Category Archives: Books

Crisis Investing for the Rest of the ’90s by Douglas Casey

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At certain points in our lives we come across individuals who profoundly alter our outlook on life. For me, one figure is Doug Casey, a writer and financial speculator. In 2004, when I decided to play the junior resource market, I subscribed to a number of newsletters dedicated to stock picking in that sector. Casey’s newsletter, the International Speculator, quickly became one of my favorites: not because of its stock picks (though, they were quite profitable), but because of Casey’s commentary of his radical viewpoints on everything from economics and philosophy to politics and science.

Casey describes himself as an anarchist, whom he defines as someone who believes in rule of no one. This differs from monarchy which means rule of one, oligarchy which means rule of few, or democracy which means rule of the people. He also subscribes to the Austrian school which believes what’s best for the world is a truly free market where there is no government intervention of any kind. While Casey is wildly optimistic about the long-term future where technological advancement will make us enormously productive, in the near term he is very negative believing that a depression is inevitable to cleanse the economy of government stimulated malinvestments.

His opinion that governments serve no useful purpose seemed shockingly ridiculous when I first came across it. But after understanding his reasoning the idea gradually grew on me and I soon adopted his philosophy. I would go on to read anything he wrote that I could get my hands on and I would try to make it to a few investment conference where he spoke. It was refreshing to hear or read someone who is willing to get across what’s on his mind without any regard for political correctness.

Casey has written several books, the favorite of mine being Crisis Investing for the Rest of the ’90s which was first published in 1993 and later updated in 1995. Despite its current obscurity, it’s one of my all-time favorite books and I recently had Casey sign it when I got the opportunity to sit down for a drink with him. Along with investing strategies and recommendations, some of which are outdated, he clearly expresses his economic and political views. The chief argument he makes in the book is that the US will soon experience a depression. Now that a depression looks like a high probability event, I thought it was worthwhile to revisit the book.

To give a little background, Casey’s first investment book, Crisis Investing, was published in 1979. In it, he recommended buying small energy stocks, selling bonds, selling real estate, and buying gold and gold stocks — all of which paid off. However, he also predicted a financial crisis that would lead to a wave of bank failures, which didn’t occur until much later during the S&L crisis.

Casey wrote a second book in 1982 titled Strategic Investing in which he recommended buying blue chip stocks and utilities; buying gold only to serve as insurance rather than as a vehicle for speculation; selling South African gold stocks which subsequently declined by around three-quarters in value; buying little known North American junior gold mining companies which enjoyed two separate runs of 1000% gains during 1982-1983 and 1985-1987; and holding off to buy real estate until the market bottoms in 1984, which in retrospect was a year off but still useful advice.

While Casey’s first two books were mostly on the mark with their investment recommendations, they both got the macroeconomic outlook wrong with both calling for what Casey termed the “Greater Depression” — a depression even worse than the Great Depression. Instead the US economy enjoyed solid growth for most of the ’80s and ’90s. In Crisis Investing for the Rest of the ’90s, Casey admits his forecasting mistake and cites several reasons why the Greater Depression was avoided during the ’80s.

First, the Fed took the necessary, but painful step of tightening monetary policy which caused many of the excesses of the economy to be wrung out. Second, there was a worldwide movement towards economic liberalization as regulation and taxes were reduced. Third, the computer revolution dramatically increased productivity. Fourth, the swift movement of women into the labor force increased family incomes. Fifth, the large expansion in the money supply mostly flooded into asset markets rather than affecting consumer prices. Sixth, the huge growth in personal, corporate, and government debt. And seventh, large US trade deficits caused many surplus nations to use their massive reserves to purchase US bonds, thereby lowering interest rates.

According to Crisis Investing for the Rest of the ’90s, the Greater Depression can’t be avoided for much longer because almost all of the previous stimuli seem to have run their course: economic liberalization is reversing; technological revolutions which cause dramatic improvements in productivity tend to be rare and short-lived phenomena (almost every single person now owns at least one computer); most women have already joined the workforce and households have become as dependent on their paychecks as they are on those of men so if either person in the household loses a job, the household would have trouble meeting its financial obligations; the expanding money supply cannot continue to flow into asset markets forever and at some point it will cause consumer prices to rise; growing debt is unsustainable and must at some point be reduced; similarly the trade deficit can’t continue indefinitely, and eventually those foreign reserves of US dollars will be dumped onto foreign exchange markets causing the dollar to plummet and prices to skyrocket.

