¹ Coauthored with David Dodd and first published in 1934.

² The Grossbaums changed their name to Graham during World War I, when German-sounding names were regarded with suspicion.

³ Graham-Newman Corp. was an open-end mutual fund (see Chapter 9) that Graham ran in partnership with Jerome Newman, a skilled investor in his own right. For much of its history, the fund was closed to new investors. I am grateful to Walter Schloss for providing data essential to estimating Graham-Newman’s returns. The 20% annual average return that Graham cites in his Postscript (p. 532) appears not to take management fees into account.

⁴ The text reproduced here is the Fourth Revised Edition, updated by Graham in 1971–1972 and initially published in 1973.

^* The two partners Graham coyly refers to are Jerome Newman and Benjamin Graham himself.

^† Graham is describing the Government Employees Insurance Co., or GEICO, in which he and Newman purchased a 50% interest in 1948, right around the time he finished writing The Intelligent Investor. The $712,500 that Graham and Newman put into GEICO was roughly 25% of their fund’s assets at the time. Graham was a member of GEICO’s board of directors for many years. In a nice twist of fate, Graham’s greatest student, Warren Buffett, made an immense bet of his own on GEICO in 1976, by which time the big insurer had slid to the brink of bankruptcy. It turned out to be one of Buffett’s best investments as well.

^* Because of a legal technicality, Graham and Newman were directed by the U.S. Securities & Exchange Commission to “spin off,” or distribute, Graham-Newman Corp.’s GEICO stake to the fund’s shareholders. An investor who owned 100 shares of Graham-Newman at the beginning of 1948 (worth $11,413) and who then held on to the GEICO distribution would have had $1.66 million by 1972. GEICO’s “later-organized affiliates” included Government Employees Financial Corp. and Criterion Insurance Co.

¹ Graham’s anecdote is also a powerful reminder that those of us who are not as brilliant as he was must always diversify to protect against the risk of putting too much money into a single investment. When Graham himself admits that GEICO was a “lucky break,” that’s a signal that most of us cannot count on being able to find such a great opportunity. To keep investing from decaying into gambling, you must diversify.

² Dante Alighieri, The Inferno, Canto XXVI, lines 112–125, translated by Jason Zweig.

^* The survey Graham cites was conducted for the Fed by the University of Michigan and was published in the Federal Reserve Bulletin, July, 1948. People were asked, “Suppose a man decides not to spend his money. He can either put it in a bank or in bonds or he can invest it. What do you think would be the wisest thing for him to do with the money nowadays—put it in the bank, buy savings bonds with it, invest it in real estate, or buy common stock with it?” Only 4% thought common stock would offer a “satisfactory” return; 26% considered it “not safe” or a “gamble.” From 1949 through 1958, the stock market earned one of its highest 10-year returns in history, averaging 18.7% annually. In a fascinating echo of that early Fed survey, a poll conducted by BusinessWeek at year-end 2002 found that only 24% of investors were willing to invest more in their mutual funds or stock portfolios, down from 47% just three years earlier.

^* Speculation is beneficial on two levels: First, without speculation, untested new companies (like Amazon.com or, in earlier times, the Edison Electric Light Co.) would never be able to raise the necessary capital for expansion. The alluring, long-shot chance of a huge gain is the grease that lubricates the machinery of innovation. Secondly, risk is exchanged (but never eliminated) every time a stock is bought or sold. The buyer purchases the primary risk that this stock may go down. Meanwhile, the seller still retains a residual risk—the chance that the stock he just sold may go up!

^† A margin account enables you to buy stocks using money you borrow from the brokerage firm. By investing with borrowed money, you make more when your stocks go up—but you can be wiped out when they go down. The collateral for the loan is the value of the investments in your account—so you must put up more money if that value falls below the amount you borrowed. For more information about margin accounts, see www.sec.gov/investor/ pubs/margin.htm, www.sia.com/publications/pdf/MarginsA.pdf, and www. nyse.com/pdfs/2001_factbook_09.pdf.

^* Read Graham’s sentence again, and note what this greatest of investing experts is saying: The future of security prices is never predictable. And as you read ahead in the book, notice how everything else Graham tells you is designed to help you grapple with that truth. Since you cannot predict the behavior of the markets, you must learn how to predict and control your own behavior.

^* How well did Graham’s forecast pan out? At first blush, it seems, very well: From the beginning of 1972 through the end of 1981, stocks earned an annual average return of 6.5%. (Graham did not specify the time period for his forecast, but it’s plausible to assume that he was thinking of a 10-year time horizon.) However, inflation raged at 8.6% annually over this period, eating up the entire gain that stocks produced. In this section of his chapter, Graham is summarizing what is known as the “Gordon equation,” which essentially holds that the stock market’s future return is the sum of the current dividend yield plus expected earnings growth. With a dividend yield of just under 2% in early 2003, and long-term earnings growth of around 2%, plus inflation at a bit over 2%, a future average annual return of roughly 6% is plausible. (See the commentary on Chapter 3.)

^* Since 1997, when Treasury Inflation-Protected Securities (or TIPS) were introduced, stocks have no longer been the automatically superior choice for investors who expect inflation to increase. TIPS, unlike other bonds, rise in value if the Consumer Price Index goes up, effectively immunizing the investor against losing money after inflation. Stocks carry no such guarantee and, in fact, are a relatively poor hedge against high rates of inflation. (For more details, see the commentary to Chapter 2.)

^* Today, the most widely available alternatives to the Dow Jones Industrial Average are the Standard & Poor’s 500-stock index (the “S & P”) and the Wilshire 5000 index. The S & P focuses on 500 large, well-known companies that make up roughly 70% of the total value of the U.S. equity market. The Wilshire 5000 follows the returns of nearly every significant, publicly traded stock in America, roughly 6,700 in all; but, since the largest companies account for most of the total value of the index, the return of the Wilshire 5000 is usually quite similar to that of the S & P 500. Several low-cost mutual funds enable investors to hold the stocks in these indexes as a single, convenient portfolio. (See Chapter 9.)

^* See pp. 363–366 and pp. 376–380.

^† For greater detail, see Chapter 6.

^* For more advice on “well-established investment funds,” see Chapter 9. “Professional administration” by “a recognized investment-counsel firm” is discussed in Chapter 10. “Dollar-cost averaging” is explained in Chapter 5.

^* See Chapter 8.

^* In “selling short” (or “shorting”) a stock, you make a bet that its share price will go down, not up. Shorting is a three-step process: First, you borrow shares from someone who owns them; then you immediately sell the borrowed shares; finally, you replace them with shares you buy later. If the stock drops, you will be able to buy your replacement shares at a lower price. The difference between the price at which you sold your borrowed shares and the price you paid for the replacement shares is your gross profit (reduced by dividend or interest charges, along with brokerage costs). However, if the stock goes up in price instead of down, your potential loss is unlimited—making short sales unacceptably speculative for most individual investors.

^† In the late 1980s, as hostile corporate takeovers and leveraged buyouts multiplied, Wall Street set up institutional arbitrage desks to profit from any errors in pricing these complex deals. They became so good at it that the easy profits disappeared and many of these desks have been closed down. Although Graham does discuss it again (see pp. 174–175), this sort of trading is no longer feasible or appropriate for most people, since only multimillion-dollar trades are large enough to generate worthwhile profits. Wealthy individuals and institutions can utilize this strategy through hedge funds that specialize in merger or “event” arbitrage.

^* The Rothschild family, led by Nathan Mayer Rothschild, was the dominant power in European investment banking and brokerage in the nineteenth century. For a brilliant history, see Niall Ferguson, The House of Rothschild: Money’s Prophets, 1798–1848 (Viking, 1998).

¹ Graham goes even further, fleshing out each of the key terms in his definition: “thorough analysis” means “the study of the facts in the light of established standards of safety and value” while “safety of principal” signifies “protection against loss under all normal or reasonably likely conditions or variations” and “adequate” (or “satisfactory”) return refers to “any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.” (Security Analysis, 1934 ed., pp. 55–56).

² Security Analysis, 1934 ed., p. 310.

³ As Graham advised in an interview, “Ask yourself: If there was no market for these shares, would I be willing to have an investment in this company on these terms?” (Forbes, January 1, 1972, p. 90.)

⁴ Source: Steve Galbraith, Sanford C. Bernstein & Co. research report, January 10, 2000. The stocks in this table had an average return of 1196.4% in 1999. They lost an average of 79.1% in 2000, 35.5% in 2001, and 44.5% in 2002—destroying all the gains of 1999, and then some.

⁵ Instead of stargazing, Streisand should have been channeling Graham. The intelligent investor never dumps a stock purely because its share price has fallen; she always asks first whether the value of the company’s underlying businesses has changed.

⁶ Just 12 months later, Juno’s shares had shriveled to $1.093.

⁷ A ticker symbol is an abbreviation, usually one to four letters long, of a company’s name used as shorthand to identify a stock for trading purposes.

⁸ This was not an isolated incident; on at least three other occasions in the late 1990s, day traders sent the wrong stock soaring when they mistook its ticker symbol for that of a newly minted Internet company.

⁹ In 2000 and 2001, Amazon.com and Qualcomm lost a cumulative total of 85.8% and 71.3% of their value, respectively.

¹⁰ Schwert discusses these findings in a brilliant research paper, “Anomalies and Market Efficiency,” available at http://schwert.ssb.rochester.edu/papers.htm.

¹¹ See Plexus Group Commentary 54, “The Official Icebergs of Transaction Costs,” January, 1998, at www.plexusgroup.com/fs_research.html.

¹² James O’Shaughnessy, What Works on Wall Street (McGraw-Hill, 1996), pp. xvi, 273–295.

¹³ In a remarkable irony, the surviving two O’Shaughnessy funds (now known as the Hennessy funds) began performing quite well just as O’Shaughnessy announced that he was turning over the management to another company. The funds’ shareholders were furious. In a chat room at www.morningstar.com, one fumed: “I guess ‘long term’ for O’S is 3 years…. I feel your pain. I, too, had faith in O’S’s method…. I had told severalfriends and relatives about this fund, and now am glad they didn’t act on my advice.”

¹⁴ See Jason Zweig, “False Profits,” Money, August, 1999, pp. 55–57. A thorough discussion of The Foolish Four can also be found at www.investor home.com/fool.htm.

^* The list of sources for investment advice remains as “miscellaneous” as it was when Graham wrote. A survey of investors conducted in late 2002 for the Securities Industry Association, a Wall Street trade group, found that 17% of investors depended most heavily for investment advice on a spouse or friend; 2% on a banker; 16% on a broker; 10% on financial periodicals; and 24% on a financial planner. The only difference from Graham’s day is that 8% of investors now rely heavily on the Internet and 3% on financial television. (See www.sia.com.)

^* The character of investment counseling firms and trust banks has not changed, but today they generally do not offer their services to investors with less than $1 million in financial assets; in some cases, $5 million or more is required. Today thousands of independent financial-planning firms perform very similar functions, although (as analyst Robert Veres puts it) the mutual fund has replaced blue-chip stocks as the investment of choice and diversification has replaced “quality” as the standard of safety.

^* Overall, Graham was as tough and cynical an observer as Wall Street has ever seen. In this rare case, however, he was not nearly cynical enough. Wall Street may have higher ethical standards than some businesses (smuggling, prostitution, Congressional lobbying, and journalism come to mind) but the investment world nevertheless has enough liars, cheaters, and thieves to keep Satan’s check-in clerks frantically busy for decades to come.

^† The thousands of people who bought stocks in the late 1990s in the belief that Wall Street analysts were providing unbiased and valuable advice have learned, in a painful way, how right Graham is on this point.

^† ‡ Interestingly, this stinging criticism, which in his day Graham was directing at full-service brokers, ended up applying to discount Internet brokers in the late 1990s. These firms spent millions of dollars on flashy advertising that goaded their customers into trading more and trading faster. Most of those customers ended up picking their own pockets, instead of paying someone else to do it for them—and the cheap commissions on that kind of transaction are a poor consolation for the result. More traditional brokerage firms, meanwhile, began emphasizing financial planning and “integrated asset management,” instead of compensating their brokers only on the basis of how many commissions they could generate.

^* This remains true, although many of Wall Street’s best analysts hold the title of chartered financial analyst. The CFA certification is awarded by the Association of Investment Management & Research (formerly the Financial Analysts Federation) only after the candidate has completed years of rigorous study and passed a series of difficult exams. More than 50,000 analysts worldwide have been certified as CFAs. Sadly, a recent survey by Professor Stanley Block found that most CFAs ignore Graham’s teachings: Growth potential ranks higher than quality of earnings, risks, and dividend policy in determining P/E ratios, while far more analysts base their buy ratings on recent price than on the long-term outlook for the company. See Stanley Block, “A Study of Financial Analysts: Practice and Theory,” Financial Analysts Journal, July/August, 1999, at www.aimrpubs.org. As Graham was fond of saying, his own books have been read by—and ignored by—more people than any other books in finance.

^* It is highly unusual today for a security analyst to allow mere commoners to contact him directly. For the most part, only the nobility of institutional investors are permitted to approach the throne of the almighty Wall Street analyst. An individual investor might, perhaps, have some luck calling analysts who work at “regional” brokerage firms headquartered outside of New York City. The investor relations area at the websites of most publicly traded companies will provide a list of analysts who follow the stock. Websites like www.zacks.com and www.multex.com offer access to analysts’ research reports—but the intelligent investor should remember that most analysts do not analyze businesses. Instead, they engage in guesswork about future stock prices.

^† Benjamin Graham was the prime force behind the establishment of the CFA program, which he advocated for nearly two decades before it became a reality.

^* The two firms Graham had in mind were probably Du Pont, Glore, Forgan & Co. and Goodbody & Co. Du Pont (founded by the heirs to the chemical fortune) was saved from insolvency in 1970 only after Texas entrepreneur H. Ross Perot lent more than $50 million to the firm; Goodbody, the fifth-largest brokerage firm in the United States, would have failed in late 1970 had Merrill Lynch not acquired it. Hayden, Stone & Co. would also have gone under if it had not been acquired. In 1970, no fewer than seven brokerage firms went bust. The farcical story of Wall Street’s frenzied over-expansion in the late 1960s is beautifully told in John Brooks’s The Go-Go Years (John Wiley & Sons, New York, 1999).

^* Nearly all brokerage transactions are now conducted electronically, and securities are no longer physically “delivered.” Thanks to the establishment of the Securities Investor Protection Corporation, or SIPC, in 1970, investors are generally assured of recovering their full account values if their brokerage firm becomes insolvent. SIPC is a government-mandated consortium of brokers; all the members agree to pool their assets to cover losses incurred by the customers of any firm that becomes insolvent. SIPC’s protection eliminates the need for investors to make payment and take delivery through a bank intermediary, as Graham urges.

^* Those who heeded Graham’s advice would not have been suckered into buying Internet IPOs in 1999 and 2000.

^† This traditional role of bankers has for the most part been supplanted by accountants, lawyers, or financial planners.

¹ For a particularly thoughtful discussion of these issues, see Walter Updegrave, “Advice on Advice,” Money, January, 2003, pp. 53–55.

² If you’re unable to get a referral from someone you trust, you may be able to find a fee-only financial planner through www.napfa.org (or www.feeonly. org), whose members are generally held to high standards of service and integrity.

³ By itself, a customer complaint is not enough to disqualify an adviser from your consideration; but a persistent pattern of complaints is. And a disciplinary action by state or Federal regulators usually tells you to find another adviser. Another source for checking a broker’s record is http://pdpi.nasdr. com/PDPI.

⁴ Robert Veres, editor and publisher of the Inside Information newsletter, generously shared these responses for this book. Other checklists of questions can be found at www.cfp-board.org and www.napfa.org.

⁵ Credentials like the CFA, CFP, or CPA tell you that the adviser has taken and passed a rigorous course of study. (Most of the other “alphabet soup” of credentials brandished by financial planners, including the “CFM” or the “CMFC,” signify very little.) More important, by contacting the organization that awards the credential, you can verify his record and check that he has not been disciplined for violations of rules or ethics.

⁶ If you have less than $100,000 to invest, you may not be able to find a financial adviser who will take your account. In that case, buy a diversified basket of low-cost index funds, follow the behavioral advice throughout this book, and your portfolio should eventually grow to the level at which you can afford an adviser.

^* The National Federation of Financial Analysts is now the Association for Investment Management and Research; its “quarterly” research publication, the Financial Analysts Journal, now appears every other month.

^* The higher the growth rate you project, and the longer the future period over which you project it, the more sensitive your forecast becomes to the slightest error. If, for instance, you estimate that a company earning $1 per share can raise that profit by 15% a year for the next 15 years, its earnings would end up at $8.14. If the market values the company at 35 times earnings, the stock would finish the period at roughly $285. But if earnings grow at 14% instead of 15%, the company would earn $7.14 at the end of the period—and, in the shock of that shortfall, investors would no longer be willing to pay 35 times earnings. At, say, 20 times earnings, the stock would end up around $140 per share, or more than 50% less. Because advanced mathematics gives the appearance of precision to the inherently iffy process of foreseeing the future, investors must be highly skeptical of anyone who claims to hold any complex computational key to basic financial problems. As Graham put it: “In 44 years of Wall Street experience and study, I have never seen dependable calculations made about common-stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.” (See p. 570.)

