不安世界中的证券——市政厅讲座，旧金山圣弗朗西斯酒店，1963年11月15日（印刷文本扫描件）

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SECURITIES

IN AN

INSECURE WORLD-

A LECTURE by

BENTAMIN GRADIAM

delivered at

TOWN HALL

SteFrancis Hotel

November 15-1963 504 per copy

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SECURITY IN AN INSECURE WORLD

A LECTURE BY

BENJAMIN GRAHAM

Doctor Rappaport has chosen a very intriguing title for my talk, "SECURITY IN AN INSECURE WORLD." I hope that not many of you came under the mistaken impression that I am going to talk about security in general. only about financial security, not about physica security, mental security, matrimonial security, or other types. Even as far as financial security 1s COn cerned, I am going to address myself only to investment policy in stocks and bonds. The title of this talk might better have been SECURITIES IN AN INSECURE WORLD, because securities are my field. I am not going to talk about savings and budget policy, life insurance, home ownership, pension plans and other matters of that kind. The reason is that I don't consider mysell an expert in those areas, and I would rather talk to you about things I hope I know more about than you do.

This resinds me of the fact that when the New York Society of Security Analysts established a journal in 1946 we gave it the simple title "The Analysts Journal. But then we got so many inquiries aud even subscriptions from psychoanalysts that we were forced in self-defense to change the name to the present title "The Financial Analysts Journal."

In the field of financial security, as limited to the problems of investment policy, I would say there are three kinds of threats or dangers that investors should recognize as possibly existing at the present time. One of them would be the threat from atomle war; the second would be the threat from inflation; and the third would be the threat from severe market fluctuations up and down, and of course primarily down. Now, I have no prescription lor financial security or for portiolio policy that could deal with the possibility of atomic war. I don't think anyone else bas; we preier to sweep that problem under the rug and go forward to things that we can deal with more effectively• The second danger I mentioned was inflation. Inflation has been a big factor in investors financial experience going back as far a$ 1900. Not many people realize that we had more inflation in the first thirty years of this century then in the second thirty years, as measured by the usual indices.

The continuation of sone degree of inflation is certainly probable in the future, and that is the chief reason why most intelligent investors now recognize that some common stocks must be ineluded in their portfolio. However, that is only... part of the question of the effect of inflation on investment policy. The fact is that both the extent of inflation and the investor's reaction to it have varied greatly over the years. It is by no means a straight-line matter. A good example is the most recent one. We have had a small inflation in recent years accompanied by a very large increase in stock-market prices, which seem to be geared not to the inflation experienced but rather to the expectation of greater inflation in the future. You probably know there has been no increase in the wholesale-price average since 1958. There has indeed been a rise of 65 per eent in the cost of living in the last live years, which of course is not negligible, but it could scarcely in itself be a sound basis for a 100 per cent rise in stock prices. Conversely, during the years 1945-1949 we did have a rather explosive kind ol intla-tion--the consumer price index, (that 18, the "cost of living") advanced over 33 per cent -but during that period stock prices actually had a small decline.

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My conclusion here is that investors! feelings and reactions regarding intla. Elon are probably more the result of the stock-market action that they bave recently earerienced than the cause ol it. Consequently there 1s great danger of investora giving Inflation t00 much weight when the market advances and ignoring it entirely, as they did in 1945-9, when the market declines. This has actually been the history of intiation and stock market behavior ever since 1900•

Ine problem of price fluctuations, or market fluctuations, la a very real one "or Investors as well as speculators, although there has been a tendency in Wall street to deny that for a number of years in the past and even currently. Actually, the real problem is not whether price fluctuations are important to the investor; it is rather the opposite, that is to find some good workable distinetion between the investor end the speculator in common stocks. As will be pointed out later that distinction has almost vanished from Wall Street, & fact which has caused a great deal of trouble in the past and will cause a great deal • of trouble in the future.

Yet only last year, although it seems a long time ago--market fluctuations, as evidenced by a decline in the Dow Jones Average Irom 735 to 535, did Ioom as extremely important to investors and speculators alike. This fall of about 27% in the Dom Jones Average was accompanied by declines ol between 50 and 90 per cent or more in most of the new securieties that had been issued in the preceding two years and bad played suck a spectacular part in the stock market activity of that period. At that time then, in May 1962, the concept of a one-way narket, which could go only upwards with very small reactions, seemed to be abandoned lor good. Hovever, wall Street bas a very short memory, and now the majority of financial authorities seem to be slipping back to the concepts of 1960 and 1961.

