Individuals should invest in the type of companies in which institutions predominate and vice versa. A change may be taking place today in that there is increasing interest by institutions in the current income part of the total return equation. That may be one explanation for the better-than-expected performance of yield stocks in 1973-1974.

The individual investor is the ultimate beneficiary of all the efforts of the investment process. He may act independently, deciding to forego consumption in order to have investment capital. He may, on the other hand, be an involuntary investor through required pension and profit-sharing plans. He may financially support the local hospital or church, which may be an investor. If that fund fares well with its investment, the requirement for his support may be diminished. It is difficult to imagine any person so far removed from the private capital system that he is not directly affected by the investment process.

The typical individual acting for himself may make his own investment decisions through a broker or a bank. He may also delegate a part or all of the decision responsibility to professionals—insurance companies, mutual funds, or investment managers. Whether he is selecting particular securities for himself or choosing someone to act for him, he is going far down the line with the process. This discussion is intended to illuminate some of the issues involved in the steps that must be taken.

The individual investor has a good intuitive sense about what to do. While he does not run detailed performance studies, he knows if he buys something and it goes up in price, he has a profit and does not need to compare this result with what might have happened to the general market.

The individual investor frequently invests for fun. He prefers to buy stocks in industries that he understands. For example, if he has a special knowledge of the retailing industry, it is added pleasure to follow retailing more closely through reading stock reports and such. He is responsive to dividend increases and feels, quite correctly, that this is a sign of the financial health of the companies he owns.

The typical investor becomes involved with what he reads about the managements of his companies and identifies with them. This is an opportunity that the managements of companies rarely exploit. Managements often try to court the institutional investor and meet him personally, but they hardly ever engage in a financial public-relations campaign designed to personify company managements for individual investors.

The individual investor frequently encourages his children to own a few shares of stock—as one gives an allowance to a child—and to follow them closely. The children thus learn how to cultivate capital. Few companies have exploited this common educational function of investors.

The individual investor necessarily relies quite heavily upon his broker. Unfortunately, many individuals feel that the broker does not place his customers’ interests first. In the late sixties the observation, "Where are the Customers’ Yachts?"* applied particularly to clients who were sold hot issues that proceeded to go down and never recover.

* An observation credited to William R. Travers, celebrated stutterer and wit and a member of the New York Stock Exchange in the post-Civil War period. Travers resided in Newport in the summer, where he kept a small-sized yacht, which he obtained in lieu of a debt. While watching a yacht race one afternoon from the deck of his craft, he noticed a boat coming alongside in which was a committee that had been assigned to pay him the respects of the squadron. He noticed that they nearly all happened to be bankers or brokers. Casting his eyes across the water to some beautiful white-winged yachts, Travers found by inquiry that they all belonged to Wall Street brokers. With his gaze still resting on the handsome squadron, he asked his distinguished visitors: "But wh-wh-where are the cu-cu-customers’ yachts?"

Individuals tend to buy less volatile stocks than institutions yet they are not as impressed by well-known names. Rather, they are influenced by their own personal familiarity with what the company does. There are very few individuals today, for example, who would buy the low-yielding, high-multiple drug group. The product lines are not readily identifiable to the individual, the industry is complex, and the securities are selling at expensive prices.

The principal objective of most investors is to make as much money as possible without losing any. I have seen four pages of detailed objectives from sophisticated investors, which not only lay down broad targets under different types of market conditions but also present quite definitive operating rules of what to do if a loss occurs, what to do if there is a gain, and so on.

I am personally attracted to the notion of a mobile objective; that is, the reestablishment of investment objectives as market conditions change and are perceived. In a falling market, preparing for the next rise becomes paramount. Contrariwise, if one is in a market rise, one should begin to focus on the reverse side of that condition.

The point of a specific percentage objective expressed as some return over a time, is quite often useful in hindsight and may develop a familiarity between investment manager and client but does little to alter the behavior of the investment manager in dealing with his clients.

Unless one is investing venture capital, I agree with the notion that one cannot expect to become rich by investing in the public market without a considerable amount of luck. For those who have the responsibility to invest, the best thing to do is maintain purchasing power. It is probably more important to study results in the light of changes in purchasing power rather than as is traditionally done in comparisons with a market average or with the results achieved by competitors.

