GROWTH STOCK APPROACH

Every investor would like to select a list of securities that will do better than the average over period of years.

A growth stock may be defined as one which has done this in the past and is expected to do so in the future.

[A company with an ordinary record cannot be called a growth company or a "growth stock" merely because its proponent expects it to do better than the average in the future.  It is just a "promising company."]

It seems only logical that the intelligent investor should concentrate upon the selection of growth stocks.

It is mere statistical chore to identify companies that have "outperformed the averages" in the past.

However, investing successfully in them is more complicated.



Two Catches of Growth Stock Investing

Two catches to watch out for in growth investing.

1.  The common stocks with good records and apparently good prospects sell at correspondingly high prices. 

• The investor may be right in his judgement of their prospects and still not fare particularly well, merely because he has paid in full (and perhaps overpaid) for the expected prosperity.

2.  His judgement as to the future may prove wrong. 

• Unusually rapid growth cannot keep up forever; when a company has already registered a brilliant expansion, its very increase in size makes a repetition of its achievement very difficult.  
• At some point the growth curve flattens out, and in many cases it turns downward.

Naturally, the purchase at a time when popular growth stocks were most favoured and active in the market would have had disastrous consequences.

• They were too obvious a choice.  
• Their future was already being paid for in the price.  
• Popular growth stocks may have failed to continue their progress and have even reported downright disappointing results.

How can your investment into growth stocks be protected?

Presumably, it is the function of intelligent investment to overcome these hazards by the exercise of sound judgement and skillful selection.

This is the natural and appropriate endeavour for the enterprising investor.

Benjamin Graham regrets that he has little concrete guidance to offer the enterprising investor in this field.

The exercise of specialized foresight, the weighing of future probabilities and possibilities are not to be learned out of books - nor can they be aided much by suggested rules and techniques.

Elaborate study of the life cycle of industries and discussing a number of "symptoms of decay"; by noticing of which the alert investor may escape out of a once expanding industry before it is too late.

These suggested techniques require more ability and application than most investors can bring to bear on the problem.

[It is debatable whether once an industry has turned downward, it will never recover and that all securities within it must be permanently avoided.]



More guidance on Growth Stock Investing

The stock of a growing company, if purchasable at a suitable price, is obviously preferable to others.

No matter how enthusiastic the investor may feel about the prospects of a particular company, however, he should set a limit upon the price that he is willing to pay for such prospects.

• Such a rule would result at times in the missing of an unusually good opportunity. 
• More often, it would mean the investor's saving himself from "going overboard" on an issue that looked especially good to him and everyone else and consequently was selling much too high.

An illustration of investing in growth stocks

Two highly successful enterprises and both were considered to have excellent prospects of long-term growth.  Both were priced at 22 times that year's earnings.  The average price of Company A in 1939 was 62 and the price of company B in 1939 was 42.  The ordinary investor was as likely to buy one issue as the other.

Company A 's earnings had risen from $2.9 per share in 1939 to $10.90 per share in 1947.  Its price was equivalent to 150 or much more than double its 1939 average.  In the same years, the profits of Company B had moved up from $1.89 to $2.13, in spite of the record prosperity of 1947 and its price had fallen from 42 to 29.


                       Company A        Company B               Company C
                       1939    1947       1939   1947               1939    1947

Price               62         150         42       29                        6      26
Earnings        2.9         10.9      1.89    2.13                  0.13     3.14
P/E                 22                        22


The choice between the attractive issue that turns out well and the one that does poorly is by no means easy to make in the growth-stock field.


At the same time, it might be interesting to add a third pharmaceutical Company C which was by no means well regarded in 1939 - for its average price was only 6 (as against 28 in 1929) and it paid no dividend.  On its past record it could not qualify at all as a growth issue.  Yet in 1947 its earnings were $3.14 per share as against only 13 cents in 1939, and its April price in 1948 had risen to 26 - a much better percentage gain than CompanyA's.

The best opportunity in the field of drug stocks turned out to be where it was least expected - an all too frequent happening.


Inferences from the above illustration for investing in Growth Stocks

• Superior results may be obtained in this field if the choices are competently made.
• Even with careful selection, some of the individual issues may fare relatively poorly.  Some may actually decline and others may have only slight advances
• Thus for good results in the growth stock field there is need not only for skillful analysis but for ample diversification as well.

