The second thing to consider with this period is intrinsic value. Buffett saw fit to begin his 1999 Sun Valley speech on the stock market by emphasizing, “Valuing is not the same as predicting.” The value of a stock to a shareholder is more accurately described by a company’s earnings not the expectations on price. Specifically, it refers to the after tax corporate profits that, in theory, should go to the stockholders.
The above graph attempts to quantify this by essentially showing what portion annually of the GDP ended up in the hands of American shareholders. From this it is easy to see the huge corporate gains made at the end of the 1920s as well as the severity of the following crash. Moving on to the mid 1960s, interest rates were low, roughly 4%, and corporate profits were high, just under 7% if the GDP. As the economy progressed into the early 80s, because of huge gains in the GDP and lackluster corporate profits, this ratio slipped and by 1982 it had reached an absolutely abysmal level at almost 3.5%, down almost 50% from 1964. There are not many factors that can cause the economy to outstrip corporate profits by such a degree and given the high interest rates of the period, inflation is at the top of the list of culprits.
An easy way to look at inflation is to look at the average price of consumer goods in US cities. The rate of change of these prices over time is analogous to the inflation rate. The graph above clearly shows how inflation rates steadily increased during the period of 1964 to 1981, peaking around 1980. Comparing this to the previous graph, the effect of higher inflation rates becomes apparent. The peak in corporate profits in 1964 corresponds to the low in inflation rates. Moving forward to 1981, inflation rates increased and corporate profits decreased. Businesses grew, sales increased and still investors suffered because the value of their returns were being discounted by record high inflation rates.
This is the second major piece in the puzzle of trying to reconstruct why the stock market did so poorly during this period. Investors were faced with sub-par profits that were being driven to even lower levels due to high interest rates. From this they predicted a dim future for the economy and consequently valued the Dow at the same level as 1964 despite huge gains in the economy. The result of this is an economy where businesses grew and investor valuations shrank. It is also a perfect example of how incredible investment opportunities are created out of periods of widespread pessimism among investors. High inflation and the resulting high interest rates had lowered investor valuations across the board. The entire US economy had just gone on sale and, for the investor who was willing to look, there were sound companies to be had for clearance prices.
This graph shows the degree to which investor valuations had driven stock prices down during the late 70s despite comparably stable earnings. The prices that investors were willing to pay for a share of the S&P 500’s earnings during the mid to late 70s and early 80s, 1974 and 1981 in particular, were on par with the likes of 1932 and 1949. It was this period that prompted Ben Graham to give his speech, “The Renaissance of Value” in September 1974 where he began by saying, “The title of this seminar implies that the concept of value had previously been in eclipse in Wall Street. This eclipse may be identified with the virtual disappearance of the once well-established distinction between investment and speculation. In my own thinking, the concept of value, along with that of margin of safety, has always lain at the heart of true investment.” Graham underlined the importance of value in the stock market by pointing out a resurgence of the so called sub-asset stocks, shares that could be purchased for less than their working capital. Overall, the purpose of the speech is to answer the same question put forth by then Chairman of the NYSE, James J. Needham, who asked, “Why the large institutions persist in tightening their concentration in a favorite few stocks while ignoring hundreds of other choice investment opportunities.”
This situation that Needham describes is fundamentally tied to the economic conditions which I described earlier that served to deflate the value of the economy. The reality is that most investors do not assess the value of the economy at large and very often they focus their concerns on the performance of individual stocks. As the value of the market as a whole declined during the late 60s and early 70s large institutions with the majority of the market share tried to distance themselves from risk capital and by 1973 had retreated to the security of a small pool of high preforming stocks dubbed “The Nifty Fifty”. In a study done by Fortune in 1973 covering the institutions with the largest market holdings, fourteen of the seventeen banks surveyed held stock in I.B.M., the markets biggest stock, and seven of those fourteen had over 7% of their common stock assets in that company. The largest financial institutions had no choice but to concentrate their assets in these few large high performing companies. Because of the so called, “Cult of Performance” associated with pension fund management these banks demanded high returns and the only way to swing around 10s of billions of dollars in a profitable manner was in through these Nifty Fifty. The concentration of demand centered on these stocks served to drive up their market value leading institutions to pay nearly 90 times the company’s earnings for a share. In his speech, Ben Graham explained how investors rationalized these stocks as good investments regardless of price,