Graham and Dodd on business quality and price...

Our distinction between the character of the enterprise and the terms of the commitment suggests a question as to which element is the more important. Is it better to invest in an attractive enterprise on unattractive terms or in an unattractive enterprise on attractive terms? The popular view unhesitatingly prefers the former alternative, and in so doing it is instinctively, rather than logically, right. Over a long period, experience will undoubtedly show that less money has been lost by the great body of investors through paying too high a price for securities of the best regarded enterprises than by trying to secure a larger income or profit from commitments in enterprises of lower grade. 

From the standpoint of analysis, however, this empirical result does not dispose of the matter. It merely exemplifies a rule that is applicable to all kinds of merchandise, viz., that the untrained buyer fares best by purchasing goods of the highest reputation, even though he may pay a comparatively high price. But, needless to say, this is not a rule to guide the expert merchandise buyer, for he is expected to judge quality by examination and not solely by reputation, and at times he may even sacrifice certain definite degrees of quality if that which he obtains is adequate for his purpose and attractive in price. This distinction applies as well to the purchase of securities as to buying paints or watches. It results in two principles of quite opposite character, the one suitable for the untrained investor, the other useful only to the analyst.  

1. Principle for the untrained security buyer: Do not put money in a low-grade enterprise on any terms.  

2. Principle for the securities analyst: Nearly every issue might conceivably be cheap in one price range and dear in another.  

We have criticized the placing of exclusive emphasis on the choice of the enterprise on the ground that it often leads to paying too high a price for a good security. A second objection is that the enterprise itself may prove to be unwisely chosen. It is natural and proper to prefer a business which is large and well managed, has a good record, and is expected to show increasing earnings in the future. But these expectations, though seemingly well-founded, often fail to be realized. Many of the leading enterprises of yesterday are today far back in the ranks. Tomorrow is likely to tell a similar story. The most impressive illustration is afforded by the persistent decline in the relative investment position of the railroads as a class during the past two decades. The standing of an enterprise is in part a matter of fact and in part a matter of opinion. During recent years investment opinion has proved extraordinarily volatile and undependable. In 1929 Westinghouse Electric and Manufacturing Company was quite universally considered as enjoying an unusually favorable industrial position. Two years later the stock sold for much less than the net current assets alone, presumably indicating widespread doubt as to its ability to earn any profit in the future. Great Atlantic and Pacific Tea Company, viewed as little short of a miraculous enterprise in 1929, declined from 494 in that year to 36 in 1938. At the latter date the common sold for less than its cash assets, the preferred being amply covered by other current assets. 

These considerations do not gainsay the principle that untrained investors should confine themselves to the best regarded enterprises. It should be realized, however, that this preference is enjoined upon them because of the greater risk for them in other directions, and not because the most popular issues are necessarily the safest. The analyst must pay respectful attention to the judgment of the market place and to the enterprises which it strongly favors, but he must retain an independent and critical viewpoint. Nor should he hesitate to condemn the popular and espouse the unpopular when reasons sufficiently weighty and convincing are at hand.