In retrospect, Casey, in his third book, again seems to be way too early in his call for a Greater Depression. Although there were several economic collapses around the world, the US escaped largely unscathed. How was Casey’s Greater Depression postponed once more? I think for all the same reasons he cited for being early in his previous calls. The US basically experienced a debt fueled economic boom that lasted from 1982 to 2007 with only minor hiccups during the S&L crisis and the post-2000 tech collapse. But I do believe credit expansion has finally ended and Casey’s Greater Depression has finally arrived and most people’s standard of living will drop significantly over the next few years, if it hasn’t already.

What’s a depression? Casey defines a depression as a period when the standard of living of most people drops significantly. It is the opposite of prosperity. The Greater Depression could be either deflationary, as in the ’30s, or inflationary. Prior to 1929 depressions were sharp and brief. This was because unemployed workers and struggling business owners had to lower their prices to avoid starvation. The Great Depression, on the other hand, was deeper than any depression before it because the Fed, as lender of last resort, provided an incentive to banks to hold a smaller reserve cushion which, in turn, caused a credit bubble that proved very painful when it burst. Also, the Great Depression was the most prolonged depression because the government implemented price and wage controls that few could afford to pay, and its public work projects and welfare programs retarded the rebuilding of capital and productive employment of labor.

On the other hand, to get a sense of what a hyperinflationary depression looks like in a major economy, one needs to go all the way back to Weimar Germany during the early ’20s. Hyperinflationary depressions occur when the government prevents the collapse of inflationary credit to wipe out banks, which would cause asset prices to drop and businesses to fail. The government does this by pumping money into the economy to devalue the currency and increase the public’s inflationary expectations, thereby reducing its demand for money and bringing about an increase in spending. However, if too much money is printed, a breakdown in confidence in the currency would ensue and prices would skyrocket as people get rid of it as soon as they get it. In nominal terms, prices of everything surges, but in real terms economic activity contracts.

Will the Greater Depression be inflationary or deflationary? According to Casey:

Betting on inflation has been the winning strategy since the bottom of the last depression, but a financial accident could change all that overnight. The inflationists will certainly be right in the long run, but they may get wiped out in the short run. In any event, the moment of truth is approaching, and there likely will be a titanic struggle between the forces of inflation and the forces of deflation. Each will probably win, but in different areas of the economy. As a result, we’re likely to see all kinds of prices going up and down like an elevator with a lunatic at the controls. It will not be a mellow experience.

Since the Great Depression, there have been numerous small recessions in the US, any one of them which could have snowballed into another deflationary depression. They didn’t because the government has had an unprecedented amount of power to stimulate the economy and forestall a financial collapse. But preventing a depression also prevents the necessary correction of previous malinvestments. Each successive recovery leads to greater excess capacity and each successive recession leads to greater government stimuli. The governments actions have linked all the previous recovery-recessions cycles into a much larger supercycle which now seems to have peaked. And the coming economic catastrophe will be made worse by people’s innate desire to have the government do something as the going gets tough. The government will respond with socialist policies as it did during the The Great Depression.

In Crisis Investing for the Rest of the ’90s, Casey believed that the Clinton administration and the Fed would have more difficulty resuscitating the economy after the next downturn because interest rates and inflation were already too low to be further reduced to stimulate the economy. Also, the government had less flexibility than in the past to increase spending, despite its increasing power, because it had become highly indebted. As it turned out, the Fed was able to bring down interest rates even further and Bush, who presided over the last recession was able to pass a substantial tax stimulus and take on more debt.

Can the government and the Fed again prevent the current recession from morphing into a depression. I’m skeptical. The Fed has already reduced the overnight rate to zero, yet total debt continues to contract. The Obama administration is about to pass a major spending stimulus, but in my view, government spending actually lengthens the downturn. The problem with the economy is that there is excess capacity in almost everything from housing to manufacturing. Government infrastructure spending will add additional capacity, which will lengthen the time required for demand to catch up to supply. Also, the spending provides a temporary increase in the demand for labor which keeps wages from falling as they should so that business can afford to hire again. These are the reasons why I believe the current economic contraction will be the deepest and most prolonged in the post-war period. Casey’s Greater Depression has likely arrived.

