On Tuesday, I read a short book that dramatically changed investor thinking and fueled the 1920s market boom.
The running belief at the time was that bonds were better, safer investments than stocks. It was considered common knowledge until Edgar Lawerance Smith ran the numbers and published his results:
Over a period of years these directors will never aim to declare all the company’s net earnings in dividends. They will turn back a part of such earnings to surplus account, and invest this increasing surplus in productive operations. Such a policy successfully carried out is in fact a practical demonstration of the principle of compound interest.
Admitting the limitations of our studies, it would nevertheless appear that we had assembled sufficient supporting evidence to isolate the force inherent in well diversified holdings of common stocks as compared with high grade bonds over a long term — particularly as this evidence is in strict accord with the known aims of corporation directors.
We may even be justified, until contrary evidence is presented, in attempting to define the law controlling long term investment values as they are manifest in common stocks as follows:
- Ove a period of years, the principal value of a well diversified holding of the common stocks of representative corporations, in essential industries, tends to increase in accordance with the operation of compound interest.
- Such stock holdings may be relied upon over a term of years to pay an average income return on such increasing values of something more than the average current rate on commercial paper.
If we are ready to accept the law, not as proved, for that is impossible, but as sufficiently indicated to warrant its acceptance as a measure of relative investment values, then we have raised a standard for long term investment which it will be hard to equal in any form of maturing obligation — any bond, note, or real mortgage.
Smith recognized that a company that earns money has a few options. It can return all of those earnings to shareholders in the form of a dividend, it can keep some of it and return the rest, or it can keep all of it. Any retained earnings can be reinvested to grow the business – build a new factory, produce more goods, add new stores, expand to new markets, sell more products.
Earnings used to grow the business compounded earnings growth, raised the value of the business, and eventually raised the price of its shares.
And that’s exactly what Smith found out. It wasn’t as though, prior to the 1920s, companies didn’t keep some of those earnings. Rather, nobody bothered to ask what affect those “kept” earnings had on the business.
As far as anyone was concerned bonds were safer investments. Bonds were better investments. They were superior in every way.
Stocks were just too speculative. And they had a good reason to believe it. Over the period (1866 – 1922) that Smith studied, investors dealt with inflation, deflation, and a few market panics. In fact, Smith’s original intent was to prove bonds were the better long term investment.
That all changed with the book. A couple of articles from the time shows the shifting view:
In a book written by Edgar Lawrence Smith, entitled “Common Stocks as Long Term Investment,” the author contends that a long term investment in diversified common stocks brings a great yield and is worth more at the end of the period than an investment in sound bonds, and that it is fully as safe.
Mr. Smith’s conclusion (arrived at in an attempt to prove the reverse to be true) is so revolutionary from generally conceded ideas on the relative merits of stocks and bonds as investments, and the arguments used in the development of his theory are so interesting, that we wish to give our readers a sketchy outline of the book. — Review of Book Entitled “Common Stocks as Long Term Investments,” Chicago Tribune Oct. 25, 1925
Do I hear a whisper that “common stocks are unsafe and not fit for investment purposes”? The temptation to assist at the obsequies of this, another worn-out investment tradition, cannot be resisted. In early times the direct ownership of productive property had numerous disadvantages. To go into business a man had himself to own a factory, a ship, a store; to buy, sell, or fabricate. The risks were enormous. There was no expeditious and reliable transportation system; no means of instantaneous communications; no universal police protection; no automatic machinery; no sound credit system; no fire insurance, theft insurance, management and every other kind of insurance; no world-wide markets; nor even the corporate form of today. The number of businesses one man could manage or have a hand in was decidedly limited. Today, however, with most of the old risks eliminated a person can own a share in a business enterprise, in a hundred different business enterprises, leave all management problems to hands far more capable than his own, and receive his income with even less trouble than the coupon cutter must go to. And management always works for the stockholder. Why is a Liberty bond one of the safest securities in the world? It is a lien on all the industries of our country — good, bad, and indifferent. Certainly a lien on the good industries alone should be safer. This is the principle adopted by the investor who owns a carefully diversified list of shares in the leading companies of the sound essential industries of this country. For a comprehensive discussion of this subject, the reader should consult the recent series of articles published in Barron’s under the title “Investing in Purchasing Power,” by Kenneth S. Van Strum, also Edgar Lawrence Smith’s book “Common Stocks as Long Term Investments,” and an article “Elements of Investment Safety” in the Harvard Business Review. — Investing for a Widow, Barron’s Dec. 21, 1925
What people failed to realize is that part of Smith’s findings was the result of the skepticism around stocks. Because stocks were considered so speculative, investors expected to earn a premium yield for that risk (investors were willing to pay more for bonds, and earn a lower yield, because of the perceived “safety” in bonds). So stocks consistently paid a higher yield than bonds. Retained earnings were the key for long term growth, but those higher yields gave his results a big boost.
