“Margin of Safety” as the Central Concept of Investment

“Margin of Safety” 

 the Central Concept of Investment

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.”* Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF
SAFETY. This is the thread that runs through all the preceding discussion of investment policy—often explicitly, sometimes in a less direct fashion. Let us try now, briefly, to trace that idea in a connected argument.
   All experienced investors recognize that the margin-of-safety concept is essential to the choice of sound bonds and preferred stocks. For example, a railroad should have earned its total fixed charges better than five times (before income tax), taking a period of years, for its bonds to qualify as investment-grade issues. This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income. (The margin above charges may be stated in other ways—

* “It is said an Eastern monarch once charged his wise men to invent him a sentence, to be ever in view, and which should be true and appropriate in all times and situations. They presented him the words: ‘ And this, too, shall pass away. ’ How much it expresses! How chastening in the hour of pride!—how consoling in the depths of affliction! ‘And this, too, shall pass away.’ And yet let us hope it is not quite true.”—Abraham Lincoln, Address to the Wis-consin State Agricultural Society, Milwaukee, September 30, 1859, in Abraham Lincoln: Speeches and Writings, 1859–1865 (Library of America, 1985), vol. II, p. 101.

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for example, in the percentage by which revenues or profits may decline before the balance after interest disappears—but the underlying idea remains the same.)
   The bond investor does not expect future average earnings to work out the same as in the past; if he were sure of that, the margin demanded might be small. Nor does he rely to any controlling extent on his judgment as to whether future earnings will be materially better or poorer than in the past, if he did that, he would have to measure his margin in terms of a carefully projected income account, instead of emphasizing the margin shown in the past record. Here the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.
The margin of safety for bonds may be calculated, alternatively, by comparing the total value of the enterprise with the amount of debt. (A similar calculation may be made for a preferred-stock issue.) If the business owes $10 million and is fairly worth $30 million, there is room for a shrinkage of two-thirds in value—at least theoretically—before the bondholders will suffer loss. The amount of this extra value, or “cushion,” above the debt may be approximated by using the average market price of the junior stock issues over a period of years. Since average stock prices are generally related to average earning power, the margin of “enterprise value” over debt and the margin of earnings over charges will in most cases yield similar results.
   So much for the margin-of-safety concept as applied to “fixed-value investments.” Can it be carried over into the field of common stocks? Yes, but with some necessary modifications.
   There are instances where a common stock may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only common stock that under depression conditions is selling for less than the amount of bonds that could safely be issued against its property and earning power.* That was the position of a

* “Earning power” is Graham’s term for a company’s potential profits or, as he puts it, the amount that a firm “might be expected to earn year after year

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host of strongly financed industrial companies at the low price levels of 1932–33. In such instances the investor can obtain the margin of safety associated with a bond, plus all the chances of larger income and principal appreciation inherent in a common stock. (The only thing he lacks is the legal power to insist on dividend payments “or else”—but this is a small drawback as compared with his advantages.) Common stocks bought under such circumstances will supply an ideal, though infrequent, combination of safety and profit opportunity. As a quite recent example of this condition, let us mention once more National Presto Industries stock, which sold for a total enterprise value of $43 million in 1972. With its $16 millions of recent earnings before taxes the company could easily have supported this amount of bonds.
   In the ordinary common stock, bought for investment under normal conditions, the margin of safety lies in an expected earning power considerably above the going rate for bonds. In former editions we elucidated this point with the following figures:

    Assume in a typical case that the earning power is 9% on the price and that the bond rate is 4%; then the stockbuyer will have an average annual margin of 5% accruing in his favor. Some of the excess is paid to him in the dividend rate; even though spent by him, it enters into his overall investment result. The undistributed balance is reinvested in the business for his account. In many cases such reinvested earnings fail to add commensurately to the earning power and value of his stock. (That is why the market has a stubborn habit of valuing earnings disbursed in dividends more generously than the portion retained in the business.)* But, if the picture is viewed as a whole, there is a reasonably close connection

 if the business conditions prevailing during the period were to continue unchanged” ( Security Analysis, 1934 ed., p. 354). Some of his lectures make it clear that Graham intended the term to cover periods of five years or more. You can crudely but conveniently approximate a company’s earning power per share by taking the inverse of its price/earnings ratio; a stock with a P/E ratio of 11 can be said to have earning power of 9% (or 1 divided by 11). Today “earning power” is often called “earnings yield.”
* This problem is discussed extensively in the commentary on Chapter 19.

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between the growth of corporate surpluses through reinvested earnings and the growth of corporate values.
   Over a ten-year period the typical excess of stock earning power over bond interest may aggregate 50% of the price paid. This figure is sufficient to provide a very real margin of safety—which, under favorable conditions, will prevent or minimize a loss. If such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favorable result under “fairly normal conditions” becomes very large. That is why the policy of investing in representative common stocks does not require high qualities of insight and foresight to work out successfully. If the purchases are made at the average level of the market over a span of years, the prices paid should carry with them assurance of an adequate margin of safety. The danger to investors lies in concentrating their purchases in the upper levels of the market, or in buying nonrepresentative common stocks that carry more than average risk of diminished earning power.
   As we see it, the whole problem of common-stock investment under 1972 conditions lies in the fact that “in a typical case” the earning power is now much less than 9% on the price paid.* Let us assume that by concentrating somewhat on the low-multiplier issues among the large companies a defensive investor may now

* Graham elegantly summarized the discussion that follows in a lecture he gave in 1972: “The margin of safety is the difference between the percentage rate of the earnings on the stock at the price you pay for it and the rate of interest on bonds, and that margin of safety is the difference which would absorb unsatisfactory developments. At the time the 1965 edition ofThe Intelligent Investor was written the typical stock was selling at 11 times earnings, giving about 9% return as against 4% on bonds. In that case you had a margin of safety of over 100 per cent. Now [in 1972] there is no difference between the earnings rate on stocks and the interest rate on stocks, and I say there is no margin of safety . . . you have a negative margin of safety on stocks . . .” See “Benjamin Graham: Thoughts on Security Analysis” [transcript of lecture at the Northeast Missouri State University business school, March, 1972], Financial History, no. 42, March, 1991, p. 9.

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acquire equities at 12 times recent earnings—i.e., with an earnings return of 8.33% on cost. He may obtain a dividend yield of about 4%, and he will have 4.33% of his cost reinvested in the business for his account. On this basis, the excess of stock earning power over bond interest over a ten-year basis would still be too small to constitute an adequate margin of safety. For that reason we feel that there are real risks now even in a diversified list of sound common stocks. The risks may be fully offset by the profit possibilities of the list; and indeed the investor may have no choice but to incur them—for otherwise he may run an even greater risk of holding only fixed claims payable in steadily depreciating dollars. Nonetheless the investor would do well to recognize, and to accept as philosophically as he can, that the old package of good profitpossibilities combined with small ultimate risk is no longer available to him.*

   However, the risk of paying too high a price for good-quality stocks—while a real one—is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to “earning power” and assume that prosperity is synonymous with safety. It is in those years that bonds and preferred stocks of inferior grade can be sold to the public at a price around par, because they carry a little higher income return or a deceptively attractive conversion privilege. It is then, also, that common stocks of obscure companies can be floated at prices far above the tangible investment, on the strength of two or three years of excellent growth.

   These securities do not offer an adequate margin of safety in any admissible sense of the term. Coverage of interest charges and preferred dividends must be tested over a number of years, including preferably a period of subnormal business such as in 1970–71. The same is ordinarily true of common-stock earnings if they are to

* This paragraph—which Graham wrote in early 1972—is an uncannily precise description of market conditions in early 2003. (For more detail, see the commentary on Chapter 3.)

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qualify as indicators of earning power. Thus it follows that most of the fair-weather investments, acquired at fair-weather prices, are destined to suffer disturbing price declines when the horizon clouds over—and often sooner than that. Nor can the investor count with confidence on an eventual recovery—although this does come about in some proportion of the cases—for he has never had a real safety margin to tide him through adversity.

   The philosophy of investment in growth stocks parallels in part and in part contravenes the margin-of-safety principle. The growth-stock buyer relies on an expected earning power that is greater than the average shown in the past. Thus he may be said to substitute these expected earnings for the past record in calculating his margin of safety. In investment theory there is no reason why carefully estimated future earnings should be a less reliable guide than the bare record of the past; in fact, security analysis is coming more and more to prefer a competently executed evaluation of the future. Thus the growth-stock approach may supply as dependable a margin of safety as is found in the ordinary investment—provided the calculation of the future is conservatively made, and provided it shows a satisfactory margin in relation to the price paid.

    The danger in a growth-stock program lies precisely here. For such favored issues the market has a tendency to set prices that will not be adequately protected by a conservativeprojection of future earnings. (It is a basic rule of prudent investment that all estimates, when they differ from past performance, must err at least slightly on the side of understatement.) The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price. If, as we suggest, the average market level of most growth stocks is too high to provide an adequate margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily. A special degree of foresight and judgment will be needed, in order that wise individual selections may overcome the hazards inherent in the customary market level of such issues as a whole.

   The margin-of-safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities. We have here, by definition, a favorable difference between price on

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the one hand and indicated or appraised value on the other. That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck. The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments. For in most such cases he has no real enthusiasm about the company’s prospects.
True, if the prospects are definitely bad the investor will prefer to avoid the security no matter how low the price. But the field  of undervalued issues is drawn from the many concerns—perhaps a majority of the total—for which the future appears neither distinctly promising nor distinctly unpromising. If these are bought on a bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results.
    The margin of safety will then have served its proper purpose.

Theory of Diversification

   There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss—not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.

   Diversification is an established tenet of conservative investment. By accepting it so universally, investors are really demonstrating their acceptance of the margin-of-safety principle, to which diversification is the companion. This point may be made more col-orful by a reference to the arithmetic of roulette. If a man bets $1 on a single number, he is paid $35 profit when he wins—but the chances are 37 to 1 that he will lose. He has a “negative margin of safety.” In his case diversification is foolish. The more numbers he bets on, the smaller his chance of ending with a profit. If he regularly bets $1 on every number (including 0 and 00), he is certain to lose $2 on each turn of the wheel. But suppose the winner received $39 profit instead of $35. Then he would have a small but important margin of safety. Therefore, the more numbers he wagers on,
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the better his chance of gain. And he could be certain of winning $2 on every spin by simply betting $1 each on all the numbers. (Incidentally, the two examples given actually describe the respective positions of the player and proprietor of a wheel with 0 and 00.)*
A Criterion of Investment versus Speculation
    Since there is no single definition of investment in general acceptance, authorities have the right to define it pretty much as they please. Many of them deny that there is any useful or dependable difference between the concepts of investment and of speculation. We think this skepticism is unnecessary and harmful. It is injurious because it lends encouragement to the innate leaning of many people toward the excitement and hazards of stock-market speculation. We suggest that the margin-of-safety concept may be used to advantage as the touchstone to distinguish an investment operation from a speculative one.
   Probably most speculators believe they have the odds in their favor when they take their chances, and therefore they may lay claim to a safety margin in their proceedings. Each one has the feeling that the time is propitious for his purchase, or that his skill is superior to the crowd’s, or that his adviser or system is trustworthy. But such claims are unconvincing. They rest on subjective judgment, unsupported by any body of favorable evidence or any
* In “American” roulette, most wheels include 0 and 00 along with numbers 1 through 36, for a total of 38 slots. The casino offers a maximum payout of 35 to 1. What if you bet $1 on every number? Since only one slot can be the one into which the ball drops, you would win $35 on that slot, but lose $1 on each of your other 37 slots, for a net loss of $2. That $2 difference (or a 5.26% spread on your total $38 bet) is the casino’s “house advantage,” ensuring that, on average, roulette players will always lose more than they win. Just as it is in the roulette player’s interest to bet as seldom as possible, it is in the casino’s interest to keep the roulette wheel spinning.
Likewise, the intelligent investor should seek to maximize the number of holdings that offer “a better chance for profit than for loss.” For most investors, diversification is the simplest and cheapest way to widen your margin of safety.

