价值的复兴

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1 mild so like to take this opportunity to thank William M Cris. Cal Chairman of the Conating Education Committec of The Institute for his efforts in organizing the Seminar and C. Roderick © Neil, CoAtind the Manufacturers Hanover Trust Company stalf for making local arrangements for the Senimar. Theodore R. Lilcy, C.RA., President of The Finmicid Analysts Pedcration and members of his salt ald assated in the arrangements. And finally, I would like to ank N Seot Bauman, C.F.)., Executive Director ol The Financial Dulysts Rescirch Foundation and its staff, Robert D. Milne, C.R.A., Prosuent of the Institute of Chartered Francial Analysts: and Jack L.. Tre not. Editor of the Financial Analysts Jounal and a Trustee of the Forsdanion for their valuable ussistance in planning the Seminar and in prepitution of these Proceedings:

David G. Watterson, C.I.A., President

The Financial Analysts Research Foundation

THE DECADE 1965-1974 ITS SIGNIFICANCE FOR FINANCIAL ANALYSTS

Benjamin Grabam

The title of this seminat The Renassance of Value? implie thai the concept of value had previously been in cclipse in Mal Street. This eclipse may be identified with the vitted disappearance of the once well-established distinction beiween arvestment and speculation In the last decade everyone became in trystor-including buyers ol stock options and odd-lot short-sellers In my own thinking the concep ol valuc, along with that of margin of safety, has always lai a the heart of true investment, while price expectations have been at the center of speculation.

Let me list some of the questions relating to the value approach that confront the financier analyst now in the light of the 1963-1074 experience:

1 Is the value approach a useful one in ferms or

(a) what it can accomplish on its own, ud

(b) by comparison of is resulis with those of obe

andiytical methous and practices?

2. To what degree should the techniques of valuation e

presented, say, in Graham, Dodd and Cordles 1962-be

modified by more recent developments, includine theoretica

thinking? 3. What is the effect of institutional domination of the sod

market on the valuation work of the securit analyst and the

decision making procedures of the financial analyst? 4. To what extent does the sheet number of practicing

analysts some 14,000 AD members, meluding 3,800

C.F.A.s and over 2,000 active C.F.A. cardidates- prevent the

average or represchtative worker from achieving worthwhile

results? This is indeed a delicate question.

The discussion that follows will not separate rach of these questions from the others, but I will try to answer them as best t can The valuc approach has been founded on the premise that in many-but by no means in all cases a lependable range of valuation can be cstablished for a common stock by analytical techniques: thai often this tange differs substantially from the current price, and that

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such differences offer rewarding opportunities for investment oporations. The phrase rewarding opportunities" implies that the stock market itscl! will vindicate the value-based operation, after an interval that averages not too long for human patience-say, three years or less. Typically, the midpoint of the value range has been lound by applying an appropriate multiplier to estimated future earnings. My present view is that this is not the best technique. Instead, the earnings figure taken should be what we callnormal current carnings and all the Tuture prospecis-favorable or unfavorable, specific or general-should enter into the multiplier. This procedural change obviates the necessity of establishing a future value and then discounting same to its present worth.

Such a procedure would carry us very far from the method first suggested in 1938 in Dr. John Burr Williams seminal book The Theory of Investment Value". His technique required an estimate of the stream of dividends to be received over a very long future period, and the summation of the discounted worth of each dividend to arrive at present, value. The various mathematical methods later developed for valuing growth stocks represent a sort of compromise between the Wilhams approach and what I now suggest. For they stop the estimated stream of dividends at a torminal year-say ten years hence-and then value the stock, usually on a conservative basis, in that terminal year. The resulting ligures of dividends and terminal value would then be discounted at a unilorm chosen rate to arrive at present value.

Those of you who have studied Security Analvis may recall that we tried to simplify the mathematical methods of several writers by suggesting a formula that employs a single variable G, representing the expected growth rate over the next seven to ten years, It read fat bottom of p. 537;

Valuc - current normal camings times the sum of 8½ plus 2G.