The written objectives of some investors are illuminating. They usually charge the investment manager to "do as well as you can without losing anything," accompanied by a hopeful pat on the back. Some are stated more succinctly in "legalese":

We understand that the investment objective of the Account is total return, taking into account both appreciation and yield, at an acceptable level of risk.

The Account will ordinarily be invested principally in a diversified portfolio of marketable common stocks and other marketable equity-type investments, including but not limited to convertible bonds and convertible preferred stocks. The Account may also hold cash, short-term obligations, and U.S. Government, corporate, and other bonds.

Or more simply:

The investment goal of this portfolio will be total return, capital and income, and it is understood that in order to achieve this goal, we may take risks commensurate with the potential gains.

In addition to the objectives, there may be a list of restrictions:

1. No purchase of (company) securities except to the extent that such securities may be an incidental part of a mutual fund in which investments are made.

2. No loans to (company).

3. No financial dealings with any subsidiaries, or affiliates of (company).

4. No loans to (company) officers or employees.

5. No puts, calls, strips, or straddles.

6. No short sales.

7. No letter stocks.

8. No investments for purpose of exercising control over management, and no more than a 5 percent holding of the sum of voting and nonvoting stock of one firm.

9. No investments in private placement bonds or direct real-estate investments, except to the extent that such investments may be part of a mutual fund in which investments are made.

10. No more than 20 percent of current market value in securities of one firm.

11. No more than 20 percent of assets under management to be invested in companies that, together with predecessor companies, have been in operation less than five years.

12. No more than 20 percent of assets in foreign securities, subject to the further marketability restrictions in (8).

Objectives may inherently reflect the market environment in which they were written; for example, one company stated their objectives to us as follows:

"The objectives of the (company) pension fund should be determined by the long-term nature of the liabilities involved. Appropriate objectives are:

1. To preserve the capital value of fund assets

2. To have sufficient liquidity to meet projected disbursements without forcing the fund managers to liquidate holdings in bad markets

3. To earn a rate of return on the equity portion of fund assets 10 percent better than the S&P 500 in up markets and at least equal it in down markets

4. To earn an overall rate of return between 8-11 percent over time (assuming annual inflation of less than 5 percent)

5. To reduce the volatility of the fund"

Some objectives grow out of the almost desperate needs of investors. Schools, hit early with rising costs and lower federal funding, were among the most pressed to project their needs onto investment attainment. One of the best efforts to increase endowment returns was made by a school that discussed its investment objectives in a report to the trustees as follows:

"The Ford Foundation report articulated an investment concept that, in fact, [school] has been following for many years. Ford suggested that, rather than viewing portfolio performance solely in terms of the dividend- and interest-income produced, the appreciation (or depreciation) in principal values should also be considered. The implication of this concept is that universities should not necessarily limit their spending to the income portion of their portfolio, but should also rely in a prudent and measured way on capital appreciation of the portfolio. In seeking to develop a portfolio performance goal for [school] based on this total return concept, this Board gave deep thought both to [school’s] needs and to feasible and historic portfolio results.

"To summarize these deliberations of two years ago—particularly for those who did not participate—our consideration of [school’s] needs suggested that operating deficits were likely to continue, thereby indicating a need for some reliance on the principal portion of our endowment fund for current operations. (These operating deficits are not unique to [school], as we all know. In Harvard and Money the authors estimated that Harvard’s operating budget will double by 1980, raising the prospect of serious deficits in that well-endowed institution.) In addition to an expanding operating budget, [school] faces significant capital investment requirements. And, despite a planned major capital fund drive, it is clear that [school’s] endowment will be called on in some measure to meet these capital needs. The net of these two factors, when priced out with detailed budgets and capital spending projections, suggested that a 12 percent return from [school’s] portfolio—allowing for a reasonable amount of inflation—was clearly needed to maintain the economic viability of the institution.

