The

 Intelligent  Investor  
Chapter  3:  A  Century  of  Stock-­‐Market  History:  The  Level  of  Stock  Prices  in  Early  
1972  
• The  intelligent  investor  should  have  a  solid  understanding  of  stock-­‐market  history  
• Price  levels  and  their  relationship  to  earnings  and  dividends  paid  are  of  paramount  
importance  
• This  background  information  gives  the  investor  the  ability  to  gauge  the  attractiveness  of  the  
current  market  level  
• A  chart  is  displayed  of  the  Dow  Jones  Industrial  Average  and  the  S&P  500  from  1871  through  
1972  
• In  only  two  of  the  nine  decades  shown  did  corporate  earnings  decrease  
• There  were  no  decades  where  average  dividend  yields  decreased  
• Growth  rates  varied  significantly  in  many  of  the  decades  studied  
• Valuation  levels  and  dividend  yield  also  fluctuated  wildly    
• The  S&P  traded  at  6.3  times  earnings  in  1949  and  rose  to  22.9  times  earnings  in  
1961  
• Dividend  yield  was  7%  in  1949  and  3%  in  1961  
• Graham  ultimately  concluded  that  the  market  was  expensive  in  1972  for  two  reasons  
• The  price  to  earnings  ratio  of  18.0  was  high  by  historical  standards  
• The  yield  available  on  common  stocks  was  less  than  half  of  the  available  yield  on  
high  quality  bonds  
• Based  on  his  conclusion  that  the  market  was  overvalued  he  recommended  the  following  
course  of  action  
• No  borrowing  to  buy  or  hold  securities    
• No  increase  in  the  proportion  of  funds  held  in  common  stocks  
• A  reduction  in  common  stock  holdings  where  needed  to  bring  it  down  to  a  
maximum  of  50%  of  the  total  portfolio  
• Commentary  on  Chapter  3  
• “You’ve  got  to  be  careful  if  you  don’t  know  where  your  going,  ‘cause  you  might  not  get  
there.”  –  Yogi  Berra  
• Graham’s  warnings  of  dangerous  valuation  levels  in  1972  proved  to  prophetic  as  the  
market  declined  37%  during  the  bear  market  of  1973-­‐1974  
• He  believed  that  the  intelligent  investor  must  never  forecast  the  future  by  
extrapolating  the  past  
• During  the    bull  market  of  the  1990’s  many  of  these  lessons  were  completely  
forgotten  
§ Forecasters  argued  that  because  stocks  had  returned  7%  on  average  since  
1802  that  investors  should  expect  that  return  regardless  of  what  level  they  
purchased  common  stocks  
§ Some  claimed  that  stocks  “always”  beat  bonds  over  a  30  year  period  and  as  
a  result  could  be  bought  without  paying  attention  to  valuations  as  long  as  
the  investor  planned  to  hold  forever  
• The  market  crash  in  the  early  2000’s  proved  that  valuation  levels  always  matter  and  
should  not  be  ignored  
• The  problem  with  extrapolating  past  market  returns  is  that  it  includes  an  inherent  
“survivorship  bias”  
§ This  means  that  many  past  companies  went  bust  and  are  not  accounted  for  
when  analyzing  historical  market  returns  
§ This  leaves  analysts  with  a  hand  full  of  exceptional  companies  that  have  
survived  to  use  as  data  points  
§ For  every  Coca  Cola  there  are  twenty  companies  from  previous  eras  that  
are  no  longer  in  existence  
 • Because  the  profits  that  companies  can  earn  are  finite  the  price  that  investors  are  
willing  to  pay  must  also  be  finite    
• If  future  returns  are  guaranteed  to  match  successful  past  returns  investors  would  
bid  up  stocks  to  unsustainable  levels  
• Extrapolating  rosy  historical  returns  into  the  future  is  illogical  and  dangerous  
according  to  Graham  
• The  performance  of  the  stock  market  relies  on  three  factors  
§ Real  growth  (the  rise  of  companies  earnings  and  dividends)  
§ Inflationary  growth  (the  general  rise  of  prices  throughout  the  economy)  
§ Speculative  growth  or  decline  (any  increase  or  decrease  in  the  investing  
public’s  appetite  for  stocks)  
• Corporate  earnings  per  share  have  grown  1.5%  to  2%  annually    
• As  we  discussed  in  the  last  chapter  3%  is  a  suitable  inflation  estimate    
• Average  dividend  yield  on  the  S&P  500  is  currently  1.7%  
• By  totaling  these  three  percentages  the  investor  can  find  the  expected  return  for  
common  stocks  
• Currently  the  expected  return  for  common  stocks  would  be  6.7%  or  3.7%  after  
inflation    
• The  only  constant  in  markets  is  that  they  continue  to  surprise  investors  
• It  is  therefore  extremely  important  for  investors  to  be  humble  and  realize  that  their  
forecasts  and  projections  are  far  from  certain    
• In  financial  markets  the  worse  the  future  looks  the  better  it  usually  turns  out  to  be