556 Appendixes TABLE 6 Pacific Partners, Ltd. Limited Overall S & P 500 Partnership Partnership Year Index (%) Results (%) Results (%) 1965 12.4 21.2 32.0 1966 –10.1 24.5 36.7 1967 23.9 120.1 180.1 1968 11.0 114.6 171.9 1969 –8.4 64.7 97.1 1970 3.9 –7.2 –7.2 1971 14.6 10.9 16.4 1972 18.9 12.8 17.1 1973 –14.8 –42.1 –42.1 1974 –26.4 –34.4 –34.4 1975 37.2 23.4 31.2 1976 23.6 127.8 127.8 1977 –7.4 20.3 27.1 1978 6.4 28.4 37.9 1979 18.2 36.1 48.2 1980 32.3 18.1 24.1 1981 –5.0 6.0 8.0 1982 21.4 24.0 32.0 1983 22.4 18.6 24.8 Standard & Poor’s 19 year compounded gain 316.4% Limited Partners 19 year compounded gain 5,530.2% Overall Partnership 19 year compounded gain 22,200.0% Standard & Poor’s 19 year annual compounded rate 7.8% Limited Partners 19 year annual compounded rate 23.6% Overall Partnership 19 year annual compounded rate 32.9% TABLE 7 Perlmeter Investments PIL Limited Year Overall (%) Partner (%) 8/1–12/31/65 40.6 32.5 1966 6.4 5.1 1967 73.5 58.8 1968 65.0 52.0 1969 –13.8 –13.8 1970 –6.0 –6.0 1971 55.7 49.3 1972 23.6 18.9 1973 –28.1 –28.1 1974 –12.0 –12.0 1975 38.5 38.5 1/1–10/31/76 38.2 34.5 11/1/76–10/31/77 30.3 25.5 11/1/77–10/31/78 31.8 26.6 11/1/78–10/31/79 34.7 28.9 11/1/79–10/31/80 41.8 34.7 11/1/80–10/31/81 4.0 3.3 11/1/81–10/31/82 29.8 25.4 11/1/82–10/31/83 22.2 18.4 Total Partnership Percentage Gain 8/1/65 through 10/31/83 4277.2% Limited Partners Percentage Gain 8/1/65 through 10/31/83 2309.5% Annual Compound Rate of Gain Overall Partnership 23.0% Annual Compound Rate of Gain Limited Partners 19.0% Dow Jones Industrial Average 7/31/65 (Approximate) 882 Dow Jones Industrial Average 10/31/83 (Approximate) 1225 Approximate Compound Rate of Gain of DJI including dividends 7% TABLE 8 The Washington Post Company, Master Trust, December 31, 1983 Current Quarter Year Ended 2 Years Ended* 3 Y ears Ended* 5 Years Ended* % Ret. Rank % Ret. Rank % Ret. Rank % Ret. Rank % Ret. Rank All Investments Manager A 4.1 2 22.5 10 20.6 40 18.0 10 20.2 3 Manager B 3.2 4 34.1 1 33.0 1 28.2 1 22.6 1 Manager C 5.4 1 22.2 11 28.4 3 24.5 1 — — Master Trust (All Managers) 3.9 1 28.1 1 28.2 1 24.3 1 21.8 1 Common Stock Manager A 5.2 1 32.1 9 26.1 27 21.2 11 26.5 7 Manager B 3.6 5 52.9 1 46.2 1 37.8 1 29.3 3 Manager C 6.2 1 29.3 14 30.8 10 29.3 3 — — Master Trust (All Managers) 4.7 1 41.2 1 37.0 1 30.4 1 27.6 1 Bonds Manager A 2.7 8 17.0 1 26.6 1 19.0 1 12.2 2 Manager B 1.6 46 7.6 48 18.3 53 12.7 84 7.4 86 Manager C 3.2 4 10.4 9 24.0 3 18.9 1 — — Master Trust (All Managers) 2.2 11 9.7 14 21.1 14 15.2 24 9.3 30 Bonds & Cash Equivalents Manager A 2.5 15 12.0 5 16.1 64 15.5 21 12.9 9 Manager B 2.1 28 9.2 29 17.1 47 14.7 41 10.8 44 Manager C 3.1 6 10.2 17 22.0 2 21.6 1 — — Master Trust (All Managers) 2.4 14 10.2 17 17.8 20 16.2 2 12.5 9 * Annualized Rank indicates the fund’s performance against the A.C. Becker universe. Rank is stated as a percentile: 1 = best performance, 100 = worst. TABLE 9 FMC Corporation Pension Fund, Annual Rate of Return (Percent) Period ending 1 Year 2 Years 3 Years 4 Years 5 Years 6 Years 7 Years 8 Years 9 Years FMC (Bonds and Equities Combined) 1983 23.0 *17.1 1982 22.8 13.6 16.0 16.6 15.5 12.3 13.9 16.3 1981 5.4 13.0 15.3 13.8 10.5 12.6 15.4 1980 21.0 19.7 16.8 11.7 14.0 17.3 1979 18.4 14.7 8.7 12.3 16.5 1978 11.2 4.2 10.4 16.1 1977 –2.3 9.8 17.8 1976 23.8 29.3 1975 35.0 * 18.5 from equities only Becker large plan median 1983 15.6 12.6 1982 21.4 11.2 13.9 13.9 12.5 9.7 10.9 12.3 1981 1.2 10.8 11.9 10.3 7.7 8.9 10.9 1980 20.9 NA NA NA 10.8 NA 1979 13.7 NA NA NA 11.1 1978 6.5 NA NA NA 1977 –3.3 NA NA 1976 17.0 NA 1975 24.1 TABLE 9 FMC Corporation Pension Fund, Annual Rate of Return (Percent) (continued) Period ending 1 Year 2 Years 3 Years 4 Years 5 Years 6 Years 7 Years 8 Years 9 Years S&P 500 1983 22.8 15.6 1982 21.5 7.3 15.1 16.0 14.0 10.2 12.0 14.9 1981 –5.0 12.0 14.2 12.2 8.1 10.5 14.0 1980 32.5 25.3 18.7 11.7 14.0 17.5 1979 18.6 12.4 5.5 9.8 14.8 1978 6.6 –0.8 6.8 