Intelligent Investor Ch.7 - Enterprise Investor - Positive Side

Portfolio Policy for the Enterprise Investor: The Positive Side

Now that we learned in the previous chapter what we should not buy or be very careful with, this chapter covers the positive side or what we should focus our time on.

There are four main areas where the Enterprise Investor should operate in:

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"

Buying in low markets and selling in high markets

The next post, which will summarize the famous chapter 8 of the Intelligent Investor including Mr. Market will go more in detail about "market timing"!  So I leave room here to fill it up in the next post!

Growth-Stock Approach

First of all, what is a growth stock? Is it a stock that performs better than the average, so what is if the average is 2% per year, and your investment increase 3% per year!? A "growth stock" is defined as a security that has performed and will perform in the future better than average butat least 15% for at least five years running.

So logically an intelligent investor should concentrate on growth stocks to buy, is it that simple? Pick the top 15-20 companies when it comes to growth and you are done!?

There are two problems, or "two catches", to this simplified approach:

• Stocks with good records and apparently good prospects sell at correspondingly high prices
• The future projections of growth might be wrong. as rapid growth cannot keep up forever

If you look at the performance of top growth fund managers and even large growth stocks over a long time, it is very seldom that they outperform the index as a whole, so why should you? Graham advises against investing in usual type for growth-stock, especially if it's reflected already in the current price-earnings ratio of higher than 20 (The Defensive Investor was set an upper limit of the purchase price at 25 times average earning of the past seven years)!

- From the note: "Graham insists on calculation the price/earnings ratio based on a multiyear average of past earnings. That way, you lower the odds that you will overestimate a company's value based on a temporarily high burst of profitability. Imagine a company that earned $3 per share over the last 12 months, but an average of only 50 cents per share over the previous six years. Which number - the sudden $3 or the steady 50 cents - is more likely to represent a sustainable trend? At 25 times the $3 it earned in the most recent year, the stock would be priced at $75. But at 25 times the average earnings of the past seven years ($6 in total earnings, divided by seven, equals 85.7 cents per share in average annual earnings), the stock would be priced at only $21.43. Which number you pick makes a big difference"

The big thing as well with growth stocks is that they normally swing a lot in market prices, independent of size. 

The big fortunes from common stocks in growth companies have come from people that in the early years of the company had great confidence and held their share, no matter what, while they increased 100-fold or more Normally, these single company investments were almost always realized by people that had a close relationship with the particular company, through employment or family connection, etc.

Three Recommended Fields for "Enterprising Investment" 

To be able to achieve better than an average result, there is a two-fold approach how to achieve it:

1. Meet an objective or rational test of underlying soundness
2. Must be different from the policy followed by most investors or speculators

From Grahams studies and experience, he acknowledges three investment approaches that meet these criteria's:

• Relatively Unpopular Large Company
• Purchase of Bargain Issues
• Special Situations

Relatively Unpopular Large Company

As the title says, the enterprising investor concentrates on larger companies that are going through a period of unpopularity. Even smaller companies can go through similar times of unpopularity, the book mentions two points while large companies are in favor:

1. Large companies possess greater resources in capital and brainpower to carry them through bad times
2.  The market is more likely to respond with reasonable speed to any improvements

So just go out and buy the six issues, "cheapest" stocks on the DJIA which were selling at the lowest multipliers of their current or previous year's earnings. This is exactly what Graham did and described in the book. During a period of 32 years, the cheap stocks did worse than the DJUA index only in three instances; the results were about the same in six cases, and clearly outperformed the average in 25 years.

- This seems to work out quite well if you buy a group of low-multiple companies but how do you approach the individual company?

As the book states " 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 in their good years, and vice versa at low prices and high multipliers in their bad years". Note that, if a company earns "next to nothing" its shares must sell at a high multiplier of these small earnings. To avoid these anomalies in a low-multiplier list is to use past average earnings.