They are returning to the ides that for the smart investor the question of stock market fluctuations does not have to be considered to any great extent. There in a two-Iold emphasis here, which Blus over the reality of stock market fluctuations. The first is the general conviction that the market can be counted on to advance so emphatically through the years that whatever declines take place are comparatively unimportant; hence if you have the true investor's attitude you don't have to concern yourselt with them, The second claim 1s a denial that the "stock market" exists at all, meaning thereby that what the market averages do Is of no real importance to the intelligent, well-advised investor or speculator. It seems to be a ruling tenet of Wall Street that if you practice the proper kind of selectivity in investments you don't have to worry about what the stockrmarket does as a whole, as shown by the averages, for at all times the good stocks will be going up and the bad ones will be going down and all you need to do is pick the good stocks and forget about the stock-market averages.

How valid are these two arguments? precio, to date tae The first ones the argument that common stocks are and always will be attractive, including the present time, because of their excellent record since 1949. involves in those terms a very fundumental and important fallacy. This is the idea that the better the past record of the stock market as such the more certain it is that common stocks are sound investments for the future. Now we all know that it a corporation has had a very good record over the pest years that is a lair indication (but no guarantee) that its record is likely to be good in the future, because it has certain business advantages which in most cases ought to continue. But you cannot say that the fact that the stock market bas risen continuously (or slightly irregularly) over a long period in the past is a guarantee that it will continue to act in the same way in the future, As I see it, the real truth is exactly the opposite, lor the higher the stock market advances the more reason there is to mistrust its future action 11 you are going to consider only the market'" internal behavior. We all know that

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Por many decades typical history of the stock market has been a succession of Large rises, im good part speculative followed Inevitably by substantial falls. Consequentin, the substantial upsweeps of the past bave always carried with them warning signals of uhappy consequences to come. It does not necessarily follow

a large rise in the price of a individual stock or in the market averages must be followed by a decline; but the only reason to view with confidence the future price of security that bas already advanced substantially in the presence of external other than than the actual price movement itself, which would Justify such confidence. & large advance in the stock market is basically a sign for caution and not a reason for confidence.

Let us discuss market'» possibilities from present levels in terms Pirst of theoretical reasoning , then in terms of some practical considerations. I world like to present three possibilities, undoubtably there are a great many more. one possibility, which in a very popular one in present thought, is that the rise that hes taken place since 1949.0 from about 163 in the Dow Jones Average, to 750 at the present time. reflects a new and a marvelously Improved character of common stocks, and therefore can be expected to continue more or less at the same rate in the future. Only much a point of view can make sense out of the prevalent practice of calculating the gains thet investors could have sade in mutual fund shares or in similar purchases over the last 14 years as a basis lor trying to persuade them to buy suen securities at their present advanced prices. As you know, this hind of calculation is doze »ll the time by mutual pand splennen'to impress investors. The SEC requires it to be accompanied by a perrinctory statement that the calculation carries no warrantly for the future, but I don't think very much emphasis is placed upon that qualitication.

The second possibility is that a good part of the rise I spoke of was an adjustment Irom an undervalued level in 1949 to a proper level on some new basis of valuation. If that is 80, a good part of the 1949-1963 rise could not be expected to be repeated from a level which is now a corrected one. Horever, we could have a satisfactor advance on the average, say 47% per annum, from whatever level turns out to be about right for today. It 750 in about the right present level then the investor might possibly expect a more or less standard 42% advance from this level, year by year, subject to moderate dowaward fluctuations.

But the third possibility is that the nature of the market has not changed

Its carliest times, as shown in our records that go back at least to the South Seas Bubble in 1720, pratically 200 years. WE have also very detailed data on stock prices in the United states since 1871, which were incorporated in the Cowles and the Standard and Poor'" records" It may well be that we shall still have the 11-too familiar alter nations of excessive optimism and excessive pessimism. most recent example of excessive pessimism is the very period which was a starting one for this market. During 1949-50 the market had the lovest peace-time price. earnings ratio in its history. Stocks sold at only about 7 times their earnings, in the market averages I am talking about, as compared with about 20 times at the present time. The implication here is that just ss stocks were evidently under-valued at seven times their earnings they might very well be overvalued at twenty times earnings or at some higher multipller that will be established later in this market and will represent a level of excessive optimism.

