The

 Intelligent  Investor  
Chapter  7:  Portfolio  Policy  for  the  Enterprising  Investor:  The  Positive  Side  
• The  enterprising  investor  will  devote  a  significant  amount  of  effort  toward  obtaining  above  
average  investment  results  
• Several  potential  bond  investments  for  the  enterprising  investor  were  discussed  in  the  
chapter  on  general  investment  policy  
• Tax-­‐free  New  Housing  Authority  bonds  guaranteed  by  the  U.S.  government  
• New  Community  bonds  that  are  high  yielding  and  taxable,  but  also  guaranteed  by  
the  U.S.  government    
• Tax-­‐free  industrial  bonds  issued  by  municipalities  and  serviced  by  lease  payments  
from  strong  corporations  
• Lower-­‐quality  bonds  that  can  be  purchased  at  low  prices  represent  bargain  opportunities  at  
the  other  end  of  the  risk  curve  
• The  following  methods  are  commonly  employed  by  the  enterprising  investor  in  relation  to  
common  stocks  
• Buying  in  low  markets  and  selling  in  high  markets  
• Buying  carefully  chosen  growth  stocks  
• Buying  bargain  issues  of  various  types  
• Buying  into  special  situations  
• Buying  in  low  markets  and  selling  in  high  markets  is  a  difficult  skill  that  will  be  discussed  in  
detail  in  future  chapters  
• Since  1949  establishing  correct  entry  and  exit  points  has  been  difficult  
• Selecting  growth  stocks  that  will  do  better  than  average  over  a  period  of  years  comes  with  
two  primary  challenges  
• Common  stocks  with  exceptional  past  records  and  bright  future  prospects  have  the  
tendency  to  trade  at  extremely  high  multiples  of  their  current  earnings  
• Unusually  rapid  growth  does  not  last  forever  and  the  bigger  the  enterprise  gets  the  
harder  it  will  be  to  replicate  past  growth  going  forward  
• The  enterprising  investor  should  avoid  paying  a  premium  for  growth  stocks  and  only  invest  
in  them  when  market  swings  put  them  on  sale  for  lower  multiples  of  their  current  earnings  
• It  is  true  that  in  a  small  number  of  cases  great  fortunes  have  been  made  from  investing  in  the  
early  stages  of  a  company  with  great  future  prospects  
• Usually  these  fortunes  are  obtained  by  insiders  that  have  some  close  relationship  to  
the  company  
• This  relationship  justifies  the  investor  deciding  to  place  a  large  portion  of  their  
funds  into  such  an  enterprise  
• An  investor  without  this  close  connection  will  continuously  question  whether  too  
much  of  their  portfolio  is  invested  in  this  company  and  will  therefore  be  tempted  to  
trade  in  and  out  of  the  company  based  on  market  swings  
• To  achieve  better  than  average  investment  results  over  the  long  term  the  investor  should  
adhere  to  the  following  rules  
• Select  securities  that  meet  objective  or  rational  tests  of  underlying  soundness  
• The  policy  must  be  different  from  one  that  is  commonly  employed  by  other  
investors  and  speculators  
• Graham  recommends  three  fields  for  the  enterprising  investor  
• Buying  into  relatively  unpopular  large  companies  
§ Because  the  market  overreacts  to  stocks  with  excellent  past  records  of  
growth  it  is  logical  to  assume  that  it  will  punish  companies  that  are  out  of  
favor  because  of  temporary  poor  results  
§ Small  companies  are  susceptible  to  this  type  of  unpopularity,  but  it  is  best  
for  the  enterprising  investor  to  focus  on  larger  companies  because  they  
have  the  capital  resources  to  make  it  through  adversity  and  because  the  
market  will  respond  to  any  signs  of  improvement  with  reasonable  speed  
 § Speculative  companies  that  have  wild  earnings  swings  which  sell  at  high  
multiples  during  poor  years  and  low  multiples  during  their  good  years  are  a  
notable  exception  
• These  stocks  tend  to  be  cyclical  and  the  market  doubts  their  ability  
to  sustain  high  profits  going  forward  as  indicated  by  the  low  
earnings  multiple  during  good  years  
• The  purchase  of  bargain  issues  
§ A  bargain  issue  is  defined  as  a  security  that  based  on  the  facts  established  
by  a  thorough  analysis  appears  to  be  worth  considerably  more  than  it  is  
selling  for  on  the  open  market  
§ This  can  include  common  stocks,  bonds  or  preferred  stocks  that  are  selling  
at  least  50%  less  than  their  indicated  value  
§ There  are  two  primary  methods  used  to  detect  bargain  valuations  in  
