John Bogle on Valuation

But we should not allow these horrible examples to blind us to the fact that there is a lot of rot in the system itself: An erosion in financial standards; misleading earnings statements; public accountants in cahoots with the companies they audit; mergers without apparent business merit; CEO compensation ratcheted up, year after year, without commensurate business achievement; a focus on short-term perception—the momentary but precise price of the stock—rather than long- term reality—the enduring but often intangible intrinsic value of the corporation. In all, Managers Capitalism took over the driver’s seat, shoving Owners Capitalism into the back seat. _______________ Note: The opinions expressed in this speech do not necessarily represent the views of Vanguard’s present management.

Short-term fluctuations in the earnings of existing investments, he argued (correctly), would lead to unreasoning waves of optimistic and pessimistic sentiment. (Lord Keynes was ahead of his time!) While competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, should correct the vagaries caused by ignorant individuals, Keynes added, the energies and skills of the professional investor would also come to be largely concerned; not with making superior long-term forecasts of the probable yield of an investment over its whole life (enterprise), but with foreseeing changes in the conventional basis of valuation (speculation) a short time ahead of the general public.described

the market as “. . . a battle of wits to anticipate the basis of conventional valuation a few months hence rather than the prospective yield of an investment over a long term of years.” In my 1951 Princeton senior thesis on the mutual fund industry, I cited Keynes’ conclusions. And this callow young kid had the temerity to disagree with the great man. Rather than professional investors succumbing to the speculative psychology of ignorant market participants, I argued, these investment professionals would focus on enterprise. In what I predicted—accurately, as it turned out—would become a far larger mutual fund industry, our portfolio managers would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic [italics added], a demand that is based essentially on the [intrinsic] performance of the corporation rather than the public appraisal reflected in the price of its shares.” Today, while the now-$12-trillion mutual fund industry holds some 35 percent of the shares of just about every public corporation in the land, the industry’s focus on speculation has actually increased many times over. Alas, the steady, sophisticated, enlightened, and analytic focus on enterprise that I had predicted from the industry’s expert professional investors has failed abjectly to materialize. I was wrong. Call the score, Keynes 1, Bogle 0. What else is new?

Putting Numbers on Keynes’s Distinction While Keynes made no attempt to quantify the relationship between enterprise and speculation in shaping stock market returns, decades later it occurred to me to do exactly that. By the late 1980s, based my own first-hand experience and my research on the financial markets, I realized that equity returns were a combination of these two essential sources: enterprise and speculation. I defined enterprise as investment return— the initial dividend yield on stocks plus the subsequent annual rate of earnings growth. I defined speculative return as the change in the price investors are willing to pay for each dollar of earnings (essentially, the return that is generated by changes in the valuation that investors place on future corporate earnings).

Investment Return and Speculative Return This dual nature of investment returns is clearly reflected in the stock market history, and remains basic in appraising the state of the stock market today. I continue to use the term speculative return to refer to the portion of the stock market’s total return that is derived from “changes in the public valuation”—that is, the changes in the price that investors are willing to pay for each dollar of earnings per share. But rather than using Keynes’ term enterprise to describe the yield of an investment over the years, I use the term investment return—the sum of the initial dividend yield plus the annual growth rate of earnings; that is, the return that corporations actually deliver to investors. Added together, investment return plus speculative return represent the total stock market return we experience. History illuminates this division of stock market returns with great clarity. The reason that stocks returned nearly 20% per year during the great bull market are clear: The dividend yield on the S&P 500 Index averaged almost 5%, the subsequent annual earnings growth was just short of 7%; the combined investment return, then, was almost 12%. But as the fear of investors at the outset changed to hope and finally to greed, the price-to-earnings ratio quadrupled—from nine to 36—adding more than eight percentage points of speculative return. The math is not very complicated: An average annual return on stocks of almost 20%.

, “S&P technology stocks, 14% of the value of the index, 21% of my portfolio; GE, 3.0% of the S&P, 1.2% of my portfolio,” and so on. All with this implicit question: “Is my ‘bet’ (as it is usually described) the right one? Or should I align my portfolio more closely to the index?” There’s a lot of casino capitalism by managers and clients alike going on in investing today, and I suppose “betting”— even betting not to lose—is as good as any word to characterize this over-reliance on the composition of an unmanaged and relatively unchanging market index. In recent years, it seems to me, this strategy has become almost tacitly accepted. Indeed, there is considerable anecdotal evidence that we have gone beyond mere measurement to action, as in “I think Coca-Cola is grotesquely overvalued.to

cost funds that don’t sell don’t count. Virtually ignored in the ICI methodology, the managers of funds that investors shun nonetheless prosper, even as their shareholders suffer. To the extent that the industry’s overly-generous appraisal of the data, along with its somewhat specious series of definitions, can be regarded as valid, what the data really show is that, quoting from the independent Morningstar Mutual Funds analysis, “the drop has been driven by investors, not by shareholder-friendly mutual fund companies,” and that a few fund families “deserve credit for keeping their expenses down, but one shouldn’t credit the entire industry for the virtues of a few—and for the diligence of investors in seeking them out.” Given the dynamic combination of (a) the increasing importance of no-load funds (sold without commissions); (b) the rapid growth of low-cost market index funds; and (c) the remarkable rise in market share of the industry’s sole mutual mutual fund complex—the unique structure adopted by a firm that operates its funds on an “at cost” basis (you’ll recognize that firm as Vanguard)—the industry’s claim that the cost of purchasing, as distinct from owning, fund shares has declined may well even be valid, as far as it goes. However, it doesn’t go nearly far enough.

But fear can last only so long. In mid-1982, the tables turned and optimism began to return. By the market high in March 2000, the P/E ratio had soared to 35 times, an annual injection of a full 5.4% of speculative return to the 10.3% investment return of the 1981-2000 period. Result: Despite a 20% decline in investment return, the total market return came to 15.7%, the highest for any comparable period in history. Sometimes, emotions overwhelm economics. Does the reversion of the ratio of market return to investment return to near parity mean that stocks are now fairly valued? We don’t know. We don’t know because no one can be sure how far the market pendulum, having swung so far toward greed, may swing toward fear. What we do know is that since emotions dominate the short-term decisions of most investors, the pendulum rarely comes to rest at fair value for any prolonged period of time. Further, we don’t know because, given the strains our economy is facing after the attack on America, there is considerably more uncertainty than usual about the economic returns that lie ahead. Financial Market Returns in the Coming Decade But let’s look ahead anyway, because we may know more than we think. First, we know that the dividend yield component of future investment return will be tiny. While over the long run, the average yield of 4% on stocks has accounted for more than 40% of the market’s investment return, today’s stock yield is but 1½%—not much gas in the market’s tank.

wealth from public investors to corporate insiders and financial intermediaries. When speculation takes precedence over investment, there is always a day of bounty for the few followed by a day of reckoning for the many. Our late bubble was but the latest "extraordinary popular delusion and the madness of crowds—tulips in Holland, shipping in the South Seas, stocks in 1929, the go-go years of the 1960s. It's all of a piece, with the past, as rational expectations were once again replaced by irrational exuberance. Our, well, flexible financial system cooperated in the madness. Aggressive earnings guidance from corporate executives, realized by fair means or foul; manipulation of revenues and expenses, balance sheets; the debasement of accounting standards; public auditors who became consultants to management, in effect, business partners; the "sell-side" analysts of Wall Street, whose recommendations were often shaped by the desire to attract investment banking clients; and the "buy-side" analysts of the mutual fund industry, who put aside their training, experience, and skepticism and succumbed to the heady spirit of the mania. But if there was a single dominant failing of the recent bubble, it was the market's overbearing focus on the momentary price of a stock rather than on the intrinsic value of a corporation. Yet the price of a stock is perception, and acting on that perception is speculation.

” In other words, if you don’t like the way your company is being run, just get out—sell to the first bidder, whether or not the price reflects the corporation’s intrinsic value. “Like it or lump it,” however, doesn’t seem a particularly enlightened approach to public policy. Dean Manne’s objections seem to assume that all of those who are interested in embracing ownership rights are “special pleaders with no real stake, activists (whose) primary interest . . . is to facilitate publicity for their own special-interest programs . . . and to interfere with the property and contractual rights of others in order to achieve their own ends,” describing corporate democracy as a “form of corporate fraud.” Though I’m confident that at least some corporate activists have agendas that might not comport with the public weal, I confess that I don’t know quite what to make of such a diatribe. But I know that I have no such agenda. I hold only this simple conviction: Owners should be allowed to behave as owners.center,

The Gotrocks Family Even before you think about index funds, however, think about the eerie nature of our financial system. Using my version of a parable from Warren Buffett’s letter in the Berkshire Hathaway 2005 Annual Report (it’s in the Little Book), here’s how investing actually works: Once upon a Time . . . a wealthy family named the Gotrocks, grown over the generations to include thousands of brothers, sisters, aunts, uncles, and cousins, owned 100 percent of every stock in the United States. Each year, they reaped the rewards of investing: all the earnings growth that those thousands of corporations generated and all the dividends that they distributed. Each family member grew wealthier at the same pace, and all was harmonious. Their investment had compounded over the decades, creating enormous wealth, because the Gotrocks family was playing a winner’s game. But after a while, a few fast-talking Helpers arrive on the scene, and they persuade some “smart” Gotrocks cousins that they can earn a larger share than the other “dumb” relatives. These Helpers convince the cousins to sell their shares in overvalued companies to other family members and to buy shares of undervalued companies from them in return. The Helpers handle the transactions, and as brokers, they receive commissions for their services. The ownership is thus rearranged among the family members. To their surprise, however, the family’s share of the generous pie that U.S.

in the number of dollars that investors are willing to pay for each dollar of corporate earnings; that is, the annualized percentage change in the P/E multiple. Simply add the two categories of return together and, viola! we have the total returns generated in the stock market. (It works!) Over the very long run, it is the economics of investing—enterprise—that has determined the total return on stocks. The momentary emotions that surround investing—speculation—so important over the short run, have ultimately proven to be virtually meaningless. For example, the 10.0 percent average annual return on U.S. stocks during the past century was almost identical to the 9.9 percentage points of investment return, an average dividend yield of 4.6 percent, plus average annual earnings growth of 5.3 percent. Speculative return added only one-tenth of one percent to that total. Despite the transient booms and busts of stock market history, for the investors who have stayed the course, buying and holding a portfolio invested across all of American business, has been an extraordinarily successful strategy. The Triumph of Speculation Keynes had predicted that otherwise sensible professional investors would gradually abandon their focus on enterprise and follow the ignorant crowd of uninformed individuals in betting on the psychology of the market, attaching their hopes to a favorable change in the conventional basis of valuation, i.e., that they are speculators.

In my thesis, I disagreed with the master. In a much larger mutual fund industry, I argued, professional investors would come to focus on the wisdom of long-term investment rather than the folly of short-term speculation. (I was surely right about the industry’s bright prospects! That $2 billion industry of 1951 is today a $12 trillion behemoth.) After reaching peak turnover of 140 percent in 1929, I predicted that fund managers would behave as “steady, sophisticated, enlightened, and analytic” investors, focused on enterprise—on corporate performance and intrinsic value—rather than momentary and evanescent share prices. Alas, fund managers turned out to behave in the reverse; “volatile, unsophisticated, unenlightened, and superficial.” Call it Keynes 1, Bogle nothing. Indeed, I have often said, after Oscar Wilde’s definition of the cynic, that our industry’s security analysts too often “know the price of everything, but the value of nothing.”

