In general, the greater dispersion of public information today puts a pre- mium on information that is exclusive. The most likely source of exclu- sive information (apologies to Schloss) is the telephone. Some mutual funds employ former journalists to ferret out investing “scoops.” They call former employees for a candid appraisal of management; they talk to suppliers and competitors. One mutual fund discovered that a just- named CEO of a prominent financial company had confessed to an asso- ciate that he was nervous about taking the job because he couldn’t read financial statements. The fund, which had been looking at the stock, immediately lost interest. Though not everyone has the resources to hire a private sleuth, some research is eminently affordable. An enterprising stockbroker kept tabs on one of his stocks, Jones Soda, by chatting up baristas at Starbucks, one of the outlets where Jones was sold. When they told him that Starbucks was dropping the brand, he sold the stock pronto. Also, there is a certain kind of conviction that can be gleaned only from hearing management answer unscripted questions. Be fore- warned, though; some executives will lie.
Graham was particularly mistrustful of executives (he did not like to visit managements for this reason). He and Dodd warned that “objective
tests of managerial ability are few.” Just as it is difficult to apportion proper credit to a winning coach, it is hard to say how much of a com- pany’s success is attributable to the executives. Investors often ascribe to managerial prowess what could be the residue of favorable conditions (or simply of good luck). Coca-Cola’s earnings were rising sharply in the early and mid-1990s, and the company’s aggressively promotional CEO, Roberto Goizueta, was feted on the cover of Fortune. Goizueta was tal- ented, but his talent was fully reflected in Coca-Cola’s earnings, and the earnings were reflected in the price of the stock. Investors, however, went a further step, pushing the stock to a lofty 45 times earnings due to their faith in management to increase earnings. Graham and Dodd referred to this as “double-counting”—that is, investors buy the stock on the basis of their faith in management and then, seeing that the stock has risen, take it as additional proof of management’s powers and bid the stock up further. In 1997, an analyst at Oppenheimer was so smitten by Goizueta, who died later that year, that he wrote that Coca-Cola had “absolute control over near-term results.”5
Such faith was misplaced on three accounts. First, Goizueta’s talent was already factored into the stock. Second, the notion that manage- ment had “absolute control” was a myth, as was demonstrated when growth tapered off. Third, to the extent it did have control, it was by “managing” Coca-Cola’s earnings, with the aid of dubious accounting contrivances. For instance, Coca-Cola made a practice of selling stakes in bottling plants and booking the gains into operating earnings to make its numbers. The suggestion that Goizueta was a magically talented guru was a warning signal. Rather than prove that Goizueta had the power to levitate earnings in the future, it raised questions about the quality of
Roger Lowenstein [59]
5Roger Lowenstein, Origins of the Crash: The Great Bubble and Its Undoing(New York: Penguin Press, 2004), p. 70.
the earnings he had achieved in the past. As reality caught up with Coca-Cola, the stock went into a decadelong funk.
Such examples should demonstrate that investing is hardly less risky today than in Graham and Dodd’s era, nor is the human spirit less vul- nerable to temptation and error. The complexity of our markets has fur- ther enhanced the need for an investing guide that is straightforward, logical, detailed, and, most especially, prudent. This and no more was the authors’ brief. Herewith Part I—a primer on intrinsic value, an explo- ration of investment as distinct from speculation, and an introduction to Graham and Dodd’s approach, their philosophy, their stratagems and guidance, and their tools.
Chapter 1
THE
SCOPE AND
LIMITATIONS OF
SECURITY
ANALYSIS. THE
CONCEPT
OF
INTRINSIC
VALUE
ANALYSIS CONNOTESthe careful study of available facts with the attempt
to draw conclusions therefrom based on established principles and sound logic. It is part of the scientific method. But in applying analysis to the field of securities we encounter the serious obstacle that investment is by nature not an exact science. The same is true, however, of law and medicine, for here also both individual skill (art) and chance are impor- tant factors in determining success or failure. Nevertheless, in these pro- fessions analysis is not only useful but indispensable, so that the same should probably be true in the field of investment and possibly in that of speculation.
In the last three decades the prestige of security analysis in Wall Street has experienced both a brilliant rise and an ignominious fall—a history related but by no means parallel to the course of stock prices. The advance of security analysis proceeded uninterruptedly until about 1927, cover- ing a long period in which increasing attention was paid on all sides to financial reports and statistical data. But the “new era” commencing in 1927 involved at bottom the abandonment of the analytical approach; and while emphasis was still seemingly placed on facts and figures, these were manipulated by a sort of pseudo-analysis to support the delusions of the period. The market collapse in October 1929 was no surprise to such ana- lysts as had kept their heads, but the extent of the business collapse which later developed, with its devastating effects on established earning power, again threw their calculations out of gear. Hence the ultimate result was that serious analysis suffered a double discrediting: the first—prior to the crash—due to the persistence of imaginary values, and the second—after the crash—due to the disappearance of real values.
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The experiences of 1927–1933 were of so extraordinary a character that they scarcely provide a valid criterion for judging the usefulness of security analysis. As to the years since 1933, there is perhaps room for a difference of opinion. In the field of bonds and preferred stocks, we believe that sound principles of selection and rejection have justified themselves quite well. In the common-stock arena the partialities of the market have tended to confound the conservative viewpoint, and con- versely many issues appearing cheap under analysis have given a disap- pointing performance. On the other hand, the analytical approach would have given strong grounds for believing representative stock prices to be too high in early 1937 and too low a year later.