cost company is probably facing comparably
increased costs of doing business.
Profitability can be expressed in two ways.
The fundamental way, which is the yardstick
used by most managements, is the return on
invested assets. This is the factor that will
cause a company to decide whether to go ahead
with a new product or process. What percent
return can the company expect on the part
of its capital invested in this particular
way in comparison to what the return might
be if the same amount of its assets was employed
in some other way? It is considerably more
difficult for the investor to use this yardstick
than it is for the corporate executive. What
the investor usually sees is not the return
on a specific amount of present-day dollars
utilized in a specific subdivision of the
business but the total earnings of the business
as a percentage of its total assets.When the
cost of capital equipment has risen as much
as it has in the last forty years, comparisons
of the return on total invested capital between
one company and another may be so distorted
by variations in the price levels at which
different companies made major expenditures
that the figures are highly misleading. For
this reason, comparing the profit margins
per dollar of sales may be more helpful as
long as one other point is kept in mind.This
is that a company that has a high rate of
sales in relation to assets may be a more
profitable company than one with a higher
profit margin to sales but a slower rate of
sales turnover. For example, a company that
has annual sales three times its assets can
have a lower profit margin but make a lot
more money than one that needs to employ a
dollar of assets in order to obtain each dollar
of annual sales. However, while from the standpoint
of profitability return on investment must
be considered as well as profit margin on
sales, from the standpoint of safety of investment
all the emphasis is on profit margin on sales.Thus
if two companies were each to experience
a 2 percent increase in operating costs and
were unable to raise prices, the one with
a 1 percent margin of profit would be running
at a loss and might be wiped out, while, if
the other had a 10 percent margin, the increased
costs would wipe out only one-fifth of its
profits.
There is one final matter to be kept in mind
in order to place this dimension of conservative
investing in proper perspective: In today's
highly fluid and competitive business world,
obtaining well-above-average profit margins
or a high return on assets is so desirable
that, whenever a company accomplishes this
goal for any significant period of time, it
is bound to be faced with a host of potential
competitors. If the potential competitors
actually enter the field, they will cut into
markets the established company now has. Normally,
when potential competition becomes actual
competition the ensuing struggle for sales
results in anything from a minor to a major
reduction in the high profit margin that had
theretofore existed. High profit margins may
be compared to an open jar of honey owned
by the prospering company. The honey will
inevitably attract a swarm of hungry insects
bent on devouring it. In the business world
there are but two ways a company can protect
the contents of its honey jar from being consumed
by the insects of competition. One is by monopoly,
which is usually illegal, although, if the
monopoly is due to patent protection, it may
not be. In any event, monopolies are likely
to end quite suddenly and do not commend themselves
as vehicles for the safest type of investing.
The other way for the honey-jar company to
keep the insects out is to operate so much
more efficiently than others that there is
no incentive for present or potential competition
to take action that will upset the existing
situation.
Now let us turn from this background discussion
of relative profitability to the heart of
the third dimension of conservative investing--
namely, the specific characteristics that
enable certain well-managed companies to maintain
above-average profit margins more or less
indefinitely. Possibly the most common characteristic
is what businessmen call the "economies of
scale."A simple example of economy of scale:A
wellrun company making one million units a
month will often have a lower production cost
for each unit than a company producing only
100,000 units in the same period. The difference
between the cost per unit of these two companies,
one ten times larger than the other, can vary
considerably from one line of business to
another. In some there may be almost no difference
at all. Furthermore, it should never be forgotten
that in any industry the larger company will
have a maximum advantage only
if it is exceedingly well run.The bigger a
company is, the harder it is to manage efficiently.
Quite often the inherent advantages of scale
are fully balanced or even more than balanced
by the inefficiencies produced by too many
bureaucratic layers of middle management,
consequent delays in making decisions, and,
at times, the seeming inability of top executives
in the largest companies to know quickly just
what needs corrective attention in various
subdivisions of their far-flung complexes.
On the other hand, when a company clearly
becomes the leader in its field, not just
in dollar volume but in profitability, it
seldom gets displaced from this position as
long as its management remains highly competent.
As discussed in examining the second dimension
of a conservative investment, such a management
must retain the ability to change corporate
ways to match the ever-changing external environment.There
is a school of investment thinking that advocates
acquiring shares in the number-two or -three
company in a field because "these can go up
to number one, whereas the leader is already
there and might slip." There are some industries
where the largest company does not have a
clear leadership position; but, where it does,
we emphatically do not agree with this viewpoint.
It has been our observation that, in many
years of trying, Westinghouse has not surpassed
General Electric, Montgomery Ward has not
overtaken Sears, and--once IBM established
early dominance in its areas of the computer
market--even the extreme efforts of some of
the largest companies in the country, including
General Electric, did not succeed in displacing
IBM from its overwhelming share of that market.
Neither have scores of smaller price-cutting
suppliers of peripheral equipment been able
to displace IBM as the main and most profitable
operator in that phase of the computer industry.
What enables a company to obtain this advantage
of scale in the first place? Usually getting
there first with a new product or service
that meets worthwhile demand and backing this
up with good enough marketing, servicing,
product improvement, and, at times, advertising
to keep existing customers happy and coming
back for more. This frequently establishes
an atmosphere in which new customers will
turn to the leader largely because that leader
has established such a reputation for performance
(or sound value) that no one is likely to
criticize the buyer adversely for making this
particular selection. In the heyday of the
attempts of others to cut into IBM's computer
business, no one will ever know how many employees
of corporations planning to use a computer
for the first time recommended IBM rather
than a smaller competitor whose equipment
they privately thought was better or cheaper.
In such instances the primary motive was probably
a feeling that if, later on, the equipment
should fail to perform, those making the recommendation
would not be blamed if they had chosen the
industry leader but could very well find their
necks out a mile if a failure occurred and
they had chosen a smaller company without
an established reputation.
There is a saying in the pharmaceutical industry
that, when a truly worthwhile new drug is
created, the company that gets in first takes
and holds 60 percent of the market, thereby
making by far the bulk of the profits. The
next company to introduce a competitive version
of the same product gets perhaps 25 percent
of the market and makes moderate profits.
The next three companies to arrive divide
perhaps 10 percent to 15 percent of the market
and earn meager profits. Any further entrants
usually find themselves in a quite unhappy
position. A trend toward the substitution
of generic for trade names may or may not
upset these ratios, and in any case there
cannot be said to be an exact formula applicable
to other industries; nevertheless, the concept
behind them should be kept in mind when an
investor attempts to appraise which companies
have a natural advantage in regard to profitability
and which do not.
Lower production costs and greater ability
to attract new customers because of a well-recognized
trade name are not the only ways that scale
can consistently give a company competitive
strength. Examining some of the factors behind
the investment strength of the soup division
of the Campbell Soup Company is illuminating.
In the first place, as by far the largest
soup canners in the nation, this company can
reduce total costs through backward integration
as smaller companies cannot. Making many of
their own cans exactly to meet their own needs
is a case in point. More important, Campbell
has enough business so that it can scatter
canning plants at strategic spots across the
nation, which makes for a sizable double advantage:
It is both a shorter haul for the grower delivering
his produce to the cannery and a shorter average
haul from cannery to supermarket. Since canned
soup is heavy in relation to its value, freight
costs are significant.This puts the smaller
canner with only one or two plants at a big
disadvantage in trying to compete in a nationwide
market. Next, and probably most important
of all, because Campbell's is a recognized
product that the customer knows and wants
when he enters the supermarket, the retailer
automatically awards to it
a prominent and fairly sizable area of his
always sought-after shelf space. In contrast,
he is usually quite reluctant to do as much
for a less-known or unknown competitor. This
prominent shelf space helps to sell the soup
and is still another factor tending to keep
the number-one company on top, a factor extremely
discouraging for potential competitors. Also
discouraging for them is Campbell's normal
advertising budget, which adds very much less
to the cost per can sold than such a budget
would for a competitor with a very much smaller
output. For reasons such as these, this particular
company has strong inherent forces tending
to protect profit margins. However, to present
a complete picture, we must note some influences
working in the opposite direction. When Campbell's
own costs rise, as they can do sharply in
an inflationary period, prices to the consumer
cannot be raised more than the average of
other foods or there could be a shift in demand
away from soups to other staples. Far more
important, Campbell has a major competitor
that most companies do not have to contend
with and that, as rising production costs
cause higher prices to the consumer, can cut
significantly into Campbell's market. This
is the American housewife fighting her battle
of the budget by making soup in her own kitchen.
This point is mentioned merely to show that
even when scale affords huge competitive advantages
and a company is well run, these characteristics,
important as they are, do not, of themselves,
assure extreme profitability.
Scale is by no means the only investment factor
tending to perpetuate the much greater profitability
and investment appeal of some companies over
others. Another which we believe is of particular
interest is the difficulty of competing with
a highly successful, established producer
in a technological area where the technology
depends on not one scientific discipline but
the interplay of two or preferably several
quite different disciplines. To explain what
I mean, let us suppose that someone develops
an electronic product that promises to open
up sizable new markets in either the computer
or instrument field. There are enough highly
capable companies in both areas that have
in-house experts able to duplicate both the
electronic hardware and the software programming
that such products require so that if the
new market appears large enough, sufficient
competition may soon develop to make the profits
of the smaller innovator rather tenuous. In
areas such as these, the successful large
company has a further built-in advantage.
Many such lines cannot be sold unless a network
of service people is available to make rapid
repair at the customers' locations.The large
established company usually
has such an organization in being. It is extremely
difficult and expensive for a small new company
introducing a worthwhile new product to establish
such a network. It may be even harder for
the new company to convince a potential buyer
that it has the financial staying power not
only to have the service network in place
when the sale is made but to keep it there
in the future. Furthermore, while all these
influences have made it difficult in the past
for the newcomer with an exciting product
to establish real leadership in most subdivisions
of the electronics industry, although a few
companies have done so, it is likely to be
still more difficult in the future. This is
because the semiconductor is becoming a larger
and larger percentage of both the total content
and the total technical know-how of more and
more products. The leading companies making
these devices also now have at least as much
in-house knowledge as the top old-line computer
and instrument companies if they elect to
compete in many new product areas that are
largely electronic. A case in point is the
dramatic success of Texas Instruments in the
sensationally growing area of hand-held calculators
and the difficulties of some of the early
pioneers in this field.
However, notice how the balance changes if,
instead of just a technology based on electronic
hardware and software, producing the product
calls for these skills to be combined with
some quite different ones such as nucleonics
or some highly specialized area of chemistry.
The large electronic companies simply do not
have the in-house skills to enter these interdisciplinary
technologies. This affords the best-run innovators
a far better opportunity to build themselves
into the type of leadership position in their
particular product line that carries with
it the broad profit margin that tends to continue
as long as managerial competence does not
weaken. I believe that some of these multidisciplinary
technological companies, in not all of which
is electronics a significant factor, have
recently proven some of the finest opportunities
for truly farsighted investing. I am inclined
to think that more such opportunities will
occur in the future.Thus, for example, I suspect
that sometime in the future new leading companies
will arise through products or processes that
utilize some of these other disciplines combined
with biology, although so far I have not seen
any company in this area that so qualifies.This
is not to say that none exists.
Technological development and scale are not
the only aspects of a company's activities
in which unusual circumstances may raise opportunities
for sustained high profit margins. In certain
circumstances these
can also occur in the area of marketing or
sales.An example is a company that has created
in its customers the habit of almost automatically
specifying its products for reorder in a way
that makes it rather uneconomical for a competitor
to attempt to displace them.Two sets of conditions
are necessary for this to happen. First, the
company must build up a reputation for quality
and reliability in a product (a) that the
customer recognizes is very important for
the proper conduct of his activities, (b)
where an inferior or malfunctioning product
would cause serious problems, (c) where no
competitor is serving more than a minor segment
of the market so that the dominant company
is nearly synonymous in the public mind with
the source of supply, and yet (d) the cost
of the product is only a quite small part
of the customer's total cost of operations.
Consequently, moderate price reductions yield
only very small savings in relation to the
risk of taking a chance on an unknown supplier.
However, even this is not enough to ensure
that a company fortunate enough to get itself
in this position will be able to enjoy above-average
profit margins year after year. Second, it
must have a product sold to many small customers
rather than a few large ones. These customers
must be sufficiently specialized in their
nature that it would be unlikely for a potential
competitor to feel they could be reached through
advertising media such as magazines or television.They
constitute a market in which, as long as the
dominant company maintains the quality of
its product and the adequacy of its service,
it can be displaced only by informed salesmen
making individual calls.Yet the size of each
customer's orders make such a selling effort
totally uneconomical! A company possessing
all these advantages can, through marketing,
maintain an above-average profit margin almost
indefinitely unless a major shift in technology
(or, as already mentioned, a slippage in its
own efficiency) should displace it. Companies
of this type can most often be found in the
moderately high technology supply area. One
of their characteristics is to maintain their
image of leadership by holding frequent technical
seminars on the use of their product, a marketing
tool that proves highly effective once a company
attains this type of position.
It should be noted that the "above-average"
profit margin or "greater than normal" return
on investment need not be--in fact, should
not be--many times that earned by industry
in general to give a company's shares great
investment appeal. Actually, if the profit
or return on investment is too spectacular,
it can be a source of danger, as the inducement
then becomes almost irresistible for all sorts
of companies
to try to compete so as to get a share of
the unusual honey pot. In contrast, a profit
margin consistently just 2 or 3 percent of
sales greater than that of the next best competitor
is sufficient to ensure a quite outstanding
investment.
To summarize the matter of the third dimension
of a truly conservative investment: It is
necessary not just to have the quality of
personnel discussed in the second dimension
but to have had that personnel (or their predecessors)
steer the company into areas of activity where
there are inherent reasons within the economics
of the particular business so that above-average
profitability is not a short-term matter.
Put simply, the question to ask in regard
to this third dimension is: "What can the
particular company do that others would not
be able to do about as well?" If the answer
is almost nothing, so that, as the business
gets more prosperous, others can rush in to
share in the company's prosperity on about
equal terms, the evidence is conclusive that
while the company's stock may be cheap, the
investment fails to qualify as to this third
dimension.
4. The Fourth Dimension.
Price of a Conservative Investment.
The fourth dimension of any stock investment
involves the priceearnings ratio--that is,
the current price divided by the earnings
per share. In the attempt to appraise whether
the price-earnings ratio is in line with a
proper valuation for that specific stock,
trouble begins to arise. Most investors, including
many professionals who should know better,
become confused on this point because they
don't have a clear understanding of what makes
the price of the particular stock go up or
down by a significant amount. This misunderstanding
has resulted in losses in billions of dollars
by investors who find out later that they
own stocks bought at prices that they never
should have paid. Even more billions have
been lost as investors have sold out, at the
wrong time and for the wrong reasons, shares
they had every reason to hold and which, if
held, would have become extremely profitable
as long-range investments. Still another result
is one that, if it happens repeatedly, will
seriously impair the ability of deserving
corporations to obtain adequate financing,
with all that this could mean in a lower standard
of living for everyone: Every time individual
stocks take sickening plunges, another group
of badly burned investors places the blame
on the system rather than on their own mistakes
or those of their advisors. They conclude
that common stocks of any type are not suitable
for their savings.
The other side of the coin is that many other
investors can be found who over the years
have prospered mightily from holding the right
stocks for considerable periods of time. Their
success may be due to understanding basic
investment rules. Or it may be due to just
plain good luck. However, the common denominator
in this success has been the refusal to sell
certain unusual high-quality stocks simply
because each has had such a sharp fast rise
that its price-earnings ratio suddenly looks
high in relation to that to which the investment
community had become accustomed.
In view of the importance of all this, it
is truly remarkable that so few have looked
beneath the surface to understand exactly
what causes these sharp price changes.Yet
the law that governs them can be stated reasonably
simply: Every significant price move of any
individual common stock in relation to stocks
as a whole occurs because of a changed appraisal
of that stock by the financial community.
Let us see how this works in practice.Two
years ago company G was considered quite ordinary.
It had earned $1 per share and was selling
at ten times earnings, or $10. During these
last two years most companies in its industry
have been showing a downward profit trend.
In contrast, a series of brilliant new products,
combined with better profit margins on old
products, enabled G company to report $1.40
per share last year and $1.82 this year and
to give promise of further gains over the
next several years. Obviously the actions
within the company that produced the sharp
contrast between G's recent results and those
of others in the industry could not have started
just two years ago but must have been going
on for some time; otherwise the operating
economies and the brilliant new products would
not have occurred. However, belated recognition
(i.e., appraisal) of how well G is qualifying
in regard to matters covered in our discussions
of the first three dimensions has now caused
the price-earnings ratio to rise to 22. When
compared with other stocks showing similar
above-average business characteristics and
comparable growth prospects, this ratio of
22 does not appear at all high. Since 22 times
$1.82 is $40, here is a stock that has legitimately
gone up 400 percent in two years. Equally
important, a record such as G's is frequently
an indication that there is now a functioning
management team capable of continued growth
for many years ahead. Such a growth, even
at a more modest rate averaging, say, 15 percent
in the next decade or two, could easily result
in profits by that time running into the thousands
rather than the hundreds of percent.
The matter of "appraisal" is the heart of
understanding the seeming vagaries of price-earnings
ratios. It should never be forgotten that
an appraisal is a subjective matter. It has
nothing necessarily to do with what is going
on in the real world about us. Rather, it
results from what the person doing the appraising
believes is going on, no matter how far from
the actual facts such a judgment may be. In
other words, any individual stock does not
rise or fall at any particular moment in time
because of what is actually happening or will
happen to that company. It rises or falls
according to the current consensus of the
financial community as to what is happening
and will happen regardless of how far off
this consensus may be from what is really
occurring or will occur.
At this point many pragmatic individuals simply
throw up their hands in disbelief. If the
huge price changes that occur in individual
stocks are made solely because of changed
appraisals by the financial community, with
these appraisals sometimes completely at variance
with what is going on in the real world of
a company's affairs, what significance have
the other three dimensions? Why bother with
the expertise of business management, scientific
technology, or accounting at all? Why not
just depend on psychologists?
