7. Portfolio Policy: The Positive Side
By definition, the enterprising investor will seek a better return for himself than can be had by run-of-the-mill investments that return merely the market rate. Consequently, he should devote considerable attention to finding investments that provide a higher return without a disproportionate measure of additional risk.
However, the reckless behavior evident in the marketplace by the demand for securities that provide slightly higher returns at a greatly elevated risk demonstrates how few enterprising entrepreneurs exercise sound judgment in their selection of investment vehicles.
The author mentions four methods by which aggressive investors select stocks:
- Attempting to buy low and sell high (market timing)
- Seeking "growth" stocks
- Seeking bargain issues of various types
- Buying into "special situations"
General Market Policy: Formula Timing
Further consideration will be given in the next chapter to the possibilities and limitations of timing the market - buying in when prices are depressed and selling out when they are inflated.
This idea has been explained, in a method that makes it appear both simple and feasible, based on past performance - but given the market's action over the long range, it is clear that it does not lend itself to statistical methods of prediction.
The 50/50 plan (half bonds, half stocks) has proven to be "about the best" formula for all investors in all periods of the market history, though there is a broad leeway to adjust the mix up to 25% in either direction. The notion that there was some feasible method to confidently alter this blend based on market behavior once held some validity, but in the present market, the market fluctuations have become to erratic for this model to be accurate.
Growth Stock Approach
Naturally, every investor would like to select the stocks of companies that will do better than average over the period of years. A "growth" stock is defined as one that has done so in the past and is expected to do so in the future, and it seems only logical that the enterprising investor should concentrate his portfolio in such stocks.
In is a fairly simple chore to identify companies that have historically outperformed the averages in its past - brokers generally keep a list of such stocks, and it seems simple to select the 15 or 20 most attractive of this group to build a portfolio that is "guaranteed" to outperform the market.
However, there are two catches to this simple idea. First, stocks that performed well in the past sell at comparatively high prices because investors expect them to perform will in the future. As such, their present prices are inflated to the future expected performance, and it is likely the investor will overpay. Second, judgment about the potential future state of a firm generally proves unreliable - a firm that has performed well in the past will not necessarily continue to do so in future, and because its price is elevated due to expectations, it will fall dramatically if the firm fails to achieve the predicted levels of performance.
Volatility is another characteristic of growth stocks: they tend toward wide swings in market price. This is as true of the largest and most established firms as well as new businesses. It is common for speculators to be drawn to companies on the basis of their past success, inflating the price on a times-earnings basis, and to divest themselves of the stock when it fails to perform to their expectations. While he companies may fare well over time, there is great volatility in its short-term price.
Reviewing the performance of 45 mutual funds that specialize in growth stocks, their ten-year performance is worse than either the DOW or S&P indices. Given that investment professionals, with all the experience and resources at their disposal and the ability to devote themselves to constant vigilance, have failed to outperform the market, there is clearly no reason at all for assuming the average investor whose experience, skills, and focus is far lesser can succeed at the same endeavor.
Three Recommended Fields for Enterprising Investment
To achieve better than average results over a long term require the investor to cling to a sound policy of selection based on two merits: each security must meet rational tests of underling soundness, and the assessment must disagree with the policy followed by most investors or speculators. The author has identified three approaches that meet these criteria, which are suited to different temperaments:
Approach 1: Unpopular Large Companies
We assume that the market overvalues stocks of firms that have shown past growth or "are glamorous for some other reason," and conversely to undervalue companies because of unsatisfactory developments of a temporary nature.
Therefore, the key requirement for the investor is to focus on a company that is fundamentally sound but is going through a period of unpopularity, given that the behavior of speculative investors exaggerates the peaks and valleys of performance and "even a mere lack of enthusiasm may impel a price to decline to absurdly low levels."
The author also suggests sticking to larger companies, as small companies have a risk of loss due to their inability to sustain a period of "protracted neglect by the market." A larger firm is better satiated to weather the loss and its price will respond with better speed to improvement.
One analysis considered the ten stocks of the DOW that sold at the lowest times-earnings - the "cheapest" stocks in the list in terms of price-to-value - and then holding them for a period of five years. Over a period of 34 years, the ten cheapest stocks outperformed the most expensive, as well as the average performance of the lot, for 25 years (73.5%), did roughly the same in six years, and had worse in only three instances.
Approach 2: Bargain Issues (Value Stocks)
The author defines a bargain stock as one that seems, by rational analysis of its financials, to be worth considerably more than it's selling for - specifically, it must be worth 50% more than its current price. This includes bonds and preferred stocks selling well under par as well as to common stocks.
One such test of value is to take the present value of the expected future earnings of a given issue (EN: I suppose this to mean treating the earnings as an annuity and calculating the present value based on an investor's required or desired rate of return.)
