Monday, 25 March 2013

The Intelligent Investor by Benjamin Graham: What the Enterprising Investor should Avoid.

Portfolio Policy for the Enterprising Investor – the Negative Side
What to Avoid
The aggressive investor should start with the same base as the defensive investor, dividing the portfolio more or less equally between stocks and bonds. 
What to Avoid
To avoid losses or returns lower than that of the defensive investor, the aggressive investor should steer clear of the following pitfalls:
1.      Avoid all preferred stocks.  Preferred stock rarely possesses upside component that is the basis for owning common stock. Yet compared to debt, preferred stock affords little protection.  Since dividends can be suspended at anytime, unlike debt, why not just own debt instead? 
2.      Avoid inferior (“high yield” or “junk”) bonds unless such bonds are purchased at least 30% below their par value for high coupon issues, or 50% below par value for other issues.  The risk of these issues is rarely worth the interest premium that they offer.
3.      Avoid all new issues.
4.      Avoid firms with “excellent” earnings limited to the recent past.
Quality bonds should have “Times Interest Earned” ratio, that is EBIT/net interest, of at least 5x
Preferred stocks, convertible bonds, and other high yield or “junk” bonds often trade significantly below par during their issue, so purchasing them at par is unwise.
During economic downturns, lower quality bonds and preferred stocks often experience “severe sinking spells” where they trade below 70% of their par value.
For the minor advantage in annual income of 1%-2%, the buyer risks losing a substantial amount of capital, which is bad business. 
Yet purchasing these issues at par value provides no ability to achieve capital gains.
Therefore, unless second grade bonds can be purchased at a substantial discount, they are bad deals!
Foreign Government Bonds are worse than domestic high yield junk, for the owner of foreign obligations has no legal or other means of enforcing their claims. 
This has been true since 1914.  
Foreign bonds should be avoided at all costs.
Investors should be wary of all new issues.  
New issues are best left for speculators
In addition to the usual risks, new issues have salesmanship behind them, which artificially raises the price and requires an additional level of resistance. 
Aversion becomes paramount as the quality of these issues decrease.
During favorable periods, many firms trade in their debt for new bonds with lower coupons. 
This inevitably results in too high a price paid for these new issues, which then experience significant declines in principal value.
Common stock issues take two forms - - those that are already traded publicly (secondary issues) and those that are not already traded publicly (IPOs). 
Stock that is already publicly traded does not ordinarily call for active selling by investment houses, whereas the issue of new stock requires an active selling effort. 
Most new issues are sold for account of the controlling interests, which allows them to cash-in their equity during the next several years and to diversify their own finances.
Not only does danger arise from the poor character of businesses brought public, but also from the favorable market conditions that permit initial public offerings.
New issues during a bull market usually follow the same cycle. 
As a bull market is established, new issues are brought public at reasonable prices, from which adequate profits may be made. 
As the market rise continues, the quality of new issues wanes. 
In fact, one important signal of a market downturn is that new common stocks of small, nondescript firms are offered at prices higher than the current level for those of medium sizes with long market histories.
In many cases, new issues of common stock lose 75% or more of their initial value
Thus, the investor should avoid new issues and their salespeople. 
These issues may be excellent values several years after their initial offering, but that will be when nobody else wants them.

No comments: