• Graham uses “common stock option warrant” as a synonym for “warrant,”

a security issued directly by a corporation giving the holder a right to purchase the company’s stock at a predetermined price. Warrants have been almost entirely superseded by stock options. Graham quips that he intends the example as a “shocker” because, even in his day, warrants were regarded as one of the market’s seediest backwaters. (See the commentary on Chapter 16.)in this unprepossessing security form. A sufficiently enterprising investor could then include an option warrant operation in his miscellany of unconventional investments.

To Sum Up

Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings. Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success.

Emhart and eltra. Emhart has done better in its business than in the stock market over the past 14 years. In 1958 it sold as high as times the current earnings-about the same ratio as for the DJIA.

Since then its profits tripled, as against a rise of less than 100% for the Dow, but its closing price in 1970 was only a third above the A Comparison of Four Listed Companies

• At the end of 1970, Emerson’s $1.6 billion in market value truly was “enormous,” given average stock sizes at the time. At year end 2002, Emerson’s

common stock had a total market value of approximately $21 billion.1958 high, versus 43% for the Dow. The record of eltra is somewhat similar. It appears that neither of these companies possesses glamour, or “sex appeal,” in the present market; but in all the statistical data they show up surprisingly well. Their future prospects? We have no sage remarks to make here, but this is what Standard & Poor’s had to say about the four companies in 1971: eltra-”Long term Prospects: Certain operations are cyclical, but an established competitive position and diversification are offsetting factors.” Emerson Electric-”While adequately priced (at 71) on the current outlook, the shares have appeal for the long term….Acontinued acquisition policy together with a strong position in industrial fields and an accelerated international program suggests further sales and earnings progress.” Emery Air Freight-”The shares appear amply priced (at 57) on current prospects, but are well worth holding for the long pull.” Emhart-”Although restricted this year by lower capital spending in the glass container industry, earnings should be aided by an improved business environment in 1972. The shares are worth holding (at 34).” Conclusions: Many financial analysts will find Emerson and Emery more interesting and appealing stocks than the other two- primarily, perhaps, because of their better “market action,” and secondarily because of their faster recent growth in earnings.

During the 15 years of the bull market ending in 1964 the annual volume had averaged “only” 712 million shares-one quarter of the 1970 figure-but the brokerage business had enjoyed the greatest prosperity in its history. If, as it appears, the member firms as a whole had allowed their overhead and other expenses to increase at a rate that could not sustain even a mild reduction in volume during part of a year, this does not speak well for either their business acumen or their financial conservatism.

A third explanation of the financial trouble finally emerged out of a mist of concealment, and we suspect that it is the most plausible and significant of the three. It seems that a good part of the capital of certain brokerage houses was held in the form of common stocks owned by the individual partners. Some of these seem to have been highly speculative and carried at inflated values. When the market declined in 1969 the quotations of such securities fell drastically and a substantial part of the capital of the firms vanished with them.

In effect the partners were speculating with the capital that was supposed to protect the customers against the ordinary financial hazards of the brokerage business, in order to make a double profit thereon. This was inexcusable; we refrain from saying more.

Nearly everyone interested in common stocks wants to be told by someone else what he thinks the market is going to do. The demand being there, it must be supplied.

Their interpretations and forecasts of business conditions, of 260 The Intelligent Investorcourse, are much more authoritative and informing. These are an important part of the great body of economic intelligence which is spread continuously among buyers and sellers of securities and tends to create fairly rational prices for stocks and bonds under most circumstances. Undoubtedly the material published by the financial services adds to the store of information available and fortifies the investment judgment of their clients.

It is difficult to evaluate their recommendations of individual securities. Each service is entitled to be judged separately, and the verdict could properly be based only on an elaborate and inclusive study covering many years. In our own experience we have noted among them a pervasive attitude which we think tends to impair what could otherwise be more useful advisory work. This is their general view that a stock should be bought if the near term prospects of the business are favorable and should be sold if these are unfavorable-regardless of the current price. Such a superficial principle often prevents the services from doing the sound analytical job of which their staffs are capable-namely, to ascertain whether a given stock appears over or undervalued at the current price in the light of its indicated long term future earning power.

The year after the ?2 high the price fell by more than half to 34.

But this time the shares did not have the bargain quality that they showed at the low quotation in 1938. After varying sorts of fluctuations the price fell to another low of ?2 in 1970 and 18 in 1972- having reported the first quarterly deficit in its history.