As the stock market bubble inflated, the mutual fund industry’s well-educated, highly-trained, experienced professional analysts and portfolio managers seemed blissfully unaware of what was going on in the financial statements of the companies into which their funds were pouring literally hundreds of billions of dollars. Somehow our professional investors either didn’t understand, or understood but ignored—I’m not sure which is worse!—the house of cards that the stock market had become. Astonishingly, even after the bear market that has devastated the value of the equity holdings of fund shareholders, the only response we’ve heard from the mutual fund industry is the sound of silence. Why? Because the overwhelming majority of mutual funds continues to engage, not in the process of long-term investing on the basis of intrinsic corporate values, but in the process of short-term speculation based on momentary stock prices. The typical fund manager has lots of interest in a company’s price momentum—its quarterly earnings and whether or not they are meeting the guidance given to Wall Street. But when it comes to what a company is actually worth—its fundamental earning power, its balance sheet, its long-term strategy, its intrinsic value—there seems to be far less interest. Yet focusing on the price of a stock— perception—rather than on the value of a corporation—reality—can hardly be a winning strategy over the long run.of

they could hardly care less. Simply put, as I ask in the book, “If the owners of corporate America don’t give a damn about the triumph of managers’ capitalism, who on earth should?” Yet our new agent/owners remain passive to a fault on governance issues.  Three, the triumph of illusion over reality. As our professional security analysts came to focus ever more heavily on illusion—the momentary precision of the price of the stock—they increasingly ignored the reality—that what really matters is the inevitably vague, but eternally transcendent, intrinsic value of the corporation. (As investment icon Benjamin Graham, mentor to Warren Buffett, perceptively put it: “In the short run, the stock market is a voting machine; in the long run it is a weighing machine.”) Measuring up, unfortunately, to Oscar Wilde’s piercing description of the cynic, our money managers came “to know the price of everything, but the value of nothing.” But when there is a gap between perception—illusion—and reality—the business fundamentals of cash flow and dividends—it is, to state the obvious, only a matter of time until the gap is reconciled . . . inevitably, in favor of reality. In Mutual Fund America:  One, the industry changed. Mutual funds, once a profession with elements of a business, gradually became a business with elements—and too few elements at that—of a profession. Our traditional guiding star of stewardship was transmogrified into a new star— salesmanship.

A half-century ago I discussed this issue in my senior thesis, noting Lord Keynes' concern about the implications for our society when "the conventional valuation of stocks is established (by) the mass psychology of a large number of ignorant individuals." The result, he suggested, "would lead to violent changes in prices, a trend intensified as even expert professionals, who, one might have supposed, would correct these vagaries, follow the mass psychology, and try to foresee changes in the public valuation." As a result, he described the stock market as, "a battle of wits to anticipate the basis of conventional values a few months hence rather than the prospective yield of an investment over a long term of years." But I had the temerity to disagree. In a far larger mutual fund industry, I suggested in my thesis, portfolio managers would "supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic, a demand that is based essentially on the (intrinsic) performance of a corporation rather than the public appraisal of the value of a share, that is, its price." Well, 50 years later, it is fair to say that the score is "Keynes one, Bogle zero." But it's not a moment too soon to measure up to my ideal for financial institutions: Moving from the folly of short-term speculation to the wisdom of long-term investment.

Congress . . . a massive failure in the governance system.” But while Enron may prove to be the worst failure of our corporate stewards, I need not tell you it is hardly alone in its failure to merit the faith of investors. Casino Capitalism Lord Keynes warned us long ago of what happens when speculation achieves predominance over enterprise, and I also quoted some of these words in my ancient university thesis: “In one of the greatest investment markets in the world, namely, New York, the influence of speculation is enormous . . . it is rare for an American to ‘invest for income,’ and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that he is attaching his hopes to a favorable change in the conventional basis of valuation, i.e., that he is a speculator. But the position is serious when enterprise becomes a mere bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” The analogy of the casino to the recent era in our financial markets is hardly far-fetched. Investors have focused on short-term speculation based on the hope that the price of a stock will rise, rather than long-term investment based on the faith that value of a corporation will grow.

Mutual fund directors are responsible for none of these decisions. Rather, in the industry’s own parlance, they are “watchdogs” for each of the 100-300 funds usually managed by the large fund complexes, approving (and rarely, if ever, disapproving) each fund’s advisory and distribution contracts, custodian agreements, and pricing and valuation procedures; and monitoring investments and portfolio quality and liquidity—part of a seemingly imposing list of 40 duties set out by the industry, but duties that, in the real world, are largely perfunctory. None of these duties, moreover, relates to a fund’s mission and its obligation to create economic value by earning the cost of its capital. Further, those approvals and that monitoring take place under the direction of the fund’s chairman—a chairman who is, almost without exception, also the chairman (or a high official) of the fund’s management company. The chairman controls the agenda; the staff reports are made by his subordinates; the responsibilities for management are theirs alone. It’s simply not reasonable to attribute the vastly higher fees paid to these independent fund directors to their having assumed vastly higher responsibilities than their management company counterparts. That leaves us with at least the possibility that such high fees are there to subtly encourage directors to act at the manager’s behest.

Such speculation not only flies in the face of intelligent investment policy, it carries heavy transaction costs and unnecessary tax costs that frustrate the objective of fund shareholders to earn returns that even approach the returns of earned in the stock market. What ever happened to long-term investing by professional managers? By anyone? In short, mutual fund managers—once considered as long-term investors—have become, to an important degree, short-term speculators. Many of the former shepherds of the flock have become the sheep of the pasture: a roaming, inconsistent, wild lot, given to impulsive—if sometimes precisely quantified—decisions that frustrate the very purpose of investing on the basis of traditional standards of corporate valuation. We have investment technology to thank for its role in helping us to engage in all of this feverish activity. But technology has given us the tools without giving us the wisdom to handle them constructively.Information

what we have learned from long years of experience: that a top-performing fund can not be selected in advance. While we may know history’s appraisal of the equity premium in the past, we never can be certain of what will be the equity premium that will prevail in the future. So, let’s consider the implications of two future environments, one bearish, the other bullish: (1) an equity return of 7% and a risk premium of 1%; and (2) an equity return of 12% and a risk premium of 4%. In the former case, the low-cost stock fund consumes 20% of the 1% risk premium compared to 220%(!) for the high-cost fund—and please recall that fully 25% of funds in the industry have costs in that range. In the latter case, costs of the low-cost fund would consume 5% of the 4% risk premium, the high-cost fund would consume 55%. This example contrasts the returns achieved by the three portfolios at various asset allocations: Exhibit IX Gross Gross Annual Return Equity Annual Return Equity Stocks Bonds Premium Stocks Bonds Premium 7% 6% 1% 12% 8% 4% Allocation Fund Return Fund Return Stocks Bonds High Cost Avg. Cost Low Cost High Cost Avg. Cost Low Cost 80% 20% 5.0% 5.6% 6.6% 9.4% 10.0% 11.0% 70 30 5.2 5.7 6.6 9.3 9.8 10.7 60 40 5.3 5.7 6.5 9.1 9.5 10.3 50 50 5.4 5.8 6.4 8.9 9.3 9.9 40 60 5.5 5.8 6.3 8.7 9.0 9.5 30 70 5.6 5.9 6.2 8.5 8.8 9.1 20 80 5.8 5.9 6.2 8.4 8.5 8.8 Note: High-cost fund: 2.2% Average-cost fund: 1.5% Low-cost fund: 0.

professionals to stay the course with the proven strategy. While I can’t say that classic indexing is the best strategy ever devised, I can assure you that the number of strategies that are worse is infinite. Creating Indexes that Beat the Market. The New Paradigm? It is a curious irony that the ETF has been adopted as the format for the new “fundamental” indexes. This “new breed” of indexers—although they are not, in fact, indexers, but active strategists—focuses on weighting portfolios by so-called “fundamental” factors. Rather than weighting by market cap, they use a combination of factors such as corporate revenues, cash flows, profits, or dividends. (For example, the portfolio is weighted by the dollar amount of dividends distributed by each corporation, rather than the dollar amount of its market capitalization.) They argue, fairly enough, that in a cap-weighted portfolio, half of the stocks are overvalued to a greater or lesser extent, and half are undervalued. The traditional indexer responds: “Of course. But who really knows which half is which.” The new fundamental indexers unabashedly answer, “we do.” They claim to know which is which. And—this will not surprise you—the fundamental factors they have identified as the basis for their portfolio selections actually have outpaced the traditional indexes in the past. (We call this “data mining.

While it was fear—fear about more terrorism, fear about the economy, fear about the unknown—that clearly took over the marketplace during the first week after the stock market re- opened following the suspension of trading on September 11, we must recognize that we were also in the late phases of the burst in the technology stock bubble that reached its zenith in March 2000. Then, it was not fear that was in the saddle, but greed. Even without the terrorist attack, stock prices were resting on a precarious perch. While now we may well be probing for a sort of “fair value” for stocks, the market pendulum, having swung so far toward greed, rarely stops at fair value as it makes it way to fear. I’ve been in the profession of trusteeship and investing for a half-century now, and I believe the most helpful perspective is to think of stock prices as consisting of two discrete elements—economics and emotions.generated

When managers of traditional active equity funds claim to have a way of uncovering extra value in our highly- (but not perfectly-) efficient U.S. stock market, investors will look at their past record, consider the manager’s strategies, and then invest or not. These new index managers are in fact active managers. But they not only claim prescience, but a prescience that gives them confidence that most sectors of the market (such as dividend-paying stocks) will remain undervalued for as far ahead as the eye can see. But, if these factors are underpriced, why won’t investors, hungry to capitalize on that apparent past inefficiency, bid up prices until the undervaluation no longer remains? Put another way, if these promoters of the purported new paradigms actually have been right in the past, won’t they therefore be wrong in the future? Interestingly, the choice of the ETF structure—rather than the standard mutual fund format—by these confident entrepreneurs would seem to belie the fact that their “fundamental indexing” approach may take decades to prove itself, if indeed it does so at all. Because by choosing the ETF format, they imply even more strongly that investors who actively buy and sell their new fundamental funds will lead to even larger short-term profits than buying and holding them for the long term. I recommend skepticism about these purported “new paradigms.” I’ve witnessed too many new paradigms over the years. None has persisted.

To state the obvious, investing for income is a long-term strategy and investing for capital gains is a short-term strategy. (The turnover of dividend-paying stocks is one-half the turnover of non-dividend paying stocks.) Investing for growth, as Lord Keynes reminded us, is all about speculation on price, while investing for income is the heart of “enterprise,” the word Keynes chose to describe the long-term yield on any investment. Things haven’t changed much: way back in 1936, he said that “In one of the greatest investment markets in the world, namely, New York, it is rare for an American to ‘invest for income,’ and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that he is attaching his hopes to a favorable change in the conventional basis of valuation, i.e., that he is a speculator. But the position is serious when enterprise becomes a mere bubble on a whirlpool of speculation.When

“This golden age for equities won’t last forever . . . but the mean for equities is probably somewhat higher than in the past, and famine will follow feast as it always has.” This firm concluded that the new mean market return would be, “7%-8% real, but below the 10% today’s bulls talk about. The real returns of around 12% generated for a decade now are simply not sustainable. Over time, returns will have to gravitate back toward the new mean.” If—if—this is so, the strategy bulletin seems to imply, stocks at today’s levels are overvalued (i.e., overpriced relative to the fundamentals) by about 20%. In such an environment of revaluation, we would face a protracted period with real stock returns in the 3%-5% range. Stocks, then, would face serious competition from bonds. For bonds, based on today’s yields, should provide returns of about 3 ½%-4% on average over the coming decade, at considerably lower risk. Given the hazardous nature of market forecasting, however, and the powerful odds against being right twice (selling at or near the highs, and buying back at or near the lows, a winning strategy of extraordinary unlikelihood), the possibility— even the probability—of inferior risk-adjusted returns on stocks should not be sufficient, in my judgment, to cause long-term investors to abandon stocks in their entirety.

