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Common Stocks as Long Term Investments

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First of all: I am not certain about how many stars to give to this book. You will understand why.

First published in 1924 this book is, perhaps, the precursor of Jeremy J. Siegel's book "Stocks for the Long Run : The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies"

Twelve tests were performed using different well-diversified common stock portfolios comparing them to bond portfolios. The main thesis is that bonds are less conservative than stocks. The metric chosen? Returns after approximately 20 years.

He considers basically 2 periods, one when dollar appreciates in real value (1866-1885) and one when dollar depreciates in real value (1901-1922). The results show that, considering capital gains and income from dividends, Commons Stocks ALWAYS beated bonds. The book is well written but some details are missing.



But why this book is so special? Stay tuned !

Irving Fisher (October 15, 1929):
"Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels, such as Mr. Babson has predicted. I expect to see the stock market a good deal higher than it is today within a few months"

Who was Irving Fisher?
In one sentence: America's most respected and famous economist, renowned for developing a theory of money that explained the valuation of Financial Assets (from Steve Keen's book Debunking Economics.)


Do you remember (from physics course) the Clapeyron's law PV=nRT ?

Well, Irving Fisher was the author of a similar "law" for economics: MV=PT (money mass, velocity of money circulation, price level, number of transactions).


Less than two weeks later: Black Monday (October 28, 1929).
DJIA closed 12.8% below previous level and fell another 11.7% the following day. Three years later stock indices had fallen 90%.

Fisher lost over US$ 100 million in today's dollars and was reduced to penure. His wealthy sister-in-law helped him, saving him from complete bankruptcy, forgiving Fisher's loans in her will. After these facts he was despised, a pariah.

What do this all have to do with this book?

Irving Fisher authored a paper entitled "The Stock Market Panic in 1929" published in 29 or 30 (I need to verify the date), when the market was not indeed in the worst condition.
Fisher:
"To my mind the problem of the stock market panic is, and will be to some extent for many years, an enigma, but I think now is the time to gather data and to make preliminary estimates of what really happened and why, because as we wait, those involved are forgetting; and if we wait too long the people whose memories are most important will have died. Some one has said that the "perspective" of the historian, about which the historian boasts so, is simply due to the fact that all those people who had the data, from which they could contradict him, are no longer living."

... And he continues talking about the causes ...

In another excerpt:
"These causes and the flight from bonds to stocks, especially AFTER THE PUBLICATION OF EDGAR SMITH'S BOOK on stocks and long term investments, and the coming of investment trusts that exploited that idea, have led to GREATER CONFIDENCE in common stocks." (the emphasis is mine)


To finish, read about 1929 in Holocaust timeline on the site historyplace, concerning depression effects.

Is this book one of the causes of WWII ?
Poor Edgar Smith. It can be very dangerous to write finance books.

I just finished reading Common Stocks as Long Term Investments by Edgar Lawrence Smith. Refreshing!

Smith sets out to prove the received wisdom of the day, that bonds outperform stocks, but the results of the research didn't bear out the conventional wisdom. In all but one of the "tests" stocks beat bonds and in some cases quite handsomely.

Despite the difficulty of obtaining data, Smith manages to construct an 85 year long stock market index from 1837 to 1923. The importance of such a long term chart is that it clearly shows the exponential nature of the growth of the market. By fitting a curve to the low points and another to the high points, Smith shows that the market was growing at approximately 2.5% annually. Should this number seem low by present standards, please take into account that back then stocks paid handsome dividends, typically between 4 and 8 per cent per annum as otherwise stocks would not be purchased in preference to bonds.

The chart constructed by Smith looks very similar to any modern day stock chart, lots of volatility. Smith then analyzed what he calls "The time hazard in the purchase of common stocks" how long it would take to break even no matter when you bought your shares and the worse case scenario was 15 years, considerably less that the period Jeremy J. Siegel found in his study Stocks for the Long Run. Essentially Smith and Siegel found the same thing, a patient enough investor won't ever lose money in the market provided the portfolio is well diversified and holds the largest companies in the various leading industries.

Smith then sets out to find out why it is that stocks beat bonds as long term investments. His three major conclusions are:

First: inflation is more likely than deflation and bonds don't have any protection against inflation. In inflationary times bonds lose purchasing power even as the face value remains the same. Stocks, to the contrary, grow in value often beyond inflation as I will explain below.

Second: for a bond to qualify as high grade, the issuing company has to have earnings above and beyond what is required to pay off the interest and the principal of the bond and this extra income accrues to the stockholders, not to the bond holders.

Third: population growth requires growth of products and services and the companies that provide them grow accordingly. Improving standard of living has the same effect, people demand more and better products and services and the companies supplying them grow accordingly. This growth is above and beyond inflation as otherwise there would be no improvement in the standard of living, quite the contrary.

Earlier I called the work refreshing because it goes back to first principles instead of relying on the hocus-pocus of charting and complex crystal ball gazing. In essence, when you own stocks you own a piece of the productive capacity of your country and, if the economy is growing, so does this productive capacity.

Where Smith falls short is in his stock picking. He talks generally about "investment management" but does not offer a superior method of picking stocks. His "tests" were based on generic methods so as not to induce bias: "In the test that follow, the only principle of sound investment that has been applied to the selection of stocks is that of diversification. Without diversification, the purchase of common stocks cannot be considered." That task, better stock picking based on price charts, was left for BuildMWell to discover. Smith looked at the tops of the price index chart to determine how patient an investor would have to be. On the contrary, BuildMWell looked at the bottoms of the price index chart and came to the brilliant conclusion that if these were indeed the bottoms then there was no better price point at which to buy.