The Intelligent Investor Chapter 3 k234k

The  Intelligent  Investor   Chapter  3:  A  Century  of  Stock-­‐Market  History:  The  Level  of  Stock  Prices  in  Early   1972   • • • •

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The  intelligent  investor  should  have  a  solid  understanding  of  stock-­‐market  history   Price  levels  and  their  relationship  to  earnings  and  dividends  paid  are  of  paramount   importance   This  background  information  gives  the  investor  the  ability  to  gauge  the  attractiveness  of  the   current  market  level   A  chart  is  displayed  of  the  Dow  Jones  Industrial  Average  and  the  S&P  500  from  1871  through   1972   • In  only  two  of  the  nine  decades  shown  did  corporate  earnings  decrease   • There  were  no  decades  where  average  dividend  yields  decreased   • Growth  rates  varied  significantly  in  many  of  the  decades  studied   Valuation  levels  and  dividend  yield  also  fluctuated  wildly     • The  S&P  traded  at  6.3  times  earnings  in  1949  and  rose  to  22.9  times  earnings  in   1961   • Dividend  yield  was  7%  in  1949  and  3%  in  1961   Graham  ultimately  concluded  that  the  market  was  expensive  in  1972  for  two  reasons   • The  price  to  earnings  ratio  of  18.0  was  high  by  historical  standards   • The  yield  available  on  common  stocks  was  less  than  half  of  the  available  yield  on   high  quality  bonds   Based  on  his  conclusion  that  the  market  was  overvalued  he  recommended  the  following   course  of  action   • No  borrowing  to  buy  or  hold  securities     • No  increase  in  the  proportion  of  funds  held  in  common  stocks   • A  reduction  in  common  stock  holdings  where  needed  to  bring  it  down  to  a   maximum  of  50%  of  the  total  portfolio   Commentary  on  Chapter  3   • “You’ve  got  to  be  careful  if  you  don’t  know  where  your  going,  ‘cause  you  might  not  get   there.”  –  Yogi  Berra   • Graham’s  warnings  of  dangerous  valuation  levels  in  1972  proved  to  prophetic  as  the   market  declined  37%  during  the  bear  market  of  1973-­‐1974   • He  believed  that  the  intelligent  investor  must  never  forecast  the  future  by   extrapolating  the  past   • During  the    bull  market  of  the  1990’s  many  of  these  lessons  were  completely   forgotten   § Forecasters  argued  that  because  stocks  had  returned  7%  on  average  since   1802  that  investors  should  expect  that  return  regardless  of  what  level  they   purchased  common  stocks   § Some  claimed  that  stocks  “always”  beat  bonds  over  a  30  year  period  and  as   a  result  could  be  bought  without  paying  attention  to  valuations  as  long  as   the  investor  planned  to  hold  forever   • The  market  crash  in  the  early  2000’s  proved  that  valuation  levels  always  matter  and   should  not  be  ignored   • The  problem  with  extrapolating  past  market  returns  is  that  it  includes  an  inherent   “survivorship  bias”   § This  means  that  many  past  companies  went  bust  and  are  not  ed  for   when  analyzing  historical  market  returns   § This  leaves  analysts  with  a  hand  full  of  exceptional  companies  that  have   survived  to  use  as  data  points   § For  every  Coca  Cola  there  are  twenty  companies  from  previous  eras  that   are  no  longer  in  existence  

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Because  the  profits  that  companies  can  earn  are  finite  the  price  that  investors  are   willing  to  pay  must  also  be  finite     If  future  returns  are  guaranteed  to  match  successful  past  returns  investors  would   bid  up  stocks  to  unsustainable  levels   Extrapolating  rosy  historical  returns  into  the  future  is  illogical  and  dangerous   according  to  Graham   The  performance  of  the  stock  market  relies  on  three  factors   § Real  growth  (the  rise  of  companies  earnings  and  dividends)   § Inflationary  growth  (the  general  rise  of  prices  throughout  the  economy)   § Speculative  growth  or  decline  (any  increase  or  decrease  in  the  investing   public’s  appetite  for  stocks)   Corporate  earnings  per  share  have  grown  1.5%  to  2%  annually     As  we  discussed  in  the  last  chapter  3%  is  a  suitable  inflation  estimate     Average  dividend  yield  on  the  S&P  500  is  currently  1.7%   By  totaling  these  three  percentages  the  investor  can  find  the  expected  return  for   common  stocks   Currently  the  expected  return  for  common  stocks  would  be  6.7%  or  3.7%  after   inflation     The  only  constant  in  markets  is  that  they  continue  to  surprise  investors   It  is  therefore  extremely  important  for  investors  to  be  humble  and  realize  that  their   forecasts  and  projections  are  far  from  certain     In  financial  markets  the  worse  the  future  looks  the  better  it  usually  turns  out  to  be