COMMONSTOCKSASLONGTERMINVESTMENTS

BYEDGARLAWRENCESMITH

NotesbyTheodorTonca

TheFluctuatingDollar

Aseriesofstudiesishereinthistitlepresented,basedon
acomparisonofhighgradebondsandcommonstocksover
differentperiodsextendingfromthecloseoftheUSCivilWar
upto1922.

Thecumulativeevidenceofthesestudiesfavorsdiversified
commonstocks,eveninperiodsofappreciatingcurrency,such
asfrom1866to1897.Since1897,withcurrencydepreciating,
thediversifiedcommonstocksselectedareshowntohavebeen
byfarthesuperiorformoflongterminvestment.

Ch.1Bonds&TheDollar

Fluctuationsinthedollarpriceofbondsresultfrom:

1.Changesinthecreditpositionoftheissuingcompanythe
prospectsofitsbeingabletopayinterestandprincipalwhen
due.Thisislargelyinfluencedbyitsearningpowerinexcess
ofcurrentinterestrequirements.

(PairwithBenGrahamsSecurityAnalysisforwhatadequate
coverageovercurrentinterestpaymentsisprescribed).

2.Changesinthecurrentdemandandsupplyofliquidcapital,
inrelationtothelengthoftheunexpiredtermandthefixed
interestrateofthebondsinquestion.*

*Themostreliableindexofthecurrentdemandforliquid
capitalisfoundinvariationsintheratecommandedby
commercialpaper.

(Onfixedmeasures)Themeasureoflengthisafixedthing,
andfromthisfact,themeasurementofcubicalcontentbecomes
afixedthing,derivedmathematicallyfromthemeasureofthe
lengthofthreedimensions.Theestablishmentofweightsas
fixedunitsbecomespossiblethroughthefactthatcubic
contentsmaybeaccuratelymeasuredinmaterialswhichdonot
varyinspecificgravity.Thusevenweightunitsarefixed
onlybecausetheycanbederivedmathematicallyfromthefixed
unitofmeasurelength.

Measuresofvalue,onthecontrary,arenotfixed.Thedollar
todayisadifferentmeasurefromthedollarofyesterday.The
markoftodaywell,letussayanhouragoisadifferent
measureofvaluefromthemarkofthemoment.Andsoitis
withthePoundSterling,Franc,Ruble,Yen,andtoaddtothe
confusiontheonlysimplewaywecandescribethevarying
valueofonefluctuatingmeasureofvalueisintermsofother
fluctuatingmeasuresofvalue.

Thebestthatcanbesaidisthatsomemeasuresofvalueare
morestablethanothers.Duringoneperiodofyearsitmaybe
thePoundSterlingwithwhichallothermeasuresarecompared
duringanotheritmaybethedollar.Butoveranyconsiderable
periodoftime,itcanbesafelystated,theactualmeasureof
truewealthortruevaluewillchange.Ithasneverremained
thesame.

Thisformerfactisofgreatermomenttoindividual
investors,whoseinvestmentsaremadewiththehappinessand
comfortoftheirchildreninmind.

SafetyofPrincipal,yesthatisthefirstessential.But
whatisprincipalisitmerelytheobligationofsome
soundorganizationtorepayacertainnumberoffluctuating
measuresofvalueatafuturedate?Whatif,atthedateof
repayment,themeasurehasshrunktoonehalfofitspresent
size?Hastheprincipalbeensafeguarded?

Ifitistrue,then,thatthedollarmayshrinkinvalue,and
thataninvestmentinbondsisdefencelessagainstsuch
shrinkage,howdoesitcomeaboutthatthemostconservative
ofourgreatfinancialinstitutionsinvestsogreata
proportionoftheirtotalassetsinbondsrepayablein
dollars?

Thereisavastdifferencebetweentheinvestmentneedsand
purposesofsuchinstitutionsfromthoseoftheindividual
investor,orthefamilyestate.

Takeaninsurancecompanyforexample.Itisbythenatureof
itsbusinessperfectlysafeguardedagainstanypossibleloss
throughthedepreciationofthedollar.Itdealsinnothing
butdollars.Itscontractscallforthepaymentoffuture
dollars.Itthereforerequirestoknowonlythatitwill
receivefromitsinvestmentsmorefuturedollarsthanitwill
havetopayout.Thepurchasingpowerofthosefuturedollars
isofnoconcerntoit.Ifdollarshaveshrunkinvalue,the
beneficiaryunderitspoliciesabsorbstheshrinkage,the
companydoesnot.