My own opinion about these three choices is that the first possibility is really out of the question. It is not in the nature of economic reality to permit net gains at the shown rates from Ig4y to 63-- something Jike 14% per annum in-cluding the dividend returns-. to continue inderinitely in the future. We Juat don't have a financial and economie system that can operate on that basis. It that were true nobody would have to work for & Ilving. I remember very well the

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number of people in the late 1920's who got a corresponding view of the stock market, gave up their jobs and plunged into wall street to take advantage of its wonderful

second possibility-which is that the market will advance pretty stead- Ily from approximately the present level, but will not have the advantage of starting IrOm a very low level. is admissible in theory. But the great problem, one that I will talk about later, is how can you determine the proper new basis for common stocks valuations and therefore how can you determine the more or less proper level tor now? I discused this question in a paper read to the American Finance Ass'n. in December 1961, and said then that the market was really adrift on a sea of unsettled standards. The old standards of value, which had been well established for decades and perhaps generations, no longer seem to be tenable; as much too conservative; but the proper new standarda of value could certainly not be worked either by somebody's inner consciousness or by mathenatical calculations. we shall have to wait, probably lor a considerable length of time before ve can determine dependable new standards. In the mean time it seemed to me that the stock market will have to carry on its calculations by a process ol trial and error, which could lead to large fluctuations around what in the end will tum out to be the new central value. I think what happened since December 1961 bears out this interpretation to some degree. Certainly the big decline in 1962 represented a sharp Pluctuation of one kind, and the impressive recovery since June 1962 may represent a fluctuation of the other kind.

No doubt you would be interested to know what I mean by the torna "old and new standards of value" as applied to the stock market level. The old standards of value-which were pretty well accepted up to say 1955 were reached by a number of different approaches based on reasoning or experience. The one I like best of course was my own, which bas been knows as the "Grabam." . It was derived from the Central Value average earnings of the 30 gtocks in the Dow Jones Industrial Average for ten years past, capitalized at twice the interest rate on high grade bonds. For example at the present time the average ernings for the last ten years are about $33 on the Dow Jones unit and the present zate on high grade bonds is 4.3 per cent. If you capitalize $33 at8. 6% - which 1s a multiplier of about 12 jou would get a central Value on the old basis of about 380, as compared with the present price of about 750.

In early 1955 when I testified before the Fulbright Committee the stock market was then about 400, my central value was also around 400 and the valuations of other "experts" using other methods all seemed to come to about that level. The action of the stock market sitte then would appear to demonstrate that these methods of valuations are ultre conservative and wuch too low, although they did work out extreme- Iy well through the stock market fluctuations Iron 1871 to about 1954, which is an exceptionally long period of time for a test. Unfortunately in this kind of work, where you are trying to determine relationships based upon past behavior, the almost invariable experience is that by the time you have had a long enough period to give you sufficient confidence in your forn of measurement just then new cone ditions supersede and the messurement is no longer dependable for the future.

We had to deal with this problem in the fourth edition of "Security Analysis" published last year, and to recognize the probability that stocks should be valued more liberally now than in the past, our chief reason for that, incidentally is not because the government'» commitment to prevent large scale depressions has changed the climate of corporate earning, from what it was prior to the Employment Act of 1946. We think this new insurance against a very severe falling off in the earnings of corporations generally would justily a higher valuation of these earnings than in former years. Hence we have added an arbitrary 50 per cent to the valuation based upon our old method. That would give us now a value of about

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5T0 For the Dow Jones Average, and a corresponding value of about 5f for the Standard Poors 500-stock average. Let me point out that the two averages stand so close together on a ten-to-one basis in their price level, dividends and earnings, that you can use the two figures almost interchangeably lor purposes of description or ar-alysis.

You must recognize that this level of 570, which is derived from an arbitrary mars up of 50% from the old level, has no special authority behind It. It was merely the best judgment that we could give on a situation which does not admit of any really dependable calculations. As a matter of lact il one is sufficiently optimistic and adroit it is quite possible to develop a nethod of valuation which sounds plausible enough and world justify the present level of 750 for the Dow Jones Average. Let me show you how that could be done. Lou say first that investors would like to get an over-all return of 72% on their money in future years. That's what common stocks have returned on the average- in dividends and price appreciation-ever since 1871, as shown by the Cowles and Molodoraky studies. Now It we can expect a rate of growth of earnings and dividends of 42% a year then all we need is a dividend retura of 3% to make up the desired 7a% total. Since the Dow Jones and Standard Poor'» dividend return 1s just a little more than 3% right now on the market price, we could buy these at the present level with confidence, as we would then get a 3% return in dividends and a 42% annual return in growth. Many people might think that even less than an overall 72% should suffice. All that sounds fine but if you reflect that by some chance the future grorth rate would be 32$ Instead of 42%- and 32% was about the actual annual growth in dividends in the Last ten years- then you get quite a difference. For if now you are expecting a 32% growth rate, you will need a 4% dividend roturn to make up the required 7z%. On that basis the Dow Jones Average is worth just about the 570 which we arbitrarily gave to ito

There is a lot of juggling with figures that can be done now as always; but none of these nethods in itselt gives a dependable result. Io a great extent the figures selected are determined by the general attitude of the man who is selecting them, and that general attitude is very often determined in turn by what the stock market has been doing. When the stock market 1s at 750 you take an optimistic attitude and use some lavorable figures, but if it shoula have a severe decline most people would jump back to the older and more conservative evaluation nethods.