Late in his life, in an interview published in 1976, Graham candidly acknowledged the inevitable failure of individual investment managers to outpace the market. He was asked, “Can the average manager obtain better results than the Standard & Poor’s Index over the years?” Graham’s blunt response: “No.” Then he explained: “In effect that would mean that the stock market experts as a whole could beat themselves—a logical contradiction.” Then he was asked whether investors should be content with earning the market’s return. Graham’s answer: “Yes.” Finally, he was asked about the objection made against the index fund—that different investors have different requirements. Again, Graham responded bluntly: “At bottom that is only a convenient cliché or alibi to justify the mediocre record of the past. All investors want good results from their investments, and are entitled to them to the extent that they are actually obtainable. I see no reason why they should be content with results inferior to those of an indexed fund or pay standard fees for such inferior results.” Graham was also well aware that the superior rewards he had reaped using his valuation principles would be difficult to achieve in the future.this

We are told about the magic of private equity and venture capital, but ignore the warnings from those who have managed them most successfully that their best days may be behind them. And we accept that all of these so-called alternative investments are a panacea that will somehow cure the ills of the more modest returns of stocks and bonds that seem so likely to lie before us. I’m not so sure. There are also great temptations to offer new services. We hear about the magic of technology that facilitates moment-by-moment account appraisal; about “screen-scraping” that combines accounts of multiple investment providers and facilitates moving money around from one provider to another; about Monte Carlo simulations that, by constructing complex multi-fund asset allocation strategies, are said to add predictability to forecasts. The whole thrust of these developments is that our value to investors can be enhanced by more sophisticated services, and that the greater the investor’s wealth, the more he or she will demand these services—but, I would add with some skepticism, only if these layers of complexity prove to be true services, and not disservices to investors. In my experiences, moving money around quickly is not the preferred route to wealth accumulation, and “don’t just do something, stand there” is not the worst of all advice.

are almost always terrible times to change investment strategies. The market, however fickle, has usually taken into account almost every eventuality. Pillar 12. Think Long-Term. Do not let transitory changes in stock prices alter your investment program. There is a lot of noise in the daily volatility of the stock market, which too often is “a tale told by an idiot, full of sound and fury, signifying nothing.” Stocks may remain overvalued, or undervalued, for years. Patience and consistency are valuable assets for the intelligent investor. The best rule: Stay the Course. During the past two years, the stock market’s noise has been the loudest in history as volatility has reached record highs. Millions of speculators are scared half to death, as they should be. But long-term investors must realize that, as greed turns to fear, much of the worry is already reflected in the lower level of stock prices. And even if it turns out we should be reducing our stock position until the decline is over, where on earth would we ever get the insight that tells us the right time to get back in? One correct decision is tough enough. Two sequential correct decisions—both made at the right moment—are nigh on impossible. Impulse is your enemy, and patience and consistency are your friends. Of my twelfth pillar of wisdom—Think Long-Term—I can only say, “Amen!” Please keep these Twelve Pillars of Wisdom in mind.

remarkable concession, “I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, but the situation has changed a great deal since then. In the old days, any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.” It is Benjamin Graham’s common sense, clear thinking, simplicity, and sense of financial history—along with his willingness to hold fast to the sound principles of long term investing— that constitute his lasting legacy. He sums up his advice: “Fortunately for the typical investor, it is by no means necessary for his success that he bring the time-honored qualities . . . of courage, knowledge, judgment and experience . . . to bear upon his program—provided he limits his ambition to his capacity and confines his activities within the safe and narrow path of standard, defensive investment. To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.

stock is not about concepts; not revenue growth, nor price-to-sales, nor site visits, nor eyeballs, nor the growth rate in the exciting early years of a new venture. Whether we’re talking about the New Economy or the Old Economy, the market value of a stock is about money—tomorrow’s earnings capitalized in today’s dollars. Second, don’t make an excessive commitment to any individual stock (especially employer stock) or to technology stocks as a group. If the past year and a half haven’t taught you that lesson, then you either aren’t paying attention, or you are truly brilliant (or lucky!) Technology is a competitive business, changing at exponential speed, and rapid future growth is hardly assured for any company. You should be aware that the technology sector of the market has provided a steady 12% to 16% of the market’s earnings during recent years, meaning that earnings growth has been no more than average. But the tech sector began the decade at 8% of the market’s value, rose to 35% (!) at the market high in March 2000, before tumbling to 15% currently, a figure more in keeping with its earning potential. Even though that relationship looks a lot more like fair value, the tech share of earnings this year is crumbling and its earnings visibility is close to zero. That means very high risk, as well as high return potential. That stock index fund I recommended to you earlier, obviously, also has 15% in technology stocks today.

the real builders of corporate intrinsic value? Isn’t this disparity both economically indefensible and morally irresponsible? The Ratchet Effect Our CEO compensation system suffers from a fatal flaw. Compensation is based importantly on comparison with peers, and often gives too much weight to stock price and too little to intrinsic corporate value. When a board finds that its own CEO’s pay reposes in the fourth quartile among his or her peers—“our CEO is better than that!”—it is all too likely to raise the compensation up to the first or second quartile. This leap, of course, drops another CEO into the fourth quartile. Duh! And so the cycle repeats, ratcheting onward and upward as the years pass, almost always on the recommendation of an ostensibly independent executive compensation consultant. The so- called “free market” that sets CEO compensation doesn’t exist. Rather, it is a closed market, one that is essentially created by compensation consultants, who have long since recognized that without generous recommendations on CEO pay, their own business will not long endure. Such a methodology is fundamentally flawed. Warren Buffett pointedly describes the typical consulting firm by naming it, tongue-in-cheek, “Ratchet, Ratchet, and Bingo.” Until we pay CEOs on the basis of corporate performance rather than on the basis of corporate peers, CEO pay will, almost inevitably, continue on its upward path.

and when earnings flag, the CEO often acts to reduce costs in order to maintain projected profits by limiting employees’ compensation, laying-off experienced and loyal workers, and slashing capital expenditures. But it seems all too likely that these near-term “efficiencies” and these failures to invest adequately for future growth will eventually erode the company’s prospects for the long-term.2 The central issue posed is the harm done when a culture of short-term speculation focused on the price of the stock overwhelms a culture of long-term investment focused on the intrinsic value of the corporation. The GE Story In addition, aggressive accounting is often required to meet aggressive earnings goals. There are few better examples of this “numbers game” environment than General Electric Co. Way back in 1998, when GE had reported earnings that were within 2% of its “guidance” for 20 consecutive quarters, Grant’s Interest Rate Observer calculated the odds of that happening in the real world as 1 in 50 billion. In 2009, GE settled a complaint from the SEC charging the firm, in Grant’s words, with “book cooking and earnings manipulation,” and paid a $50 million fine. Editor James Grant added: “the crimes to which GE allegedly stooped reveal a management besotted with its own share price.

largest corporation in the world fell to $160 billion. Net loss in market capitalization since 2000: $420 billion, likely the largest decline in a company’s market valuation in history. Constructive Regulation The issue of earnings engineering has not gone unnoticed by regulators. The SEC recently acted to confront the widespread aggressiveness by corporations in reporting their financial results. Among other things, the Commission emphasized that the presentation of GAAP measures in earnings reports should have “equal or greater prominence” to non-GAAP measurements. The SEC also warned against “cherry-picking” adjustments such as including non-recurring gains and excluding non-recurring charges, in an effort “to achieve the most positive measure.” This reform is long overdue. In addition, the Commission also recently approved the recommendation by the Public Company Accounting Oversight Board of new rules that “would make auditors describe any significant issues they reviewed” with board audit committees, and to “explain any challenging, subjective, or complex judgements.”3 It is high time that the principle of full disclosure reaches this deeply into the complex details of convoluted corporate accounting. There is much more work to be done. Where Are the Stockholders? Even as the manager/agents of our corporations were acting in their own self-interest, our corporate shareholder agents were barely to be seen. Dare I describe it as “the Silence of the Funds”?

corporation should serve?” Of course, the principal goal of the money management agents must be that the corporations whose shares they hold are managed with the interests of their shareholders as their highest priority. But there can be no doubt that producing long-term growth in the intrinsic value of the firm should remain the optimal goal of the modern corporation. Not the evanescent swings in short-term stock prices, but the durable creation of the intrinsic value of the business. After all, paraphrasing Warren Buffett: When the price of a stock temporarily over-performs or under-performs the business, a limited number of shareholders—either sellers or buyers—receive out- sized benefits at the expense of those they trade with. [But] over time, the aggregate gains made by the firm’s shareholders must of necessity, match the business gains of the corporation. But lest we forget, “the public interest” means the interest of our society as a whole. Princeton’s Uwe Reinhardt nicely sums it up. The goal of our society must be “genuine wealth creation for the economy as a whole. It is not only about financial wealth, but about the total wealth created by all of the nation’s human capital, its physical infrastructure, and its governmental institutions, including national security and the law.” Corporate managers and money managers alike have a vested interest in the preservation of the values shaped by these other contributors to their own wealth and to the wealth of our nation.

