In our introductory discussion we set forth the difficulties inherent in efforts to apply the analytical technique to speculative situations. Since the speculative factors bulk particularly large in common stocks, it follows that analysis of such issues is likely to prove inconclusive and unsatisfactory; and even where it appears to be conclusive, there is danger that it may be misleading. At this point it is necessary to consider the function of common-stock analysis in greater detail. We must begin with three realistic premises. The first is that common stocks are of basic importance in our financial scheme and of fascinating interest to many people; the second is that owners and buyers of common stocks are generally anxious to arrive at an intelligent idea of their value; the third is that, even when the underlying motive of purchase is mere speculative greed, human nature desires to conceal this unlovely impulse behind a screen of apparent logic and good sense. To adapt the aphorism of Voltaire, it may be said that if there were no such thing as common-stock analysis, it would be necessary to counterfeit it.
Broad Merits of Common-stock Analysis. We are thus led to the question: “To what extent is common-stock analysis a valid and truly valuable exercise, and to what extent is it an empty but indispensable ceremony attending the wagering of money on the future of business and of the stock market?” We shall ultimately find the answer to run somewhat as follows: “As far as the typical common stock is concerned–an issue picked at random from the list–an analysis, however elaborate, is unlikely to yield a dependable conclusion as to its attractiveness or its real value. But in individual cases, the exhibit may be such as to permit reasonably confident conclusions to be drawn from the processes of analysis.” It would follow that analysis is of positive or scientific value only in the case of the exceptional common stock, and that for common stocks in general it must be regarded either as a somewhat questionable aid to speculative judgment or as a highly illusory method of aiming at values that defy calculation and that must somehow be calculated none the less.
Perhaps the most effective way of clarifying the subject is through the historical approach. Such a survey will throw light not only upon the changing status of common-stock analysis but also upon a closely related subject of major importance, viz., the theory of common-stock investment. We shall encounter at first a set of old established and seemingly logical principles for common-stock investment. Through the advent of new conditions, we shall find the validity of these principles impaired. Their insufficiency will give rise to an entirely different concept of common-stock selection, the so-called “new-era theory,” which beneath its superficial plausibility will hold possibilities of untold mischief in store. With the prewar theory obsolete and the new-era theory exploded, we must finally make the attempt to establish a new set of logically sound and reasonably dependable principles of common-stock investment.
History of Common-stock Analysis. Turning first to the history of common-stock analysis, we shall find that two conflicting factors have been at work during the past 30 years. On the one hand there has been an increase in the investment prestige of common stocks as a class, due chiefly to the enlarged number that have shown substantial earnings, continued dividends, and a strong financial condition. Accompanying this progress was a considerable advance in the frequency and adequacy of corporate statements, thus supplying the public and the securities analyst with a wealth of statistical data. Finally, an impressive theory was constructed asserting the preeminence of common stocks as long-term investments. But at the time that the interest in common stocks reached its height, in the period between 1927 and 1929, the basis of valuation employed by the stock-buying public departed more and more from the factual approach and technique of security analysis and concerned itself increasingly with the elements of potentiality and prophecy. Moreover, the heightened instability in the affairs of industrial companies and groups of enterprises, which has undermined the investment quality of bonds in general, has of course been still more hostile to the maintenance of true investment quality in common stocks.
Analysis Vitiated by Two Types of Instability. The extent to which common-stock analysis has been vitiated by these two developments, (1) the instability of tangibles and (2) the dominant importance of intangibles, may be better realized by a contrast of specific common stocks prior to 1920 and in more recent times. Let us consider four typical examples: Pennsylvania Railroad; Atchison, Topeka, and Santa Fe Railway; National Biscuit; and American Can.
