15. Stock Selection for the Enterprising Investor
The present chapter departs from the defensive strategy of choosing sound companies and avoiding risk, and considers the approach of the investor that is willing to assume an additional level of risk to achieve better than market performance.
The author pauses to express "grave reservations" about this approach. While it seems entirely reasonable to believe that an investor can beat the market by exercising skill and discretion in selecting issues that will yield better than average results and avoiding those likely to achieve worse, there is no historical evidence that this has ever been done reliably and consistently.
Mainly, this is because any estimation of the future value of a stock is a matter of prediction - which is inherently problematic, given that the present information about a firm may be inaccurate or unknown even to insiders of the firm, the factors that determine the future performance of a business are too numerous and diverse to yield a method of calculation, and the interplay among firms in the market, as well as factors pertaining to the market itself, are beyond the bounds of estimation and calculation.
As such, the present market price and future market price arise from the interplay of supply and demand among a large number of buyers and sellers, each of whom applies his own methods of fortune-telling to identify issues that will perform better in future - the degree to which these predictions differ creates dissonance that causes prices to fluctuate, and the degree to which they agree causes buyers to set a price that considers their collective opinions and their desired return.
It may also be somewhat ironic that the method of valuation the author has proposed for choosing stocks defensively are yet one more voice in the crowd - though the author remains confident that identifying weaknesses that should warn investors away from weak securities is more reliable than the attempt to identify qualities that should cue investors to strength - ultimately, the two practices rely upon the same methods of prediction.
The Graham-Newton Methods
The author considers the methods of the Graham-Newton Corporation, between 1926 and 1956. A footnote indicates this was the authors own firm, which he dissolved when he retired from active investment management. These methods are classified as:
- Arbitrages: Investment in securities that were expected to be exchanged under mergers, acquisitions, and reorganizations of firms
- Liquidations: Purchase of securities in firms that were bankrupt or near bankrupt on the expectation the cash settlement would exceed share prices by at least 20%
- Hedges: purchase of convertible bonds and preferred stock that could be redeemed for common shares if the market conditions were favorable, or retained to earn interest if they were not.
- Bargain Issues: Acquiring stocks whose market price was a third less than the per-share net asset value of the firm.
Essentially, all of these investments could be considered "self-liquidating": it was expected that would be redeemed for cash in excess of the price of acquisition in fairly short order.
The author does not go into details as to the calculations used for these methods, as they are beyond the expertise of the reader for whom the present book is written.
However, the strategy used here was still not based on the expectation that a firm would have improved performance in future, driving up the value of its stock, merely the analysis that the stock was worth more in terms of asset value than it was presently selling - that is, the notion that the firm was able to identify a "discount" that could soon be sold for fair value.
Another method for seeking to outperform the market is to seek out secondary companies that are presently making "a good showing," appear to have a satisfactory record, and appear to "hold no charm" for the majority of investors.
Past evidence does maintain that smaller firms have the potential to make dramatic progress, which is the aggressive investor's primary interest. However, the ranks of secondary companies contain a large number of weak firms whose past performance has been erratic, hence the second criterion. And finally, the current price of a stock that is already the apple of Wall Street's fickle eye is likely to be inflated by commonly held expectations of its future performance, which detracts from the earnings and amplifies the risk of any additional investor.
The investor is left to his own devices for discovering a method for identifying firms that have the potential for extraordinary growth. The author knows of no such method, however, he suggests such an investor refer to the Standard and Poor's Stock Guide, a publication to contains condensed statistical information on more than 4,500 companies - "a condensed panorama of the splendors and miseries of the stock market. It's almost certain that the information an investor might care to consider is contained within this volume.
However, the author does recommend using some defensive criteria to mitigate risk, even when dealing with smaller firms. He adapts his defensive criteria to the following:
Applying these criteria to all 4,500 companies in the present guide, the author identified about 150 companies that meet all six of these criteria for selection. From there, the aggressive investor is left to his own judgment - or his own partialities and prejudices, of making his selections from that list.
Diversification is of increased importance to mitigate the risk when purchasing secondary firms. It is recommended that the investor assemble a portfolio of at least 15 promising but fairly strong firms.
Single Criteria for Choosing Common Stocks
The author considers whether it is possible to determine a single criterion by which to choose common stocks. The author has given this some consideration and has arrived at two possibilities that would have had acceptable results based on past data:
- Dow issues with a low price-to-earnings ratio
- Any issue priced below the current per-share book value
The author goes into some detail of other criteria considered (low PE for any stock, high dividend return, long dividend record, size of the enterprise, debt-to-equity structure, low price compared to previous high, a high-quality ranking by S&P) and found none of these to be very reliable when applied in isolation.
The lesson to be taken for this, aside of avoiding small companies entirely, is that a stock tends to fetch a better price in future if its present price is a significant bargain when compared to the value of its assets.
Bargain Issues (Net Current Asset Stocks)
A bit more consideration is given to stocks that are considered to be "bargains" as a consequence of their present price being less than the net current assets per share (book value), as this seems to be a ridiculously simple and effective method for selecting investments: any firm that can be had for a price that is less than its liquidation value seems an obvious choice.
The author provides a brief analysis that seems to suggest that such stocks are the fallen angels of the market - well-established companies with household brands that once traded at a considerable premium but that, after a period of difficulty, were sold off with such abandon that their price plummeted to less than the value of the firm.
This further underscores the fickle nature of Wall street, that firms that can sell for greatly inflated values can fall to beneath their salvage costs, even though the firms would seem to be entirely viable in terms of the demand for their product and their financial ability to weather a few years of disappointing performance.
Naturally, the opposite tendency is true of new and entirely unproven firms that come into favor, and whose prices skyrocket well above the asset value of the firm, or any reasonable estimation of the future value they have the capability of producing. It simply defies logic, but "Wall street takes this madness in stride."
But returning specifically to the notion of bargain issues, it does seem reasonable to conclude that an investor can make money in them without taking on serious risk, given that even if the firm should fail, its salvage value will enable the investor to recover a fair portion of the funds he has invested.
However, a bargain-hunter must still find enough of them to make a diversified group, and maintain patience if they fail to advance soon after they are purchased. One example is given at a stock whose price was less than half its book value, but took about four years for its price to appreciate in the market.
Special Situations of "Workouts"
The notion of a "special" situation implies something exceptional or highly unusual for a stock, so there can be no definition that provides details of sufficient depth to identify what is meant, but a few examples are provided:
- Borden acquired Kayser-Roth by giving 1.5 shares of its own stock in exchange for each share of the acquired firm. In terms of price, this means that Borden would "pay" $39 for shares in KR that were selling for 28.
- Nabisco made a cash offer for Aurora Plastics of $11 in cash for a stock that was selling at between $8.50 and $9
- The firm of Universal-Marion was dissolved. Holders of the stock who had paid $21.50 before the announcement was made would be paid $28.50 per share from the liquidation.
Since these situations are unusual, the author will not go into them in much detail, except to suggest that discovering when such an event will soon occur is the result of much rumor and speculation, and instances are rare when anyone outside a firm has reliable information about an upcoming movement of this type. When such rumors are seen as credible, the market quickly adjusts to eliminate the margin entirely.
On the other hand, there are an increasing number of mergers that are expected, or even announced, that fail to be consummated. The profit is not realized, and the shares of the firm often plummet, as even to consider selling out to another firm is a testament that the holders and management have little confidence in the independent viability of their enterprise.
As such, investing in special situations is highly uncertain without inside knowledge - and even with such knowledge, it remains uncertain as well as being illegal.