Let me now point out a striking area in which the uncertainty of the proper valuation of common stocke In brought to the fore. That is this very question of the relationship between dividend return on stocks and the interest rate on bonds. FOr fifty years or more it was a tenet in wall Street that stocks should yield considerably more than bonds. In speculative markets stocks might rise until their yield became less than that of bonds. But this very development was a sure sign that you were in a dangerous market.. one heading for a bad lall. A friend of mine, head of an important brokerage house, was so enamored of that idea he used it .. constantly in his market letters. More than that he actually had the relation. ship between stock yields and bond yields printed in a nice chart-design on neck ties Imported from Paris, which he distributed to his friends including me. For awhile I wore this tie at some of my lectures, and said that this was the first time that anybody had analyized the technical position of the stock market from his necktime. Well, since 1958 stocks have been ylelding considerably less than. bonds with no sign of a return to old relationships. Hence my broker friends found that this concept increasing hard to stick to. About two years ago, actual- Iy not very long belore the big market break, in a huge newspaper advertisement he abandoned this concept completely, said it was all bosh to talk about stock yields as the basis of evaluation, claimed the main thing was the psychology and attitude of the public; and assested this factor was strongly bullish and justified

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confident buying of stocks. My chief reason for mentioning this incident is that I had just spent a lot of time studying the weekly analyses of the stock market by one di our oldest financial services which started in 1909 and I found the Identical experience took place just 30 years before in this service (whose name I also won't mention.) For many years they talked about the standard relationship between stock yields and bond yields, and they used it to determine the probable top levels for the stock market advances. In the great bull market of the late 1920's this relationship proved to be very unreliable as a short-term market forecaster. So they too, in a spectacular statement using almost the same language, turned their back completely on the comparison of stock yields and bond yields and said that the market's psychology was the best basis for forecasting. That happened sometime In 1928, and they stick to this viewpoint to the great crash of 1929.

The present relationship gives considerably lover yields on stocks than on bonds. High grade bonds yield about 430 per cent while the stocks averages yield a little bit more than 3% Because that relationship has existed for the past live years does it represent a permanent relationship for the future, or 1s it only an indication that the stock market bas been clearly overvalued for five years, in the same way that it was clearly undervalued during the period 1949-1954? Inis is the many billion dollar question. You won't be able to get the answer to that by mathematies; you won't be able to get it from an expert such as me or anybody else; so you'll have to answer that question for yourself.

But the thought that the stock market may have been over falued in the last five years, just as it was undervalued filteen years ago, brings us to the third possibility which I enumerated, namely that we are still going to have wide fluctuations in the future. Ihis I consider the most probable one, though it is far from certain. My reason for thinking that we shall have these wide fluctuations. of which we had a taste in 1962, in May particularly- is that I don't see any change in human natures vis-e-vis the stock market which is sunricient to establish more restraints in the public behavior than it shoved over so many decades in the past. The actions Of the public with respect to low-grade new issues during the 1960•61 extravaganza in that field are an indication of its Inherent lack of restraint. Jou ought to remember a1so, that many of the highest grade common stocktissues were forced up to excessive levels by « market entbusiasm which produced large subsequent declines. Let me give you some examples: The most impressive to my mind was that of Inter. national Business Machines which 1s undoubtably the leading common stock in the i entire market. Speculative enthusiasm pushed it up to 607 in December 1961, from which It declined to 300 in June 1962-- a fall of more than 50% in the short period of 6 months. General Electric, which is the oldest high grade investment common stock, declined from a high of 100 in 1960 to 54 in 1962. Dow Chemical, one of our best chemical companies, fell from a high of 101 to a low of 40, and U.S. Steel which Is an old leader, shrank from 109 in 1959 to a low of 38 in 1962. These very wide swings underline the fact that the stock market is basically the same now as it always was, in the sense it 1s still subject to very substantial over-evaluation at ¡sometimes and 'undoubtably substantial under evaluations at others.

My basic conclusion is that investors a vell as speculators must be prepared in their thinking and in their policy for wide price movements in either direction, They should not be taken in by soothing statements that a real investor doesn't have to worry about the fluctuations of the stock market.

It is time now to say what little I can say about the probable course of the stock market from the present level. No doubt that is the point which would interest the audience most and on which I can be the least enlightening. In my view there is an important difference between the present stock market and the market at more or less the same level in December 1961. At that time I had no hesitation about predicting that then there would have to be a fairly near-term collapse of the new-issue market, which had passed all bounds in speculative excesses. And if that

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collapsed it would surely effect in some serious way the general level of stock prices, it might possibly usher in the bear market which inwardly I have been ex-pecting for some time past. The new issue collapse came per schedule and it dia have a major adverse effect on the rest of the market. But a recovery began in a comparatively short time, and it has carried the market averages to new heights, which were contrary to my invard expectations but not to any specifie predictions which I made. I would like to point out that the last time I made any stock market predictions was in the year 1914, when my firm judged me qualified to write their daily market letter, based on the fact that I had one month's experience in wall street. Since then I have given up making predictions.