| Year | Range for stock | Earned per share | Paid per share |
|---|---|---|---|
| 1904 | 70-56 | $4.63 | $3.00 |
| 1905 | 74-66 | 4.98 | 3.00 |
| 1906 | 74-61 | 5.83 | 3.25 |
| 1907 | 71-72 | 5.32 | 3.50 |
| 1908 | 68-52 | 4.46 | 3.00 |
| 1909 | 76-63 | 4.37 | 3.00 |
| 1910 | 69-61 | 4.60 | 3.00 |
| 1911 | 65-59 | 4.14 | 3.00 |
| 1912 | 63-60 | 4.64 | 3.00 |
| 1913 | 62-53 | 4.20 | 3.00 |
| 1923 | 48-41 | 5.16 | 3.00 |
| 1924 | 50-42 | 3.82 | 3.00 |
| 1925 | 55-43 | 6.23 | 3.00 |
| 1926 | 57-49 | 6.77 | 3.125 |
| 1927 | 68-57 | 6.83 | 3.50 |
| 1928 | 77-62 | 7.34 | 3.50 |
| 1929 | 110-73 | 8.82 | 3.875 |
| 1930 | 87-53 | 5.28 | 4.00 |
| 1931 | 64-16 | 1.48 | 3.25 |
| 1932 | 23-7 | 1.03 | 0.50 |
| 1933 | 42-14 | 1.46 | 0.50 |
| 1934 | 38-20 | 1.43 | 1.00 |
| 1935 | 33-27 | 1.81 | 0.50 |
| 1936 | 45-28 | 2.94 | 2.00 |
| 1937 | 50-20 | 2.07 | 1.25 |
| 1938 | 25-14 | 0.84 | 0.50 |
| Year | Range of stock | Earned per share | Paid per share |
|---|---|---|---|
| 1904 | 89-64 | $9.47 | $4.00 |
| 1905 | 93-78 | 5.92 | 4.00 |
| 1906 | 111-85 | 12.31 | 4.50 |
| 1907 | 108-66 | 15.02 | 6.00 |
| 1908 | 101-66 | 7.74 | 5.00 |
| 1909 | 125-98 | 12.10 | 5.50 |
| 1910 | 124-91 | 8.89 | 6.00 |
| 1911 | 117-100 | 9.30 | 6.00 |
| 1912 | 112-103 | 8.19 | 6.00 |
| 1913 | 106-90 | 8.62 | 6.00 |
| 1923 | 105-94 | 15.48 | 6.00 |
| 1924 | 121-97 | 15.47 | 6.00 |
| 1925 | 141-116 | 17.19 | 7.00 |
| 1926 | 172-122 | 23.42 | 7.00 |
| 1927 | 200-162 | 18.74 | 10.00 |
| 1928 | 204-183 | 18.09 | 10.00 |
| 1929 | 299-195 | 22.69 | 10.00 |
| 1930 | 243-168 | 12.86 | 10.00 |
| 1931 | 203-79 | 6.96 | 10.00 |
| 1932 | 94-18 | 0.55 | 2.50 |
| 1933 | 80-35 | 1.03(d) | Nil |
| 1934 | 74-45 | 1.03(d) | Nil |
| 1935 | 60-36 | 1.38 | 2.00 |
| 1936 | 89-59 | 1.56 | 2.00 |
| 1937 | 95-33 | 0.60 | 2.00 |
| 1938 | 45-22 | 0.83 | Nil |
American Can was a typical example of a prewar speculative stock. It was speculative for three good and sufficient reasons: (1) It paid no dividend; (2) its earnings were small and irregular; (3) the issue was “watered,” i.e, a substantial part of its stated value represented no actual invstment in the business. By contrast, Pennsylvania, Atchison, and National Biscuit were regarded as investment common stocks—also for three good and sufficient reasons: (1) They showed a satisfactory record of continued dividends; (2) the earnings were reasonably stable and averaged substantially in excess of the dividends paid; and (3) each dollar of stock was backed by a dollar or more of actual investment in the business.