This valuacion formula-like those it purported, to approximate-had the great defect of failing to allow for changes in the basic rate of interest. But the one development in the past decade that has had the greatest influence on stock values and, somewhat belatedly, on stock prices has been the phenomenal advance in interest rates. For the three years preceding the publication of our text the yield or AAA bonds averaged 4.+ percent, and that was also the figure just ten years ago. But for the three years 1971-1973 the average was 7.5 percent, and nost recently 9½ percent

It would seem logical to me tu make common-stock valuations vary inversely with represcotative current interest rates corresponding to the malyst's use of representative curren, earnings. Suppose we restated our 1972 formula with that objective, making it reflect the then going AAA rate of 4. percent. The expression would then read:

alue - barmys times the sum ol 3712 plus 8.8 G., divided by the AAA rite.

Since analvsts have a weakness for figures, you might like to hear two or three results based on this revised formula. For the DJA taking Gas its historic 4% percent and the AAA rate of its 3-ycar average of 7 percent, we get a multiplier of 10.2. Applying this to the 1971-75 average camings of the Pow, its central valuc would be about 750, 11 instead ol three-year avcrage figures you took the recent bond rate of 9½ percent and the most recent inflation-aided annual carnings ot about $93 the indicated central valuc would be the sume 750. (The higher earnings are offset by the higher interest divisor.)

These calculations, for what they are worth, suggest that the Dow at its recent low level of 627 was undervalued by about 15 Dercent Whether this would presage a near or delayed end of the current bear market I leave to wiser or bolder heads than mine. However, this same method when applied to individual issues would indicate that many have been more significantly under-priced in the present market. Take Firestone as an example. Its carnings have grown at a better rate in the past decade than those of the Dow the figures for 1971-73 show 3 1 16 percent increase from 1961-63 for Firestone versus 66 percent for the DJIA. If we assume the same future G of 4% percent for Firestone as for the Dow, and hence the same multiplier of 10.2 x 1971-73 carnings. our valuation would be 24 for the tire company shares, fully 90 percent above their 1974 low. Incidentally, this would just about equal the current book value of Firestonc-a previously minor detail in the investment picture but one to which I am inclined to ascribe major importance under today's new conditions. Firestone is, of course, only one example of the discrepancy between the current level of the Dow-which includes several first-tier institutional favorites-and that of the current run-of-the-mine good sized company.

A multiplier based on expected growth and interest rates alone would imply that a company's financial structure and debt position do not enter into ine valuation process. This might be the case if the formula were applied-as originally intended-only to bigh-growi companies, whose prospects are considered so good that they are assumed to face no financial problems. But if we seck to generalize our formula to apply to average growth companics, we must recognize that

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many of these may be in unsatisfactory financiai condition, caused in part by inflation pressures and in good part also by the over expansion it corporate debt in the past decade. (L consider the total figures lor corporate debt since 1968, published in the June 1974 issuc of the Sures a Current Busies, to be most disquieting They show an overall increase of 74 percent i only five years, with more to come in

I see no satistactory way of reducing the multiplier to allow lor a helos pal delit position. My advice to malysts would be rather to avoid tempring a formal vaduation of such companies. In other words, limit put appraisals to enterprises of investment quality, excluding from at category suchas do not meet specilic criteria of financial strength. his satement brings me back to our old position that speculative mumpics cunot be dealt with at all by the analyst with satisfactory perill results. By my own rather strict quantitative criteria, firestone wuld pass the financial strength test by a modest margin. Such tests might well evelude up to half ol the NYSE. list today from investinent Consideration, but there would remain cnough qualifying issucs to give The analysts and the investor an ample selcetion. It should bo clear that I hate fath in the valuation process as a guide to investment choices. bur that 1 would limit this technique rather strictly to companies that mect criteria of financial soundness. Also, I should require that the buy decisions based on this approach involve a margin-of-salety faetor. This inight well be a purchase price not over two-thirds of the central appraised value

How would such a policy have worked out during the past decade? Several times the market price ol Firestone tell below our formula value, but not by the one third margin. (The indicated buying level in 1970 was 16 against its low of 17%, followed by the next year's high of 281) Other Studies have led me to believe that a computer type valuation job of this kind would have found a considerable number of cases where shares of sound companies could have been obtained for less than two-thirds of their formula-value. On the whole one would have done quic well over this period by buying on this basis and selling at a 50 percen profit when obtamable. I see no reason to think that a similar policy could not be tollowed with satisfactory results in the future: (It should be unnecessary for me to add that these results are tot guaranteed.)