^* In 1972, an investor in corporate bonds had little choice but to assemble his or her own portfolio. Today, roughly 500 mutual funds invest in corporate bonds, creating a convenient, well-diversified bundle of securities. Since it is not feasible to build a diversified bond portfolio on your own unless you have at least $100,000, the typical intelligent investor will be best off simply buying a low-cost bond fund and leaving the painstaking labor of credit research to its managers. For more on bond funds, see the commentary on Chapter 4.

^* By “junior stock issues” Graham means shares of common stock. Preferred stock is considered “senior” to common stock because the company must pay all dividends on the preferred before paying any dividends on the common.

^* After investors lost billions of dollars on the shares of recklessly assembled utility companies in 1929–1932, Congress authorized the SEC to regulate the issuance of utility stocks under the Public Utility Holding Company Act of 1935.

^* In more recent years, most mutual funds have almost robotically mimicked the Standard & Poor’s 500-stock index, lest any different holdings cause their returns to deviate from that of the index. In a countertrend, some fund companies have launched what they call “focused” portfolios, which own 25 to 50 stocks that the managers declare to be their “best ideas.” That leaves investors wondering whether the other funds run by the same managers contain their worst ideas. Considering that most of the “best idea” funds do not markedly outperform the averages, investors are also entitled to wonder whether the managers’ ideas are even worth having in the first place. For indisputably skilled investors like Warren Buffett, wide diversification would be foolish, since it would water down the concentrated force of a few great ideas. But for the typical fund manager or individual investor, not diversifying is foolish, since it is so difficult to select a limited number of stocks that will include most winners and exclude most losers. As you own more stocks, the damage any single loser can cause will decline, and the odds of owning all the big winners will rise. The ideal choice for most investors is a total stock market index fund, a low-cost way to hold every stock worth owning.

^* Graham’s point about chemical and oil companies in the 1960s applies to nearly every industry in nearly every time period. Wall Street’s consensus view of the future for any given sector is usually either too optimistic or too pessimistic. Worse, the consensus is at its most cheery just when the stocks are most overpriced—and gloomiest just when they are cheapest. The most recent example, of course, is technology and telecommunications stocks, which hit record highs when their future seemed brightest in 1999 and early 2000, and then crashed all the way through 2002. History proves that Wall Street’s “expert” forecasters are equally inept at predicting the performance of 1) the market as a whole, 2) industry sectors, and 3) specific stocks. As Graham points out, the odds that individual investors can do any better are not good. The intelligent investor excels by making decisions that are not dependent on the accuracy of anybody’s forecasts, including his or her own. (See Chapter 8.)

^* This figure, now known as the “dividend payout ratio,” has dropped considerably since Graham’s day as American tax law discouraged investors from seeking, and corporations from paying, dividends. As of year-end 2002, the payout ratio stood at 34.1% for the S & P 500-stock index and, as recently as April 2000, it hit an all-time low of just 25.3%. (See www.barra.com/ research/fundamentals.asp.) We discuss dividend policy more thoroughly in the commentary on Chapter 19.

^* Why is this? By “the rule of 72,” at 10% interest a given amount of money doubles in just over seven years, while at 7% it doubles in just over 10 years. When interest rates are high, the amount of money you need to set aside today to reach a given value in the future is lower—since those high interest rates will enable it to grow at a more rapid rate. Thus a rise in interest rates today makes a future stream of earnings or dividends less valuable—since the alternative of investing in bonds has become relatively more attractive.

^* These industry groups, ideally, would not be overly dependent on such unforeseeable factors as fluctuating interest rates or the future direction of prices for raw materials like oil or metals. Possibilities might be industries like gaming, cosmetics, alcoholic beverages, nursing homes, or waste management.

¹ Because so few of today’s individual investors buy—or should buy—individual bonds, we will limit this discussion to stock analysis. For more on bond funds, see the commentary on Chapter 4.

² You should also get at least one year’s worth of quarterly reports (on Form 10-Q). By definition, we are assuming that you are an “enterprising” investor willing to devote a considerable amount of effort to your portfolio. If the steps in this chapter sound like too much work to you, then you are not temperamentally well suited to picking your own stocks. You cannot reliably obtain the results you imagine unless you put in the kind of effort we describe.

³ You can usually find details on acquisitions in the “Management’s Discussion and Analysis” section of Form 10-K; cross-check it against the footnotes to the financial statements. For more on “serial acquirers,” see the commentary on Chapter 12.

⁴ To determine whether a company is an OPM addict, read the “Statement of Cash Flows” in the financial statements. This page breaks down the company’s cash inflows and outflows into “operating activities,” “investing activities,” and “financing activities.” If cash from operating activities is consistently negative, while cash from financing activities is consistently positive, the company has a habit of craving more cash than its own businesses can produce—and you should not join the “enablers” of that habitual abuse. For more on Global Crossing, see the commentary on Chapter 12. For more on WorldCom, see the sidebar in the commentary on Chapter 6.

⁵ For more insight into “moats,” see the classic book Competitive Strategy by Harvard Business School professor Michael E. Porter (Free Press, New York, 1998).

⁶ See Cyrus A. Ramezani, Luc Soenen, and Alan Jung, “Growth, Corporate Profitability, and Value Creation,” Financial Analysts Journal, November/ December, 2002, pp. 56–67; also available at http://cyrus.cob.calpoly.edu/.

⁷ Jason Zweig is an employee of AOL Time Warner and holds options in the company. For more about how stock options work, see the commentary on Chapter 19, p. 507.

⁸ See note 19 in the commentary on Chapter 19, p. 508.

⁹ For more on these issues, see the commentary on Chapter 12 and the superb essay by Joseph Fuller and Michael C. Jensen, “Just Say No to Wall Street,” at http://papers.ssrn.com.

¹⁰ Stock splits are discussed further in the commentary on Chapter 13.

^* “Dilution” is one of many words that describe stocks in the language of fluid dynamics. A stock with high trading volume is said to be “liquid.” When a company goes public in an IPO, it “floats” its shares. And, in earlier days, a company that drastically diluted its shares (with large amounts of convertible debt or multiple offerings of common stock) was said to have “watered” its stock. This term is believed to have originated with the legendary market manipulator Daniel Drew (1797–1879), who began as a livestock trader. He would drive his cattle south toward Manhattan, force-feeding them salt along the way. When they got to the Harlem River, they would guzzle huge volumes of water to slake their thirst. Drew would then bring them to market, where the water they had just drunk would increase their weight. That enabled him to get a much higher price, since cattle on the hoof is sold by the pound. Drew later watered the stock of the Erie Railroad by massively issuing new shares without warning.

^† Graham is referring to the precise craftsmanship of the immigrant Italian stone carvers who ornamented the otherwise plain facades of buildings throughout New York in the early 1900s. Accountants, likewise, can transform simple financial facts into intricate and even incomprehensible patterns.

^* The king probably took his inspiration from a once-famous essay by the English writer William Hazlitt, who mused about a sundial near Venice that bore the words Horas non numero nisi serenas, or “I count only the hours that are serene.” Companies that chronically exclude bad news from their financial results on the pretext that negative events are “extraordinary” or “nonrecurring” are taking a page from Hazlitt, who urged his readers “to take no note of time but by its benefits, to watch only for the smiles and neglect the frowns of fate, to compose our lives of bright and gentle moments, turning away to the sunny side of things, and letting the rest slip from our imaginations, unheeded or forgotten!” (William Hazlitt, “On a Sun-Dial,” ca.1827.) Unfortunately, investors must always count the sunny and dark hours alike.

^* The company to which Graham refers so coyly appears to be American Machine & Foundry (or AMF Corp.), one of the most jumbled conglomerates of the late 1960s. It was a predecessor of today’s AMF Bowling Worldwide, which operates bowling alleys and manufactures bowling equipment.

^* Nowadays, investors need to be aware of several other “accounting factors” that can distort reported earnings. One is “pro forma” or “as if” financial statements, which report a company’s earnings as if Generally Accepted Accounting Principles (GAAP) did not apply. Another is the dilutive effect of issuing millions of stock options for executive compensation, then buying back millions of shares to keep those options from reducing the value of the common stock. A third is unrealistic assumptions of return on the company’s pension funds, which can artificially inflate earnings in good years and depress them in bad. Another is “Special Purpose Entities,” oraffiliated firms or partnerships that buy risky assets or liabilities of the company and thus “remove” those financial risks from the company’s balance sheet. Another element of distortion is the treatment of marketing or other “soft” costs as assets of the company, rather than as normal expenses of doing business. We will briefly examine such practices in the commentary that accompanies this chapter.

^* Northwest Industries was the holding company for, among other businesses, the Chicago and Northwestern Railway Co. and Union Underwear (the maker of both BVD and Fruit of the Loom briefs). It was taken over in 1985 by overindebted financier William Farley, who ran the company into the ground. Fruit of the Loom was bought in a bankruptcy proceeding by Warren Buffett’s Berkshire Hathaway Inc. in early 2002.

^* Graham is referring to the provision of Federal tax law that allows corporations to “carry forward” their net operating losses. As the tax code now stands, these losses can be carried forward for up to 20 years, reducing the company’s tax liability for the entire period (and thus raising its earnings after tax). Therefore, investors should consider whether recent severe losses could actually improve the company’s net earnings in the future.

^† Investors should keep these words at hand and remind themselves of them frequently: “Stock valuations are really dependable only in exceptional cases.” While the prices of most stocks are approximately right most of the time, the price of a stock and the value of its business are almost never identical. The market’s judgment on price is often unreliable. Unfortunately, the margin of the market’s pricing errors is often not wide enough to justify the expense of trading on them. The intelligent investor must carefully evaluate the costs of trading and taxes before attempting to take advantage of any price discrepancy—and should never count on being able to sell for the exact price currently quoted in the market.

^* “Mean figure” refers to the simple, or arithmetic, average that Graham describes in the preceding sentence.

^aThree-fifths of special charges of 82 cents in 1970 deducted here.

^* Graham appears to be using “earnings on capital funds” in the traditional sense of return on book value—essentially, net income divided by the company’s tangible net assets.

^* See pp. 299–301.

^† Recent history—and a mountain of financial research—have shown that the market is unkindest to rapidly growing companies that suddenly report a fall in earnings. More moderate and stable growers, as ALCOA was in Graham’s day or Anheuser-Busch and Colgate-Palmolive are in our time, tend to suffer somewhat milder stock declines if they report disappointing earnings. Great expectations lead to great disappointment if they are not met; a failure to meet moderate expectations leads to a much milder reaction. Thus, one of the biggest risks in owning growth stocks is not that their growth will stop, but merely that it will slow down. And in the long run, that is not merely a risk, but a virtual certainty.

¹ For more on how stock options can enrich corporate managers—but not necessarily outside shareholders—see the commentary on Chapter 19.

² All the above examples are taken directly from press releases issued by the companies themselves. For a brilliant satire on what daily life would be like if we all got to justify our behavior the same way companies adjust their reported earnings, see “My Pro Forma Life,” by Rob Walker, at http://slate. msn.com/?id=2063953. (“…a recent post-workout lunch of a 22-ounce, bone-in rib steak at Smith & Wollensky and three shots of bourbon is treated here as a nonrecurring expense. I’ll never do that again!”)

³ In 2002, Qwest was one of 330 publicly-traded companies to restate past financial statements, an all-time record, according to Huron Consulting Group. All information on Qwest is taken from its financial filings with the U.S. Securities and Exchange Commission (annual report, Form 8K, and Form 10-K) found in the EDGAR database at www.sec.gov. No hindsight was required to detect the “change in accounting principle,” which Qwest fully disclosed at the time. How did Qwest’s shares do over this period? At year-end 2000, the stock had been at $41 per share, a total market value of $67.9 billion. By early 2003, Qwest was around $4, valuing the entire company at less than $7 billion—a 90% loss. The drop in share price is not the only cost associated with bogus earnings; a recent study found that a sample of 27 firms accused of accounting fraud by the SEC had overpaid $320 million in Federal income tax. Although much of that money will eventually be refunded by the IRS, most shareholders are unlikely to stick around to benefit from the refunds. (See Merle Erickson, Michelle Hanlon, and Edward Maydew, “How Much Will Firms Pay for Earnings that Do Not Exist?” at http:// papers.ssrn.com.)

⁴ Global Crossing formerly treated much of its construction costs as an expense to be charged against the revenue generated from the sale or lease of usage rights on its network. Customers generally paid for their rights up front, although some could pay in installments over periods of up to four years. But Global Crossing did not book most of the revenues up front, instead deferring them over the lifetime of the lease. Now, however, because the networks had an estimated usable life of up to 25 years, Global Crossing began treating them as depreciable, long-lived capital assets. While this treatment conforms with Generally Accepted Accounting Principles, it is unclear why Global Crossing did not use it before October 1, 1999, or what exactly prompted the change. As of March 2001, Global Crossing had a total stock valuation of $12.6 billion; the company filed for bankruptcy on January 28, 2002, rendering its common stock essentially worthless.

⁵ I am grateful to Howard Schilit and Mark Hamel of the Center for Financial Research and Analysis for providing this example.

⁶ Returns are approximated by dividing the total net value of plan assets at the beginning of the year by “actual return on plan assets.”

⁷ Do not be put off by the stupefyingly boring verbiage of accounting footnotes. They are designed expressly to deter normal people from actually reading them—which is why you must persevere. A footnote to the 1996 annual report of Informix Corp., for instance, disclosed that “The Company generally recognizes license revenue from sales of software licenses upon delivery of the software product to a customer. However, for certain computer hardware manufacturers and end-user licensees with amounts payable within twelve months, the Company will recognize revenue at the time the customer makes a contractual commitment for a minimum nonrefundable license fee, if such computer hardware manufacturers and end-user licensees meet certain criteria established by the Company.” In plain English, Informix was saying that it would credit itself for revenues on products even if they had not yet been resold to “end-users” (the actual customers for Informix’s software). Amid allegations by the U.S. Securities and Exchange Commission that Informix had committed accounting fraud, the company later restated its revenues, wiping away $244 million in such “sales.” This case is a keen reminder of the importance of reading the fine print with a skeptical eye. I am indebted to Martin Fridson for suggesting this example.

⁸ Martin Fridson and Fernando Alvarez, Financial Statement Analysis: A Practitioner’s Guide (John Wiley & Sons, New York, 2002); Charles W. Mulford and Eugene E. Comiskey, The Financial Numbers Game: Detecting Creative Accounting Practices (John Wiley & Sons, New York, 2002); Howard Schilit, Financial Shenanigans (McGraw-Hill, New York, 2002). Benjamin Graham’s own book, The Interpretation of Financial Statements (HarperBusiness, New York, 1998 reprint of 1937 edition), remains an excellent brief introduction to the basic principles of earnings and expenses, assets and liabilities.

^* Of Graham’s four examples, only Emerson Electric still exists in the same form. ELTRA Corp. is no longer an independent company; it merged with Bunker Ramo Corp. in the 1970s, putting it in the business of supplying stock quotes to brokerage firms across an early network of computers. What remains of ELTRA’s operations is now part of Honeywell Corp. The firm formerly known as Emery Air Freight is now a division of CNF Inc. Emhart Corp. was acquired by Black & Decker Corp. in 1989.

^* This measure is captured in the line “Net per share/book value” in Table 13-2, which measures the companies’ net income as a percentage of their tangible book value.

^* In each case, Graham is referring to Section C of Table 13-2 and dividing the high price during the 1936–1968 period by the low price. For example, Emery’s high price of 66 divided by its low price of 1/8 equals 528, or a ratio of 528 to 1 between the high and low.

^* At the end of 1970, Emerson’s $1.6 billion in market value truly was “enormous,” given average stock sizes at the time. At year-end 2002, Emerson’s common stock had a total market value of approximately $21 billion.

^* Graham was right. Of the “Nifty Fifty” stocks that were most fashionable and highly valued in 1972, Emery fared among the worst. The March 1, 1982, issue of Forbes reported that since 1972 Emery had lost 72.8% of its value after inflation. By late 1974, according to the investment researchers at the Leuthold Group in Minneapolis, Emery’s stock had already fallen 58% and its price/earnings ratio had plummeted from 64 times to just 15. The “overenthusiasm” Graham had warned against was eviscerated in short order. Can the passage of time make up for this kind of excess? Not always: Leuthold calculated that $1000 invested in Emery in 1972 would be worth only $839 as of 1999. It’s likely that the people who overpaid for Internet stocks in the late 1990s will not break even for decades—if ever (see the commentary on Chapter 20).

^* Graham’s point is that, based on their prices at the time, an investor could buy shares in these two companies for little more than their book value, as shown in the third line of Section B in Table 13-2.

¹ As we will see in Chapter 19, this rationale often means, in practice, “to provide funds for the continued growth of the company’s top managers’ wealth.”

² Appearing on CNBC on December 30, 1999, EMC’s chief executive, Michael Ruettgers, was asked by host Ron Insana whether “2000 and beyond” would be as good as the 1990s had been. “It actually looks like it’s accelerating,” boasted Ruettgers. When Insana asked if EMC’s stock was overvalued, Ruettgers answered: “I think when you look at the opportunity we have in front of us, it’s almost unlimited…. So while it’s hard to predictwhether these things are overpriced, there’s such a major change taking place that if you could find the winners today—and I certainly think EMC is one of those people—you’ll be well rewarded in the future.”

³ The “Y2K bug” or the “Year 2000 Problem” was the belief that millions of computers worldwide would stop functioning at one second past midnight on the morning of January 1, 2000, because programmers in the 1960s and 1970s had not thought to allow for the possibility of any date past 12/31/1999 in their operating code. U.S. companies spent billions of dollars in 1999 to ensure that their computers would be “Y2K-compliant.” In the end, at 12:00:01 A.M. on January 1, 2000, everything worked just fine.