| Year | Range for stock | Earned per share | Paid per share |
|---|---|---|---|
| 1909 | 120-97 | $7.67 | $5.75 |
| 1910 | 120-100 | 9.86 | 6.00 |
| 1911 | 144-117 | 10.05 | 8.75 |
| 1912 | 161-114 | 9.59 | 7.00 |
| 1913 | 130-104 | 11.73 | 7.00 |
| 1914 | 139-120 | 9.52 | 7.00 |
| 1915 | 132-116 | 8.20 | 7.00 |
| 1916 | 131-118 | 9.72 | 7.00 |
| 1917 | 123-80 | 9.87 | 7.00 |
| 1918 | 111-90 | 11.63 | 7.00 |
| (old basis - ignoring stock split) | (old basis) | (old basis) | |
| 1923 | 370-266 | $35.42 | $21.00 |
| 1924 | 541-352 | 38.15 | 28.00 |
| 1925 | 553-455 | 40.53 | 28.00 |
| 1926 | 714-518 | 44.24 | 35.00 |
| 1927 | 1,309-663 | 49.77 | 42.00 |
| 1928 | 1,367-1,117 | 51.17 | 49.00 |
| 1929 | 1,657-980 | 57.40 | 52.50 |
| 1930 | 1,628-1,148 | 59.68 | 56.00 |
| 1931 | 1,466-637 | 50.05 | 49.00 |
| 1932 | 820-354 | 42.70 | 49.00 |
| 1933 | 1,061-569 | 36.93 | 49.00 |
| 1934 | 866-453 | 27.48 | 42.00 |
| 1935 | 637-389 | 22.93 | 31.50 |
| 1936 | 678-503 | 30.28 | 35.00 |
| 1937 | 584-298 | 28.35 | 28.00 |
| 1938 | 490-271 | 30.80 | 28.00 |
If we study the range of market price of these issues during the decade preceding the World War (or the 1909-1918 period for National Biscuit), we note that American Can fluctuated widely from year to year in the fashion regularly associated with speculative media but that Pennsylvania, Atchison, and National Biscuit showed much narrower variations and evidently tended to oscillate about a base price(i.e., 97 for Atchison, 64 for Pennsylvania, and 120 for National Biscuit) that seemed to represent a well-defined view of their investment or intrinsic value.
| Year | Range for stock | Earned per share | Paid per share |
|---|---|---|---|
| 1904 | … | $0.51 | 0 |
| 1905 | … | 1.39(d) | 0 |
| 1906 | … | 1.30(d) | 0 |
| 1907 | 8-3 | 0.57(d) | 0 |
| 1908 | 10-4 | 0.44(d) | 0 |
| 1909 | 15-8 | 0.32(d) | 0 |
| 1910 | 14-7 | 0.15(d) | 0 |
| 1911 | 13-9 | 0.07 | 0 |
| 1912 | 47-11 | 8.86 | 0 |
| 1913 | 47-21 | 5.21 | 0 |
| 1923 | 108-74 | 19.64 | $5.00 |
| 1924 | 164-96 | 20.51 | 6.00 |
| 1925 | 297-158 | 32.75 | 7.00 |
| 1926 | 379-233 | 26.34 | 13.25 |
| 1927 | 466-262 | 24.66 | 12.00 |
| 1928 | 705-423 | 41.16 | 12.00 |
| 1929 | 1,107-516 | 48.12 | 30.00 |
| 1930 | 940-628 | 48.48 | 30.00 |
| 1931 | 779-349 | 30.66 | 30.00 |
| 1932 | 443-178 | 19.56 | 30.00 |
| 1933 | 603-297 | 30.24 | 24.00 |
| 1934 | 689-542 | 50.32 | 24.00 |
| 1935 | 898-660 | 34.98 | 24.00 |
| 1936 | 825-660 | 34.80 | 36.00 |
| 1937 | 726-414 | 36.48 | 24.00 |
| 1938 | 631-425 | 26.10 | 24.00 |
Prewar Conception of Investment in Common Stocks. Hence the prewar relationship between analysis and investment on the one hand and price changes and speculation on the other may be set forth as follows: Investment in common stocks was confined to those showing stable dividends and fairly stable earnings; and such issues in turn were expected to maintain a fairly stable market level. The function of analysis was primarily to search for elements of weakness in the picture. If the earnings were not properly stated; if the balance sheet revealed a poor current position, or the funded debt was growing too rapidly; if the physical plant was not properly maintained; if dangerous new competition was threatening, or 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 of these defects or some other one might be sufficient to condemn the issue from the standpoint of the cautious investor.