So that’s it. To sum up my long career (so far!): My enthusiasm for life and for this industry, ever changing, remains; caring about our investors, making them the primary focus of our efforts; earning— and, I believe, deserving—their trust; helping to build a fiduciary society with a noble purpose; making a difference in an industry that I’m proud to have joined almost 66 years ago; and still striving to measure up to Paul Samuelson’s 1993 appraisal of me as a man who “changed a basic industry in the optimal direction.” Whatever the case proves to be, whatever the future may hold, the mutual fund industry has changed, in part because I took the road less traveled—indeed, never traveled before—all those years ago. What better way to close these remarks than with these words by Robert Frost? “I shall be telling this with a sigh Somewhere ages and ages hence: Two roads diverged in a wood, and I— I took the one less travelled by, And that has made all the difference.” * * * On the very day that I completed this final draft of this essay, I received a neatly handwritten note from a young and appreciative shareholder who had read my book Common Sense on Mutual Funds. He then invested in the Vanguard Total Stock Market Index Fund, and intends to hold it forever. In one more of the happy coincidences that have marked my long career; his closing words were, “And that has made all the difference.”

capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” First Principles So let me sum up my first point: Eroded by the dominance of short-term speculation, our Investment Standards are deteriorating. Part of the reason is that investors focus far too much attention on the momentary rises and falls of the stock market, which are in so many respects just noise—in Shakespearian terms, “a tale told by an idiot, full of sound and fury, signifying nothing.” The stock market is in fact a derivative, a collection of the current market prices of some 3,500 publicly-held corporations. Those stock prices derive their value from the dividend yields and earnings growth that these corporations collectively generate. Intrinsic value (investment return) is one phrase we use to describe this phenomenon. Intrinsic value is reflected in the real market—essentially, what U.S. businesses actually accomplish. Real companies, with real strategies, managed and operated by real people, producing real products and real services ever more efficiently, with real returns earned for real owners, and real dividends distributed to those owners. The intrinsic value reflected in the real market is the expected future cash flows generated by all of those corporations, discounted over time. For any individual corporation, those future flows are uncertain. But the cash flows for all corporations in aggregate generally track the growth of our U.S.

economy, which has moved forward, despite interruptions, at a steady pace of about 2 ½% per year (in inflation adjusted dollars) over the past century. When the stock market leaps up and plunges down— second-by-second, day-by-day, year-by-year—it reflects nothing more than those transitory emotions— hope, and greed, and fear—that have affected investors (or, I should say, speculators) forever. These emotions represent investors’ reactions to momentary events, or their expectations of future events, or their expectations of how other investors might perceive these events. That’s why we call it the expectations market, with speculative sentiment often raising or lowering stock prices far above or below their intrinsic value. In other words, speculative return reflects the change in price investors are willing to pay for each dollar of earnings. Over the long run, however, speculative return has played no role whatsoever in shaping the market’s total returns. Rather, it is investment return that has accounted for virtually all of the long-run returns generated by stocks. Over the entire history of the U.S.has

Despite (or perhaps, because of) the dominance of (value-reducing) speculation over (value-enhancing) investment—a net minus for our society—the financial industry’s claim on the resources of our society has steadily increased—from 5% of our gross domestic product (GDP) in 1980, to 6% in 1990, to 7 ½% in 2000, and to an estimated 10% last year. That’s real money—some $1.6 trillion dollars. What a counter-productive progression for our society as a whole! Rather than participating in the “real” economy, far too many of our nation’s best and brightest have been attracted to the lottery-like payouts garnered by the croupiers of the Wall Street Casino. Instead of focusing on building wealth through the real long-term growth of corporate intrinsic value, Wall Street concentrates on the quick payoffs from short-term speculation. But this short-termism is not sustainable. As Economics Nobel Laureate Joseph E. Stiglitz says, “successful growth has to be based on long-term investment.” It is in this very prosperity—for investors, yes, but even more for the financial system—that we find much of the reason for the decline in the ethical standards of finance. Money, like power, corrupts. And absolute money corrupts absolutely. This is not just hearsay. During my long career, I’ve witnessed great deterioration in our standards of conduct.

∑ Nomination of directors. Even if our money manager/agents wanted to do the right thing in honoring the needs of the shareholders they represent by striking a blow at excessive compensation, retirement plans, corporate accounting standards, and political contributions, they rarely have the proxy access they need to do so. Yes, mutual funds have the latent power to nominate directors to corporate boards. But they do essentially nothing. I know of no significant example of a mutual fund nominating director candidates. To put a spin on an old idiom, “the flesh is strong, but the spirit is unwilling.” “Capitalism without Owners Will Fail” America’s institutional money managers must focus on owning companies that create long-term intrinsic value for the owners of their shares, rather than short-term market prices for the renters of their shares. Only then can Corporate America remain the prime engine of our nation’s growth and prosperity. But too many of our money managers have abdicated their responsibilities to long-term investors. Robert A. G. Monks, founder of Institutional Shareholder Services, writes in his 2011 essay Capture that “corporations have effectively captured the United States: its judiciary, its political system, and its national wealth, without assuming any of the responsibilities of domination.” He too cites executive compensation, describing it as “the smoking gun . . .

Quantitative Investing—An Example of Financial Innovation Few commentators seem to have noticed that the rise of speculation in the financial markets represents not just a difference in degree from its earlier form, but a difference in kind. Speculation has come to mean, not only the inevitable uncertainty surrounding a company’s profits or losses, its assets and liabilities, but the uncertainty surrounding the market price of its shares. The focus of the new market is less on business fundamentals, and more on the market valuation of a company’s shares . . . the expectations market. Decades before that baneful trend reached its full flower, legendary investor and author (The Intelligent Investor) Benjamin Graham warned about the rise in speculation. Here are some excerpts from his prescient 1958 keynote speech to The New York Society of Security Analysts—more than a half- century ago!

That shift toward higher volatility began during the “Go-Go Years” of the late 1960s, when “hot” managers were treated like Hollywood stars and marketed in the same fashion. It has largely continued ever since. (The creation of index funds was a rare and notable exception. An all-market index fund has Beta of 1.00.) But as the inevitable “reversion to the mean” in fund performance came into play, these aggressive manager stars proved more akin to comets— speculators who too often seem to soar into the sky and then flame out—focused on changes in short-term corporate earnings expectations, stock price momentum, and other quantitative measures. Too often, they forgot about prudence, due diligence, research, balance sheet analysis, and other old-fashioned notions of intrinsic value and long-term investing. With all the publicity focused on the success of these momentary stars, and the accompanying publicity about “the best” funds for the year or even the quarter, along with the huge fees and compensation paid to fund management companies and the huge compensation paid to fund portfolio managers of the “hot” funds, of course the manager culture changed. But even a short-term failing in performance became a career risk, so it became best to be agile and flexible, and watch over the portfolio in, as they say, “real time.” As equity fund assets soared, more aggressive funds proliferated, and steady and deliberate decision making was no longer the watchword.

In the past, the speculative elements of a common stock resided almost exclusively in the company itself; they were due to uncertainties, or fluctuating elements, or downright weaknesses in the industry, or the corporation’s individual setup . . . But in recent years a new and major element of speculation has been introduced into the common-stock arena from outside the companies . . .This attitude may be described in a phrase; primary emphasis upon future expectations. The concept of future prospects and particularly of continued growth in the future invites the application of formulas out of higher mathematics to establish the present value of the favored issues . . . Highly imprecise assumptions can be used to justify practically any value one wished, however high . . . a new kind of philosopher’s stone that can produce or justify any desired valuation for a really “good stock.” Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics, the more uncertain and speculative are the conclusions we draw therefrom . . . Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.

More broadly, the management (or mis-management) of numbers is hardly the only instance of the dominance of numbers over reality in our society today.4 Our lives, as New York Times columnist David Brooks recently observed, “are now mediated through data-collecting computers.” Big Data, as it is called, “is really good at exposing when our intuitive view of reality is wrong . . . (giving us) wonderful ways to understand the present and the future.” Brooks continues . . . “Computer-driven data analysis excels at measuring the quantity of social interactions but not the quality. . . . Data creates bigger haystacks . . . many, many more statistically significant correlations, most of which are spurious and deceptive. The haystack gets bigger, but the needle we are looking for is still buried deep inside.”5 Worse, the trust that we place in numbers comes at the expense of trust in our own judgment and our values, and in our colleagues and communities. It’s bad enough when the focus on stock price over intrinsic value results in speculation and disrupts markets. But in the long run, business fundamentals trump market expectations that are based on current and expected numbers. When businesses rely too heavily on numbers, they tend to focus on the relatively predictable short run—on reported earnings and market expectations—than the far less predictable, but far more important, long run of creating durable intrinsic corporate value.

What Keynes termed “speculation,” I defined as speculative return—the change in the price investors are willing to pay for each dollar of earnings (essentially, the return that is generated by changes in the valuation or discount rate that investors place on future corporate earnings). Simply adding speculative return to—or subtracting it from—investment return produces the total return generated by the stock market. For example, if stocks begin a decade with a dividend yield of 4 percent and experience subsequent earnings growth of 5 percent, the investment return would be 9 3 Keynes, John Maynard. The General Theory of Employment, Interest, and Money, 1936.

“Vanguard: Saga of Heroes” A Lecture by John C. Bogle Founder and former Chief Executive, The Vanguard Group Before Dr. Elliot McGucken’s Class in Artistic Entrepreneurship and Technology 101 Pepperdine University Malibu, CA February 27, 2007 I’ve spent a lot of time and thought on the challenge of measuring up to Dr. McGucken’s high appraisal of my career, the scores of speeches that I’ve delivered, and especially my 2005 book, The Battle for the Soul of Capitalism. To find The Battle on the same reading list as The Odyssey—let alone on the same planet!—adds even more to my burden in meeting your expectations this evening. Just two weeks ago, however, an article in the Arts & Leisure section of the Sunday New York Times gave me a unifying theme for this evening’s lecture. The article was about someone with whom most of you students may be familiar: Brad McQuaid, creator of EverQuest, a 3-D fantasy video game operating in the virtual world, with 500,000 players, each paying $15 a month for the privilege. (Not as popular as the champion, “World of Warcraft,” with 5 million players, but amazing in its own right.) Typical of my generation, alas, I am not among those players. But in my constant attempt to understand what appeals to today’s young citizens, and my effort—however unlikely to bear fruit—to understand the new virtual world, I did read the Times article from start to finish. It was about Mr. McQuaid’s new virtual game, “Vanguard: Saga of Heroes.

Keynes argued that even “expert professionals” would gradually focus, not on investment (“making superior long-term forecasts of cash flow over the life of a company”), but on speculation (“forecasting changes in the general public’s valuation of the company’s shares”). I cited those very words in my thesis, and then had the temerity to disagree with the great man. In what I accurately predicted would become a far larger mutual fund industry, portfolio managers would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic [italics added], a demand that is based essentially on the [intrinsic] performance of a corporation rather than the public appraisal of the value of a share, that is, its price.” Alas, the sophisticated and analytic demand that I had predicted from the industry’s expert professional investors failed to materialize. Call the score, Keynes 1, Bogle 0. To this very day, nonetheless, I hold fast to the ideals I expressed in my thesis, summarized in its conclusion. “The principal function of investment companies is the management of their investment portfolios”—focusing on investing rather than speculating. Everything else is incidental.” The role of the mutual fund is to serve—"to serve the needs of both individual and institutional investors . . . to serve them in the most efficient, honest, and economical way possible.

those years earlier, and, to my shame, what I dismissed.) During the recent era, we entered the age of expectations investing, where projected growth in corporate earnings—especially earnings guidance and its subsequent achievement, by fair means or foul—became the watchword of investors. Never mind that the reported earnings were too often a product of financial engineering that served the short-term interest of corporate managers and Wall Street security analysts alike. But when long-term owners of stocks become short-term renters of stocks, and when the momentary precision of the price of the stock takes precedence over the eternal vagueness of the intrinsic value of the corporation itself, concern about corporate governance is the first casualty. The single most important job of the corporate director is to assure that management is creating value for shareholders; yet our new agent/investors seemed not to care when that goal became secondary. While these institutional agents now hold absolute voting control over corporate America, all we hear from these money managers is the sound of silence. Not only because they are more likely to be short-term speculators than long-term investors, but also because they are managing the pension and thrift plans of the corporations whose stocks they hold, and thus face a serious conflict of interest when controversial proxy issues are concerned.

 Three, the triumph of illusion over reality. As our professional security analysts came to focus far more heavily on illusion—the momentary precision of the price of the stock—they increasingly ignored the reality—that what really matters is the inevitably vague, but eternally transcendent, intrinsic value of the corporation. Measuring up, unfortunately, to Oscar Wilde’s wonderful description of the cynic, our money managers came “to know the price of everything, but the value of nothing.” When there is a gap between perception—illusion—and reality, it is, to state the obvious, only a matter of time until the gap is reconciled—inevitably, in favor of reality. In Mutual Fund America:  One, the industry changed. Mutual funds, once a profession with elements of a business, gradually became a business with elements of a profession. Our traditional guiding star of stewardship was transmogrified into a new star—salesmanship. Largely focused on management when I wrote my Princeton thesis about the industry, our predominant focus today is on marketing—increasing fee revenues by building up assets under management, often by creating, promoting, and advertising speculative funds that meet the fads and fashions of the day. As you will soon learn, our fund investors have paid a terrible price.  Two, the conglomerates take over.