Summary on investing in Growth Stocks

1. The enterprising investor may properly buy growth stocks.
2. He should beware of paying excessively for them.  He might well limit the price by some practical rule.
3. A growth stock program will not be automatically successful; its outcome will depend on the foresight and judgement of the investor or his advisors rather than on any  clear-cut methods of analysis.

Avoid buying these securities when available at full prices

In selecting investments, in terms of psychology as well as arithmetic, we are guided by three requirements of:

1. underlying safety,
2. simplicity of choice, and
3. promise of  satisfactory results.

Using these criteria has led to the exclusion from the field of recommended investment a number of security classes which are normally regarded as suitable for various kinds of investors.

INVESTMENTS TO AVOID AT FULL PRICES

Advised against the purchase at FULL PRICES of three important categories of securities:

(a) foreign bonds;

(b) ordinary corporate bonds and preferred stocks, under present conditions of relative yield when the best grade issues yield little more than his US Savings Bonds;

(c) secondary common stocks, including, original offerings of such issues.

By full prices, we mean 

• prices close to par for bonds or preferred stocks, and 
• prices that represent about the fair business value of the enterprise in the case of common stocks.

ADVICE FOR DEFENSIVE INVESTORS

The greater number of defensive investors are to avoid these categories REGARDLESS OF PRICE.

ADVICE FOR ENTERPRISING INVESTORS

Enterprising investors are to buy them only when obtainable at BARGAIN PRICES - which is defined as prices not more than two-thirds of the appraisal value of the securities.

REASONINGS

FOREIGN GOVERNMENT BONDS

Why people buy and why they should avoid purchasing foreign Government bonds?  

• They wanted "just a little more income."  The country seemed like a good risk - and that was enough.  The purchasers of the foreign Government bonds must have told themselves that the bonds are practically riskless, presumably on the ground that the country was a far different kind of debtor than other know riskier countries.  
• At times, the buyer was obtaining just a slight percentage more on his money than the yield on AAA corporate bonds - and this hardly enough to warrant the assumption of a recognized risk.  
• By what process of calculation could the buyers of the foreign Government bonds assure themselves that at no time before their maturity date, would that country suffer severe economic, or internal political, or international problems?  Also, the high interest rates themselves helped to make default inevitable, especially in distressed countries offering by high interest on their foreign Government bonds.

CORPORATE BONDS OR PREFERRED STOCKS

How to entice people to buy corporate bonds or preferred stocks?  

          For corporate bonds and preferred stocks to be bought, these would either 

• have to increase their yields so as to offer a reasonable alternative to US Savings Bonds for individual investors or 
• else would be bought solely by financial institutions - insurance companies, savings banks, commercial banks, and the like,  Such institutions have their own justification for buying corporate securities at current yields.

SECONDARY COMMON STOCKS

How and when to buy secondary common stocks?  

• Secondary issues, for the most part, do fluctuate about a central level which is well below their fair value.  They reach and even surpass that value at times; but this occurs in the upper reaches of bull markets, when the lessons of practical experience would argue against the soundness of paying the prevailing prices for common stocks.  The aggressive investor should accept the central market levels which are normal for that class as their guide in fixing own levels for purchase.  Financial history says clearly that the investor may expect satisfactory results, on the average, from secondary common stocks only if he buys them for less than their value to a private owner, that is, on a bargain basis. 
• [There is a paradox here, nevertheless.  The average well-selected secondary company may be fully as promising as the average industrial leader.  What the smaller concern lacks in inherent stability it may readily make up in superior possibilities of growth.  Consequently, it may appear illogical to many readers to term "unintelligent" the purchase of such secondary issues at their full "enterprise value."  ]

Intelligent Investor

Benjamin Graham

Portfolio Policy for the Enterprising Investor

Negative Approach

1. Avoid ordinary corporate bonds as long as the best grade issues yield little more than his US Savings Bonds ("risk free" bonds).
2. Leave high-grade preferred stocks to corporate buyers (they enjoy a tax benefit).
3. Avoid inferior types of bonds and preferred stocks unless they can be bought at a bargain levels (at least 30% under par).
4. Let someone else buy foreign government bond issues, even though the yield may be attractive.
5. Be wary of all kinds of new issues (new bonds, new preferred stocks and new stocks), including convertible bonds and preferreds that seem quite tempting.
6. Be wary of common stocks with excellent earnings confined to the recent past.

The Positive Approach (4 Approaches)

1. Buying in low markets and selling in high markets.
2. Buying carefully chosen "growth stocks".
3. Buying bargain issues of various types.
4. Buying into "special situations".

