As I look over the stock market picture for the past seven years it occurs to me that next to liquid capital the investor must have patience and courage. The bad break of the past few weeks is the 7th bad break since 1930. In between each break the market arose to heights that would have permitted several hundred percent profit over the previous lows. Any investor who had the patience to wait for a bad break and then bought could have made much money. Most people do not have the patience to wait for the bad break. The average speculator is tied up in the market to the hilt when the break comes and has no liquid cash for the bargains that prevail.
There are two theories of present slump:
1. That the old depression is not yet over—we have not yet reached normal—this is the 7th set-back of the old depression.
2. The depression was over two years ago. Since March 1935 we have been going thru a boom. This is the first collapse after recovery.
I am inclined to follow the first theory! Certainly my law practice does not indicate that the depression has ended.
NOVEMBER 22, 1937
Following are some of the high and low stock prices for this year. Stocks are now at low points and most of the losses occurred in the recent recession which still proceeds.
AT&T 187-140; B&O 40 1/2-8 1/8; Gen. Elec. 64 7/8-34; G.M. 70 1/2-31 1/4; Radio 12 3/4-4 3/4; Repub. 47 1/4-12 1/2; Warner 18-4 3/4; West. U. 83 1/2-25 1/8; Yo. S &T 101 7/8-35.
There is growing belief among economists that the present recession is not an ordinary one; that the upturn since 1932 was false, based on government spending, monetary manipulation; that this recession is a liquidation of this false prosperity and that it will develop into a major depression or inflation unless the gov’t balances the budget etc. Steel operations down to 40%.
If the gov’t continues its spending etc. it means ultimate inflation and crash.
If the gov’t stops spending, balances the budget, it means bad business during the period of adjustment but ultimately a sound recovery.
Either way the outlook is not promising.
NOVEMBER 26, 1937
The more I see of the recent stock market slump the more I am impressed with the fact that the American people look upon the stock market as a place to gamble and not to invest. In times of rising market the average American becomes over-optimistic: he invests his whole capital in common stocks of the most speculative variety; often extends himself on margin. Then when a slump comes he finds himself over-extended; no cash reserve to fall back upon; he becomes unduly pessimistic and sells at a loss. The European investor takes his capital—no matter how small—half he invests in government bonds—25% in high-grade dividend paying stocks—and the remaining 25% he will use to gamble on speculative stocks offering possibility of large gains. In the long run he comes out best. His possibility of loss is limited and in an abnormally low market like in 1932 he has capital for unusual bargains. What the American needs is not only stock exchange regulations but also an education on the investment possibilities of the stock market.
The average man who buys real estate for investment makes a careful study of the property, the location, the income, etc. and hires a lawyer to examine the title. He then expends a lot of time and energy to collect rents, make repairs, etc. At the end of 10 years if he can say that his investment shows an annual return of 6% and then a reasonable capital profit when he sells, then he will consider that investment a success. That same man when he buys stocks either will not investigate because he does not know how or because he is lazy. He bets his money as in a horse race and does not feel his venture a success unless his money is doubled in a very short time.
If the patience and care used in a real estate investment were used in making a stock investment, there would be much greater chance of success.
DECEMBER 21, 1937
The business slump continues and the stock market is stagnant although the stores are having a fair Christmas season.
Mr. R. C. S. told me another depression story today. He made $150,000 in the real estate brokerage business in the 1920s—before he was 45. Then lost $70,000 in stock of Republic Rubber Company. After that loss he put the rest of his money in 2nd mortgages bought at discount. In the foreclosure period following 1929 he bought in many properties to protect his 2nd mortgages—assumed the first mortgage expecting to pay out of rent. Then in the 1930s, he could not rent or sell the properties and lost everything. Ended in a nervous breakdown and is just now recovering. Trying to start again as a real estate broker to earn a living. Asked what he would do with the $150,000 if he had the chance again, he said: “I would buy an annuity or government bonds. It would have made me secure for life.” Is especially rabid against buying vacant lots for investment. Taxes and lack of income make them more speculative than the stock market.
The more I hear of these things the more difficult does the whole problem of investment become. Real estate is surrounded with many perils as shown during the past few years. Investment in securities is even more difficult. It requires a knowledge of intricate corporate affairs, of accounting, of business cycles and also the ability to follow the trend of national and international economic and political affairs. Even bonds are full of risk because large corporations put out so many issues that it is difficult even for the expert to determine which is a first mortgage. The recent history of corporate reorganization and bankruptcy shows that bondholders fared badly. The only solution seems to be to make a life study of it—just like any other profession—and then use your best judgment. In addition to this the investor must have a sense of business values—be conservative and yet able to act quickly when he sees opportunity. Very few can qualify and yet the rewards are great.