"In testing the feasibility of realizing an average annual return of 12 percent, the Board considered evidence presented in the University of Chicago’s study* indicating that long-term total returns from randomly selected common stocks have averaged approximately 9 percent annually over a 40-year period. As many of you will recall, we reasoned that if this kind of return was a historical fact in unmanaged portfolios, a professionally managed fund should exceed this result by a substantial margin. We also concluded that professional management of our portfolio should yield us an even greater margin when compared to investment alternatives in either fixed income securities or thrift institutions. (This is not to suggest that under certain market conditions fixed income securities would not be an attractive alternative for [school’s] fund managers, from both income and capital appreciation standpoints.)

* L. Fisher, and James Lone, "Rates of Returns on Investments in Common Stocks (1926-1965)," The Journal of Business of the Graduate School of Business, University of Chicago, July 1968.

"As a further check on our thinking, we researched quite carefully the publicly available data on the performance of many mutual funds. Here we found evidence that over five-, ten-, and even fifteen-year periods, average returns on the order of 12 percent had been realized. And, during our recent interviews with prospective nonbank fund managers, we developed some corroborating evidence that astute professional management could, in fact, provide [school] with an average total return of 12 percent over the long term.

"In summary, if the endowment is to fulfill the demands that we believe the [school] will have to make on it, it must substantially outperform the market averages over the long term, and we believe that this not only must be done but that—with proper management—it can be done."

Yield

Investing for yield attempts to optimize current return. Many institutions today, like colleges and foundations, have a growing need for current operating funds. Despite the fact that they believe that increased market value averaged over a time is a meaningful measure, few institutions feel comfortable for very long in the old-fashioned "spending of capital." They are a lot happier with a high current return and are attracted to yield-oriented portfolios. Individuals have always liked a dividend check coming in now and then. Changes in the market price of a portfolio have always seemed a bit ethereal to individual investors, whereas a tangible check in the hand is evidence that the company’s investment is working out. Increases in dividends were one of the things to which an individual was most responsive. It suggested that the company’s fortunes were improving far more than just reports of higher income per share.

The individual investor may look at the total dollars he receives as a return from his investment portfolio, computing the yield based on market price. Individual investors frequently figure yield on cost price. This is not a bad notion as long as one uses it to examine the performance record of previous decisions rather than determining a basis for new decisions. The best way to invest for yield may be to look at high-income securities to see whether the income level suffices for whatever one’s individual forecast about future inflation may be or to examine the rates of increases of past dividends.

One can use dividend trends as one might employ a trend line of earnings per share. The traditional method of obtaining high portfolio yields is to invest a portion of an account in cash or fixed income securities, which produce a higher yield than equities. After the entire income requirement is derived from those sources, the remainder of the portfolio is invested in appreciation-oriented equities. Such a balance may have been more appropriate when it was a novel suggestion than currently when so many portfolios have implemented this strategy. Use of this strategy is why income securities may be more underpriced relative to the total market than securities that were purchased for appreciation. If growth stocks are overpriced, they have already been discounted.

One of the principal objectives of investing for yield may be to uphold the purchasing power of the income dollar. Few institutional investors plot the increase in income stream as an objective when analyzing portfolio performance. There is an excellent argument that such an income stream, with an almost complete disregard of the capital value, is a valid investment objective. Individual investors, as we have already stated, tend to look at their portfolio performance by growth of income stream as well as changes in capital value. Growth in dividends has been a good inflation hedge. The income stream produced by the S & P 500 increased at a 4.4 percent annual rate between 1964 and 1974.

Corporate attitudes toward dividends are critical when determining a company’s dividend policy. Dividends are difficult to pay out, since they must be produced from after-tax earnings. In no way can a company directly get the dividends back in the event it needs additional financial strength for difficult days. A cash-rich company like General Motors has few aggressive opportunities because of its already dominant market share in the automotive industry. It has determined, however, based upon an imputed examination of its dividend practice, to pay out approximately 50 percent of earnings in a trough of the business cycle. For earnings that can be attributed to an expansion in demand above trough, it has determined to pay out 80 percent of these extraordinary gains, usually in the form of an extra.

In this way the company maintains financial strength and still rewards its shareholders for the excellent business conditions it may enjoy. Most companies seem to have a more simplistic payout formula, usually as a percentage of reported earnings. Because reported earnings have recently been liberalized for shareholder-reporting purposes and reported earnings increased, the payout was dropped. A typical disbursement may be expected to be somewhat less now than ten years ago.

