The Investor and Inflation

Inflation, and the fight against it, has been very much in the public’s mind in recent years. The shrinkage in the purchasing power of the dollar in the past, and particularly the fear (or hope
by speculators) of a serious further decline in the future, has greatly influenced the thinking of Wall Street. It is clear that those with a fixed dollar income will suffer when the cost of living advances, and the same applies to a fixed amount of dollar princi-pal. Holders of stocks, on the other hand, have the possibility that a loss of the dollar’s purchasing power may be offset by advances in
their dividends and the prices of their shares.

On the basis of these undeniable facts many financial authorities have concluded that (1) bonds are an inherently undesirable form of investment, and (2) consequently, common stocks are by their very nature more desirable investments than bonds. We have heard of charitable institu
tions being advised that their portfolios should consist 100% of stocks and zero percent of bonds.* This is quite a reversal from the earlier days when trust investments were.

By the late 1990s, this advice—which can be appropriate for a foundation or endowment with an infinitely long investment horizon—had spread to indi-vidual investors, whose life spans are finite. In the 1994 edition of his influ-ential book, Stocks for the Long Run, finance professor Jeremy Siegel of the Wharton School recommended that “risk-taking” investors should buy on
margin, borrowing more than a third of their net worth to sink 135% of their assets into stocks. Even government officials got in on the act: In February 1999, the Honorable Richard Dixon, state treasurer of Maryland, told the audience at an investment conference: “It doesn’t make any sense for any-one to have any money in a bond fund.”restricted by law to high-grade bonds (and a few choice preferred stocks).

Our readers must have enough intelligence to recognize that even high-quality stocks cannot be a better purchase than bonds under all conditions—i.e., regardless of how high the stock market may be and how low the current dividend return compared with the rates available on bonds. A statement of this kind would be as absurd as was the contrary one—too often heard years ago—that any bond is safer than any stock. In this chapter we shall try to apply various measurements to the inflation factor, in order to reach some conclusions as to the extent to which the investor may wisely be influenced by expectations regarding future rises in the
price level.

In this matter, as in so many others in finance, we must base our views of future policy on a knowledge of past experience. Is infla-tion something new for this country, at least in the serious form it has taken since 1965? If we have seen comparable (or worse) infla-tions in living exp
erience, what lessons can be learned from them in confronting the inflation of today? Let us start with Table 2-1, a condensed historical tabulation that contains much information about changes in the general price level and concomitant changes in the earnings and market value of common stocks. Our figures will begin with 1915, and thus cover 55 years, presented at five- year inte
rvals. (We use 1946 instead of 1945 to avoid the last year of wartime price controls.)

The first thing we notice is that we have had inflation in the past—lots of it. The largest five-year dose was between 1915 and 1920, when the cost of living nearly doubled. This com
pares with the advance of 15% between 1965 and 1970. In between, we have had three periods of declining prices and then six of advances at varying rates, some rather small. On this showing, the investor should clearly allow for the probability of continuing or recurrent inflation to come.

Can we tell what the rate of inflation is likely to be? No clear answer is suggested by our table; it shows variations of all sorts. It would seem sensible, however, to take our cue from the rather con- sistent record of the past 20 years. The average annual rise in the consumer price level for this period has been 2.5%; that for 1965–1970 was 4.5%; that for 1970 alone was 5.4%. Official govern-ment policy has been strongly against large-scale inflation, and there are some reasons to believe that Federal policies will be more effective in the future than in recent years.* We think it would be reasonable for an investor at this point to base his thinking and decisions on a probable (far from certain) rate of future inflation of,say, 3% per annum. (This would compare with an annual rate of about 21/2% for the entire period 1915–1970.)

What would be the implications of such an advance? It would eat up, in higher living costs, about one-half the income now obtainable on good medium-term tax-free bonds (or our assumed after-tax equivalent from high-grade corporate bonds). This would be a serious shrinkage, but it should not be exaggerated. It would not mean that the true value, or the purchasing power, of the investor’s fortune need be reduced over the years. If he spent half
his interest income after taxes he would maintain this buying power intact, even against a 3% annual inflation.

But the next question, naturally, is, “Can the investor be reason-ably sure of doing better by buying and holding other things than high-grade bonds, even at the unprecedented rate of return offered in 1970–1971?” Would not, for example, an all-stock program be preferable to a part-bond, part-stock program? Do not common stocks have a built-in protection against inflation, and are they not almost certain to give a better return over the years than will bonds? Have not in fact stocks treated the investor far better than have bonds over the 55-year period of our study?