On the positive side, analysis was concerned with finding those issues which met all the requirements of investment and in addition offered the best chance for future enhancement. The process was largely a matter of comparing similar issues in the investment class, e.g., the group of dividend-paying Northwestern railroads. Chief emphasis would would be laid upon the relative showing for past years, in particular the average earnings in relation to price and the stability and the trend of earnings. To a lesser extent, the analyst sought to look into the future and to select the industries or the individual companies that were likely to show the most rapid growth.
Speculation Characterized by Emphasis on Future Prospects. In the prewar period it was the well-considered view that when prime emphasis was laid upon what was expected of the future, instead of what had been accomplished in the past, a speculative attitude was thereby taken. Speculation, in its etymology, meant looking forward; investment was allied to “vested interests”–to property rights and values taking root in the past. The future was uncertain, therefore speculative; the past was known, therefore the source of safety. Let us consider a buyer of American Can common in 1910. He may have bought it believing that its price was going to advance or be “put up” or that its earnings were going to increase or that it was soon going to pay a dividend or possibly that it was destined to develop into one of the country’s strongest industrials. From the prewar standpoint, although one of these reasons may have been more intelligent or creditable than aonother, each of them constituted a speculative motive for the purchase.
Technique of Investing in Common Stocks Resembled That for Bonds. Evidently there was a close similarity between the technique of investing in common stocks and that of investing in bonds. The common-stock investor, also, wanted a stable business and one showing an adequate margin of earnings over dividend requirements. Naturally he had to content himself with a smaller margin of safety than he would demand of a bond, a disadvantage that was offset by a larger income return (6% was standard on a good common stock compared with 4½% on a high-grade bond), by the chance of an increased dividend if the business continued to prosper, and–generally of least importance in his eyes–by the possibility of a profit. A common-stock investor was likely to consider himself as in no very different position from that of a purchaser of second-grade bonds; essentially his venture amounted to sacrificing a certain degree of safety in return for larger income. The Pennsylvania and Atchison examples during the 1904-1913 decade will supply specific confirmation of the foregoing description.
Buying Common Stocks Viewed as Taking a Share in a Business. Another useful approach to the attitude of the prewar common-stock investor is from the standpoint of taking an interest in a private business. The typical common-stock investor was a business man, and it seemed sensible to him to value any corporate enterprise in much the same manner as he would value his own business. This meant that he gave at least as much attention to the asset values behind the shares as he did to their earnings records. It is essential to bear in mind the fact that a private business has always been valued primarily on the basis of the “net worth” as shown by its statement. A man contemplating the purchase of a partnership or stock interest in a private undertaking will always start with the value of that interest as shown “on the books,” i.e., the balance sheet, and will then consider whether or not the record and prospects are good enough to make such a commitment attractive. An interest in a private business may of course be sold for more or less than its proportionate asset value; but the book value is still invariably the starting point of the calculation, and the deal is finally made and viewed in terms of the premium or discount from book value involved.
Broadly speaking, the same attitude was formerly taken in an investment purchase of a marketable common stock. The first point of departure was the par value, presumably representing the amount of cash or property originally paid into the business; the second basal figure was the book value, representing the par value plus a ratable interest in the accumulated surplus. Hence in considering a common stock, investors asked themselves: “Is this issue a desirable purchase at the premium above book value, or the discount below book value, represented by the market price?” “Watered stock” was repeatedly inveighed against as a deception practiced upon the stock-buying public, who were misled by a fictitious statement of the asset values existing behind the shares. Hence one of the protective functions of security analysis was to discover whether or not the value of the fixed assets, as stated on the balance sheet of a company, fairly represented the actual cost or reasonable worth of the properties.