The important point now is that the current high levels of the market are not accompanied by these excesses in the nev-issue market and in some other direc. tions which made it appear so vulnerable in 1961. It is the general view in Wall Street that such characteristie abuses must develop again before the stock market can have another collapse, - or before a true bear market can begin (ll it isn't against the law to use the dirty words "hear market"). These abuses would include large public participation by amal people who don't know what they are doing, high borrowings on margin, the reneval of the new-issues spree and so on. Now this contention sounds plausible enough based on experience, and so one might guess that the market could well continue generally upward lor quite a while, But let me point" out "for the record" that it is not impossible in theory that the market's high level alone could sooner or later precipitate a collapse without the necessity for these technical weaknesses to show themselves. The collapse might be triggered by some untoward economic or political development. But if things do happen that way it will be the first time in market bistory, I believe, that we would have the end of a bulk market without the excesses and abuses of the sort I have mentioned. But there is alvays a first time for everything.

My opinion then regarding the present market level must be rather inconclusive, and I shall base my later prescription of policy on the assumption that investors cannot have a dependable view on the market'» future action in the next year or so, but that & large and disturbing decline is likely to take place gain sometie in the future, and that we should be prepared in thought and action LOI it, is a necessary assumption lor investors to make, and for sensible speculators too it there are, any such.

The second claim which is that there is no real "stock narket" but only, as the Wall Street people like to say, only "a market of stocka"-. deserves a moment or two of discussion What they mean by saying this is that investment results depend only on what happens to individual securities, some of which will go up and others down, and that it is illusory to talk about what happens to the market as a whole as having a major bearing on how the investor lares. I disagree with that point of view on three grounds.

The first is that I doubt that the warket is really so much different in this respect from what it always was in the pasto ket in 1928 and 1929, and I am sure that the disparity and diversity of stocks between those that acted well and those that acted poorly was almost as great then as we see now. But despite that fact it was essential for investors to be guided by a view as to the general level of the stock market. It is suprising to me that wall Street people haven't taken the time to make a study of the spread in price movements between individual stocks in recent yeers as compared with what happen-ed in former years. (I have a student at UCIA who is going to make this study and it may prove quite illuminatory). ~ The second reason is that there is actually a considerable underlying consistency in the stock market il you measure its movements by comparing two averages which seem to be quite different. One of them Is the Dow Jones Industrial Average, which consists of only 30 stocks, and the other is the Standard & Poor's Composite Average which consists of 500 stocks. You might well assume that il there

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is sunderiying diversity of price movements then an average including only 30 stocks would certainly behave different from one embracing 500. But 11 you observe the fluctuations in both averages, now given by most newspapers you get virtually a ten-to-one change, which means a parity change, almost day by day and certainly month by mortis and year by year. In the past ten years the Dor Jones Average rose From. a 275 mid-point in 1953, to 750, while the Standard Poor's index rose from 24.7 to

An interesting boint is that the apparently miscellaneous group of 500 issues actually had a slightly better advance than the gilt-edge or blue-chip stocks in the Dow Jones Average. This indicates that you cannot tell a priority bang groupfol stocke is going to do over the future years in comparison with any other.

1 think the third and most important reason why the investor should /led to emphasize his selection of individual stocks, and to neglect the general level of the stock market is the fact that there is no indication that the investor can do better than the market averages by making his own selections or by taking expert

The outstanding support for that pessimistic statement is found in the

of the investment funds, which represent a combination of about the best financial brains in the country, and a tremendous expenditure, of money, time, and carefully directed effort. The record shows that the funds have had great dif liculty as à whole in equaling the performance of the 30 stocks in the Dow Jones Averages or the 500 Standard & Poor « Index, If an investor had been able, by some rouga aCrOSs-the-board diversification to make up a portfolio approximating these averages ne voud have had every reason to expect about as good results as were shown by the very intelligent and careful stock selections by the investment-fondi managers. But the great justilication for the mutual funds is that very few investors actually do follow such & sound and simple policy.

I must reluctantly arpress some stepticisn about the general efficacy of economic forecasting, of stock market forecasting, and ol' expert selection of common stocks, in their relation to the investment and speculative profits which can be made therefrom. Iet me give you my reasons: I say first that to the extent that an economic forecast appears dependable and it is generally so only for the short term--its effect is likely to be already reflected in the market level, and there is no way to make money from It For example, ve cannot say because the forecast loz 1964 1s favorable that common stocks should be bought today. The price of common stocks today, as everybody should know reflects the general expectation of a good 1964. On the other hand, Ionger term business forecasts have proven unellable on the whole.

