The Intelligent Investor - BENJAMIN GRAHAM

Commentary on Chapter 7 187 experiment. It’s the end of 1989, and you’re Japanese. Here are the facts: • Over the past 10 years, your stock market has gained an annual average of 21.2%, well ahead of the 17.5% annual gains in the United States. • Japanese companies are buying up everything in the United States from the Pebble Beach golf course to Rockefeller Center; meanwhile, American firms like Drexel Burnham Lambert, Finan- cial Corp. of America, and Texaco are going bankrupt. • The U.S. high-tech industry is dying. Japan’s is booming. In 1989, in the land of the rising sun, you can only conclude that investing outside of Japan is the dumbest idea since sushi vending machines. Naturally, you put all your money in Japanese stocks. The result? Over the next decade, you lose roughly two-thirds of your money. The lesson? It’s not that you should never invest in foreign markets like Japan; it’s that the Japanese should never have kept all their money at home. And neither should you. If you live in the United States, work in the United States, and get paid in U.S. dollars, you are already making a multilayered bet on the U.S. economy. To be prudent, you should put some of your investment portfolio elsewhere—simply because no one, anywhere, can ever know what the future will bring at home or abroad. Putting up to a third of your stock money in mutual funds that hold foreign stocks (including those in emerging markets) helps insure against the risk that our own backyard may not always be the best place in the world to invest. www.fx1618.com

CHAPTER 8 The Investor and Market Fluctuations To the extent that the investor’s funds are placed in high-grade bonds of relatively short maturity—say, of seven years or less—he will not be affected significantly by changes in market prices and need not take them into account. (This applies also to his holdings of U.S. savings bonds, which he can always turn in at his cost price or more.) His longer-term bonds may have relatively wide price swings during their lifetimes, and his common-stock portfolio is almost certain to fluctuate in value over any period of several years. The investor should know about these possibilities and should be prepared for them both financially and psychologically. He will want to benefit from changes in market levels—certainly through an advance in the value of his stock holdings as time goes on, and perhaps also by making purchases and sales at advantageous prices. This interest on his part is inevitable, and legitimate enough. But it involves the very real danger that it will lead him into speculative attitudes and activities. It is easy for us to tell you not to speculate; the hard thing will be for you to follow this advice. Let us repeat what we said at the outset: If you want to speculate do so with your eyes open, knowing that you will proba- bly lose money in the end; be sure to limit the amount at risk and to separate it completely from your investment program. We shall deal first with the more important subject of price changes in common stocks, and pass later to the area of bonds. In Chapter 3 we supplied a historical survey of the stock market’s action over the past hundred years. In this section we shall return to that material from time to time, in order to see what the past record promises the investor—in either the form of long-term appreciation of a portfolio held relatively unchanged through www.fx1618.com 188

The Investor and Market Fluctuations 189 successive rises and declines, or in the possibilities of buying near bear-market lows and selling not too far below bull-market highs. Market Fluctuations as a Guide to Investment Decisions Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which he may try to do this: the way of timing and the way of pricing. By timing we mean the endeavor to anticipate the action of the stock market—to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value. A less ambitious form of pricing is the simple effort to make sure that when you buy you do not pay too much for your stocks. This may suffice for the defen- sive investor, whose emphasis is on long-pull holding; but as such it represents an essential minimum of attention to market levels.1 We are convinced that the intelligent investor can derive satis- factory results from pricing of either type. We are equally sure that if he places his emphasis on timing, in the sense of forecasting, he will end up as a speculator and with a speculator’s financial results. This distinction may seem rather tenuous to the layman, and it is not commonly accepted on Wall Street. As a matter of business practice, or perhaps of thoroughgoing conviction, the stock brokers and the investment services seem wedded to the principle that both investors and speculators in common stocks should devote careful attention to market forecasts. The farther one gets from Wall Street, the more skepticism one will find, we believe, as to the pretensions of stock-market forecast- ing or timing. The investor can scarcely take seriously the innumer- able predictions which appear almost daily and are his for the asking. Yet in many cases he pays attention to them and even acts upon them. Why? Because he has been persuaded that it is impor- tant for him to form some opinion of the future course of the stock www.fx1618.com

190 The Intelligent Investor market, and because he feels that the brokerage or service forecast is at least more dependable than his own.* We lack space here to discuss in detail the pros and cons of mar- ket forecasting. A great deal of brain power goes into this field, and undoubtedly some people can make money by being good stock- market analysts. But it is absurd to think that the general public can ever make money out of market forecasts. For who will buy when the general public, at a given signal, rushes to sell out at a profit? If you, the reader, expect to get rich over the years by following some system or leadership in market forecasting, you must be expecting to try to do what countless others are aiming at, and to be able to do it better than your numerous competitors in the market. There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he is himself a part. There is one aspect of the “timing” philosophy which seems to have escaped everyone’s notice. Timing is of great psychological importance to the speculator because he wants to make his profit in * In the late 1990s, the forecasts of “market strategists” became more influ- ential than ever before. They did not, unfortunately, become more accurate. On March 10, 2000, the very day that the NASDAQ composite index hit its all-time high of 5048.62, Prudential Securities’s chief technical analyst Ralph Acampora said in USA Today that he expected NASDAQ to hit 6000 within 12 to 18 months. Five weeks later, NASDAQ had already shriveled to 3321.29—but Thomas Galvin, a market strategist at Donaldson, Lufkin & Jenrette, declared that “there’s only 200 or 300 points of downside for the NASDAQ and 2000 on the upside.” It turned out that there were no points on the upside and more than 2000 on the downside, as NASDAQ kept crashing until it finally scraped bottom on October 9, 2002, at 1114.11. In March 2001, Abby Joseph Cohen, chief investment strategist at Goldman, Sachs & Co., predicted that the Standard & Poor’s 500-stock index would close the year at 1,650 and that the Dow Jones Industrial Average would finish 2001 at 13,000. “We do not expect a recession,” said Cohen, “and believe that corporate profits are likely to grow at close to trend growth rates later this year.” The U.S. economy was sinking into recession even as she spoke, and the S & P 500 ended 2001 at 1148.08, while the Dow fin- ished at 10,021.50—30% and 23% below her forecasts, respectively. www.fx1618.com

The Investor and Market Fluctuations 191 a hurry. The idea of waiting a year before his stock moves up is repugnant to him. But a waiting period, as such, is of no conse- quence to the investor. What advantage is there to him in having his money uninvested until he receives some (presumably) trust- worthy signal that the time has come to buy? He enjoys an advan- tage only if by waiting he succeeds in buying later at a sufficiently lower price to offset his loss of dividend income. What this means is that timing is of no real value to the investor unless it coincides with pricing—that is, unless it enables him to repurchase his shares at substantially under his previous selling price. In this respect the famous Dow theory for timing purchases and sales has had an unusual history.* Briefly, this technique takes its signal to buy from a special kind of “breakthrough” of the stock averages on the up side, and its selling signal from a similar break- through on the down side. The calculated—not necessarily actual—results of using this method showed an almost unbroken series of profits in operations from 1897 to the early 1960s. On the basis of this presentation the practical value of the Dow theory would have appeared firmly established; the doubt, if any, would apply to the dependability of this published “record” as a picture of what a Dow theorist would actually have done in the market. A closer study of the figures indicates that the quality of the results shown by the Dow theory changed radically after 1938— a few years after the theory had begun to be taken seriously on Wall Street. Its spectacular achievement had been in giving a sell signal, at 306, about a month before the 1929 crash and in keeping its followers out of the long bear market until things had pretty well righted themselves, at 84, in 1933. But from 1938 on the Dow theory operated mainly by taking its practitioners out at a pretty good price but then putting them back in again at a higher price. For nearly 30 years thereafter, one would have done appreciably better by just buying and holding the DJIA.2 In our view, based on much study of this problem, the change in the Dow-theory results is not accidental. It demonstrates an inher- ent characteristic of forecasting and trading formulas in the fields of business and finance. Those formulas that gain adherents and * See p. 3. www.fx1618.com

192 The Intelligent Investor importance do so because they have worked well over a period, or sometimes merely because they have been plausibly adapted to the statistical record of the past. But as their acceptance increases, their reliability tends to diminish. This happens for two reasons: First, the passage of time brings new conditions which the old formula no longer fits. Second, in stock-market affairs the popularity of a trading theory has itself an influence on the market’s behavior which detracts in the long run from its profit-making possibilities. (The popularity of something like the Dow theory may seem to cre- ate its own vindication, since it would make the market advance or decline by the very action of its followers when a buying or selling signal is given. A “stampede” of this kind is, of course, much more of a danger than an advantage to the public trader.) Buy-Low–Sell-High Approach We are convinced that the average investor cannot deal success- fully with price movements by endeavoring to forecast them. Can he benefit from them after they have taken place—i.e., by buying after each major decline and selling out after each major advance? The fluctuations of the market over a period of many years prior to 1950 lent considerable encouragement to that idea. In fact, a classic definition of a “shrewd investor” was “one who bought in a bear market when everyone else was selling, and sold out in a bull mar- ket when everyone else was buying.” If we examine our Chart I, covering the fluctuations of the Standard & Poor’s composite index between 1900 and 1970, and the supporting figures in Table 3-1 (p. 66), we can readily see why this viewpoint appeared valid until fairly recent years. Between 1897 and 1949 there were ten complete market cycles, running from bear-market low to bull-market high and back to bear-market low. Six of these took no longer than four years, four ran for six or seven years, and one—the famous “new-era” cycle of 1921–1932—lasted eleven years. The percentage of advance from the lows to highs ranged from 44% to 500%, with most between about 50% and 100%. The percentage of subsequent declines ranged from 24% to 89%, with most found between 40% and 50%. (It should be remembered that a decline of 50% fully offsets a pre- ceding advance of 100%.) www.fx1618.com