Casey makes the point that government money printing, regulation, and taxes (all of which have been increasing in response to public pressure) actually benefit the wealthy at the expense of the masses. The rich have the capital and access to credit to purchase hard assets and protect themselves from inflation, while wages that most people depend on to survive tend to be sticky and don’t rise as quickly as prices do in response to inflation. The rich can afford to hire lawyers and accountants to use regulatory loopholes to get around the rules that the rest of the population is forced to abide by. And although the rich pay the bulk of the governments tax receipts, they also pay most political donations and lobbying to influence the government to spend in a way that benefits them. Always the most socialistic and centrally planned economies tend to have the most uneven distribution of wealth.

The best course of action for the government is to do nothing and let the depression cleanse the economy. Sure, we could see a financial meltdown where the entire banking system defaults and millions of Americans lose their jobs. But according to Casey:

The physical world is unlikely to be changed much by the Greater Depression, but the way people relate to the world will change a great deal. A real estate collapse doesn’t mean buildings will tumble. But their prices will and their owners may change. A corporation’s bankruptcy doesn’t mean that the factories or technology it owned will vanish; they will become the property of a different corporation. A government default on its bonds doesn’t mean the country (which is not at all the same thing as the government) is bankrupt. It just means that those who held the bonds are poorer and those who otherwise would have been taxed to pay the bonds are richer. In other words, all the real wealth will still be there, but its ownership will change. And some commodities will become more (or less) valuable relative to other commodities. The people who wind up wealthy as the Greater Depression unfolds will, predictably, be those who understand what’s going on.

There have been numerous financial collapses around the world during the past century. But those countries that embarked on economic liberalization as a medicine such as post-war Germany and recently Russia, were rewarded with quick recoveries. The US could as well by simply abolishing the Fed, instituting a 100% gold-backed dollar, restricting the government’s role to national defense and protecting personal and property rights, and eliminating almost all regulations and taxes. Since none of this is going to happen, we can expect the government’s actions to soften the Greater Depression from what it otherwise would feel like, at the cost of  significantly prolonging it.

How do we protect ourselves from the Greater Depression? A conventional portfolio includes stocks, bonds, real estate, and cash. But in the event of a financial collapse a conventional portfolio would suffer severe losses. According to Casey, a hedge portfolio allows one to keep an exposure to these assets as well as own assets that thrive when most assets struggle. A good portfolio should balance safety, yield, growth, and liquidity.

Casey prefers to use a “10 x 10″ strategy in which he divides his portfolio into ten unrelated areas, each of which have the potential to increase tenfold over the course of a business cycle. This method has the benefit of diversification while still offering a high return. If 10 different ideas can’t be found, then restrict any investment to 10% of your portfolio and hold onto your cash balance for future opportunities. Ideas which offer ten-to-one returns won’t be found with large-cap stocks or mutual funds. Where they can be found are in low-cap stocks and using leverage to trade commodities, bonds, options, convertibles, or real estate.

An alternative approach, one in which capital preservation is given utmost importance, is the Permanent Portfolio which was developed by Harry Browne and Terry Coxon. The main idea is to put a fixed percentage of your savings into investments that move inversely to each other so that your portfolio is hedged against every possible economic environment whether it’s prosperity, recession, depression, inflation, or deflation. The recommended asset allocation is as follows: gold 20%, silver 5%, Swiss franc assets 10%, real estate/resource stocks 15%, US stocks 15%, and T-Bills and T-Bonds 35%.

Casey recommends placing half of your capital in the Permanent Portfolio and the other half in speculative investments. Additionally, hedge strategies can be a good idea when you’re unsure about the overall market direction. You can go long one stock which you like and short another stock you think is overpriced. The same strategy can be applied to commodities as well.

To know when to buy stocks and which stocks to buy, Casey falls back on the methodology developed by Benjamin Graham. Graham would analyze a company’s financial statements and buy its shares only if they met certain well-defined criteria for both high value and low risk. In a cheap market, one can find numerous companies that fit the billing. However, if a market is dangerously overpriced it will be hard to find any. Graham’s criteria are:

  1. an earnings yield that is at least twice the current AAA yield;
  2. a P/E less than 40 percent of its previous five-year high;
  3. a dividend yield of more than two-thirds the current bond yield;
  4. a share price of less than two-thirds book value; and
  5. a share price of less than two-thirds net current assets;

While these criteria may help to uncover value, a stock may be cheap because it’s in danger of going bankrupt. So Graham required a company to have at least one of the following characteristics to test for safety:

  1. the company should have total debt less than book value;
  2. the company’s current assets should equal at least twice its current liabilities;
  3. the company’s earnings should have grown at a compound rate of more than 7 percent for the last ten years; and/or
  4. the company should have no more than two drops in earnings of more than 5 percent in the last ten years.

