Here the vast majority of issues appear to be cut out, by their per- formance record and their price ratios, in accordance with the defensive investor’s needs as we judge them. We exclude one crite- rion from our tests of public-utility stocks—namely, the ratio of current assets to current liabilities. The working-capital factor takes care of itself in this industry as part of the continuous financing of its growth by sales of bonds and shares. We do require an adequate proportion of stock capital to debt. 4 In Table 14-4 we present a résumé of the 15 issues in the Dow Jones public-utility average. For comparison, Table 14-5 gives a similar picture of a random selection of fifteen other utilities taken from the New York Stock Exchange list. As 1972 began the defensive investor could have had quite a wide choice of utility common stocks, each of which would have met our requirements for both performance and price. These com- panies offered him everything he had a right to demand from simply chosen common-stock investments. In comparison with prominent industrial companies as represented by the DJIA, they offered almost as good a record of past growth, plus smaller fluctu- ations in the annual figures—both at a lower price in relation to earnings and assets. The dividend return was significantly higher. The position of the utilities as regulated monopolies is assuredly more of an advantage than a disadvantage for the conservative investor. Under law they are entitled to charge rates sufficiently remunerative to attract the capital they need for their continuous expansion, and this implies adequate offsets to inflated costs. While the process of regulation has often been cumbersome and perhaps dilatory, it has not prevented the utilities from earning a fair return on their rising invested capital over many decades. 356 The Intelligent Investor celed and decommissioned nuclear energy plants; nor did he foresee the consequences of bungled regulation in California. Utility stocks are vastly more volatile than they were in Graham’s day, and most investors should own them only through a well-diversified, low-cost fund like the Dow Jones U.S. Utilities Sector Index Fund (ticker symbol: IDU) or Utilities Select Sec- tor SPDR (XLU). For more information, see: www.ishares.com and www. spdrindex.com/spdr/. (Be sure your broker will not charge commissions to reinvest your dividends.) TABLE 14-4 Data on the Fifteen Stocks in the Dow Jones Utility Av erage at September 30, 1971 Earns. Per Share Price Price/ 1970 Sept. 30, Book Price/ Book Div. vs. 1971 Earned a Dividend Value Earnings Value Yield 1960 Am. Elec. Power 26 2.40 1.70 18.86 11 ϫ 138% 6.5% +87% Cleveland El. Ill. 34 3 ⁄4 3.10 2.24 22.94 11 150 6.4 86 Columbia Gas System 33 2.95 1.76 25.58 11 129 5.3 85 Commonwealth Edison 35 1 ⁄2 3.05 2.20 27.28 12 130 6.2 56 Consolidated Edison 24 1 ⁄2 2.40 1.80 30.63 10 80 7.4 19 Consd. Nat. Gas 27 3 ⁄4 3.00 1.88 32.11 9 86 6.8 53 Detroit Edison 19 1 ⁄4 1.80 1.40 22.66 11 84 7.3 40 Houston Ltg. & Power 42 3 ⁄4 2.88 1.32 19.02 15 222 3.1 135 Niagara-Mohawk Pwr. 15 1 ⁄2 1.45 1.10 16.46 11 93 7.2 32 Pacific Gas & Electric 29 2.65 1.64 25.45 11 114 5.6 79 Panhandle E. Pipe L. 32 1 ⁄2 2.90 1.80 19.95 11 166 5.5 79 Peoples Gas Co. 31 1 ⁄2 2.70 2.08 30.28 8 104 6.6 23 Philadelphia El. 20 1 ⁄2 2.00 1.64 19.74 10 103 8.0 29 Public Svs. El. & Gas 25 1 ⁄2 2.80 1.64 21.81 9 116 6.4 80 Sou. Calif. Edison 29 1 ⁄4 2.80 1.50 27.28 10 107 5.1 85 Average 28 1 ⁄2 2.66 1.71 23.83 10.7ϫ 121% 6.2% +65% a Estimated for year 1971. TABLE 14-5 Data on a Second List of Public-Utility Stocks at September 30, 1971 Earns. Per Share Price Price/ 1970 Sept. 30, Book Price/ Book Div. vs. 1971 Earned Dividend Value Earnings V alue Yield 1960 Alabama Gas 15 1 ⁄2 1.50 1.10 17.80 10 ϫ 87% 7.1% +34% Allegheny Power 22 1 ⁄2 2.15 1.32 16.88 10 134 6.0 71 Am. Tel. & Tel. 43 4.05 2.60 45.47 11 95 6.0 47 Am. Water Works 14 1.46 .60 16.80 10 84 4.3 187 Atlantic City Elec. 20 1 ⁄2 1.85 1.36 14.81 11 138 6.6 74 Baltimore Gas & Elec. 30 1 ⁄4 2.85 1.82 23.03 11 132 6.0 86 Brooklyn Union Gas 23 1 ⁄2 2.00 1.12 20.91 12 112 7.3 29 Carolina Pwr. & Lt. 22 1 ⁄2 1.65 1.46 20.49 14 110 6.5 39 Cen. Hudson G. & E. 22 1 ⁄4 2.00 1.48 20.29 11 110 6.5 13 Cen. Ill. Lt. 25 1 ⁄4 2.50 1.56 22.16 10 114 6.5 55 Cen. Maine Pwr. 17 3 ⁄4 1.48 1.20 16.35 12 113 6.8 62 Cincinnati Gas & Elec. 23 1 ⁄4 2.20 1.56 16.13 11 145 6.7 102 Consumers Power 29 1 ⁄2 2.80 2.00 32.59 11 90 6.8 89 Dayton Pwr. & Lt. 23 2.25 1.66 16.79 10 137 7.2 94 Delmarva Pwr. & Lt. 16 1 ⁄2 1.55 1.12 14.04 11 117 6.7 78 Average 23 1 ⁄2 2.15 1.50 21.00 11 ϫ 112% 6.5% +71% For the defensive investor the central appeal of the public-utility stocks at this time should be their availability at a moderate price in relation to book value. This means that he can ignore stockmar- ket considerations, if he wishes, and consider himself primarily as a part owner of well-established and well-earning businesses. The market quotations are always there for him to take advantage of when times are propitious—either for purchases at unusually attractive low levels, or for sales when their prices seem definitely too high. The market record of the public-utility indexes—condensed in Table 14-6, along with those of other groups—indicates that there have been ample possibilities of profit in these investments in the past. While the rise has not been as great as in the industrial index, the individual utilities have shown more price stability in most periods than have other groups.