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conclusive line of reasoning. We greatly doubt whether the man who stakes money on his view that the market is heading up or down can ever be said to be protected by a margin of safety in any useful sense of the phrase.
   By contrast, the investor’s concept of the margin of safety—as developed earlier in this chapter—rests upon simple and definite arithmetical reasoning from statistical data. We believe, also, that it is well supported by practical investment experience. There is no guarantee that this fundamental quantitative approach will continue to show favorable results under the unknown conditions of the future. But, equally, there is no valid reason for pessimism on this score.
    Thus, in sum, we say that to have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.
Extension of the Concept of Investment
   To complete our discussion of the margin-of-safety principle we must now make a further distinction between conventional and unconventional investments. Conventional investments are appropriate for the typical portfolio. Under this heading have always come United States government issues and high-grade, dividend-paying common stocks. We have added state and municipal bonds for those who will benefit sufficiently by their tax-exempt features. Also included are first-quality corporate bonds when, as now, they can be bought to yield sufficiently more than United States savings bonds.
   Unconventional investments are those that are suitable only for the enterprising investor. They cover a wide range. The broadest category is that of undervalued common stocks of secondary companies, which we recommend for purchase when they can be bought at two-thirds or less of their indicated value. Besides these, there is often a wide choice of medium-grade corporate bonds and preferred stocks when they are selling at such depressed prices as to be obtainable also at a considerable discount from their apparent value. In these cases the average investor would be inclined to call the securities speculative, because in his mind their lack of a first-quality rating is synonymous with a lack of investment merit.
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   It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity—provided that the buyer is informed and experienced and that he practices adequate diversification. For, if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment. Our favorite supporting illustration is taken from the field of real-estate bonds. In the 1920s, billions of dollars’ worth of these issues were sold at par and widely recommended as sound investments. A large proportion had so little margin of value over debt as to be in fact highly speculative in character. In the depression of the 1930s an enormous quantity of these bonds defaulted their interest, and their price collapsed—in some cases below 10 cents on the dollar. At that stage the same advisers who had recommended them at par as safe investments were rejecting them as paper of the most speculative and unattractive type. But as a matter of fact the price depreciation of about 90% made many of these securities exceedingly attractive and reasonably safe—for the true values behind them were four or five times the market quotation.*
   The fact that the purchase of these bonds actually resulted in what is generally called “a large speculative profit” did not prevent them from having true investment qualities at their low prices. The “speculative” profit was the purchaser’s reward for having made an unusually shrewd investment. They could properly be called investment opportunities, since a careful analysis would have shown that the excess of value over price provided a large margin of safety. Thus the very class of “fair-weather investments” which we stated above is a chief source of serious loss to naïve security buyers is likely to afford many sound profit opportunities to the sophisticated operator who may buy them later at pretty much his own price.†
* Graham is saying that there is no such thing as a good or bad stock; there are only cheap stocks and expensive stocks. Even the best company becomes a “sell” when its stock price goes too high, while the worst company is worth buying if its stock goes low enough.
† The very people who considered technology and telecommunications stocks a “sure thing” in late 1999 and early 2000, when they were hellishly overpriced, shunned them as “too risky” in 2002—even (cont’d on p. 522)

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   The whole field of “special situations” would come under our definition of investment operations, because the purchase is always predicated on a thoroughgoing analysis that promises a larger realization than the price paid. Again there are risk factors in each individual case, but these are allowed for in the calculations and absorbed in the overall results of a diversified operation.
   To carry this discussion to a logical extreme, we might suggest that a defensible investment operation could be set up by buying such intangible values as are represented by a group of “common-stock option warrants” selling at historically low prices. (This example is intended as somewhat of a shocker.)* The entire value of these warrants rests on the possibility that the related stocks may some day advance above the option price. At the moment they have no exercisable value. Yet, since all investment rests on reasonable future expectations, it is proper to view these warrants in terms of the mathematical chances that some future bull market will create a large increase in their indicated value and in their price. Such a study might well yield the conclusion that there is much more to be gained in such an operation than to be lost and that the chances of an ultimate profit are much better than those of an ultimate loss. If that is so, there is a safety margin present even
 (cont’d from p. 521) though, in Graham’s exact words from an earlier period, “the price depreciation of about 90% made many of these securities exceedingly attractive and reasonably safe.” Similarly, Wall Street’s analysts have always tended to call a stock a “strong buy” when its price is high, and to label it a “sell” after its price has fallen—the exact opposite of what Graham (and simple common sense) would dictate. As he does throughout the book, Graham is distinguishing speculation—or buying on the hope that a stock’s price will keep going up—from investing, or buying on the basis of what the underlying business is worth.
* Graham uses “common-stock option warrant” as a synonym for “warrant,” a security issued directly by a corporation giving the holder a right to purchase the company’s stock at a predetermined price. Warrants have been almost entirely superseded by stock options. Graham quips that he intends the example as a “shocker” because, even in his day, warrants were regarded as one of the market’s seediest backwaters. (See the commentary on Chapter 16.)

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in this unprepossessing security form. A sufficiently enterprising investor could then include an option-warrant operation in his miscellany of unconventional investments. 1
To Sum Up
   Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertak-ings. Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success.
    The first and most obvious of these principles is, “Know what you are doing—know your business.” For the investor this means: Do not try to make “business profits” out of securities—that is, returns in excess of normal interest and dividend income—unless you know as much about security values as you would need to know about the value of merchandise that you proposed to manufacture or deal in.
   A second business principle: “Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.” For the investor this rule should determine the conditions under which he will permit someone else to decide what is done with his money.
    A third business principle: “Do not enter upon an operation—that is, manufacturing or trading in an item—unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular, keep away from ventures in which you have little to gain and much to lose.” For the enterprising investor this means that his operations for profit should be based not on optimism but on arithmetic. For every investor it means that when he limits his return to a small figure—as formerly, at least, in a conventional bond or preferred stock—he must demand convincing evidence that he is not risking a substantial part of his principal.
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   A fourth business rule is more positive: “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it—even though others may hesitate or differ.” (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.) Similarly, in the world of securities, courage becomes the supreme virtueafter adequate knowledge and a tested judgment are at hand.
   Fortunately for the typical investor, it is by no means necessary for his success that he bring these qualities to bear upon his program— provided he limits his ambition to his capacity and confines his activities within the safe and narrow path of standard, defensive investment. To achieve satisfactory investment results is easier than most people realize; to achievesuperior results is harder than it looks.


If we fail to anticipate the unforeseen or expect the unexpected in a universe of infinite possibilities, we may find ourselves at the mercy of anyone or anything that cannot be programmed, categorized, or easily referenced.
                                                                                                            —Agent Fox Mulder, The X-Files

F I R S T ,   D O N ’ T   L O S E
What is risk?
    You’ll get different answers depending on whom, and when, you ask. In 1999, risk didn’t mean losing money; it meant making less money than someone else. What many people feared was bumping into somebody at a barbecue who was getting even richer even quicker by day trading dot-com stocks than they were. Then, quite suddenly, by 2003 risk had come to mean that the stock market might keep dropping until it wiped out whatever traces of wealth you still had left.
    While its meaning may seem nearly as fickle and fluctuating as the financial markets themselves, risk has some profound and permanent attributes. The people who take the biggest gambles and make the biggest gains in a bull market are almost always the ones who get hurt the worst in the bear market that inevitably follows. (Being “right” makes speculators even more eager to take extra risk, as their confidence catches fire.) And once you lose big money, you then have to gamble even harder just to get back to where you were, like a racetrack or casino gambler who desperately doubles up after every bad bet. Unless you are phenomenally lucky, that’s a recipe for disaster. No wonder, when he was asked to sum up everything he had learned in his long career about how to get rich, the legendary financier J. K.
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Klingenstein of Wertheim & Co. answered simply: “Don’t lose. ” 1 This graph shows what he meant:

Losing some money is an inevitable part of investing, and there’s nothing you can do to prevent it. But, to be an intelligent investor, you must take responsibility for ensuring that you never lose most or all of your money. The Hindu goddess of wealth, Lakshmi, is often portrayed standing on tiptoe, ready to dart away in the blink of an eye. To keep her sym-1 As recounted by investment consultant Charles Ellis in Jason Zweig, “Wall Street’s Wisest Man,” Money, June, 2001, pp. 49–52.

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bolically in place, some of Lakshmi’s devotees will lash her statue down with strips of fabric or nail its feet to the floor. For the intelligent investor, Graham’s “margin of safety” performs the same function: By refusing to pay too much for an investment, you minimize the chances that your wealth will ever disappear or suddenly be destroyed.

Consider this: Over the four quarters ending in December 1999, JDS Uniphase Corp., the fiber-optics company, generated $673 million in net sales, on which it lost $313 million. Its tangible assets totaled $1.5 billion. Yet, on March 7, 2000, JDS Uniphase’s stock hit $153 a share, giving the company a total market value of roughly $143 billion.2 And then, like most “New Era” stocks, it crashed. Anyone who bought it that day and still clung to it at the end of 2002 faced these prospects:

2 JDS Uniphase’s share price has been adjusted for later splits.

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Even at a robust 10% annual rate of return, it will take more than 43 years to break even on this overpriced purchase!

T H E   R I S K   I S   N O T   I N   O U R   S T O C K S , 
B U T   I N   O U R S E L V E S

Risk exists in another dimension: inside you. If you overestimate how well you really understand an investment, or overstate your ability to ride out a temporary plunge in prices, it doesn’t matter what you own or how the market does. Ultimately, financial risk resides not in what kinds of investments you have, but in what kind of investor you are. If you want to know what risk really is, go to the nearest bathroom and step up to the mirror. That’s risk, gazing back at you from the glass.
   As you look at yourself in the mirror, what should you watch for? The Nobel-prize–winning psychologist Daniel Kahneman explains two factors that characterize good decisions:
•   “well-calibrated confidence” (do I understand this investment as well as I think I do?)
•   “correctly-anticipated regret” (how will I react if my analysis turns out to be wrong?).
    To find out whether your confidence is well-calibrated, look in the mirror and ask yourself: “What is the likelihood that my analysis is right?” Think carefully through these questions:
•   How much experience do I have? What is my track record with similar decisions in the past?
•   What is the typical track record of other people who have tried this in the past?3
•   If I am buying, someone else is selling. How likely is it that I know something that this other person (or company) does not know?
•   If I am selling, someone else is buying. How likely is it that I know something that this other person (or company) does not know?
3 No one who diligently researched the answer to this question, and honestly accepted the results, would ever have day traded or bought IPOs.

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•   Have I calculated how much this investment needs to go up for me to break even after my taxes and costs of trading?
   Next, look in the mirror to find out whether you are the kind of person who correctly anticipates your regret. Start by asking: “Do I fully understand the consequences if my analysis turns out to be wrong?”
Answer that question by considering these points:
•    If I’m right, I could make a lot of money. But what if I’m wrong?
     Based on the historical performance of similar investments, how much could I lose?
•   Do I have other investments that will tide me over if this decision turns out to be wrong? Do I           already hold stocks, bonds, or funds with a proven record of going up when the kind of similar investments I’m considering goes down? Am I putting too much of my capital at risk with this new investment?
•   When I tell myself, “You have a high tolerance for risk,” how do I know? Have I ever lost a lot of money on an investment? How did it feel? Did I buy more, or did I bail out?
•   Am I relying on my willpower alone to prevent me from panicking at the wrong time? Or have I controlled my own behavior in advance by diversifying, signing an investment contract, and dollar-cost averaging?
   You should always remember, in the words of the psychologist Paul Slovic, that “risk is brewed from an equal dose of two ingredients—probabilities and consequences. ” 4 Before you invest, you must ensure that you have realistically assessed your probability of being right and how you will react to the consequences of being wrong.
P A S C A L ’ S   W A G E R
The investment philosopher Peter Bernstein has another way of summing this up. He reaches back to Blaise Pascal, the great French mathematician and theologian (1623–1662), who created a thought 4 Paul Slovic, “Informing and Educating the Public about Risk,” Risk Analysis, vol. 6, no.
 4 (1986), p. 412.