The Investor and Market Fluctuations 193 Nearly all the bull markets had a number of well-defined char- acteristics in common, such as (1) a historically high price level, (2) high price/earnings ratios, (3) low dividend yields as against bond yields, (4) much speculation on margin, and (5) many offerings of new common-stock issues of poor quality. Thus to the student of stock-market history it appeared that the intelligent investor should have been able to identify the recurrent bear and bull mar- kets, to buy in the former and sell in the latter, and to do so for the most part at reasonably short intervals of time. Various methods were developed for determining buying and selling levels of the general market, based on either value factors or percentage move- ments of prices or both. But we must point out that even prior to the unprecedented bull market that began in 1949, there were sufficient variations in the successive market cycles to complicate and sometimes frustrate the desirable process of buying low and selling high. The most notable of these departures, of course, was the great bull market of the late 1920s, which threw all calculations badly out of gear.* Even in 1949, therefore, it was by no means a certainty that the investor could base his financial policies and procedures mainly on the endeavor to buy at low levels in bear markets and to sell out at high levels in bull markets. It turned out, in the sequel, that the opposite was true. The * Without bear markets to take stock prices back down, anyone waiting to “buy low” will feel completely left behind—and, all too often, will end up abandoning any former caution and jumping in with both feet. That’s why Graham’s message about the importance of emotional discipline is so important. From October 1990 through January 2000, the Dow Jones Industrial Average marched relentlessly upward, never losing more than 20% and suffering a loss of 10% or more only three times. The total gain (not counting dividends): 395.7%. According to Crandall, Pierce & Co., this was the second-longest uninterrupted bull market of the past century; only the 1949–1961 boom lasted longer. The longer a bull market lasts, the more severely investors will be afflicted with amnesia; after five years or so, many people no longer believe that bear markets are even possible. All those who forget are doomed to be reminded; and, in the stock market, recovered memories are always unpleasant. www.fx1618.com

194 The Intelligent Investor market’s behavior in the past 20 years has not followed the former pattern, nor obeyed what once were well-established danger sig- nals, nor permitted its successful exploitation by applying old rules for buying low and selling high. Whether the old, fairly regular bull-and-bear-market pattern will eventually return we do not know. But it seems unrealistic to us for the investor to endeavor to base his present policy on the classic formula—i.e., to wait for demonstrable bear-market levels before buying any common stocks. Our recommended policy has, however, made provision for changes in the proportion of common stocks to bonds in the portfolio, if the investor chooses to do so, according as the level of stock prices appears less or more attractive by value stan- dards.* Formula Plans In the early years of the stock-market rise that began in 1949–50 considerable interest was attracted to various methods of taking advantage of the stock market’s cycles. These have been known as “formula investment plans.” The essence of all such plans—except the simple case of dollar averaging—is that the investor automati- cally does some selling of common stocks when the market advances substantially. In many of them a very large rise in the market level would result in the sale of all common-stock holdings; others provided for retention of a minor proportion of equities under all circumstances. This approach had the double appeal of sounding logical (and conservative) and of showing excellent results when applied retro- spectively to the stock market over many years in the past. Unfor- tunately, its vogue grew greatest at the very time when it was destined to work least well. Many of the “formula planners” found themselves entirely or nearly out of the stock market at some level in the middle 1950s. True, they had realized excellent profits, but in a broad sense the market “ran away” from them thereafter, and * Graham discusses this “recommended policy” in Chapter 4 (pp. 89–91). This policy, now called “tactical asset allocation,” is widely followed by insti- tutional investors like pension funds and university endowments. www.fx1618.com

The Investor and Market Fluctuations 195 their formulas gave them little opportunity to buy back a common- stock position.* There is a similarity between the experience of those adopting the formula-investing approach in the early 1950s and those who embraced the purely mechanical version of the Dow theory some 20 years earlier. In both cases the advent of popularity marked almost the exact moment when the system ceased to work well. We have had a like discomfiting experience with our own “central value method” of determining indicated buying and selling levels of the Dow Jones Industrial Average. The moral seems to be that any approach to moneymaking in the stock market which can be easily described and followed by a lot of people is by its terms too simple and too easy to last.† Spinoza’s concluding remark applies to Wall Street as well as to philosophy: “All things excellent are as difficult as they are rare.” Market Fluctuations of the Investor’s Portfolio Every investor who owns common stocks must expect to see them fluctuate in value over the years. The behavior of the DJIA since our last edition was written in 1964 probably reflects pretty well what has happened to the stock portfolio of a conservative investor who limited his stock holdings to those of large, promi- nent, and conservatively financed corporations. The overall value advanced from an average level of about 890 to a high of 995 in * Many of these “formula planners” would have sold all their stocks at the end of 1954, after the U.S. stock market rose 52.6%, the second-highest yearly return then on record. Over the next five years, these market-timers would likely have stood on the sidelines as stocks doubled. † Easy ways to make money in the stock market fade for two reasons: the natural tendency of trends to reverse over time, or “regress to the mean,” and the rapid adoption of the stock-picking scheme by large numbers of people, who pile in and spoil all the fun of those who got there first. (Note that, in referring to his “discomfiting experience,” Graham is—as always— honest in admitting his own failures.) See Jason Zweig, “Murphy Was an Investor,” Money, July, 2002, pp. 61–62, and Jason Zweig, “New Year’s Play,” Money, December, 2000, pp. 89–90. www.fx1618.com

196 The Intelligent Investor 1966 (and 985 again in 1968), fell to 631 in 1970, and made an almost full recovery to 940 in early 1971. (Since the individual issues set their high and low marks at different times, the fluc- tuations in the Dow Jones group as a whole are less severe than those in the separate components.) We have traced through the price fluctuations of other types of diversified and conservative common-stock portfolios and we find that the overall results are not likely to be markedly different from the above. In general, the shares of second-line companies* fluctuate more widely than the major ones, but this does not necessarily mean that a group of well- established but smaller companies will make a poorer showing over a fairly long period. In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.† A serious investor is not likely to believe that the day-to-day or even month-to-month fluctuations of the stock market make him richer or poorer. But what about the longer-term and wider changes? Here practical questions present themselves, and the psy- chological problems are likely to grow complicated. A substantial rise in the market is at once a legitimate reason for satisfaction and a cause for prudent concern, but it may also bring a strong tempta- tion toward imprudent action. Your shares have advanced, good! * Today’s equivalent of what Graham calls “second-line companies” would be any of the thousands of stocks not included in the Standard & Poor’s 500-stock index. A regularly revised list of the 500 stocks in the S & P index is available at www.standardandpoors.com. † Note carefully what Graham is saying here. It is not just possible, but prob- able, that most of the stocks you own will gain at least 50% from their low- est price and lose at least 33% from their highest price—regardless of which stocks you own or whether the market as a whole goes up or down. If you can’t live with that—or you think your portfolio is somehow magically exempt from it—then you are not yet entitled to call yourself an investor. (Graham refers to a 33% decline as the “equivalent one-third” because a 50% gain takes a $10 stock to $15. From $15, a 33% loss [or $5 drop] takes it right back to $10, where it started.) www.fx1618.com

The Investor and Market Fluctuations 197 You are richer than you were, good! But has the price risen too high, and should you think of selling? Or should you kick yourself for not having bought more shares when the level was lower? Or— worst thought of all—should you now give way to the bull-market atmosphere, become infected with the enthusiasm, the overconfi- dence and the greed of the great public (of which, after all, you are a part), and make larger and dangerous commitments? Presented thus in print, the answer to the last question is a self-evident no, but even the intelligent investor is likely to need considerable will power to keep from following the crowd. It is for these reasons of human nature, even more than by calcu- lation of financial gain or loss, that we favor some kind of mechan- ical method for varying the proportion of bonds to stocks in the investor’s portfolio. The chief advantage, perhaps, is that such a formula will give him something to do. As the market advances he will from time to time make sales out of his stockholdings, putting the proceeds into bonds; as it declines he will reverse the proce- dure. These activities will provide some outlet for his otherwise too-pent-up energies. If he is the right kind of investor he will take added satisfaction from the thought that his operations are exactly opposite from those of the crowd.* Business Valuations versus Stock-Market Valuations The impact of market fluctuations upon the investor’s true situ- ation may be considered also from the standpoint of the share- holder as the part owner of various businesses. The holder of marketable shares actually has a double status, and with it the privilege of taking advantage of either at his choice. On the one hand his position is analogous to that of a minority shareholder or silent partner in a private business. Here his results are entirely dependent on the profits of the enterprise or on a change in the underlying value of its assets. He would usually determine the value of such a private-business interest by calculating his share of the net worth as shown in the most recent balance sheet. On the * For today’s investor, the ideal strategy for pursuing this “formula” is rebal- ancing, which we discuss on pp. 104–105. www.fx1618.com

198 The Intelligent Investor other hand, the common-stock investor holds a piece of paper, an engraved stock certificate, which can be sold in a matter of minutes at a price which varies from moment to moment—when the mar- ket is open, that is—and often is far removed from the balance- sheet value.* The development of the stock market in recent decades has made the typical investor more dependent on the course of price quotations and less free than formerly to consider himself merely a business owner. The reason is that the successful enterprises in which he is likely to concentrate his holdings sell almost constantly at prices well above their net asset value (or book value, or “balance-sheet value”). In paying these market premiums the investor gives precious hostages to fortune, for he must depend on the stock market itself to validate his commitments.† This is a factor of prime importance in present-day investing, and it has received less attention than it deserves. The whole struc- ture of stock-market quotations contains a built-in contradiction. The better a company’s record and prospects, the less relationship the price of its shares will have to their book value. But the greater the premium above book value, the less certain the basis of deter- mining its intrinsic value—i.e., the more this “value” will depend on the changing moods and measurements of the stock market. Thus we reach the final paradox, that the more successful the com- pany, the greater are likely to be the fluctuations in the price of its shares. This really means that, in a very real sense, the better the * Most companies today provide “an engraved stock certificate” only upon special request. Stocks exist, for the most part, in purely electronic form (much as your bank account contains computerized credits and debits, not actual currency) and thus have become even easier to trade than they were in Graham’s day. † Net asset value, book value, balance-sheet value, and tangible-asset value are all synonyms for net worth, or the total value of a company’s physical and financial assets minus all its liabilities. It can be calculated using the bal- ance sheets in a company’s annual and quarterly reports; from total share- holders’ equity, subtract all “soft” assets such as goodwill, trademarks, and other intangibles. Divide by the fully diluted number of shares outstanding to arrive at book value per share. www.fx1618.com