* It is striking to observe in this table that the relative price/earnings ratios of the industrials and the utilities have changed places during the past two decades. Stock Selection for the Defensive Investor 359 * In a remarkable confirmation of Graham’s point, the dull-sounding Stan- dard & Poor’s Utility Index outperformed the vaunted NASDAQ Composite Index for the 30 years ending December 31, 2002. TABLE 14-6 Development of Prices and Price/Earnings Ratios for Various Standard & Poor’s Averages, 1948–1970. Industrials Railroads Utilities Year Price a P/E Ratio Price a P/E Ratio Price a P/E Ratio 1948 15.34 6.56 15.27 4.55 16.77 10.03 1953 24.84 9.56 22.60 5.42 24.03 14.00 1958 58.65 19.88 34.23 12.45 43.13 18.59 1963 79.25 18.18 40.65 12.78 66.42 20.44 1968 113.02 17.80 54.15 14.21 69.69 15.87 1970 100.00 17.84 34.40 12.83 61.75 13.16 a Prices are at the close of the year. These reversals will have more meaning for the active than for the passive investor. But they suggest that even defensive portfolios should be changed from time to time, especially if the securities purchased have an apparently excessive advance and can be replaced by issues much more reasonably priced. Alas! there will be capital-gains taxes to pay—which for the typical investor seems to be about the same as the Devil to pay. Our old ally, experience, tells us here that it is better to sell and pay the tax than not sell and repent. Investing in Stocks of Financial Enterprises A considerable variety of concerns may be ranged under the rubric of “financial companies.” These would include banks, insurance companies, savings and loan associations, credit and small-loan companies, mortgage companies, and “investment companies” (e.g., mutual funds).* It is characteristic of all these enterprises that they have a relatively small part of their assets in the form of material things—such as fixed assets and merchandise inventories—but on the other hand most categories have short- term obligations well in excess of their stock capital. The question of financial soundness is, therefore, more relevant here than in the case of the typical manufacturing or commercial enterprise. This, in turn, has given rise to various forms of regulation and supervi- sion, with the design and general result of assuring against unsound financial practices. Broadly speaking, the shares of financial concerns have pro- duced investment results similar to those of other types of common shares. Table 14-7 shows price changes between 1948 and 1970 in six groups represented in the Standard & Poor’s stock-price indexes. The average for 1941–1943 is taken as 10, the base level. 360 The Intelligent Investor * Today the financial-services industry is made up of even more components, including commercial banks; savings & loan and mortgage-financing compa- nies; consumer-finance firms like credit-card issuers; money managers and trust companies; investment banks and brokerages; insurance companies; and firms engaged in developing or owning real estate, including real-estate investment trusts. Although the sector is much more diversified today, Graham’s caveats about financial soundness apply more than ever. The year-end 1970 figures ranged between 44.3 for the 9 New York banks and 218 for the 11 life-insurance stocks. During the sub- intervals there was considerable variation in the respective price movements. For example, the New York City bank stocks did quite well between 1958 and 1968; conversely the spectacular life- insurance group actually lost ground between 1963 and 1968. These cross-movements are found in many, perhaps most, of the numerous industry groups in the Standard & Poor’s indexes. We have no very helpful remarks to offer in this broad area of investment—other than to counsel that the same arithmetical stan- dards for price in relation to earnings and book value be applied to the choice of companies in these groups as we have suggested for industrial and public-utility investments. Railroad Issues The railroad story is a far different one from that of the utilities. The carriers have suffered severely from a combination of severe competition and strict regulation. (Their labor-cost problem has of Stock Selection for the Defensive Investor 361 TABLE 14-7 Relative Price Movements of Stocks of Various Types of Financial Companies Between 1948 and 1970 1948 1953 1958 1963 1968 1970 Life insurance 17.1 59.5 156.6 318.1 282.2 218.0 Property and liability insurance 13.7 23.9 41.0 64.7 99.2 84.3 New York City banks 11.2 15.0 24.3 36.8 49.6 44.3 Banks outside New York City 16.9 33.3 48.7 75.9 96.9 83.3 Finance companies 15.6 27.1 55.4 64.3 92.8 78.3 Small-loan companies 18.4 36.4 68.5 118.2 142.8 126.8 Standard & Poor’s composite 13.2 24.8 55.2 75.0 103.9 92.2 a Year-end figures from Standard & Poor’s stock-price indexes. Average of 1941– 1943 = 10. course been difficult as well, but that has not been confined to