My Key Takeaways From Chapter 6 and Commentary 6 of the Intelligent Investor. Part 7/16. To Be Continued.

Chapter 6 Portfolio Policy for the Enterprising Investor: Negative Approach

The most useful generalizations for the enterprising investor are of a negative sort. Let him leave high-grade preferred stocks to corporate buyers. Let him also avoid inferior types of bonds and preferred stocks unless they can be brought at bargain levels-which means ordinarily at prices at least 30% under par for high coupon issues, and much less for the lower coupons. He will let someone else buy foreign-government bond issues, even though the yield may be attractive. He will also by wary of all kinds of new issues, including convertible bonds and preferreds that seem quite tempting and common stock with excellent earnings confined to the recent past.

Second-Grade Bonds and Preferred Stocks

Since in late-1971 it is possible to find first-rate corporate bonds to yield 7.25%, and even more, it would not make much sense to buy second-grade issues merely for the higher return they offer. In fact corporations with relatively poor credit standing have found it virtually impossible to sell “straight bonds”-i.e., nonconvertibles-to the public in the past 2 years. Hence their debt financing has been done by the sale of convertible bonds (or bonds with warrants attached), which place them in a separate category. It follows that virtually all the nonconvertible bonds of inferior rating represent older issues which are selling at a large discount. Thus they offer the possibility of a substantial gain in principal value under favorable future conditions-which would mean here a combination of an improved credit rating for the company and lower general interest rates.

Something should be said now about investing in second-grade issues, which can readily be found to yield any specified return up to 8% or more. The main difference between first and second grade bonds is usually found in the number of times the interest charges have been covered by earnings.

Foreign Government Bonds

All investors with even small experience know that foreign bonds, as a whole, have had a bad investment history since 1914.

We have no concrete reason to be concerned about the future history of well-regarded foreign bonds such as those of Australia or Norway. But we do know that, if and when trouble should come, the owner of foreign obligations has no legal or other means of enforcing his claim. Default on interest + depreciation

New Issues Generally

Our one recommendation is that all investors should be wary of new issues. There are 2 reasons for this double caveat. The first is that new issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance. The 2nd is that most new issues are sold under “favorable market conditions”- which means favorable for the seller and consequently less favorable for the buyer.

Commentary on Chapter 6

“The punches you miss are the ones that wear you out.” – Boxing trainer Angelo Dundee

In this chapter, Graham lists his “don’ts” for aggressive investors. Here is a list for today.

Junkyard Dogs?

High-yield bonds-which Graham calls “second-grade” or “lower-grade” and today are called “junk bonds”-get a brisk thumbs-down from Graham.

Since 1978, an annual average of 4.4% of the junk-bond market has gone into default-but even after those defaults, junk bonds have still produced an annualized return of 10.5%, versus 8.6% for 10-year U.S. Treasury bonds.

The Vodka-and-Burrito Portfolio

Graham considered foreign bonds no better a bet than junk bonds.

But emerging markets bond funds seldom move in synch with the U.S. stock market, so they are one of the rare investments that are unlikely to drop merely because the Dow is down.

Dying a Trader’s Death

Day trading-holding stocks for a few hours at a time-is one of the best weapons ever invented for committing financial suicide.

When you trade instead of invest, you turn long-term gains (taxed at a maximum capital-gains rate of 20%) into ordinary income (taxed at a maximum rate of 38.6%).

The Early Bird Gets Wormed

Among the get-rich-quick toxins that poisoned the mind of the investing public in the 1990s, one of the most lethal was the idea that you can build wealth by buying IPOs.

Most of the high returns on IPOs are captured by members of an exclusive private club-the big investment banks and fund houses that get shares at the initial (or “underwriting”) price, before the stock begins public trading.

Most important, buying IPOs is a bad idea because it flagrantly violates one of Graham’s most fundamental rules: No matter how many other people want to buy a stock, you should buy only if the stock is a cheap way to own a desirable business.

But when we’re in public instead of in private, when valuation suddenly becomes a popularity contest, the price of a stock seems more important than the value of the business it represents. As long as someone else will pay even more than you did for a stock, why does it matter what the business is worth? This chart shows why it matters.