The Intelligent Investor

Benjamin Graham

DEFENSIVE AND ENTERPRISING INVESTORS

The basic characteristics of an investment portfolio will be determined largely by the position of the individual owner.

• Savings banks, life insurance companies and "legal" trust funds:  High grade bonds and high grade preferred stocks.
• The well to do and experienced businessman, as long as he considers these to be attractive purchases:  Any kind of bond or stock. 

Those who cannot afford to take risks should be content with a low return on their invested funds.





DEFENSIVE AND ENTERPRISING INVESTORS

The general notion is the rate of return which the investor should aim for is more or less proportionate to the degree of risk he is ready to run.

The better view is the rate of return sought should be dependent, rather, on the amount of INTELLIGENT EFFORT the investor is wiling and able to bring to bear on his task.

An intelligent investor is one who is endowed with the capacity for knowledge and understanding.

The minimum return goes to the passive or defensive investor, who wants both safety and freedom from concern.

The maximum return would be realized by the alert and enterprising investor who exercises maximum intelligence and skill.

In many cases, there may be less real risk associated with buying a "bargain issue" offering the chance of a large profit than with a conventional bond purchase yielding under 3 per cent.

The kinds of investments that are suitable for  defensive and enterprising investors

A.  The defensive investor will buy:
1.  US Savings Bonds (and/or tax-exempt securities)
2.  A diversified list of leading common stocks, at prices that seem reasonable in the light of past market experience - or
2a.  Shares of leading investment funds

B.  The enterprising investor will buy:
1, 2, 2a.   As above
3.  Growth stocks, but with caution.
4.  Also, or alternatively, representative common stocks when the general market is historically low
5.  Secondary common stocks, corporate bonds and preferred stocks at bargain levels.
6.  Some exceptional convertible issues, even at full prices.


There are important categories of securities which the intelligent individual investor will not buy.  These are as follows:

1.  Investment-grade corporate bonds and preferred stocks when their current yields are lower or only slightly higher than US Savings bonds or foreign government issues at full prices.
2.  Leading common stocks when the market is at high levels as judged by past experience.
3.  Secondary common stocks, except at tempting low prices.
4.  As a corollary of 3, he will not buy new issues of common stocks, with infrequent exceptions.  (This does not refer to the exercise of subscription rights on leading issues.)


The intelligent investors should not support new security financing except on terms which offer them proportionately as attractive a combination of income and safety as is obtainable by the purchase of US Savings Bonds plus common stocks of leading corporations at normal market prices.


The Intelligent Investor
Benjamin Graham

Are you an intelligent investor? What does intelligent means in investing?

Benjamin Graham

Intelligent investor:  this is an investor "endowed with the capacity for knowledge and understanding."

Intelligent here is not to be taken to mean "smart" or "shrewd" or gifted with unusual foresight or insight.  

The intelligence here presupposed is a trait more of the character than of the brain.



Defensive investor

For example, a widow who must live on the money left her.

Her chief emphasis will be on the avoidance of any serious mistakes or losses, in the sense of conserving capital.

Her second aim will be freedom from effort, annoyance and the need for frequent decisions.

A woman in this position, with substantial funds, will not be satisfied to leave her financial affairs entirely in the hands of others.

She will want to understand - at least in general terms - what is being done with her money and why.

She will probably want to participate to the extent of approving the broad policy of investment, of keeping track of its results and of judging independently whether or not she is being competently advised.

This will be equally true of men who wish to throw the major burden of their investment operations on the shoulders of others.

For all these defensive investors, intelligent action will mean largely the exercise of firmness in the application of relatively simple principles of sound procedure.



Enterprising investor

These are not distinguished from the others by their willingness to take risks - for in that case they should be called speculators.

Their determining trait is rather their willingness to devote time and care to the selection of sound and attractive investments.  

It is not suggested that the enterprising investor must be a fully-trained expert in the field.

He may derive his information and ideas from others, particularly from security analysts.

But the decisions will be his own and in the last reckoning he must rely upon his own understanding and judgment.

The first rule of intelligent action by the enterprising investor must be that he will never embark on a security purchase which he does not fully comprehend and which he cannot justify by reference to the results of his personal study or experience.

Portfolio Policy for the Enterprising Investor (Benjamin Graham)

The activities characteristics of the enterprising investor may be classified under four heads:

1.  Buying in low market and selling in high markets
2.  Buying carefully chosen "growth stocks"
3.  Buying bargain issues of various types
4.  Buying into "special situations"

Benjamin Graham
The Intelligent Investor

Quote 

"The purpose of this book is to supply, in a form suitable for laymen, guidance in the adoption of an investment policy.  Comparatively little will be said here about the technique of analysing securities; attention will be paid chiefly to investment principles and investors' attitudes."