The answer involves timing. Because of a financial-community
appraisal that is at variance with the facts,
a stock may sell for a considerable period
for much more or much less than it is intrinsically
worth. Furthermore, many segments of the financial
community have the habit of playing "follow
the leader," particularly when that leader
is one of the larger New York City banks.This
sometimes means that when an unrealistic appraisal
of a stock is already causing it to sell well
above what a proper recognition of the facts
would justify, the stock may stay at this
too high level for a long period of time.
Actually, from this already too high a price
it may go even higher.
These wide variations between the financial
community's appraisal of a stock and the true
set of conditions affecting it may last for
several years. Always, however--sometimes
within months, sometimes only after a much
longer period of time--the bubble bursts.
When a stock has been selling too high because
of unrealistic expectations, sooner or later
a growing number of stockholders grow tired
of waiting.Their selling soon more than exhausts
the buying power of the small number of additional
buyers who still have faith in the old appraisal.The
stock then comes tumbling down. Sometimes
the new appraisal that follows is quite realistic.
Frequently, however, as this re-examination
evolves under
the emotional pressure of falling prices,
the negative is overemphasized, resulting
in a new financial-community appraisal that
is significantly less favorable than the facts
warrant and that may then prevail for some
time. However, when this happens, much the
same thing occurs as when the appraisal is
too favorable. The only difference is that
the process is reversed. It may take months
or years for a more favorable image to supplant
the existing one. Nevertheless, as pleasing
earnings mount upward, sooner or later this
happens.
Fortunate holders--those who don't sell out
as such a stock starts to rise--then benefit
from the phenomenon that provides the greatest
reward in relation to the risk involved the
stock market can produce. This is the dramatic
improvement in price that results from the
combined effect of both a steady improvement
in per-share earnings and a sharp, simultaneous
increase in the price-earnings ratio. As the
financial community quite correctly discovers
that the fundamentals of the company (now
its new image) have much more investment worth
than had been recognized when the old image
was in effect, the resulting increase in the
price-earnings ratio is frequently an even
more important factor in the increased price
of the stock than the actual increase in per-share
earnings that accompanies it.This is precisely
what happened in our Gcompany example.
We are now in a position to begin to get a
true perspective on the degree of conservatism--that
is, of basic risk in any investment. On the
lowest end of the risk scale and most suitable
for wise investment is the company that measures
quite high in regard to the first three dimensions
but currently is appraised by the financial
community as less worthy, and therefore has
a lower price-earnings ratio, than these fundamental
facts warrant. Next least risky and usually
quite suitable for intelligent investment
is the company rating quite high in regard
to the first three dimensions and having an
image and therefore a price-earnings ratio
reasonably in line with these fundamentals.
This is because such a company will continue
to grow if it truly has these attributes.
Next least risky and, in my opinion, usually
suitable for retention by conservative investors
who own them but not for fresh purchase with
new funds are companies that are equally strong
in regard to the first three dimensions but,
because these qualities have become almost
legendary in the financial community, have
an appraisal or price-earnings ratio higher
than is warranted by even the strong fundamentals.
In my opinion there are important reasons
such stocks should usually be retained, even
though their prices seem too high: If the
fundamentals are genuinely strong, these companies
will in time increase earnings not only enough
to justify present prices but to justify considerably
higher prices. Meanwhile, the number of truly
attractive companies in regard to the first
three dimensions is fairly small. Undervalued
ones are not easy to find. The risk of making
a mistake and switching into one that seems
to meet all of the first three dimensions
but actually does not is probably considerably
greater for the average investor than the
temporary risk of staying with a thoroughly
sound but currently overvalued situation until
genuine value catches up with current prices.
Investors who agree with me on this particular
point must be prepared for occasional sharp
contractions in the market value of these
temporarily overvalued stocks. On the other
hand, it is my observation that those who
sell such stocks to wait for a more suitable
time to buy back these same shares seldom
attain their objective. They usually wait
for a decline to be bigger than it actually
turns out to be. The result is that some years
later when this fundamentally strong stock
has reached peaks of value considerably higher
than the point at which they sold, they have
missed all of this later move and may have
gone into a situation of considerably inferior
intrinsic quality.
Continuing up our scale of ascending risks,
we come next to the stocks that are average
or relatively low in quality in regard to
the first three dimensions but have an appraisal
in the financial community either lower than,
or about in line with, these not very attractive
fundamentals. Those with a poorer appraisal
than basic conditions warrant may be good
speculations but are not suitable for the
prudent investor. In the fast-moving world
of today there is just too much danger of
adverse developments severely affecting such
shares.
Finally we come to what is by far the most
dangerous group of all: companies with a present
financial-community appraisal or image far
above what is currently justified by the immediate
situation. Purchase of such shares can cause
the sickening losses that tend to drive investors
away from stock ownership in droves and threaten
to shake the investment industry to its foundations.
If anyone wants to make a case-by-case study
of the contrast between the financial-community
appraisals that prevailed at one time about
some quite colorful companies and the fundamental
conditions that subsequently came to light,
he will find plenty of material in a business
library or the files of the larger Wall Street
houses. It is alarming to read some of the
reasons given in brokerage reports recommending
purchase of these shares and then to compare
the outlook described in such documents with
what actually was to happen. A fragmentary
list of such companies might include: Memorex
high 1737/8, Ampex high 497/8, Levitz Furniture
high 60½, Mohawk Data Sciences high 111,
Litton Industries high 101¾, Kalvar high
176½.
The list could go on and on and on. However,
more examples would serve only to make the
same point over and over. Since it should
already be quite apparent how important is
the habit of evaluating any difference that
may exist between a contemporary financial-community
appraisal of a company and the fundamental
aspects of that company, it should be more
productive for us to spend our time examining
further the characteristics of these financial-community
appraisals. First, however, to avoid risk
of misunderstanding, it seems advisable to
avoid semantic confusion by defining two of
the words in our original statement of the
rule governing all major changes in the price
of common stocks: Every significant price
move of any individual common stock in relation
to stocks as a whole occurs because of a changed
appraisal of that stock by the financial community.
The phrase "significant price changes" is
used rather than merely "price changes." This
is to exclude the kind of minor price variation
that occurs if, say, an estate has twenty
thousand shares of a stock that a clumsy broker
rapidly dumps on the market with the result
that the stock drops a point or two and then
usually recovers as the liquidation ends.
Similarly, at times an institution will determine
that on going into a new situation it must
buy a minimum number of shares. The result
is frequently a small onetime bulge that subsides
on completion of this sort of buying. Such
moves, in the absence of a genuinely changed
appraisal of the company by the financial
community as a whole, have no important or
long-term effect on the price of the shares.
Usually such small price changes disappear
once the special buying or selling is over.
The term "financial community" has been used
to include all those able and enough interested
to be potentially ready to buy or sell a particular
stock at some price, keeping in mind that,
with regard to impact on price, the importance
of each of these potential buyers and sellers
is weighted by the amount of buying or selling
power each is in a position to exercise.
5. More about the Fourth Dimension.
Up to this point our discussion of the financial
community's appraisal of a stock may have
given the impression that this appraisal is
nothing more than an evaluation of that particular
equity, considered by itself. This is oversimplification.
Actually it always results from the blending
of three separate appraisals: the current
financial-community appraisal of the attractiveness
of common stocks as a whole, of the industry
of which the particular company is a part,
and, finally, of the company itself.
Let us first examine the matter of industry
appraisals. Everyone knows that, over long
periods of time, there can be a sizable decline
in the price-earnings ratio the financial
community will pay to participate in an industry
as it passes from an early stage when huge
markets appear ahead to a much later period
where it, in turn, may be threatened by new
technologies. Thus, in the early years of
the electronics industry, companies making
electronic tubes, in that period the fundamental
building block of all electronics, sold at
very high price-earnings ratios. Then price-earnings
ratios shrank drastically as the development
of semiconductors steadily narrowed the tube
market. Makers of magnetic memory devices
have more recently suffered the same fate
for the same reason. All this is obvious and
thoroughly understood. What is not so obvious
or comparably understood is how the image
of an industry can rise or fall in financial-community
status, not because of such overpowering influences
as these but because at a given time the financial
community is stressing one particular set
of industry background influences rather than
another.Yet both sets of background conditions
may have
been quite valid for some time, and both may
give every indication of continuing to be
for the reasonable future.
The chemical industry may be cited as an example.
From the depths of the Great Depression until
the middle 1950s, the shares of the largest
U.S. chemical companies sold at quite high
price-earnings ratios compared to most other
stocks. The financial community's idea of
these companies might have been depicted in
a cartoon as an endless conveyor belt. At
one end were scientists making breathtaking
new compounds in test tubes. After passing
through mysterious and hard-to-imitate factories,
these materials came out at the other end
as fabulous new products such as nylon,DDT,synthetic
rubber,quick-drying paint, and endless other
new materials that seemed sure to be an ever-increasing
source of wealth for their fortunate producers.
Then, as the 1960s arrived, the image changed.
The chemical industry, to the investment community,
came to resemble steel or cement or paper
in that it was selling bulk commodities on
a basis of technical specification so that
Jones's chemicals were more or less identical
with Smith's. Capital-intensive industries
usually are under major pressure to operate
at high rates of capacity in order to amortize
their large fixed investments.The result is
frequently intense price competition and narrowing
profit margins.This changed image caused the
shares of the major chemical companies to
sell at significantly lower price-earnings
ratios in relation to stocks as a whole in
the, say, ten-year period that ended in 1972
than they had in the past.While still considerably
higher than in many industries, chemical price-earnings
ratios started more closely to resemble those
of industries like steel, paper, and cement.
Now the remarkable thing about all this is
that with one important exception there was
little or nothing different in the fundamental
background of this industry in the 1960s than
there was in the prior thirty years. It is
true that in the latter half of the 1960s
there was a serious glut of capacity in certain
areas such as the manufacture of most synthetic
textile products.This was a major temporary
depressant of the earnings of certain of the
leading chemical companies, particularly DuPont.
But the basic characteristics of the industry
had in no way changed sufficiently to account
for this rather drastic change in the industry's
status in the financial community. Chemical
manufacture always had been capital-intensive.
Most products had always been sold on a technical
specification basis so that Jones could seldom
raise his price above Smith's. On the other
hand, as a host of new and greatly improved
pesticides,
packaging materials, textiles, drugs, and
countless other products have shown, the 1960s
and the 1970s have afforded this industry
an ever-expanding market. Opportunities seem
almost limitless for human brains to rearrange
molecules so as to create products not found
in nature that will have special properties
to cater to the needs of man better or more
cheaply than the previously used natural materials.
Finally, in both the previous period of higher
and the more recent period of lower esteem
for chemical stocks, still another factor
had remained almost constant. The older and
larger-volume chemical products, representing
in a sense the "first step" processing of
tailored materials from such basic sources
of molecules as salt or hydrocarbons, were
inevitably products sold mainly by specification
and on a price-competitive basis. Nevertheless,
for the alert company there always was and
continued to be the opportunity to process
these first-step products into much more complicated
and higher-priced ones. These, at least for
a while, could be sold on a much more proprietary
and therefore less competitive basis. As these
products in turn become price competitive,
the alert companies have consistently found
still newer ones to add to the higher-profit-margin
end of their lines.
In other words, all the favorable factors,
so much in the financial community's mind
when chemical stocks were darlings of the
market, continued to be there after they had
lost considerable status. But the unfavorable
factors so much in the forefront in the 1960s
were also there in the earlier period when
they were largely ignored.What had shifted
was the emphasis, not the facts.
But the facts, too, can change. Starting about
the middle of 1973, chemical stocks began
regaining favor in the financial community.This
was because a new view of the industry was
starting to prevail. In the scarcity-plagued
economy the major industrial nations have
been experiencing for the first time (except
during major wars) in modern times, manufacturing
capacity can be increased only gradually;
hence, it may be years before cutthroat price
competition will occur again.This image opens
up a whole new ballgame for the investor in
chemical stocks.The problem for investors
now becomes one of determining whether the
background facts warrant the new image and,
if they do, whether chemical stocks, in relation
to the market as a whole, have risen more
than or not as much as may be warranted by
the new situation.
Recent financial history offers countless
other examples of much larger changes in price-earnings
ratios that occurred because the financial
community's appraisal of the industry's background
changed radically while the industry itself
remained almost exactly the same. In 1969
the computer peripheral stocks were great
market favorites. These were the companies
making all the special equipment that could
be added to the central computing unit or
mainframe of a computer to increase the user's
benefits from that central unit. High-speed
printers, extra memory units, and keyboard
devices to eliminate the need for keypunch
operators in getting data into a computer
were some of the major products in this group.
The prevailing image then was that these companies
had an almost limitless future. While the
central computer itself was largely developed
and its market would be dominated by a few
strong, established companies, the small independent
would be able to undercut the big companies
in these peripheral areas.Today there is a
new awareness of the financial strain on small
companies with products that are usually leased
rather than sold and of the determination
of the major computer mainframe manufacturers
to fight for the market of the products "hung
on" their equipment. Have the fundamentals
changed or is it the appraisal of the fundamentals
that has changed?
An extreme case of a changed appraisal is
the way in which the financial community looked
on the fundamentals of the franchising business
and franchise stocks in 1969 in contrast to
1972. Here again, as with computer peripheral
stocks, all the problems of the industry were
inherently there when these stocks were being
bought at such high price-earnings ratios
but were being overlooked when the prevailing
image was one of uninterrupted growth for
the company momentarily doing well.
In this whole matter of industry image, the
investor's problem is always the same. Is
the current prevailing appraisal one more
favorable, less favorable, or about the same
as that warranted by the basic economic facts?
At times this can present an acute problem
to even the most sophisticated investors.
One example occurred in December 1958 when
Smith, Barney & Co., traditionally conservative
investment bankers, took a pioneering step
that seems purely routine today but appeared
quite the contrary at that time: They made
a public offering of the equity shares of
the A. C. Nielsen Co.This company had no factories,
no tangible product, and therefore no inventories.
Instead it was in the "service business,"
receiving fees for supplying market-research
information to its customers. It was true
that in 1958 banks and insurance companies
had long been well regarded in the marketplace
as industries
worthy of conservative investment. However,
such industries were hardly comparable. Since
the book value of a bank or insurance company
is in cash, liquid investments or accounts
receivable, the investor buying a bank or
insurance stock seemed to have a hard core
of value to fall back on that did not exist
for this new kind of service company being
introduced to the financial public. However,
investigation of the A. C. Nielsen situation
revealed unusually good fundamentals. There
was an honest and capable management, a uniquely
strong competitive position and good prospects
for many years of further growth. Nevertheless,
until experience showed how the financial
community would react to its first exposure
to this kind of an industry, there did appear
to be some reason for hesitation in buying.Would
it take years for a realistic appraisal of
the investment worth of such a company to
displace the fear that might be engendered
by the lack of some of the familiar yardsticks
of value? It may seem ridiculous today, when
for many years a company like A. C. Nielsen
has enjoyed a price-earnings ratio signifying
a very high investment appraisal, but some
of us who decided to take a chance on the
fundamentals being recognized and bought these
shares at that time experienced a sensation
almost like stepping off a cliff and seeing
if the air would support us, so new was the
concept of a service company in contrast to
concepts to which we were accustomed. Actually
within a few years the pendulum swung quite
the other way. As A. C. Nielsen's profits
grew and grew, a new concept arose in Wall
Street.A large number of companies, many quite
different in economic fundamentals but all
dealing in services rather than products,
were lumped together in a financial-community
image as parts of a highly attractive service
industry. Some began selling at higher price-earnings
ratios than they might have deserved.As always,
in time, fundamentals dominated, and this
false image formed by lumping quite different
companies into one group faded away.
This point cannot be overstressed: The conservative
investor must be aware of the nature of the
current financial-community appraisal of any
industry in which he is interested. He should
constantly be probing to see whether that
appraisal is significantly more or less favorable
than the fundamentals warrant. Only by judging
properly on this point can he be reasonably
sure about one of the three variables that
will govern the long-term trend of market
price of stocks of that industry.
6. Still More about the Fourth Dimension.
The financial community's appraisal of a company's
own characteristics is an even more important
factor in the price-earnings ratio than is
the appraisal of the industry in which the
company is engaged. The most desirable investment
traits of individual companies have been defined
in our discussion of the first three dimensions
of a conservative investment. In general,
the more closely the financial community's
appraisal of a particular stock approaches
these characteristics, the higher will be
its price-earnings ratio.To the degree by
which it falls below these standards, the
price-earnings ratio will tend to decline.The
investor can best determine which stocks are
importantly undervalued or overvalued by a
shrewd determination of the degree to which
the real facts concerning any particular company
present an investment situation significantly
better or significantly worse than that painted
by the current financial image of that company.
In making a determination as to the relative
attractiveness of two or more stocks, investors
often confuse themselves by attempting too
simple a mathematical approach to such a problem.
Let us suppose, for example, they compare
two companies, the profits of each of which,
after careful study, appear to afford prospects
of growing at a rate of 10 percent a year.
If one is selling at ten times earnings and
the other at twenty times, the stock selling
at ten times earnings appears cheaper. It
may be. It also may not be. There can be a
number of reasons for this. The seemingly
cheaper company may have such a leveraged
capitalization (interest charges and preferred
dividends that must be earned before anything
accrues to the common-stock holder) that the
danger
of interruption of the expected growth rate
may be much greater in the lower price-earnings-ratio
stock. Similarly, for purely business reasons,
while the growth rate would seem a most probable
estimate for both stocks, nevertheless the
chance of the unexpected upsetting these estimates
may be considerably more for the one stock
than for the other.