Thesameistrueofsavingsbanks,commercialbanksandtrust
companies.Theirinvestmentsareallmadetoprotecttheir
dollarobligations.Theirconcernissotoconducttheir
affairsthattheywillalwayshaveavailablemoredollarsthan
theywillbecalledupon,undertheircommitments,topayout,
atthesametimederivingaprofitaboveoperatingexpenses.

Toanindividualatemporarydeclineinthemarketquotations
onhissecurityholdingsisnotofsuchseriousimport,
providedheknowsthathisassetsaresoundandofrealvalue.
Furthermore,heissubjecttonolawsastowhathemayormay
notinvestin,andforthisreason,iffornoother,heshould
atleaststudythepossibilitiesofprofitableinvestmentin
securitieswhichthelargerinstitutionalinvestorsare
preventedbylawfromconsidering,andwhichforthatreason
maybesellinguponabasisofhigherincomereturn.

Ch.2Bonds&CommonStocks

Thereare,ofcourse,awidevarietyofbonds.Butasthis
discussionisconfinedtothequestionofconservative
longterminvestment,weneedconsideronlythosebondswhich,
atthetimeofpurchase,areregardedaswellsecuredbythe
mortgageorpriorlienonpropertywhichhasbeen
authoritativelyappraisedaswellworthinexcessofthetotal
amountofbondsissuedagainstit.

Itisworthwhiletocallattentiontothefactthatsuch
appraisalsarelargelybasedonthecostofconstructionor
thecostofreproducingtheproperties,andthatsuchcosts
alonearenocriterionoftherealvalueofthepropertiesat
alaterdate,ifachangeoccursintheindustrythatrenders
apartorallofthepropertyobsolete,oriftheconstruction
orlocationofthepropertywasnotwiselyplannedin
connectionwiththebusinesstobedone.

(SafeBondsImplySafeStocks)Letusseehowitwouldwork
outifourfathershadinvestedsolelyincommonstocks,not
withthethoughtofimmediatespeculativegain,athoughtthat
itisunfortunatelymostdifficulttoeliminatefromthe
choiceofcommonstocks,butwiththesobermindedpurposeof
providing:

1.ConstancyofIncome
2.SafetyofPrincipal

Constancyorregularityofincomeisplacedfirstbecauseit
isthefactorthatisordinarilyconsideredtobemostat
hazardincommonstocksascontrastedwithbonds.

Ch.3ComparisonBetweenCommonStocks&Bonds19011922

(ImportantofTests)Theimportanceofthesetestsliesin
theircumulativeforce.Nosingletestwouldhavemorethan
passingsignificance.Butallofthemtogetherarestrongly
indicativeofunderlyingfactorswhichhavebeenoverlookedby
toolargeaproportionofindividualinvestors.

Eachtestassumestheinvestmentofapprox.$10,000inten
diversifiedcommonstocksoflargecompaniesandaninvestment
ofanequalamountinhighgradebonds.Theycovertheentire
periodfrom1866to1922,andthesupposedpurchaseofstocks
ismadewithoutreferencetotheconditionofthestockmarket
atthetimeofpurchaseexceptinthosetestswhereapeakin
themarkethasbeendeliberatelychosen(Tests7&8).

Everytestexceptoneshowsbetterresultsareobtainedfrom
commonstocksthanfrombonds.

IncomeTestNo.2:Itisinterestingtonotethatthislist,chosenwith
moreregardtothepastrecordofthecompaniesinvolved,thantothe
popularityofthesecuritiesonthemarketatthetimeofpurchase,didnot
resultasfavorably,eitherintotalreturnorinenhancementofcapital
value,yetitshowedadecidedlymorefavorableresultthanthemost
conservativebondsyielding4%.

IncomeTestNo.3:Attentioniscalledtothedecidedlymorefavorable
resultsobtainedfromwelldiversifiedstockschosenonthestrictly
mechanicalbasesofTestsNo.s1&3ascomparedwithTestNo.2.Like
knowledge,alittleanalysisisadangerousthing.

Itisneverthelesstobesupposedthatthoroughtechnicalanalysisinthe
selectionofstocksshouldshowpossibilitiesofevengreaterreturnswiththe
safetyofdiversificationmaintained.Andyetthereisadefinitehazard
connectedwithdiggingtoodeepfortechnicalreasonsjustifyinghigheryield.
Abroad,generalviewhasitsdistinctadvantages.