rail- roads.) Automobiles, buses, and airlines have drawn off most of their passenger business and left the rest highly unprofitable; the trucks have taken a good deal of their freight traffic. More than half of the railroad mileage of the country has been in bankruptcy (or “trusteeship”) at various times during the past 50 years. But this half-century has not been all downhill for the carriers. There have been prosperous periods for the industry, especially the war years. Some of the lines have managed to maintain their earn- ing power and their dividends despite the general difficulties. The Standard & Poor’s index advanced sevenfold from the low of 1942 to the high of 1968, not much below the percentage gain in the public-utility index. The bankruptcy of the Penn Central Trans- portation Co., our most important railroad, in 1970 shocked the financial world. Only a year and two years previously the stock sold at close to the highest price level in its long history, and it had paid continuous dividends for more than 120 years! (On p. 423 below we present a brief analysis of this railroad to illustrate how a competent student could have detected the developing weaknesses in the company’s picture and counseled against ownership of its securities.) The market level of railroad shares as a whole was seri- ously affected by this financial disaster. It is usually unsound to make blanket recommendations of whole classes of securities, and there are equal objections to broad condemnations. The record of railroad share prices in Table 14-6 shows that the group as a whole has often offered chances for a large profit. (But in our view the great advances were in them- selves largely unwarranted.) Let us confine our suggestion to this: There is no compelling reason for the investor to own railroad shares; before he buys any he should make sure that he is getting so much value for his money that it would be unreasonable to look for something else instead.* 362 The Intelligent Investor * Only a few major rail stocks now remain, including Burlington Northern, CSX, Norfolk Southern, and Union Pacific. The advice in this section is at least as relevant to airline stocks today—with their massive current losses and a half-century of almost incessantly poor results—as it was to railroads in Graham’s day. Selectivity for the Defensive Investor Every investor would like his list to be better or more promising than the average. Hence the reader will ask whether, if he gets him- self a competent adviser or security analyst, he should not be able to count on being supplied with an investment package of really supe- rior merits. “After all,” he may say, “the rules you have outlined are pretty simple and easygoing. A highly trained analyst ought to be able to use all his skill and techniques to improve substantially on something as obvious as the Dow Jones list. If not, what good are all his statistics, calculations, and pontifical judgments?” Suppose, as a practical test, we had asked a hundred security analysts to choose the “best” five stocks in the Dow Jones Average, to be bought at the end of 1970. Few would have come up with identical choices and many of the lists would have differed com- pletely from each other. This is not so surprising as it may at first appear. The underlying reason is that the current price of each prominent stock pretty well reflects the salient factors in its financial record plus the general opinion as to its future prospects. Hence the view of any analyst that one stock is a better buy than the rest must arise to a great extent from his personal partialities and expectations, or from the placing of his emphasis on one set of factors rather than on another in his work of evaluation. If all analysts were agreed that one particular stock was better than all the rest, that issue would quickly advance to a price which would offset all of its previous advantages.* Stock Selection for the Defensive Investor 363 * Graham is summarizing the “efficient markets hypothesis,” or EMH, an aca- demic theory claiming that the price of each stock incorporates all publicly available information about the company. With millions of investors scouring the market every day, it is unlikely that severe mispricings can persist for long. An old joke has two finance professors walking along the sidewalk; when one spots a $20 bill and bends over to pick it up, the other grabs his arm and says, “Don’t bother. If it was really a $20 bill, someone would have taken it already.” While the market is not perfectly efficient, it is pretty close most of the time—so the intelligent investor will stoop to pick up the stock market’s $20 bills only after researching them thoroughly and minimizing the costs of trading and taxes. Our statement that the current price reflects both known facts and future expectations was intended to emphasize the double basis for market valuations. Corresponding with these two kinds of value elements are two basically different approaches to security analysis. To be sure, every competent analyst looks forward to the future rather than backward to the past, and he realizes that his work will prove good or bad depending on what will happen and not on what has happened. Nevertheless, the future itself can be approached in two different ways, which may be called the way of prediction (or projection) and the way of protection.