Benjamin Graham

Chapter 7 – Portfolio Policy for the Enterprising Investor: The Positive Side

Summary and Discussion  – Chapter 7 – Portfolio Policy for the Enterprising Investor: The Positive Side
Notes on The Intelligent Investor by Benjamin Graham
Notes by Jason Fernando
Created December 6th, 2013
Last updated December 13th, 2013
Reference document: Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003.

50-Word Recap

  • Value investing is not concerned with timing the market.
  • To achieve above-average results over the long-term, it is necessary to think and act differently and rationally.
  • Investment in large but unpopular companies, severely undervalued companies, and “special situations” are three promising approaches for dedicated (or “enterprising”) value investors.

The two essential pillars of value investing are psychology and arithmetic.

For those “enterprising” investors who are willing and able to commit the additional time and effort necessary to pursue above-average returns, Graham notes the following bond investments as candidates for investigation:

“(1) Tax-free New Housing Authority bonds effectively guaranteed by the United States government.

(2) Taxable but high-yielding New Community Bonds, also guaranteed by the United States government.

(3) Tax-free industrial bonds issued by municipalities, but serviced by lease payments made by strong corporations.” [1]

Note that of these three, only the third is still in existence, hence its emphasis in bold.

Graham also notes that “low-quality bonds” may also be attractive provided that they are “obtainable at such low prices as to constitute true bargain opportunities.” [2]

Operations in Common Stocks

Graham summarizes the “[t]he activities specially characteristic of the enterprising investor in the common-stock field” in four points:

“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” [3]

General Market Policy—Formula Timing

The following chart, compiled by StockCharts.com and accessible at http://stockcharts.com/freecharts/historical/djia1900.html, shows the price fluctuations of the US Dow Jones Industrial Average (DJIA) between 1900 and 2013.

Long-Term DJIA

In theory, an investor could make good money by consistently buying shares in DJIA companies (or, via the more recent innovation of mutual, ETF, and index funds, the DJIA as a whole) during ‘trough’ periods of price decline, and subsequently selling those shares at ‘peak’ periods of price appreciation. Doing so on any consistent basis, however, is next to impossible, and Graham elects to “exclude [such] operations… from our terms of reference.” [4] Market timing, as this would-be practice is called, is simply not the subject of The Intelligent Investor.

On the other hand, there is a simple and effective method buying low and selling high which does not call for any uncanny ability to time the market: that method is the “50-50 plan” of portfolio rebalancing which Graham discussed previously in Chapter 4 (general portfolio policy for the defensive investor). To briefly recap this method, it calls for the creation of a portfolio equally split between high quality bonds and high quality common stocks, where the investor rebalances the portfolio repeatedly after a pre-determined time interval. If, for example, the bond portion of the portfolio appreciates in price such that its market value corresponds to more than 50% of the overall market value of the portfolio, the investor would then sell whatever quantity of bonds are required to bring the market value of the bond component down to 50% of the overall portfolio. If, in this scenario, the common stock component had fallen to below 50% of the portfolio, then the proceeds from the sale of the bonds would be used to purchase common shares in order to return the market value of the common stock portion back to 50%. This process ensures that securities are bought at low prices (in our example, common stocks) and sold at high prices (in our example, bonds).

Although the 50-50 split is recommended for most investors, Graham posits that investors can modify this ratio to between a minimum of 25% and a maximum of 75% for each component (stocks or bonds). Such asymmetrical allocations increase the risk of error on the part of the investor, so it is imperative that such a decision is only undertaken by “those investors who have strong convictions about either the danger or the attractiveness of the general market level.” [5] Increasing the stock/bond component above 50% is logical only on condition that the investor has strong reason to believe that the price of stocks/bonds is generally low. Conversely, the investor should only decrease the stock/bond component below 50% if she has strong reason to believe that the price of stocks/bonds is generally high.

Growth-Stock Approach

On face value, the selection of growth stocks (as defined and discussed previously) seems like a no-brainer. After all, why wouldn’t want to include companies who have shown above-average growth relative to their peers? Though as Graham notes, “[t]here are two catches to this simple idea.” [6] These are:

  1. “[T]hat common stocks with good records and apparently good prospects sell at accordingly high prices”; and
  2. “[T]hat [the investor’s] judgment 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 repetition of its achievement more difficult. At some point the growth curve flattens out, and in many cases it turns downward.” [7]

For those wishing to invest in growth stocks irrespective of these risks, Graham cautions against buying any issues with a current price-to-earnings ratio higher than 20 times the average earnings of the past seven years.