There are, of course, many other approaches of the valuation type, and different analysts may favor different formulas with differen: parameters than the two I have been using. I have mysell been intrigued by the idea of choosing stocks aniong those that are obtainable at not more than one-balt theit former high quotation, provided that they

meet criteria of value independent of the price record. A rechnique at this sort would have worked fine, according to my studies, up to and including the post-1970 market recovery. Under more recent conditions it would mercly have aaded a pice-decline criterion to the determination of buy points based on the viluation approach for practically all issues of the Firestone type an acquisition pricelat (wo-thirds 01 analysts valuation would be at less than half of the previous market high.

Let me pass on to a fattor in the valuation process that in my thinking has taken son considerable importance under present conditions. This is the book value ligure, to be viewed either as a point of departure for more refined calculations or as a practically usabic measure of a common stock's value. For years we have all pron well disregarded asset values, except for financial enterprises and some special cases. But in recent markets a large number perhaps majority-of NYSE commons have actually Nuctuated in price both above and below their asset values. Even. Polarnid was recenty obtainable at less than book valic! This faet would seem to establish a realistic relationship in many cases between net worch and intrinsic br analysts value. One might well speak today of the Renaissance Book Value."

You are all intelligent enough to appreciate that am not now saying that Avon Products is only worth its book figure of Sit pe share on that Chicago Milwaukee common is to be valued at the 5 1 19 per share shown on the balance sheet. In a substantlal percen e issucs the book value figures have no worthwhile connection with the investment value of the shares. But the analyst has today perhaper thousand stocks or more to choose from in which the asset salue may actually fall within his range of appraised value, In many of these one he could then settle for the net worth as his preferred specific igure vi value, and base his buy-and-sell points on this convenient measure.

This approach can put the choice of marketable common stod on a basis corresponding to that of investment in a private, nou quoted enterprise. If the commitment would be attractive as an ordinars business venture it should be even more attractive as part of a publicly held enterprise, with the added advantages of diversification and ready markctability

However, in my experience marketability has proved of dubious overall advantage. It has led investors ustray at least as much as it has helped them. it has made them stock-marker minded instead of valuc-minded. I have a puritanic vision of the true investor as somcone who is entirely disinterested in what the stock market does except on two sorts of occasions that meet his convenience. The first occasion when the market obligingly permits him to buy a group of common

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stocks at less than their indicated salue, the second is when with cqual Courtesy it permits him to sell at nor more than one half their former high quecation those that are of no importance to him. True, he may sometimes dispose oi an arvestment at a loss. But that should not be because the market price went down; it should be beeause things went badly for the company and the troc value of the shares declined below tic pace he pid for then, Of course the investor may also use che Sick macket to swich out of issucs he owns mto others that offer more vene at ruling prices.)

(you are now beanerome of the old-time religion You mai not be converted, but it shouldn't do you any harm.)

At this point let me consider briefly an approach with which we were closely identified when managing the Graham Newman fund. This was the purchase of shares at less than their working capital vilue, That such od-results for us over a foryeperiod of decision-making that we eventually renounced all other comman-stock choices based mr the usual aluation procedures, and concentrated on These sub asset stacks The renaissance of value which we are talking about today, involves the reappearance of this kind ot investment opportunity, Value Line publication last month listed 100 such issues in the non-financial category. Their compilation suggests that there must be at least twice as many sub-working-capital choices in the Standard & Poors Monthly Stock Guide. (However, don't waste S25 in sending for an advertised list of 1000 Stocks Priced at Less Than Working Capital.? Those responsible incscusably omitted to deduct the debt land preferred stock liabilities from the working capital in arriving at the amount available for the common.)