* Those who emphasize prediction will endeavor to anticipate fairly accurately just what the company will accomplish in future years—in particular whether earnings will show pronounced and persistent growth. These conclusions may be based on a very care- ful study of such factors as supply and demand in the industry—or volume, price, and costs—or else they may be derived from a rather naïve projection of the line of past growth into the future. If these authorities are convinced that the fairly long-term prospects are unusually favorable, they will almost always recommend the stock for purchase without paying too much regard to the level at which it is selling. Such, for example, was the general attitude with respect to the air-transport stocks—an attitude that persisted for many years despite the distressingly bad results often shown after 1946. In the Introduction we have commented on the disparity between the strong price action and the relatively disappointing earnings record of this industry. 364 The Intelligent Investor * This is one of the central points of Graham’s book. All investors labor under a cruel irony: We invest in the present, but we invest for the future. And, unfortunately, the future is almost entirely uncertain. Inflation and inter- est rates are undependable; economic recessions come and go at random; geopolitical upheavals like war, commodity shortages, and terrorism arrive without warning; and the fate of individual companies and their industries often turns out to be the opposite of what most investors expect. Therefore, investing on the basis of projection is a fool’s errand; even the forecasts of the so-called experts are less reliable than the flip of a coin. For most peo- ple, investing on the basis of protection—from overpaying for a stock and from overconfidence in the quality of their own judgment—is the best solu- tion. Graham expands on this concept in Chapter 20. By contrast, those who emphasize protection are always espe- cially concerned with the price of the issue at the time of study. Their main effort is to assure themselves of a substantial margin of indicated present value above the market price—which margin could absorb unfavorable developments in the future. Generally speaking, therefore, it is not so necessary for them to be enthusias- tic over the company’s long-run prospects as it is to be reasonably confident that the enterprise will get along. The first, or predictive, approach could also be called the quali- tative approach, since it emphasizes prospects, management, and other nonmeasurable, albeit highly important, factors that go under the heading of quality. The second, or protective, approach may be called the quantitative or statistical approach, since it emphasizes the measurable relationships between selling price and earnings, assets, dividends, and so forth. Incidentally, the quantita- tive method is really an extension—into the field of common stocks—of the viewpoint that security analysis has found to be sound in the selection of bonds and preferred stocks for invest- ment. In our own attitude and professional work we were always committed to the quantitative approach. From the first we wanted to make sure that we were getting ample value for our money in concrete, demonstrable terms. We were not willing to accept the prospects and promises of the future as compensation for a lack of sufficient value in hand. This has by no means been the standard viewpoint among investment authorities; in fact, the majority would probably subscribe to the view that prospects, quality of management, other intangibles, and “the human factor” far out- weigh the indications supplied by any study of the past record, the balance sheet, and all the other cold figures. Thus this matter of choosing the “best” stocks is at bottom a highly controversial one. Our advice to the defensive investor is that he let it alone. Let him emphasize diversification more than individual selection. Incidentally, the universally accepted idea of diversification is, in part at least, the negation of the ambitious pre- tensions of selectivity. If one could select the best stocks unerringly, one would only lose by diversifying. Yet within the limits of the four most general rules of common-stock selection suggested for the defensive investor (on pp. 114–115) there is room for a rather considerable freedom of preference. At the worst the indulgence of Stock Selection for the Defensive Investor 365 . expectations, or from the placing of his emphasis on one set of factors rather than on another in his work of evaluation. If all analysts were agreed that one particular stock was better than all the. in the quality of their own judgment—is the best solu- tion. Graham expands on this concept in Chapter 20. By contrast, those who emphasize protection are always espe- cially concerned with the. diversification more than individual selection. Incidentally, the universally accepted idea of diversification is, in part at least, the negation of the ambitious pre- tensions of selectivity. If one