13.7 1977 7.7 6.9 16.1 1976 23.7 30.3 1975 37.2 2. Important Rules Concerning Taxability of Investment Income and Security Transactions (in 1972) Editor’s note: Due to extensive changes in the rules governing such transactions, the following document is presented here for historical purposes only. When first written by Benjamin Graham in 1972, all the information therein was correct. However, intervening developments have rendered this document inaccurate for today’s purposes. Follow- ing Graham’s original Appendix 2 is a revised and updated version of “The Basics of Investment Taxation,” which brings the reader up-to- date on the relevant rules. Rule 1—Interest and Dividends Interest and dividends are taxable as ordinary income except (a) income received from state, municipal, and similar obligations, which are free from Federal tax but may be subject to state tax, (b) dividends representing a return of capital, (c) certain dividends paid by investment companies (see below), and (d) the first $100 of ordinary domestic-corporation dividends. Rule 2—Capital Gains and Losses Short-term capital gains and losses are merged to obtain net short-term capital gain or loss. Long-term capital gains and losses are merged to obtain the net long-term capital gain or loss. If the net short-term capital gain exceeds the net long-term capital loss, 100 per cent of such excess shall be included in income. The maxi- mum tax thereon is 25% up to $50,000 of such gains and 35% on the balance. A net capital loss (the amount exceeding capital gains) is deductible from ordinary income to a maximum of $1,000 in the current year and in each of the next five years. Alternatively, unused losses may be applied at any time to offset capital gains. (Carry-overs of losses taken before 1970 are treated more liberally than later losses.) Note Concerning “Regulated Investment Companies” Most investment funds (“investment companies”) take advan- tage of special provisions of the tax law, which enable them to be Appendixes 561 taxed substantially as partnerships. Thus if they make long-term security profits they can distribute these as “capital-gain divi- dends,” which are reported by their shareholders in the same way as long-term gains. These carry a lower tax rate than ordinary divi- dends. Alternatively, such a company may elect to pay the 25% tax for the account of its shareholders and then retain the balance of the capital gains without distributing them as capital-gain divi- dends. 3. The Basics of Investment Taxation (Updated as of 2003) Interest and Dividends Interest and dividends are taxed at your ordinary-income tax rate except (a) interest received from municipal bonds, which is free from Federal income tax but may be subject to state tax, (b) dividends rep- resenting a return of capital, and (c) long-term capital-gain distribu- tions paid by mutual funds (see below). Private-activity municipal bonds, even within a mutual fund, may subject you to the Federal alter- native minimum tax. Capital Gains and Losses Short-term capital gains and losses are merged to obtain net short- term capital gain or loss. Long-term capital gains and losses are merged to determine your net long-term capital gain or loss. If your net short-term capital gain exceeds the net long-term capital loss, that excess is counted as ordinary income. If there is a net long-term capi- tal gain, it is taxed at the favorable capital gains rate, generally 20%— which will fall to 18% for investments purchased after December 31, 2000, and held for more than five years. A net capital loss is deductible from ordinary income to a maxim- um of $3,000 in the current year. Any capital losses in excess of $3,000 may be applied in later tax years to offset future capital gains. Mutual Funds As “regulated investment companies,” nearly all mutual funds take advantage of special provisions of the tax law that exempt them from 562 Appendixes corporate