INVESTORS OR COWBOYS?

The 19th century was a period of unbounded commercial growth in the US, and to feed this growth there developed an unquenchable thirst for new capital. Money initially flowed across the Atlantic from Europe, particularly from England. But by the mid 19th century the US stock market was starting to mature, and as the century progressed it was increasingly able to contribute to its own capital needs.

So what was the US stock market like during the mid to late 1800s? Historians and writers like to focus on the cowboy element. Since the Securities and Exchange Commission was yet to be created, it wasn't regulation that guided investor behaviour but rather the moral compass of each participant. Insider trading was rife, and an appointment to a company board or two meant there was no shortage of information to trade on. It's a period characterised by the ‘robber barons' — stock manipulators such as Jacob Little, Daniel Drew, Jim Fisk and Jay Gould.

In describing this period, historians focus on the stories of insider trading and market manipulation, which means descriptions of how legitimate investors went about making investment decisions are difficult to find. Perhaps this is why Americans were perceived both then and for decades after as traders who looked on stocks as providing a quick buck rather than a long-term stream of dividend income. And maybe it's why Keynes held the same view when in 1936 he wrote, ‘It is rare, one is told, for an American to invest, as many Englishmen still do, “for income”; and he will not readily purchase an investment except in the hope of capital appreciation.'⁷⁵

But dig deep enough and you'll discover this view wasn't universal. Even in its infancy, Wall Street saw people behaving as true investors, calculating their own values for stocks and investing accordingly, rather than simply trading shifting stock prices. William Armstrong referred to ‘intrinsic value' in his 1848 pamphlet ‘Stocks, and Stock-jobbing in Wall Street'. He noted that, although intrinsic value is the principal determinant in setting the market prices of securities, it isn't the only factor involved.

CORNELIUS VANDERBILT

Investors in the 19th century paid a lot of attention to a stock's ‘par value', being the minimum price at which new equity could be issued. Investors treated it as a base of value, in much the same way as the face value of a bond. Earnings yields and dividend yields were calculated using the fixed par value as the denominator, rather than the constantly changing market price as they are today.

This faith in par value was linked to investors' expectations that the price of any stock investment was matched by the value of its hard assets. The 19th-century financial analyst Henry Varnum Poor, founder of Standard & Poor's, wrote of stock issues where this didn't occur as follows: ‘Such enormous additions to the capital of companies, without any increase in facilities … threaten more than anything else to destroy the value of railway property as well as to prove most oppressive to the public.'

Poor was stating that stocks are worth what their assets are worth. This view was so firmly held that stocks selling above book value per share (the net value of their assets as recorded on the balance sheet divided by the total number of shares) were referred to as ‘watered down stock', and any suggested value above book value was referred to as ‘water'. This view isn't held today. Value is now seen as coming from a company's earnings power, and a great business idea can see strong profits generated from a small asset base. Today we accept that stocks with good earnings prospects will trade at multiples of book value. This is perhaps one of the biggest conceptual shifts in stock valuation to have occurred since Poor's time.

But even then the idea that a stock's value and its book value were inseparably linked was being challenged. One of the challengers was the wealthy industrialist Cornelius Vanderbilt, who had built his wealth on the back of a steamship and rail empire second to none. In the years following the American Civil War, he'd gained controlling interests in several rail companies, one being the Hudson River Railroad. In 1867 he orchestrated a new issue of Hudson River stock. Shareholders were asked to stump up just $54 per share for a stock with a $100 par value. At the time this was an outrageous thing to do. Railroad regulator and executive Charles F. Adams Jr. described it as an ‘astounding' act of ‘financial legerdemain'.

In other words, Adams thought Vanderbilt was performing an act of trickery — of trying to make two equal one and a half. Vanderbilt didn't think intrinsic value should be measured in cold, hard assets. Despite having had a minimum of schooling he was a shrewd businessman. He'd built his wealth on an appreciation that cash flows and profits were the real drivers of value. Vanderbilt's critics felt that after the sub-par capital raising Hudson River's dividend must fall, but they were silenced when the company subsequently delivered a very healthy 8 per cent dividend on par.

