Investment wisdom from the good old, bad old days

The Baltimore Sun

Outselling Chicken Soup for the Soul these days on is what one might call "Chicken Soup for the Investor's Soul." (Let's assume investors do in fact have souls.)

Security Analysis by Benjamin Graham and David Dodd is climbing the charts despite a price of $140 for the newest edition, despite its 766 pages, despite chapter titles such as "Capitalization Structure" and despite the fact that it was first published early in the Franklin D. Roosevelt administration.

At least two investment houses are distributing free copies to clients.

"The biggest event in the world of investment publishing this year," the Financial Times predicted of the book's recent re-release. "A time-tested classic," said T. Rowe Price Chairman Brian C. Rogers in a blurb.

Can an Oprah endorsement be far off?

Security Analysis is the feel-good sensation of 2008 for two reasons. First, it explains very clearly how not to lose money in financial bubbles. Newly bankrupt readers, their timing off by a couple of years, will gain in wisdom what they lack in net worth.

Second, Graham and Dodd's way of thinking adds to a widespread - though not universal - sense that stocks are cheap and that the Dow Jones dive is over.

"We do not know how long fear and irrational pricing will grip the market," Longleaf Partners, one of the firms handing out the book, wrote to clients two weeks ago. "But we do know that this is the most compelling opportunity set we have seen in 33 years."

It was a long way down.

At yesterday's close of 8,668, the Dow Jones industrial average has fallen 38 percent from its peak of 14,093 in October 2007. Standard & Poor's index of 500 large companies, a broader market measure, is down even more. Neither index is higher than it was in 2002 - or 1997! (Thanks to dividends, however, returns since then have been more than zero.)

A wise-guy hedge-fund manager sent holiday cards with a stock chart like a Christmas tree - steeply up one side, steeply down the other. It was a fanciful distortion - but unfortunately not much of one.

The positive case for stocks, however, is more than just, "stock prices used to be high and now they're low."

Relative to corporate profits, which is the reason to buy shares, stocks are the least expensive they've been in a long time. Most investors know the price/earnings ratio - what you pay for a stream of profits. Divide the stock price by the most recent 12 months' earnings per share.

Graham and Dodd took a more conservative approach, reasoning that profits are volatile. They looked at a multiyear average of earnings - as many as 10 years. The long-term average Graham and Dodd P/E ratio for the S&P; 500 is 16. During the dot-com madness it got as high as 40; as recently as last year it was in the high 20s. Now it's about 14. The last time it was that low was the mid-1980s.

True, at points in history it has been much lower - in single digits in the 1930s and early 1980s. But there are reasons to believe stocks won't retest those depths.

The bullish case that got everybody excited about stocks in the 1990s - that technology, productivity improvements and global trade would boost profits - is not necessarily defunct. Productivity growth - output per hour of labor, in the most common measurement - has held up pretty well all this decade.

High interest rates, traditionally the stock market's enemy, are nowhere in sight. Rates are so low, in fact, that stocks "are the cheapest they have been since the Depression" when compared with what you can earn on a 10-year Treasury note, Longleaf wrote to clients.

The S&P; 500's dividend yield is 3.2 percent. Try making that in your money market fund.

To be sure, U.S. and world economic growth will be very disappointing for the next few years. The American economy was quite sluggish emerging from the 2001 recession, and there's even less reason to expect a brisk recovery from this recession. Dividends will be cut. Profits probably will decline.

But we won't experience another depression. Huge amounts of government dollars bailing out companies and soon to be bailing out consumers should see to that.

At 8,668, the Dow has already anticipated a ton of bad news. And don't assume profits will plunge too deeply. They boomed in the mid-2000s even as the overall economy struggled, pumping up that denominator that makes the Graham-Dodd P/E ratio so attractive.

Nothing in investing is certain. But Security Analysis talks about a "margin of safety," a price so low that even unexpected adverse events won't cause grievous harm. The margin of safety in a diversified stock portfolio is indisputably much more comfortable now than it was a year ago or 10 years ago.

Put that in your bowl and slurp it.

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