⁴ For more on the folly of stock splits, see Jason Zweig, “Splitsville,” Money, March, 2001, pp. 55–56.

⁵ Posting no. 3622, December 7, 1999, at the Exodus Communications message board on the Raging Bull website (http://ragingbull.lycos.com/ mboard/boards.cgi?board=EXDS&read=3622).

⁶ Posting no. 3910, December 15, 1999, at the Exodus Communications message board on the Raging Bull website (http://ragingbull.lycos.com/ mboard/boards.cgi?board=EXDS&read=3910).

⁷ See Graham’s speech, “The New Speculation in Common Stocks,” in the Appendix, p. 563.

^* Graham describes his recommended investment policies in Chapters 4 through 7.

^† As we have discussed in the commentaries on Chapters 5 and 9, today’s defensive investor can achieve this goal simply by buying a low-cost index fund, ideally one that tracks the return of the total U.S. stock market.

^* In early 2003, the yield on 10-year, AA-rated corporate bonds was around 4.6%, suggesting—by Graham’s formula—that a stock portfolio should have an earnings-to-price ratio at least that high. Taking the inverse of that number (by dividing 4.6 into 100), we can derive a “suggested maximum” P/E ratio of 21.7. At the beginning of this paragraph Graham recommends that the “average” stock be priced about 20% below the “maximum” ratio. That suggests that—in general—Graham would consider stocks selling at no more than 17 times their three-year average earnings to be potentially attractive given today’s interest rates and market conditions. As of December 31, 2002, more than 200—or better than 40%—of the stocks in the S & P 500-stock index had three-year average P/E ratios of 17.0 or lower. Updated AA bond yields can be found at www.bondtalk.com.

^* An easy-to-use online stock screener that can sort the stocks in the S & P 500 by most of Graham’s criteria is available at: www.quicken.com/ investments/stocks/search/full.

^† When Graham wrote, only one major mutual fund specializing in utility stocks—Franklin Utilities—was widely available. Today there are more than 30. Graham could not have anticipated the financial havoc wrought by canceled and decommissioned nuclear energy plants; nor did he foresee the consequences of bungled regulation in California. Utility stocks are vastly more volatile than they were in Graham’s day, and most investors should own them only through a well-diversified, low-cost fund like the Dow Jones U.S. Utilities Sector Index Fund (ticker symbol: IDU) or Utilities Select Sector SPDR (XLU). For more information, see: www.ishares.com and www. spdrindex.com/spdr/. (Be sure your broker will not charge commissions to reinvest your dividends.)

^* In a remarkable confirmation of Graham’s point, the dull-sounding Standard & Poor’s Utility Index outperformed the vaunted NASDAQ Composite Index for the 30 years ending December 31, 2002.

^* Today the financial-services industry is made up of even more components, including commercial banks; savings & loan and mortgage-financing companies; consumer-finance firms like credit-card issuers; money managers and trust companies; investment banks and brokerages; insurance companies; and firms engaged in developing or owning real estate, including real-estate investment trusts. Although the sector is much more diversified today, Graham’s caveats about financial soundness apply more than ever.

^* Only a few major rail stocks now remain, including Burlington Northern, CSX, Norfolk Southern, and Union Pacific. The advice in this section is at least as relevant to airline stocks today—with their massive current losses and a half-century of almost incessantly poor results—as it was to railroads in Graham’s day.

^* Graham is summarizing the “efficient markets hypothesis,” or EMH, an academic theory claiming that the price of each stock incorporates all publicly available information about the company. With millions of investors scouring the market every day, it is unlikely that severe mispricings can persist for long. An old joke has two finance professors walking along the sidewalk; when one spots a $20 bill and bends over to pick it up, the other grabs his arm and says, “Don’t bother. If it was really a $20 bill, someone would have taken it already.” While the market is not perfectly efficient, it is pretty close most of the time—so the intelligent investor will stoop to pick up the stock market’s $20 bills only after researching them thoroughly and minimizing the costs of trading and taxes.

^* This is one of the central points of Graham’s book. All investors labor under a cruel irony: We invest in the present, but we invest for the future. And, unfortunately, the future is almost entirely uncertain. Inflation and interest rates are undependable; economic recessions come and go at random; geopolitical upheavals like war, commodity shortages, and terrorism arrive without warning; and the fate of individual companies and their industries often turns out to be the opposite of what most investors expect. Therefore, investing on the basis of projection is a fool’s errand; even the forecasts of the so-called experts are less reliable than the flip of a coin. For most people, investing on the basis of protection—from overpaying for a stock and from overconfidence in the quality of their own judgment—is the best solution. Graham expands on this concept in Chapter 20.

¹ Adjusted for stock splits. To many people, MicroStrategy really did look like the next Microsoft in early 2000; its stock had gained 566.7% in 1999, and its chairman, Michael Saylor, declared that “our future today is better than it was 18 months ago.” The U.S. Securities and Exchange Commission later accused MicroStrategy of accounting fraud, and Saylor paid an $8.3 million fine to settle the charges.

² Jon Birger, “The 30 Best Stocks,” Money, Fall 2002, pp. 88–95.

¹ By the time you read this, much will already have changed since year-end 2002.

² David Dreman, “Bubbles and the Role of Analysts’ Forecasts,” The Journal of Psychology and Financial Markets, vol. 3, no. 1 (2002), pp. 4–14.

³ You can calculate this ratio by hand from a company’s annual reports or obtain the data at websites like www.morningstar.com or http://finance.yahoo.com.

⁴ For more on what to look for, see the commentary on Chapters 11, 12, and 19. If you are not willing to go to the minimal effort of reading the proxy and making basic comparisons of financial health across five years’ worth of annual reports, then you are too defensive to be buying individual stocks at all. Get yourself out of the stock-picking business and into an index fund, where you belong.

^* The Friend-Blume-Crockett research covered January 1960, through June 1968, and compared the performance of more than 100 major mutual funds against the returns on portfolios constructed randomly from more than 500 of the largest stocks listed on the NYSE. The funds in the Friend-Blume-Crockett study did better from 1965 to 1968 than they had in the first half of the measurement period, much as Graham found in his own research (see above, pp. 158 and 229–232). But that improvement did not last. And the thrust of these studies—that mutual funds, on average, underperform the market by a margin roughly equal to their operating expenses and trading costs—has been reconfirmed so many times that anyone who doubts them should found a financial chapter of The Flat Earth Society.

^* As we discuss in the commentary on Chapter 9, there are several other reasons mutual funds have not been able to outperform the market averages, including the low returns on the funds’ cash balances and the high costs of researching and trading stocks. Also, a fund holding 120 companies (a typical number) can trail the S & P 500-stock index if any of the other 380 companies in that benchmark turns out to be a great performer. The fewer stocks a fund owns, the more likely it is to miss “the next Microsoft.”

^* In this section, as he did also on pp. 363–364, Graham is summarizing the Efficient Market Hypothesis. Recent appearances to the contrary, the problem with the stock market today is not that so many financial analysts are idiots, but rather that so many of them are so smart. As more and more smart people search the market for bargains, that very act of searching makes those bargains rarer—and, in a cruel paradox, makes the analysts look as if they lack the intelligence to justify the search. The market’s valuation of a given stock is the result of a vast, continuous, real-time operation of collective intelligence. Most of the time, for most stocks, that collective intelligence gets the valuation approximately right. Only rarely does Graham’s “Mr. Market” (see Chapter 8) send prices wildly out of whack.

^† Graham launched Graham-Newman Corp. in January 1936, and dissolved it when he retired from active money management in 1956; it was the successor to a partnership called the Benjamin Graham Joint Account, which he ran from January 1926, through December 1935.

^* An “unrelated” hedge involves buying a stock or bond issued by one company and short-selling (or betting on a decline in) a security issued by a different company. A “related” hedge involves buying and selling different stocks or bonds issued by the same company. The “new group” of hedge funds described by Graham were widely available around 1968, but later regulation by the U.S. Securities and Exchange Commission restricted access to hedge funds for the general public.

^* In 2003, an intelligent investor following Graham’s train of thought would be searching for opportunities in the technology, telecommunications, and electric-utility industries. History has shown that yesterday’s losers are often tomorrow’s winners.

^* The successor corporation to Industrial National Bank of Rhode Island is FleetBoston Financial Corp. One of its corporate ancestors, the Providence Bank, was founded in 1791.

^* For today’s investor, the cutoff is more likely to be around $1 per share—the level below which many stocks are “delisted,” or declared ineligible for trading on major exchanges. Just monitoring the stock prices of these companies can take a considerable amount of effort, making them impractical for defensive investors. The costs of trading low-priced stocks can be very high. Finally, companies with very low stock prices have a distressing tendency to go out of business. However, a diversified portfolio of dozens of these distressed companies may still appeal to some enterprising investors today.

^* In Graham’s terms, a large amount of goodwill can result from two causes: a corporation can acquire other companies for substantially more than the value of their assets, or its own stock can trade for substantially more than its book value.

^* Technically, the working-capital value of a stock is the current assets per share, minus the current liabilities per share, divided by the number of shares outstanding. Here, however, Graham means “net working-capital value,” or the per-share value of current assets minus total liabilities.

^* Le coeur a ses raisons que la raison ne connaît point. This poetic passage is one of the concluding arguments in the great French theologian’s discussion of what has come to be known as “Pascal’s wager” (see commentary on Chapter 20).

^* As discussed in the commentary on Chapter 7, merger arbitrage is wholly inappropriate for most individual investors.

¹ Patricia Dreyfus, “Investment Analysis in Two Easy Lessons” (interview with Graham), Money, July, 1976, p. 36.

² See the commentary on Chapter 11.

³ There are also many newsletters dedicated to analyzing professional portfolios, but most of them are a waste of time and money for even the most enterprising investor. A shining exception for people who can spare the cash is Outstanding Investor Digest (www.oid.com).

¹ As a brief example of how convertible bonds work in practice, consider the 4.75% convertible subordinated notes issued by DoubleClick Inc. in 1999. They pay $47.50 in interest per year and are each convertible into 24.24 shares of the company’s common stock, a “conversion ratio” of 24.24. As of year-end 2002, DoubleClick’s stock was priced at $5.66 a share, giving each bond a “conversion value” of $137.20 ($5.66 24.24). Yet the bonds traded roughly six times higher, at $881.30—creating a “conversion premium,” or excess over their conversion value, of 542%. If you bought at that price, your “break-even time,” or “payback period,” was very long. (You paid roughly $750 more than the conversion value of the bond, so it will take nearly 16 years of $47.50 interest payments for you to “earn back” that conversion premium.) Since each DoubleClick bond is convertible to just over 24 common shares, the stock will have to rise from $5.66 to more than $36 if conversion is to become a practical option before the bonds mature in 2006. Such a stock return is not impossible, but it borders on the miraculous. The cash yield on this particular bond scarcely seems adequate, given the low probability of conversion.

² Like many of the track records commonly cited on Wall Street, this one is hypothetical. It indicates the return you would have earned in an imaginary index fund that owned all major convertibles. It does not include any management fees or trading costs (which are substantial for convertible securities). In the real world, your returns would have been roughly two percentage points lower.

³ However, most convertible bonds remain junior to other long-term debt and bank loans—so, in a bankruptcy, convertible holders do not have prior claim to the company’s assets. And, while they are not nearly as dicey as high-yield “junk” bonds, many converts are still issued by companies with less than sterling credit ratings. Finally, a large portion of the convertible market is held by hedge funds, whose rapid-fire trading can increase the volatility of prices.

⁴ For more detail, see www.fidelity.com, www.vanguard.com, and www. morningstar.com. The intelligent investor will never buy a convertible bond fund with annual operating expenses exceeding 1.0%.

^* How “shocked” was the financial world by the Penn Central’s bankruptcy, which was filed over the weekend of June 20–21, 1970? The closing trade in Penn Central’s stock on Friday, June 19, was $11.25 per share—hardly a going-out-of-business price. In more recent times, stocks like Enron and WorldCom have also sold at relatively high prices shortly before filing for bankruptcy protection.

^* Penn Central was the product of the merger, announced in 1966, of the Pennsylvania Railroad and the New York Central Railroad.

^† This kind of accounting legerdemain, in which profits are reported as if “unusual” or “extraordinary” or “nonrecurring” charges do not matter, anticipates the reliance on “pro forma” financial statements that became popular in the late 1990s (see the commentary on Chapter 12).

^* A railroad’s “transportation ratio” (now more commonly called its operating ratio) measures the expenses of running its trains divided by the railroad’s total revenues. The higher the ratio, the less efficient the railroad. Today even a ratio of 70% would be considered excellent.

^† Today, Penn Central is a faded memory. In 1976, it was absorbed into Consolidated Rail Corp. (Conrail), a federally-funded holding company that bailed out several failed railroads. Conrail sold shares to the public in 1987 and, in 1997, was taken over jointly by CSX Corp. and Norfolk Southern Corp.

^† Ling-Temco-Vought Inc. was founded in 1955 by James Joseph Ling, an electrical contractor who sold his first $1 million worth of shares to the public by becoming his own investment banker, hawking prospectuses from a booth set up at the Texas State Fair. His success at that led him to acquire dozens of different companies, almost always using LTV’s stock to pay for them. The more companies LTV acquired, the higher its stock went; the higher its stock went, the more companies it could afford to acquire. By 1969, LTV was the 14th biggest firm on the Fortune 500 list of major U.S. corporations. And then, as Graham shows, the whole house of cards came crashing down. (LTV Corp., now exclusively a steelmaker, ended up seeking bankruptcy protection in late 2000.) Companies that grow primarily through acquisitions are called “serial acquirers”—and the similarity to the term “serial killers” is no accident. As the case of LTV demonstrates, serial acquirers nearly always leave financial death and destruction in their wake. Investors who understood this lesson of Graham’s would have avoided such darlings of the 1990s as Conseco, Tyco, and WorldCom.

^* The sordid tradition of hiding a company’s true earnings picture under the cloak of restructuring charges is still with us. Piling up every possible charge in one year is sometimes called “big bath” or “kitchen sink” accounting. This bookkeeping gimmick enables companies to make an easy show of apparent growth in the following year—but investors should not mistake that for real business health.

^† The “bond-discount asset” appears to mean that LTV had purchased some bonds below their par value and was treating that discount as an asset, on the grounds that the bonds could eventually be sold at par. Graham scoffs at this, since there is rarely any way to know what a bond’s market price will be on a given date in the future. If the bonds could be sold only at values below par, this “asset” would in fact be a liability.

^† We can only imagine what Graham would have thought of the investment banking firms that brought InfoSpace, Inc. public in December 1998. The stock (adjusted for later splits) opened for trading at $31.25, peaked at $1305.32 per share in March 2000, and finished 2002 at a princely $8.45 per share.

^* Graham would have been disappointed, though surely not surprised, to see that commercial banks have chronically kept supporting “unsound expansions.” Enron and WorldCom, two of the biggest collapses in corporate history, were aided and abetted by billions of dollars in bank loans.

^* In June 1972 (just after Graham finished this chapter), a Federal judge found that NVF’s chairman, Victor Posner, had improperly diverted the pension assets of Sharon Steel “to assist affiliated companies in their takeovers of other corporations.” In 1977, the U.S. Securities and Exchange Commission secured a permanent injunction against Posner, NVF, and Sharon Steel to prevent them from future violations of Federal laws against securities fraud. The Commission alleged that Posner and his family had improperly obtained $1.7 million in personal perks from NVF and Sharon, overstated Sharon’s pretax earnings by $13.9 million, misrecorded inventory, and “shifted income and expenses from one year to another.” Sharon Steel, which Graham had singled out with his cold and skeptical eye, became known among Wall Street wags as “Share and Steal.” Posner was later a central force in the wave of leveraged buyouts and hostile takeovers that swept the United States in the 1980s, as he became a major customer for the junk bonds underwritten by Drexel Burnham Lambert.

^* The “large dilution factor” would be triggered when NVF employees exercised their warrants to buy common stock. The company would then have to issue more shares, and its net earnings would be divided across a much greater number of shares outstanding.

^† Jackie G. Williams founded AAA Enterprises in 1958. On its first day of trading, the stock soared 56% to close at $20.25. Williams later announced that AAA would come up with a new franchising concept every month (if people would step into a mobile home to get their income taxes done by “Mr. Tax of America,” just imagine what else they might do inside a trailer!). But AAA ran out of time and money before Williams ran out of ideas. The history of AAA Enterprises is reminiscent of the saga of a later company with charismatic management and scanty assets: ZZZZ Best achieved a stock-market value of roughly $200 million in the late 1980s, even though its purported industrial vacuum-cleaning business was little more than a telephone and a rented office run by a teenager named Barry Minkow. ZZZZ Best went bust and Minkow went to jail. Even as you read this, another similar company is being formed, and a new generation of “investors” will be taken for a ride. No one who has read Graham, however, should climb on board.

^* In “Abou Ben Adhem,” by the British Romantic poet Leigh Hunt (1784–1859), a righteous Muslim sees an angel writing in a golden book “the names of those who love the Lord.” When the angel tells Abou that his name is not among them, Abou says, “I pray thee, then, write me as one that loves his fellow men.” The angel returns the next night to show Abou the book, in which now “Ben Adhem’s name led all the rest.”

^* By purchasing more common stock at a premium to its book value, the investing public increased the value of AAA’s equity per share. But investors were only pulling themselves up by their own bootstraps, since most of the rise in shareholders’ equity came from the public’s own willingness to over-pay for the stock.