Corporate liquidity has declined. Cash as a percentage of total assets currently is slightly less than a decade ago, and corporate borrowings are up. The reconciliation of these figures suggests that the residual of retained earnings had to be committed to replace capital assets at higher costs rather than to support new business. Some reported earnings were not available for distribution, although it is normally expected by investors that all of reported income, assuming that a company wished to establish such a policy, could be paid out as cash to the shareholders.

Corporations occasionally use dividends to attract shareholder loyalty at a time when it might otherwise be criticized. U.S. Industries raised its dividend in 1974 in the face of declining earnings when management was plagued by suits from dissident shareholders and division heads. The increase was followed quickly by the withdrawal of a commercial-paper rating by Moody’s, based in part upon the results of an unconsolidated finance subsidiary. One can surmise that the dividend increase was used as a shareholder bribe. Utilities have raised dividends coincident with higher borrowings and rising capital costs.

Statistically, one of the most responsive causal items between stock-price performance and fundamentals is the dividend increase. If one could accurately forecast such increases, it would be possible to marginally outperform the market. Most institutional analysts, however, by spending all of their time in attempting to forecast earnings per share in an environment that does not give credit to dividends, scarcely attempt to forecast the timing or extent of dividend increases.

I suggest that such an effort is possible and rewarding. Increasingly, investors will be investing for yield. In an inflationary environment, they will be interested in the type of yield that grows, rather than remains static, as in a bond or preferred stock. Just as company managements tend to persist with successful management decisions if they are good, so do investors reveal consistent patterns for dividend increases.

One must remember that dividends are paid out of cash and not necessarily out of earnings. However, a low payout in relationship to past historical norms—that is, a low ratio of current dividends to earnings—is a strong indication that a change may be pending. A company whose working capital has steadily increased at the same time that earnings have increased is an especially likely candidate for a dividend change.

Companies also tend to make dividend decisions on a seasonal pattern. Dividends are likely to be increased at the same time each year, in combination with the company’s own forecasting cycle. In the past decade, dividends have not advanced at the same rate as earnings, reflecting in part the fact that not all earnings have been translated into cash and that companies have needed a higher proportion of net income to replace plant and equipment.

It is critical for a company to avoid dividend cuts. There is probably no greater evidence of a company’s deterioration than a reduction in its payment to shareholders. This is an extreme position, taken very reluctantly and usually under pressure from outside lenders, indicative that the company has exhausted its borrowing reserve. Deteriorating earnings are the principal sign, but more directly one can look in the balance sheet for bank covenants and the amount of retained earnings that are available for the payment of dividends. These reflect the degree of harshness and concern the commercial banker is imposing upon the company.

It has been my impression that companies with commercial bankers on the board may be slightly quicker to cut their dividends than those without. Once a major institutional security cuts its dividend, a process of exchange of hands of nearly the entire capitalization begins, during which several years of poor stock prices will follow. Almost regardless of the price to which the stock falls early after a dividend cut, one can expect a long time of disappointing price performance from a major income-producing security.

The best example recently is an entirely new industry that grew up as an income-producing vehicle. The real-estate investment trusts were granted conduit status by the Internal Revenue Service in the early sixties. As such, they paid no corporate tax as long as they paid over 90 percent of their earnings to shareholders. And yet these companies were a financing vehicle, just like mortgage bankers or banks. In fact, banks were providing the principal source of funds to the real-estate investment trusts. A $4 billion industry grew up that served to take money from large institutional investors, essentially banks and insurance companies, and later corporations through commercial paper, and to lend this money for construction and development loans.

The average maturity of the loan by the real-estate investment trust was longer than its borrowings. As such, the real-estate investment trust was borrowing short and lending long—a prescription for indigestion when money tightened. Nevertheless, the underlying security became a progressively more attractive income vehicle. Real-estate investment trust prices started at something slightly over hook value; as they added leverage on top of the equity, they sold at two to three times book value. Subsequent issues of equity at the market price increased this value because the company could take the premium it received over book and add leverage on top of that inflated price. It was a great scheme, so long as business conditions were conducive to the industry it served—the housing industry. Lenders were willing to lend to progressively marginal companies in the field, and investors recognized that they had vehicles for income and not appreciation. A number of these securities were sold to dividend-hungry people, and the industry records of dividend growth were quite phenomenal.

