Bargain-Issue Pattern in Secondary Companies (2): How to profit from these bargains?

Bargains in stocks of Secondary Companies

If secondary issues tend NORMALLY to be undervalued, what reason has the investor to hope that he can profit by such a situation?

For if this undervaluation persists indefinitely, will he not always be in the same position market wise as when he bought the issue?

The answer here is somewhat complicated.

Substantial profits from the purchase of secondary companies at bargain prices arise in a variety of ways.

1. First, the dividend return is high.
2. Second, the reinvested earnings are substantial in relation to the price paid and will ultimately affect the price.  In a five- to seven-year period these advantages can bulk quite large in a well-selected list.
3. Third, when a bull market appears, it is most generous to low-priced issues; thus it tends to raise the typical bargain issue to at least a reasonable level.
4. Fourth, even during relatively featureless market periods a continuous process of price adjustment goes on, under which secondary issues that were undervalued may rise at least to the normal level for their type of security.

An illustration of performance of undervalued securities (bargains companies)

Performance of two groups of undervalued securities selected at the beginning of 1940.

(Reference:  pp 689 and 690 of Security Analysis, by Graham and Dodd, 1940 Edition)

                                               (Excluding Dividends Received)

                                         Market Price                            Market Price

                                         Dec 31, 1939                           Dec 31, 1947

Group A 

10 Stocks

Total                                 120 5/8                                    449

Group B

10 Stocks     

Total                                  115                                         367 7/8

Total of Both Groups        236                                         817 
                                                                                         INCREASE 246%

Observations and Inferences/Conclusions

This performance is superior not only to that of the Dow-Jones list but to that of the growth-stock list as well.

Allowance should be made for the fact, that nearly all the smaller companies benefited more from the war than did the bigger ones.  

The figures, thus, prove without a doubt that under favourable conditions, bargain issues can yield a handsome profit.

His experience over many years led Benjamin Graham to assert that the average results from this area of activity are satisfactory.