JAY GOULD

An infamous business opponent of Vanderbilt was the cunning, ruthless and brilliant stock tactician Jay Gould. As already noted, Gould typified the manipulative activities of the 19th-century robber barons. When he died in 1892 he had amassed a fortune of $70 million. While historians like to emphasise his manipulative and speculative activities, there was a lot more to Gould than that. Charles Dow said of him: ‘He endeavored to “foresee future conditions in a property” and to exercise patience in waiting for the desired results after a commitment has been made on the basis of the forecast of future value.'

This side of Gould's character is rarely written about. He is more commonly described as an inside trader and stock manipulator. But Dow's description of Gould sounds more characteristic of today's Warren Buffett, an investor capable of waiting patiently until a stock falls sufficiently in price to buy. So it seems the American value investor, while not prevalent, was around well before the dawn of the 20th century.

JAMES MEDBERY

US finance writer James Medbery died in 1873 while still in his mid thirties. His classic book, Men and Mysteries of Wall Street, had been published three years earlier. On reading it I found his writing to be characterised by a maturity you wouldn't expect in such a young person. Sections are pure Ben Graham.

Chapter 11 of his book carries the same message as chapter 8 of Graham's classic, The Intelligent Investor, a chapter Graham called ‘The Investor and Market Fluctuations'. Predating Graham's book by nearly 80 years, Medbery observes that special and sensational crises can cause ‘fluctuations below intrinsic value'. But perhaps the most interesting quote in Medbery's book foreshadows Buffett's well-worn quip, ‘Be fearful when others are greedy and greedy when others are fearful'. Here it is:

You will find confidence where the registry shows there should have been distrust, hesitation which ought to have been daring, doubts where faith would have been wealth. This weakness of humanity is the life of speculation.

Medbery also makes an interesting comment regarding the perennial bane of the investor's life — coming up with the most appropriate figures to plug into intrinsic value formulae. He states that what distinguishes successful from unsuccessful investors (in his day investors were called ‘speculators') are the subjective inputs, in that successful investors possess insights others lack, and that blind reliance on systems and formulae doesn't deliver success. He writes:

The reader ought to thoroughly understand, however, that there is no royal road to speculation. Given all the conditions of the problem, and profits could be ciphered out with the accuracy of a mathematical demonstration. But the unknown quantities are the stumbling-blocks of system mongers. Integrity and ability in directors, the earning capacity of the property of a corporation, the chances of the future as well as the past, are essential points to the final judgment …

Here, almost 150 years ago, Medbery was describing perfectly the dilemma facing today's stock analysts (as it no doubt will 150 years from now!). It's not about finding the best intrinsic value formula. It's not about black-box computing systems. It's not about the simple extrapolation of historical data. The most important inputs are insightful subjective judgements regarding a company's future business prospects.

In Medbery's day value investing was largely considered a pedestrian and unreliable way to make money. With an unregulated stock market, insider trading and market manipulation were seen as faster and more reliable. But Medbery leaves us in no doubt that the practice of calculating intrinsic values and comparing them to market prices did exist in 19th-century America. The question is: how many people invested this way?

A clue was offered by stockbroker-turned-investment-educator Richard Wyckoff. He describes activity in the Wall Street broking firm Price, McCormick & Co, where he worked in the late 19th century (you need to be aware that in his day ‘statistics' was the term used for fundamental analysis):

Few of these clients seemed to know much about the market … Everyone [the brokers] seemed to concentrate on handling the business. Little or no attention was paid to the statistical side – unearthing opportunities or trading in a scientific way. In fact this seemed to be the rule throughout the street. For everyone who considered the statistical side of securities, there were twenty trading on tips.

Cynics would argue that nothing has changed since Wyckoff's day.

UNITED STATES STEEL

The year 1901 saw the need for a corporate valuation the magnitude of which eclipsed any valuation before it. Sixty-five-year-old steel tycoon Andrew Carnegie had reached the end of his working career. In the decades following the American Civil War, Carnegie had built Carnegie Steel into the largest and most efficient steel producer in the US. At the turn of the 20th century the company, of which Carnegie owned half, was still in private hands.