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experiment in which an agnostic must gamble on whether or not God exists. The ante this person must put up for the wager is his conduct in this life; the ultimate payoff in the gamble is the fate of his soul in the afterlife. In this wager, Pascal asserts, “reason cannot decide” the probability of God’s existence. Either God exists or He does not—and only faith, not reason, can answer that question. But while the probabilities in Pascal’s wager are a toss-up, the consequences are perfectly clear and utterly certain. As Bernstein explains: 

   Suppose you act as though God is and [ you] lead a life of virtue and abstinence, when in fact there is no god. You will have passed up some goodies in life, but there will be rewards as well. Now suppose you act as though God is not and spend a life of sin, selfishness, and lust when in fact God is. You may have had fun and thrills during the relatively brief duration of your lifetime, but when the day of judgment rolls around you are in big trouble.5
   Concludes Bernstein: “In making decisions under conditions of uncertainty, the consequences must dominate the probabilities. We never know the future.” Thus, as Graham has reminded you in every chapter of this book, the intelligent investor must focus not just on getting the analysis right. You must also ensure against loss if your analysis turns out to be wrong—as even the best analyses will be at least some of the time. The probability of making at least one mistake at some point in your investing lifetime is virtually 100%, and those odds are entirely out of your control. However, you do have control over the consequences of being wrong. Many “investors” put essentially all of their money into dot-com stocks in 1999; an online survey of 1,338 Americans by Money Magazine in 1999 found that nearly one-tenth of them had at least 85% of their money in Internet stocks. By ignoring Graham’s call for a margin of safety, these people took the wrong side of Pascal’s wager. Certain that they knew the probabilities of being 
5 “The Wager,” in Blaise Pascal,Pensées (Penguin Books, London and New York, 1995), pp. 122–125; Peter L. Bernstein, Against the Gods (John Wiley & Sons, New York, 1996), pp. 68–70; Peter L. Bernstein, “Decision Theory in Iambic Pentameter,” Economics & Portfolio Strategy, January 1, 2003, p. 2.

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right, they did nothing to protect themselves against the consequences of being wrong.
   Simply by keeping your holdings permanently diversified, and refusing to fling money at Mr. Market’s latest, craziest fashions, you can ensure that the consequences of your mistakes will never be catastrophic. No matter what Mr. Market throws at you, you will always be able to say, with a quiet confidence, “This, too, shall pass away.”


We know very well two partners who spent a good part of their lives handling their own and other people’s funds on Wall Street. Some hard experience taught them it was better to be safe and careful rather than to try to make all the money in the world. They established a rather unique approach to security operations, which combined good profit possibilities with sound values. They avoided anything that appeared overpriced and were rather too quick to dispose of issues that had advanced to levels they deemed no longer attractive. Their portfolio was always well diversified, with more than a hundred different issues represented. In this way they did quite well through many years of ups and downs in the general market; they averaged about 20% per annum on the several millions of capital they had accepted for management, and their clients were well pleased with the results.*
   In the year in which the first edition of this book appeared an opportunity was offered to the partners’ fund to purchase a half-interest in a growing enterprise. For some reason the industry did not have Wall Street appeal at the time and the deal had been turned down by quite a few important houses. But the pair was impressed by the company’s possibilities; what was decisive for them was that the price was moderate in relation to current earnings and asset value. The partners went ahead with the acquisition, amounting in dollars to about one-fifth of their fund. They became closely identified with the new business interest, which prospered.†
* The two partners Graham coyly refers to are Jerome Newman and Benjamin Graham himself.
† Graham is describing the Government Employees Insurance Co., or GEICO, in which he and Newman purchased a 50% interest in 1948, right 532

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   In fact it did so well that the price of its shares advanced to two hundred times or more the price paid for the half-interest. The advance far outstripped the actual growth in profits, and almost from the start the quotation appeared much too high in terms of the partners’ own investment standards. But since they regarded the company as a sort of “family business,” they continued to maintain a substantial ownership of the shares despite the spectacular price rise. A large number of participants in their funds did the same, and they became millionaires through their holding in this one enterprise, plus later-organized affiliates.*
   Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pon-dering, and countless individual decisions.
       Are there morals to this story of value to the intelligent investor?
An obvious one is that there are several different ways to make and keep money in Wall Street. Another, not so obvious, is that one lucky break, or one supremely shrewd decision—can we tell them apart?—may count for more than a lifetime of journeyman efforts.1  But behind the luck, or the crucial decision, there must usually exist a background of preparation and disciplined capacity. One needs to be sufficiently established and recognized so that these opportunities will knock at his particular door. One must
 around the time he finished writing The Intelligent Investor. The $712,500 that Graham and Newman put into GEICO was roughly 25% of their fund’s assets at the time. Graham was a member of GEICO’s board of directors for many years. In a nice twist of fate, Graham’s greatest student, Warren Buffett, made an immense bet of his own on GEICO in 1976, by which time the big insurer had slid to the brink of bankruptcy. It turned out to be one of Buffett’s best investments as well.
* Because of a legal technicality, Graham and Newman were directed by the U.S. Securities & Exchange Commission to “spin off,” or distribute, Graham-Newman Corp.’s GEICO stake to the fund’s shareholders. An investor who owned 100 shares of Graham-Newman at the beginning of 1948 (worth $11,413) and who then held on to the GEICO distribution would have had $1.66 million by 1972. GEICO’s “later-organized affiliates” included Government Employees Financial Corp. and Criterion Insurance Co.

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have the means, the judgment, and the courage to take advantage of them.
   Of course, we cannot promise a like spectacular experience to all intelligent investors who remain both prudent and alert through the years. We are not going to end with J. J. Raskob’s slogan that we made fun of at the beginning: “Everybody can be rich.” But interesting possibilities abound on the financial scene, and the intelligent and enterprising investor should be able to find both enjoyment and profit in this three-ring circus. Excitement is guaranteed.


Successful investing is about managing risk, not avoiding it. At first glance, when you realize that Graham put 25% of his fund into a single stock, you might think he was gambling rashly with his investors’ money. But then, when you discover that Graham had painstakingly established that he could liquidate GEICO for at least what he paid for it, it becomes clear that Graham was taking very little financial risk. But he needed enormous courage to take the psychological risk of such a big bet on so unknown a stock.1
   And today’s headlines are full of fearful facts and unresolved risks: the death of the 1990s bull market, sluggish economic growth, corporate fraud, the specters of terrorism and war. “Investors don’t like uncertainty,” a market strategist is intoning right now on financial TV or in today’s newspaper. But investors have never liked uncertainty—and yet it is the most fundamental and enduring condition of the investing world. It always has been, and it always will be. At heart, “uncertainty” and “investing” are synonyms. In the real world, no one has ever been given the ability to see that any particular time is the best time to buy stocks. Without a saving faith in the future, no one would ever invest at all. To be an investor, you must be a believer in a better tomorrow. The most literate of investors, Graham loved the story of Ulysses, told through the poetry of Homer, Alfred Tennyson, and Dante. Late in his life, Graham relished the scene in Dante’sInferno when Ulysses describes inspiring his crew to sail westward into the unknown waters beyond the gates of Hercules:
1 Graham’s anecdote is also a powerful reminder that those of us who are not as brilliant as he was must always diversify to protect against the risk of putting too much money into a single investment. When Graham himself admits that GEICO was a “lucky break,” that’s a signal that most of us cannot count on being able to find such a great opportunity. To keep investing from decaying into gambling, you must diversify.

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“O brothers,” I said, “who after a hundred thousand 
perils have reached the west,
 in this little waking vigil
 that still remains to our senses,
let us not choose to avoid the experience
of the unpeopled world that lies behind the sun.
Consider the seeds from which you sprang:
You were made not to live like beasts,
but to seek virtue and understanding.”
With this little oration I made my shipmates
 so eager for the voyage
that it would have hurt to hold them back.
And we swung our stern toward the morning
and turned our oars into wings for the wild flight.2
   Investing, too, is an adventure; the financial future is always an uncharted world. With Graham as your guide, your lifelong investing voyage should be as safe and confident as it is adventurous.
2 Dante Alighieri, The Inferno, Canto XXVI, lines 112–125, translated by Jason Zweig.


1. The Superinvestors of Graham-and-Doddsville
                                                  by Warren E. Buffett

EDITOR’S NOTE: This article is an edited transcript of a talk given at Columbia University in 1984 commemorating the fiftieth anniversary of Security Analysis, written by Benjamin Graham and David L. Dodd. This specialized volume first introduced the ideas later popularized in The Intelligent Investor. Buffett’s essay offers a fascinating study of how Graham’s disciples have used Graham’s  value investing approach to realize phenomenal success in the stock market.
   Is the Graham and Dodd “look for values with a significant margin of safety relative to prices” approach to security analysis out of date? Many of the professors who write textbooks today say yes. They argue that the stock market is efficient; that is, that stock prices reflect everything that is known about a company’s prospects and about the state of the economy. There are no undervalued stocks, these theorists argue, because there are smart security analysts who utilize all available information to ensure unfailingly appropriate prices. Investors who seem to beat the market year after year are just lucky. “If prices fully reflect available information, this sort of investment adeptness is ruled out,” writes one of today’s textbook authors.
   Well, maybe. But I want to present to you a group of investors who have, year in and year out, beaten the Standard & Poor’s 500 stock index. The hypothesis that they do this by pure chance is at 

