Go to ...

ModernGraham

Value Investing Research Since 2006

RSS Feed

Tuesday, December 12, 2017

Portfolio Policy for the Enterprising Investor: Negative Approach (MG Book Club Chapter Six)


photo (6)

Portfolio Policy for the Enterprising Investor: Negative Approach

This is the sixth discussion of the ModernGraham Book Club’s reading of The Intelligent Investor by Benjamin Graham (affiliate link).  In last week’s discussion, we discussed the fifth chapter, which outlined four basic rules for Defensive Investors to follow, keeping in mind the Defensive Investor is one who is not willing to spend much time on analyzing investment opportunities.  This week we will discuss the sixth chapter, which is titled “Portfolio Policy for the Enterprising Investor: Negative Approach.”  I encourage you to purchase the book (preferably by clicking the link to Amazon, because a purchase through that link will help support the club) and join in with us as we read through a chapter each week; however, even if you don’t have the book I think you will find our discussions to be very useful in your own understanding of value investing, and you can still bring a lot to the discussion from your own experiences as an investor.  Whether this is the first day you’ve ever been interested in investing, or you have decades of experience with the stock market, we’d love to hear your thoughts in the comments below!

In this chapter, Graham makes some suggestions on bonds which Enterprising Investors should avoid, including high-grade preferred stocks, inferior types of bonds and preferred stocks, foreign-government bond issues, and new issues.  He then elaborates on some of the reasons behind avoiding these types of bonds.

Please feel free to leave a comment on this post with your own responses to the questions, along with any other thoughts you have, and return throughout the next couple of days to see what others have said. If you find something that has been said by another commentator interesting, feel free to respond to them with another comment.  We’ve had some great discussions the last few weeks, so keep it up!

ModernGraham’s Comments

Ben

This chapter begins introducing some detail into the Enterprising Investor’s portfolio, but it does so by eliminating some possible investments from contention.  I agree solidly with Graham on a number of points here, but only on the individual level.  That is, I do not think the Enterprising Investor should invest in an individual preferred stock, inferior bond, foreign bond, or new issue; however, some limited investments may be worthwhile if they are done in a group.  For example, in 2009 I purchased HYG, a high-yield bond fund managed by iShares.  At the time, the trading price of this exchange-traded fund (ETF) was around $70 and the yield was around 10%.  I looked at the fund and decided that since there were around 55 bond holdings involved, the chances of all of them defaulting was rather low.  On the other hand, the chance that the fund would return to a trading range of around $90 or $100 seemed higher, and in the meantime, the investment would yield 10%.  It has turned out well, as the fund is currently trading above $94 and is still yielding nearly 6%.  Some instances like that may be available in the areas of foreign bonds as well, and it is important to remember that Graham lived in a time when some of the tools available to the individual investor today did not exist.  That said, it is still very important to analyze each opportunity in detail to determine if the risk level and the price make sense; do not blindly invest in a fund simply because it is a fund rather than an individual issue.  Rather, invest in the fund when it is extremely clear that it is undervalued.

Heather 

I had a hard time wading through this chapter and at a few points I considered eschewing it all together. That said, I did find this chapter helpful in that it gave greater insight into the pitfalls to avoid when investing. When Twitter had their IPO a few months back, there was quite a bit of discussion among financial journalists as to the asking price, leading to speculation that it would “pop” on its first day. (See this article for an example). Unfortunately for the majority of Americans, this 73% rise in shares was unattainable as only insiders were given the opportunity to purchase at the original price. Zweig notes something similar when he discusses how buying IPOs from 1960-2001 would lead the investor to be worth 533 decillion (that’s 33 zeros!). The reality, Zweig notes, is that during that time period very few would actually have been in a position to be allowed to invest in the IPO at the starting price. This means that a handful of investors are making money by selling their stock to the rest of us at a much higher price, at times beyond what the company is worth.

Graham also warns about second-rate bonds by stressing that the return rate on these bonds is higher because they are not as secure of an investment, so while you have the possibility of a high return, nothing is guaranteed. Reminding us yet again that we need to do research rather than just handing over our money at the prospect of a good deal.

Discussion Questions

Please leave a comment below and feel free to answer any of these questions, or just give your general thoughts.

  1. What quote from this chapter do you think best summarizes the point Graham is making?
  2. What do you think of Graham’s suggestions that Enterprising Investors avoid these types of investments?
  3. Have you invested in any such opportunities?
  4. How can we balance avoiding the risk inherent in these opportunities with the potential return they present?
  5. What other types of investments do you think should be added to the “Do not touch” list?
  6. What did you think of the chapter overall?

Next Week’s Discussion: Chapter Seven

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

When reading the next chapter, try to think about how the concepts Graham presents in the chapter could apply to your own investments, whether you consider yourself a Defensive Investor or an Enterprising Investor.

What are some other ways to participate?

