Chapter 9. Investment Guides

INTRODUCTION

This is a book about investment guides, not a book about investment. Nevertheless, I shall condense one man's experi­ence in this chapter and set forth some considerations on investment that I have developed out of many years of observa­tion, activity, and reading. Understanding something about the nature of investment can help the investor who makes his own decisions about buying and selling individual securities. It can also help the investor who buys investment company shares, for greater understanding of investment problems will help him appraise the performance of his company. A restatement may even be useful to managers of investment funds themselves.

INVESTMENT INVOLVES RISK

Risk is inherent in the environment (social, political, eco­nomic and natural) in which we live. Holding cash entails some risk. Using funds to produce income or increase their monetary value also entails risk. How much risk he is likely to run, the investor must learn to assess (it is presumed that he knows how much risk he is willing to run). And in spite of all that is known and has been written in the investment guides, the degree of risk cannot be precisely or scientifically measured.

The investment guides has an economic reason for exist­ence largely because it tends to reduce risk for the investor. To discuss risk in the modern economic world would require assessment of social and political tendencies, international problems, monetary management, business cycles, technological changes, labor-management relations, fiscal policies, and even the winds of fashion. Besides this general context of risk, there are the risks inherent in change within industries and within the affairs of single companies. Even superficial treatment of any one of these risks would require a book as long as this. So far as we can tell at mid-century, the only trend worth predicting is a trend toward bewilderingly rapid social change.

Rapid change means greater risk. Good investment manage­ment should lessen risk, however, and sound investment man­agement is one of the two reasons for investment companies. How can investment companies reduce risk and increase re­turn? Most managements rely upon diversification and timing as their principal instruments.

DIVERSIFICATION

To spread risk by diversification is the very essence of invest­ment company theory and operation. Stripped of qualifications, diversification means avoiding putting too many eggs in one basket. As applied to investment company practice, diversifica­tion is an effort to distribute risk somewhat in accordance with insurance principles.

Classic treatments of diversification also reveal some of its limitations. When Britain was the world's greatest investor, a British financial writer formulated a geographic distribution of investment as a means of protecting capital. He stated three tests for maintaining a sound investment position:

1. Ability to realize some considerable portion of the invested capital at any time without loss



2. Maintenance of the total realizable value of all the securities held at a fairly permanent level



3. Regularity of income *

* Henry Lowenfeld, "Geographical Distribution," Financial Review of Re­views (London: Popular Financial Booklets XXIX, 1907) and "Tests for Every Investor's Real Position," ibid. (XLVII, 1908).

The absence of reference to capital gain indicates the date of publication—before World War I, when it was assumed that the sound currencies of the civilized world, pound sterling, franc, dollar, or mark, would always have more or less the same pur­chasing power.

The specific recommendations are of more than historical in­terest. The investor was to buy ten securities having an aggre­gate value of £10,042 in 1904:

The annual income from these holdings was £476, or about 4.75 per cent.

The list of securities mirrors the international character of British investment in the days when Europe was the world's banker. The geographic division is approximately as follows:

One should note that only 10 per cent of the fund was to be invested in common stocks. The predominance of government obligations is also noteworthy. Today, common stocks are more likely to predominate, and the investment guides tell you more often it is likely to be capital gains than income. Underlying this revolution is the belief that fixed-income securities (bonds and high-grade preferred stocks) tend to shrink in value as com­modity prices and the cost of living rise. The income from such securities cannot grow and make up for declines in purchasing power at the grocer's or the department store. (The significance of inflation is so great that it will be dealt with separately. The significance of governments' loss of their reputation as worthy debtors is so great that this book cannot deal with it at all.)

The value of geographical diversification is easily overrated. The Great Depression of the thirties swept away values in the United States, France, Brazil, Peru, and Germany alike. The armor of protection offered by purely regional diversification was pierced. Only since the recovery of Western Europe in the late 1950's have investors returned in a limited way to geo­graphic distribution of investment.

Diversification, forthe investment guides and the in­dividual investor, can take the form of putting money into dif­ferent industries. Such diversification is most valuable, of course, when applied to common stocks. Experience shows that profits fluctuate more violently in some types of industry than in others. One broad classification runs as follows:

Capital goods: goods used to produce other goods, exempli­fied by the iron and steel and machine tool industries

Consumer goods: goods bought principally by individuals and used up quickly, exemplified by the output of the food, apparel, and gasoline industries

Consumer durable goods: goods bought principally by indi­viduals but used up more slowly, exemplified by the out­put of the automobile and electrical appliance industries

Services: work or commodities purchased both by business enterprises and by individuals, exemplified by the activ­ity of gas and electric companies, the producers of enter­tainment, the providers of shoe shines, permanent waves, and public relations

Financial institutions: specialized services in the provision of money, credit, risk-sharing, etc., exemplified in the work of banks, insurance companies, and the like

A record of the statistics of profits earned by all companies engaged in these various classifications of activity reveals great variation in year-to-year earnings. Generally, the magnitude of fluctuation in the prices of common stocks of these companies is related to the fluctuation in their earnings. In other words, a steel or machinery stock (other things being equal) is more risky than a electric utility stock, i.e., it may fluctuate more substantially in a given period of time.