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least worth examining. Crucial to this examination is the fact that these winners were all well known to me and pre-identified as superior investors, the most recent identification occurring over fifteen years ago. Absent this condition—that is, if I had just recently searched among thousands of records to select a few names for you this morning—I would advise you to stop reading right here. I should add that all these records have been audited. And I should further add that I have known many of those who have invested with these managers, and the checks received by those participants over the years have matched the stated records.
   Before we begin this examination, I would like you to imagine a national coin-flipping contest. Let’s assume we get 225 million Americans up tomorrow morning and we ask them all to wager a dollar. They go out in the morning at sunrise, and they all call the flip of a coin. If they call correctly, they win a dollar from those who called wrong. Each day the losers drop out, and on the subsequent day the stakes build as all previous winnings are put on the line. After ten flips on ten mornings, there will be approximately 220,000 people in the United States who have correctly called ten flips in a row. They each will have won a little over $1,000.
   Now this group will probably start getting a little puffed up about this, human nature being what it is. They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping.
   Assuming that the winners are getting the appropriate rewards from the losers, in another ten days we will have 215 people who have successfully called their coin flips 20 times in a row and who, by this exercise, each have turned one dollar into a little over $1 million. $225 million would have been lost, $225 million would have been won.
   By then, this group will really lose their heads. They will probably write books on “How I Turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning.” Worse yet, they’ll probably start jetting around the country attending semi-nars on efficient coin-flipping and tackling skeptical professors with, “If it can’t be done, why are there 215 of us?”
   But then some business school professor will probably be rude enough to bring up the fact that if 225 million orangutans
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had engaged in a similar exercise, the results would be much the same—215 egotistical orangutans with 20 straight winning flips.
   I would argue, however, that there are some important differences in the examples I am going to present. For one thing, if (a) you had taken 225 million orangutans distributed roughly as the U.S. population is; if (b) 215 winners were left after 20 days; and if (c) you found that 40 came from a particular zoo in Omaha, you would be pretty sure you were on to something. So you would probably go out and ask the zookeeper about what he’s feeding them, whether they had special exercises, what books they read, and who knows what else. That is, if you found any really extraordinary concentrations of success, you might want to see if you could identify concentrations of unusual characteristics that might be causal factors.
   Scientific inquiry naturally follows such a pattern. If you were trying to analyze possible causes of a rare type of cancer—with, say, 1,500 cases a year in the United States—and you found that 400
of them occurred in some little mining town in Montana, you would get very interested in the water there, or the occupation of those afflicted, or other variables. You know that it’s not random chance that 400 come from a small area. You would not necessarily know the causal factors, but you would know where to search.
   I submit to you that there are ways of defining an origin other than geography. In addition to geographical origins, there can be what I call an intellectual origin. I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville. A concentration of winners that simply cannot be explained by chance can be traced to this particular intellectual village.
   Conditions could exist that would make even that concentration unimportant. Perhaps 100 people were simply imitating the coin-flipping call of some terribly persuasive personality. When he called heads, 100 followers automatically called that coin the same way. If the leader was part of the 215 left at the end, the fact that 100 came from the same intellectual origin would mean nothing. You would simply be identifying one case as a hundred cases. Similarly, let’s assume that you lived in a strongly patriarchal society
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and every family in the United States conveniently consisted of ten members. Further assume that the patriarchal culture was so strong that, when the 225 million people went out the first day, every member of the family identified with the father’s call. Now, at the end of the 20-day period, you would have 215 winners, and you would find that they came from only 21.5 families. Some naive types might say that this indicates an enormous hereditary factor as an explanation of successful coin-flipping. But, of course, it would have no significance at all because it would simply mean that you didn’t have 215 individual winners, but rather 21.5 randomly distributed families who were winners.
   In this group of successful investors that I want to consider, there has been a common intellectual patriarch, Ben Graham. But the children who left the house of this intellectual patriarch have called their “flips” in very different ways. They have gone to different places and bought and sold different stocks and companies, yet they have had a combined record that simply can’t be explained by random chance. It certainly cannot be explained by the fact that they are all calling flips identically because a leader is signaling the calls to make. The patriarch has merely set forth the intellectual theory for making coin-calling decisions, but each student has decided on his own manner of applying the theory.
   The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market. Essentially, they exploit those discrepancies without the efficient market theorist’s concern as to whether the stocks are bought on Monday or Thursday, or whether it is January or July, etc. Incidentally, when businessmen buy businesses—which is just what our Graham &  Dodd investors are doing through the medium of marketable stocks—I doubt that many are cranking into their purchase decision the day of the week or the month in which the transaction is going to occur. If it doesn’t make any difference whether all of a business is being bought on a Monday or a Friday, I am baffled why academicians invest extensive time and effort to see whether it makes a difference when buying small pieces of those same businesses. Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of
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any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value.
   I always find it extraordinary that so many studies are made of price and volume behavior, the stuff of chartists. Can you imagine buying an entire business simply because the price of the business had been marked up substantially last week and the week before? Of course, the reason a lot of studies are made of these price and volume variables is that now, in the age of computers, there are almost endless data available about them. It isn’t necessarily because such studies have any utility; it’s simply that the data are there and academicians have worked hard to learn the mathematical skills needed to manipulate them. Once these skills are acquired, it seems sinful not to use them, even if the usage has no utility or negative utility. As a friend said, to a man with a hammer, everything looks like a nail.
   I think the group that we have identified by a common intellectual home is worthy of study. Incidentally, despite all the academic studies of the influence of such variables as price, volume, seasonality, capitalization size, etc., upon stock performance, no interest has been evidenced in studying the methods of this unusual concentration of value-oriented winners.
   I begin this study of results by going back to a group of four of us who worked at Graham-Newman Corporation from 1954 through 1956. There were only four—I have not selected these names from among thousands. I offered to go to work at Graham-Newman for nothing after I took Ben Graham’s class, but he turned me down as overvalued. He took this value stuff very seriously! After much pestering he finally hired me. There were three partners and four of us at the “peasant” level. All four left between 1955 and 1957 when the firm was wound up, and it’s possible to trace the record of three.
   The first example (see Table 1, pages 549–550) is that of Walter Schloss. Walter never went to college, but took a course from Ben Graham at night at the New York Institute of Finance. Walter left Graham-Newman in 1955 and achieved the record shown here over 28 years.
   Here is what “Adam Smith”—after I told him about Walter—wrote about him in Supermoney (1972):
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   He has no connections or access to useful information. Practically no one in Wall Street knows him and he is not fed any ideas. He looks up the numbers in the manuals and sends for the annual reports, and that’s about it.
   In introducing me to [Schloss] Warren had also, to my mind, described himself. “He never forgets that he is handling other people’s money and this reinforces his normal strong aversion to loss.” He has total integrity and a realistic picture of himself. Money is real to him and stocks are real—and from this flows an attraction to the “margin of safety” principle.
   Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does. He doesn’t worry about whether it’s January, he doesn’t worry about whether it’s Monday, he doesn’t worry about whether it’s an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again. He owns many more stocks than I do—and is far less interested in the underlying nature of the business: I don’t seem to have very much influence on Walter. That’s one of his strengths; no one has much influence on him.
   The second case is Tom Knapp, who also worked at Graham-Newman with me. Tom was a chemistry major at Princeton before the war; when he came back from the war, he was a beach bum. And then one day he read that Dave Dodd was giving a night course in investments at Columbia. Tom took it on a noncredit basis, and he got so interested in the subject from taking that course that he came up and enrolled at Columbia Business School, where he got the MBA degree. He took Dodd’s course again, and took Ben Graham’s course. Incidentally, 35 years later I called Tom to ascertain some of the facts involved here and I found him on the beach again. The only difference is that now he owns the beach!
   In 1968 Tom Knapp and Ed Anderson, also a Graham disciple, along with one or two other fellows of similar persuasion, formed Tweedy, Browne Partners, and their investment results appear in Table 2. Tweedy, Browne built that record with very wide diversification. They occasionally bought control of businesses, but the record of the passive investments is equal to the record of the control investments.
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   Table 3 describes the third member of the group who formed Buffett Partnership in 1957. The best thing he did was to quit in 1969. Since then, in a sense, Berkshire Hathaway has been a continuation of the partnership in some respects. There is no single index I can give you that I would feel would be a fair test of investment management at Berkshire. But I think that any way you figure it, it has been satisfactory.
   Table 4 shows the record of the Sequoia Fund, which is managed by a man whom I met in 1951 in Ben Graham’s class, Bill Ruane. After getting out of Harvard Business School, he went to Wall Street. Then he realized that he needed to get a real business education so he came up to take Ben’s course at Columbia, where we met in early 1951. Bill’s record from 1951 to 1970, working with relatively small sums, was far better than average. When I wound up Buffett Partnership I asked Bill if he would set up a fund to handle all our partners, so he set up the Sequoia Fund. He set it up at a terrible time, just when I was quitting. He went right into the two-tier market and all the difficulties that made for comparative performance for value-oriented investors. I am happy to say that my partners, to an amazing degree, not only stayed with him but added money, with the happy result shown.
   There’s no hindsight involved here. Bill was the only person I recommended to my partners, and I said at the time that if he achieved a four-point-per-annum advantage over the Standard & Poor’s, that would be solid performance. Bill has achieved well over that, working with progressively larger sums of money. That makes things much more difficult. Size is the anchor of performance. There is no question about it. It doesn’t mean you can’t do better than average when you get larger, but the margin shrinks. And if you ever get so you’re managing two trillion dollars, and that happens to be the amount of the total equity evaluation in the economy, don’t think that you’ll do better than average!
   I should add that in the records we’ve looked at so far, throughout this whole period there was practically no duplication in these portfolios. These are men who select securities based on discrepancies between price and value, but they make their selections very differently. Walter’s largest holdings have been such stalwarts as Hudson Pulp & Paper and Jeddo Highland Coal and New York Trap Rock Company and all those other names that come instantly to mind to even a casual reader of the business pages. Tweedy
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Browne’s selections have sunk even well below that level in terms of name recognition. On the other hand, Bill has worked with big companies. The overlap among these portfolios has been very, very low. These records do not reflect one guy calling the flip and fifty people yelling out the same thing after him.
   Table 5 is the record of a friend of mine who is a Harvard Law graduate, who set up a major law firm. I ran into him in about 1960 and told him that law was fine as a hobby but he could do better. He set up a partnership quite the opposite of Walter’s. His portfolio was concentrated in very few securities and therefore his record was much more volatile but it was based on the same discount-from-value approach. He was willing to accept greater peaks and valleys of performance, and he happens to be a fellow whose whole psyche goes toward concentration, with the results shown. Incidentally, this record belongs to Charlie Munger, my partner for a long time in the operation of Berkshire Hathaway. When he ran his partnership, however, his portfolio holdings were almost completely different from mine and the other fellows mentioned earlier.
   Table 6 is the record of a fellow who was a pal of Charlie Munger’s—another non–business school type—who was a math major at USC. He went to work for IBM after graduation and was an IBM salesman for a while. After I got to Charlie, Charlie got to him. This happens to be the record of Rick Guerin. Rick, from 1965 to 1983, against a compounded gain of 316 percent for the S&P, came off with 22,200 percent, which, probably because he lacks a business school education, he regards as statistically significant.
   One sidelight here: it is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately with people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find that you can talk to him for years and show him records, and it doesn’t make any difference. They just don’t seem able to grasp the concept, simple as it is. A fellow like Rick Guerin, who had no formal education in business, understands immediately the value approach to investing and he’s applying it five minutes later. I’ve never seen anyone who became a gradual convert over a ten-year period to this approach. It doesn’t seem to be a matter of IQ or academic training. It’s instant recognition, or it is nothing.
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   Table 7 is the record of Stan Perlmeter. Stan was a liberal arts major at the University of Michigan who was a partner in the advertising agency of Bozell & Jacobs. We happened to be in the same building in Omaha. In 1965 he figured out I had a better business than he did, so he left advertising. Again, it took five minutes for Stan to embrace the value approach.
   Perlmeter does not own what Walter Schloss owns. He does not own what Bill Ruane owns. These are records madeindependently. But every time Perlmeter buys a stock it’s because he’s getting more for his money than he’s paying. That’s the only thing he’s thinking about. He’s not looking at quarterly earnings projections, he’s not looking at next year’s earnings, he’s not thinking about what day of the week it is, he doesn’t care what investment research from any place says, he’s not interested in  price momentum, volume, or anything. He’s simply asking: What is the business worth?
   Table 8 and Table 9 are the records of two pension funds I’ve been involved in. They are not selected from dozens of pension funds with which I have had involvement; they are the only two I have influenced. In both cases I have steered them toward value-oriented managers. Very, very few pension funds are managed from a value standpoint. Table 8 is the Washington Post Company’s Pension Fund. It was with a large bank some years ago, and I suggested that they would do well to select managers who had a value orientation.
   As you can see, overall they have been in the top percentile ever since they made the change. The Post told the managers to keep at least 25 percent of these funds in bonds, which would not have been necessarily the choice of these managers. So I’ve included the bond performance simply to illustrate that this group has no particular expertise about bonds. They wouldn’t have said they did. Even with this drag of 25 percent of their fund in an area that was not their game, they were in the top percentile of fund management. The Washington Post experience does not cover a terribly long period but it does represent many investment decisions by three managers who were not identified retroactively.
   Table 9 is the record of the FMC Corporation fund. I don’t manage a dime of it myself but I did, in 1974, influence their decision to select value-oriented managers. Prior to that time they had selected managers much the same way as most larger companies. They now
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rank number one in the Becker survey of pension funds for their size over the period of time subsequent to this “conversion” to the value approach. Last year they had eight equity managers of any duration beyond a year. Seven of them had a cumulative record better than the S&P. All eight had a better record last year than the S&P. The net difference now between a median performance and the actual performance of the FMC fund over this period is $243 million. FMC attributes this to the mindset given to them about the selection of managers. Those managers are not the managers I would necessarily select but they have the common denominator of selecting securities based on value.
   So these are nine records of “coin-flippers” from Graham-and-Doddsville. I haven’t selected them with hindsight from among thousands. It’s not like I am reciting to you the names of a bunch of lottery winners—people I had never heard of before they won the lottery. I selected these men years ago based upon their framework for investment decision-making. I knew what they had been taught and additionally I had some personal knowledge of their intellect, character, and temperament. It’s very important to understand that this group has assumed far less risk than average; note their record in years when the general market was weak. While they differ greatly in style, these investors are, mentally, always buying thebusiness, not buying the stock. A few of them sometimes buy whole businesses. Far more often they simply buy small pieces of businesses. Their attitude, whether buying all or a tiny piece of a business, is the same. Some of them hold portfolios with dozens of stocks; others concentrate on a handful. But all exploit the difference between the market price of a business and its intrinsic value.
   I’m convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.
   I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, “I have here a six-shooter and I have
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slipped one cartridge into it. Why don’t you just spin it and pull it once? If you survive, I will give you $1 million.” I would decline—perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice—now that would be a positive correlation between risk and reward!
   The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.
   One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.
   Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people who think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million, particularly if you do it by buying ten $40 million piles for $8 million each. Since you don’t have your hands on the $400 million, you want to be sure you are in with honest and reasonably competent people, but that’s not a difficult job.
   You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying businesses. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.
    In conclusion, some of the more commercially minded among
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you may wonder why I am writing this article. Adding many converts to the value approach will perforce narrow the spreads between price and value. I can only tell you that the secret has been out for 50 years, ever since Ben Graham and Dave Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the 35 years that I’ve practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing over the last 30 years. It’s likely to continue that way. Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.

