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

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“The punches you miss are the ones that wear you out.” – Angelo Dundee 

• The enterprising investor should start with a similar framework to that of the defensive investor – a divided allocation of funds between stocks and bonds
  • They will be willing to branch out into other securities as well but each such decision should be well reasoned and justified (what you don’t do is as important to your success as what you do)
  • Don’t be too eager to buy a security (can increase the price you end up paying) or trade too frequently (turning long term capital gains into normal income). The term “Long term investor” is redundant
• First Grade vs Second Grade (Junk) Bonds
  • Typically differentiated by the number of times the interest charges have been covered by earnings 
  • Unwise to buy a bond or preferred stock that lacks adequate safety merely to chase yield
  • “If a company must pay high rates of interest in order to borrow money, that is a fundamental signal that it is risky”
• Bond prices are quoted in percentages of “par value,” or 100. A bond priced at 85 is selling at 85% of principal value and is called a “discount bond.” Bonds selling above 100 are “premium bonds”
• Graham advises against foreign government bonds and junk bonds. However today, investors may choose to invest in these areas utilizing bond funds for added diversification (1978 – 2003 average of 4.4% of junk bond market went into default annually). One benefit of foreign bonds in emerging markets is they are typically uncorrelated with domestic markets
• New Issues – Be Weary
  1. Special Salesmanship behind them (and typically carry a built in commission or “underwriting discount”
  2. Sold under “favorable market conditions” (to seller)
• Bull market periods give rise to large number of private companies going public
  • Like individual stocks, IPOs have “cycles,” and oscillate between under and over provided. Begin to increase in appearance mid-bull cycle
• New Common Stock Offerings 
  1. For companies already listed, additional shares are generally first offered “pro-rata,” to existing shareholders. Subscription price is typically below current market value giving the “rights,” to subscribe an initial money value
  2. For private companies, IPOs allow controlling interests (VCs, executives etc) to cash in on a favorable market and diversify their own finances. Business financing is often done instead with the issuance of preferred shares
• Good returns are possible but most high returns on IPOs are captured by the investment banks & select pool of investors that get in at the initial “underwriting,” price
• This has lead to: IPO = It’s probably overpriced. Imaginary profits only. Insiders Private Opportunity. Idiotic Preposterous and Outrageous

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

“It requires a great deal of boldness and a great deal of caution to make a great fortune; and when you have got it, it requires ten times as much wit to keep it.” – Nathan Rothschild 

• Operations in Common Stocks
  • Buying in low markets and selling in high markets
    • This often proves difficult/impossible to time correctly 
  • Buying carefully chosen “growth stocks”
    • Mere statistical chore to find companies that have out-preformed in the past
      • However companies with good records and apparently good prospects sell at correspondingly high prices
      • Investor may be accurate in judgement of stocks prospects but overpay due to these prospects already being “priced in”
      • Past growth makes future growth that much more difficult. Financial Physics says, “The bigger they get the slower they grow”
      • Graham suggests enterprising investors pay no more than a current price to earnings ratio of 20x (for defensive investors he suggests no more than 25x price to earnings over the prior 7 years)
        • When the multiplier gets above 25-30 things can get ugly. Between 1960 and 1999 only 8/150 Fortune 500 companies managed to grow by an average of 15% or more for two decades. Only 10% of large companies increased earnings 20% for five consecutive years, 3% for 10 years straight, none for 15 years in a row
      • The investment caliber of a company may not change over a span of many years but the risk of its stock can vary wildly – the more enthusiastic the public becomes – the faster the stock price grows relative to earnings, the riskier the stock becomes. 
  • Buying bargain issues of various types
    • Two Tests: Appraisal (estimating future earnings & applying accepted multiplier + Value of Business to Private Investor (paying attention to realizable value of assets, particularly net current assets or working capital)
      • Easiest to spot is common stock selling for less than companies current assets (such as cash, marketable securities & inventories) less liabilities (including preferred stock and long term debt)
      • Graham recommends buying if a stock is selling at 2/3 or less than its appraisal value
    • The Relatively Unpopular Large Company
      1. Currently Disappointing Results
         • Example, Pfizer fell 3.4% in single day due to reports that Viagra was causing heart attacks. When research later showed no cause for alarm the stock surged
      2. Protracted Neglect or Unpopularity  
         • Need to be sure this is a cyclical or temporary setback & not a fundamental shift in the business/industry 
  • Ideally selling below its past average price and its past average price/earnings multiplier 
  • Smaller companies face similar dynamics but Graham warms that they have a greater risk of definitive loss of profitability OR protracted neglect from investors (who tend to gravitate towards better known issues)
    • During WWII smaller companies experienced greater growth as the normal competition for sales was suspended allowing sales and profit margins to be expanded (knowing macro trends and environment can be very important in security selection)
  • As the flip side to seeking unpopular shares, be wary of segments or companies that are “in style”
  • Arguments for Bargain Priced Secondary Issues
    1. Dividend return is generally high
    2. Reinvested earnings are substantial in relation to the price paid
    3. Bull market is most generous to low-priced issues
    4. Continuous price adjustment can bring previously low price to normal level
       • While a single detached share of a primary company is generally worth the same as a share in a controlling block in secondary issues the single share is worth less than its worth to a controlling owner. This creates more controversial shareholder management relations
  • Buying into “special situations”
    • Distressed or Defaulted Bonds can be bought at a major discount (and have little value if the company cannot be restructured). If company recovers the bond often recovers as well & bond holders are even granted stock in the reorganized firm in some circumstances
    • Buying stock of companies set to be acquired (to gain the approval of a majority of shareholders, the acquiring company often has to pay a premium)
    • Wall Street commonly undervalues issues that are involved in any sort of legal proceedings
• Nearly all of the richest people in America gained this wealth through one industry or single company. But almost no small fortunes are kept this way (better to diversify). Only 64 of the 400 richest Americans in 1982 remained on the Fortune list in 2002 (despite only needing an annual growth rate of 4.5% to be included). 
• If you live in the United States, work in the United States and get paid in the US dollar you have already made a multi-layered bet on the US economy. A portion of your investment funds should be in foreign markets for diversity 

*Reminder that enterprising investor is someone who is willing to spend more time researching his or her portfolio. NOT someone who is willing to take more risk than average

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