6. Portfolio Policy: Negative Approach

The "aggressive" investor should start from the same foundation as the defensive one - a division between high-grade bonds and high-grade stocks bought at reasonable prices. From this core he can branch out into other kinds of securities, but in each case he should have a well-reasoned justification for the departure.

There is no single or ideal pattern for aggressive investors, as each will select investments based on his own competence, interests, and preferences. His approach to making such investments is generally negative - it is expected he will wish to purchase any security that has a potential for higher return, unless he can identify a reason not to do so.

Second-Rate Bonds and Preferred Stocks

At the time the book was written, it was possible to find first-rate corporate bonds yielding a higher rate of return that makes investors reluctant to accept second-rate bonds that offered higher yields, because this was the equivalent of extending credit to a company whose credit-worthiness was in question.

An aggressive investor may purchase second-rate bonds to seek a higher return, and even a conservative investor (especially the "widower" profile, who uses investments to generate a needed income) may be led to do so because their need exceeds the return they could achieve by investing more prudently, even though experience clearly shows it is unwise to buy an investment merely because the yield is attractive (and failing to consider the borrower's ability to repay at all).

However, the present high rate of interest represents an unusual moment in time, where the rate is elevated. It is more typical for high-grade bonds to yield a return of about 4.25% rather than the present 7.25% rate. When interest rates return to a normal level, this will again become a consideration for the aggressive investor.

The factor by which the "grade" of a bond is assessed is times-interest-earned - the ratio that compares the interest paid by a firm to the amount of profit generated (a company with a profit of $10m that pays $2m on its loans each year has a TIE of 5). The higher this number is, the greater the security for the investor, as it assures him of the company's ability to pay the interest owed on its borrowings.

The danger in purchasing second-rate bonds is that the issuer is not creditworthy, and may not have sufficient earnings to make interest payments. It is not uncommon for such companies to suspend interest payments when their cash flows are insufficient, or even nearly insufficient, to keep current on their debts.

The author specifically mentions the "income bonds" issued by the railroads, which promised an attractive return that they were ultimately unable to pay. In the course of a single year (1946), even the price at which the investor could rid himself of the bond fell by more than 30%, because interest payments were not being made and the ability to redeem the bond at face value at maturity was even in question.

Simply stated, it is a bad decision to accept a higher level of risk in exchange for a mere 1% or 2% of additional interest. Second-grade bonds selling at par are almost always a bad purchase, though it might be mathematically sensible to purchase them at 70% of face value, there is still risk of ever seeing a return on the investment.

The risk in second-grade bonds is the income of the company, and nearly all suffer in bad markets. On the other hand, a large proportion recover their position when the market conditions are favorable, and a long-term investor might fund that things ultimately "work out all right: in the end - that is, the high returns paid when the company is able compensate the holder for the losses taken when interest is suspended or the bond surrendered at less than its maturity value.

For practical purposes, second-grade issues are an investment best avoided. A high rate of return is not attractive when there is doubt about whether the return will be realized. Most investors cannot purchase enough bonds to diversify against risk, and market risk generally affects all securities equally. Finally, it is common sense to avoid buying securities at face value if long experience indicates they will suspend interest payments and lose 30% of their value in the next weak market cycle.

Foreign Government Bonds

The bonds issued by foreign governments have a history of offering a higher interest rate than those issued by the US government. They have also, as a whole, have a miserable reputation of paying the interest as promised. Largely, it is because nations are like corporations in terms of their creditworthiness, though their management chances direction rather more frequently, and there is no legal mechanism for a creditor to enforce his claim on a foreign government.

There is no concrete reason to doubt the future solvency of developing nations such as Australia or Norway, which presently offer investors a handsome return for extending them credit. But neither was there any concrete reason to doubt the future solvency of Cuba, the Belgian Congo, Greece, Czechoslovakia, and Poland, all of which issued bonds that initially seemed quite attractive, but which had to be sold at pennies on the dollar, if they could be sold at all, a few years later.

The argument in favor of purchasing foreign bonds is often made on political rather than economic grounds: that it is a moral obligation for citizens of wealthy nations to contribute to the development of the inferior ones, that it evens out the balance of trade, that improving the welfare of other nations increases our export market, etc. None of these makes purchasing foreign bonds attractive as a method of investment, though they might qualify as a method of charitable donation.

New Bond Issues

There is much attention given to new bond issues, with the implication that they are especially attractive to investors - but the author's take is that investors should be exceptionally wary of them.

Primarily, new issues are backed by considerable salesmanship: issuing companies and their investment bankers go to great lengths to make the investment more attractive than it actually is - so investors should be well advised to exercise caution and be doubtful about the claims made.

Also, most companies seek to issue new bonds under the most favorable market conditions - for themselves. Which is to say that the borrower seeks to pay as little interest as possible - and in terms of bonds, this means as low a return as buyers are likely to accept.

The effects become even more pronounced as the quality of a bond decreases: from high-quality bonds, to second-rate bonds, and finally to common-stock issuance. In many instances, established firms attempt to refinance their debt, offering "new" bonds at a lower rate and retiring older ones - akin to refinancing any other kind of loan at a lower rate.

Within a short among of time, "new" issues will become "old" issues and will be priced according to their value - which, if the company succeeded at stirring up the market in their favor, will be less than the price at which they were initially issued.

With this in mind, the investor should regard any new issue of bonds with the same scrutiny and discretion as he would give to any bond already on the market, with the added level of uncertainty that the information at his disposal may be distorted for sales purposes.

New Stock Offerings

In Initial Public Offering of stock is made when a firm that has been privately owned decides to incorporate. This is generally coordinated to maximize the profit to the current owner who sell shares to the general public.

This is considered to be a favorable opportunity for an investor, as those who can "get in early" can often reap substantial rewards by other investors who, desiring to own a piece of a new firm, optimistically bid up the price of the shares.

This excitement and "heedlessness" leads to a sharp increase in price, then an inevitable collapse in which the new issue may lose 75% of more of its offering price - such that "many" issues will fall as far below their initial offering price as they had formerly rise above it.

But it also poses considerable peril, as private firms are not required to disclose their financial statements to the public, nor to report their performance, the information about a firm that is converting to a corporation is scant and highly unreliable.

It is an elementary requirement of the intelligent inventor to avoid trading on emotion - hopefulness as well as panic - and to resist the promises of salesmen who are seeking to increase the profit of the seller, not the buyer, of a new issue. The lure of easy money has led many who invest in IPOs to lose two dollars for every dollar they have made.

Some new issues can be excellent investments, but generally not until a few years later, when the calamity of excitement and disappointment has died down and they can be purchased at their true worth, and sometimes at a fraction thereof.