If you are a blogger, you can give your thoughts in a post on your own site, link to the discussion here on ModernGraham, and I will be sure to let our readers know that the conversation is going on over at your site as well.

In addition, you can use the hashtag #MGBookClub in social media to talk about the book on Twitter or Facebook!

Tags: , ,

6 Responses “Portfolio Policy for the Enterprising Investor: Negative Approach (MG Book Club Chapter Six)”

  1. Tom
    March 31, 2014 at 2:54 pm

    Just discovered your website. I “read” Intelligent Investor a few years ago and learned from it, but not really digested it and found no one to discuss it with, so turned to Buffett and Graham’s other “followers.” Will try to catch up re the chapters. Some quickie comments in Graham’s INTRODUCTION and your questions: (1) Re Santayana: We know what he meant, but very limited as applied to the present, including stocks. Much is “new” and not properly correlated with the past, whether in science (e.g., DNA and physics, etc.) and with stocks. (2) Graham’s attempt to speak of enduring “principles” and “applications” is an outmoded, though still treasured, effort. Principles also change, unless so abstract as to be useless and uninformative. (3) Graham’s attempt radically to distinguish “investing” and “speculating” is helpful in the extreme, but a many of us do both, limiting speculating to a very small 1%-5% of our portfolios. Options are of course not adequately addressed by Graham, and bonds today clearly should not be even close to 50% of a portfolio – interest thereon could even pay taxes and meet inflation. (4) Graham’s objective(s) is(are) admirable. Graham’s emphasis on “tangible book value” is misplaced. Buffett changes that emphasis, partially with Munger’s help (e.g., See’s, Heinz, et alia.)

  2. Tom
    March 31, 2014 at 9:42 pm

    Ok, skipping to Chap 6 and it’s “negative approach”: (1) The second paragraph is the critical point and summation of this chapter. GENERALLY, the individual enterprising investor should avoid investing in preferred stocks, including high-grade preferred stocks, second-grade bonds, foreign government bonds, new issues (hesitantly qualifies this to “be wary,” but it would be better to wait), new common-stock offerings. One sentence in reference to “New Common-Stock Offerings” jumped out at me “The heedlessness of the public and the willingness of selling organizations to sell whatever may be profitably sold can only have one result – price collapse.” As to bonds, there are always issues of low interest rates and inflation, which in the current day impels one to reject Graham’s emphasis on 25%-50% in a portfolio. Overall, the chapter is insightful and sobering. It may be unsettling to “fixed income” investors who are severely restricted in knowledge and time or interest to be an intelligent investor .

  3. John M.
    April 6, 2014 at 1:52 pm

    1) There are several things Graham states to avoid, and I feel the clear message is to avoid a sales pitch – by the investment bank offering an IPO, or a company pitching a high coupon. “An elementary requirement for the intelligent investor is an ability to resist the blandishments of salesmen offering new common-stock issues during bull markets. Even if one or two can be found that can pass severe tests of quality and value, it is probably bad policy to get mixed up in this sort of business… For every dollar you make in this way you will be lucky if you end up by losing only two.
    2) I think it is a wise suggestion by Graham for the enterprising investor to avoid these issues. He has learned over time that they are bad investments on average. In our time you might be able to diversify out some and maybe most of the non-systematic risk with diversified junk bond funds or foreign funds (like EFT’s), and this seems to be the only way to justify this kind of investment, but you should still approach it with caution. I would never invest into an IPO because you do not have a proven track record that has stood the test of the public eye over time, and I hate a strong sales pitch. I would also never invest in shares of a foreign company that I cannot use the U.S. legal system to protect me.
    3) I have invested in high yield bond funds and foreign company funds. My goal was simply to help diversify out more non-systematic risk.
    4) These opportunities are best done in a group investment environment like an EFT with low costs. I think it is only justified when the risk is spread over a large pool of investors, and then you have the potential to get a diverse base of investments.
    5) I think short run speculating on homes and cars should be added to the list. If you are a realtor with a contractor license, then you can assure you don’t pay a ridiculous premium on maintenance and repair expense; even then it is risky. I think the same applies to investing in old cars. You will rarely be able to safely assure a profit after taxes and expenses. The television shows make them sound fun, but they should be for a hobby or part of your planned living expense. If you happen to make a profit, then great, but don’t bet your mortgage/rent payment on it.
    6) I like the way Graham starts the enterprising investor criteria with what to clearly avoid. In my economic and investments classes there is one key theme, and Graham follows it too: You can diversify out of your portfolio non-systematic risk, but systematic risk will move all portfolios. You should use your well planned investments to take advantage of cheap opportunities presented by systematic risk influenced markets. If I had a 50/50 mix of equities and bonds before the downturn, I could have theoretically taken my appreciated bonds and bought cheap equities. I know timing is everything, but I would have at least had the opportunity to do this in some fashion.

    I also enjoyed the parts on day trading. Day traders, charters, and trend traders do terrible on average. Relying on charts and trends is a poor form of gambling, and the brokerage firms are the casinos that always win.