Another far more important and far less understood
way to reach wrong conclusions is to rely
too much on simple comparisons of the price-earnings
ratios of stocks that seem to be offering
comparable opportunities for growth. To illustrate
this, let us assume that there are two stocks
with an equally strong prospect of doubling
earnings over the next four years and that
both are selling at twenty times earnings,
while in the same market companies which are
sound otherwise but have no growth prospects
are selling at ten times earnings. Let us
suppose that four years later the price-earnings
ratios of stocks as a whole are unchanged
so that generally sound stocks, but ones with
no growth prospects, are still selling at
ten times earnings. Let us also suppose that
at this same time, four years later, one of
our two stocks has much the same growth prospects
for the time ahead as it had four years before
so that the financial community's appraisal
is that this stock should again double its
earnings over the next four years.This means
it would still be selling at twenty times
the doubled earnings of the past four years,
or, in other words, that it had also doubled
in price in that period. In contrast, at this
same time, four years after our example had
started, the second stock had also doubled
its earnings, just as had been expected, but
at this point the financial community's appraisal
is for flat earnings in an otherwise sound
company over the next four years. This would
mean that owners of this second stock were
in for a market disappointment even though
the four-year doubling of earnings had come
through exactly as forecast. With an image
of "no growth in earnings for the next four
years." they would now be seeing a price-earnings
ratio of only ten in this second stock. Therefore,
while the earnings had doubled, the price
of the stock had remained the same.All this
can be summarized in a basic investment rule:The
further into the future profits will continue
to grow, the higher the price-earnings ratio
an investor can afford to pay.
This rule, however, should be applied with
great caution. It should never be forgotten
that the actual variations in price-earnings
ratio will result not from what will actually
happen but from what the financial community
currently believes will happen. In a period
of general market
optimism a stock may sell at an extremely
high price-earnings ratio because the financial
community quite correctly envisages many years
of great growth ahead. But many years will
have to elapse before this growth is fully
realized. The great growth that had been correctly
discounted in the price-earnings ratio is
likely to become "undiscounted" for a while,
particularly if the company experiences the
type of temporary setback that is not uncommon
for even the best of companies. In times of
general market pessimism, this kind of "undiscounting"
of some of the very finest investments can
reach rather extreme levels. When it does,
it affords the patient investor, with the
ability to distinguish between current market
image and true facts, some of the most attractive
opportunities common stocks can offer for
handsome longterm profits at relatively small
risk.
A rather colorful example of how sophisticated
investors attempt to anticipate a changed
investment-community appraisal of a company
occurred on March 13, 1974. The previous day
the New York Stock Exchange closing price
of Motorola was 485/8. On March 13 the closing
quotation was 60, a gain of almost 25 percent!
What had happened was that after the close
of the exchange on the 12th, an announcement
was made that Motorola was getting out of
the television business and was selling its
U.S. television plants and inventory to Matsushita,
a large Japanese manufacturer, for approximate
book value.
Now it had been known generally that Motorola's
television business was operating at a small
loss and to that extent was draining the profits
of the rest of the company's business.This
of itself would warrant the news to cause
some increase in the price of the shares,
although hardly the degree of rise that actually
occurred. Considerably more complex reasoning
was the main motivation behind the buying.
For some time a considerable body of investors
had believed that Motorola's profitable divisions,
particularly its Communications Division,
made this company one of the very few American
electronics companies qualified as being of
truly high-grade investment status. For example,
Spencer Trask and Co. had issued a report
by security analyst Otis Bradley that discussed
the investment merits of Motorola's Communications
Division in considerable detail.This report
took the unusual approach of calculating the
current and estimated future price-earnings
ratio, not for Motorola's earnings as a whole
but merely for this one division alone. The
report compared the estimated sales volume
and price-earnings ratio of just this one
division with those of Hewlett-Packard and
Perkin-Elmer, generally considered to be among
the very finest of electronics companies from
an investment standpoint. From the report
the inference could easily be drawn (this
was not specifically stated) that the investment
quality of Motorola's Communications Division
was such that it was worth, by itself, the
then current price of Motorola shares so that,
in effect, a buyer of the stock was getting
all the other divisions for nothing.
With this opinion about Motorola existing
in some highly sophisticated places, what
may be judged to have induced such eager buying
on the Matsushita news? These Motorola enthusiasts
had long known that many elements of the financial
community were inclined to look with disfavor
on the stock because of its television-manufacturing
image. Most of the financial community, upon
hearing "Motorola." first thought of television
and secondly of semiconductors. At the time
of the Matsushita announcement, Standard & Poor's
stock guide, in the small amount of space
available for listing the principal business
of each company, described Motorola as "Radio
& T.V.: semiconductors." all of which, though
not inaccurate, was misleading in that it
suggested a different sort of company from
what, in fact, Motorola really was and completely
overlooked the very important Communications
Division, which at the time comprised almost
half of the company.
Some of those buying Motorola on the Matsushita
news undoubtedly rushed in merely because
the news was good and therefore could be expected
to send the stock up. But there is reason
to ascribe considerable buying to the belief
that the financial community's appraisal of
the company had been considerably less favorable
than the facts warranted. The historical record
was such that in the television business Motorola
was regarded more as an "also ran" than as
an industry leader such as Zenith. With the
television operations no longer blurring investors'
vision of what else was there, a new image
with a very much higher price-earnings ratio
would arise.
Were those who rushed in to pay these higher
prices for Motorola wise in so doing? Not
entirely. In subsequent weeks the shares lost
the immediate gain so that a degree of patience
would have paid. In downward markets, a change
for the worse in the financial community's
image of a company gets accepted far more
quickly than a change for the better. Just
the opposite is true in rising markets. Unfortunately
for those who rushed in to buy Motorola on
this news, the immediately ensuing weeks saw
a sharp upturn in short-term interest rates
which
produced a downward trend in the general market
and accentuated the widespread bear-market
psychology then prevailing.
Perhaps another influence was also at work
against those who snapped up Motorola shares
overnight.This influence is one of the most
subtle and dangerous in the entire field of
investment and one against which even the
most sophisticated investors must constantly
be on guard.When for a long period of time
a particular stock has been selling in a certain
price range, say from a low of 38 to a high
of 43, there is an almost irresistible tendency
to attribute true value to this price level.
Consequently, when, after the financial community
has become thoroughly accustomed to this being
the "value" of the stock, the appraisal changes
and the stock, say, sinks to 24, all sorts
of buyers who should know better rush in to
buy. They jump to the conclusion that the
stock must now be cheap. Yet if the fundamentals
are bad enough, it may still be very high
at 24. Conversely, as such a stock rises to,
say, 50 or 60 or 70, the urge to sell and
take a profit now that the stock is "high"
becomes irresistible to many people. Giving
in to this urge can be very costly.This is
because the genuinely worthwhile profits in
stock investing have come from holding the
surprisingly large number of stocks that have
gone up many times from their original cost.The
only true test of whether a stock is "cheap"
or "high" is not its current price in relation
to some former price, no matter how accustomed
we may have become to that former price, but
whether the company's fundamentals are significantly
more or less favorable than the current financialcommunity
appraisal of that stock.
As previously mentioned, there is a third
element of investmentcommunity appraisal that
also must be considered, along with its appraisal
of the industry and of the particular company.
Only after all three are blended together
can a worthwhile judgment be reached as to
whether a stock is cheap or high at any given
time.This third appraisal is that of the outlook
for stocks in general. To see the rather extreme
effect such general market appraisals can
have in certain periods and how far these
views can vary from the facts, it may be well
to review the two most extreme such appraisals
of this century. Ridiculous as it may seem
to us today, in the period from 1927 to 1929,
the majority of the financial community actually
believed we were in a "new era." For years
earnings of most U.S. companies had been growing
with monotonous regularity. Not only had serious
business depressions become a thing of the
past but a great engineer and businessman,
Herbert Hoover,
had been elected President. His competence
was expected to assure even greater prosperity
from then on. In such circumstances it seemed
to many that it had become virtually impossible
to lose by owning stocks.And many who wanted
to cash in as much as possible on this sure
thing bought on margin to obtain more shares
than they could otherwise afford. We all know
what happened when reality shattered this
particular appraisal. The agony of the Great
Depression and the bear market of 1929 to
1932 will be long remembered.
Contrary in outlook, but similar in being
spectacularly wrong, was the investment community's
appraisal of common stocks as an investment
vehicle in the three years from mid-1946 to
mid-1949. Most companies' earnings were extremely
pleasing. However, pursuant to the then current
appraisal, stocks were selling at the lowest
price-earnings ratios in many years. The financial
community was saying that "these earnings
don't mean anything." that they were "just
temporary and would shrink sharply or disappear
in the depression that must come." The financial
community remembered that the Civil War had
been followed by the panic of 1873, which
marked the onset of a very severe depression
that lasted until 1879. Following World War
I had come the even worse crash of 1929 and
another six years of major depression. Since
World War II had involved a vastly greater
effort and therefore a greater distortion
of the economy than World War I, it was assumed
that an even bigger bear market and an even
worse depression were on the horizon. As long
as this appraisal lasted, most stocks were
so much on the bargain counter that when it
began to dawn on the investment community
that this image was false and that no severe
depression lay in wait, the foundations had
been laid for one of the longest periods of
rising stock prices in U.S. history.
Since the bear market of 1972-1974 brought
with it the only other time in this century
when most price-earnings ratios were about
as low as they were in the 1946-1949 period,the
question obviously arises as to the soundness
of the financial community's appraisal that
brought this about. Are the fears engendering
these historically low price-earnings ratios
valid? Could this be another 1946-1949 all
over again? An attempt will be made to throw
some light on these matters in a later section
of this book.
There is a basic difference between the factors
that affect changes in the general level of
all stock prices and those that affect the
relative price-earnings ratio of one stock
compared to another within that general level.
For reasons already discussed, the factors
at any given moment that
affect this relative price-earnings ratio
of one stock to another are solely matters
of the current image in the investment community
of the particular company and the particular
industry to which that company belongs. However,
the level of stocks as a whole is not solely
a matter of image but results partly from
the financial community's current appraisal
of the degree of attractiveness of common
stocks and partly from a certain purely financial
factor from the real world.
This real-world factor is mainly involved
with interest rates. When interest rates are
high in either the long- or short-term money
markets, and even more so when they are high
in both, there is a tendency for a larger
part of the pool of investment capital to
flow toward those markets, so the demand for
stocks is less. Stocks may be sold to transfer
funds to these markets. Conversely, when rates
are low, funds flow out of those markets and
into stocks.Therefore, higher interest rates
tend to lower the level of all stocks and
lower interest rates to raise that level.
Similarly, when the public is in a mood to
save a larger percentage of its income, more
funds flow into the total capital pool and
there is a more bullish pull on stock prices
than when the pool of capital funds is rising
more slowly. However, this is a much smaller
influence than is the level of interest rates.
An even smaller influence is the degree of
fluctuation in new stock issues, which are
a drain on the capital pool available to the
stock market.The reason the new-issue supply
is not a bigger factor on the general level
of stock prices is that when other influences
cause stocks to be in favor, the new-issue
volume rises to take advantage of this situation.When
common-stock prices reach low levels, supply
of new issues tends to diminish drastically.As
a result, fluctuations in new-issue volume
are much more a result of other influences
than an influencing factor themselves.
This fourth dimension to stock investing might
be summarized in this way: The price of any
particular stock at any particular moment
is determined by the current financial-community
appraisal of the particular company, of the
industry it is in, and to some degree of the
general level of stock prices. Determining
whether at that moment the price of a stock
is attractive, unattractive or somewhere in
between depends for the most part on the degree
these appraisals vary from reality. However,
to the extent that the general level of stock
prices affects the total picture, it also
depends somewhat on correctly estimating coming
changes in certain purely financial factors,
of which interest rates are by far the most
important.
Part Three
DEVELOPING AN INVESTMENT PHILOSOPHY
Dedication to Frank E. Block
This book was first published at the request
of the Institute of Chartered Financial Analysts
made under the C. Stewart Shepard Award. This
award was conferred on Frank E. Block C.F.A.
in recognition of his outstanding contribution
through dedicated effort and inspiring leadership
in advancing the Institute of Chartered Financial
Analysts as a vital force in fostering the
education of financial analysts, in establishing
high ethical standards of conduct, and in
developing programs and publications to encourage
the continuing education of financial analysts.
1. Origins of a Philosophy.
To understand any disciplined approach to
investment, it is first necessary to understand
the objective for which the methodology is
designed. For any part of the funds supervised
by Fisher & Co., except for funds temporarily
in cash or cash equivalents awaiting more
suitable opportunities, it is the objective
that they be invested in a very small number
of companies that, because of the characteristics
of their management, should both grow in sales
and more importantly in profits at a rate
significantly greater than industry as a whole.They
should also do so at relatively small risk
in relation to the growth involved.To meet
Fisher & Co. standards, a management must
have a viable policy for attaining these ends
with all the willingness to subordinate immediate
profits for the greater long-range gains that
this concept requires. In addition, two characteristics
are necessary. One is the ability to implement
long-range policy with superior day-to-day
performance in all the routine tasks of business
operation. The other is that when significant
mistakes occur, as is bound at times to happen
when management strives for unique benefits
through innovative concepts, new products,
etc., or because management becomes too complacent
through success, these mistakes are recognized
clearly and remedial action is taken.
Because I believe I best understand the characteristics
of manufacturing companies, I have confined
Fisher & Co. activities largely to manufacturing
enterprises that use a combination of leading
edge technology and superior business judgment
to accomplish these goals. In recent years,
I have confined Fisher & Co. investments solely
to this group, because on the few occasions
when I have invested outside it,
I have not been satisfied with the results.
However, I see no reason why the same principles
should not be equally profitable when applied
by those with the necessary expertise in such
fields as retailing, transportation, finance,
etc.
No investment philosophy, unless it is just
a carbon copy of someone else's approach,
develops in its complete form in any one day
or year. In my own case, it grew over a considerable
period of time, partly as a result of what
perhaps may be called logical reasoning, and
partly from observing the successes and failures
of others, but much of it through the more
painful method of learning from my own mistakes.
Possibly the best way of trying to explain
my investment approach to others is to use
the historical route. For this reason I will
go back into the early, formative years, attempting
to show block by block how this investment
philosophy developed.
THE BIRTH OF INTEREST.
My first awareness of the stock market and
the opportunities which changing stock quotations
might make possible occurred at a fairly early
age. With my father the youngest of five and
my mother the youngest of eight, at my birth
I had only one surviving grandparent. This
may have been one of the reasons why I felt
particularly close to my grandmother. At any
rate, I went to see her one afternoon when
I was barely out of grammar school. An uncle
dropped in to discuss with her his views of
business conditions in the year ahead, and
how this might affect the stocks she owned.
A whole new world opened up to me. By saving
some money, I had the right to buy a share
in the future profits of any one I might choose
among hundreds of the most important business
enterprises of the country. If I chose correctly,
these profits could be truly exciting. I thought
the whole subject of judging what makes a
business grow an intriguing one, and here
was a game that if I learned to play it properly
would by comparison make any other with which
I was familiar seem drab, meaningless and
unexciting. When my uncle left, my grandmother
turned to me and said how sorry she was that
he happened to come in when I was there, forcing
her to spend time on matters which could not
possibly interest me. I told her that, to
the contrary, the hour he spent with her had
seemed like ten minutes, and that I had just
heard something that interested me tremendously.Years
later
I was to realize how very few were the shares
she owned and how extremely superficial were
the comments I heard that day, but the interest
that was kindled by that conversation has
continued all during my life.
With this degree of interest and in a period
when most businesses were far less concerned
with the legal hazards of dealing with minors
than is the case today, I was able to make
a few dollars for myself during the roaring
bull market of the middle 1920's. I was strongly
discouraged from this, however, by my physician
father, who felt that it would simply teach
me gambling habits. This was unlikely, as
I am not by nature inclined to take chances
merely for the sake of taking chances, which
is the nature of gambling. On the other hand,
as I look back upon it, my tiny scale stock
activities of that period taught me almost
nothing of any great value so far as investment
policies were concerned.
FORMATIVE EXPERIENCES.
Before the Great Bull Market of the 1920's
was to come to its crashing end, I did have
an experience, however, that was to teach
me much of real importance for use in the
years ahead. In the 1927 to 28 academic year
I was enrolled as a first-year student in
Stanford University's then fledgling Graduate
School of Business.Twenty per cent of that
year's course, that is one day a week, was
devoted to visiting some of the largest business
enterprises in the San Francisco Bay area.
Professor Boris Emmett, who conducted this
activity, had not been given this responsibility
because of the usual academic background.
In those days, the large mail order companies
obtained a significant part of their merchandise
through contracts with suppliers whose sole
customer was one or the other of these firms.These
contracts frequently were so hard on the manufacturer
and afforded him so little profit margin that
from time to time a manufacturer would find
himself in severe financial difficulty. It
was not in the interest of the mail order
houses to see their vendors fail. Professor
Emmett had for some years been the expert
employed by one such mail order firm with
the job of salvaging these faltering companies
when they had been squeezed too tightly. As
a result, he knew a great deal about management.
One of the rules under which this course was
conducted was that we would visit no company
that would just take us through the plant.
After "seeing the wheels go around," the management
had to be
willing to sit down with us so that, under
the very shrewd questioning of our professor,
we could learn something of what the strengths
and weaknesses of the business really were.
I recognized that this was a learning opportunity
of just the type that I was seeking. I was
able to jockey myself into a position to take
particular advantage of it. In that day, over
a half century ago, when the ratio of automobiles
to people was tremendously lower than it is
today, Professor Emmett did not have a car.
I did. I offered to drive him to these various
plants. I did not learn much from him on the
way over. However, each week on the way back
to Stanford, I would hear comments of what
he really thought of that particular company.This
provided me with one of the most valuable
learning experiences I have ever been privileged
to enjoy.
Also on one of these trips I formed a specific
conviction that was to prove of tremendous
dollar value to me a few years in the future.
It was actually to lay the foundation for
my business. One week we visited not one but
two manufacturing plants that were located
next door to each other in San Jose. One was
the John Bean Spray Pump Company, the world
leaders in the manufacture of the type of
pumps that were used to spray insecticides
on orchards to combat natural pests.The other
was the Anderson-Barngrover Manufacturing
Company, also world leaders, but in the field
of equipment used by fruit canneries. In the
1920's the concept of a "growth company" had
not yet been verbalized by the financial community.
However, as I somewhat awkwardly worded it
to Professor Emmett, "I thought that those
two companies had probabilities of growing
very much beyond their present size to a degree
that I had seen in no other company we had
visited." He agreed with me.