The answer to these questions is somewhat complicated. Com-mon stocks have indeed done better than bonds over a long period of time in the past. The rise of the DJIA from an average of 77 in 1915 to an average of 753 in 1970 works out at an annual com- pounded rate of just about 4%, to which we may add another 4% for average dividend return. (The corresp
onding figures for the S & P composite are about the same.) These combined figures of 8%
This is one of Graham’s rare misjudgments. In 1973, just two years after President Richard Nixon imposed wage and price controls, inflation hit 8.7%, its highest level since the end of World War II. The decade from 1973 through 1982 was the most inflationary in modern American history, as the cost of living more than doubled.per year are of course much better than the return enjoyed from bonds over the same 55-year period. But they do not exceed that now offered by high-grade bonds. This brings us to the next logical question: Is there a persuasive reason to believe that common stocks are likely to do much better in future years than they have in the last five and one-half decades?

Our answer to this crucial question must be a flat no. Common stocks may do better in the future than in the past, but they are far from certain to do so. We must deal here with two diff
erent time elements in investment results. The first covers what is likely to occur over the lo
ng-term future—say, the next 25 years. The second applies to what is likely to happen to the investor—both financially and psychologically—over short or intermediate periods, say five ye
ars or less. His frame of mind, his hopes and apprehensions, his satisfaction or discontent with what he has done, above all his deci- sions what to do next, are all determined not in the retr
ospect of a lifetime of investment but rather by his experience from year to year.

On this point we can be categorical. There is no close time con-nection between inflationary (or deflationary) conditions and the movement of common-stock earnings and prices. The obvi
ous example is the recent period, 1966–1970. The rise in the cost of liv-ing was 22%, the largest in a five-year period since 1946–1950. But both stock earnings and stock prices as a whole have declined since 1965. There are similar contradictions in both directions in the record of previous five-year periods.

Inflation and Corporate Earnings

Another and highly important approach to the subject is by a study of the earnings rate on capital shown by American business.This has fluctuated, of course, with the general rate of economic activity, but it has shown no general tendency to advance with wholesale prices or the cost of living. Actually this rate has fallen rather markedly in the past twenty years in spite of the inflation of the period. (To some degree the decline was due to the charging of more liberal
depreciation rates. See Table 2-2.) Our extended stud- ies have led to the conclusion that the investor cannot count on much above the recent five-year rate earned on the DJIA group— about 10% on net tangible assets (book value) behind the shares. Since the market value of these issues is well above their book value—say, 900 market vs. 560 book in mid-1971—the earnings on current market price work out only at some 61 ⁄4%. (This relation-ship is generally expressed in the reverse, or “times earnings,”manner—e.g., that the DJIA price of 900 equals 18 times the actual earnings for the 12 months ended June 1971.)
Our figures gear in directly with the suggestion in the previous chapter * that the investor may assume an average dividend return of about 3.5% on the market value of his stocks, plus an apprecia- tion of, say, 4% annually resulting from reinvested profits. (Note that each dollar added to book value is here assumed to increase the market price by about $1.60.)
The reader will object that in the end our calculations make no allowance for an increase in common-stock earnings and values to result from our projected 3% annual inflation. Our justification is the absence of any sign that the inflation of a comparable amount in the past has had any direct effect on reported per-share earnings. The cold figures demonstrate that all the large gain in the earnings of the DJIA unit in the past 20 years was due to a proportionately
large growth of invested capital coming from reinvested profits. If inflation had operated as a separate favorable factor, its effect would have been to increase the “value” of previously existing capital; this in turn should increase the rate of earnings on such old capital and therefore on the old and new capital combined. But nothing of the kind actually happened in the past 20 years, during which the wholesale price level has advanced nearly 40%. (Busi-ness earnings should be influenced more by wholesale prices than by “consumer prices.”) The only way that inflation can add to common stock values is by raising the rate of earnings on cap- ital inve
stment. On the basis of the past record this has not been the case.
In the economic cycles of the past, good business was accompa- nied by a rising price level and poor business by falling prices. It was generally felt that “a little inflation” was helpful to business profits. This view is not contradicted by the history of 1950–1970,which reveals a combination of generally continued prosperity and generally rising prices. But the figures indicate that the effect of all this on the earning power of common-stock capital (“equity capital”)
has been quite limited; in fact it has not even served to maintain the rate of earnings on the investment. Clearly there have been impor-tant offsetting influences which have prevented any increase in the real profitability of American corporations as a whole. Perhaps the most important of these have been (1) a rise in wage rates exceed- ing the gains in productivity, and (2) the need for huge amounts of new capital, thus holding down the ratio of sales to capital
employed.
Our figures in Table 2-2 indicate that so far from inflation having benefited our corporations and their shareholders, its effect has been quite the opposite. The most striking figures in our table are those for the growth of corporate debt between 1950 and 1969. It is
surprising how little attention has been paid by economists and by Wall Street to this devel
opment. The debt of corporations has expanded nearly fivefold while their profits before taxes a little more than doubled. With the great rise in interest rates during this period, it is evident that the aggregate corporate debt is now an adverse economic factor of some magnitude and a real problem for many individual enterprises. (Note that in 1950 net earnings after interest but before income tax were about 30% of corporate debt, while in 1969 they were only 13.2% of debt. The 1970 ratio must have been even less satisfactory.) In sum it appears that a signifi-
cant part of the 11% being earned on corporate equities as a whole is accomplished by the use of a large amount of new debt costing 4% or less after tax credit. If our corporations had maint
ained the debt ratio of 1950, their earnings rate on stock capital would have fallen still lower, in spite of the inflation.
The stock market has considered that the public-utility enter-prises have been a chief victim of inflation, being caught between a great advance in the cost of borrowed money and the difficulty of raising the rates charged under the regulatory process. But this may be the place to remark that the very fact that the unit costs of electricity, gas, and telephone services have advanced so much less than the general price index puts these companies in a strong strategic position for the future. They are entitled by law to charge rates sufficient for an adequate return on their invested capital, and this will probably protect their shareholders in the future as it has in the inflations of the past.