DECEMBER 23, 1937
I just finished reading a book by [Morrell Walker] Gaines on the
Art of Investment
(1922). I found it very instructive. Gaines first tries to show the difference between speculation and investment. He believes that certain safeguards can be built up against risk—that by study and hard work the intelligent investor can determine the business cycle we are in—can arrange to switch from common stocks to short-term bonds when speculation is rife—from short-term bonds or treasury bonds to long-term bonds after prosperity has broken and the downward swing has started—to sell the long-term bonds and switch to common stocks again when the bottom has been reached and signs of upturn begin to appear. His theory is to invest in the strongest income securities—and this return plus an occasional capital increase every two or three years in boom markets—will ultimately mean substantial profits. If the capital is not lost and if the profit is consecutive (even if not large) the fund will grow with amazing rapidity.
Defenses
To guard against loss of capital is most important.
1. Increase liquid assets when security prices are high and speculation rampant. Substitute short-time bonds for long-time bonds and common stocks. Get ready for the inevitable crash. Even if you sell too early—it is better than too late. It is sometimes wise to sell at a price you fixed when you bought the stock.
2. Deal only in well-seasoned securities with a broad market. Slow stocks may tie you up at a critical time.
3. As far as possible deal only in income bearing securities that can be held through a slump. Then if you don’t sell out in time, even tho you may see low prices, you may get a reasonable return on your investment and will probably come out in the end.
4. Buy the stocks outright—not on margin. If you do borrow—borrow from banks—conservatively. If you borrow when stocks are low and money plentiful—you take less risk than when stocks are high and a crash is imminent.
1. First line of attack is accrual of income. Money doubles in 14 years at 5%—12 yrs. at 6%—and 10 yrs at 7%. 1000 for 40 years at 6% will amount to $165,000.
2. Second line of attack is to get an occasional capital increase every few years by sale of securities at higher prices. It is hard to pick a security that will go up quickly but it is less difficult to pick a security that will go up in 2 or 3 years. The difficulty diminishes with the distance. If a good security is bought below value, the investor need not be much concerned with the daily ups and downs of the market. Eventually the market will come up to him and recognize the value of the security. This means recognizing the long swings in the business cycle. It means switching to high-grade common stocks in time of depression when they sell below value—and switching again to bonds in time of prosperity when common stocks are selling at a premium and speculation is rife. When prices are high, that is the time to guard against depreciation. When prices are low that is the time for action with liquid capital. An investor who is loaded in time of depression with high priced common stocks is rendered helpless and can only wait and hope his stocks are strong enough to carry thru. Another source of profit is buying stocks of reorganized companies. It is best to wait until the reorganization is complete and buy the new stocks. Generally the old stockholders get tired of waiting and throw the new stock on the market for what it will bring. If the reorganization has been drastic and takes place just before an upturn in business comes then it should be a good investment.
3. There is a proper security for each phase of the business cycle—and each security—whether bonds or stocks—should bear dividends. The dividend return may vary but should be unbroken. The profit from sale of securities will be irregular and at long intervals. As the cycle changes the security should be changed. It is hard to always judge the exact place in a cycle but it is fairly easy to know whether we are in a period of great prosperity and speculation or in a period of blackness and despair. It is most difficult to know when the turn comes. It is best not to wait for the turn but to follow the simple theory of buying when a security is selling below value and to sell when above value. You will probably lose some profits but this is better than waiting too long. A conservative investor will be satisfied to increase principal to an extent that will double the dividend return. This may not sound like much but if the increase is consecutive and none of the principal lost, it will mount rapidly.
Other general points.
1. Depression is time of greatest profit. The investor who has liquid funds and the courage to act can lay the basis for great profits. The speculator is usually broke or tied up with high-priced stocks.
2. A period of railroad reorganization offers great opportunities in the stocks and bonds of the reorganized companies. If drastically reorganized, the companies will be stronger than ever. Prosperous years are ahead and the new stocks will sell below value.
3. Not too much of your capital should be risked on one particular theory. You may be wrong. You must judge the risk as well as the profit and the latter should outweigh the former.
4. Business will always come back. It will remain neither depressed nor exalted.
5. The stock market forecasts business in only a limited way. The beginning of a stock market movement usually is caused by the trend of business but in the end the movement is carried too high or too low—by the extreme optimism or despair of human nature.
6. As a general rule only strong companies are worth investing in. After a severe depression this may be broadened to include 2nd grade companies which have survived the panic in good shape and have prosperous years ahead. At such times the risk is less. The risk is greatest at the top of a boom.
7. A certain amount of cash, bonds or other liquid securities should always be set aside for protection or to seize unexpected opportunities.
8. A major risk should not be taken for a minor profit. Real skill appears in appraising the risk. If it can be discovered where risks have been exaggerated by the public in lowness of price, the profit naturally follows.
9. The investor has this great advantage over the merchant or speculator—his assets are always liquid. He can switch from the treas. bonds to short or long-term bonds or to stocks with great rapidity—and he can still maintain steady dividends even tho they are lower. The investor should consider his work as a business or profession—his capital is most precious and must not be lost or tied up. He must be more interested in broad economic movements than in day by day fluctuations of the stock market. He must not let his long viewpoint be disturbed by too close contact with the stock market. He is not interested in tips. The investor must be hot in action—cold in thought.