Diversification does not end with spreading investment among industry groups according to their responsiveness to the ups and downs of the business cycle. Recent trends in industry have intensified a difficult problem for investors. At one time, only the largest industrial corporations made a great number of different classes of products. In the last decade, however, a variety of circumstances has led to mergers, consolidations, and acquisitions even among enterprises of lesser size. As a result, a much larger number of companies are making many products, often of an entirely unrelated character. The investor, therefore, needs to find out which products make the most contribution to sales and profits and in what direction management is mov­ing.

As an example of a large measure of diversification in the activity of one company, one might cite E. I. Du Pont de Nemours Corporation. The list of its divisions and products is too long to present fully, but an indication of the scope of op­erations can be gathered from the following: Elastomer Chem­icals Department, Electrochemical Department, Explosives Department, Fabrics and Finishes Department, Film Depart­ment, Industrial and Biochemical’s Department.
Only a few individual products can be listed: Neoprene and chemicals for natural and synthetic rubber production; sodium, cyanides, peroxides, solvents, commercial explosives, nitric acid, sodium nitrate, industrial nitrocellulose; military and sporting powders; vinyl plastic materials; pyroxylin-coated fabrics for bookbinding, luggage, and automobile and furniture upholstery; synthetic elastomer-coated fabrics; "Teflon" TFE fluorocarbon and "Lecton" acrylic resin enamels and coated glass fabrics; protective and decorative finishes, "Duco" lacquer enamels and "Lucite" acrylic finishes; "7" line of automotive and household specialties; cellophane, acetate, polyethylene and "Mylar" poly­ester film; biochemicals, including insecticides, fungicides, and chemicals; and "Zerone" and "Zerex" anti-rust antifreeze.

Sales to textile mills of nylon, "Orion," and "Dacron," and the more recently introduced elastic fiber "Lycra" aggregate be­tween 25 and 30 per cent of total sales.

The following instance of diversification in output came about through merger and acquisition rather than internally, as in the case of Du Pont.

Olin Mathieson Chemical Corporation has six operating di­visions:

Metals include brass and aluminum; packaging includes cel­lophane, cigarette papers, and Kraft-paper products; energy embraces nuclear fields, nuclear reactor cores, and high-energy fuels.

There is no substitute for diversification. Yet "scatteration," diversification carried too far, is as much a defect in invest­ment policy as is insufficient diversification. By and large, American investment companies have done a better job than the British in this respect. Managers in this country have re­jected the notion that there is great value merely in multiplying the number of securities held. Rather, they have sought to com­bine reasonable participation in a representative number of securities with selectivity. It might be said that American in­vestment companies have recognized that diversification requires both breadth and depth. British companies that are smaller than their American counterparts often have three to four times as many individual securities in their portfolios. To have between five and six hundred securities in a fund of $20 million seems to be scatteration, an expression of timidity or of effort to escape from the responsibilities of management.

Obviously, the investor must recognize that the number of securities held is not the sole test of effective diversification. An investment company with 100 common stocks, 10 of which rep­resent 50 per cent of the total holdings, is not as broadly diversi­fied as another whose 10 largest holdings make up only 20 per cent of the total.

A word about diversification for the individual investor may not be amiss here. Many portfolios show a tendency toward scatteration. An investor with $50,000 in common stocks other than investment guides shares need not own between twenty-five and thirty separate issues. The following is not a prescrip­tion; conditions change, and price shifts must be considered. Other securities may be substituted, therefore, but the person with a modest amount to invest can obtain a very satisfactory degree of diversification in, say, six or seven securities of the fol­lowing types: American Telephone & Telegraph; American Electric Power; Westinghouse Electric; Du Pont de Nemours; Sears, Roebuck; National Dairy Products; Texaco.

It is difficult to think of a time when the investor with this, or a similar, portfolio would not participate either in the re­wards of a period of prosperity and expansion or in the growth of the nation. The portfolio can be modified to meet the particu­lar objectives of the investor by choosing more specialties, by investing in more dynamic issues, or by apportioning the dollar amount to be invested in different kinds of securities.

