Friday, 16 January 2015

Purchase of Bargain Issues

We define a bargain issue as one which, on the basis of facts established by analysis, appears to be worth considerably more than it is selling for.

The genus includes bonds and preferred stocks selling well under par, as well as common stocks.

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.

What kind of facts would warrant the conclusion that so great a discrepancy exists?

How do bargains come into existence, and how does the investor profit from them?

There are two tests by which a bargain common stock is detected.

The first is by our method of appraisal.  This relies largely on estimating future earnings and then multiplying these by a factor appropriate to the particular issue.

The second 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.

Courage in depressed markets

At low point in the general market a large proportion of common stocks are bargain issues, as measured by these standards.

It is true that current earnings and the immediate prospects may both be poor, but a level-headed appraisal of average future conditions would indicate values far above ruling prices. 

Thus the wisdom of having courage in depressed markets is vindicated not only by the voice of experience but also by application of plausible techniques of value analysis.

The same vagaries of the marketplace which recurrently establish a bargain condition in the general list account for the existence of many individual bargains at almost all market levels.

The market is always 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 two major sources of undervaluation:  (a) currently disappointing results, and (b) protracted neglect or unpopularity.

The private-owner test

The private-owner test would ordinarily start with the net worth as shown in the balance sheet.  The question then arises as to whether the indicated earning power is sufficient to validate the net worth as a measure of what a private buyer would be justified in paying for the business as a whole.

If the answer is definitely yes, we suggest that an ordinary investor should find the common stock attractive at a price one-third or more below such a figure.

If instead of using all the net worth as a starting point the investor considered only the working capital and applied his test to that, he would have a more convincing demonstration of the existence of a bargain opportunity.

For it is something of an axiom that a business is worth to any private owner at least the amount of its working capital, since it could ordinarily be sold or liquidated for more than this figure.

Hence, if a common stock can be bought at no more than two-thirds of the working -capital value alone- disregarding all the other assets - and if the earnings record and prospects are reasonably satisfactory, there is strong reason to believe that the investor is getting substantially more than his money's worth.

Benjamin Graham
The Intelligent Investor

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