common  stocks  
• The  appraisal  method  which  relies  on  estimating  future  earnings  
and  the  appropriate  multiple  of  earnings  for  the  security  
• The  second  method  is  to  value  the  business  in  terms  of  what  a  
private  market  buyer  would  pay  for  the  whole  company  
§ Both  methods  rely  on  future  earnings  estimates,  but  the  private  market  
value  places  a  larger  emphasis  on  the  realizable  value  of  the  assets  
• Of  particular  importance  are  net  current  assets  or  working  capital  
§ Investors  who  have  conducted  levelheaded  appraisals  during  general  
market  declines  have  been  rewarded  handsomely    
§ The  two  major  sources  of  undervaluation  are  current  disappointing  results  
and  protracted  neglect  or  unpopularity  
§ Unfortunately  for  the  investor  there  are  many  instances  of  companies  that  
experience  a  decline  in  earnings  that  proves  to  be  permanent  
§ The  best  way  to  guard  against  this  risk  is  to  make  sure  that  the  security  has  
achieved  stable  earnings  over  the  past  decade  
§ The  ideal  investment  is  a  large  and  prominent  corporation  selling  well  
below  its  past  average  price  and  price-­‐to-­‐earnings  multiple  
§ A  third  potential  catalyst  for  undervaluation  is  the  market’s  failure  to  
recognize  a  company’s  true  earning  power  
• Many  times  a  situation  like  this  comes  about  because  accounting  
methods  temporarily  hide  an  asset’s  strength  or  ability  to  create  
future  earnings  
§ The  most  easily  identifiable  bargain  issues  are  those  that  sell  for  less  than  
their  net  working  capital  after  deducting  prior  obligations  
• This  indicates  that  the  buyer  is  paying  nothing  for  fixed  assets  or  
any  goodwill  items    
• The  number  of  issues  available  meeting  this  qualification  declines  
significantly  during  bull  markets  
• Because  the  type  of  business  that  meets  this  qualification  is  often  in  
a  distressed  industry  it  is  important  to  engage  in  these  investments  
on  a  diversified  basis      
§ A  secondary  company  is  one  that  is  not  a  leader  in  a  fairly  important  
industry  
• Because  of  their  lower  quality  it  is  common  to  find  bargains  among  
these  companies  
• Any  company  that  has  established  itself  as  a  growth  stock  is  usually  
not  considered  a  secondary  company  
• During  bull  markets  investors  tend  to  become  very  enthused  about  
secondary  companies  because  of  their  ability  to  expand  the  size  of  
their  business  
 • In  bear  markets  investors  begin  to  doubt  the  sustainability  of  
secondary  companies  going  forward  and  prefer  to  place  their  funds  
with  industry  leaders  
• As  a  result  secondary  companies  can  often  be  purchased  for  very  
low  multiples  of  their  earnings  during  times  of  market  distress  
• The  truth  is  that  secondary  companies  are  generally  quite  large  in  
comparison  to  privately  owned  businesses  and  should  be  able  to  
compete  as  a  going  concern  while  earning  a  fair  return  on  invested  
capital  
• The  pendulum  swings  from  overvaluation  to  bargain  opportunities  
with  secondary  companies  
• Investors  can  make  money  on  secondary  issues  when  the  dividend  
return  is  high  or  reinvested  earnings  are  substantial    
• Bull  markets  tend  to  treat  low  priced  issues  kindly  by  pushing  
secondary  companies  closer  to  fair  value  
• Even  in  flat  markets  prices  tend  to  adjust  and  those  with  low  
multiples  can  rise  toward  more  generous  valuations  
• Secondary  companies  with  poor  recent  earnings  records  that  can  
be  corrected  in  the  future  serve  as  another  opportunity  for  the  
enterprising  investor  to  make  money  
• If  a  larger  company  decides  to  purchase  a  smaller  secondary  
company  they  will  have  to  pay  a  premium  to  the  market  price  
which  will  be  beneficial  to  existing  shareholders  
• Special  Situations,  or  “Workouts”  
§ The  most  common  special  situation  takes  place  when  a  large  company  
agrees  to  buy  a  small  company  
§ In  order  for  the  transaction  to  take  place  the  purchaser  needs  the  
consenting  vote  of  the  existing  shareholders  in  the  target  company  
§ To  achieve  this  goal  the  purchasing  company  offers  a  price  to  existing  
shareholders  in  the  target  company  that  is  significantly  above  the  current  
market  price  
§ Shrewd  investors  can  make  money  from  buying  at  the  market  price  and  
