- That was the position of a host of strongly financed industrial companies at the low price levels of 1932–33. In such instances the investor can obtain the margin of safety associated with a bond, plus all the chances of larger income and principal appreciation inherent in a common stock.
- (The only thing he lacks is the legal power to insist on dividend payments “or else”—but this is a small drawback as compared with his advantages.)
- Common stocks bought under such circumstances will supply an ideal, though infrequent, combination of safety and profit opportunity.
- As a quite recent example of this condition, let us mention once more National Presto Industries stock, which sold for a total enterprise value of $43 million in 1972. With its $16 millions of recent earnings before taxes the company could easily have supported this amount of bonds.
- Assume in a typical case that the earning power is 9% on the price and that the bond rate is 4%; then the stock buyer will have an average annual margin of 5% accruing in his favor.
- Some of the excess is paid to him in the dividend rate; even though spent by him, it enters into his overall investment result. The undistributed balance is reinvested in the business for his account.
- In many cases such reinvested earnings fail to add commensurately to the earning power and value of his stock. (That is why the market has a stubborn habit of valuing earnings disbursed in dividends more generously than the portion retained in the business.)*
- But, if the picture is viewed as a whole, there is a reasonably close connection between the growth of corporate surpluses through reinvested earnings and the growth of corporate values.
- Over a ten-year period the typical excess of stock earning power over bond interest may aggregate 50% of the price paid.
- This figure is sufficient to provide a very real margin of safety— which, under favorable conditions, will prevent or minimize a loss.
- If such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favorable result under “fairly normal conditions” becomes very large.
- That is why the policy of investing in representative common stocks does not require high qualities of insight and foresight to work out successfully.
- As we see it, the whole problem of common-stock investment under 1972 conditions lies in the fact that “in a typical case” the earning power is now much less than 9% on the price paid.**
- Let us assume that by concentrating somewhat on the low-multiplier issues among the large companies a defensive investor may now acquire equities at 12 times recent earnings—i.e., with an earnings return of 8.33% on cost.
- He may obtain a dividend yield of about 4%, and he will have 4.33% of his cost reinvested in the business for his account.
- On this basis, the excess of stock earning power over bond interest over a ten-year basis would still be too small to constitute an adequate margin of safety.
- For that reason we feel that there are real risks now even in a diversified list of sound common stocks.
- The risks may be fully offset by the profit possibilities of the list; and indeed the investor may have no choice but to incur them—for otherwise he may run an even greater risk of holding only fixed claims payable in steadily depreciating dollars.
- Nonetheless the investor would do well to recognize, and to accept as philosophically as he can, that the old package of good profit possibilities combined with small ultimate risk is no longer available to him.***
* This problem is discussed extensively in the commentary on Chapter 19.
** Graham elegantly summarized the discussion that follows in a lecture he gave in 1972: “The margin of safety is the difference between the percentage rate of the earnings on the stock at the price you pay for it and the rate of interest on bonds, and that margin of safety is the difference which would absorb unsatisfactory developments. At the time the 1965 edition of The
*** This paragraph—which Graham wrote in early 1972—is an uncannily precise description of market conditions in early 2003. (For more detail, see the commentary on Chapter 3.)