Once upon a time, bonds were considered the best investments in all the land. Stocks were speculative and risky. Bonds were “safe.”
As luck would have it, Edgar Lawrence set out to test a theory and happened upon an interesting result. Lawrence originally thought that stocks did better during periods of inflation, bonds during periods of deflation.
It turned out stocks did better under both periods because retained earnings, reinvested back into a business, would grow more earnings and the business would appreciate in value. It naturally created a compounding effect that showed up in the stock price over time.
Of course, this is common knowledge today but it was a new idea at the time. Lawrence published his results in a book titled Common Stocks as Long Term Investments, with little fanfare, at first.
But John Maynard Keynes helped popularize it with a review written in May of 1925. The book would go on to be, at least partially, blamed for the stock bubble and burst of 1929 (what started as a sound premise devolved to chasing price action). Here are the highlights of Keynes’s review:
The results are striking. Mr. Smith finds in almost every case (in ten tests out of eleven), not only when prices were rising, but also when they were falling, that common stocks have turned out best in the long run, indeed, markedly so; whilst in the odd case there was not much to choose between the two… Were the superior average results obtained at the cost of an inconvenient irregularity of income as between one year and another? On the contrary, he found that, even in the worst years, his index of ordinary shares gave, almost invariably, a better yield than his index of standard bonds.
This actual experience in the United States over the past fifty years affords prima facie evidence that the prejudice of investors and investing institutions in favour of bonds as being’ safe’ and against common stocks as having, even the best of them, a ‘speculative’ flavour, has led to a relative over-valuation of bonds and under-valuation of common stocks.
It is dangerous, however, 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. Otherwise there is a danger of expecting results in the future which could only follow from the special conditions which have existed in the United States during the past fifty years. Mr. Smith claims that the general causes for the relative advantages of common stocks are discoverable, and that they are of a kind as likely to operate in the immediate future as in the immediate past. I may summarise these causes, expressing some of them in my own way and some of them in his, as follows:
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2) Even in the most carefully selected list of bonds, one or other of them will occasionally go wrong. But whilst the possibility of default cannot be ruled out, no bond ever pays more than the stipulated rate of interest. Thus there can be no exceptional successes to average out with exceptional failures. The purchaser of a selection of common stocks can afford to make an occasional mistake; the purchaser of bonds cannot. In other words, the actual average return from bonds, after allowing for unavoidable losses, is always somewhat less than the apparent average rate of interest at the date of investment.3) The ‘human factor’ in the management of the companies concerned favours the shares. ‘The management of every company is on the side of the common stock and opposed to the interests of the bondholders. The management does not want the bondholders to get more benefit from the operation of the company than is absolutely necessary to make it possible for the company to sell more bonds if such additional sale of bonds can be made to show a profit to the stockholders.’ In particular, the management will avail themselves of their rights to repay bonds at dates most advantageous to the shareholders and most disadvantageous to the bondholders.
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5) I have kept until last what is perhaps Mr. Smith’s most important, and is 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 into the business. Thus there is an element of compound interest operating in favour of a sound industrial investment. Over a period of years, the real value of the property of a sound industrial is increasing at compound interest, quite apart from the dividends paid out to the shareholders. Thus whilst an index of bonds yields, as we have seen, less in the long run than its initial apparent rate of interest, an index of shares yields more in the long run than its initial apparent rate of interest. So far, therefore, from the higher apparent rate of interest on shares, as compared with that on bonds, being required to compensate the greater risk of loss, the reverse is true. Shares work out better than bonds by more than the difference between the apparent rates of interest upon each.Mr. Smith has made an estimate of what this element of compound interest has amounted to upon the average. He finds that over a long period the average rise in market value of typical common stocks is approximately equal to the value which would have accumulated on the assumption that the concerns set aside annually out of current profits a sum equal to 2 1/2 per cent of their capital, and retained these sums to fructify in the business… But the effect of this accumulation over a period of years is, like all compound interest effects, of startling magnitude. It is sufficient to recoup after a moderate interval even those investors in common stocks who were so imprudent or so unfortunate as to make their initial investment at the top of a boom.
Mr. Smith applies one final test of comparative advantage which is the most overwhelming of all. He assumes that the ultra-prudent investor forms an investment reserve out of the surplus income of common stocks, as compared with that of an equal initial investment in bonds, regarding as income only that amount which he would have received from bonds and reinvesting the balance in additional shares. In this case the capital appreciation of his holding over a period of about twenty years varies from 104 per cent in the least favourable case to 355 per cent in the most favourable case-a calculation which certainly provides a big margin against the unexpected.
Sources:
The Collected Writings of John Maynard Keynes, Vol. 12
Related Reading:
Birth of Stocks for the Long Run
The Downside of Chasing Huge Wins
Lessons from Keynes the Investor