Observing the predilection of investors to implicitly assume that the future will resemble the past, Keynes warned: “It is dangerous to apply to the future inductive arguments based on past experience unless we can distinguish the broad reasons for what it (the past) was.” A decade later, in 1935, in his amazing The General Theory of Employment, Interest, and Money, Keynes focused on the two broad reasons that explain the returns on stocks. The first was what he called enterprise—“forecasting the prospective yield of an asset over its entire life.” The second was speculation—“forecasting the psychology of the market.” Together, these two factors explain “The State of Long-Term Expectation” for an investment, the title of Chapter 12 of The General Theory. From his vantage point in London, Keynes observed that, “in one of the greatest investment markets in the world, namely, New York, the influence of speculation is enormous . . . It is rare for an American to ‘invest for income,’ and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that he is attaching his hopes to a favorable change in the conventional basis of valuation, i.e., that he is a speculator.” Today, 70 years after Keynes wrote those words, the same situation prevails, only far more strongly.

The second reason for the debasement of the values of our capitalistic system is that our new investor/agents not only seemed to ignore the interests of their principals, but also seemed to forget their own investment principles. In the latter part of the twentieth century, the predominant focus of institutional investment strategy turned from the wisdom of long-term investing to the folly of short-term speculation. During the recent era, we entered the age of expectations investing, where projected growth in corporate earnings—especially earnings guidance and its subsequent achievement, by fair means or foul—became the watchword of investors. Never mind that the reported earnings were too often a product of financial engineering that served the short-term interest of corporate managers and Wall Street security analysts alike. But when long-term owners of stocks become short-term renters of stocks, and when the momentary precision of the price of the stock takes precedence over the eternal vagueness of the intrinsic value of the corporation itself, concern about corporate governance is the first casualty. The single most important job of the corporate director is to assure that management is creating value for shareholders; yet our new investors seemed not to care when that goal became secondary. While our institutional agents now hold absolute voting control of corporate America, all we hear from these money managers is the sound of silence.

Lord Keynes’s confidence that speculation would dominate enterprise was based on the then- dominant ownership of stock by individuals, largely ignorant of business operations or valuations, leading to excessive, even absurd short-term market fluctuations based on events of an ephemeral and insignificant character. Short-term fluctuations in the earnings of existing investments, he argued (correctly), would lead to unreasoning waves of optimistic and pessimistic sentiment. While competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, Keynes added, should correct the vagaries caused by ignorant individuals, the energies and skill of the professional investor would come to be largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. He therefore described the market as “. . . a battle of wits to anticipate the basis of conventional valuation a few months hence rather than the prospective yield of an investment over a long term of years.” In my 1951 Princeton senior thesis on the mutual fund industry, I cited Keynes’ conclusions. And I had the temerity to disagree with the great man, arguing that he was wrong.than

professional investors succumbing to the speculative psychology of ignorant market participants, I argued, these pros would focus on enterprise. In what I predicted—accurately—would become a far larger mutual fund industry, our portfolio managers would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic [italics added], a demand that is based essentially on the [intrinsic] performance of the corporation rather than the public appraisal reflected in the price of its shares.” Alas, the sophisticated and analytic focus on enterprise that I had predicted from the industry’s expert professional investors has failed to materialize; rather, the emphasis on speculation by mutual funds has actually increased many fold. Call the score, Keynes 1, Bogle 0. Interestingly, Keynes was well aware of the fallibility of forecasting stock returns, noting that “it would be foolish in forming our expectations to attach great weight to matters which are very uncertain.” He added (shades of Frank Knight!) that “by very uncertain I do not mean the same thing as ‘improbable.’” While Keynes made no attempt to quantify the relationship between enterprise and speculation in shaping stock market returns, however, it occurred to me, decades later, to do exactly that.

(Reversion to the mean is alive and well in the mutual fund industry!) Yes, the large-cap Standard and Poor’s 500 Stock Index not only seems high—at an astonishing 29 times earnings it is high—but also seems significantly overvalued relative to the small- and mid-cap stocks that represent the remaining 25% of the market’s $13.5 trillion value . . . but the fundamental theory of indexing is grounded in owning the entire stock market, and that option is available in at least a few index funds. What is more, some 75% of the $2.8 trillion of equity mutual fund assets is invested in those same 500 S&P stocks. So, for the “500” index funds and the industry as a whole, the exposure to market risk is not significantly different. Yes, interim variations in the gap between industry and index returns will surely expand and contract in the future . . . but in the long run the mutual fund industry will have to recognize the inevitability of the failure of its existing investment modus operandi to earn returns that are sufficient to overcome its costs, and add economic value for fund shareholders.Speculation

Putting Numbers on Keynes’s Distinction By the late 1980s, based my own first-hand experience and my research on the financial markets, I concluded that the two essential sources of equity returns were: (1) economics, and (2) emotions. What Keynes had described as enterprise I called “economics.” What Keynes termed “speculation,” I found well-defined by “emotions.” The former I defined as investment return— the initial dividend yield on stocks plus the subsequent annual rate of earnings growth. The latter I defined as speculative return—the change in the price investors are willing to pay for each dollar of earnings. (Essentially, the return that is generated by changes in the valuation or discount rate that investors place on future corporate earnings.) Simply adding speculative return to investment return produces the total return generated by the stock market. For example, if stocks begin a decade with a dividend yield of 4 percent and experience subsequent earnings growth of 5 percent, the investment return would be 9 percent.5 If the price-earnings ratio rises from fifteen times to twenty times, that 33 percent increase, spread over a decade, would translate into an additional speculative return of about 3 percent annually. Simply adding the two returns together, the total return on stocks would come to 12 percent. It’s not very complicated! This remarkably simple numeric approach of separating enterprise and speculation—i.e.

“The financial system takes on special significance in Minsky’s theory, not only because finance exerts a strong influence on business activity, but also because this system is particularly open—or, as some might claim, prone—to innovation, as is abundantly evident today. Continues Minsky: ‘Since finance and industrial development are in a symbiotic relationship, financial evolution plays a crucial role in the dynamic patterns of the economy.’ “In addition to emphasizing the relations between finance and business, Minsky identified progression through at least five distinct stages of capitalism. The five stages can be labeled as follows: merchant capitalism (1607-1813), industrial capitalism (1813-1890), banker capitalism (1890-1933), managerial capitalism (1933-1982), and money-manager capitalism (1982-present). But the broad historical framework that Minsky developed in the last years of his life has gone almost unnoticed. According to Minsky, money-manager capitalism ‘became a reality in the 1980s as institutional investors, by then the largest repositories of savings in the country, began to exert their influence on financial markets and business enterprises.’ “The raison d’être for money managers, and basis by which they are held accountable, is the maximization of the value of the investments made by their clients. Not surprisingly, therefore, business executives became increasingly attuned to short-term profits and the stock-market valuation of their firm.

During the recent era, we entered the age of expectations investing, where projected growth in corporate earnings—especially earnings guidance and its subsequent achievement, by fair means or foul—became the watchword of investors. Never mind that the reported earnings were too often a product of financial engineering that served the short-term interest of both corporate managers and Wall Street security analysts. When long-term owners of stocks become short-term renters of stocks, and when the momentary precision of the price of the stock takes precedence over the eternal vagueness of the intrinsic value of the corporation, concern about corporate governance is the first casualty. The single most important job of the corporate director is to assure that management is creating value for shareholders; yet investors seemed not to care when that goal became secondary. If the owners of corporate America don’t give a damn about corporate governance, I ask you, who on earth should?the

Thinking About What Lies Ahead For Investors Remarks by John C. Bogle, Founder, The Vanguard Group at the CFA Society of Washington Washington, DC June 13, 2012 I’m honored by your invitation to return to our Nation’s Capital to provide some perspectives on the current investment environment, and to offer some reflections on the challenges that lay ahead for investment professionals, and of course for our investors as well. I’ll begin by discussing one of the great basics of investing—the simple sources of stock returns—so often overlooked by the short-term horizon s that drive the strategies of so many investors (or is it “speculators”) today. Then I’ll present some reasonable expectations for future returns, and give you my blunt appraisal of the typical 8 percent return assumption that most pension funds are relying on to meet future benefit obligations. I’ll close with some reflections on the many difficult challenges that investors face today. I. The Basics of Investing Let’s begin with some fundamentals. Stock prices, in fact, are derivatives. True! Their value is derived from the present value of a corporation’s future cash flows, in which stocks represent an ownership share. In other words, stocks represent an investment in the intrinsic value of a firm. Sellers decide, in effect, that they will capitalize on the value of those future flows, and buyers use their capital to acquire those flows. In the long run, it is these economics that drive stock price returns.

Most notable among those changes are: first, the growing dominance of agents (giant banks and investment banks, and institutional money managers) as stock owners over principals (individual investors); and second, the ascendance of short-term speculation over long-term investment, focused on the illusion represented by the momentary precision of stock prices rather than the reality represented by intrinsic value—simply put, the discounted value of future cash flows. Both of these major changes in how we invest have played a critical role in creating a dysfunctional and expensive financial system, and in turn have ill-served our real economy.management

Complexity has, in far too many cases, replaced simplicity as the core of mutual fund management and financial planning, and financial innovation threatens to overwhelm the tried and true principles of sound investing. Each of these trends makes your responsibilities as a financial planner more challenging to honor. But simply being aware of how our investment world has changed ought to provide useful perspective, and enable you to better fulfill your vital responsibilities to your clients. So let’s consider these three issues. I. The Triumph of Speculation over Investment We’ll begin by talking about the difference between investment and speculation. Investing, to me, is all about the long-term ownership of businesses, focused on the gradual accretion in intrinsic value that is derived from the ability of our corporations to produce the goods and services that our consumers and savers demand, to compete effectively, to thrive on entrepreneurship, and to capitalize on change, adding value to our society.cumulative

With these profound, indeed, earth-shaking changes, our financial markets have become far more volatile and unpredictable than the underlying businesses that they ultimately represent, which collectively account for their aggregate market capitalization. Put another way, investors are more volatile than investments. Economic reality governs the returns earned by our businesses, but emotions and perceptions—the swings of hope, greed, and fear among the participants in our financial system—govern the returns earned in our markets. Emotional factors sometimes magnify, sometimes minimize, this central core of economic reality, and financial crises can arise at any time, but in the long-term it is reality that triumphs over illusion. Warren Buffett states the issue with his usual clarity. His firm, Berkshire Hathaway, is publicly held, and he regularly hammers home to his shareholders the message that he prefers its shares to trade at or around its intrinsic value—neither materially higher nor lower. He explains: “Intrinsic value is the discounted value of the cash that can be taken out of the business during its remaining life . . . When the stock temporarily over-performs or under-performs the business, a limited number of shareholders—either sellers or buyers—receive out-sized benefits at the expense of those they trade with. [But] over time, the aggregate gains made by Berkshire shareholders must of necessity match the business gains of the company.