A second test pays a greater level of attention to the realizable value of the assets of a firm, with particular emphasis on the net current assets and working capital. (EN: I find this too vague even to guess at what the author means.)
In rare instances, one may find a company whose total market capitalization is less than the company's net assets, even deducting all its liabilities - that is, the liquidation value of the firm would exceed its per-share price. During the period of 1957-1959, the author identified 85 shares on the American exchanges that fell to such a ridiculously low price.
Bargains can often be found among secondary companies - those that are not leaders in fairly sizable industries, and have not been identified as "growth" stocks. It is generally true tat investors show a pronounced preference for industry leaders and a corresponding lack of interest in companies that are of secondary importance, such that these secondary firms sell at much lower prices in relation to earnings and assets.
This is largely based on the notion of monopolization - that within any given industry, the largest firm will continue to grow and displace the profits of every other firm. Effectively, that any firm that was not number-one in its industry was on a path to extinction. However, this does not bear out, and there is nor reason to expect the typical mid-sized company will fail to continue in business indefinitely.
Considering a ten-year period, smaller firms have increased by 280% in value, whereas larger firms increased merely 40%. Ultimately, the competition to be "the leader" leads secondary firms to be more enterprising in their business operations, whereas the complacency of firms that are already in command of their industries makes their management lethargic. As such, smaller companies will, in time, displace the leader in an established industry, and are positioned to become the leaders in emerging industries.
Naturally, there is the common notion that a stock that is presently undervalued will continue to remain undervalued - there seems to be no reason the market would recognize the error of its estimation. The author gives a number of reasons such firms remain a good investment:
- The dividend yield will be relatively high
- Earnings reinvested are substantial in relation to price and will ultimately improve its value
- A bull market is ordinarily most generous to low-priced issues
- Even during relatively flat periods in the market, secondary issues rise have a tendency to rise toward the average
- The factors that lead to a disappointing record of earnings can be more easily corrected by management, and will have a more dramatic effect on their performance
- Smaller firms may be acquired by larger ones, and historically, the price paid has almost always been relatively generous
Approach 3: Special Situations of "Workouts"
Not so long ago, the market could almost guarantee an attractive return to those who know their way around it, and this was true under almost any market situation, by virtue of being able to predict with some accuracy major developments, such as mergers and acquisitions. The implication is that, in the turbulence of the current market, it is considerably more risky and less profitable to take this approach, but the author permits that the market may stabilize again and that this approach may again be practical "in years to come."
Acquisitions among firms are increasingly common: it often seems to be good business for a large enterprise to diversify or expand by simply purchasing a smaller firm rather than beginning a new venture from scratch. In order to acquire another firm, it must offer its shareholders a deal that is more attractive than maintaining their investment in the present, independent firm - that is, to pay a premium over the market value that makes selling their shares more attractive. As such, an investor who can predict an acquisition can obtain shares at the market price and receive an outstanding offer, above the market price of shares, from a prospective acquiring firm.
This works not only with stocks, but also with bonds, as evidenced by the great deal of money made by shrewd investors who acquired the bonds of railroads in bankruptcy, whose value was depressed due to the expectation that the salvage value of the bonds would be significantly less than the liquidation value of the firm's assets. Similar opportunities arose out of the breakup of public utilities pursuant to legislation to decentralize them.
The underlying factor is the tendency of investors to drastically undervalue issues that are involved in any sort of complicated legal proceeding - a common maxim that one should "never buy into a lawsuit" has great impact on speculators, and great potential to profit those who are less skittish and recognize that panic has driven prices to unduly low levels.
Ultimately, the exploitation of "special situations" requires a somewhat unusual mentality and skill, and is likely to be appealing only to a small percentage of enterprising investors, so the author feels the present book is not the appropriate place to fully explore on the practice.
Broader Implications of Rules for Investment
The author's approach to investment strategies defines approaches for the defensive/passive investor and the aggressive/enterprising investor - and there is no room in this philosophy for a blended approach or a middle ground. Better performance, and greater satisfaction, will reward the investor who selects a strategy and remains consistent to it than were he to make a half-hearted attempt at two conflicting ones that would put his investment portfolio at odds with itself.
The enterprising investor seeks to pursue any investment opportunity where his knowledge and judgment indicate a profit potential, when measured by rational standards, that can exceed the market performance.
The defensive investor meanwhile is guided by safety, simplicity of choice, and results that do not necessarily exceed the market, but merely keep his investment in pace with it, and categorically avoids risky ventures that seem promising.
The author then considers the consequences of every investor following the same strategy - a highly unlikely proposition. (EN: And highly speculative, and based on imaginary scenarios, so I don't see the point in giving it much attention.)