INTRODUCTION

The stock market is filled with individuals who know the price of
everything, but the value of nothing
.

—PHILIP FISHER

I made it through Yale graduate school on a $200 monthly stipend—$100 for rent in a nasty part of New Haven and $100 for food, secondhand clothes, and not much else. My shoes were held together with duct tape, and dinners at the end of the month were often bread and orange juice, sometimes bread and water. I started teaching economics at Yale in 1971, a newly minted PhD with a three-month-old son, $12,000 annual income, and less than $100 in the bank.

The Yale economics department asked students what courses they would like added to the curriculum and the runaway winners were Marx and the stock market. I wasn’t interested in Marx, but the chair of my thesis committee was James Tobin, who would be awarded the Nobel Prize in Economics, in part for his analysis of financial markets. So, I volunteered to create a stock market course and asked Jim to recommend a textbook. His immediate answer was The Theory of Investment Value, by John Burr Williams, which had been published more than thirty years earlier, in 1938, and was not really a textbook. It was Williams’s PhD thesis and had been rejected by several publishers for being overly academic (it had algebraic symbols!). Harvard University Press published it, but Williams had to pay part of the printing cost himself.

Tobin’s recommendation was inspired. John Burr Williams and Benjamin Graham laid the foundation for value investing—assessing stocks based on the cash they generate rather than trying to predict zigs and zags in stock prices. Their way of thinking is central to the success of many legendary value investors, including Warren Buffett, Laurence Tisch, and Michael Larson.

I didn’t use Williams’s treatise as a textbook but, over and over, I have relied on the insights I learned from Tobin, Williams, Graham, and Buffett. I’ve been investing and teaching investing for more than forty years now, and I’ve learned that some lessons are well worth learning, others are not. Their lessons are worth learning.

Financial markets are always changing, but underneath these innovations are some core concepts like present value, leverage, hedging, efficient markets, and the conservation of value. These enduring principles are more important than temporary details. Investing is not a multiple-choice test that can be passed by memorizing soon-obsolete facts like the name of the largest brokerage firm or the number of stocks traded on the New York Stock Exchange.

The great British economist John Maynard Keynes wrote:

The master-economist must possess a rare combination of gifts. He must be mathematician, historian, statesman, philosopher—in some degree. He must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought. He must study the present in the light of the past for the purposes of the future. No part of man’s nature or his institutions must lie entirely outside his regard.

The same could be said of the master investor. How can we calculate present values without mathematics? How can we gauge uncertainty without statistics? However, a deep understanding of investments requires recognition of the limitations of mathematical and statistical models, no matter how scientific they appear, no matter if they were developed by Nobel laureates.

Tobin came to Yale in 1950 when the economics department decided that it needed a mathematical economist. Yes, one mathematical economist among a faculty of perhaps sixty. When Tobin retired, every Yale economist was more mathematical than Tobin had been in 1950, some frighteningly so. Mathematicians had become the gods of economics, and knowing nothing about the real world was almost a badge of honor. When Gérard Debreu was awarded the Nobel Prize in Economics in 1983, reporters tried to get him to say something about Ronald Reagan’s economic policies. Debreu firmly refused to say anything, some suspected because he didn’t know or care—and was proud of it.

Mathematical models are too often revered more for their elegance than their realism. Too many economists assume whatever is needed—no matter how preposterous—in order to make their models mathematically tractable. I listened to a finance lecture at Yale where a future Nobel laureate began his talk with a brutally candid statement: “Making whatever assumptions are needed, here is my proof.”

This cavalier attitude may work great for publishing academic papers that no one reads, but it is a recipe for disaster on Wall Street where real people risk real money and may literally be betting the bank based on a model concocted out of convenience.

At about the same time I heard this lecture, the New Statesman gave an award for this definition of an economist:

An inhabitant of cloud-cuckoo land; one knowledgeable in an obsolete art; a harmless academic drudge whose theories and laws are but mere puffs of air in face of the anarchy of banditry, greed, and corruption which holds sway in the pecuniary affairs of the real world.

In recent years, the inhabitants of cloud-cuckoo land have been joined on the economics pedestal by new gods: number crunchers.

When I first started teaching investments, computers were just becoming popular, and my wife’s grandfather (“Popsie”) knew that my PhD thesis used Yale’s big computer to estimate an extremely complicated economic model. Popsie had bought and sold stocks for decades. He even had his own desk at his broker’s office where he could trade gossip and stocks.