IncomeTestNo.7:TencommonstocksinJanuary1892,selecteduponthe
followingbasis:

1.Agroupofrailroadandindustrialstocksofcompanieshavingthelargest
totalcapitalizationin1892wereselected.

2.Thesewerethengroupedaccordingtoindustries.

3.Oneortwostocksweretakenfromeachgrouponthebasisofregularityof
dividendpaymentsovertheperiodoffrom35yearspreviousto1892.

*Furtherreading:MartinsBostonStockMarketEightyEightYears
(17981886).

Ch.5FinancialConditions18661885

Baseduponthechangeinthepurchasingpowerofthedollar
therehasneverbeenaperiodwhichsofavoredthepurchaseof
longtermbondsasagainstthepurchaseofcommonstocksas
theperiodfrom18661885.Weshallfind,however,inour
laterpagesthatthereisaforceinherentincommonstocks
whichisindependentoffluctuationsindollarvalues,and
accountsforthefactthatinspiteofthetheoretical
advantageofbondsoverstocksinthisperiod,thelatterheld
theirown.

Thepanicof1873(failureofJayCook&Co.onSeptember
18,1873,followedinrapidsuccessionbythefailureofother
leadingbankersandonSept.20th,bythatoftwotrust
companies,threebankinghousesandclosureoftheNewYork
StockExchangefor10days,somethingpreviouslyunknownin
itshistory.

*Theeffectsofthepanicwereseverelyfeltbybusinessintereststhrough
thelongyearsfollowing,anditwasnotuntilthefallof1879thatthe
recoverywascomplete.

Onthegeneralprinciplethatnostocksshouldbebought
thatarenotpayingdividendsatthetimeofpurchase,suchis
notasoundassumption,tobesure,whencompleteanalysisis
possible.

Ch.9LawofIncreasingCommonStockValues&IncomeReturn

Pg.7681(singlemostimportantchaptertobefoundin
book,readinitsentirety).

*Furtherreading:TheFinancialPolicyofCorporations(allvolumes)by
ArthurStoneDewing.

Ch.10TimeHazardinthePurchaseofCommonStocks

Ouranalysisofthistimehazardmaybesummarizedas
follows:

Numberoftimeswhenalossinprincipalvaluelasts:

1year 13times 15.1% 78.1%

2years 8times 9.3% 87.4%
3years 2times 2.3% 89.7%
4years 4times 4.7% 94.4%
6years 2times 2.3% 96.7%
7years 1time 1.1% 97.8%
10years 1time 1.1% 98.9%
15years 1time 1.1% 100%

*Numberoftimeswhentheyearsucceedingtheyearofpurchaseshowsnoloss:
54timesor63%

Thesefigures,whichimplythetotalabsenceofanyjudgement
intheselectionofthetimewhenpurchasesaremade,suggest
thatinbuyingawelldiversifiedgroupofrepresentative
commonstocksinessentialindustries,ourchancesofcoming
outeven,orofmakingaprofitinprincipalvalues,are:
Within1year,78in1002years87in1004years,94in
100.

Thereremainonlyaboutsixchancesinonehundredthatwe
shouldhavetowaitfrom6to15yearsbeforehavingan
opportunitytoliquidateuponeventerms.

Byeliminatingthepeakyearswereducethenumberofyears
assumedpurchasebyfivetoeightyone:

Numberoftimeswhenalossinprincipalvaluelasts:

1year 13times 16.1% 82.8%

2years 8times 9.9% 92.7%
3years 2times 2.4% 95.1%
4years 4times 4.9% 100%

*Numberoftimestheyearsucceedingtheyearofpurchaseshowsnoloss:54
timesor66.7%

Ch.11AFewGeneralities

Noonemayberegardedashavinginvestedconservatively
whosefundshavesufferedapermanentlossofrealasopposed
tonominalvalue.Thisisthefirstrequisiteofconservatism.

Butitmaybeheldasequallytruethatnofundis
conservativelyinvestedifitdoesnotenhanceincapital
valueatanormalrateapproximatingtheaverageincreasein
equityvaluesofthecountryasawhole,asexpressedin
dollars,afterpayingtheinvestorareturncommensuratewith
therateobtainableonhighgradebonds.

Ch.12FluctuationsinBondValues

Readchapterinitsentiretyforindepthdescriptionofthe
underlyingfactorseffectingchangesintherealvaluesof
bondsandmortgages.(1)Depreciationofthedollar.2)A
generalincreaseincurrentinterestrates.3)Thechanging
creditpositionofthedebtorcompany).