^† Graham’s point is that investment banks are not entitled to take credit for the gains a hot stock may produce right after its initial public offering unless they are also willing to take the blame for the stock’s performance in the longer term. Many Internet IPOs rose 1,000% or more in 1999 and early 2000; most of them lost more than 95% in the subsequent three years. How could these early gains earned by a few investors justify the massive destruction of wealth suffered by the millions who came later? Many IPOs were, in fact, deliberately underpriced to “manufacture” immediate gains that would attract more attention for the next offering.

^* The first four sentences of Graham’s paragraph could read as the official epitaph of the Internet and telecommunications bubble that burst in early 2000. Just as the Surgeon General’s warning on the side of a cigarette pack does not stop everyone from lighting up, no regulatory reform will ever prevent investors from overdosing on their own greed. (Not even Communism can outlaw market bubbles; the Chinese stock market shot up 101.7% in the first half of 1999, then crashed.) Nor can investment banks ever be entirely cleansed of their own compulsion to sell any stock at any price the market will bear. The circle can only be broken one investor, and one financial adviser, at a time. Mastering Graham’s principles (see especially Chapters 1, 8, and 20) is the best way to start.

¹ This document, like all the financial reports cited in this chapter, is readily available to the public through the EDGAR Database at www.sec.gov.

² The demise of the Chromatis acquisition is discussed in The Financial Times, August 29, 2001, p. 1, and September 1/September 2, 2001, p. XXIII.

³ When accounting for acquisitions, loading up on WOOPIPRAD enabled Tyco to reduce the portion of the purchase price that it allocated to goodwill. Since WOOPIPRAD can be expensed up front, while goodwill (under the accounting rules then in force) had to be written off over multi-year periods, this maneuver enabled Tyco to minimize the impact of goodwill charges on its future earnings.

⁴ In 2002, Tyco’s former chief executive, L. Dennis Kozlowski, was charged by state and Federal legal authorities with income tax fraud and improperly diverting Tyco’s corporate assets for his own use, including the appropriation of $15,000 for an umbrella stand and $6,000 for a shower curtain. Kozlowski denied all charges.

⁵ Disclosure: Jason Zweig is an employee of Time Inc., formerly a division of Time Warner and now a unit of AOL Time Warner Inc.

¹ eToys’ prospectus had a gatefold cover featuring an original cartoon of Arthur the aardvark, showing in comic style how much easier it would be to buy tchotchkes for children at eToys than at a traditional toy store. As analyst Gail Bronson of IPO Monitor told the Associated Press on the day of eToys’ stock offering, “eToys has very, very smartly managed the development of the company last year and positioned themselves to be the children’s center of the Internet.” Added Bronson: “The key to a successful IPO, especially a dot-com IPO, is good marketing and branding.” Bronson was partly right: That’s the key to a successful IPO for the issuing company and its bankers. Unfortunately, for investors the key to a successful IPO is earnings, which eToys didn’t have.

^* Here Graham is describing Real Estate Investment Trust, which was acquired by San Francisco Real Estate Investors in 1983 for $50 a share. The next paragraph describes Realty Equities Corp. of New York.

^† The actor Paul Newman was briefly a major shareholder in Realty Equities Corp. of New York after it bought his movie-production company, Kayos, Inc., in 1969.

^* Graham, an avid reader of poetry, is quoting Thomas Gray’s “Elegy Written in a Country Churchyard.”

^* Realty Equities was delisted from the American Stock Exchange in September 1973. In 1974, the U.S. Securities and Exchange Commission sued Realty Equities’ accountants for fraud. Realty Equities’ founder, Morris Karp, later pleaded guilty to one count of grand larceny. In 1974–1975, the overindebtedness that Graham criticizes led to a financial crisis among large banks, including Chase Manhattan, that had lent heavily to the most aggressive realty trusts.

^† “Heteroclite” is a technical term from classical Greek that Graham uses to mean abnormal or unusual.

^* By “volume,” Graham is referring to sales or revenues—the total dollar amount of each company’s business.

^† “Asset backing” and book value are synonyms. In Table 18-2, the relationship of price to asset or book value can be seen by dividing the first line (“Price, December 31, 1969”) by “Book value per share.”

^† †Graham is citing his research on value stocks, which he discusses in Chapter 15 (see p. 389). Since Graham completed his studies, a vast body of scholarly work has confirmed that value stocks outperform growth stocks over long periods. (Much of the best research in modern finance simply provides independent confirmation of what Graham demonstrated decades ago.) See, for instance, James L. Davis, Eugene F. Fama, and Kenneth R. French, “Characteristics, Covariances, and Average Returns: 1929–1997,” at http://papers.ssrn.com.

^* Air Products and Chemicals, Inc., still exists as a publicly-traded stock and is included in the Standard & Poor’s 500-stock index. Air Reduction Co. became a wholly-owned subsidiary of The BOC Group (then known as British Oxygen) in 1978.

^† You can determine profitability, as measured by return on sales and return on capital, by referring to the “Ratios” section of Table 18-3. “Net/sales” measures return on sales; “Earnings/book value” measures return on capital.

^* American Home Products Co. is now known as Wyeth; the stock is included in the Standard & Poor’s 500-stock index. American Hospital Supply Co. was acquired by Baxter Healthcare Corp. in 1985.

^* “Nearly 30 times” is reflected in the entry of 2920% under “Price/book value” in the Ratios section of Table 18-4. Graham would have shaken his head in astonishment during late 1999 and early 2000, when many high-tech companies sold for hundreds of times their asset value (see the commentary on this chapter). Talk about “almost unheard of in the annals of serious stock-market valuations”! H & R Block remains a publicly-traded company, while Blue Bell was taken private in 1984 at $47.50 per share.

^* Graham is alerting readers to a form of the “gambler’s fallacy,” in which investors believe that an overvalued stock must drop in price purely because it is overvalued. Just as a coin does not become more likely to turn up heads after landing on tails for nine times in a row, so an overvalued stock (or stock market!) can stay overvalued for a surprisingly long time. That makes short-selling, or betting that stocks will drop, too risky for mere mortals.

^† International Harvester was the heir to McCormick Harvesting Machine Co., the manufacturer of the McCormick reaper that helped make the midwestern states the “breadbasket of the world.” But International Harvester fell on hard times in the 1970s and, in 1985, sold its farm-equipment business to Tenneco. After changing its name to Navistar, the remaining company was booted from the Dow in 1991 (although it remains a member of the S & P 500 index). International Flavors & Fragrances, also a constituent of the S & P 500, had a total stock-market value of $3 billion in early 2003, versus $1.6 billion for Navistar.

^* For more of Graham’s thoughts on shareholder activism, see the commentary on Chapter 19. In criticizing Harvester for its refusal to maximize shareholder value, Graham uncannily anticipated the behavior of the company’s future management. In 2001, a majority of shareholders voted to remove Navistar’s restrictions against outside takeover bids—but the board of directors simply refused to implement the shareholders’ wishes. It’s remarkable that an antidemocratic tendency in the culture of some companies can endure for decades.

^* McGraw-Hill remains a publicly-traded company that owns, among other operations, BusinessWeek magazine and Standard & Poor’s Corp. McGraw–Edison is now a division of Cooper Industries.

^* In “the May 1970 debacle” that Graham refers to, the U.S. stock market lost 5.5%. From the end of March to the end of June 1970, the S & P 500 index lost 19% of its value, one of the worst three-month returns on record.

^* National Presto remains a publicly-traded company. National General was acquired in 1974 by another controversial conglomerate, American Financial Group, which at various times has had interests in cable television, banking, real estate, mutual funds, insurance, and bananas. AFG is also the final resting place of some of the assets of Penn Central Corp. (see Chapter 17).

^* Whiting Corp. ended up a subsidiary of Wheelabrator-Frye, but was taken private in 1983. Willcox & Gibbs is now owned by Group Rexel, an electrical-equipment manufacturer that is a division of Pinault-Printemps-Redoute Group of France. Rexel’s shares trade on the Paris Stock Exchange.

¹ Ask yourself which company’s stock would be likely to rise more: one that discovered a cure for a rare cancer, or one that discovered a new way to dispose of a common kind of garbage. The cancer cure sounds more exciting to most investors, but a new way to get rid of trash would probably make more money. See Paul Slovic, Melissa Finucane, Ellen Peters, and DonaldG. MacGregor, “The Affect Heuristic,” in Thomas Gilovich, Dale Griffin, and Daniel Kahneman, eds., Heuristics and Biases: The Psychology of Intuitive Judgment (Cambridge University Press, New York, 2002), pp. 397–420, and Donald G. MacGregor, “Imagery and Financial Judgment,” The Journal of Psychology and Financial Markets, vol. 3, no. 1, 2002, pp. 15–22.

² “Serial acquirers,” which grow largely by buying other companies, nearly always meet a bad end on Wall Street. See the commentary on Chapter 17 for a longer discussion.

³ Jeremy Siegel, “Big-Cap Tech Stocks are a Sucker’s Bet,” Wall Street Journal, March 14, 2000 (available at www.jeremysiegel.com).

⁴ Yahoo!’s stock split two-for-one in February 2000; the share prices given here are not adjusted for that split in order to show the levels the stock actually traded at. But Yahoo!’s percentage return and market value, as cited here, do reflect the split.

⁵ Counting the effect of acquisitions, Yahoo!’s revenues were $464 million. Graham criticizes high P/E ratios in (among other places) Chapters 7 and 11.

⁶ Yum! was then known as Tricon Global Restaurants, Inc., although its ticker symbol was YUM. The company changed its name officially to Yum! Brands, Inc. in May 2002.

⁷ See “CEO Speaks” and “The Bottom Line,” Money, May 2000, pp. 42–44.

⁸ In early 2003, Capital One’s chief financial officer resigned after securities regulators revealed that they might charge him with violations of laws against insider trading.

⁹ For a more advanced look at this bizarre event, see Owen A. Lamont and Richard H. Thaler, “Can the Market Add and Subtract?” National Bureau of Economic Research working paper no. 8302, at www.nber.org/papers/w8302.

¹⁰ CMGI began corporate life as College Marketing Group, which sold information about college professors and courses to academic publishers—a business that bore a faint but disturbing similarity to National Student Marketing, discussed by Graham on p. 235.

¹¹ All stock prices for Red Hat are adjusted for its two-for-one stock split in January 2000.

¹² Ironically, 65 years earlier Graham had singled out Brown Shoe as one of the most stable companies on the New York Stock Exchange. See the 1934 edition of Security Analysis, p. 159.

¹³ We use a nine-month period only because Red Hat’s 12-month results could not be determined from its financial statements without including the results of acquisitions.

^* Ironically, takeovers began drying up shortly after Graham’s last revised edition appeared, and the 1970s and early 1980s marked the absolute low point of modern American industrial efficiency. Cars were “lemons,” televisions and radios were constantly “on the fritz,” and the managers of many publicly-traded companies ignored both the present interests of their outside shareholders and the future prospects of their own businesses. All of this began to change in 1984, when independent oilman T. Boone Pickens launched a hostile takeover bid for Gulf Oil. Soon, fueled by junk-bond financing provided by Drexel Burnham Lambert, “corporate raiders” stalked the landscape of corporate America, scaring long-sclerotic companies into a new regimen of efficiency. While many of the companies involved in buy-outs and takeovers were ravaged, the rest of American business emerged both leaner (which was good) and meaner (which sometimes was not).

^* The irony that Graham describes here grew even stronger in the 1990s, when it almost seemed that the stronger the company was, the less likely it was to pay a dividend—or for its shareholders to want one. The “payout ratio” (or the percentage of their net income that companies paid out as dividends) dropped from “60% to 75%” in Graham’s day to 35% to 40% by the end of the 1990s.

^* In the late 1990s, technology companies were particularly strong advocates of the view that all of their earnings should be “plowed back into the business,” where they could earn higher returns than any outside shareholder possibly could by reinvesting the same cash if it were paid out to him or her in dividends. Incredibly, investors never questioned the truth of this patronizing Daddy-Knows-Best principle—or even realized that a company’s cash belongs to the shareholders, not its managers. See the commentary on this chapter.

^* Superior Oil’s stock price peaked at $2165 per share in 1959, when it paid a $4 dividend. For many years, Superior was the highest-priced stock listed on the New York Stock Exchange. Superior, controlled by the Keck family of Houston, was acquired by Mobil Corp. in 1984.

^* Today, virtually all stock splits are carried out by a change in value. In a two-for-one split, one share becomes two, each trading at half the former price of the original single share; in a three-for-one split, one share becomes three, each trading at a third of the former price; and so on. Only in very rare cases is a sum transferred “from earned surplus to capital account,” as in Graham’s day.

^† Rule 703 of the New York Stock Exchange governs stock splits and stock dividends. The NYSE now designates stock dividends of greater than 25% and less than 100% as “partial stock splits.” Unlike in Graham’s day, these stock dividends may now trigger the NYSE’s accounting requirement that the amount of the dividend be capitalized from retained earnings.

^* This policy, already unusual in Graham’s day, is extremely rare today. In 1936 and again in 1950, roughly half of all stocks on the NYSE paid a so-called special dividend. By 1970, however, that percentage had declined to less than 10% and, by the 1990s, was well under 5%. See Harry DeAngelo, Linda DeAngelo, and Douglas J. Skinner, “Special Dividends and the Evolution of Dividend Signaling,” Journal of Financial Economics, vol. 57, no. 3, September, 2000, pp. 309–354. The most plausible explanation for this decline is that corporate managers became uncomfortable with the idea that shareholders might interpret special dividends as a signal that future profits might be low.

^† The academic criticism of dividends was led by Merton Miller and Franco Modigliani, whose influential article “Dividend Policy, Growth, and the Valuation of Shares” (1961) helped win them Nobel Prizes in Economics. Miller and Modigliani argued, in essence, that dividends were irrelevant, since an investor should not care whether his return comes through dividends and a rising stock price, or through a rising stock price alone, so long as the total return is the same in either case.

^* Graham’s argument is no longer valid, and today’s investors can safely skip over this passage. Shareholders no longer need to worry about “having to break up” a stock certificate, since virtually all shares now exist in electronic rather than paper form. And when Graham says that a 5% increase in a cash dividend on 100 shares is less “probable” than a constant dividend on 105 shares, it’s unclear how he could even calculate that probability.

^† Subscription rights, often simply known as “rights,” are used less frequently than in Graham’s day. They confer upon an existing shareholder the right to buy new shares, sometimes at a discount to market price. A shareholder who does not participate will end up owning proportionately less of the company. Thus, as is the case with so many other things that go by the name of “rights,” some coercion is often involved. Rights are most common today among closed-end funds and insurance or other holding companies.

^* The administration of President George W. Bush made progress in early 2003 toward reducing the problem of double-taxation of corporate dividends, although it is too soon to know how helpful any final laws in this area will turn out to be. A cleaner approach would be to make dividend payments tax-deductible to the corporation, but that is not part of the proposed legislation.

¹ Benjamin Graham, The Intelligent Investor (Harper & Row, New York,1949), pp. 217, 219, 240. Graham explains his reference to Jesus this way: “In at least four parables in the Gospels there is reference to a highly critical relationship between a man of wealth and those he puts in charge of his property. Most to the point are the words that “a certain rich man” speaks to his steward or manager, who is accused of wasting his goods: ‘Give an account of thy stewardship, for thou mayest be no longer steward.’ (Luke, 16:2).” Among the other parables Graham seems to have in mind is Matt., 25:15–28.

² Benjamin Graham, “A Questionnaire on Stockholder-Management Relationship,” The Analysts Journal, Fourth Quarter, 1947, p. 62. Graham points out that he had conducted a survey of nearly 600 professional security analysts and found that more than 95% of them believed that shareholders have the right to call for a formal investigation of managers whose leadership does not enhance the value of the stock. Graham adds dryly that “such action is almost unheard of in practice.” This, he says, “highlights the wide gulf between what should happen and what does happen in shareholder-management relationships.”

³ Graham and Dodd, Security Analysis (1934 ed.), p. 508.

⁴ The Intelligent Investor, 1949 edition, p. 218.

⁵ 1949 edition, p. 223. Graham adds that a proxy vote would be necessary to authorize an independent committee of outside shareholders to select “the engineering firm” that would submit its report to the shareholders, not to the board of directors. However, the company would bear the costs of this project. Among the kinds of “engineering firms” Graham had in mind were money managers, rating agencies and organizations of security analysts. Today, investors could choose from among hundreds of consulting firms, restructuring advisers, and members of entities like the Risk Management Association.

⁶ Tabulations of voting results for 2002 by Georgeson Shareholder and ADP’s Investor Communication Services, two leading firms that mail proxy solicitations to investors, suggest response rates that average around 80% to 88% (including proxies sent in by stockbrokers on behalf of their clients, which are automatically voted in favor of management unless the clients specify otherwise). Thus the owners of between 12% and 20% of all shares are not voting their proxies. Since individuals own only 40% of U.S. shares by market value, and most institutional investors like pension funds and insurance companies are legally bound to vote on proxy issues, that means that roughly a third of all individual investors are neglecting to vote.

⁷ 1949 edition, p. 224.

⁸ 1949 edition, p. 233.

