• Choose a category
• All
• Classic-Fiction

By Root 2649 0

individual forecasts were wide of the mark. This is an instance in support of our general view that composite or group estimates are likely to be a good deal more dependable than those for individual companies. Ideally, perhaps, the security analyst should pick out the three or four companies whose future he thinks he knows the best, and concentrate his own and his clients’ interest on what he forecasts for them. Unfortunately, it appears to be almost impossible to distinguish in advance between those individual forecasts which can be relied upon and those which are subject to a large chance of error. At bottom, this is the reason for the wide diversification practiced by the investment funds. For it is undoubtedly better to concentrate on one stock that you know is going to prove highly profitable, rather than dilute your results to a mediocre figure, merely for diversification’s sake. But this is not done, because it cannot be done dependably. 4 The prevalence of wide diversification is in itself a pragmatic repudiation of the fetish of “selectivity,” to which Wall Street constantly pays lip service.*

TABLE 11-2 The Dow Jones Industrial Average

(The Value Line’s Forecast for 1967–1969 (Made in Mid-1964) Compared With Actual Results in 1968)

Factors Affecting the Capitalization Rate

Though average future earnings are supposed to be the chief determinant of value, the security analyst takes into account a number of other factors of a more or less definite nature. Most of these will enter into his capitalization rate, which can vary over a wide range, depending upon the “quality” of the stock issue. Thus, although two companies may have the same figure of expected earnings per share in 1973–1975—say $4—the analyst may value one as low as 40 and the other as high as 100. Let us deal briefly with some of the considerations that enter into these divergent multipliers.

1. General Long-Term Prospects. No one really knows anything about what will happen in the distant future, but analysts and investors have strong views on the subject just the same. These views are reflected in the substantial differentials between the price/earnings ratios of individual companies and of industry groups. At this point we added in our 1965 edition:

For example, at the end of 1963 the chemical companies in the DJIA were selling at considerably higher multipliers than the oil companies, indicating stronger confidence in the prospects of the former than of the latter. Such distinctions made by the market are often soundly based, but when dictated mainly by past performance they are as likely to be wrong as right.

We shall supply here, in Table 11-3, the 1963 year-end material on the chemical and oil company issues in the DJIA, and carry their earnings to the end of 1970. It will be seen that the chemical companies, despite their high multipliers, made practically no gain in earnings in the period after 1963. The oil companies did much better than the chemicals and about in line with the growth implied in their 1963 multipliers.5 Thus our chemical-stock example proved to be one of the cases in which the market multipliers were proven wrong.*

2. Management. On Wall Street a great deal is constantly said on this subject, but little that is really helpful. Until objective, quantitative, and reasonably reliable tests of managerial competence are devised and applied, this factor will continue to be looked at through a fog. It is fair to assume that an outstandingly successful company has unusually good management. This will have shown itself already in the past record; it will show up again in the estimates for the next five years, and once more in the previously discussed factor of long-term prospects. The tendency to count it still another time as a separate bullish consideration can easily lead to expensive overvaluations. The management factor is most useful, we think, in those cases in which a recent change has taken place that has not yet had the time to show its significance in the actual figures.

Two spectacular occurrences of this