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.
•
•