TIMING

The attempt to buy and sell securities so as to catch, or take advantage of, turns or swings in the market is called "timing." It offers great temptations. The possibilities of a 100 per cent batting average are illustrated by a simple example: $100 in­vested in the Dow-Jones industrial stock averages at the begin­ning of 1915 followed by sale at every subsequent major peak thereafter and repurchase at every major bottom would repre­sent such an accomplishment. By the close of 1959, the invest­ment would be worth approximately $345,000. Further, an investment of $100 in January 1915 in the industry having the largest advance in the stock market, with periodic changes in the best-acting groups, would have grown to the astronomical figure of $12.5 billion by December 31, 1959.

Obviously, the gains from being "right" consistently over a long period of time would be fantastic. Obviously, too, no one ever has been "right" in this sense. At least, no public record shows that anyone, professional trader or keen outsider, has so nearly approached financial omniscience.

There are two classic studies of the achievement of those who have tried to "beat the stock market." One reflected the stock market a half-century ago. An examination of four thousand speculative accounts extending over a period of ten years dis­closed that 80 per cent of the accounts showed a final loss, that the tendency to buy at the top and sell at the bottom was most prevalent, and that early success almost invariably led to ex­cesses. A study of five hundred accounts between July 1901 and March 1903, with transactions wholly or largely confined to United States Steel Corporation common stock, was made because the stock's price at the beginning and end of the period was almost identical and was also midway between the highest and lowest prices during the period. Three hundred forty-three accounts sustained a net loss; 88 accounts had a net profit; 52 accounts were about even; and the results in 17 ac­counts were unknown, although the purchasers had taken up the stock in all cases at a considerable loss. The total deficit in losing accounts was $1,245,000 and in profitable accounts the gains aggregated $228,000. Unfortunately, the amount of equity of the owners is unknown.*

* Thomas Gibson, The Pitfalls of Speculation (New York: The Moody Cor­poration, 1906), p. 105.

A second study was made along more scientific lines.* One conclusion was that the public is inexperienced and uninformed. From 80 to 90 per cent of the accounts employed invested capi­tal of less than $5,000; 30 per cent were odd-lot accounts; and a like percentage dealt almost exclusively in low-priced stocks during the period. The percentage of accounts showing profits was larger for investment-type accounts than for other cate­gories, but this is only true before adjustment for book profits and losses. Three-quarters of the approximately six hundred studied were active for a period of less than two years, which included twenty months of revival and expansion, as the period covered was from January 1934 to December 1937.

* P. F. Wendt, The Classification and Financial Experience of the Cus­tomers of A Typical Stock Exchange Firm, 1933 to 1938 (Ann Arbor: Edwards Brothers, Inc., 1941).

The evi­dence seemed to confirm earlier research by the same econ­omist, which showed that many traders had insufficient capital, were guilty of overbuying and excessive borrowing, made poor selections as to individual securities, and lacked patience. In fact, the conclusion was reached that analysis of the incidence of overhead costs should have deterred market dealings. If this study had been prepared by the investment company industry as selling literature, little could have been added to stress the mischief of stock trading on small capital.

These remarks of Bernard Baruch's about the hopelessness of trying to "beat the market" need no further comment, except to point out that he was writing at a time when income taxes and commissions ate up a much smaller part of the gross profit: "If you are ready and able to give up everything else—to study the whole history and background of the market and all of the principal companies whose stocks are on the board as carefully as a medical student studies anatomy, to glue your nose to the tape at the opening of every day of the year and never take it off until night—if you can do all that, and, in addition, you have the cool nerves of a great gambler, the sixth sense of a kind of clairvoyant, and the courage of a lion, you have a Chinaman's chance."

The foregoing observations may appear to refer to individuals only, but the investor can also judge the trading of an invest­ment company by its turnover, i.e. the volume of total purchases and sales in relation to the size of the portfolio. A consistently high turnover should be critically examined. As a rule, the an­nual turnover of investment companies has been moderate, with some exceptions.

Most investment companies (whether open-end or closed-end funds) do not try to "beat the market." From studies, experi­ence, and observation, they have found the pitfalls on this road. With relatively few exceptions, policy now is limited to shifts among different stocks or industry groups and to moderate shifts among different stocks or industry groups and to mod­erate shifts from common stocks to bonds and preferred stocks. In recent years, few investment companies have gone all out, i.e., have not at any time sold 50 per cent or more of their com­mon stocks and bought short-term obligations.

The best single index of investment company portfolio policy with respect to the withdrawal from, and return of, funds into common stocks to take advantage of market fluctuations is the change in the ratio of cash and equivalent (short-term obliga­tions) to other assets. Table 13 shows the movement of such a ratio for a group of closed-end companies.

