Buy the Book: Edgar Lawrence Smith set out to prove a theory, only to fail. But, in failure, he discovered that stocks had a hidden advantage over bonds in the long run. His work was published in 1924 and influenced the late ’20s market boom.
The Notes
- The book is a collection of failed studies to prove the theory that to protect purchasing power, bonds were better investments than stocks during deflation, while stocks were better than bonds during inflation.
- “Bonds as a class, have certain recognized attributes. A diversification of common stocks has its own attributes, which differ from those of bonds. Each class has its useful purpose and its proper place in any investment plan.”
- Conservative investments, pre-1920s, meant a large allocation to bonds. Stocks were often overlooked as being too speculative to be considered “safe” for long term investing.
- Stocks represent ownership in a business, with the value and income fluctuating with the earning power of the business.
- Bonds represent a promise to pay an amount of money in the future and an annual set rate of interest on the amount for the life of the bond.
- “The value of stocks, expressed in dollars, increases with the growth and prosperity of the country and the industry represented. It also increases in proportion as dollars themselves decrease in purchasing power as expressed in a higher cost of living. Stocks are subject to temporary hazards of hard times, and may be destroyed in value by a radical change in the arts or by poor management.”
- The value of bonds may change due to changes in the credit quality of the company or changes in demand in relation to the maturity/yield of the bond.
- “‘Safety of principal,’ yes — that is the first essential.”
- “To an individual, a temporary decline in the market quotations on his security holdings is not of such serious import, provided he knows that his assets are sound and of real value.”
- The selection of stocks for each test was based on 1) constancy of income and 2) safety of principal.
- “Without diversification, the purchase of common stocks cannot be considered.”
- There were 11 tests in total over different periods of inflation and deflation. Each test assumed $10,000 invested in 10 stocks versus the same amount in high-grade bonds, with every advantage given to bonds.
- 10 out of 11 tests showed stocks produced a higher total return than bonds. The one exception was the period 1866-1885. It saw two market panics, falling interest rates, and deflation.
- The Panic of 1873, began with the failure of Jay Cook & Co., followed by other bankers, two trust companies, and a few banks. The NYSE closed for 10 days. Currency payments between New York banks were suspended for 40 days. The recovery finally ended in 1879.
- “Like knowledge, a little analysis is a dangerous thing.”
- The conclusion from the tests is that stocks benefit from an underlying factor that offers an advantage over bonds in the long run.
- Management never declares all of a companies earnings as dividends. Instead, it retains some of the earnings. The retained earnings, reinvested back into a business, can grow more earnings and the business would appreciate in value. The author equates this reinvestment of earnings to a compounding effect that showed up in the stock price over time.
- “In the selection of securities for investment, we must consider more than the expected income yield upon the amount invested, and may quite properly weigh the probability of principal enhancement over a term of years without departing from the most conservative viewpoint.”
- The risk of stocks is the “misfortune to invest at the very peak of a noteworthy rise, those periods in which the average market value of our holdings remains less than the amount we paid for them…”
- The author looked at the number of times, from 1837 to 1922, where the following year ended in a loss in value for stocks and how long the “loss” lasts (out of 86 periods):
- The succeeding year ends in no losses: 54 times or 63.0% of the time.
- 1 year: 13 times or 15.1% of the time.
- 2 years: 8 times or 9.3%
- 3 years: 2 times or 2.3%
- 4 years: 4 times or 4.7%
- 6 years: 2 times or 2.3%
- 7 years: 1 time or 1.1%
- 10 years: 1 time or 1.1%
- 15 years: 1 time or 1.1%
- “The management of every company is on the side of the common stock and opposed to the interests of the bondholders. The management does not want the bondholders to get more benefit from the operation of the company than is absolutely necessary to make it possible for the company to sell more bonds if such additional sale of bonds can be made to show a profit to the stockholders.”
- “No one may be regarded as having invested conservatively whose funds have suffered a permanent loss of real as opposed to nominal value. This is the first requisite of conservatism.”
- “It is generally recognized that common stocks are subject to changes in market value, which may be at times rapid. But it is not so generally recognized that bonds and mortgages are subject to changes in real value almost as drastic as stocks, rarely as rapid, but perhaps more insidious in that they are no so easily appraised. The words “bond” and “mortgage” have for so long connoted security and safety, while the word “stock” has been so widely accepted as synonymous with risk and hazard, that an investor feels he is necessarily acting with more prudence and conservatism when he buys bonds and mortgages than when he buys stocks. Yet frequently this is not the case.”
- The risks of bonds: depreciation of the dollar, increase in interest rates, and worsening credit position of the company.
- The author took the study a step further to test reinvesting dividends back into stocks (not sure if it’s a new idea for the time). Obviously, it compounded the returns for stocks. Keep in mind: during this period it was common for stock dividend yields to be higher than bond yields.
- “Sound investment management, while always subject to error, cannot fail to improve investment results if the principal of diversification is strictly adhered to.”
- The Principal Functions of Investment Management:
- Establish a sound investment plan specific to the investor.
- Determine what proportion of funds belong in stocks and bonds based on current conditions.
- Watch for changing conditions and adjust the stock/bond proportions as needed.
- Study various industries and select the most promising industries.
- Study the management and fundamentals of leading companies in the chosen industries.
- Watch for changing conditions in leading companies/industries and make changes as needed based on sound analysis.
- Diversification is fundament, but within limits to not dilute the quality of management.