Also, through spending part of the time on
these automobile trips by asking Professor
Emmett about his previous business experiences,
I learned something else that was to stand
me in good stead in the years ahead. This
was the extreme importance of selling in order
to have a healthy business. A company might
be an extremely efficient manufacturer or
an inventor might have a product with breathtaking
possibilities, but this was never enough for
a healthy business. Unless that business contained
people capable of convincing others as to
the worth of their product, such a business
would never really control its own destiny.
It was later that I was to build on this base
to conclude that even a strong sales arm is
not enough. For a company to be a truly worthwhile
investment, it must not only be able to sell
its products, but also be able to
appraise changing needs and desires of its
customers; in other words, to master all that
is implied in a true concept of marketing.
FIRST LESSONS IN THE SCHOOL OF EXPERIENCE.
As the summer of 1928 approached and my first
year in the business school came to an end,
an opportunity arose which seemed to me too
good to pass up. In contrast to the hundreds
of students that are enrolled each year in
this school today, my class, being only the
third in the graduate school's history, contained
nineteen students. The graduating class one
year ahead of me contained only nine. Just
two of these nine were trained in finance.
In that day of great stock market ferment,
both were snapped up by New York-based investment
trusts. At the last minute, an independent
San Francisco bank, which years later was
acquired by the Crocker National Bank of that
city, sent down to the school a request for
a graduate trained in investments.The school
was anxious not to pass up this opportunity
because if their representative merited the
approval of the bank, it could be the forerunner
of many opportunities for placing future graduates
in the years to come. However, they had no
graduate to send. It was not easy to do, but
when I heard of this opportunity, I finally
persuaded the school to send me with the thought
that if I were to make good, I would stay
there. If I could not fill the job, I would
come back and take second-year courses, with
the bank realizing that the school had made
no pretense of sending them a completely trained
student.
Security analysts in those pre-crash days
were called statisticians. It was three successive
years of sensationally falling stock prices
that were to occur just a short time ahead
that caused the work of Wall Street's statisticians
to fall into such disrepute that the name
was changed to security analysts.
I found that I was to be the statistician
for the investment banking end of the bank.
In those days, there was no legal barrier
to banks being in the brokerage or investment
banking business. The work I was assigned
to do was extremely simple. In my opinion,
it was also intellectually dishonest.The investment
arm of the bank was chiefly engaged in selling
high interest rate, new issues of bonds on
which they made quite sizable commissions
as part of underwriting syndicates. No attempt
was made to evaluate the quality of these
bonds or any stocks
they sold, but rather in that day of a seller's
market they gratefully accepted any part of
a syndicate offered them by their New York
associates or by the large investment banking
houses. Then the security salesmen for the
bank would portray to their customers that
they had a statistical department capable
of surveying those customers' holdings and
issuing to them a report on each security
handled.What was actually done in those "security
analyses" was to look up the data on a particular
company in one of the established manuals
of the day, such as Moody's or Standard Statistics.Then
someone like myself, with no further knowledge
than what was reported in that manual, would
simply paraphrase the wording of the manual
to write his own report.Any company that was
doing a large volume of sales was invariably
reported as "well managed," just because it
was big. I was under no direct orders to recommend
that customers switch some of the securities
I "analyzed" into whatever security the bank
was attempting to sell at the moment, but
the whole atmosphere was one of encouraging
this type of analysis.
BUILDING THE BASICS.
It was not very long before the superficiality
of the whole procedure caused me to feel that
there must be a better way to do this. I was
extremely fortunate in having an immediate
boss who completely understood why I was concerned
and granted me the time to make an experiment
which I proposed to him. At that time, in
the fall of 1928, there was a great deal of
speculative interest in radio stocks. I introduced
myself as a representative of the investment
arm of the bank to the buyers of the radio
department of several retail establishments
in San Francisco. I asked them their opinions
of the three major competitors in this industry.
I was given surprisingly similar opinions
from each of them. In particular, I learned
a great deal from one man who was himself
an engineer and who had worked for one of
these companies. One company, Philco, which
from my standpoint unfortunately was privately
owned so that it represented no stock market
opportunity, had developed models which had
especial market appeal. As a result, they
were getting market share at a beautiful profit
to themselves because they were highly efficient
manufacturers. RCA was just about holding
its own market share, whereas another company,
which was a stock market favorite of the day,
was slipping drastically and showing signs
of getting
into trouble. None of this was the direct
business of the bank, for it was not handling
radio stocks. Nevertheless, an evaluative
report seemed likely to help me considerably
within the bank because many key bank officers
who would see it were personally involved
in speculation in these issues. Nowhere in
material from Wall Street firms who were talking
about these "hot" radio issues could I find
a single word about the troubles that were
obviously developing for this speculative
favorite.
In the ensuing twelve months, as the stock
market continued on its reckless but merry
way with most stocks climbing to new highs,
I noticed with increasing interest how the
stock I had singled out for trouble was sagging
further and further in that rising market.
It was my first lesson in what later was to
become part of my basic investment philosophy:
reading the printed financial records about
a company is never enough to justify an investment.
One of the major steps in prudent investment
must be to find out about a company's affairs
from those who have some direct familiarity
with them.
At this early point, however, I had not achieved
the next logical step in this type of reasoning:
It is also necessary to learn as much as possible
about the people who are running a company
under investment considerations, either by
getting to know those people yourself or by
finding someone in whom you have confidence
who knows them well.
As 1929 started to unfold, I became more and
more convinced of the unsoundness of the wild
boom that seemed to be continuing. Stocks
continued climbing to ever higher prices on
the amazing theory that we were in a "new
era." Therefore, in the future, year after
year of advancing per-share earnings could
be taken as a matter of course.Yet as I tried
to appraise the outlook for America's basic
industries, I saw a number of them with supply-demand
problems that seemed to me to indicate their
outlook was getting rather wobbly.
In August of 1929 I issued another special
report to the officers of the bank. I predicted
that the next six months would see the beginning
of the greatest bear market in a quarter of
a century. It would be very satisfying to
my ego, if at this point, I could alter drastically
the tale of just what happened and leave the
impression that, having been exactly right
in my forecasting, I then profited greatly
from all this wisdom.The facts were quite
to the contrary.
Even though I felt strongly that the whole
stock market was too high in those dangerous
days of 1929, I was nevertheless entrapped
by the lure of the market. This caused me
to look around to find a few
stocks that "were still cheap" and were worthwhile
investments because "they had not gone up
yet."As a result of the small profits from
the tiny amount of stock transactions a few
years back and the saving of a good part of
my salary, plus some money I had earned in
college, I managed to scrape together several
thousand dollars as 1929 went along. I divided
this almost equally among three stocks which,
in my ignorance, I thought were still undervalued
in that overpriced market. One was a leading
locomotive company with a still quite low
price-earnings ratio. With railroad equipment
being one of the most cyclical of all industries,
it takes very little imagination to see what
was to happen to that company's sales and
profits in the business depression that was
about to engulf us. The other two were a local
billboard company and a local taxicab company,
also selling at very low price-earnings ratios.
In spite of my success in ferreting out what
was going to happen to the radio stocks, I
just did not have the sense to start making
similar inquiries from people who knew about
these two local enterprises, even though obtaining
such information or even getting to meet the
people who ran these businesses would have
been relatively simple, since they were close
at hand. As the depression increased, I learned
rather vividly why these companies had been
selling at such low price-earnings ratios.
By 1932, only a tiny percentage of my original
investment was represented by the market value
of the shares in these companies.
THE GREAT BEAR MARKET.
Fortunately for my future well-being, I have
an intense dislike for losing money. I have
always believed that the chief difference
between a fool and a wise man is that the
wise man learns from his mistakes, while the
fool never does. The corollary of this is
that it behooved me to go over my mistakes
pretty carefully and not to repeat them again.
My approach to investing expanded as I learned
from my 1929 mistakes. I learned that, while
a stock could be attractive when it had a
low price-earnings ratio, a low price-earnings
ratio by itself guaranteed nothing and was
apt to be a warning indicator of a degree
of weakness in the company. I began realizing
that, all the then current Wall Street opinion
to the contrary, what really counts in determining
whether a stock is cheap or overpriced is
not its ratio to the current year's earnings,
but its ratio to the earnings a few years
ahead. If I could build up
in myself the ability to determine within
fairly broad limits what those earnings might
be a few years from now, I would have unlocked
the key both to avoiding losses and to making
magnificent profits!
In addition to learning that a low price-earnings
ratio was just as apt to be a sign that a
stock was an investment trap as that it was
a bargain, acute awareness of my miserable
investment performances during the Great Bear
Market made me vividly aware of something
of possibly even greater importance. I had
been spectacularly right in my timing of when
the bull market bubble was about to burst,
and almost right in judging the full force
of what was to happen.Yet except for a possible
small boost in my reputation among a very
small circle of people, this had done me no
good whatsoever. From then on, I was to realize
that all the correct reasoning about an investment
policy or about the desirability or purchase
or sale of any particular stock did not have
the least bit of value until it was translated
into action through the completion of specific
transactions.
A CHANCE TO DO MY THING.
In the spring of 1930 I made a change of employers.
I only mention this because it triggered the
events that were to cause the emergence of
the investment philosophy that has guided
me since that time. A regional brokerage firm
came to me and made me a salary offer which,
at age 22 and for that time and place, I found
quite difficult to refuse. Furthermore, they
offered me a vastly more appealing work assignment
than the dissatisfying experience as a "statistician"
in the investment banking arm of the bank.
With no assigned duties whatsoever, I was
to be free to devote my time to finding individual
stocks which I thought were particularly suitable
candidates for either purchase or sale because
of their characteristics. I was then to write
reports on my conclusions to circulate among
the brokers employed by this firm to help
them stimulate business that would be profitable
for their clients.
This offer came to me just after Herbert Hoover
had made his famous "Prosperity is just around
the corner" statement. Several partners of
the firm involved implicitly believed this.
As a result of the 1929 crash, their total
payroll had dropped from 125 employees to
75. They told me that if I accepted their
offer, I would be number 76. I was just as
bearish at the time as they were bullish.
I felt sure the bear market was
a long way from over. I told them that I would
come on one condition. While they were free
to fire me at any time if they did not like
the quality of my work, lack of seniority
must be no influence whatsoever if adverse
financial markets forced them to make further
reduction in payroll.They agreed to this provision.
FROM DISASTER, OPPORTUNITY SPRINGS.
As employers, I could not have asked for nicer
people. In the ensuing eight months, I had
one of the most valuable business educational
experiences of my life. I saw at first hand
example after example of how the investment
business should not be conducted. As 1930
unfolded and stocks once again continued on
what seemed like an almost endless decline,
my employers' position got more and more precarious.
Then, just before Christmas of 1930, we, who
had so far survived the economic holocaust,
witnessed the grim picture of the whole firm
being suspended from the San Francisco Stock
Exchange for insolvency.
This grim news for my associates was to prove
one of the most fortunate business developments,
if not the most fortunate, of my life. For
some time I had had vague plans that when
prosperity returned I would start my own business
by charging clients a fee for managing their
investments. I am purposely using this roundabout
way to describe the activities of an investment
counselor or an investment advisor because
in those days neither of these terms had yet
been used. However, with almost everyone in
the financial business retrenching during
that gloomy January of 1931, the only security
industry job I could find was a purely clerical
and, to me, a quite unattractive one. If I
had properly analyzed the situation, I would
have realized that this was exactly the right
time to start a new business of the kind I
had in mind. I was to find that there were
two reasons for this. One was that, after
almost two years of the most severe bear market
this nation had ever seen, nearly everyone
was so dissatisfied with their existing brokerage
connections that they were in the mood to
listen even to someone both young and advocating
a radically different approach to the handling
of their investments as was I. Also, as the
economy reached its depths in 1932, many key
businessmen had so little to do in pursuing
their own affairs that they had the time to
see someone who was calling on them. In more
normal times, I would never have gotten by
their secretaries. One of the most worthwhile
clients of my entire business career, and
a man whose family's investments I still handle,
was a typical example of this. Some years
afterwards he told me that on the day I called
he had had almost nothing to do and had already
finished reading the sports section of the
newspaper. So when my name and purpose were
told him by his secretary, he thought,"Listening
to this guy will at least occupy my time."
He confessed, "If you had come to see me a
year or so later, you never would have gotten
into my office."
A FOUNDATION IS FORMED.
All this was to result in several years of
very hard work in a tiny office with low overhead.
With no windows and merely glass partitions
to serve as two of the walls, my total floor
space was little larger than that needed to
jam together a desk, my chair, and one other
chair. For this, together with free local
telephone service and a reasonable amount
of secretarial help from the secretary-receptionist
of the gentleman from whom I leased this space,
I paid the princely sum of $25 per month.
My only other expenses were stationery, postage
and a very occasional long distance call.
The account book still in my possession provides
an indication of how difficult it really was
to start a new business in 1932.After very
long hours of work over and above this overhead,
I made a net profit averaging $2.99 per month
for that year. In the still difficult year
of 1933, I did a trifle better, showing an
improvement of just under 1000 percent, an
average monthly earnings of just over $29.This
possibly was about what I would have made
as a newsboy selling papers on the street.Yet
in what those years were to bring me in the
future, they were two of the most profitable
years of my life.They provided me with the
foundation for an extremely profitable business
and with a group of highly loyal clients by
1935. It would be nice if I could claim that
it was brilliant thinking on my part that
caused me to start my business when I did
rather than waiting until better times were
to arrive.Actually, it was the unattractiveness
of the only job that seemed open to me that
pushed me into it.
2. Learning from Experience.
While I had been working at the bank, I had
noticed with considerable interest a news
item about the two neighboring San Jose companies
that had intrigued me so much during my student
days at the Stanford Business School. In 1928
the John Bean Manufacturing Co. and the Anderson-Barngrover
Manufacturing Co. had merged with a leading
vegetable canning manufacturer, Sprague Sells
Corporation of Hoopeston, Illinois, to form
a brand new entity called the Food Machinery
Corporation.
As in other periods of rampant speculation
the nation was in the throes of such a stock
buying mania that the supply of Food Machinery
Corporation stock offered for sale rose in
price in an attempt to meet the demand. In
that same year of 1928, at least twenty other
new issues, and perhaps twice that many,were
sold by members of the San Francisco Stock
Exchange to eager buyers in the Bay area.The
lack of soundness of some of these issues
was little short of appalling.An officer of
one stock exchange firm, that sold shares
in a company that was to sell bottled water
from across the Pacific, told me that these
shares were sold without a complete set of
financial statements in the hands of the underwriters,
who had little more than a photograph of the
spring from which the water was supposed to
come and a minor amount of personal contact
with the selling shareholders! In the public
mind, the stock of the Food Machinery Corporation
was just another of the exciting new offerings
of that year,neither significantly better
nor worse than the rest. It was offered at
a price of $21½.
In those days, pools for the manipulation
of shares were entirely legal. A local group
with little expertise in running a pool but
headed
by a man with great enthusiasm for Food Machinery
Corporation decided to "run an operation"
in the company's shares.The methods of all
these pools were fundamentally similar. The
members would sell stock back and forth among
themselves at gradually rising prices.All
this activity on the stock tape would attract
the attention of others, who would then start
to buy and take the pool's shares off its
hands at still higher prices. Some highly
skilled manipulators, some of whom had made
many millions of dollars and one of whom,
a year or so later, was to offer me a junior
partnership, were quite experienced and able
practitioners of this rather questionable
art. Manipulation was not the objective of
the operators of this Food Machinery pool,
however. As the autumn of 1929 was to arrive
and stocks were to face the precipice that
lay ahead, the pool managed to buy for itself
most of the shares that had been offered to
the public. Although the quoted price of the
Food Machinery shares at the peak was in the
high 50's, there was very little stock in
the hands of the public as a result.
As in each of the succeeding years the general
level of business activities worsened relative
to the year before, it was obvious what was
to happen to the flotsam and jetsam of small
companies that went public in the 1928 excitement.
One after another of these companies passed
into bankruptcy, with many of the remainder
reporting losses rather than profits.The market
for the shares of these firms largely dried
up.
There were one or two companies in this group
other than Food Machinery that were fundamentally
both sound and attractive. However, the general
public showed no discrimination whatsoever,considering
all of them little more than speculative junk.By
the time the market was to reach its final
low in 1932, and again equal that low at the
time of closing of the entire banking system
of the country coincidental with the inauguration
of Franklin D. Roosevelt on March 4, 1933,
Food Machinery shares were down to a price
of between $4 and $5, with the all-time low
being 100 shares at $3¾.
FOOD MACHINERY AS AN INVESTMENT OPPORTUNITY.
As 1931 unfolded and I cast about seeking
an opportunity for my infant business, I looked
upon Food Machinery's situation with increasing
excitement.
Recognizing the costliness of my not having
taken the trouble to meet with and judge the
managements of the two local companies in
which I had lost such a large percentage of
my investment a few years before, I determined
never to make this mistake again.The more
I got to know the Food Machinery people, the
greater my respect for them grew. Because
in many ways this company, as it existed in
the depths of the Great Depression, was a
microcosm of the type of opportunity I was
to seek in the years ahead. It may be helpful
to explain just what it was that caused me
nearly a half century ago to see such a future
in this particular corporation.
Parenthetically and unfortunately, I did not
carry my policy of indepth field analysis
through to its logical conclusion in the immediate
years. I was less diligent in getting to know
and to judge managements that were located
in more distant areas.
In the first place, even though Food Machinery
was relatively small, it was a world leader
in size and, I believe, in quality of the
product line in each of the three activities
in which it was engaged. This gave the firm
the advantage of scale; that is, as a large
and efficient manufacturer the firm could
also be a low-cost producer.
Next, its marketing position was, from a competitive
standpoint, extremely strong. Its products
were highly regarded by its customers. It
controlled its own sales organization. Furthermore,
its canning machinery lines, with a large
number of installations already in the field,
had a "locked up" market of some proportions.
This consisted of spare and replacement parts
for the equipment already in the field.