One of the "dangers" of selling a large part of the common stocks out of a portfolio with the hope of replacing them later on at lower prices is the attitude of stockholders, and in the case of open-end companies, potential buyers. Should the market continue to rise for six months or a year while the fund had a large cash position, the quarterly reports would present a poor comparison with other funds that had maintained a more fully invested position in common stocks.

Assume, for example, that a fund had been wise and coura­geous enough to have sold out 50 per cent of its common stocks in December, 1928. After all, the stock market, using the Dow-Jones industrial average as a measure, had already risen from around 150 early in 1927 to 300 at the end of 1928. In the ensuing nine months, prices rose to 390. What would the reaction of investors have been in July or August 1929?

Source: Industry Surveys, (New York: Standard & Poor's Corporation, November 3, 1960). The companies are Adams Express, American European Securities, American International, General American Investors, and Lehman Corporation in all years. Beginning with 1945 includes Consolidated Investment Trust, Dominick Fund, and Tri-Continental Corporation. Prior to 1952, included Capital Administration.

Timing, then, is an attribute that the investor should not seek too ardently, either in the purchase of investment company shares or in his investment in individual shares.

FORMULA PLANS

One of the most interesting developments in recent years has been the investment guides through formula plans. As set forth succinctly by one student, the basis of formula plans is: "If the problem of timing cannot be met by forecasting the cycle or by rejecting forecasting, what is to be done?" Attempts have been made to protect investment funds against some of the losses from adverse fluctuations in security prices and to ensure that such funds will retain some of the profits from favorable fluctuations. The essence of such plans is that the investment fund shall at all times consist of two por­tions—a defensive fund consisting of securities having relatively small price fluctuations (high-grade bonds and preferred stocks) and an aggressive fund made up of securities having considerable price volatility (mainly common stocks). As secu­rity prices rise, the defensive portion of the fund is to be en­larged relative to the aggressive segment. As security prices decline, the aggressive portion is to be increased through trans­fer from the defensive section of the fund. Important premises of these plans, "it is clear, are (1) that security prices will con­tinue to fluctuate and that the amplitude of fluctuation of some security prices will be greater than that of others, and (2) that the direction of security price movements cannot be forecast accurately and consistently." *

* Marshall D. Ketchum, "Investment Management Through Formula Timing Plans," Journal of Business, July 1, 1947, p. 156. Two excellent descriptions of these plans and its various refinements are H. G. Carpenter, Investment Timing by Formula Plans (New York: Harper & Brothers, 1947), and Lucile Tomlin-son, Successful Investment Formulas (New York: Barron's Publishing Co., Inc., 1947).

A few investment companies have adopted formula plans, and several colleges set up and followed a number of plans in the management of their portfolios. For illustration, two major classes of approach are outlined in summary fashion. The first approach requires starting from a stock market average, say Standard and Poor's index of five hundred stocks, which in­cludes industrial, public utility, and railroad stocks. It is decided that 52 (1940 = 10) seems to be a reasonable point in the light of the record of earnings and dividends. We propose to reduce our common stock holdings by 10 per cent when the average rises by 10 per cent from this point and to add 10 per cent to our common stock holdings whenever the average falls 10 per cent.

The second plan proceeds as follows: We believe that for our purpose, it is desirable to have 60 per cent of our fund in fixed-income securities and 40 per cent in common stocks. Every sixty days, we will review our portfolio and cut back our com­mon stock holdings if the value exceeds 40 per cent of the total market value of the portfolio. Conversely, if the common stocks add up to less than 40 per cent of the total, we will add suffi­ciently to bring up the aggregate value of common stocks to the 40 per cent ratio.

The success of these plans requires, in large part, that the course of common stock prices proceed in wave-like move­ments, thus:

If, perversely, stock prices continue to rise or fall without much interruption over a period of time, the formula plan will not work. Experience during the fifties, when common stocks were sold several times and could not be bought back at lower prices, led to the abandonment of a number of formula plans.*

* A comprehensive and clear discussion of formula timing, perhaps some­what too detailed for the average investor, may be found in Sherman F. Feyler, Income Growth with Security (New York: The Macmillan Company, 1958); see also C. S. Cottle and W. T. Whitman, Investment Timing: The Formula Plan Approach (New York:  McGraw-Hill Book Company, Inc.,  1953).

Frequently, 20 per cent of the stocks gained well over 40 per cent. On the other hand, at least 20 per cent of the shares chosen at random frequently fell in price over a one-year period. One observer reached this con­clusion:* Even if the timing of purchases is excellent, the rate of return on a portfolio through price appreciation can vary widely depending on its composition. If the future continues to resemble the past, proper security analysis can lead to hand­some, even generous returns. If the analysis is faulty, however, the rewards will be meager indeed.

