A wise man once said, 'You must always learn from your mistakes'. That said, it goes without saying that it would be even smarter and more profitable too, to learn from other people's mistakes. Keeping these words in mind, we can review how Benjamin Graham, the 'father of value investing', chose to expound on the two different perspectives from which people invested in the stock market during two different times in the history of the US.
Let's go back to World War I (1914-1919). One was the 'Pre-war' concept of stock market investing, prior to World War I. And the second pertained to the period immediately after World War I. The drastic change in attitudes, the reasons for that change and a critical examination of each of the investing strategies adopted by the masses during those times has tons to teach an ardent student of investing.
During that time, it was commonly accepted that when prime emphasis was laid upon what was expected of the future, instead of what had been accomplished in the past, it was a speculative attitude that was being taken. Simply put, speculation meant looking forward; investment was associated with values taking root in the past.
The future was uncertain, and therefore speculative. The past was known, and therefore a source of safety. We could take the example of someone buying a company's stock because he believed that its price was going to go up, or that its earnings were going to increase or that it was soon going to pay a dividend, or that it was possibly destined to develop into one of the strongest companies in the sector. From the pre-war standpoint, each of these reasons constituted a speculative motive for the purchase.
Investment - Investment in stocks was restricted to those companies showing a history of stable dividends and fairly stable earnings. Such company's in turn were expected to maintain a fairly stable market level. At the time, the function of equity research was primarily to search for any kind of negatives in the picture. If the earnings were not properly stated, if the balance sheet showed that the company was in a bad position financially, if debt was growing too rapidly, if the physical plant was not properly maintained, if dangerous new competition was threatening, if the company was losing ground in the industry, if the management was deteriorating or was likely to change for the worse, if there was reason to fear for the future of the industry as a whole - any such defects would be enough for a cautious investor to avoid such a company.
In terms of searching for investment opportunities, the analysis was focused on finding those companies which met all the requirements of investment and in addition offered the best chance for future growth. The main emphasis was laid upon the relative performance of the company for past years, in particular the average earnings in relation to price, the stability of the earnings and the trend of earnings. To a lesser extent, the analysis sought to look towards the future and to select the industries or individual companies that were likely to show the most rapid growth.
The stock investor wanted a stable business and one showing an adequate margin of earnings over the dividends paid out by the company, and a chance of an increased dividend if the business continued to prosper. Intentionally, the least amount of emphasis was put on targeting the possibility of a profit by way of an increase in the stock price. To the extent that a stock investor was likely to consider himself similar to a purchaser of corporate bonds; the only difference being that he was willing to sacrifice a certain degree of safety (that of the prior claim of a bond) in return for larger income.
Another important feature of this era was that buying stocks was viewed as taking a share in a private business. The typical stock market investor was a business man, and it seemed sensible to him to value any corporate enterprise in the same manner that he would value his own business. This also meant that he gave as much attention to the assets behind the shares as he did to their earnings records.
In conclusion, during the pre-war period, investment in stocks was based on a threefold concept.
- A suitable and established dividend return
- A stable and adequate earnings record
- A satisfactory backing of tangible assets
Common-stock commitments motivated by any other viewpoint were characterized as speculative, and it was not expected that they should be justified by a serious analysis.
This was a detailed view of Benjamin Graham's observation of the investment attitude during times before the First World War in the US. In the next article, we shall have a look at how & why this attitude changed post World War I and how this change of attitude directly led to one of the biggest and most maniacal bull markets in the history of stock market investing (the years before 1929).