It seems no more than ordinury sense to conclude that if one can make up, say a 30 stock portfolio of issues obtainable at less than Working capital, and if these issues meet other value criteria including the analysts's heliet that the enterprise has reasonably good long term prospects, why not limit one's selection to such issues and forget the more standard valuation methods and choices we have previously discussed? I think the question is a logical one. but it raises various practice issues: How lane will such fire saie stocks as Valuc Line called thein-continue to be giver away what would be the consequences i a large number of decision-makers began as of tomorrow to concentrate on that group; what should the malyst do When thest are no longer available?

Such questions are actually related to broader aspects of the value approach. involving • the armlabilin of attractive investment opportunities if and when most investors and their advisers followed this doctrine. I shall return to that problem later.

Some-interesting questions relating to intrinsie values marker price hire raised by the take-over bids that are now part of our daily financial fare. The most spectacular such event occured a few weeks ago, when two large companies actively competed to buy athird, with the result that within a single month the price of ESB Inc, advanced from 112 to over 41 We have always considered the value of the business to a private ow ner as a significant element in appraising a stock issue. We now have a pardiel figure for security analysts to think about: the price that might be offered for a given company bs a workd-be requirer. In that respect the ESB transaction and the Marcor one that followed it offer much encouragement to those who believe that the real value of most common stocks is well above their present marker level.

There IS another aspect of take-overs that I want to bring up here. on a somewhat persomil basis, because it relates to an old and losing battle that 1 have long fought to make stockholders less sheeplike vist-vis their managements, You will reeal that the first bid of INCO was termed a hostile act? by the ESB munagement, who vowed to fight it tooth and mail. Several managements have recently asked stockholders to vote charter changes that would make such acquisitions more diffel to accomplish against their opposition -in other words make i more difficuit to deprive present officers of their jobs ind more dithcüit for stockholders to obtai an attracrive price for their shares. The stockholders, still sheeplike, generally approve such proposals li this movement becomes widespread it could really barnt investors interests. I hope that finimcial analysts will form sound judgment about what is involved here and do that they can to dissuade stockholders from cutting their own throats in such a foolish and reckless lashion. This might well be a subject for the FAr to discuss and take an official stand on.

There is at least a superficial similarity between the paces offered in takeovers and those formerly ruling in the market for the first-fier issues, as represented by "the favorite fifty' The large institutions have acted somewhat in the role of conglomerates cute ding ther empires by extravagant acquisitions. The P/E ratio of Avon Products averaged 55 m 1972, and reached 65 at the high ot 140. This multiplier could not have been justified by any conservative valuation formulac such as those we have been discussing. It was not made by speculators in i runaway bull market, it had the active or passive support of the institutions that have been large bolders of Avan.

As Tsee it, institutions were persuaded to pay outlandish mulripliers for shares of the Avor type by a combination of three influences: First, the huge amounts of money they have to administer,

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most of which they decided to place in equities Second, the comparatively small number of issucs to which them operations were confined, in part because they had to choose multi-million-share companies for their block transactions, and partly by their insistence on high growth prospects. The third influence was the cult of performance. especially in pension-fund management. The arithmetic here is deceptively simple. 11 a company's carnings will increasc 15 pereent this year, and if the P/E ratio remains unchanged, then presto! the investment" shows a 15 percent pertormance, plus the small dividend 11 the P/s ratio advances-is it did for Avon in almost every year-the performance becomes that much better. These results are entirely independent of the price levels at which these issues are bought. Of course, in this fintasia the institutions were pulling themselves up by their own bootstraps something not hard to do in Wall Street, but impossible to maintain forever.

These institutional policies raise two implications of importance for financial analysts. First, what should a conservative analyst have done in the heady area and era of high-growth, high-multipher companies? I must say mournilly that he would have to do the near-impossible-namely, tum his back on them and let them alone, The institutions themselves had gradually transformed these investment-type companies into speculative stocks. I repeat that the ordinary andyst cannot expect long-term satisfactory results in the field of speculative issues, whether they are speculative by the compauy's circumstances or by the high price levels at which they habitually sell. My second inference is a positive one for the investing public and for the analyst who may advise a non institutional clientele. We have many complaints that institutional dominance of the stock market has put the small investor at a disadvantage because he can't compote with the trust companies huge resources, ctc. The lacts are quite the opposite. It may be that the institutions are better equipped than the individual to speculate in the market, I'in not competent to pass on that. But im convinced that an individual investor with sound principles, and soundly advised, can do distinetly hotter over the long pull than i large institution, Where the trust company may have to conline its operations to 300 concerns or less, the individual has up to 3000 issucs for his investigations and choice. Most true bargains are not available in large blocks, by this very fact the institutions are well-nigh eliminated as competitors of the bargain hunter.

