Winston Churchill once saw a man leap fifteen stories to his death from a hotel balcony in New York City. The day was October 24, 1929, Black Thursday. But the poor soul died in the early morning, before the market opened; the idea of mass suicides at the time of “The Crash” is a myth, fueled, in part, by the future prime minister’s own story.
Still, the 1929 market meltdown was horrific enough, wiping out the life savings of thousands of Americans. Andrew Carnegie, who died a decade before the crash, missed seeing U.S. Steel soar to a market capitalization of almost $59 billion in 1929—then plummet back to earth, worth just $5 billion three years later. The stock was in line with the overall market, which plunged almost 90 percent in the same period. Those titans of industry still alive in 1929, progressed through various stages of grief, beginning with outright denial. Ninety-year-old John D. Rockefeller initially claimed all was well, “the fundamental conditions of the country are sound…” he huffed. It was Black Tuesday and the market fell another 12 percent that day.
Market Fantasies
Unlike the much-debated Great Depression that followed, the causes of the market crash are not very controversial. Between 1920 and 1929, stocks grew by roughly 500 percent, about eight times faster than corporate earnings. The pace was unsustainable, and reality finally caught up.
So, what propelled this massive expansion in stock values—irrational exuberance to the nth degree? The continued democratization of investing was a big part of it. What Jay Cooke started with war bonds sixty years earlier took on a life of its own in the 1920s. As Harper’s magazine put it, the stock market was no longer a preserve for the super-wealthy. Now even “the butcher and the baker and the candlestick maker” could make a fortune.
And that, in a nutshell, was the whole idea. Unhindered by regulation and propelled by easy bank credit and margin loans, money poured into stocks and bonds creating its own upward price momentum. Every investment seemed like a sure winner. A Columbia business professor explained it this way:
“The carouse of the 1920s succeeded in mixing up speculative and investment viewpoints in inextricable fashion…From these figures was born the new gospel that common stocks as a whole were not risky commitments, as we had always been taught, but rather sure-fire bearers of increasing dividends and ultimate price appreciation.”
The professor was Benjamin Graham, and he had a lot more to say about investing.
Wall Street Matures
As we will see, Graham was a market theorist, but he wasn’t the first. As trading grew during the late 1800s, publishers raced to meet the demand for news. In 1889, the journalist Charles H. Dow joined with stock broker Edward Jones to create The Wall Street Journal. Dow was a rather grim man with a passion for method and precision, and the seemingly erratic nature of stock prices disturbed him. He was also a careful observer. In his WSJ articles, Dow began to define some key principles explaining market behavior along with certain rules for investing. Stocks, he believed, were like any commodity and their prices reacted to fluctuations in supply and demand. Tracking prices over time allowed astute investors to predict future movements.
Moreover, there wasn’t just one pricing trend, but several, ranging from the daily, to long-term horizons. This meant the savvy analyst could recognize bear- and bull-markets and know when to build a portfolio and when to unload before a decline became a rout. The volume of trading was important too—confirming or negating, a stock price’s trajectory.
Underlying Dow’s theory was the subtle notion that the market was omniscient, absorbing all available economic, industry, and company news. Today, we call it the “efficient market hypothesis.” For Dow, it meant traders accumulating business data were wasting their time—all relevant information was already captured in stock prices. The market discounted everything.
A New Strategy
That did not appear to be the case in 1929 as stocks, including the bluest of “Blue Chips,” spiraled downward. But the market had changed radically in the three decades since Dow was writing. Everything was bigger, and there was more of it. Along with more buyers and sellers, the number of brokerage houses had grown exponentially with financial news sources keeping pace. Reporting requirements were still lax, but bankers and investors pressured companies to disclose information and the New York Stock Exchange required some level of corporate transparency. The question was, were people paying attention?
Benjamin Graham could see they were not. He and his colleague, David Dodd, believed it was possible to make sound, reasoned, investment decisions and it had little to do with imbalances in supply and demand. Speculators had forgotten or simply ignored principles that determined what a stock was actually worth, and what made it an attractive investment. They needed a reminder.
In 1934, Graham and Dodd published Security Analysis. The book’s foundational idea was that would-be investors could determine a stock’s “intrinsic value” through a rigorous analysis of the issuing company’s financial and operational data along with consideration of economic and industry factors. A comparison with the stock’s trading price would dictate the investment decision. Dispassionate, rational analysis would prevent the type of frenetic trading based on rumors and over-hyped news that had caused the 1929 disaster.
The authors described bond and other securities analysis as well, along with the need for diversification and an investment “Margin of Safety.” But the book’s strength is the technical detailing of financial statement analysis and the business fundamentals that drive value, including earnings power, dividend capacity, balance sheet strength, cash flow projections, and risk assessment. Ultimately, Securities Analysis illuminates the techniques that convert financial data into value implications—essentially the market capitalization and discounted cash flow methods we use today.
Graham understood that most investors lacked the education or financial acumen to perform “fundamental analyses” and his methods anticipate the further evolution of the financial analyst profession. His book was still suggested reading decades later when, yours truly, studied to become a CFA.
In fact, both traditions live on. Charles Dow’s theorems morphed into various forms of “chartism” and “technical analysis,” practiced by legions of investors and market pundits today. Graham’s methods are foundational for business appraisers and are routinely used in financial reporting, tax and litigation matters, and investment banking—any place the value of a business is important.
What This Means for Owners & Advisors
Graham and Dodd’s core principles of business appraisal are still valid, but valuation science has progressed over time to incorporate new financial scholarship along with vastly improved technology. In particular, as derivative securities and alternative investments grow in popularity, recent techniques using Black-Scholes modeling and stochastic simulation are required to capture their complex features. Simple rules apply:
- Business owners requiring a valuation must ensure their specialists are professionals with appropriate experience and credentials.
- In many cases, business appraisals are subject to legal scrutiny or regulatory oversight, including the specialist’s independence. Both clients and their experts must be aware of compliance requirements and tailor the engagement accordingly.
- Valuation experts work in a constantly changing discipline that requires familiarity with best practices, regular training, and access to appropriate market evidence.
PCE valuation advisors have decades of experience serving customers in a wide range of industries. We emphasize collaborative relationships with our clients in order to ensure the timely exchange of information and the delivery of work products that exceed your expectations.
Steven G. Krug, PhD, CFA, is a Director in PCE’s Valuation Group, specializing in valuations for financial reporting, transactions, tax and estate planning, ESOPs, and litigation support. His PhD in history informs his perspective on the evolution of American finance and capital markets.
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