Added to this sound base was the most exciting
part of the business. For a company of its
size, the firm enjoyed a superbly creative
engineering or research department. The company
was perfecting equipment in promising new
product areas. Among these were the first
mechanical pear peeler ever to be offered
to the industry, the first mechanical peach
pitter, and a process for synthetically coloring
oranges. Oranges from areas which produced
fruit with the most juice was at a competitive
disadvantage because the product looked less
attractive to the housewife than other types
in which intrinsic quality was no better.
At only one other time in my business life
have I seen a company which, in my judgment,
had on the horizon as big a dollar volume
of potentially successful new products in
relation to the then existing size of business
as was the case with the Food Machinery Corporation
in the period from 1932 through 1934.
By this time, I had learned enough to know
that, no matter how attractive, such matters
by themselves were not sufficient to assure
great success. The quality of the people involved
in the company was just as critical. I use
the word quality to encompass two quite different
characteristics. One of these is business
ability. Business ability can be further broken
down into two very different types of skills.
One of these is handling the day-to-day tasks
of business with above-average efficiency.
In the day-to-day tasks, I include a hundred
and one matters, varying all the way from
constantly seeking and finding better ways
to produce more efficiently to watching receivables
with sufficient closeness. In other words,
operating skill implies above-average handling
of the many things that have to do with the
near-term operation of the business.
However, in the business world, top-notch
managerial ability also calls for another
skill that is quite different. This is the
ability to look ahead and make long-range
plans that will produce significant future
growth for the business without at the same
time running financial risks that may invite
disaster. Many companies contain managements
that are very good at one or the other of
these skills. However, for real success, both
are necessary.
Business ability is only one of the two "people"
traits that I believe is absolutely essential
for a truly worthwhile investment.The other
falls under the general term of integrity
and encompasses both the honesty and the personal
decency of those who are running a company.Anyone
receiving his first indoctrination into the
investment world in the period that preceded
the 1929 crash would have seen rather vivid
examples of the extreme importance of integrity.
The owners and managers of a business are
always closer to that business's affairs than
are the stockholders. If the managers do not
have a genuine sense of trusteeship for the
stockholders, sooner or later the stockholders
may fail to receive a significant part of
what is justly due them. Managers preoccupied
by their own personal interests are not likely
to develop an enthusiastic team of loyal people
around them--something that is an absolute
must if a business is to grow to a size that
one or two people can no longer control.
As I saw the situation in those dark days
of the deep depression, and as I see it now
after all these years, this infant Food Machinery
Corporation was unusually attractive from
the "people" standpoint. John D. Crummey,
the president and son-in-law of the original
founder of the John Bean Manufacturing Co.,
was not only an extremely efficient operating
head and highly regarded by his customers
and his employees,
but also he was a deeply religious man who
scrupulously lived up to a high moral code.
The chief engineer of the company was a brilliant
conceptual designer. Also of considerable
importance, he was a man who designed along
lines that would give his products worthwhile
patent protection. Finally, to round out the
strength of this relatively small organization,
John Crummey persuaded his son-in-law, Paul
L. Davies, who was reluctant to abandon what
appeared to be a most promising career in
banking, to join the company to give it financial
strength and conservatism. Actually, Paul
Davies at first made this move so reluctantly
that he only agreed to take a one-year leave
of absence from the bank to help his family
business over the first rough year of merger.
During that year, he became so interested
in the exciting prospects that lay ahead that
he decided to stay permanently with the company.
Later, as its president, he was to lead it
to a size and degree of prosperity that was
to dwarf the pleasing accomplishments of the
next few years.
This then was a company that inherently had
desirable characteristics that are only occasionally
found among available investments.The people
were outstanding.Yet, small as the company
was, it was not just one man who was making
key contributions. In relation to competitors,
the company was unusually strong, it was handling
its business well, and it had in the offing
enough new product lines with potentials that
were large in relation to the then size of
the company. Even if some of these products
did not materialize, the future should be
very bright with others.
ZIGGING AND ZAGGING.
However, to all this should be added something
of equal importance if an investment is to
prove a genuine bonanza. The largest profits
in the investment field go to those who are
capable of correctly zigging when the financial
community is zagging. If the future of the
Food Machinery Corporation had been properly
appraised at that time, the profits that were
to accrue to those who bought the shares in
the 1932–1934 period would have been very
much smaller. It was only because the true
worth of this company was not generally recognized
and Food Machinery was thought to be just
another of the many "flaky" companies which
were sold to the public at the height of a
speculative orgy that it was possible to buy
these shares in quantity at the ridiculous
price to
which they had sunk.This matter of training
oneself not to go with the crowd but to be
able to zig when the crowd zags, in my opinion,
is one of the most important fundamentals
of investment success.
I wish I had the command of English to be
able to describe adequately the degree of
my internal, emotional and intellectual excitement
as I contemplated what this as yet financially
unrecognized Food Machinery Corporation might
do for both my tiny personal finances and
for the infant business I was attempting to
get started. My timing seemed right. Like
a spring that had been compressed too far
and was starting to recoil, the years from
1933 to 1937 were to see stocks as a whole
advancing slowly at first, and then bursting
into a full bloom bull market, followed by
a sizable break in 1938 and a full recovery
the following year.With a deep conviction
that Food Machinery would vastly outperform
the market as a whole, I bought my clients
every share that I was able to convince them
to hold. I made the possibilities of this
business the spearhead of my approach in talking
to any potential clients I could reach. I
felt that here was just the type of unique,
almost once in a lifetime, opportunity that
Shakespeare so well described when he said,"There
is a tide in the affairs of men which, taken
at the flood, leads on to fortune." In those
exciting years when my hopes were high and
both my purse and reputation in the financial
community were almost non-existent, I quoted
those exciting words to myself time and time
again to stiffen my determination.
CONTRARY, BUT CORRECT.
Much has been written in the literature of
investments on the importance of contrary
opinion. Contrary opinion, however, is not
enough. I have seen investment people so imbued
with the need to go contrary to the general
trend of thought that they completely overlook
the corollary of all this which is: when you
do go contrary to the general trend of investment
thinking, you must be very, very sure that
you are right. For example, as it became obvious
that the automobile was largely to displace
the streetcar and the shares of the once favored
urban railways began to sell at ever lower
price-earnings ratios, it would have been
a rather costly thing just to be contrary
and buy streetcar securities only on the grounds
that because everyone thought they were in
a declining stage, they must be attractive.
Huge profits are frequently available to
those who zig when most of the financial community
is zagging, providing they have strong indications
that they are right in their zigging.
If a quotation from Shakespeare was a vital
force in formulating my policies on the matter,
so also, strangely enough, was a popular song
from World War I. As one of the very thinning
ranks of those who can still remember how
the home front reacted in the stirring days
of 1918, I might point out that in its excitement
and enthusiasm for that war the American public
had a naivete then quite different from its
grimness about such matters in World War II,
when the horrors of war were more clearly
understood. Firsthand news of the casualties
and the filth and the terror of those in the
front lines had not yet permeated the continental
United States in 1918. As a result, the popular
music of the day was filled with cheerful
and humorous war songs in a way that happened
on a much smaller scale in World War II, and
not at all during the Vietnam fiasco. Most
of these songs came out in the form of sheet
music for pianos. One of these songs, published
with a picture of a proud mama looking down
on parading soldiers, had the title, "They're
All Out of Step But Jim."
I recognized from the very first that I was
running a distinct risk of being "out of step."
My very early purchases of Food Machinery
and a number of other companies were bought
"out of phase." when their intrinsic merit
was completely unrecognized by the financial
community. I might be completely wrong in
my thinking and the financial community could
be right. If so, nothing would be worse for
my clients or myself than letting my firm
convictions about a particular situation lock
up a sizable amount of funds unprofitably
for an endless period of years because I zigged
when the financial community had zagged, and
I had been wrong in doing so.
However, while I realized thoroughly that
if I were to make the kinds of profits that
are made possible by the process that I have
described as zigging when the rest zags, it
was vital that I have some sort of quantitative
check to be sure that I was right in zigging.
PATIENCE AND PERFORMANCE.
With this in mind, I established what I called
my three-year rule. I have repeated again
and again to my clients that when I purchase
something for them, not to judge the results
in a matter of a month or a year, but
to allow me a three-year period. If I have
not produced worthwhile results for them in
that time, they should fire me. Whether I
have been successful in the first year or
unsuccessful can be as much a matter of luck
as anything else. In my management of individual
stocks over all these years I have followed
the same rule, only once having made an exception.
If I have a deep conviction about a stock
that has not performed by the end of three
years, I will sell it. If this same stock
has performed worse rather than better than
the market for a year or two, I won't like
it. However, assuming that nothing has happened
to change my original view of the company,
I will continue to hold it for three years.
In the second half of 1955, I bought a substantial
number of shares in two companies in which
I had never previously invested.They proved
to be almost a classic example of the advantages
and problems of investing contrary to the
currently accepted view of the financial community.
Looking back, 1955 could be considered the
beginning of a period of almost fifteen years
that might be termed the "first Golden Age
of electronic stocks." I am using the adjective
"first" so that there can be no confusion
in anyone's mind with what I believe will
be considered the Golden Age for semiconductor
stocks, something which I suspect lies ahead
of us and will be associated with the 1980's.
At any rate, in 1955 and immediately thereafter,
the financial community was about to be dazzled
by a whole series of electronic companies
which were to show gains that by 1969 had
reached truly spectacular proportions. IBM,Texas
Instruments,Varian, Litton Industries and
Ampex are a few that come to mind. However,
in 1955, all of that lay ahead. At that time,
with the exception of IBM, all these stocks
were considered highly speculative and beneath
the notice of conservative investors or big
institutions. However, sensing part of what
might lie ahead, I acquired what for me were
rather sizable positions in both Texas Instruments
and Motorola during the latter parts of 1955.
Today Texas Instruments is the largest world-wide
producer of semiconductors, with Motorola
running a close second. At that time, Motorola's
position in the semiconductor industry was
insignificant. It was no factor at all in
causing me to buy the shares. Rather, I became
impressed both with the people and with Motorola's
dominant position in the mobile communications
business, where an enormous potential seemed
to lie; whereas the financial community was
valuing it as just another television and
radio producer. Motorola's subsequent
rise in the semiconductor area, resulting
at least in part from their acquiring the
services of Dr. Daniel Noble, was all to come
later and was additional icing on the cake
not anticipated by me at the time of purchase.
In the case of Texas Instruments, aside from
an equally great liking and respect for the
people, I was influenced by a quite different
set of beliefs. I saw, as did others, a tremendous
future that could be built out of their transistor
business as the complexities of semiconductors
were yielding to human ingenuity. I felt that
those were people who could compete on at
least even terms, and probably better than
even terms, with General Electric, RCA,Westinghouse,
and other giant companies despite the opinion
of much of Wall Street. A number of people
criticized me for risking funds in a small
"speculative company" which they felt was
bound to suffer from the competition of the
corporate giants.
After buying these shares, the near-term results
in the stock market were quite different.
Within a year, Texas Instruments had increased
in value quite handsomely. Motorola fluctuated
in a range from 5 percent to 10 percent below
my cost of purchase. It performed sufficiently
poorly that one of my major clients became
so irritated by its market action that he
refused to call Motorola by name. He only
referred to it as "that turkey which you bought
me." These unsatisfactory quotations were
to continue for moderately over a year. Yet
as awareness of the investment significance
of the communications arm of Motorola was
to seep into the consciousness of the financial
community, together with the first signs of
a turnabout in the semiconductor area, the
stock then became a rather spectacular performer.
While I was buying Motorola, I was doing so
in conjunction with a large insurance company
that had let the Motorola management know
that they were also interested in the conclusions
of my first visit. Shortly after the insurance
company too had bought a significant amount
of Motorola stock, they submitted their entire
portfolio to a New York bank for appraisal.With
the exception of Motorola, the bank divided
their portfolio into three groups: most attractive,
less attractive, and least attractive. They
refused to place Motorola in any category,
however, saying this was not the type of company
on which they spent time; therefore they had
no opinion about it.Yet one of the officials
of the insurance company told me over three
years later that in the face of this rather
negative Wall Street view, Motorola had by
that time outperformed every other stock in
their portfolio! If I had not had my
"three-year rule," I might have been less
firm in holding my own Motorola intact through
a period of poor market action and of some
client criticism.
TO EVERY RULE, THERE ARE EXCEPTIONS... BUT
NOT MANY.
Have I ever sold stock because of this three-year
rule and then later wished I had not made
this sale because of a subsequent major rise
in the stock? Actually, there have only been
a relatively small number of times when I
have made a sale triggered by this three-year
rule and nothing else.This is not because
there have been so few times that purchases
made by me have failed to provide the major
rise which was my purpose in initiating them.
In the majority of such cases, further insights
about the company opened up as I continued
to investigate additional aspects of the situation,
and these insights caused me to change my
views about it. However, in those relatively
few cases where it was the three-year rule
and only that which caused me to sell, I cannot
recall a single case where subsequent market
action caused me to wish I had held on to
the shares.
Have I ever violated my own three-year rule?
The answer is yes, exactly once, and this
was many years later, toward the middle of
the 1970's. Three years before, I had acquired
a moderately substantial block of shares in
the Rogers Corporation. Rogers had expertise
in certain areas of polymer chemistry, and
I believed they were on the way to developing
various semiproprietary families of products
which would show quite dramatic increase in
sales and not just for a year or two, but
for many years.Yet, at the end of three years
the stock was down, and so were the earnings
of the company. Several influences were at
work, however, which made me feel this was
one time to ignore my own standards and to
make this "the exception that proves the rule."
One of these influences was my strong feeling
about Norman Greenman, the company's president.
I was convinced he had unusual ability, the
determination to see these matters through,
as well as something else which I consider
of great value to an intelligent investor:
the kind of honesty that caused him not to
conceal repeated bad news that could not fail
but be embarrassing for him to tell. He saw
to it that those interested in his company
understood all
the unfavorable aspects of what was happening,
as well as the favorable potentials.
There was another element which influenced
me greatly: a major reason the company's profits
were so poor was that Rogers was spending
a quite disproportionate amount of money on
a single new product development seeming to
offer prospects of great results.This was
diverting both money and people from other
potentially exciting new products which were
getting less corporate effort. New products
of this type do have magnificent potential.
When the painful decision was made to abandon
all the effort on this one particular product,
it was not long before it became quite apparent
that several other innovations of great promise
were starting to flower. All this, however,
took time. In the meanwhile, the company's
failure to live up to the hopes of many of
those who had bought the shares caused the
stock to drop to levels that were absurd in
relation to its sales, its assets, or any
type of normal earning power. Here seemed
a classic example of zigging when the financial
community was zagging.Therefore, three-year
rule or no, I sizably further increased my
holdings and those of my clients, even though
a few of those clients, influenced by the
years of waiting and the negative performance,
looked at this with a degree of apprehension.As
so often happens in situations of this sort,
when the turn came, it came fast. As it became
apparent that the betterment of earnings was
not a one- or twoyear matter, but gave strong
indications of being but the basis for years
of genuine growth, the stock continued to
rise proportionately.
AN EXPERIMENT WITH MARKET TIMING.
All this, however, gets me years ahead of
my story, because back in the 1930's there
were other things I also had to learn through
trial and error as my investment philosophy
was gradually taking shape. In my casting
around for ways to make money through common
stocks, I began realizing that I might have
a worthwhile by-product from my study of the
Food Machinery Corporation. Enough of their
business was dependent on the fruit and vegetable
canning industry so that in order to be reasonably
sure I was right about my Food Machinery purchases,
I had inadvertently learned a good deal about
what influenced the fortunes of the fruit
and vegetable canning companies themselves.This
industry was highly cyclical because of both
fluctuating
general business conditions and erratic weather
influences as they affected specific crops.
As long as I was becoming somewhat familiar
with the characteristics of the packing industry
anyway, I decided I might as well try and
take advantage of this knowledge, not through
long-term investments, as I was doing with
Food Machinery, but through in and out transactions
in the shares of the California Packing Corporation,
then an independent company and the largest
fruit and vegetable canner.Three different
times, from the depths of the Big Depression
to the end of that decade, I bought shares
of this company. Each time, I sold them at
a profit.
Superficially, this might sound like I was
doing something quite worthwhile. Nevertheless
when, for reasons I will explain shortly,
I endeavored a few years later to analyze
the wise and unwise moves I made in my business,
it became increasingly apparent to me how
silly these activities were.They took a great
deal of time and effort that could well have
been devoted to other things. Yet the total
rewards in dollars in relation to the sums
at risk were insignificant in comparison to
the profits I had made for my people in Food
Machinery and in other situations where I
had bought for long-range gains and held over
a considerable period of years. Furthermore,
I had seen enough of in and out trading, including
some done by extremely brilliant people, that
I knew that being successful three times in
a row only made it that much more likely that
the fourth time I would end in disaster.The
risks were considerably more than those involved
in purchasing equal amounts of shares in companies
I considered promising enough to want to hold
them for many years of growth.Therefore, at
the end of World War II, by which time much
of my present investment philosophy was largely
formulated, I had made what I believe was
one of the more valuable decisions of my business
life.This was to confine all efforts solely
to making major gains over the long run.
REACHING FOR PRICE, FOREGOING OPPORTUNITY.
During the 1930's I learned, or at least partially
learned, something else which I consider truly
important. I have already mentioned my complete
failure to benefit from my correct forecasts
of the Great Bear Market which started in
1929. All the correct reasoning in the world
is of no
benefit in stock investment unless it is turned
into specific action. My first experience
in operating my own business occurred during
the depth of the Great Depression, when very
small amounts of money became of abnormal
significance. Possibly because of this, or
possibly because of my personal characteristics,
as I started my business I found myself constantly
battling for "eighths and quarters." Brokers
who knew much more than I did kept telling
me if I believed that a stock would rise in
a few years to several times its current price,
it really made very little difference whether
I acquired its shares at $10 or $10¼.Yet
I continually placed limit orders with no
better reason for a limit than a purely arbitrary
decision on my part that I would pay, say,
$101/8 and no more. Logically, this is ridiculous.
