The Times That Try Investors' Souls
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*Graham and Doddsville Revisited* -- "The Intelligent Investor in
the 21st Century" (8/28/98)
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"The underlying principles of sound investment should not alter
from decade to decade, but the application of these principles
must be adapted to significant changes in the financial
mechanisms and climate." (Benjamin Graham)
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Abby vs. Byron
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For the last few years, there has been a high visibility debate
between Abby Cohen and Byron Wien as to whether or not the Market
has been overvalued. Cohen and Wien are the head honchos of
investment policy at Goldman Sachs and Morgan Stanley,
respectively. If I recall the newspaper clippings correctly, a
few years ago in a public forum Cohen asked Wien if it wasn't
possible that his benchmarks of valuation might not have become
outdated. Wien, who has been around too long to dismiss her
question with juvenile sophistry, later reported being badly
shaken by the question.
Wien came to Wall Street in the early 1950's. At the time,
dividend yields on common stocks had fallen below the interest
rate on bonds. Historically, this had always been a sure sign
that stocks were overvalued. The newcomers said it was a new
era. Predictably, the older and wiser hands on Wall Street
scoffed: This time is different -- oh, sure. But, Wien
recalled, things did turn out to be different, as the great
post-war Bull Market continued until the early 1970's. What
troubled Wien about this recollection was that it was not enough
for the old timers to say: I'm sorry. As a consequence of their
intellectual sclerosis, the Old Guard was swept aside from the
Wall Street scene like dinosaurs being displaced by mammals.
(Benjamin Graham retired from Wall street in 1955, in part
because he had lost interest in keeping up with the changing
times, and in part because he was interested in pursuing other
interests.)
Nevertheless, Wien has stuck to a model that has found stocks to
be overvalued as the Bull Market surged on. In July, Wien's
model showed stocks to be overvalued 18%. As of Friday 8/21/98,
the ever-astute Andrew Bary reported in Barron's: "Wien notes
that his model that measures the relative appeal of stocks and
bonds showed that stocks were undervalued at Friday's lows,
marking the first such occurrence in recent years." A week
later, the S&P 500 has declined another 5%, and prices of medium
term Treasuries have declined roughly 8%.
GADR's rough and ready valuation model -- see
web.idirect.com --
indicates that the Dow's median annualized 4 year cash earnings
yield straddles 5.7% and 6.5%. By comparison, intermediate term
Treasuries are just a shade above 4.9%
This week's Barron's (8/31/98, p. 18) reports that Wien, while
by no means sanguine about today's Market, foresees higher
earnings growth in 1999 than do many of his colleagues.
Unsurprisingly, Cohen remains optimistic, and stands by her Dow
9300 forecast for year end 1998. For whatever it's worth, Wien
sees Dow 10,000 in 1999 as "a possibility".
On The Technical Side
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Media alarums notwithstanding, super investor Laszlo Birinyi
reports that cash flows into stocks remain positive, a bullish
near term sign.
Of particular note, insider purchases are strongly bullish. The
ratio of purchases to sales is almost 3 times what it was in May,
when the indicator was bearish. Insider buying is both a
technical and a fundamental indicator. On the technical side, it
is a measure of supply and demand for the stock itself. On the
fundamental side, no one has better information about a company's
current and future prospects than people inside the company.
Insider purchases are not an infallible indicator -- no indicator
is. For example, insider purchases were strong going into the
Bear Market of 1973 to 1974, the worst of the post World War II
period. Nevertheless, insider purchases are one of the best
predictors of future performance of underlying fundamentals.
What Is The Safest Course?
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GADR's assumption is that the typical reader expects to be
invested in securities for the next 20 years or so, and will have
funds available for additional investments along the way. For
investors that fit this profile, it is clear from the historical
record that there is virtually no scenario in which making
regular investments ("dollar cost averaging") into an Index fund,
or a portfolio of common stocks of quality companies, will not
outperform other asset classes -- like cash, bonds, or real
estate -- over the long haul. The investor who pursues this
course will outperform all but a handful of investors,
professional or otherwise.
Alternative investment strategies are almost without limit. Yet,
whether through faults of theory or application, there are only a
tiny percentage of investors who have demonstrated a long term
ability to outperform Indexing, much less dollar cost averaging
into an Index fund or similar portfolio of quality common stocks.
Seen in this light, the safest course is to to be fully
invested in common stocks and continue to invest additional funds
through thick and then.
Graham wrote in The Intelligent Investor that vast sums
could be earned by moving in and out of the Market at just the
right time. But, he added, the likelihood of most investors
actually doing so was similar to that of finding money growing on
trees.
It has been repeatedly stated, by commentators with a variety of
agenda, that money invested in the stock market in 1929 would
have been under water for more than 20 years thereafter. This is
a relevant consideration for those who do not anticipate having
additional sums to invest going forward. But, for those who will
have funds to invest along the way, it is very misleading.