⁹ Eugene F. Fama and Kenneth R. French, “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?” Journal of Financial Economics, vol. 60, no. 1, April, 2001, pp. 3–43, especially Table 1; see also Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists (Princeton Univ. Press, Princeton, 2002), pp. 158–161. Interestingly, the total dollar amount of dividends paid by U.S. stocks has risen since the late 1970s, even after inflation—but the number of stocks that pay a dividend has shrunk by nearly two-thirds. See Harry DeAngelo, Linda DeAngelo, and Douglas J. Skinner, “Are Dividends Disappearing? Dividend Concentration and the Consolidation of Earnings,” available at: http://papers.ssrn.com.

¹⁰ Perhaps Benjamin Franklin, who is said to have carried his coins around in an asbestos purse so that money wouldn’t burn a hole in his pocket, could have avoided this problem if he had been a CEO.

¹¹ A study by BusinessWeek found that from 1995 through 2001, 61% out of more than 300 large mergers ended up destroying wealth for the shareholders of the acquiring company—a condition known as “the winner’s curse” or “buyer’s remorse.” And acquirers using stock rather than cash to pay for the deal underperformed rival companies by 8%. (David Henry, “Mergers: Why Most Big Deals Don’t Pay Off,” BusinessWeek, October 14, 2002, pp. 60–70.) A similar academic study found that acquisitions of private companies and subsidiaries of public companies lead to positive stock returns, but that acquisitions of entire public companies generate losses for the winning bidder’s shareholders. (Kathleen Fuller, Jeffry Netter, and Mike Stegemoller, “What Do Returns to Acquiring Firms Tell Us?” The Journal of Finance, vol. 57, no. 4, August, 2002, pp. 1763–1793.)

¹² With interest rates near record lows, such a mountain of cash produces lousy returns if it just sits around. As Graham asserts, “So long as this surplus cash remains with the company, the outside stockholder gets little benefit from it” (1949 edition, p. 232). Indeed, by year-end 2002, Microsoft’s cash balance had swollen to $43.4 billion—clear proof that the company could find no good use for the cash its businesses were generating. As Graham would say, Microsoft’s operations were efficient, but its finance no longer was. In a step toward redressing this problem, Microsoft declared in early 2003 that it would begin paying a regular quarterly dividend.

¹³ Robert D. Arnott and Clifford S. Asness, “Surprise! Higher Dividends = Higher Earnings Growth,” Financial Analysts Journal, January/February, 2003, pp. 70–87.

¹⁴ Doron Nissim and Amir Ziv, “Dividend Changes and Future Profitability,” The Journal of Finance, vol. 56, no. 6, December, 2001, pp. 2111–2133. Even researchers who disagree with the Arnott-Asness and Nissim-Ziv findings on future earnings agree that dividend increases lead to higher future stock returns; see Shlomo Benartzi, Roni Michaely, and Richard Thaler, “Do Changes in Dividends Signal the Future or the Past?” The Journal of Finance, vol. 52, no. 3, July, 1997, pp. 1007–1034.

¹⁵ The tax reforms proposed by President George W. Bush in early 2003 would change the taxability of dividends, but the fate of this legislation was not yet clear by press time.

¹⁶ Historically, companies took a common-sense approach toward share repurchases, reducing them when stock prices were high and stepping them up when prices were low. After the stock market crash of October 19, 1987, for example, 400 companies announced new buybacks over the next 12 days alone—while only 107 firms had announced buyback programs in the earlier part of the year, when stock prices had been much higher. See Murali Jagannathan, Clifford P. Stephens, and Michael S. Weisbach, “Financial Flexibility and the Choice Between Dividends and Stock Repurchases,” Journal of Financial Economics, vol. 57, no. 3, September, 2000, p. 362.

¹⁷ The stock options granted by a company to its executives and employees give them the right (but not the obligation) to buy shares in the future at a discounted price. That conversion of options to shares is called “exercising” the options. The employees can then sell the shares at the current market price and pocket the difference as profit. Because hundreds of millions of options may be exercised in a given year, the company must increase its supply of shares outstanding. Then, however, the company’s total net income would be spread across a much greater number of shares, reducing its earnings per share. Therefore, the company typically feels compelled to buy back other shares to cancel out the stock issued to the option holders. In 1998, 63.5% of chief financial officers admitted that counteracting the dilution from options was a major reason for repurchasing shares (see CFO Forum, “The Buyback Track,” Institutional Investor, July, 1998).

¹⁸ One of the main factors driving this change was the U.S. Securities and Exchange Commission’s decision, in 1982, to relax its previous restrictions on share repurchases. See Gustavo Grullon and Roni Michaely, “Dividends, Share Repurchases, and the Substitution Hypothesis,” The Journal of Finance, vol. 57, no. 4, August, 2002, pp. 1649–1684.

¹⁹ Throughout his writings, Graham insists that corporate managements have a duty not just to make sure their stock is not undervalued, but also to make sure it never gets overvalued. As he put it in Security Analysis (1934 ed., p. 515), “the responsibility of managements to act in the interest of their shareholders includes the obligation to prevent—in so far as they are able—the establishment of either absurdly high or unduly low prices for their securities.” Thus, enhancing shareholder value doesn’t just mean making sure that the stock price does not go too low; it also means ensuring that the stock price does not go up to unjustifiable levels. If only the executives of Internet companies had heeded Graham’s wisdom back in 1999!

²⁰ Incredibly, although options are considered a compensation expense on a company’s tax returns, they are not counted as an expense on the income statement in financial reports to shareholders. Investors can only hope that accounting reforms will change this ludicrous practice.

²¹ See George W. Fenn and Nellie Liang, “Corporate Payout Policy and Managerial Stock Incentives,” Journal of Financial Economics, vol. 60, no. 1, April, 2001, pp. 45–72. Dividends make stocks less volatile by providing a stream of current income that cushions shareholders against fluctuations in market value. Several researchers have found that the average profitability of companies with stock-buyback programs (but no cash dividends) is at least twice as volatile as that of companies that pay dividends. Those more variable earnings will, in general, lead to bouncier share prices, making the managers’ stock options more valuable—by creating more opportunities when share prices will be temporarily high. Today, about two-thirds of executive compensation comes in the form of options and other noncash awards; thirty years ago, at least two-thirds of compensation came as cash.

²² Apple Computer Inc. proxy statement for April 2001 annual meeting, p. 8 (available at www.sec.gov). Jobs’ option grant and share ownership are adjusted for a two-for-one share split.

^* By the late 1990s, this advice—which can be appropriate for a foundation or endowment with an infinitely long investment horizon—had spread to individual investors, whose life spans are finite. In the 1994 edition of his influential book, Stocks for the Long Run, finance professor Jeremy Siegel of the Wharton School recommended that “risk-taking” investors should buy on margin, borrowing more than a third of their net worth to sink 135% of their assets into stocks. Even government officials got in on the act: In February 1999, the Honorable Richard Dixon, state treasurer of Maryland, told the audience at an investment conference: “It doesn’t make any sense for anyone to have any money in a bond fund.”

^* This is one of Graham’s rare misjudgments. In 1973, just two years after President Richard Nixon imposed wage and price controls, inflation hit 8.7%, its highest level since the end of World War II. The decade from 1973 through 1982 was the most inflationary in modern American history, as the cost of living more than doubled.

^* See p. 25.

^* John Pierpont Morgan was the most powerful financier of the late nineteenth and early twentieth centuries. Because of his vast influence, he was constantly asked what the stock market would do next. Morgan developed a mercifully short and unfailingly accurate answer: “It will fluctuate.” See Jean Strouse, Morgan: American Financier (Random House, 1999), p. 11.

^* The investment philosopher Peter L. Bernstein feels that Graham was “dead wrong” about precious metals, particularly gold, which (at least in the years after Graham wrote this chapter) has shown a robust ability to out-pace inflation. Financial adviser William Bernstein agrees, pointing out that a tiny allocation to a precious-metals fund (say, 2% of your total assets) is too small to hurt your overall returns when gold does poorly. But, when gold does well, its returns are often so spectacular—sometimes exceeding 100% in a year—that it can, all by itself, set an otherwise lackluster portfolio glittering. However, the intelligent investor avoids investing in gold directly, with its high storage and insurance costs; instead, seek out a well-diversified mutual fund specializing in the stocks of precious-metal companies and charging below 1% in annual expenses. Limit your stake to 2% of your total financial assets (or perhaps 5% if you are over the age of 65).

¹ The U.S. Bureau of Labor Statistics, which calculates the Consumer Price Index that measures inflation, maintains a comprehensive and helpful website at www.bls.gov/cpi/home.htm.

² For a lively discussion of the “inflation is dead” scenario, see www.pbs. org/newshour/bb/economy/july-dec97/inflation_12-16.html. In 1996, the Boskin Commission, a group of economists asked by the government to investigate whether the official rate of inflation is accurate, estimated that it has been overstated, often by nearly two percentage points per year. For the commission’s report, see www.ssa.gov/history/reports/boskinrpt.html. Many investment experts now feel that deflation, or falling prices, is an even greater threat than inflation; the best way to hedge against that risk is by including bonds as a permanent component of your portfolio. (See the commentary on Chapter 4.)

³ For more insights into this behavioral pitfall, see Eldar Shafir, Peter Diamond, and Amos Tversky, “Money Illusion,” in Daniel Kahneman and Amos Tversky, eds., Choices, Values, and Frames (Cambridge University Press,2000), pp. 335–355.

⁴ That year, President Jimmy Carter gave his famous “malaise” speech, in which he warned of “a crisis in confidence” that “strikes at the very heart and soul and spirit of our national will” and “threatens to destroy the social and the political fabric of America.”

⁵ See Stanley Fischer, Ratna Sahay, and Carlos A. Vegh, “Modern Hyper- and High Inflations,” National Bureau of Economic Research, Working Paper 8930, at www.nber.org/papers/w8930.

⁶ In fact, the United States has had two periods of hyperinflation. During the American Revolution, prices roughly tripled every year from 1777 through 1779, with a pound of butter costing $12 and a barrel of flour fetching nearly $1,600 in Revolutionary Massachusetts. During the Civil War, inflation raged at annual rates of 29% (in the North) and nearly 200% (in the Confederacy). As recently as 1946, inflation hit 18.1% in the United States.

⁷ I am indebted to Laurence Siegel of the Ford Foundation for this cynical, but accurate, insight. Conversely, in a time of deflation (or steadily falling prices) it’s more advantageous to be a lender than a borrower—which is why most investors should keep at least a small portion of their assets in bonds, as a form of insurance against deflating prices.

⁸ When inflation is negative, it is technically termed “deflation.” Regularly falling prices may at first sound appealing, until you think of the Japanese example. Prices have been deflating in Japan since 1989, with real estate and the stock market dropping in value year after year—a relentless water torture for the world’s second-largest economy.

⁹ Ibbotson Associates, Stocks, Bonds, Bills, and Inflation, 2003 Handbook(Ibbotson Associates, Chicago, 2003), Table 2-8. The same pattern is evident outside the United States: In Belgium, Italy, and Germany, where inflation was especially high in the twentieth century, “inflation appears to have had a negative impact on both stock and bond markets,” note Elroy Dimson, Paul Marsh, and Mike Staunton in Triumph of the Optimists: 101 Years of Global Investment Returns (Princeton University Press, 2002), p. 53.

¹⁰ Thorough, if sometimes outdated, information on REITs can be found at www.nareit.com.

¹¹ For further information, see www.vanguard.com, www.cohenandsteers. com, www.columbiafunds.com, and www.fidelity.com. The case for investing in a REIT fund is weaker if you own a home, since that gives you an inherent stake in real-estate ownership.

¹² A good introduction to TIPS can be found at www.publicdebt.treas.gov/ of/ofinflin.htm. For more advanced discussions, see www.federalreserve. gov/Pubs/feds/2002/200232/200232pap.pdf, www.tiaa-crefinstitute.org/ Publications/resdiags/73_09-2002.htm, and www.bwater.com/research_ ibonds.htm.

¹³ For details on these funds, see www.vanguard.com or www.fidelity.com.

^* “It is said an Eastern monarch once charged his wise men to invent him a sentence, to be ever in view, and which should be true and appropriate in all times and situations. They presented him the words: ‘ And this, too, shall pass away.’ How much it expresses! How chastening in the hour of pride!—how consoling in the depths of affliction! ‘And this, too, shall pass away.’ And yet let us hope it is not quite true.”—Abraham Lincoln, Address to the Wisconsin State Agricultural Society, Milwaukee, September 30, 1859, in Abraham Lincoln: Speeches and Writings, 1859–1865 (Library of America,1985), vol. II, p. 101.

^* “Earning power” is Graham’s term for a company’s potential profits or, as he puts it, the amount that a firm “might be expected to earn year after year if the business conditions prevailing during the period were to continue unchanged” (Security Analysis, 1934 ed., p. 354). Some of his lectures make it clear that Graham intended the term to cover periods of five years or more. You can crudely but conveniently approximate a company’s earning power per share by taking the inverse of its price/earnings ratio; a stock with a P/E ratio of 11 can be said to have earning power of 9% (or 1 divided by 11). Today “earning power” is often called “earnings yield.”

^* This problem is discussed extensively in the commentary on Chapter 19.

^* Graham elegantly summarized the discussion that follows in a lecture he gave in 1972: “The margin of safety is the difference between the percentage rate of the earnings on the stock at the price you pay for it and the rate of interest on bonds, and that margin of safety is the difference which would absorb unsatisfactory developments. At the time the 1965 edition of The Intelligent Investor was written the typical stock was selling at 11 times earnings, giving about 9% return as against 4% on bonds. In that case you had a margin of safety of over 100 per cent. Now [in 1972] there is no difference between the earnings rate on stocks and the interest rate on stocks, and I say there is no margin of safety…you have a negative margin of safety on stocks…” See “Benjamin Graham: Thoughts on Security Analysis” [transcript of lecture at the Northeast Missouri State University business school, March, 1972], Financial History, no. 42, March, 1991, p. 9.

^* This paragraph—which Graham wrote in early 1972—is an uncannily precise description of market conditions in early 2003. (For more detail, see the commentary on Chapter 3.)

^* In “American” roulette, most wheels include 0 and 00 along with numbers 1 through 36, for a total of 38 slots. The casino offers a maximum payout of 35 to 1. What if you bet $1 on every number? Since only one slot can be the one into which the ball drops, you would win $35 on that slot, but lose $1 on each of your other 37 slots, for a net loss of $2. That $2 difference (or a 5.26% spread on your total $38 bet) is the casino’s “house advantage,” ensuring that, on average, roulette players will always lose more than they win. Just as it is in the roulette player’s interest to bet as seldom as possible, it is in the casino’s interest to keep the roulette wheel spinning. Likewise, the intelligent investor should seek to maximize the number of holdings that offer “a better chance for profit than for loss.” For most investors, diversification is the simplest and cheapest way to widen your margin of safety.

^* Graham is saying that there is no such thing as a good or bad stock; there are only cheap stocks and expensive stocks. Even the best company becomes a “sell” when its stock price goes too high, while the worst company is worth buying if its stock goes low enough.

^† The very people who considered technology and telecommunications stocks a “sure thing” in late 1999 and early 2000, when they were hellishly overpriced, shunned them as “too risky” in 2002—even though, in Graham’s exact words from an earlier period, “the price depreciation of about 90% made many of these securities exceedingly attractive and reasonably safe.” Similarly, Wall Street’s analysts have always tended to call a stock a “strong buy” when its price is high, and to label it a “sell” after its price has fallen—the exact opposite of what Graham (and simple common sense) would dictate. As he does throughout the book, Graham is distinguishing speculation—or buying on the hope that a stock’s price will keep going up—from investing, or buying on the basis of what the underlying business is worth.

^* Graham uses “common-stock option warrant” as a synonym for “warrant,” a security issued directly by a corporation giving the holder a right to purchase the company’s stock at a predetermined price. Warrants have been almost entirely superseded by stock options. Graham quips that he intends the example as a “shocker” because, even in his day, warrants were regarded as one of the market’s seediest backwaters. (See the commentary on Chapter 16.)

¹ As recounted by investment consultant Charles Ellis in Jason Zweig, “Wall Street’s Wisest Man,” Money, June, 2001, pp. 49–52.

² JDS Uniphase’s share price has been adjusted for later splits.

³ No one who diligently researched the answer to this question, and honestly accepted the results, would ever have day traded or bought IPOs.

⁴ Paul Slovic, “Informing and Educating the Public about Risk,” Risk Analysis, vol. 6, no. 4 (1986), p. 412.

⁵ “The Wager,” in Blaise Pascal, Pensées (Penguin Books, London and New York, 1995), pp. 122–125; Peter L. Bernstein, Against the Gods (John Wiley & Sons, New York, 1996), pp. 68–70; Peter L. Bernstein, “Decision Theory in Iambic Pentameter,” Economics & Portfolio Strategy, January 1, 2003, p. 2.

^* The study, in its final form, was Lawrence Fisher and James H. Lorie, “Rates of Return on Investments in Common Stock: the Year-by-Year Record, 1926–65,” The Journal of Business, vol. XLI, no. 3 (July, 1968), pp. 291–316. For a summary of the study’s wide influence, see http:// library.dfaus.com/reprints/work_of_art/.

^* See pp. 50–52.

^† The “price/earnings ratio” of a stock, or of a market average like the S & P 500-stock index, is a simple tool for taking the market’s temperature. If, for instance, a company earned $1 per share of net income over the past year, and its stock is selling at $8.93 per share, its price/earnings ratio would be 8.93; if, however, the stock is selling at $69.70, then the price/earnings ratio would be 69.7. In general, a price/earnings ratio (or “P/E” ratio) below 10 is considered low, between 10 and 20 is considered moderate, and greater than 20 is considered expensive. (For more on P/E ratios, see p. 168.)