I have observed it to be a bad investment
habit that is deeply ingrained in many people
besides myself, but not ingrained at all in
others.
The potential dangers of arbitrary limits
were made clear to me as the result of a mistake
of someone else. I remember as though it were
yesterday running into one of my more important
clients by chance on the sidewalk in front
of a San Francisco bank. I told him that I
had just come back from visiting the Food
Machinery Corporation, the outlook was never
so exciting, and that I thought he should
buy some additional shares. He completely
agreed with me and asked where the stock had
closed that particular afternoon. I told him
$34½. He gave me a significant order and
said he would pay $33¾ but no more. Over
the next day or two the stock fluctuated in
a range just fractionally above his bid. It
never got down to it. I phoned him twice,
urging him to go up a quarter of a point so
that I could buy stock. Unfortunately he replied,
"No, that is my price." Within a few weeks
the stock had risen over 50 percent and, after
allowing for stock split-ups, never again
in the company's history was it to come down
to anywhere near where he could have bought
it.
This gentleman's actions made an impression
on me that my own stupidity had not. Gradually,
I was to overcome much of this weakness of
mine. I am thoroughly aware that if a buyer
desires to acquire a very large block of stock,
he cannot completely ignore this matter of
an eighth or a quarter, because by buying
a very few shares he can significantly put
the price up on himself for the balance. However,
for the great majority of transactions, being
stubborn about a tiny fractional difference
in the price can prove extremely costly. In
my own case, I have completely conquered it
in regard to buying, but only partially in
regard to
selling. Within the past year, my placing
a small sell order with a limit rather than
at the market caused me to miss a transaction
by exactly a quarter of a point, with the
result that, as I write this, the shares are
now down 35 percent from where I placed my
order. At levels only halfway between that
limit order and current prices, I sold only
part of this not very large holding.
3. The Philosophy Matures.
Our entry into World War II was not entirely
without some significance in the development
of my investment philosophy. Early in 1942
I found myself in an unaccustomed role as
a ground officer doing various business related
jobs for the Army Air Corps. For three and
a half years, I simply "beached" my business
as I performed my not very valuable services
on behalf of Uncle Sam. In recent years, I
have frequently said that I did quite a job
for my country. Neither Hitler nor Emperor
Hirohito ever succeeded in getting a man into
the territories I defended.These were Arkansas,Texas,
Kansas, and Nebraska! At any rate, during
this time of various desk type jobs wearing
Uncle Sam's uniform, I found that almost without
warning I would alternate between two different
types of periods. For a while, I would have
so much to do that the last thing I would
be able to think about was my peacetime business.
At other times, I would sit at my desk with
very little to do. When things were slow,
I found it less unpleasant to analyze in great
detail just how I would build up my business
when the happy day that I would no longer
be wearing a uniform might arise than it was
to think of the personal living and Army type
problems with which, from a short-range point
of view, I was confronted. It was during such
periods that my present investment philosophy
took steadily more definite shape. It was
then I decided there was not enough future
in the type of in and out trading that I have
described in the stock of California Packing.
During this period, I reached two other conclusions
that were to be of some significance to my
future business. Before the war I had served
all types of clients, large and small, with
varying types of objectives.
Most, but not all, of my business had been
focused on finding unusual companies that
would enjoy significant, above-average growth
in future years. After the war, I would limit
my clientele to a small group of large investors
with the objective of concentrating solely
on this single class of growth investment.
For tax reasons, growth was more likely to
benefit these clients.
My other major conclusion was that the chemical
industry would enjoy a period of major growth
in the postwar years.Therefore, a high priority
project on returning to civilian life was
to endeavor to find the most attractive of
the larger chemical companies and make this
a major holding for the funds I was handling.
I by no means spent 100 percent of my time
doing this, but in the first year after restarting
my business I did spend a rather considerable
amount of time in talking to anyone I could
find who had real knowledge of this complex
industry. Such people as distributors who
handled the lines of one or more large companies,
professors in the chemical departments of
the universities who had intimate knowledge
of chemical business people, and even some
of those in the major construction companies
that had put up plants for various of the
chemical producers all proved extremely worthwhile
sources of background information. By combining
these inputs with analyses of the usual financial
data, it only took about three months to narrow
the choices down to one of three companies.
From there on, the going was slower and the
decisions more difficult. However, by the
spring of 1947 I decided that the Dow Chemical
Company would be my choice.
E PLURIBUS UNUM.
There were many reasons for the choice of
Dow Chemical from the many promising chemical
firms. I believe it might be worthwhile to
enumerate some of them because they are clear
examples of the type of things I seek in the
relatively small number of companies in which
I desire to place funds. As I began to know
various people in the Dow organization, I
found that the growth that had already occurred
was in turn creating a very real sense of
excitement at many levels of management. The
belief that even greater growth lay ahead
permeated the organization. One of my favorite
questions in talking to any top business executive
for the first time is what he considers to
be the most
important long-range problem facing his company.
When I asked this of the president of Dow,I
was tremendously impressed with his answer:
"It is to resist the strong pressures to become
a more military-like organization as we grow
very much larger, and to maintain the informal
relationship whereby people at quite different
levels and in various departments continue
to communicate with each other in a completely
unstructured way and, at the same time, not
create administrative chaos."
I found myself in complete agreement with
certain other basic company policies. Dow
limited its involvement to those chemical
product lines where it either was or had a
reasonable chance of becoming the most efficient
producer in the field as the result of greater
volume, better chemical engineering and deeper
understanding of the product or for some other
reason. Dow was deeply aware of the need for
creative research not just to be in front,
but also to stay in front.There was also a
strong appreciation of the "people factor"
at Dow. There was in particular a sense of
need to identify people of unusual ability
early, to indoctrinate them into policies
and procedures unique to Dow, and to make
real efforts to see if seemingly bright people
were not doing well at one job, they be given
a reasonable chance to try something else
that might be more suitable to their characteristics.
I found that although Dow's founder, Dr. Herbert
Dow, had died some seventeen years before,
his beliefs were held in such respect that
one or another of his sayings was frequently
quoted to me. While his comments were directed
primarily at matters within Dow, I decided
that at least two of them were equally appropriate
to my own business, in that they could be
applied at least as well as to optimizing
the selection of investments as to matters
internal to the Dow Chemical Company. One
of these was "Never promote someone who hasn't
made some bad mistakes, because if you do,
you are promoting someone who has never done
anything."The failure to understand this element
by so many in the investment community has
time and again created unusual investment
opportunities in the stock market.
The truly worthwhile accomplishment in the
business world nearly always requires a considerable
degree of pioneering, in which ingenuity has
to be seasoned with practicality. This is
particularly true when the gains are sought
through leading edge technological research.
No matter how able the people are and no matter
how good may be most of their ideas, there
are times when such efforts are bound to fail,
and fail dismally. When this happens and the
current year's earnings drop
sharply below previous estimates as the costs
of the failure are added up, time and again
the investment community's immediate consensus
is to downgrade the quality of the management.
As a result, the immediate year's lower earnings
produce a lower than the historic price earnings
ratio to magnify the effect of reduced earnings.
The shares often reach truly bargain prices.
Yet if this is the same management that in
other years has been so successful, the chances
are the same ratio of average success to average
failure will continue on in the future. For
this reason, the shares of companies run by
abnormally capable people can be tremendous
bargains at the time one particular bad mistake
comes to light. In contrast, the company that
doesn't pioneer, doesn't take chances, and
merely goes along with the crowd is liable
to prove a rather mediocre investment in this
highly competitive age.
The other of Dr. Dow's comments which I have
tried to apply to the process of investment
selection is "If you can't do a thing better
than others are doing it, don't do it at all."
In this day of heavy-handed government intervention
in so many types of business activities, of
high taxes and labor unions, and of rapid
shifts in public taste from one product to
another, it seems to me that the risk of common
stock ownership is seldom warranted unless
it is confined to companies with enough competitive
spirit constantly to be trying and frequently
succeeding in doing things in a manner superior
to industry in general. In no other way are
profit margins usually broad enough to meet
the demands of growth. This is, of course,
particularly true during periods when inflation
is having a significant effect in eating away
at reported profits.
HISTORY VERSUS OPPORTUNITY.
There were some remarkable parallels between
the period when I was starting my business
at the depths of the Great Depression and
during the years 1947 through the very early
1950's, when I was restarting it after a military
service interlude of three and a half years.
Both periods were times when it was unusually
hard to obtain immediate results for clients
in the face of overwhelming general pessimism.
Both were times that were to prove spectacularly
rewarding for those who had the patience.
In the earlier period, stocks were driven
to perhaps the lowest level in relation to
real value seen in the Twentieth Century,
not just because of the economic havoc wrought
by the Great Depression, but
also because prices were discounting the worry
of many investors as to whether the American
system of private enterprise would itself
survive. It survived, and in the ensuing years
the rewards of those able and willing to invest
in the right stocks were fabulous.
Just a few years after World War II, another
fear kept stocks at levels almost as low in
relation to intrinsic value as those seen
at the depths of the Great Depression.This
time, business was good and corporate earnings
were steadily rising. Nevertheless, almost
the entire investment community were mesmerized
by a simple comparison. A relatively few years
after the Civil War, a period of immediate
prosperity was followed by the Panic of 1873,
and almost six years of deep depression. A
somewhat similar period of prosperity after
World War I was followed by the Crash of 1929
and the even deeper depression of about the
same length. In World War II, the costs of
war had run on a per diem basis about ten
times that of World War I. "Therefore." reasoned
the dominant investment view of this period,
"current excellent earnings don't mean anything."
They will be followed by a horrendous crash
and a period of extreme adversity when all
would suffer.
Year after year went by, and the per-share
earnings of more corporations rose. Along
about 1949, this period became known as the
era in which "American business is worth more
dead than alive." because as soon as word
spread that a publicly owned company was about
to go out of business, its shares would rise
dramatically.The liquidating value of many
a company was so much more than its current
market valuation.Year followed year, and slowly
it began dawning on the investment public
that perhaps stocks were being held back because
of a myth.The expected business decline never
did arrive and, excepting for two relatively
minor recessions in the 1950's, the stage
was being set for the great rewards to long-term
investors that were to follow.
As I write these words in the closing weeks
before the decade of the 80's is about to
start, it amazes me that more attention has
not been paid to restudying the few years
of stock market history that started in the
second half of 1946 to see whether true parallels
may actually exist between that period and
the present. Now, for the third time in my
lifetime, many stocks are again at prices
which, by historic standards, are spectacularly
low. In relation to reported book value, they
may not be quite as cheap as they were in
the post-World War II period. However, if
that reported book value is adjusted for replacement
value in real dollars, they may perhaps be
cheaper than in either of the two prior, bargain
value periods.The question arises: are the
worries that are holding back stock values
in the present period, such matters as the
high cost of energy or the dangers from the
political left or of overextended credit,
with the inevitable resulting drain on the
level of business activity as liquidity is
restored, more serious and more apt to stop
the future growth in this country than the
fears that held back stock prices in these
two prior periods? If not, once the problems
of overextended credit have been solved, it
might be logical to assume that the 1980's
and period beyond may offer the same sort
of rewarding opportunities that characterized
the two former periods of abnormally low prices.
LESSONS FROM THE VINTAGE YEARS.
From a business standpoint, the fifteen years
from 1954 through 1969 were a magnificent
time for me, as most of the relatively few
stocks I was holding advanced significantly
more than did the market as a whole. Even
so, I managed to make some bad mistakes. Successes
came from diligent application of the approaches
I have already spelled out. It is the mistakes
that are more noteworthy. Each brought its
own new lesson.
Good fortune can breed laxness. The mistake
which now embarrassed me the most, although
it was not the most costly, arose from the
careless application of a sound principle.
In the early 1960's, I had technological investments
that were proving quite pleasing in the electronic,
chemical, metallurgical, and machinery industries.
I did not have a comparable investment in
the promising drug field, and started seeking
one. Along the way, I talked to a medical
specialist who was preeminent in his field.
At the time, he was tremendously excited about
a new drug family about to be introduced by
a small Midwestern manufacturer. These drugs
he felt could have quite favorable impact
on the future earnings of this firm relative
to others in this field.The potential market
seemed very, very exciting.
I then talked to just one of the officers
of this company and to only a few other investment
people, all of whom were equally excited about
the potentials of this new drug. Unfortunately,
I did not pursue my standard checks either
with other drug companies or with other experts
knowledgeable in this particular specialty
to see if they might have contrary evidence
to offer. Regretfully, I subsequently learned,
none of the proponents had made a thorough
investigation either.
The stock was selling at a price well above
its worth before considering the benefits
of this new family of drugs, but at a price
which could have been but a minor fraction
of potential value if the new drugs were all
their supporters imagined. I bought the shares
only to see them drop, at first a mere 20
percent and then over 50 percent. Ultimately
the whole company was sold for cash at this
low price to a large nonpharmaceutical corporation
seeking to enter the drug field. Even at this
price, now somewhat less than half of what
I had paid for the shares, I subsequently
learned that the acquiring company lost money
on the deal. Not only did this new family
of drugs fail to measure up to the extensive
hopes that had been enthusiastically projected
by my friend, the medical specialist, but
also on painful "post-mortem" reexamination
of the situation, I found that there were
management problems in this small drug manufacturer.With
a more thorough investigation both failings
would, I believe, have become apparent to
me.
From that embarrassing time forward, I have
tried to be particularly thorough in making
investigations in periods when things were
going well.The only reason this particular
investment folly wasn't more costly stemmed
from my caution. Since I had had only a slight
contact with the management, I made only a
small initial investment, planning to buy
more as I got to know the company better.Their
troubles overtook me before I had a chance
to compound my original folly.
As the long bull market was reaching its final
peak in 1969 another mistake occurred.To understand
what happened it is necessary to recreate
the psychological fever which gripped most
investors in technological and scientific
stocks at that time. Shares of these companies,
particularly many of the smaller ones, had
enjoyed advances far greater than the market
as a whole. During 1968 and 1969 only one's
imagination seemed to cap the dreams of imminent
success for many of these companies. Some
of these situations did have genuine potential,
of course. Discrimination was at a low ebb.
For example, any company serving the computer
industry in any way promised a future, many
believed, that was almost limitless. This
contagion spread into instrument and other
scientific companies as well.
Up to this time, I resisted the temptation
to go into any of the similar companies that
had just "gone public" at very high prices
in the previous year or two.Yet, being in
frequent contact with those who were sponsoring
these excitement inducing companies, I kept
looking for a few that might be genuinely
attractive. In 1969 I did find an equipment
company working in an extremely interesting
new frontier of technology; one that had a
real basis for its existence.The firm was
run by a brilliant and honest president. I
can remember still, after a long luncheon
session with this man, my pacing up and down
the airport awaiting my airplane home and
trying to determine whether I should buy this
company's shares at the prevailing market.
After considerable deliberation, I decided
to go ahead.
I was right in diagnosing the potential of
this company for it did grow in the years
that followed. Nevertheless, it was a poor
investment. My mistake lay in the price I
paid to participate in the promise. Some years
later, after the company had shown rather
respectable growth, I sold these shares, but
at a price very little different from my original
cost.While I believe I was right in selling
when I thought the company had reached a point
where its future growth was considerably more
uncertain, nevertheless selling an investment
at a meager profit after it has been held
for a number of years is not the way to make
capital grow or even protect it against inflation.
In this case, disappointing performance was
the result of being seduced by the excitement
of the times into paying an unrealistic initiation
price.
DO FEW THINGS WELL.
A policy judgment that was wrong for me engendered
quite a different kind of mistake, and one
which did cost a significant amount of dollars.
My mistake was to project my skill beyond
the limits of experience. I began investing
outside the industries which I believe I thoroughly
understood, in completely different spheres
of activity; situations where I did not have
comparable background knowledge.
When it comes to manufacturing companies that
serve industrial markets or to companies on
the leading edge of technology that are serving
manufacturers, I believe that I know what
to look for--where both the strong points
and pitfalls may lie. However, different skills
proved important in evaluating companies making
and selling consumertype products. When the
products of competitive companies are essentially
rather similar to one another, and when changes
in market share depend largely on shifting
public tastes or on fashions greatly influenced
by the effectiveness of advertising, I learned
that the abilities which I had in selecting
outstanding technological companies did not
extrapolate
to the point where I could identify what produces
unusual success in real estate operations.
Others may do well in quite diverse investment
arenas. Perhaps, unlike the other types of
mistakes I have made during my business career,
this one should properly be ignored by others.
Nevertheless, an analyst must learn the limits
of his or her competence and tend well the
sheep at hand.
STAY OR SELL IN ANTICIPATION OF POSSIBLE MARKET
DOWNTURNS?
Should an investor sell a good stock in the
face of a potentially bad market? On this
subject, I fear I hold a minority view given
the investment psychology prevalent today.
Now more than ever, the actions of those who
control the vast bulk of equity investments
in this country appear to reflect the belief
that when an investor has achieved a good
profit in a stock and fears the stock might
well go down, he should grab his profit and
get out. My view is rather different. Even
if the stock of a particular company seems
at or near a temporary peak and that a sizable
decline may strike in the near future, I will
not sell the firm's shares provided I believe
that its longer term future is sufficiently
attractive. When I estimate that the price
of these shares will rise to a peak quite
considerably higher than the current levels
in a few years time, I prefer to hold. My
belief stems from some rather fundamental
considerations about the nature of the investment
process. Companies with truly unusual prospects
for appreciation are quite hard to find for
there are not too many of them. However, for
someone who understands and applies sound
fundamentals, I believe that a truly outstanding
company can be differentiated from a run-of-the-mill
company with perhaps 90 percent precision.