Investment in Common Stocks Based on Threefold Concept. We thus see that investment in common stocks was formerly based upon the threefold concept of: (1) a suitable and established dividend return, (2) a stable and adequate earnings record, and (3) a satisfactory backing of tangible assets. Each of these three elements could be made the subject of careful analytical study, viewing the issue both by itself and in comparison with others of its class. 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.
During the postwar period, and particularly during the latter stage of the bull market culminating in 1929, the public acquired a completely different attitude towards the investment merits of common stocks. Two of the three elements above stated lost nearly all their significance, and the third, the earnings record, took on an entirely novel complexion. The new theory or principle may be summed up in the sentence: “The value of a common stock depends entirely upon what it will earn in the future.”
From this dictum the following corollaries were drawn:
- That the dividend rate should have slight bearing upon the value.
- That since no realtionship apparently existed between assets and earning power, the asset value was entirely devoid of importance.
- That past earnings were significant only to the extent that they indicated what changes in the earnings were likely to take place in the future.
This complete revolution in the philosophy of common-stock investment took place virtually without realization by the stock-buying public and with only the most superficial recognition by financial observers. An effort must be made to reach a thorough comprehension of what this changed viewpoint really signifies. To do so we must consider it from three angles; its causes, its consequences and its logical validity.
Causes for This Changed Viewpoint. Why did the investing public turn its attention from dividends, from asset values, and from average earnings to transfer it almost exclusively to the earnings trend, i.e., to the changes in earnings expected in the future? The answer was, first, that the records of the past were proving an undependable guide to investment; and, second, that the rewards offered by the future had become irresistibly alluring.
The new-era concepts had their root first of all in the obsolescence of the old-established standards. During the last generation the tempo of economic change has been speeded up to such a degree that the fact of being long established has ceased to be, as once it was, a warranty of stability. Corporations enjoying decade-long prosperity have been precipitated into insolvency within a few years. Other enterprises, which had been small or unsuccessful or in doubtful repute, have just as quickly acquired dominant size, impressive earnings and the highest rating. The major group upon which investment interest was chiefly concentrated, viz., the railroads, failed signally to participate in the expansion of national wealth and income and showed repeated signs of definite retrogression. The street railways, another important medium of investment prior to 1914, rapidly lost the greater portion of their value as the result of the development of new transportation agencies. The electric and gas companies followed an irregular course during this period, since they were harmed rather than helped by the war and postwar inflation, and their impressive growth was a relatively recent phenomenon. The history of industrial companies was a hodge-podge of violent changes, in which the benefits of prosperity were so unequally and so impermanently distributed as to bring about the most unexpected failures alongside of the most dazzling successes.
In the face of all this instability it was inevitable that the threefold basis of common-stock investment should prove totally inadequate. Past earnings and dividends could no longer be considered, in themselves, an index of future earnings and dividends. Furthermore, these future earnings showed no tendency whatever to be controlled by the amount of the actual investment in the business–the asset values–but instead depended entirely upon a favorable industrial position and upon capable or fortunate managerial policies. In numerous cases of receivership, the current assets dwindled, and the fixed assets proved almost worthless. Because of this absence of any connection between both assets and earnings and between assets and realizable values in backruptcy, less and less attention came to be paid either by financial writers or by the general public to the formerly important question of “net worth,” or “book value”; and it may be said that by 1929 book value had practically disappeared as an element in determining the attractiveness of a security issue. It is a significant confirmation of this point that “watered stock,” once so burning an issue, is now a forgotten phrase.