¹ If dividends are not included, stocks fell 47.8% in those two years.

¹ By the 1840s, these indexes had widened to include a maximum of seven financial stocks and 27 railroad stocks—still an absurdly unrepresentative sample of the rambunctious young American stock market.

² See Jason Zweig, “New Cause for Caution on Stocks,” Time, May 6, 2002, p. 71. As Graham hints on p. 65, even the stock indexes between 1871 and the 1920s suffer from survivorship bias, thanks to the hundreds of automobile, aviation, and radio companies that went bust without a trace. These returns, too, are probably overstated by one to two percentage points.

² Those cheaper stock prices do not mean, of course, that investors’ expectation of a 7% stock return will be realized.

³ See Jeremy Siegel, Stocks for the Long Run (McGraw-Hill, 2002), p. 94, and Robert Arnott and William Bernstein, “The Two Percent Dilution,” working paper, July, 2002.

^* See Graham’s “Conclusion” to Chapter 2, p. 56–57.

^* Graham’s objection to high-yield bonds is mitigated today by the widespread availability of mutual funds that spread the risk and do the research of owning “junk bonds.” See the commentary on Chapter 6 for more detail.

^† † The “New Housing” bonds and “New Community debentures” are no more. New Housing Authority bonds were backed by the U.S. Department of Housing and Urban Development (HUD) and were exempt from income tax, but they have not been issued since 1974. New Community debentures, also backed by HUD, were authorized by a Federal law passed in 1968. About $350 million of these debentures were issued through 1975, but the program was terminated in 1983.

^* A bond’s “coupon” is its interest rate; a “low-coupon” bond pays a rate of interest income below the market average.

^* While Graham’s logic remains valid, the numbers have changed. Corporations can currently deduct 70% of the income they receive from dividends, and the standard corporate tax rate is 35%. Thus, a corporation would pay roughly $24.50 in tax on $100 in dividends from preferred stock versus $35 in tax on $100 in interest income. Individuals pay the same rate of income tax on dividend income that they do on interest income, so preferred stock offers them no tax advantage.

¹ For more about the distinction between physically and intellectually difficult investing on the one hand, and emotionally difficult investing on the other, see Chapter 8 and also Charles D. Ellis, “Three Ways to Succeed as an Investor,” in Charles D. Ellis and James R. Vertin, eds., The Investor’s Anthology (John Wiley & Sons, 1997), p. 72.

² A recent Google search for the phrase “age and asset allocation” turned up more than 30,000 online references.

³ James K. Glassman and Kevin A. Hassett, Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market (Times Business,1999), p. 250.

⁴ For a fascinating essay on this psychological phenomenon, see Daniel Gilbert and Timothy Wilson’s “Miswanting,” at www.wjh.harvard.edu/˜dtg/ Gilbert_&_Wilson (Miswanting).pdf.

⁵ For the sake of simplicity, this example assumes that stocks rose instantaneously.

⁶ For the 2003 tax year, the bottom Federal tax bracket is for single people earningless than $28,400 or married people (filing jointly) earning less than $47,450.

⁷ Two good online calculators that will help you compare the after-tax income of municipal and taxable bonds can be found at www.investinginbonds. com/cgi-bin/calculator.pl and www.lebenthal.com/index_infocenter.html. To decide if a “muni” is right for you, find the “taxable equivalent yield” generated by these calculators, then compare that number to the yield currently available on Treasury bonds (http://money.cnn.com/markets/bondcenter/ or www.bloomberg.com/markets/C13.html). If the yield on Treasury bonds is higher than the taxable equivalent yield, munis are not for you. In any case, be warned that municipal bonds and funds produce lower income, and more price fluctuation, than most taxable bonds. Also, the alternative minimum tax, which now hits many middle-income Americans, can negate the advantages of municipal bonds.

⁸ For an excellent introduction to bond investing, see http://flagship.van guard.com/web/planret/AdvicePTIBInvestmentsInvestingInBonds.html#Inter estRates. For an even simpler explanation of bonds, see http://money.cnn. com/pf/101/lessons/7/. A “laddered” portfolio, holding bonds across a range of maturities, is another way of hedging interest-rate risk.

⁹ For more information, see www.vanguard.com, www.fidelity.com, www. schwab.com, and www.troweprice.com.

¹⁰ For an accessible online summary of bond investing, see www.aaii.com/ promo/20021118/bonds.shtml.

¹¹ In general, variable annuities are not attractive for investors under the age of 50 who expect to be in a high tax bracket during retirement or who have not already contributed the maximum to their existing 401(k) or IRA accounts. Fixed annuities (with the notable exception of those from TIAA-CREF) can change their “guaranteed” rates and smack you with nasty surrender fees. For thorough and objective analysis of annuities, see two superb articles by Walter Updegrave: “Income for Life,” Money, July, 2002, pp. 89–96, and “Annuity Buyer’s Guide,” Money, November, 2002, pp. 104–110.

¹² For more on the role of dividends in a portfolio, see Chapter 19.

^* At the beginning of 1949, the average annual return produced by stocks over the previous 20 years was 3.1%, versus 3.9% for long-term Treasury bonds—meaning that $10,000 invested in stocks would have grown to $18,415 over that period, while the same amount in bonds would have turned into $21,494. Naturally enough, 1949 turned out to be a fabulous time to buy stocks: Over the next decade, the Standard & Poor’s 500-stock index gained an average of 20.1% per year, one of the best long-term returns in the history of the U.S. stock market.

^† Graham’s earlier comments on this subject appear on pp. 19–20. Just imagine what he would have thought about the stock market of the late 1990s, in which each new record-setting high was considered further “proof” that stocks were the riskless way to wealth!

^* The Dow Jones Industrial Average closed at a then-record high of 381.17 on September 3, 1929. It did not close above that level until November 23, 1954—more than a quarter of a century later—when it hit 382.74. (When you say you intend to own stocks “for the long run,” do you realize just how long the long run can be—or that many investors who bought in 1929 were no longer even alive by 1954?) However, for patient investors who reinvested their income, stock returns were positive over this otherwise dismal period, simply because dividend yields averaged more than 5.6% per year. According to professors Elroy Dimson, Paul Marsh, and Mike Staunton of London Business School, if you had invested $1 in U.S. stocks in 1900 and spent all your dividends, your stock portfolio would have grown to $198 by 2000. But if you had reinvested all your dividends, your stock portfolio would have been worth $16,797! Far from being an afterthought, dividends are the greatest force in stock investing.

^† Why do the “high prices” of stocks affect their dividend yields? A stock’s yield is the ratio of its cash dividend to the price of one share of common stock. If a company pays a $2 annual dividend when its stock price is $100 per share, its yield is 2%. But if the stock price doubles while the dividend stays constant, the dividend yield will drop to 1%. In 1959, when the trend Graham spotted in 1957 became noticeable to everyone, most Wall Street pundits declared that it could not possibly last. Never before had stocks yielded less than bonds; after all, since stocks are riskier than bonds, why would anyone buy them at all unless they pay extra dividend income to compensate for their greater risk? The experts argued that bonds would outyield stocks for a few months at most, and then things would revert to “normal.” More than four decades later, the relationship has never been normal again; the yield on stocks has (so far) continuously stayed below the yield on bonds.

^* See pp. 56–57 and 88–89.

^† For another view of diversification, see the sidebar in the commentary on Chapter 14 (p. 368).

^* Today’s defensive investor should probably insist on at least 10 years of continuous dividend payments (which would eliminate from consideration only one member of the Dow Jones Industrial Average—Microsoft—and would still leave at least 317 stocks to choose from among the S & P 500 index). Even insisting on 20 years of uninterrupted dividend payments would not be overly restrictive; according to Morgan Stanley, 255 companies in the S & P 500 met that standard as of year-end 2002.

^† The “Rule of 72” is a handy mental tool. To estimate the length of time an amount of money takes to double, simply divide its assumed growth rate into 72. At 6%, for instance, money will double in 12 years (72 divided by 6 = 12). At the 7.1% rate cited by Graham, a growth stock will double its earnings in just over 10 years (72/7.1 = 10.1 years).

^* Graham makes this point on p. 73.

^† To show that Graham’s observations are perennially true, we can substitute Microsoft for IBM and Cisco for Texas Instruments. Thirty years apart, the results are uncannily similar: Microsoft’s stock dropped 55.7% from 2000 through 2002, while Cisco’s stock—which had risen roughly 50-fold over the previous six years—lost 76% of its value from 2000 through 2002. As with Texas Instruments, the drop in Cisco’s stock price was sharper than the fall in its earnings, which dropped just 39.2% (comparing the three-year average for 1997–1999 against 2000–2002). As always, the hotter they are, the harder they fall.

^* “Earnings multiplier” is a synonym for P/E or price/earnings ratios, which measure how much investors are willing to pay for a stock compared to the profitability of the underlying business. (See footnote † on p. 70 in Chapter 3.)

^† Investors can now set up their own automated system to monitor the quality of their holdings by using interactive “portfolio trackers” at such websites as www.quicken.com, moneycentral.msn.com, finance.yahoo.com, and www.morningstar.com. Graham would, however, warn against relying exclusively on such a system; you must use your own judgment to supplement the software.

^* To update Graham’s figures, take each dollar amount in this section and multiply it by five.

^* In today’s markets, to be considered large, a company should have a total stock value (or “market capitalization”) of at least $10 billion. According to the online stock screener at http://screen.yahoo.com/stocks.html, that gave you roughly 300 stocks to choose from as of early 2003.

¹ Peter Lynch with John Rothchild, One Up on Wall Street (Penguin, 1989), p. 23.

² Kevin Landis interview on CNN In the Money, November 5, 1999, 11A. M. eastern standard time. If Landis’s own record is any indication, focusing on “the things that you know” is not “all you really need to do” to pick stocks successfully. From the end of 1999 through the end of 2002, Landis’s fund (full of technology companies that he claimed to know “firsthand” from his base in Silicon Valley) lost 73.2% of its value, an even worse pounding than the average technology fund suffered over that period.

³ Sarah Lichtenstein and Baruch Fischhoff, “Do Those Who Know More Also Know More about How Much They Know?” Organizational Behavior and Human Performance, vol. 20, no. 2, December, 1977, pp. 159–183.

⁴ See Gur Huberman, “Familiarity Breeds Investment”; Joshua D. Coval and Tobias J. Moskowitz, “The Geography of Investment”; and Gur Huberman and Paul Sengmuller, “Company Stock in 401(k) Plans,” all available at http://papers.ssrn.com.

⁵ According to finance professor Charles Jones of Columbia Business School, the cost of a small, one-way trade (either a buy or a sell) in a New York Stock Exchange–listed stock dropped from about 1.25% in Graham’s day to about 0.25% in 2000. For institutions like mutual funds, those costs are actually higher. (See Charles M. Jones, “A Century of Stock Market Liquidity and Trading Costs,” at http://papers.ssrn.com.)

⁶ To help determine whether the stocks you own are sufficiently diversified across different industrial sectors, you can use the free “Instant X-Ray” function at www.morningstar.com or consult the sector information (Global Industry Classification Standard) at www.standardandpoors.com.

⁷ For more on the rationale for keeping a portion of your portfolio in foreign stocks, see pp. 186–187.

⁸ Source: spreadsheet data provided courtesy of Ibbotson Associates. Although it was not possible for retail investors to buy the entire S & P 500 index until 1976, the example nevertheless proves the power of buying more when stock prices go down.

^* Here Graham has made a slip of the tongue. After insisting in Chapter 1 that the definition of an “enterprising” investor depends not on the amount of risk you seek, but the amount of work you are willing to put in, Graham falls back on the conventional notion that enterprising investors are more “aggressive.” The rest of the chapter, however, makes clear that Graham stands by his original definition. (The great British economist John Maynard Keynes appears to have been the first to use the term “enterprise” as a synonym for analytical investment.)

^* “High-coupon issues” are corporate bonds paying above-average interest rates (in today’s markets, at least 8%) or preferred stocks paying large dividend yields (10% or more). If a company must pay high rates of interest in order to borrow money, that is a fundamental signal that it is risky. For more on high-yield or “junk” bonds, see pp. 145–147.

^† As of early 2003, the equivalent yields are roughly 5.1% on high-grade corporate bonds and 4.7% on 20-year tax-free municipal bonds. To update these yields, see www.bondsonline.com/asp/news/composites/html or www.bloomberg.com/markets/rates.html and www.bloomberg.com/markets/ psamuni.html.

^* For a recent example that painfully reinforces Graham’s point, see p. 146 below.

^* Bond prices are quoted in percentages of “par value,” or 100. A bond priced at “85” is selling at 85% of its principal value; a bond originally offered for $10,000, but now selling at 85, will cost $8,500. When bonds sell below 100, they are called “discount” bonds; above 100, they become “premium” bonds.

^* New issues of common stock—initial public offerings or IPOs—normally are sold with an “underwriting discount” (a built-in commission) of 7%. By contrast, the buyer’s commission on older shares of common stock typically ranges below 4%. Whenever Wall Street makes roughly twice as much for selling something new as it does for selling something old, the new will get the harder sell.

^† Recently, finance professors Owen Lamont of the University of Chicago and Paul Schultz of the University of Notre Dame have shown that corporations choose to offer new shares to the public when the stock market is near a peak. For technical discussion of these issues, see Lamont’s “Evaluating Value Weighting: Corporate Events and Market Timing” and Schultz’s “Pseudo Market Timing and the Long-Run Performance of IPOs” at http:// papers.ssrn.com.

^* In the two years from June 1960, through May 1962, more than 850 companies sold their stock to the public for the first time—an average of more than one per day. In late 1967 the IPO market heated up again; in 1969 an astonishing 781 new stocks were born. That oversupply helped create the bear markets of 1969 and 1973–1974. In 1974 the IPO market was so dead that only nine new stocks were created all year; 1975 saw only 14 stocks born. That undersupply, in turn, helped feed the bull market of the 1980s, when roughly 4,000 new stocks flooded the market—helping to trigger the over-enthusiasm that led to the 1987 crash. Then the cycle swung the other way again as IPOs dried up in 1988–1990. That shortage contributed to the bull market of the 1990s—and, right on cue, Wall Street got back into the business of creating new stocks, cranking out nearly 5,000 IPOs. Then, after the bubble burst in 2000, only 88 IPOs were issued in 2001—the lowest annual total since 1979. In every case, the public has gotten burned on IPOs, has stayed away for at least two years, but has always returned for another scalding. For as long as stock markets have existed, investors have gone through this manic-depressive cycle. In America’s first great IPO boom, back in 1825, a man was said to have been squeezed to death in the stampede of speculators trying to buy shares in the new Bank of Southwark; the wealthiest buyers hired thugs to punch their way to the front of the line. Sure enough, by 1829, stocks had lost roughly 25% of their value.

^* Here Graham is describing rights offerings, in which investors who already own a stock are asked to pony up even more money to maintain the same proportional interest in the company. This form of financing, still widespread in Europe, has become rare in the United States, except among closed-end funds.

^* In Graham’s day, the most prestigious investment banks generally steered clear of the IPO business, which was regarded as an undignified exploitation of naïve investors. By the peak of the IPO boom in late 1999 and early 2000, however, Wall Street’s biggest investment banks had jumped in with both feet. Venerable firms cast off their traditional prudence and behaved like drunken mud wrestlers, scrambling to foist ludicrously overvalued stocks on a desperately eager public. Graham’s description of how the IPO process works is a classic that should be required reading in investment-banking ethics classes, if there are any.

¹ See www.calpers.ca.gov/whatshap/hottopic/worldcom_faqs.htm and www. calpers.ca.gov/whatsnew/press/2002/0716a.htm; Retirement Systems of Alabama Quarterly Investment Report for May 31, 2001, at www.rsa.state.al. us/Investments/quarterly_report.htm; and John Bender, Strong Corporate Bond Fund comanager, quoted in www.businessweek.com/magazine/content/01_22/ b3734118.htm.

² These numbers are all drawn from WorldCom’s prospectus, or sales document, for the bond offering. Filed May 11, 2001, it can be viewed at www.sec.gov/ edgar/searchedgar/companysearch.html (in “Company name” window, enter “WorldCom”). Even without today’s 20/20 hindsight knowledge that WorldCom’s earnings were fraudulently overstated, WorldCom’s bond offering would have appalled Graham.

³ For documentation on the collapse of WorldCom, see www.worldcom.com/ infodesk.

¹ In the early 1970s, when Graham wrote, there were fewer than a dozen junk-bond funds, nearly all of which charged sales commissions of up to 8.5%; some even made investors pay a fee for the privilege of reinvesting their monthly dividends back into the fund.

² Edward I. Altman and Gaurav Bana, “Defaults and Returns on High-Yield Bonds,” research paper, Stern School of Business, New York University,2002.

³ Graham did not criticize foreign bonds lightly, since he spent several years early in his career acting as a New York–based bond agent for borrowers in Japan.

⁴ Two low-cost, well-run emerging-markets bond funds are Fidelity New Markets Income Fund and T. Rowe Price Emerging Markets Bond Fund; for more information, see www.fidelity.com, www.troweprice.com, and www. morningstar.com. Do not buy any emerging-markets bond fund with annual operating expenses higher than 1.25%, and be forewarned that some of these funds charge short-term redemption fees to discourage investors from holding them for less than three months.