Assuming all this is true we must recur to the question we raised at the outset. How many linancial analysts can carn a good living by locating undervalued issues and recommending them to individual

investors, In all honesty 1 cannot sast that there is room for 11,000 analysts, or a large proportion thereof an this arca of activity, But em assert that the influx of analysts into the undervalued sphere in the past has never been so great as to cut down its profit possibutties through that kind ol over-cultivation and over competition. (The Value-malyst (vas more likely to sulier from loncliness.) Trie, bargain issues have repeatedly become scarce in bull markets, but that was not because all the analysts became value conscious, but because of the general upswing in prices (Perhaps one could even have determined whether the marker level was getting too high or loo low by counting the nuber of issues selling, below working capital value When such opportunities have virtually disappeared, past experience indicates that investors should have taken themselves out of the stock market and plunged up to their necks ip U.S. Treasury bills.)

So far I have been talking about the virtues of the valuc approach as if I had never heard of such newer discoveries is the random walk? the efficient market efficient portfolios *the Beta coelficient, ad others such, I have heard bout them, and I want to talk dirst for a moment about Beta. This is a more or less uscful measure of past price fluctuations of common stocks. What bothers me is that authorities now equate the Beta idea with the concept of risk, Price variability yes: risk no. Real investment risk is measured not by the percent that. stock may decline in price in relation to the general market in at gen period, butoby the danger of a loss of quarty and caruns power through economic changes or deterioraton in management, In the five editions of The Intelligent Investor 1 have used the example of A & P shares in 1936-1939 to illustrate the basic difference befween fluctuations in price and changes in value By contrast, in the last decade the price decline of A & Pshares from 13 to 8 paralleled pretty well a corresponding loss of trade position prolability, and intrinsid value. The idea of measuring investment risks by price fluctuations I repugnant to me, for the very-reason that it confuses what the stock market says with what actually happens to the owners stake in the business.

Let me pass now to the doctrine of the efficient market. 1am particularly interested in this because of its negative implications for the work of security analysts generally. The subicct is dealt with briell in my current article in the Francial, Inalysts Journal, bat it has such porential importance for this audience that I shall try another crack af it here

Let me shorten slightly the definition of an efficient market that appears on p. 97 ol The Stoch Market by Lorie and Hamilton, An efficient market is que on which a large number of buyers and sellers cause the prices to reflect tally what is knowable about the prospects

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tor the companics dealt in?" The key phrase for me is reflect filly." Let us assume first that it means only that the market has and uses all knowable mormation about every company's prospects, and hence that there is no point for analysts to spend their time trying to obtain additional information, 1 dissent from that statement to the exteni that world render meaningless the current controversy and concern on the use of "material information's particularly as obtained by security anilysts from managements. If in all cases the market dready knows ind refleets all that is knowable about each enterprise then there should be no such thing as "material inside information."

But that is not my chiel quarrel with the concept of the efficient market.* There is a strong implication in the Loric and Hamilton book that because the market reflects fully all the knowable facts it thereby establishes correct or reasonably correct prices for common stocks Hence, only the superior security analyst can successfully select the stocks that should be bought or sold. These exceptional people-in the authors words bave a quicker and more profound understanding of the economic consequences to individual firms of changes in the cconomic environment or changes within the firm itself." They have "a rare and valuable talent." I disagrec completely with this viewpoint. To establish the right price for a stock the market must have adequate information, but it by no means follows that if the markct has Chis information It will thercupon establish the right price. The market's cyiluation of the same data can vary over a wide range, dependent on bullish, enthusiasm, concentrated speculative interest and similar influences, or bearish disillusionment. Knowledge is only one ingredient on arriving at a stock's proper price. The other ingredient, fully as important as information is sound judgment. Take Avon Products, which sold at 440 carly last year, or $8 billion for the company and under 20-or a mere $1.2 billion-last month. Was the market for Avon efficient on both these dates, in the sense that the price reflected fully and properly (the latter my addition to the Lorie and Hamilton phrase) the knowable facts. Were the changes in the short period in the environment or the company's prospects sufficient to cut 85 percent from the true value of this highly prolitable, well-managed, and strongly linanced enterprise?