Attention Shifted to the Trend of Earnings. Thus the prewar approach to investment, based upon past records and tangible facts, became outworn and was discarded. Could anything be put in its place? A new conception was given central importance–that of trend of earnings. The past was important only in so far as it showed the direction in which the future could be expected to move. A continuous increase in profits proved that the company was on the upgrade and promised still better results in the future than had been accomplished to date. Conversely, if the earnings had declined or even remained stationary during a prosperous period, the future must be thought unpromising, and the issue was certainly to be avoided.
The Common-stocks-as-long-term-investments Doctrine. Along with this idea as to what constituted the basis for common-stock selection emerged a companion theory that common stocks represented the most profitable and therefore the most desirable media for long-term investment. This gospel was based upon a certain amount of research, showing that diversified lists of common stocks had regularly increased in value over stated intervals of time for many years past. The figures indicated that such diversified common-stock holdings yielded both a higher income return and a greater principal profit than purchases of standard bonds.
The combination of these two ideas supplied the “investment theory” upon which the 1927-1929 stock market proceeded. Amplifying the principle stated on page 356, the theory ran as follows:
- “The value of a common stock depends on what it can earn in the future.”
- “Good common stocks are those which have shown a rising trend of earnings.”
- “Good common stocks will prove sound and profitable investments.”
These statements sound innocent and plausible. Yet they concealed two theoretical weaknesses that could and did result in untold mischief. The first of these defects was that they abolished the fundamental distinctions between investment and speculation. The second was that they ignored the price of a stock in determining whether or not it was a desirable purchase.
New-era Investment Equivalent to Prewar Speculation. A moment’s thought will show that “new-era investment,” as practiced by the public and the investment trusts, was almost identical with speculation as popularly defined in preboom days. Such “investment” meant buying common stocks instead of bonds, emphasizing enhancement of principal instead of income, and stressing the changes of the future instead of the facts of the established past. It would not be inaccurate to state that new-era investment was simply old-style speculation confined to common stocks with a satisfactory trend of earnings. The impressive new concept underlying the greatest stock-market boom in history appears to be no more than a thinly disguised version of the old cynical epigram: “Investment is successful speculation.”
Stocks Regarded as Attractive Irrespective of Their Prices. The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis. If a public-utility stock was selling at 35 times its maximum recorded earnings, instead of 10 times its average earnings, which was the preboom 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.
Investment Trusts Adopted This New Doctrine. An ironical sidelight is thrown on this 1928–1929 theory by the practice of the investment trusts. These were formed for the purpose of giving the untrained public the benefit of expert administration of its funds–a plausible idea and one that had been working reasonably well in England. The earliest American investment trusts laid considerable emphasis upon certain time-tried principles of successful investment, which they were much better qualified to follow than the typical individual. The most important of these principles were:
- To buy in times of depression and low prices and to sell out in times of prosperity and high prices.
- To diversify holdings in many fields and probably many countries.
- To discover and acquire undervalued individual securities as the result of comprehensive and expert statistical investigations.
The rapidity and completeness with which these traditional principles disappeared from investment-trust technique is one of the many marvels of the period. The idea of buying in times of depression was obviously inapplicable. It suffered from the fatal weakness that investment trusts could be organized only in good times, so that they were virtually compelled to make their initial commitments in bull markets. The idea of world-wide geographical distribution had never exerted a powerful appeal upon the provincially minded Americans (who possibly were right in this respect), and with things going so much better here than abroad this principle was dropped by common consent.
Analysis Abandoned by Investment Trusts. But most paradoxical was the early abandonment of research and analysis in guiding investment-trust policies. However, since these financial institutions owed their existence to the new-era philosophy, it was natural and perhaps only just that they should adhere closely to it. Under its canons investment had now become so beautifully simple that research was unnecessary and elaborate statistical data a mere incumbrance. The investment process consisted merely of finding prominent companies with a rising trend of earnings and then buying their shares regardless of price. Hence the sound policy was to buy only what every one else was buying–a select list of highly popular and exceedingly expensive issues, appropriately known as the “blue chips.” The original idea of searching for the undervalued and neglected issues dropped completely out of sight. Investment trusts actually boasted that their portfolios consisted exclusively of the active and standard (i.e., the most popular ahd highest priced) common stocks. With but slight exaggeration, it might be asserted that under this convenient technique of investment, the affairs of a ten-million-dollar investment trust could be administerd by the intelligence, the training and the actual labors of a single thirty-dollar-a-week clerk.