⁵ The definitive source on brokerage costs is the Plexus Group of Santa Monica, California, and its website, www.plexusgroup.com. Plexus argues persuasively that, just as most of the mass of an iceberg lies below the ocean surface, the bulk of brokerage costs are invisible—misleading investors into believing that their trading costs are insignificant if commission costs are low. The costs of trading NASDAQ stocks are considerably higher for individuals than the costs of trading NYSE-listed stocks (see p. 128, footnote 5).

⁶ Real-world conditions are still more harsh, since we are ignoring state income taxes in this example.

⁷ Barber and Odean’s findings are available at http://faculty.haas.berkeley. edu/odean/Current%20Research.htm and http://faculty.gsm.ucdavis.edu/ ˜bmbarber/research/default.html. Numerous studies, incidentally, have found virtually identical results among professional money managers—so this is not a problem limited to “naïve” individuals.

⁸ See www.microsoft.com/msft/stock.htm, “IPO investment results.”

⁹ Jay R. Ritter and Ivo Welch, “A Review of IPO Activity, Pricing, and Allocations,” Journal of Finance, August, 2002, p. 1797. Ritter’s website, at http:// bear.cba.ufl.edu/ritter/, and Welch’s home page, at http://welch.som.yale. edu/, are gold mines of data for anyone interested in IPOs.

¹⁰ Message no. 9, posted by “GoldFingers 69,” on the VA Linux (LNUX) message board at messages.yahoo.com, dated December 16, 1999. MSFT is the ticker symbol for Microsoft Corp.

^* As already noted (see p. 96, footnote †), the New Housing Authority and New Community bonds are no longer issued.

^† Today these “lower-quality bonds” in the “special situation” area are known as distressed or defaulted bonds. When a company is in approaching) bankruptcy, its common stock becomes essentially worthless, since U.S. bankruptcy law entitles bondholders to a much stronger legal claim than shareholders. But if the company reorganizes successfully and comes out of bankruptcy, the bondholders often receive stock in the new firm, and the value of the bonds usually recovers once the company is able to pay interest again. Thus the bonds of a troubled company can perform almost as well as the common stock of a healthy company. In these special situations, as Graham puts it, “no true distinction exists between bonds and common stocks.”(or

^* Note very carefully what Graham is saying here. Writing in 1972, he contends that the period since 1949—a stretch of more than 22 years—is too short a period from which to draw reliable conclusions! With his mastery of mathematics, Graham never forgets that objective conclusions require very long samples of large amounts of data. The charlatans who peddle “time-tested” stock-picking gimmicks almost always base their findings on smaller samples than Graham would ever accept. (Graham often used 50-year periods to analyze past data.)

^† Today, the enterprising investor can assemble such a list over the Internet by visiting such websites as www.morningstar.com (try the Stock Quickrank tool), www.quicken.com/investments/stocks/search/full, and http://yahoo. marketguide.com.

^* Over the 10 years ending December 31, 2002, funds investing in large growth companies—today’s equivalent of what Graham calls “growth funds”—earned an annual average of 5.6%, underperforming the overall stock market by an average of 3.7 percentage points per year. However, “large value” funds investing in more reasonably priced big companies also underperformed the market over the same period (by a full percentage point per year). Is the problem merely that growth funds cannot reliably select stocks that will outperform the market in the future? Or is it that the high costs of running the average fund (whether it buys growth or “value” companies) exceed any extra return the managers can earn with their stock picks? To update fund performance by type, see www.morningstar.com, “Category Returns.” For an enlightening reminder of how perishable the performance of different investment styles can be, see www.callan.com/resource/periodic_ table/pertable.pdf.

^* Graham makes this point to remind you that an “enterprising” investor is not one who takes more risk than average or who buys “aggressive growth” stocks; an enterprising investor is simply one who is willing to put in extra time and effort in researching his or her portfolio.

^† Notice that Graham insists on calculating the price/earnings ratio based on a multiyear average of past earnings. That way, you lower the odds that you will overestimate a company’s value based on a temporarily high burst of profitability. Imagine that a company earned $3 per share over the past 12 months, but an average of only 50 cents per share over the previous six years. Which number—the sudden $3 or the steady 50 cents—is more likely to represent a sustainable trend? At 25 times the $3 it earned in the most recent year, the stock would be priced at $75. But at 25 times the average earnings of the past seven years ($6 in total earnings, divided by seven, equals 85.7 cents per share in average annual earnings), the stock would be priced at only $21.43. Which number you pick makes a big difference. Finally, it’s worth noting that the prevailing method on Wall Street today—basing price/earnings ratios primarily on “next year’s earnings”—would be anathema to Graham. How can you value a company based on earnings it hasn’t even generated yet? That’s like setting house prices based on a rumor that Cinderella will be building her new castle right around the corner.

^* Recent examples hammer Graham’s point home. On September 21, 2000, Intel Corp., the maker of computer chips, announced that it expected its revenues to grow by up to 5% in the next quarter. At first blush, that sounds great; most big companies would be delighted to increase their sales by 5% in just three months. But in response, Intel’s stock dropped 22%, a one-day loss of nearly $91 billion in total value. Why? Wall Street’s analysts had expected Intel’s revenue to rise by up to 10%. Similarly, on February 21, 2001, EMC Corp., a data-storage firm, announced that it expected its revenues to grow by at least 25% in 2001—but that a new caution among customers “may lead to longer selling cycles.” On that whiff of hesitation, EMC’s shares lost 12.8% of their value in a single day.

^* Today’s equivalent of investors “who have a close relationship with the particular company” are so-called control persons—senior managers or directors who help run the company and own huge blocks of stock. Executives like Bill Gates of Microsoft or Warren Buffett of Berkshire Hathaway have direct control over a company’s destiny—and outside investors want to see these chief executives maintain their large shareholdings as a vote of confidence. But less-senior managers and rank-and-file workers cannot influence the company’s share price with their individual decisions; thus they should not put more than a small percentage of their assets in their own employer’s stock. As for outside investors, no matter how well they think they know the company, the same objection applies.

^* Drexel Firestone, a Philadelphia investment bank, merged in 1973 with Burnham & Co. and later became Drexel Burnham Lambert, famous for its junk-bond financing of the 1980s takeover boom.

^† This strategy of buying the cheapest stocks in the Dow Jones Industrial Average is now nicknamed the “Dogs of the Dow” approach. Information on the “Dow 10” is available at www.djindexes.com/jsp/dow510Faq.jsp.

^* Among the steepest of the mountains recently made out of molehills: In May 1998, Pfizer Inc. and the U.S. Food and Drug Administration announced that six men taking Pfizer’s anti-impotence drug Viagra had died of heart attacks while having sex. Pfizer’s stock immediately went flaccid, losing 3.4% in a single day on heavy trading. But Pfizer’s shares surged ahead when research later showed that there was no cause for alarm; the stock gained roughly a third over the next two years. In late 1997, shares of Warner-Lambert Co. fell by 19% in a day when sales of its new diabetes drug were temporarily halted in England; within six months, the stock had nearly doubled. In late 2002, Carnival Corp., which operates cruise ships, lost roughly 10% of its value after tourists came down with severe diarrhea and vomiting—on ships run by other companies.

^* By “net working capital,” Graham means a company’s current assets (such as cash, marketable securities, and inventories) minus its total liabilities (including preferred stock and long-term debt).

^* From 1975 through 1983, small (“secondary”) stocks outperformed large stocks by an amazing average of 17.6 percentage points per year. The investing public eagerly embraced small stocks, mutual fund companies rolled out hundreds of new funds specializing in them, and small stocks obliged by underperforming large stocks by five percentage points per year over the next decade. The cycle recurred in 1999, when small stocks beat big stocks by nearly nine percentage points, inspiring investment bankers to sell hundreds of hot little high-tech stocks to the public for the first time. Instead of “electronics,” “computers,” or “franchise” in their names, the new buzzwords were “.com,” “optical,” “wireless,” and even prefixes like “e-” and “I-.” Investing buzzwords always turn into buzz saws, tearing apart anyone who believes in them.

^* Defaulted railroad bonds do not offer significant opportunities today. However, as already noted, distressed and defaulted junk bonds, as well as convertible bonds issued by high-tech companies, may offer real value in the wake of the 2000–2002 market crash. But diversification in this area is essential—and impractical without at least $100,000 to dedicate to distressed securities alone. Unless you are a millionaire several times over, this kind of diversification is not an option.

^* A classic recent example is Philip Morris, whose stock lost 23% in two days after a Florida court authorized jurors to consider punitive damages of up to $200 billion against the company—which had finally admitted that cigarettes may cause cancer. Within a year, Philip Morris’s stock had doubled—only to fall back after a later multibillion-dollar judgment in Illinois. Several other stocks have been virtually destroyed by liability lawsuits, including Johns Manville, W. R. Grace, and USG Corp. Thus, “never buy into a lawsuit” remains a valid rule for all but the most intrepid investors to live by.

¹ Lisa Gibbs, “Optic Uptick,” Money, April, 2000, pp. 54–55.

² Brooke Southall, “Cisco’s Endgame Strategy,” InvestmentNews, November 30, 2000, pp. 1, 23.

¹ “The Truth About Timing,” Barron’s, November 5, 2001, p. 20. The headline of this article is a useful reminder of an enduring principle for the intelligent investor. Whenever you see the word “truth” in an article about investing, brace yourself; many of the quotes that follow are likely to be lies. (For one thing, an investor who bought stocks in 1966 and held them through late 2001 would have ended up with at least $40, not $11.71; the study cited in Barron’s appears to have ignored the reinvestment of dividends.)

² The New York Times, January 7, 1973, special “Economic Survey” section, pp. 2, 19, 44.

³ Press release, “It’s a good time to be in the market, says R. M. Leary & Company,” December 3, 2001.

⁴ You would also have saved thousands of dollars in annual subscription fees (which have not been deducted from the calculations of these newsletters’ returns). And brokerage costs and short-term capital gains taxes are usually much higher for market timers than for buy-and-hold investors. For the Duke study, see John R. Graham and Campbell R. Harvey, “Grading the Performance of Market-Timing Newsletters,” Financial Analysts Journal, November/December, 1997, pp. 54–66, also available at www.duke.edu/ ˜charvey/research.htm.

⁵ For more on sensible alternatives to market timing—rebalancing and dollar-cost averaging—see Chapters 5 and 8.

⁶ Carol J. Loomis, “The 15% Delusion,” Fortune, February 5, 2001, pp. 102–108.

⁷ See Jason Zweig, “A Matter of Expectations,” Money, January, 2001, pp. 49–50.

⁸ Louis K. C. Chan, Jason Karceski, and Josef Lakonishok, “The Level and Persistence of Growth Rates,” National Bureau of Economic Research, Working Paper No. 8282, May, 2001, available at www.nber.org/papers/ w8282.

⁹ Almost exactly 20 years earlier, in October 1982, Johnson & Johnson’s stock lost 17.5% of its value in a week when several people died after ingesting Tylenol that had been laced with cyanide by an unknown outsider. Johnson & Johnson responded by pioneering the use of tamper-proof packaging, and the stock went on to be one of the great investments of the 1980s.

¹⁰ For the observation that it is amazingly difficult to remain on the Forbes 400, I am indebted to investment manager Kenneth Fisher (himself a Forbes columnist).

¹¹ In the late 1990s, the forecasts of “market strategists” became more influential than ever before. They did not, unfortunately, become more accurate. On March 10, 2000, the very day that the NASDAQ composite index hit its all-time high of 5048.62, Prudential Securities’s chief technical analyst Ralph Acampora said in USA Today that he expected NASDAQ to hit 6000 within 12 to 18 months. Five weeks later, NASDAQ had already shriveled to 3321.29—but Thomas Galvin, a market strategist at Donaldson, Lufkin & Jenrette, declared that “there’s only 200 or 300 points of downside for the NASDAQ and 2000 on the upside.” It turned out that there were no points on the upside and more than 2000 on the downside, as NASDAQ kept crashing until it finally scraped bottom on October 9, 2002, at 1114.11. In March 2001, Abby Joseph Cohen, chief investment strategist at Goldman, Sachs & Co., predicted that the Standard & Poor’s 500-stock index would close the year at 1,650 and that the Dow Jones Industrial Average would finish 2001 at 13,000. “We do not expect a recession,” said Cohen, “and believe that corporate profits are likely to grow at close to trend growth rates later this year.” The U.S. economy was sinking into recession even as she spoke, and the S & P 500 ended 2001 at 1148.08, while the Dow finished at 10,021.50—30% and 23% below her forecasts, respectively.

^* See p. 3.

^* Without bear markets to take stock prices back down, anyone waiting to “buy low” will feel completely left behind—and, all too often, will end up abandoning any former caution and jumping in with both feet. That’s why Graham’s message about the importance of emotional discipline is so important. From October 1990 through January 2000, the Dow Jones Industrial Average marched relentlessly upward, never losing more than 20% and suffering a loss of 10% or more only three times. The total gain (not counting dividends): 395.7%. According to Crandall, Pierce & Co., this was the second-longest uninterrupted bull market of the past century; only the 1949–1961 boom lasted longer. The longer a bull market lasts, the more severely investors will be afflicted with amnesia; after five years or so, many people no longer believe that bear markets are even possible. All those who forget are doomed to be reminded; and, in the stock market, recovered memories are always unpleasant.

^* Graham discusses this “recommended policy” in Chapter 4 (pp. 89–91). This policy, now called “tactical asset allocation,” is widely followed by institutional investors like pension funds and university endowments.

^* Many of these “formula planners” would have sold all their stocks at the end of 1954, after the U.S. stock market rose 52.6%, the second-highest yearly return then on record. Over the next five years, these market-timers would likely have stood on the sidelines as stocks doubled.

^† Easy ways to make money in the stock market fade for two reasons: the natural tendency of trends to reverse over time, or “regress to the mean,” and the rapid adoption of the stock-picking scheme by large numbers of people, who pile in and spoil all the fun of those who got there first. (Note that, in referring to his “discomfiting experience,” Graham is—as always—honest in admitting his own failures.) See Jason Zweig, “Murphy Was an Investor,” Money, July, 2002, pp. 61–62, and Jason Zweig, “New Year’s Play,” Money, December, 2000, pp. 89–90.

^* Today’s equivalent of what Graham calls “second-line companies” would be any of the thousands of stocks not included in the Standard & Poor’s 500-stock index. A regularly revised list of the 500 stocks in the S & P index is available at www.standardandpoors.com.

^† Note carefully what Graham is saying here. It is not just possible, but probable, that most of the stocks you own will gain at least 50% from their lowest price and lose at least 33% from their highest price—regardless of which stocks you own or whether the market as a whole goes up or down. If you can’t live with that—or you think your portfolio is somehow magically exempt from it—then you are not yet entitled to call yourself an investor. (Graham refers to a 33% decline as the “equivalent one-third” because a 50% gain takes a $10 stock to $15. From $15, a 33% loss [or $5 drop] takes it right back to $10, where it started.)

^* For today’s investor, the ideal strategy for pursuing this “formula” is rebalancing, which we discuss on pp. 104–105.

^* Most companies today provide “an engraved stock certificate” only upon special request. Stocks exist, for the most part, in purely electronic form (much as your bank account contains computerized credits and debits, not actual currency) and thus have become even easier to trade than they were in Graham’s day.

^† Net asset value, book value, balance-sheet value, and tangible-asset value are all synonyms for net worth, or the total value of a company’s physical and financial assets minus all its liabilities. It can be calculated using the balance sheets in a company’s annual and quarterly reports; from total shareholders’ equity, subtract all “soft” assets such as goodwill, trademarks, and other intangibles. Divide by the fully diluted number of shares outstanding to arrive at book value per share.

^* Graham’s use of the word “paradox” is probably an allusion to a classic article by David Durand, “Growth Stocks and the Petersburg Paradox,” The Journal of Finance, vol. XII, no. 3, September, 1957, pp. 348–363, which compares investing in high-priced growth stocks to betting on a series of coin flips in which the payoff escalates with each flip of the coin. Durand points out that if a growth stock could continue to grow at a high rate for an indefinite period of time, an investor should (in theory) be willing to pay an infinite price for its shares. Why, then, has no stock ever sold for a price of infinity dollars per share? Because the higher the assumed future growth rate, and the longer the time period over which it is expected, the wider the margin for error grows, and the higher the cost of even a tiny miscalculation becomes. Graham discusses this problem further in Appendix 4(p. 570).

^* The more recent history of A & P is no different. At year-end 1999, its share price was $27.875; at year-end 2000, $7.00; a year later, $23.78; at year-end 2002, $8.06. Although some accounting irregularities later came to light at A & P, it defies all logic to believe that the value of a relatively stable business like groceries could fall by three-fourths in one year, triple the next year, then drop by two-thirds the year after that.

^* “Only to the extent that it suits his book” means “only to the extent that the price is favorable enough to justify selling the stock.” In traditional brokerage lingo, the “book” is an investor’s ledger of holdings and trades.

^† This may well be the single most important paragraph in Graham’s entire book. In these 113 words Graham sums up his lifetime of experience. You cannot read these words too often; they are like Kryptonite for bear markets. If you keep them close at hand and let them guide you throughout your investing life, you will survive whatever the markets throw at you.

^* Graham has much more to say on what is now known as “corporate governance.” See the commentary on Chapter 19.

^* By what Graham called “the rule of opposites,” in 2002 the yields on long-term U.S. Treasury bonds hit their lowest levels since 1963. Since bond yields move inversely to prices, those low yields meant that prices had risen—making investors most eager to buy just as bonds were at their most expensive and as their future returns were almost guaranteed to be low. This provides another proof of Graham’s lesson that the intelligent investor must refuse to make decisions based on market fluctuations.

