Sunday, 15 October 2017

Bargain-Issue Pattern in Secondary Companies (1): What led to creating these bargains?

Definition of Secondary Companies

A secondary company is one which is not a leader in a fairly important industry.

It is usually one of the smaller concerns in the field.

It may also equally be the chief unit in an unimportant line.

Any company that has established itself as a growth stock is not ordinarily considered as "secondary" company.

Stock Market's Attitude toward Secondary Companies

(a)  1920

In 1920, 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 dimension.

(b)  Post 1931 -1933 depression

The 1931 - 1933 depression had a particularly devastating impact on companies below the first rank either in size or 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 meant further that in many instances the price has fallen so low as to establish the issue in the bargain class.

No sound rational reasons for rejecting stocks of secondary companies

When investors rejected the stocks of secondary companies, even though these sold at a 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 1999 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, a 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 earning n the whole a fair return on their invested capital.

The stock market's attitude toward secondary companies create instances of major undervaluation.

The stock market's attitude toward secondary companies tends to be unrealistic and consequently to create in normal times innumerable instances of major undervaluation.

As it happens, the war period and the post-war boom were more beneficial to the smaller concerns than to the larger ones, because then the normal competition for sales was suspended and the former could expand sales and profit margins more spectacularly.

  • Thus by 1946 the market's pattern had completely reversed itself.  
  • Whereas the leading stocks in the Dow-Jones Industrial Average had advanced only 40 percent from the end of 1938 to the 1946 high, Standard & Poor's Index of low-priced stocks had shot up no less than 280 per cent in the same period.  
  • Speculators and many self-styled investors - with the proverbial short memories of people in the stock market - were eager to buy both old and new issues of unimportant companies at inflated levels.   

Thus, the pendulum had swung clear to the opposite extreme.

  • The very class of secondary issues which had formerly supplied by far the largest proportion of bargain opportunities was now presenting the greatest number of examples of over-enthusiasm and overvaluation.
  • If past experience can be relied upon, the post-war bull market will itself prove to have created an enlarged crop of bargain opportunities.
  • For in all probability a large proportion of the new common stock offerings of that period will fall into disfavour, and they will join many secondary companies of older vintage in entering the limbo of chronic undervaluation.

The Intelligent Investor
Benjamin Graham

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