The sale of Carnegie Steel was initiated by its 39-year-old President, Charles Schwab. Weeks before the sale, Schwab had been the guest speaker at a testimonial dinner in New York. He sensed that Carnegie was soon to retire, so that night, when he fell into conversation with New York's titan of corporate finance, J.P. Morgan, he was prepared for the direction the discussion was about to take. Morgan was keen for Carnegie to sell, and his plan was to combine the operations of Carnegie Steel with Federal Steel and nine other steel companies to create a publicly owned steel giant. The new company, United States Steel, would be listed on the Stock Exchange, with the House of Morgan controlling the $1.4 billion float. To put this into perspective, $1.4 billion represented four times the size of the US federal government budget of the day. Carnegie's take was $225 639 000, immediately gaining him the title of the wealthiest man in the world. So with all this moving and shaking you'd reckon some pretty sophisticated financial modelling would have gone into the valuation of both Carnegie Steel and the float price for US Steel. Not so. The following provides an insight into how the valuation was undertaken.

After Schwab's preliminary meetings with Morgan, he needed to broach the sale with Carnegie, and he sought advice from Carnegie's wife, Louise, regarding the best way to do it. Schwab felt comfortable talking to Louise so he visited her at the Carnegie home in New York. Twenty-two years her husband's junior, Louise was friendly with Schwab's own wife, Rana. Louise was keen for her husband to retire and was willing to offer advice to Schwab. Carnegie was a keen golfer so Louise suggested Schwab broach the subject of the sale over a round of golf.

At the completion of the quickly organised game (which Schwab ensured Carnegie won), Schwab raised the subject, asking Carnegie what price he'd be prepared to accept. Carnegie thought about it overnight and the next day presented Schwab with a single sheet of paper on which he'd scribbled a figure in pencil. The figure was $480 million, of which Carnegie was entitled to slightly less than half. Schwab took the piece of paper to Morgan, who agreed on the spot. There it was. The biggest corporate deal in history was valued without the benefit of a complex mathematical model, a corporate analyst or an advisory house.

It can only be speculated how Carnegie came up with his price; we have no insight into how he did. But given that he was an industrialist rather than a corporate financier it was unlikely to have been a sophisticated calculation. Whether Carnegie based his price on the cost of rebuilding his factories or on a multiple of the dollars his foundries and mills were spitting out, we'll never know. He was pitting his valuation skills against the great J.P. Morgan, the most savvy financier in the country. Morgan most likely based his calculation on projected earnings. Vanderbilt had stressed to Morgan years earlier that earnings were an important consideration in valuation, and, since Carnegie Steel was generating an annual profit of around $40 million, Carnegie sold out at a multiple of 12 times. We know Morgan was prepared to pay more; in fact, he later admitted to Carnegie he would have paid a $100 million more, which meant Morgan was looking at Carnegie Steel in terms of a 14.5 times multiple.

But perceptions of value are a moving feast. When US Steel first hit the stock market it opened at 38 and moved quickly to 55. Only two years later it was trading at 9. Subsequent to the float the US Bureau of Corporations issued its own valuation of US Steel, stating it was worth only half the $1.4 billion float price. Which all goes to show that valuation is a rubbery exercise at the best of times. Carnegie must have been amused by all of this price speculation subsequent to the sale. He took his $225 million in bonds, not shares. Carnegie had avoided the stock market all his life and wasn't about to throw his fortune into its unpredictable clutches. Carnegie spent the last 18 years of his life donating much of the sale proceeds to charity.

By now I hope you've developed a view on what the term ‘intrinsic value' means — that it's an estimate at best rather than a figure that can be nailed precisely. Even so it's one of the most important principles underlying sound investment. Thomas Gibson put it this way in 1906 in his book The Pitfalls of Speculation: ‘The great basic principle of speculation, the foundation upon which the entire structure rests, is the recognition of value.'⁷⁶

CHARLES DOW

One man with great insight into the concepts of valuation and what ultimately drives share prices was Charles Dow, whose name has already been raised several times in this book.

In the 31 July 1902 edition of The Wall Street Journal, Dow responded to a reader who wrote asking, ‘How can a man living at an interior city, where he sees quotations only once or twice a day, make money by trading in stocks?' Dow's reply warned of excessive trading and the handicap of brokers' commissions. He felt that in some ways the ‘out-of-town trader' was advantaged by not being exposed to the rumours and sudden movements in prices that were the bane of the office trader. The following two quotes are drawn directly from the editorial:

The out-of-towner wants to begin his campaign with a conviction that the stock which he buys is selling below its value.

He must just sit on his stock, which is intrinsically below its value, until the other people observe that it is selling too low and begin to buy it or manipulate it.