* Eugene M. Lerner, "Rate of Return on Common Stocks," Financial Analysts Journal (New York) September-October 1960, p. 47.

Past patterns or assumptions predicated on mathematical formulas do not furnish the best guides for investment manage­ment. This opinion holds for investment companies as well as individuals.

Formula plans tend to play down the significance of selec­tivity, i.e., of the choice of one stock or industry against another. Yet selectivity is so important that unfortunate selection of se­curities may deprive a formula plan, which has given the right answer of a good part of its advantage. For example, the sale of electric utility stocks in July or August 1959, when the gen­eral market reached a high point, would have been unprofitable, for the group as a whole continued to rise with little setback into early 1961. On the other hand, the purchase of large amounts of Standard Oil Company of New Jersey would have turned out less profitably than that of many other stocks at what proved to be a turning point in the market; the purchase of Douglas Aircraft would have shown a severe loss two years later.

In a careful study, it has been shown that during every year of the great bull market of the fifties, 20 per cent of the stocks in the portfolio composed of the Dow-Jones combined average of sixty-five stocks (industrial, public utility, and railroad) appreciated by at least 10 per cent.

Dollar Averaging

This is an innovation that has gained in popularity in recent years. In reality, it is a variation of formula timing.  The basic idea is simple. Stock prices fluctuate as optimism waxes and wanes, or business expands and contracts. Begin with the as­sumption that the record of forecasters is not too good. Let us, then, eliminate forecasting. Why not invest a fixed amount, let us say, $1,000 on January 1 and quarterly thereafter, in the stock of a strong company in an industry that seems certain to participate in America's growth.

The first purchase is made when the stock is selling at $50 per share. Twenty shares are bought (commissions and other costs are omitted). Three months later, the stock has declined to $42. Now twenty-four shares are bought. The average cost of each of the forty-four shares is a little more than $45. If the stock had risen in price to $55 during the quarter-year following the first purchase, the number of shares bought would have been only eighteen. In other words, when prices fall, the $1,000 buys a larger number of shares; when prices rise, the $1,000 will buy a smaller number of shares. Thus, investors buy more advanta­geously when prices are low, or at any rate lower, and are less tempted to sell when stocks are depressed. The temptation to buy when prices are high is kept in check by the use of only a fixed amount of money. The result of purchases over several years, and certainly over a longer term, will be an investment made at weighted average prices, a larger number of shares hav­ing been bought at low rather than high prices.

Experience and studies show that as a rule, a rigid policy of dollar averaging in a representative standard stock would work out well.

A dollar averaging plan started in 1929, when the combined index of Standard and Poor's five hundred stocks stood at $26.02 per share (1941-1943 = 10), and implemented by annual com­mitments of $1,000 annually would have resulted in the follow­ing: If continued through 1958, the investor would have had 2,010 shares with a market value at 1959 prices of $57.38, or approximately $115,000. The paper profit on the $30,000 in­vested would have been $85,000. The investor who began his program in 1939, 1944, 1949, or 1954 would also have substan­tial gains. The rise in prices between 1954 and 1959 was so steady that the gain would have been rather moderate.*

* Leonard W. Olscher, "Dollar Averaging in Theory and Practice," ibid. p.51.

Despite these studies, one does not, in actuality, buy the "averages" but specific stocks. In almost any period, the dollar results to the investor would depend on the stock or stocks he chose. Nevertheless, dollar averaging does have much to recom­mend it.

Investment company shares are often purchased with the thought of dollar averaging. Not only are open-end shares bought under contractual plans but MIP (monthly investment plans) purchases of closed-end investment company shares are popular. This is a further indication of the determination of many investors to leave "beating the market" to professional traders, and it is an expression of confidence in the long-term potential of common stocks.

One should remember, however, that there is a difference in dollar averaging in the stock of X Manufacturing Company and dollar averaging in the stock of an open-end or closed-end in­vestment company of the diversified management type. In the latter case, the management may shift its policies and change the portfolio, so that fluctuations in the net asset value do not follow the general course of the market. To illustrate: Under a given set of industrial conditions and profits, the stock of X Manufacturing Company may rise from 50 to 60 in a year, then fall in two years to 45 and, in the next year, rise to 70. Assume that this parallels the changes in industrial shares generally. The results will be very satisfactory for the investor who has "dollar averaged" monthly or quarterly. However, during this same period, an investment company stock, owing to diversifica­tion of the underlying portfolio or to a shift of a substantial part of it into stocks or groups that have risen less than the stock market generally or than X Manufacturing, may have the fol­lowing pattern: the net asset value rises from 50 to 56 in the first year, and in the next two years declines to 48, and then rises in the fourth year only to 60. The greater stability would reduce the advantage of averaging.

