The Theory of Common Stock Investment

Chapter Summary

This chapter attempts to answer 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 the stock market?”

Chapter in Detail

– “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.” (Does the group agree with this notion that some stocks are un-analyzable?)

– History Lesson: Turning to the history of common stock analysis we find that two conflicting
factors have been at work during the past 30 years (prior to 1934):

Common stock analysis has been vitiated by two developments:

1. The instability of tangibles

2. The dominant importance of intangibles

Example: Speculative (American Can Company)

Year Range for Stock Earned per Share Paid per Share
1904 - $0.51 0
1905 - -1.39 0
1906 - -1.31 0
1907 $3-8 -0.57 0
1908 $4-10 -0.44 0
1909 $8-15 -0.32 0
1910 $7-14 -0.15 0
1911 $9-13 $0.07 0
1912 $11-47 8.86 0
1913 $21-47 5.21 0
1923 $74-108 19.64 $5.00
1924 $96-164 20.51 6
1925 $158-297 32.75 7
1926 $233-379* 26.34 13.25
1927 $262-466 24.66 12
1928 $423-705 41.16 12
1929 $516-1107 48.12 30
1930 $628-940 48.48 30
1931 $349-779 30.66 30
1932 $178-443 19.56 24

• Stock was split 6 for 1 in 1926.

American Can 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 investment in the
business

Example: Investment (National Biscuit Company)

Year Range for Stock Earned per Share Paid per Share
1909 $97-120 $7.67 $5.75
1910 $100-120 9.86 6
1911 $117-144 10.05 8.75
1912 $114-161 9.59 7
1913 $104-130 11.73 7
1914 $120-139 9.52 7
1915 $-116-132 8.2 7
1916 $118-131 9.72 7
1917 $80-123 9.87 7
1918 $90-111 11.63 7
1923 $266-370 35.42 21
1924 $352-541* 38.15 28
1925 $455-553 40.53 28
1926 $518-714 44.24 35
1927 $663-1309 49.77 42
1928 $1117-1367 51.17 49
1929 $980-1657 57.4 52.5
1930 $1148-1628 59.68 56
1931 $637-1466 50.05 49
1932 $354-820 42.7 49

• Stock split 4 for 1 in 1922.

National Biscuit Company can be regarded an investment common stock also for three good reasons:

1. Shows a satisfactory record of continued dividends

2. The earnings were reasonably stable and averaged substantially in excess of the dividends paid
3. Each dollar of stock was backed by a dollar or more of actual investment in the business

Old Era Theory (Pre war period)

– Speculation characterized by emphasis on future prospects (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.)

– Technique of investing in common stocks resembled that for bonds

– Buying common stocks viewed as taking a share in a business (An interest in a private business may 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.)
– Investment in common stocks based on threefold concept:

1. A suitable and established dividend return

2. A stable and adequate earnings record
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.

New Era Theory (Post war period)

– The new era theory of 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:

1. The dividend rate should have slight bearing upon the value
2. Since no relationship apparently existed between assets and earning power, the asset value was entirely
devoid of importance.
3. Past earnings are significant only to the extent that they indicated what changes the in the earnings were
likely to take place in the future.

In this sense new era investment was almost identical with speculation as popularly defined in preboom days.

– Stocks regarded as attractive irrespective of their prices (If say, 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) Sound familiar?
Practical Application

This chapter by and large outlines the principles upon which Value Investing were founded, anyone would do
very well to apply the (old era) principles and heed Graham's words of caution pertaining to the “new era”

Quotes

“Analysis is concerned with finding those issues which met all the requirements of investment and in addition
offer the best chance for future enhancement.” pg. 304

“In considering a common stock, investors should ask themselves: Is this issue a desirable purchase at the
premium above book value or the discount below book value, represented by the market price?”

“Why work for a living when a fortune can be made on Wall Street without working.”