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The

 Intelligent  Investor  
Chapter  6:  Portfolio  Policy  for  the  Enterprising  Investor:  Negative  Approach  
• The  enterprising  investor,  like  the  defensive  investor,  should  begin  with  a  division  between  
high-­‐grade  common  stocks  and  bonds  purchased  at  reasonable  price  levels  
• Unlike  the  defensive  investor,  the  enterprising  investor  is  willing  to  branch  out  into  other  
types  of  securities  when  there  is  a  justified  rationale  
• The  field  of  available  choices  is  wide  and  depends  on  the  investor’s  competence,  resources  
and  preferences  
• Graham  suggests  that  the  enterprising  investor  stay  away  from  inferior  types  of  bonds  and  
preferred  stocks  unless  they  can  be  purchased  at  bargain  levels  
• 30%  of  par  and  even  less  for  issues  with  lower  coupon  rates  are  recommended  
• Foreign  bonds  will  be  avoided  completely  
• The  enterprising  investor  is  also  extremely  wary  of  new  issues    
• This  includes  convertible  bonds,  preferred  stocks,  and  common  stocks  that  have  
only  produced  earnings  in  the  recent  past  
• Second-­‐grade  bond  issues  need  to  be  compared  to  the  coupon  rate  of  existing  high-­‐grade  
bonds  and  older  second-­‐grade  bond  issues  
• In  1971  high-­‐grade  bonds  were  trading  at  7.25%  so  Graham  recommended  against  
buying  second-­‐grade  bonds  just  for  the  extra  yield  
• Older  issues  of  second-­‐grade  bonds  were  trading  at  a  large  underlying  discount  to  
par  creating  the  opportunity  for  price  appreciation    
• During  this  time  period  corporations  with  bad  credit  could  not  even  issue  regular  
bonds  and  were  forced  to  issue  convertible  bonds  that  had  warrants  attached  to  
them  
• The  main  difference  between  first-­‐grade  and  second-­‐grade  bonds  is  the  number  of  times  
their  interest  payment  is  covered  by  earnings  
• Graham  recommended  a  multiple  of  five  as  a  good  starting  point  
• Experience  has  proved  it  unwise  to  purchase  second-­‐grade  bonds  or  preferred  stocks  just  
because  of  the  extra  yield  
• These  securities  tend  to  trade  well  below  par  during  poor  market  conditions  and  as  
a  result  the  enterprising  investor  should  wait  until  they  are  trading  at  a  substantial  
discount  to  par  
• In  some  cases  this  decline  takes  place  regardless  of  the  fact  that  operating  results  
remain  satisfactory  
• There  is  a  high  probability  that  these  securities  will  trade  closer  to  par  when  the  
market  recovers  
• It    makes  very  little  sense  to  buy  securities  at  par  that  will  eventually  trade  at  a  price  
significantly  lower  
• Because  of  their  poor  investment  history  and  lack  of  legal  claim  Graham  counsels  the  
enterprising  investor  to  avoid  foreign  government  bonds  altogether    
• Loss  of  principle  must  be  mitigated  first  and  never  exchanged  for  a  few  extra  basis  points  in  
yield    
• Investors  should  be  skeptical  of  new  issues  and  they  should  be  subjected  to  careful  
examination  and  severe  testing  before  they  are  purchased  
• There  are  two  reasons  to  be  skeptical  of  new  issues  
• They  have  a  special  salesmanship  behind  them  from  investment  bankers  
• They  are  generally  sold  under  favorable  market  conditions  for  the  seller  and  not  for  
the  buyer  
• Many  of  the  new  issues  being  sold  are  safe  in  relation  to  their  recent  earnings  and  could  
prove  profitable  if  those  earnings  continue  into  the  future  
• Unfortunately,  recent  earnings  are  not  predictive  of  how  a  company  will  perform  under  
future  economic  conditions  
• There  are  two  types  of  new  issuances  for  common  stocks  
The  first  type  are  for  companies  that  are  already  listed  publicly    

§ These  shares  are  offered  first  on  a  pro  rata  basis  to  existing  investors  
§ The  offering  price  is  usually  set  below  the  current  market  price  
§ These  new  shares  are  underwritten  by  an  investment  bank,  but  because  
there  are  already  existing  investors  in  the  company  it  usually  requires  
minimal  sales  effort    
• The  second  type  is  the  placement  of  stock  for  a  company  that  was  formerly  privately  
owned  
§ This  effort  is  usually  undertaken  in  order  to  allow  controlling  private  
investors  to  cash  out  of  the  company  during  favorable  market  conditions  
§ These  issuances  often  lead  to  disappointing  investment  results  because  of  
the  character  of  the  business  and  the  market  conditions  under  which  they  
were  sold  
• A  predictable  pattern  takes  place  during  bull  markets  
§ During  the  middle  of  a  bull  market  new  issuances  of  common  stock  begin  to  
take  place  at  valuation  levels  that  are  not  unreasonable  
§ As  the  market  continues  to  rise  more  private  companies  try  to  go  public  
§ Typically  the  prices  become  more  exorbitant  and  the  quality  of  the  
businesses  become  poorer  
§ At  the  end  of  the  bull  market  new  issuances  will  begin  to  trade  at  the  same  
level  or  higher  than  existing  proven  businesses    
• The  intelligent  investor  has  the  ability  to  resist  the  sales  efforts  behind  new  
issuances  of  common  stocks  
• While  profits  are  sometimes  achieved  by  the  investors  of  new  issuances  early  in  the  
bull  market  cycle,  over  time  this  type  of  investing  is  too  speculative  to  be  
consistently  profitable  
• Commentary  on  Chapter  6  
• “The  punches  you  miss  are  the  ones  that  wear  you  out.”  –  Boxing  trainer  Angelo  
Dundee  
• What  Graham  referred  to  as  second-­‐grade  bond  issues  are  known  today  as  high  
yield,  or  junk  bonds  
• Because  of  mutual  funds  they  are  now  much  more  easily  accessible  to  ordinary  
investors  
• Since  1978  the  annual  average  default  rate  on  these  types  of  bonds  is  4.4%  
• Even  after  defaults  they  have  achieved  a  slightly  better  annual  return  than  U.S.  
Treasury  bonds  
• As  a  result  junk  bond  funds  are  a  minor  option  for  the  intelligent  investor  especially  
during  periods  of  market  distress  
• When  analyzing  individual  high  yield  bonds  the  investor  must  make  sure  that  pretax  
earnings  are  sufficient  to  meet  the  proposed  interest  expense  
• Graham  considered  foreign  bonds  to  be  even  less  dependable  than  junk  bonds  
• Because  of  their  lack  of  correlation  with  U.S.  stocks  and  bonds  emerging  market  
bond  funds  may  be  suitable  for  a  small  percentage  of  the  enterprising  investor’s  
portfolio    
§ It  is  recommended  that  this  portion  of  the  portfolio  remain  below  10%  
• Day  trading  is  a  fools  errand  because  of  the  high  transaction  costs  and  short  term  
capital  gains  taxes  
• Building  wealth  through  IPOs,  or  initial  public  offerings,  was  one  of  the  largest  
investment  fallacies  of  the  1990’s  internet  bubble  
• While  early  investors  in  Microsoft  and  Amazon  made  profitable  gains  the  majority  of  
IPOs  were  losers  
• One  of  the  biggest  problems  was  that  ordinary  investors  only  have  access  to  shares  
after  they  have  rocketed  above  their  initial  offering  price  
• Many  investors  were  buying  based  on  the  hope  of  increasing  prices,  while  ignoring  
the  underlying  business  fundamentals