waiting  for  the  deal  to  close  at  the  offer  price  
§ Another  form  of  special  situation  investing  is  buying  discounted  bonds  of  
companies  that  are  currently  in  bankruptcy  
§ These  bonds  can  potentially  be  worth  significantly  more  after  the  company  
has  gone  through  the  reorganization  process    
§ Holding  companies  that  are  breaking  up  or  spinning  off  separate  units  is  
another  opportunity  for  the  enterprising  investor  to  profit  from  special  
situations  
§ In  general  there  is  a  tendency  for  security  markets  to  undervalue  
companies  that  are  involved  in  complicated  legal  proceedings  
• Investment  policy  depends  primarily  on  the  whether  the  investor  is  aggressive  
(enterprising)  or  defensive  (passive)  
• The  enterprising  investor  must  have  the  ability  to  view  his  securities  as  business  enterprises  
• There  is  no  middle  ground  in  distinguishing  between  being  an  enterprising  or  defensive  
investor  
• Trying  to  be  half  enterprising  and  half  defensive  is  likely  to  produce  terrible  investment  
results  
• The  enterprising  investor  can  pursue  any  security  operation  for  which  his  training  and  
judgment  are  adequate  and  which  appears  to  offer  a  promising  chance  of  success  when  
measured  by  established  business  standards  
• The  defensive  investors  should  be  guided  largely  by  the  principles  of  underlying  safety,  
simplicity  of  choice  and  satisfactory  results  
• The  defensive  investor  should  avoid  foreign  bonds,  ordinary  preferred  stocks  and  secondary  
common  stocks  
• The  enterprising  investor  should  only  invest  in  these  types  of  securities  when  they  can  be  
acquired  at  less  than  two  thirds  of  their  appraised  value  
• The  enterprising  investor  should  recognize  that  there  are  benefits  and  drawbacks  in  smaller  
concerns  
• The  downside  is  the  inherent  lack  of  stability,  but  the  upside  is  the  prospect  of  
superior  growth  
• These  types  of  businesses  should  only  be  bought  at  less  than  their  private  market  
value  
• A  secondary  company  is  often  worth  more  to  a  controlling  shareholder  than  a  minority  
shareholder  which  places  a  great  importance  on  shareholder-­‐management  communication  
• Commentary  on  Chapter  7  
• “It  requires  a  great  deal  of  boldness  and  a  great  deal  of  caution  to  make  a  great  
fortune;  and  when  you  have  got  it,  it  requires  ten  times  as  much  wit  to  keep  it.”  –  
Nathan  Mayer  Rothschild  
• In  financial  markets  hindsight  is  20/20,  but  foresight  is  extremely  difficult    
• Because  foresight  is  so  tough  investors  should  stay  away  from  market  timing  
• When  the  stock  of  a  company  grows  faster  than  the  company’s  operating  results  
investors  usually  end  up  disappointed    
• A  great  company  will  make  a  bad  investment  if  you  pay  too  much  for  it  
• The  bigger  a  company  gets  the  more  difficult  it  will  be  for  it  to  grow  quickly  
• Growth  stocks  priced  at  25  to  30  times  current  earnings  have  a  low  probability  of  
producing  strong  investment  returns  
• Very  few  companies  can  reasonably  expect  to  grow  their  earnings  by  20%  over  a  
period  of  five  years  or  more    
• The  intelligent  investor  takes  interest  in  growth  companies  when  they  have  become  
unpopular  for  a  temporary  reason  
• Unpopular  large  companies  are  a  prime  target  for  the  intelligent  investor  
• Graham,  like  Andrew  Carnegie  before  him,  acknowledges  that  great  fortunes  have  
been  built  by  investors  who  put  all  of  their  eggs  in  one  basket  that  they  knew  very  
well  
• The  intelligent  investor  should  be  cognizant  of  the  fact  that  many  of  these  investors  
had  large  control  positions  in  these  companies    
• Furthermore,  many  fortunes  have  been  lost  by  remaining  concentrated  in  one  
company’s  stock  
• Companies  being  sold  for  less  than  their  net  working  capital  are  a  great  profit  
opportunity,  but  they  must  be  bought  in  a  diversified  manner  
• The  company  has  become  this  cheap  only  because  of  some  sort  of  major  problem  
that  could  threaten  the  business  as  a  going  concern  
• By  purchasing  these  companies  in  a  diversified  portfolio  the  intelligent  investor  can  
mitigate  bankruptcy  risk  
• Foreign  stocks  purchased  at  reasonable  valuations  serve  as  another  useful  
diversification  tool  for  the  intelligent  investor