Intelligent Investor Ch.6 - Enterprise Investor Negative Approach

Portfolio Policy for the Enterprising Investor: Negative Approach

The starting point for an "Aggressive" or "Enterprise" investor should be the same as the Defensive Investor, i.e. high-grade bonds and high-grade common stocks. From this starting point, Graham starts what an Enterprise Investor should not invest in (negative approach):

• Leave High-grade preferred stock to corporate buyers
• Low-quality types of bonds (junk?) and preferred stocks, unless you but them at a big bargain, minimum 30% under par for high-coupon bonds (interest rate at least 8%)or high dividend-yielding preferred stocks (>10%)
• Foreign-government bonds
• New issues, such as convertible bonds, preferreds, and common stocks

For standard bond investments, the Aggressive Investor does the same as the Defensive Investor, e.g. high-grade taxable bonds and/or good-quality tax-free bonds.

Second-Grade Bonds and Preferred Stocks

Second-Grade, or "lower quality bonds than high-grade bonds", should return higher yields than the high-grade, as normally the credit rating is not that high and by that your risk is higher! 

The main difference between second- and first- grade, though is normally found in the number of how many times the interest costs are covered by the earnings. 

Many investors need these higher-yielding bonds or "income bonds" for a living but in exchange for higher risk. In general, the increased yield is not worth the additional risk - at least if you by them at full principal value or at par! (Bond prices are quoted in percentages of "par value" or 100. A bond priced at "85" is selling at 85% of its principal value).

The book suggests, that it is (1) better to buy high-grade bonds at a discount and (2) second-grade bonds at an even higher discount to par value. Second-grade bonds and preferred stocks suffer more in bad markets but on the other hand, recover their positions when favorable conditions return. This includes even preferred stocks that fail to pay dividends for many years.

Foreign Government Bonds

Normally Graham sees no problem or concerns with well-regarded foreign bonds of a rich creditor nation, such as Australia or Norway. He is more concerned with nations who can come into trouble or even default (don't pay) their interest - so in general, he does not directly recommend any foreign bonds

New issues

Convertible and Preferreds

New issues are not recommended and have two reasons to be wary of:

• New issues normally have a built-in commission included and a big sales push to place them on the market
• New issues are sold under "favorable market conditions" - as we learn that the market is good for the seller and by that less favorable for the buyer

New Common-Stock Offerings

As the book writes, there are two different forms of financing via common-stock offerings:

1. The company is already listed and additional shares are offered to existing stockholders. The price is set below the current market price (also called "right offerings")
2. The private company goes public and gives the public a share of the company, this is normally done in favorable market condition (read expensive for a value investor)

Graham points out that as bull markets start, more companies go public and they race goes on. It was very rare to find value "diamonds" for a reasonable price, so the wisest answer the book gives us is: 

"Some of theses 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"