The man in the steet, having been urged to entrust his funds to the superior skill of investment experts–for substantial compensation–was soon reassuringly told that the trusts would be careful to buy nothing except what the man in the street was buying himself.
The Justification Offered. Irrationality could go no further; yet it is important to note that mass speculation can flourish only in such an atmosphere of illogic and unreality. The self-deception of the mass speculator must, however, have its element of justification. This is usually some generalized statement, sound enough within its proper field, but twisted to fit the speculative mania. In real estate booms, the “reasoning” is usually based upon the inherent permanence and growth of land values. In the new-era bull market , the “rational” basis was the record of long-term improvement shown by diversified common-stock holdings.
A Sound Premise Used to Support an Unsound Conclusion. There was, however, a radical fallacy involved in the new-era application of this historical fact. This should be apparent from even a superficial examination fo the data contained in the small and rather sketchy volume from which the new-era theory may be said to have sprung. The book is entitled Common Stocks as Long Term Investments, by Edgar Lawrence Smith, published in 1924. Common stocks were shown to have a tendency to increase in value with the years, for the simple reason that they earned more than they paid out in dividends and thus the reinvested earnings added to their worth. In a representative case, the company would earn an average of 9%, pay 6% in dividends, and add 3% to surplus. With good management and reasonble luck the fair value of the stock would increase with its book value, at the annual rate of 3% compounded. This was, of course, a theoretical rather than a standard pattern, but the numerous instances of results poorer than “normal” might be offset by examples of more rapid growth.
The attractiveness of common stocks for the long pull thus lay essentially in the fact that they earned more than the bond-interest rate upon their cost. This would be true, typically, of a stock earning $10 and selling at 100. But as soon as the price was advanced to a much higher price in relation to earnings, this advantage disappeared, and with it disappeared the entire theoretical basis for investment purchases of common stocks. When in 1929 investors paid $200 per share for a stock earning $8, they were buying an earning power no greater than the bond-interest rate, without the extra protection afforted by a prior claim. Hence in using the past performances of common stocks as the reason for paying prices 20 to 40 times their earnings, the new-era exponents were starting with a sound premise and twisting it into a woefully unsound conclusion.
In fact their rush to take advantage of the inherent attractiveness of common stocks itself produced conditions entirely different from those which had given rise to this attractiveness and upon which it basically depended, viz., the fact that earnings had averaged some 10% on market price. As we have seen, Edgar Lawrence Smith plausibly explained the growth of common-stock values as arising from the building up of asset values through the reinvestment of surplus earnings. Paradoxically enough, the new-era theory that exploited this finding refused to accord the slightest importance to the asset values behind the stocks it favored. Furthermore, the validity of Mr. Smith’s conclusions rested necessarily upon the assumption that common stocks could be counted on to behave in the future about as they had in the past. Yet the new-era theory threw out of account the past earnings of corporations except in so far as they were regarded as pointing to a trend for the future.
Examples Showing Emphasis on Trend of Earnings. Take three companies with the follwoing exhibits:
| Year | Company A (Electric Power & Light) | Company B (Bangor & Aroostook R. R.) | Company C (Chicago Yellow Cab) |
|---|---|---|---|
| 1925 | $1.01 | $6.22 | $5.52 |
| 1926 | 1.45 | 8.69 | 5.60 |
| 1927 | 2.09 | 8.41 | 4.54 |
| 1928 | 2.37 | 6.94 | 4.58 |
| 1929 | 2.98 | 8.30 | 4.47 |
| 5-year average | $1.98 | $7.71 | $4.94 |
| High price, 1929 | 86⅝ | 90⅜ | 35 |
The 1929 high prices for these three companies show that the new-era attitude was enthusiastically favorable to Company A, unimpressed by Company B, and definitely hostile to Company C. The market considered Company A shares worth more than twice as much as Company C shares, although the latter earned 50% more per share than Company A in 1929 and its average earnings were 150% greater.