income tax. After selling long-term holdings, mutual funds can distribute the profits as “capital-gain dividends,” which their share- holders treat as long-term gains. These are taxed at a lower rate (gen- erally 20%) than ordinary dividends (up to 39%). You should generally avoid making large new investments during the fourth quarter of each year, when these capital-gain distributions are usually distributed; oth- erwise you will incur tax for a gain earned by the fund before you even owned it. 4. The New Speculation in Common Stocks 1 What I shall have to say will reflect the spending of many years in Wall Street, with their attendant varieties of experience. This has included the recurrent advent of new conditions, or a new atmo- sphere, which challenge the value of experience itself. It is true that one of the elements that distinguish economics, finance, and secu- rity analysis from other practical disciplines is the uncertain valid- ity of past phenomena as a guide to the present and future. Yet we have no right to reject the lessons of the past until we have at least studied and understood them. My address today is an effort toward such understanding in a limited field—in particular, an endeavor to point out some contrasting relationships between the present and the past in our underlying attitudes toward invest- ment and speculation in common stocks. Let me start with a summary of my thesis. In the past the specu- lative elements of a common stock resided almost exclusively in the company itself; they were due to uncertainties, or fluctuating elements, or downright weaknesses in the industry, or the corpora- tion’s individual setup. These elements of speculation still exist, of course; but it may be said that they have been sensibly diminished by a number of long-term developments to which I shall refer. But in revenge a new and major element of speculation has been intro- duced into the common-stock arena from outside the companies. It comes from the attitude and viewpoint of the stock-buying public and their advisers—chiefly us security analysts. This attitude may be described in a phrase: primary emphasis upon future expecta- tions. Nothing will appear more logical and natural to this audience than the idea that a common stock should be valued and priced Appendixes 563 primarily on the basis of the company’s expected future perfor- mance. Yet this simple-appearing concept carries with it a number of paradoxes and pitfalls. For one thing, it obliterates a good part of the older, well-established distinctions between investment and speculation. The dictionary says that “speculate” comes from the Latin “specula,” a lookout. Thus it was the speculator who looked out and saw future developments coming before other people did. But today, if the investor is shrewd or well advised, he too must have his lookout on the future, or rather he mounts into a common lookout where he rubs elbows with the speculator. Secondly, we find that, for the most part, companies with the best investment characteristics—i.e., the best credit rating—are the ones which are likely to attract the largest speculative interest in their common stocks, since everyone assumes they are guaranteed a brilliant future. Thirdly, the concept of future prospects, and par- ticularly of continued growth in the future, invites the application of formulas out of higher mathematics to establish the present value of the favored issues. But the combination of precise formu- las with highly imprecise assumptions can be used to establish, or rather to justify, practically any value one wishes, however high, for a really outstanding issue. But, paradoxically, that very fact on close examination will be seen to imply that no one value, or rea- sonably narrow range of values, can be counted on to establish and maintain itself for a given growth company; hence at times the market may conceivably value the growth