Benjamin Graham

Chapter 6 – Portfolio Policy for the Enterprising Investor: Negative Approach

Summary and Discussion – Chapter 6 – Portfolio Policy for the Enterprising Investor: Negative Approach
Notes on The Intelligent Investor by Benjamin Graham
Notes by Jason Fernando
Created December 3rd, 2013
Last updated December 6th, 2013
Reference document: Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003.

50-Word Recap

  • Preferred stocks, low-grade bonds, foreign-government bonds and IPOs should be ignored under most or all conditions.
  • Don’t chase yields, meaning: don’t purchase a given security simply because of the attractive interest payments which they provide.
  • Preservation of capital is of paramount importance.

Graham begins this chapter by noting that, given the extensive range of potential avenues available to the “enterprising investor” (meaning, the investor who has the time, temperament, and inclination to pursue intelligent investments that go above and beyond the tried and true defensive approach expressed in the previous chapters), it is easier to define what one ought not to do. Hence the following prohibitions: [1]

    • No high-grade preferred stocks.
  • No low-grade preferred stocks, “unless they can be bought at bargain levels”.
      • By “bargain levels”, Graham means “at prices at least 30% under par” for low-grade preferred stocks paying above-average dividends. Higher prices (though still under par) can be tolerated provided that the dividend paid by the preferred stocks in question are lower than their above-average counterparts. [2]
  • No low-grade bonds, “unless they can be bought at bargain levels”.
      • By “bargain levels”, Graham means “at prices at least 30% under par” for bonds paying above-average interest rates. Higher prices (though still under par) can be tolerated provided that the interest paid by the bonds in question are lower than their above-average counterparts. [3]
  • No “foreign-government bond issues, even though the yield may be attractive.”
  • No “new issues, including convertible bonds and [preferred stocks] that seem quite tempting and common stocks with excellent earnings confined to the recent past.”
    • Note that this prohibition expressly forbids investment in so-called “IPOs” (“initial public offerings”) of which companies such as Facebook and Twitter are but recent examples. [4]

Second-Grade Bonds and Preferred Stocks

A dangerous trap for investors to fall into concerns the apparent attractiveness of high-yielding “secondary grade” bonds. The term “secondary” here denotes that the bonds are of inferior quality to their “high-grade” counterparts. Examples of “high-grade” bonds include those offered directly by the U.S. government, the most notable being U.S. Treasury Bonds. Examples of “secondary” or “low-grade” bonds are less standardized, but they are often found offered by corporations and/or state or municipal governments with less than sterling financial conditions. The higher yield offered on these bonds is a function of market participants’ demands to be compensated for the (perceived) risk of owning said bonds, relative to their “high-grade” counterparts.

Graham cautions against the misguided (though all too common) practice of buying “secondary” / “low-grade” bonds merely for the heightened interest payments which they provide:

“Experience clearly shows that it is unwise to buy a bond or a preferred [stock] which lacks adequate safety simply because the yield is attractive. (Here the word “merely” imples that the issue is not selling at a large discount and thus does not offer an opportunity for a substantial gain in principal value.) Where such securities are bought at full prices—that is, not many points under 100 [meaning, 100% of its principal value]—the chances are very great that at some future time the holder will see much lower quotations [by “quotations”, Graham means the price at which the investor can sell the bond].” [5]

Market participants have a tendency to reactionarily sell low-quality investments such as low-grade bonds in the event of a general market decline. This constitutes an additional risk of which prospective purchasers of said bonds must be aware. Its principal implication is that such bonds are at risk of being sold with exaggerated urgency in the event of a general market decline. Conversely, it is precisely under those exaggerated conditions which an investor would be wise to survey the low-grade bond market in search of bonds trading significantly under their principal value. Needless to say, in doing so one would nevertheless always be mindful of the risk of default associated with such bonds.

Graham neatly illustrates his investment logic regarding bonds, as follows:

“It is bad business to accept an acknowledged possibility of a loss of principal in exchange for a mere 1 or 2% of additional yearly income. If you are willing to assume some risk you should be certain that you can realize a really substantial gain in principal value if things go well. Hence a second-grade 5.5 or 6% bond selling at part [meaning, at 100% of its principal value] is almost always a bad purchase. The same issue at 70 [meaning, at 70% of its principal value] might make more sense—and if you are patient you will probably be able to buy it at that level.” [6]

Graham ends his discussion of low-grade bonds and preferred stock by noting that, although an investor might hypothetically be able to “come out alright” by purchasing such securities, this is contingent on her ability to hold these securities throughout the rousing declines which will invariably eventually occur, and to in fact add to her position in those securities during the trough of those declines. This kind of psychological discipline is exceedingly rare, being contrary to our typical instincts. This reason alone is sufficient to justify ruling out such purchases on the part of all but the most psychologically disciplined investors.

Foreign Government Bonds [7]

One of the principal problems with purchasing foreign government bonds is that the purchaser does not have any legal recourse in the event that the issuing government defaults on said bonds.