responsibility must always be to their shareholders.” Shortly thereafter, “there is some indication that costs are too high,” and that “future industry growth can be maximized by concentration on a reduction of sales charges and management fees.” (My advice, however, fell upon deaf ears.) After analyzing mutual fund performance, I concluded that “funds can make no claim to superiority over the market averages,” perhaps an early harbinger of my decision to create, nearly a quarter-century later, the world’s first index mutual fund. Still later in the thesis, I urged that “fund influence on corporate policy . . . should always be in the best interest of shareholders, not the special interests of the fund’s managers.” (Again, my advice fell by the wayside, and shareholders remain ill-served by the passive governance policies of most funds.) Finally, I predicted that rather than engaging in short-term speculation focused on forecasting the psychology of the stock market, funds would bring far greater focus on wise long- term investment. Defying Lord Keynes’s prediction that professional investors would join the ignorant crowd of stock traders, I predicted that fund managers would be “steady, sophisticated, enlightened, and analytic” institutional investors, focused on corporate performance and intrinsic value rather than momentary and evanescent share prices. (Once again, I was wrong.

government should act to arouse these sleeping giants as to the rights and responsibilities of stock ownership. Until then, I like the section of Sarbanes-Oxley that puts the audit committee—rather than management—in charge of hiring the auditor and overseeing the engagement. That extraordinary latent power is limited by the fact that it is the management that appoints the Audit Committee, and that even the most qualified of audit committee members rarely has the knowledge to analyze the issues— especially the issues behind the issues—in depth. Perhaps the Audit Committee should retain its own consultant to assure that the significant issues surrounding the corporation’s financial statement receive a full airing. (Management will not easily warm to this idea.) One of the pressures of the current era is the focus on building “corporate value,” so often defined as a focus on the inevitably evanescent short-term stock price. But we all understand that it is the long- term intrinsic value of the corporation we should be focused on. Yes, over the long haul the two must be the same. (Ask Warren Buffett.1) But corporate financial statements and reporting often seem fixated on the stock price. It must be obvious that much of the financial engineering that goes on today is only for the here-and-now, and is inevitably zeroed-out over time. But corporate managers are focused on the price of the stock and “earnings guidance” that must be met, lest Wall Street’s rancor be incurred.

are usually laid to easy credit; the cavalier attitude toward risk of our bankers and investment bankers; “securitization,” in which the traditional link between borrower and lender was severed; the extraordinary leverage built into the financial system by derivative securities of mind- boggling complexity; and the failure of our regulators to do their job. The Securities & Exchange Commission was almost apathetic in its failure to recognize what was happening in the capital markets. The Commodity Futures Trading Commission allowed the trading and valuation of derivatives to proceed opaquely, without demanding transparency and the sunlight of full disclosure. And let’s not forget Congress, which in the name of “free-market capitalism” rolled back many vital regulations and gutted the Glass-Steagall Act, which, since the early 1930s, had separated traditional banking from investment banking. Market participants—now dominated by speculators, not investors—also joined the parade of miscreants, and our professional security analysts failed to do their job of appraising company balance sheets, largely ignoring the huge credit risks assumed by the new breed of bankers and investment bankers. And let’s not forget our credit rating agencies, which happily bestowed AAA ratings on securitized loans in return for enormous fees that were paid in return by the issuers themselves. (It’s called “conflict of interest.”) Yes, there’s plenty of blame to pass around.

explain “The State of Long-Term Expectation” for an investment, the title of Chapter 12 of The General Theory. From his vantage point in London, Keynes observed that, “in one of the greatest investment markets in the world, namely, New York, the influence of speculation is enormous . . . It is rare for an American to ‘invest for income,’ and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that he is attaching his hopes to a favorable change in the conventional basis of valuation, i.e., that he is a speculator.” Today, 75 years after Keynes wrote those words, the same situation prevails, only far more strongly. Lord Keynes’s conviction that speculation would dominate enterprise in the financial markets was based on his belief that individuals, who were then the dominant force in the markets, were largely ignorant of business operations and lacking financial savvy, prone to betting on how other investors might value their stocks in the short term. (A “beauty contest,” Keynes posited; not a contest to pick the most beautiful woman, but to pick the woman whom other voters choose as the most beautiful.) This second-derivative gambling mentality leads to excessive, even absurd, short-term market fluctuations based on investors’ responses to events of an ephemeral and insignificant character.

Within eight years, the merger fell apart. But it was the new partners who fired me as the CEO of Wellington Management in January 1974. Within months, I came back as CEO of the Wellington Funds, and started Vanguard as a mutual company that would be responsible for the funds’ operations and the ongoing appraisal of their managers (including, of course, the firm that had just fired me). I quickly took on the task of restoring Wellington Fund to its traditional balanced focus. With the board’s consent, I directed Wellington Management to return Wellington Fund to its original investment values—less focus on growth and more focus on income. Indeed, I presented to Wellington a sample stock portfolio designed to produce a 70 percent increase in the fund’s annual income income dividend over the subsequent five years, and set that goal as our objective. The fund’s portfolio manager was not amused, but he complied, the dividend soared, the objective was met, and the strategy worked. Restoring Wellington Fund to its founding investment values saved it, and today it is once again the industry’s largest balanced fund ($75 billion). Some of you may think of me as the “anti-analyst” because I came to focus on the simple math of investing, the tautology that led to Vanguard’s formation of the world’s first index mutual fund in 1975. Simply put, gross return in the stock market, less the costs of active investing, equals the net returns earned by investors as a group.

”1 The second was speculation—“forecasting the psychology of the market.” Together, it is these two factors that explain “The State of Long-Term Expectation” for stocks, the title of Chapter 12 of The General Theory. From his vantage point in London, Keynes observed that “in one of the greatest investment markets in the world, namely, New York, the influence of speculation is enormous . . . It is rare for an American to ‘invest for income,’ and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that he is attaching his hopes to a favorable change in the conventional basis of valuation, i.e., that he is a speculator.” Today, 75 years after Keynes wrote those words, the same counterproductive situation prevails, only far more powerfully.1936)

Short-term fluctuations in the earnings of the stocks of business firms, he argued (correctly), would lead to unreasoning waves of optimistic and pessimistic sentiment. Keynes’ “Battle of Wits” Keynes conceded that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, should correct the vagaries caused by ignorant individuals. Yet he predicted that the energies and skills of the professional investor would come to be largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. He therefore described the market as “. . . a battle of wits to anticipate the basis of conventional valuation a few months hence rather than the prospective yield of an investment over a long term of years.”

having Wall Street security analysts with only a superficial knowledge of the business telling me how to run it; and, above all, freedom from of the pressures on marketing, with company growth remaining secondary to serving shareholders “with management operating in the most efficient, honest, and economical way possible.” (A quote directly from my 1951 Princeton senior thesis on the mutual fund industry and its proper role in our economy.) Simply put, the mutual structure provided the freedom to focus, not on the ephemeral and volatile price of a corporation’s stock, but on building the enduring intrinsic value that a corporation must provide to its clients over the long term, and offering excellent products and services at the lowest possible prices. Strategy Follows Structure Importantly, the mutual “at-cost” structure largely dictated the strategies that we would follow. Here’s how mutual mutual fund management companies differ from others, in seven key areas: 1. Profit Strategy ∑ Mutual firm—Maximize return on capital for fund shareholders. ∑ Manager Ownership—Serving two masters: conflicting mandates to maximize returns—management company stockholders vs. mutual fund shareholders. 2. Pricing Strategy ∑ Mutual—The lower the cost, the higher the return to shareholders. ∑ Manager—Whatever the traffic will bear. 3. Service Strategy ∑ Mutual—Service excellence, offered at cost. ∑ Manager—Service excellence, but costs must be increased in order to achieve it. 4.

Lord Keynes’s confidence that speculation would crowd out enterprise came at a time when individual investors dominated stock ownership. Since “the crowd” was largely ignorant of business operations and valuations, Keynes argued, excessive—even absurd—short-term market fluctuations would occur, reflecting events of an ephemeral and insignificant character. Short-term fluctuations in the earnings of existing investments, he correctly argued, would lead to unreasoning waves of optimistic and pessimistic sentiment. Competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, Keynes added, should correct the vagaries caused by ignorant individuals. But he expected such competition to do the reverse. The energies and skill of the professional investor would come to be largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. Keynes described the market as “a battle of wits to anticipate the basis of conventional valuation a few months hence rather than the prospective yield of an investment over a long term of years.” My first encounter with that priceless wisdom took place in the course of my research for my 1951 Princeton senior thesis on the mutual fund industry.

In my 1951 Princeton senior thesis on the mutual fund industry, I cited Keynes’ conclusions. And I had the temerity to disagree with the great man. Rather than professional investors succumbing to the speculative psychology of ignorant market participants, I argued, these experienced pros would focus on enterprise. In what I predicted—accurately—would become a far larger mutual fund industry, our portfolio managers would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic [italics added], a demand that is based essentially on the [intrinsic] performance of the corporation rather than the public appraisal reflected in the price of its shares.” Alas, the sophisticated and analytic focus on enterprise that I had predicted from the industry’s expert professional investors has utterly failed to materialize. In fact, the emphasis on speculation by mutual funds has actually increased many fold. Call the score, Keynes 1, Bogle 0. Interestingly, Keynes was well aware of the fallibility of forecasting stock returns, noting that “it would be foolish in forming our expectations to attach great weight to matters which are very uncertain.” He added that “by very uncertain I do not mean the same thing as ‘improbable.’” While Keynes made no attempt to quantify the relationship between enterprise and speculation in shaping stock market returns, however, it occurred to me, decades later, to do exactly that.

While some of this activity is necessary to provide the liquidity that has been the hallmark of U.S. financial markets, it has grown into an orgy of speculation that pits one manager against another, and one investor (or speculator) against another—a “paper economy” that, as Minsky warned, can devastate the real economy where our citizens save and invest. It must be obvious that our present economic crisis was, by and large, foisted on Main Street by Wall Street—the mostly innocent public taken to the cleaners, as it were, by the mostly greedy financiers. The economist Henry Kaufman warned about this very problem in his book, On Money and Markets, published in 2000: 1 Using the valuation model developed by Dr. Robert Shiller of Yale, the valuations were even more extreme. In October 2007, stocks sold at prices equal to 27 times earnings during the prior ten years, compared to the long-term multiple of 16 times. Result (if you agree with his premise): at the market peak, phantom wealth totaled nearly $7 trillion.