We see in this history how wide can be the vicissitudes of a major American enterprise in little more than a single generation, and also with what miscalculations and excesses of optimism and pessimism the public has valued its shares. In 1938 the business was really being given away, with no takers; in 1961 the public was clamoring for the shares at a ridiculously high price. After that came a quick loss of half the market value, and some years later a substantial further decline. In the meantime the company was to turn from an outstanding to a mediocre earnings performer; its profit in the boom year 1968 was to be less than in 1958; it had paid a series of confusing small stock dividends not warranted by the current additions to surplus; and so forth. A. & P. was a larger company in 1961 and 1972 than in 1938, but not as well run, not as profitable, and not as attractive.* There are two chief morals to this story. The first is that the stock market often goes far wrong, and sometimes an alert and coura202 The Intelligent Investor

• The more recent history of A & P is no different. At year end 1999, its

share price was $27.875; at year end 2000, $7.00; a year later, $23.78; at year end 2002, $8.06. Although some accounting irregularities later came to light at A & P, it defies all logic to believe that the value of a relatively stable business like groceries could fall by three fourths in one year, triple the next year, then drop by two thirds the year after that.geous investor can take advantage of its patent errors. The other is that most businesses change in character and quality over the years, sometimes for the better, perhaps more often for the worse.

The impact of market fluctuations upon the investor’s true situation may be considered also from the standpoint of the shareholder as the part owner of various businesses. The holder of marketable shares actually has a double status, and with it the privilege of taking advantage of either at his choice. On the one hand his position is analogous to that of a minority shareholder or silent partner in a private business. Here his results are entirely dependent on the profits of the enterprise or on a change in the underlying value of its assets. He would usually determine the value of such a private-business interest by calculating his share of the net worth as shown in the most recent balance sheet. On the other hand, the common-stock investor holds a piece of paper, an engraved stock certificate, which can be sold in a matter of minutes at a price which varies from moment to moment—when the market is open, that is—and often is far removed from the balancesheet value.*

The development of the stock market in recent decades has made the typical investor more dependent on the course of price quotations and less free than formerly to consider himself merely a business owner. The reason is that the successful enterprises in which he is likely to concentrate his holdings sell almost constantly at prices well above their net asset value (or book value, or “balance-sheet value”). In paying these market premiums the investor gives precious hostages to fortune, for he must depend on the stock market itself to validate his commitments.† This is a factor of prime importance in present-day investing, and it has received less attention than it deserves. The whole structure of stock-market quotations contains a built-in contradiction. The better a company’s record and prospects, the less relationship the price of its shares will have to their book value. But the greater the premium above book value, the less certain the basis of determining its intrinsic value—i.e., the more this “value” will depend on the changing moods and measurements of the stock market. Thus we reach the final paradox, that the more successful the company, the greater are likely to be the fluctuations in the price of its shares. This really means that, in a very real sense, the better the quality of a common stock, the more speculative it is likely to be—at least as compared with the unspectacular middle-grade issues.* (What we have said applies to a comparison of the leading growth companies with the bulk of well-established concerns; we exclude from our purview here those issues which are highly speculative because the businesses themselves are speculative.)

The argument made above should explain the often erratic price behavior of our most successful and impressive enterprises. Our favorite example is the monarch of them all—International Business Machines. The price of its shares fell from 607 to 300 in seven months in 1962–63; after two splits its price fell from 387 to 219 in 1970. Similarly, Xerox—an even more impressive earnings gainer in recent decades—fell from 171 to 87 in 1962–63, and from 116 to 65 in 1970. These striking losses did not indicate any doubt about the future long-term growth of IBM or Xerox; they reflected instead a lack of confidence in the premium valuation that the stock market itself had placed on these excellent prospects.

The previous discussion leads us to a conclusion of practical importance to the conservative investor in common stocks. If he is to pay some special attention to the selection of his portfolio, it might be best for him to concentrate on issues selling at a reasonably close approximation to their tangible-asset value—say, at not more than one-third above that figure. Purchases made at such levels, or lower, may with logic be regarded as related to the company’s balance sheet, and as having a justification or support independent of the fluctuating market prices. The premium over book value that may be involved can be considered as a kind of extra fee paid for the advantage of stock-exchange listing and the marketability that goes with it.

A caution is needed here. A stock does not become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years. This may appear like demanding a lot from a modestly priced stock, but the prescription is not hard to fill under all but dangerously high market conditions. Once the investor is willing to forgo brilliant prospects—i.e., better than average expected growth—he will have no difficulty in finding a wide selection of issues meeting these criteria.

In our chapters on the selection of common stocks (Chapters 14 and 15) we shall give data showing that more than half of the DJIA issues met our asset-value criterion at the end of 1970. The most widely held investment of all—American Tel. & Tel.—actually sells below its tangible-asset value as we write. Most of the light-andpower shares, in addition to their other advantages, are now (early 1972) available at prices reasonably close to their asset values. The investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipliers of both earnings and tangible assets. As long as the earning power of his holdings remains satisfactory, he can give as little attention as he pleases to the vagaries of the stock market. More than that, at times he can use these vagaries to play the master game of buying low and selling high.