Furthermore, a diversified portfolio, by its very nature, multi­plies the number of changes in policy that may be made during any period by the managements of the companies whose securi­ties are held. Exposure to such changes would certainly be less by dollar averaging in one or two stocks. On the other hand, if the investor makes a poor choice, the benefits from dollar aver­aging may be disappointing. In the period 1950-1959, for instance, Woolworth, Chrysler, or United Fruit would not have done well.

It is so easy to make the more advantageous selections in retrospect. However, the greatest danger in dollar averaging probably is not the stock chosen, whether an individual stock or an investment company share, but the risk of running out on the plan when the course of the market has been downward or stag­nant and the investor has become discouraged. This also applies to investment clubs. The advantages of dollar averaging accrue from a rigid adherence to the plan regardless of the investor's current judgment as to the outlook.

In sum, dollar averaging, although not an infallible guide to riches, will often serve the investor well who adheres to the "rules" and does not run out when the real test is reached — when the quotations have fallen substantially from the price prevailing on the date of first purchase.

INFLATION AND DEFLATION

Because of the constant repetition of the inflationary factor as a reason for buying investment company shares, and the cer­tainty that protection against rising prices through participation in the growth of the economy by the purchase of common stocks will be the very heart of sales efforts in connection with vari­able annuities, two observations seem appropriate at this point. Because of rather uncritical statements in sales material and market letters, as well as in the financial press, the following ideas have gained all but complete acceptance: (1) inflation is bound to occur; (2) common stocks offer infallible protection as a "hedge" against inflation. The area of assumption is so broad and touches so many aspects of the economy that only the briefest discussion is possible. For brevity's sake, I present a number of flat assertions rather than detailed argument.

1. The correlation between commodity price changes and the cost of living is slight. Between 1927 and 1929, the wholesale price index changed from 62.0 to 61.9 (1947-1949 — 100), and the cost of living changed from 74.2 to 73.3. Meanwhile, indus­trial common stock prices measured by the Dow-Jones indus­trial stock averages rose from 152 to 380.

More recently, between September 1953 and autumn 1956, industrial common stock prices advanced from around 250 to 500. There was almost no change during this period in whole­sale commodity prices; the cost-of-living index rose from 115.2 to 116.8.

If the federal government deficit be regarded as the best index of inflation, the $12.4 billion deficit in the 1959 fiscal year, the largest in peace-time history, was accompanied by almost no change in wholesale commodity prices and by a rise of only about 1 per cent in the cost-of-living index.

On the other hand, if low interest rates be regarded as the best measure of inflation, let it be noted that in the period be­fore World War II, the average yield on high-grade corporate bonds was only 2.95 per cent; short-term interest rates, as meas­ured by Treasury bills, were as low as 0.058 per cent. Yet, indus­trial common stocks yielded as much as 4.2 per cent after the cuts in dividends following the 1937-1938 business contraction, and common stocks were depressed.

Nevertheless, over long periods of time, inflation has had a tendency to raise common stock prices. The impact will not be even or predictable, however, and other influences may reduce or cancel out the inflationary factor.

2. Over a long span of years, the average annual return on all the common stocks listed on the New York Stock Exchange is at the rate of about 5 per cent from income and 5 per cent from increase in price. This holds true of a period of about seventy-five years, including World Wars I and II. An interest­ing analysis of British experience has been made.* An invest­ment in equities made in 1919 and held through 1959 would show an average annual increase at the compound rate of 3.75 per cent. It is properly said that if the rate of growth is to continue, "obviously there is justification for buying Ordinary Shares (common stocks) on a much lower yield basis than Fixed Interest securities. The basic assumption can, however, only be made by the very long-term investor who cannot be forced to sell on unfavorable terms and ignores short-term fluctuations."

* de Zoete and Gorton, Equity and Fixed Interest Investment: A Study, 1919-1960 (London, I960).

3. In the absence of war, the increase in the cost of living or of commodity prices, from all indications would be so small as to cut greatly the validity of expectation of inflation as a rea­son for buying common stocks.

A study recently made in the United Kingdom again is illu­minating.* From 1275 to 1949, there were three great inflation­ary periods: 1525-1650, 1744-1792, and 1939-1946. The first period was associated with debasement of coinage, plus a heavy influx of gold and silver from the Western Hemisphere; the sec­ond, with the rise of banking and credit instruments; the third, with World War II. Both the Napoleonic War and World War I were followed by such severe deflation that no major perma­nent shift upward occurred in the level of prices. The historical evidence, aside from periods of major economic upheaval, ac­cording to Dr. Lipsey, suggests that the investor who guides himself by this evidence should put the odds very slightly in favor of deflation rather than inflation.