The Investor and Market Fluctuations 199 quality of a common stock, the more speculative it is likely to be—at least as compared with the unspectacular middle-grade issues.* (What we have said applies to a comparison of the leading growth companies with the bulk of well-established concerns; we exclude from our purview here those issues which are highly speculative because the businesses themselves are speculative.) The argument made above should explain the often erratic price behavior of our most successful and impressive enterprises. Our favorite example is the monarch of them all—International Busi- ness Machines. The price of its shares fell from 607 to 300 in seven months in 1962–63; after two splits its price fell from 387 to 219 in 1970. Similarly, Xerox—an even more impressive earnings gainer in recent decades—fell from 171 to 87 in 1962–63, and from 116 to 65 in 1970. These striking losses did not indicate any doubt about the future long-term growth of IBM or Xerox; they reflected instead a lack of confidence in the premium valuation that the stock mar- ket itself had placed on these excellent prospects. The previous discussion leads us to a conclusion of practical importance to the conservative investor in common stocks. If he is to pay some special attention to the selection of his portfolio, it might be best for him to concentrate on issues selling at a reason- ably close approximation to their tangible-asset value—say, at not more than one-third above that figure. Purchases made at such levels, or lower, may with logic be regarded as related to the * Graham’s use of the word “paradox” is probably an allusion to a classic article by David Durand, “Growth Stocks and the Petersburg Paradox,” The Journal of Finance, vol. XII, no. 3, September, 1957, pp. 348–363, which compares investing in high-priced growth stocks to betting on a series of coin flips in which the payoff escalates with each flip of the coin. Durand points out that if a growth stock could continue to grow at a high rate for an indefinite period of time, an investor should (in theory) be willing to pay an infinite price for its shares. Why, then, has no stock ever sold for a price of infinity dollars per share? Because the higher the assumed future growth rate, and the longer the time period over which it is expected, the wider the margin for error grows, and the higher the cost of even a tiny mis- calculation becomes. Graham discusses this problem further in Appendix 4 (p. 570). www.fx1618.com

200 The Intelligent Investor company’s balance sheet, and as having a justification or support independent of the fluctuating market prices. The premium over book value that may be involved can be considered as a kind of extra fee paid for the advantage of stock-exchange listing and the marketability that goes with it. A caution is needed here. A stock does not become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years. This may appear like demanding a lot from a modestly priced stock, but the prescription is not hard to fill under all but danger- ously high market conditions. Once the investor is willing to forgo brilliant prospects—i.e., better than average expected growth—he will have no difficulty in finding a wide selection of issues meeting these criteria. In our chapters on the selection of common stocks (Chapters 14 and 15) we shall give data showing that more than half of the DJIA issues met our asset-value criterion at the end of 1970. The most widely held investment of all—American Tel. & Tel.—actually sells below its tangible-asset value as we write. Most of the light-and- power shares, in addition to their other advantages, are now (early 1972) available at prices reasonably close to their asset values. The investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipli- ers of both earnings and tangible assets. As long as the earning power of his holdings remains satisfactory, he can give as little attention as he pleases to the vagaries of the stock market. More than that, at times he can use these vagaries to play the master game of buying low and selling high. The A. & P. Example At this point we shall introduce one of our original examples, which dates back many years but which has a certain fascination for us because it combines so many aspects of corporate and investment experience. It involves the Great Atlantic & Pacific Tea Co. Here is the story: www.fx1618.com

The Investor and Market Fluctuations 201 A. & P. shares were introduced to trading on the “Curb” market, now the American Stock Exchange, in 1929 and sold as high as 494. By 1932 they had declined to 104, although the company’s earnings were nearly as large in that generally catastrophic year as previ- ously. In 1936 the range was between 111 and 131. Then in the busi- ness recession and bear market of 1938 the shares fell to a new low of 36. That price was extraordinary. It meant that the preferred and common were together selling for $126 million, although the com- pany had just reported that it held $85 million in cash alone and a working capital (or net current assets) of $134 million. A. & P. was the largest retail enterprise in America, if not in the world, with a continuous and impressive record of large earnings for many years. Yet in 1938 this outstanding business was considered on Wall Street to be worth less than its current assets alone—which means less as a going concern than if it were liquidated. Why? First, because there were threats of special taxes on chain stores; second, because net profits had fallen off in the previous year; and, third, because the general market was depressed. The first of these reasons was an exaggerated and eventually groundless fear; the other two were typical of temporary influences. Let us assume that the investor had bought A. & P. common in 1937 at, say, 12 times its five-year average earnings, or about 80. We are far from asserting that the ensuing decline to 36 was of no importance to him. He would have been well advised to scrutinize the picture with some care, to see whether he had made any mis- calculations. But if the results of his study were reassuring—as they should have been—he was entitled then to disregard the mar- ket decline as a temporary vagary of finance, unless he had the funds and the courage to take advantage of it by buying more on the bargain basis offered. Sequel and Reflections The following year, 1939, A. & P. shares advanced to 1171⁄2, or three times the low price of 1938 and well above the average of 1937. Such a turnabout in the behavior of common stocks is by no means uncommon, but in the case of A. & P. it was more striking than most. In the years after 1949 the grocery chain’s shares rose www.fx1618.com

202 The Intelligent Investor with the general market until in 1961 the split-up stock (10 for 1) reached a high of 701⁄2 which was equivalent to 705 for the 1938 shares. This price of 701⁄2 was remarkable for the fact it was 30 times the earnings of 1961. Such a price/earnings ratio—which compares with 23 times for the DJIA in that year—must have implied expec- tations of a brilliant growth in earnings. This optimism had no jus- tification in the company’s earnings record in the preceding years, and it proved completely wrong. Instead of advancing rapidly, the course of earnings in the ensuing period was generally downward. The year after the 701⁄2 high the price fell by more than half to 34. But this time the shares did not have the bargain quality that they showed at the low quotation in 1938. After varying sorts of fluctua- tions the price fell to another low of 211⁄2 in 1970 and 18 in 1972— having reported the first quarterly deficit in its history. We see in this history how wide can be the vicissitudes of a major American enterprise in little more than a single generation, and also with what miscalculations and excesses of optimism and pessimism the public has valued its shares. In 1938 the business was really being given away, with no takers; in 1961 the public was clamoring for the shares at a ridiculously high price. After that came a quick loss of half the market value, and some years later a substantial further decline. In the meantime the company was to turn from an outstanding to a mediocre earnings performer; its profit in the boom-year 1968 was to be less than in 1958; it had paid a series of confusing small stock dividends not warranted by the current additions to surplus; and so forth. A. & P. was a larger com- pany in 1961 and 1972 than in 1938, but not as well-run, not as profitable, and not as attractive.* There are two chief morals to this story. The first is that the stock market often goes far wrong, and sometimes an alert and coura- * The more recent history of A & P is no different. At year-end 1999, its share price was $27.875; at year-end 2000, $7.00; a year later, $23.78; at year-end 2002, $8.06. Although some accounting irregularities later came to light at A & P, it defies all logic to believe that the value of a relatively sta- ble business like groceries could fall by three-fourths in one year, triple the next year, then drop by two-thirds the year after that. www.fx1618.com

The Investor and Market Fluctuations 203 geous investor can take advantage of its patent errors. The other is that most businesses change in character and quality over the years, sometimes for the better, perhaps more often for the worse. The investor need not watch his companies’ performance like a hawk; but he should give it a good, hard look from time to time. Let us return to our comparison between the holder of mar- ketable shares and the man with an interest in a private business. We have said that the former has the option of considering himself merely as the part owner of the various businesses he has invested in, or as the holder of shares which are salable at any time he wishes at their quoted market price. But note this important fact: The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more.* Thus the investor who permits himself to be stampeded or unduly wor- ried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment.† Incidentally, a widespread situation of this kind actually existed during the dark depression days of 1931–1933. There was then a psychological advantage in owning business interests that had no quoted market. For example, people who owned first mortgages on real estate that continued to pay interest were able to tell them- selves that their investments had kept their full value, there being no market quotations to indicate otherwise. On the other hand, many listed corporation bonds of even better quality and greater * “Only to the extent that it suits his book” means “only to the extent that the price is favorable enough to justify selling the stock.” In traditional brokerage lingo, the “book” is an investor’s ledger of holdings and trades. † This may well be the single most important paragraph in Graham’s entire book. In these 113 words Graham sums up his lifetime of experience. You cannot read these words too often; they are like Kryptonite for bear markets. If you keep them close at hand and let them guide you throughout your investing life, you will survive whatever the markets throw at you. www.fx1618.com

204 The Intelligent Investor underlying strength suffered severe shrinkages in their market quotations, thus making their owners believe they were growing distinctly poorer. In reality the owners were better off with the listed securities, despite the low prices of these. For if they had wanted to, or were compelled to, they could at least have sold the issues—possibly to exchange them for even better bargains. Or they could just as logically have ignored the market’s action as temporary and basically meaningless. But it is self-deception to tell yourself that you have suffered no shrinkage in value merely because your securities have no quoted market at all. Returning to our A. & P. shareholder in 1938, we assert that as long as he held on to his shares he suffered no loss in their price decline, beyond what his own judgment may have told him was occasioned by a shrinkage in their underlying or intrinsic value. If no such shrinkage had occurred, he had a right to expect that in due course the market quotation would return to the 1937 level or better—as in fact it did the following year. In this respect his posi- tion was at least as good as if he had owned an interest in a private business with no quoted market for its shares. For in that case, too, he might or might not have been justified in mentally lopping off part of the cost of his holdings because of the impact of the 1938 recession—depending on what had happened to his company. Critics of the value approach to stock investment argue that listed common stocks cannot properly be regarded or appraised in the same way as an interest in a similar private enterprise, because the presence of an organized security market “injects into equity ownership the new and extremely important attribute of liquidity.” But what this liquidity really means is, first, that the investor has the benefit of the stock market’s daily and changing appraisal of his holdings, for whatever that appraisal may be worth, and, second, that the investor is able to increase or decrease his investment at the market’s daily figure—if he chooses. Thus the existence of a quoted market gives the investor certain options that he does not have if his security is unquoted. But it does not impose the current quotation on an investor who prefers to take his idea of value from some other source. Let us close this section with something in the nature of a para- ble. Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is www.fx1618.com

The Investor and Market Fluctuations 205 very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position. The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed—this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such sig- nals are misleading at least as often as they are helpful. Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies. Summary The most realistic distinction between the investor and the spec- ulator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices. Market www.fx1618.com