    I suppose starting your own small business is kid of like an IPO when you try to get investors. In this case, however, you can demand a greater amount of information about the business before you invest (banks protect themselves with personal guarantees too). Does anyone feel that investing in your own small business fits the enterprising investor profile based on the ideas of Graham? It seems so, if you invest enough effort.

  4. Richard
    April 6, 2014 at 7:35 pm

    1. Quote: “Experience clearly shows that it is unwise to buy a bond or a preferred which lacks adequate safety merely because the yield is attractive.” This is a common mistake among many investors living off their investment income. I have been tempted to fall for this pitfall in stock purchases in the past so I am well aware of the allure higher yields can have. In the bond market I did buy a mutual fund many years ago that invests in “emerging market bonds”. Guess why; because of the higher yields at the time. The yield today is not that attractive and if I had it to do over again I would have just bought some quality dividend growth stocks.

    2. Classifying myself as a defensive investor, I totally agree with Graham’s advise to avoid these less than mainstream investments, unless of course that happens to be one’s area of expertise.

    3. My only experience investing in these types of issues is as stated in my answer to question one. I chose a bond fund only because all the “talking head” experts proclaim it is the prudent thing to do. I chose emerging market bonds because of the higher yield and its lower correlation to the stock market. I chose a mutual fund because at the time my career kept me too busy to focus the energy necessary to select individual issues. During the next major market correction I will reduce my bond exposure down to an amount equal to one years worth of living expenses. That is assuming my bond fund doesn’t crash as bad as the stock market like it did during the great recession (so much for low correlation coefficients). The value of my bond fund dropped 40% while my utilities stocks dropped only 20%. Today my stock fund is still down about 8% while my utilities stocks are up over 30% and paying a yield higher than my bond fund. I no longer listen to “talking heads”.

    4. The way I balance the risk vs reward for these other types of investments is to avoid them altogether. It works perfectly!

    5. Do not touch high P/E stocks like Apple used to be just a few months back. Or like INTC used to be many years back. I think it was Dr. Graham who called this the “greater fool theory” by hoping there will be someone who will pay a higher price than I paid in order to secure a profit. This is the same principle as market timing except it is applied to an individual stock. I also do not touch stocks with shaky or erratic financial histories just because it is impossible for me to determine where they are likely to be in five years or so.

    6. I don’t remember disagreeing with anything Dr. Graham had to say in chapter six. My hero.

  5. April 9, 2014 at 1:24 pm

    1. What quote from this chapter do you think best summarizes the point Graham is making?

    “The most useful generalizations for the enterprising investor are of a negative sort. Let him leave high-grade preferred stocks to corporate buyers. Let him also avoid inferior types of bonds and preferred stocks unless they can be bought at bargain levels—which means ordinarily at prices at least 30% under par for high-coupon issues, and much less for the lower coupons. He will let someone else buy foreign-government bond issues, even though the yield may be attractive. He will also be wary of all kinds of new issues, including convertible bonds and preferreds that seem quite tempting and common stocks with excellent earnings confined to the recent past.”

    2. What do you think of Graham’s suggestions that Enterprising Investors avoid these types of investments?

    I think it’s reasonable due to the risks inherent in these types of investments.

    3. Have you invested in any such opportunities?

    No, I have not.

    4. How can we balance avoiding the risk inherent in these opportunities with the potential return they present?

    Buy a basket of them and buy all of them at a great discount to intrinsic value. If this cannot be done, I think it’s best to stay away from all of them.

    5. What other types of investments do you think should be added to the “Do not touch” list?

    Stocks that are priced much too optimistic with expectations set too high compared to a reasonable and conservatively calculated intrinsic value. Except for this I’m not really sure I have anything to add, but clearly all kinds of investments that somebody tries to sell you where the incentives are not aligned with your own should be avoided. All businessmen promoting and selling investments that will make you rich should be kindly but definitely dismissed.

    6. What did you think of the chapter overall?

    Enjoyed the chapter and all the wisdom that is discussed by Graham in the text.

    This post has also been published at http://hurricanecapital.wordpress.com.

  6. Mark
    April 13, 2014 at 8:54 pm

    I did not find this Chapter as useful except fot the followingpoints:
    Government bonds from foreign countries have done poorly for a very long ime. The owner of foreign governmment bonds has had no recourse to the law if there is a default. The exception is very deeply discounted bonds.

    A reasonably reliable indicator that a bull market has reached its high is when small company IPO’s are at higher prices than prices of middle size companies that have been around for many years.

    The investor must have the will to ward off the coaxing of brokers to indulge in bull market speculation.

    In a bull market new stocks may go up dramatically providing an opportunity for quick money. But many of these stocks fall just as dramatically. An example from the book was Aetna Maintenance Company.

Leave a Reply

Your email address will not be published. Required fields are marked *

More Stories From Feature

About Benjamin Clark