Tables 1–9 follow:

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2. Important Rules Concerning Taxability of InvestmentIncome and Security Transactions (in 1972)
 Editor’s note: Due to extensive changes in the rules governing such transactions, the following document is presented here for historical purposes only. When first written by Benjamin  Graham in 1972, all the information therein was correct. However, intervening developments have rendered this document inaccurate for today’s purposes. Following Graham’s original Appendix 2 is a revised and updated version of “The Basics of Investment Taxation,” which brings the reader up-to-date on the relevant rules.
Rule 1—Interest and Dividends
              Interest and dividends are taxable as ordinary income except (a) income received from state, municipal, and similar obligations, which are free from Federal tax but may be subject to state tax, (b) dividends representing a return of capital, (c) certain dividends paid by investment companies (see below), and (d) the first $100 of ordinary domestic-corporation dividends.
Rule 2—Capital Gains and Losses
              Short-term capital gains and losses are merged to obtain net short-term capital gain or loss. Long-term capital gains and losses are merged to obtain the net long-term capital gain or loss. If the net short-term capital gain exceeds the net long-term capital loss, 100 per cent of such excess shall be included in income. The maximum tax thereon is 25% up to $50,000 of such gains and 35% on the balance.
   A net capital loss (the amount exceeding capital gains) is deductible from ordinary income to a maximum of $1,000 in the current year and in each of the next five years. Alternatively, unused losses may be applied at any time to offset capital gains. (Carry-overs of losses taken before 1970 are treated more liberally than later losses.)
Note Concerning “Regulated Investment Companies”
          Most investment funds (“investment companies”) take advantage of special provisions of the tax law, which enable them to be
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taxed substantially as partnerships. Thus if they make long-term security profits they can distribute these as “capital-gain dividends,” which are reported by their shareholders in the same way as long-term gains. These carry a lower tax rate than ordinary dividends. Alternatively, such a company may elect to pay the 25% tax for the account of its shareholders and then retain the balance of the capital gains without distributing them as capital-gain dividends.
3. The Basics of Investment Taxation (Updated as of 2003)

Interest and Dividends
           Interest and dividends are taxed at your ordinary-income tax rate except (a) interest received from municipal bonds, which is free from Federal income tax but may be subject to state tax, (b) dividends representing a return of capital, and (c) long-term capital-gain distributions paid by mutual funds (see below). Private-activity municipal bonds, even within a mutual fund, may subject you to the Federal alternative minimum tax.
Capital Gains and Losses
        Short-term capital gains and losses are merged to obtain net short-term capital gain or loss. Long-term capital gains and losses are merged to determine your net long-term capital gain or loss. If your net short-term capital gain exceeds the net long-term capital loss, that excess is counted as ordinary income. If there is a net long-term capital gain, it is taxed at the favorable capital gains rate, generally 20%—which will fall to 18% for investments purchased after December 31, 2000, and held for more than five years.
   A net capital loss is deductible from ordinary income to a maximum of $3,000 in the current year. Any capital losses in excess of $3,000 may be applied in later tax years to offset future capital gains.
Mutual Funds
     As “regulated investment companies,” nearly all mutual funds take advantage of special provisions of the tax law that exempt them from
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corporate income tax. After selling long-term holdings, mutual funds can distribute the profits as “capital-gain dividends,” which their shareholders treat as long-term gains. These are taxed at a lower rate (generally 20%) than ordinary dividends (up to 39%). You should generally avoid making large new investments during the fourth quarter of each year, when these capital-gain distributions are usually distributed; otherwise you will incur tax for a gain earned by the fund before you even owned it.
4. The New Speculation in Common Stocks1
     What I shall have to say will reflect the spending of many years in Wall Street, with their attendant varieties of experience. This has included the recurrent advent of new conditions, or a new atmosphere, which challenge the value of experience itself. It is true that one of the elements that distinguish economics, finance, and security analysis from other practical disciplines is the uncertain validity of past phenomena as a guide to the present and future. Yet we have no right to reject the lessons of the past until we have at least studied and understood them. My address today is an effort toward such understanding in a limited field—in particular, an endeavor to point out some contrasting relationships between the present and the past in our underlying attitudes toward investment and speculation in common stocks.
    Let me start with a summary of my thesis. In the past the speculative elements of a common stock resided almost exclusively in the company itself; they were due to uncertainties, or fluctuating elements, or downright weaknesses in the industry, or the corporation’s individual setup. These elements of speculation still exist, of course; but it may be said that they have been sensibly diminished by a number of long-term developments to which I shall refer. But in revenge a new and major element of speculation has been introduced into the common-stock arena from outside the companies. It comes from the attitude and viewpoint of the stock-buying public and their advisers—chiefly us security analysts. This attitude may be described in a phrase: primary emphasis upon future expectations.
   Nothing will appear more logical and natural to this audience than the idea that a common stock should be valued and priced
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primarily on the basis of the company’s expected future performance. Yet this simple-appearing concept carries with it a number of paradoxes and pitfalls. For one thing, it obliterates a good part of the older, well-established distinctions between investment and speculation. The dictionary says that “speculate” comes from the Latin “specula,” a lookout. Thus it was the speculator who looked out and saw future developments coming before other people did. But today, if the investor is shrewd or well advised, he too must have his lookout on the future, or rather he mounts into a common lookout where he rubs elbows with the speculator.
   Secondly, we find that, for the most part, companies with the best investment characteristics—i.e., the best credit rating—are the ones which are likely to attract the largest speculative interest in their common stocks, since everyone assumes they are guaranteed a brilliant future. Thirdly, the concept of future prospects, and particularly of continued growth in the future, invites the application of formulas out of higher mathematics to establish the present value of the favored issues. But the combination of precise formulas with highly imprecise assumptions can be used to establish, or rather to justify, practically any value one wishes, however high, for a really outstanding issue. But, paradoxically, that very fact on close examination will be seen to imply that no one value, or  reasonably narrow range of values, can be counted on to establish and maintain itself for a given growth company; hence at times the market may conceivably value the growth component at a strikingly low figure.
   Returning to my distinction between the older and newer speculative elements in common stock, we might characterize them by two outlandish but convenient words, viz.: endogenous and exogenous. Let me illustrate briefly the old-time speculative common stock, as distinguished from an investment stock, by some data relating to American Can and Pennsylvania Railroad in 1911–1913. (These appear in Benjamin Graham and David L. Dodd, SecurityAnalysis, McGraw-Hill, 1940, pp. 2–3.) 

   In those three years the price range of “Pennsy” moved only between 53 and 65, or between 12.2 and 15 times its average earnings for the period. It showed steady profits, was paying a reliable $3 dividend, and investors were sure that it was backed by well over its par of $50 in tangible assets. By contrast, the price of Amer-
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ican Can ranged between 9 and 47; its earnings between 7 cents and $8.86; the ratio of price to the three-year average earnings moved between 1.9 times and 10 times; it paid no dividend at all; and sophisticated investors were well aware that the $100 par value of the common represented nothing but undisclosed “water,” since the preferred issue exceeded the tangible assets available for it. Thus American Can common was a representative speculative issue, because American Can Company was then a speculatively capitalized enterprise in a fluctuating and uncertain industry. Actually, American Can had a far more brilliant long-term future than Pennsylvania Railroad; but not only was this fact not suspected by investors or speculators in those days, but even if it had been it would probably have been put aside by the investors as basically irrelevant to investment policies and programs in the years 1911–1913.
   Now, to expose you to the development through time of the importance of long-term prospects for investments. I should like to use as my example our most spectacular giant industrial enterprise—none other than International Business Machines, which last year entered the small group of companies with $1 billion of sales. May I introduce one or two autobiographical notes here, in order to inject a little of the personal touch into what otherwise would be an excursion into cold figures? In 1912 I had left college for a term to take charge of a research project for U.S. Express Company. We set out to find the effect on revenues of a proposed revo-lutionary new system of computing express rates. For this purpose we used the so-called Hollerith machines, leased out by the then Computing-Tabulating-Recording Company. They comprised card punches, card sorters, and tabulators—tools almost unknown to businessmen, then, and having their chief application in the Cen-sus Bureau. I entered Wall Street in 1914, and the next year the bonds and common stock of C.-T.-R. Company were listed on the New York Stock Exchange. Well, I had a kind of sentimental interest in that enterprise, and besides I considered myself a sort of technological expert on their products, being one of the few financial people who had seen and used them. So early in 1916 I went to the head of my firm, known as Mr. A. N., and pointed out to him that C.-T.-R. stock was selling in the middle 40s (for 105,000 shares); that it had earned $6.50 in 1915; that its book value—
Appendixes 566
including, to be sure, some nonsegregated intangibles—was $130; that it had started a $3 dividend; and that I thought rather highly of the company’s products and prospects. Mr. A. N. looked at me pityingly. “Ben,” said he, “do not mention that company to me again. I would not touch it with a ten-foot pole. [His favorite expression.] Its 6 per cent bonds are selling in the low 80s and they are no good. So how can the stock be any good? Everybody knows there is nothing behind it but water.” (Glossary: In those days that was the ultimate of condemnation. It meant that the asset account of the balance sheet was fictitious. Many industrial companies—notably U.S. Steel—despite their $100 par, represented nothing but water, concealed in a written-up plant account. Since they had “nothing” to back them but earning power and future prospects, no self-respecting investor would give them a second thought.)

