My Key Takeaways From Chapter 7 and Commentary 7 of the Intelligent Investor. Part 8/16. To Be Continued.

Chapter 7 Portfolio Policy for the Enterprising Investor: The Positive Side

Operations in Common Stocks

The activities specially characteristic of the enterprising investor in the common-stock field may be classified under 4 heads:

  1. Buying in low markets and selling in high markets
  2. Buying carefully chosen “growth stocks”
  3. Buying bargain issues of various types
  4. Buying into “special situations”

General Market Policy-Formula Timing

We reserve for the next chapter our discussion of the possibilities and limitations of a policy of entering the market when it is depressed and selling out in the advanced stages of a boom.

20 years ago it was possible to discuss in great detail a number of clear-cut formulas for varying the percentage held in common stocks, with confidence that these plans had practical utility. The times seem to have passed such approaches by, and there would be little point in trying to determine new levels for buying and selling out of the market patterns since 1949.

Growth-Stock Approach

There are 2 catches to this simple idea. The 1st is that common stocks with good records and apparently good prospects sell at correspondingly high prices. The 2nd is that his judgment as to the future may prove wrong. Unusually rapid growth cannot keep up forever; when a company has already registered a brilliant expansion, its very increase in size makes a repetition of its achievement more difficult.

Consequently, we should advise against the usually type of growth-stock commitment for the enterprising investor. This is one in which excellent prospects are fully recognized in the market and already reflected in a current price-earnings ratio of, say, higher than 20. (For the defensive investor we suggested an upper limit of purchase price at 25 times average earnings of the past 7 years. The 2 criteria would be about equivalent in most cases.)

The striking thing about growth stocks as a class is their tendency toward wide swings in market price.

*Table 7-1 Average Results of “Growth Funds,” 1961-1970

3 Recommended Fields for “Enterprising Investment”

To obtain better than average investment results over a long pull requires a policy of selection or operation possessing a twofold merit: (1) It must meet objective or rational tests of underlying soundness; and (2) it must be different from the policy followed by most investors or speculators. Our experience and study leads us to recommend 3 investment approaches that meet these criteria.

  1. The Relatively Unpopular Large Company

The key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity. While small companies may also be undervalued for similar reasons, and in many cases may later increase their earnings and share price, they entail the risk of a definitive loss of profitability and also of protracted neglect by the market in spite of better earnings. The large companies thus have a double advantage over the others. 1st they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base. 2nd the market is likely to respond with reasonable speed to any improvement shown.

*Table 7-2 Average Annual Percentage Gain or Loss on Test Issues, 1937-1969

But in considering individual companies a special factor of opposite import must sometimes to be taken into account. Companies that are inherently speculative because of widely varying earnings tend to sell both at a relatively high price and at a relatively low multiplier in their good years, and conversely at low prices and high multipliers in their bad years.

*Table 7-3 Chrysler Common Prices and Earnings, 1952-1970

Perhaps the aggressive investor should start with the “low multiplier” idea, but add other quantitative and qualitative requirements thereto in making up his portfolio.

  1. Purchase of Bargain Issues

We define a bargain issue as one which, on the basis of facts establish by analysis, appears to be worth considerably more than it is selling for. To be concrete as possible, let us suggest that an issue is not a true “bargain” unless the indicated value is at least 50% more than the price.

There are 2 tests by which a bargain common stock is detected. The 1st is by the method of appraisal. This relies largely on estimating future earnings and then multiplying these by a factor appropriate to the particular issue. The 2nd test is the value of the business to a private owner. This value also is often determined chiefly by expected future earnings-in which case the result may be identical with the first. But in the second test more attention is likely to be paid to the realizable value of the assets, with particular emphasis on the net current assets or working capital.

The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks. Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels. Thus we have what appear to be 2 major sources of undervaluation: (1) currently disappointing results and (2) protracted neglect or unpopularity.

The many experiences of this type suggest that the investor would need more than a mere falling off in both earnings and price to give him a sound basis for purchase. He should require an indication of at least reasonable stability of earnings over the past decade or more-i.e., no year of earning deficit-plus sufficient size and financial strength to meet possible setbacks in the future. The ideal combination here is thus that of a large and prominent company selling both well below its past average price and its past average price/earnings multiplier. This would no doubt have ruled out most of the profitable opportunities in companies such as Chrysler, since their low-price years are generally accompanied by high price/earnings ratios.

A 3rd cause for an unduly low price for a common stock may be the market’s failure to recognize its true earnings picture.

The type of bargain issue that can be most readily identified is a common stock that sells for less than the company’s net working capital alone, after deducting all prior obligations. This would mean that the buyer would pay nothing at all for the fixed assets-buildings, machinery, etc., or any good-will items that might exist.

  1. Bargain-Issue Pattern in Secondary Companies

We have defined a secondary company as one that is not a leader in a fairly important industry. By way of exception, any company that has established itself as a growth stock is not ordinarily considered “secondary.”

In the great bull market of the 1920s relatively little distinction was drawn between industry leaders and other listed issues, provided the latter were of respectable size. The public felt that a middle-sized company was strong enough to weather storms and that it had a better chance of really spectacular expansion than one that was already of major dimensions. The depression years 1931-32, however had a particularly devastating impact on the companies below the first rank either in size or in inherent stability. As a result of that experience investors have since developed a pronounced preference for industry leaders and a corresponding lack of interest most of the time in the ordinary company of secondary importance. This has meant that the latter group have usually sold at much lower prices in relation to earnings and assets than have the former. It has meant further that in many instances the price has fallen so low as to establish the issue in the bargain class.

