If one examined the data when presented in the mid-sixties, one accepted the hypothesis that markets generally were efficient. After adjustment for volatility, there were few, if any, investors who systematically could produce returns above that which could have been achieved by chance. Furthermore, performance figures on institutional investors—essentially the more readily available mutual funds—were not predictive of future success. The entire notion of selecting mutual funds based upon past performance data being predictive was faulty.

Institutions should have accepted this academic challenge but gradually the notion that markets were efficient became widely accepted by institutional investors. At the present time, institutional investors among themselves admit that they cannot beat the market with large sums of money. They seem today to be even stronger adherents of the efficient-market hypothesis than academics. The strong form of the efficient-market hypothesis claims that securities are accurately priced at all times, reflecting the balance-of-judgment about the information that is available at any given time on the expected outcomes that will affect equities. Many institutional investors operate on this hypothesis today, providing client services in the form of risk adjustments and other handholding supplanting their earlier stress on portfolio construction and stock picking.

The weak form of the efficient-market hypothesis says that there may be imperfections in security pricing, but that these are too expensive for most institutional investors to exploit. From this weak form, we can derive a restatement for shaping investment policy.

It is possible to diagram the market (Figure 2) showing the tendency of individual securities toward something called normal value on any given day. This is based upon the natural force of potential buyers and sellers who withhold their potential action from the marketplace because they are not attracted to making transactions at a given price. A more customarily understood function is through active buyers and sellers operating at the margin. The spread around normal value is wider for securities of smaller market capitalization. Markets in the area of less capitalization are not so efficient because the institutional investors who are dominating the pricing mechanism cannot operate conveniently with the same historic techniques they have used in thin markets. Size is an important determinant based upon ease of institutionalization, but there can be other characteristics as well—mundane industries, a geographic bias, and even a bias according to certain days of the calendar for different security universe subsets.

The inefficiently priced security can be analogous to the half-life of an artificially created element. When exposed to natural conditions, it tends to decay toward a stable condition quite rapidly. All of the laboratory measurement problems of artificially created elements are present in measuring the existence of imperfectly priced securities. The more time one expends to uncover inefficiently priced securities, the more likely the examiner is to find one whose half-life has decayed to the point where it approximates an efficiently priced security.

The theory of security pricing may be generally stated: the more accessible a security is to institutional investors, the more likely it is to be correctly priced in relation to similar securities. The entire universe from which the security may be drawn may not be correctly priced vis-à-vis all securities. The difficulty in exploiting market imperfections is inversely proportional to the incidence of institutional acceptance characteristics. Time erodes imperfect pricing without any investment action.

The investment process deals with allocation of capital, which is, in a sense, the promise of future goods and services that will be provided—modified to the extent that promises can be broken because they are inconvenient. The rights of capital, be they to pollute or infringe upon rights of others, can shrink without any transactions taking place to increase or decrease their value. Without the strength of law or precedent to enforce previously made business dealings, capital does not exist. It is not the repository of something—like oil or a building. It merely represents a promise that the proceeds from such things will be allocated according to a prescribed plan.

When the allocation is not in force, the capital ceases to exist; and when the allocation of capital is limited, it bears a shrinkage. Today, we say we are capital short, meaning that many of the projects which should be undertaken involve large expenditures of capital. The only way in which we can have capital is to forego expenditures for current goods and services; capital is the expectation that future goods and services will be paid back with some return. In an inflationary environment this becomes more difficult, since future capital is systematically eroded. Part of the shortage, in my view, comes about from erosion of the force of promises rather than from excessive demand for capital. But, essentially, you have both things taking place. Because of inflation and a world which has undergone a rapid economic transformation, the demand for capital is high and, because of changes in the force of promises, the supply of capital (promises) is lower.

Selection Techniques

Stock selection techniques are basically in two forms: top-down and bottom-up. The top-down approach involves beginning with an analysis of the overall economic environment, then narrowing to industries which may be especially favored and, finally, selecting companies within an industry which will be head and shoulders above other companies in the same industry. Portfolio weightings can be arbitrarily set as stronger or weaker than weightings in a popularly used market index, such as Standard & Poor’s 500.

The bottom-up approach ignores industry divisions of the market and looks for those few places where the pricing may be imperfect, which for some reason has slipped the attention of investors. It attempts to uncover underpriced securities, which, it is presumed, are likely to appreciate more in value than the market in general. Each security in effect is ranked against the entire market, rather than against a narrower universe of its own industry or other category.