Investment versus Speculation: the Intelligent Investor

Investment versus Speculation

What do we mean by “investor”? Throughout this book the term will be used in contradistinction to “speculator.” As far back as 1934, in our textbook Security Analysis,we attempted a precise
formulation of the difference between the two, as follows: “An investment operation is one which, upon thorough analysis prom-ises safety of principal and an adequate return. Operations not
meeting these requirements are speculative.”

While we have clung tenaciously to this definition over the ensuing 38 years, it is worthwhile noting the radical changes that have occurred in the use of the term “investor” during this period.After the great market decline of 1929–1932 all common stocks were widely regarded as speculative by nature. (A leading author-ity stated flatly that only bonds could be bought for investment.)Thus we had then to defend our definition against the charge that it gave too wide scope to the concept of investment.

Now our concern is of the opposite sort. We must prevent our readers from accepting the
common jargon which applies the term“investor” to anybody and everybody in the stock market. In ourlast edition we cited the following headline of a front-page article of our leading financial journal in June 1962:

SMALL INVESTORS BEARISH, THEY ARE SELLING ODD-LOTS SHORT

In October 1970 the same journal had an editorial critical of what it called“reckless
investors,” who this time were rushing in on the buying side.
These quotations well illustrate the confusion that has been dominant for many years in the use of the words investment and speculation. Think of our suggested definition of investment given above, and compare it with the sale of a few shares of stock by an inexperienced member of the public, who does not even own what he is selling, and has some largely emotional convi
ction that he will be able to buy them back at a much lower price. (It is not irrel-evant to point out that when the 1962 article appeared the market had already experienced a decline of major size, and was now get-ting ready for an even greater upswing. It was about as poor a time as possible for selling short.) In a more general sense, the later-used phrase“reckless investors” could be regarded as a laughable con-tradiction in terms—something like “spendthrift misers
”—were this misuse of language not so mischievous.

The newspaper employed the word “investor” in these instances because, in the easy language of Wall Street, everyone who buys or sells a security has become an investor, regardless of what he buys, or for what purpose, or at what price, or whether for cash or on margin. Compare this with the attitude of the public toward common stocks in 1948, when over 90% of those queried expre
ssed themselves as opposed to the purchase of common stocks. About half gave as their reason “not safe, a gamble,” and about half, the reason “not familiar with.”* It is indeed ironical

The survey Graham cites was conducted for the Fed by the University of Michigan and was pub
lished in the Federal Reserve Bulletin, July, 1948.People were asked, “Suppose a man deci des
not to spend his money. He can either put it in a bank or in bonds or he can invest it. What do you think would be the wisest thing for him to do with the money nowadays—put it in the bank, buy savings bonds with it, invest it in real estate, or buy common stock with it?” Only 4% thou
ght common stock would offer a “satisfactory”return; 26% considered it “not safe” or a “gamble.” From 1949 through 1958, the stock market earned one of its highest 10-year returns in history,

(though not surprising) that common-stock purchases of all kinds were quite generally regarded as highly speculative or risky at a time when they were selling on a most attractive basis, and due soon to begin their greatest advance in history; conversely the very fact they had advanced to what were undoubtedly dangerous lev-els as judged by past experience later transformed them into “invest-ments,” and the entire stock-buying public into “investors.”

