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

optimism regarding its future
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    The main drawback of a typical smaller sized company is its vulnerability to a sudden and perhaps permanent loss of its earning power. Undoubtedly such adverse developments occur in a larger proportion of cases in this group than among the larger enterprises. As an offset to this we have the fact that the successful small company can multiply its value far more impressively than those which are already of enormous size. For example, the growth of Philip Morris, Inc., in market value from 5 millions in 1934 to 90 millions in 1939, accompanying a 1,200% increase in net earnings, would have been quite inconceivable in the case of American Tobacco. Similarly, the growth of Pepsi-Cola has far outstripped in percentage that of Coca-Cola; the same is true of General Shoe vs. International Shoe; etc.
    But most students will try to locate the potential Philip Morris opportunities, by gaging future possibilities with greater or less care, and will then buy their shares even at a fairly high price—rather than make their commitments in a diversified group of “bargain issues” with only ordinary prospects. Our own experience leads us to favor the latter technique, although we cannot guarantee brilliant results therefrom under present-day conditions. Yet judging from observations made over a number of years, it would seem that investment in apparently undervalued common stocks can be carried on with a very fair degree of over-all success, provided average alertness and good judgment are used in passing on the future-prospect question—and provided also that commitments are avoided at times when the general market is statistically much too high. Two older examples of this type of opportunity are given here, to afford the reader some notion of former stock markets.

    * Earnings before contingency reserves were $40.95 per share.
    In these cases the market price had failed to reflect adequately the indicated earning power.
    Market Behavior of Standard and Nonstandard Issues. A close study of the market action of common stocks suggests the following further general observations:
    1. Standard or leading issues almost always respond rapidly to changes in their reported profits—so much so that they tend regularly to exaggerate marketwise the significance of year-to-year fluctuations in earnings.
    2. The action of the less familiar issues depends largely upon what attitude is taken towards them by professional market operators. If interest is lacking, the price may lag far behind the statistical showing. If interest is attracted to the issue, either manipulatively or more legitimately, the opposite result can readily be attained, and the price will respond in extreme fashion to changes in the company’s exhibit.
    Examples of Behavior of Nonstandard Issues
. The following two examples will illustrate this diversity of behavior of nonrepresentative common stocks.
    B UTTE AND S UPERIOR C OPPER (A CTUALLY Z INC ) C OMPANY C OMMON

    These were extraordinarily large earnings and dividends. Even allowing for the fact that they were due to wartime prices for zinc, the market price showed none the less a striking disregard of the company’s spectacular exhibit. The reason was lack of general interest or of individual market sponsorship.
    Contrast the foregoing with the appended showing of the common stock of Mullins Body (later Mullins Manufacturing) Corporation.
    Between 1924 and 1926 we note the characteristic market swings of a low-priced “secondary” common-stock issue. At the beginning of 1927 the shares were undoubtedly attractive, speculatively, at about 10, for the price was low in relation to the earnings of the three years previously. A substantial, but by no means spectacular, rise in profits during 1927–1928 resulted in a typical stock-market exploitation. The price advanced from 10 in 1927 to 95 in 1928 and fell back again to 10 in 1929.

    A contrast of another kind is afforded by the behavior of the aircraft-manufacturing stocks in 1938–1939, as compared with that of war beneficiaries in 1915–1918. The two following examples will illustrate the relationship between market price in 1938 and 1939 and actual performance at the time.

    In these cases the market was evidently capitalizing the as yet unrealized profits from war orders as if they supplied a
permanent
basis of futureearnings. The contrast between the Butte and Superior price-earnings ratio in 1915–1916 and that of these