Analysts tend to pursue the bottom-up approach, while portfolio managers favor the top-down. Although institutions can be segregated as favoring one over another, it is better, in my opinion, to run both techniques in parallel. Where a given investment opportunity satisfies the criteria of both techniques, one may be doubly encouraged by the likelihood of profit, since one technique confirms the other.

Within both approaches rests the opportunity to utilize fundamental and technical analysis. Fundamental analysis involves studies of the economy and of corporate enterprises that relate to earnings, assets, sales, and dividends; indeed, all activity which relates to securities analysis, but only in relation to what a company does and the currently prevailing price for its security. This analysis utilizes the marketplace as a single slice in time. The only information purpose of past price action is to establish price norms and not trends. There is a judgment that undervalued securities tend to move toward a higher normal value, and securities which are overvalued tend to move downward to a more normal value.

Technical analysis, on the other hand, concerns itself entirely with market price trends. In a sense it presumes the market is relatively perfect, and that the judgment of investors is revealed in pricing. It seems logical that there would be information content in price trends. Although statistical support for technical techniques is lacking, there is evidence that technical tools in the hands of a skilled technician add to the decision process. Price trends have a persistency and are occasionally revealed by recurring technical patterns. Some investors, particularly short-term traders, rely entirely upon technical studies as the patience required for the unfolding of fundamental value in the marketplace may be too great.

Again, my own preference is for a blending of both approaches, with fundamental input given a very high weight at all times and technical information being given a moderate weight in decision-making at critical turning points. In general, it may be said that fundamental analysis claims it is the best investment tool for determining what to buy or sell; technical analysis portends superiority for targeting the moment when!

One of the most difficult tasks an investor has in stock selection is his judgment and analysis of management capability. Large institutional investors consider that their junior people have the skills to analyze management talents, motivations, goals, and aspirations on the basis of intensive interviews. Most young analysts, however, do not have the investment background to undertake this task. Nor can they always relate well to the life styles and demands of those they are attempting to analyze. They can, on the other hand, be the subjects of excessive sales zeal by an excessively articulate management, with smoothness and salesmanship being taken as mistaken substitutes for objectivity and drive.

Other analysts feel that management skills, whatever they may be, are revealed in published accounting information. Income statement, balance sheet, and growth adequately testify to the presence of management skill. Although luck may be involved, the likelihood that it will be a causal factor for good corporate figures is reduced to a low level in a period of at least five years.

Corporate accounting is sufficiently loose and generally not responsive to immediate change. Accounting figures can hide company deterioration for a long period of time. Several examples come to mind. We had invested in an insurance company where the level of profitability had deteriorated steadily for five years, although adjusted earnings rose in excess of 10 percent annually. The company had been using its reserves, which were tucked in the corner of various accounts in each of those years—assuming that each subsequent year would allow a build-up of the reserve account. This company was eventually sold to a larger insurance company which makes a specialty of cleaning up sick situations.

Another company we were involved in had the best operating figures in its industry. It was founded and dominated by one man. When he died, he left control of the company evenly balanced between two sons-in-law and a son. For a while there was no change in the company’s progress. The policies of the father continued until there was rapid deterioration as the younger generation lost control of some of the subsidiaries. Hard feelings resulted, and the company became only a mild reflection of its former strength.

One of the most flagrant examples of the inadequacy of accounting figures was a printing-machine company working three shifts a day shipping machines to an unconsolidated leasing subsidiary across the street. R. Hoe’s warehouse was full of unsold equipment. Managements resort to these expediencies only very rarely; they cannot remain in effect for very long.

One problem with numbers in analyzing companies is that they may lag. At best they are coincident and hardly ever do they lead. One cannot use numbers as a guide for stock selection except in a universe so neglected by investors that stock prices lag fundamental changes. In a closely followed universe like most institutionalized securities, numbers may be inadequate. The numbers themselves fall behind changes that have taken place within the company. Moreover, there is intense competition among the numerous brokers and institutions who follow the securities and try to act ahead of the changes. The investor making a decision after numbers have been published for a closely studied universe will lag.

And yet, "number crunching" among analysts for large institutions is a most common activity. Perhaps by so doing, they are performing some religious service, giving the ceremonial due to traditional analyst-like activities. Certainly there is little evidence within a highly institutionalized environment that quantitative techniques lead to profit-producing results. Most studies involved in forecasting earnings per share have suggested that analysts in general have no skill at this activity; furthermore, even in those few areas where they have skill, it has not been rewarding.. The only reason forecasting earnings per share must be done in an economic environment is that clients and others think it is useful, although it cannot be verified.

