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Author: ZenvestorB Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 441  
Subject: Chapter 7 Date: 1/6/2001 5:29 AM
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Hi Everybody,

Here's my take on a summary of Chapter 7, Portfolio Policy for the Enterprising Investor: The Positive Side.

The enterprising investor, by definition, will devote a fair amount of attention and efforts toward obtaining a better than run-of-the-mill investment result.

In the bond area, the enterprising investor might be interested in special opportunities like:

(1) Tax-free New Housing Authority bonds effectively guaranteed by the US government.

(2) Taxable high yielding New Community bonds, also guaranteed by the US government.

(3) Tax-free industrial bonds issued by Municipalities, but serviced by lease payments made by strong corporations.

(4) There may be lower-quality bonds obtainable at such low prices to constitute true bargain opportunities. (These would belong in the "special situation" area where no true distinction exists between bonds and common stocks.)

In the common stock field, enterprising investors typically are interested in these types of activities:

1. Buying in low markets and selling in high markets.
2. Buying carefully chosen "growth stocks".
3. Buying bargain issues of various types.
4. Buying into special situations.

Related to Buying in low markets and selling in high markets, for many tears this idea appeared both simple and feasible, at least from first inspection of a market chart covering its periodic fluctuations. But the markets action in the past 20 years has not lent itself to operations of this sort on any mathematical basis. The fluctuations that have taken place, while not inconsiderable in extent, would have required a special talent or "feel" for trading to take advantage of them. This talent is quite different from the intelligence that II is assuming for the reader.

Related to the Growth Stock approach, though it seems logical for the intelligent investor to concentrate on the stocks of companies that are expected to do better than average over a period of years into the future, there are two catches to this idea. The first is that common stocks with good records and good prospects sell at correspondingly high prices. The investor may be right in his judgement of the companies prospects and still not fare well merely because he has paid in full (or perhaps Overpaid) for the expected prosperity. The second is that his judgement as to the future may prove wrong. Unusually rapid growth cannot keep up forever; when a company has already registered a brilliant expansion, its very increase in size makes a repetition of its achievement more difficult. Consequently, II advises against the usual type of growth stock commitment for the enterprising investor. This is typically a situation where the excellent prospects are fully recognized in the market and already reflected in a current price earnings ratio of, say, 20x.

Related to Bargain Issues and Special Situations, II proposes to obtain a better than average investment result over a long pull by requiring a policy of selection possessing a two-fold merit:

1. It must meet objective or rational tests of underlying soundness.
2. It must be different from the policy followed by most investors or speculators.

II recommends 3 investment approaches that meet these criteria but each differ widely from one another and each may require a different type of knowledge and temperament.

The three approaches are:

1. The relatively unpopular large company.
2. Purchase of bargain issues.
3. Special Situations.

Related to the relatively unpopular large company, if we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it's logical to expect that it will undervalue companies that are out of favor because of unsatisfactory developments of a temporary nature. The key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity. The large companies have a double advantage. First, they have the resources in capital and brainpower to carry them through adversity and back to a satisfactory earnings base. Second, the market is likely to respond with reasonable speed to any improvement shown.

Related to the purchase of bargain issues, a bargain issue is one which, on the basis of facts established by analysis, appears to be worth considerably more than its selling for. To be concrete, II suggests that an issue is not a true bargain unless the indicated value is at least 50% more than the price.

There are two tests by which a bargain common stock is detected. The first is by the method of appraisal. This relies on estimating future earnings and then multiplying these by a factor appropriate to the particular issue. The second test is the value of the business to a private owner. This value is often determined chiefly by expected future earnings, like the first test, but in the second test more attention is likely to be paid to the realizable value of the assets with particular emphasis on the net current assets or working capital.

The same vagaries of the marketplace that recurrently establish a bargain condition in general also account for the existence of many individual bargains at almost all market levels. A mere lack of interest or enthusiasm may impel a price decline to absurdly low levels. Thus we have what appear to be two major sources of undervaluation:

1. Currently disappointing results.
2. Protracted neglect or unpopularity.

However, neither of these causes, if considered by itself alone, can be relied on as a guide to successful common stock investment. The many experiences of this type suggests that the investor would need more than a mere falling off in both earnings and price to give him a sound basis for purchase. He should require an indication of at least reasonable stability of earnings over the past decade or more, plus sufficient size and financial strength to meet possible setbacks in the future. The ideal combination here is that of a large prominent company selling both below its past average price and its past average price/earnings multiplier. (With a possible 20x earnings p/e ceiling.)

One type of bargain issue that can be most readily identified is a common stock that sells for less than the company's net working capital alone, after deducting all prior obligations. This would mean that the buyer would pay nothing at all for the fixed assets or any goodwill items that might exist. Very few companies turn out to have an ultimate value less than the working capital alone, although scattered instances may be found.

There are special factors to consider when dealing with bargain issues in secondary companies. A secondary company is one that is not a leader in a fairly important industry. Thus it is usually one of the smaller concerns in its field. By way of exception, any company that has established itself as a growth stock is not ordinarily considered secondary.

Investors have typically developed a pronounced preference for industry leaders and a correspondingly lack of interest most of the time in the ordinary company of secondary importance. This has meant that the latter group has usually sold at much lower prices in relation to earnings and assets than have the former. This stock market attitude toward secondary companies tend to be unrealistic and consequently to create in normal times innumerable instances of major undervaluations. But the pendulum can swing clear to the opposite extreme. In extreme times of bullishness in the secondary sector, the very class of secondary issues that had formerly supplied by far the largest proportion of bargain opportunities, was now presenting the greatest number of examples of overenthusiasm and overvaluation. Then as to be expected the ensuing market declines fell most heavily on these overvaluations. In some cases the pendulum may have gone as far as definite undervaluation.

Related to special situations, the typical special situation grows out of the increasing number of acquisitions and possible arbitrage or workout situations. There are similar opportunities in break-ups and spin-offs. The underlying factor here is the tendency of the security markets to undervalue issues that are involved in any sort of complicated or legal proceedings.

At the end of the chapter, there is a very helpful kind of summary of II's investing premise. It's the section called "Broader Implications of Our Rules for Investment" on pages 90 - 93.


ZB
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