The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [69]
The key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity. While small companies may also be undervalued for similar reasons, and in many cases may later increase their earnings and share price, they entail the risk of a definitive loss of profitability and also of protracted neglect by the market in spite of better earnings. The large companies thus have a double advantage over the others. First, they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base. Second, the market is likely to respond with reasonable speed to any improvement shown.
A remarkable demonstration of the soundness of this thesis is found in studies of the price behavior of the unpopular issues in the Dow Jones Industrial Average. In these it was assumed that an investment was made each year in either the six or the ten issues in the DJIA which were selling at the lowest multipliers of their current or previous year’s earnings. These could be called the “cheapest” stocks in the list, and their cheapness was evidently the reflection of relative unpopularity with investors or traders. It was assumed further that these purchases were sold out at the end of holding periods ranging from one to five years. The results of these investments were then compared with the results shown in either the DJIA as a whole or in the highest multiplier (i.e., the most popular) group.
The detailed material we have available covers the results of annual purchases assumed in each of the past 53 years.5 In the early period, 1917–1933, this approach proved unprofitable. But since 1933 the method has shown highly successful results. In 34 tests made by Drexel & Company (now Drexel Firestone)* of one-year holding—from 1937 through 1969—the cheap stocks did definitely worse than the DJIA in only three instances; the results were about the same in six cases; and the cheap stocks clearly outperformed the average in 25 years. The consistently better performance of the low-multiplier stocks is shown (Table 7-2) by the average results for successive five-year periods, when compared with those of the DJIA and of the ten high-multipliers.
TABLE 7-2 Average Annual Percentage Gain or Loss on Test Issues, 1937–1969
The Drexel computation shows further that an original investment of $10,000 made in the low-multiplier issues in 1936, and switched each year in accordance with the principle, would have grown to $66,900 by 1962. The same operations in high-multiplier stocks would have ended with a value of only $25,300; while an operation in all thirty stocks would have increased the original fund to $44,000.†
The concept of buying “unpopular large companies” and its execution on a group basis, as described above, are both quite simple. But in considering individual companies a special factor of opposite import must sometimes to be taken into account. Companies that are inherently speculative because of widely varying earnings tend to sell both at a relatively high price and at a relatively low multiplier in their good years, and conversely at low prices and high multipliers in their bad years. These relationships are illustrated in Table 7-3, covering fluctuations of Chrysler Corp. common. In these cases the market has sufficient skepticism as to the continuation of the unusually high profits to value them conservatively, and conversely when earnings are low or nonexistent. (Note that, by the arithmetic, if a company earns “next to nothing” its shares must sell at a high multiplier of these minuscule profits.)
As it happens Chrysler has been quite exceptional in the DJIA list of leading companies, and