206 The Intelligent Investor movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell. It is far from certain that the typical investor should regularly hold off buying until low market levels appear, because this may involve a long wait, very likely the loss of income, and the possible missing of investment opportunities. On the whole it may be better for the investor to do his stock buying whenever he has money to put in stocks, except when the general market level is much higher than can be justified by well-established standards of value. If he wants to be shrewd he can look for the ever-present bargain oppor- tunities in individual securities. Aside from forecasting the movements of the general market, much effort and ability are directed on Wall Street toward selecting stocks or industrial groups that in matter of price will “do better” than the rest over a fairly short period in the future. Logical as this endeavor may seem, we do not believe it is suited to the needs or temperament of the true investor—particularly since he would be competing with a large number of stock-market traders and first- class financial analysts who are trying to do the same thing. As in all other activities that emphasize price movements first and underlying values second, the work of many intelligent minds con- stantly engaged in this field tends to be self-neutralizing and self- defeating over the years. The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market quotations are there for his conve- nience, either to be taken advantage of or to be ignored. He should never buy a stock because it has gone up or sell one because it has gone down. He would not be far wrong if this motto read more simply: “Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop.” An Added Consideration Something should be said about the significance of average mar- ket prices as a measure of managerial competence. The shareholder www.fx1618.com

The Investor and Market Fluctuations 207 judges whether his own investment has been successful in terms both of dividends received and of the long-range trend of the aver- age market value. The same criteria should logically be applied in testing the effectiveness of a company’s management and the soundness of its attitude toward the owners of the business. This statement may sound like a truism, but it needs to be emphasized. For as yet there is no accepted technique or approach by which management is brought to the bar of market opinion. On the contrary, managements have always insisted that they have no responsibility of any kind for what happens to the market value of their shares. It is true, of course, that they are not accountable for those fluctuations in price which, as we have been insisting, bear no relationship to underlying conditions and values. But it is only the lack of alertness and intelligence among the rank and file of share- holders that permits this immunity to extend to the entire realm of market quotations, including the permanent establishment of a depreciated and unsatisfactory price level. Good managements produce a good average market price, and bad managements pro- duce bad market prices.* Fluctuations in Bond Prices The investor should be aware that even though safety of its prin- cipal and interest may be unquestioned, a long-term bond could vary widely in market price in response to changes in interest rates. In Table 8-1 we give data for various years back to 1902 covering yields for high-grade corporate and tax-free issues. As individual illustrations we add the price fluctuations of two representative railroad issues for a similar period. (These are the Atchison, Topeka & Santa Fe general mortgage 4s, due 1995, for generations one of our premier noncallable bond issues, and the Northern Pacific Ry. 3s, due 2047—originally a 150-year maturity!—long a typical Baa- rated bond.) Because of their inverse relationship the low yields correspond to the high prices and vice versa. The decline in the Northern * Graham has much more to say on what is now known as “corporate gov- ernance.” See the commentary on Chapter 19. www.fx1618.com

208 The Intelligent Investor Pacific 3s in 1940 represented mainly doubts as to the safety of the issue. It is extraordinary that the price recovered to an all-time high in the next few years, and then lost two-thirds of its price chiefly because of the rise in general interest rates. There have been star- tling variations, as well, in the price of even the highest-grade bonds in the past forty years. Note that bond prices do not fluctuate in the same (inverse) pro- portion as the calculated yields, because their fixed maturity value of 100% exerts a moderating influence. However, for very long maturities, as in our Northern Pacific example, prices and yields change at close to the same rate. Since 1964 record movements in both directions have taken place in the high-grade bond market. Taking “prime municipals” (tax- free) as an example, their yield more than doubled, from 3.2% in January 1965 to 7% in June 1970. Their price index declined, corre- spondingly, from 110.8 to 67.5. In mid-1970 the yields on high- grade long-term bonds were higher than at any time in the nearly 200 years of this country’s economic history.* Twenty-five years earlier, just before our protracted bull market began, bond yields were at their lowest point in history; long-term municipals returned as little as 1%, and industrials gave 2.40% compared with the 41⁄2 to 5% for- merly considered “normal.” Those of us with a long experience on Wall Street had seen Newton’s law of “action and reaction, equal and opposite” work itself out repeatedly in the stock market—the most noteworthy example being the rise in the DJIA from 64 in 1921 to 381 in 1929, followed by a record collapse to 41 in 1932. But this time the widest pendulum swings took place in the usually staid and slow-moving array of high-grade bond prices and yields. Moral: Nothing important on Wall Street can be counted on to occur exactly in the same way as it happened before. This repre- * By what Graham called “the rule of opposites,” in 2002 the yields on long- term U.S. Treasury bonds hit their lowest levels since 1963. Since bond yields move inversely to prices, those low yields meant that prices had risen—making investors most eager to buy just as bonds were at their most expensive and as their future returns were almost guaranteed to be low. This provides another proof of Graham’s lesson that the intelligent investor must refuse to make decisions based on market fluctuations. www.fx1618.com

www.fx1618.com TABLE 8-1 Fluctuations in Bond Yields, and in Prices of Two Representative Bond Issues, 1902–1970 Bond Yields Bond Prices S&P AAA S&P A. T. & S. F. Nor. Pac. 4s, 1995 3s, 2047 Composite Municipals 1902 low 4.31% 3.11% 1905 high 1051⁄2 79 1920 high 6.40 5.28 1920 low 69 491⁄2 1928 low 4.53 3.90 1930 high 105 73 1932 high 5.52 5.27 1932 low 75 463⁄4 1946 low 2.44 1.45 1936 high 1171⁄4 851⁄4 1970 high 8.44 7.06 1939–40 low 991⁄2 311⁄2 1971 close 7.14 5.35 1946 high 141 943⁄4 1970 low 51 323⁄4 1971 close 64 371⁄4

210 The Intelligent Investor sents the first half of our favorite dictum: “The more it changes, the more it’s the same thing.” If it is virtually impossible to make worthwhile predictions about the price movements of stocks, it is completely impossible to do so for bonds.* In the old days, at least, one could often find a useful clue to the coming end of a bull or bear market by studying the prior action of bonds, but no similar clues were given to a com- ing change in interest rates and bond prices. Hence the investor must choose between long-term and short-term bond investments on the basis chiefly of his personal preferences. If he wants to be certain that the market values will not decrease, his best choices are probably U.S. savings bonds, Series E or H, which were described above, p. 93. Either issue will give him a 5% yield (after the first year), the Series E for up to 55⁄6 years, the Series H for up to ten years, with a guaranteed resale value of cost or better. If the investor wants the 7.5% now available on good long-term corporate bonds, or the 5.3% on tax-free municipals, he must be prepared to see them fluctuate in price. Banks and insurance com- panies have the privilege of valuing high-rated bonds of this type on the mathematical basis of “amortized cost,” which disregards market prices; it would not be a bad idea for the individual investor to do something similar. The price fluctuations of convertible bonds and preferred stocks are the resultant of three different factors: (1) variations in the price of the related common stock, (2) variations in the credit standing of the company, and (3) variations in general interest rates. A good many of the convertible issues have been sold by companies that have credit ratings well below the best.3 Some of these were badly affected by the financial squeeze in 1970. As a result, convertible issues as a whole have been subjected to triply unsettling influences in recent years, and price variations have been unusually wide. In the typical case, therefore, the investor would delude himself if he expected to find in convertible issues that ideal combination of the safety of a high-grade bond and price * An updated analysis for today’s readers, explaining recent yields and the wider variety of bonds and bond funds available today, can be found in the commentary on Chapter 4. www.fx1618.com

The Investor and Market Fluctuations 211 protection plus a chance to benefit from an advance in the price of the common. This may be a good place to make a suggestion about the “long- term bond of the future.” Why should not the effects of changing interest rates be divided on some practical and equitable basis between the borrower and the lender? One possibility would be to sell long-term bonds with interest payments that vary with an appropriate index of the going rate. The main results of such an arrangement would be: (1) the investor’s bond would always have a principal value of about 100, if the company maintains its credit rating, but the interest received will vary, say, with the rate offered on conventional new issues; (2) the corporation would have the advantages of long-term debt—being spared problems and costs of frequent renewals of refinancing—but its interest costs would change from year to year.4 Over the past decade the bond investor has been confronted by an increasingly serious dilemma: Shall he choose complete stability of principal value, but with varying and usually low (short-term) interest rates? Or shall he choose a fixed-interest income, with considerable variations (usually downward, it seems) in his princi- pal value? It would be good for most investors if they could compromise between these extremes, and be assured that neither their interest return nor their principal value will fall below a stated minimum over, say, a 20-year period. This could be arranged, without great difficulty, in an appropriate bond contract of a new form. Important note: In effect the U.S. government has done a similar thing in its combination of the original savings- bonds contracts with their extensions at higher interest rates. The suggestion we make here would cover a longer fixed investment period than the savings bonds, and would introduce more flexibil- ity in the interest-rate provisions.* It is hardly worthwhile to talk about nonconvertible preferred stocks, since their special tax status makes the safe ones much more desirable holdings by corporations—e.g., insurance companies— * As mentioned in the commentary on Chapters 2 and 4, Treasury Inflation- Protected Securities, or TIPS, are a new and improved version of what Gra- ham is suggesting here. www.fx1618.com

212 The Intelligent Investor than by individuals. The poorer-quality ones almost always fluctu- ate over a wide range, percentagewise, not too differently from common stocks. We can offer no other useful remark about them. Table 16-2 below, p. 406, gives some information on the price changes of lower-grade nonconvertible preferreds between Decem- ber 1968 and December 1970. The average decline was 17%, against 11.3% for the S & P composite index of common stocks. www.fx1618.com

COMMENTARY ON CHAPTER 8 The happiness of those who want to be popular depends on others; the happiness of those who seek pleasure fluctuates with moods outside their control; but the happiness of the wise grows out of their own free acts. —Marcus Aurelius DR. JEKYLL AND MR. MARKET Most of the time, the market is mostly accurate in pricing most stocks. Millions of buyers and sellers haggling over price do a remarkably good job of valuing companies—on average. But sometimes, the price is not right; occasionally, it is very wrong indeed. And at such times, you need to understand Graham’s image of Mr. Market, probably the most brilliant metaphor ever created for explaining how stocks can become mispriced.1 The manic-depressive Mr. Market does not always price stocks the way an appraiser or a private buyer would value a business. Instead, when stocks are going up, he happily pays more than their objective value; and, when they are going down, he is desperate to dump them for less than their true worth. Is Mr. Market still around? Is he still bipolar? You bet he is. On March 17, 2000, the stock of Inktomi Corp. hit a new high of $231.625. Since they first came on the market in June 1998, shares in the Internet-searching software company had gained roughly 1,900%. Just in the few weeks since December 1999, the stock had nearly tripled. What was going on at Inktomi the business that could make Inktomi the stock so valuable? The answer seems obvious: phenomenally fast 1 See Graham’s text, pp. 204–205. 213 www.fx1618.com

