Sensex Highs & The 100-Year Investing Secret You Need Now 

Hello everyone, Rahul shah here, trying to make investing accessible and profitable for the average investor.

I am sure most of you may not have heard of Edgar Lawrence Smith. It is unfortunate though. I think he deserves to be more famous than he is currently.

Exactly hundred years ago, Edgar Lawrence Smith's book 'Common Stocks as Long Term Investments' was published.

Now, here's the interesting bit.

He is one of the few authors who changed the central message of his book upon realising that the original message had flaws. Yes, that's right.

While going in, Edgar wanted to argue that stocks perform better than bonds during inflationary periods and vice versa during deflationary periods.

Let me repeat that. Edgar was of the view that during inflationary periods, stocks outperformed whereas when there is a deflation, bonds did better.

However, when he looked at the data, he was in for a shock. This theory was not well supported by facts. He was unable to find any 20-year period where bonds managed to outperform stocks. It was always stocks outperforming bonds. Edgar was proven wrong.

He therefore had to start his book with a 'mea culpa' or a confession if you will.

He admitted that he had failed in proving his theory with facts.

Luckily for us, this failure led him to evaluate stocks more deeply. And it eventually gave birth to a profound insight.

This insight that came to Edgar was quite simple. He observed that well-managed companies do not distribute their entire profits as dividends to shareholders. In good years if not in all years, these companies retain a part of their profits and put them back into the business.

Let me explain with numbers.

If a company earns Rs 100 as profits, it does not distribute all of it as dividends. Instead, it may retain say Rs 70 and invest it back in the business. This way, the value of its plant and property keeps going up and therefore, the value of its shares.

Now, this may seem as a very basic principle to you as this is something we are taught in every finance course.

In fact, the huge wealth that had been amassed back then by titans like Carnegie, Rockefeller and Ford, was based on this very principle. These people had retained a large part of their profits to invest back into the business for funding growth and producing ever-greater profits.

However, it did not catch the imagination of the US investors the way Edgar Lawrence Smith's book did.

May be when ownership is sliced into small pieces, which are known as stocks, they were perceived to be a short-term gamble on market movements.

The stocks of even the best companies were considered as speculations. it was widely believed that gentlemen preferred bonds.

Edgar Lawrence Smith's book played a huge role in clearing this misconception.

Stocks began to be seen in a better light. They started gaining widespread acceptance. As a matter of fact, it is argued that the US stock market bull run of the 1920s had Edgar Lawrence Smith's book as its intellectual foundation.

Now, interestingly, if this book is being held responsible for starting the equity cult in the USA or changing the perception about stocks from being a 'speculative instrument' to being an 'investment-worthy asset class', the same book is also being held responsible for triggering the famous stock market crash of 1929.

Yes, you heard that right. When the great crash of 1929 happened, Edgar Lawrence Smith's book was seen as one of the culprits.

Well, the reason is not hard to find. As Ben Graham used to remind his protege Warren Buffett, you get in more trouble from a good idea than a bad one. And this is exactly what happened.

You see, the idea that stocks can outperform bonds is a good one but there are certain limiting factors that need to be taken into account.

When Edgar's book was published, stocks were attractively priced vis-a-vis bonds.

However, as this good idea became more popular, investors started piling into stocks. And as stock prices went up, their valuation advantage vis-a-vis bonds started to go down. Eventually, stock prices went so high that their valuations no longer made sense, and this led to one of the biggest crashes in the US stock market history.

The takeaway, therefore, is quite clear.

Stocks may have an advantage over bonds over the long term. However, one also has to be careful about the price being paid to buy those stocks. If the price paid is too high or if you invest in the wrong stocks, there could be wealth destruction and you could end up losing your hard-earned money.

I believe that this key lesson from this interesting case study is more important now than ever, at least as far as the Indian investors are concerned.

When the stock market crashed after the pandemic, stocks were certainly attractively priced vis-a-vis bonds and had a much better risk-reward equation.

However, as this good idea has gained ground and as more and more investors have started investing into stocks, this advantage is fast coming down.

There are a lot of stocks where the risk-reward equation is no longer attractive and where, investors would be better off staying away from them.

Please note that we are not pessimists and are not trying to scare investors.

Thanks to our close to two-decade experience in the stock market, we are aware of the dangers of irrational exuberance and the kind of risks it poses to your hard-earned money.

Stocks do have an advantage over bonds over the long term as Edgar Lawrence Smith proved. However, this does not mean that stocks can give good returns irrespective of the price paid.

The famous 1929 crash was caused because investors thought stocks can give better returns irrespective of the price paid. Nothing could be further from the truth.

Even the best stocks turn into a bad investment when bought at expensive valuations. Therefore, please ensure that you are not overpaying by a huge amount even if the stock is of a very good quality. Fix an upper limit for the PE multiple that you are going to pay for a stock. This upper limit should be based on the stock's quality and its long-term historical PE ratio. A small premium over historical PE multiple is fine if the stock has good growth prospects. However, pay a very high premium and you are asking for trouble.

So, please be careful about this. Sticking to this one simple rule can save you from a lot of trouble in the future.