In the latter part of 1972, one began to notice items in the press where various real-estate investment trusts advertised proudly that they had been able to place some of their money in real-estate projects around the country. One advertised pride in its ability to spend money. One could assume that the field became overcrowded. There was more money available than projects and some loans were of low quality.

Despite this reasonably simplistic observation, dividends still increased and stocks continued to rise. Major brokerage houses had teams of two or three people following the industry. The securities were also found in portfolios of individuals and institutions who bought them because they thought that others, wanting income, would pay progressively higher prices to maintain the yield level as dividends were raised.

As many know, dividend cuts became rampant throughout the industry in 1973. First, many loans went sour and stocks plummeted as dividends were cut. At one time during 1973-1974, the securities in this industry sold at two times earnings, yields on past norms indicating cuts yet to come of 30 to 50 percent. Some stocks in the industry fell to zero as companies went bankrupt or their loans were called.

Income-oriented investors had to sell these stocks out of their portfolios, so they felt, at any price. The price declines were the most vicious I have ever observed, especially when one considers that if the projects were correctly appraised in the first place and were foreclosed, a mortgage-holding trust might now be attractive for quite different purposes; that is, it could be an equity trust by changing its charter. Metropolitan Life Insurance Company foreclosed on many farms during the Great Depression, but became a large landholder and later established the base for its insurance growth. The morals of looking at the real-estate investment trusts are severalfold: (1) avoid dividend cuts; (2) be careful of leverage working against you; (3) yet to be proven, don’t be too hasty in determining what business your company may be in.

Profit

There is a European investment axiom: "Buy assets, sell earnings." This implies that one should buy potentially productive, but not currently earning, assets and sell them when they are appraised on the basis of their earnings. Many European merchant bankers traditionally make this sort of investment. They buy for their private account asset-oriented companies that may be in trouble. They place management to improve the situation and then distribute the companies to the public when they can be priced on an earnings basis.

In the American market the price to book value relationship has averaged about 2.0 times in the post-World War II period, suggesting that the stock market is priced on the basis of earnings and not assets. More recently, in late 1974, this ratio fell on the average stock to below book. With an average close to book value and with book value understated, it is possible to find in the American market (for the first time in over a decade) many opportunities where one can apply the canny European investment styles. I have suggested to several Europeans that the foreign investor may be more successful in the American market than his native counterpart. He should utilize his European techniques and not try to imitate, which I believe most do, what they think of as sophisticated American investment strategy.

Investing for gain seems to be everyone’s goal. During the two-and-a-half decade bull market that ended in 1966, investing for gain seemed quite easy. While the analogy of the Random Walk Theory dart board has been overdone, it was appropriate, particularly in hindsight. Since then, any one who has produced and maintained an investment gain either has been very lucky or unusually skillful.

Individual investors usually have very modest appreciation objectives. Except for wild trading practices in the hope of producing instant profit late in the bull market, individual investors appear to invest in value-oriented securities, anticipating that their assets would adjust to the inflation rate, but they recognize that they will not get rich from this procedure. Most do not keep careful records; they don’t know from one year to the next what the gain has been.

Individual investors know that they produce a loss if the security sells below cost or if there has been a dramatic price change. Many individuals have in their portfolios some of the popular glamour stocks, such as Polaroid or IBM, at very low tax cost. These securities were bought in a diversified portfolio back in the fifties by more venturesome investors; of course, their tax cost is only a few dollars a share. Investors in Polaroid who have seen the stock as high as $169 a share are well aware that they have lost money at a market price of $20, although their tax cost may still be lower than the current market.

Institutions tend to be more impressed with investing for gain. In the first place, they keep shorter-term accounting records and respond with enthusiasm or dismay whenever there is a change of market value in a large portfolio. At Keystone, daily portfolio pricing sheets were distributed to portfolio managers at the end of the day and each manager considered we made or lost whatever million dollars profit or gain occurred from the preceding day. This response to essentially nonsensical short-term information built into one’s system a myopic attitude to the time horizon in which a security was expected to perform.