With regards to fixed income instruments, Casey views bonds as a triple bet on the solvency of the issuer, on the value of the currency, and on the level of interest rates. On March 1993, when Casey wrote his last book, interest rates were at their lowest levels since the early 1960s. Also, the level of debt for the US government and many corporations were at historically high levels. And inflation was always a serious concern as long as the currency was not backed by anything tangible. Casey didn’t like bonds then and since the same conditions apply today he doesn’t like them today either.

Casey firmly believes gold is best suited to serve as money because it satisfies Aristotle’s properties of an ideal money: it’s durable, divisible, convenient, consistent, and has intrinsic value. And not surprisingly gold as been widely used as money for thousands of years through most of human history. The US dollar which can no longer be redeemed for gold has become the unsecured liability of a bankrupt government. As the Greater Depression unfolds people will rush to the security of gold because the economic turmoil will lead to emergency stimulative spending, and when coupled with falling tax receipts, government deficits will explode. The only way it can be financed is by printing huge amounts of dollars which would devalue all existing dollars and increase the value of any competing currency which has a stable amount of supply like gold.

Gold coins should be purchased rather than bullion because they are convenient to carry and you don’t need a scale or calipers to know what you’re getting. The best coins to purchase are Austrian 100 Coronas, Krugerrands, Maple Leafs, Eagles, and Sovereigns. Casey predicted gold to rise well over $1,000 during the Greater Depression. Gold has already touched $1,000 and if the government is successful in creating inflation, then gold should increase much more.

In a rising gold price environment, gold stocks should perform well, but Casey cautions before buying them. Gold stocks represent fractional ownership interests in a business that may or may not be successful. Gold stocks, especially those of the juniors, are some of the most volatile securities in existence, so timing is extremely important. But if you get that right then you could easily make multiples of your initial investment. In early 1993 Casey felt that sentiment on both the major and junior gold stocks was very negative. The juniors, for example, were down 97 percent from their peak reached in the summer of 1987. Today the juniors find themselves in the same environment after a couple of bull markets. Casey thinks the juniors represent a good speculation.

Silver should perform well for the same reasons as gold because of silver’s historic role as money. Industrial demand may drop off during the Greater Depression, but safe haven buying should more than make up for it. At the time of writing, Casey believed silver at under $4 was at a classic bottom. He reasoned that the gold/silver ratio was at an all-time high of 90 to 1, silver was selling far below its cost of production, and in real terms silver was cheaper in 1993 than it was 25 years previously. Pre-1966 US silver dimes, quarters, and half dollars which at the time of writing sold for a mere 1 percent to 5 percent above melt value represented excellent buys to Casey, especially considering that in the past they sold for premiums of up to 35 percent.  At today’s price of around $10, silver is again historically cheap compared to gold.

Casey believed copper wasn’t a good speculation because demand will drop off along with economic activity and all the new deposits were very low-cost meaning that they will stay in production and new ones will keep coming on stream. The same could be said today, although copper prices have already fallen significantly.

The historical trend for commodities is down as technological advances and the accumulation of capital reduce the cost of production. However, Casey correctly predicted a counter-cyclical rise in commodity prices. New suburbs eating into the most productive farmland, lack of water availability for irrigation, and negative long-term effects of chemical fertilizers and pesticides on the soil all should cause short-term supply problems. With prices at historical lows and below the cost of production, the late ’90s were an ideal time to buy agricultural commodities. I’m sure Casey still likes agriculture, but perhaps not as much as before.

In Crisis Investing for the Rest of the ’90s, Casey believed small oil stocks represented good values. He argued that although the world is never going to run out of oil, the price of oil should rise because it’s as cheap as its ever been. If shortages occur, it would be because of government wars, embargoes, price controls or production quotas. That said, the geological supply of oil is declining every year.  Even during an economic contraction demand will only take a temporary dip because Third World demand is very inelastic. Today, Casey is still bullish on oil because at around $40, it’s again historically cheap.