"That risk cannot be avoided.  But by bearing it clearly in mind we may succeed in reducing it." 

 Related:

### Attractive Buying Opportunities arise through a Variety of Causes

Most security buyers obtain advice without paying for it specifically. You and your financial advisors..

Most security buyers obtain advice without paying for it specifically.

They should be wary of all persons, whether customers' brokers or security salesmen, who promise spectacular income or profits.

This applies both to the selection of securities and to guidance in the elusive art of trading in the market.



For defensive investors

Defensive investors, as we have defined them, will not ordinarily be equipped to pass independent judgement on the security recommendations made by their advisers.

But they can be explicit - and even repetitiously so - in stating the kind of securities they want to buy.

If they follow our prescription, they will confine themselves to US Savings Bonds and the common stocks of leading corporations purchased at levels that are not high in the light of experience and analysis.

The security analyst of any reputable stock exchange house can make up a suitable list of such common stocks and can certify to the investor whether or not the existing price level is a reasonably conservative one as judged by past experience.



For aggressive investors

The aggressive investor will ordinarily work in active co-operation with his advisers.

He will want their recommendations explained in detail and he will insist on passing his own judgment upon them.

This means that the investor will gear his expectations and the character of his security operations to the development of his own knowledge and experience in the field.  

Only in the exceptional case, where the integrity and competence of the advisers have been thoroughly demonstrated, should the investor act upon the advice of others without understanding and approving the decision made.  

The relationship between the investment banker and the investor

Investment Bankers

The term "investment banker" is applied to a firm which engages to an important extent in originating, underwriting, and selling new issues of stocks and bonds.  (To underwrite means to guarantee to the issuing corporation or other issuer, that the security will be fully sold.)

Much of the theoretical justification for maintaining active stock markets, notwithstanding their frequent speculative excesses, lies in the fact that organized security exchanges facilitate the sale of new issues of bonds and stocks.  

The relationship between the investment banker and the investor is basically that of the salesman to the prospective buyer.



The investment banker and the financial institutions (banks and insurance companies)

For many years the great bulk of the new offerings has consisted of bond issues which were purchased in the main by financial institutions such as banks and insurance companies.  

In this business the security salesmen have been dealing with shrewd and experienced buyers.  

Hence any recommendations made by the investment bankers to these customers has had to pass careful and skeptical scrutiny.

Thus these transactions are almost always effected on a businesslike footing.  



The investment banker and the individual security buyer

But a different situation obtains in the relationship between the individual security buyer and the investment banking firms, including the stockbrokers acting as underwriters.

Here the purchaser is frequently inexperienced and seldom shrewd.

He is easily influenced by what the salesman tells him, especially in the case of common-stock issues, since often his unconfessed desire in buying is chiefly to make a quick profit.  

The effect of all this is that the public investor's protection lies less in his own critical faulty than in the scruples and ethics of the offering houses.  

It is a tribute to the honesty and competence of the underwriting firms that they are able to combine fairly well the discordant roles of adviser and salesman.

But it is imprudent for the buyer to trust himself to the judgment of the seller.

The bad results of this unsound attitude show themselves recurrently in the underwriting field and with notable effect in the sale of new common-stock issues during periods of active speculation.

The intelligent investor will pay attention to the advice and recommendations received from investment banking houses, especially those known to him to have an excellent reputation; but he will be sure to bring sound and independent judgment to bear upon these suggestions - either his own, if he is competent, or that of some other type of adviser.



Benjamin Graham
Intelligent Investor

Broader implications of adopting a sound investment policy

Investment policy, as it has been developed and taught by Benjamin Graham, depends in the first place upon a choice by the investor of either the defensive (passive) or aggressive (enterprising) role.

The aggressive investor must have a considerable knowledge of security values - enough, in fact, to warrant viewing his security operations as equivalent to a business enterprise.  

There is no room in this philosophy for a middle ground, or a series of gradations, between the passive and aggressive status.

Many, perhaps most, investors seek to place themselves in such an intermediate category; in our opinion that is a compromise that is more likely to produce disappointment than achievement.

It follows from this reasoning that the majority of security owners should elect the defensive classification.