214 Commentary on Chapter 8 growth. In the three months ending in December 1999, Inktomi sold $36 million in products and services, more than it had in the entire year ending in December 1998. If Inktomi could sustain its growth rate of the previous 12 months for just five more years, its revenues would explode from $36 million a quarter to $5 billion a month. With such growth in sight, the faster the stock went up, the farther up it seemed certain to go. But in his wild love affair with Inktomi’s stock, Mr. Market was over- looking something about its business. The company was losing money—lots of it. It had lost $6 million in the most recent quarter, $24 million in the 12 months before that, and $24 million in the year before that. In its entire corporate lifetime, Inktomi had never made a dime in profits. Yet, on March 17, 2000, Mr. Market valued this tiny business at a total of $25 billion. (Yes, that’s billion, with a B.) And then Mr. Market went into a sudden, nightmarish depression. On September 30, 2002, just two and a half years after hitting $231.625 per share, Inktomi’s stock closed at 25 cents—collapsing from a total market value of $25 billion to less than $40 million. Had Inktomi’s business dried up? Not at all; over the previous 12 months, the company had generated $113 million in revenues. So what had changed? Only Mr. Market’s mood: In early 2000, investors were so wild about the Internet that they priced Inktomi’s shares at 250 times the company’s revenues. Now, however, they would pay only 0.35 times its revenues. Mr. Market had morphed from Dr. Jekyll to Mr. Hyde and was ferociously trashing every stock that had made a fool out of him. But Mr. Market was no more justified in his midnight rage than he had been in his manic euphoria. On December 23, 2002, Yahoo! Inc. announced that it would buy Inktomi for $1.65 per share. That was nearly seven times Inktomi’s stock price on September 30. History will probably show that Yahoo! got a bargain. When Mr. Market makes stocks so cheap, it’s no wonder that entire companies get bought right out from under him.2 2 As Graham noted in a classic series of articles in 1932, the Great Depres- sion caused the shares of dozens of companies to drop below the value of their cash and other liquid assets, making them “worth more dead than alive.” www.fx1618.com

Commentary on Chapter 8 215 TH I N K FOR YOU R S E LF Would you willingly allow a certifiable lunatic to come by at least five times a week to tell you that you should feel exactly the way he feels? Would you ever agree to be euphoric just because he is—or miserable just because he thinks you should be? Of course not. You’d insist on your right to take control of your own emotional life, based on your experiences and your beliefs. But, when it comes to their financial lives, millions of people let Mr. Market tell them how to feel and what to do—despite the obvious fact that, from time to time, he can get nuttier than a fruitcake. In 1999, when Mr. Market was squealing with delight, American employees directed an average of 8.6% of their paychecks into their 401(k) retirement plans. By 2002, after Mr. Market had spent three years stuffing stocks into black garbage bags, the average contribu- tion rate had dropped by nearly one-quarter, to just 7%.3 The cheaper stocks got, the less eager people became to buy them—because they were imitating Mr. Market, instead of thinking for themselves. The intelligent investor shouldn’t ignore Mr. Market entirely. Instead, you should do business with him—but only to the extent that it serves your interests. Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them. You do not have to trade with him just because he constantly begs you to. By refusing to let Mr. Market be your master, you transform him into your servant. After all, even when he seems to be destroying values, he is creating them elsewhere. In 1999, the Wilshire 5000 index—the broadest measure of U.S. stock performance—gained 23.8%, pow- ered by technology and telecommunications stocks. But 3,743 of the 7,234 stocks in the Wilshire index went down in value even as the average was rising. While those high-tech and telecom stocks were hotter than the hood of a race car on an August afternoon, thousands of “Old Economy” shares were frozen in the mud—getting cheaper and cheaper. The stock of CMGI, an “incubator” or holding company for Internet 3 News release, The Spectrem Group, “Plan Sponsors Are Losing the Battle to Prevent Declining Participation and Deferrals into Defined Contribution Plans,” October 25, 2002. www.fx1618.com

FIGURE 8-1 From Stinkers to Stars www.fx1618.com Company Business 1999 Total Return 2002 Final value 2000 2001 of $1,000 Angelica industrial uniforms –43.7 94.1 invested Ball Corp. metal & plastic packaging –12.7 1.8 19.3 46.0 1/1/1999 Checkers Drive-In Restaurants fast food –45.5 19.2 55.3 2.1 Family Dollar Stores discount retailer –25.1 63.9 66.2 5.0 1,328 International Game Technology gambling equipment –16.3 33.0 41.1 11.2 2,359 J B Hunt Transportation trucking –39.1 136.1 42.3 26.3 1,517 Jos. A. Bank Clothiers apparel –62.5 21.9 38.0 201.6 1,476 Lockheed Martin defense & aerospace –46.9 50.0 57.1 24.7 3,127 Pier 1 Imports home furnishings –33.2 58.0 39.0 10.3 1,294 UST Inc. snuff tobacco –23.5 63.9 70.5 1.0 2,665 21.6 32.2 1,453 2,059 1,241 Wilshire Internet Index 139.1 –55.5 –46.2 –45.0 315 Wilshire 5000 index (total stock market) 23.8 –10.9 –11.0 –20.8 778 Sources: Aronson + Johnson + Ortiz, L.P.; www.wilshire.com

Commentary on Chapter 8 217 start-up firms, went up an astonishing 939.9% in 1999. Meanwhile, Berk- shire Hathaway—the holding company through which Graham’s greatest disciple, Warren Buffett, owns such Old Economy stalwarts as Coca- Cola, Gillette, and the Washington Post Co.—dropped by 24.9%.4 But then, as it so often does, the market had a sudden mood swing. Figure 8-1 offers a sampling of how the stinkers of 1999 be- came the stars of 2000 through 2002. As for those two holding companies, CMGI went on to lose 96% in 2000, another 70.9% in 2001, and still 39.8% more in 2002—a cumulative loss of 99.3%. Berkshire Hathaway went up 26.6% in 2000 and 6.5% in 2001, then had a slight 3.8% loss in 2002—a cumulative gain of 30%. CAN YOU B EAT TH E PR OS AT TH E I R OWN GAM E? One of Graham’s most powerful insights is this: “The investor who permits himself to be stampeded or unduly worried by unjustified mar- ket declines in his holdings is perversely transforming his basic advan- tage into a basic disadvantage.” What does Graham mean by those words “basic advantage”? He means that the intelligent individual investor has the full freedom to choose whether or not to follow Mr. Market. You have the luxury of being able to think for yourself.5 4 A few months later, on March 10, 2000—the very day that NASDAQ hit its all- time high—online trading pundit James J. Cramer wrote that he had “repeat- edly” been tempted in recent days to sell Berkshire Hathaway short, a bet that Buffett’s stock had farther to fall. With a vulgar thrust of his rhetorical pelvis, Cramer even declared that Berkshire’s shares were “ripe for the banging.” That same day, market strategist Ralph Acampora of Prudential Securities asked, “Norfolk Southern or Cisco Systems: Where do you want to be in the future?” Cisco, a key to tomorrow’s Internet superhighway, seemed to have it all over Norfolk Southern, part of yesterday’s railroad system. (Over the next year, Nor- folk Southern gained 35%, while Cisco lost 70%.) 5 When asked what keeps most individual investors from succeeding, Gra- ham had a concise answer: “The primary cause of failure is that they pay too much attention to what the stock market is doing currently.” See “Benjamin Graham: Thoughts on Security Analysis” [transcript of lecture at Northeast Missouri State University Business School, March, 1972], Financial History magazine, no. 42, March, 1991, p. 8. www.fx1618.com

218 Commentary on Chapter 8 The typical money manager, however, has no choice but to mimic Mr. Market’s every move—buying high, selling low, marching almost mind- lessly in his erratic footsteps. Here are some of the handicaps mutual- fund managers and other professional investors are saddled with: • With billions of dollars under management, they must gravitate toward the biggest stocks—the only ones they can buy in the multimillion-dollar quantities they need to fill their portfolios. Thus many funds end up owning the same few overpriced giants. • Investors tend to pour more money into funds as the market rises. The managers use that new cash to buy more of the stocks they already own, driving prices to even more dangerous heights. • If fund investors ask for their money back when the market drops, the managers may need to sell stocks to cash them out. Just as the funds are forced to buy stocks at inflated prices in a rising market, they become forced sellers as stocks get cheap again. • Many portfolio managers get bonuses for beating the market, so they obsessively measure their returns against benchmarks like the S & P 500 index. If a company gets added to an index, hun- dreds of funds compulsively buy it. (If they don’t, and that stock then does well, the managers look foolish; on the other hand, if they buy it and it does poorly, no one will blame them.) • Increasingly, fund managers are expected to specialize. Just as in medicine the general practitioner has given way to the pediatric allergist and the geriatric otolaryngologist, fund managers must buy only “small growth” stocks, or only “mid-sized value” stocks, or nothing but “large blend” stocks.6 If a company gets too big, or too small, or too cheap, or an itty bit too expensive, the fund has to sell it—even if the manager loves the stock. So there’s no reason you can’t do as well as the pros. What you cannot do (despite all the pundits who say you can) is to “beat the pros at their own game.” The pros can’t even win their own game! Why should you want to play it at all? If you follow their rules, you will lose—since you will end up as much a slave to Mr. Market as the pro- fessionals are. 6 Never mind what these terms mean, or are supposed to mean. While in public these classifications are treated with the utmost respect, in private most people in the investment business regard them with the contempt nor- mally reswervwedwfo.rfjxok1es6t1ha8t .acreon’mt funny.