As for residential real estate Casey states the following:

A house is just an expensive consumer item, like a suit or a car; each has a service life, after which it must be scrapped. The houses built today become total write-offs in thirty to forty years. Any residual value is strictly in the land.

According to Casey, the best indicator for valuing a house is to calculate what it will rent for. Before the 1970s, when real estate was sound value, the rule of thumb for property rentals was 1 percent of market value per month. At the time of writing, mortgage rates were at their lowest levels in twenty years. When rates start to move up prices will decline.

Casey recommended staying away from urban and suburban areas where technological advances in telecommunications make being in a particular place to conduct business less important and traffic congestion makes it hard to get to where you want anyway. Thus cities will fade as economic centers. He recommended selling properties that have already significantly appreciated. The return on the property should it be rented should, after all costs, be significantly above the bank deposit yield, or at least 6 percent per year in real terms. Also, a house or building shouldn’t be considered a bargain unless it’s available considerably below replacement costs, say around 50 cents on the dollar. The most profitable real estate purchases will be unique and upmarket properties that the rich would want: not what the average American would want because he is going to lose what he’s got, not be buying more.

Casey was early in his bearishness on real estate. As it turned out, the bubble got even bigger before bursting. But to his credit, Casey believed certain real estate would prosper; in particular resort towns because the rich will increasingly want insulation from all the problems the cities offer and they are fun places to live in. He felt qualities one should look for in a good resort town are natural beauty, ambiance, facilities, and isolation. And it was best to buy property with at least 10 acres of land and not more than a twenty minutes drive from town. Casey’s favorite town was Aspen.

When Crisis Investing for the Rest of the ’90s was written, commercial real estate was nearing the end of the longest boom in history and vacancy rates already reached historic highs. Casey believed the sector would crash because interest rates would soon rise and cause the vacancy rate to rise further leading to more loans going bad and more property being sold. Instead interest rates fell even further, and aside from a minor correction at the turn of the millennium, the commercial real estate crash has only now commenced.

Certain international real estate offers much more upside for much less risk than can be found in the US. A big advantage of foreign property is diversification. Three approaches to buying in foreign countries are to buy in countries that are politically distressed and have currencies even weaker than the dollar (essentially you’re betting on a turnaround), buying in countries that are basically sound and near countries that are experiencing turmoil and are positioned to profit from their neighbors’ problems, and to buy in countries that are very sound with ingrained free-market traditions that can be counted on to do well despite the conditions elsewhere.

In a terrific call, Casey believed Japan’s real estate and stock markets were still extremely overvalued based on traditional valuation metrics despite their corrections and, in fact, recommended shorting them in Crisis Investing for the Rest of the ’90s. He would probably still be bearish on Japan as long as the Greater Depression remains.

Although Casey is bearish in the near term on the economy and most financial assets, it’s important to point out that the he is incredibly optimistic about the long-term future:

Herman Kahn, the late military strategist and futurist, held the view point that humans, who “until just 200 years ago were few, poor, and at the mercy of forces of nature; but 200 years from now they will be numerous, rich, and largely in control of the forces of nature”. Kahn believed things will turn out well. I believe his projections will prove highly conservative both in how good things will be and in how quickly they will be come so.

Casey’s optimism for mankind is based on its work ethic, political freedom, and technology which have been a factor since the prosperity boom ushered in by the Industrial Revolution 200 years ago and will continue to be in play in the future. While continued economic progress will be the long-term trend, in the short-term a Greater Depression is inevitable to cleanse the economy of past malinvestments and put it on a solid footing for the future. 200 years from now the Greater Depression will look like a small bump in the road similar to how we today view any of the depressions that occurred during the 19th century.

Casey’s Crisis Investing for the Rest of the ’90s is one of my favorite books because it was able to clearly explain why the prosperity that Americans enjoyed during the past two decades was created by credit expansion and temporary government spending, neither of which were sustainable. Although his Greater Depression didn’t unfold as quickly as he predicted, he did point out that financial collapses are incredibly difficult to time. If indeed this current recession turns out to be Casey’s Greater Depression, then most of his investment recommendations should pay off. I am personally employing his strategies to protect my portfolio.

