Two defining eras in investing history - Part II - Views on News from Equitymaster

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Two defining eras in investing history - Part II

Jul 9, 2009

This two part article began with our first part, which discussed Benjamin Graham's observation of what people in the stock market considered as 'investment' and 'speculation' in the period before the First World War in the US. It would be advisable to first go through that article to get the continuity of what the following article will talk about.Post the First World War, there was a drastic change in attitudes of most stock market investors. For them, what constituted an 'investment' in the stocks underwent a sea change and they acquired a newfound attraction towards certain advantageous features of investing in stocks.

And in the bargain, two of the three necessary criteria that constituted an 'investment' in the pre-war times - i.e. a suitable and established dividend rate and a satisfactory backing of tangible assets - completely lost their significance. The third aspect - that of the company's historical record of earnings - took on an entirely different meaning for investors. And this was that the past earnings of a company were only useful to the extent that they indicate what changes in earnings one could expect out of the company in future. This indication, more often than not, was taken from the trend in which the company's earnings were moving during the most recent couple of years.

And this ended up becoming the biggest focus area for investors and analysts alike. As Graham summarised, the value of a stock came to depend solely and entirely on what it will earn in the future.

So, why exactly did this change in attitude take place? Two major reasons. First, due to the economic instability surrounding the days of the First World War, in the eyes of investors the past ceased to be a reliable guide to making investing decisions. Second, due to this very same instability and period of fast and swift economic changes, the future offered some very tempting potential rewards.

What happened is that suddenly, many companies that had enjoyed good profitability for decades in the past began falling into insolvency within a few years. Similarly, many other companies which had been small, unsuccessful or of questionable reputation just as quickly acquired a dominant size, impressive earnings, and a good reputation.

For example, railroad companies, one of the major sectors on which a lot of sound investment interest prevailed during the pre-war days, showed a lackluster performance subsequently. The environment was full of erratic changes, which in a short span of time began favouring some sectors and equally suddenly pulled the rug from under some others.

Thus things like average past earnings, dividends, and the amount of the actual investment in the business (a business's tangible assets), now began to seem like having almost no relation to what the business would do in the future. What began to look more significant is that the company should have a favorable position in the industry at that point of time. The amount of attention formerly paid to the 'book value' of the company got sidelined as its current and forecasted earnings took on a significance that overshadowed all emphasis on the asset values behind the shares. By 1929 'book value' had practically disappeared as a factor to be considered in judging the attractiveness of a stock.

By then, a continuous increase in profits proved that the company was on the rise and thus promised even better results in the future than it had already achieved. The opposite was also taken as true; if the earnings had declined or remained stagnant even during a boom, its future was thought to be terrible and such a stock was surely to be avoided. And prices of individual stocks reflected this attitude. Also another observation that started doing the rounds during the late 1920's is that a diversified list of stocks had regularly increased in value over stated intervals of time for many years past.

All in all, the 'investment theory' upon which the 1927 - 1929 stock market was built was that - the value of a stock depends on what it can earn in the future, and good stocks are those which have shown a rising trend of earnings and will prove sound and profitable investments. The scariest and most damaging part of this whole perspective was that they ignored the price of a stock in determining whether or not it was a desirable purchase.

As Graham & Dodd state in their seminal book Security Analysis, 'If a public-utility stock was selling at 35 times its maximum recorded earnings, instead of 10 times its average earnings, which was the pre-boom standard, the conclusion to be drawn was not that the stock was now too high but merely that the standard of value had been raised. Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price. Hence all upper limits disappeared, not only upon the price at which a stock could sell but even upon the price at which it would deserve to sell. This fantastic reasoning actually led to the purchase at $100 per share of common stocks earning $2.50 per share. The identical reasoning would support the purchase of these same shares at $200, at $1,000, or at any conceivable price.

An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only necessary to buy "good" stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic. Countless people asked themselves, "Why work for a living when a fortune can be made in Wall Street without working?" The ensuing migration from business into the financial district resembled the famous gold rush to the Klondike, except that gold was brought to Wall Street instead of taken from it.'

And in this manner, a whole era of stockmarket investors talked themselves into one of the biggest stock market booms the world has ever seen, culminating in 1929, and followed by the most tragic consequences.

Since those times, we have advanced significantly in terms of putting in place sophisticated technology and strict regulation that have gone a long way in helping an investor gain information and conveniently execute trades on the stock exchanges. But the primeval emotions that led to the above described extraordinary boom and subsequent bust continue to rule the minds of many an investor to this day. And these tendencies are most nakedly on display during a raging bull market, like the one we have just witnessed (ending in January 2008 here in India), and the ones that we are sure to witness in the years to come.


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