* R. G. Lipsey, "Does Money Always Depreciate?" Lloyds' Bank Review, No. 58, October 1960, p. 1.

NO ONE KNOWS

No one knows what the earnings of a company (except perhaps an electric or gas company or, to a lesser degree, a bank) will be several years hence.

Even if the investor knew the earnings results several years off, he would not even then know at what price the stock would sell because: (a) common stock valuation almost always can differ by between 12 to 15 per cent; (b) much larger differences in valuation result from changes in the market valuation of a dollar of earnings.

If large and small investors were persuaded of the foregoing, much disappointment would be eliminated and less confidence would be expressed in the future price movements of stocks. Instead of the assurance that X Manufacturing stock will sell at $65 per share, it would be more frequently said that the stock of X Manufacturing should sell at $65 per share.

Economic, financial, and industrial conditions change too rapidly to permit accurate forecasting of earnings three to five years hence. As the professionals say, there are too many "im­ponderables." This is merely a way of saying there are too many uncertainties. Phases of the business cycle may not recur in the way that had been anticipated. The commodity price level may be lower or higher than had been projected. Demand may have been accelerated by new uses for a product or cut down by the substitution of competitive products. Higher labor costs could not, perhaps, be passed on in prices.

New supplies may come on the market from domestic or foreign competitors. One striking example must suffice: In 1956, Aluminum Com­pany of America earned $89.6 million. Almost every forecast of the trend of sales and profits was more glowing than the last. One did not need to be an expert to observe how the use of aluminum was growing. Here was a splendid company in every respect. Five years later, in 1960, Alcoa earned $40.0 million!

The more distressing fact is that if the investor was provided with the fabled "crystal ball" and guessed earnings correctly, he might still be way off concerning the price of the stock at the end of a three- or five-year period.

Given all the facts concerning a company, there will still be a difference of at least 12 to 15 per cent in the value placed on the stock by various analysts. Value measures a flow of future earnings and dividends, and the very same set of facts will lead different analysts and investors to different conclusions about the future. Proof of this is always present during a reorganiza­tion of a company and the working out of a recapitalization plan. One would need to work through the testimony of witnesses in proceedings before the Securities and Exchange Com­mission, in its reports to courts in reorganization proceedings, or in proceedings before the Interstate Commerce Commission in order to understand why 12 to 15 per cent is actually a very modest difference of opinion. Valuation proceedings growing out of tax litigation involving stock of closed corporations tell the same story. And the competitive bidding of investment banking firms for the stock of companies like Schering Corpora­tion, whose stock was wholly owned by the Alien Property Custodian, underlines the wide spread in opinions about stock valuation when no market has heretofore existed.

For this reason, I contend that no one can prove that an actively traded industrial stock is "worth" 50, say, but not 56 or 58.

Finally, there are an infinite number of glaring examples of differences in valuation placed on stocks by the market, which can be explained only in terms of super confidence, or lack of confidence. For example, could the reader who covers the last column of the following tabulation and concentrates on the earning and dividend list, conclude that the price record would be anything like that set down in the final column?

Yes, these are the facts about American Telephone & Tele­graph, whose price more than doubled and then fell to less than 40 per cent of the highest price on a change in earnings that was relatively small while the dividend rate was un­changed.

Here is an example from a more recent period:

This is the story of Anaconda Copper. The stock made its high in 1946, although earnings soared in the two following years, in each of which the dividend was raised substantially. Given these facts, who could have concluded that the stock would sell at 30 in 1948, which was a far cry from the quotation of 52 of 1946, and even below the lowest price of 1946. The rea­sons? A general lack of confidence and fear of a postwar depres­sion.

There are several reasons for this discussion, one of which is that it will perhaps serve to sober critics who rub their hands with glee when an investment company has made what seems to be a mistake. The management of funds is no easy task, and its difficulties are intensified by the vagaries of the stock market. Stock prices seem to fluctuate because of economic, social, polit­ical and psychological reasons—for reasons both rational and irrational. Perhaps that is why the course of stock prices is often described in terms applied to persons. The market is "dull" or "feverish," "strong" or "weak," "buoyant" or "listless."