The Intelligent Investor by Benjamin Graham

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I just finished reading Benjamin Graham’s The Intelligent Investor for the second time. My first read was in 2004 when I finally had enough money to invest and was looking for guidance. At the time, I found the investing world crowded with so-called pundits who advocated strategies that conflicted with one another.

So I focused my attention on the person who has had the most successful investment career — Warren Buffett. Frequently in his interviews and essays he cites The Intelligent Investor as “by far the best book about investing ever written” and Benjamin Graham as the man that influenced his life more than any other except his father.

After reading it, I, too, was captivated by its insights and strategies due to their simplicity and time-tested correctness. The book is as relevant today as it was at the time of its first publication in 1949. It surely would have kept its readers out of the recent dot-com crash.

Although I must concede that I am a speculator rather than an investor, I keep Graham’s emphasis on value and margin of safety in my mind when engaging in any speculation. And as I become older, I intend to adhere to the principles offered by The Intelligent Investor to a greater degree as preservation of capital becomes my chief concern.

I often find myself wanting to re-read the book, but my lack of spare time dissuades me. So I thought it would be useful after my recent reading to compile a brief summary of the book for easy reference. Others might also find this abbreviation useful, but I must warn, this doesn’t replace reading the book in its entirety — especially if one has never read it.

Outline of The Intelligent Investor

What is Investing?

  • “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
  • “To have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.”
  • A margin of safety when applied to bonds is the ability of a company to earn in excess of interest requirements that is counted on to protect the investor against loss from possible future deterioration in earnings.
  • A security of low-quality can be a good investment if it can be demonstrated that it is cheap enough.
  • Speculation can be intelligent or unintelligent. Unintelligent speculation arises when (1) speculating when you think you are investing, (2) speculating in a field where you lack proper knowledge and skill, and (3) risking more money than you can afford to lose.

Investing Psychology

  • “The investor’s chief problem — and even his worst enemy — is likely to be himself.”
  • “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it — even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”
  • “The kind of securities to be purchased and the rate of return to be sought depend not on the investor’s financial resources but on his financial equipment in terms of knowledge, experience, and temperament.”

General Portfolio Policy

  • An investor should have between 25% and 75% of his portfolio in stocks, and the balance in bonds. During bear markets when valuations become attractive he may increase the stock weighting up to 75%. In bull markets, when market levels become dangerously high, he may reduce his stock allocation to as low as 25%.
  • Continuous and uniform purchases of common stocks have proven to be rewarding over time.
  • Investors in high tax brackets would be better off by selecting municipal bonds, which are tax free, rather than corporates.
  • Foreign government bonds should be avoided because the investor has no legal or other means of enforcing his claim.
  • Investors should be weary of new issues because they have a strong sales force behind them which can make them appear more attractive than otherwise they would be. Also, new issues are usually sold under favorable market conditions which means favorable for the seller and unfavorable for the buyer.
  • When considering a company’s earnings, the average earnings of the past 7 to 10 years should be considered to iron out the ups and downs of the business cycle. It also reduces the problem of accounting for special charges and credits. They should be included in the average earnings.

Portfolio Policy for the Defensive Investor

  • The defensive (or passive) investor aims to avoid making mistakes and losing capital. He will also seek to minimize his effort in accomplishing this.
  • Defensive investors can choose from federal, municipal, and corporate bonds. Only investment grade municipals and corporates need be considered.
  • Preferred shares lack both the legal claim of the bondholder and the profit possibilities of the common shareholder. Thus, they are too unconventional for the defensive investor.
  • Criteria for bond selection by the conservative investor:
    1. Earnings-Coverage Test. Examining the past 7 years should reveal that the industrial company has earned before taxes during its worst year at least 33% of principal amount of debt. This figure could be as low as 20% for a public utility and 25% for a railroad.
    2. Size of Enterprise. The volume of business should be very large, or in the case of municipalities, the population should be of a significant number.
    3. Debt/Market Cap Ratio. A low ratio indicates that senior issues will have substantial cushion from future adverse developments since the large equity base will have to first bear the brunt.
    4. Asset Value. While this number in relation to the total debt is generally not nearly as important as a company’s earnings power, it is the chief protection for bonds of public utilities, real estate businesses, and investment companies.
  • Rules for common stock selection for the defensive investor:
    1. The portfolio should be diversified with a minimum of 10 issues, but not more than 30.
    2. “Each company selected should be large, prominent, and conservatively financed”. A company is conservatively financed if its net current assets exceeds its total debt. Also, current assets should be twice the current liabilities.
    3. Each company should have a uninterrupted dividend payment record of at least 20 years.
    4. The purchase price of the share should not exceed 25 times average earnings, and not more than 20 times the earnings over the past 12 months.
    5. The issue should not cost more than one-third over its tangible asset value. A small premium over book value can be viewed as the price for marketability of the security.
    6. There should be some earnings for each of the past 10 years.
    7. A minimum increase of at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end.
    8. Current price should not be more than 15 times average earnings of the past three years. Also the earnings/price ratio should be at least as high as the yield currently obtainable on a high-grade bond.

