Edgar Lawrence Smith’s book Common Stocks as Long-Term Investments was published exactly one hundred years ago.
Now, here’s the interesting bit.
He is one of the few authors who changed the central message of his book upon realizing that the original message had flaws. Yes, that’s right.
While going in, Edgar wanted to argue that stocks perform better than bonds during inflationary periods and vice versa during deflationary periods.
Let me repeat that. Edgar believed that stocks outperformed during inflationary periods, whereas bonds performed better during deflation.
However, when he looked at the data, he was in for a shock.
The facts did not support this theory. He was unable to find any 20-year period during which bonds outperformed stocks. It was always stocks outperforming bonds. Edgar was proven wrong.
He, therefore, had to start his book with a ‘mea culpa’ or a confession, if you will.
He admitted that he had failed to prove his theory with facts. Luckily for us, this failure led him to evaluate stocks more deeply, which eventually gave birth to a profound insight.
This insight that came to Edgar was quite simple. He observed that well-managed companies do not distribute their entire profits as dividends to shareholders.
In good years, if not in all years, these companies retain a part of their profits and put them back into the business.
Let me explain with numbers.
If a company earns ₹100 as profits, it does not distribute all of it as dividends. Instead, it may retain, say, ₹70 and invest it back in the business. This way, the value of its plant and property keeps going up and therefore, the value of its shares.
Now, this may seem like a very basic principle to you, as it is something we are taught in every finance course.
In fact, the huge wealth that had been amassed back then by titans like Andrew Carnegie, John D. Rockefeller and Henry Ford was based on this very principle.
These people retained a large part of their profits to invest back into the business for funding growth and producing ever-greater profits.
However, it did not catch the imagination of the US investors the way Edgar Lawrence Smith’s book did.
When ownership is sliced into small pieces, known as stocks, it may have been perceived as a short-term gamble on market movements.
The stocks of even the best companies were considered speculations. It was widely believed that gentlemen preferred bonds.
Edgar Lawrence Smith’s book played a huge role in clearing this misconception.
Stocks began to be seen in a better light. They started gaining widespread acceptance. As a matter of fact, it is argued that the US stock market bull run of the 1920s had Edgar Lawrence Smith’s book as its intellectual foundation.
Now, interestingly, if this book is being held responsible for starting the equity cult in the US or changing the perception about stocks from being a ‘speculative instrument’ to being an ‘investment-worthy asset class’, the same book is also being held responsible for triggering the famous stock market crash of 1929.
Yes, you heard that right. When the great crash of 1929 happened, Edgar Lawrence Smith’s book was seen as one of the culprits.
Well, the reason is not hard to find. As Ben Graham used to remind his protege Warren Buffett, you get in more trouble from a good idea than a bad one. And this is exactly what happened.
The idea that stocks can outperform bonds is a good one, but certain limiting factors must be taken into account.
When Edgar’s book was published, stocks were attractively priced vis-a-vis bonds.
However, as this good idea became more popular, investors started piling into stocks. And as stock prices went up, their valuation advantage vis-a-vis bonds started to go down.
Eventually, stock prices went so high that their valuations no longer made sense, and this led to one of the biggest crashes in the US stock market history.
The moral of the story
The takeaway, therefore, is quite clear. Stocks may have an advantage over bonds over the long term.
However, one also has to be careful about the price being paid to buy those stocks. If the price paid is too high or if you invest in the wrong stocks, there could be wealth destruction, and you could end up losing your hard-earned money.
I believe that this key lesson from this interesting case study is more important now than ever, at least as far as the Indian investors are concerned.
When the stock market crashed after the pandemic, stocks were certainly attractively priced vis-a-vis bonds and had a much better risk-reward equation.
However, as this good idea has gained ground and as more and more investors have started investing in stocks, this advantage is fast coming down.
There are a lot of stocks where the risk-reward equation is no longer attractive and where, investors would be better off staying away from them.
Please note that we are not pessimists and are not trying to scare investors.
Thanks to our close to two-decade experience in the stock market, we are aware of the dangers of irrational exuberance and the kind of risks it poses to your hard-earned money.
All we are asking you is to be aware of both the business quality as well as valuations when laying out money for investment in the current environment.
Don’t buy bad-quality businesses no matter how bright the future and do not overpay no matter how good the business quality.
Happy investing.
Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.
This article is syndicated from Equitymaster.com.