Nobody knows what the stock market will do. Judging from past experience, stocks will continue to sell in three zones: at higher prices than they should, judging from all relevant fac­tors; at about where they should, according to that judgment; or substantially below the prices that one would expect from sound analysis. Such periods may last for many months. That is why diversification, formula timing, and dollar averaging have been used—because investment is more nearly an art than a science.
I am inclined to believe that investment company managers can perform no service to investors more valuable than insist­ence on their lack of omniscience. It would be too much to expect investment companies to admit their good fortune in the past decade. At a number of times when the economy seemed to be faltering and stock prices had been declining for months, or when the price level was rather static, some dramatic event galvanized the economy or renewed inflationary fears.

For example, from the end of 1955 to the end of 1957, few investment companies reported a significant gain in net asset value. Had no significant improvement taken place in the next year, it is conceivable that "tired" and disappointed investors might have adopted a less enthusiastic view of investment com­pany shares. However, when Communist China shelled the off­shore islands and the ruler of Iraq was assassinated in August 1958, stock prices advanced rapidly because heavier defense expenditures as well as a deficit in the federal budget appeared to be inevitable.

By the end of the third quarter of 1958, investment com­panies again reported a substantial gain in net asset value. Sales of new shares rose, after having shown practically no change be­tween the first half of 1957 and 1958. In 1958, sales of open-end shares rose 20 per cent between the second and third quar­ter of that year. In truth, the Chinese leaders and Nasser-in­spired cliques had been of immeasurable help. Portfolio changes could hardly have accomplished the gains reported merely by owning a reasonably sound portfolio of common stocks. A simi­lar lift had been given stock prices earlier by the Suez Canal crisis.

Candor requires the statement that events which cannot be forecast may have a greater influence on portfolio values than the most careful planning and analysis, especially as long as international affairs are controlled by leaders who subordinate economic to nationalistic goals or who are motivated by the drive for power.

QUESTIONS TO ASK IN SELECTING AN INVESTMENT COMPANY

1. When was the fund organized?

An old fund has a record. In investing in a new fund, the most important factor to consider is the character of the sponsorship.

2. How big is the fund?

Bigness is neither an assurance of superiority nor a handi­cap. There is no clear evidence that size is of overriding importance.

3. Who are the underwriters or sponsors of the fund?

The investor needs to know something about the firm that puts its stamp of identification on the fund (see also Point 1). Very often, the management contract has been made with a corporation whose stock is owned by the un­derwriters. This is permitted under the Investment Company Act.

 4. How much must the investor pay in the way of a sales commission to buy shares in the fund?

The average selling charge or "load" is 8 to 8.5 per cent of the net asset value per share. The charge is not unreason­able, provided that the investor clearly understands that shares in funds should not be bought in expectation of quick profits.

5. What is the basis of the management fee?

The management fee is an annual cost, whereas the sell­ing commission is charged only when the shares are bought. The standard management fee is 0.5 per cent of the assets annually. The fund usually pays the fee in quarterly por­tions. The fee is not unreasonably high (see also Point 6).

6. Is the rate of the management fee reduced as the size of the
fund grows?

Since the costs of management do not rise proportion­ately with the increase in net assets, there is a growing opin­ion that the fee should be reduced if the assets increase; thus, a 0.5 per cent annual fee might be reduced to 0.375 per cent when net assets exceed $50 million, and so on. A number of funds have adopted this practice for some years.

7. What type of fund is it?

The following are the principal types of funds:

Common stock funds. These ordinarily have 90 per cent of their assets in common stocks.

Income stock funds. These emphasize stocks that show relatively high yields, so that the dividend payments made to shareholders in the fund may be comparatively large.

Growth stock funds. These emphasize prospects of a rise in value. Usually, this means a sacrifice of income because "growth stocks" generally sell at prices that show relatively low yields.
Balanced funds. These generally include one-third or more bonds and/or preferred stocks among their invest­ments to provide "balance and to reduce the size of price fluctuations in the shares of the fund.

Specialty or specialized funds. These tend to confine in­vestment to one or a few industries, to one type of security, or to enterprises operating in a particular geographic region.

8. What is the fund's objective?

The prospectus includes a statement of objectives, such as capital appreciation, stability of income, long-term par­ticipation in the development of the economy, or the sin­gling out of undervalued securities. Objectives also may include a program of remaining fully invested at all times, or of maintaining a position that will allow the fund to try to take advantage of changes in the business cycle and shift its investments in order to benefit from swings in stock prices.

9. If the fund has functioned over a period of years, what has its record been?

The record may be tested by the extent to which net assets per share, adjusted for capital gains distributions, have risen in a rising market and the extent to which they have fallen in value in a declining market. The investor should not be swayed by a rise or fall during a short period of three or four months. The investor should also examine the investment guides to see the return on the average price, exclusive of capi­tal gains distributions.