• They do not have the time, or the determination, or the mental equipment to embark upon investing as a quasi business.   
• They should therefore be satisfied with the reasonably good return obtainable from a defensive portfolio, and they should stoutly resist the recurrent temptation to increase this return by deviating into other paths.

The enterprising investor may properly embark upon any security operation for which his training and judgement are adequate and which appears sufficiently promising when measured by established business standards.


Benjamin Graham
The Intelligent Investor

Benjamin Graham's Intelligent Investor - What the Enterprising Investor should Buy

Portfolio Policy for the Enterprising Investor - the Positive Side

•

•Selection of Bonds 

•In addition to the US Bonds described in previous chapters, US guaranteed bonds like “New Housing Authority Bonds” and “New Community Bonds” (both of which were widely available in 1972), as well as tax free municipal bonds serviced by lease payments of A rated corporations, are good investments. 

•

•Selection of Bonds 

•Lower quality bonds may be attainable at true bargains in “special situations”, however these have characteristics that are more similar to common stocks.

•

•Selection of Stocks

•The enterprising investor usually conducts 4 activities:

1.      Buying in low markets and selling in high markets.

2.      Buying carefully chosen growth stocks.

3.      Buying bargain issues.

4.      Buying into “special situations”.

•

•1.      Market timing - This is a difficult proposition at best.  Market timing is more of a speculative activity.

•

•2.      Growth Stocks – This also is difficult.  These issues are already fully priced.  In fact, their growth may cease at any time.  As a firm grows, its very size inhibits further growth at the same rate.  Therefore, the investor risks not only overpaying for growth stocks, but also choosing the wrong ones.  In fact, the average growth fund does not fair much better than the indexes.  Also, growth stocks fluctuate widely in price over time, which introduces a speculative element.  The more enthusiastic the public becomes, the more speculative the stock becomes as its price rises in comparison to the firm’s earnings.

•

•3.      Special Situations – This is a specialty field that includes workouts in bankruptcy and risk arbitrage arising from mergers and acquisitions.  However, since the 1970s, this field has become increasingly risky with available returns less than were previously realizable.  In addition, this field requires a special mentality as well as special equipment.  Thus, to the common investor, this area is highly speculative.

•

•4.      Bargain Issues – This is the area in which the common investor has the enterprising investor has the greatest chance for long term success. 

•

•The market often undervalues large companies undergoing short-term adversity. 

•The market also will undervalue small firms in similar circumstances. 

•Large firms generally possess the capital and intellectual resources necessary to carry the firm through adversity; plus, the market recognizes the recovery of large firms faster than it does for small firms.  

•Small firms are more likely to lose profitability that is never to be regained, and when earnings do improve, they may go unnoticed by the market.

•

•One way to profit from this strategy is to purchase those issues of the DJIA that have either the highest dividend yields or the lowest earnings multiples. 

•The investment returns using this method should result in a return approximately 50% better than purchasing equal amounts of all 30 DJIA issues.  

•This is a sound starting point for the enterprising investor.

•

•Caution must be paid not to purchase companies that are inherently speculative due to economic swings, such as the Big 3 automakers. 

•These firms have high prices and low multipliers in their good years, and low prices and high multipliers in their bad years.  

•When earnings are significantly low, the P/E is high to adjust for the underlying value of the firm during all economic periods.  

•To avoid this mistake, the stock selected should have a low price in reference to past average earnings.  

•

•Bargain issues are defined as those that worth considerably more than their market price based upon a thorough analysis of the facts.  

•To be a true bargain, an issue’s price must be at least 50% below its real value. 

•This includes bonds and preferred stocks when they sell far under par. 

•

•

•There are two ways to determine the true value of a stock. 

•Both methods rely upon estimating future earnings. 

•

•In the first method, the cumulative future earnings are discounted at an appropriate discount rate, or in the alternative, the earnings are multiplied by an appropriate p/e multiple.  

•

•

•In the second method, more attention is paid to the realizable value of the assets with particular emphasis on the net current assets or working capital.

•

•

•During bear markets, many issues are bargains by this definition. 

•Courage to purchase these issues in depressed markets often is later vindicated. 

•In any case, bargains can be found in almost all market conditions (except for the highest) due to the market’s vagaries. 

•The market often makes mountains out of molehills. 

•In addition to currently disappointing results, a lack of interest also can cause an issue to plummet.

•

•

•Many stocks, however, never recover. 

•Determining which stocks have temporary problems from those that have chronic woes is not easy. 

•

•Earnings should be proximately stable for a minimum of 10 years with no earnings deficit in any year. 