The recommendation is that the enterprise investor should start with low-multiplier ideas, but add other quantitative and qualitative requirements before buying the common stock of a large unpopular company!

Purchase of Bargain Issues

A bargain is an issue that sells much cheaper than it is worth, i.e. in Graham words, a "true" bargain is that the indicated value is at least 50% more than the price, both applicable for bonds and preferred stocks selling under par as well as common stocks. 

There are two different tests made to decide on a bargain:

1. Method of appraisal: Estimating future earnings and then multiplying these by an appropriate factor. If the result of the value is sufficiently higher than the market price and there is confidence by the investor, that might be a bargain.
2. Value of the business for a private owner: In this case, we look at the balance sheet on the asset side, especially the famous net current asset or working capital

At low points in the general market, a large portion of stocks are bargain issues. The market is normally overreacting, in good times giving too much upside in securities and in bad times undervaluing common stocks more than deserved.  

Two major sources appear to give undervaluation:

1. Currently disappointing results
2. Unpopularity or lengthy neglect

As Graham states, neither of these causes should be considered alone to make a successful investment. How do we know that the disappointing results are only temporary?!

We need more "meat" on the bones here to take and make an investment decision. The investor "requires 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 future"

The ideal combination here is that of a large and prominent company selling both well below its past average price and its past average price/earnings multiplier. But this approach would have ruled out a lot of profitable companies, as their low-price years are generally accompanied by high price/earnings ratios!!!

The best and easiest bargain issues is a company that sells for less than the company's net-working capital alone, after debuting all prior obligations (By "net working capital", Graham means a company's current assets (such as cash, marketable securities, and inventories) minus its total liabilities (including preferred stock and long-term debt). This would mean that the buyer would pay nothing at all for the fixed assets, such as buildings, machinery, etc, or any goodwill items that might exist!

At low points, you have several of these bargain issues available and normally theses bargains trade close to their net-current-asset value after two years. The most remarkable was that none of the issues Graham has tested showed significant losses!

Bargain-Issue Pattern in Secondary Companies 

Early on, many investor had not given secondary (or small) companies the attention they deserved. Investors rejected secondary companies, they were sold at relatively low prices, and investor expresses a belief that such companies face a dark future. On the other hand "blue chips" companies were totally overpriced as their future possibilities seemed to be limitless. Both assumptions were unrealistic. There is no sound reason why a small or middle-sized company should not continue its operation and by that as well get a fair return of the invested capital.

In the following ways can an investor profit from buying "secondary" companies at bargain prices:

1. Dividend return is relatively high
2. Reinvested earnings are substantial in relation to the price paid
3. The bull market is most generous to low-priced issues and by that raise the typical bargain issues to reasonable prices
4. During normal market conditions, bargain issues may return close to the normal level
5. Disappointing earnings may be corrected by the advent of new conditions, new policies or by a change in management
6. Smaller companies can be acquired by larger ones

Special Situations

The special situations mentioned here covers "arbitrages and workouts". The situations have become riskier and less profitable than before - but you never know what will happen in the future!

(1) The typical situation has occurred due to the increasing amount of larger companies acquiring smaller ones. When a large company buys a smaller company, there is a premium of the current price paid to get approval from the shareholders of the targeted company. 

(2) Another typical special situation is to purchase bonds of companies in bankruptcy. These bonds were traded with big discount, as the uncertainty of business continuation. When the old bonds were exchanged for new bonds during the reorganization, you could sell them for a higher price. Of course, there were several risks included in these kinds of deals, but if succeeded, it gave a good profit on the whole arbitrage. (An arbitrage is simultaneous buying and selling fo securities, currency or commodities in different markets or in derivative forms in order to take advantage of different prices for the same asset!)

(3) A third special situation opportunity was created by the breakup of public-utility holding companies to separate operating companies when legislation was changed. Markets normally undervalue issues that are involved in any sort of complicated legal proceedings

Special situations are very "special" and the enterprise investor should further study these situations and only allocate a small percentage, but only if the cases are well understood.