Chapter 7: Portfolio Policy for the Enterprising Investor: The Positive Side
**Quick update** Thanks for reading, I’ve compiled this entire series into an electronic copy that you can take offline → here
Welcome back to the Intelligent Investor series. In this chapter of The Intelligent Investor, Graham gives us some advice on what to look for in “growth stocks” and some recommendations on strategies that are appropriate for an Enterprising Investor. Here’s the list of preceding posts if you’d like to get caught up:
All or nothing
Although this chapter is organized rather logically, one thread that runs throughout is Graham’s ask that you decide whether you’ll be an Enterprising Investor, or a Defensive Investor. He points out, you cannot be casual or an “in-between” investor. If you want to be Enterprising , then you must decide to commit to it fully.
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
The message being you cannot be half a business man and expect half the return, nor can you be half an aggressive investor and expect half the return. You must fully commit to the analysis and exercise of your investment plans.
Growth Stocks
Graham opens his advice for the chapter with a discussion of the attributes to seek in a growth stock and “behind the curtain” material on their attractiveness. A “Growth Stock” can be defined as one that has done better than the average over a period of years and is expected to do so in the future.
Right away, Graham describes some concerns he has in investing in “growth stocks” :
- Common stocks with good records and good expectations sell at correspondingly high prices
- Judgement of the future may prove incorrect
He remarks , “the growth curve will flatten, and sometimes turns downward”.
As he elaborates on his feelings about growth stocks, he notes some major points:
- growth company investment does not benefit from diversification (but the Intelligent Investor understands that allocating massively to one company should be reserved for people tied closely to the management of the company)
- a defensive investor should set an upper limit of a purchase price at 25x average earnings over the past 7 years. (Concerns with P/E > 20)
- the faster the advance a “high-growth” stock’s price gets compared to actual growth of earnings, the riskier the proposition it becomes.
Recommendations for the “Enterprising Investor”
Graham offers three distinct policy approaches that are fit for the Enterprising Investor to use. Surely, each of the three approaches must :
- Meet objective or rational tests of underlying soundness
- Be different from most investors and speculators
Approach 1 — Relatively Large and Unpopular:
This approach hinges on the idea that the market will undervalue — relatively — companies that are out of favor because of unsatisfactory developments of a temporary nature.
The key here being to focus on larger companies going through a period of unpopularity. Small companies might become undervalued as well but present more risk because, unlike large companies:
- smaller companies do not have access to large amounts of capital and brain power to carry them through adversity
- smaller companies can’t be as sure the market will respond with reasonable speed to any improvement
When looking at the special factors while considering individual companies, one should know that companies that are inherently speculative because of wide earnings swings tend to sell at relatively high prices and low multiple in good years and low price with high multiples in bad years. A way to handle that when you’re crunching the numbers is to require that the price be low in relation to the past mean earnings or a similar test (assume a minimum of 7 years of earnings data). Therefore , the aggressive investor should incorporate ideas of the “low-multiplier” into their investment tactics and continue to add other quantitative and qualitative requirements as well.
Approach 2 — Purchase of bargain issues:
This approach has an emphasis on issues that, on the basis of facts by analysis, appears to be worth considerably more that it is currently selling for.
An issue is not considered a “bargain” unless the indicated value is at least 50% more than the price.
Two bargain tests:
- Method of appraisal: Estimate future earnings then multiply by a factor appropriate for the issue. If the result is sufficiently above market price, and the investor has confidence in the technique by which the analysis was conducted, buy the issue.
- Value of the business to the private owner: Using the same future earnings estimates as the first test, paying more attention to value of assets (with an emphasis on net current assets or working capital).
Graham indicates that there are two major sources of undervaluation:
- Currently disappointing results
- Protracted neglect or unpopularity
He confirms that you cannot , and must not rely on these tests alone. Further, you should place a heavy emphasis on the stability of earnings over the past decade. There should be no year of earnings deficit and the company should be of sufficient size and financial strength to meet possible future setbacks.
An ideal situation in this scenario is a large and prominent company selling for both well below past average prices and its past P/E multiplier. An easy test summing up to: a common stock that sells for less than the companies net working capital alone, after deducting all prior obligations. [Net working capital = current assets (cash, securities, inventories) — all total liabilities (including preferred stock & long term debt)].
Approach 3 — Special Situations or Workouts:
In the case of what Graham deems “Special situations” he’s speaking directly about arbitrage and other styles of investing which he does not seem to want to dive into. He regards these tactics as reserved for a very specific subset of investors — that is really is not intended for anyone not highly familiar in working with arbitrage and confident in their analysis.
Zweig’s commentary throughout the chapter is highly insightful, often adding data to Graham’s advice. I think a few of his quotes below work well for pocketable summations of the chapter:
A great company is not a great investment if you pay too much for its stock
Growth stocks are worth buying when their prices are reasonable, but when their P/E ratios go above 25 or 20, the odds get ugly
He also adds some information on finding the NYSE and NASDAQ scorecards for stocks that have hit new lows in the past year in the Journal. Recalling information from a previous chapter, Zweig also offers that putting 1/3 of your stock money in mutual funds that hold foreign stocks (including those in emerging markets) helps to insure against against the risk that our own backyard may not always be the best place in the world to invest.
As I continue to work through the chapters, my goal is to post on each chapter’s central tenets. If you find something out of place, or care to strike up a discussion feel free to comment or find me on twitter @DavidCappelucci.2
Recommend the article if you found value in it and would like to follow along.
-David