Similarly, take the case where an individual stock 1s favored by one of my ova fraternity of security analysis is because he is optimistic about Its future earnings and general prospects, Io the extent that investors generally agree that this company has good future prospects tosthat extent its prospects are also likely to be fully reflected and perhaps over reflected in the market price. Sometimes you find the contrary case where a Wall Street man may say "Nobody Likes this stock, nobody has confidence in It, but I have confidence in it and I know its results are going to be better in the future." That's an interesting and valuable conclusion if true. The trouble is that in most cases you can't rely on its dependability Ihe man may be right or he may be wrong in saying that some un. popular stock is going to have a very good future. That is the diloma all investors face in trying to make money out of forecasts as to the future prospects any individual security.

Now, with respect to stock market forecasting as such, as a separate oe-cupation or amusement, I don't think there is any good evidence that a recognized and publicly used method of stock market forecasting can be relied upon to be pro-

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fitabic. Let ne illustrate what I mean by reference to the famous "Dow Theory" widen is the best known of the methods used for forecasting the stock market. made sone elaborate studies of the results of applying the mechanical concepta of the Don Theory, in which you have well defined signals to buy and sell stocks by the movement of the average through resistance points upward or downward. I found that when I studied the record from 1898 to 1933, a period ol' about 35 years- the results from following this mechanical method were femarkably good. About 1933, the time when the Dow Theory had show itself a very useful method for dealing with the market action in the 1920's and early 1930'%, the public's Interest in the Theory increased enormousLy. esoterie preseription followed only by a ler devoted adherents, and about which everybody else bad been pretty septical. The Dow Theory became extremely popular after 1933. I studied the consequences of using exactiy the same method in the market after 1933, and I found peculiarly enough that in no case in the next 25 years did one benefit through following the Dow signals mechanically. By this I mean that one was never able to buy his stocks back at a lower price than he sold them for.

As you know, the Dow Iheory is still persued by a number of practitioners and services. I think all of them will tell you that it is not a mechanical theOry son; and that a large clement of judgment has to enter in the interpretation of the signals. But once you introduce that element you don't have a true theory anymore, you just have a certain expertise which may or may not be dependable and

Let me now make a general observation. For obvious reasons it is impossible for investors as a whole, and therefore for the average investor or speculator, to do better than the general martet. The reason is that you are the general market and you can't do better than yourselves. I do believe it is possible for a minority of investors to get significantly better results than the average. Ivo conditions are necessary for that. One is that they must follow some sound prine ciples of selection which are related to the value of the securities and not to their market price action. The other 1s that their method of operation must be basically different than that of the majority of security buyers. They have to out themselves orp from the general public and put themselves into a special cata...

I will touch more brietly on that point later.

Now, let me summarize up this stage. The investor needs common stocks in his portfolio, but these introduce hazards of wide fluctuations which he cannot so pera he tike care in bla expect to avoid more successfully than others unless perhaps he thinks independently from the crowd, that is unless he is constitutionally different from the

Now let me come to part two: what investment policy to follow under the conditions discussed! My vieve thereon are and definite and strong. In my nearly fifty years of experience in Wall Street I've found that I know less and less about what the stock market is going to do but I know more and more about what investors ought to dos and that's a pretty vital change in attitude. The first point is that the investor is required by the very insecurity ruling in the world of today to maintain at all times some division of bis funds between bonds and stocks (cash and various types of interest-bearing deposits may be vieved as bond-equivalents.) My suggestion is that the minimum position of this portionIo held in common stocks should be 25% and the wazimum should be 75% Consequently the maximum bolding of bonds would be 75% and the minimum 25% the figures being reversed. Any variations made in his portfolio mix should be held within these 25% and 75% figures. Any such variations should be clearly based on value considerations, which would lead him to own more common stocks when the market seems low in relation to value and less common stocks when the market seems high

montimportant seaguept

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in relation to value.

