You can, of course, get the annual report, and throw the thing away if there are fifteen footnotes or if the notes are incomprehensible.

  Ultimately, there is only one defensive quality that can serve as protection, and that is common sense. Does it really make sense to believe that this cigarette company is increasing its earnings 30 percent a year? Does it make sense to believe that in an industry as easy to enter as shell homes, this producer is going to continue earning 50 percent more every year? If the company is in a number of different businesses, did it really generate the earnings, or did it buy them, or did it borrow them?

  There are enough things to worry about in life already, but there is no choice but to say be skeptical and on your guard.

  2:

  CO-OPTING SOME OF THE SUPERCURRENCY

  ALL right, the numbers dance around sometimes, but it is the only wheel in town. You still need some of the M3 because it is so much higher octane than M 1 and M2 . What we all should have done was to find a grandfather who sold his ratchet company to that great fount of Supercurrency, IBM. Then all this would be academic. Granddad’s ineptness we can lament, and it is hard to create Supercurrency because you have to go through the whole diaper stage with a new company. And we are not going to get in on the first batch of freshly baked Supercurrency in each company because that is when the insiders sell to the outsiders, and we are outsiders. But at some stage we must successfully co-opt some of the stuff just to get out of the prole ranks of the M1’s. Maybe we can just buy something that will go up a lot. After all, a $5,000 investment in Avon Products in 1950 would have grown to $2.3 million, roughly, today, and $5,000 in the Haloid Company that year would today be Xerox and about $3 million. You only have to find one such plum. Is that still possible for an individual?

  If you ask this question inside the securities business, you get two answers.

  The first is from the New York Stock Exchange and the retail firms who have many branch offices and deal directly with the public. They say that the public has equal access to information, and that individuals have invested successfully for years and will continue to do so.

  The second answer comes from the investment professionals, who think the day of the individual investor is over. “There used to be individual investors in mortgages,” one said. “Your grandmother might have held a mortgage on somebody’s house, a mortgage on a house maybe in another town brought to her by a mortgage broker who knew she was looking for an income. That doesn’t go on anymore.”

  Earlier, we looked at a convulsive period for the whole structure: the banking system that absorbed a run on commercial paper, and the investment community which absorbed—barely—the collapse of undercapitalized brokerage firms. It survived. The structure shuddered a lot but stayed intact, and has now been bolstered. Within the structure, however, changes continue to take place. Institutions continue to increase their share of the trading markets. (Much of the public stock, remember, comes from the conversion of the family company to Supercurrency, and that tends to stay locked up in trusts.) Here is what has happened, the institutional share of trading (in average shares per day):

  1952 800,000

  1955 1,300,000

  1960 1,600,000

  1965 3,500,000

  1971 15,900,000

  Plainly, the days of Mr. Smith in Portland, Oregon, selling to Mr. Jones in Portland, Maine, are mostly gone, and so is everything that went along with Owning a Share in America. In order to increase their share of the market, many small investors had to institutionalize their investing.

  When I think of the individual investor taking to the field these days, a quarterback called Harry Theofilides comes to mind. (He comes to mind because a sportswriter called William Wallace did a column about him; otherwise he would not come to mind.) Harry Theofilides was five feet ten. He played with the Redskins until Vince Lombardi came, but Lombardi was not about to have a quarterback who was only five-ten. Harry Theofilides was cut, and went to the Jets, where he came off the bench in a game against the Giants, pumped the team to three touch-downs, including a couple of touchdown passes, and hit for something like seven of nine the following week against the Vikings.

  “Nobody ever beat me out,” said Theofilides. He was cut for Al Woodall, who is six feet five, and went off to the Edmonton Eskimos in Canada.

  “Ever since I’ve been in football,” Theofilides said, somewhat bitterly, “I’ve been told I’m too short, that I can’t see over the defensive linemen. Well, who can? Defensive linemen, when they come at you with their hands up, they’re over seven feet tall. Nobody can see over them. You do a quick slide into the gaps between them and then you look. Sonny Jurgensen told me he could never see; he just threw the ball where he thought the receiver ought to be.”

  The individual investor has to be considered about five-ten on the investment field, and there are a lot of other people out there who, with their research and their computers and their staffs, are over seven feet tall with their hands up. The odds against a superior performance by an individual investor have to be considered to have gone up markedly since the people who are seven feet tall with their hands up have come onto the scene. It was easy enough for Mr. Jones in one of the Portlands to sell quietly to Mr. Smith in the other one; they were at least the same size.

  Plainly, for a great number of investors, safety and a passive return are one course. The gap between the passive return, which doesn’t want to accept risk, and the aggressive return, which will accept it, has narrowed considerably. The return from a tax-free municipal approaches the average return on the bulk of industrial stocks. Utilities, unexciting as a part of the game and facing financing problems, still are assured of revenue growth. Some of them have partially tax-free returns, and have a tradition of increasing their dividends every year.

