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.
•