Now while this is the classic language of investment authorities, it is amazing how many people think in exactly opposite terms. That was brought home to me shortly after the May 1962 break when a savings-and-loan company representative came to me with questions. The first question he asked me

"Don't you think that common stocks now are less safe than before because of the decline in the market?" That hit me between the eyes. Here were financial people who could seriously consider that stocks less safe because they have declined in price than they were after they had advanced in price. The policy I propose to have more common stocks when the market seems to be low and less when it seems to be high by value standards is obviously opposed to the psychology of investors generally and tỏ that of speculators alvays. It is particularly true now because of the great confusion between investment and speculation which I shall refer to later. I suppose the idea of having more common stocks at 1ow levels than at high levels ia a "counsel of perfection" for most investors. But it could be followed by many investors to the extent of an inflexible rule that they should not increase the percentage of common stocks in their portfolio as the market advances, except of course through the rise in the market itself. However, a more sophisticatéd application, which would take advantage of a rise in the market level for sales, could be something like thil. Use a t'ixed 50-50 division between bonds and stocks. when the market level of the stocks rises to a point where they constitute 55% of the total of maybe 60%, you would then sell out enough to bring your proportion back to 50%, putting the proceeds back into bonds or into savings banks. And conversely when the market went down so that your common stock proportion had fallen 45% or 40%, you would use some of your bond money to buy common stocks and bring it back to the 50% That was the famous Jale University system, which was one of the carliest formula methods known. They used a 35% basis ¡or common stocks, a percentage which at that time was regarded as pretty rash for an institution of learning. When a market rise brought it up to 40% they sold out one eighth of their holdings, to get back to 35%; when it went down to 30% they bought one sixth to bring the ratio up again to 35% It was a good system until 2222 the market ran away on the upside, and then they decided they had t0o little in : common stocks. Now they are up to a 50 to 55% ratio, like the other universities, I think, and they don't follow the formula anymore.

Another approach that is practicable, but from a different point of view, is the "Dollar Averaging" method, in which you put the same amount of money in common stocks year after year, or quarter after quarter. In that way you buy more shares of stocks when the market level is low and lever shares when its high. Ihat method has worked out extremely well for those who have had (a) the money, (b) the time, and (e) the character necessary to persue a consistent policy over the years regardless of whether the market has been going up or down. If you can do that you are guaranteed satisiactory success in your investments.

Let me add that there are countless variants of this type, which are called "formula plaris." The main need here is for the investor to select some rule which seems to be suitable los his point of view, one which will keep him out of mise chief, and one, I insist, which will always maintain some. interest in common stocks regardless of how high the market level goes. For if you you had followed one of these older formulas which took you out of common stocks entirely at some level of the market, your disappointment would have been so great because of the ensueing advance as probably to ruin you from the standpoint of intelligent investing for the rest of your life.

Now let me come to the problems of security selection. we have talked about a bond component (and/or a cash-equivalent component) and a common stock component. There's a wide choice in the bond component, but the decision is not of

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too much importance in most cases. In the taxable list, you can put your money in U.S. Savings Bonds at 35%; which you can redeem at will; you can buy long term U.S. Government Bonds at about 4.10% taxable; you can buy high grade, long-term corporate bonds at 4.30%, or 42% il you do a little selectings you can have savings deposits in commercial banks which give you up to 4i% if held lor one year; you can buy savings-and loan shares (bear in mind that they are not deposits but shares) which now yield up to 5% in California. Another choice of great importance are tax-free state and municipal bonds, which yield up to about 32% for good quality and long maturity. For most investors who are in a tax bracket of more than 30%, tax-free bonds have been the most attractable for many years. They actually were in part a gift to the investor of which he didn't take advantage up to the extent he should have as against taxable bonds. advantage has diminished, because tax free bonds have advanced relative to others, but it is still persuasive for people of substantial means. I would like to point out that in 1953 municipal bonds yielded 2.93% and U.S. Government taxable bonds 3.08%, nearly the same return despite the full tax on the governments. In October 63 the municipal average was 3.28% and that of U.S. Government bonds 4.06%, so you see the advantage that has serued to the past holder of tax-free bonds as compared with U.s. government.

One question for the investor which I won't go into, and I am glad I havn't. got the time to do it, is whether he should take advantage of the 5% rate offered by some of the savings and loan associations in California. Let me say that I am not an expert on savings- and loan associations, and I don't want to get drawn into the controversy that has now begun as to whether their methods are completely sound and their prospects are completely dependable. I just want to say in general terms that nobody can assume that he can get exactly the same degree of safety and dependability in a standard type of investmeat yielding 5% as in one yielding 4%. ept noble in a standard type of yes

With respect to prefered stocks the import point is that they do not belong in the individual investor's portfolio, The reason is they have a great tax advantage for corporate owners which they don't have for individual owners. Corporate owners save 85% of the tas on these dividends, individual owners save & very small amount, which may disappear pretty soon in the new law. It should be obvious that preferred stocks should be bought only by corporate investors just as tax-free bonds should be bought only by people who pay income tax. You may have noticed last week that one of the public utility companies offered a bond issue and a preferred-stock issue at practically the same yield, although hitherto preferred stocks have always yielded quite a bit more than the bonds to which they were ane rest tax drastage of junior. The great tax advantage of preferred stocks to corporate buyers is now belatedly showing its effect on relative yields.

