20
THE MODERN ERA
As the 1920s progressed, the concept of basing a company's value on its projected earnings was gaining momentum. The long-established counterargument — that the balance sheet alone is sufficient to measure value — appealed to people's intuitive sense. There it was all laid out: what the business owned, what it owed. Take one from the other and that must be what it's worth. But increasingly analysts were questioning this idea. After all, if a kid could generate $50 a month selling homemade lemonade from a street stall, then surely that business had to be worth more than a trestle table, two pitchers and a lemon squeezer.
Ben Graham described the post–World War I period as being characterised by a shift to the ‘New-Era Theory'.115 It began with the release, in 1924, of Edgar Lawrence Smith's bestseller Common Stocks as Long Term Investments. The book contained a chart showing shifts in stock prices between 1837 and 1923. Smith had noticed that over the 86-year period values of listed companies had trended upwards, but not in a straight line. Smith overlaid two trend lines, each of which defined an ever-rising arc. He said the arcs were defined by a compounding function at the rate of 2.5 per cent per year; that is, on average, profits increased by 2.5 per cent every year. This increase in profits, he explained, was due to management retaining a proportion of earnings each year rather than paying out the lot as dividends, which meant the businesses were not only growing but doing so at an exponential rate. Smith was proposing that the stock market was a compounding machine:
Over a period of years, the principal value of a well diversified holding of the common stocks of representative corporations, in essential industries, tends to increase in accordance with the operation of compound interest.
To date the analysts who'd been using earnings to calculate value were less concerned with future earnings. They'd been applying a multiple to recent (historical) earnings, believing that this way they were dealing with facts. The earnings they used had been seen, measured and recorded. Smith gave them a different focus. He said there was an important force driving stock prices — retained earnings — and this force was forever upward. He proposed that valuations be based on future not historical earnings. Since the economy was picking up steam around that time, earnings had been growing, which meant Smith's ideas really gained some traction. Adding fuel to the fire was the belief that his historical growth figure of 2.5 per cent was too conservative. Businesses were experiencing double-digit growth at that time. Many believed that ahead was an era of unlimited corporate growth and economic prosperity. The dawn of a New Era! No multiple seemed too large to apply to current earnings.
Smith didn't deny the existence of the market cycle, but he did propose there was little risk in buying stocks at very high prices. He argued that if prices subsequently fell it was only a matter of time before the compounding produced by retained earnings would see the stock price recover. His message was interpreted by the investing public to mean that price didn't matter. This caused share prices to rocket, and the rising prices only reinforced their belief that Smith must be correct — for a while anyway.
As a postscript to this story, Edgar Lawrence Smith has been given too much credit for coming up with the idea of the stock price growing due to the reinvestment of retained earnings. Maybe his book's popularity persuaded people of its originality. So many times history gets the facts wrong, and as the story is retold the myth is perpetuated. I can't tell you who first came up with the idea but George Garr Henry wrote the following words, 14 years before Smith's book was published:
Rich men whose income is in excess of their wants can afford to forgo something in the way of yearly return for the sake of a strong prospect of appreciation in value. Such men naturally buy bank and trust-company stocks, whose general characteristic is a small return upon the money invested, but a strong likelihood of appreciation in value. This is owing to the general practice of well-regulated banks to distribute only about half their earnings in dividends and to credit the rest to surplus, thus insuring a steady rise in the book value of the stock.116
Smith's theory didn't save investors from the bloodbath that followed the 1929 Crash. At its lowest post-Crash level the Dow Jones had collapsed by 89 per cent from its September 1929 peak, and it didn't recover its pre-Crash nominal value until 1954. It seems financial theories are great until subsequent events prove them to be wrong.
This whole issue of growth investing is periodically revisited, usually at times when the economy is buoyant. The concept of growth in earnings due to reinvestment of earnings is intuitively appealing. But the use of unrealistic growth projections re-emerges periodically, leading to periods of unrealistic valuations — and every time it happens, investors fall into the same old trap.
