This is the first of a three-part series on timeless Benjamin Graham writings. On this Part 1, Ben Graham points out the fundamental distinctions between investments and speculation.
One of the disastrous consequences of the New Era madness in Wall Street has been the disappearance of the former clean-cut distinctions between investment and speculation in common stocks. Old-time investment, with its emphasis on book value and the past record, was shortsighted and naive, but it possessed the supreme virtue of moderation. Present-day “investment,” as practiced by investment trusts and everyone else, is not much more than an undisciplined wagering upon the future and as such logically indistinguishable from speculation.
Common stocks have one important characteristics and one important speculative characteristic. Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the reinvestment of undistributed earnings–incidentally, with no clear-cut plus or minus response to inflation. However, most of the time common stocks are subject to irrational and excessive price fluctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble–i.e., to give way to hope, fear and greed.
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 percent of those queried expressed 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 (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 levels as judged by past experience later transformed them into “investments” and the entire stock-buying public into “investors.”
We must recognize that the situation existing today is not typical of all bear markets. Broadly speaking, it is new and unprecedented. It is a strange, ironical aftermath of the “new era” madness. It reflects the extraordinary results of profound but little understood changes in the financial attitude of the people, and the financial fabric of the country.
Two plausible and seemingly innocent ideas, the first that good stocks are good investments; the second, that values depend on earning power–were distorted and exploited into a frenzied financial gospel which ended by converting all our investors into speculators, by making our corporations rich and their stockholders poor, by reversing the relative importance of commercial loans and Wall Street loans, by producing topsy-turvy accounting policies and wholly irrational standards of value–and in no small measure was responsible for the paradoxical depression in which we find ourselves submerged.
Behind the simple fact that a great many stocks are selling for much less than their working capital lies a complex of causes, results and implications. The remainder of this article will deal with the causes of the present unique situation, while other ramified aspects will be developed in succeeding articles. The current contrast between market prices and liquid assets is accounted for in large measure by the huge flood of new cash which stockholders in recent years have poured into the treasuries of their corporations by the exercise of subscription rights. This phenomenon, which was one of the distinguishing features of the 1928-1929 bull market, had two quite opposite consequences. On the one hand the additional funds received greatly improved the companies’ cash and their working capital position; on the other hand the additional shares issued greatly increased the supply of stocks, weakened their technical position, and intensified their market decline. The same circumstance, therefore, served both to improve the values behind a stock and to depress the price.
It is doubtful, however, that the declines would have gone to the current extraordinary lengths if during the last decade investors had not lost the habit of looking at balance sheets. Much of the past year’s selling of stocks has been due to fear rather than necessity. If these timid holders were thoroughly aware that they were selling out at only a fraction of the liquid assets behind their shares, many of them might have acted differently. But since value has come to be associated exclusively with earning power, the stockholder no longer pays any attention to what his company owns–not even its money in the bank.
It is undoubtedly true that the old-time investor laid too much stress upon book values and too little upon what the property could earn. It was a salutary step to ignore the figures at which the plants were carried on the books, unless they showed a commensurate earning power.
But like most sound ideas in Wall Street, this one was carried too far. It resulted in excessive emphasis being laid on the reported earnings–which might only be temporary or even deceptive–and in a complete eclipse of what had always been regarded as a vital factor in security values, namely the company’s working capital position.
Businesses have come to be valued in Wall Street on an entirely different basis from that applied to private enterprise. In good times the prices paid on the Stock Exchange were fantastically high, judged by ordinary business standards; and now, by the law of compensation, the assets of these same companies are suffering an equally fantastic undervaluation. A third reason that stocks now sell below their liquid asset value is the fear of future operating losses. Many readers will assert that this is the overshadowing cause of the present low market level. These quotations reflect not only the absence of earning power, but the existence of “losing power” which threatened to dissipate the working capital behind the shares today.
Being against speculation is almost like being against sin. But speculation really is a sin to the untrained member of the public. The ordinary man is more apt to get poorer by speculating on the market. A man can earn some money by taking a sensible attitude toward investment, but I don’t see how a man can earn money by being an untrained speculator. He just doesn’t put enough into it to justify the hopes of getting something out of it.