    I returned to my statistician’s cubbyhole, a chastened young man. Mr. A. N. was not only experienced and successful, but extremely shrewd as well. So much was I impressed by his sweep-ing condemnation of Computing-Tabulating-Recording that I never bought a share of it in my life, not even after its name was changed to International Business Machines in 1926.
    Now let us take a look at the same company with its new name in 1926, a year of pretty high stock markets. At that time it first revealed the good-will item in its balance sheet, in the rather large sum of $13.6 million. A. N. had been right. Practically every dollar of the so-called equity behind the common in 1915 had been nothing but water. However, since that time the company had made an impressive record under the direction of T. L. Watson, Sr. Its net had risen from $691,000 to $3.7 million—over fivefold—a greater percentage gain than it was to make in any subsequent eleven-year period. It had built up a nice tangible equity for the common, and had split it 3.6 for one. It had established a $3 dividend rate for the new stock, while earnings were $6.39 thereon. You might have expected the 1926 stock market to have been pretty enthusiastic about a company with such a growth history and so strong a trade position. Let us see. The price range for that year was 31 low, 59 high. At the average of 45 it was selling at the same 7-times multiplier of earnings and the same 6.7 per cent dividend yield as it had done in 1915. At its low of 31 it was not far in excess of its tangible book value, and in that respect was far more conservatively priced than eleven years earlier.
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    These data illustrate, as well as any can, the persistence of the old-time investment viewpoint until the culminating years of the bull market of the 1920s. What has happened since then can be summarized by using ten-year intervals in the history of IBM. In 1936 net expanded to twice the 1926 figures, and the average multiplier rose from 7 to 171⁄2. From 1936 to 1946 the gain was 21⁄2 times, but the average multiplier in 1946 remained at 171⁄2. Then the pace accelerated. The 1956 net was nearly 4 times that of 1946, and the average multiplier rose to 321⁄2. Last year, with a further gain in net, the multiplier rose again to an average of 42, if we do not count the unconsolidated equity in the foreign subsidiary.
   When we examine these recent price figures with care we see some interesting analogies and contrasts with those of forty years earlier. The one-time scandalous water, so prevalent in the balance sheets of industrial companies, has all been squeezed out—first by disclosure and then by writeoffs. But a different kind of water has been put back into the valuation by the stock market—by investors and speculators themselves. When IBM now sells at 7 times its book value, instead of 7 times earnings, the effect is practically the same as if it had no book value at all. Or the small book-value portion can be considered as a sort of minor preferred-stock component of the price, the rest representing exactly the same sort of commitment as the old-time speculator made when he bought Woolworth or U.S. Steel common entirely for their earning power and future prospects.
   It is worth remarking, in passing, that in the thirty years which saw IBM transformed from a 7-times earnings to a 40-times earnings enterprise, many of what I have called the endogenous speculative aspects of our large industrial companies have tended to disappear, or at least to diminish greatly. Their financial positions are firm, their capital structures conservative: they are managed far more expertly, and even more honestly, than before. Furthermore, the requirements of complete disclosure have removed one of the important speculative elements of years ago—that derived from ignorance and mystery.
   Another personal digression here. In my early years in the Street one of the favorite mystery stocks was Consolidated Gas of New York, now Consolidated Edison. It owned as a subsidiary the profitable New York Edison Company, but it reported only dividends received from this source, not its full earnings. The unreported Edi-
Appendixes 568
son earnings supplied the mystery and the “hidden value.” To my surprise I discovered that these hush-hush figures were actually on file each year with the Public Service Commission of the state. It was a simple matter to consult the records and to present the true earnings of Consolidated Gas in a magazine article. (Incidentally, the addition to profits was not spectacular.) One of my older friends said to me then: “Ben, you may think you are a great guy to supply those missing figures, but Wall Street is going to thank you for nothing. Consolidated Gas with the mystery is both more interesting and more valuable than ex-mystery. You youngsters who want to stick your noses into everything are going to ruin Wall Street.”
   It is true that the three M’s which then supplied so much fuel to the speculative fires have now all but disappeared. These were Mystery, Manipulation, and (thin) Margins. But we security analysts have ourselves been creating valuation approaches which are so speculative in themselves as to pretty well take the place of those older speculative factors. Do we not have our own “3M’s” now—none other than Minnesota Mining and Manufacturing Company—and does not this common stock illustrate perfectly the new speculation as contrasted with the old? Consider a few figures. When M. M. & M. common sold at 101 last year the market was valuing it at 44 times 1956 earnings, which happened to show no increase to speak of in 1957. The enterprise itself was valued at $1.7 billion, of which $200 million was covered by net assets, and a cool $11⁄2 billion represented the market’s appraisal of “good will.” We do not know the process of calculation by which that valuation of good will was arrived at; we do know that a few months later the market revised this appraisal downward by some $450 million, or about 30 per cent. Obviously it is impossible to calculate accurately the intangible component of a splendid company such as this. It follows as a kind of mathematical law that the more important the good will or future earning-power factor the more uncertain becomes the true value of the enterprise, and therefore the more speculative inherently the common stock.
   It may be well to recognize a vital difference that has developed in the valuation of these intangible factors, when we compare earlier times with today. A generation or more ago it was the standard rule, recognized both in average stock prices and in formal or legal
Appendixes 569
valuations, that intangibles were to be appraised on a more conservative basis than tangibles. A good industrial company might be required to earn between 6 per cent and 8 per cent on its tangible assets, represented typically by bonds and preferred stock; but its excess earnings, or the intangible assets they gave rise to, would be valued on, say, a 15 per cent basis. (You will find approximately these ratios in the initial offering of Woolworth preferred and common stock in 1911, and in numerous others.) But what has happened since the 1920s? Essentially the exact reverse of these relationships may now be seen. A company must now typically earn about 10 per cent on its common equity to have it sell in the average market at full book value. But its excess earnings, above 10 per cent on capital, are usually valued more liberally, or at a higher multiplier, than the base earnings required to support the book value in the market. Thus a company earning 15 per cent on the equity may well sell at 131⁄2 times earnings, or twice its net assets. This would mean that the first 10 per cent earned on capital is valued at only 10 times, but the next 5 per cent—what used to be called the “excess”—is actually valued at 20 times.
   Now there is a logical reason for this reversal in valuation procedure, which is related to the newer emphasis on growth expectations. Companies that earn a high return on capital are given these liberal appraisals not only because of the good profitability itself, and the relative stability associated with it, but perhaps even more cogently because high earnings on capital generally go hand in hand with a good growth record and prospects. Thus what is really paid for nowadays in the case of highly profitable companies is not the good will in the old and restricted sense of an established name and a profitable business, but rather their assumed superior expectations of increased profits in the future.
   This brings me to one or two additional mathematical aspects of the new attitude toward common-stock valuations, which I shall touch on merely in the form of brief suggestions. If, as many tests show, the earnings multiplier tends to increase with profitability—i.e., as the rate of return on book value increases—then the arithmetical consequence of this feature is that value tends to increase directly as the square of the earnings, but inversely the book value. Thus in an important and very real sense tangible assets have become a drag on average market value rather than a source
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thereof. Take a far from extreme illustration. If Company A earns $4 a share on a $20 book value, and Company B also $4 a share on $100 book value, Company A is almost certain to sell at a higher multiplier, and hence at higher price than Company B—say $60 for Company A shares and $35 for Company B shares. Thus it would not be inexact to declare that the $80 per share of greater assets for Company B are responsible for the $25 per share lower market price, since the earnings per share are assumed to be equal.
   But more important than the foregoing is the general relationship between mathematics and the new approach to stock values. Given the three ingredients of (a) optimistic assumptions as to the rate of earnings growth, (b) a sufficiently long projection of this growth into the future, and (c) the miraculous workings of compound interest—lo! the security analyst is supplied with a new kind of philosopher’s stone which can produce or justify any desired valuation for a really “good stock.” I have commented in a recent article in the Analysts’ Journal on the vogue of higher mathematics in bull markets, and quoted David Durand’s exposition of the striking analogy between value calculations of growth stocks and the famous Petersburg Paradox, which has challenged and confused mathematicians for more than two hundred years. The point I want to make here is that there is a special paradox in the relationship between mathematics and investment attitudes on common stocks, which is this: Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw therefrom. In forty-four years of Wall Street experience and study I have never seen dependable calculations made about common-stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.
   The older ideas of common-stock investment may seem quite naïve to the sophisticated security analyst of today. The great emphasis was always on what we now call the defensive aspects of the company or issue—mainly the assurance that it would continue its dividend unreduced in bad times. Thus the strong rail-

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roads, which constituted the standard investment commons of fifty years ago, were actually regarded in very much the same way as the public-utility commons in recent years. If the past record indicated stability, the chief requirement was met; not too much effort was made to anticipate adverse changes of an underlying character in the future. But, conversely, especially favorable future prospects were regarded by shrewd investors as something to look for but not to pay for.
   In effect this meant that the investor did not have to pay anything substantial for superior long-term prospects. He got these, virtually without extra cost, as a reward for his own superior intelligence and judgment in picking the best rather than the merely good companies. For common stocks with the same financial strength, past earnings record, and dividend stability all sold at about the same dividend yield.
   This was indeed a shortsighted point of view, but it had the great advantage of making common-stock investment in the old days not only simple but also basically sound and highly profitable. Let me return for the last time to a personal note. Somewhere around 1920 our firm distributed a series of little pamphlets entitled Lessons for Investors. Of course it took a brash analyst in his middle twenties like myself to hit on so smug and presumptuous a title. But in one of the papers I made the casual statement that “if a common stock is a good investment it is also a good speculation.” For, reasoned I, if a common stock was so sound that it carried very little risk of loss it must ordinarily be so good as to possess excellent chances for future gains. Now this was a perfectly true and even valuable discovery, but it was true only because nobody paid any attention to it. Some years later, when the public woke up to the historical merits of common stocks as long-term investments, they soon ceased to have any such merit, because the public’s enthusiasm created price levels which deprived them of their built-in margin of safety, and thus drove them out of the investment class. Then, of course, the pendulum swung to the other extreme, and we soon saw one of the most respected authorities declaring (in 1931) that no common stock could ever be an investment.
   When we view this long-range experience in perspective we find another set of paradoxes in the investor’s changing attitude toward capital gains as contrasted with income. It seems a truism

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to say that the old-time common-stock investor was not much interested in capital gains. He bought almost entirely for safety and income, and let the speculator concern himself with price appreciation. Today we are likely to say that the more experienced and shrewd the investor, the less attention he pays to dividend returns, and the more heavily his interest centers on long-term appreciation. Yet one might argue, perversely, that precisely because the old-time investor did not concentrate on future capital appreciation he was virtually guaranteeing to himself that he would have it, at least in the field of industrial stocks. And, conversely, today’s investor is so concerned with anticipating the future that he is already paying handsomely for it in advance. Thus what he has projected with so much study and care may actually happen and still not bring him any profit. If it should fail to materialize to the degree expected he may in fact be faced with a serious temporary and perhaps even permanent loss.
   What lessons—again using the pretentious title of my 1920 pamphlet—can the analyst of 1958 learn from this linking of past with current attitudes? Not much of value, one is inclined to say. We can look back nostalgically to the good old days when we paid only for the present and could get the future for nothing—an “all this and Heaven too” combination. Shaking our heads sadly we mutter, “Those days are gone forever.” Have not investors and security analysts eaten of the tree of knowledge of good and evil prospects? By so doing have they not permanently expelled themselves from that Eden where promising common stocks at reasonable prices could be plucked off the bushes? Are we doomed always to run the risk either of paying unreasonably high prices for good quality and prospects, or of getting poor quality and prospects when we pay what seems a reasonable price?
   It certainly looks that way. Yet one cannot be sure even of that pessimistic dilemma. Recently, I did a little research in the long-term history of that towering enterprise, General Electric—stimu-lated by the arresting chart of fifty-nine years of earnings and dividends appearing in their recently published 1957 Report. These figures are not without their surprises for the knowledgeable analyst. For one thing they show that prior to 1947 the growth of G. E. was fairly modest and quite irregular. The 1946 earnings, per share adjusted, were only 30 per cent higher than in 1902—52 cents ver-

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sus 40 cents—and in no year of this period were the 1902 earnings as much as doubled. Yet the price-earnings ratio rose from 9 times in 1910 and 1916 to 29 times in 1936 and again in 1946. One might say, of course, that the 1946 multiplier at least showed the well-known prescience of shrewd investors. We analysts were able to foresee then the really brilliant period of growth that was looming ahead in the next decade. Maybe so. But some of you remember that the next year, 1947, which established an impressive new high for G.E.’s per-share earnings, was marked also by an extraordinary fall in the price-earnings ratio. At its low of 32 (before the 3-for-1 split) G.E. actually sold again at only 9 times its current earnings and its average price for the year was only about 10 times earnings. Our crystal ball certainly clouded over in the short space of twelve months.
   This striking reversal took place only eleven years ago. It casts some little doubt in my mind as to the complete dependability of the popular belief among analysts that prominent and promising companies will now always sell at high price-earnings ratios—that this is a fundamental fact of life for investors and they may as well accept and like it. I have no desire at all to be dogmatic on this point. All I can say is that it is not settled in my mind, and each of you must seek to settle it for yourself.
   But in my concluding remarks I can say something definite about the structure of the market for various types of common stocks, in terms of their investment and speculative characteristics. In the old days the investment character of a common stock was more or less the same as, or proportionate with, that of the enterprise itself, as measured quite well by its credit rating. The lower the yield on its bonds or preferred, the more likely was the common to meet all the criteria for a satisfactory investment, and the smaller the element of speculation involved in its purchase. This relationship, between the speculative ranking of the common and the investment rating of the company, could be graphically expressed pretty much as a straight line descending from left to right. But nowadays I would describe the graph as U-shaped. At the left, where the company itself is speculative and its credit low, the common stock is of course highly speculative, just as it has always been in the past. At the right extremity, however, where the company has the highest credit rating because both its past record

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and future prospects are most impressive, we find that the stock market tends more or less continuously to introduce a highly speculative element into the common shares through the simple means of a price so high as to carry a fair degree of risk.
   At this point I cannot forbear introducing a surprisingly relevant, if quite exaggerated, quotation on the subject which I found recently in one of Shakespeare’s sonnets. It reads:

                                          Have I not seen dwellers on form and favor
                                          Lose all and more by paying too much rent?
   Returning to my imaginary graph, it would be the center area where the speculative element in common-stock purchases would tend to reach its minimum. In this area we could find many well-established and strong companies, with a record of past growth corresponding to that of the national economy and with future prospects apparently of the same character. Such common stocks could be bought at most times, except in the upper ranges of a bull market, at moderate prices in relation to their indicated intrinsic values. As a matter of fact, because of the present tendency of investors and speculators alike to concentrate on more glamorous issues, I should hazard the statement that these middle-ground stocks tend to sell on the whole rather below their independently determinable values. They thus have a margin-of-safety factor supplied by the same market preferences and prejudices which tend to destroy the margin of safety in the more promising issues. Furthermore, in this wide array of companies there is plenty of room for penetrating analysis of the past record and for discriminating choice in the area of future prospects, to which can be added the higher assurance of safety conferred by diversification.
   When Phaëthon insisted on driving the chariot of the Sun, his father, the experienced operator, gave the neophyte some advice which the latter failed to follow—to his cost. Ovid summed up Phoebus Apollo’s counsel in three words:
                                                   Medius tutissimus ibis
                                                   You will go safest in the middle course
   I think this principle holds good for investors and their security analyst advisers.

