Dec

9

I remember when Philip Carret appeared on "Wall Street Week" at age 98. Louis Rukeyser asked him in what he invested at such an advanced age. Mr. Carret replied that he was 100% invested in stocks. But, Mr. Rukeyser asked, what about the common advice to subtract one's age from 100 to determine the percentage of one's assets to invest in stocks? Hogwash, replied Mr. Carret. Stocks provide the best return on investment.

I recently read Mr. Carret's 1931 book, "The Art of Speculation". I know this is not a new book for this website. Victor Niederhoffer wrote the foreword for the Wiley Investment Classics version. However, I will note a few things from the book that I found instructive.

Definition of speculation (from Webster's dictionary): "the act or practice of buying land or goods, etc., in expectation of the rise of price and of selling them at an advance". Mr. Carret felt the use of the word "expectation" instead of "hope" was very important. Speculation is based on an intelligent expectation of a change in price. A trade based merely on hope is not speculation, but gambling.

Philip CarretCommon stockholders are last in line to receive assets of a bankrupt company. Thus they take more risk than bondholders or preferred stockholders. Beginning with this fact of capital structure, Mr. Carret shows why common shareholders must also, on average, receive higher returns than bondholders or preferred stockholders. Bondholders and preferred stockholders have fixed claims on a company's assets and cash flow. When a company grows, all the benefits of the growth go to common stockholders. It works like leverage. Common stockholders' equity may be only 50% of the assets of the company, but 100% of the benefit of profit growth accrues to common stockholders.

Using similar logic, Mr. Carret shows that non-dividend-paying companies should on average provide superior returns to dividend-paying companies. He presents data from the 1920s showing that a sample of non-dividend-paying stocks indeed had superior returns to a sample of dividend-paying companies.

Seeing the constant fluctuations in stock prices, many people think it would be easy to make profits buying at price A and selling at price B. However, most people fail at speculation because:

- Good buying and selling points are obvious after the fact, but hard to forecast

- Those who trade frequently to catch small fluctuations are killed by vig

- Most traders tend to sell winners quickly, but stubbornly hang on to losers, eventually suffering huge losses "Having no sounder reason for his purchase than a tip the average trader has little courage and is easily frightened into taking small profits. On the other hand, he is stubborn enough to feel that any stock he has purchased must at least be worth what he paid for it" (p.66).

"For practical purposes the occurrence of ripples and waves in the price movement is unpredictable. To attempt to trade on such movements is mere gambling with the odds against the trader by a considerable margin. It is astounding that thousands of otherwise intelligent persons persist in trying to make money in this way" (p.69).

Mr. Carret believed the longer-term fluctuations related to the business cycle were much easier to forecast than short-term movements. He believed a major cause of the business cycle was the "inability of the majority of mankind to maintain a regimen of hard work in the face of easy living conditions" (p. 71). He suggested that one could use economic indicators in a contrary fashion to forecast stock price movements. Statistics showing a weak economy were bullish; those showing a strong economy were bearish. He found blast furnace capacity utilization to have some value as a predictive indicator.

"Borrowed money is the lifeblood of speculation" (p. 101). Interest rates greatly influence the direction of stock prices. "A bull market undermines itself" (p. 119) as prosperity and increased borrowing for speculation drive up interest rates. One of Mr. Carret's specific methods might be difficult to replicate today. He suggested borrowing money when interest rates were low to buy stocks with higher dividend yields than the interest rate on the borrowed funds. A stock bought in this fashion would "carry itself" and have a high probability of moving higher. With today's much lower dividend yields, such stocks are probably difficult to find today.

Bernard BaruchA third important factor in forecasting the direction of stock prices is sentiment. By 1927, both economic indicators and interest rates warned of trouble ahead, and many Wall Street professionals turned bearish. However, public enthusiasm for stocks overwhelmed all other influences and carried prices rapidly higher. In 1929, with the Dow Jones Industrial Average 100% higher than in 1927, economist Paul Clay said that the bull market would continue as long as the public had money and courage to continue buying stocks. Mr. Clay wished for an "index of courage" to foretell the breaking point.

Mr. Carret said that a speculator should consider that he is a business manager of a fund and use business principles to manage the fund well. Mr. Carret's "twelve commandments for speculators" were:

(1) Never hold fewer than ten different securities covering five different fields of business.

(2) At least once in six months reappraise every security held.

(3) Keep at least half the total fund in income-producing securities.

(4) Consider yield the least important factor in analyzing any stock.

(5) Be quick to take losses, reluctant to take profits.

(6) Never put more than 25% of a given fund into securities about which detailed information is not readily and regularly available.

(7) Avoid "inside information" as you would the plague.

(8) Seek facts diligently, advice never.

(9) Ignore mechanical formulas [such as price-earnings ratios] for valuing securities.

(10) When stocks are high, money rates rising, business prosperous, at least half a given fund should be placed in short-term bonds.

(11) Borrow money sparingly and only when stocks are low, money rates low or falling, and business depressed.

(12) Set aside a moderate proportion of available funds for the purchase of long-term options on stocks of promising companies whenever available.


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