The distinction between investment and speculation in common stocks has always been a useful one and its disappearance is a cause for concern. We have often said that Wall Street as an inst
itu-tion would be well advised to reinstate this distinction and to emphasize it in all its dealings with the public. Otherwise the stock exchanges may some day be blamed for heavy speculative losses,which those who suffered them had not been properly warned against. Ironically, once more, much of the recent financial embar-rassment of some stock-exchange firms seems to have come from the inclusion of speculative common stocks in their own capital funds. We trust that the reader of this book will gain a reasonably clear idea of the risks that are inherent in common
-stock commit-ments—risks which are inseparable from the opportunities of profit that they offer, and both of which must be allowed for in the investor’s calculations.

What we have just said indicates that there may no longer be such a thing as a simon-pure investment policy comprising repre-sentative common stocks—in the sense that one can always wait to buy them at a price that involves no risk of a market or “quota- tional” loss large enough to be disquieting. In most periods the investor must recognize the existence of a speculative factor in his common-stock holdings. It is his task to keep this component within minor limits, and to be prepared financially and psycholog-ically for adverse results that may be of short or long duration.

Two paragraphs should be added about stock speculation per se, as distinguished from the spe
culative component now inherent averaging 18.7% annually. In a fascinating echo of that early Fed survey, a poll conducted by BusinessWeek at year-end 2002 found that only 24% of investors were willing to invest more in their mutual funds or stock portfolios, down from 47% just three years earlier.

in most representative common stocks. Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook. More than that, some speculation is necessary and
unavoidable, for in many common-stock situations there are sub-stantial possibilities of both profit and loss, and the risks therein must be assumed by someone.* There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seri-ously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.

In our conservative view every nonprofessional who operates on margin† should recognize that he is ipso facto speculating, and it is his broker’s duty so to advise him. And everyone who buys a so-called “hot” common-stock issue, or makes a purchase in any way similar thereto, is either speculating or gambling. Speculation is always fascinating, and it can be a lot of fun while you are ahead of the game. If you want to try your luck at it, put aside a portion— the smaller the
better—of your capital in a separate fund for this purpose. Never add more money to this account just because the * Speculation is beneficial on two levels: First, without speculation, untested new companies (like Amazon.com or, in earlier times, the Edison Electric Light Co.) would never be able to raise the necessary capital for expansion.The alluring, long-shot chance of a huge gain is the grease that lubricates the machinery of innovation. Secondly, risk is exchanged (but never elimi-nated) every time a stock is bought or sold. The buyer purchases the primary risk that this stock may go down. Meanwhile, the seller still retains a residual risk—the chance that the stock he just sold may go up!

Major world stock exchange expands investor access to

Tokyo Stock Exchange
Major world stock exchange expands investor access to include timely inancial news with Web-based system

In the fast-paced world of international invest-ment, time is money. Within minutes, billions
of dollars change hands over the Tokyo Stock Exchange (TSE), one of the world’s major stock
exchanges. To an outsider, the frenzied buying and selling of stocks might seem almost random.
Yet behind most stock sales and purchases is a well-thought-out investment strategy driven
in part by current inancial news. Recognizing this, the Tokyo Stock Exchange developed an
innovative system, called the Timely Disclosure Network (TDnet), that gives investors instant
access to Adobe Portable Document Format (PDF) iles with inancial information on TSE-
listed companies.

The Tokyo Stock Exchange launched TD net in 1998, and soon after it recommended to the
1,940 companies listed on the Exchange that they submit disclosure documents in Adobe PDF.
The reasons, according to Koji Yoshida, who oversees disclosure for the TSE, are simple:
“Compact Adobe PDF iles maintain the integ-rity of company information, deliver it in a format that is universally accessible, and can be distributed quickly over the Internet.” This rapid,ficient document distribution is critical, since the TDnet Web site can receive more than one million hits daily from viewers worldwide.

Speed, convenience with Adobe PDF
Each listed company on the TSE iles approxi-mately 20 pages of disclosure documents, such as annual and interim inancial reports and other press releases. Previously, these docu-ments were submitted on paper and stored at TSE ofices. Financial analysts and investors who wanted to review information had to come to the Exchange and read the papers, making infor-mation dificult to access for most people. By moving documents online in Adobe PDF, the TSE greatly expanded investor access to inancial information and streamlined the delivery of disclosure documents for companies.

Now, listed companies use Adobe Acrobat soft-ware to create Adobe PDF iles that the TSE dis-tributes over satellite and private networks and posts on TDnet for immediate viewing. During peak periods, the TSE can receive as many as 700 documents daily from listed companies. “TDnet is a powerful system that shortens the distance between investors and companies,” explains Yoshida. “With platform- and application-independent Adobe PDF iles, we know that inves-tors—no matter where they are and no matter what systems they are
using—can access essential inancial information.”

Easy conversion of any document
An important factor in the TSE’s decision to adopt Adobe Acrobat and Adobe PDF for online document delivery is the openness of both the application and the format. Because the TSE
does not dictate which application listed com-panies must use to create disclosure statements,