The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [24]
What would be the implications of such an advance? It would eat up, in higher living costs, about one-half the income now obtainable on good medium-term tax-free bonds (or our assumed after-tax equivalent from high-grade corporate bonds). This would be a serious shrinkage, but it should not be exaggerated. It would not mean that the true value, or the purchasing power, of the investor’s fortune need be reduced over the years. If he spent half his interest income after taxes he would maintain this buying power intact, even against a 3% annual inflation.
But the next question, naturally, is, “Can the investor be reasonably sure of doing better by buying and holding other things than high-grade bonds, even at the unprecedented rate of return offered in 1970–1971?” Would not, for example, an all-stock program be preferable to a part-bond, part-stock program? Do not common stocks have a built-in protection against inflation, and are they not almost certain to give a better return over the years than will bonds? Have not in fact stocks treated the investor far better than have bonds over the 55-year period of our study?
The answer to these questions is somewhat complicated. Common stocks have indeed done better than bonds over a long period of time in the past. The rise of the DJIA from an average of 77 in 1915 to an average of 753 in 1970 works out at an annual compounded rate of just about 4%, to which we may add another 4% for average dividend return. (The corresponding figures for the S & P composite are about the same.) These combined figures of 8% per year are of course much better than the return enjoyed from bonds over the same 55-year period. But they do not exceed that now offered by high-grade bonds. This brings us to the next logical question: Is there a persuasive reason to believe that common stocks are likely to do much better in future years than they have in the last five and one-half decades?
Our answer to this crucial question must be a flat no. Common stocks may do better in the future than in the past, but they are far from certain to do so. We must deal here with two different time elements in investment results. The first covers what is likely to occur over the long-term future—say, the next 25 years. The second applies to what is likely to happen to the investor—both financially and psychologically—over short or intermediate periods, say five years or less. His frame of mind, his hopes and apprehensions, his satisfaction or discontent with what he has done, above all his decisions what to do next, are all determined not in the retrospect of a lifetime of investment but rather by his experience from year to year.
On this point we can be categorical. There is no close time connection between inflationary (or deflationary) conditions and the movement of common-stock earnings and prices. The obvious example is the recent period, 1966–1970. The rise in the cost of living was 22%, the largest in a five-year period since 1946–1950. But both stock earnings and stock prices as a whole have declined since 1965. There are similar contradictions in both directions in the record of previous five-year periods.
Inflation and Corporate Earnings
Another and highly important approach to the subject is by a study of the earnings rate on capital shown by American business. This has fluctuated, of course, with the general rate of economic activity, but it has shown no general tendency to advance with wholesale prices or the cost of living. Actually this rate has fallen rather markedly in the past twenty years