I cited Keynes’s conclusions, and then had the temerity to disagree with the great man. Rather than professional investors succumbing to the speculative psychology of ignorant market participants, I argued, these pros would focus on enterprise. In what I predicted—accurately, as it turned out—would become a far larger mutual fund industry, our portfolio managers would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic [italics added], a demand that is based essentially on the [intrinsic] performance of the corporation rather than the public appraisal reflected in the price of its shares.” Alas, the sophisticated and analytic focus on enterprise that I had predicted from the industry’s expert professional managers has failed abjectly to materialize. Rather, the emphasis on speculation by mutual funds has increased many fold. He was right. I was wrong. Ah, callow youth! Call the score, Keynes 1, Bogle 0. Keynes was well aware of the fallibility of forecasting stock returns, noting that “it would be foolish in forming our expectations to attach great weight to matters which are very uncertain.” He added that “by very uncertain I do not mean the same thing as ‘improbable.to

Putting Numbers on Keynes’s Distinction By the late 1980s, based my own first-hand experience and my research on the financial markets, I concluded that the two essential sources of equity returns were: (1) economics, and (2) emotions. What Keynes had described as enterprise I called “economics.” What Keynes termed “speculation,” I found well-defined by “emotions.” The former I defined as investment return— the initial dividend yield on stocks plus the subsequent annual rate of earnings growth. The latter I defined as speculative return—the change in the price investors are willing to pay for each dollar of earnings. (Essentially, the return that is generated by changes in the valuation or discount rate that investors place on future corporate earnings.) Simply adding speculative return to investment return produces the total return generated by the stock market. For example, if stocks begin a decade with a dividend yield of 4 ½ percent and experience subsequent earnings growth of 4 ½ percent, the investment return would be 9 percent.a

Consider with me now how the erosion in the conduct and values of business has been fostered by the profound—and largely unnoticed—change in the nature of our financial markets. That change reflects two radically different views of what investing is all about, two distinct markets. One is the real market of intrinsic business value. The other is the expectations market of momentary stock prices. Enterprise vs. Speculation It’s a curious fact that I’ve been concerned about this sharp dichotomy for my entire adult life. Really! In my senior thesis at Princeton University, completed way back in 1951, I cited the words of the great British economist John Maynard Keynes, in his wonderful Chapter 13 of The General Theory. There, Keynes drew the classic distinction between enterprise (“forecasting the prospective yield of assets over their whole life”) and speculation (“forecasting the psychology of the markets”). Keynes was deeply concerned about the societal implications of the growing role of short-term speculation on stock prices. “A conventional valuation [of stocks] which is established [by] the mass psychology of a large number of ignorant individuals,” he wrote, “is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really matter much to the prospective yield, since there will be no strong roots of conviction to hold it steady. . . resulting in unreasoning waves of optimistic and pessimistic sentiment.

quantify the relationship between enterprise and speculation in shaping stock market returns, however, it occurred to me, decades later, to do exactly that by putting numbers on Keynes’s distinction. By the late 1980s, based on my own first-hand experience and my research on the financial markets, I concluded that, consistent with what Keynes had written, the two essential sources of equity returns were: (1) investment (Keynes’ “enterprise”), and (2) speculation (the word Keynes used). I defined Investment Return as the initial dividend yield on stocks plus their subsequent annual rate of earnings growth over a decade. I defined Speculative Return as the change in the price investors are willing to pay for each dollar of earnings (essentially, the rate of return on stocks that is generated by changes in the valuation that investors place on future corporate earnings). Simply adding speculative return to investment return, I concluded, produces the Total Return generated by the stock market. For example, if stocks begin a decade with a dividend yield of 4 percent and generate subsequent earnings growth of 5 percent, their investment return would be 9 percent. If the price-earnings ratio rises from 15 times to 20 times, that 33 percent increase, spread over a decade, would translate into an additional speculative return of about 3 percent annually. Simply adding the two returns together, the total return on stocks would come to 12 percent. It’s not very complicated!

The Commodity Futures Trading Commission allowed the trading and valuation of derivatives to proceed opaquely, without transparency, without demanding the sunlight of full disclosure, and without concern for the ability of the counterparties to meet their financial obligations if their bets went sour. And let’s not forget Congress, which passed responsibility for regulation of the derivatives market to the CFTC almost as an afterthought. Congress allowed—indeed encouraged—risk-taking by our government-sponsored (now essentially government-owned) enterprises—Fannie Mae and Freddie Mac—allowing them to expand far beyond the capacity of their capital, and pushing them to lower their lending standards. Congress also gutted the Glass- Steagall Act of 1933, which had separated traditional banking and investment banking, a separation that for more than 60 years well-served our national interest. Our professional security analysts also have much to answer for, especially in their almost universal failure to recognize the huge credit risks assumed by the new breed of bankers and investment bankers who were far more interested in earnings growth for their institutions than in the sanctity of their balance sheets.AAA

During the 1920s and 1930s, there was little consideration of security analysts as a separate part of the investment business. The people performing analytical functions were known as “statisticians." One observer said “analysts were statisticians with the professional rating and financial rewards of third-class library clerks.” Slowly, however, our statisticians began to develop some of the techniques of modern security appraisal. In those days it was not a glamorous job. Analysts were considered "back-office men who were expected to keep the salesmen posted on bond ratings, earnings, and interest coverage.” They were considered overhead, quickly terminated when commissions declined. 2 Many of the comments contained in this section of my remarks are based on Nancy Regan’s superb 2012 book called The Gold Standard—A Fifty-Year History of the CFA Charter. I hope all you will give it the close attention it deserves.

Given the three ingredients of (a) optimistic assumptions as to the rate of earnings growth, (b) a sufficiently long projection of this growth into the future, and (c) the miraculous workings of compound interest—lo! the security analyst is supplied with a new kind of philosopher’s stone which can produce or justify any desired valuation for a really “good stock.” Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw therefrom . . . Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment . . . Have not investors and security analysts eaten of the tree of knowledge of good and evil prospects? By so doing have they not permanently expelled themselves from that Eden where promising common stocks at reasonable prices could be plucked off the bushes? This obvious reference to Original Sin reflected Graham’s deep concern about quantifying the unquantifiable (and doing so with false precision). The implications of that bite into the apple of quantitative investing were barely visible when Graham spoke in 1958.this

” Then, prophetically, Lord Keynes predicted that this trend would intensify as even “expert professionals, possessing judgment and knowledge beyond that of the average private investor, who, one might have supposed, would correct these vagaries . . . would be concerned, not with making superior long-term forecasts of the probable yield on an investment over its entire life, but with forecasting changes in the conventional valuation a short time ahead of the general public.” As a result, Keynes warned, the stock market would become “a battle of wits to anticipate the basis of conventional valuation a few months hence rather than the prospective yield of an investment over a long term of years.” In my thesis, I cited those very words, and then had the temerity to disagree.mutual

fund industry, would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic [italics added], a demand that is based essentially on the [intrinsic] performance of a corporation [Keynes’ enterprise], rather than the public appraisal of the value of a share, that is, its price.” Alas, the steady sophisticated, enlightened, and analytic demand I had predicted from our expert professional investors is nowhere to be seen. Quite the contrary! Our money managers, following Oscar Wilde’s definition of the cynic, seem to know “the price of everything but the value of nothing.” Portfolio turnover of equity mutual funds, then running steadily about 15 percent, year after year—a six-year average holding period for the average stock in a fund’s portfolio—actually soared skyward. In recent years, fund turnover has averaged above 100 percent—an average holding period of less than one year. So, a half-century after I wrote those words in my thesis, I must reluctantly concede the obvious: the worldly-wise Keynes was right, and that the callously idealistic Bogle was wrong. Call the score, Keynes 1, Bogle 0. It wasn’t even a close fight! “The Job of Capitalism is Likely to be Ill-Done” During the recent era, we have paid a high price for the shift that Keynes so accurately predicted.

As professional institutional investors moved their focus from the wisdom of long- term investment to the folly of short-term speculation, “the capital development of the country [became] a by-product of the activities of a casino.” Just as he warned, “when enterprise becomes a mere bubble on a whirlpool of speculation, the job of capitalism is likely to be ill- done.” In the recent era, its job has indeed been ill-done. The triumph of emotions over economics that has been reflected in the casino mentality of so many institutional investors has had harsh consequences. Yet when perception—the precise but momentary price of the stock— vastly departs from reality—the hard-to-measure but enduring intrinsic value of the corporation— the gap can be reconciled only in favor of reality.stock

Isn’t it high time we stand on their shoulders and shape national policy away from the moral relativism of peer conduct and greed and short-term speculation—gambling on expectations about stock prices? Isn’t it high time to return to the moral absolutism of fiduciary duty, to return to our traditional ethic of long-term investment focused on building the intrinsic value of our corporations—prudence, due diligence, and active participation in corporate governance? So, yes, now is time for reform. Today’s agency society has ill-served the public interest. The failure of our money manager agents represents not only a failure of modern-day capitalism, but a failure of modern-day capitalists. As Lord Keynes warned us, “when enterprise becomes a mere bubble on a whirlpool of speculation, the job of capitalism will be ill-done.” That is where we are today, and the consequences have not been pretty. In all, our now-dominant money management sector has turned its focus away from the enduring nature of the intrinsic value of the goods and services created, produced, and distributed by our corporate businesses, and toward the ephemeral price of the corporation’s stock—the triumph of perception over reality.of

When long-term owners of stocks become short-term renters of stocks, and when the momentary precision of the price of the stock takes precedence over the eternal vagueness of the intrinsic value of the corporation, concern about corporate governance is the first casualty. The single most important job of the corporate director is to assure that management is creating value for shareholders; yet investors seemed not to care. If the owners of corporate America don’t give a damn about corporate governance, I ask you, who on earth should? And so in corporate America we have the staggering increases in executive compensation, unjustified by corporate performance and grotesquely disproportionate to the pathetically small increase in real (inflation-adjusted) compensation of the average worker; financial engineering that dishonors the idea of financial statement integrity, and the failure of the traditional gatekeepers we rely on to oversee corporate management—our auditors, our regulators, our legislators, our directors. In investment America, control has devolved to a new class of institutional owners. The 25 largest institutional investors alone hold nearly 40 percent of all stocks, yet all we hear from these agent-owners on corporate malfeasance is the sound of silence.

and meet the demands of the expectations market. But the job of building intrinsic value in the real business market over the long term is a tough, demanding task, accomplished only by the superior corporation. This focus on stock prices and speculation holds dire consequences for our society (but not, of course, for our stock brokers, investment bankers, and money managers), even as any economically-strong society depends on the continuing creation of intrinsic value in our corporate world. I raised this same issue rather more tartly in a speech I gave at Princeton University’s Center for Economic Policy Studies in 2002, the core ideas of which in turn found their way to a prominent role in my Battle book. The theme of that speech—entitled “Don’t Count On It. The Perils of Numeracy”—was that “in our society, in economics, and in finance, we place too much trust in numbers. But numbers are not reality. At best, they’re a pale reflection of reality. At worst, they’re a gross distortion of the truths we seek to measure . . . (Yet) we worship hard numbers and accept the momentary precision of stock prices rather than the eternal vagueness of intrinsic corporate value as the talisman of investment reality.” The Real Market and the Expectations Market Perhaps this distinction between the Real Market and the Expectations Market was best expressed by Roger Martin, dean of the Rotman School of Business at the University of Toronto.

career that followed) on the mutual fund industry. It was entitled, “The Economic Role of the Investment Company.” This dual nature of returns is reflected when we look at stock market returns over the decades. Using Keynes’s idea, I divide stock market returns into two parts: (1) Investment Return (enterprise), consisting of the initial dividend yield on stocks plus their subsequent earnings growth, which together form the essence of what we call “intrinsic value”; and (2) Speculative Return, the impact of changing price/earnings multiples on stock prices. Let’s begin with investment returns on the average annual investment return on stocks over the decades since 1900. (Chart 2a) Note first the steady contribution of dividend yields to total return during each decade; always positive, only once outside the range of 3 percent to 7 percent, and averaging 4.5 percent. Then note that the contribution of earnings growth to investment return, with the exception of the depression-ridden 1930s, was positive in every decade, usually running between 4 percent and 7 percent, and averaging 5 percent per year. Result: Total investment returns (the top line, combining dividend yield and earnings growth) were negative in only a single decade (again, in the 1930s). These total investment returns—the gains made by business—were remarkably steady, generally running in the range of 8 percent to 13 percent each year, and averaging 9.5 percent. Enter speculative return.

a company’s stock than it is to build the intrinsic value of the corporation itself. And we seem to have forgotten Benjamin Graham’s implicit caution about the transience of short-term perception, compared to the durability of long-term reality: “In the short run, the stock market is a voting machine; in the long run it is a weighing machine.” The Mutual Fund Industry My strong statements regarding the failure of modern day capitalism are manifested in grossly excessive executive compensation; financial engineering; earnings “guidance,” with massive declines in valuations if it fails to be delivered; enormous, casino-like trading among institutional investors; staggering political influence, borne of huge campaign contributions; and, in the financial arena, bestowal of wealth to traders and managers that is totally disproportionate to the value they add to investors’ wealth. Indeed, the financial sector actually subtracts value from our society. Finance is what is known to economists as a “rent-seeking” enterprise, one in which our intermediaries—money managers, brokers, investment bankers—act as agents for parties on both sides of each transaction. Our intermediaries pit one party against another, so what would otherwise be a zero-sum game becomes a loser’s game, simply because of the intermediation costs extracted by the various croupiers. (Other examples of rent-seekers include casinos, the legal system, and government. Think about it!)