Average vs. Trend of Earnings. These relationships between price and earnings in 1929 show definitely that the past exhibit was no longer a measure of normal earning power but merely a weather vane to show which way the winds of profit were blowing. That the average earnings had ceased to be a dependable measure of future earnings must indeed be admitted, because of the greater instability of the typical business to which we have previously alluded. But it did not follow at all that the trend of earnings must therefore be a more dependable guide than the average; and even if it were more dependable, it would not necessarily provide a safe basis, entirely by itself, for investment.
The accepted assumption that because earnings have moved in a certain direction for some years past they will continue to move in that direction is fundamentally no different from the discarded assumption that because earnings averaged a certain amount in the past they will continue to average about that amount in the future. It may well be that the earnings trend offers a more dependable clue to the future than does the earnings average. But at best such an indication of future results is far from certain, and, more important still, there is no method of establishing a logical relationship between trend and price. This means that the value placed upon a satisfactory trend must be wholly arbitrary, and hence speculative, and hence inevitably subject to exaggeration and later collapse.
Danger in Projecting Trends into the Future. There are several reasons why we cannot be sure that a trend of profits shown in the past will continue in the future. In the broad economic sense, there is the law of diminishing returns and of increasing competition which must finally flatten out any sharply upward curve of growth. There is also the flow and ebb of the business cycle, from which the particular danger arises that the earnings curve will look most impressive on the very eve of a serious setback. Considering the 1927–1929 period we observe that since the trend-of-earnings theory was at bottom only a pretext to excuse rank speculation under the guise of “investment,” the profit-mad public was quite willing to accept the flimsiest evidence of the existence of a favorable trend. Rising earnings for a period of five, or four, or even three years only, were regarded as an assurance of uninterrupted future growth and a warrant for projecting the curve of profits indefinitely upward.
Example: The prevalent heedlessness on this score was most evident in connection with the numerous common-stock flotations during this period. The craze for a showing of rising profits resulted in the promotion of many industrial enterprises that had been favored by temporary good fortune and were just approaching, or had already reached, the peak of their prosperity. A typical example of this practice is found in the offering of preferred and common stock of Schletter and Zander, Inc., a manufacturer of hosiery (name changed later to Signature Hosiery Company). The company was organized in 1929, to succeed a company organized in 1922, and the financing was effected by the sale of 44,810 shares of $3.50 convertible preferred shares at $50 per share and 261,349 voting-trust certificates for common stock at $26 per share. The offering circular presented the following exhibit of earnings from the constituent properties:
| Year | Net after federal taxes | Per share of preferred | Per share of common |
|---|---|---|---|
| 1925 | $172,058 | $3.84 | $0.06 |
| 1926 | 339,920 | 7.58 | 0.70 |
| 1927 | 563,856 | 12.58 | 1.56 |
| 1928 | 1,021,308 | 22.79 | 3.31 |
The subsequent record was as follows:
| 1929 | 812,136 | 18.13 | 2.51 |
| 1930 | 179,875(d) | 4.01(d) | 1.81(d) |
In 1931 liquidation of the company’s assets was begun, and a total of $17 per share in liquidating dividends on the preferred had been paid up to the end of 1933. (Assets then remaining for liquidation were negligible.) The common was wiped out.
This example illustrates one of the paradoxes of financial history, viz., that at the very period when the increasing instability of individual companies had made the purchase of common stocks far more precarious than before, the gospel of common stocks as safe and satisfactory investments was preached to and avidly accepted by the American public.