Dow had fielded a similar question from another reader a year earlier: ‘Is there any way by which an outsider who cannot watch fluctuations of the market hourly can trade in stocks with a fair chance of making money?' Dow's response was directed to both investors and traders. For the traders he stressed the importance of cutting losses and letting profits run, and for the investors he advised them to:

… buy stocks for investment; that is, to pay for them outright when they are selling below value and wait until they are up to value, getting the difference for profit. Value is determined by the margin of safety over dividends, the size and tendency of earnings: the soundness of the balance sheet and of operating methods, and general prospects for the future.⁷⁷

These statements are remarkably similar to those made by Ben Graham decades later. Like Dow, Graham didn't believe that the out-of-towner was disadvantaged. Of the stock market Graham said: ‘The farther away you get from it the more regular it appears — and the easier to profit by.'^a78

For those of you who've read Graham's books Security Analysis and The Intelligent Investor, or those pithy one-liners by his ‘out-of-towner' disciple Warren Buffett, Dow's editorials will have a familiar ring. The fact is that the seeds for much of what appears in Security Analysis were sown long before the release of its first edition in 1934, as the following should show.

VALUE INVESTING BEFORE BEN GRAHAM'S SECURITY ANALYSIS

Many believe that value investing had its birth in 1934, when Security Analysis was released. Here is a typical reference to the subject from a recent book: ‘Graham, a value investor, invented the disciplines for analyzing stocks. Before Graham, Wall Street had no investing rules or principles.'⁷⁹ This statement fails to acknowledge the concepts and writings delivered by many great investors before Graham. To demonstrate, I'll let the following quotes do the talking. They describe investment principles often attributed to Graham yet delivered years before him.

Here's Henry Hall (1907) on Graham's requirement to seek a ‘margin of safety' between the intrinsic value and market price before making an investment: ‘So far as safety of capital is concerned, the ideal is most nearly attained by buying in times of great depression, or during a panic, when stocks are below their actual investment worth. The margin of safety on a purchase is then the largest.'⁸⁰

And here's Charles Dow (1901) on the idea that the long-term determinant of prices is value: ‘The tendency of prices over a considerable length of time will always be toward values.'⁸¹

Graham stressed that price and value were not the same thing. He personalised this phenomenon in the form of a hypothetical character called Mr Market, encouraging readers to take advantage of Mr Market's bipolar personality. So when Mr Market offered his business on the cheap he was there to be taken advantage of.

Here's Thomas Gibson (1910) on a similar theme: ‘Prices frequently become divorced temporarily from values through manipulation, fighting for control or technical conditions, but the hiatus must sooner or later disappear and prices and values will be reconciled. It is when prices are lower or higher than values, present or prospective, that we have our greatest speculative opportunities.'⁸²

And this from John Houghton (1694), more than two centuries before Gibson: ‘… if they have hopes of great Gain, they will not sell their Share for 10l. If they fear Loss they'll sell for less; and so Actions rise and fall according to hopes or fears … I find a great many understand not this affair, therefore I write this.'⁸³

Graham was against buying on margin, but so were those before him, such as Moses Smith (1887): ‘The position of a man who has paid for what he holds is impregnable. The bears may do their worst; but they cannot hurt him, if he will only keep cool, and laugh at their fictions.'⁸⁴

Graham told us: ‘To enjoy a reasonable chance for continued better than average results, the investor must follow policies which are not popular in Wall Street.'⁸⁵ In 1930 Fred Kelly said: ‘… your only chance to make money from Wall Street is to be somewhat unusual. Since the majority must be wrong, success can only come from doing the opposite from what the crowd is doing.'⁸⁶

On the requirement for patience when investing, a common theme of Graham's, Joseph de la Vega (1688) said: ‘Whoever wishes to win in this game must have patience and money.'⁸⁷

Graham told us: ‘The investor's chief problem — and even his worst enemy – is likely to be himself.' Richard Wyckoff (1930) said: ‘Something in the very nature of most men seems to work against them.'⁸⁸ And William Worthington Fowler (1870) said: ‘… a man is befooled, bewitched and bedeviled by what he hears in the market'.⁸⁹

Warren Buffett was enlightened when Graham taught him to value stocks by first looking at companies in their entirety. To again quote Henry Hall (1907): ‘The purchase of a share of stock is an investment in the business, exactly as though the buyer were a partner in the enterprise.'⁹⁰

