Monday, 25 March 2013

Benjamin Graham's Intelligent Investor - What the Enterprising Investor should Buy

Portfolio Policy for the Enterprising Investor - the Positive Side
Selection of Bonds 
In addition to the US Bonds described in previous chapters, US guaranteed bonds like “New Housing Authority Bonds” and “New Community Bonds” (both of which were widely available in 1972), as well as tax free municipal bonds serviced by lease payments of A rated corporations, are good investments. 
Selection of Bonds 
Lower quality bonds may be attainable at true bargains in “special situations”, however these have characteristics that are more similar to common stocks.
Selection of Stocks
The enterprising investor usually conducts 4 activities:
1.      Buying in low markets and selling in high markets.
2.      Buying carefully chosen growth stocks.
3.      Buying bargain issues.
4.      Buying into “special situations”.
1.      Market timing - This is a difficult proposition at best.  Market timing is more of a speculative activity.
2.      Growth Stocks – This also is difficult.  These issues are already fully priced.  In fact, their growth may cease at any time.  As a firm grows, its very size inhibits further growth at the same rate.  Therefore, the investor risks not only overpaying for growth stocks, but also choosing the wrong ones.  In fact, the average growth fund does not fair much better than the indexes.  Also, growth stocks fluctuate widely in price over time, which introduces a speculative element.  The more enthusiastic the public becomes, the more speculative the stock becomes as its price rises in comparison to the firm’s earnings.
3.      Special Situations – This is a specialty field that includes workouts in bankruptcy and risk arbitrage arising from mergers and acquisitions.  However, since the 1970s, this field has become increasingly risky with available returns less than were previously realizable.  In addition, this field requires a special mentality as well as special equipment.  Thus, to the common investor, this area is highly speculative.
4.      Bargain Issues – This is the area in which the common investor has the enterprising investor has the greatest chance for long term success. 
The market often undervalues large companies undergoing short-term adversity
The market also will undervalue small firms in similar circumstances. 
Large firms generally possess the capital and intellectual resources necessary to carry the firm through adversity; plus, the market recognizes the recovery of large firms faster than it does for small firms.  
Small firms are more likely to lose profitability that is never to be regained, and when earnings do improve, they may go unnoticed by the market.
One way to profit from this strategy is to purchase those issues of the DJIA that have either the highest dividend yields or the lowest earnings multiples. 
The investment returns using this method should result in a return approximately 50% better than purchasing equal amounts of all 30 DJIA issues.  
This is a sound starting point for the enterprising investor.
Caution must be paid not to purchase companies that are inherently speculative due to economic swings, such as the Big 3 automakers. 
These firms have high prices and low multipliers in their good years, and low prices and high multipliers in their bad years.  
When earnings are significantly low, the P/E is high to adjust for the underlying value of the firm during all economic periods.  
To avoid this mistake, the stock selected should have a low price in reference to past average earnings.  
Bargain issues are defined as those that worth considerably more than their market price based upon a thorough analysis of the facts.  
To be a true bargain, an issue’s price must be at least 50% below its real value. 
This includes bonds and preferred stocks when they sell far under par. 
There are two ways to determine the true value of a stock. 
Both methods rely upon estimating future earnings. 
In the first method, the cumulative future earnings are discounted at an appropriate discount rate, or in the alternative, the earnings are multiplied by an appropriate p/e multiple.  
In the second method, more attention is paid to the realizable value of the assets with particular emphasis on the net current assets or working capital.
During bear markets, many issues are bargains by this definition. 
Courage to purchase these issues in depressed markets often is later vindicated. 
In any case, bargains can be found in almost all market conditions (except for the highest) due to the market’s vagaries. 
The market often makes mountains out of molehills. 
In addition to currently disappointing results, a lack of interest also can cause an issue to plummet.
Many stocks, however, never recover. 
Determining which stocks have temporary problems from those that have chronic woes is not easy. 
Earnings should be proximately stable for a minimum of 10 years with no earnings deficit in any year
In addition, the firm should have sufficient financial strength to meet future possible setbacks.
Ideally, the large and prominent company should be selling below both its average price and its past average price/earnings multiple. 
This rule usually disqualifies from investment companies like Chrysler, whose low price years are accompanied by high price earnings ratios.  The Chrysler type of roller coaster is not a suitable investment activity.
The easiest value to recognize is one where the firm sells for the price of its net working capital after all long-term obligations.  This means that the buyer pays nothing for fixed assets like buildings and machinery. 
In 1957, 150 common stocks were considered bargain issues.  Of these, 85 issues appeared in the S & P Monthly Guide.  The gain for these issues in two years was 75%, compared to 50% for the S & P industrials.  This constitutes a good investment operation.  During market advances bargain issues are difficult to find.    
Secondary issues, those that are not the largest firms in the most important industries, but that otherwise possess large market positions, may be purchased profitably under the conditions that follow. 
Secondary issues should have a high dividend yield, their reinvested earnings should be substantial compared to their price, and the issues should purchased well below their market highs. 
Regardless of the circumstance, purchasing a firm’s issue prior to its acquisition usually results in a realized gain for the investor.
General Rules for Investment  
The aggressive investor must have a considerable knowledge of security values and must devote enough time to the pursuit as to consider it a business enterprise.  
Those who place themselves in an intermediate category between defensive and aggressive are likely to produce only disappointment.  There is no middle ground. 
Thus, a majority of security owners should position themselves as defensive investors who seek safety, simplicity, and satisfactory results.         
General Rules for Investment
As stated earlier, all investors should avoid purchase at full price of all foreign bonds, ordinary preferred stocks, and secondary issues. 
Full price” is defined to be the fair value of a common stock or the par value of a bond.         
General Rules for Investment
Most secondary issues fluctuate below fair value and only surpass their value in the upper reaches of a bull market. 
Thus, the only logic for owning common secondary issues is that they are purchased far below their worth to a private owner, that is, on a bargain basis. 
In secondary companies, the average common share is worth much less to an outside investor than the share is worth to a controlling owner. 
In any case, the distinction between a primary and secondary issue often is difficult to determine.

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