^* An updated analysis for today’s readers, explaining recent yields and the wider variety of bonds and bond funds available today, can be found in the commentary on Chapter 4.

^* As mentioned in the commentary on Chapters 2 and 4, Treasury Inflation-Protected Securities, or TIPS, are a new and improved version of what Graham is suggesting here.

¹ See Graham’s text, pp. 204–205.

² As Graham noted in a classic series of articles in 1932, the Great Depression caused the shares of dozens of companies to drop below the value of their cash and other liquid assets, making them “worth more dead than alive.”

³ News release, The Spectrem Group, “Plan Sponsors Are Losing the Battle to Prevent Declining Participation and Deferrals into Defined Contribution Plans,” October 25, 2002.

⁴ A few months later, on March 10, 2000—the very day that NASDAQ hit its all-time high—online trading pundit James J. Cramer wrote that he had “repeatedly” been tempted in recent days to sell Berkshire Hathaway short, a bet that Buffett’s stock had farther to fall. With a vulgar thrust of his rhetorical pelvis, Cramer even declared that Berkshire’s shares were “ripe for the banging.” That same day, market strategist Ralph Acampora of Prudential Securities asked, “Norfolk Southern or Cisco Systems: Where do you want to be in the future?” Cisco, a key to tomorrow’s Internet superhighway, seemed to have it all over Norfolk Southern, part of yesterday’s railroad system. (Over the next year, Norfolk Southern gained 35%, while Cisco lost 70%.)

⁵ When asked what keeps most individual investors from succeeding, Graham had a concise answer: “The primary cause of failure is that they pay too much attention to what the stock market is doing currently.” See “Benjamin Graham: Thoughts on Security Analysis” [transcript of lecture at Northeast Missouri State University Business School, March, 1972], Financial History magazine, no. 42, March, 1991, p. 8.

⁶ Never mind what these terms mean, or are supposed to mean. While in public these classifications are treated with the utmost respect, in private most people in the investment business regard them with the contempt normally reserved for jokes that aren’t funny.

⁷ See the brilliant column by Walter Updegrave, “Keep It Real,” Money, February, 2002, pp. 53–56.

⁸ See Jason Zweig, “Did You Beat the Market?” Money, January, 2000, pp. 55–58.

⁹ The neuroscience of investing is explored in Jason Zweig, “Are You Wired for Wealth?” Money, October, 2002, pp. 74–83, also available at http:// money.cnn.com/2002/09/25/pf/investing/agenda_brain _short/index.htm. See also Jason Zweig, “The Trouble with Humans,” Money, November, 2000, pp. 67–70.

¹⁰ It’s also worth asking whether you could enjoy living in your house if its market price was reported to the last penny every day in the newspapers and on TV.

¹¹ In a series of remarkable experiments in the late 1980s, a psychologist at Columbia and Harvard, Paul Andreassen, showed that investors who received frequent news updates on their stocks earned half the returns of investors who got no news at all. See Jason Zweig, “Here’s How to Use the News and Tune Out the Noise,” Money, July, 1998, pp. 63–64.

¹² Federal tax law is subject to constant change. The example of Coca-Cola stock given here is valid under the provisions of the U.S. tax code as it stood in early 2003.

¹³ This example assumes that the investor had no realized capital gains in 2002 and did not reinvest any Coke dividends. Tax swaps are not to be undertaken lightly, since they can be mishandled easily. Before doing a tax swap, read IRS Publication 550 (www.irs.gov/pub/irspdf/p550.pdf). A good guide to managing your investment taxes is Robert N. Gordon with Jan M. Rosen, Wall Street Secrets for Tax-Efficient Investing (Bloomberg Press, Princeton, New Jersey, 2001). Finally, before you pull the trigger, consult a professional tax adviser.

^* It is a violation of Federal law for an open-end mutual fund, a closed-end fund, or an exchange-traded fund to sell shares to the public unless it has “registered” (or made mandatory financial filings) with the SEC.

^† The fund industry has gone from “very large” to immense. At year-end 2002, there were 8,279 mutual funds holding $6.56 trillion; 514 closed-end funds with $149.6 billion in assets; and 116 exchange-trade funds or ETFs with $109.7 billion. These figures exclude such fund-like investments as variable annuities and unit investment trusts.

^* Lists of the major types of mutual funds can be found at www.ici.org/ pdf/g2understanding.pdf and http://news.morningstar.com/fundReturns/ CategoryReturns.html. Letter-stock funds no longer exist, while hedge funds are generally banned by SEC rules from selling shares to any investor whose annual income is below $200,000 or whose net worth is below $1 million.

^† Today, the maximum sales load on a stock fund tends to be around 5.75%. If you invest $10,000 in a fund with a flat 5.75% sales load, $575 will go to the person (and brokerage firm) that sold it to you, leaving you with an initial net investment of $9,425. The $575 sales charge is actually 6.1% of that amount, which is why Graham calls the standard way of calculating the charge a “sales gimmick.” Since the 1980s, no-load funds have become popular, and they no longer tend to be smaller than load funds.

^† Nearly every mutual fund today is taxed as a “regulated investment company,” or RIC, which is exempt from corporate income tax so long as it pays out essentially all of its income to its shareholders. In the “option” that Graham omits “to avoid clutter,” a fund can ask the SEC for special permission to distribute one of its holdings directly to the fund’s shareholders—as his Graham-Newman Corp. did in 1948, parceling out shares in GEICO to Graham-Newman’s own investors. This sort of distribution is extraordinarily rare.

^* Dual-purpose funds, popular in the late 1980s, have essentially disappeared from the marketplace—a shame, since they offered investors a more flexible way to take advantage of the skills of great stock pickers like John Neff. Perhaps the recent bear market will lead to a renaissance of this attractive investment vehicle.

^† “Performance funds” were all the rage in the late 1960s. They were equivalent to the aggressive growth funds of the late 1990s, and served their investors no better.

^* For periods as long as 10 years, the returns of the Dow and the S & P 500 can diverge by fairly wide margins. Over the course of the typical investing lifetime, however—say 25 to 50 years—their returns have tended to converge quite closely.

^* One of the “doomed companies” Graham refers to was National Student Marketing Corp., a con game masquerading as a stock, whose saga was told brilliantly in Andrew Tobias’s The Funny Money Game (Playboy Press, New York, 1971). Among the supposedly sophisticated investors who were snookered by NSM’s charismatic founder, Cort Randell, were the endowment funds of Cornell and Harvard and the trust departments at such prestigious banks as Morgan Guaranty and Bankers Trust.

^* As only the latest proof that “the more things change, the more they stay the same,” consider that Ryan Jacob, a 29-year-old boy wonder, launched the Jacob Internet Fund at year-end 1999, after producing a 216% return at his previous dot-com fund. Investors poured nearly $300 million into Jacob’s fund in the first few weeks of 2000. It then proceeded to lose 79.1% in 2000, 56.4% in 2001, and 13% in 2002—a cumulative collapse of 92%. That loss may have made Mr. Jacob’s investors even older and wiser than it made him.

^† Intriguingly, the disastrous boom and bust of 1999–2002 also came roughly 35 years after the previous cycle of insanity. Perhaps it takes about 35 years for the investors who remember the last “New Economy” craze to become less influential than those who do not. If this intuition is correct, the intelligent investor should be particularly vigilant around the year 2030.

^* Today’s equivalent of Graham’s “scarce exceptions” tend to be open-end funds that are closed to new investors—meaning that the managers have stopped taking in any more cash. While that reduces the management fees they can earn, it maximizes the returns their existing shareholders can earn. Because most fund managers would rather look out for No. 1 than be No. 1, closing a fund to new investors is a rare and courageous step.

¹ See Jason Zweig, “Did You Beat the Market?” Money, January, 2000, pp. 55–58; Time /CNN poll #15, October 25–26, 2000, question 29.

¹ Sector funds specializing in almost every imaginable industry are available—and date back to the 1920s. After nearly 80 years of history, the evidence is overwhelming: The most lucrative, and thus most popular, sector of any given year often turns out to be among the worst performers of the following year. Just as idle hands are the devil’s workshop, sector funds are the investor’s nemesis.

² The research on mutual fund performance is too voluminous to cite. Useful summaries and links can be found at: www.investorhome.com/mutual. htm#do, www.ssrn.com (enter “mutual fund” in the search window), and www.stanford.edu/˜wfsharpe/art/art.htm.

³ That’s not to say that these funds would have done better if their “super-star” managers had stayed in place; all we can be sure of is that the two funds did poorly without them.

⁴ There’s a second lesson here: To succeed, the individual investor must either avoid shopping from the same list of favorite stocks that have already been picked over by the giant institutions, or own them far more patiently. See Erik R. Sirri and Peter Tufano, “Costly Search and Mutual Fund Flows,” The Journal of Finance, vol. 53, no. 8, October, 1998, pp. 1589–1622; Keith C. Brown, W. V. Harlow, and Laura Starks, “Of Tournaments and Temptations,” The Journal of Finance, vol. 51, no. 1, March, 1996, pp. 85–110; Josef Lakonishok, Andrei Shleifer, and Robert Vishny, “What Do Money Managers Do?” working paper, University of Illinois, February, 1997; Stanley Eakins, Stanley Stansell, and Paul Wertheim, “Institutional Portfolio Composition,” Quarterly Review of Economics and Finance, vol. 38, no. 1, Spring, 1998, pp. 93–110; Paul Gompers and Andrew Metrick, “Institutional Investors and Equity Prices,” The Quarterly Journal of Economics, vol. 116, no. 1, February, 2001, pp. 229–260.

⁵ Amazingly, this illustration understates the advantage of index funds, since the database from which it is taken does not include the track records of hundreds of funds that disappeared over these periods. Measured more accurately, the advantage of indexing would be overpowering.

⁶ See Benjamin Graham, Benjamin Graham: Memoirs of the Dean of Wall Street, Seymour Chatman, ed. (McGraw-Hill, New York, 1996), p. 273, and Janet Lowe, The Rediscovered Benjamin Graham: Selected Writings of the Wall Street Legend (John Wiley & Sons, New York, 1999), p. 273. As Warren Buffett wrote in his 1996 annual report: “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.” (See www.berkshirehathaway. com/1996ar/1996.html.)

⁷ A complete listing of the S & P 500’s constituent companies is available at www.standardandpoors.com.

⁸ See Noel Capon, Gavan Fitzsimons, and Russ Alan Prince, “An Individual Level Analysis of the Mutual Fund Investment Decision,” Journal of Financial Services Research, vol. 10, 1996, pp. 59–82; Investment Company Institute, “Understanding Shareholders’ Use of Information and Advisers,” Spring, 1997, at www.ici.org/pdf/rpt_undstnd_share.pdf, p. 21; Gordon Alexander, Jonathan Jones, and Peter Nigro, “Mutual Fund Shareholders: Characteristics, Investor Knowledge, and Sources of Information,” OCC working paper, December, 1997, at www.occ.treas.gov/ftp/workpaper/ wp97-13.pdf.

⁹ Investors can search easily for funds that meet these expense hurdles by using the fund-screening tools at www.morningstar.com and http://money. cnn.com.

¹⁰ See Matthew Morey, “Rating the Raters: An Investigation of Mutual Fund Rating Services,” Journal of Investment Consulting, vol. 5, no. 2, November/ December, 2002. While its star ratings are a weak predictor of future results, Morningstar is the single best source of information on funds for individual investors.

¹¹ Unlike a mutual fund, a closed-end fund does not issue new shares directly to anyone who wants to buy them. Instead, an investor must buy shares not from the fund itself, but from another shareholder who is willing to part with them. Thus, the price of the shares fluctuates above and below their net asset value, depending on supply and demand.

¹² For more information, see www.morningstar.com and www.etfconnect. com.

¹³ Unlike index mutual funds, index ETFs are subject to standard stock commissions when you buy and sell them—and these commissions are often assessed on any additional purchases or reinvested dividends. Details are available at www.ishares.com, www.streettracks.com, www.amex.com, and www.indexfunds.com.

¹⁴ See Sequoia’s June 30, 1999, report to shareholders at www.sequoia fund.com/Reports/Quarterly/SemiAnn99.htm. Sequoia has been closed to new investors since 1982, which has reinforced its superb performance.

¹⁵ Jason Zweig, “What Fund Investors Really Need to Know,” Money, June, 2002, pp. 110–115.

¹⁶ See interview with Ellis in Jason Zweig, “Wall Street’s Wisest Man,” Money, June, 2001, pp. 49–52.

¹ Alternatively, you could buy back the call option, but you would have to take a loss on it—and options can have even higher trading costs than stocks.

¹ To put this statement in perspective, consider how often you are likely to buy a stock at $30 and be able to sell it at $600.

² Benjamin Graham, The Intelligent Investor (Harper & Row, 1949), p. 4.

³ A “hedge fund” is a pool of money, largely unregulated by the government, invested aggressively for wealthy clients. For a superb telling of the LTCM story, see Roger Lowenstein, When Genius Failed (Random House, 2000).

⁴ John Carswell, The South Sea Bubble (Cresset Press, London, 1960), pp. 131, 199. Also see www.harvard-magazine.com/issues/mj99/damnd. html.

⁵ Constance Loizos, “Q&A: Alex Cheung,” InvestmentNews, May 17, 1999, p. 38. The highest 20-year return in mutual fund history was 25.8% per year, achieved by the legendary Peter Lynch of Fidelity Magellan over the two decades ending December 31, 1994. Lynch’s performance turned $10,000 into more than $982,000 in 20 years. Cheung was predicting that his fund would turn $10,000 into more than $4 million over the same length of time. Instead of regarding Cheung as ridiculously overoptimistic, investors threw money at him, flinging more than $100 million into his fund over the next year. A $10,000 investment in the Monument Internet Fund in May 1999 would have shrunk to roughly $2,000 by year-end 2002. (The Monument fund no longer exists in its original form and is now known as Orbitex Emerging Technology Fund.)

⁶ Lisa Reilly Cullen, “The Triple Digit Club,” Money, December, 1999, p. 170. If you had invested $10,000 in Vilar’s fund at the end of 1999, you would have finished 2002 with just $1,195 left—one of the worst destructions of wealth in the history of the mutual-fund industry.

⁷ See www.thestreet.com/funds/smarter/891820.html. Cramer’s favorite stocks did not go “higher consistently in good days and bad.” By year-end 2002, one of the 10 had already gone bankrupt, and a $10,000 investment spread equally across Cramer’s picks would have lost 94%, leaving you with a grand total of $597.44. Perhaps Cramer meant that his stocks would be “winners” not in “the new world,” but in the world to come.

⁸ The only exception to this rule is an investor in the advanced stage of retirement, who may not be able to outlast a long bear market. Yet even an elderly investor should not sell her stocks merely because they have gone down in price; that approach not only turns her paper losses into real ones but deprives her heirs of the potential to inherit those stocks at lower costs for tax purposes.

^* Raskob (1879–1950) was a director of Du Pont, the giant chemical company, and chairman of the finance committee at General Motors. He also served as national chairman of the Democratic Party and was the driving force behind the construction of the Empire State Building. Calculations by finance professor Jeremy Siegel confirm that Raskob’s plan would have grown to just under $9,000 after 20 years, although inflation would have eaten away much of that gain. For the best recent look at Raskob’s views on long-term stock investing, see the essay by financial adviser William Bernstein at www.efficientfrontier.com/ef/197/raskob.htm.

^* Graham’s “brief discussion” is in two parts, on p. 33 and pp. 191–192. For more detail on the Dow Theory, see http://viking.som.yale.edu/will/ dow/dowpage.html.

^† Mutual funds bought “letter stock” in private transactions, then immediately revalued these shares at a higher public price (see Graham’s definition on p. 579). That enabled these “go-go” funds to report unsustainably high returns in the mid-1960s. The U.S. Securities and Exchange Commission cracked down on this abuse in 1969, and it is no longer a concern for fund investors. Stock-option warrants are explained in Chapter 16.

^* The Penn Central Transportation Co., then the biggest railroad in the United States, sought bankruptcy protection on June 21, 1970—shocking investors, who had never expected such a giant company to go under (see. 423). Among the companies with “excessive” debt Graham had in mind were Ling-Temco-Vought and National General Corp. (see pp. 425 and 463). The “problem of solvency” on Wall Street emerged between 1968 and 1971, when several prestigious brokerages suddenly went bust.

^* See Chapter 2. As of the beginning of 2003, U.S. Treasury bonds maturing in 10 years yielded 3.8%, while stocks (as measured by the Dow Jones Industrial Average) yielded 1.9%. (Note that this relationship is not all that different from the 1964 figures that Graham cites.) The income generated by top-quality bonds has been falling steadily since 1981.

^* “Air-transport stocks,” of course, generated as much excitement in the late 1940s and early 1950s as Internet stocks did a half century later. Among the hottest mutual funds of that era were Aeronautical Securities and the Missiles-Rockets-Jets & Automation Fund. They, like the stocks they owned, turned out to be an investing disaster. It is commonly accepted today that the cumulative earnings of the airline industry over its entire history have been negative. The lesson Graham is driving at is not that you should avoid buying airline stocks, but that you should never succumb to the “certainty” that any industry will outperform all others in the future.

^* Tangible assets include a company’s physical property (like real estate, factories, equipment, and inventories) as well as its financial balances (such as cash, short-term investments, and accounts receivable). Among the elements not included in tangible assets are brands, copyrights, patents, franchises, goodwill, and trademarks. To see how to calculate tangible-asset value, see footnote † on p. 198.