Graham told us in The Intelligent Investor: ‘You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.' Philip L. Carret (1927) said: ‘Seek facts diligently, advice never.'⁹¹

Graham described intrinsic value as a concept, not a specifically determinable number. Francis Wrigley Hirst (1911) said: ‘The value is the real worth — a thing undefinable and impossible to ascertain.'⁹²

In Security Analysis Graham said of intrinsic value that ‘in general terms it is understood to be that value which is justified by the facts'. He also outlined the principles for inter-period and intercompany comparison.⁹³ Charles Dow (1902) said: ‘The two requisites for analysis which shall be of any value are, first, the existence of such figures as will disclose the vital facts, and second, the existence of similar figures for previous years or for other companies with which fair comparison can be made.'⁹⁴

Ben Graham was an investment great. He was an articulate teacher, and he had a superlative mind. The quotes given above, however, cover some of the most important principles he wrote of yet predate his teachings by decades or, in some cases, by centuries. This is in no way meant as a criticism or to be disrespectful. They merely remind us that many of the concepts found in Security Analysis had been embraced and taught by many great investors who came before him.

BUFFETT'S PITHY ONE-LINERS

Warren Buffett is well known for his ability to distil complex concepts of investing into simple and clear one-liners. Yet, like Graham, he was not the originator of most of these ideas. Here are some historical takes on several of his better-known quotes.

Buffett: ‘A truly great business must have an enduring “moat” that protects excellent returns on invested capital.'⁹⁵ Francis Wrigley Hirst (1911): ‘A natural monopoly or a franchise conferred by public charter is the most stable basis for investment.'⁹⁶

Buffett: ‘If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter.'⁹⁷ Charles Dow (1902): ‘There is no getting away from the proposition that a man should not invest his money in something that he does not know about, and that when he does so, he is speculating, and moreover, speculation in a very dangerous fashion.'⁹⁸

Buffett: ‘In all cases an exceptional management is a vital factor.'⁹⁹ Francis Wrigley Hirst (1911): ‘The most important consideration of all is management, and here the advantage of investment in a local concern with which the investor is well acquainted can readily be perceived.'¹⁰⁰

Buffett, on investing successfully: ‘What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.'¹⁰¹ Henry Clews (1908): ‘And yet self knowledge, with self control, may prevent these natural disqualifications from seriously interfering with success.'¹⁰²

Buffett: ‘Only buy something you'd be perfectly happy to hold if the market shut down for ten years.' Louis Guenther (1910): ‘But as long as a stock has intrinsic merit behind it, returns good dividends and has borne a good reputation, it is immaterial from the investor's viewpoint whether it is listed or not.'¹⁰³

Buffett: ‘My favourite holding period is forever.' Matthew Hale Smith (1870): ‘Men who buy long and hold what they buy, reap golden fortunes.'¹⁰⁴ And Francis Wrigley Hirst (1911): ‘The essence of investment should be that it is for long periods.'¹⁰⁵

Buffett: ‘People who can't tolerate seeing their stocks fall by 50% shouldn't own stocks.' Thomas Mortimer (1801): ‘The value of the funds, in this case, might sink near fifty per cent in a few days, owing to the vast concourse of sellers … and public tranquility being restored, the funds would recover their full value. If we have patience, some would say, and do not part with our property in the funds, the state of affairs may alter, and we shall not be losers.'¹⁰⁶

Buffett, on selecting an appropriate discount rate: ‘It is what can be produced by our second best investment idea. And then we aim to exceed it. In other words it's an opportunity cost.' The anonymous author of ‘Remarks on the Celebrated Calculations' (1720), already quoted in chapters 16 and 17: ‘The main principle, on which the whole science of stock-jobbing is built … is always to be estimated according to the rate [a dividend] bears to the price of the stock, because the purchaser is supposed to compare that rate with the profits he might make of money, if otherwise employed.'¹⁰⁷

As with my comments about Graham, I'm not trying to be critical of Buffett. I have absolutely no right or any platform from which to do that anyway. Buffett has more runs on the board of investment success than any investor past or present, but he has placed on public record that none of his investment ideas are original. You often hear people say Buffett possesses a ‘secret' that underlies his investment success. I feel that's unlikely, but I do believe he has an exceptional intellect, an intimate understanding of the financial markets, and the capacity to think and invest independently. Ultimately, he's taken the ideas of those who came before him and executed them brilliantly.