It is vastly more difficult to forecast what
a particular stock is going to do in the next
six months. Estimates of short-term performance
start with economic estimates of the coming
level of general business.Yet the forecasting
record of seers predicting changes in the
business cycle has generally been abysmal.They
can seriously misjudge if and when recessions
may occur, and are worse in predicting their
severity and duration. Furthermore, neither
the stock market as a whole nor the course
of any
particular stock tends to move in close parallel
with the business climate. Changes in mass
psychology and in how the financial community
as a whole decided to appraise the outlook
either for business in general or for a particular
stock can have overriding importance and can
vary almost unpredictably. For these reasons,
I believe that it is hard to be correct in
forecasting the short-term movement of stocks
more than 60 percent of the time no matter
how diligently the skill is cultivated. This
may well be too optimistic an estimate. On
the face of it, it doesn't make good sense
to step out of a position where you have a
90 percent probability of being right because
of an influence about which you might at best
have a 60 percent chance of being right.
Moreover, for those seeking major gains through
long-term investments, the odds of winning
are not the only consideration. If the investment
is in a well-run company with sufficient financial
strength, even the greatest bear market will
not erase the value of holding. In contrast,
time after time, truly unusual stocks have
subsequent peaks many hundreds of percent
above their previous peaks.Thus, risk/reward
considerations favor long-term investment.
So, putting it in the simplest mathematical
terms, both the odds and the risk/reward considerations
favor holding. There is a much greater chance
of being wrong in estimating adverse short-term
changes for a good stock than in projecting
its strong, long-term price appreciation potential.
If you stay with the right stocks through
even a major temporary market drop, you are
at most going to be temporarily behind 40
percent of the former peak at the very worst
point and will ultimately be ahead; whereas
if you sell and don't buy back you will have
missed long-term profits many times the short-term
gains from having sold the stock in anticipation
at a short-term reversal. It has been my observation
that it is so difficult to time correctly
the near-term price movements of an attractive
stock that the profits made in the few instances
when this stock is sold and subsequently replaced
at significantly lower prices are dwarfed
by the profits lost when timing is wrong.
Many have sold too soon and have either never
gotten back in or have postponed reinvestment
too long to recapture the profits possible.
The example I will use to illustrate this
point is the weakest one I have experienced.
In 1962, two of the major electronics investments
I had made had risen to heights that made
the outlook for near-term price movement extremely
dangerous. Texas Instruments was selling at
over fifteen times the price I had paid for
it seven years before. Another
company which I bought a year or so later,
and which I shall call by the fictitious name
of "Central California Electronics." had enjoyed
a similar percentage rise. Prices had gone
too far. I consequently informed each of my
clients that the prices of these two stocks
were unrealistically high and discouraged
them from using these prices in measuring
their current net worth. This is a practice
I have rarely followed, and then only when
I had an unusually strong conviction that
the next important move for one or more of
my stocks would be sharply downward. Nevertheless,
in the face of this conviction, I urged my
clients to maintain their holdings, in the
belief that some years ahead both stocks would
rise to very much higher levels. When the
correction in values came for these two stocks,
it proved even more severe than I had anticipated.
Texas Instruments at its subsequent bottom
sold off 80 percent from its 1962 peak. Central
California Electronics did not perform quite
so badly, but still sold off by almost 60
percent. My beliefs were being tested in the
extreme!
However, within a few years Texas Instruments
was once again selling at new high levels
more than double its 1962 high. Patience had
paid off here. Central California Electronics'
performance was not a happy one. As the general
stock market started to recover, problems
within the management of Central California
Electronics became apparent. Changes in personnel
occurred. I became quite worried and made
what I believe was a thorough investigation.
I reached two conclusions and neither one
pleased me. One was that I had misjudged the
former management. I should have been more
aware of its deficiencies, yet wasn't. Neither
could I be sufficiently enthusiastic about
the new management to warrant continuing to
hold the shares. I consequently sold these
holdings in the following twelve-month period
at a price only slightly better than half
of the 1962 peak. Even so, my clients, depending
on the applicable purchase price, gained from
seven to ten times the original cost.
As I have already indicated, I am deliberately
citing a weak example rather than a dramatic
one to illustrate why I believe it pays to
ignore near-term fluctuations in situations
that hold real promise. My error in the Central
California Electronics instance was not in
holding the shares through a temporary decline,
but in something far more important. I had
grown too complacent as a result of the enormous
success of my investments in this company.
I began paying too much attention to what
I was hearing from top management and not
doing sufficient checking
with people at lower levels and with customers.When
I recognized the situation and acted upon
it, I was then able to make the same kind
of gains I had expected to make in Central
California Electronics by switching these
funds to other electronic companies, chiefly
Motorola, which fortunately rose in the next
few years to a value several times higher
than the prior peak of Central California
Electronics.
IN AND OUT MAY BE OUT OF THE MONEY.
There is more to learn from the Texas Instruments
and Central California Electronics situations.When
I originally acquired these Texas Instruments
shares in the summer of 1955, they were bought
for the longest type of long-range investment.
It seemed to me the company fully warranted
this degree of confidence. About a year later,
the stock had doubled. With one exception,
the various owners of the funds I managed,
familiar as they were with my method of operations,
showed no more interest in taking a profit
than did I. However, at that time I had one
relatively new account owned by people who,
in their own business, were used to building
up inventory when markets were low and cutting
it back sharply when they were high. Now that
Texas Instruments had doubled, they brought
strong pressure to sell, which for a time
I was able to resist. When the stock rose
an additional 25 percent to give them a profit
of 125 percent of their cost, the pressure
to sell became even stronger.They explained,"We
agree with you.We like the company, but we
can always buy it back at a better price on
a decline." I finally compromised with them
by persuading them to keep part of their holding
and sell the rest.Yet when the big drop occurred
several years later and the shares fell 80
percent from their peak, this new bottom was
still almost 40 percent higher than the price
at which this particular holder was so eager
to sell!
After a very sharp advance,a stock nearly
always looks too high to the financially untrained.This
client demonstrated another risk to those
who follow the practice of selling shares
that still have unusual growth prospects simply
because they have realized a good gain and
the stock appears temporarily overpriced.
These investors seldom buy back at higher
prices when they are wrong and lose further
gains of dramatic proportions.
At the risk of being repetitious, let me underscore
my belief that the short-term price movements
are so inherently tricky to predict that I
do
not believe it possible to play the in and
out game and still make the enormous profits
that have accrued again and again to the truly
longterm holder of the right stocks.
THE LONG SHADOW OF DIVIDENDS
In these comments I have tried to show how,
as the years have passed, various experiences
gradually helped to shape my investment philosophy.
However, looking back, I find no specific
event, either a mistake or a favorable opportunity,
which caused me to reach the conclusions I
have on the matter of dividends. Many observations
over a long period of years gradually crystallized
my views. I started out taking for granted
the belief, as widely accepted forty years
ago as it is today, that dividends were something
highly favorable to the stockholder and something
which should be welcomed enthusiastically.
Then I began seeing companies that had so
many exciting looking new ideas flowing from
their research departments that they could
not capitalize upon them all. Resources were
too scarce or too expensive. I began thinking
how much better it might be for some stockholders
if, instead of paying dividends, more of the
company's resources were retained and invested
in more of these innovative products.
I began increasingly to recognize that the
interests of all stockholders were not identical.
Some investors needed dividend income to support
their lifestyle. These stockholders would
undoubtedly prefer current dividends to greater
future profits and increased value for their
shares resulting from increased investment
in promising products and technologies. These
investors could find investments in firms
whose needs and opportunities for productive
use of capital were not too demanding.
But how about the stockholder whose earning
power or other income sources exceeded needs
and who was regularly saving money anyway?
Would it not be better for this investor if
the company passed up its dividends, which
would often be subject to a fairly high income
tax rate, and instead reinvested the funds,
tax-free, in future growth?
Shortly after World War II, when I started
concentrating my investment activities almost
solely on the attainment of major, long-range
capital appreciation, another aspect of the
dividend payout issue became even more apparent.The
companies with the greatest growth prospects
were under tremendous pressure to pay no dividends
at all. Their need for funds and their ability
to use funds productively was too large. The
cost of developing these new products was
just the first heavy drain on capital needed
to finance growth. There followed the heavy
marketing expense needed to introduce them
to the customer. With success, plant expansion
was needed to service a growing volume. Once
the new line was on its way, there were further
capital requirements for the increased inventories
and accounts receivable which, in most cases,
grow almost in direct proportion to the volume
of the business.
There seemed a natural fit of interest between
those firms with bountiful investment opportunities
and certain investors who sought to make the
greatest possible profit in relation to the
risk involved and who neither needed additional
income nor wanted to pay unnecessary taxes.
Such investors should, I believe, mainly confine
investments to non-dividend-paying companies
with strong earning power and with attractive
places to reinvest their earnings. These were
the clients I sought to serve.
Recently, however, the situation has become
less clear-cut. Institutional holders have
become an increasingly dominant force in day-today
stock transactions. Institutions such as pension
and profit sharing funds pay no income tax
on their dividends. Many of them as a matter
of policy will not invest in a company unless
it pays some dividend, no matter how small.Attracting
and holding these buyers have caused many
companies with unusual prospects to initiate
modest dividend payments of rather small percentage
total annual earnings. Managers of some would-be
growth companies have concurrently reduced
their payout dramatically. Today, the skill
in investing retained earnings wisely has
become a more critical factor in separating
the unusual company from the pack.
For these reasons, I have come to believe
that the most that can be said on this subject
of dividends is that it is an influence that
should be downgraded very sharply by those
who do not need the income. In general, more
attractive opportunities will be found among
stocks with a low dividend payout or none
at all. However, so general is the feeling
among those who determine dividend policies
that paying out dividends is beneficial to
the investor (as it is for some) that occasionally
I have found truly attractive opportunities
among higher dividend payout companies, although
this has not happened very often.
4. Is the Market Efficient?
By the coming of the 1970's nearly all of
my investment philosophy was firmly in place,
molded by my experience of four prior decades.
It is not coincidence that with only one exception
all of both the wise and the foolish actions
I have mentioned as examples that helped form
the background of this philosophy were incidents
that occurred during these four prior decades.
This does not mean that I have made no mistakes
in the 1970's. Unfortunately, it seems that
no matter how much I try, sometimes I must
stub my toe more than once in the same way
before I truly learn. However, in the examples
I have used I usually took the first instance
when a particular type of event happens to
illustrate my point, which explains why all
but one of the examples I used occurred during
these earlier periods.
It might be helpful to notice the striking
parallels in each of these past ten-year periods.
With the possible exception of the 1960's,
there has not been a single decade in which
there was not some period of time when the
prevailing view was that external influences
were so great and so much beyond the control
of individual corporate managements that even
the wisest common stock investments were foolhardy
and perhaps not for the prudent. In the 1930's
there were years when this view, influenced
by the Great Depression, was at its most extreme,
but perhaps not any more than the fear of
what the German war machine and World War
II might do in the 1940's, or the certainty
that another major depression would hit in
the 1950's, or fear of inflation, hostile
government actions, etc., in the 1970's. Yet
every one of these periods created investment
opportunities that seemed almost incredible
with all the advantages of hindsight. In each
of these five decades there were not a few,
but many common stock opportunities that ten
years later yielded profits running to many
hundreds of percent for those who had bought
and stayed with the shares. In some instances
profits ran well into the thousands of percent.
Again in every one of these five decades some
stocks which were the speculative darlings
of the moment were to prove the most dangerous
kind of trap for those who blindly followed
the crowd rather than those who really knew
what they were doing. All of these ten-year
periods essentially resembled the others in
that the greatest opportunities came from
finding situations that were extremely attractive
but that were undervalued because at that
particular moment the financial community
had significantly misjudged the situation.
As I look back on the various forces that
buffeted the securities market over this fifty-year
period and at the great waves of public optimism
and pessimism that succeeded each other over
this time span, the old French proverb, "Plus
ca change, plus c'est la meme chose" (the
more things change, the more they remain the
same), comes to mind. I have not the slightest
doubt that as we enter the emerging decade
of the 1980's, with all the problems and the
prospects that it now offers, the same will
continue to hold true.
THE FALLACY O F THE EFFICIENT MARKET.
In the last few years, too much attention
has been paid to a concept that I believe
is quite fallacious. I refer to the notion
that the market is perfectly efficient. Like
other false beliefs in other periods, a contrary
view may open up opportunities for the discerning.
For those unfamiliar with "efficient" market
theory, the adjective "efficient" does not
refer to the obvious mechanical efficiency
of the market. A potential buyer or seller
can get his order to the market where a transaction
can be executed very effectively within a
matter of a couple of minutes. Neither does
"efficiency"refer to the delicate adjustment
mechanism which causes stock prices to move
up or down by fractions of a point in response
to modest changes in the relative pressure
of buyers and sellers. Rather, this concept
holds that at any one time the market "efficient"
prices are assumed to reflect fully and realistically
all that is known about the company. Unless
someone has some significant, illicit inside
information, there is no way genuine bargains
can be found,
since the favorable influences that make a
potential buyer believe that an attractive
situation exists are already reflected in
the price of stock!
If the market was as efficient as it has become
fashionable to believe, and if important opportunities
to buy or significant reasons to sell were
not constantly occurring, stock returns should
not subsequently have the huge variations
that they do. By variation, I am not referring
to changes in prices for the market as a whole,
but rather the dispersion of relative price
changes of one stock against another. If the
market is efficient in prospect, then the
nexus of analysis that leads to this efficiency
must be collectively poor.
Efficient market theory grew out of the academic
School of Random Walkers.These people found
that it was difficult to identify technical
trading strategies that worked well enough
after transactions costs to provide an attractive
profit relative to the risks taken. I don't
disagree with this.As you have seen, I believe
that it is very, very tough to make money
with in and out trading based on short-term
market forecasts. Perhaps the market is efficient
in this narrow sense of the word.
Most of us are or should be investors, not
traders. We should be seeking investment opportunities
with unusual prospects over the long run and
avoiding investment opportunities with poorer
prospects. This has always been the central
tenet of my approach to investments in any
case. I do not believe that prices are efficient
for the diligent, knowledgeable, long-term
investor.
Directly applicable to this is an experience
I had in 1961. In the fall of that year, as
in the spring of 1963, I undertook the stimulating
duty of substituting for the regular finance
professor in teaching the senior course of
investments at Stanford University's Graduate
School of Business. The concept of the "efficient"
market was not to see the light of day for
many years to come and had nothing to do with
my motivation in the exercise I am about to
describe. Rather, I wanted to show these students
in a way they would never forget that the
fluctuations of the market as a whole were
insignificant compared to the differences
between the changes in price of some stocks
in relation to others.
I divided the class into two groups.The first
group took the alphabetical list of stocks
on the NewYork Stock Exchange, starting with
the letter A; the second group, those starting
with the letter T. Every stock was included
in alphabetical order (except preferreds and
utilities, which I consider to be a different
breed of cats). Each student was assigned
four stocks. Each student looked up the closing
price as of the last day of
business of 1956, adjusted the stock dividends
and stock splits (rights were ignored as not
having sufficient impact to be worthy of the
additional calculations), and compared this
price with the price as of Friday, October
13th (if nothing else, a colorful closing
date!). The percentage increase or decrease
that occurred in each stock over this period
of almost five years was noted. The Dow Jones
averages rose from 499 to 703, or by 41 percent
in this period. Altogether, there were 140
stocks in this sample.The results are displayed
in the following table:
These data are quite insightful. In a period
when the Dow Jones averages rose 41 percent,
38 stocks, or 27 percent of the total, showed
a capital loss. Six of them, or 4 percent
of the total, recorded a loss of over 50 percent
of their total value. In contrast, roughly
one quarter of the stocks realized capital
gains that would have been considered spectacular.
To drive the point home, I noted that if a
person invested $10,000 in equal amounts in
the five best stocks on this list, at the
outset of this four and three-quarter year
period, his capital would now be worth $70,260.
On the other hand, if he had invested the
$10,000 in the five worst stocks, his capital
would have shrunk to $3,180. These extreme
results were most unlikely. It would take
luck, either good or bad, as well as skill,
to hit either of these extremes. It would
not be so implausible for a person with real
investment judgment to have picked five out
of the ten best stocks for his $10,000 investment,
in which case his net worth on Friday the
13th would have been $52,070. Similarly, some
investors consistently select stocks for the
wrong reasons and manage to pick lemons.For
them selecting five out of the ten poorest
in performance
is also not an entirely unrealistic expectation
of results. In that case, the $10,000 investment
would have shrunk to $4,270. On the basis
of this comparison, there might be, in less
than five years, a difference of $48,000 between
a wise and an unwise investment program.
A year and a half later, when I also taught
this same course, I repeated the exact same
exercise, with the exception that instead
of using the letters A and T, I selected two
different letters in the alphabet from which
to form the sample of stocks. Again, over
a five-year time frame, but with a different
starting and a different closing date, the
degree of variation was almost exactly the
same.
Looking back on most markets of five-year
duration, I believe that one can find stock
performance results that are about as disparate.
Some of this dispersion may come as the result
of surprises--important new information about
a stock's prospects that could not be reasonably
foreseen at the outset of the period. Most
of the differences, however, can be anticipated
at least roughly both in terms of direction
and general magnitude of gains and losses
relative to the market.
THE RAYCHEM CORPORATION.
In view of this kind of evidence, it is hard
for me to see how anyone can consider the
stock market efficient, again using the word
"efficient" as it is used by the proponents
of this theory. But to belabor the point further,
let me take a stock market situation of just
a very few years ago. In the early years of
the 1970's,the shares of the Raychem Corporation
had considerable prestige in the market place
and were accordingly selling at a relatively
high price-earnings ratio. Some of the reasons
warranting this prestige may be perceived
by some comments made by the company's Executive
Vice President, Robert M. Halperin. In outlining
what he called the four cardinal points to
Raychem's operating philosophy, he stated:
1.Raychem will not do anything technically
simple (i. e., something that would be easy
for potential competitors to copy).
2.Raychem won't do anything unless it can
be vertically integrated; that is, Raychem
must conceive the product, manufacture it,
and sell it to the customer.
3.Raychem won't do anything unless there is
a substantial opportunity for real proprietary
protection, which generally means
patent protection. Unless this occurs, research
and development energies will not be employed
on a project, even though otherwise it might
fit into Raychem's skills.
4.Raychem will only go into new products when
it believes it can become the market leader
in whatever niche, sometimes smaller, sometimes
larger, that product attempts to capture.