New Issues Generally [8]

Graham’s commentary on this point is worth including verbatim:

“There are two reasons for [our recommendation that new issues/IPOs, while potentially attractive, are nonetheless worth subjecting to closer examination and scrutiny than other classes of investment]. The first is that new issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance. The second is that most new issues are sold under “favorable market conditions”—which means favorable for the seller and consequently less favorable for the buyer.” [9]

This prescient observation bears an important implication, which is that periods during which new issues / IPOs are especially frequentare a likely indication that the market is reaching its peak. More specifically, it is a likely indication that Wall Street has come to the conclusion that the market is trading at or near a high-point in prices. Therefore, investors should be wary of participating in new issues if for no other reason than the high likelihood that they will pay too elevated a price for their shares.

Graham notes that low-quality “issues” (meaning, companies) generally carry increased risk relative to their high-quality counterparts, and for two reasons: First, such companies are by definition in a questionable financial condition. Many recent IPOs, such as the social networking companies Twitter, Facebook, and Zynga, have earnings records that are dubious and recent (if they exist at all!). Second, such companies are sold more aggressively than others and to a less experienced audience. If you are swayed by the marketing push which accompanies a questionable new issue, it is likely that you fall into the category of impressionable and inexperienced investors upon whom Wall Street focuses its sales of low-quality issues. Be wary of this pitch; it serves the interests of Wall Street and the companies on issue, but never that of the unwitting purchaser.

New Common-Stock Offerings 

A footnote to page 142 written by Jason Zweig is worth repeating:

“In Graham’s day, the most prestigious investment banks generally steered clear of the IPO business, which was regarded as an undignified exploitation of naïve investors. By the peak of the IPO boom in late 1999 and early 2000, however, Wall Street’s biggest investment banks had jumped in which both feet. Venerable firms cast off their traditional prudence and behaved like drunken mud wrestlers, scrambling to foist ludicrously overvalued stocks on a desperately eager public. Graham’s description of how the IPO process works is a classic that should be required reading in investment-banking ethics classes, if there are any.”

The description which Zweig refers to can be summarized in the following diagram, which I refer to as the “life cycle” of the IPO market:

IPO Market Cycle

It would, of course, be profitable to purchase some shares of IPOs provided that they are purchased at the right time and for the right price. Needless to say, timing the market in this manner is next to impossible on any ad-hoc basis, and fully impossible on a consistent basis. Nonetheless, for those investors who are inclined to roll the dice of the IPO market, Graham offers the following recommendations:

    1. If you can, aim for the middle: “Somewhere in the middle of the bull market the first common-stock flotations [the term “flotations” here is synonymous with the term “issues”; he is referring the companies’ stocks newly listed on the exchange] make their appearance. These are priced not unattractively, and some large profits can be made by the buyers of the early issues.” [10]
  • Keep your eye on the exit: “One fairly dependable sign of the approaching end of a bull swing is the fact that the new common stocks of small and nondescript companies are offered at prices somewhat higher than the current level for many medium-sized companies with a long market history.”
  • Get out while you can: “The heedlessness of the public and the willingness of selling organizations to sell whatever may be profitably sold can have only one result—price collapse. In many cases the new issues lose 75% or more of their offering price [meaning, the price at which they are initially sold—or “offered”—to the public]. The situation is worsened by the aforementioned fact that, at bottom, the public has a real aversion to the very kind of small issue that it bought so readily in its careless moments.”
  • Slow and steady wins the race: “Many [IPO] issues fall, proportionately, as much below their true value as they formerly sold above it.” Therefore, “[s]ome of these issues may prove excellent buys—a few years later, when nobody wants them and they can be had at a small fraction of their true worth.” [11]

That last point is an excellent synopsis of the logic of value investing.

 

At the time of publication, Jason Fernando had no positions in any of the securities mentioned in this article. He does not intend to trade any of the securities mentioned in this article within 48 hours of publication.

Footnotes
[1] 133-134.
[2] The logic here is that preferred stocks which pay above-average dividends are generally at higher risk of default, because the higher dividend payments exert an increased toll on their balance sheets. Therefore, one needs above-average incentive (i.e. the preferred stocks priced significantly under par) in order to justify the above-average risk implied by above-average dividends.
[3] The logic here is that bonds which pay above-average interest rates are generally at higher risk of default, because these heightened rates imply that investors require above-average compensation for the perceived risk of default by the bond issuer. Therefore, one needs above-average incentive (i.e. the bond priced significantly under par) in order to justify the above-average risk implied by above-average interest rates.
[4] No doubt future readers will have different, hitherto unknown names spring to mind. The point is that this category of investments is, viewed from the vantage-point of history, notoriously prone to irrational exuberance by its “investors” (not to mention dubious if not fraudulent practices by its purveyors, who often have a vested interest in driving up the price through marketing hyperbole).
[5] 136.
[6] 136-137.
[7] 138.
[8] 139.
[9] 139.
[10] 142.
[11] 142.

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