Institutional portfolios tend to be slightly more volatile than the market, suggesting that, in converse, individual portfolios should be slightly less volatile. On good days in the market an institutional portfolio could be expected to go up more and on bad days it would go down more. Most institutions are oriented toward doing well in a bull market. Indeed, that is when there is the greatest attention to see whether or not one is keeping pace. A bear market is expected, by the institutional frame of mind, to be of short duration and not too significant for investment-trading purposes. To the contrary, there have been as many bear-market months as bull-market months in the five years 1969 through 1974. So it seemed from the price behavior of the average stock. In fact, the Dow Jones Industrial Average declined 30 out of 60 months in 1969 to 1973—a 50 percent record.

There is a strong tendency for institutional portfolios to increase their volatility; that is, to buy riskier securities as the market rises. The more stable, defensive securities do well enough in a bull-market period but appear to fall behind the more exciting investments of one’s competitors. To the extent that competitive performance establishes the base by which institutions are measured, there is an almost irresistible tendency to take higher degrees of risk as the market pace accelerates.

There is an almost equally strong tendency to reduce volatility as the market declines. Thus, at the top of the market, an institutional portfolio would have its maximum degree of risk volatility and its lowest at the bottom. An appropriate investment strategy, investing for optimum gain, would stress the converse. As the market rises, one should, on a mechanical basis, reduce volatility and make less risky investments. As the market recedes, one should increase the risk so that at the very bottom the risk is close to maximum.

A decade or more ago, bank trust departments were nearly the ideal depository for assets. Banks could be counted upon to be the conservators. They would accept the management of portfolios, maintain the holdings in only the highest quality bonds and stocks, and make very few decisions. Banks would give an investor a "piece of the rock" without pretense that there would be large gains or high performance. This was especially appropriate for the very large sums attracted to banks and trust companies.

The pressure from clients for more gains, coupled with bank managements wanting to find a reason to increase their fees, pulled and pushed bank operations into the performance race in the late sixties. The banks suddenly tried to imitate mutual funds with portfolio razzle-dazzle, topnotch people, and an investment style that was out of date by the time they adopted it. In a business sense, this change left large opportunities for traditional conservators of assets but these opportunities have not yet been fully recognized.

More importantly, the conversion of bankers to traders is a glaring example of institutional investors putting their own needs ahead of those of their clients. The clients’ large pension and endowment funds did not need, in fact could not achieve, for the sums in their possession, the gains promised by institutions. They could have reached their goals more easily by continuing in the low-cost conservatory mood of the fifties and sixties.

The capital-gains tax structure is a major hindrance for any individual investor who strives to achieve portfolio gain. In the first place, there is evidence that "countertrend" strategy is more appropriate in order to maximize gain. It is better to accept profits when you have them, which means establishing a capital gain and reinvesting the proceeds in securities that have underperformed those you elected to sell. When an individual follows this procedure, he must pay a capital-gains tax. This leaves him with less to reinvest than he had originally, for his asset base is eroded by the amount of the tax. In part, the individual investor does faulty accounting to the extent that he computes his net worth based upon full market value of the securities. He does not put aside something to offset accrued capital-gains taxes, and figures his profit in terms of market prices with no thought of Uncle Sam.

The capital-gains tax is in effect a no-interest loan from the government, tied to a specific piece of collateral. To consider that it is part of the investor’s net worth, as is usually done, results in some very faulty decisions and may be one of the reasons for the stock market’s very low liquidity in the early seventies.

Few individual investors have been happy with the tax-shelter investments they have undertaken. I have looked at many real-estate, oil-drilling, and cattle deals for investors and have seen few that should be undertaken were it not for special tax features. In general, this is an area that has been exploited only by the very wealthy who have battalions of specialists Structuring deals especially for them. They have a continuing employment relationship with the people who put the deals together. By the time tax-shelter deals are put out on a merchant basis to a sales force, the individual investor has cause to be very wary of the prospective investment result.

Growth

I once was interviewed by a reporter new to the investment field who asked: "What are the objectives of your clients?" I replied, "Total return, a combination of income and appreciation, without taking excessive risk of loss."

The reporter asked again, "Oh, appreciation means you buy growth stocks?" "No," I said, "we don’t buy growth stocks because so many people have bought stocks associated with growth of earnings that they have already discounted, in our opinion, more than the prospect of the earnings growth, which was supposed to enhance the price."

