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.

Intrinsic Value of Preferred Stock

1.  When preferred stock is non-callable, non-convertible, has no maturity date and pays dividends at a fixed rate, the value of the preferred stock can be calculated using the perpetuity formula:

V = D/r

V = value
D = dividend
r = required rate of return




2.  For a non-callable, non-convertible preferred stock with maturity at time, n, the value of the stock can be calculated using another formula.

Value
= PV of Dividends received + PV of Final Selling Price of Preferred Stock
= D1/(1+r)^1 + D2/(1+r)^2 + ....... + F/(1+r)^n




http://www.investopedia.com/articles/fundamental-analysis/11/valuation-prefered-stock.asp

Risks of Equity Securities

Preference shares are less risky than common shares.

Putable common shares are less risky than callable or non-callable common shares.

Callable common and callable preference shares are more risky than their non-callable counterparts.

Cumulative preference shares are less risky than non-cumulative preference shares as they accrue unpaid dividends.



Risks (> = more risky than)

Common shares  >  Preference shares

Callable or non-callable common shares > Putable common shares

Callable common stocks > Non-callable common stocks

Callable preference shares > Non-callable preference shares

 Non-cumulative preference shares > Cumulative preference shares

Margin of Safety Concept in Bonds and Preferred Stocks (Fixed Value Investments)

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.”  Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy—often explicitly, sometimes in a less direct fashion. Let us try now, briefly, to trace that idea in a connected argument.

All experienced investors recognize that the margin-of-safety concept is essential to the choice of sound bonds and preferred stocks. 

For example, a railroad should have earned its total fixed charges better than five times (before income tax), taking a period of years, for its bonds to qualify as investment-grade issues. 

• This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income. 
• (The margin above charges may be stated in other ways — for example, in the percentage by which revenues or profits may decline before the balance after interest disappears—but the underlying idea remains the same.)
• The bond investor does not expect future average earnings to work out the same as in the past; if he were sure of that, the margin demanded might be small. 
• Nor does he rely to any controlling extent on his judgment as to whether future earnings will be materially better or poorer than in the past, if he did that, he would have to measure his margin in terms of a carefully projected income account, instead of emphasizing the margin shown in the past record. 
• Here the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. 
• If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.

The margin of safety for bonds may be calculated, alternatively, by comparing the total value of the enterprise with the amount of debt. (A similar calculation may be made for a preferred-stock issue.) 

• If the business owes $10 million and is fairly worth $30 million, there is room for a shrinkage of two-thirds in value—at least theoretically—before the bondholders will suffer loss. 
• The amount of this extra value, or “cushion,” above the debt may be approximated by using the average market price of the junior stock issues over a period of years. 
• Since average stock prices are generally related to average earning power, the margin of “enterprise value” over debt and the margin of earnings over charges will in most cases yield similar results.

So much for the margin-of-safety concept as applied to “fixed value investments.” Can it be carried over into the field of common stocks? Yes, but with some necessary modifications.

Ref:  The Intelligent Investor by Benjamin Graham

CHAPTER 20 “Margin of Safety” as the Central Concept of Investment




Also read:

• Margin of Safety Concept in The Business Venture of Buying and Selling Stocks
• Margin of Safety Concept in Conventional and Unconventional Investments
• Margin of Safety Concept in Speculation and Investment
• Margin of Safety Concept in Diversification
• Margin of Safety Concept in Undervalued or Bargain Stockss
• Margin of Safety Concept in Growth Stocks
• Margin of Safety in Good-Quality and Low-Quality Stocks.
• Margin of Safety Concept in Common Stocks
• Margin of Safety Concept in Bonds and Preferred Stocks
• 
  

The Benefits and Drawbacks of Preferred Stock Investing

The Benefits and Drawbacks of Preferred Stock Investing
BY STOCK RESEARCH PRO • MAY 8TH, 2009

Some companies issue two types of stock: common and preferred stock. While each offers a portion of ownership in the company, there are significant differences between the two. Preferred stock is often seen as a hybrid instrument; a mix between a stock and a bond. Although preferred stock is an equity security, it has many characteristics that are similar to a debt instrument.

Why Companies Offer Preferred Stock
For the issuing company, preferred stock can be easier to market than common stock as most holders of preferred shares tend to be bond institutional investors. This is due to tax law that enables U.S. corporations that pay income taxes to exclude a large portion (70%) of their dividend income from taxable income. Additionally, if cash flow problems arise for the issuing company, they may suspend dividend payments to preferred shareholders.

Even so, the amount of preferred stock issued by a company usually represents a very small percentage of its funding (compared to common stock and debt).

Unique Features of Preferred Stock
The following is a list of common characteristics of preferred stock:
Redeemable: A preferred stock is said to be redeemable or “callable” in that the company that issues the shares reserves the right to redeem them at a pre-determined price and its own discretion.
Participating: This feature enables preferred share holders to participate in the dividends to common shareholders, usually at a pre-determined rate.
Convertible: The convertible option provides preferred shareholders with the option of converting preferred stock to common stock.
Cumulative: Under the cumulative feature, if the company fails to pay its dividend to preferred shareholders, it must make up the dividend before any dividends can be paid to common shareholders.

The Benefits of Preferred Stock Investing for Individuals
The fact that individuals do not enjoy the same tax advantages as corporations should not preclude them from considering investment in preferred stock. Some of the benefits of preferred stock investing for individual investors include:
• Greater price stability and payment priority (of both dividends and liquation proceeds) than common stock holders
• Greater liquidity than many bond holdings
• Relatively low investment per share

The Potential Downside to Investing in Preferred Stock
The “callability” and limited upside potential are the two negative factors most often referenced for preferred stock. Additionally, preferred shareholders do not receive voting rights and, like bond holders, are exposed to interest rate changes.


http://www.stockresearchpro.com/the-benefits-and-drawbacks-of-preferred-stock-investing

Bullbear Stock Investing Notes
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