The technique of accounting used today was not devised for reporting to outside shareholders. It is cost accounting based upon historic figures. It compensates for its deficiencies in meeting investor reporting objectives by its accuracy: the books balance and the accounting principles, limited though they may be, are sufficiently well stated so that they can be duplicated by a variety of different accounting firms and be reasonably comparable. The trouble is that it just doesn’t represent useful information for investment decision-making.

The terminology used in investor accounting can be a problem. We use concepts like "asset value" to suggest a transfer price when none is present. I can remember a mutual-fund shareholder—a minister on the West Coast—writing me and wondering why he had to pay capital gains taxes two years in a row on a capital gains distribution from his fund when the asset value had gone down. No one had apparently told him when he bought the fund at net asset value that he was picking up accrued capital gains tax liability which had been attributable to the holding period of prior investors in the fund.

Earnings per share suggest a notion of cash in the register at the end of the year that could be paid out to shareholders or reinvested aggressively in new businesses at the option of the management. Few people consciously recognize that earnings per share may include a large component of the accountant’s estimate of future cash that will be received. Leasing companies take into current income part of the residual value of the estimated resale value of equipment they may sell in ten years. Insurance companies count as earnings part of the commission costs required to generate new sales contracts. These are not earnings in the sense that they are something one can spend; rather they are estimates of future cash flows, and the estimates may fall very wide of the mark.

There is little an investor can do to break these figures apart. An institutional investor could, but most have developed such a cynical attitude that they are concerned only with reported earnings per share, rather than in making any adjustment for unusual depreciation practices or adjustments to arrive at any quality of earnings index. Some attempts are being made now to arrive at a conception of discretionary cash flow, or free cash flow. This figure would adjust for higher costs of replacement equipment, the time element from which one can forecast future flows, and the discount rate at which these flows must revert to present value. None of these factors is present in the use of earnings per share. Perhaps one of the reasons why securities drop to a very low earnings multiple in an inflationary period is because the investor is intuitively responding to the notion that earnings (as a valuation technique) may not be a meaningful concept.

Current price-level accounting has been criticized by the Financial Analysts’ Federation. The source of distress is that it is the function of financial analysts and not of accountants to make estimates. This view is parochial, since few financial analysts have the information (in fact, they would be prevented from having the information) required to make adjustments that the accountants make. Current price-level accounting is essential at rates of inflation in excess of 5 percent; they may be desirable under all conditions, anyway. If the information required to make the adjustments to current price level cannot be broadly disseminated, at least a company’s own accountants should have that information, and accounting firms will develop good or poor reputations on their ability to arrive at correct appraisals.

Accounting is critical for investment decision-making if one is employing quantitative techniques. We will see in the future a sharp increase in use of accounting information for investment decision-making, and more accounting people are specializing in shareholder reporting with special reports for that purpose, rather than merely producing an adaptation of reports designed for companies to monitor their internal progress.

The top-down approach, as mentioned previously, starts with the economy. If, for a large institution, stock selection is not a worthwhile activity, then surely the differences in results will be made by skills in dealing with macro-issues. Questions, such as mix among cash, bonds, and stock; industry ratings; defensive positions; and so forth, will be the principal determinants of investment results.

These issues can be dealt with by experienced people only Many economic forecasts are available from well-qualified sources through the daily newspaper, and most large investors have their own economic staff making independent gross-national-product estimates. In fact, most businessmen consider themselves good amateur economists and have some views as to whether the economy is likely to move up or down. A smaller number of people will be able to derive independently a forecast for the national-income accounts but will have some impressions which amount to the same result.

An independent economic forecast, however, is not useful in the investment area if it merely confirms the consensus. The fact that a consensus exists suggests that it has already been discounted by market action and to act on the consensus is not rewarding. The practice I subscribe to is the identification of the economic consensus and an examination of those parts of the consensus with which I might disagree. Within this conflict are many profitable opportunities for investment.

The conventional forecast recently was that inflation rates would decline as business plateaued in 1973-1974. The bond market was priced to suggest that inflation rates would be imbedded at 5 percent or 6 percent, which was the conventional forecast of inflation rates by institutional investors. They ignored the fact that overseas rates were considerably higher and rising. Furthermore, inflationary expectations were built into union contracts and consumers’ behavior was likely to push prices above the 10 percent level. In a structured, controlled economy, free market forces, like mild recessions, do not bring prices down except in the very late stages.

An inflationary forecast was a nonconsensus position. It identified the investment opportunities in commodity-oriented industries and other fields, like chemicals, operating at capacity where prices could be promptly raised to reflect new conditions. Coincidentally, these fields were also quite asset rich, providing them with other desirable characteristics within a classic inflationary environment.