component at a strik- ingly low figure. Returning to my distinction between the older and newer spec- ulative elements in common stock, we might characterize them by two outlandish but convenient words, viz.: endogenous and exoge- nous. Let me illustrate briefly the old-time speculative common stock, as distinguished from an investment stock, by some data relating to American Can and Pennsylvania Railroad in 1911–1913. (These appear in Benjamin Graham and David L. Dodd, Security Analysis, McGraw-Hill, 1940, pp. 2–3.) In those three years the price range of “Pennsy” moved only between 53 and 65, or between 12.2 and 15 times its average earn- ings for the period. It showed steady profits, was paying a reliable $3 dividend, and investors were sure that it was backed by well over its par of $50 in tangible assets. By contrast, the price of Amer- 564 Appendixes ican Can ranged between 9 and 47; its earnings between 7 cents and $8.86; the ratio of price to the three-year average earnings moved between 1.9 times and 10 times; it paid no dividend at all; and sophisticated investors were well aware that the $100 par value of the common represented nothing but undisclosed “water,” since the preferred issue exceeded the tangible assets available for it. Thus American Can common was a representative speculative issue, because American Can Company was then a speculatively capitalized enterprise in a fluctuating and uncertain industry. Actually, American Can had a far more brilliant long- term future than Pennsylvania Railroad; but not only was this fact not suspected by investors or speculators in those days, but even if it had been it would probably have been put aside by the investors as basically irrelevant to investment policies and programs in the years 1911–1913. Now, to expose you to the development through time of the importance of long-term prospects for investments. I should like to use as my example our most spectacular giant industrial enter- prise—none other than International Business Machines, which last year entered the small group of companies with $1 billion of sales. May I introduce one or two autobiographical notes here, in order to inject a little of the personal touch into what otherwise would be an excursion into cold figures? In 1912 I had left college for a term to take charge of a research project for U.S. Express Com- pany. We set out to find the effect on revenues of a proposed revo- lutionary new system of computing express rates. For this purpose we used the so-called Hollerith machines, leased out by the then Computing-Tabulating-Recording Company. They comprised card punches, card sorters, and tabulators—tools almost unknown to businessmen, then, and having their chief application in the Cen- sus Bureau. I entered Wall Street in 1914, and the next year the bonds and common stock of C T R. Company were listed on the New York Stock Exchange. Well, I had a kind of sentimental inter- est in that enterprise, and besides I considered myself a sort of technological expert on their products, being one of the few finan- cial people who had seen and used them. So early in 1916 I went to the head of my firm, known as Mr. A. N., and pointed out to him that C T R. stock was selling in the middle 40s (for 105,000 shares); that it had earned $6.50 in 1915; that its book value— Appendixes 565 . in their common stocks, since everyone assumes they are guaranteed a brilliant future. Thirdly, the concept of future prospects, and par- ticularly of continued growth in the future, invites the. some contrasting relationships between the present and the past in our underlying attitudes toward invest- ment and speculation in common stocks. Let me start with a summary of my thesis. In the. speculator. Secondly, we find that, for the most part, companies with the best investment characteristics—i.e., the best credit rating—are the ones which are likely to attract the largest speculative