Let me comment briefly on the results shown in Table 1, first in terms of the figures, second in terms of the fundamental differences between our present approach and that generally followed by financial analysts in their portfolio selections, and third in terms of their possible implications for both the professional investor and the lay investor.
The annual percentage results shown in the table appear to me at least modestly satisfactory in themselves though not loss-proof in severe bear markets-and quite impressive when compared with the DJIA figures and especially those of the comprehensive Value-Line Composite Index. By any of our simple methods the investor could have averaged five percent to fifteen percent greater than in a typical NYSE random portfolio. The use of the p /E-ratioapproach in our group purchases would have worked out quite a bit better than either of the other criteria. It would have given an average return of some eighteen percent, including dividends, for the thirteen years 1960-1973. But the 1973 portfolio shows a loss of some twenty-five percent to the end of 1974, about the same as the Dow. This decline could have been reduced to about fifteen percent, less dividends, if each individual issue had been required to meet all our three criteria to qualify for purchase. Similarly, a portfolio acquired in 1974 would have shown a shrinkage of only seven percent or less to the end of the year , if all three criteria had been imposed. It is reassuring that not only the 1974 losses but the 1973 shrinkage as well would have disappeared in the market rise to March 7 last.
Mr. Irving Kahn, C. F. A., has kindly supplied me with price and earnings material for the years 1951-1960, enabling me to apply two of my criteria to that earlier decade (book-value data were not included). The partial tests I made for the period gave encouraging results from the two approaches-surprisingly good ones in fact from purchases at half the previous two-year highs. Two such tests covering about 300 purchases in various years indicated profits of twenty percent and twenty-seven percent per annum, exclusive of dividends. For individual years the results sometimes failed to equal the large rises of the Dow in that heady bull market; and there were also indications that better results would have followed from confining purchases to stocks paying dividends. Overall, however, the combination of wide individual fluctuations with the general upswing in the decade did provide an excellent milieu for simple operations of our type, with results that should have satisfied all but the impatient and over-greedy. Overall, therefore, my tests cover a period of just twenty-five years in the past.
Nevertheless, to most, our techniques themselves must seem too simple to be convincing. They involve no forecasts of the economy or of the stock market, and no selectivity among industries and individual companies. The sole reliance is placed on a single criterion of price attractiveness, applied indiscriminately on a group basis. Let us take a moment to compare "portfolio construction" by our approach with that of the well-known Markowitz-Sharpe technique, known in financial literature under the title of "efficient portfolios." Following our prescription, nothing could have been simpler, in almost any year, than to pick out from Moody's or Standard & Poor's or the Value-Line services an otherwise random portfolio of common stocks selling at less than half their high prices of the two preceding years. (But in some years the high level of the market made such low price relationships hard to find in sufficient quantity.)
The other two criteria are also relatively easy to apply by mere inspection of the figures-no computer work is necessary.
On the other hand, the Markowitz-Sharpe approach requires that the security analyst estimate for a given universe of common stocks both the profit potentially and the risk of price decline-otherwise disguised as our friend the "beta" — for each component issue. According to their theories, it would then be possible for a computer to select the portfolio of any convenient size that offers the best percentage of profit for a pre-accepted risk factor, or conversely the one that offers the lowest percentage of expectable downward price movement for a pre-selected level of anticipated profit. The method is indeed highly mathematical and complicated enough to require twenty pages of description and discussion in Lorie and Hamilton's recent book, The Stock Market. But proponents and discussants alike do not seem to have realized to what extent the application of these methods depends on fallible human estimates and judgments of both expectable profits and anticipable price declines of many individual issues.
Self-respecting security analysts should be dissatisfied with my own three approaches in the bare-bones form in which they have been presented. Most would be sure that they could have gotten better results than my calculations show by adding either a little or a lot to the procedure I followed. The first question one is likely to ask is: "Why limit ourselves to just one criterion for stock selection? Why not require that the portfolio issues meet all three or at least two of our conditions for purchase? Again one may ask why I have not tested out other logical criteria, such as a minimum dividend return – presumably in relation to going bond-interest rates – or a minimum rate of past earnings growth – as set forth, say, in the Value-Line analyses – or, thirdly, some relatively simple tests of financial strength, etc.
I have indeed made some supplementary tests of the first kind, which combined two or more of my criteria, but the results before 1972 were not persuasive. In 1962 for example, my 10X earnings criterion would have produced an annual profit rate of twenty-one percent while our 30-stock portfolio bought at half the 1960-1961 high prices yielded a corresponding gain of 12½ percent. A third group that met both of these tests would have shown a profit of thirty-two percent, excluding dividends, over an average holding period of 1.7 years, thus averaging an in-between annual rate of 18.3 percent.
However, as Table 1 shows, the temporary bad results of 1973 and 1974 could have been appreciably improved by insisting that each portfolio stock meet all three of my criteria, and by setting the book-value test at twothirds thereof, instead of 100 percent, as heretofore.
What I have been presenting so far is by no means a single cut-and-dried method for buying and selling common stocks-though it could easily be reduced to so narrow a scope. But the very fact that my research has been carried out on a three-pronged basis should suggest that there is an ample field there for additional studies by the body of financial analysts, and thus for a variety of individual judgments as to the most appealing criteria and other parameters – to use a now fashionable word – for this type of investment technique.
Early in 1975 it would have been possible to find a large number of common stocks, each meeting an assortment of quantitative criteria. Let me enumerate the following seven
(1) A price under 5.3X last twelve months' earnings. (This would represent our standard requirement of an earnings yield twice the current Aaa bond rate of 9½ percen)t.