1929 the companion theory for the “blue chips” was that no price was too high for them because their future possibilities were limitless. Both these views were exaggerations and were productive of serious investment errors.

Substantial profits from the purchase of secondary companies at bargain prices arise in a variety of ways. 1st the dividend return is relatively high. 2nd the reinvested earnings are substantial in relation to the price paid and will ultimately affect the price. 3rd a bull market is ordinarily most generous to low-priced issues; thus it tends to raise the typical bargain issue to at least a reasonable level. 4th even during relatively featureless market periods a continuous process of price adjustment goes on, under which secondary issues that were undervalued may rise at least to the normal level for their type of security. 5th the specific factors that in many cases made for a disappointing record of earnings may be corrected by the advent of new conditions, or the adoption of new policies, or by a change in management.

An important new factor in recent years has been the acquisition of smaller companies by larger ones, usually as part of a diversification program.

When interest rates were much lower than in 1970, the field of bargain issues extended to bonds and preferred stocks that sold at large discounts from the amount of their claim. Currently we have a different situation in which even well-secured issues sell at large discounts if carrying coupon rates of, say, 4.5% or less.

  1. Special Situations, or “Workouts”

But in recent years, for reasons we shall develop later, the field of “arbitrages and workouts” became riskier and less profitable. It may be that in years to come conditions in this field will become more propitious.

The typical “special situation” has grown out of the increasing number of acquisitions of smaller firms by large ones, as the gospel of diversification of products has been adopted by more and more managements.

The underlying factor here is the tendency of the security markets to undervalue issues that are involved in any sort of complicated legal proceedings

Broader Implications of Our Rules for Investment

Investment policy, as it has been developed here, depends in the first place on a choice by the investor of either the defensive (passive) or aggressive (enterprising) role. The aggressive investor must have a considerable knowledge of security values-enough, in fact, to warrant viewing his security operations as equivalent to a business enterprise. There is no room in this philosophy for a middle ground, or a series of gradations, between the passive and aggressive status.

We advise against the purchase at “full prices” of 3 important categories of securities: (1) foreign bonds, (2) ordinary preferred stocks, and (3) secondary common stocks, including, of course, original offerings of such issues. By “full prices” we mean prices close to par for bonds or preferred stock, and prices that represent about the fair business value of the enterprise in the case of common stocks. The greater number of defensive investors are to avoid these categories regardless of the price; the enterprising investor is to buy them only when obtainable at bargain prices, which we define as prices not more than 2-3rds of the appraisal value of the securities.

There is a paradox here, nevertheless. The average well-selected secondary company may be fully as promising as the average industry leader. What the smaller concern lacks in inherent stability it may readily make up in superior possibilities of growth. Consequently, it may appear illogical to many readers to term “unintelligent” the purchase of such secondary issues at their full “enterprise value.” We think that the strongest logic is that of experience. Financial history says clearly that the investor may expect satisfactory results, on the average, from secondary common stocks only if he buys them for less than their value to a private owner, this is, on a bargain basis. The last sentence indicates that this principle relates to the ordinary outside investor. Anyone who can control a secondary company, or who is part of a cohesive group with such control, is fully justified in buying the shares on the same basis as if they were investing in a “close corporation” or other private business. The distinction between the position, and consequent investment policy, of insiders and outsiders becomes more important as the enterprise itself becomes less important.

Commentary on Chapter 7

As the Danish philosopher Soren Kierkegaard noted, life can only be understood backwards-but it must be lived forwards.

For most investors, market timing is a practical and emotional impossibility.

The faster these companies grew, the more expensive their stocks became. And when stocks grow faster than companies, investors always end up sorry. Growth stocks are worth buying when their prices are reasonable, but when their price/earnings ratios go much above 25 or 30 the odds get ugly.

• Journalist Carol Loomis found that from 1960 through 1999, only eight of the largest 150 companies on the Fortune 500 list managed to raise their earnings by an annual average of at least 15% for 2 decades.
• Looking at 5 decades of data, the research firm of Sanford C. Bernstein & Co. showed that only 10% of large U.S. companies had increased their earnings by 20% for at least 5 consecutive years; only 3% had grown by 20% for at least 10 years straight; and not a single one had done it for 15 years in a row.
• An academic study of thousands of U.S. stock from 1951 through 1998 found that over all 10-year periods, net earnings grew by an average of 9.7% annually. But for the biggest 20% of companies, earnings grew by an annual average of just 9.3%.

The intelligent investor, however, gets interested in big growth stocks not when they are at their most popular-but when something goes wrong.

The great successes of life are made by concentration. However, almost no small fortunes have been made this way-and not many big fortunes have been kept this way.

The Bargain Bin

Grab a copy of today’s Wall Street Journal, turn to the “Money & Investing” section, and take a look at the NYSE and NASDAQ Score-cards to find the day’s lists of stocks that have hit new lows for the past year-a quick and easy way to search for companies that might pass Graham’s net-working-capital tests. (Online, try http://quote.morningstar.com/highlow.html?msectio….)
To see whether a stock is selling for less than the value of net working capital (what Graham’s followers call “net nets”) download or request the most recent quarterly or annual report from the company’s website or from the EDGAR database at www.sec.gov. From the company’s current assets, subtract its total liabilities, including any preferred stock and long-term debt. (Or consult your local public library’s copy of Value Line Investment Survey, saving yourself a costly annual subscription. Each issue carries a list of “Bargain Basement Stocks” that come close to Graham’s definition.)

 

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