Commentary on Chapter 8 219 Instead, recognize that investing intelligently is about controlling the controllable. You can’t control whether the stocks or funds you buy will outperform the market today, next week, this month, or this year; in the short run, your returns will always be hostage to Mr. Market and his whims. But you can control: • your brokerage costs, by trading rarely, patiently, and cheaply • your ownership costs, by refusing to buy mutual funds with excessive annual expenses • your expectations, by using realism, not fantasy, to forecast your returns7 • your risk, by deciding how much of your total assets to put at hazard in the stock market, by diversifying, and by rebalancing • your tax bills, by holding stocks for at least one year and, when- ever possible, for at least five years, to lower your capital-gains lia- bility • and, most of all, your own behavior. If you listen to financial TV, or read most market columnists, you’d think that investing is some kind of sport, or a war, or a struggle for survival in a hostile wilderness. But investing isn’t about beating oth- ers at their game. It’s about controlling yourself at your own game. The challenge for the intelligent investor is not to find the stocks that will go up the most and down the least, but rather to prevent yourself from being your own worst enemy—from buying high just because Mr. Market says “Buy!” and from selling low just because Mr. Market says “Sell!” If you investment horizon is long—at least 25 or 30 years—there is only one sensible approach: Buy every month, automatically, and whenever else you can spare some money. The single best choice for this lifelong holding is a total stock-market index fund. Sell only when you need the cash (for a psychological boost, clip out and sign your “Investment Owner’s Contract”—which you can find on p. 225). To be an intelligent investor, you must also refuse to judge your financial success by how a bunch of total strangers are doing. You’re not one penny poorer if someone in Dubuque or Dallas or Denver 7 See the brilliant column by Walter Updegrave, “Keep It Real,” Money, Feb- ruary,w20w02w, p.fpx. 5136–5168. .com

220 Commentary on Chapter 8 beats the S & P 500 and you don’t. No one’s gravestone reads “HE BEAT THE MARKET.” I once interviewed a group of retirees in Boca Raton, one of Florida’s wealthiest retirement communities. I asked these people— mostly in their seventies—if they had beaten the market over their investing lifetimes. Some said yes, some said no; most weren’t sure. Then one man said, “Who cares? All I know is, my investments earned enough for me to end up in Boca.” Could there be a more perfect answer? After all, the whole point of investing is not to earn more money than average, but to earn enough money to meet your own needs. The best way to measure your invest- ing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go. In the end, what mat- ters isn’t crossing the finish line before anybody else but just making sure that you do cross it.8 YOU R MON EY AN D YOU R B RAI N Why, then, do investors find Mr. Market so seductive? It turns out that our brains are hardwired to get us into investing trouble; humans are pattern-seeking animals. Psychologists have shown that if you present people with a random sequence—and tell them that it’s unpre- dictable—they will nevertheless insist on trying to guess what’s coming next. Likewise, we “know” that the next roll of the dice will be a seven, that a baseball player is due for a base hit, that the next winning num- ber in the Powerball lottery will definitely be 4-27-9-16-42-10—and that this hot little stock is the next Microsoft. Groundbreaking new research in neuroscience shows that our brains are designed to perceive trends even where they might not exist. After an event occurs just two or three times in a row, regions of the human brain called the anterior cingulate and nucleus accumbens automatically anticipate that it will happen again. If it does repeat, a natural chemical called dopamine is released, flooding your brain with a soft euphoria. Thus, if a stock goes up a few times in a row, you reflexively expect it to keep going—and your brain chemistry changes 8 See Jason Zweig, “Did You Beat the Market?” Money, January, 2000, pp. 55–58. www.fx1618.com

Commentary on Chapter 8 221 as the stock rises, giving you a “natural high.” You effectively become addicted to your own predictions. But when stocks drop, that financial loss fires up your amygdala— the part of the brain that processes fear and anxiety and generates the famous “fight or flight” response that is common to all cornered ani- mals. Just as you can’t keep your heart rate from rising if a fire alarm goes off, just as you can’t avoid flinching if a rattlesnake slithers onto your hiking path, you can’t help feeling fearful when stock prices are plunging.9 In fact, the brilliant psychologists Daniel Kahneman and Amos Tver- sky have shown that the pain of financial loss is more than twice as intense as the pleasure of an equivalent gain. Making $1,000 on a stock feels great—but a $1,000 loss wields an emotional wallop more than twice as powerful. Losing money is so painful that many people, terrified at the prospect of any further loss, sell out near the bottom or refuse to buy more. That helps explain why we fixate on the raw magnitude of a market decline and forget to put the loss in proportion. So, if a TV reporter hollers, “The market is plunging—the Dow is down 100 points! ” most people instinctively shudder. But, at the Dow’s recent level of 8,000, that’s a drop of just 1.2%. Now think how ridiculous it would sound if, on a day when it’s 81 degrees outside, the TV weatherman shrieked, “The temperature is plunging—it’s dropped from 81 degrees to 80 degrees! ” That, too, is a 1.2% drop. When you forget to view chang- ing market prices in percentage terms, it’s all too easy to panic over minor vibrations. (If you have decades of investing ahead of you, there’s a better way to visualize the financial news broadcasts; see the sidebar on p. 222.) In the late 1990s, many people came to feel that they were in the dark unless they checked the prices of their stocks several times a day. But, as Graham puts it, the typical investor “would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judg- 9 The neuroscience of investing is explored in Jason Zweig, “Are You Wired for Wealth?” Money, October, 2002, pp. 74–83, also available at http:// money.cnn.com/2002/09/25/pf/investing/agenda_brain _short/index.htm. See also Jason Zweig, “The Trouble with Humans,” Money, November, 2000, pp. 67–7w0. ww.fx1618.com

222 Commentary on Chapter 8 N EWS YOU COU LD US E Stocks are crashing, so you turn on the television to catch the latest market news. But instead of CNBC or CNN, imagine that you can tune in to the Benjamin Graham Financial Network. On BGFN, the audio doesn’t capture that famous sour clang of the market’s closing bell; the video doesn’t home in on brokers scurrying across the floor of the stock exchange like angry rodents. Nor does BGFN run any footage of investors gasping on frozen sidewalks as red arrows whiz overhead on electronic stock tickers. Instead, the image that fills your TV screen is the facade of the New York Stock Exchange, festooned with a huge banner reading: “SALE! 50% OFF!” As intro music, Bachman-Turner Overdrive can be heard blaring a few bars of their old barn- burner, “You Ain’t Seen Nothin’ Yet.” Then the anchorman announces brightly, “Stocks became more attractive yet again today, as the Dow dropped another 2.5% on heavy volume—the fourth day in a row that stocks have gotten cheaper. Tech investors fared even better, as leading companies like Microsoft lost nearly 5% on the day, making them even more affordable. That comes on top of the good news of the past year, in which stocks have already lost 50%, putting them at bargain levels not seen in years. And some prominent analysts are optimistic that prices may drop still further in the weeks and months to come.” The newscast cuts over to market strategist Ignatz Anderson of the Wall Street firm of Ketchum & Skinner, who says, “My forecast is for stocks to lose another 15% by June. I’m cau- tiously optimistic that if everything goes well, stocks could lose 25%, maybe more.” “Let’s hope Ignatz Anderson is right,” the anchor says cheer- ily. “Falling stock prices would be fabulous news for any investor with a very long horizon. And now over to Wally Wood for our exclusive AccuWeather forecast.” www.fx1618.com

Commentary on Chapter 8 223 ment.” If, after checking the value of your stock portfolio at 1:24 P.M., you feel compelled to check it all over again at 1:37 P.M., ask yourself these questions: • Did I call a real-estate agent to check the market price of my house at 1:24 P.M.? Did I call back at 1:37 P.M.? • If I had, would the price have changed? If it did, would I have rushed to sell my house? • By not checking, or even knowing, the market price of my house from minute to minute, do I prevent its value from rising over time?10 The only possible answer to these questions is of course not! And you should view your portfolio the same way. Over a 10- or 20- or 30- year investment horizon, Mr. Market’s daily dipsy-doodles simply do not matter. In any case, for anyone who will be investing for years to come, falling stock prices are good news, not bad, since they enable you to buy more for less money. The longer and further stocks fall, and the more steadily you keep buying as they drop, the more money you will make in the end—if you remain steadfast until the end. Instead of fear- ing a bear market, you should embrace it. The intelligent investor should be perfectly comfortable owning a stock or mutual fund even if the stock market stopped supplying daily prices for the next 10 years.11 Paradoxically, “you will be much more in control,” explains neurosci- entist Antonio Damasio, “if you realize how much you are not in con- trol.” By acknowledging your biological tendency to buy high and sell low, you can admit the need to dollar-cost average, rebalance, and sign an investment contract. By putting much of your portfolio on per- manent autopilot, you can fight the prediction addiction, focus on your long-term financial goals, and tune out Mr. Market’s mood swings. 10 It’s also worth asking whether you could enjoy living in your house if its market price was reported to the last penny every day in the newspapers and on TV. 11 In a series of remarkable experiments in the late 1980s, a psychologist at Columbia and Harvard, Paul Andreassen, showed that investors who received frequent news updates on their stocks earned half the returns of investors who got no news at all. See Jason Zweig, “Here’s How to Use the News and Tune Out the Noise,” Money, July, 1998, pp. 63–64. www.fx1618.com

224 Commentary on Chapter 8 WH E N M R. MAR KET G IVE S YOU LE MON S, MAKE LEMONADE Although Graham teaches that you should buy when Mr. Market is yelling “sell,” there’s one exception the intelligent investor needs to understand. Selling into a bear market can make sense if it creates a tax windfall. The U.S. Internal Revenue Code allows you to use your realized losses (any declines in value that you lock in by selling your shares) to offset up to $3,000 in ordinary income.12 Let’s say you bought 200 shares of Coca-Cola stock in January 2000 for $60 a share—a total investment of $12,000. By year-end 2002, the stock was down to $44 a share, or $8,800 for your lot—a loss of $3,200. You could have done what most people do—either whine about your loss, or sweep it under the rug and pretend it never happened. Or you could have taken control. Before 2002 ended, you could have sold all your Coke shares, locking in the $3,200 loss. Then, after wait- ing 31 days to comply with IRS rules, you would buy 200 shares of Coke all over again. The result: You would be able to reduce your tax- able income by $3,000 in 2002, and you could use the remaining $200 loss to offset your income in 2003. And better yet, you would still own a company whose future you believe in—but now you would own it for almost one-third less than you paid the first time.13 With Uncle Sam subsidizing your losses, it can make sense to sell and lock in a loss. If Uncle Sam wants to make Mr. Market look logical by comparison, who are we to complain? 12 Federal tax law is subject to constant change. The example of Coca-Cola stock given here is valid under the provisions of the U.S. tax code as it stood in early 2003. 13 This example assumes that the investor had no realized capital gains in 2002 and did not reinvest any Coke dividends. Tax swaps are not to be undertaken lightly, since they can be mishandled easily. Before doing a tax swap, read IRS Publication 550 (www.irs.gov/pub/irspdf/p550.pdf). A good guide to managing your investment taxes is Robert N. Gordon with Jan M. Rosen, Wall Street Secrets for Tax-Efficient Investing (Bloomberg Press, Princeton, New Jersey, 2001). Finally, before you pull the trigger, con- sult a prowfewssiwona.fl xta1x a6d1vis8e.r.com