By the mid-1970's, awareness of these unusual
strengths was sufficiently prevalent among
those who controlled large institutional funds
so that sizable blocks of shares had been
taken out of the market by people who believed
that Raychem was a situation of unusual competitive
strength and attractiveness. However, it was
another aspect of this company that gave Raychem
its greatest appeal to these holders and was
probably the cause of the high price-earnings
ratio at which it was then selling. Many considered
that Raychem, which was spending an above
average percentage of sales on new project
development, had perfected a research organization
capable of producing an important enough stream
of new products so that the company could
be depended on to show an uninterrupted upward
trend in sales and profits.These research
products had quite justifiably a special appeal
to the financial community because many of
the newer ones only indirectly competed with
older products of other companies. Primarily,
the new products enabled high-priced labor
to do the same job in considerably less time
than had previously been required.There were
enough savings offered to the ultimate customer
of these products to justify a price which
should afford Raychem a pleasing profit margin.
All this caused the stock toward the end of
1975 to reach a high of over $42½ (price
adjusted for subsequent stock splits)--a level
about 25 times the estimated earnings for
the fiscal year ending June 30, 1976.
RAYCHEM, DASHED EXPECTATIONS, AND THE CRASH
Toward the close of the June 30, 1976, fiscal
year, Raychem was hit by two hammer blows,
which were to play havoc with the price of
the stock and with the company's reputation
in the financial community. The financial
community had become very excited about a
proprietary
polymer, Stilan, which enjoyed unique advantages
over other compounds used by the airplane
industry for coating wire and which was then
in the final research stages. Furthermore,
the polymer was to be the first product in
which Raychem would go basic, that is, make
the original chemicals in its own plant rather
than buying raw materials from others and
compounding them. Because of the appeal of
the product, Raychem had allocated by a considerable
margin more funds to this research product
than to any other in its history. The financial
community assumed this product was already
on its way to success, and after passing through
the usual "learning curve" experienced by
all new products it would become highly profitable.
Actually, quite the opposite was occurring.
In the words of the Raychem management, Stilan
was "a scientific success but a commercial
failure." Improved products of an able competitor,
while technically not as desirable as Stilan,
proved adequate for the job and were far cheaper.
Raychem management recognized this. In the
course of a relatively few weeks, management
reached the painful decision to abandon the
product and write off the heavy investments
made in it.The resulting charge to earnings
for that fiscal year was some $9.3 million.
This charge-off caused earnings, exclusive
of some offsetting special gains, to drop
to $.08 a share from $7.95 the previous fiscal
year.
The financial community was as much upset
by the erosion of the great confidence in
the company's research ability as by the precipitous
drop in earnings. Largely ignored was the
basic rule that some new product developments
are bound to fail in all companies.This is
inherent in all industrial research activity
and in a well-run company is far more than
offset in the long run by other successful
new products. It may have been just bad luck
that the particular project on which the most
money had been spent had been the one to fail.
At any rate, the effect on the stock price
was dramatic. By the fourth quarter of 1976,
the stock had dropped to a low of approximately
$14¾ (again adjusted for subsequent splits
amounting to six to one) or to approximately
onethird its former high. Of course, only
a tiny amount of stock could be bought or
sold at the low point for the year. Of greater
impact, the stock was available at prices
only moderately above this low level for months
thereafter.
Another development also affected the profits
of the company at this moment and contributed
to Raychem's fall from favor. One of the most
difficult tasks for those responsible for
the success of any growing
company is to change the management structure
appropriately as the company grows to allow
for the difference between what is needed
for proper control of small companies and
optimum control of big companies. Until the
end of the 1976 fiscal year, Raychem management
had been set up along divisional lines based
largely on manufacturing techniques; that
is, on the basis of the products produced.
This worked well when the company was smaller,
but was not conducive to serving the customer
most efficiently as the company was growing.
Therefore, at about the end of the 1975 fiscal
year, top Raychem management started working
on a "big company" management concept. The
firm restructured the divisions by the industry
served rather than by the physical and chemical
composition of the products being manufactured.
The target date to make the change was set
at the end of the 1976 fiscal year. This was
done at a time when there was not the least
thought within the management that this date
would coincide with the time of the huge write-off
for the abandonment of Stilan.
Everyone in Raychem knew that when the organizational
change was to occur there would be at least
one quarter and probably a minimum of two
of substantially reduced earnings. While making
these changes caused almost no change in the
individuals on the Raychem management payroll,
so many people now had different superiors,
different subordinates, and different co-workers
with whom they had to interface their activities
that a time of inefficiency and adjustment
was bound to occur until Raychem employees
learned how best to coordinate their work
with the new faces with whom they were now
dealing. Perhaps no stronger indication could
have existed to justify long-range confidence
in this company or to indicate that management
was not concerned with short-term results
than its decision to go ahead with this project
as planned rather than to postpone what was
bound to be a second blow to Raychem's current
earnings.
Actually, this significant change worked with
considerably less difficulty than had been
anticipated.As expected, the first-quarter
earnings of the new fiscal year were much
lower than would have been the case if the
change had not been made. However, the change
was working so well that as the second quarter
progressed, the short-term costs of what had
been done had largely been eliminated. Fundamentally
these developments should have been considered
bullish by analysts. Raychem was now in a
position to handle growth properly in a way
that could not have been done before. It had
successfully hurdled a barrier of the type
that is most
apt to dull the luster of otherwise attractive
growth companies. By and large, the financial
community did not seem to recognize this,
however, and instead the temporary further
shrinkage of earnings was just one more factor
holding the stock at the low levels to which
it had fallen.
Making these price levels even more attractive
to potential investors was another influence
that I have seen happen in other companies
shortly after they had abandoned a major research
project that had proved unsuccessful. One
financial effect of the abandonment of Stilan
was that a sizable amount of money that had
heretofore been devoted to that project was
now free to be allocated elsewhere. Even more
important, it had similarly freed the time
of key research people for other endeavors.Within
a year or two much like a field of flowers
starting to bloom when rain follows drought,
the company began to enjoy what was possibly
a greater number of attractive research projects
in relation to its size than had ever before
been experienced.
RAYCHEM AND THE EFFICIENT MARKET.
Now what has Raychem's situation to do with
this theory of an "efficient market" that
has recently gained such a following in certain
financial quarters? According to that theory,
stocks automatically and instantly adjust
to whatever is known about a company, so that
only those who might possess illicit "inside
information" that is not known to others could
benefit from what might lie ahead for a particular
stock. In this instance, at the drop of a
hat, the Raychem management would and did
explain to anyone interested all the facts
I have just cited and explained how temporary
they believed was the period of poor earnings.
Actually, well after all this had happened
and when profits were climbing to a new all-time
high level, the Raychem management went even
further. On January 26, 1978, they held a
long one-day meeting at their headquarters
which I had the privilege of attending. Raychem
management invited to this meeting the representatives
of all institutions, brokerage houses, and
investment advisors who either had any interest
in Raychem or they thought might have. At
this meeting the ten most senior executives
of Raychem explained with what I believe was
extreme frankness and in detail, such as I
have only occasionally seen at similar meetings
of other companies, the prospects, the
problems, and the current status of Raychem
matters under their jurisdiction.
In the year or two following this meeting,
Raychem's earnings growth developed exactly
as might have been inferred from what was
said there. During that period, the stock
was to much more than double from the price
of $23¼ at which it was selling that day.Yet
in the weeks immediately following this meeting,
there was no particular effect on the stock
whatsoever. Some of those present were obviously
impressed by the picture being presented.
Too many, however, were still under the influence
of the double shock that they had experienced
a year or two before.They obviously mistrusted
what was being told them then. So much for
the theory of an efficient market.
What kind of conclusion does the investor
or the investment professional reach from
experiences like Raychem? By and large, those
who have accepted and been influenced by this
theory of the "efficient market" fall into
two groups. One is students, who have had
a minimum of practical experience.The other,
strangely enough, seems to be many managers
of large institutional funds.The individual
private investor, by and large, has paid relatively
little attention to this theory.
From this experience gained in applying my
personal investment philosophy, I would conclude
that in my field of technological stocks,
as the decade of the 1970's comes to an end,
there would therefore be more attractive opportunities
among the larger companies, the market for
which is dominated by the institutions, than
among the small technological companies where
the individual private investor plays a considerably
bigger role. Just as some ten years earlier
those who recognized the folly of the then
prevailing concept of the two-tier market
benefited from recognizing that particular
nonsense for what it was, so in each decade
false ideas arise creating opportunities for
those with investment discernment.
CONCLUSION
This then is my investment philosophy as it
has emerged over a half century of business
experience. Perhaps the heart of it may be
summarized in the following eight points:
1.Buy into companies that have disciplined
plans for achieving dramatic long-range growth
in profits and that have inherent
qualities making it difficult for newcomers
to share in that growth. There are so many
details, both favorable and unfavorable, that
should also be considered in selecting one
of these companies that it is obviously impossible
in a monograph of this length to cover them
adequately. For those interested, I have attempted
to summarize this subject as concisely as
I could in the first three chapters of Conservative
Investors Sleep Well.* A brief outline appears
in the Appendix.
2.Focus on buying these companies when they
are out of favor; that is, when, either because
of general market conditions or because the
financial community at the moment has misconceptions
of its true worth, the stock is selling at
prices well under what it will be when its
true merit is better understood.
3.Hold the stock until either (a) there has
been a fundamental change in its nature (such
as a weakening of management through changed
personnel), or (b) it has grown to a point
where it no longer will be growing faster
than the economy as a whole. Only in the most
exceptional circumstances, if ever, sell because
of forecasts as to what the economy or the
stock market is going to do, because these
changes are too difficult to predict. Never
sell the most attractive stocks you own for
short-term reasons. However, as companies
grow, remember that many companies that are
quite efficiently run when they are small
fail to change management style to meet the
different requirements of skill big companies
need.When management fails to grow as companies
grow, shares should be sold.
4.For those primarily seeking major appreciation
of their capital, de-emphasize the importance
of dividends. The most attractive opportunities
are most likely to occur in the profitable,
but low or no dividend payout groups. Unusual
opportunities are much less likely to be found
in situations where high percentage of profits
is paid to stockholders.
5.Making some mistakes is as much an inherent
cost of investing for major gains as making
some bad loans is inevitable in even the best
run and most profitable lending institution.
The important thing is to recognize them as
soon as possible, to understand their causes,
and to learn how to keep from repeating the
mistakes.
*Conservative Investors Sleep Well, Harper
& Row, 1975.
Willingness to take small losses in some stocks
and to let profits grow bigger and bigger
in the more promising stocks is a sign of
good investment management. Taking small profits
in good investments and letting losses grow
in bad ones is a sign of abominable investment
judgment. A profit should never be taken just
for the satisfaction of taking it.
6.There are a relatively small number of truly
outstanding companies. Their shares frequently
can't be bought at attractive prices. Therefore,
when favorable prices exist, full advantage
should be taken of the situation. Funds should
be concentrated in the most desirable opportunities.
For those involved in venture capital and
quite small companies, say with annual sales
of under $25,000,000, more diversification
may be necessary. For larger companies, proper
diversification requires investing in a variety
of industries with different economic characteristics.
For individuals (in possible contrast to institutions
and certain types of funds), any holding of
over twenty different stocks is a sign of
financial incompetence.Ten or twelve is usually
a better number. Sometimes the costs of the
capital gains tax may justify taking several
years to complete a move toward concentration.
As an individual's holdings climb toward as
many as twenty stocks, it nearly always is
desirable to switch from the least attractive
of these stocks to more of the attractive.
It should be remembered that ERISA stands
for Emasculated Results: Insufficient Sophisticated
Action.
7.A basic ingredient of outstanding common
stock management is the ability neither to
accept blindly whatever may be the dominant
opinion in the financial community at the
moment nor to reject the prevailing view just
to be contrary for the sake of being contrary.
Rather, it is to have more knowledge and to
apply better judgment, in thorough evaluation
of specific situations, and the moral courage
to act "in opposition to the crowd" when your
judgment tells you you are right.
8.In handling common stocks, as in most other
fields of human activity, success greatly
depends on a combination of hard work, intelligence,
and honesty.
Some of us may be born with a greater or lesser
degree of each of these traits than others.
However, I believe all of us can "grow" our
capabilities in each of these areas if we
discipline ourselves and make the effort.
While good fortune will always play some part
in managing common stock portfolios, luck
tends to even out. Sustained success requires
skill and consistent application of sound
principles. Within the framework of my eight
guidelines, I believe that the future will
largely belong to those who, through self-discipline,
make the effort to achieve it.
Appendix.
Key Factors in Evaluating Promising Firms*
My philosophy calls for making a relatively
small number of investments but only in unusually
promising companies. Obviously, I am
looking for signs of growth potential in the
companies I study. As important, I am trying,
through my analysis, to avoid risk. I want
to make sure
that the firm’s management has the wherewithal
to capitalize on the
potential and to minimize my investment risks
in the process. Summarized below are some
of the defensive characteristics that I search
for in
the companies that are to meet my standards
of unusual promise when I
undertake financial analysis, interviews with
management, and discussions with informed
people associated with the industry.
FUNCTIONAL FACTORS
1. The firm must be one of the lowest-cost
producers of its products or
services relative to its competition, and
must promise to remain so.
a. A comparatively low breakeven will enable
this firm to survive depressed market conditions
and to strengthen its market
*Excerpts from Fisher, Conservative Investors
Sleep Well, Harper & Row, 1975. Chapters 1–3.
and pricing position when weaker competitors
are driven out
of the market.
b. A higher than average profit margin enables
the firm to generate more funds internally
to sustain growth without as
much dilution caused by equity sales or strain
caused by overdependence on fixed-income financing.
2. A firm must have a strong enough customer
orientation to recognize changes in customer
needs and interests and then to react
promptly to those changes in an appropriate
manner. This capability should lead to generating
a flow of new products that more
than offset lines maturing or becoming obsolete.
3. Effective marketing requires not only understanding
of what
customers want, but also explaining to them
(through advertising,
selling or other means) in terms the customer
will understand.
Close control and constant monitoring of the
cost/effectiveness
of market efforts are required.
4. Even nontechnical firms today require a
strong and well-directed
research capability to (a) produce newer and
better products, and
(b) perform services in a more effective or
efficient way.
5. There are wide differences in the effectiveness
of research. Two
important elements of more productive research
are (a) market/
profit consciousness, and (b) the ability
to pool necessary talent
into an effective working team.
6. A firm with a strong financial team has
several important
advantages:
a. Good cost information enables management
to direct its
energies toward those products with the highest
potential
for profit contribution.
b. The cost system should pinpoint where production,
marketing, and research costs are inefficient
even in sub-parts of the
operation.
c. Capital conservation through tight control
of fixed and working capital investments.
7. A critical finance function is to provide
an early warning system
to identify influences that could threaten
the profit plan sufficiently ahead of time
to devise remedial plans to minimize
adverse surprises.
PEOPLE FACTORS.
1. To become more successful, a firm needs
a leader with a determined entrepreneurial
personality combining the drive, the
original ideas, and the skills necessary to
build the fortunes of the
firm.
2. A growth-oriented chief executive must
surround himself with
an extremely competent team and to delegate
considerable
authority to them to run the activities of
the firm. Teamwork, as
distinct from dysfunction struggles for power,
is critical.
3. Attention must be paid to attracting competent
managers at
lower levels and to training them for larger
responsibilities. Succession should largely
be from the available talent pool. The need
to recruit the chief executive from outside
is a particularly dangerous sign.
4. The entrepreneurial spirit must permeate
the organization.
5. More successful firms usually have some
unique personality
traits—some special ways of doing things
that are particularly
effective for their management team. This
is a positive not a negative sign.
6. Management must recognize and be attuned
to the fact that the
world in which they are operating is changing
at an ever increasing rate.
a. Every accepted way of doing things must
be reexamined periodically, and new, better
ways sought.
b. Changes in managerial approaches involve
necessary risks,
which must be recognized, minimized and taken.
7. There must be a genuine, realistic, conscious
and continuous
effort to have employees at every level, including
the blue collar
workers, believe that their company is really
a good place to
work.
a. Employees must be treated with reasonable
dignity and
decency.
b. The firm’s work environment and benefits
programs should
be supportive of motivation.
c. People must feel they can express grievances
without fear and
with reasonable expectation of appropriate
attention and
action.
d. Participatory programs seem to work well
and be an important
source of good ideas.
8. Management must be willing to submit to
the disciplines required
of sound growth. Growth requires some sacrifice
of current profits
to lay the foundation for worthwhile future
improvement.
BUSINESS CHARACTERISTICS.
1. Although managers rely heavily on return
of assets in considering new investments,
investors must recognize that historic assets
stated at historic costs distort comparisons
of firms’ performance.
Favorable profit to sales ratios, notwithstanding
differences in
turnover ratios, may be a better indicator
of the safety of an
investment, particularly in an inflationary
environment.
2. High margins attract competition, and competition
erodes profit
opportunities. The best way to mute competition
is to operate so
efficiently that there is no incentive left
for the potential entrant.
3. Efficiencies of scale are often counterbalanced
by the inefficiencies of bureaucratic layers
of middle management. In a well-run
firm, however, the industry leadership position
creates a strong
competitive advantage that should be attractive
to investors.
4. Getting there first in a new product market
is a long step toward
becoming first. Some firms are better geared
to be there first.
5. Products are not islands. There is an indirect
competition, for
example, for consumers’ dollars. As prices
change, some products
may lose attractiveness even in well-run,
low-cost companies.
6. It is hard to introduce new, superior products
in market arenas
where established competitors already have
a strong position.
While the new entrant is building the production,
marketing
power, and reputation to be competitive, existing
competitors
can take strong defensive actions to regain
the market threatened.
Innovators have a better chance of success
if they combine technology disciplines, e.g.,
electronics and nucleonics, in a way that
is
novel relative to existing competitive competencies.
7. Technology is just one avenue to industry
leadership. Developing
a consumer “franchise” is another. Service
excellence is still another.
Whatever the case, a strong ability to defend
established markets
against new competitors is essential for a
sound investment.
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