•In addition, the firm should have sufficient financial strength to meet future possible setbacks.

•

•Ideally, the large and prominent company should be selling below both its average price and its past average price/earnings multiple. 

•This rule usually disqualifies from investment companies like Chrysler, whose low price years are accompanied by high price earnings ratios.  The Chrysler type of roller coaster is not a suitable investment activity.

•

•

•The easiest value to recognize is one where the firm sells for the price of its net working capital after all long-term obligations.  This means that the buyer pays nothing for fixed assets like buildings and machinery. 

•

•In 1957, 150 common stocks were considered bargain issues.  Of these, 85 issues appeared in the S & P Monthly Guide.  The gain for these issues in two years was 75%, compared to 50% for the S & P industrials.  This constitutes a good investment operation.  During market advances bargain issues are difficult to find.    

•

•Secondary issues, those that are not the largest firms in the most important industries, but that otherwise possess large market positions, may be purchased profitably under the conditions that follow. 

•Secondary issues should have a high dividend yield, their reinvested earnings should be substantial compared to their price, and the issues should purchased well below their market highs. 

•Regardless of the circumstance, purchasing a firm’s issue prior to its acquisition usually results in a realized gain for the investor.

•

•General Rules for Investment  

•The aggressive investor must have a considerable knowledge of security values and must devote enough time to the pursuit as to consider it a business enterprise.  

•Those who place themselves in an intermediate category between defensive and aggressive are likely to produce only disappointment.  There is no middle ground. 

•Thus, a majority of security owners should position themselves as defensive investors who seek safety, simplicity, and satisfactory results.         

•

•General Rules for Investment

•As stated earlier, all investors should avoid purchase at full price of all foreign bonds, ordinary preferred stocks, and secondary issues. 

•“Full price” is defined to be the fair value of a common stock or the par value of a bond.         

•

•General Rules for Investment

•Most secondary issues fluctuate below fair value and only surpass their value in the upper reaches of a bull market. 

•Thus, the only logic for owning common secondary issues is that they are purchased far below their worth to a private owner, that is, on a bargain basis. 

•In secondary companies, the average common share is worth much less to an outside investor than the share is worth to a controlling owner. 

•In any case, the distinction between a primary and secondary issue often is difficult to determine.

•

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.

•

•

What is Investing?

Graham, Chapter 1: 

Graham lays out his definition of investing right from the start of this chapter. His description is "an investment operation is one which, upon thorough analysis promises safety of principal and an adequate return" (p. 18). He labels anything not meeting these standards as speculation. 

Graham then describes two different approaches to investing: defensive and aggressive. 

Obviously, safety is a big concern for the defensive investor, and that shows in his example of putting half of your money in stocks and half in bonds. He lists other approaches of defensive investing, like investing only in well established companies, and dollar-cost averaging. 

Graham's take on aggressive investing isn't as kind. The three types of the aggressive approach (trading the market, short-term selectivity, and long-term selectivity) are all considered to have less profitability. This is explained by the possibility of the aggressive investor being wrong on his or her market timing.

The Intelligent Investor by Benjamin Graham

Related:

Investment, speculation and gambling

The Intelligent Investor: The Defensive Investor and Common Stocks

The Intelligent Investor: General Portfolio Policy for the Defensive Investor

The Intelligent Investor: The Positive Side to Portfolio Policy for the Enterprising Investor

The Intelligent Investor: A Negative Approach to Portfolio Policy for the Enterprising Investor

Investment Policies (Based on Benjamin Graham)

Graham separates Intelligent Investors into two camps: Defensive and Enterprising

Graham also goes on to separate intelligent investors into two camps:

• Defensive Investor: One who wants safety and less involvement
• Enterprising Investor: One who wants higher returns that he/she is willing to work for

In contrast to the conventional view, an enterprising investor is not one who is more risky or aggressive; instead, it is one who has an interest in investing and is willing to work hard for it. I think it is important for investors to figure out which category they fall into. 

Most people fall into the “defensive investor” category.  Graham provides examples such as::

•  a widow who cannot afford unnecessary risks, 
• a physician who cannot devote the time for proper analysis, and 
• a young man whose small investment will not return enough gain to justify the extra effort. 

The beginning investor should not try to beat the market.

The investor only realizes a loss in value through the sale of the asset or the significant deterioration of the firm’s underlying value.  Careful selection and diversification helps to avoid these risks.  

A more common and difficult problem is overpaying for securities; that is, paying more for a security than its intrinsic value warrants.