INVESTMENT OWNER’S CONTRACT I, _____________ ___________________, hereby state that I am an investor who is seeking to accumulate wealth for many years into the future. I know that there will be many times when I will be tempted to invest in stocks or bonds because they have gone (or “are going”) up in price, and other times when I will be tempted to sell my investments because they have gone (or “are going”) down. I hereby declare my refusal to let a herd of strangers make my financial decisions for me. I further make a solemn commitment never to invest because the stock market has gone up, and never to sell because it has gone down. Instead, I will invest $______.00 per month, every month, through an automatic investment plan or “dollar-cost averaging program,” into the following mutual fund(s) or diversified portfolio(s): _________________________________, _________________________________, _________________________________. I will also invest additional amounts whenever I can afford to spare the cash (and can afford to lose it in the short run). I hereby declare that I will hold each of these investments continually through at least the following date (which must be a minimum of 10 years after the date of this contact): _________________ _____, 20__. The only exceptions allowed under the terms of this contract are a sudden, pressing need for cash, like a health-care emergency or the loss of my job, or a planned expenditure like a housing down payment or a tuition bill. I am, by signing below, stating my intention not only to abide by the terms of this contract, but to re-read this document whenever I am tempted to sell any of my investments. This contract is valid only when signed by at least one witness, and must be kept in a safe place that is easily accessible for future reference. Signed: Date: _____________ ___________________ _______________ ____, 20__ Witnesses: _____________ ___________________ _____________ ___________________ www.fx1618.com

CHAPTER 9 Investing in Investment Funds One course open to the defensive investor is to put his money into investment-company shares. Those that are redeemable on demand by the holder, at net asset value, are commonly known as “mutual funds” (or “open-end funds”). Most of these are actively selling additional shares through a corps of salesmen. Those with nonredeemable shares are called “closed-end” companies or funds; the number of their shares remains relatively constant. All of the funds of any importance are registered with the Securities & Exchange Commission (SEC), and are subject to its regulations and controls.* The industry is a very large one. At the end of 1970 there were 383 funds registered with the SEC, having assets totaling $54.6 bil- lions. Of these 356 companies, with $50.6 billions, were mutual funds, and 27 companies with $4.0 billions, were closed-end.† There are different ways of classifying the funds. One is by the broad division of their portfolio; they are “balanced funds” if they have a significant (generally about one-third) component of bonds, or “stock-funds” if their holdings are nearly all common stocks. (There are some other varieties here, such as “bond funds,” “hedge * It is a violation of Federal law for an open-end mutual fund, a closed-end fund, or an exchange-traded fund to sell shares to the public unless it has “registered” (or made mandatory financial filings) with the SEC. † The fund industry has gone from “very large” to immense. At year-end 2002, there were 8,279 mutual funds holding $6.56 trillion; 514 closed-end funds with $149.6 billion in assets; and 116 exchange-trade funds or ETFs with $109.7 billion. These figures exclude such fund-like investments as variable annuities and unit investment trusts. www.fx1618.com 226

Investing in Investment Funds 227 funds,” “letter-stock funds,” etc.)* Another is by their objectives, as their primary aim is for income, price stability, or capital apprecia- tion (“growth”). Another distinction is by their method of sale. “Load funds” add a selling charge (generally about 9% of asset value on minimum purchases) to the value before charge.1 Others, known as “no-load” funds, make no such charge; the manage- ments are content with the usual investment-counsel fees for han- dling the capital. Since they cannot pay salesmen’s commissions, the size of the no-load funds tends to be on the low side.† The buy- ing and selling prices of the closed-end funds are not fixed by the companies, but fluctuate in the open market as does the ordinary corporate stock. Most of the companies operate under special provisions of the income-tax law, designed to relieve the shareholders from double taxation on their earnings. In effect, the funds must pay out vir- tually all their ordinary income—i.e., dividends and interest received, less expenses. In addition they can pay out their realized long-term profits on sales of investments—in the form of “capital- gains dividends”—which are treated by the shareholder as if they were his own security profits. (There is another option here, which we omit to avoid clutter.)‡ Nearly all the funds have but one class * Lists of the major types of mutual funds can be found at www.ici.org/ pdf/g2understanding.pdf and http://news.morningstar.com/fundReturns/ CategoryReturns.html. Letter-stock funds no longer exist, while hedge funds are generally banned by SEC rules from selling shares to any investor whose annual income is below $200,000 or whose net worth is below $1 million. † Today, the maximum sales load on a stock fund tends to be around 5.75%. If you invest $10,000 in a fund with a flat 5.75% sales load, $575 will go to the person (and brokerage firm) that sold it to you, leaving you with an initial net investment of $9,425. The $575 sales charge is actually 6.1% of that amount, which is why Graham calls the standard way of calculating the charge a “sales gimmick.” Since the 1980s, no-load funds have become popular, and they no longer tend to be smaller than load funds. ‡ Nearly every mutual fund today is taxed as a “regulated investment company,” or RIC, which is exempt from corporate income tax so long as it pays out essentially all of its income to its shareholders. In the “option” that www.fx1618.com

228 The Intelligent Investor of security outstanding. A new wrinkle, introduced in 1967, divides the capitalization into a preferred issue, which will receive all the ordinary income, and a capital issue, or common stock, which will receive all the profits on security sales. (These are called “dual- purpose funds.”)* Many of the companies that state their primary aim is for capital gains concentrate on the purchase of the so-called “growth stocks,” and they often have the word “growth” in their name. Some spe- cialize in a designated area such as chemicals, aviation, overseas investments; this is usually indicated in their titles. The investor who wants to make an intelligent commitment in fund shares has thus a large and somewhat bewildering variety of choices before him—not too different from those offered in direct investment. In this chapter we shall deal with some major ques- tions, viz: 1. Is there any way by which the investor can assure himself of better than average results by choosing the right funds? (Subques- tion: What about the “performance funds”?)† 2. If not, how can he avoid choosing funds that will give him worse than average results? 3. Can he make intelligent choices between different types of funds—e.g., balanced versus all-stock, open-end versus closed- end, load versus no-load? Graham omits “to avoid clutter,” a fund can ask the SEC for special permis- sion to distribute one of its holdings directly to the fund’s shareholders—as his Graham-Newman Corp. did in 1948, parceling out shares in GEICO to Graham-Newman’s own investors. This sort of distribution is extraordinarily rare. * Dual-purpose funds, popular in the late 1980s, have essentially disap- peared from the marketplace—a shame, since they offered investors a more flexible way to take advantage of the skills of great stock pickers like John Neff. Perhaps the recent bear market will lead to a renaissance of this attractive investment vehicle. † “Performance funds” were all the rage in the late 1960s. They were equiv- alent to the aggressive growth funds of the late 1990s, and served their investors no better. www.fx1618.com

Investing in Investment Funds 229 Investment-Fund Performance as a Whole Before trying to answer these questions we should say some- thing about the performance of the fund industry as a whole. Has it done a good job for its shareholders? In the most general way, how have fund investors fared as against those who made their investments directly? We are quite certain that the funds in the aggregate have served a useful purpose. They have promoted good habits of savings and investment; they have protected count- less individuals against costly mistakes in the stock market; they have brought their participants income and profits commensurate with the overall returns from common stocks. On a comparative basis we would hazard the guess that the average individual who put his money exclusively in investment-fund shares in the past ten years has fared better than the average person who made his common-stock purchases directly. The last point is probably true even though the actual perfor- mance of the funds seems to have been no better than that of com- mon stocks as a whole, and even though the cost of investing in mutual funds may have been greater than that of direct purchases. The real choice of the average individual has not been between constructing and acquiring a well-balanced common-stock portfo- lio or doing the same thing, a bit more expensively, by buying into the funds. More likely his choice has been between succumbing to the wiles of the doorbell-ringing mutual-fund salesman on the one hand, as against succumbing to the even wilier and much more dangerous peddlers of second- and third-rate new offerings. We cannot help thinking, too, that the average individual who opens a brokerage account with the idea of making conservative common- stock investments is likely to find himself beset by untoward influ- ences in the direction of speculation and speculative losses; these temptations should be much less for the mutual-fund buyer. But how have the investment funds performed as against the general market? This is a somewhat controversial subject, but we shall try to deal with it in simple but adequate fashion. Table 9-1 gives some calculated results for 1961–1970 of our ten largest stock funds at the end of 1970, but choosing only the largest one from each management group. It summarizes the overall return of each of these funds for 1961–1965, 1966–1970, and for the single years www.fx1618.com

TABLE 9-1 Management Results of Ten Large Mutual Fundsa www.fx1618.com (Indicated) 5 years, 10 years, 1969 1970 Net Assets, 5 years, 1966–1970 1961–1970 December –14.3% +2.2% 1961–1965 (all +) –11.9 –6.4 1970 (all +) –7.4 +2.2 (millions) –12.7 –5.8 Affiliated Fund 71% +19.7% 105.3% –10.6 +2.3 $1,600 Dreyfus 97 +18.7 135.4 –80.0 –7.2 2,232 Fidelity Fund 79 +31.8 137.1 – 4.0 +0.6 Fundamental Inv. 79 + 1.0 + 4.0 –9.1 819 Invest. Co. of Am. 82 +37.9 81.3 –13.3 –3.8 1,054 Investors Stock Fund 54 + 5.6 152.2 –10.3 –2.9 1,168 Mass. Inv. Trust 18 +16.2 2,227 National Investors 61 +31.7 63.5 – 8.9 –2.2 1,956 Putnam Growth 62 +22.3 44.2 United Accum. 74 – 2.0 112.2 – 8.3 +3.5 747 104.0 –11.6 +8.7 684 Average 72 18.3 72.7 1,141 Standard & Poor’s 77 +16.1 105.8 $13,628 (total) composite index 78 + 2.9 DJIA 104.7 83.0 a These are the stock funds with the largest net assets at the end of 1970, but using only one fund from each management group. Data supplied by Wiesenberger Financial Services.