"Hmm, you want growth of capital but you don’t buy growth stocks. I don’t understand."

The exchange, which actually went on in three, different, ten-minute segments spread throughout a two-hour interview, illustrated to m the confusion between growth in stock selection and growth as a portfolio objective. Growth as it relates to the nature of a company of a type of earnings pattern may be quite similar to portfolio growth, which may be achieved by a variety of different methods.

Confusion caused by the use of the same word for means and ends has established a number of suspiciously unattractive investment procedures. It may well be, in fact recently has been, a far better way of achieving portfolio growth to invest in high-income securities and to pursue an active trading policy than to buy premier growth favorites that have already been identified by most as the best institutional universe.

It may be that the best way to achieve investment growth is to alternate between high risk and low risk at various points of a market cycle. One way to identify different points of the market cycle is to examine one’s own investment experience. If, after a period, results have been very successful, one can assume he is not at the beginning of a bull market, but somewhere along in the rise. Correspondingly, if growth stocks have declined sharply in terms of market price, it does not mean necessarily that these companies have ceased to be good growth vehicles.

A strange phenomenon is occurring now, and much discussion is taking place within academic and investment circles about the implications of Zero Population Growth (ZPG) on the investment structure. It may well be, some would argue, that growth itself is no longer a principal objective of companies; moreover, it may change as an objective for portfolios. Perhaps, as most companies had a 15 percent compound growth-rate objective in the sixties and portfolios had similar or greater objectives, we will move to a base where growth itself is not highly prized, but qualitative factors, perhaps containing the ingredients of social responsibility, will be prized. That is, companies that provide attractive environments for their employees and do not pollute the air and the sea or that are innovative in providing useful cultural services for the country will become prized more for these characteristics than for growth of profits. Discussions regarding zero-growth are so embryonic that it is difficult to quantify the terms that may be used. However, I suspect that considerations of this sort will become commonplace in future investment portfolios.

Another implication of the zero-growth argument for investors is that a company must be aggressive, assertive, and competitive within its field if it expects to grow in an essentially nonexpanding environment. Certain companies are growth companies that have been swept along within a growth industry. Some of the second-grade computer companies had these characteristics, in that the growth of the industry was perhaps being sponsored by IBM and a few others. But a number of weak companies had, for a while, growth characteristics and were being propelled forward by the activities of someone else.

To the other extreme, there are weak companies in nongrowth industries, like steel and railroad. Such industries have long since stopped growing. Being no longer competitive, they have accepted a docile role of survivorship and mediocrity.

In between are companies in industries formerly growing but now static, where competitive pressures forced the companies to knock each other off. Home-building and building-materials companies are examples in this type of industry environment. There is perhaps no industry more closely tied to general population growth and prosperity than the housing industry. As both features seem to wane in importance, housing starts—cyclical anyway—have plummeted. Pricing pressures have forced home-building companies into precarious financial conditions, and among the raw-material-oriented companies, building materials have been the weakest so far in the early seventies.

Strong industries are those that by definition are growing at a rate in excess of the economy, presumably at least twice as fast. The economy was growing on the order of 5 percent. This might be a combination of 3 percent real growth and 2 percent GNP deflator. Now it is growing at 1 to 2 percent real growth and 7 or 8 percent GNP deflator, for a total of 10 percent. Industries doing respectively double these figures could be classified as growth industries.

Inflation

For some time since World War II, inflation has been a principal stimulus to investment by individuals. Of course, the primary purpose in investing has been necessity. Either saving for future consumption was required or surplus funds had to be invested. In either case, the investment funds were those for which one individual would forego consumption and transfer to another who required them for current consumption.

The funds were still used to support the current economy, but one man’s saving was converted to an investment in another man’s consumption, which was greater than his original means. When the process reverses and there is a reduction in the investment, the second man, who is the recipient of the investment in the first instance, foregoes consumption in order to pay off his debt. The acceptance of the paid-off debt means that the first man presumably now wishes to consume. In both cases consumption levels are identical. There is merely a shift in asset ownership.