Few economists take pride in their recent forecasting ability. Most use government figures which have contained a number of statistical and sampling errors. Also, they are, for the most part, domestically oriented with very little experience in international monetary conditions, the Euro-dollar market, and business cycles abroad. Few economists specialize in the relationship between economies, yet many are experts on a single economy. As the world moves toward greater independence through the adoption of increased international trade, the traditional economic tools will be found wanting.

Economists have been befuddled by the American economy since 1971 when price controls were established. We have gone through the first American inflationary recession. This type of recession is without precedent in the post-World War II United States, but it is quite like the economic pauses which characterized. the European recovery. It may well be that the United States has adopted the full characteristics of the Atlantic Alliance membership.

Few economists recognize the parallels between the United States and Europe: socially, economically, and politically. In prior years the United States worker was striving to achieve mobility for his family, to obtain a college education, and thereby graduate from blue-collar to white-collar ranks. A college education is now available in the United States to nearly anyone with minimal skills. Work effort by a blue-collar worker is not a prerequisite for the next generation to make this transition. On the contrary, it appears socially desirable for many white-collar children to join trades and work with their hands. Blue-collar work has been upgraded, financially and socially, to such an extent that it is no longer a status or financial barrier.

Family incomes have risen by the pattern of women working. A wife may work for domestic independence rather than for economic necessity. Our currency is no longer the bulwark of Western trade now that we have exported dollars to the world in return for consumer goods. Our currency is subject to the same pressures and fluctuations of any other major country, but it remains immune to pressure from none. Politically, we will probably enter a phase of strong legislative government, a characteristic of our European partners.

The American businessman even looks like his European counterpart more each day. He has had a full order book for some time, and yet he is pessimistic about the future. He has liquidity strains from borrowed capital and is facing inflation rates that have only been seen in Europe, Japan, and the more stable countries of South America. He, too, is behaving like his European counterpart. American consumers, in the face of uncertainty are taking down consumer debt and buying durable goods before they become unavailable at present prices.

One of the principal roles economists can play in the investment process is that of a high-level tipster. To the extent that economists are called in as consultants in government and industry, they pass on the insights received from these different activities to investment institutions. I can think of no case where economists violated a specific confidence. But I can think of many where economists were useful in conveying impressions they received from visits with government officials in Washington.

Nearly all the leading economists who have dealt with the investment community have been active consultants to our government. Many have been members of the Council of Economic Advisors. When I was director of research for F. S. Moseley & Co., one member of the Council was my brokerage client while he was in Washington. Every six months, I would receive a telephone call from Washington with the same conversation. He would ask how I felt about different sectors of the economy, the market, interest rates, and overseas conditions. Each time I started to give an answer, he would cut me off in the middle. I had the feeling that once I began my answer, the economist knew what it would be. This continued to the benefit of my commission business for several years. All the time I felt that I was perhaps having some hand in shaping the economic recommendations that were going to the President.

I was dismayed, however, to think that my forecasts might have been worthwhile, based upon the sketchy information that was available to me at that time. My experience with economists as investors tends to place them into two camps—either wildly speculative, as they treat the stock market as a nonserious number game, or excessively conservative. Like many academics, they tend toward the gloomy side and are not very anxious to risk even a small amount of capital. Rarely, and in no case to my knowledge, are their own investment programs well balanced.

All of the leading economists who deal with investment people are articulate and scholarly. This combination would be rare in most other fields, but I suspect that articulateness is essential in order to convert their research work into a marketable product for investors.

Another influence in determining the value of a company may be its name. Some companies have an old, moss-covered title like Pacific Car & Foundry which may no longer be appropriate for the business in which the company is pre-eminent. Pacific Car & Foundry has the largest single share of truck manufacturing business west of the Mississippi—an outgrowth of its original business, the manufacture of railroad cars. It correctly changed with the times and saw itself in the manufacturing business for transportation units, rather than merely suffering from the marketing myopia of providing railroad cars to a no-growth industry. The company recently changed its name to PACCAR—a name which ties in with its past but gives no specific hint of what type of transportation business is being transacted.

The name changes which took place in the late sixties have been well documented. The addition of "onics" and "natics" gave the impression of far more technological content to many companies than was supported by the facts. Companies which had small divisions in exotic areas assumed the name of the smaller division and ignored the more prosaic, basic part of the business which was associated with low multiples.