Investing in Investment Funds 231 1969 and 1970. We also give average results based on the sum of one share of each of the ten funds. These companies had combined assets of over $15 billion at the end of 1969, or about one-third of all the common-stock funds. Thus they should be fairly representative of the industry as a whole. (In theory, there should be a bias in this list on the side of better than industry performance, since these bet- ter companies should have been entitled to more rapid expansion than the others; but this may not be the case in practice.) Some interesting facts can be gathered from this table. First, we find that the overall results of these ten funds for 1961–1970 were not appreciably different from those of the Standard & Poor’s 500- stock composite average (or the S & P 425-industrial stock aver- age). But they were definitely better than those of the DJIA. (This raises the intriguing question as to why the 30 giants in the DJIA did worse than the much more numerous and apparently rather miscellaneous list used by Standard & Poor’s.)* A second point is that the funds’ aggregate performance as against the S & P index has improved somewhat in the last five years, compared with the preceding five. The funds’ gain ran a little lower than S & P’s in 1961–1965 and a little higher than S & P’s in 1966–1970. The third point is that a wide difference exists between the results of the indi- vidual funds. We do not think the mutual-fund industry can be criticized for doing no better than the market as a whole. Their managers and their professional competitors administer so large a portion of all marketable common stocks that what happens to the market as a whole must necessarily happen (approximately) to the sum of their funds. (Note that the trust assets of insured commercial banks included $181 billion of common stocks at the end of 1969; if we add to this the common stocks in accounts handled by investment advisers, plus the $56 billion of mutual and similar funds, we must conclude that the combined decisions of these professionals pretty well determine the movements of the stock averages, and that the * For periods as long as 10 years, the returns of the Dow and the S & P 500 can diverge by fairly wide margins. Over the course of the typical investing lifetime, however—say 25 to 50 years—their returns have tended to converge quite closely. www.fx1618.com

232 The Intelligent Investor movement of the stock averages pretty well determines the funds’ aggregate results.) Are there better than average funds and can the investor select these so as to obtain superior results for himself? Obviously all investors could not do this, since in that case we would soon be back where we started, with no one doing better than anyone else. Let us consider the question first in a simplified fashion. Why shouldn’t the investor find out what fund has made the best show- ing of the lot over a period of sufficient years in the past, assume from this that its management is the most capable and will there- fore do better than average in the future, and put his money in that fund? This idea appears the more practicable because, in the case of the mutual funds, he could obtain this “most capable manage- ment” without paying any special premium for it as against the other funds. (By contrast, among noninvestment corporations the best-managed companies sell at correspondingly high prices in relation to their current earnings and assets.) The evidence on this point has been conflicting over the years. But our Table 9-1 covering the ten largest funds indicates that the results shown by the top five performers of 1961–1965 carried over on the whole through 1966–1970, even though two of this set did not do as well as two of the other five. Our studies indicate that the investor in mutual-fund shares may properly consider compara- tive performance over a period of years in the past, say at least five, provided the data do not represent a large net upward movement of the market as a whole. In the latter case spectacularly favorable results may be achieved in unorthodox ways—as will be demon- strated in our following section on “performance” funds. Such results in themselves may indicate only that the fund managers are taking undue speculative risks, and getting away with same for the time being. “Performance” Funds One of the new phenomena of recent years was the appearance of the cult of “performance” in the management of investment funds (and even of many trust funds). We must start this section with the important disclaimer that it does not apply to the large majority of well-established funds, but only to a relatively small www.fx1618.com

Investing in Investment Funds 233 section of the industry which has attracted a disproportionate amount of attention. The story is simple enough. Some of those in charge set out to get much better than average (or DJIA) results. They succeeded in doing this for a while, garnering considerable publicity and additional funds to manage. The aim was legitimate enough; unfortunately, it appears that, in the context of investing really sizable funds, the aim cannot be accomplished without incurring sizable risks. And in a comparatively short time the risks came home to roost. Several of the circumstances surrounding the “performance” phenomenon caused ominous headshaking by those of us whose experience went far back—even to the 1920s—and whose views, for that very reason, were considered old-fashioned and irrelevant to this (second) “New Era.” In the first place, and on this very point, nearly all these brilliant performers were young men—in their thirties and forties—whose direct financial experience was limited to the all but continuous bull market of 1948–1968. Sec- ondly, they often acted as if the definition of a “sound investment” was a stock that was likely to have a good rise in the market in the next few months. This led to large commitments in newer ventures at prices completely disproportionate to their assets or recorded earnings. They could be “justified” only by a combination of naïve hope in the future accomplishments of these enterprises with an apparent shrewdness in exploiting the speculative enthusiasms of the uninformed and greedy public. This section will not mention people’s names. But we have every reason to give concrete examples of companies. The “perfor- mance fund” most in the public’s eye was undoubtedly Manhattan Fund, Inc., organized at the end of 1965. Its first offering was of 27 million shares at $9.25 to $10 per share. The company started out with $247 million of capital. Its emphasis was, of course, on capital gains. Most of its funds were invested in issues selling at high mul- tipliers of current earnings, paying no dividends (or very small ones), with a large speculative following and spectacular price movements. The fund showed an overall gain of 38.6% in 1967, against 11% for the S & P composite index. But thereafter its perfor- mance left much to be desired, as is shown in Table 9-2. www.fx1618.com

234 The Intelligent Investor TABLE 9-2 A Performance-Fund Portfolio and Performance (Larger Holdings of Manhattan Fund, December 31, 1969) Shares Issue Price Earned Dividend Market Held 1969 1969 Value (thousands) (millions) 60 Teleprompter 99 $ .99 none $ 6.0 190 Deltona 601⁄2 2.32 none 11.5 280 Fedders 34 1.28 $ .35 9.5 105 Horizon Corp. 531⁄2 2.68 none 5.6 150 Rouse Co. 34 none 5.1 130 Mattel Inc. 641⁄4 .07 8.4 120 Polaroid 125 1.11 .20 15.0 244a Nat’l Student Mkt’g 281⁄2 1.90 .32 6.1 56 Telex Corp. 901⁄2 .32 none 5.0 100 Bausch & Lomb 773⁄4 .68 none 7.8 190 Four Seasons Nursing 66 1.92 .80 12.3b 20 Int. Bus. Machines 365 none 7.3 41.5 Nat’l Cash Register 160 .80 3.60 6.7 100 Saxon Ind. 109 8.21 1.20 10.9 105 Career Academy 50 1.95 none 5.3 285 King Resources 28 3.81 none 8.1 .43 none .69 $130.6 Other common stocks 93.8 Other holdings 19.6 Total investmentsc $244.0 a After 2-for-1 split. b Also $1.1 million of affiliated stocks. c Excluding cash equivalents. Annual Performance Compared with S & P Composite Index 1966 1967 1968 1969 1970 1971 Manhattan Fund – 6 % +38.6% – 7.3% –13.3% –36.9% + 9.6% S & P Composite –10.1% +23.0% +10.4% – 8.3% + 3.5% +13.5% www.fx1618.com

Investing in Investment Funds 235 The portfolio of Manhattan Fund at the end of 1969 was unorthodox to say the least. It is an extraordinary fact that two of its largest investments were in companies that filed for bankruptcy within six months thereafter, and a third faced creditors’ actions in 1971. It is another extraordinary fact that shares of at least one of these doomed companies were bought not only by investment funds but by university endowment funds, the trust departments of large banking institutions, and the like.* A third extraordinary fact was that the founder-manager of Manhattan Fund sold his stock in a separately organized management company to another large concern for over $20 million in its stock; at that time the man- agement company sold had less than $1 million in assets. This is undoubtedly one of the greatest disparities of all times between the results for the “manager” and the “managees.” A book published at the end of 19692 provided profiles of nine- teen men “who are tops at the demanding game of managing bil- lions of dollars of other people’s money.” The summary told us further that “they are young . . . some earn more than a million dol- lars a year . . . they are a new financial breed . . . they all have a total fascination with the market . . . and a spectacular knack for coming up with winners.” A fairly good idea of the accomplish- ments of this top group can be obtained by examining the pub- lished results of the funds they manage. Such results are available for funds directed by twelve of the nineteen persons described in The Money Managers. Typically enough, they showed up well in 1966, and brilliantly in 1967. In 1968 their performance was still good in the aggregate, but mixed as to individual funds. In 1969 they all showed losses, with only one managing to do a bit better than the S & P composite index. In 1970 their comparative perfor- mance was even worse than in 1969. * One of the “doomed companies” Graham refers to was National Student Marketing Corp., a con game masquerading as a stock, whose saga was told brilliantly in Andrew Tobias’s The Funny Money Game (Playboy Press, New York, 1971). Among the supposedly sophisticated investors who were snookered by NSM’s charismatic founder, Cort Randell, were the endow- ment funds of Cornell and Harvard and the trust departments at such presti- gious banks as Morgan Guaranty and Bankers Trust. www.fx1618.com

236 The Intelligent Investor We have presented this picture in order to point a moral, which perhaps can best be expressed by the old French proverb: Plus ça change, plus c’est la même chose. Bright, energetic people—usually quite young—have promised to perform miracles with “other people’s money” since time immemorial. They have usually been able to do it for a while—or at least to appear to have done it—and they have inevitably brought losses to their public in the end.* About a half century ago the “miracles” were often accompanied by flagrant manipulation, misleading corporate reporting, outra- geous capitalization structures, and other semifraudulent financial practices. All this brought on an elaborate system of financial con- trols by the SEC, as well as a cautious attitude toward common stocks on the part of the general public. The operations of the new “money managers” in 1965–1969 came a little more than one full generation after the shenanigans of 1926–1929.† The specific mal- practices banned after the 1929 crash were no longer resorted to— they involved the risk of jail sentences. But in many corners of Wall Street they were replaced by newer gadgets and gimmicks that produced very similar results in the end. Outright manipulation of prices disappeared, but there were many other methods of draw- ing the gullible public’s attention to the profit possibilities in “hot” issues. Blocks of “letter stock”3 could be bought well below the quoted market price, subject to undisclosed restrictions on their sale; they could immediately be carried in the reports at their full market value, showing a lovely and illusory profit. And so on. It is * As only the latest proof that “the more things change, the more they stay the same,” consider that Ryan Jacob, a 29-year-old boy wonder, launched the Jacob Internet Fund at year-end 1999, after producing a 216% return at his previous dot-com fund. Investors poured nearly $300 million into Jacob’s fund in the first few weeks of 2000. It then proceeded to lose 79.1% in 2000, 56.4% in 2001, and 13% in 2002—a cumulative collapse of 92%. That loss may have made Mr. Jacob’s investors even older and wiser than it made him. † Intriguingly, the disastrous boom and bust of 1999–2002 also came roughly 35 years after the previous cycle of insanity. Perhaps it takes about 35 years for the investors who remember the last “New Economy” craze to become less influential than those who do not. If this intuition is correct, the intelligenwt inwvewsto.rfxsh1ou6ld1b8e.pcaortimcularly vigilant around the year 2030.