Friday, 16 January 2015

Bargain-issue pattern in Secondary Companies

We have defined a secondary company as one which is not a leader in a fairly important industry.

Thus, it is usually one of the smaller concerns in its field, but it may equally well be the chief unit in an unimportant line.

By way of exception, any company that has established itself as a growth stock is not ordinarily considered as "secondary."

In the 1920's 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 for really spectacular expansion than one which was already of major dimensions.

The 1931-33 depression

The 1931-33 depression, however, had a particularly devastating impact on 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 in the ordinary company of secondary importance.  

This has meant that the latter group has usually sold at much lower prices in relation to earnings and assets than have the former.

It has also meant further that in many instances the price has fallen so low as to establish the issue in the bargain class.

When investors rejected the stocks of secondary companies, even though these sold at relatively low prices, they were expressing a belief or fear that such companies faced a dismal future.

In fact, at least subconsciously, they calculated that any price was too high for them because  they were heading for extinction - just as in 1929 the companion theory for the "blue chips" was that no price was too high for them because their future possibilities were limitless.

Both of these views were exaggerations and were productive of serious investment errors.

Actually, the typical middle-sized listed company is a large one when compared with the average privately-owned business.

There is no sound reason why such companies should not continue indefinitely in operation, undergoing the vicissitudes characteristic of our economy but earnings on the whole a fair return on their invested capital.  

This brief review indicates that the stock market's attitude toward secondary companies tends to be unrealistic and consequently to create in normal times innumerable instances of major undervaluation.

Benjamin Graham
The Intelligent Investor

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