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5. A Case History: Aetna Maintenance Co.
   The first part of this history is reproduced from our 1965 edition, where it appeared under the title “A Horrible Example.” The second part summarizes the later metamorphosis of the enterprise.
   We think it might have a salutary effect on our readers’ future attitude toward new common-stock offerings if we cited one “hor-rible example” here in some detail. It is taken from the first page of Standard & Poor’s Stock Guide, and illustrates in extreme fashion the glaring weaknesses of the 1960–1962 flotations, the extraordinary overvaluations given them in the market, and the subsequent collapse.
   In November 1961, 154,000 shares of Aetna Maintenance Co. common were sold to public at $9 and the price promptly advanced to $15. Before the financing the net assets per share were about $1.20, but they were increased to slightly over $3 per share by the money received for the new shares.
   The sales and earnings prior to the financing were: 
The corresponding figures after the financing were:
 June 1963              $4,681,000      $ 42,000 (def.)          $0.11 (def.)
June 1962                 4,234,000           149,000                  0.36
In 1962 the price fell to 22⁄3, and in 1964 it sold as low as 7⁄8. No dividends were paid during this period.
   COMMENT: This was much too small a business for public participation. The stock was sold—and bought—on the basis ofone good year; the results previously had been derisory. There was nothing in
Appendixes 576
the nature of this highly competitive business to insure future stability. At the high price soon after issuance the heedless public was paying much more per dollar of earnings and assets than for most of our large and strong companies. This example is admittedly extreme, but it is far from unique; the instances of lesser, but inexcusable, overvaluations run into the hundreds.
Sequel 1965–1970
       In 1965 new interests came into the company. The unprofitable building-maintenance business was sold out, and the company embarked in an entirely different venture: making electronic devices. The name was changed to Haydon Switch and Instrument Co. The earnings results have not been impressive. In the five years 1965–1969 the enterprise showed average earnings of only 8 cents per share of “old stock,” with 34 cents earned in the best year, 1967. However, in true modern style, the company split the stock 2 for 1 in 1968. The market price also ran true to Wall Street form. It advanced from 7⁄8 in 1964 to the equivalent of 161⁄2 in 1968 (after the split). The price now exceeded the record set in the enthusiastic days of 1961. This time the overvaluation was much worse than before. The stock was now selling at 52 times the earnings of its only good year, and some 200 times its average earnings. Also, the company was again to report a deficit in the very year that the new high price was established. The next year, 1969, the bid price fell to $1.
       QUESTIONS: Did the idiots who paid $8+ for this stock in 1968 know anything at all about the company’s previous history, its five-year earnings record, its asset value (very small)? Did they have any idea of how much—or rather how little—they were getting for their money? Did they care? Has anyone on Wall Street any responsibility at all for the regular recurrence of completely brain-less, shockingly widespread, and inevitable catastrophic speculation in this kind of vehicle?
6. Tax Accounting for NVF’s Acquisition of Sharon Steel Shares
1.  NVF acquired 88% of Sharon stock in 1969, paying for each share $70 in NVF 5% bonds, due 1994, and warrants to buy 11⁄2

Appendixes 577
shares of NVF at $22 per share. The initial market value of the bonds appears to have been only 43% of par, while the warrants were quoted at $10 per NVF share involved. This meant that the Sharon holders got only $30 worth of bonds but $15 worth of warrants for each share turned in, a total of $45 per share. (This was about the average price of Sharon in 1968, and also its closing price for the year.) The book value of Sharon was $60 per share. The difference between this book value and the market value of Sharon stock amounted to about $21 million on the 1,415,000 shares of Sharon acquired.
2.  The accounting treatment was designed to accomplish three things: (a) To treat the issuance of the bonds as equivalent to a “sale” thereof at 43, giving the company an annual deduction from income for amortization of the huge bond discount of $54 million. (Actually it would be charging itself about 15% annual interest on the “proceeds” of the $99 million debenture issue.) (b) To offset this bond-discount charge by an approximately equal “profit,” consisting of a credit to income of one-tenth of the difference between the cost price of 45 for the Sharon stock and its book value of 60. (This would correspond, in reverse fashion, to the required practice of charging income each year with a part of the price paid for acquisitions in excess of the book value of the assets acquired.) (c) The beauty of this arrangement would be that the company could save initially about $900,000 a year, or $1 per share, in income taxes from these two annual entries, because the amortization of bond discount could be deducted from taxable income but the amortization of “excess of equity over cost” did not have to be included in taxable income.
3. This accounting treatment is reflected in both the consolidated income account and the consolidated balance sheet of NVF for 1969, and pro forma for 1968. Since a good part of the cost of Sharon stock was to be treated as paid for by warrants, it was necessary to show the initial market value of the warrants as part of the common-stock capital figure. Thus in this case, as in no other that we know, the warrants were assigned a substantial value in the balance sheet, namely $22 million+ (but only in an explanatory note).
Appendixes 578
7. Technological Companies as Investments
     In the Standard & Poor’s services in mid-1971 there were listed about 200 companies with names beginning with Compu-, Data, Electro-, Scien-, Techno-. About half of these belonged to some part of the computer industry. All of them were traded in the market or had made applications to sell stock to the public.
   A total of 46 such companies appeared in the S & P Stock Guide for September 1971. Of these, 26 were reporting deficits,  only six were earning over $1 per share, and only five were paying dividends.
   In the December 1968 Stock Guide there had appeared 45 companies with similar technological names. Tracing the sequel of this list, as shown in the September 1971 Guide, we find the following developments:

Total                                    Price       Price Declined       Price Declined       Dropped from
Companies                     Advanced     Less Than Half      More Than Half     Stock Guide
45                                          2                   8                           23                       12

COMMENT: It is virtually certain that the many technological companies not included in the Guide in 1968 had a poorer subsequent record than those that were included; also that the 12 companies dropped from the list did worse than those that were retained. The harrowing results shown by these samples are no doubt reasonably indicative of the quality and price history of the entire group of “technology” issues. The phenomenal success of IBM and a few other companies was bound to produce a spate of public offerings of new issues in their fields, for which large losses were virtually guaranteed.


Introduction: What This Book Expects to Accomplish
1.   “Letter stock” is stock not registered for sale with the Securities and Exchange Commission (SEC),          and for which the buyer supplies a letter stating the purchase was for investment.
2.     The foregoing are Moody’s figures for AAA bonds and industrial stocks.
Chapter 1. Investment versus Speculation:
Results to Be Expected by the Intelligent Investor
1.   Benjamin Graham, David L. Dodd, Sidney Cottle, and Charles Tatham, McGraw-Hill, 4th. ed., 1962.        A  fascimile copy of the 1934 edition of Security Analysis was reissued in 1996 (McGraw-Hill).
2.   This is quoted from Investment and Speculation, by Lawrence Cham-berlain, published in 1931.
3.   In a survey made by the Federal Reserve Board.
4.   1965 edition, p. 8.
5.    We assume here a top tax bracket for the typical investor of 40% applicable to dividends and 20% applicable to capital gains.
Chapter 2. The Investor and Inflation
1.   This was written before President Nixon’s price-and-wage “freeze” in August 1971, followed by          his “Phase 2” system of controls. These important developments would appear to confirm the             views expressed above.
2.   The rate earned on the Standard & Poor’s index of 425 industrial stocks was about 111⁄2% on                asset value—due in part to the inclusion of the large and highly profitable IBM, which is not one        of the DJIA 30 issues.