Often, by the time the name changes became effective, the change was motivated by factors which had long since ceased to be influential. Some companies with small health units, for example, would adopt a name suggesting they were dominant in the health-care industry, yet that industry might have ceased to become a recognized glamour field. Name changes to influence stock valuation by association with a recognized glamour field are very likely to be unproductive. It is an indication to investors that caution in that field should be observed.

Another type of name change which may confuse investors centers around companies which have gotten into trouble and have frequently split themselves apart, changing their name in order that an unpleasant history be left behind. Saturn Industries was one of the hot glamour issues of the sixties which collapsed late in the decade. The three divisions which had been consistently profitable were kept, reformed, and named Tyler Corporation. A growth track of those three divisions remained consistent through the sixties. Therefore, Tyler was unblemished by the decline of its larger predecessor, Saturn.

Name changes often involve a reconstruction of past records. The most innovative reconstruction and name change to my knowledge was the creation of Computer Technology Corporation by James Ling in the mid sixties. While Ling was engaged in "Operation Redeployment"—selling off small pieces of his subsidiary companies to the public in order to establish separate public markets for each division—he concluded correctly that it would be wise to have a high multiple, computer-related activity within his complex.

The only part of LTV that was doing much with computing was his own tabulating department, preparing invoices and doing regular mundane accounting chores. How could one glamorize such an inherently unglamorous field? With the bravado for which he became justly famous, Ling decided to spin off his accounting department, recreate a record from cost-accounting figures of what the payroll and absorption of overhead would have been for that department, name it Computer Technology, and hire a topnotch IBM salesman as president with instructions to get additional business.

Computer Technology was created and spun off, and it achieved a high market valuation. Several years after it had a separate identity, Ling sold the company for a huge profit. Prudential Insurance bought the parent company’s interest in Computer Technology for about $20 million. After the sale, Ling was said to have been amazed at being able to take a staff function, such as accounting, and sell it to a sophisticated investor at a huge premium.

Name changes often involve related accounting modifications. Accountants allow numbers to be discarded if they relate to noncontinuing operations. A parent company can then wipe out past losses by erasing them in the present. The sale or, for that matter, just the planned sale of an existing activity is enough to allow an auditor to go back and expunge the contribution of a mistake in the prior years.

Fuqua Industries, which has not changed its name for some years, is a company that seems to be increasing its earnings by 20 percent annually to the $2.50 level. Each year, it reports earnings in the $2.50 per share area, which are up from a restated figure of $2.00 for the prior year. The explanation is always a reduction in the contribution of subsidiaries that are to be discontinued.

In selecting a security, one should be aware of event investing. Brokers like to promote securities that involve a specific reason for the security to be bought immediately. One of the greatest problems they have is in interesting a potential client in taking action on a security that same day.

The broker can tell his client: "XYZ must be bought today because event W will happen next week, which will make the stock go up." Occasionally, significant events can be forecast in advance, but this occurs so rarely that it is not worth the effort to be sensitive to events of that nature. Inside information, as we know, is illegal. An investor in possession of information which might influence a significant price change is legally prohibited from acting upon such information.

From time to time, it is possible to act upon information that is already in the public domain but has not been disseminated. Some information, although significant, may be well ahead of price changes. Securities that are owned by individuals are frequently not as responsive to information in such publications as The Wall Street Journal as those owned by institutions. After all, individual investors do not have access to the same sources as the institutions and anyone reading these conventional sources has a simple proprietary advantage. Even items like dividend increases, historically closely correlated with price changes, are not fully discounted by individual investors until the higher dividend check is received. That is the only time at which some individual shareholders know that a dividend increase has taken place, even though the amount of the dividend is automatically deducted from the market price of the stock on the day it sells "ex-dividend."

In 1969, the Food and Drug Administration banned the use of cyclamates in soft drinks. Studies had shown that large quantities of cyclamate would cause death in rats and, therefore, by government fiat the rapidly growing diet-drink industry was wiped out. To my knowledge, there was no advance warning of this development, and it had great implications. Clearly, the bottlers would not slow down but would attempt to sell their diet-branded drinks with some amount of sugar.

Sugar is a commodity where small changes in volume, one could argue, influence a large change in price. Sugar stocks on the morning of the announcement had a delayed opening and rose 25 percent from their previous night’s close. The event was a specific action by government, the projected result would be a forecasted increase in sugar sales, with higher prices and substantially larger profits for the sugar companies.

The sugar stocks were selling at low multiples and high yields anyway at this time, so this news incrementally should have been very attractive to them. However, there were many other reasons for the unattractiveness of sugar stocks. Principal among them was the fact that the market was undergoing a large decline, concentrated in low-quality issues.