We come finally to common-stock investment. My recommendation is that the investor choose either his own list of, say, 20 or 30 representative and leading companies, or else put his money in several of the well-established mutual funds. There Is usually an advantage for the shrewd investor in buying shares of the closed-end investment companies on the New York Stock Exchange, when obtainable at discounts irom net asset value, rather than paying the premium added on to the price of most open end shares.)

Many investors would think my prescription too gimple. If they can get ree sults equal to the averages in this easy way why shouldn't they try to get a substantially higher return by careful and competently-advised selection? My short answer has already been given: If the investment funds as a whole can't beat the averages, even pretty clever investors as a whole can't do it either. The underlying problem of selection is that the "good stockso chiefly the growth stocks with better than average prospects--tend to be fully priced and

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often overpriced." At the other extreme new stock offerings, when the craze 1s one, are likely to combine fourth rate quality with absurdly high price-carnings ratios. There are better opportunities in between these extremes, but most investors don't Look for them there.

As I see It, the fundamental problem in common stocks is the market's 12- jection of a large speculative element into the strongest and best companies by establishing an untenably high price for them. (The rise Of IBM Or 607, B00n followed by a fall to 300, is the best illustration of my point.) This bas add-edgreatly to the confusion between investment and speculation, because it 1s easy to tell oneself that the shares of a good company are always a sound investment, regardless of price. From this it was an easy step to calling everyone an 1n-vestor who bought his shares outright, and finally to calling every Wall Street customer an investor--period.

My recent crusade has been to persuade wall street that it has nade a mistake, and harmed Itself, in suppressing the word "speculation" from its vocabulary. Speculation is not bad in itsell, overspeculation i». It is important that the public should have a fairly good idea of the extent to which it is speculating, not only when it busy a "hot issue" at a completely silly price, but even when it buys into a wonderful concern such as IBM at 70 times Its highest recorded earn- Ings. Io my mind the most valuable contribution that security analysts could make to the art of investing would be the determination of the investment and speculative component» in the current price of any given common stock, so that the 1n-tending buyer might have som notion of the risks he is taking as well as what profit he might make. I have pointed out that my own conservative appratsal put the Investment component 1n IBM'$ 1961 price at not more than $200 per share - about $6 billion lor the entire enterprise--the remainder of the quotation representing a speculative valuation of the company's undoubtedly brilliant Future. Conversely, I stated that at least 00% of the highest pricos 55) 0_ International Harvester in 1961 could be ascribea to its Investrent value. This did not prove that Harvester was a better buy than IBMIt was, as it turned out--but it did demonstrate that the risk factor involved was much smaller.

Ist me raise a final question: Despiin rather discouraging resulta from ! endeavors to prediet market moves or to select the most attractive companies, can the intelligent investor follow any policies of common-stock selection that promine better than average results? I think it in possible for some stronge minded investors to do this, by buying value rather than prospects or popularity. Some examples of this approach: (I) Select stocks of Important con- Pa 221062971 on a 20-glamour 5a018-BoB Internatoba Haraster. Sous extraordinary results could have been obtained since 1933 by buying each yeas the shares of the six companies in the Dow Jones Ind. Average which sold at the lovest multiplier of their recent earning». (2) Buy definitely "bargain issues." Typieally these would be shares that sold for less their value in working-capital alone, with nothing paid for fixed assets and goodwill. These were quite numerous up to as late as 1951, and were consistently profitable when diversi. ¡lestion was observed, fov such opportunities remain; perhaps they have been supplanted by shares of smaller companies «olling on a relatively depressed basis and likely to be taken over by « larger concern at a good advance in price. (3) Finally there is the wide fiold Of ""pecial "Ituation"- reorgenization», mergeI, take-overs, Iiquidations, ete. This 1s a professional area, but it 1s not Impossible for Intelligent investors to profit handsomely from It 11 they approach security operations as they would a commercial business. CONCLUSION.

The Investor must recognize that there are uncertain and hence speculative

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inherent in any policy he follows--even an all- Government-bond program. Ee must deal with these uncertainties by a polley of continuous compromise be- "ween bonds and conmon stocks, and by adequate diversification. (Exception: He may put and keep most of his funds in shares of a promising business with which he is closely connected.) He must make a strong effort to have more money invested in common stocks at lover market levels (at least on the basis of cost) than at what he recognizes to be potentially high levels. Most Important, he must maintain a philosophical attitude towards the inescapable variations "is financial position and the inevitable "mistake»" associated with these variations

According to an old wall street story, when a certain broker was asked by « client to recommend 1«Bues to buy, he always asked in seturn, "What 1s Jour "reference! Do you want to eat well or to sleep well?" I am optimist enough to believe that by following sound policies almost any investor -even in this Insecure world should be able to eat well enough without having to lose any Biceps