Doesthismeanthatbondsarenottobeconsideredassound
investmentsatanytime?Farfromit.Therehavebeenperiod
whenbondholdershaveprofitedgreatlyfromfavorable
underlyingconditions,periodsduringwhichthedollar
increasedinpurchasingpowerwhilegeneralinterestrates
weretendingdownward.

Thusbetween1866&1885wehaveourbondholdersgainingboth
indollarvalues,asaresultoffallinginterestrates,and
inactualpurchasingpowerofthesedollars,whilefrom1902
to1920theylostheavilybecauseofreversetendenciesin
thesetwogreatunderlyingfactors.

Ch.14InvestmentManagement

Inbuyingbonds,aninvestorreduceshisownroutinetoa
minimum.Heacceptsthestipulatedrateofincomeprovidedby
thetermsofthebondanddelegatestotheissuingcompanies
allresponsibilityforsettingasideadequatereservesto
protectthisstipulatedincome,andhedelegatestothemthe
exerciseofjudgementinreinvestingthesereserves.Infact,
hedelegatestothemtheentiremanagementofhisinvested
funds.

Tocompensatethemforthismanagement,forrelievinghimof
allresponsibilityandofkeepingallbutthesimplest
records,theinvestoragreesthattheissuingcompaniesmay
retainallearningsoverandabovetheincomereturnwhichhe
hasagreedtoaccept.Heestablishesnoreservesofhisown,
andrelinquishesalltitletothereservesthatare
establishedforhim.Suchreserves,whileprotectinghis
income,accruetothebenefitofthestockholdersofthe
companieswhosebondsheholds.

Thepurchaserofabondisaninvestor,butheexercisesnone
ofthefunctionsofinvestmentmanagementwithregardtohis
investedfunds.Hepaysthecorporationwhichissuesthebonds
asubstantialsumforexercisingthisfunctionforhim,anda
surveyofthepricesatwhichbondsindifferentindustries
selldisclosesthefactthathepaysontheaveragemorefor
thisserviceinthoseindustrieswhosestabilizedearnings
callfortheleastresponsibilityonthepartoftheissuing
companies.

Soundinvestmentmanagement,whilealwayssubjecttoerror
(icanpersonallyattesttothis)cannotfailtoimprove
averageinvestmentresultsiftheprincipleofdiversification
isstrictlyadheredto.

Butdiversificationmaybecarriedtoexcess.Noinvestoror
groupofindividualsresponsibleforanyinvestmentfundcan
keepconstantlyinformedregardingtoolongalistof
securitiesrepresentingtoowideavarietyofindustries,
locationsandmanagements.Therearewellrecognized
limitationstothediversityofitemsuponwhichcontinuous
judgementmaybeexercised.Betterresultsareobtainedwhen
theselimitationsareadmittedasfacts.

Wemay,then,summarizetheprincipalfunctionsofinvestment
managementasfollows:

1.Itwillfirstestablishasoundinvestmentplansuitableto
thepurposesoftheinvestor.

2.Itwillthendeterminewhatproportionofthefundunder
itsmanagementshallbeinequitiesandwhatproportionin
bondsundercurrentindustrialandeconomicconditions.

3.Itwillputitselfinapositiontowatchforchangein
conditionsandbepreparedtomodifytheseproportionsin
harmonywithsuchchanges.

4.Itwillstudythecurrentconditionsofvariousindustries
andgroupsofindustries,andwillselectasitsfielda
diversificationofthosewhichuponreliabledatamaybe
regardedasthemorepromising.

5.Itwillthenexaminethemanagementandfinancial
structureofthecompaniesintheseindustries.

6.Itwillwatchforchangesbothintheconditionsof
industriesandofindividualcorporationsandbepreparedto
changetheinvestmenttoaccordwithsoundanalysisofthe
latestavailableinformation.

7.Itwillretaindiversificationasitsfundamental
principle,butwillestablishreasonablelimitationsto
diversificationinordernottodilutethequalityof
managementapplied.

Thesearenosimpletasks.Theyaretaskswhicheach
individualinvestor,responsiblenotonlyforhisownwelfare
butforthewelfareofthoseheistoleavebehindhim,must
appraiseinrelationbothtohisownexperienceandtraining
inahighlytechnicalfieldandinrelationtotheamountof
timeandthefacilitiesatthisdisposaltoproperlyundertake
it.

End