Security Analysis : Sixth Edition, Foreword by Warren Buffett: Additional Aspects of Security Analysis. Discrepencies Between Price and Value

when operating in 1939 or later.
    3. Make composite purchases of the list when the shares can be bought at a substantial discount from normal value, say, atsuch value. Or purchases may be made on a scale downwards, beginning say, at 80% of normal value.
    4. Sell out such purchases when a price is reached substantially above normal value, say,higher, or from 20% to 50% higher on a scale basis.
    This was the general scheme of operations developed by Roger Babson many years ago. It yielded quite satisfactory results prior to 1925. But—as we pointed out in Chap. 37—during the 1921–1933 cycle (measuring from low point to low point) it would have called for purchasing during 1921, selling out probably in 1926, thus requiring complete abstinence from the market during the great boom of 1927–1929, and repurchasing in 1931, to be followed by a severe shrinkage in market values. A program of this character would have made far too heavy demands upon human fortitude.
    The behavior of the market since 1933 has offered difficulties of a different sort in applying these mechanical formulas—particularly in determining normal earnings from which to compute normal values. It is scarcely to be expected that an idea as basically simple as this one can be utilized with any high degree of accuracy in catching the broad market swings. But for those who realize its inherent limitations it may have considerable utility, for at least it is likely on the average to result in purchases at intrinsically attractive levels—which is more than half the battle in common-stock investment.
    “Catching the Swings” on a Marginal Basis Impracticable. From the ordinary speculative standpoint, involving purchases on margin and short sales, this method of operation must be set down as impracticable. The outright owner can afford to buy too soon and to sell too soon. In fact he must expect to do both and to see the market decline farther after he buys and advance farther after he sells out. But the margin trader is necessarily concerned with immediate results; he swims with thetide, hoping to gage the exact moment when the tide will turn and to reverse his stroke the moment before. In this he rarely succeeds, so that his typical experience is temporary success ending in complete disaster. It is the essential character of the speculator that he buys because he thinks stocks are going up not because they are cheap, and conversely when he sells. Hence there is a fundamental cleavage of viewpoint between the speculator and the securities analyst, which militates strongly against any enduringly satisfactory association between them.
    Bond prices tend undoubtedly to swing through cycles in somewhat the same way as stocks, and it is frequently suggested that bond investors follow the policy of selling their holdings near the top of these cycles and repurchasing them near the bottom. We are doubtful if this can be done with satisfactory results in the typical case. There are no well-defined standards as to when high-grade bond prices are cheap or dear corresponding to the earnings-ratio test for common stocks, and the operations have to be guided chiefly by a technique of gaging market moves that seems rather far removed from “investment.” The loss of interest on funds between the time of sale and repurchase is a strong debit factor, and in our opinion the net advantage is not sufficient to warrant incurring the psychological dangers that inhere in any placing of emphasis by the investor upon market movements.
    Opportunities in “Secondary” or Little-known Issues. Returning to common stocks, although overvaluation or undervaluation of leading issues occurs only at certain points in the stock-market cycle, the large field of “nonrepresentative” or “secondary” issues is likely to yield instances of undervaluation at all times. When the market leaders are cheap, some of the less prominent common stocks are likely to be a good deal cheaper. During 1932–1933, for example, stocks such as Plymouth Cordage, Pepperell Manufacturing, American Laundry Machinery and many others, sold at unbelievably low prices in relation to their past records and current financial exhibits. It is probably a matter for individual preference whether the investor should purchase an outstanding issue like General Motors at about 50% of its conservative valuation or a less prominent stock like Pepperell at about 25% of such value.
    The Impermanence of Leadership
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