THE 1930s
The 1930s was a fertile period for investment theory. It saw the publication of Graham and Dodd's Security Analysis, John Burr Williams' The Theory of Investment Value and Keynes' General Theory. While Keynes' book is largely a work of economics, its eloquently written twelfth chapter, ‘The State of Long-Term Expectation', is pure stock market.
The 1930s could well be remembered as the decade of the dividend. Robert Wise kicked it off. In an article he wrote for the 8 September 1930 issue of Barron's magazine, ‘Investing for True Values', he defined a stock's value as follows: ‘The proper price of any security, whether a stock or bond, is the sum of all future income payments discounted at the current rate of interest in order to arrive at the present value.'
Essentially it was a restatement of Pisano's 700-year-old concept of discounting future cash flows. Wise is barely remembered today, but Williams, who restated the same principle, is. Williams is credited with proposing that stocks can be valued by discounting their future dividends. Again the credit is undue but probably given because The Theory of Investment Value, in which he discussed the concept, was a bestseller. Interestingly, Williams never claimed the idea as his; other people made that mistake. He even acknowledged Wise's 1930 article in a footnote in chapter 5 of his book.
As far as stock analysis goes, there's no doubt the most significant work to come out of the 1930s was Graham and Dodd's Security Analysis, first published in 1934. Despite its dual authorship, Security Analysis is largely Graham's voice, based on his teachings at Columbia University. At Graham's request, Dodd sat in on his classes to take notes and subsequently assisted in compiling the manuscript. Graham had already been working as a Wall Street broker for 20 years and as a lecturer at Columbia University since 1928. He'd also established his credentials as a writer, having been published in Forbes magazine and The Magazine of Wall Street.
Security Analysis was released at a time when US authorities were tightening standards of financial reporting. Since Graham's style relied heavily on analysis of the balance sheet and profit and loss statement, Security Analysis was a book for its day.
FROM THE SIXTIES TO TODAY
Following the 1929 Crash investors turned their backs on the stock market. It wasn't until 1954, 25 years later, that the Dow Jones Industrial Index regained its September 1929 peak of 381 points. Twenty-five years was long enough for a new generation of investors to be present in the market, a generation ready to repeat the same mistakes their parents had. The 1960s delivered a rebirth of the 1920s growth stock phenomenon. The exuberant stock market of the sixties saw the development of the ‘Nifty Fifty', which included market darlings Eastman Kodak, Xerox and Polaroid. In keeping with Edgar Lawrence Smith's concept of stocks as compounding machines, no multiple seemed too high to pay for these growth stocks. The Nifty Fifty was a group of buy-and-hold stocks promising the dream of future riches. Investors believed they could be bought at any price multiple for this dream to be delivered, so their prices were bid up to unrealistic levels certain to disappoint. And, just as in 1929, disappoint they did.
It reminds us that cycles repeat, and forever will continue to do so.
When it comes to valuation theory, some big names have cropped up in the decades from the early sixties to today: Edgar O. Edwards and Philip W. Bell (1961), Myron J. Gordon (1956, 1962), Ben Graham (again! 1976) and James Ohlson (1995). Their ideas sculpted Pisano's original discounting formula into the formulae familiar to and used by today's financial analysts. In Part IV we'll be taking a close look at them and asking the question: ‘How do we “calculate” value?'
Chapter summary
- As the 1920s progressed the concept of using a company's earnings to calculate its stock value was gaining momentum.
- In 1924 Edgar Lawrence Smith proposed in his best-selling book Common Stocks as Long Term Investments that stock prices grew at an average compounding rate of 2.5 per cent per year.
- Smith's book popularised the idea that it was okay to pay high multiples of current earnings for companies offering the possibility of significant future growth.
- The concept of valuing stocks by discounting their potential future dividend stream was popularised by John Burr Williams in his 1938 book The Theory of Investment Value.
- During periods of stock euphoria, such as the late 1920s and the 1960s, investors became too optimistic regarding future earnings growth rates, leading to inflated stock prices.