Take at the other extreme the large group of stocks selling for less than their working capital. Is the market "cfficient" in maintaining these "fire sale"t price levels? Surely it does not lack, the essential information about companies. What it does lack is judgment, courage and patience. In situations of this kind lie the best opportunities for Tinancial analysts to prove their mettle.

The value approach has always been, more dependable when applied to senior issucs than to common stocks. is particular purpose in bond analysis is to determine whether the enterprise has a fair value so comfortably in excess of its debt as to provide an adequate mirgin oi salcty. The standard caleulation of interest coverage has much the sume function. There is much work of truly professional calibre that analy can do in the vast area of bonds and preferred stocks-and to some degree also, in that of convertible issues The field his become n mcreasingly important one, especially since all wellrounded portiolios should have their bond component.

Any security analyst worth his salt should be able to decide whether a given senior issue has enough statistically based protsction t warrent its consideration for investment. This job has been neglected at times in the past ten years-most gluringly in the case of the Penn Central debt structure, It is an unforgivable blot on the record of our profession that the Pean-Central bands were allowed to sell in 196S at the same prices as good public-utility issues. An examination of that system's record in previous years- noting mier ala, its peculiar accounting and the fact that it paid virtually no income taxes world have clearly called for moving out of the bonds, to say nothing of the stock even at prices well below its high of 86. We now have a situation in which all bonds sell at high yields, but many companies have ai pverextended debt position. Also, many of them do not Seem to have sufficiently strong protective provision in their bond indentures prevent them from offering new debt in exchange for ther au remon sunk, seen am debt in erent le thin common stock (A striking example is the current bond for stock operation of Caesar's World.) These widespread present mancrvers seem to me to be so many daggers thrust in the solt bodies of the poo creditors. Bondholders can and should take stepst legalit necessary protect their interests against such forms of invasion.

Thus security analysts could well advise host of worthwhile switching in the bond field. Even in the Federal debt structure- where safety is not at issue-the multiplicity of indirect U.S. Government obligations of all sorts, including some tax exempts, suggest many opportunities for investors to improve their yields. Similarly, we have seen many convertible issues selling at close to a parity price with the common, in the typical case the senior issue has offered a higher sicla than the junior shares. Thus a switch from the common stock into the senior issue in these cases would be a plain matter of common sense. (Examples: Studebaker-Worthington and Engelhard Mineral preferred vs. common.)

Let me close with a few words of counsel from an 80 rear-old veteran of many a bull and many a bear market. Do those things us an

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analyst that you know you can do well, and only those things If you can really beat the market by charts, by astrology, or by some rare and valuable gift of your own, then that the row you should hoe. If you re really good at picking the stocks most likely to succeed in the next twelve months, base your work on the endeavor. If you can foretell the next important development in tie cconomy, or in technology, or in consumers preferences, and gauge its consequences for various equity values, then concentrale on that particular activity. But in cach case you must prove to yoursell by honest, no-bluffing sell-examination, and by continuous testing of performance, that you have wint it tikes to produce worthwhile results.

If you believe- as I have always believed-that the value approach is inherently sound, workable, and profitable, then devote yourself to that principle. Stick to it, and don't be led astray by Wall Street's tashions, its illusions, and its constunt chase after the last dollar. Let me emphasize that it does not take a genius or even a superior talent to be successful as a value analyst. What it needs is, first, reasonable good intelligence, second, sound principles of operation; third, and most important, firmness of character.

But whatever path you follow as financial analysts, hold on to your moral and intellectual integrity. Wall Street in the past decade tell far short of its once praiseworthy chical standards, to the great detrimen of the public it serves and of the financial community itself. When I was in elementary school in this city, more than 70 years ago, we had to write various maxims in our copybooks. The first on the list wast Honesty is the best policy. " It is still the best policy, as our new President reminded us last month.