Quality Effort: Tribute to Arnold Bernhard

Cover Story, by Mark Robertson, Managing Partner December 1st, 2014

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The field of stock evaluation is a worthy challenge ... and an exciting adventure.

It was 1958. The second “hottest” year in stock market history was winding to a close. Arnold Bernhard, founder of the Value Line Investment Survey, documented his experience and methods in his book, “The Evaluation of Common Stocks.” We are grateful to Ted Brooks for urging this exploration (the book is available 2nd hand via Amazon, etc.) and we started a book review in the September 2014 issue and we’ll continue it here with a staggering reinforcement of the mission critical nature (and opportunity) of a quality definition and emphasis. The field of stock evaluation is a worthy challenge … and an exciting adventure. Thanks, Arnold … and Ted.

The book starts with this statement on the cover:

Stocks are not always worth what they sell for. Sometimes they are carried too high, sometimes too low, by mass excitement. Sooner or later, though, they move into line with value. This book explains how to project the normal value of stocks into the future.

Business Model (and Life Cycle) Analysis

Bernhard starts with a series of sales/earnings graphics for about 20 companies.

Conclusion: It appears then that stock prices are governed, as to general trend, by earnings (and dividends) over a period of time.

This reconciles nicely with our mantra that stock prices follow earnings … eventually.

One cannot postulate that a typical price/earnings ratio, or even a moving average P/E ratio, is a reasonable standard for determining what a stock’s market price will be, or should be, at all times. Each stock has its own individual P/E ratio — and that P/E ratio of the individual stock normally varies at different levels of earnings.

My interpretation of that is that P/E ratios are industry-specific in general and are completely dependent on company life cycle.

(1) Over the long term, environmental influences (e.g. inflation) can be disregarded. Earnings potential and sustainability dictates the value of a stock.

(2) Discard the notion of a general P/E ratio for all stocks. Also discard the notion of a “fixed P/E ratio” for an individual stock at all points of its life cycle.

Making The Grade

One useful disciplined standard is that based on the concept of “quality.” The quality of a stock, as The Value Line Investment Survey uses the term, is an index of the stock’s general safety.

Bernhard specifies that quality is centered on growth and stability, specifically the dependability and sustainability of earnings. Earnings are framed throughout the book as “dividend-paying ability.” Keep in mind that the average dividend yield in 1958 was 3.7% and had been 7.6% as recently as 1949.

For the conservative investor, the Quality Grade comes first. We believe that the core component of any portfolio starts with the strength of consistent and sustainable business model characteristics (top line growth and profitability) and is at the essence of sleep-at-night investing.

Quality, in truth, is a highly useful measure of defense against unforeseeable contingencies. But it is not a measure of whether a stock is cheap, or dear, at the time.

The two accompanying graphics drive this point home — indelibly, for most investors. The first graphic provides a listing of companies from 1958 that Bernhard categorized from highest to lowest quality. Column “A” featured the “bluest of the blue chips.” Every single one of these companies persists and — in most cases — thrives, over 50 years later. $10,000 invested into these companies is now worth $707,274, as detailed in the second accompanying graphic.

The companies in Column “C” have all disappeared from the planet by either bankruptcy (in most cases) or acquisition. $10,000 would now be $0. Boom.

Forecasting Return Potential

I do not understand how any investor can buy a common stock without having a clear idea of its quality and its [return potential] over the long term.

We’re clearly on the same page as Arnold with our belief that the most important characteristics of any investment are quality and return forecast.

There you have it. Bernhard provides the recipe for portfolio design and management — particularly for the core component of any portfolio. Discover quality. Own it when the return forecast is right.

Once the portfolio is built, watch continuously for developments that might alter the rankings. Continuous supervision does not imply frequent change, but does require attention to the current developments that might change the ranks of a stock. Diversify broadly.

The Value Line methods are objective and disciplined. Results are generally superior but not guaranteed. Far from perfect.

We are constantly trying to improve, too, but we feel like this journey with Arnold and the genesis and foundations of Value Line provides substantial validation and reinforcement for much of what we do at Manifest Investing. And for that — Ted Brooks — we thank you. There’s more to follow. Stay tuned.

Tweaking Quality Ratings

Several subscribers (including Ken Kavula) have — at times — expressed concern over high quality ratings for unproven companies. The list of quality companies from 1958 is a powerful lesson that extinction is reality and that “thriving survival” is a whole lot better.

The concern has been over companies with excellent quality ratings that have not been TESTED by a bear market or recession. Therefore, effective immediately, we will make an adjustment to quality ratings — effectively penalizing companies that have not had their mettle tested. Companies with less than four years of actual operating results and/or limited forecast information will be adjusted downward. It’s not a major change and we may tweak it — but it’s one that makes a whole lot more sense in the wake of Arnold’s lessons. Bernhard was right. This can be a most exciting adventure.