WS: INTELLIGENT INVESTOR V

INTELLIGENT INVESTOR V

The activities specially characteristic of the enterprising investor in the stock market may be classified under four areas:

1. Buying in low markets and selling in high markets
2. Buying carefully chosen "growth stocks"
3. Buying bargain stocks
4. Buying into "special situations"

Market Timing

For many years in the past this bright idea (buying low and selling high) appeared both simple and feasible, at least from first inspection of a market chart covering its periodic fluctuations. We have already admitted ruefully that the market's action in the past 20 years has not lent itself to predictability by any mathematical means. The fluctuations that have taken place, while not inconsiderable in extent, would have required a special talent or "feel" for trading to take advantage of them. This is something quite different from the intelligence which we are assuming in our readers, and we must exclude operations based on such skill from our terms of reference. (Translation: Graham wisely tells us that "market timing / charting" is ungrounded folly and is to be avoided by any intelligent investor.)

The Paradox of Growth Stocks

Every investor would like to select the stocks of companies that will do better than the average over a period of years. A growth stock may be defined as one that has done this in the past and is expected to do so in the future. Thus it seems only logical that the intelligent investor should concentrate upon the selection of growth stocks. Actually the matter is more complicated, as we shall try to show.

It is a mere statistical chore to identify companies that have "outperformed the averages" in the past. The investor can obtain a list of 50 or 100 such enterprises from his broker. Why, then, should he not merely pick out the 15 or 20 most likely looking issues of this group and lo! he has a guaranteed-success stock portfolio?

There are two catches to this simple idea. The first is that common stocks with good records and apparently good prospects sell at correspondingly high prices. The investor may be right in his judgment of their prospects and still not fare particularly well, merely because he has paid in full (and perhaps overpaid) for the expected prosperity. The second is that his judgment as to the future may prove wrong. Unusually rapid growth cannot keep up forever; when a company has already registered a brilliant expansion, its very increase in size makes a repetition of its achievement more difficult. At some point the growth curve flattens out, and in many cases it turns downward.

It is obvious that if one confines himself to a few chosen instances, based on hindsight, he could demonstrate that fortunes can readily be either made or lost in the growth-stock field. How can one judge fairly of the overall result obtainable here? We think that reasonably sound conclusions can be drawn from a study of the results achieved by the investment funds specializing in the growth-stock approach. The authoritative manual entitled Investment Companies, published annually by Arthur Wiesenberger & Company, members of the New York Stock Exchange, computes the annual performance of some 120 such "growth funds" over a period of years. Of these, 45 have records covering ten years or more. The average overall gain for these companies-- unweighted for size of fund-- works out at 108% for the decade 1961-1970, compared with 105% for the S&P composite and 83% for the DJIA. In the two years 1969 and 1970 teh majority of the 126 "growth funds" did worse than either index. Similar results were found in our earlier studies. The implication here is that no outstanding rewards came from diversified investment in growth companies as compared with that in common stocks generally.

There is no reason at all for thinking that the average intelligent investor, even with much devoted effort, can derive better results over the years from the purchase of growth stocks than the investment companies specializing in this area. Surely these organizations have more brains and better research facilities at their disposal than you do. Consequently we should advise against the usual type of growth-stock commitment for the enterprising investor. This is one in which the excellent prospects are fully recognized in the market and already reflected in the current price-earnings ratio of, say, higher than 20. (For the defensive investor we suggested an upper limit of purchase price at 25 times average earnings of the past seven years. The two criteria would be about equivalent in most cases.)

The striking thing about growth stocks as a class is their tendency toward wide swings in market price. This is true of the largest and longest-established companies-- such as General Electric and International Business Machines-- and even more so of newer and smaller successful companies. They illustrate our thesis that the main characteristic of the stock market since 1949 has been the injection of a highly speculative element into the shares of companies which have scored the most brilliant successes, and which themselves would be entitled to a high investment rating. (Their credit standing is of the best, and they pay the lowest interest rates on their borrowings.) The investment caliber of such a company may not change over a long span if years, but the risk characteristic of its stock will depend on what happens to it in the stock market. The more enthusiastic the public grows about it, and the faster its advance as compared with the actual growth in its earnings, the riskier a proposition it becomes.

But is it not true, the reader may ask, that the really big fortunes from common stocks have been garnered by those who made a substantial commitment in the early years of a company in whose future they had great confidence, and who held their original shares unwaveringly while they increased 100-fold or more in value? The answer is "Yes." But the big fortunes from single-company investments are almost always realized by persons who have a close relationship with the particular company-- through employment, family connection, etc.-- which justifies them in placing a large part of their resources in one medium and holding on to this commitment through all vicissitudes, despite numerous temptations to sell out at apparently high prices along the way. An investor without such close personal contact will constantly be faced with the question of whether too large a portion of his funds are in this one medium. Each decline-- however temporary it proves in the sequel-- will accentuate his problem; and internal and external pressures are likely to force him to take what seems to be a goodly profit, but one far less than the ultimate bonanza.


Three Recommended Fields for "Enterprising Investment"...

...to be continued...


Credits: This article is extracted (with modifications) from Ben Graham's 1973 edition of The Intelligent Investor, Chapter 7.

POSTED :12 Jun 2006