Inflation has been generally accelerating since the depression. There have been periods of very low inflation levels under artificial price-control conditions or when the economy operated below capacity. But in general in this economic cycle as with most others of history, inflation rates move up until there is massive debt liquidation, a war, or a depression.

The shift from bonds to stocks, which took place in investment portfolios in the mid to late fifties and early sixties, was precipitated by interest-rate increases that reduced the capital value of bond portfolios and accompanied a rising stock market. This attracted investors to downgrade their investment quality, in a classical sense, in order to protect the purchasing power of their funds. They did not accept one other technique traditionally used by individuals for protecting purchasing power: converting funds into purchased goods that may be needed in the future. The American consumer has always responded to higher prices by withholding funds from consumption or by saving until conditions improve, although the decision is not especially economic. The European consumer, on the other hand, has responded to uncertainty in the past by spending while he has the chance and before prices go higher.

In the mid seventies for the first time the American consumer began to behave like his European counterpart. Inflation rates are common ingredients in the pricing of both bonds and stocks. Bonds, earlier studies show, have traditionally been priced at approximately 12 percent, 3 percent real return, plus an increment for the imbedded rate of inflation, or the rate of inflation expected by investors over the period for which the bonds would be held. So although a bond may yield 10 percent to maturity, this implies an expected inflation rate of approximately 8 percent per year, with a residual real return of money of approximately 2 percent.

The real return will be realized to the extent to which the bond is paid off, and the expected inflation rate is close to actual for the period to he covered. Similarly, equities are priced according to some notion of real growth which, if exactly the same as the economy, might be in the 2 to 3 percent region, plus a discount rate applied to future earnings of the expected rate of inflation. Presumably the inflation rate is the same as that applied to bonds, if bonds and stocks are being priced by the same universe of investors.

There is an unusual offset, however, in that equities represent a call on real assets, which are the basis for producing earnings on capital. Moreover, the typical American company has an equity-debt ratio of four to one and essentially is borrowing in current dollars and converting to real assets for payment in future dollars. There is some factor to be subtracted from the discount rate of inflation on future earnings, since an equity in an inflationary environment reflects somewhat greater value. This is due to the fact that U.S. corporations are net borrowers, and that real assets are likely to be appreciating in current-dollar terms.

This discount factor varies according to the nature of the corporation, but in every case it will be more than zero. Therefore, the discount rate applied to future earnings is something less than that applied to bonds. The only bond adjustment factor, beyond that of uncertainty, is the possibility of higher interest rates creating a better reinvestment opportunity for the current income produced by bonds. The higher the reinvestment rate is than the original rate, the lower the capital value is from what had been estimated, assuming the interest rate is greater because of inflation or a deterioration in credit of quality.

An examination of market periods in Europe, Japan, and the United States in which inflation rates have doubled—that is, increased from 2 to 4 percent, or 3 to 6 percent, or the like—suggests that inflation is a neutral to mildly positive influence on equity prices, although not directly coincident with stock prices except during the late stage blow-off period. Under these conditions when people treat cash as a hot potato, they use the stock market as a readily available device to increase the velocity of investment funds. We all know that there is nothing like a bull market to use up funds very quickly. When inflation in Germany approximated 1,000 percent between mid 1923 and 1924, its stock market appreciated commensurately, although business conditions were bad.

Inflation inserts a new item of uncertainty into business decision-making. With fluctuating prices of raw materials, labor, and services, businessmen respond to the uncertainty by building up profit-margin safeguards. Usually, in a nonprice-controlled environment, these safeguards are more than adequate for the demands being placed upon the income statement. For example, the recession of early 1974 was the first post-World War II recession in which corporate profits rose. Although the recession was accompanied by a virulent period of price increases, those securities in industries like oil, in which price rises had been most pronounced, were similarly those companies that had the greatest increase in corporate profits. Businessmen responded to the uncertainty about pricing at their own retail end.

Inflation may make business decision-making more difficult, but there is little evidence that it makes it less successful from a profit-margin standpoint. To be sure, profits, if adjusted on a real basis, may decline when business declines. That would be expected in any normal business cycle. However, the definition of inflation is a period of price increases. Although perhaps lagging somewhat through the industrial cycle, the cost of raw materials is generally an adjustment to allow profits to be made under the new business conditions.