The Evaluation of Common Stocks by Kendall J. Anderson, CFA, Anderson Griggs Investments
Stocks are not always worth what they sell for. Sometimes they are carried too high, sometimes too low, by mass excitement. Sooner or later, though, they move into line with value.” – Arnold Bernhard
I have met many financially secure families over the years. Most earned this financial security by working hard, while saving as much as possible, for a very long time. Some inherited a safety net, some married into wealth, and a few lucky people just did everything right at the right time. What I have not come across is anyone who gained financial security quickly in a short period by investing in the capital markets. I know there are a few of these wonder kids somewhere on the planet, but I haven’t met them. And of course, being human and carrying a little bag of envy around with me every day, I would not have believed they accomplished this feat on skill alone. There had to be a great deal of luck involved.
Knowing full well that luck passed over me about the time I was born, I followed the lead of the majority on the road to financial security by working hard and saving as much as I could. It helped that I chose to work in the investment field. This opened up the door for gaining some element of skill in minimizing my number of investment mistakes, which we all make at some point.
I began my career as a financial intermediary: a registered representative better known today as a financial advisor. Basically, I was one of those guys who would talk with you and then advise you to buy a mutual fund or some other product designed and managed by someone else. Selling mutual funds was fine for a while, but I wanted to increase my investment skill, so I purchased a one-year subscription to the Value Line Investment Survey which included weekly updates. It was my introduction to a systematic method of the evaluation of common stocks. Some years later, I obtained a copy of Arnold Bernhard’s 1959 book, The Evaluation of Common Stocks. I remember I purchased it from the local library’s annual book sale for less than a dollar. What a bargain!
For those of you not familiar with Arnold Bernhard, an introduction is appropriate. Mr. Bernhard was born in 1901 in New York City. He grew up in Newark, DE and Rutherford, NJ, and graduated from Williams College. After graduating in 1925, he began a career as a reporter with New York newspapers. The great bull market of the late 1920’s enticed him into the investment business. He began his career as an employee of Jesse Livermore, one of the most widely known stock speculators of the day. It took just a short time for Mr. Bernhard to recognize that Livermore’s trading was completely indifferent to any standard of value, so off Mr. Bernhard went again, landing at Moody’s Investors Service, where he worked as an analyst and account executive. However, the effects of the great crash found him out of a job in 1931. At this point, he started Arnold Bernhard & Company, an investment counselling firm.
Five years later he published the first edition of the Value Line Investment Survey. It was duplicated on a mimeograph machine and mailed to a few interested parties. What I find so special about the survey is that it is based on the assumption that there is “a standard that can signal when stocks are overvalued, and when they are undervalued, a standard that would not give way to emotionalism” (valueline.com). This idea, that prices can be over or undervalued, directly conflicted with the efficient market hypothesis which holds that all information is reflected immediately in stock prices, so that any attempt to outperform the market is wasted effort.
Because of this, the survey includes years of data that is produced consistently, and thus it is easy to compare one company to another. For an analyst, this is one of the most difficult, not to mention boring, parts of the job, having to adjust data from multiple sources so that all final numbers are produced in identical fashion.
The inside flap of The Evaluation of Common Stocks states: “The key to Mr. Bernhard’s book is to be found in his statement, ‘If all the deviltry of all the crooked stock market riggers of all time were raised to the hundredth power, it would count as nothing compared to the desolation wrought by deluded crowds [of investors] whose imagination knows no discipline.’” Here we are fifty-five years after publication, with more than one crooked stock market rigger spending his or her days in federal prison for dirty deeds committed in the past, and still the primary reason individuals fail as investors is because of an undisciplined approach to investing.
Mr. Bernhard did his best to correct this during his lifetime. His book is a transcript of a series of presentations he gave at the Bernard M. Baruch School of Business and Public Administration of the City College in New York. He discussed a widely held but fallacious generalization about stock evaluation, quality and appreciation potential, and current valuation and whether stocks are cheap or dear to their own intrinsic value. In his final presentation, he gave a method for building and maintaining a portfolio of individual companies.
Price/Earnings (P/E) Ratio as a Measure of Value
Most of you know that the P/E ratio is the current price of a stock divided by the company’s earnings per share. This ratio is one of the most widely used statistics to determine whether a market price is high or low. I came under the P/E spell early on. Initially I believed the lower the P/E the better, but Mr. Bernhard’s little book enhanced my understanding and my use of the P/E ratio in our own determination of value. Because of this, I want to share with you some statements he makes in his book about the P/E ratio.
- One cannot generalize that stocks are worth 10 times earnings, which is a common assumption. The truth is that each stock has its own characteristic price/earnings ratio.
- Yet it would also be misleading to assert that an average, or typical, price/earnings ratio is a reliable criterion of the value of a stock in all phases of its business cycle.
- The price/earnings ratio, if taken at the highest and the lowest prices of the year, would fluctuate even more [than the annual average price/earnings ratio].
- When the earnings rise, the price/earnings ratio tends to fall. But when the earnings fall, the price/earnings ratio tends to rise [on cyclicals].
- …the fact that the price/earnings ratio of a cyclical stock normally goes down as the earnings rise.
- Each stock has its own individual price/earnings ratio…
- …the price/earnings ratio of the individual stock normally varies at different levels of earnings.
- …in determining how a stock should be valued in relation to earnings, or dividend-paying ability, we must discard the idea of a general price/earnings ratio for all stocks, for we have found that each stock has its individual price/earnings ratio.
- We must discard the idea of a fixed price/earnings ratio for the individual stock at all levels of earnings, because we have found that the price/earnings ratio of even the individual stock varies—and normally varies—at different levels of earnings.
(Bernhard, The Evaluation of Common Stocks, pgs. 26-36)
I have chosen to highlight Mr. Bernhard’s comments on the P/E ratio for a very important reason. It is the season for forecasts. Invariably, many firms and individuals will forecast a level for the Dow Jones or the Standard and Poor’s 500 index based on a multiple of estimated earnings; a P/E ratio for the entire market. One of the easiest mistakes we can make is to assume these estimated market P/E ratios are normal and can be relied upon to estimate the fair value of an individual common stock. Mr. Bernhard reminds us that each company has its own individual price/earnings ratio and we must discard the idea of a general price/earnings ratio for all stocks.
Market forecasts are fun to read. Some will prove to be accurate, most will not. More importantly for us is that we understand that a market forecast is just an educated guess and should not be used to estimate whether an individual company is a bargain or if it is fully valued.
Until next time,
Kendall J. Anderson, CFA
The Evaluation of Common Stocks by Arnold Bernhard