Nonetheless, he wanted advice from a twenty-one-year-old kid who had no money and had never bought a single share of stock in his life—me—because I worked with computers. “Ask the computer what it thinks of Schlumberger,” he’d say. “Ask the computer what it thinks of GE.”

Things haven’t changed much. Too many people still think that computers are infallible. No matter what kind of garbage we put in, computers will spit out gospel. Nope. Garbage in, garbage out. As with theoretical models based on convenient assumptions, statistical patterns uncovered by torturing data are worse than worthless. They have bankrupted investors large and small.

Mathematics is not enough. Statistics is not enough. Master investors need common sense; they need to understand human nature, and they need to control their emotions.

FEAR AND GREED

I have a friend, Blake, who netted a million dollars in cash when he downsized by selling a McMansion and buying a smaller home. About a year after the sale, I asked him what he had done with the money and I was flabbergasted when he told me that he had been holding it in his checking account. He didn’t know what the interest rate was, so I checked. It was 0.01 percent. That’s right, one one-hundredths of a percent.

I asked why and Blake said he didn’t want to lose any money. True enough, his money wasn’t going to go below $1 million, but it wasn’t going to go much above $1 million, either. He was losing a lot of money compared to how much money he might have if he invested in stocks. A return of 0.01 percent on $1 million is $100 in a year’s time. A portfolio of blue-chip stocks with 2 percent dividend yields would generate $20,000 in dividends in a year’s time. There is a pretty big difference between $100 and $20,000.

It gets worse. With normal 5 percent dividend growth, the anticipated long-return from the blue-chip stock portfolio is 7 percent. If dividends and prices go up by 5 percent the first year, the first-year return is $70,000, compared to $100. That’s a heavy price to pay for safety.

It is true, as Blake said adamantly, there is no guarantee what stock prices will be day to day, week to week, or year to year. Stock prices could drop 5, 10, even 20 percent in a single day, even more in a year.

I tried to convince Blake of the wisdom of a value-investor perspective. Invest in ten, twenty, or thirty great companies with 2 percent dividend yields and then forget about it. Don’t check stock prices every day. He could think about something else—his family, his job, his hobbies. While he is minding his own business, his stock portfolio will pay $20,000 dividends the first year, somewhat more the next year, and even more the year after that, with all dividends automatically reinvested.

Ten years from now, he can check his portfolio. He will have accumulated ten years of healthy dividends reinvested to earn even more dividends. The market prices of his stocks will almost surely be higher ten years from now than they are today, probably much higher. The economy will be much larger, corporate earnings will be much higher, and dividends will be much higher—so will stock prices. If the dividends and earnings on his stocks grow by an average of 5 percent a year and price-earnings ratios are about the same then as they are today, his portfolio will be worth about $2 million, as opposed to $1,001,000 if he leaves his money in a checking account paying 0.01 percent interest for ten years

Blake reluctantly agreed to invest $500,000 in stocks. Wouldn’t you know it, he called me the next day to complain that the value of his portfolio had dropped by $195. (No, I am not making this up.) He wanted to sell his stocks before he lost any more money.

Other people are the exact opposite. I have another friend, Emma, who gets the same thrills from buying and selling stocks that other people get from winning and losing money in Las Vegas. Every weekday morning, Emma bolts out of bed, excited to start a new day filled with buying and selling stocks. News tidbits, stock price blips, and chat-room rumors provide jolts of excitement as Emma moves quickly to buy or sell before others do. By the end of the day, she has sold everything she bought during the day because she doesn’t want to be blindsided by overnight news. Emma wants to be in control, to begin every day with cash that she can deploy during the day as she does battle with other investors.

On weekends, Emma is bored and restless. For some people, Monday is Blue Monday—the day they have to go back to work. For Emma, Monday is Merry Monday—the day she gets to start living again.

Emma is a gambling addict. Some people love to watch slot-machine wheels spin; Emma loves to watch stock prices dance. Profits are exhilarating. Losses are an incentive to keep betting, hoping to recoup those losses and believing that she is due for a win. Daytrading stocks is entertainment, but it is not cheap.

I hope this book will convince you that Blake and Emma are bad role models. Sensible investors can make a lot more money than Blake’s checking account without taking as many risks as Emma’s dice rolls. The secret is value investing—buying solid stocks at attractive prices, and leaving them alone.

Value investing is admittedly more adventurous than checking accounts and more boring than day-trading, but it is more rewarding than both.

Part I of this book will argue that a value-investing strategy can help intelligent investors select profitable investments without unbearable financial stress. Part II will describe several detailed examples of value investing.

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