Endnotes 580
3.   A chart issued by American Telephone & Telegraph in 1971 indicates that the rates charged for          residential telephone services were somewhat less in 1970 than in 1960.
4.   Reported in the Wall Street Journal, October, 1970.
Chapter 3. A Century of Stock-Market History:
 The Level of Stock Prices in Early 1972
1.   Both Standard & Poor’s and Dow Jones have separate averages for public utilities and                          transportation (chiefly railroad) companies. Since 1965 the New York Stock Exchange has                    computed an index representing the movement of all its listed common shares.
2.   Made by the Center for Research in Security Prices of the University of Chicago, under a grant            from the Charles E. Merrill Foundation.
3.   This was first written in early 1971 with the DJIA at 940. The contrary view held generally on Wall        Street was exemplified in a detailed study which reached a median valuation of 1520 for the DJIA        in 1975.This would correspond to a discounted value of, say, 1200 in mid-1971. In March 1972            the DJIA was again at 940 after an intervening decline to 798. Again, Graham was right. The                “detailed study” he mentions was too optimistic by an entire decade: The Dow Jones Industrial             Average did not close above 1520 until December 13, 1985!
Chapter 4. General Portfolio Policy: The Defensive Investor
1.   A higher tax-free yield, with sufficient safety, can be obtained from certain Industrial Revenue             Bonds, a relative newcomer among financial inventions. They would be of interest particularly to         the enterprising investor.
Chapter 5. The Defensive Investor and Common Stocks
1.   Practical Formulas for Successful Investing, Wilfred Funk, Inc., 1953.
2.   In current mathematical approaches to investment decisions, it has become standard practice to        define “risk” in terms of average price variations or “volatility.” See, for example, An Introduction          to Risk and Return, by Richard A. Brealey, The M.I.T. Press, 1969. We find this use of the word             “risk” more harmful than useful for sound investment decisions—because it places too much                emphasis on market fluctuations.
3.   All 30 companies in the DJIA met this standard in 1971.
Endnotes 581
Chapter 6. Portfolio Policy for the Enterprising Investor:Negative Approach
1.   In 1970 the Milwaukee road reported a large deficit. It suspended interest payments on its                  income bonds, and the price of the 5% issue fell to 10.
2.   For example: Cities Service $6 first preferred, not paying dividends, sold at as low as 15 in 1937          and at 27 in 1943, when the accumulations had reached $60 per share. In 1947 it was retired by          exchange for $196.50 of 3% debentures for each share, and it sold as high as 186.
3.   An elaborate statistical study carried on under the direction of the National Bureau of Economic         Research indicates that such has actually been the case. Graham is referring to W. Braddock               Hickman, Corporate Bond Quality and Investor Experience (Princeton University Press, 1958).                  Hickman’s book later inspired Michael Milken of Drexel Burnham Lambert to offer massive high-       yield financing to companies with less than sterling credit ratings, helping to ignite the                        leveraged-  buyout and hostile takeover craze of the late 1980s.
4.   A representative sample of 41 such issues taken from Standard & Poor’s Stock Guide shows that         five lost 90% or more of their high price, 30 lost more than half, and the entire group about two-       thirds. The many not listed in the Stock Guide undoubtedly had a larger shrinkage on the whole.
Chapter 7. Portfolio Policy for the Enterprising Investor:The Positive Side
1.   See, for example, Lucile Tomlinson, Practical Formulas for Successful Investing; and Sidney Cottle          and W. T. Whitman,Investment Timing: The Formula Approach, both published in 1953.
2.    A company with an ordinary record cannot, without confusing the term, be called a growth                 company or a “growth stock” merely because its proponent expects it to do better than the                average in the future. It is just a “promising company.” Graham is making a subtle but important        point: If the definition of a growth stock is a company that will thrive in the future, then that’s             not  a definition at all, but wishful thinking. It’s like calling a sports team “the champions” before         the season is over. This wishful thinking persists today; among mutual funds, “growth” portfolios         describe their holdings as companies with “above-average growth
Endnotes 582
potential” or “favorable prospects for earnings growth.” A better definition might be companies whose net earnings per share have increased by an annual average of at least 15% for at least five years running. (Meeting this definition in the past does not ensure that a company will meet it in the future.)
3.   See Table 7-1.
4.   Here are two age-old Wall Street proverbs that counsel such sales: “No tree grows to Heaven”            and “A bull may make money, a bear may make money, but a hog never makes money.”
5.   Two studies are available. The first, made by H. G. Schneider, one of our students, covers the                years 1917–1950 and was published in June 1951 in the Journal of Finance. The second was                made  by Drexel Firestone, members of the New York Stock Exchange, and covers the years                1933–1969. The data are given here by their kind permission.
6.   See pp. 393–395, for three examples of special situations existing in 1971.
Chapter 8. The Investor and Market Fluctuations
1.   Except, perhaps, in dollar-cost averaging plans begun at a reasonable price level.
2.   But according to Robert M. Ross, authority on the Dow theory, the last two buy signals, shown in        December 1966 and December 1970, were well below the preceding selling points.
3.   The top three ratings for bonds and preferred stocks are Aaa, Aa, and A, used by Moody’s, and          AAA, AA, A by Standard & Poor’s. There are others, going down to D.
4.   This idea has already had some adoptions in Europe—e.g., by the state-owned Italian electric-            energy concern on its “guaranteed float-ing rate loan notes,” due 1980. In June 1971 it                        advertised   in New York that the annual rate of interest paid thereon for the next six months               would be 81⁄8%.
   One such flexible arrangement was incorporated in The Toronto-Dominion Bank’s “7%–8% debentures,” due 1991, offered in June 1971. The bonds pay 7% to July 1976 and 8% thereafter, but the holder has the option to receive his principal in July 1976.
Endnotes 583
Chapter 9. Investing in Investment Funds
1.  The sales charge is universally stated as a percentage of the selling price, which includes the              charges, making it appear lower than if applied to net asset value. We consider this a sales                    gimmick unworthy of this respectable industry.
2.  The Money Managers, by G. E. Kaplan and C. Welles, Random House, 1969.
3.  See definition of “letter stock” on p. 579.
4.  Title of a book first published in 1852. The volume described the “South Sea Bubble,” the tulip            mania, and other speculative binges of the past. It was reprinted by Bernard M. Baruch, perhaps          the only continuously successful speculator of recent times, in 1932. Comment: That was locking        the stable door after the horse was stolen. Charles Mackay’s Extraordinary Popular Delusions and        the Madness of Crowds (Metro Books, New York, 2002) was first published in 1841. Neither a light        read nor always strictly accurate, it is an extensive look at how large numbers of people often              believe very silly things—for instance, that iron can be transmuted into gold, that demons most          often show up on Friday evenings, and that it is possible to get rich quick in the stock market. For      a more factual account, consult Edward Chancellor’s Devil Take the Hindmost (Farrar, Straus &              Giroux, New York, 1999); for a lighter take, try Robert Menschel’s Markets, Mobs, and Mayhem:            A Modern Look at the Madness of Crowds ( John Wiley & Sons, New York, 2002).
Chapter 10. The Investor and His Advisers
1.  The examinations are given by the Institute of Chartered Financial Analysts, which is an arm of             the  Financial Analysts Federation. The latter now embraces constituent societies with over 50,000       members.
2.  The NYSE had imposed some drastic rules of valuation (known as “haircuts”) designed to                      minimize this danger, but apparently they did not help sufficiently.
3.  New offerings may now be sold only by means of a prospectus prepared under the rules of the           Securities and Exchange Commission. This document must disclose all the pertinent facts about         the issue and issuer, and it is fully adequate to inform the prudent investor as to the exact nature          of the security offered him. But the very copiousness
Endnotes 584
of the data required usually makes the prospectus of prohibitive length. It is generally agreed that only a small percentage of individuals buying new issues read the prospectus with thoroughness. Thus they are still acting mainly not on their own judgment but on that of the house selling them the security or on the recommendation of the individual salesman or account executive.
Chapter 11. Security Analysis for the Lay Investor: General Approach
1.  Our textbook, Security Analysis by Benjamin Graham, David L. Dodd, Sidney Cottle, and Charles          Tatham (McGraw-Hill, 4th ed., 1962), retains the title originally chosen in 1934, but it covers much       of the scope of financial analysis.
2.  With Charles McGolrick, Harper & Row, 1964, reissued by HarperBusiness, 1998.
3.  These figures are from Salomon Bros., a large New York bond house.
4.   At least not by the great body of security analysts and investors.Exceptional analysts, who can           tell  in advance what companies are likely to deserve intensive study and have the facilities and           capability to make it, may have continued success with this work. For details of such an approach         see Philip Fisher,Common Stocks and Uncommon Profits, Harper & Row, 1960.
5.   On p. 295 we set forth a formula relating multipliers to the rate of expected growth.
6.   Part of the fireworks in the price of Chrysler was undoubtedly inspired by two two-for-one stock       splits taking place in the single year 1963—an unprecedented phenomenon for a major company. In the early 1980s, under Lee Iacocca, Chrysler did a three-peat, coming back from the brink of bankruptcy to become one of the best-performing stocks in America. However, identifying managers who can lead great corporate comebacks is not as easy as it seems. When Al Dunlap took over Sunbeam Corp. in 1996 after restructuring Scott Paper Co. (and driving its stock price up 225% in 18 months), Wall Street hailed him as little short of the Second Coming. Dunlap turned out to be a sham who used improper accounting and false financial statements to mislead Sunbeam’s investors—including the revered money managers Michael Price and Michael Steinhardt, who had hired him. For a keen dissection of Dunlap’s career, see John A. Byrne, Chainsaw (HarperCollins, New York, 1999).
Endnotes 585
7.  Note that we do not suggest that this formula gives the “true value” of a growth stock, but only that it approximates the results of the more elaborate calculations in vogue.

Chapter 12. Things to Consider About Per-Share Earnings

1.  Our recommended method of dealing with the warrant dilution is discussed below. We prefer to consider the market value of the warrants as an addition to the current market price of the common stock as a whole.

Chapter 13. A Comparison of Four Listed Companies

1.  In March 1972, Emery sold at 64 times its 1971 earnings!

Chapter 14. Stock Selection for the Defensive Investor

1.  Because of numerous stock splits, etc., through the years, the actual average price of the DJIA list was about $53 per share in early 1972.

2.  In 1960 only two of the 29 industrial companies failed to show current assets equal to twice current liabilities, and only two failed to have net current assets exceeding their debt. By December 1970 the number in each category had grown from two to twelve.

3.  But note that their combined market action from December 1970 to early 1972 was poorer than that of the DJIA. This demonstrates once again that no system or formula will guarantee superior market results. Our requirements “guarantee” only that the portfolio-buyer is getting his money’s worth.

4.  As a consequence we must exclude the majority of gas pipeline stocks, since these enterprises are heavily bonded. The justification for this setup is the underlying structure of purchase contracts which “guarantee” bond payments; but the considerations here may be too complicated for the needs of a defensive investor.

Chapter 15. Stock Selection for the Enterprising Investor

1. Mutual Funds and Other Institutional Investors: A New Perspective, I. Friend, M. Blume, and J. Crockett, McGraw-Hill, 1970. We should add that the 1966–1970 results of many of the funds we studied were
Endnotes 586
somewhat better than those of the Standard & Poor’s 500-stock composite and considerably better than those of the DJIA.
2.  Personal note: Many years before the stock-market pyrotechnics in that particular company the author was its “financial vice-president” at the princely salary of $3,000 per annum. It was then really in the fireworks business. In early 1929, Graham became a financial vice president of Unexcelled Manufacturing Co., the nation’s largest producer of fireworks. Unexcelled later became a diversified chemical company and no longer exists in independent form.
3.  The Guide does not show multipliers above 99. Most such would be mathematical oddities, caused by earnings just above the zero point.
Chapter 16. Convertible Issues and Warrants
1.  This point is well illustrated by an offering of two issues of Ford Motor Finance Co. made simultaneously in November 1971. One was a 20-year nonconvertible bond, yielding 71⁄2%. The other was a 25-year bond, subordinated to the first in order of claim and yielding only 41⁄2%; but it was made convertible into Ford Motor stock, against its then price of 681⁄2. To obtain the conversion privilege the buyer gave up 40% of income and accepted a junior-creditor position.
2.  Note that in late 1971 Studebaker-Worthington common sold as low as 38 while the $5 preferred sold at or about 77. The spread had thus grown from 2 to 20 points during the year, illustrating once more the desirability of such switches and also the tendency of the stock market to neglect arithmetic. (Incidentally the small premium of the preferred over the common in December 1970 had already been made up by its higher dividend.)
Chapter 17. Four Extremely Instructive Case Histories
1.  See, for example, the article “Six Flags at Half Mast,” by Dr. A. J. Briloff, in Barron’s, January 11, 1971.
Chapter 18. A Comparison of Eight Pairs of Companies
1.  The reader will recall from p. 434 above that AAA Enterprises tried to enter this business, but quickly failed. Here Graham is making a pro-
Endnotes 587
found and paradoxical observation: The more money a company makes, the more likely it is to face new competition, since its high returns signal so clearly that easy money is to be had. The new competition, in turn, will lead to lower prices and smaller profits. This crucial point was overlooked by overenthusiastic Internet stock buyers, who believed that early winners would sustain their advantage indefinitely.
Chapter 19. Shareholders and Managements: Dividend Policy
1.  Analytical studies have shown that in the typical case a dollar paid out in dividends had as much as four times the positive effect on market price as had a dollar of undistributed earnings. This point was well illustrated by the public-utility group for a number of years before 1950. The low-payout issues sold at low multipliers of earnings, and proved to be especially attractive buys because their dividends were later advanced. Since 1950 payout rates have been much more uniform for the industry.
Chapter 20. “Margin of Safety” as the Central Concept of Investment
1.  This argument is supported by Paul Hallingby, Jr., “Speculative Opportunities in Stock-Purchase Warrants,”Analysts’ Journal, third quarter 1947.
1.  Veracity requires the admission that the deal almost fell through because the partners wanted assurance that the purchase price would be 100% covered by asset value. A future $300 million or more in market gain turned on, say, $50,000 of accounting items. By dumb luck they got what they insisted on.
1.  Address of Benjamin Graham before the annual Convention of the National Federation of Financial Analysts Societies, May 1958.

Acknowledgments from Jason Zweig

 My heartfelt gratitude goes to all who helped me update Graham’s work, including: Edwin Tan of HarperCollins, whose vision and sparkling energy brought the project to light; Robert Safian, Denise Martin, and Eric Gelman of Money Magazine, who blessed this endeavor with their enthusiastic, patient, and unconditional support; my literary agent, the peerless John W. Wright; and the indefatigable Tara Kalwarski of Money. Superb ideas and critical readings came from Theodore Aronson, Kevin Johnson, Martha Ortiz, and the staff of Aronson + Johnson + Ortiz, L.P.; Peter L. Bernstein, president, Peter L. Bernstein Inc.; William Bernstein, Efficient Frontier Advisors; John C. Bogle, founder, the Vanguard Group; Charles D. Ellis, founding partner, Greenwich Associates; and Laurence B. Siegel, director of investment policy research, the Ford Foundation. I am also grateful to Warren Buffett; Nina Munk; the tireless staff of the Time Inc. Business Information Research Center; Martin Fridson, chief executive officer, FridsonVision LLC; Howard Schilit, president, Center for Financial Research & Analysis; Robert N. Veres, editor and publisher, Inside Information; Daniel J. Fuss, Loomis Sayles & Co.; F. Barry Nelson, Advent Capital Management; the staff of the Museum of American Financial History; Brian Mattes and Gus Sauter, the Vanguard Group; James Seidel, RIA Thomson; Camilla Altamura and Sean McLaughlin of Lipper Inc.; Alexa Auerbach of Ibbotson Associates; Annette Larson of Morningstar; Jason Bram of the Federal Reserve Bank of New York; and one fund manager who wishes to remain anonymous. Above all, I thank my wife and daughters, who bore the brunt of my months of round-the-clock work. Without their steadfast love and forbearance, nothing would have been possible.
Editor's note: Entries in this index, carried over verbatim from the print edition of this title, are unlikely to correspond to the pagination of a given e-book's software reader. Nor are these entries hyperlinked. However, entries in this index, and other terms, may be easily located by using the search feature of your e-book reader software.

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