Three Recommended Fields for “Enterprising Investment”

“To obtain better than average investment results over a long pull,” it is necessary to adhere to the following criteria:

  1. That one’s selections for investment (i.e. companies, bonds) “must meet objective or rational tests of underlying soundness;” and
  2. That it be “different from the policy followed by most investors or speculators.” [8]

To achieve this, Graham recommends “three investment approaches that meet these criteria,” noting that they each “differ widely from one another, and each may require a different type of knowledge and temperament on the part of those who assay it.” These are: investment in “relatively unpopular” large companies, purchase of “bargain issues”, and investment in “special situations”.

Approach I: Investment in Relatively Unpopular Large Companies

The logic here is that, just as the stock market routinely overvalues companies which have become “glamorous” among investors, so too does it “undervalue—relatively, at least—companies that are out of favour because of unsatisfactory developments of a temporary nature.” Accordingly, investors can profit from concentrating on “larger companies that are going through a period of unpopularity.”

Why does Graham focus on “larger companies” rather than smaller ones? The reason is twofold:

  1. Larger companies have more resources and are therefore in a better position to weather the short-term adversity which is depressing their stock price;
  2. Larger companies are better known and are therefore likely to regain the favour of investors more quickly than their smaller counterparts once they have made progress in addressing their short-term problems. [9]

A note of caution: “[I]n considering individual companies [for investment in accordance with Approach I] a special factor… must sometimes be taken into account. Companies that are inherently speculative because of widely varying earnings tend to sell both at a relatively high price and at a relatively low multiplier [price-to-earnings ratio] in their good years, and conversely at low prices and high multipliers in their bad years.” Such companies might lead to erratic results when included in a list of “undervalued” companies; they may seem undervalued in one year, only to “bounce back” into overvaluation the next. To mitigate against this confusion, one can “avoid inclusion of such anomalous issues [stocks] in a low-multiplier list by requiring also that the price be low in relation to past average earnings or by some similar test.” [10] The qualification that the price to earnings ratio (what Graham often calls the “multiple” or “multiplier” be calculated in relation to average earnings goes a long way toward smoothing out the erratic impression left by such “inherently speculative” companies.

Graham closes this chapter by noting that a recent experiment in this approach yielded disappointing results. “This one bad instance,” he writes, “should not vitiate conclusions based on 30-odd experiments, but its recent happening gives it a special averse weight. Perhaps the aggressive [11] investor should start with the “low-multiplier” idea, but add other quantitative and qualitative requirements thereto in making up his portfolio.” [12]

Approach II: Purchase of Bargain Issues

First things first, what is a “bargain issue”?

“We define a bargain issue as one which, on the basis of facts established by analysis, appears to be worth considerably more than it is selling for. [This] includes bonds and preferred stocks selling well under par, as well as common stocks. To be as concrete as possible, let us suggest that an issue is not a true “bargain” unless the indicated value is at least 50% more than the price.” [13]

Another way of phrasing this is that A bargain issue is a publically traded financial security (such as a bond, preferred stock, or common stock) whose price is less or equal to 50% of its fair value.

How, then, can one discern whether a given security is a “bargain issue”? Graham offers two “tests”: the “method of appraisal”, and the “value of the business to a private owner”. Let’s start with general definitions and then more on to more detailed descriptions.

  1. The Method of Appraisal
    1. “This relies largely on estimating future earnings and then multiplying these by a factor appropriate to the particular issue. If the resultant value is sufficiently above market price—and if the investor has confidence in the technique employed—he can tag the stock as a bargain.”
  2. The Value of the Business to a Private Owner
    1. “This value is also often determined chiefly by expected future earnings—in which case the result may be identical with [the method of appraisal]. But in the second test more attention is likely to be paid to the realizable value of the assets, with particular emphasis on the net current assets or working capital.”
      1. What Graham’s saying is that, to estimate the value of a company, you can put yourself in the mind of someone who is considering whether or not to buy the company outright and take it off the market (“taking it private,” as it were). What would such a person be looking for? Well, two factors come chiefly to mind: the expected earnings of the company in the future, and the current “working capital” of the company. Another way of thinking about this second factor is that it represents the “liquidation value” of the company, meaning: the sum of money which the private owner could expect to gain in the event that she closed the company and liquidated (sold) its assets. The idea here is that a company whose shares are being sold for a price equal to or less than this liquidation value is almost certainly being undervalued by the market. In this scenario, what the market is “saying” is that the company is worth nothing more than its working value, meaning that the brand, human resources, and future earnings capacity of the company are all being priced at zero or less! Such bargains are rare, but they do in fact occur.