  A second course is to buy the so-called great companies and not sell them. This is the course of the University of Rochester, which has had a remarkably successful investment portfolio. The university, being an institution, has a long time horizon; it is prepared to take the sudden down-drafts these stocks face in bad markets because it feels that over the course of a generation it will achieve a superior return. Rochester has large positions in Kodak and Xerox, both of which are in the university’s backyard, and some of which were given to it. The individual still faces the question, What is a great company? because great companies become mature and not-so-great. Early growth is an invitation to competition, and the growth companies of one era are not always those of the next. Nonetheless, it is possible, by concentrating on some of the characteristics below, to find companies which can be held for a long time.

  Both of these courses assume the ability to leave the game element behind, entertaining as that may be.

  Finally, a minority of individuals, those with some time and the proclivity to do their own work, can do very well. For the people who are seven feet tall with their hands up are that way for everybody—even themselves—and nobody anywhere can see over them. You will have to take a quick step and look in the gaps between them.

  But a time may be coming in which it would be possible to be successful with just the old tenet that used to work, anticipate the institutions. While institutions are big and muscular, their records are not all that awesome. Furthermore, their managers talk to each other and tend to run in packs, like beagles. All you have to do is find the scent before the beagles do.

  For institutions, too, have been burned. They love the security of a front-running company with growing earnings, and they are wary of small companies because they cannot move in and out of them well in size. If you can find the smaller, growing company and sell it to the institutions when it gets a bit bigger, you will have stepped into the gap between them. That sort of front-running means the stock can go onto the Approved List of the banks, and a trust officer can put it into his accounts without being criticized.

  You will be, by now, paying some attention to the accounting, and you will be listening hardest to your own common sense. You will have husbanded your time and not wasted it on those industries—about 80 percent of them—that do not have favorable characteristics in the long term. Very likely, the company you find will be financially strong, so that it will not have to sell more stock or borrow unfavorably. It will have a leading edge in its key products and the capability of improving that edge, through research if that is the way it is done. It will have control over its own prices, and a labor component low enough not to be a problem, or at least controlled labor costs. It will be in an area that common sense will tell you is growing. All of these things will have contributed to its nice profit margins and its profits.

  All of these factors can be the ones to look for in finding something adolescent that is bought to be sold. If in addition, the company has something unique that makes competition difficult, you may have a great company that can be held.

  In the 1960’s it was fashionable to look to high technology for all of these characteristics, as well as for the something unique. Xerox and Polaroid were protected by rings of patents. But the lead time in patent protection is diminishing; if one polymer is patented, there may be a similar one which works equally well. Further, virtually everybody in the investment business underestimated how much the government flow of research and development money meant, even though the best of the pure companies (as the two above) were not dependent on that. In Avon Products, it was the sales force that was so hard to duplicate.

  I have a bias about this particular philosophy which you should correct for, because it is the one that served best when I was first learning. A bunch of us sat at the knee of one of the great apostles of the Growth Theory, a man who went out to the mutual funds and pension funds and preached the true gospel. Since then we have learned that those growing earnings can be such a security blanket to the buyer that he pays too much for them, so even when the stepladder is true and the company is going to maintain the growth, it pays to buy them at the low end of the swings in their price-earnings ratios. Periodically Mr. Market gets manic. A true growth company may swing from selling at twenty times earnings in a bad market to forty-five times in a hypertensed market, and it does pay to wait for the troughs.

  Anyway, we sat at the great man’s knee, and then we went out to apply the theory. We would wait tensely while the mentor graded our papers. I bring this up because I remember bringing in a stock that provides the perfect example of what an individual can do by himself. The mentor had bid us study Gillette. The mentor held up a pack of Blue Blades, very dramatic. “This will double, and if you know a double, you can do better than that.” People used up the Blue Blades, threw them away, and bought more. Gillette dominated its market with an army of salesmen. Its displays were on every drugstore counter, and it was going into other grooming items.

  What else was like Gillette? We were to go out scouting. I took a careful walk around a drugstore, and then I went to the manuals, and then I brought my stock to the mentor and waited for my very good grade.

  I had a stock called Tampax. It had no debt, no preferred, and plenty of cash. Its product was a leading product. It was like Gillette in that you used it, threw it away, and bought more. It had flexibility in the pricing. Its profits grew every year. I wanted an A for my idea.

  I got a B, and I protested.

  “It’s a very good little company,” said the mentor. “I suppose Kimberly-Clark or Scott could compete with it. But what is so unique?”

  “What is unique is that when people go to the drugstore, they don’t know the name of any other product,” I said. “Like Kleenex. Tell me the name of what else competes with Kleenex. A generic name is better than patents.”

  The mentor wouldn’t change my B to an A.

  “It’s a solid B,” he said. But the earnings grew perhaps 15 percent a year; we were looking at technological companies whose earnings grew 50 percent a year, making oscilloscopes and particle accelerators and other patented, super-sophisticated stuff, protected by patents and by technical staffs with hundreds of Ph.D.’s in physics.

  “Yours is a population-growth stock,” said the mentor. “I don’t see why it’s ever going to grow considerably faster, although that fifteen percent could compound. Texas Utilities and Coca-Cola increase their earnings every year too, and those stocks are already on the approved lists of all the banks.”