(2) A dividend return of at least six percent. (This is an arbitrary figure, and may appear too low to some of you compared with bond yields. ) Experience shows that the dividend return usually plays a small part in the overall results of a less-than-three-years' holding of common stocks – which our method prescribes – except to the important degree that rate changes may influence the price movement.
(3) A price less than half the 1972-1974 high. This is readily obtainable and corresponds to one of our single criteria.
(4) A price less than two-thirds of book value. The figure is set at this large discount first because it is now readily obtainable,
and second it suggests the appealing technique of buying at two-thirds of book and selling within, say, two years at 100 percent of book — for a 50 percent-plus profit.
(5) A satisfactory past growth rate — as measured simply by 1974 earnings at least twice those of 1964. About half the NYSE issues would meet this criterion.
(6) A sound financial condition from the standpoint of debt. I apply this by requiring that each company pass at least
two of the following three tests:
a. Current Assets = 1.9X Current Liabilities.
b. Current Assets = Current liabilities plus debt.
c. Stock equity (including preferred stock) = Current liabilities plus debt.
About half the NYSE list met two of these requirements, based on their 1973 balance sheets.
(7) Earnings stability, as shown by both of the following:
a. No deficit in the 1965-1974 decade.
b. Not more than two years of decline in per share earnings – 5% or more – in the ten years of 1965-1974.
I applied these seven criteria at the close of 1974 to four random samples aggregating 100 NYSE issues. The number meeting each requirement ranged from a minimum of fifty percent to a maximum of eighty percent. What is most interesting perhaps is that thirty-two issues met all seven criteria — indicating that some 500 listed issues in all would have been available for such further selective processes as you analysts would insist upon. Hence, these could have offered as many as seventeen 30-stock portfolios — all different. In the aggregate, portfolios of this kind should prove statistically almost fool-proof, and they all promise a satisfactory rate of return over the next two years-unless the economic sky actually falls down upon us, as a few Cassandras are predicting, not without their disquieting arguments.
On this crucial point it seems to me that we might as well base our investment policy on the assumption that now-as always in the past – the bear market and the recession – depression will prove temporary, and offer more opportunities than risks to those who do not borrow money to buy stocks. I see no clear alternatives to such a combination of courage, optimism, and patience.
Returning for a moment to the idea of buying stocks below their working-capital value – with which I began this paper – I have a compilation that lists as many as 600 such opportunities taken from the S&P Monthly Stock Guide at 1974 year-end — about one company out of six in the booklet. More than half of these were selling at twothirds or less of net-current — asset value, and also more than half at less than five times last twelve months' earnings.
Of the two latter bargain categories about 100 were listed on the NYSE, and 31 of these were available at both less than two-thirds working-capital-value and less than five times earnings.
At the market level of December 1974, security analysis had become almost a superfluity. The selectivity element might pretty well have been limited to the factor of financial strength or credit risk; beyond that it was by no means clear to me that even my seven criteria could be expected to yield results significantly better than any purely random 30 stock portfolio — chosen by the so-called dart-throwing method assumed often by academics of the "efficient market" or anti-security analysis school.
A basic question raised in this paper is not whether elaborate security analysis is required for common-stock selection under 1974-1975 conditions – to which my answer would be no – but rather the extent to which the simple approaches expounded today could be expected to prove rewarding to the stock markets of the future – say of the next 10 or 15 years – which will make up a significant part of the working careers of those in my audience. Those of you who have been following this presentation closely will have adduced that my attitude partakes of both the negative and the positive on the need for elaborate security analysis. I do not have much confidence in the practical worth for most analysts of detailed studies of individual companies, with emphasis placed either on their comparative past performance or on predictions of their relative future performance over a one-to-five-years time span.
My reputation – such as it is, or perhaps as recently revived – seems to be associated chiefly with the concept of "Value". But I have been truly interested solely in such aspects of value as present themselves in a clear and convincing manner, derived from basic elements of earning power and balance-sheet-position, with no emphasis at all placed on such matters as small variations in the growth rate from quarter to quarter, or the inclusion or exclusion of minor items in calculating the so-called "primary earnings". Most significant here, I have resolutely turned my back on efforts to predict the future.
To that extent I share the skepticism expressed by the "efficient market" theoreticians as to the ability of all but very superior security analysts to do a good job of individual stock selection. But this is far from saying that I think that individual stock prices reflect in general and under most conditions the "fair value" of each issue. On the contrary, my present emphasis on the tendency of most stocks to fluctuate widely and often wildly in price over the years should show my conviction that stock prices are often out of line with their fair or intrinsic values.
I see no reason to expect the disappearance or any great diminution of the age-old tendency of most common stocks to move up and down over a wide percentage range: I deem this a consequence of the psychological or rather the pathological nature of stock speculation. Nor have there been any signs that the institutional dominance of the stock market in the past decade has tended to lessen the amplitude of these fluctuations. We cannot predict the overall performance of common stocks in the next fifteen years — the exhilarating achievement of better than fifteen percent per annum for 1944-1959 was followed by practically a zero performance in 1960-1974. But in both the rewarding and the disillusioning periods the bulk of individual issues persisted in their wide upswings and downswings. It is happening once again in the current market. (The zebra will grow older but will not change his stripes.)
Coming back in conclusion to stocks selection in future years let me make two undeniable assertions: The first is that the behavior of stock prices in the past fifteen years and more does indicate that relatively simply criteria of purchase and sale could have been applied on a group basis with satisfactory results throughout this period, except naturally in 1973 and 1974; secondly, if the general character of future common-stock movements will resemble basically that of the past, in their tendency to move up and down, then there is good reason for financial analysts to develop and apply systematically – each in his individual fashion – the type of investment policy I have discussed today.