Portfolio Policy for the Aggressive Investor

  • The enterprising (or active, or aggressive) investor is more willing to devote time to the selection of sound securities which could deliver a better than average return.
  • An enterprising investor should also divide his portfolio between high-grade bonds and high-grade stocks. He could purchase other types of securities if their is well-reasoned justification for the purchase. He should avoid purchasing preferred stocks and low-grade bonds (unless they can be bought for at least 30% under par for high-coupon issues and much less for the lower coupons). Also, he should avoid new issues, foreign government bonds, and common stocks with excellent earnings confined to the recent past.
  • It is dangerous to purchase a security with a greater yield and, a correspondingly greater risk attached to it, than is obtainable in a high-grade issue. If more risk is assumed then there should be a higher likelihood of gain in principal value. Hence, a low-coupon issue selling at par has more downside risk than if it were priced well-below par.
  • Second-grade bonds and preferred stocks can suffer a severe declines in value during bear markets, but can significantly appreciate during bull markets.
  • Four activities that enterprising investors tend to engage in are:
    1. Buying in low markets and selling in high markets. This is an extremely difficult practice and can lead to speculation. Investors can limit this through the flexible 25% to 75% weighting that can be given to stocks.
    2. Buying carefully chosen growth stocks. There are two problems with this approach. Growth stocks sell at a premium to account for its future growth prospects. So even if the company were to satisfy the market’s future expectations the share price may still not rise. Another problem is that one could be wrong and the company may not achieve the expected growth targets. After all, no company can out pace the growth of the economy forever. There are many investment growth funds, but very few of them have consistently earned a rate of return above the market indexes. Therefore, it is unreasonable to expect most individual investors to beat the indexes, where most professionals have failed.
    3. Buying bargain issues of various types.
    4. Buying into special situations.
  • To obtain better than average results over a long period requires an approach that is (1) able to pass objective and rational tests of underlying soundness, and (2) different from what is undertaken by most investors and speculators.
  • Rules for common stock selection for the aggressive investor:
    1. Financial Condition: (a) current assets at least 1.5 times current liabilities, and (b) debt not more than 110% of net current assets (for industrial companies)
    2. Earnings stability: No deficit in the last five years.
    3. Dividend record: Some current dividend.
    4. Earnings growth: Last year’s earnings more than than those of five years ago.
    5. Price: less than 120% of net tangible assets.

Regarding gold, Graham urges investors to disregard it as an investment due to its historically disappointing performance:

The standard policy of people all over the world who mistrust their currency has been to buy and hold gold. This has been against the law for American citizens since 1935 — luckily for them. In the past 35 years the price of gold in the open market has advanced from $35 per ounce to $48 in early 1972 — a rise of only 35%. But during all this time the holder of gold has received no income return on his capital, and instead has incurred some annual expense for storage. Obviously, he would have done much better with his money at interest in a savings bank, in spite of the rise in the general price level.

As a gold bug, I of course, strongly disagree with his view. Although gold only increased 35% in the 35 years prior to 1972, it has performed much better since then. In fact, in the 35 years since 1972 gold has returned 8% per year matching the 7.7% gain in the Dow Jones Industrial Average (ignoring dividends).

When screening for stocks using Graham’s criteria in today’s market one will find it difficult to find anything (aside from some troubled homebuilders and financial companies) that satisfies each condition. Perhaps this is a reflection of the dangerous overvaluation US stocks are currently enjoying.

The ideas put forth by The Intelligent Investor seem to be forgotten by today’s investors who are more concerned about the return on their capital rather than the return of their capital. Unfortunately, the next painful bear market should serve to bring Graham’s classic to prominence once again.