It’s worth dwelling on that phrase: “the critical functioning structure that defines how the world works.” As the New Yorker writer John Lanchester observed: “That’s a hell of a big thing to find a flaw in.” Lanchester continued: “the people in power thought they knew more than they did. The bankers evidently knew too much math and not enough history—or maybe they didn’t know enough of either.” Think about it: In our financial system, we have ignored both math and history, and largely focus our expectations on the returns that the financial markets may deliver. We’ve also ignored the exorbitant costs extracted from our returns by Wall Street traders and money managers, costs that substantially diminish—indeed often overwhelm—our participation in the returns that our corporations earn and the excessive taxes that we incur in this era of record levels of speculative trading. Together, these costs have devastated the real (inflation-adjusted) returns that remain for investors. In all, our now-dominant money management sector has turned its focus away from the enduring nature of the intrinsic value of the goods and services created, produced, and distributed by our corporate businesses, and toward the ephemeral price of the corporation’s stock—the triumph of perception over reality. We live in a world in which it is far easier to hype the price of a company’s stock than it is to build the intrinsic value of the corporation itself.

This “ratchet effect,” the product of the compensation consultants who, I can assure you, don’t make a living by recommending salary cuts, is a real problem, to which the only solution is a demand by stockholders to require corporate performance—not peer compensation—as a condition of compensation above a certain (modest) norm. But, as I’ve noted, since our all-powerful institutions have serious conflicts of interest and behave more like speculators than investors, don’t hang by your thumbs awaiting this reform. The other major culprit enabling excessive executive compensation is the heavy reliance on stock options. They seem to be “free,” but they’re not. So as seemingly reasonable as they may seem, such options can significantly dilute the interest of the “real” shareholders of the company. To avoid such dilution, companies typically buy back stock in the market, whether or not these prices are reasonably related to company achievement. Further, stock prices (as I’ve already noted) often have little to do with the amount of real intrinsic value the company, and its executives and staff, are creating (or dissipating). The idea that stock options link the interest of executives with the interests of shareholders turns out to be, simply, a canard.

therefore, business executives became increasingly attuned to short-term profits and the stock-market valuation of their firm. The growing role of institutional investors fostered continued financial-system evolution by providing a ready pool of buyers of securitized loans, structured finance products, and myriad other exotic innovations . . . something (is) basically wrong with the financial structure.” My own views of our flawed financial system closely parallel these views of Minsky and Keynes. Let me turn, then, to my own concerns about the current state of our commercial institutions—in particular, our giant publicly-held corporations—and our giant investment institutions—now largely owned by giant publicly-held financial conglomerates. Both corporate America and investment America represent a peculiar mix of business and profession, but they have moved a long way from the traditional values of capitalism. The origins of modern capitalism, beginning with the Industrial Revolution in Great Britain back in the late 18th century, had to do, yes, with entrepreneurship and risk-taking, with raising capital, with vigorous competition, with free markets, and with the returns on capital going to those who put up the capital. Central to these values of early capitalism was the fundamental principle of trusting and being trusted. But by the latter part of the 20th century, we were to witness the erosion of the very structure of capitalism.

between enterprise (“forecasting the prospective yield of the asset over its whole life”) and speculation (“forecasting the psychology of the markets”). Keynes was deeply concerned about the societal implications of the growing role of short-term speculation on stock prices. “A conventional valuation [of stocks] which is established [by] the mass psychology of a large number of ignorant individuals,” he wrote, “is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really matter much to the prospective yield . . . resulting in unreasoning waves of optimistic and pessimistic sentiment.” Then, prophetically, Lord Keynes predicted that this trend would intensify, as even “expert professionals, possessing judgment and knowledge beyond that of the average private investor would become concerned, not with making superior long-term forecasts of the probable yield on an investment over its entire life, but with forecasting changes in the conventional valuation a short time ahead of the general public.” As a result, Keynes warned, the stock market would become “a battle of wits to anticipate the basis of conventional valuation a few months hence rather than the prospective yield of an investment over a long term of years.” In my thesis, I cited those very words, and then had the temerity to disagree with the great man.

brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment. Benjamin Graham, Right Again Graham was right (of course!) It is hardly news to this audience that the emphasis on future expectations noted by Graham continues to be pervasive today. The desire to quantify and model all aspects of our financial lives has carried the day. Even our learned financial journals are peppered with papers offering abstract models that purport to beat the market. But for me, I’m reminded of Albert Einstein’s famous observation: “Not everything that counts can be counted, and not everything that can be counted counts.” As investment professionals, money managers, and security analysts, we ought to focus primarily on investing based on long-term intrinsic corporate value rather than speculating on short-term, even momentary prices in the stock market. It is not the ephemeral perception of the price of a stock that varies from moment to moment that counts; it is the enduring reality of intrinsic value—however difficult to discern that counts. Make no mistake, the worth of a corporation is still neither more nor less than the discounted value of its future cash flows. So financial professionals need a new primary focus—on security analysis rather than market analysis.

Portfolio managers, in what I predicted—accurately, as it turned out—would become a far larger mutual fund industry, would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic [italics added], a demand that is based essentially on the [intrinsic] performance of a corporation [Keynes’s enterprise], rather than the public appraisal of the value of a share, that is, its price [Keynes’s speculation].” Alas, the steady sophisticated, enlightened, and analytic demand I had predicted from our expert professional investors is now nowhere to be seen. Quite the contrary! Our money managers, following Oscar Wilde’s definition of the cynic, seem to know “the price of everything but the value of nothing.” Portfolio turnover of equity mutual funds, then running steadily about 15 percent, year after year—has soared in recent years to more than 100 percent—an average holding period of less than one year. So, a half-century-plus after I wrote those words in my thesis, I must reluctantly concede the obvious: Keynes’ sophisticated cynicism was right, and Bogle’s callow idealism was wrong. But that doesn’t mean we should let that system prevail forever.

Investment returns (top line of figures) are generated by the initial (known) dividend yield on stocks (red bar), about 2 percent today, plus subsequent earnings growth (blue bar), averaging about 5 percent. A reasonable expectation for investment return in the coming decade is therefore around 7 percent, measured in today’s dollars. Such a return would be well below the historical norm of 9 percent (second column from the right)—creating a huge gap in appreciation of cumulative equity wealth during the coming decade. (Reminder: These are the market returns, before investment costs. Investors as a group do not—indeed cannot—earn these returns.) The second element, speculative return (green bar), depends entirely on investor expectations and investor behavior. Unlike investment return, speculative return is enormously variable. We can easily measure it by the number of dollars that investors are willing to pay for each dollar of future earnings on stocks. If valuations a decade hence prove to be materially higher or lower than today’s price-earnings multiple of about 16 times, speculative return would be an important factor in the stock market’s performance. For example, a valuation of 20 times could add about 2 percentage points per year, to returns raising that 7 percent investment return to a 9 percent total return. A drop to 12 times, on the other hand, would cost about 3 percentage points, dropping the 7 percent return to just 4 percent.

Not surprisingly, therefore, business executives became increasingly attuned to short-term profits and the stock- market valuation of their firm. The growing role of institutional investors fostered continued financial-system evolution by providing a ready pool of buyers of securitized loans, structured finance products, and myriad other exotic innovations.” To drive this point home, think of investing as consisting of two different games. Here’s how Roger Martin, dean of the Rotman School of Management of the University of Toronto, describes them. One is “the real market, where giant publicly held companies compete. Where real companies spend real money to make and sell real products and services, and, if they play with skill, earn real profits. This game also requires real strategy, determination, and expertise; real innovation and real foresight.”

Never mind that the reported earnings were too often a product of financial engineering that served the short- term interest of corporate managers and Wall Street security analysts alike. But when long-term owners of stocks become short-term renters of stocks, and when the momentary precision of the price of the stock takes precedence over the eternal vagueness of the intrinsic value of the corporation itself, concern about corporate governance is the first casualty. The single most important job of the corporate director is to assure that management is creating value for shareholders; yet when that goal became secondary, our new investors seemed not to care. While their 70 percent ownership position gives our institutional agents absolute voting control of corporate America, all we hear from these money managers is the sound of silence. Not only because they are more likely to be short-term speculators than long-term investors, but also because they are managing the pension and thrift plans of the corporations whose stocks they hold, and thus face a serious conflict of interest where controversial proxy issues are concerned.

Investing Today In a New York Times piece in August, I was quoted (correctly) as saying “this is the worst time for investing that I’ve ever seen.” It is. Because while the prospects for future returns on stocks are highly likely to be positive, albeit below long-term norms, based on the methodology I developed for realistic return expectations a quarter century ago that has met the test of time. In it, I separate stock returns into two components: investment return, and speculative return. (This is the math part of the talk!) I show that future investment returns—the current dividend yield (about 2 percent today) plus subsequent earnings growth (probably about 5 percent) would likely be around 7 percent, measured in nominal dollars, well below the historical norm of 9 percent—a huge gap over the long-term. Consider that each dollar invested at 7 percent over a quarter century would grow by 5.4 times; at 9 percent, by 8.6 times. The second element, speculative return, depends entirely on investor opinion and investor behavior, and we can easily measure it by the number of dollars that investors are willing to pay for future earnings on stocks. If valuations a decade hence were materially higher or lower than today’s price-earnings multiple of about 16 times, speculative return could be an important factor in the stock market’s performance. For example, a valuation of 20 times could add almost 2 percentage points per year, raising that 7 percent to 9 percent.

latter part of the twentieth century, the predominant focus of institutional investment strategy turned from the wisdom of long-term investing to the folly of short-term speculation. During the recent era, we entered the age of expectations investing, where projected growth in corporate earnings—especially earnings guidance and its subsequent achievement, by fair means or foul— became the watchword of investors. Never mind that the reported earnings were too often a product of financial engineering that served the short-term interest of corporate managers and Wall Street security analysts alike. But when long-term owners of stocks become short-term renters of stocks, and when the momentary precision of the price of the stock takes precedence over the eternal vagueness of the intrinsic value of the corporation itself, concern about corporate governance is the first casualty. The single most important job of the corporate director is to assure that management is creating value for shareholders; yet our new agent/investors seemed not to care when that goal became secondary. While these institutional agents now hold absolute voting control over corporate America, all we hear from these money managers is the sound of silence.