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The Enterprising Investor – The Intelligent Investor Book Review (Chapters 6, 7, & 15)
This is Part 3 of our book review of The Intelligent Investor, Revised Edition, Updated with New Commentary by Jason Zweig (affiliate link). Part 3 covers Chapters 6, 7, & 15 with the topic being The Enterprising Investor.
You may find the Introduction and relevant links at: The Intelligent Investor Book Review in 30 Minutes
Who is the Enterprising Investor?
Graham differentiated between the Defensive Investor and the Enterprising Investor. The main difference being the investors willingness to make the required effort to invest more aggressively.
The Enterprising Investor has the time and experience (or proper guidance) in investing to expand the possible universe of opportunities beyond conservative investments. It is an active approach that requires constant attention and monitoring. He or she are willing to put forth the extra effort required for dynamic portfolio management, research, and selection of individual investments.
Portfolio Policy for the Enterprising Investor: Negative Approach – Chapter 6
Graham first addresses the enterprising investor by giving him a list of “don’ts”. When the enterprising investor is willing to step beyond the scope of the defensive investor he should have an astute rationalization for the departure.
He advises investors to avoid lower rated bonds and preferred stock unless there is substantial upside potential in the price of the securities. Lower rated securities have a tendency to plummet in adverse markets.
The small additional annual income you receive form lower rated securities is not worth the risk unless there is the possibility of large capital gains. In other words, you should not be buying lower rated issues at a price close to Par (100). A bond selling at 66 has the potential of a 50% capital gain versus no capital gains for a bond bought at 100.
He also thought it was imprudent to buy new issues. He noted there are always exceptions to the rule. However, generally new issues are brought to market when it’s favorable for the company and with great hype and sales promotion; and therefore, probably not a bargain price for the investor.
Graham didn’t like foreign bonds because of their poor investment history. Zweig points out in the commentary that some of Graham’s criticisms have been mitigated with the advent of exchange traded funds (ETFs) and mutual funds that specialize in lower-rated securities and foreign bonds.
Portfolio Policy for the Enterprising Investor: Positive Approach – Chapter 7
The goal of the enterprising investor is to achieve a higher than average rate of return. Graham laid out four activities where the enterprising investor can go beyond the defensive investor. These are buying in low priced markets and selling in high priced markets (tactical asset allocation), buying growth stocks, buying bargain issues, and buying “special situations”.
Where the defensive investor would stick close to a 50% stock, 50% bond or cash plan, the enterprising investor has more leeway to take valuation into account. Portfolio reblancing can be adjusted based on the attractiveness of an asset’s valuation. Graham sets an equity allocation minimum of 25%, maximum of 75%, based on the attractiveness of valuations.
For the enterprising investor to buy a growth stock, he will usually have to find a larger company that is currently unpopular. The price of a growth stock usually reflects the expected growth, and that growth is, many times, over estimated by the markets. That means the enterprising investor must be extra careful when picking growth stocks.
Buying bargain issues means finding stocks that are selling for less that their intrinsic value. A stock may be undervalued due to disappointing earnings or general disfavor. The best bargain would be a well established company priced well below its average historical price and it’s past average price/earnings ratio.
The last activity for the enterprising investor would be searching for a “special situation. This would involve cases where a small company would be a good fit for a large company to acquire. Graham notes that only a small percentage of enterprise investors might engage in this activity.
Graham ends the chapter by emphasizing the importance of choosing to be a defensive or enterprising investor. There is no in-between. The enterprising investor must have the training and judgement (or guidance) to both measure and maintain a margin of safety standard. If you are not willing to make the effort you should be a defensive investor.
Stock Selection for the Enterprising Investor – Chapter 15
Graham contends that large portions of the stock market are out of favor because investors concentrate on investments with the best growth prospects. They ignore valuation and essentially pay whatever price the market is currently asking for the perceived future growth.
The result is many sound companies, with more modest or moderate prospects, are ignored and left out of favor. It is the intelligent investor who will attempt to take advantage of this phenomenon by identifying companies whose share prices do not fully reflect the real value of the company.
The enterprising investor can begin his search by looking for companies that meet the following criteria. Unlike the defensive investor, the enterprise investor has no minimum limit on the size of the company.
1. Strong Financial condition:
– current assets at least 1.5 times current liabilities
– total debt to net current assets ratio less that 1.1
2. Earnings Stability
– positive earnings for at least 5 years
3. Currently pays a dividend
4. Current earnings greater than years ago
5. Stock price less than 120% of net tangible assets
(Benjamin Clark at ModernGraham.com does an excellent job of analyzing several hundred stocks to examine whether they meet the criteria for the defensive or enterprising investor.)
In addition, Graham offered two simple alternative methods for choosing high probability stocks. One: purchase stocks with a low price/earnings ratio from a quality list (i.e. Dow Jones Industrial Average List), and two: purchase a diversified group of stocks selling under their working capital value (Net Net Stocks).
The common principle for the enterprising investor is finding bargains. You should avoid lower tier issues unless they are validated as bargains.
In the commentary, Jason Zweig provides excellent content on Return On Investment Capital (ROIC) and how it can be used to compare one company to another. He also points out that successful investors have two things in common: First, they are disciplined and consistent, and second, they put a great deal of thought into their process, but give little thought to what the market is doing.
Continue to Part 4:
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