  So I didn’t buy Tampax at 5, adjusted for splits. The mentor was right for that time: the technology stocks moved much faster. A couple of years later the pace accelerated, so that their patents were no protection, and then there was price-cutting in some of the products. Some of those technological companies are far bigger today, and some are treated as cyclical companies. But Tampax is around 120. I feel dumb every time I think about it.

  There are numbers of other examples of front-running, solidly managed companies in growing fields with some sort of edge about them. Some of the ones that worked in the recent past were as easy to understand as Johnson & Johnson, Band-Aids and baby powder, and McDonald’s, the ubiquitous hamburger stands. MGIC, the Mortgage Guaranty Insurance Corporation, filled a conspicuous gap in mortgage insurance. Not only did these companies make it through the sixties and the Big Bear, but they are up better than 1000 percent from their lows of a decade ago. (That doesn’t mean they are necessarily headed for that in the decade ahead.)

  You have plenty of competition in looking for the outstanding steady growers, but you only need one for real success, and you can be sure that if you find one, somebody—a nice bank probably—will buy it from you at a premium some other time, even if you are only five-ten and the other fellows are seven feet tall with their hands up.

  3:

  BETA, OR SPEAK TO ME SOFTLY IN ALGEBRA

  THERE is no System in the market, and there are many approaches that work. The generation now in command has had just time enough to learn that at some point any of them can fail. It is a bright generation, so that discovery was damaging to its self-confidence. This generation entered the sixties full of beans. The generation ahead of them on Wall Street had clearly been paralyzed by the memory of the Great Depression. The new generation had moved in with the appropriate lack of inhibitions. The older generation had lacked real, serious security analysis. Now there were ten thousand security analysts. The older generation had relied on country-club information and a few statisticians with green sleeve garters. Now there were computers to screen and filter, to assemble a stunning variety of comparisons and ratios, to do charts and measure relative strength. The financial rewards for the new generation were great, but that was only right and proper for gentlemen and ladies of business-school education, rational intelligence, daring and perception.

  Then along came a severe test and took away not only some of the profits, but some of the scientific and self-confident aura of the whole business. The security analysts turned out to be just as wrong as they were right.

  Writing in the January-February, 1972, issue of the Financial Analysts Journal, the director of research of a large institution assessed statistically the research which went to institutions. That is research presumably painstaking and not horseback, aimed at a sophisticated audience. The results weren’t much different from the Standard & Poor’s averages, and were summarized as “consistently mediocre.” Some were good, some were bad, and taken all together they weren’t so handsome. (The article may have been a bit unfair in that it was based on published material. The best work of the best security analysts goes unpublished. Analysts are paid indirectly with the commissions of clients, and those clients are quite likely to make up a list—a short list, at that—of the analysts and the firms they want to reward. If an analyst has a bright idea, it is going to go first to his biggest client, and then to his next biggest, and so on. By the time it gets to the nth client, or into print, it has lost much of its value, but it is only from print that surveys and evaluations in the Analysts Journal can be made.)

  Not only did the work of the security analysts follow the price of the stock more than the course of reality, but much of the technical apparatus also blew its tubes. The performance of the funds has already been discussed, and in aggregate, the performance of the managers left something to be desired.

  The more sensitive and alert money managers were the ones to engage in some self-questioning. Notes from portfolio-manager seminars reveal a change in the tenor of the meetings over a course of four or five years. As the jackets came off and the drinks were poured in the earlier meetings, the questions ran to: All right, what’s hot? What do we buy now? How long have we got? By recent times, the questions had taken on a Kierkegaardian tone—at least so far as this field is concerned—full of doubt and musings. What is a portfolio, as opposed to a list of stocks? Can portfolios be managed as portfolios? Does anyone do it? What is a buy? What is a sale? Which one do you concentrate on? Can anyone outperform anyone else? What is risk?

  The last question got asked a lot after some of the portfolios went down 40 percent. After all, why pay a professional to lose 40 percent of your money? Maybe something was wrong with the whole process: assessing where the economy was going, making some sort of market judgment, letting the security analysts scout their stocks, and building the portfolio, with the portfolio manager using his experience, judgment, rational intelligence, intuition, and Fingerspitzgefühl. Maybe that was the wrong way; maybe there was something missing from the process. Maybe that something was risk, the opportunity for loss.

  A headlong race to include the risk factor in all the calculations began, even though the professionals for years were accustomed to speak of the downside risk. But maybe you could quantify the risk, so that you wouldn’t have to depend on the portfolio manager’s judgment. Thus was born what came to be called the beta cult, after the Greek letter beta, β. Beta stood for the measurement of market risk through the variability of the rate of return, and thus could be considered a component in capital asset pricing theory. The beta cult gave Wall Street a new jargon to toss around. A dozen Wall Street houses offered beta measurement services, some taking full-page ads in The Wall Street Journal and the New York Times to announce their discoveries. The math and computer people had a quick resurgence, and some senior people growled, as did Lemont Richardson of Booz Allen, “These people with math and computer backgrounds who think they can assign precise degrees of risk to five or six decimal places are nothing but charlatans.”