Graham, near the beginning of The Intelligent Investor,
provides the following worst case scenario. An investor
purchased equal dollar amounts of DJIA component stocks in
January 1929, when the Dow was 300. Every January, for the next
19 years, the investor continued to invest equal dollar amounts
into the DJIA, plus reinvesting all dividends. (Nowadays, this
can be simply done through the purchase of so-called "Diamonds"
[AMEX: DIA]) Twenty years later, in January 1949, the Dow stood
at 177, down over 30% from its January 1929 level. But,
according to Graham's calculations, the investor earned an
average of 8% annually, thereby handily outperforming other asset
classes.
The reason for this is that shares were being purchased all the
way down from 177 to 41, and all the way back up from 41 to 177.
Hence, based on equal dollar amount purchases, the investor was
purchasing a greater number of shares at lower prices than at
higher prices. Further, when prices were lowest, dividend yields
were highest, and thus, reinvestment of dividends was occurring
at the most favorable prices and the greatest number of shares.
Why Not Wait For Super Bargains?
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In uncertain times like these, it would be perfectly consistent
with Value Investing principles to advise investors to cash out
of stocks now, and wait for the super bargains that will
inevitably come along -- before advising that investors return to
common stocks. But, this would be inconsistent with investor
psychology, a consideration never far from Graham's mind. The
price movement of undervalued stocks tends to be saw-toothed, on
the way down and on the way back up. On the way down, there are
a number of "false bottoms", and on the way back up there are
usually "false rallies". Many studies have shown that the
overwhelming likelihood is that investors will get out of an
overvalued Market too soon and back into an undervalued one too
late.
Pessimism might tempt the buy-and-hold investor to falter in
discipline and get out of stocks until "conditions improve".
But, history has shown that the pessimism will be far greater at
the time to re-enter, when viewed in retrospect.
Providence willing, GADR will issue for the next 20 or 30 years.
Over that span, it would be possible to advise: First do this;
now do that; then do such and such; now do this and that; and so
on for the next 2 or 3 decades. But, assuming a normal bell
curve distribution, the average reader will follow half of this
advice and ignore the other half. The odds of beating dollar
cost averaging are small enough when an alternative strategy, of
whatever nature, is followed to the last detail. These odds
worsen exponentially to the degree an investor deviates from even
the most successful alternative strategy.
Therefore, I feel it would be value-subtracted, rather than
value-added, to advise any course other than
dollar-cost-averaging into an Index product or quality common
stocks. In the meanwhile, for those who are determined to devise
their own alternative strategy, GADR will endeavor to elucidate
the principles of Graham and his Value Investing successors, in
light of what Graham called "significant changes in the financial
mechanisms and climate."
Moving The Goal Posts -- To The Detriment Of The Model Dow
Portfolio
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Consistent with dollar-cost-averaging, GADR's Model Dow Value
Portfolio -- see web.idirect.com
Public List -- is being altered to presume an equal dollar
amount purchase of shares in January 1998. Had this been
announced before now, it would have appeared to be changing the
rules in GADR's favor. Now that the Dow Value Portfolio is down
for the year, assuming an equal dollar amount share purchase at
the beginning of 1998 worsens, rather than improves, the
portfolio's current performance.
All four of the portfolio's components, AT&T, Boeing, GM, and IBM
are still far short of the companies they should be. Boeing has
yet to get its production problems straightened out. AT&T
intends to pay TCI a sum for an unproven means of providing local
phone service that is comparable to the cost of building a new
local phone loop from scratch. GM has yet to demonstrate that it
has a new cooperative relationship with its workers. IBM is much
further along than the others in returning to "great company"
status. Yet, the company that put the PC on the map, before
completely dropping the ball, continues to struggle to make PC's
profitably.
Nevertheless, when they were selected in January 1997, these 4
firms were what Graham called "leading companies in important
industries". They still are.
By the way, for those who are considering waiting on the
sidelines hoping to purchase the next Microsoft or Intel at a
bargain price, consider the fact that IBM once owned 40% of
Microsoft and 10% of Intel, but subsequently sold these stakes.
Had IBM stuck with buy-and-hold, the favorable financial
consequences for IBM would have been staggering. And yet, IBM
had far more knowledge about the internal workings and future
prospects of these companies than most investors have about
any company.
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Graham and Doddsville Revisited
Editor: Reynolds Russell, Registered Investment Advisor
web.idirect.com
Web Site Development/Design: ariana <brla@earthlink.net>
Consultants: Axel Gunderson, Wayne Crimi, Bernard F. O'Rourke,
Allen Wolovsky
In addition to editing GADR, Reynolds Russell offers investment
advisory services. His goal is to provide clients with total
returns in excess of those produced by the S&P 500.
His investment strategy applies the principles of Value Investing
established by Benjamin Graham to the circumstances of today's
economy and securities markets.
For further information, reply via e-mail to: gadr@nyct.net
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"There are no sure and easy paths to riches in Wall Street
or anywhere else." (Benjamin Graham)
(C) Reynolds Russell 1998.
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