Why do misvaluations occur? Graham lists two reasons—“(1) currently disappointing results and (2) protracted neglect or unpopularity”—while noting that “neither of these causes, if considered by itself alone, can be relied on as a guide to successful common-stock investment.” [14]

The intelligent investor needs “more than a mere falling off in both earnings and price to give him a sound basis for purchase. He should require an indication of at least reasonable stability of earnings over the past decade or more—i.e., no year of earnings deficit—plus sufficient size and financial strength to meet possible setbacks in the future. The ideal combination here is thus that of a large and prominent company selling both well below its past earnings price and its past price/earnings multiplier.” [15]

The type of bargain issue that can be most readily identified is a common stock that sells for less than the company’s net working capital alone, after deducting all prior obligations. This would mean that the buyer would pay nothing at all for the fixed assets—buildings, machinery, etc., or any good-will items that might exist.” [16]

→ Graham notes that in a test performed concerning the two-year performance of 85 companies which were trading at or below their net working capital, the companies, “[by something of a coincidence,” “each… advanced… to somewhere in the neighbourhood of the aggregate net-current-asset value.”

Undervalued Smaller Companies

Graham notes that that “the stock market’s attitude toward secondary companies [by which he means smaller companies that are not necessarily glamorous ‘leaders’ in their industry] tends to be unrealistic and consequently to create in normal times innumerable instances of major undervaluation.” Conversely, investors tend to exaggerate the security of large “blue chip” companies, leading to the erroneous belief that “no price [is] too high for them because their future possibilities [are assumed to be] limitless.” Graham views both these extreme views as “serious investment errors”, arguing that “the typical middle-sized [publically traded] company is a large one when compared with the average privately owned business.” and that “[t]here is no sound reason why such [smaller] companies should not [survive and remain profitable] indefinitely.” [17]

There is, however, a significant caution which here needs to be raised. Because of their smaller market sizes, small companies generally experience more volatile price fluctuations than their large counterparts. Therefore, in boom times in which market participants are keen to speculate on rising prices, small companies gain increased attention. One must therefore be mindful of the swinging pendulum of the market, so as to ensure that one sells high during such periods of inflated prices rather than buying high.

In a footnote to page 173, Jason Zweig notes that during such “boom times” in the market for small companies, investment banks tend to capitalize on the mania by bringing new small companies onto the market (and into the jaws of speculators; or rather, the other way around) through IPOs. This rush-to-the-market typically comes in waves, in which bankers are eager to capitalize on some “hot” new investment fad. Zweig cites the “electronics, computers, and franchise” craze of the 1975-1983 period and the “.com, optical, and wireless” boom of the late 1990s as examples. His concluding phrase should be remembered as an aphorism for value investors: “Investing buzzwords always turn into buzz saws, tearing apart anyone who believes in them.

The outcome of such manias follows an almost mathematical predictability: “As was to be expected the ensuing market declines fell most heavily on these overvaluations. In some cases the pendulum swing may have gone as far as definite undervaluation.” Therefore if you see a “hot” new company in a glamorous sector and are tempted to buy it during a time in which that sector is receiving much fanfare among investment banks and speculators, be patient: The chances are that if you wait long enough you will be able to buy a much larger share at a much lower price than you would if you bought into the short-term pandemonium. As the Grahamian proverb goes,

“Profit is not in the buying or the selling; it is in the waiting.”

Faced with this reasoning, a questioning arises: “If most secondary issues tend normally to be undervalued, what reason has the investor to believe that he can profit from such a situation? For if it persists indefinitely, will he not always be in the same market position as when he bought the issue?” This is an important question, and it does point to a legitimate concern with the practice of bargain-hunting among “secondary issues”. However, Graham argues that this risk is more than compensated by the following six advantages:

    1. (Potentially) High Dividends. “First, the dividend return is relatively high” [18]
    2. Effective Reinvestment of Dividends. “Second, the reinvested earnings are substantial in relation to the price paid and will ultimately affect the price.” [19]
    3. Upward Potential in Bull Markets. “Third, a bull market is ordinarily most generous to low-priced issues.”
    4. Upward Regression to the Mean. “Fourth, even during relatively featureless market periods a continuous process of price adjustment goes on, under which [undervalued companies] may rise at least to the normal level of their type of security.”
    5. Time’s on Your Side. “Fifth, the specific factors that in many cases made for a disappointing record of earnings may be corrected by the advent of new conditions, or the adoption of new policies, or by a change in management.” [20]
    6. Potential for M&A (“Mergers and Acquisitions”). Sixth, “An important factor in recent years has been the acquisition of smaller companies by larger ones, usually as part of a diversification program. In these cases the consideration paid has almost always been relatively generous, and much in excess of the bargain levels existing not long before.” [21]

Approach III: Special Situations, Arbitrages, and “Workouts”

First things first, What does this section actually refer to? In a nutshell, Graham is referring to situations in which a small companies is set to purchased by a larger company. Usually such acquisitions are made in order to allow the large company to more easily expand into a new line of products or services in a relatively cost-effective manner. For instance, if SmallCarCompanyTM has developed an incredible new electrical motor and LargeCarCompanyTM is in the process of planning their expansion into the electric vehicles market, it may be more cost-effective for LargeCarCompanyTM to purchase SmallCarCompanyTM outright instead of developing their own electric motor from scratch. Similarly, companies are sometimes acquired primarily out of an interest in the acquired company’s patent portfolio. In other instances, company X will acquire company Y in order to shut down company Y’s operations and therefore remove a current or potential competitor. (There are, of course, many other scenarios which these examples have not raised).

Graham’s point is that well-positioned investors can profit handsomely by investing in the soon-to-be-acquired companies prior to their acquisitions, due to the fact that the company doing the acquiring almost always pays a relatively large premium for the shares of the company being acquired. [22]

Another instance cited by Graham concerns the breakup of large companies into numerous smaller companies. Sometimes, a large company will “spin off” a part of their business in this manner, creating a new publicly-traded entity with its own stock. Such new “spin-offs” occasionally present profitable opportunities for perceptive investors—but of course this is not always the case. For instance, a given company might “spin-off” a part of its business based on the premise that that part will be more profitable on its own (such as in the event that belonging to the larger company was exposing the spin-off business to unnecessary financial or legal liabilities, bad PR, etc.). In such an instance, the value of the spin-off company might well be greater than its initial offering price, signalling a profitable opportunity for investors. Conversely, however, a large company might spin off a part of their business for the opposite reason, namely that it is a hindrance to the larger enterprise. In such an instance, one would be generally advised to steer clear of the issue, provided that its asking price is not sufficiently low as to warrant its consideration on the basis of undervaluation.

Graham cites lawsuits as a factor which routinely causes undue undervaluation of companies on the public markets. Such lawsuits can hold “[companies’] prices down to unduly low levels,” thus signalling a potentially attractive buying opportunity. [23]

Broad Implications of Our Rules for Investment

  1. It is of paramount importance that the investor decide whether she intends to be Defensive or Aggressive/Enterprising in her approach.
    1. “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… between the [defensive] and aggressive status.” [24]
  2. “It follows… that the majority of [investors] should elect the defensive [style of investing]… They should therefore be satisfied with the… return… obtainable from a defensive portfolio… and they should stoutly resist the recurrent temptation to increase this return by deviating into other paths.”

Footnotes
[1] 155.
[2] 155.
[3] 156.
[4] 156.
[5] 157.
[6] 158.
[7] 158.
[8] 162.
[9] 163.
[10] 165.
[11] Note that Graham uses the terms aggressive and enterprising interchangeably; they refer not to one who is willing to take on “more risk”, but to one who is willing to put in the time and effort required to achieve above-average returns on her investments.
[12] 166.
[13] 166.
[14] 167.
[15] 168.
[16] 169.
[17] 171.
[18] Of course, this depends on the company in question; not all pay dividends, let alone high ones.
[19] This is based on the assumption that A) the company in question pays dividends; and B) the investor chooses to reinvest his dividends in the company (preferably through an automatic “dividend re-investment plan” (although these are not always available; their availability is not required, and therefore varies from one company to the next).
[20] 172.
[21] 173.
[22] The principal reason for this is that such acquisitions need to be approved by the board of directors and the shareholders of the company that is being acquired. Those parties are unlikely to approve an acquisition unless it is deemed of sufficient financial interest—hence the de-facto requirement that a premium be paid.
[23] 175.
[24] 176.

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