Then sentiment shifted. As investors switched to stocks, prices rose, stock yields fell below bond yields, and Smith’s “law” (specifically #2) stopped being true. But investors didn’t care because prices were rising:
In the century’s first 20 years, stocks normally yielded more than high-grade bonds. That relationship now seems quaint, but it was then almost axiomatic. Stocks were known to be riskier, so why buy them unless you were paid a premium?
And then came along a 1924 book–slim and initially unheralded, but destined to move markets as never before–written by a man named Edgar Lawrence Smith. The book, called Common Stocks as Long Term Investments, chronicled a study Smith had done of security price movements in the 56 years ended in 1922. Smith had started off his study with a hypothesis: Stocks would do better in times of inflation, and bonds would do better in times of deflation. It was a perfectly reasonable hypothesis.
To report what Edgar Lawrence Smith discovered, I will quote a legendary thinker–John Maynard Keynes, who in 1925 reviewed the book, thereby putting it on the map. In his review, Keynes described “perhaps Mr. Smith’s most important point … and certainly his most novel point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back in the business. Thus there is an element of compound interest (Keynes’ italics) operating in favor of a sound industrial investment.”
It was that simple. It wasn’t even news. People certainly knew that companies were not paying out 100% of their earnings. But investors hadn’t thought through the implications of the point. Here, though, was this guy Smith saying, “Why do stocks typically outperform bonds? A major reason is that businesses retain earnings, with these going on to generate still more earnings–and dividends, too.”
That finding ignited an unprecedented bull market. Galvanized by Smith’s insight, investors piled into stocks, anticipating a double dip: their higher initial yield over bonds, and growth to boot. For the American public, this new understanding was like the discovery of fire.
But before long that same public was burned. Stocks were driven to prices that first pushed down their yield to that on bonds and ultimately drove their yield far lower. What happened then should strike readers as eerily familiar: The mere fact that share prices were rising so quickly became the main impetus for people to rush into stocks. What the few bought for the right reason in 1925, the many bought for the wrong reason in 1929.
Astutely, Keynes anticipated a perversity of this kind in his 1925 review. He wrote: “It is dangerous…to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was.” If you can’t do that, he said, you may fall into the trap of expecting results in the future that will materialize only if conditions are exactly the same as they were in the past. The special conditions he had in mind, of course, stemmed from the fact that Smith’s study covered a half century during which stocks generally yielded more than high-grade bonds. — Warren Buffett on the Stock Market
The public took Smith’s general findings that stocks were better long term investments and ran with it. Like the housing bubble, the ’20s bull market took off, fed on itself, and ended in disaster.
Not long after, the public sentiment shifted back (and would stay that way for a couple of decades). Stocks were once again too speculative, even though most companies that retained earnings continued growing – compounding in value – despite what its stock price showed.
- Put These Charts on Your Wall – C. Bilello
- Six Trillion Reasons for Stocks’ Rise – BloombergGadfly
- The Great Equity-for-Debt Swap – Felder Report
- Discipline is Having the Strength to Say No – MicroCapClub
- Decisions, Decisions – A Wealth of Common Sense
- The Good Thing About Climate Change: Opportunity (pdf) – GMO
- Equity Factor-Based Investing: A Practitioner’s Guide (pdf) – Vanguard
- The Wrong Side of Right – Farnam Street
- Managing Our Hub Economy – HBR
- Whole Foods and the Future of Grocery Stores – Washington Post
- The Bit Bomb – Aeon
- What We Get Wrong About Technology – T. Harford